Client Alerts

Triple Flip Flop: Safe Harbor Sinks Lehman Appeal

Client Alerts | August 12, 2020 | Creditors’ Rights and Bankruptcy Litigation

The Second Circuit has affirmed, on appeal, the dismissal of an attempt by the Lehman Brothers estate to unwind payments made in connection with a series of collateralized debt obligation (“CDO”) structures. The decision, Lehman Brothers Special Financing Inc. v. Branch Banking and Trust Company (In re Lehman Brothers Holdings, Inc.), marks the third time that a court has rejected Lehman’s position that the documentation used in those CDO structures used an impermissible “flip clause” and that Lehman should be able to claw back payments received by noteholders.

The decision demonstrates the continued vitality of the Bankruptcy Code’s securities safe harbors notwithstanding the Supreme Court’s 2016 Merit Management decision (discussed in our recent alert). The decision also provides reassurance to investors that the CDO structures used by Lehman should not be vulnerable to bankruptcy attack in other cases.


The litigation concerned 44 synthetic CDO transactions set up and marketed by Lehman to investors who were interested in taking synthetic long positions on credit default swaps opposite Lehman’s LBSF subsidiary. The investors bought notes issued by trusts established by Lehman, and the indenture trustees invested the note proceeds in securities to be held as collateral. The transaction documents provided that the collateral would be held and used to make payments under the swap agreements unless there was a termination event. The Lehman parent (LBHI) provided credit enhancement.

The transaction documents contained priority provisions that specified different waterfalls following a default depending upon who was the defaulting party. If there was a default by the noteholders or the trusts, the collateral would be liquidated and paid to Lehman ahead of the noteholders. If there was a default by LBHI or LBSF, the collateral would be liquidated and paid to the noteholders ahead of Lehman.

When LBHI (but not LBSF) filed for bankruptcy, the indenture trustees terminated the swap agreements, liquidated the collateral and after paying expenses paid the balance of the proceeds to the noteholders. There was nothing left for Lehman.

After LBSF also filed for bankruptcy, Lehman brought several suits against noteholders of those CDOs, generally alleging that the payment waterfalls were based on what Lehman termed “flip clauses” that Lehman claimed were unenforceable ipso facto clauses. In general, an ipso facto clause is a provision of a contract that creates a default or forfeiture or a modification of the debtor’s rights automatically upon the filing of a bankruptcy petition. Such clauses are generally invalidated under the Bankruptcy Code.

Most of the noteholder defendants filed a motion to dismiss the complaint partially based on the safe harbor of section 560 (related to, but not identical to, the section 546(e) safe harbor discussed in our prior alert), which protects the “exercise of any contractual right of any swap participant … to cause the liquidation, termination, or acceleration of one or more swap agreements” from being stayed or avoided due to the Bankruptcy Code provisions regarding ipso facto clauses. The defendants argued that the clauses in question were not ipso facto clauses and that the safe harbor applied regardless.

Bankruptcy Court Decision

The Bankruptcy Court granted the motion and dismissed Lehman’s complaint against the moving noteholders in a decision dated June 28, 2016, resting upon three independent bases:

  1. The Bankruptcy Court found that, for most of the relevant CDO structures, the contractual provisions regarding priority of payment were not “flip clauses,” as argued by Lehman, because no “flip” occurred.
  2. The Bankruptcy Court found that even had a “flip” occurred, it would not have violated the ipso facto prohibitions because those prohibitions do not apply to pre-petition events, and the termination of the swaps agreements occurred before LBSF filed for bankruptcy.
  3. The Bankruptcy Court found that the transactions were protected by the safe harbor of section 560.

District Court Decision

Lehman appealed the decision to the District Court, which affirmed the Bankruptcy Court’s decision, as discussed in our prior alert . The District Court opinion was based solely upon the safe harbor, and neither adopted nor rejected the other two legs of the Bankruptcy Court decision.

Court of Appeals Decision

The Court of Appeals, like the District Court, based its decision solely upon the safe harbor of Bankruptcy Code section 560. It rejected Lehman’s general argument that the safe harbor should be read narrowly, and specifically rejected Lehman’s arguments that:

  1. as the contractual provisions regarding priority of payment were located in the trust indentures, rather than in the ISDA Master Agreement that governed the swaps, the priority provisions were not pursuant to a “swaps agreement,”
  2. the payment of collateral proceeds to the noteholders was not a “liquidation, termination or acceleration” of a swap, and
  3. the trustees were not protected by the safe harbor because they were not “swap participant[s]”.

The opinion holds that because the priority provisions of the indentures were referenced in the swaps agreements, and incorporated by reference, those provisions fit within the broad definition of “swaps agreements.”

The opinion further holds that the distribution of the proceeds of collateral by the trustees to noteholders constitutes the “liquidation of the swaps agreements,” rejecting Lehman’s argument that “liquidation” refers narrowly to only the fixing of the amount of the claim. This portion of the decision was based on an analysis of the “specific context in which that language was used,” and turns on the court’s conclusion that the purpose of the safe harbor – “to shield swap participants from the risks associated with a counterparty’s bankruptcy” – would be frustrated if the safe harbor was not interpreted to include the unwinding of the transactions and the distribution of proceeds.

In reaching this conclusion, the court specifically rejected Lehman’s argument that the Supreme Court’s Merit Management decision, discussed in our prior alerts, dictated a different result. It reasoned that the safe harbor could protect defendants, consistent with Merit Management, because the challenged action was part of the liquidation process. The court also criticized Lehman Bros. Holdings Inc. v. BNY Corp. Tr. Servs. Ltd and Lehman Bros. Special Fin. Inc. v. Ballyrock ABS CDO 2007-1 Ltd., decisions rendered in other Lehman adversary proceedings in 2010 and 2011 in which Judge Peck had interpreted section 560 more restrictively.

The third issue addressed in the opinion arose from the structure of the transactions. Lehman argued that the trustees that terminated the swaps and distributed collateral proceeds were not themselves “swaps participants” and thus the challenged actions were not “the exercise of [a] contractual right of a swap participant” protected by section 560. However, the court ruled that the trustees were exercising rights “of” swap participants (the issuers of the notes) such that the safe harbor applies.

Looking Forward

The Court of Appeals decision confirms the lessons of the District Court decision. Courts will likely read Merit Management narrowly, and not as a more general call to roll back safe harbor protections.

The decision should also provide general comfort to investors in other CDO structures. The solicitation materials that Lehman prepared for the CDO structures advised investors that the priority provisions at issue would be enforceable in a future bankruptcy. A decision in favor of Lehman would have had the effect of allowing a party in Lehman’s position to use a bankruptcy to effect an early termination of swaps contracts at a propitious time – a feature that is not permitted under the express terms of the contracts.

The broad scope of the decision is augmented by the court’s reliance solely upon safe harbor grounds. The first two legs of the Bankruptcy Court’s decision were tied to the specific contractual terms of the Lehman CDOs and the specific elements of the Lehman procedural history. By affirming based solely on the safe harbor, the Court of Appeals makes it more likely that the decision will be applicable in a wide range of possible cases.

Kleinberg Kaplan represents certain defendants in the Lehman adversary proceeding.