In the recent decision of Lehman Bros. Special Fin. Inc. v. Bank of Am. Nat’l Assoc. (In re Lehman Bros. Holdings Inc.), 2016 WL 3621180 (Bankr. S.D.N.Y. June 28, 2016),  the U.S. Bankruptcy Court for the Southern District of New York held that certain priority payment provisions in swap agreements do not constitute impermissible ipso facto provisions and that the distribution of liquidated swap agreement collateral is protected by the safe harbor in Bankruptcy Code Section 560.

The case involved synthetic collateralized debt obligation transactions (“CDOs”) structured by Lehman Brothers Special Financing (“LBSF”) in the years before the Lehman empire’s collapse.  On September 15, 2008, LBSF’s parent, Lehman Brothers Holdings, Inc. (“LBHI”) filed for bankruptcy.  LBHI’s bankruptcy filing caused LBSF to become a defaulting party under the CDOs, and gave the noteholders a priority claim on the collateral under the waterfall provisions.  LBSF did not file for bankruptcy until three weeks later.  During that three-week period, many Issuers terminated their swaps with LBSF based on the default caused by LBHI’s bankruptcy filing.  In most cases, the collateral was liquidated and distributed to noteholders prior to the occurrence of LBSF’s own bankruptcy filing (a “pre-pre transaction”).  In some cases, although termination occurred prior to LBSF’s bankruptcy, liquidation and distribution occurred afterwards (a “pre-post transaction”).

LBSF commenced an adversary proceeding against 250 defendant noteholders, Issuers, and indenture trustees, seeking to invalidate the priority of payment provisions as impermissible ipso facto clauses and to claw back approximately $1 billion in proceeds of the liquidated collateral distributed to the noteholders in both pre-pre and pre-post transactions.  The bankruptcy court granted the defendants’ motion to dismiss.

First, the court ruled that the CDO provisions that determined waterfall priority only when termination occurred were not impermissible ipso facto provisions under Bankruptcy Code sections 363(e)(1), 363(l) & 541.  On the other hand, the CDO provisions that gave LBSF priority in the waterfall from the outset, but deprived LBSF of this priority when there was an early termination based upon an LBSF event of default (such as its bankruptcy), were possibly impermissible ipso facto provisions.

Nevertheless, because the early terminations in this case all occurred before LBSF filed for bankruptcy (with only the collateral being liquidated postpetition in the pre-post transactions), the court ruled that none of the priority provisions violated the anti-ipso facto provisions of the Bankruptcy Code.  In this case, the court declined to adopt the “singular event” theory, and held instead that “any modification of LBSF’s rights that occurred prior to the LBSF Petition Date cannot be the basis of a violation of the anti-ipso facto provisions.”

Second, the court held that the distributions made pursuant to the priority provisions in the CDOs were protected by Bankruptcy Code section 560’s safe harbor.  The court observed that the common meaning of “liquidate” “include[s] the payment of the proceeds of the liquidation.”  Moreover, “[l]iquidation of a swap . . . must refer to something other than its termination.”  Accordingly, the court concluded that “section 560 protects the enforcement of the Priority Provisions and the distribution of the proceeds of the sale of the Collateral as part of the exercise of the right to liquidate the Swaps.”

Carl D. Neff is a partner with the law firm of Fox Rothschild LLP.  You can reach Carl at (302) 622-4272 or at