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Crediting Freshfields’ Arguments, The Second Circuit Holds that Priority Provisions in Lehman Brothers’ CDOs are Enforceable And Protected By Safe Harbor for Swap Participants

In re Lehman Bros. Holdings, Inc., 2020 U.S. App. LEXIS 25398 (2d Cir. Aug. 11, 2020)

On August 11, 2020, the United States Court of Appeals for the Second Circuit (the “Second Circuit”) affirmed that provisions (the “Priority Provisions”) setting priority of payments in CDOs marketed by Lehman Brothers Special Finance, Inc. (“LBSF”) were enforceable, and dismissed LBSF’s attempt to claw back approximately $1 billion of distributions to the CDO noteholders (the “Noteholders”) that were made after Lehman Brothers Holdings Inc. (“LBHI”) commenced a bankruptcy case in 2008.  Crediting the arguments of the Structured Finance Industry Group—represented by Freshfields as amicus curiae—the Second Circuit held that, even if the Priority Provisions functioned as ipso facto clauses that modified the rights of LBSF upon the filing of a bankruptcy case, the safe harbor established in Section 560 of the United States Bankruptcy Code (“Section 560”) exempted the Priority Provisions from the Code’s general prohibition on ipso facto clauses.

The Second Circuit’s decision provides comfort to swap participants that the Priority Provisions—which are standard market provisions designed to protect parties to swap agreements from the insolvency of their counterparties or their counterparties’ guarantors—will be protected from invalidation by the Bankruptcy Code’s general prohibition on ipso facto clauses.


In 2010, LBSF brought adversary proceedings against hundreds of Noteholders with positions in 44 synthetic CDOs issued by LBSF and related entities.  LBSF sought the return of approximately $1 billion that was distributed to these Noteholders upon the filing of LBHI’s bankruptcy petition.[1]

In each of the CDO transactions, LBSF established a special purpose vehicle (the “Issuer”) to market and issue notes to the Noteholders pursuant to an indenture agreement (the “Indenture”).  The Issuer used the proceeds from the Notes to acquire securities to serve as collateral (the “Collateral”), and the income from the Collateral was used by the Issuer to make scheduled payments to Noteholders.  The Issuer then entered a swap agreement with LBSF governed by an ISDA Master Agreement and related documentation (together, the “Swap Agreement”).  Pursuant to the Swap Agreement, the Issuer provided LBSF credit protection for certain reference securities in exchange for regular payments to the Issuer, with such payments guaranteed by LBHI.  The Issuers used these payments to supplement coupon payments made to Noteholders.  Third party indenture trustees (the “Trustees”) held the Collateral in trust for the benefit of LBSF and the Noteholders.[2]

The Indentures contained Priority Provisions which governed the order in which distributions of proceeds from the Collateral would be made to LBSF or, alternately, the Noteholders under different circumstances.  The Priority Provisions specified that, if terminations payments were owed due to LBSF’s default, LBSF’s right to receive proceeds from the sale of the Collateral would be subordinated to that of the Noteholders.[3]

LBHI’s commencement of a bankruptcy case in 2008 was an event of default for LBSF which allowed for early termination of the Swap Agreements.  In response, most Issuers terminated the Swap Agreements, which caused the Trustees to sell the Collateral and pay the proceeds to the Noteholders.  Because the proceeds were insufficient to satisfy the Noteholders’ claims in full, LBSF did not receive any payment, notwithstanding that LBSF was “in the money”—i.e., its swap positions had value—when LBHI commenced its bankruptcy case.[4]

In 2010, approximately two years after LBSF commenced its own Chapter 11 case, LBSF sued the Noteholders, seeking a declaration that, because the Priority Provisions altered LBSF’s contractual rights to receive payment upon the filing of LBHI’s bankruptcy petition, they functioned as ipso facto provisions that are unenforceable pursuant to Sections 365, 541 and 363 of the Bankruptcy Code.  LBSF argued that, because the Priority Provisions were unenforceable, it should be able to claw back for the benefit of its creditors the approximately $1 billion of Collateral proceeds that were distributed to the Noteholders.[5]

In June of 2016, the United States Bankruptcy Court for the Southern District of New York dismissed LBSF’s complaint in its entirety, holding, among other things, that Section 560 of the Bankruptcy Code exempted the Priority Provisions from the Code’s general prohibitions on enforcement of ipso facto clauses against a debtor that has commenced a bankruptcy case.  After the United States District Court for the Southern District of New York affirmed the Bankruptcy Court’s decision, LBSF appealed to the Second Circuit.[6]

The Second Circuit’s Decision

The Second Circuit affirmed the District Court’s decision to dismiss LBSF’s complaint in its entirety.

Section 560 of the Bankruptcy Code protects, among other things, the right of a “swap participant” to “cause the liquidation, termination, or acceleration” of a “swap agreement” upon a counterparty’s insolvency or commencement of a bankruptcy case.[7]  In other words, Section 560’s safe harbor permits swap participants to modify or terminate an executory swap contract solely because of the commencement of a bankruptcy case, notwithstanding the Bankruptcy Code’s general prohibition on doing so.

On appeal to the Second Circuit, LBSF argued that Section 560 does not apply to the Priority Provisions because they were contained in the Indentures, and therefore were not “swap agreements” protected by Section 560’s safe harbor.  LBSF also argued that, because the right to distribute the Collateral pursuant to the Priority Provisions was found only in the Indentures, and not the Swap Agreements themselves, the Trustees were not exercising the rights of a swap participant, as required by Section 560, when they distributed the Collateral proceeds.  Finally, LBSF argued that, even if the Trustees were exercising the rights of swap participants to terminate and liquidate a swap agreement, the term “liquidate” in Section 560 does not include distribution of Collateral but includes only the act of calculating the portion of the Collateral to which the Noteholders and LBSF were entitled upon termination.

The Second Circuit rejected LBSF’s arguments on all counts.  Because the Priority Provisions were incorporated by reference into the Swap Agreements, they formed part of a “swap agreement” for purposes of Section 560.[8]  The Second Circuit also found that, when distributing the collateral upon LBSF’s default, the Trustees were exercising the rights of the Issuers—who were indisputably parties the swap agreements.  Thus, the Trustees were exercising the rights “of” a swap participant, as required for Section 560’s safe harbor to apply.[9]  Finally, because the purpose of Section 560 is to protect swap participants from bankruptcy risk by enabling them to unwind their transactions upon termination, the Second Circuit interpreted the term “liquidation” in Section 560 to include the act of distributing the Collateral proceeds pursuant to the Priority Provisions.[10]  In reaching this latter conclusion, the Second Circuit expressly credited the amicus brief of SFIG—represented by Freshfields[11]—which provided “a number of industry-specific” examples showing that, “as used in the securities industry,” the term “liquidate” refers to the distribution of assets.[12]

Implications for Structured Finance Industry Participants

LBSF will have until August 25, 2020 and November 9, 2020 to seek, respectively, a rehearing en banc before the Second Circuit and review from the Supreme Court, both of which are rarely granted.  In the meantime, the Second Circuit’s decision should provide comfort to participants in the structured finance industry that Section 560 allows parties to swap agreements to utilize priority-of-payment provisions to unwind their swap transactions upon the bankruptcy of a counterparty or, as was the case here, a counterparty’s guarantor.  This, in turn, shields swap participants from some of the risks typically associated with the bankruptcy of a contract counterparty.  To ensure that their swap transactions are protected by Section 560, swap participants should, when drafting their swap agreements, verify that (i) the priority-of-payment provisions (typically contained in an indenture) are incorporated expressly into the ISDA master agreements, schedules and confirmations that typically govern swap transactions, and (ii) the indentures are drafted to make clear that, when the indenture trustee liquidates the collateral supporting the parties’ obligations, the trustee is exercising the rights of the parties to the swap agreements.

Please do not hesitate to reach out to your usual Freshfields contacts if you have any questions.

[1] In re Lehman Bros. Holdings, Inc., 2020 U.S. App. LEXIS 25398, at *6 (2d Cir. Aug. 11, 2020).

[2] See id. at *6-8.

[3] Id. at *8-9.

[4] Id. at *9.

[5] Id. at *9-10.

[6] Id. at *10-12.

[7] 11 U.S.C. § 560.

[8] Lehman Bros., 2020 U.S. App. LEXIS 25398, at *17-19.

[9] Id. at *28-30.

[10] Id. at *20-26.

[11] Madlyn Gleich Primoff, Tim Harkness, David Livshiz, Henry Hutten and Jill Serpa of Freshfields’ New York office represented SFIG.

[12] Lehman Bros., 2020 U.S. App. LEXIS 25398, at *26 & n.9.