Lehman Bankruptcy Judge Prevents Trigger of CDO Subordination Provision Based on Credit Support Provider and Swap Counterparty Bankruptcy Filings

January 1, 0001


It has long been a basic rule of U.S. bankruptcy law, subject to certain important exceptions, that contract provisions creating a default or altering the rights or duties of a debtor simply because the debtor files for bankruptcy are unenforceable. Recently, the Bankruptcy Court for the Lehman Brothers bankruptcy cases applied and arguably expanded this rule in examining a collateralized debt obligation (“CDO”) transaction. The result may have significant impacts not only on CDO vehicles and other structured finance transactions but on many unrelated transactions in bankruptcy. Judge Peck’s decision is expressly limited to the extraordinary facts of Lehman and does not address whether his analysis would apply in other situations. It is not clear how broadly the decision will apply if sustained on appeal.[1]

The payment waterfalls of most CDO transactions give priority to swap counterparties over noteholders. In many cases, the priority is “flipped” and noteholders then receive priority when there is a swap counterparty default. The recent memorandum decision of Judge Peck of the U.S. Bankruptcy Court for the Southern District of New York, in Lehman Brothers Special Financing, Inc. v. BNY Corporate Trustee Services, Ltd., Case No. 08-13555, Adv. No. 09-01242 (January 25, 2010) (“Ruling”), may preclude enforcement of such “flip” priorities in the bankruptcy of the swap counterparty. Granting summary judgment to debtor Lehman Brothers Special Financing, Inc. (“Special Financing”), Judge Peck held that CDO provisions subordinating collateral payments to Special Financing, as swap counterparty on its default due to the insolvency of Special Financing and Lehman Brothers Holdings, Inc. (“Holdings”) were an unenforceable ipso facto clause. If Judge Peck’s ruling is sustained on appeal, Special Financing’s claim for an early termination amount would be paid from available collateral before the claims due to noteholders. The Ruling also potentially conflicts with decisions from the English High Court of Justice (Chancery Division) and the English Court of Appeal (Civil Division) which held these CDO provisions enforceable under English law.

The Ruling suggests drafting lessons for default provisions in any contract. Some of the impacts on existing transactions, as well as more specific practical implications for future structured finance deals, are discussed below.


Special Financing was a Lehman entity that regularly served as counterparty in structured finance swap transactions (“Swap Transactions”)[2] with structured finance vehicles (“Issuers”) that issue securities (including senior and junior notes), swapping cash flows derived from the underlying investments. In some cases, Special Financing paid cash flows that better matched the obligations of the Issuer to its noteholders; in other cases, Special Financing paid returns based on notional investments. In nearly all cases, Holdings acted as “credit support provider” for Special Financing, essentially guaranteeing its performance. The obligations of the Issuer to both Special Financing (as swap counterparty) and its noteholders were typically secured by a pledge of the investments held by the vehicle. In the controversy addressed in the Ruling, the collateral was pledged under a Supplemental Trust Deed governed by English law. Under the terms of the pledge, so long as neither Special Financing nor Holdings was in default, Special Financing benefited from a first priority interest in collateral; on default of Special Financing or Holdings, the priority “flipped” and the noteholders would become the senior creditors.

Holdings filed for Chapter 11 bankruptcy protection on September 15, 2008, and Special Financing followed Holdings into bankruptcy on October 3, 2008. Citing Special Financing’s filing, the Issuer (acting through BNY Corporate Trustee Services, Ltd.) sent notice on December 1 that it was terminating the swap agreement with Special Financing (“Swap Agreement”).

Before the Ruling, both the English High Court of Justice (Chancery Division), and after appeal, the English Court of Appeal (Civil Division), ruled that the subordination “flip” provisions in the payment waterfall were enforceable under English law[3] and that the bankruptcy of Holdings on September 15, 2008 was the default that triggered the “flip,” entitling noteholders to take a senior claim against the proceeds of the pledged collateral. Special Financing commenced an adversary proceeding before Judge Peck after the English High Court of Justice issued its decision, but before the decision was upheld by the English Court of Appeal, seeking a ruling that the “flip” provision was not triggered by a bankruptcy default.

Special Financing’s primary argument in its summary judgment motion was that the “flip” provision was an ipso facto clause unenforceable in bankruptcy. An ipso facto clause is one that specifies a default or dispossesses the debtor of an interest in property solely as a result of the insolvency of the party, the commencement of a bankruptcy proceeding, or appointment of a trustee. An ipso facto clause may purport to affect a bankruptcy debtor’s interests in property (governed by Section 541 of the Bankruptcy Code) or to terminate or modify a debtor’s rights arising from executory contracts (governed by Section 365). While there are notable exceptions to the rule, generally ipso facto clauses are unenforceable in bankruptcy. The Ruling applies this general rule in a new and particularly broad fashion.

The Ruling focuses on two primary issues in determining whether the ipso facto provisions contained in the payment waterfall were unenforceable in bankruptcy. First, Judge Peck held that language in the ISDA Master Agreement governing the Swap Transactions demonstrated that the swap agreements as a whole constituted “executory contracts” under Section 365 of the Bankruptcy Code.[4] While Judge Peck observes that “all obligations of the parties under the ISDA Master Agreement remain outstanding” on termination of the underlying Swap Transaction, and that “the failure of either party to complete performance would constitute a material breach excusing the performance of the other,” he does not specifically identify the “material mutual obligations” that warrant characterization of the contract as “executory.”

Next, in an issue of first impression, Judge Peck determined that the prohibition against ipso facto clauses in Section 365(e)(1), which invalidates any clause altering a debtor’s rights based on “commencement of a case under this title,” when construed broadly means that Holdings’s filing on September 15 prevented trigger of the ipso facto clauses against Special Financing from that date forward.[5] In so ruling, Judge Peck observed that nothing in the language or the legislative history of Section 365(e)(1) suggested an intent to limit ipso facto protection to those situations where the debtor had sought bankruptcy protection, and therefore the subordination “flip” would not have been enforceable even if triggered by Holdings’s earlier filing. The Ruling notes that extending Section 365(e)(1) protection based on a bankruptcy filing other than the debtor’s own filing may only make sense in the context of an “integrated enterprise” such as Lehman. Judge Peck also ruled that Section 560 of the Bankruptcy Code, which generally protects the right to liquidate, terminate, or accelerate obligations under “swap agreements” notwithstanding Section 365(e)(1), did not cover the Note Documents (which contained the subordination “flip” provisions and the Supplemental Trust Deeds) because these documents were not part of the “swap agreements” themselves as reflected in the separate Swap Agreement Documents. This latter conclusion is particularly surprising in light of the structure of a CDO transaction, in which the Issuer is created for the purpose of facilitating a single integrated transaction and — notwithstanding the use of documents that on their face contemplate a repeated transaction — all the documents are intended to work together to facilitate the overall objectives of the transaction.


The Ruling notes that it does not intend to advance a broad rule that would always make it appropriate for one debtor to invoke ipso facto protection based on a bankruptcy filing by another corporate affiliate. Moreover, the Ruling goes to great lengths to explain the uniqueness of the Lehman bankruptcy case, possibly reflecting an acknowledgement of certain extraordinary features of the decision and a corresponding desire on Judge Peck’s part to undercut future reliance on the decision.[6] To the extent Judge Peck’s broader interpretation of 365(e)(1) applies outside of these specific facts, Judge Peck appears to intend that it would be limited to cases of “integrated enterprises” as noted in the Ruling. If so construed, affiliated companies which file for bankruptcy close in time (although not on the same day) are those most likely to benefit from this decision as these cases seem most likely to apply the conclusion Judge Peck reaches. It is unclear whether and how far this rule may be applied, but retroactively treating ipso facto protection for the later bankruptcy as occurring on the date of the first bankruptcy presents numerous opportunities for frustrating the expectations of contract parties.

Certain aspects of the structure of these CDO transactions may have played a role in Judge Peck’s decision not to enforce the subordination “flip” provisions. In first ruling that the contract containing the “flip” provision was executory, Judge Peck concluded that the form Master Agreement was a “central part” of the Swap Transaction and relied heavily on the form ISDA Master Agreement to determine that obligations remained on both sides. Judge Peck then limited the application of the “swap agreement” safe harbor provision in Section 560 of the Bankruptcy Code to only the actual swap (the Swap Agreement Documents, including the form ISDA Master Agreement), and not the supporting Note Documents which contained the “flip” provision itself. From the noteholders’ perspective, the Ruling likely represents the worst of both worlds. While parties cannot insure that a judge will always treat their agreements in the manner intended by the parties, with planning it may be possible in any transaction to weaken a judge’s ability to construe different documents as one integrated executory contract. The chances of a judge determining that separate documents are an integrated executory contract are diminished if contract parties expressly state in the documents that they intend to treat each document as a separate agreement, and if each separate agreement is supported by its own consideration. Conversely, if the goal is to treat separate documents as one integrated agreement, parties should make this intent clear in the documents themselves.

Parties drafting default provisions should also consider whether their interests may be equally served by alternate language if the ipso facto provision poses a concern. Section 365(e)’s ipso facto protection is triggered only by specific insolvency or financial condition defaults in a contract. To this point, courts have largely refrained from extending ipso facto protection to defaults that may accompany insolvency but are not explicitly defined as insolvency defaults. For instance, a transaction may be structured to trigger defaults upon the failure to pay money after a certain number of days, regardless of the party’s financial condition. The utility and feasibility of such alternate approaches can be expected to vary by transaction.


If the Ruling is upheld in its broadest terms, the ripples of this wave of increased bankruptcy protection could touch not only the synthetic CDO and structured finance market, but could also have broader implications for many market participants in terms of financing opportunities, risk mitigation and, for banks, capital requirements.

A. CDO and Structured Finance Market

The Ruling may have a significant impact on the ratings of many synthetic CDOs. Synthetic CDOs became a thriving market during the early-to mid-2000s, accounting for a fair portion of the annually multi-billion dollar CDO market at that time. These derivative-based transactions were especially common throughout Europe and Asia, due in part to lower capital availability relative to the United States and greater investor familiarity with derivative products. After the global credit downturn in 2008, Standard & Poor’s, Ltd. (“S&P”) and Moody’s Investor Services (“Moody’s”) issued separate reports stating they were revising the ratings methodologies of synthetic CDOs and that the credit quality of swap counterparties would be a relevant factor in their updated methodologies. The increased risk that a swap counterparty could go bankrupt while still retaining a senior spot in the waterfall could lead S&P and Moody’s to take a further critical review of the synthetic CDOs they rate, and the credit ratings of the swap counterparties therein. This increased risk may also limit the issuance of new synthetic CDOs due to the difficulty and cost in getting high enough ratings for the issuance to be feasible. Many cash flow CDOs also have swap counterparties providing currency, interest rate or other protections. These transactions also will be affected by the Ruling, although presumably to a lesser degree than is the case with synthetic CDOs, due to the typically lower levels of risk exposure cash flow CDO issuers have to their swap counterparties.

A less efficient CDO new issuance market also may limit the reemergence and future growth of the credit default swap (“CDS”) market. Synthetic CDOs accounted for approximately 15% of the notional amount of outstanding credit default swaps. In standard CDS transactions, investment banks have often sold credit protection on securities to customers, many of whom wanted to hedge their positions and lower their exposure to market risk. In the past, the investment banks have sometimes sponsored synthetic CDOs to repurchase this credit protection while paying a lower premium for such protection, thereby significantly reducing the investment banks’ overall risk exposure in the positions while locking in a profit due to the differences in the premium payments. The Ruling, together with other relevant market factors, may render synthetic CDO transactions less desirable for investment, effectively reducing the universe of alternatives available to investment banks to reduce their risk on CDS transactions. Due to the increased cost of hedging, the cost of any CDS could increase, which could reduce the overall market size and increase the costs for many businesses and other market participants to hedge their investment risks.

B. Limiting Safe Harbor for Derivative Transactions

A broad reading of the ipso facto clause could also prevent execution of certain derivative terms. Judge Peck determined in the Ruling that the safe harbor for derivative transactions contained in Section 560 of the Bankruptcy Code is intended mainly to facilitate the termination, netting and liquidation process. The Ruling may imply that this safe harbor does not protect other terms in the swap agreements or other security documents and related transactions that are not expressly referenced as part of the swap transactions. Parties often enter into transactions under swap agreements in the context of a broader transaction or with related security agreements.

Taken to its broadest conclusions, the Ruling could be read to state that these swap agreements can be separated from those related transactions in the bankruptcy proceedings, despite the fact that the parties intended the terms to work as a whole. A broad interpretation of the Ruling may also suggest that ISDA's termination valuation terms (e.g., permitting a non-defaulting party to value a transaction on the side of a bid-ask quotation favorable to such party rather than at a mid-market level) are unenforceable ipso facto clauses because they are based on the bankruptcy of the Debtor. More directly tying security documents and related transactions to the swap agreements themselves may lead courts to apply Section 560 protection to broader components of the transaction, or even the entire transaction as a whole.

C. Risk and Capital Requirements

If the Ruling is followed by other courts, the increased cost of the transactions may reduce the economic efficiency of certain CDOs and other synthetic asset-backed deals.

Moreover, because investment banks have often historically used synthetic CDO transactions to limit their exposure to outstanding CDS, their loan portfolios and other risks, any increased costs or further reduced availability in the synthetic CDO market could compel investment banks to either increase their capital base held against other transactions or to limit their exposure in the CDS and other derivatives markets. Such changes could significantly increase a company’s cost in effectively hedging its risk exposure.


Judge Peck’s decision could have broad and as yet unknown implications. If the Ruling is sustained on appeal, the implications for both CDOs and other transactions will develop as further cases work their way through the courts, and as the market reacts through innovative structuring and drafting in new transactions. At a minimum, parties should consider the Ruling’s impact on a broad array of existing and future transactions.

The bankruptcy and securitization lawyers of O’Melveny & Myers LLP are market leaders in the areas discussed in this Client Alert and are known for their pragmatic and commercial approaches to client work. Please do not hesitate to contact the authors of this Alert to discuss the implications the Ruling may have for your business.

[1] Given the importance of the Ruling an appeal seems likely. The time to appeal has not run.

[2] The Swap Transactions were memorialized within several different documents. Each series of notes was governed by a Supplemental Trust Deed and other note documents (the “Note Documents”). The Note Documents included the subordination flip provision as well as a provision modifying amounts payable upon the early redemption of a note in the event that Special Financing defaulted under the related “swap agreement” (the “Swap Agreement”). The Swap Agreement itself was composed of a form Master Agreement drafted by the International Swaps and Derivatives Association, Inc. (the “ISDA Master Agreement”), schedules, and written confirmation (the “Swap Agreement Documents”). Each Supplemental Trust Deed referenced the separate Swap Agreement Documents. Under the Swap Agreement, Holdings was a “credit support provider,” acting as guarantor of Special Financing’s obligations under the Swap Transactions.

[3] Judge Peck notes in his Memorandum Decision that the English courts were not considering U.S. bankruptcy law.

[4] “Executory contract” is not a term defined in the Bankruptcy Code. Courts generally agree that an executory contract is a contract as to which material performance remains due on both sides. Judge Peck’s conclusion that the Swap Agreement was executory was based on the following reasoning:

The language and structure of the ISDA Master Agreement that forms a central part of the Swap Agreement of the Swap Agreement demonstrate that these contracts are executory. Paragraph 9(c) of each ISDA Master Agreement expressly provides that the obligations of the parties under the relevant Swap Agreement shall survive the termination of any transaction. Given that all obligations of the parties under the ISDA Master Agreement remain outstanding, the failure of either party to complete performance would constitute a material breach excusing the performance of the other. In addition, each of [Special Financing] and [Issuer] has unsatisfied contractual obligations to make various payments. These outstanding obligations to make payments pursuant to the Swap Agreement constitute sufficient grounds to find that the contract in question is executory.

Ruling, pp. 12-13 (internal citations omitted).

[5] Section 365(e)(1) provides that an executory contract may not be terminated or modified by certain events related to insolvency, including “the commencement of a case under this title,” notwithstanding any provision in the contract otherwise allowing termination or modification. The Ruling first determined that the “flip” provision documents only flipped priority of payments after certain affirmative acts took place (including the sale of the collateral). As the collateral had not been affected as of October 3 (the date of Special Financing’s bankruptcy petition), Judge Peck determined that the “flip” provision was not triggered before the Special Financing bankruptcy filing. The Ruling then determined that “commencement of a case under this title” could include the related bankruptcy filing of Holdings on September 15.

[6] Judge Peck limited his reading of Section 365(e)(1) to the particularly unique facts of the Lehman Brothers bankruptcy, noting that Holdings and Special Financing were “integrated enterprises,” that the Lehman entities were “perhaps the most complex and multi-faceted business ventures ever to seek the protection of chapter 11,” and that the “extraordinary panic” precipitating Holdings’s filing and the magnitude of the Lehman bankruptcy made it difficult for all the Lehman entities to file on one day.