Key High Court Decision Enforces Contractual Subordination Provisions Common in Structured Finance Transactions

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Structured finance transactions effected under English law commonly contain provisions in the payment waterfall giving claims of swap counterparties priority over claims of noteholders, so long as the swap counterparty performs its obligations under the swap arrangements. If the swap counterparty defaults on its obligations, the priorities “flip” such that the noteholders take priority over the swap counterparty. In Perpetual Trustee Co Ltd v BNY Corporate Trustee Services Ltd & Anor, [2009] EWHC 1912 (Ch) (28 July 2009), the swap counterparty challenged these provisions, arguing that they are unenforceable under English law when the default giving rise to the “flip” is an insolvency of the swap counterparty. On 28 July 2009, the English High Court of Justice, Chancery Division rejected the swap counterparty’s claims and upheld the “flipping priority” provisions.

This decision is important for the structured finance market, as the validity of these provisions has long been assumed and an adverse decision would not only have cast doubt on many existing deals which contain such provisions, but it would have removed this solution as a mechanism to protect noteholders from swap counterparty risk in future transactions.

Set out below is a brief discussion of this seminal case.

Key Facts and Issues

In October 2002, Lehman Brothers International (Europe) established a multi-issuer secured obligations programme as a way to provide quasi-credit insurance for various loans and other obligations owed to entities within the Lehman Brothers group. Under this programme, the Lehman group companies formed special purpose vehicles to issue notes to investors. The SPVs used the proceeds of the notes to purchase government bonds or other secure investments which were then pledged as collateral to secure the SPVs’ obligations under the notes. The SPVs also entered into a swap agreement with Lehman Brothers Special Financing Inc. (“LBSF”) pursuant to which LBSF, as swap counterparty, paid the SPVs amounts due by the SPVs to the investors in exchange for amounts equal to the yield on the collateral. The amount by which the sum payable by LBSF under the swap exceeded the yield on the collateral represented the premium for the credit insurance provided by the investors.

Under the transaction documents, LBSF, as swap counterparty, had priority over the proceeds of the collateral so long as it was not in default under the swap arrangements. However, if an event of default occurred under the swap agreements in respect of which LBSF was the defaulting party, the priorities reversed such that the claims of the noteholders assumed priority over those of LBSF.

On 3 October 2008, LBSF applied for bankruptcy protection under Chapter 11 of the US Bankruptcy Code. Neither the SPVs nor LBSF made any further periodic payments to the investors under the programme documents. Accordingly, certain investors instructed the Trustee to liquidate the collateral and, in reliance on the “flipping priority” provisions contained in the payment waterfall, apply the proceeds to satisfy all obligations owed to the noteholders before any amounts were paid in respect of obligations owed to LBSF as swap counterparty.

In the Perpetual case, LBSF argued that the “flipping priority” provisions are unenforceable under English law, at least when triggered by an insolvency of the party whose claims are subordinated as a result. LBSF asserted that the effect of the “flipping priority” provision was to cause assets of its estate to be distributed to the investors in priority to its other creditors, and cited the long-established principle that parties under English law cannot, as a matter of public policy, contractually provide for a different distribution of their assets in bankruptcy than that which would result under the Insolvency Act 1986 (i.e., in particular, pari passu distribution amongst unsecured creditors).

Existing Law

Since 1873, courts in England have recognised the principle that “a man is not allowed…to provide for a different distribution of his effects in the event of bankruptcy from that which the law provides”.[1] In other words, in the absence of mortgages, charges and other formal security arrangements, a debtor cannot contractually offer a preference to one unsecured creditor at the expense of the others. In Perpetual, LBSF argued that the “flipping priority” provisions fell foul of this principle by depriving the LBSF bankruptcy estate of assets which otherwise would have been available for distribution amongst its creditors.

In response, counsel for the investors cited several cases establishing a key exception to this rule -- namely, that the grant of an interest in property which terminates on the insolvency of the grantee (but not the grantor) is enforceable.[2] The most instructive in this line of cases is Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd [2002] 1 WLR 1150.

Money Markets International involved the London Stock Exchange, which was formed as a mutual company. Membership on the Stock Exchange was evidenced by B shares issued to each of the members. Under the rules of the Stock Exchange, a member which defaulted on its obligations under the stock exchange contracts, including by becoming insolvent, could be declared a defaulter, at which point its membership was forfeited and could be forcibly retransferred to a new member. The claimant, having been wound up by the High Court in Dublin pursuant to a resolution of its members, challenged the retransfer of its B shares on the grounds that it was invalid under the principle set out in Ex parte MacKay. Noting that the case history on this question is muddled and that “it is not possible to discern a coherent rule, or even an entirely coherent set of rules, to enable one to assess in any particular case whether [a deprivation provision] falls foul of the [Ex parte MacKay] principle”[3], Neuberger J on the balance of the facts presented in Money Markets International upheld the retransfer of the claimant’s B shares.

The Decision

The Chancellor in Perpetual sided with the investors, ruling that the subordination clause contained in the trust deed is valid and not contrary to public policy. The Chancellor recognised that much uncertainty lies between the principle set out in Ex parte MacKay and the exception for grants of property interests determinable on an insolvency of the grantee. In his view, it is and will continue to be necessary in each case to construe the relevant facts carefully to determine where along the spectrum the documents in a particular case fall. In support of the decision to uphold the “flipping priority” provision at issue in Perpetual, the Chancellor cited the following rationale:

1.   It is necessary to consider the structure of the transaction as a whole, not the “flipping priority” (or other deprivation clause) in isolation. In this case, the security conferred as a result of the “flipping priority” was in respect of the collateral acquired by the SPVs with the proceeds of the notes, not in respect of property derived directly or indirectly from LBSF.

2.   As a general rule, courts should not be quick to interpret commercial transactions so as to invalidate them, particularly where, as here, doubt might be cast on other long-term commercial transactions.

3.   Commercially, it was appropriate in this case for LBSF to have security for the SPVs’ obligations under the swap agreement in priority to the obligations owed to the investors. However, it was clear that the parties intended LBSF's priority to be conditional on LBSF continuing to perform the swap agreement.

4.   LBSF's priority never extended after an event of default under the swap agreement, and accordingly its prior-ranking interest in the collateral was always limited and conditional, and could never have passed to a liquidator or trustee in bankruptcy free from such limitations and conditions.

Leave to appeal has been granted.


The Perpetual decision provided critical reinforcement for “flipping priority” provisions contained in many English law-governed structured finance transactions. While some older transactions often placed swap counterparties behind the noteholders in the payment waterfall, swap counterparties objected to this treatment and for some time have been almost universally successful in negotiating for higher priority. However, at the behest of ratings agencies tasked with rating the various tranches of notes issued in these transactions, “flipping priority” provisions were introduced to address the (previously believed remote) possibility of swap counterparty default. Until Perpetual, the market widely assumed these provisions to be valid. Thus, the Perpetual decision holding them to be so should provide critical underpinning for this mechanism, enabling its continued use in future transactions to fairly balance the interests of swap counterparties and noteholders in the transaction collateral.

Should you have any questions regarding the Perpetual case or related matters, please do not hesitate to contact one of the members of our team.

[1] James LJ in Ex parte MacKay (1873) LR 8 Ch App 643 (p. 647).
[2] See materials discussed at paragraphs 89 and 90, Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd [2002] 1 WLR 1150.
[3] Id. paragraph 117.