The UK Supreme Court unanimously ruled that a flip provision in a swap agreement favoring note holders was triggered by the bankruptcy filing of a Lehman entity despite the anti-deprivation rule that is aimed at attempts to withdraw an asset on bankruptcy thereby reducing the value of the insolvent estate. While the policy behind the anti-deprivation rule is that parties cannot deprive the bankrupt of property which would otherwise be available for creditors, said the Court, that policy must be given a common sense application which prevents its application to complex bona fide commercial derivatives transactions which do not have as their predominant purpose the deprivation of the property of one of the parties on bankruptcy. Belmont Park Investments PTY Limited v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc., July 27, 2011, UKSC 38.
This appeal arose out of the insolvency of the Lehman Brothers group, which had established a synthetic debt repackaged note issuance program to provide or mimic a form of credit insurance to a Lehman entity against credit events. The commercial purpose of the transaction was achieved through the issue of synthetic credit-linked notes by special purpose vehicles set up in tax-friendly jurisdictions. The investors in the notes were, among others, pension funds, private investment companies and private individuals.
In order to service the interest payments under the notes, the issuer entered into a swap agreement with the Lehman entity under which the entity received the income on the collateral and, in return, paid the issuer the amount of interest due to the note holders under the terms of the notes. However, the Lehman entity would lose its priority claim to the collateral if it was in default under the swap agreement, triggering a change in priority in favor of the note holders, the so-called flip. The events of default under the swap were numerous and included a bankruptcy filing. In this context, the Court said that the combined effect of section 5 of the ISDA Master Agreement that constituted the swap agreement and a provision in the swap confirmation was that the institution by Lehman of proceedings for Chapter 11 relief would be an event of default.
Writing for the Supreme Court, Lord Collins concluded that commercial sense and the absence of an intention to evade insolvency laws are highly relevant factors in the application of the anti-deprivation rule. He said that the rule does not apply to bona fide commercial transactions which do not have as their main purpose the deprivation of the property of one of the parties on bankruptcy. Since the contractual provisions challenged in the present appeal were part of a complex commercial transaction entered into in good faith, reasoned the Court, the collateral was in substance provided by the note holders and there was no suggestion that the flip provisions were deliberately intended to evade insolvency law, and thus they did not offend the anti-deprivation rule.
So long as there was no risk of default, the note holders were prepared for Lehman to have priority when it came to unwinding the transaction. But the scheme provided, and was sold on the basis that, if Lehman defaulted the note holders would have priority both in relation to repayment and in relation to the unwind costs. The right granted to Lehman was a security right over assets purchased with the note holders’ money, and, from the very inception, the priority, and the extent of the benefits, enjoyed by Lehman in respect of the security were contingent upon there being no event of default.
Indeed, in a concurring opinion, Lord Walker observed that the note holders were substantively the only party who contributed real assets, in many cases the pension funds of hard-working citizens. The Lehman entity contributed only promises, said Lord Walker, and then proved unable to perform them. Its only proprietary interest was under a charge to secure sums that might become due to it on performance of its obligations.
In a concurring opinion, Lord Mance agreed that the insolvency legislation did not render redundant the common law anti-deprivation principle: However, he would have dismissed the appeal on the basis that the Lehman entity could not be regarded as having been deprived of any property. On his reading of the documentation, the Lehman entity could not be said to enjoy the contractual priority until the occurrence of certain events. Thus once an event of default under the swap occurred, the entity was not deprived of the priority but simply prevented from acquiring it in the first place.
Lord Mance also noted that the anti-deprivation principle finds a parallel in section 541 of the US Bankruptcy Code. But the English case law has to date focused on deprivation of property, he said, and has not recognized any equivalent principle to that enacted in section 365(e) of the Code. Further, section 365(e) is itself qualified by the safe harbor provisions of section 560, which specifically protect a non-defaulting swap participant’s contractual rights to liquidate, terminate or accelerate a swap agreement because of a condition of the kind specified in section 365(e)(1), that is the insolvency or financial condition of the debtor and the commencement of a bankruptcy case.
A US federal bankruptcy judge considered section 560 inapplicable because he concluded that there was nothing in the ISDA Master Agreement or the swap agreement referring to the note holder priority. It is not for a UK court to go further into that conclusion, said Lord Mance, which may yet be challenged in further United States litigation. What it does suggest, he continued, is that any general rule invalidating ipso facto termination clauses ought to be a matter for legislative attention, rather than novel common law development.