On August 11, 2020, the U.S. Circuit Court of Appeals for the Second Circuit (the Second Circuit) affirmed the distribution of collateral proceeds under the safe harbor protections of section 560 of the Bankruptcy Code.1 The case stems from the chapter 11 bankruptcy proceedings of Lehman Brothers Holdings Inc. (LBHI). The case in question was brought by Lehman Brothers Special Financing Inc. (LBSF), a subsidiary of LBHI, in 2010 to claw back payments it made to certain noteholders (the Noteholders) and other parties in the wake of LBHI’s bankruptcy.
Several LBSF entities formed a special-purpose entity (the Issuer) for the purpose of issuing notes to the Noteholders pursuant to an indenture (the Indenture). The notes were collateralized by securities acquired with the proceeds of the note issuances (the Collateral), which Collateral was held by trustees (the Trustees) for the benefit of the secured parties. LBSF then entered into a credit default swap with the Issuer under an ISDA master agreement (the ISDA), and the terms of those documents incorporated by reference the priority of payment provisions of the Indenture (the Priority Provisions).
The Priority Provisions contemplated several scenarios that would trigger a return of the Noteholders’ principal and proceeds of the Collateral, each with specific payment waterfalls. In the event that LBSF was the defaulting party under the ISDA, the Indenture instructed the Trustees to terminate the credit default swap and liquidate the Collateral, distributing the proceeds thereof to the Noteholders before LBSF.
Ultimately, LBHI’s chapter 11 filing triggered a cross-default under the ISDA with LBSF designated as the defaulting party. Accordingly, the credit default swaps (which were in-the-money for LBSF) were terminated. The Trustees liquidated the Collateral and, because LBSF was the defaulting party, the proceeds thereof were distributed to the Noteholders before LBSF. LBSF subsequently brought suit to recover the amounts distributed to the Noteholders. At the Second Circuit, LBSF made three primary arguments, none of which prevailed. Each of those arguments is described below.
1. Whether the Priority Provisions are included within the scope of protections afforded to “swap agreements”
LBSF argued that the Priority Provisions did not satisfy the Bankruptcy Code definition of a “swap agreement,” and therefore were not entitled to the section 560 safe harbor permitting the termination, liquidation, or acceleration of obligations under executory contracts notwithstanding the Bankruptcy Code’s restriction on ipso facto clauses and the automatic stay.
As an initial matter, we note that section 560 of the Bankruptcy Code provides a safe harbor for the benefit of swap participants.2 In short, it creates an exception to the ipso facto restrictions and the automatic stay, and permits the exercise of a swap participant’s contractual rights to cause the liquidation, termination, or acceleration of swap agreements.
One of the elements of section 560’s safe harbor is that the contractual rights to liquidate, terminate, or accelerate obligations must be included in a “swap agreement” – a term defined by the Bankruptcy Code.3 Neither party disputed that the ISDA itself was a swap agreement. Instead, LBSF argued that the Priority Provisions – which were included in the Indenture, not the ISDA – did not form part of the swap agreement at issue. LBSF argued, therefore, that the scope of the section 560 safe harbor did not extend to the Priority Provisions and the distribution to the Noteholders was improper.
The lower courts held, and the Second Circuit affirmed, that the Priority Provisions were included in the swap agreement definition because, on its face, the definition includes any terms or conditions that are incorporated by reference in a swap. The Second Circuit analyzed the terms of the ISDA purporting to incorporate the Indenture by reference, which stated that amounts payable to LBSF were “subject in any case to the Priority of Payments set out in the Indenture.” Applying relevant precedent, the Second Circuit affirmed that such language sufficiently incorporated the Priority Provisions into the ISDA, and thus the Priority Provisions formed part of the swap agreement at issue.
2. Whether “liquidation” includes the wind-down of transactions and the distribution of proceeds
LBSF argued that the right to liquidate a swap agreement means only that a swap participant may ascertain the precise amount of debt, not that the transactions thereunder could be wound down and proceeds distributed.
The section 560 safe harbor permits the exercise of a swap participant’s contractual right to cause the termination, liquidation, or acceleration of swap agreements. The Second Circuit, after noting that the term “liquidation” is undefined in the Bankruptcy Code, analyzed the intent and purpose behind the safe harbor and found that it was enacted to provide special status to such agreements, to permit their timely unwind, and to provide a measure of certainty and finality to the resolution of troubled market participants. Accordingly, the Second Circuit held that the Trustee’s act of distributing the proceeds of the Collateral to the Noteholders was permissible under the section 560 safe harbor. LBSF’s interpretation, according to the Second Circuit, would “hardly protect swap counterparties if it merely sheltered their ability to determine amounts owed, but not to distribute the proceeds” thereof.
3. Whether the Trustees are “swap participants”
LBSF argued that the Trustees were not entitled to terminate the credit default swaps and liquidate the Collateral because they were not “swap participants,” and therefore unable to avail themselves of the section 560 safe harbor.
An element of the section 560 safe harbor requires that the contractual rights to cause the termination, liquidation, or acceleration of a swap agreement be those “of any swap participant.” The lower courts held, and the Second Circuit agreed, that LBSF misinterpreted the statutory language, and that the section 560 safe harbor does not require the contractual rights be exercised “by” a swap participant, but instead only requires the contractual rights be those “of” a swap participant. Accordingly, the Trustees properly exercised the rights “of” a swap participant. Since the Indenture expressly directed the Trustees to exercise any rights to terminate the credit default swap and liquidate the Collateral, the Second Circuit held that the Trustees’ actions were not impermissible.
This case is of particular importance with regard to analyzing safe harbor rights under the Bankruptcy Code. As exhibited in this case, facts matter in any later analysis of a party’s actions and exercise of such safe harbor rights. This case more fully develops safe harbor precedent and provides further certainty to parties that are structuring transactions with an eye to bankruptcy risk. In addition to providing additional color to such analysis, this case counsels on the prudence of parties ensuring any third party acting on their behalf is expressly authorized to do so. Further, if parties will rely on ancillary documents to supplement the safe harbor rights contained in trading contracts, they should ensure such terms are properly incorporated into the primary swap agreement documents.
- In re Lehman Bros. Holdings Inc., No. 18-1079, 2020 WL 4590247 (2d Cir. Aug. 11, 2020). Unless otherwise noted herein, all citations that would otherwise be contained in this Client Alert are to the foregoing Second Circuit opinion. Such citations are omitted for the sake of brevity.
- Section 560 reads:
“The exercise of any contractual right of any swap participant or financial participant to cause the liquidation, termination, or acceleration of one or more swap agreements because of a condition of the kind in [the Bankruptcy Code section prohibiting ipso facto clauses] or to offset or net out any termination values or payment amounts arising under or in connection with the termination, liquidation, or acceleration of one or more swap agreements shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title.”
11 U.S.C. § 560.
- The “swap agreement” definition is comprehensive but, as relevant here, includes “any agreement, including the terms and conditions incorporated by reference in such agreement, which is [a swap].” See 11 U.S.C. § 101(53B)(A)(i).
Client Alert 2020-490
