Finding a Safe Harbor After the Storm

By: William Accordino

St. John’s Law Student

American Bankruptcy Institute Law Review Staffer

     In In re Lehman Brothers Holdings Inc. (“Lehman”), Judge Shelley C. Chapman of the United States Bankruptcy Court for the Southern District of New York dismissed a complaint filed by Lehman Brothers Holding Inc. (“LBHI”) and Lehman Brothers Special Financing Inc. (“LBSF”) challenging the early termination of forty-four credit default swap agreements.[1] The complaint alleged the subsequent liquidation of the collateral underlying those agreements after the early termination and the distribution of those proceeds violated the Bankruptcy Code (“Code”) despite LBSF’s default.[2] Of the forty-four swap agreements, the court found five contained provisions that “effected an ipso facto modification of LBSF’s rights . . . .”[3] However, the distributions from those transactions were protected by the Code’s safe harbor provision.[4] Judge Chapman found the priority provisions in the other thirty-nine swap agreements did not operate as ipso facto clauses because they did not modify any rights of LBSF.[5] The payment priority for those agreements was not set at any time prior to the termination of the swap, thus no right to payment priority could be modified by a termination.[6] As a result, all nineteen counts of the complaint were dismissed for failure to state a cause of action.[7]

     The holding in this case stands in contrast to two similar cases involving LBHI and LBSF decided by Judge Peck in 2010.[8] In In re Lehman Brothers Holdings Inc. (“BNY,”) the swap agreements at issue were similar to the five agreements that Judge Chapman found modified LBSF’s rights upon termination.[9] Judge Peck held the provisions in those transactions that caused the flip in the payment priority between LBSF and the noteholders operated as ipso facto clauses.[10] Judge Peck reached a similar result in another case, In re Lehman Brothers Holdings Inc. (“Ballyrock”).[11] In both BNY and Ballyrock, unlike the instant matter, Judge Peck found those provisions were not a part of the swap agreement and, therefore, not protected by the safe harbor provisions contained in section 560 of the Code.[12] In addition to ruling on the matter  in BNY, Judge Peck laid down some controversial dicta regarding the relevant date for the application of the anti-ipso facto clauses in the Code.[13]

     In developing the “singular event theory,” Judge Peck theorized the bankruptcy filing of LBHI could be considered the “case” triggering the protections of sections 365 and 541 of the Code for LBSF.[14] It was entirely unnecessary for Judge Peck to address this point because all the swaps at issue in BNY and Ballyrock were terminated after both LBHI and LBSF had filed for bankruptcy.[15] The timing of the terminations varied in this case but Judge Chapman found that LBSF’s filing was the relevant date for the purpose of invoking the Code’s anti-ipso facto provisions, overruling Judge Peck’s singular event theory.[16] If Judge Peck had applied the singular event theory to Lehman, the result would have been the same because she also found all forty-four transactions were protected by the safe harbor provision.[17]

     Neither Judge Peck nor Judge Chapman decided their piece of the Lehman Brothers bankruptcy in a vacuum. Judge Peck ruled on BNY and Ballyrock in the immediate aftermath of the financial collapse.[18] Judge Chapman acknowledged the difficult position that Judge Peck was in, but she also discussed the need for “perspectives on difficult legal questions [to] develop and evolve over time.”[19] Judge Chapman found the safe harbor provision required the broad interpretation she applied “to promote the stability and efficiency of the financial markets.”[20] One argument against safe harbors is the provisions run counter to the reason behind the automatic stay; the company “can be worth more than the sum of its parts” and the stay can allow the company to maintain its value during bankruptcy proceedings.[21] The thought is that all involved parties will receive better value from the bankrupt entity’s portfolio if it can be sold in large pieces before the swap counterparties can terminate their transactions.[22] Even if counterparties are not able to terminate, however, there is unlikely to be any real value in a bankrupt financial institution’s portfolio if it is laden with credit default agreements in which that institution has already defaulted. Given the divergent decisions by Judge Peck and Judge Chapman and the possibility of future conflicting rulings, Congress may need to address the issue.


[1] In re Lehman Bros. Holdings, Inc., 553 B.R. 476, 494 (Bankr. S.D.N.Y. 2016) [hereinafter Lehman]. In a credit default swap agreement, two parties take opposing positions as to the credit worthiness of the indebted party from the loans that make up the collateral underlying the agreements. The seller of the swap agreement is essentially guaranteeing repayment of those loans while the buyer makes periodic payments to the seller. The buyer will only receive payment if the debtors from the loans in the collateral default. See Brief for Defendant at 5-8, In re Lehman Bros. Holdings Inc., 553 B.R. 476 (Bankr. S.D.N.Y. 2016) (No. 1:10-ap-03547).

[2] In re Lehman, 553 B.R. at 494.

[3] Id.

[4] Id.

[5] Id.

[6] Id. at 493.

[7] Id. at 494, 507-09.

[8] See In re Lehman Bros. Holdings Inc., 422 B.R. 407 (Bankr. S.D.N.Y. 2010) [hereinafter BNY]; see also In re Lehman Bros. Holdings Inc., 452 B.R. 31 (Bankr. S.D.N.Y. 2010) [hereinafter Ballyrock].

[9] In re BNY, 422 B.R. at 422.

[10] Id. at 420.

[11] In re Ballyrock, 452 B.R. at 34.

[12] In re BNY, 422 B.R. at 421; see also In re Ballyrock, 452 at 40.

[13] In re BNY, 422 B.R. at 418-19; see also In re Lehman, 553 B.R. at 497.

[14] In re BNY, 422 B.R. at 419-20.

[15] Id. at 413-14.

[16] In re Lehman, 553 B.R. at 497.

[17] Id. at 501.

[18] See id. at 497

[19] Id.

[20] Id. at 502.

[21] Mark J. Roe & Stephen D. Adams, Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio, 32 Yale J. on Reg. 363, 377-78 (2015).

[22] Id. at 375-76.