The Unenforceability of Flip Clauses in Swap Agreements

By: Piergiorgio Maselli

St. John's Law Student

American Bankruptcy Institute Law Review Staff

In Lehman Bros. Special Financing, Inc. v. Ballyrock (In re Lehman Bros. Holdings Inc.),[1] the United States Bankruptcy Court for the Southern District of New York held that a so-called “flip clause” in a swap agreement, which reordered the payment priorities in a collateralized debt obligation (“CDO”) transaction,[2] was an unenforceable ipso facto[3] clause of the type that is not protected by the safe harbor provisions of the Bankruptcy Code (the “Code”).[4] Lehman and Ballyrock’s swap agreement[5] provided that in the event of a party’s default, the non-defaulting party was entitled to terminate the agreement and alter the priority of payments under the agreement.[6] Since bankruptcy was an element of default, Lehman’s bankruptcy filing triggered the flip clause and placed it below CDO noteholders in the “waterfall” of termination payments. The flip clause, if enforced, would have eliminated Lehman’s right to receive funds that it would have received if not for its bankruptcy, and thus Ballyrock claimed that Lehman’s bankruptcy filing effectively deprived it of its right to collect termination payments.[7]

Section 560 of the Code allows certain ipso facto clauses to be enforced in bankruptcy where such clauses relate to the “liquidation, termination, or acceleration” of swap agreements upon a counterparty’s bankruptcy.[8] The Court interpreted section 560 narrowly and held that the flip clause fell outside section 560’s safe harbor because subordination was not a “liquidation, termination, or acceleration” of the swap.[9]

This decision, although establishing a novel rule of bankruptcy law, was not unexpected, as Judge Peck had previously ruled in Lehman Bros. Special Financing, Inc. v. BNY Corporate Transaction Services (In re Lehman Bros. Holdings Inc.)[10] that the reordering of payment priorities in CDO transaction waterfalls could not be conditioned on the bankruptcy of a party.[11] This narrow interpretation of the safe harbor provision may have far reaching implications to securitization transactions and the securitization markets in general. Given the proliferation of such clauses in recent years, at a minimum, this court’s decision may encourage parties to attempt to renegotiate aspects of certain financial securities markets contracts. Considering other jurisdictions’, and in particular England’s,[12] enforcement of these clauses, this case could provide reluctance for the use of trustees and counterparties in the United States.[13]

[13] Id. at 416–17 (finding that English Courts have interpreted their own bankruptcy statute to uphold validity of flip clauses in swap agreements). The English Court of Appeal had an opportunity to consider the enforceability of a flip clause in the same transaction, but had arrived at the opposite conclusion. See id. at 411 (noting that English Courts, in parallel proceeding of same transaction, found that the payment redistribution under the waterfall did not violate “anti-deprivation principle” under English law, and was therefore enforceable).