Overview

On 25 January, 2010, Judge James Peck of the US Bankruptcy Court for the Southern District of New York
Bankruptcy Court (the Bankruptcy Court) introduced more turmoil into the world of structured financial transactions by denying enforcement of a so-called “flip” clause in connection with a swap agreement. Had the clause, found in the collateral documents supporting a structured note program, been enforced, it would have granted payment priority to holders of notes underlying the swap over Lehman Brothers Special Financing Inc. (LBSF), an affiliate of the issuer.

In his decision, Judge Peck found that the provision in question — a relatively common clause in structured deals that changes or “flips” the payment priority of a swap counterparty from first to last upon default by the counterparty — was unenforceable because it violated the ipso facto provisions in Sections 365(e)(1) and 541(c)(1)(B) of the US Bankruptcy Code that prohibit modification of a contract solely as a result of a bankruptcy. Judge Peck offered two alternate rationales for his conclusion that the ipso facto provisions were applicable in this case. First, contrary to the findings of English courts reviewing the same facts, Judge Peck found that the “flip” for reversal of priority purposes did not occur on the date of the first event of default under LBSF’s contract, but instead took effect only when the contract counterparty sent a notice of default and termination, which occurred after LBSF filed for Chapter 11 protection. Second, Judge Peck found that the business affairs of LBSF and its parent, Lehman Brothers Holdings Inc. (LBHI), were so intertwined that the Chapter 11 filing of LBHI was sufficient to give LBSF the protection of the ipso facto provision of the Bankruptcy Code even before LBSF made its own filing. These rationales could have far reaching implications in the Lehman Chapter 11 cases and future bankruptcy cases because they expand the scope of the ipso facto provisions of the Bankruptcy Code in unanticipated ways. The decision has not yet been formally implemented, and it will be subject to appeal, but LBSF has already taken steps to use this decision to improve its position in other cases and negotiations.

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