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Lehman, Synthetic CDOs, Sapphires, etc.

posted by Stephen Lubben

The Lehman bankruptcy court is out with a new decision that has the financial community somewhat miffed, since it removes one more piece of their mistaken belief that they don't have to understand or deal with the Bankruptcy Code. The decision will also lead to some interesting discussions with members of the English bench, who reached a contrary decision with regard to the same issue and parties. I'm extending an open invitation to all the judges to join me for coffee and bagels at my apartment on the UES to sort things out.

I've represented the transaction in question, which involved the issuance of synthetic CDOs, in this simplified diagram. The key thing to understand is that under the terms of the deal, which contains an Slide2 English choice of law clause, the priority rights to the collateral switch if there is a Lehman default under the CDS contract. And Lehman Brothers Holding's chapter 11 filing in September 2008 constituted a default, since Holdings was a "credit support provider" under the terms of the CDS contract. The CDS buyer, LBSF, also filed a chapter 11 case of its own in October 2008, resulting in another default.

The other thing to understand is that there are reportedly about 1,000 similar Lehman transactions waiting in the wings.

The US bankruptcy court held that the collateral priority switch was an unenforceable ipso facto (bankruptcy termination) clause, and that the derivative "safe harbor" provisions in the Code did not apply.

The UK Court of Appeal, affirming a decision of the High Court of Justice, reached the exact opposite conclusion, holding that the deal did not violate the "anti-deprivation rule," which is essentially their rule against ipso facto clauses, based on a case from 1818.

(How we ended up with the pseudo Latin, when their rule is from 1818 and ours is from 1978, I don't know.)

My thoughts on the bankruptcy court decision, and the conflict with the prior decision from the UK, after the jump.

To my mind, the central part of the bankruptcy court's opinion comes at page 16, where the court begins to discuss the debtor's (LBSF) estate. Noting that the priority "flip" was not automatic, but rather turned on several administrative steps not completed in the time between Holding's chapter 11 filing and the LBSF petition date, the court held that the debtor had not yet lost its rights in the collateral upon bankruptcy.  And for those readers who are thinking that the answer is to automate the collateral flip in the next deal, the court also notes that neither §365(e)(1) nor §541(c)(1)(B) -- the Code provisions invalidating bankruptcy terminations clauses -- require that a clause be triggered by the debtor's bankruptcy.  Rather a clause triggered by any bankruptcy filing would seem to be invalidated by these provisions -- of course, the party seeking to invoke either statutory provision would have to find themselves in bankruptcy at some point to assert such an argument.

However, there is one obvious transactional lesson from the opinion. Namely, the court refused to apply the safe harbors, particularly §560, to the agreements in question because the collateral documents, including the priority flipping provision, were not even referenced in the CDS documentation. That is, the collateral agreements were not protected contracts. This suggests the need for a more "bespoke" CDS contract in future CDO deals, although that response supports the notion that the safe harbors are overbroad and in need of repeal.

What of the conflict between the High Court, the Court of Appeal and the New York bankruptcy court? The Court of Appeal's decision seems to place a lot of weight on the notion that the priority flip provision was somehow different from typical bankruptcy termination clauses, because it had been in place since inception of the deal, and thus Lehman's rights in the collateral were always contingent. The lead opinion also ascribes some import to the notion that it was the noteholder's funds that purchased the collateral in the first instance.

The first argument seems rather slippery, and would, if adopted in the U.S., convert the rule against bankruptcy termination clauses into a rule against subsequent acquisition of a bankruptcy termination clause -- which largely duplicates the work of the rules against preferences and fraudulent transfers. The collective nature of an insolvency proceeding would seem to argue against such a wide-open grant of contractual autonomy.

The second argument, based on the source of funds for the collateral, in some sense cuts the other way. That is, it gives special rights to a purchase money provider, even if they failed to exercise the special rights that such providers are already provided under debtor-creditor law (at least under US state laws like UCC article 9).

The courts also disagree on the significance of the gap between Holdings' chapter 11 filing and LBSF filing. Apparently the English courts have tended toward ease of administration in their anti-deprivation rule, eschewing the American court's notion that a contract might be incompletely terminated before bankruptcy. Under the English approach, it appears that a contract is either terminated before bankruptcy or it's not -- there is no middle.

Fundamentally, the problem is that contract law is state law, while bankruptcy in the United States is federal and thus subject to the Supremacy Clause of the Constitution. An important thing to think about whenever one uses an English  choice of law clause in a deal where a default is likely to result in a U.S. chapter 11 case. In this case, the choice of law clause served to override New York contract law, but it did nothing to trump federal bankruptcy law, which rather routinely rides over contractual provisions.

Leaving the English courts to wonder why they even bothered, I suppose.


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While the actual outcome may well be correct as a matter of English domestic law, the reasoning of the English Court of Appeal is highly questionable and in some respects plainly mistaken - see Look Chan Ho, 'The principle against divestiture and the pari passu fallacy' (2010) 25:1 Butterworths Journal of International Banking and Financial Law 3, available at http://ssrn.com/abstract=1541203.

Judge Peck talked about harmonizing the US and UK decisions. It seems to me that harmony is properly achieved if the English court grants relief by applying US bankruptcy law pursuant to the UK enactment of the UNCITRAL Model Law on Cross-Border Insolvency; see Look Chan Ho, 'Applying foreign law under the UNCITRAL Model Law on Cross-Border Insolvency' (2009) 24:11 Butterworths Journal of International Banking and Financial Law 655, available at http://ssrn.com/abstract=1530880.

Hey guys. Great post. Interested to see what the outcome will be.

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