Challenges to Swap Agreements by Investment Banks: a Question of Priorities, Contributed by Antony Woodhouse and Verity Barker, Lawrence Graham LLP

Belmont Park Investments PTY Ltd v BNY Corporate Trustee Services Ltd & Anor [2011] UKSC 38

In a recent decision, the UK Supreme Court has unanimously upheld the validity of noteholder priority provisions with an insolvent U.S. swap counter-party in a multi-national transaction. The Court has given helpful guidance on the nature and scope of the “anti-deprivation” principle in another fall out from the Lehman collapse.

The Court’s ruling conflicts directly with a U.S. court’s decision given in the administration of Lehman’s bankrupt estate, and places Bank of New York (“BNY”), the acting trustee in the transaction, in a difficult position. It remains to be seen how the English and U.S. courts will co-operate on the global administration of the Lehman estate, particularly in resolving these issues relating to Lehman’s Dante Collateral Debt Obligation (CDO) programme, which had an overall value in the region of $12.5 billion at the time of Lehman’s bankruptcy.

CDO Programme

The Belmont Australian investor group were noteholders (Noteholders) in a multi-issuer secured obligation programme established by Lehman in October 2002. The Noteholders purchased credit linked synthetic notes from various special purpose vehicles (SPVs) incorporated in tax friendly jurisdictions. The subscription proceeds were used by the issuer to purchase secure investments, (Collateral), which form the subject of this dispute. The Collateral was held by BNY in its role as trustee.

In order to service the interest payments under the notes, the issuer entered into swap agreements with the swap-counterparty, Lehman Brothers Special Financing, Inc. (LBSF). LBSF was a company registered in Delaware and based in New York. Lehman Brothers Holdings, Inc. (LBHI) acted as LBSF’s guarantor under the swap. Each series of notes was a synthetic CDO with its performance linked to the performance of a swap for that series between the SPV and LBSF. The attraction for the Noteholders was that they would receive a higher interest rate under the swap than that received on the Collateral. The transaction documents are governed by English law and the parties submitted to the courts of this jurisdiction.

LBHI applied for Chapter 11 protection on 15 September 2008 and LBSF made a similar filing on 3 October 2008. After 15 September 2008, there were no more periodic payments paid to the Noteholders. On the ordinary maturity of the notes, the swap counter-party (LBSF) would receive payment first. However, on the occurrence of an event of default where the fault lay on the part of LBSF, such as the insolvency of LBSF (and arguably LBHI), there was a reversal of priorities so that the Noteholders would be entitled to priority of payment on a close-out. In practice, there would only be sufficient Collateral to pay whichever party was first in line in terms of priority, after which the Collateral would be exhausted.

The Proceeedings

In May and June 2009, Perpetual Trustee Company Limited (Perpetual) a holder of various credit linked synthetic portfolio notes, together with the Noteholders, issued proceedings under the Civil Procedure Rules, Part 8, in the High Court seeking a declaration as to the validity of the priority provisions, known as “flip clauses,” under English law, and asking for orders for realisation of the Collateral and application of the Noteholders’ priority. LBSF applied to intervene in that litigation on the basis that the flip clauses violated the ipso facto provisions of 11 U.S.C. §365(e)(1) and 11 U.S.C. §541(c)(1)(B) of the U.S. Bankruptcy Code and were unenforceable. It also argued that any attempt to distribute the Collateral was in breach of the automatic stay under that statute. The noteholder priority was upheld by Sir Andrew Morritt CVO1 and the Court of Appeal,2 and subsequently appealed by LBSF to the Supreme Court.

Anti-deprivation Principle

The anti-deprivation principle is founded on some 200 years of case law establishing the public policy that a party should not enter into an agreement that, in the event of its own bankruptcy, would deprive the creditors of the benefit of property which the insolvency legislation requires to be available to meet those creditors’ claims. The principle applies equally to corporate entities and individuals, and is important to ensure that full effect is given to the policy inherent in the insolvency legislation. The House of Lords last examined this issue in its landmark decision in British Eagle International Airlines Ltd v Cie Nationale Air France.3

Whilst recognising that it was not easy to identify the precise nature or limits of the anti-deprivation principle, the Supreme Court gave guidance on its nature and scope, which also has wider connotations for the securitisation and derivatives markets. Lord Collins delivered the leading judgment in which he identified four characteristics of the anti-deprivation principle.

First, the rule would apply only if there was a deliberate intention to evade insolvency laws. That does not mean that a subjective intention would be required, but it did suggest that in borderline cases a commercially sensible transaction entered into in good faith should not be held to infringe the anti-deprivation rule. Lord Collins stated at paragraph 101 of the judgment:

The policy behind the anti-deprivation rule is clear, that the parties cannot, on bankruptcy, deprive the bankrupt of property which would otherwise be available for creditors. It is possible to give that policy a common sense application which prevents its application to bona fide commercial transactions which do not have as their predominant purpose, or one of their main purposes, the deprivation of the property of one of the parties on bankruptcy.4

The second characteristic was that, contrary to the pari passu principle, the anti-deprivation rule did not apply if the deprivation resulted from an event other than insolvency.

The Court further considered the “flawed asset” analysis which had been given prominence in the Belmont judgments in the High Court and the Court of Appeal. This argument considered the extent to which LBSF’s interest in the Collateral was an interest determinable on bankruptcy (the so called “flawed asset”) or an absolute interest which is made defeasible on bankruptcy by a condition subsequent. Lord Collins noted that if it were sufficient to show that it was an inherent feature of an asset from the inception of its grant that it can be taken away from the grantee, this would “empty the basic rule of any substantive content.”5

Lastly, Lord Collins examined the importance of the source of the assets. In the Court of Appeal, Lord Neuberger’s conclusion had relied to a large extent on the fact that the Collateral was acquired with monies provided by the Noteholders, and that the change in priorities was included to ensure that they were repaid out of these assets. Although not determinative, Lord Collins suggested that the source of the assets may be an important and sometimes decisive factor in concluding that the transaction was a commercial one entered into in good faith and outside the scope of the anti-deprivation principle.

In conclusion, Lord Collins upheld the parties’ freedom to contract and cautioned that the courts should be slow to interfere in complex commercial transactions:

Despite statutory inroads, party autonomy is at the heart of English commercial law. Plainly there are limits to party autonomy in the field with which this appeal is concerned, not least because the interests of third party creditors will be involved. But, as Lord Neuberger stressed [in the Court of Appeal], it is desirable that, so far as possible, the courts give effect to contractual terms which parties have agreed. And there is a particularly strong case for autonomy in cases of complex financial instruments such as those involved in this appeal.6

Impact of the Decision

This decision is a welcome boost to one of the core principles of English insolvency law, but it clashes directly with the U.S. Bankruptcy Court’s decision of Judge Peck7 made in parallel U.S. proceedings commenced by Lehman. As the potential clash of jurisdictions had been clear since the start of both proceedings, the English and U.S. courts have been mindful of issues of comity.

In awarding summary judgment in Lehman’s favour, Peck J examined the same provisions which, at that time, had been upheld by the Court of Appeal. Peck J found that the priority clauses contravened the ipso facto provisions under the U.S. Bankruptcy Code, which prevent any termination or modification of contractual rights or obligations as the result of the onset of bankruptcy.

The U.S. decision considered in detail the effect of the voluntary filing for bankruptcy of LBHI prior to that of LBSF and whether, as BNY contended on the Noteholders’ behalf, the event of default triggered under the documentation had removed the right to swap counter-party priority from LBSF’s estate before it filed for bankruptcy. In a somewhat surprising decision to English eyes, Peck J found that the U.S. Bankruptcy Court should not place over reliance on which specific Lehman entity had filed for bankruptcy first and that the actions of the credit support provider and corporate could be imputed to the subsidiary “at a time of extraordinary panic in the global markets.”8 Unfortunately, the U.S. proceedings settled before there was any appeal or other resolution of the conflict in these two decisions.

Those seeking to rely on English law priority provisions, where a swap counter-party is subject to U.S. jurisdiction, will therefore still be unsure as to whether they are entitled to enforce their rights, despite the clear decision of the UK Supreme Court on the validity of those provisions under English law. Much emphasis has been put by the Noteholders on the fact that they should be entitled to rely on the terms on which they bargained and the jurisdiction in which they elected. To date, the Noteholders have not been party to any U.S. proceedings and the Collateral is held by a London registered branch of BNY.

The decision in Rubin v Eurofinance9 is also instructive. In this case, the English Court of Appeal found in principle that judgments made in New York in adversary proceedings following bankruptcy could be applied against a company not subject to U.S. jurisdiction and which had operated under a trust governed by English law. Although that case (and other similar current cases) may yet be appealed to the UK Supreme Court, it demonstrates the potential for problems as a result of the cross border enforcement of conflicting awards.

(c) 2011 Lawrence Graham LLP

Antony Woodhouse is a partner within Lawrence Graham LLP’s dispute resolution practice. Telephone +44 (0) 20 7759 6987; E-mail antony.woodhouse@lg-legal.com.

Verity Barker is an associate within Lawrence Graham LLP’s dispute resolution practice and has significant experience in contentious banking and financial services matters. Telephone +44 (0) 20 7759 6781; E-mail verity.barker@lg-legal.com.

Lawrence Graham acted for the Noteholders in the Belmont appeals.