Client Alert-U.S. Court of Appeals for the Second Circuit Issues Decision Interpreting the Bankruptcy Code’s Section 560 Safe Harbor for Swap Agreements

Aug 24, 2020
  • FisherBroyles News

On August 11, 2020, the United States Court of Appeals for the Second Circuit issued an Opinion in Lehman Brothers Special Financing Inc. (“LBSF”) v. Bank of America, N.A., et. al, No. 18-1079,[1] an adversary proceeding brought in the Chapter 11 bankruptcy proceeding of Lehman Brothers Holdings, Inc. (“LBHI”), considered the largest bankruptcy case in U.S. history.  LBSF appealed a decision of the bankruptcy court, affirmed on appeal by the district court, granting the defendants’ motion to dismiss.  The bankruptcy court held that, in the context of synthetic collateralized debt obligations (“CDOs”) entered into by LBSF and related swap agreements, certain “Priority Provisions” that subordinated LBSF’s payment priority to claims of the noteholder defendants were enforceable by virtue of the “safe harbor” provided in section 560 of the Bankruptcy Code (the “Code”).  Section 560 exempts “swap agreements” from the Code’s prohibition in section 365(e)(1) of the Code of “ipso facto clauses”–clauses that terminate or modify contractual rights or obligations when a party seeks relief in bankruptcy.  The Second Circuit in its Opinion affirmed the judgment of the district court upholding the bankruptcy court’s decision.


In each of the synthetic CDO transactions involved in the case, LBSF (and its affiliates) established a special purpose vehicle (the “Issuer”) through which it marketed and sold notes (the “Notes”) pursuant to an indenture. The proceeds of the Note offering were used to purchase certain highly-rated securities pledged as collateral to the indenture trustee for the benefit of holders of the Notes (the “Noteholders”). The  income generated by the collateral was used by the Issuer to make scheduled interest payments to the Noteholders. The Issuer, in turn, entered into a swap agreement with LBSF under an ISDA Master Agreement and other related contracts, including the Schedule and Confirmation.   Under the terms of the swap agreement, the Issuer agreed to sell LBSF a credit default swap—credit protection against the potential default of certain “reference entities” or “reference obligations”—that was guaranteed by LBHI. In exchange for this credit protection, LBSF made regular payments to the Issuer that were passed on to the Noteholders as a supplement to the interest payments. The swap agreement provided that if the reference entities experienced certain “credit events,” the Issuer could owe LBSF payment from the collateral, but if the transaction reached its scheduled maturity without a credit event occurring, then the Noteholders would be repaid the principal amount of their investment from the collateral.  The indenture trustees—a third party entity—held the collateral in trust for the benefit of the secured parties—primarily LBSF and the Noteholders.[2]

The indenture for the Notes included “Priority Provisions” or so-called “flip clauses.”  Under the Priority Provisions, LBSF enjoyed payment priority over the Noteholders in certain circumstances. But in other circumstances—including in the case of LBSF’s default—priority was “flipped,” and LBSF’s payment was subordinated to that of the Noteholders.  Specifically, LBSF’s priority was lowered below that of the Noteholders upon certain LBSF events of default occurring, including LBHI’s bankruptcy.  The swap agreement cross-referenced the Priority Provisions in the indenture.  Payment to the Noteholders was to be made out of proceeds obtained from liquidation of the collateral, which the indenture trustee could liquidate upon a default under the swap, including the bankruptcy of LBHI.[3]

After LBHI filed for bankruptcy, which constituted an event of default by LBSF under the ISDA Master Agreement, the indenture trustee terminated the swap, liquidated the collateral and made payments to the Noteholders pursuant to the Priority Provisions. When the early terminations occurred, LBSF was “in the money”—that is, its swap position had value—but because it was the defaulting party, the Noteholders received payment priority over LBSF. The proceeds from the collateral were insufficient to make any payment to LBSF after they were drawn from to pay the Noteholders.  LBSF’s drop in priority pursuant to the Priority Provisions underlay the dispute between LBSF and the defendant Noteholders. Specifically, at issue was the enforceability in bankruptcy of the Priority Provisions that subordinated LBSF’s payment priority upon its default.  LBSF filed an adversary proceeding in the LBHI bankruptcy case to recover over $1 billion in payments made to the Noteholders arguing, among other things, that the Priority Provisions were not protected by the special protections granted to swap agreements under section 560 and were merely unenforceable ipso facto clauses.  The bankruptcy court rejected that argument and its decision was affirmed by the district court on the basis that the Priority Provisions were enforceable under the safe harbor for swap agreements in section 560.[4]

Second Circuit’s Decision

As discussed in the Second Circuit’s Opinion, section 560 exempts swap agreements from the Code’s prohibition of ipso facto clauses by protecting a swap participant’s contractual right to terminate, liquidate, or accelerate a transaction upon a counterparty’s bankruptcy:

The exercise of any contractual right of any swap participant or financial participant to cause the liquidation, termination, or acceleration of one or more swap agreements because of a condition of the kind specified in section 365(e)(1) of this title [which prohibits ipso facto clauses] or to offset or net out any termination values or payment amounts arising under or in connection with the termination, liquidation, or acceleration of one or more swap agreements shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title.[5]

By its terms, the court noted that the section 560 safe harbor permits swap participants to modify or terminate an executory contract solely because of the commencement of a bankruptcy case.  Originally enacted in 1990,[6] the legislative history of section 560 indicates that it was meant to protect the stability of swap markets and to ensure that swap markets are “not destabilized by uncertainties regarding the treatment of their financial instruments under the Bankruptcy Code.”[7]  Subsequent amendments to the Code in 2005 expanded the definition of “swap agreement” and amended section 560 to clarify that it protects a swap participant’s contractual right to liquidate and accelerate a swap agreement—in addition to its right to terminate the swap.[8]

On appeal, LBSF argued that the Priority Provisions were included in the indenture and not the swap.  Therefore, the Noteholders could not be afforded the protections afforded under section 560 for “swap agreements.” The Second Circuit rejected this argument, finding that the schedule to the swap incorporated the relevant provisions of the indenture by providing that all payments shall be recoverable from the collateral “subject in any case to the Priority of Payments set out in the Indenture.”[9] The court noted that the Code’s definition of the term “swap agreement” includes “any agreement, including the terms and conditions incorporated by reference in such agreement, which is” a swap.[10]  Because the Priority Provisions were incorporated into the swap by reference, the court held they were part of the swap and entitled to the protection in  section 560.[11]

LBSF further argued that the application of the Priority Provisions and the distribution of the proceeds to the Noteholders were not protected by section 560 because that section applies to the “liquidation, termination and acceleration” of swaps. LBSF contended that “liquidation” only means the fixing of the debt or the amount due. Relying on the context and purpose of section 560, as well as its legislative history, the Second Circuit held that “the term ‘liquidation,’ as used in section 560, must include the disbursement of proceeds from the liquidated collateral.”[12]  In that regard, the court noted that reading section 560’s reference to “liquidation” of a swap agreement to include distribution of the collateral “furthers the statutory purpose of protecting swap participants from the risks of a counterparty’s bankruptcy filing by permitting parties to quickly unwind the swap.”[13]  By contrast, the court concluded that LBSF’s reading of “liquidation,” would render hollow the non-defaulting counterparty’s rights under the safe harbor: simply calculating amounts due would provide no security to swap participants if they were unable to collect.[14]

LBSF also argued that the protections were not available because the indenture trustee that exercised the rights under the swap was not a “swap participant” as defined in the Code.  Rather, only the Issuer was the party to the swap with LBSF and thus could be considered a “swap participant.”  The Second Circuit rejected this argument as well because under the indenture the Issuer granted to the indenture trustee all of its rights under the swap.  The court held that section 560 allows for the exercise of a right of a swap participant, but does not require that the right be exercised by the swap participant.[15]


The Second Circuit’s decision is significant in that it is the first court of appeals decision to address the enforceability in bankruptcy of flip provisions such as the Priority Provisions involved in the case and the interpretation of synthetic CDO transactions.  The court’s decision departs from two prior Lehman bankruptcy cases, in which Judge Peck, a distinguished retired bankruptcy judge, held flip provisions to be unenforceable ipso facto clauses.[16]  In that regard, Judge Peck concluded that “a mandated elimination of a substantive right to receive funds that existed prior to the bankruptcy of [Lehman Brothers Holdings Inc.] should not be entitled to any protection under safe harbor provisions that, by their express terms, are limited exclusively to preserving the right to liquidate, terminate and accelerate a qualifying financial contract.”[17] The Second Circuit in its opinion expressly disagreed with that statement, noting that “the term ‘liquidation’, as used in section 560, is in our view broad enough to include the subordination of LBSF’s payment priority and distribution according to the amended waterfall of payment priorities.”[18]


For additional information, please contact Julian Hammar at [email protected] or Hollace Cohen at [email protected]


[1] Hereinafter, the “Opinion,” which is available here.

[2] See Opinion at 7-8.

[3] See Opinion at 8-9.

[4] See Opinion at 9, 12.

[5] 11 U.S.C. §560.

[6] See Act of June 25, 1990, Pub. L. No. 101-311, §106(a),104 Stat. 267 (1990).

[7] See H.R. Rep. No. 101-484, at 1 (1990), as reprinted in 1990 U.S.C.C.A.N. 223, 223.

[8] See Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, 119 Stat. 23 (2005) (amending Code sections 101(53B) (definition of the term “swap agreement”) and 560).

[9]  Opinion at 17.

[10] 11 U.S.C. § 101(53B)(A)(i) (emphasis added).

[11] See Opinion at 17.

[12] Opinion at 18.

[13] Opinion at 20-21.

[14] See Opinion at 21.

[15] See Opinion at 25.  The Second Circuit also rejected LBSF’s state-law causes of action because they required “LBSF to allege plausibly that it was entitled to the payments, and therefore rose and fell with the disposition of the bankruptcy-law claims.”

[16] Lehman Bros. Special Fin., Inc. v. BNY Corporate Trustee, 422 B.R. 407, 420-22 (Bankr. S.D.N.Y. 2010); Lehman Bros. Holdings, Inc. v. Ballyrock ABS CDO 2007-1 Ltd, 452 B.R. 31 (Bankr. S.D.N.Y. 2011).

[17] Ballyrock, 452 B.R. at 40.

[18] Opinion at 24 n.11.

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