In re Lehman Bros. Holdings Inc. Raises Questions About Application of Safe Harbors to Complex Financial Products

This Emerging Issues Analysis analyzes a case that narrowed the protections that the Bankruptcy Code was thought to provide to participants in the derivatives markets. The court ruled that "flip" provisions of swap documents triggered by a Lehman Brothers bankruptcy are unenforceable and that actions to enforce the swap documents violate bankruptcy's automatic stay, notwithstanding the Bankruptcy Code's "safe harbors" for swap agreements.

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In a decision issued on January 25, 2010, the U.S. Bankruptcy Court for the Southern District of New York substantially narrowed the protections that the Bankruptcy Code was thought to provide to participants in the derivatives markets. Lehman Bros. Special Fin. Inc. v. BNY Corporate Tr. Servs. (In re Lehman Bros. Holdings Inc.), 422 B.R. 407 (Bankr. S.D.N.Y. 2010). Specifically, the bankruptcy court granted summary judgment in favor of Lehman Brothers Special Financing Inc. ("LBSF") and against the Trustee (the "Trustee") with respect to a series of notes, ruling that "flip" provisions of swap documents triggered by a Lehman Brothers bankruptcy are unenforceable and that actions to enforce the swap documents violate bankruptcy's automatic stay, notwithstanding the "safe harbors" for swap agreements contained in the Bankruptcy Code. The decision has several important implications for the financial community.

The Underlying Structure: Swaps and Flips

This case involves two series of credit-linked synthetic portfolio notes (the "Notes") issued by Saphir Finance Public Limited Company ("Saphir")-a special-purpose entity created by Lehman Brothers International (Europe)-in connection with a multi-issuer secured obligation program. Each series of Notes was governed by a supplemental trust deed (a "Supplemental Trust Deed") which referenced a credit default swap agreement (a "Swap Agreement") linked to that series. Each Swap Agreement was evidenced by a written confirmation and related ISDA Master Agreement, schedules, and annexes entered into between Saphir, as the issuer of the Notes, and LBSF, as the swap counterparty.

The Notes were secured by collateral held by the Trustee in trust for the benefit of the creditors of Saphir. Saphir's creditors included Perpetual Trustee Company Limited, as the holder of the Notes (the "Noteholder"), and LBSF, as the swap counterparty. Under the Supplemental Trust Deed, the rights of LBSF to the collateral would normally take priority over those of the Noteholder. The documents provided, however, that in the event of default by LBSF under the Swap Agreement, the order of priority "flipped," so that the Noteholder would be entitled to priority over amounts otherwise payable to LBSF. In addition, as is often the case in derivatives contracts, the Swap Agreement provided that a bankruptcy filing by either LBSF or its parent, Lehman Brothers Holdings Inc. ("LBHI"), would be an event of default and therefore a trigger for the "flip" provision. [footnote omitted]

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