UK Chancery Court temporarily defends attack by Lehman’s counsels

Vinod Kothari


We have always contended that the concept of bankruptcy remoteness is a product of good times, and has not been tested in bad times such as these.

The latest in the series of shocks to bankruptcy remote vehicles is the contention of the counsels for Lehman before the UK Chancery Court in Perpetual Trustee Co. Ltd  v. BNY Corporate Trustee Services Ltd [2009] EWHC 1912 (Ch).

Transaction structure

The case pertains to a multi-issuer synthetic CDO program called Dante Program. The structure is the familiar synthetic CDO structure, wherein several Irish SPVs, in this case, Saphir Finance Public Limited Company, Zircon Finance Ltd and Beryl Finance Ltd, would issue notes to the investors and raise funding. The funding would be in government bonds or other secured investments (Collateral). The SPVs would enter into a swap (perhaps a credit default swap, or total rate of return swap) under which Lehman Brothers Special Financing (LBSF) would make periodic payments to the issuing SPV, which, in turn, would pay the coupon to investors in the notes.  The Collateral would be charged, first, in favour of LBSF as the swap counterparty, and thereafter, in favour of the investors of various classes in descending order of priority. The collateral trustee in the present case is BNY Corporate Trustee Services, and Perpetual and Belmont (Note Trustees) were the trustee for the noteholders based out of Australia, New Zealand and Papua New Guinea.

As Lehman filed for bankruptcy, the payments under the swap were not made. Hence, the swap payments were defaulted post 15th Sept 2008. Pursuant to this, the Note Trustees filed a claim against the Trustee, for realization of the collateral, as an event of default under the swap agreement had taken place. The terms of issue provided that the noteholders would have a priority over the swap counterparty, if an event of default on the part of the swap counterparty had occurred.

Contentions of LBSF counsel

LBSF denied the claim of the noteholders, taking shelter under sections 362(a)(3), 365(e)(1) and 541(c)(1)(B) of the US Bankruptcy Code. They also contended that the action of the Note Trustees be stayed until resolution of the matter by the Bankruptcy Court in the Southern District of New York (SDNY) where Lehman’s bankruptcy proceedings are going on. Section 362 of the US Bankruptcy Court provides for automatic stay on proceedings against the property of an entity after a bankruptcy petition has been filed. The section marks a significant difference between US and UK insolvency laws – the latter do not have a provision for automatic stay against creditors or security interest holders. Section 365 allows a bankruptcy trustee to disown onerous clauses in contracts of the bankrupt.

In essence, the Note Trustee pleaded that as an event of default had occurred, the interest of the noteholders overtook priority over that of LBSF, while on behalf of LBSF, it was pleaded that LBSF could take shelter under benevolent provisions of the US Bankruptcy code and prevent the subordination of LBSF.

LBSF has filed a motion in the SDNY Bankruptcy court which was due to come for hearing on 5thAugust 2009. Text of the motion is available here.

Contracting out of bankruptcy law?

The arguments in this case tread over a very significant topic in bankruptcy laws – is it possible for contractual clauses to override bankruptcy laws? In other words, can parties contract out of bankruptcy laws? For instance, bankruptcy laws provide for a particular manner of priority in distribution of the estate of a bankrupt. Could parties have provided by contract for a different order? The most logical answer would have been no, because if that was the case, bankruptcy laws would lose their meaning. But then bankruptcy proofing that structured finance transactions seek to attain, is actually, in a manner of speaking, contracting out of  bankruptcy laws.

Counsel for LBSF pleaded that a clause in the swap documents was void under English law. The clause (Clause 5.5 of the Supplemental Trust Deed) provided that the Collateral would be held by the trustee with first priority to the swap counterparty, unless the swap counterparty had committed an event of default.  Note that this clause is most usual clause in any synthetic CDO issuance, and is most logical and easily understandable. The CDO issuing SPV has obligations on account of the protection it sells to the swap counterparty, and obligation to pay interest and principal to the noteholders. The idea of holding the collateral with the SPV is that any protection sold by an SPV has no meaning unless it is backed by assets – therefore, the SPV backs the protection it sells to the swap counterparty with the collateral. The collateral will continue to enure  for the benefit of the swap counterparty, but if the swap counterparty has defaulted under the terms of the swap, the swap gets cancelled, and the collateral flows back to the investors. If this was not the case, the investors have no support of the collateral at all, and the investors have taken the risk of bankruptcy of the swap counterparty, whereas the very idea of interposing an SPV between the swap counterparty and the investors is that the investors remain immune from the bankruptcy risk of the swap counterparty.

In essence, what the counsels for LBSF were pleading was both against concept of bankruptcy remoteness and against common intuition. The counsels relied upon a ruling in Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd [2002] 1 WLR 1150. wherein a UK court had held that if a clause in a contract provides for deprivation of the property of someone upon bankruptcy, such a clause is invalid. In that case, the court had held: “There cannot be a valid contract that a man's property shall remain his until bankruptcy, and on the happening of that event go over to someone else, and be taken from his creditors.”

The ruling, for most part, has dwelt upon the breadth of the above principle in Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd. The counsel for the Note Trustees contended that if this principle was to be applied widely, it would frustrate myriad contracts in the commercial world, many of which contain re-alignment of priorities in the event of default of a party to the contract.

LBSF counsel relied upon an old English ruling in Ex parte Mackay (1873) LR 8 Ch App 643, wherein it had been held that “in my opinion a man is not allowed … to provide for a different distribution of his effects in the event of bankruptcy from that which the law provides. It appears to me that this is a clear attempt to evade the operation of the bankruptcy laws”.

LBSF counsel also cited from other English rulings. For instance,  Ex parte Jay (1880) 14 Ch D 19, holding as follows: “"a simple stipulation that, upon a man's becoming bankrupt, that which was his property up to the date of the bankruptcy should go over to someone else and be taken away from his creditors, is void as being a violation of the policy of the bankrupt law.”

The Chancery court, however, dismissed the arguments. The Chancellor held:

“In my view clause 5.5 of the Supplemental Trust Deeds is not contrary to public policy on the grounds relied on or at all. I reach that conclusion for a number of reasons. First it is necessary to consider the structure of the transaction as a whole, not the terms of clause 5.5 of the Supplemental Trust Deed in isolation. The security conferred by that clause is in respect of the collateral. The collateral was bought by the issuer with the money subscribed by the investors for the notes. In no sense was it derived directly or indirectly from Lehman BSF as the swap counterparty. Second, on general principles the court should not be astute to interpret commercial transactions so as to invalidate them, particularly when, as counsel for Belmont suggested, consequential doubt might be cast on other long-standing commercial arrangements. Third, the involvement of Lehman BSF is the consequence of the swap agreement under which it sought and obtained, in effect, credit insurance in respect of the Reference Entities. As long as that agreement was being performed it was appropriate for Lehman BSF to have security for the obligations of the issuer as the other party to the swap agreement in priority to security in respect of the issuer's obligations to the noteholders under the trust deeds and the terms and conditions of the notes. It is plain that the intention of all parties was that the priority afforded to Lehman BSF was conditional on Lehman BSF continuing to perform the swap agreement. Fourth, so regarded, the priority of Lehman BSF never extended to a time after the event of default in respect of which it was the defaulting party had occurred. Fifth, it follows that such beneficial interest by way of security as Lehman BSF had in the collateral was, as to its priority, always limited and conditional. As such it never could have passed to a liquidator or trustee in bankruptcy free from those limitations and conditions as to its priority”.

The reasons cited by the judge are most significant and appreciable. The collateral was sitting in the transaction to provide asset backing to both the investors and the swap counterparty. The swap counterparty was provided seniority during the performance of the payments by the swap counterparty. But obviously, the swap counterparty cannot contend that even if fails to make the swap payments, it must still continue to enjoy the collateral. The shifting of priorities is critical to the very nature of the transaction, which is to provide protection against bankruptcy of the swap counterparty. If the swap counterparty still has superior rights over the collateral despite  bankruptcy, there is no bankruptcy remoteness at all. What the counsels for LBSF were claiming would, if approved by the courts, terminate the whole concept of bankruptcy remoteness.

The present case was adjourned, in view of the pending proceedings in SDNY bankruptcy court. This was done in pursuance of the protocol under UNCITRAL’s model law on cross border insolvency.

Subsequent to the ruling of the Chancery court, the counsels for LBSF have applied to the US bankruptcy court to appoint LBSF as representative of the bankrupt’s estate and to seek the assistance of a foreign court in protecting the property of the bankruptcy.

It would be interesting to watch out for further developments in the case as this case would be one out of many where, post-credit-crisis, the concept of bankruptcy remoteness will face the tough test that it has been escaping all this while.

Important links:

See the Ruling of the Chancery court, Dated August 7, 2009

To know more about Special Purpose Vehicles see our page on SPVs here.