Second Circuit Does Not Flip Flop on Enforceability of Flip Clauses

September 29, 2020Herrick Restructuring Review

The Herrick Restructuring Review provides insights and information related to restructuring and finance litigation. The Herrick team regularly represents official and ad hoc creditor committees, hedge funds, distressed debt investors, bondholders, and other parties in interest, and often serve as conflicts or special counsel for large-scale complex litigation matters.

On August 11, 2020, the Second Circuit addressed the long-standing question of whether flip clauses are enforceable in bankruptcy. Affirming a Southern District of New York decision, the Court found in Lehman Brothers Special Financing Inc. v. Bank of America N.A. that flip clauses are protected under the safe harbor and therefore enforceable in bankruptcy.[1] Investors should take comfort that this decision puts the final nail in the coffin of the earlier controversial decisions in the Lehman Brothers chapter 11 proceedings that had ruled such provisions unenforceable.


Prior to filing for bankruptcy, Lehman Brothers sold hundreds of millions of dollars of notes in synthetic collateralized debt obligation transactions (“CDOs” and each, a “CDO Transaction”). In these CDO Transactions, a Lehman Brothers subsidiary (“LBSF”) used a special purpose vehicle (the “Issuer”) to sell notes to investors pursuant to an indenture. The Issuer used proceeds to acquire highly rated securities, which served as collateral for the notes.

The Issuer then sold LBSF a credit default swap, under which LBSF made payments to the Issuer. Lehman Brothers Holdings, Inc. (“LBHI”) guaranteed LBSF’s obligations under the swap. Under certain provisions in the transaction documents (the “Priority Provisions”), LBSF enjoyed payment priority over the noteholders in certain cases. But if LBSF defaulted, its right to payment was subordinated to full payment of the noteholder claims. LBHI’s 2008 bankruptcy filing constituted an event of default under the indenture and the credit default swap. The provision under which the noteholders obtained the right to liquidate the collateral if LBSF defaulted is known as a “flip clause.”

Prior Flip Clause Litigation

In prior Bankruptcy Court decisions in the Lehman Brothers case, Bankruptcy Judge James Peck had found flip clauses unenforceable and found that the trustee’s right to liquidate the collateral was not protected by the safe harbor of section 560 of the Bankruptcy Code.[2] In the first case, where Bank of New York Mellon was the indenture trustee, Judge Peck ruled that although LBHI filed for chapter 11 on September 15, 2008, and LBSF filed for chapter 11 on October 3, 2008, he treated both cases as a “singular event” and ruled that the automatic stay applied with respect to LBSF as of the date of LBHI’s filing. He also held that the flip clause was an ipso facto clause and unenforceable under section 365(e)(1) of the Bankruptcy Code. Judge Peck’s rulings were considered controversial when the case was decided. BNYwas appealed, but the parties settled before the appeal was determined, so the BNYprecedent remained in place. Judge Peck reached a substantially similar decision in the next flip clause case, Lehman Bros. Special Financing, Inc. v. Ballyrock (In re Lehman Bros. Holdings Inc.), 452 B.R. 31 (Bankr. S.D.N.Y. 2011).

In September 2010, LBSF sought to invalidate another flip clause in a case where Bank of America was the indenture trustee, based on a flip clause that was substantially identical to the one in BNY. In the Bank of America litigation, LBSF sought to recover approximately $1 billion that had been distributed to the noteholders after Bank of America had liquidated the collateral. But by the time that the Bank of America case was litigated, Judge Peck had retired and Bankruptcy Judge Shelley Chapman had replaced him as the judge in the Lehman Brothers bankruptcy.

The Bank of America litigation was stayed by various other rulings in the Lehman case, so Judge Chapman’s decision was not issued until 2016. In the Bank of America litigation, the defendants filed a motion to dismiss, which Judge Chapman granted.[3] In distinguishing BNY and Ballyrock, Judge Chapman found that since those cases had been decided, the Second Circuit had repeatedly held that the safe harbor provisions of the Bankruptcy Code require a “broad and literal interpretation,” rather than the more narrow interpretation of those provisions contained in BNY and Ballyrock. LBSF appealed to the District Court, which affirmed, agreeing with the Bankruptcy Court that the Priority Provisions were enforceable under the “safe harbor” codified at section 560 of the Bankruptcy Code.[4] LBSF appealed to the Second Circuit, which affirmed Judge Chapman’s decision.[5]

Second Circuit’s Opinion

Before the Second Circuit, LBSF contended that the Priority Provisions are unenforceable ipso facto clauses. The Second Circuit disagreed, affirming the District Court’s decision and adopting the District Court’s reasoning.

While the Bankruptcy Code generally prohibits enforcement of ipso factoclauses, section 560 of the Code carves out an exception for swap agreements, stating that the exercise of a contractual right of a swap participant “to cause the liquidation, termination, or acceleration of one or more swap agreements” or to offset or net out any termination values or payment amounts arising in connection with the “termination, liquidation, or acceleration of one or more swap agreements” will not be “stayed, avoided, or otherwise limited” by any other provision in the Code. In other words, this safe harbor explicitly permits swap participants to terminate an executory contract solely because of the commencement of a bankruptcy case.

Citing legislative history, the Second Circuit noted that section 560 was enacted in 1990 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. The Second Circuit also noted that, in 2005, Congress amended section 560, broadening the definition of “swap agreement” to include virtually all derivatives.

The Second Circuit held that, even if the Priority Provisions were ipso facto clauses, their enforcement was nevertheless permissible under the section 560 safe harbor. The decision was based on three factors: (1) Definition of “Swap Agreements”; (2) Definition of the Right to “cause the liquidation . . . of one or more swap agreements”; and (3) Definition of “Swap Participant.”

  1. Definition of “Swap Agreements”

LBSF contended that the Priority Provisions, which were laid out in the indenture agreements (not the master agreement), were not part of the swap agreement and, therefore, were not protected under the section 560 safe harbor. The Second Circuit disagreed, finding that the master agreement incorporated the Priority Provisions by reference and, therefore, the Priority Provisions were also swap agreements under section 560.

  1. Definition of the right to “cause the liquidation . . . of one or more swap agreements”

As noted above, section 560 affords safe harbor when a swap participant exercises its contractual right to cause the liquidation, termination, or acceleration of a swap agreement. The parties disputed the meaning of the term “liquidation” as used in section 560. The Bankruptcy Code does not define the term “liquidation.”

According to Black’s Law Dictionary, to “liquidate” means “[t]o settle (an obligation) by payment or other adjustment” or “[t]o ascertain the precise amount of (debt, damages, etc.).” Bearing in mind the context in which the language was used, the Second Circuit concluded that the term “liquidation” includes the disbursement of proceeds from the liquidated collateral. The Court noted that, by affording swap agreements special treatment, section 560 “shields swap participants from some of the risks associated with a counterparty’s bankruptcy and enables them to unwind the transactions” and that reading section 560’s reference to liquidation of a swap agreement to include distribution of the collateral furthered the statutory purpose of protecting swap participants from the risks of a counterparty’s bankruptcy filing.

  1. Definition of “Swap Participant”

Finally, LBSF contended that the trustees who terminated the swaps and distributed the proceeds of the collateral were not “swap participants.” As a result, according to LBSF, the trustees’ actions fell outside the ambit of section 560’s safe harbor, which specifically protects certain contractual rights of “swap participant[s]” only.

The Second Circuit disagreed with LBSF and instead agreed with the District Court, which pointed out that section 560 requires the exercise of a contractual right “of” any swap participant, not “by” one. Accordingly, the fact that the trustees liquidated the swap does not place the transaction outside the ambit of the safe harbor.


The Second Circuit’s decision provides much-needed comfort to investors by affirming their right to act on bargained-for flip clauses and confirming that the Bankruptcy Code aims to protect swap participants from the risks of a counterparty’s bankruptcy filing. This decision is especially comforting given the history of prior inconsistent decisions. Thus, the Second Circuit’s ruling brings clarity to an issue that, until now, had conflicting precedent in New York courts.

[1] Case 18-1079 (August 11, 2020).

[2] Lehman Bros. Special Fin. Inc. v. BNY Corp. Trustee Servs. Ltd., 422 B.R. 407 (Bankr. S.D.N.Y. 2010) (JMP) (“BNY”).

[3] 553 B.R. 476 (Bankr. S.D.N.Y. 2016).

[4] 2018 WL 1322225 (S.D.N.Y. Mar. 14, 2018).

[5] 970 F.3d 91 (2d Cir. 2020).

For more information on this alert or other restructuring & finance litigation matters please contact:

Stephen B. Selbst at +1 212 592 1405 or [email protected]

© 2020 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.