US Court Ruling Raises Questions about Swap Priorities in Securitization Transactions
The recent US Bankruptcy Court ruling in Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Ltd. has called into question the enforceability of a common provision used in securitization transactions. The ruling delivered by Judge James Peck on January 25, 2010 held that conditional priority or “flip” provisions, which are designed to subordinate swap termination payments in the event of swap provider bankruptcy, are unenforceable.
The priorities of payments in securitization transactions are usually set out in a provision known as the waterfall clause. Typically, certain payments to swap providers occupy a higher position in the waterfall when the swap provider is not in default than when the swap provider is in default – basically a “flip” provision. The bankruptcy of the swap provider is a default which brings into effect the flip provision and lowers the priority of the swap provider with respect to certain payments. Under the US Bankruptcy Code any contractual provision which purports to create a default or alter the rights of the debtor exclusively because the debtor files for bankruptcy is void (commonly referred to as ipso facto clauses). Judge Peck found that a flip provision was void on this basis.
This ruling conflicts with the English High Court of Justice (Chancery Division) and the English Court of Appeal (Civil Division) which ruled, in parallel proceedings, that a flip provision was enforceable.
The issue has arisen in recent Canadian transactions and while the better view may be that the US decision will not be followed in Canada, the issue has not yet been fully resolved in Canada either legally or from a market practice perspective.
