A series of cases in the US and UK have emerged over the past six months, as Lehman (as swap counterparty) and noteholders both demand priority access to the millions of dollars worth of collateral in these structured deals being held by trustees.
"It's a major headache for the trustees. There is a possibility that they end up between a rock and a hard place – the English court says one thing and the US court says another. That would be an unsatisfactory outcome, as we're talking about the two major financial centres of the world. They need to get on with it and come up with a solution that works," says one London-based lawyer at an international law firm with knowledge of the cases.
On August 11, judge John Peck of the US bankruptcy court of the southern district of New York decided he would rule on a case filed by Lehman involving a series of notes issued under the Dante programme, a multi-issuer secured obligation programme established by Lehman Brothers International Europe in October 2002 worth more than $2 billion. The case focuses on certain contractual provisions – known as flip-clauses – which stipulate that noteholders are senior to the swap counterparty (Lehman's Delaware-incorporated subsidiary Lehman Brothers Special Financing) in the priority-of-payment provisions, meaning they can access collateral held in these deals first. Lehman is seeking to have the clauses ruled unenforceable so that it will have priority in collecting the collateral.
The case will be watched closely by noteholders of structured deals in which Lehman was swap counterparty. The English courts have already ruled in favour of noteholders of the Dante programme – represented by two Australian investment firms, Perpetual Trustee and Belmont Park Investments – upholding the enforceability of these flip-clauses. Lehman had argued that the flip-clause should be invalid as the English bankruptcy code states that any clauses that force a party to forfeit its property as a result of its insolvency are unenforceable. But on July 28, the senior English judge overseeing the case, Andrew Morrit, ruled Lehman's claim on the collateral had always been conditional on its performing under the swap contract, and therefore the flip-clause was enforceable.
However, it is unclear what view the US courts will take on proceedings. In New York, Lehman litigators are striving to prove the flip-clause is unenforceable, arguing it contravenes the US bankruptcy code, which precludes any contract from being terminated or modified as a direct result of the debtor filing for insolvency. They also argue that the flip-clause is not eligible for safe-harbour protection under the bankruptcy code, and therefore should be ruled invalid.
But other US lawyers dispute Lehman's arguments, which are also being employed in a handful of similar US legal disputes over the collateral in structured finance deals. These include Lehman minibonds sold to Asian investors, certain credit-linked notes purchased by insurer American Family Life Assurance Company, and a collateralised debt obligation (CDO) of an asset-backed security (ABS) called Ballyrock ABS CDO 2007-1.
Many litigators argue US bankruptcy law trumps everything, and as such the flip-clauses should be rendered unenforceable, but others disagree. "I think Lehman's wrong on the bankruptcy arguments because these are safe-harboured contracts. They also make these very narrow arguments that say only the right to terminate the swap is safe-harboured and not the right to re-order the priority of payments," says one US litigator at an international law firm with knowledge of the case.
In the English courts, Lehman is set to appeal Morrit's judgement. Lehman litigators have also indicated that, dependent on the results of the appeal and the case in the US, they might seek to invoke certain provisions under model international trade laws drawn up by the United Nations, in particular the Cross-Border Insolvency Regulations 2006, with a view to importing US bankruptcy law into the English courts. Therefore, the US proceedings could yet come to bear on English judgements, although the Chancellor has not expressed a view on whether this would be possible.
"There is no clear precedent for the importing of US bankruptcy law, but a number of people think you might be able to do it. There's a question as to how broad the [UN] regulations are meant to be. Are they meant to import that law or are they just meant to help out?" asks one London-based lawyer at an international law firm with knowledge of the case.
"It would be a remarkable result and I think it would cause huge consternation in the UK, not to mention the far-reaching implications it would have for the financial community here," says another London-based lawyer.