Lehman Bros: 250 Defendants Dismissed from $1B Lawsuit

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By Daniel Gill

July 1 — A New York bankruptcy court dismissed nearly all 250 defendants, and 19 out of some 25 counts, from a complaint brought by Lehman Brothers Special Financing Inc. against nominal defendant Bank of America N.A. and a vast array of other financial sector defendants ( Lehman Bros. Special Fin. Inc. v. Bank of Am. N.A. (In re Lehman Bros. Special Fin. Inc.), 2016 BL 206966, Bankr. S.D.N.Y., No. 10-03547 (SCC), 6/28/16 ).

Judge Shelley C. Chapman of the U.S. Bankruptcy Court for the Southern District of New York on June 28 granted an omnibus motion to dismiss the lawsuit. The judge concluded that clauses in a variety of complex debt instruments providing that Lehman Brothers’ bankruptcy would be an event of default of those agreements were not made unenforceable by the Bankruptcy Code.

The court also found that any distributions of funds that occurred after the bankruptcy case was filed were protected by “safe harbor” provisions in the Code.

The court ruled that Chapter 11 debtor Lehman Brothers Special Financing Inc. (LBSF), a subsidiary of Lehman Brothers Holdings Inc. (LBHI), failed to state claims for which relief could be granted against the 250 defendants.

Judge Chapman reached a different result from her colleague Judge James M. Peck, who examined similar questions years earlier in another suit brought in the same bankruptcy case.

Swaps and Credit Protection

In an adversary proceeding (lawsuit) filed in September, 2010, LBSF sought to recover about $1 billion in funds that were transferred to a host of holders of secured notes or trust certificates and default swap agreements (swaps) which were entered in conjunction with the other instruments. These instruments were secured by certain liquid investments which were held by a trustee or “similar financial agent.”

The rights of the parties under these swaps and related agreements would depend on various factors considered at the time of a default, defined by the instruments. One of these events of default was the filing of a bankruptcy case by LBSF or, importantly, by LBHI, because “LBHI was a guarantor of LBSF's payment obligations under the Swaps and served as credit support provider to LBSF,” the court said.

On Sept. 15, 2008, LBHI famously filed its Chapter 11 petition, commencing what the court said is “considered one of the most complex, multi-faceted, and largest business bankruptcies in history.” LBSF filed its own bankruptcy petition 18 days later, on October 3, 2008.

After LBHI filed for Chapter 11, the court explained, the other (i.e., non-Lehman Brothers) parties delivered Termination Notices based on the bankruptcy-caused defaults, and accelerated the amount due on the notes. The trustees then monetized the collateral they were holding and distributed the money therefrom according to priorities established in the various instruments for each transaction.

The amount of money realized from liquidating the collateral “was insufficient to make any payment to LBSF under the Waterfall” (i.e, the cash distribution scheme) after payments were made on the note holder priority.

Ipso Facto Clause Enforceable?

LBSF filed suit with the court to recover the approximately $1 billion distributed to the other parties under a number of legal theories, including avoiding preferential and fraudulent, or constructively fraudulent, transfers (11 U.S.C. §§547, 548 and 549). But at the heart of the debtor's claims was its argument that the bankruptcy-triggered event of default was an unenforceable “ ipso facto” clause under the Bankruptcy Code.

LBSF alleged that the priority provisions in the instruments were unenforceable, because they were triggered solely because of the voluntary bankruptcy filings. The debtor alleged that these provisions were unenforceable “ipso facto clauses” pursuant to Bankruptcy Code Sections 365(e)(1), 541(c)(1)(B) and 363(l). These code sections provide that a contract provision that modifies a debtor's rights solely because the debtor is in bankruptcy is unenforceable as against public policy favoring access to the debt relief available in bankruptcy.

According to the debtor, the provisions were unenforceable, and therefore there was no valid event of default; thus any early termination of the agreement or distribution of collateral based thereon was improper.

The defendants, on the other hand, argued in their omnibus motion to dismiss that the provisions were not unenforceable, and if they were, they were protected by application of 11 U.S.C. §560, a safe harbor provision specifically addressing rights “to liquidate, terminate, or accelerate a swap agreement.”

Split Authority — In the Same Case

Among other factors the court considered in its analysis, it examined earlier rulings by another judge also in LBSF's bankruptcy case, but in a different adversary proceeding brought against other defendants. In Lehman Bros. Speical Fin. Inc. v. BNY Corp. Trustee Servs. Ltd (In re Lehman Bros. Holdings Inc.) , 422 B.R. 407 (Bankr. S.D.N.Y. 2010), Judge Peck examined the same issue and determined that similar priority provisions were unenforceable ipso facto clauses.

In BNY, Judge Peck held that LBSF “was entitled to claim the protections of section 365 as of the LBHI Petition Date,” the court said. In other words, Judge Peck decided that under those circumstances the bankruptcy case of another debtor — the parent — was sufficient to trigger the ipso facto protections in the subsidiary’s bankruptcy.

Judge Chapman concluded she was not bound by that decision, which she said was dicta, in this adversary proceeding, and she “decline[d] to adopt the ‘singular event’ theory and holds that any modification of LBSF’s rights that occurred prior to the LBSF Petition Date cannot be the basis of a violation of the anti-ipso facto provisions.”

“Critical to Judge Peck's holding that the priority provisions at issue in BNY were unenforceable ipso facto clauses,” Judge Chapman said, “was his conclusion that there was a modification of LBSF's rights . . . that occurred after the LBSF Petition Date.” The facts were different in the instant case, according to the judge's conclusion.

In this case, while some of the disputed transactions occurred after LBSF filed its bankruptcy case, many occurred before LBSF's filing, but were based on the trigger of the parent/guarantor LBHI's bankruptcy filing 18 days earlier. The debtor argued that Judge Peck's opinion supported a reading that LBHI's bankruptcy was a “singular event,” triggered by a bankruptcy filing, such that the default provisions should be unenforceable.

But the court declined to follow this “singular event” theory and instead ruled that the bankruptcy case filed by another entity did not “run afoul” of the anti- ipso facto bankruptcy sections, “because such modification [to the debtor's contractual rights] occurred and was fully effective prior to the LBSF Petition Date.”

There were three types of transactions at issue, according to the court. The majority of the transactions were what the court called “Pre-Pre Transactions”: these were the swaps which were terminated before LBSF filed bankruptcy, and for which the collateral was liquidated and distributed before LBSF's bankruptcy.

The court called the second group “Pre-Post Transactions.” These related to the swaps which were terminated prior to LBSF's petition date, but for which the collateral was liquidated and distributed subsequent to the filing. The court treated these first two groups the same.

The court found that these transfers did not involve an ipso facto modification of the debtor's rights because those rights were fixed as of the instruments' early termination, which occurred prior to the filing of the relevant bankruptcy case, that of LBSF.

Statutory Safe Harbor

The last group, which the court treated differently from the first two, involved what the court called the “Post-Post Transactions,” wherein the swaps were terminated and the collateral liquidated after LBSF's bankruptcy commenced.

Because the debtor's rights vis-á-vis these instruments were modified by the filing of the bankruptcy, the court found that there was an ipso facto modification of the debtor's rights. However, the court found that the anti- ipso facto Code provisions did not come to the debtor's aid, because “the safe harbor of section 560 nonetheless protects the Distributions in these Transactions from clawback.”

The language of Bankruptcy Code Section 560 is “plain and controlling on its face” and should be interpreted broadly, the court said. That section carves out from the Code's anti- ipso facto statutes the “exercise of any contractual right of any swap participant or financial participant to cause the liquidation, termination, or acceleration of one or more swap agreements.”

To contact the reporter on this story: Daniel Gill in Washington at dgill@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com

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