On August 11, 2009, Judge James Peck of the Federal bankruptcy court in New York denied a motion by a unit of The Bank of New York Mellon Corp. (“BNYM”) to dismiss an action by a subsidiary of Lehman Brothers Holdings Inc. relating to the priority of claims in connection with credit-linked notes (“CLNs”) issued by a program known as “Dante”. The Lehman subsidiary had entered into credit default swaps relating to the CLNs and claims that it is owed $70 million in connection with their early termination. The BNYM unit acted as trustee under the Dante program.
The terms of many securitization transactions, including the Dante program, provide for the subordination of early termination payments owed to a swap provider upon that provider’s default, including its bankruptcy. Lehman has challenged this standard provision, arguing that it is contrary to the U.S. Bankruptcy Code (the “Code”) ipso facto (or “anti-deprivation”) provisions. Contract provisions that trigger a termination upon the bankruptcy of a party are known as ipso facto clauses.
The High Court in England last month confirmed the Dante subordination provisions under English law, which governs the terms of the transaction. However, Lehman sought a temporary stay under the English proceedings pending its claim in the U.S. Bankruptcy Court.
The outcome of this case will have implications on securitization transactions if Lehman prevails. Specifically, a determination that the contractual provisions that provide for the subordination of Lehman in the event of its insolvency constitute ipso facto provisions that are not enforceable under the Code would effectively re-write the priorities of payment “waterfalls” in many securitization indentures and/or security agreements. As a result, early termination payments owed to bankrupt swap counterparties in such circumstances would receive priority over other payments, possibly including those to noteholders. Such a decision also could result in rating agencies revisiting ratings on notes, which could result in downgrades. A decision is expected from the bankruptcy court in September.