UK Supreme Court affirms flip clauses in securitisation waterfall

Global securitisation transactions saved from challenge

28 July, 2011: 

On 27^th July 2011, the UK Supreme Court rendered its ruling in Belmont Park Investments PTY Limited v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc [2011] UKSC 38.

This is not just a relief to the way securitization transactions world-over are written but a landmark ruling in global bankruptcy laws. The ruling of the Court of Appeal earlier [(2009) EWCA Civ 1160] gone in the same direction as the SC ruling now, but pointers from the corresponding US litigation [Re Lehman Brothers Holdings Inc, 422 BR 407 (US Bankruptcy Court, SDNY, 2010) had had the impact of questioning what sounds so very intuitive, and was a universal practice not just in securitisation transactions but in innumerable commercial transactions. We had commented on this litigation earlier, see our comment here. The Supreme Court ruling vindicates our stand.

Briefly, this is what the case pertains to. Lehman Bros, in good days, had structured a synthetic CDO transaction where collateral was placed with the trustees. Note that synthetic CDO transactions are typically partly funded, and the proceeds of the issuance of CLNs is invested in highly-rated collateral. The collateral is held by trustees in trust for the protection buyer (in this case, Lehman), but should the protection buyer suffer an event of default or bankruptcy event, the swap is cancelled, and the collateral is then redirected to pay off the investors in priority. This is universally the feature of all synthetic CDO transactions globally. The provision is also colloquially known as flip provision.

The structure was challenged in the UK Court of Appeal ruling, on a classic anti-deprivation rule of bankruptcy laws. The rule is based on the pro-bankrupt stance of bankruptcy laws, that contracts which are onerous for the bankrupt are voidable. That is, if some clause in a contract seeks to deprive a bankrupt from a benefit that he would otherwise get, the clause can be avoided. Obvious enough, the provision for diversion of the collateral from the benefit of Lehman to noteholders could be regarded as depriving the bankrupt of a security interest, and hence, illegal.

The UK Supreme Court held that the anti-deprivation rule is applicable only where a contractual provision is designed to defeat the interest of the bankrupt. Commercial sense and good faith prevail over this rule. In categorical language, the Supreme Court rejected the argument that a clause such as the one in the Lehman synthetic CDO will be questionable on the grounds of bankruptcy laws:  “It would go well beyond the proper province of the judicial function to discard 200 years of authority, and to attempt to re-write the case law in the light of modern statutory developments.”  The ruling holds that party autonomy is the mainstay of English judicial system, though in-roads have been made by statute on several occasions. “And there is a particularly strong case for autonomy in cases of complex financial instruments such as those involved in this appeal”.

The ruling was rendered by a 7-judge Bench.

Note: We continue to watch developments on this interesting topic of litigation. Please stay in touch. For latest news feeds, join our mailing list at www.vinodkothari.com/mailinglist.htm

[Reported by: Vinod Kothari]

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