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Insolvency Deprivation, Public Policy and Priority Flip Clauses

Sarah Worthington, Professor of Law, London School of Economics and Political Science, London, UK

Lawyers are used to preparing for the worst. Contract terms, security arrangements, insurance and guarantees are all designed to arm the well-prepared against disaster. It matters, then, that certain protective provisions may be void on public policy grounds. Perhaps predictably, the Lehman Brothers liquidation has provided a new test case.

In Perpetual Trustee Co Ltd v BNY Corporate Trustee Services Ltd,1 the Court of Appeal was asked to strike down a priority flip clause which switched the priority enjoyed over collateral away from a Lehman Brothers credit default swaps counterparty and in favour of third party noteholders (including Perpetual Trustee Co Ltd) in defined circumstances, to the potential detriment of the now insolvent Lehman Brothers counterparty. The administrators argued that the priority flip clause breached the 'anti-deprivation rule' and was therefore void on the grounds of public policy. The anti-deprivation rule broadly asserts that 'there cannot be a valid contract that a manís property shall remain his until his bankruptcy, and on the happening of that event shall go over to someone else, and be taken away from his creditors.' The Court of Appeal found against the administrators and in favour of the third parties, affirming the judgment of Morritt J, the Chancellor, in the High Court. The case is now likely to go on appeal to the Supreme Court. The issue is important, given the potential application of the same rule to other structured finance and securitisation deals.

The facts and findings in the Perpetual Trustee case

The facts in the Perpetual Trustee case are complicated, but the key elements are as follows. All the transactions (except the purchase of the collateral) were governed by English law. Noteholders such as Perpetual Trustee Co Ltd purchased Notes through a special purpose vehicle ('the Issuer') formed by a Lehman company in a tax friendly jurisdiction. The Issuer used the subscription monies to purchase government bonds or other secure investments ('the collateral') vested in a trust corporation (BNY Corporate Trustee Services Ltd, 'the Trustee'). A credit default swap was entered into by the Issuer and a Lehman company, Lehman Brothers Special Financing Inc ('LBSF', the second defendant). Under the credit default swap LBSF paid to the Issuer the amounts due by the Issuer to the Noteholders in exchange for sums equal to the yield on the collateral. The net excess paid by LBSF under this swap was, effectively, the premium for the notional 'credit insurance' provided by the Noteholders. The amount payable by LBSF to the Issuer on the maturity of the Notes (or on early redemption or termination) was the initial principal amount subscribed by the Noteholders less amounts calculated by reference to defined credit events during a specified period, thereby delivering the effective insurance aspect of the programme. The insurance may have been intended to enhance the credit rating accorded to the Notes; it presumably also generated additional fees for Lehman Brothers.

The focus of litigation was the clause which provided for security over the collateral. The collateral was charged by the Issuer in favour of the Trustee to secure the Issuerís obligations to the Noteholders and LBSF on terms which changed their respective priorities on the occurrence of certain specified events (including the insolvency or default of LBSF, or the insolvency of the ultimate parent of LBSF (i.e. Lehman Bros Holdings Inc ('LBHI')). The relevant clause was in the Supplemental Trust Deed, clause 5.5, in these terms:


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