Second Circuit Affirms Enforceability of Swaps’ Flip Provisions

August 13, 2020

Swaps, together with repurchase agreements, forward contracts, securities contracts and commodities contracts receive special treatment under the bankruptcy code-they are largely exempt from the automatic stay, bankruptcy termination clauses, i.e. ipso facto clauses contained in them are enforceable and transfers made pursuant to them are unavoidable as preferences or constructive fraudulent transfers. But the application of these statutory provisions to actual transactions continues to spur litigation.

Flip Provisions

A provision on which the lower courts in the S.D.N.Y. were split upon is known as the flip provision. Flip provisions are included in synthetic transactions where the swap is part of a secured notes offering. In the CDO transaction that was before the Second Circuit, the issuer issued secured notes under an indenture. The proceeds of the note offering were used to purchase certain securities pledged as collateral to the trustee for the benefit of the noteholders. The issuer in turn entered into a credit default swap with Lehman Brothers Special Financing Inc. (“LBSF”), which was guaranteed by Lehman Brothers Holdings, Inc. The indenture for the notes includes a priority of payments waterfall, pursuant to which LBSF’s priority is lowered below that of the noteholders upon certain events, including LBSF’s bankruptcy. The payment to the noteholders is made out of proceeds obtained from liquidation of the collateral, which the indenture trustee may liquidate upon a default under the swap, including the bankruptcy of LBSF.

After LBSF filed for bankruptcy, the indenture trustee terminated the swap, liquidated the collateral and made payments to the noteholders. In the bankruptcy case, LBSF filed an action to recover over $1 billion in payments made to the noteholders arguing, among other things, that the flip provision was not protected by special protections granted to swap agreement and was a merely an unenforceable ipso facto clause. 

In two prior Lehman cases, Judge Peck (retired) held flip provisions to be unenforceable ipso facto clauses.1 In the case that found its way to the Second Circuit, however, Judge Chapman found the provision enforceable and the district court affirmed.2  

Flip Provisions Are Enforceable in the Second Circuit 

First, LBSF argued that the waterfall provision was included in the indenture, not the swap, and therefore it cannot enjoy the protections afforded in the bankruptcy code to swap agreements. The Second Circuit rejected this contention since the schedule to the swap incorporated the relevant provisions of the indenture by providing that all payments shall be recoverable from the collateral “subject in any case to the Priority of Payments set out in the Indenture.”  Since the priority of payment provision is incorporated into the swap by reference, the Second Circuit held it was part of the swap and entitled to the protections afforded to swaps.

Next, LBSF argued that the application of the priority of payments provision and the distribution of the proceeds to the noteholders are not protected under section 560, which applies to liquidation, termination and acceleration of swaps. That is because, according to LBSF, liquidation only means the fixing of the debt or the amount due. Relying on the context and purpose of section 560, the Second Circuit held that “the term ‘liquidation,’ as used in section 560, must include the disbursement of proceeds from the liquidated collateral.”

Finally, LBSF argued that the protections were not available because the indenture trustee that exercised the rights under the swap was not a “swap participant” as defined in the bankruptcy code; rather the issuer was the party to the swap with LBSF. The Second Circuit rejected this argument as well since under the indenture the issuer granted to the trustee all of its rights under the swap. Section 560, reasoned the Second Circuit, allows for the exercise of a right of a swap participant, but does not require that the right be exercised by the swap participant. 


The Second Circuit is the first Circuit court to speak to the enforceability of flip provisions in bankruptcy and on the interpretation of synthetic CDO transactions. While not binding outside the Circuit, it is reasonable to expect that it will be influential outside the Circuit, and of course binding in many of the largest cases that are filed in the S.D.N.Y.

View the case: Lehman Brothers Special Financing Inc. v. Branch Banking and Trust Company, No. 18-1079 (2d Cir. August 11, 2020)


1.) Lehman Bros. Special Fin,, Inc. v. BNY Corporate Trustee, 422 B.R. 407, 420-22 (Bankr. S.D.N.Y. 2010); Lehman Bros. Holdings, Inc. v. Ballyrock ABS CDO 2007-1 Ltd, 452 B.R. 31 (Bankr. S.D.N.Y. 2011).
2.) Lehman Bros. Special Fin., Inc. v. Bank of America NA, 553 B.R. 476 (Bankr. S.D.N.Y 2016), aff’d 2018 WL 1322225 (S.D.N.Y. March 14, 2018).

Subscribe to Dechert Updates