In re Lehman Brothers Holdings, Inc.

Lehman Brothers Special Financing, Inc. (LBSF) (plaintiff), an indirect subsidiary of Lehman Brothers Holdings, Inc. (LBHI), structured, negotiated, and marketed 44 synthetic credit-default obligations (CDOs) with different groups of noteholders (defendants). To effectuate the CDOs, LBSF created special-purpose vehicles (the issuers) (defendants) that sold notes to the noteholders pursuant to indenture agreements. Using the proceeds from each note, the issuers purchased income-generating securities, which in turn served as collateral for the noteholders. The collateral was held by a third-party trustee (defendant). The income from the collateral was used to make interest payments to the noteholders. Additionally, for each CDO, the issuer entered into a swap agreement with LBSF. Pursuant to each swap, LBSF made regularly scheduled payments to the issuers. If certain credit events occurred, the issuer owed LBSF payments under the swap, which would be made from the collateral. Each synthetic CDO therefore contained two main components, the indenture agreement and the swap agreement. The relevant agreements cross-referenced each other. Under the swap agreement, if an event of default occurred, the CDO could be terminated early, and the trustee had the right to liquidate the collateral and distribute the proceeds pursuant to a priority stated in the indenture. In the event of default by LBSF, LBSF’s payments from the collateral were subordinated to the noteholders’ payments. LBHI declared bankruptcy in 2008, constituting an event of default on LBSF’s part under the swap agreement. Consequently, the collateral was liquidated, but the noteholders received priority in payment of the proceeds. After the payments to the noteholders, there was nothing left to pay LBSF, even though its swap agreement held value at the time. In September 2010, LBSF instituted an adversarial proceeding against the noteholders, the trustee, and the issuers, arguing that the prioritization was an unenforceable ipso facto provision in violation of the Bankruptcy Code because it modified the parties’ rights based solely on the institution of bankruptcy proceedings. In response, the noteholders, the trustee, and the issuers moved to dismiss the adversarial action, arguing that the prioritization was allowed under the exemption for ipso facto clauses in swap agreements under § 560 of the Bankruptcy Code. The bankruptcy court granted the motion to dismiss, the district court affirmed the bankruptcy court’s ruling, and LBSF appealed.