Bankruptcy Judge Invalidates Securitization Payment Structure
A federal bankruptcy court judge in New York ruled earlier this week that long-held assumptions about payments owed to a counterparty in securitization deals cannot be enforced under US Bankruptcy Code, in a decision set to upend the securitization market. The decision was handed down by Judge James Peck, the judge overseeing the Lehman Brothers bankruptcy proceedings, who said that certain contractual provisions in a Lehman collateralized default obligation (CDO) are unenforceable under Chapter 11. The CDO, called Dante, was also hedged by a credit default swap (CDS) provided by Lehman Brothers Special Financing (LBSF). Lehman Brothers Holding Inc. (LBHI) provided credit support to LBSF before both units filed bankruptcy in fall 2008. After Lehman went bankrupt, trustees for the bondholders initially laid claim to the Dante obligations. When they did not receive compensation under the agreements of the CDO, they took Lehman to court. Peck dismissed the trustees' claim under ipso facto clauses, and by doing so, threw off previously accepted principles of securitization. "From a credit perspective, [the] ruling has important implications because it contravenes what have been longstanding market assumptions as to the enforceability of the documents as agreed to by the parties at the beginning of the transaction, and more specifically, the priority of payment provisions," according to commentary on the ruling from credit rating agency Moody's Investors Service. Structured finance transactions often contain swaps - interest rate swaps, basis swaps, foreign exchange swaps, total return swaps and credit default swaps (CDS). Moody's said the presence of this derivative contract can sometimes introduce additional risk of counter-party default. At the time of default, a counterparty could fail to meet its obligations to the issuer and/or be owed a swap termination payment if it is "in the money" at the default event. In the case of Dante, the bankruptcy triggered early redemption of notes and required distribution of collateral proceeds that secured the notes. The United Kingdom law governing the program documentation provides that payments to the swap counter-party precede payment to noteholders. A default by the counterparty due to bankruptcy would require that payments be made to the swap counterparty only after noteholders are paid in full. Peck decided these subordination provisions constitute "ipso facto" clauses -- those that seek to modify the relationship of contracting parties due to bankruptcy filing -- that are void under bankruptcy law. The ruling contradicts previous decisions on the same case within United Kingdom courts. Additionally, Moody's said the ruling may bear "profound" and far-reaching implications for structured finance transactions. "[The ruling] challenges long-held assumptions relating to the subordination of swap termination payments to a swap counterparty following a swap counterparty bankruptcy," Moody's said in an e-mailed statement, adding that determining the impact on individual securities will require case-specific analysis. Write to Diana Golobay.