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The High Court1 in England has confirmed the validity under English law of contractual provisions common in structured finance transactions which subordinate payments to a swap counterparty in circumstances where the swap counterparty has defaulted on its obligations under the terms of the relevant swap agreement.
The case involves the following parties to a multi-issuer synthetic CDO programme, called the Dante Programme: (a) certain noteholders (namely, Perpetual Trustee Company Limited (“Perpetual”) and Belmont Park Investments Pty Ltd & Ors (“Belmont”, and together with Perpetual, the “Noteholders”)), (b) Lehman Brothers Special Financing Inc. (“LBSF”) as swap counterparty, and (c) BNY Corporate Trustee Services Limited (“BoNY”) as trustee.
The relevant facts are:
The issues to be determined by the High Court were whether to grant the stay of proceedings requested by LBSF and, if not, what orders to make in respect of such proceedings.
LBSF argued that the Subordination Provision violates the general rule of pari passu distribution among creditors under English insolvency law and is therefore void under English law. In doing so, LBSF relied on what has been described as the “anti-deprivation principle”:
“there cannot be a valid contract that a man’s property shall remain his until bankruptcy, and on the happening of that event go over to someone else, and be taken from his creditors”2
“a man in not allowed ... to provide for a different distribution of his effects in the event of bankruptcy from that which the law provides. It appears to me that this is a clear attempt to evade the operation of the bankruptcy laws”3
However, the Noteholders contended that the anti-deprivation principle only invalidates a contract which as a result of bankruptcy proceedings seeks to remove an asset from a bankrupt’s estate which was his at the commencement of the bankruptcy proceedings and does not invalidate a contract in which the bankrupt’s interest is limited to cease on its bankruptcy.
The High Court had to consider:
(a) the breadth of the anti-deprivation principle;
(b) whether it applies if there is no insolvency process in relation to LBSF in England; and
(c) whether it applies if the clause operates on an event other than the bankruptcy of LBSF (for example, as a result of a payment default).
The Chancellor reviewed the case law concerning the anti-deprivation principle and concluded, although it is clear that: (a) a contract purporting to exclude the mandatory provisions of the Insolvency Act 1986 is contrary to public policy and therefore void; and (b) there exists an exception to such principle for the grant of an interest in property determinable on the insolvency of the grantee (but not the grantor), that between these two extremes there exists an uncertain area.
However, the Chancellor was able to conclude that the Subordination Provision was not contrary to English public policy and was enforceable. He did so for the following reasons:
Having made such a determination, the Chancellor concluded that the two further issues before the Court (the issues referred to at (b) and (c) above) did not arise although he did give his views on these issues suggesting that the case is likely to go further. In summary:
On the basis that the hearing relating to the indemnities to which BoNY is entitled as a condition to it enforcing the security has been deferred, the Chancellor was of the view that the hearing relating to the application by LBSF for a stay of proceedings should also be deferred. In doing so, the Chancellor has effectively permitted LBSF to pursue any rights of appeal in the English courts and, more importantly, recognised that the application of US bankruptcy law could result in a different conclusion on the enforceability of the Subordination Provision.
This case highlights some of the uncertainties concerning transactions that were not structured with the insolvency of swap providers in mind. The case has stirred interest among market participants as subordination provisions have become a common feature in rated structured finance transactions.4 If these provisions were found to be unenforceable, the ratings of many structured finance transactions would likely be impacted. Until now, the enforceability of such provisions in structured finance transactions has not been tested by the English courts. It is likely that the decision of the High Court will be appealed by LBSF.
1 See Perpetual Trustee Co. Ltd v BNY Corporate Trustee Services Ltd and Lehman Brothers Special Financing Inc.; Belmont Park Investments Pty Ltd & Ors v BNY Corporate Trustee Services Ltd and Lehman Brothers Special Financing Inc.  EWHC 1912 (Ch)