Finance Update — March 2014: has the US flipped on the enforceability of liquidation protocols in swaps?

By Brian Cain

Despite earlier cases concluding so-called flip clauses were ineffective under the US Bankruptcy Code rules on ipso facto provisions, a US court has now recognised as effective the liquidation protocol contained in an ISDA governed interest rate swap. This may provide parties with a method of ensuring certainty where US-based counterparties are involved in finance transactions that include swap agreements.

Lehman had entered into 20 interest rate swap agreements with the Michigan State Housing Development Authority. When Lehman entered bankruptcy proceedings in the US, this constituted an event entitling Michigan State Housing Development Authority to close out the swap, which it duly did in accordance with the liquidation protocol of the swap agreement. It duly paid the amount it calculated under the protocol to the relevant Lehman party.

Lehman argued that the protocol for liquidating the swap and in particular the procedures for calculating the amounts due to it did not fall within the safe harbour provisions of section 560 of the US Bankruptcy Code, which stated terms aimed at the liquidation, termination or acceleration of swap agreements were exempt from the ipso facto rules. An ipso facto provision under US law is a provision in an executory contract that permits that agreement’s termination due to the bankruptcy, insolvency or financial condition of a party. Such terms cannot be enforced unless they fall within one of the ‘safe harbours’ specified in the code, some of which relate to qualifying financial agreements, which include swap agreements…

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