Document Type

Research Memorandum

Publication Date




Credit default swap agreements (“swaps”) are contracts between two entities in which the counterparties are effectively taking opposing positions on the credit worthiness of a debt instrument that acts as the collateral underlying the swap. For example, counterparty A makes payments to counterparty B in the hopes that the debtor defaults or a counterparty commits an event of default specified in the agreement, such as filing for bankruptcy. Swaps are generally executory contracts and thus may generally be rejected by a trustee or a debtor in bankruptcy pursuant to section 365 of the United States Bankruptcy Code (“the Code”). However, pursuant to section 365 of the Code, a trustee may not reject an executory contract solely because of a provision in the agreement conditioned on a party filing for bankruptcy (“Anti-Ipso Facto Provision”). Swaps are also subject to section 560 of the Code (the “Safe Harbor Provision”), one of the Code’s safe harbor provisions. Section 560 allows a swap participant to “cause the liquidation, termination, or acceleration” of a swap agreement even if a counterparty files for bankruptcy. The consequences of an event of default vary by agreement; penalty payments or a change in the payment priorities of the defaulting counterparty (“flip clause”) are common. A flip clause is a provision which changes the party’s payment priority for the proceeds from the liquidation of the collateral underlying the swap. Whether a flip clause is covered by the Safe Harbor Provision is the subject of this memo.

There are three cases involving the Lehman Bros. bankruptcy that are of particular importance to this issue. In the immediate fallout from the 2008 financial crisis, and the collapse of the swap market, Judge Andrew J. Peck decided two cases related to the early termination of swap agreements as a result of Lehman’s bankruptcy. Judge Peck found the penalty payments were covered by the Safe Harbor Provision but the flip clauses were not because a change in payment priority created different rights than those the defaulting party held before the bankruptcy filing. Judge Peck retired in 2014 and in 2016 Judge Shelley C. Chapman decided another case from the Lehman Bros bankruptcy. Judge Chapman applied a plain reading of the Safe Harbor Provision to hold flip clauses were covered as a part of the “liquidation, termination, or acceleration of the agreement.”

This memorandum addresses the issue of whether the safe harbor provisions set forth in the Code cover flip clauses triggered by the early termination of a swap agreement. Part I addresses Judge Peck’s narrow reading of the Safe Harbor Provision in the aftermath of the financial crisis. Part II notes cases that addressed safe harbor provisions in between Judge Peck and Judge Chapman’s rulings. Part III discusses Judge Chapman’s plain reading of the Safe Harbor Provision. Part IV summarizes the case that dealt with another of the Code’s safe harbor provisions.


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