Lehman Bankruptcy Court Interprets Safe Harbor Protections

The following post comes to us from James L. Bromley, partner and a leader of the global restructuring and insolvency practice at Cleary Gottlieb Steen & Hamilton LLP, and is based on a Cleary Gottlieb alert memorandum.

On April 19, 2012, the United States Bankruptcy Court for the Southern District of New York granted in part a motion to dismiss claims asserted by Lehman Brothers Holdings Inc. (together with its debtor-affiliates, “Lehman”) against JPMorgan Chase Bank, N.A (“JPMorgan”). [1] The claims at issue arose from JPMorgan’s efforts in the months leading up to Lehman’s bankruptcy to mitigate its exposure as Lehman’s primary clearing bank by requiring Lehman to post a significant amount of additional collateral and expand the scope of the obligations secured by that collateral. Lehman and its creditors’ committee challenged these transactions under the avoidance provisions of the Bankruptcy Code and asserted other causes of action, including common law claims for unjust enrichment and invalidation of the contractual amendments that improved JPMorgan’s position.

The decision applies the safe harbor protections of Section 546(e) to dismiss Lehman’s preference and constructive fraud claims. However, the court rejected JPMorgan’s efforts to apply Section 546(e) more broadly, allowing Lehman’s parallel common law claims to proceed even where they are based on similar allegations. The decision also applies a relaxed pleading standard to Lehman’s claims for actual fraud, under which it found that Lehman had adequately alleged facts to state a claim under Section 548(a)(1)(A). The decision thus provides support for a literal application of the safe harbor protections to dismiss certain claims at the pleading stage. However, the decision also suggests that even where a transaction falls within the scope of Section 546(e), artful pleading may permit plaintiffs to survive a motion to dismiss. The decision thus underscores the importance of considering potential litigation risks and costs when analyzing transactions with distressed counterparties.

Background [2]

Before Lehman sought bankruptcy protection in September 2008, JPMorgan served as Lehman’s clearing bank and as the agent for its tri-party repurchase agreements (“Repos”). In this role, JPMorgan cleared securities trades for Lehman’s broker-dealer subsidiary (Lehman Brothers Inc., “LBI”) and its customers. JPMorgan also extended intraday credit to Lehman to satisfy its payments to Repo counterparties, secured by a lien on the accounts of LBI that were maintained at JPMorgan.

In August 2008, Lehman agreed to enter into a series of agreements with JPMorgan that altered this relationship (collectively, the “August Guarantee”). These agreements added Lehman Brothers Holdings Inc. (“LBHI”) and several other subsidiaries as additional parties, each of whom would be severally obligated to JPMorgan. Pursuant to the August Guarantee, LBHI posted collateral with JPMorgan to secure obligations under the clearing agreement, and granted JPMorgan a lien on certain accounts that LBHI held at JPMorgan (in addition to the accounts already pledged by LBI). LBHI also issued a guarantee covering all liabilities owed to JPMorgan under the clearing agreement.

As concerns over its financial condition mounted, Lehman executed an additional series of agreements with JPMorgan in September 2008, just days before its bankruptcy filing (the “September Guarantee”, and together with the August Guarantee, the “Guarantee Agreements”). This September Guarantee covered not only JPMorgan’s exposure under the clearing agreement, but all exposure that JPMorgan had to LBHI and any of LBHI’s subsidiaries, including liabilities relating to derivative transactions. These agreements also expanded the universe of accounts constituting collateral to include all of the accounts of LBHI and all of its subsidiaries at JPMorgan.

Pursuant to the Guarantee Agreements, LBHI posted significant amounts of cash and securities to JPMorgan as collateral, and JPMorgan continued to provide clearing and Repo services to Lehman. After Lehman and its creditors’ committee obtained discovery from JPMorgan under Federal Rule of Bankruptcy Procedure 2004 (“Rule 2004”), Lehman commenced an adversary proceeding against JPMorgan, seeking to avoid the transfers made and obligations incurred pursuant to the Guarantee Agreements. Lehman’s complaint also asserted alternative causes of action both under the Bankruptcy Code and state law. While the parties agreed to begin discovery, JPMorgan nonetheless sought to dismiss Lehman’s complaint in its entirety. [3]

The Bankruptcy Court’s Decision

A. Literal Reading of Safe Harbor Protections

The court applied a literal reading to the requirements of Section 546(e) of the Bankruptcy Code, which exempts from avoidance “transfer[s]” by or to a “financial institution” or “financial participant” that are made “in connection with” a class of defined “securities contract[s].” The court found that transfers made to JPMorgan in connection with its securities clearing agreement satisfied each of these definitions.

First, the decision found that JPMorgan “quite obviously” qualified as a “financial participant,” because it is a party to outstanding safe harbor contracts totaling at least $1 billion in gross notional or principal dollar amount, as well as a “financial institution,” because it is a chartered national banking association. Second, the decision held that “securities contracts” are broadly defined, encompassing “virtually any contract for the purchase or sale of securities, any extension of credit for the clearance or settlement of securities transactions, and a wide array of related contracts, including security agreements and guarantee agreements.” Similarly, the decision found that the grant of a lien or perfection of a security interest constitutes a “transfer” for purposes of the Bankruptcy Code and thus, all of the transfers of cash and securities, as well as liens and security interests granted in connection with the Guarantee Agreements, fell within the safe harbor protections of Section 546(e).

The court thus rejected Lehman’s argument that certain collateral transfers were not made “in connection with” a securities contract because there was allegedly no exposure under JPMorgan’s clearing contracts at the time of those transfers. Specifically, the decision clarified that the “in connection with” requirement of Section 546(e) does not include any temporal requirement that would require the transfer to relate to then-outstanding amounts owed. The court noted that “such a focus is not well-suited to analyzing liabilities under complex financial relationships with exposures that change materially and rapidly with movements of the markets.” Instead, the safe harbors applied simply because the transfers related to – and thus were made “in connection with” – JPMorgan’s safe-harbored securities clearing agreement.

B. “Obligations” Are Not “Transfers” for the Purposes of the Safe Harbor Protections

The Lehman debtors also sought to avoid “obligations” incurred under the Guarantee Agreements, as opposed to the transfers themselves. This argument was based on the absence of any express reference in Section 546(e) to “obligations”. Lehman argued that this absence was of particular import where the Bankruptcy Code’s avoidance powers extend to both transfers and the incurrence of obligations.

The court agreed that the incurrence of “obligations” is not protected from avoidance under Section 546(e). Specifically, the decision focuses on the statutory definition of “transfer”, which refers to all modes of “disposing or parting” with property. The court held that even such a broad definition of transfer did not encompass the incurrence of “obligations” – a term that the Bankruptcy Code does not otherwise define.

On the particular facts of the Guarantee Agreements, the court found that this was a distinction without a difference. Specifically, even if Lehman were to succeed in avoiding the obligations incurred under the Guarantee Agreements, the transfers made under those agreements would remain immune under Section 546(e). Because there were no unsatisfied obligations that JPMorgan sought to enforce, the court explained that any challenge to “obligations” led only “to a dead end for purposes of obtaining a recovery.” However, the decision leaves open the possibility that an unsecured obligation in respect of which no transfer was made – such as an unsecured guarantee – could be subject to avoidance even if it was otherwise granted in favor of a qualified institution in connection with a safe harbored transaction.

C. Claims for Actual Fraud Survive Under Relaxed Pleading Standards

The decision also evaluated Lehman’s claims for actual fraudulent conveyance – which fall outside the scope of Section 546(e)’s safe harbors – under a relaxed pleading standard. Traditionally, Rule 9(b) of the Federal Rules of Civil Procedure requires that plaintiffs plead the circumstances of claims that sound in fraud with particularity. Some bankruptcy courts, however, have relaxed that standard, where a trustee may lack access to evidence necessary for its pleading. Under such a relaxed pleading standard, allegations of circumstantial badges of fraud can suffice. JPMorgan argued that a relaxed pleading standard should not apply after the Supreme Court’s decision in Ashcroft v. Iqbal, 556 U.S. 662 (2009), or to a debtor-in-possession such as Lehman.

The court disagreed. First, the court held that while Iqbal toughened the pleading standards under Rule 8 for claims that do not sound in fraud, it did not speak to the sufficiency of circumstantial badges of fraud under Rule 9(b). Second, the decision found that the Lehman estate had suffered an enormous loss of personnel and thus faced the same disadvantage as a bankruptcy trustee, particularly given the complexity of the challenged transactions. Finally, the court found Lehman’s access to pre-complaint discovery under Rule 2004 insufficient to require application of ordinary pleading standards.

D. The Safe Harbors Do Not Preclude Alternative Causes of Action or Challenges to JPMorgan’s Setoff Rights

Beyond its avoidance claims, Lehman also brought a variety of alternative causes of action based on similar facts that sought parallel relief, such as claims for unjust enrichment or to declare the September Guarantee unenforceable for lack of consideration. JPMorgan had moved to dismiss each of these claims, arguing that such claims were preempted by federal bankruptcy law, had not been pled with particularity, or failed to state a claim. In particular, JPMorgan focused on certain of Lehman’s common law claims that shared material characteristics of the constructive fraudulent conveyance claims that are subject to the Bankruptcy Code’s safe harbor protections.

The decision permits each of these claims to proceed to discovery, finding that the literal language of Section 546(e) does not bar all claims that a debtor might bring in challenging a pre-petition transaction. As the court explained,

Th[e] expansive approach to identifying other workable theories of recovery is not impacted by the safe harbors. The safe harbors are not all encompassing and do not offer ‘fail safe’ protection against every cognizable claim made in relation to transactions that may fit within the statutory framework. The safe harbors necessarily do not extend to the open waters of litigation and are not an impenetrable barrier to other claims against a market participant that has behaved in a manner that may expose the actor to potential liability. In sum, these important protections do not grant complete immunity from every conceivable claim made by Plaintiffs. Indeed, how could they?

Notably, the surviving counts include claims brought under Sections 553 and 542 of the Bankruptcy Code that challenge JPMorgan’s exercise of its contractual rights to set off against collateral posted pursuant to the Guarantee Agreements. Lehman asserted that JPMorgan intentionally procured additional collateral from Lehman in the weeks leading up to its bankruptcy in order to create a right of setoff that would put JPMorgan ahead of other creditors. While JPMorgan argued that the Bankruptcy Code’s safe harbors protected that right of setoff, the decision held that JPMorgan’s ability to set off depends on the as yet undetermined validity of the September Guarantee. If the September Guarantee is ultimately determined to be unenforceable, the safe harbors would not protect JPMorgan’s setoff.

Key Lessons

As the court itself noted, the decision provides important lessons for lenders and counterparties considering amendments or credit enhancements to mitigate the risk of continuing to transact with distressed counterparties:

  • Even where Section 546(e)’s safe harbors apply to a transaction, creative plaintiffs may be able to challenge the transaction by pleading alternative causes of action beyond preferences and constructive fraud. This underscores the importance of considering potential litigation costs and risks when seeking to limit exposure to companies in financial distress.
  • Unsecured obligations (such as a guarantee) from a distressed counterparty may be subject to avoidance (and disallowance of related claims) even in connection with a transaction that would otherwise be protected by Section 546(e). As such, there can be no assurance that such guarantees will be immune from challenge, or enable incremental recoveries in the event of a bankruptcy.
  • Even if the safe harbor protections are appropriately applied, courts may permit allegations of actual fraud to proceed to discovery notwithstanding plaintiffs’ inability to satisfy the traditional heightened pleading requirements of Rule 9(b). The decision demonstrates that this remains the case even where a debtor avails itself of discovery under Rule 2004.


[1] Lehman Brothers Holdings Inc. v. JPMorgan Chase Bank, N.A. (In re Lehman Brothers Holdings Inc.), Adv. Pro. No. 10-03266 (JMP), 2012 Bankr. LEXIS 1721 (Bankr. S.D.N.Y Apr. 19, 2012).
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[2] This summary of the transactions at issue is drawn from the decision and Lehman’s complaint against JPMorgan. Because of the procedural posture, the court has made no factual findings, and many of the operative allegations are disputed by JPMorgan.
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[3] Incidentally, after JPMorgan’s motion to dismiss was fully submitted, the United States Supreme Court issued its decision in Stern v. Marshall, 131 S. Ct. 2594 (2011). Joining a growing number of lower courts, the decision holds that Stern does nothing to affect the bankruptcy court’s authority to decide a motion to dismiss, which involves no factual findings and remains subject to a de novo standard of review on appeal.
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