A New Threat For Structured Finance Transactions: Flip Clauses Enforceable?

A recent U.S. bankruptcy case has challenged the enforceability of a common structured finance provision and exposed many highly rated transactions to the risk of downgrade and default.

In many structured finance transactions, investors acquire notes of a special purpose issuer secured by or linked to specific assets or collateral. Often the issuer will enter into a swap to hedge interest rate or currency risks or to assume additional credit risk and generate additional returns. In most transactions, amounts payable to a swap counterparty are factored into cash flows and take priority over amounts payable to investors, except for unexpected swap termination payments where the termination was caused by a default or the bankruptcy of the swap counterparty. Without this subordination mechanism, also known as a "flip clause":