Vol 9 (2012) - Issue 1

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Priority Flip Clauses: A Proposed Solution

Priority Flip Clauses: A Proposed Solution Cecilia Poullain, Analysis and Structuring, Fixed Income Department, Natixis Asset Management, Paris, France The 'priority flip clause' question has re-emerged with the decision by the UK Supreme Court on 27 July 2011 to uphold the validity of these clauses in the appeal in Belmont Park Investments Pty Limited & Ors v BNP Corporate Trustee Services Limited and Lehman Special Financing Inc.

The 'priority flip' is a clause commonly found in structured transactions, and in particular structured credit transactions. The clause provides that, if the swap counterparty defaults, it will no longer be first in line for the proceeds of sale of the collateral. Instead, the Noteholders will be paid out in full before the markto- market is paid to the swap counterparty.

This question came to the forefront in the Lehman bankruptcy case in 2009-2010. Unusually, both the UK and US courts were called to decide whether the clauses were valid if the swap counterparty was insolvent. However, the UK court upheld the validity of the clause and the US court found it to be unenforceable (the Lehman case settled in 2010).

The UK Supreme Court’s decision in the Belmont Park case has only served to confirm this difference of opinion.

For investors, the difference is vital: the UK decision means that they recover close to 100% of their investment; the US decision results in a recovery closer to zero.


A proposed solution

Financially, neither the US nor the UK decision is fair. On the one hand, the Noteholders bought Notes on the basis that they were not taking counterparty risk. In addition, they were not being paid to take counterparty risk. This is precisely why the 'priority flip' exists: because the parties have contractually agreed that the Noteholders will not take a mark-to-market risk on the swap triggered by a counterparty failure.

On the other hand, credit-linked notes are often compared to ‘funded CDS’. In a CDS, the Buyer of protection pays the premium; in a CDO, the issuer pays the coupon (see Figure 1).

There is therefore some logic in saying that the economic result should be similar under each instrument if a default occurs.

To take an example, let’s assume that the protection seller under a CDS and the Noteholder of a CDO have each agreed to bear the risk on an identical tranche, and that the mark-to-market has moved 20% in favour of the buyer of protection in each case.

If the buyer of protection is in default, and the seller under the CDS decides to terminate the CDS, it would have to pay the mark-to-market of 20% to the buyer even if the tranche has not been reduced as a result of defaults in the portfolio. In other words, the value of the instrument is affected by the defaults in the portfolio beneath the attachment point.