The Supreme Court has provided important jurisprudence on the nature and scope of the anti-deprivation principle (the principle), while upholding the validity of subordination, or "flip", provisions (Belmont Park Investments PTY Limited v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc [2011] UKSC 38).

Belmont had invested in notes issued by a special purpose vehicle, which had used subscription monies to buy collateral. The issuer entered into a swap agreement with Lehman Brothers Special Financing Inc (LBSF) under which it paid income on the collateral and, in exchange, received amounts required to service payments under the notes.

The terms of the notes included a waterfall (priority of payments) that required the proceeds of sale of the collateral to be applied to pay LBSF before noteholders. However, if LBSF defaulted under the swap, priority would "flip" and LBSF's claim on the collateral would become subordinate to that of the noteholders.

The value of the collateral was insufficient to meet payments in full to both noteholders and LBSF, so LBSF sought to apply the principle to invalidate the flip provisions.

The principle, which derives from common law, provides that parties cannot contractually agree that assets belonging to one party will, on that party's insolvency, become the other party's property. Such a clause would unfairly deprive the insolvent estate, and therefore creditors, of assets.

The Supreme Court unanimously confirmed the existence of the principle. Lord Mance observed that the principle covers different ground to the Insolvency Act 1986, which also invalidates certain terms that are unfairly detrimental to creditors. Lord Collins stated that the principle is also distinct from the rule that parties cannot contract out of the statutory distribution of an insolvent estate (British Eagle International Airlines Ltd v Cie Nationale Air France [1975] 1 WLR 785). However, while the existence of the principle is easy to state, its exact limits are harder to define.

The lead judgment of the Supreme Court was delivered by Lord Collins, who identified the following four characteristics of the principle:

An intention to evade insolvency laws. The principle will only apply if there is a deliberate intention to evade insolvency laws. A subjective intention is not necessarily required, and there may be cases where the intention is obvious and may be inferred. In borderline cases, a commercial transaction entered into in good faith should not fall foul of the principle.

Deprivation on insolvency. If the deprivation results from an event other than insolvency, then the principle will not apply. So forfeiture of assets as a result of a counterparty's breach would not be invalidated under the principle. Interesting questions arise if the breach and insolvency coincide, or if the breach post-dates the insolvency. In the Court of Appeal decision in Belmont, Lords Neuberger and Patten said, obiter, that the principle would prevent deprivation, on any grounds, after insolvency (www.practicallaw.com/5-501-3028). The Supreme Court did not directly answer these questions.

The "flawed asset" analysis. The "flawed asset" argument is that if a party becomes entitled to property on fulfilment of a precondition that it is solvent then, on insolvency, it has not been deprived of property. So the principle would not apply because ownership could not have passed to the insolvent party.

This reasoning has been prominent, although not determinative, in Belmont in the judgments of the High Court, the Court of Appeal, and Lord Mance in the Supreme Court. Lord Collins, with whom the other judges agreed, made less of this approach. He observed that there may be occasions when a contractual term could fall foul of the principle, despite it amounting to a flawed asset provision. The line of reasoning remains relevant but should not, of itself, determine whether the principle applies.

Substance of economic interests. The source of the assets in question must be an influential, although not conclusive, factor, in determining whether the principle applies. If a term provides that, following the insolvency of a party, assets are allotted to the person that paid for them, the term is less likely to offend the principle.

Applying this model to the facts in Belmont, Lord Collins upheld the validity of the flip provisions. The transaction made commercial sense, and there was no suggestion that the flip provisions were intended to evade insolvency laws. Additionally, the subscription monies of the noteholders were the source of the funds to buy the collateral.

The timing of deprivation could also have been relevant. If the flip in priorities occurred when LBSF's parent company filed for protection under Chapter 11 of the US Bankruptcy Code, it would have occurred before LBSF's filing for Chapter 11. Lord Collins did not dwell on this, given the strength of other arguments to uphold the flip provisions.

A different approach to the principle was adopted by Briggs J in Lomas and others (administrators of Lehman Brothers International (Europe)) v JFB Firth Rixson Inc and others [2010] EWHC 3372 (see Briefing "The ISDA Master Agreement: a welcome step to increased certainty", www.practicallaw.com/2-504-8802). The judges' comments in Belmont suggest that it should not be disregarded.

Briggs J had felt that where the insolvent party had performed its part of the bargain, the courts should be slow to deprive it of the consideration for its performance. Conversely, where the insolvent party has not provided its part of the bargain, then the courts would more readily uphold a clause that deprives it of property. Lord Collins neither disagreed with the approach, nor fully integrated it into the reasons for his decision. Lords Mance and Walker both gave support to Briggs J's approach. There are points of overlap with the characteristics expounded by Lord Collins, particularly as an enlargement of his guidelines concerning economic substance.

The existence and scope of the principle have been confirmed, while LBSF's attempt to widen the scope of the principle has been checked. Nevertheless, administrators of insolvent counterparties can take cheer: the principle cannot be avoided by technical drafting of flawed asset provisions, as the courts will also examine the purpose and substance of a transaction. Parties to complex financial transactions will be reassured that a desire to uphold commercial transactions, entered into in good faith, was at the heart of the Supreme Court's judgment.