Derivatives and Bankruptcy Safe Harbors
Swaps. Repos. CDOs. CMOs. Commodity futures. Options. Currency hedges. Credit enhancements. Freight forward contracts.
Once the sole province of Wall Street investment banks and brokers, these and many other types of derivative instruments have become a common part of the every day business strategy of many enterprises such as airlines, utilities, manufacturers and retailers. In fact, trading in derivatives has become a key method by which enterprises that are reliant on commodities such as heating oil, jet fuel, corn, or bauxite, which are subject to wide market price swings, or which trade globally and, thus, are subject to fluctuations in currency exchange, moderate or hedge their risk.
In the United States, derivatives can be traded on national exchanges, such as the New York Mercantile Exchange or the New York Stock Exchange and this on-exchange trading activity typically is accomplished through a broker or other professional. Trades on a national exchange are made subject to the rules of the particular exchange and its self regulating organization, as well as any applicable federal or state statutory or regulatory scheme. Millions of derivative transactions also are entered into privately, “off exchange” or over the counter (OTC), with the trades negotiated directly between two counterparties. In many cases, individual OTC transactions are entered into and made subject to master netting agreements between the trading parties that follow a form developed by the International Swaps and Dealers Association (ISDA). The ISDA form contains the non-economic terms, such as termination, acceleration and liquidation rights, of each OTC trade, while the economic terms, such as rate, price, term and volume, are set forth in individual confirmations that can be generated electronically or on paper. Although the ISDA form is widely used, in some cases, the documentation may not be so formal or even complete.
Derivative trades often are not closed and cashed out, nor are they settled in hard goods. Rather the parties’ obligations to each other are rolled over and the obligations netted out on a daily, weekly or other basis, with the “out of the money” party making a margin or net settlement payment or increasing the collateral it posts to offset its liability to the counterparty. The ability to continually net, roll over and demand additional margin or collateral are key to the smooth functioning of the securities, commodities and derivative markets. Indeed, these trades are often done back-to-back, such that in one instance a party is a seller and in the next, a buyer.
What happens, then, when a party to one of these transactions files for protection under the United States Bankruptcy Code, 11 U.S.C. § 101, et seq.? Can the music stop and if so, who has the power to stop it? Can a debtor continue to trade and when and under what circumstances would either the debtor or a non-debtor counterparty want to do so?
The U.S. Bankruptcy Code
The filing of a petition for relief under the Bankruptcy Code is a watershed event. Effective on the petition date, an estate comprised of all of the debtor’s rights and interests in property, including inchoate litigation, property and contract rights, is formed. Actions against the debtor or its estate based on events occurring or contracts entered into pre-petition generally are stayed, and the commencement of a case even prohibits the setoff of mutual debts unless relief from the stay is granted by the bankruptcy court. The filing of a bankruptcy case also vests the debtor in possession or bankruptcy trustee with certain rights and powers, such as a qualified right to assume, reject, or assume and assign executory contracts and unexpired leases. To facilitate a debtor’s ability to retain and/or realize value from its pre-petition contractual rights, the Bankruptcy Code renders unenforceable certain types of contractual provisions, such as anti- assignment clauses and clauses that permit a party to terminate a contract based on a debtor’s insolvency or the filing of a bankruptcy case (so called “ipso facto clauses”). A debtor even is permitted to bring litigation to recover monies paid out during the 90-day period prior to the petition date on account of antecedent debts and to undo some property transfers.
These provisions and many others like them in the Bankruptcy Code are purposefully designed to give the debtor breathing room to assess its situation, delay or prevent the forfeiture of valuable property and contract rights, collect its assets and take the steps necessary to reorganize. These goals directly conflict, however, with the proper functioning of the securities and commodities markets, which require parties to be able to timely close existing trades in order to engage in new ones. Indeed, the insolvency of even one large market participant can have a calamitous effect upon the market as a whole and might cause otherwise healthy counterparties to become insolvent very quickly.
Derivatives Safe Harbors
To prevent the policies underlying the Bankruptcy Code from disrupting the securities and commodities markets, the Bankruptcy Code contains numerous safe harbor provisions that, taken together, are designed to neutralize the impact of a bankruptcy filing upon non-debtor counterparties. Among other things, these safe harbor provisions permit the non-debtor counterparty to exercise set off rights under securities contracts, commodities contracts, forward contracts, repurchase contracts, swap agreements, master netting agreements or similar instruments (collectively, Derivatives), exercise contractual or exchange specific rights to liquidate, terminate or accelerate Derivatives, and also exempt prepetition settlement payments, margin payments and certain transfers made in connection with Derivatives from avoidance as a preference or a constructive fraudulent conveyance. In other words, when they apply, the safe harbor provisions render the automatic stay, the prohibition against the enforcement of ipso facto clauses and all of the other special protections afforded to debtors automatically ineffective when it comes to Derivatives.
Sounds great, right? Yes, but the devil is always in the details. To take advantage of any of these safe harbor provisions, the non-debtor counterparty must be sure that the transaction at issue is a Derivative within the various definitions set forth in the Bankruptcy Code. In addition, the non-debtor counterparty must, itself, be a stockbroker, commodities broker, forward contract merchant, financial institution, financial participant, securities clearing agency, repo participant, or a swap participant under the applicable Bankruptcy Code definitions to qualify for many of the protections at issue here. The transfers at issue also must be made by, to or on behalf of a qualifying entity, and cannot be fraudulent or otherwise suspect. And, the individual transaction at issue must be shown to have been made pursuant to a master agreement that qualifies as a Derivative.
The good news is that the definitions in the Bankruptcy Code are very broad and were recently amended to broaden their reach even further. For example, section 546(e) of the Bankruptcy Code was amended in December 2006 to apply to “transfers made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency” in connection with a securities, commodities or forward contract as well as settlement and margin payments. Before the 2006 amendment, transfers made in connection with securities or commodities contracts that did not qualify as a settlement or margin payment would not have been protected from avoidance as a preference or a constructive fraudulent conveyance or from being the subject of a turnover action. This situation lead to substantial litigation as to whether a particular transfer was or was not a settlement or margin payment and a split of authority among the courts as to whether a payment that was not “common in the securities industry” could ever qualify as a settlement payment. Now, section 546(e) more broadly protects “transfers,” as long as they are made by, to or for the benefit of one of the listed entities and in connection with one of the enumerated Derivatives contracts.
Limitations on the Safe Harbors
All that being said, there are instances when the Bankruptcy Code safe harbors do not protect the non-debtor counterparty.
For example, the non-debtor party cannot exercise a set-off unless the debts at issue are mutual. This means that an entity cannot set off amounts owed to an affiliate by the debtor against a debt the entity owes to the debtor, unless all of the debts are covered by the same master netting agreement. Similarly, a non-debtor cannot set off amounts a debtor owes to it arising out of a pre-petition trade against amounts it owes the debtor based on a post-petition claim such as a preference. And, even when a non-debtor counterparty might wish to let a pre-petition trade continue to its stated termination point, because it is out of the money on the petition date and thus terminating the trade would result in money being owed to the debtor, it may not be able to do so. In this circumstance, the debtor might seek to preserve its gains by filing a motion to reject the contract, the effect of which will be to terminate the Derivative and liquidate the trade as of the date the contract is rejected.
The safe harbors also do not give the non-debtor counterparty any rights that it does not already have under the parties’ existing Derivatives agreements or under applicable law or regulation. In other words, if the parties’ pre-petition Derivative agreement or applicable law does not permit the non-debtor party to terminate, accelerate or liquidate the Derivative upon the filing of a bankruptcy case by the counterparty, then the non-debtor party will not have that right irrespective of whether the Derivative might otherwise qualify for protection under the Bankruptcy Code safe harbors. The safe harbors also cannot cure a collateral deficiency, nor protect a party when the underlying transaction is either void under applicable state law or fraudulent.
Likewise, any claims against a debtor arising out of post-petition trades may be disallowed if the trading activity is not approved by the bankruptcy court. While section 363 of the Bankruptcy Code permits a chapter 11 debtor to engage in “ordinary course” business transactions without court approval, the debtor is required to seek court approval for transactions outside the ordinary course. Even if the debtor routinely traded Derivatives pre-petition, court approval should be obtained as a protective measure.
Trading with a Debtor
As noted above, the Bankruptcy Code permits the non-debtor counterparty to exercise any rights it may have to accelerate, terminate or liquidate a Derivative notwithstanding the automatic stay and the anti-forfeiture provisions of the Bankruptcy Code. In most cases, the non-debtor party will exercise its rights as soon as possible upon learning that its counterparty has filed a bankruptcy petition, in order to cut any potential losses and set off any amounts due to the non-debtor party against the collateral the non-debtor party holds. It should be noted, however, that if the counterparty is “out of the money,” any amounts due to the debtor would be measured and payable upon the termination of the outstanding trade.1 By contrast, payments due from a debtor over and above any collateral held by or for the benefit of the counterparty would be measured as of the liquidation/termination date, but would not be payable until after confirmation of the debtor’s plan and, even then, likely would be payable at a fraction of the actual claim amount.
The filing of a chapter 11 petition also does not mean that the debtor is going out of business or that pre-petition trading activity should or must stop. The Bankruptcy Code permits a chapter 11 debtor to continue operating its business. In many cases, a debtor will want to continue trading Derivatives post-petition, particularly when the debtor is an airline or engaged in another business for which the trading of Derivatives is a key hedge against rising costs that might threaten its ability to reorganize. To that end, many debtors will seek the bankruptcy court’s permission to continue to trade Derivatives post-petition.
Post-petition costs incurred by a debtor in connection with the operation of its business or the administration of the estate are afforded a higher priority than unsecured pre-petition claims and generally are paid in full. That being said, the Bankruptcy Code safe harbors that protect the rights of a non-debtor counterparty with respect to Derivatives entered into pre-petition do not apply to post-petition trading activity. As such, the non-debtor counterparty should require the debtor to seek entry of an order protecting the counterparty’s right to exercise contractual remedies post-petition before it enters into any such activity.
The Bankruptcy Code safe harbors also do not prevent litigation when there is a dispute as to the terms of the trade. If the relevant OTC Derivative is not clearly documented or has not been reduced to a writing (even an electronic writing) and there is a disagreement over terms between the parties, the non-debtor counterparty may be forced to litigate the dispute in the bankruptcy court. The non-debtor party may be delayed or prohibited from terminating the Derivative or liquidating collateral while the litigation is pending, or it may be held liable for damages to the estate if the bankruptcy court finds that the safe harbors were inapplicable or the Derivative did not permit early termination. While clear documentation is the best way to avoid litigation, if litigation becomes inevitable, the non-debtor should seek relief from the bankruptcy court in order to avoid running afoul of the automatic stay.
The bottom line is that the Bankruptcy Code safe harbors will protect a non-debtor counterparty’s right to exercise its rights and remedies and prohibit the debtor from avoiding what might otherwise be preferential pre-petition transfers, but only if the transaction at issue and the entities involved qualify for such special treatment under the definitions set out in the Bankruptcy Code. The safe harbors also will not create remedies or rights where none otherwise exist. Market participants should consult with bankruptcy counsel to ensure that their pre-petition trading documents and transfers meet the applicable Bankruptcy Code definitions, contain all rights and remedies, and that any post-petition trading activity is covered by an adequate protective order.
1 See 11 U.S.C. §§ 562, 542.