Financial Contract Amendments to Bankruptcy Code

What the financial regulators hope to achieve — continued liquidity and transparency in the international financial system — are arguably inapposite to the goals of the U.S. reorganization process, as are the special rights offered market participants under these provisions. Qualifying transactions trump two fundamental pillars of the U.S. reorganization process: 1) a breathing space for the debtor in the form of an automatic stay; and 2) equality of treatment of similarly situated creditors, enforced in part through the estate's ability to avoid and recover circumscribed pre-bankruptcy transfers for the benefit of all creditors. Even prior to these amendments, parties to financial contracts under the Bankruptcy Code had an ability to terminate pre-petition contracts, liquidate collateral, and apply or offset proceeds notwithstanding the automatic stay. They are insulated from preference and even fraudulent conveyance claims (absent actual fraud committed within a year of the petition date). As a result, these provisions have never been popular with the relatively few bankruptcy courts that have encountered them, since judges are forced to balance the abstract greater good of the international financial system against the reality of the reorganization case in front of them. Accordingly, a good portion of the amendments are devoted to “clarifying” existing law to make it as difficult as possible for an otherwise well-meaning court to find ambiguities in the statute and then interpret around them.

The original safe harbor provisions in the Bankruptcy Code when it was enacted in 1978 resulted from a decision under the former Bankruptcy Act, Seligson v. New York Produce Exchange, 394 F. Supp. 125 (S.D.N.Y. 1975), which concerned a fraudulent conveyance claim resulting from a margin payment received in a commodity broker's insolvency. With additional provisions and wording clarifications added from time to time, prior to the present legislation the financial contract provisions had a hodgepodge quality that created uncertainty as to which transactions were entitled to safe harbor treatment, an uncertainty that added risk and cost to market transactions. This legislation seeks to reduce such uncertainty and harmonize the various protections between and among financial products and those parties eligible to benefit from them, and to make those protections as consistent as possible with similar, simultaneous changes made to the Federal Deposit Insurance Act (FDIA) and the Federal Credit Union Act.

Repos

One form that this harmonization takes is the expansion of the various definitions of safe harbored products and parties. Qualifying repurchase agreements, for example, were previously limited to transactions of a year or less, and the subject of the repo had to be obligations of the United States or agencies of the United States, or guaranteed by the United States or agencies of the United States. Section 101(47). Although the 1-year limitation remains, the subject matter of a qualifying repo has been expanded to include the obligations of enumerated foreign governments (making the statute consistent with prior regulations promulgated under the FDIA in the case of a bank failure) as well as certain mortgage-related securities, mortgage loans, or interests in mortgage-related securities or mortgage loans (but not a repo embedded in a participation agreement in a commercial mortgage loan, although a repo of participations in commercial mortgage loans does qualify). The amendment makes clear that master agreements, such as the Bond Market Association's standard industry form, qualify as repos, although not those transactions entered into under the master, which don't themselves qualify. Options to enter into repos or any combination of permitted transactions are also permitted. The definition of repo extends to security agreements, other credit enhancements and even guarantees “in connection with” any qualifying transaction, subject to a calculations of damages described in a new Section 562 discussed below. The old definition of “repo participant” in Section 101(46), which was broad to begin with, is further expanded by removing a condition as to the timing of the transaction. Finally, the legislative history confirms existing case law that repos which meet the definitions of other safe harbored financial contracts (and vice-versa), such as securities contracts or commodities contracts, are entitled to safe harbor treatment under those provisions even if they do not qualify as repurchase agreements under Section 101(47).

Securities Contracts

The definition of “securities contract” set out in Section 741(7) is expanded and clarified by the addition of specific language extending the definition to, among other things, contracts for the purchase, sale or loan of mortgage loans or interests in mortgage loans “including an interest therein or based on the value thereof” or related options, but, as with repos, excluding any purchase, sale or obligation to repurchase any participation in a commercial mortgage loan. “Securities contract” specifically includes repos and reverse repos on “securities,” as that term is defined, and also includes options entered into on a national securities exchange relating to foreign currencies, margin loans, guarantees by or to securities clearing agencies, any agreement or transaction similar to those enumerated, and any combination, or option respecting any of the foregoing, and, like repos, any master agreement, security agreement, other credit enhancement or guarantee subject, once again, to the damage calculation in new Section 562.

Although the Bankruptcy Code definition of “securities contract” historically has been much broader than that of “repurchase agreement,” this was balanced by the fact that only a stockbroker, financial institution or securities clearing agency could be party to a securities contract, while any “entity,” that broadest of parties in the bankruptcy definitional spectrum, could be party to a repurchase agreement.

Financial Institution

This has changed. Although the definition of “financial institution” at Section 101(22) has been modified to include a federally insured credit union or its successor receiver, liquidating agent or conservator, the definition of “securities clearing agency” at Section 101(48) has been slightly modified to make clear that to qualify, such an agency need not be registered if an SEC order states it need not be, and the definition of “stockbroker” at Section 101(53A) has been modified not at all; the statute introduces a new qualifying entity, the “financial participant” in a new Section 101(22A). This important change was intended to give safe harbor rights to active market participants that do not fit into other protected classes, and could include, on a case-by-case basis, such entities as hedge funds, major corporations, and affiliates of investment banks that do not meet the test to be a “stockbroker.”

Financial Participant

Except with respect to clearing organizations, status as a “financial participant” is purely a function of financial market activity. To meet the test, an entity must have: 1) a total of not less than $1 billion in notional or actual outstanding financial contracts; or 2) gross mark-to-market positions of not less than $1 million (aggregated across counterparties, including the debtor, but not including such entity's own affiliates) on any day within a 15-month period prior to the counterparty's bankruptcy filing date. A party meeting either test is a financial participant for Bankruptcy Code purposes.

Swap Contracts

Swap contracts were not protected under the Bankruptcy Code until 1990, when swaps were still in their infancy. The new amendments reflect not only the exponential growth in the uses of swap and similar derivative products in succeeding years, but also attempt to cover new permutations and uses of the swaps and derivatives as well as those not yet contemplated. This was done in rewriting Section 101(53B) by specifying a large number of swap types, while at the same time broadening already broad language concerning what should be considered a swap for bankruptcy purposes in the future. Illustrative products specifically enumerated, some of which arguably did not fall within the prior definition in Section 101(53B), include the addition of certain types of precious metals agreements, equity and equity index swaps, debt index or debt swaps, total return, credit spread or credit swaps, commodity index or commodity swaps, or weather swaps, derivatives or options as well as any other arrangement similar to those specified which in the future becomes the subject of recurrent dealings in the swap markets and is a forward swap future or option.

Additionally, new Section 101(53B) contains similar protections to those given in the repo and securities provisions for master agreements, security agreements, other credit enhancements and guarantees, with the same limitations as well. It is made clear that the definition given to swaps in the Bankruptcy Code is for bankruptcy purposes only, and has no application under any other statute, regulation or rule.

One cautionary note: Because swaps and derivative products are adaptable to a variety of uses, there was a concern that they could be used to document ordinary commercial transactions. The legislative history indicates that “swap agreement” should not be interpreted to permit parties to document “[t]raditional commercial arrangements, such as supply agreements, or other non-financial market transactions, such as commercial, residential or consumer loans” as swap transactions and get safe harbor protection. It will be interesting to see how the courts will interpret “swap agreement” in light of this admonition.

'Forward Contracts'

The definition of “forward contracts,” at Section 101(25), and “commodity contracts,” at Section 761(7), are both expanded to include conforming language regarding master agreements, security agreements, other credit enhancements and guarantees, with any damages subject to the limitations of new Section 562.

Those who can be party to a forward contract, ie, a “forward contract merchant” defined in Section 101(26), have been expanded to include, among others, a Federal Reserve bank, an estate, trust or governmental unit.

New Sections

The legislation adds two completely new sections to the Bankruptcy Code. The first, Section 562, referred to several times above, creates rules for the timing and measurement of damages in the event that the debtor or trustee rejects, or the non-debtor counterparty exercises its rights to terminate or accelerate a financial contract. In such circumstances, damages will be measured from the earlier of the date of rejection or the date or dates of liquidation, termination or acceleration. If there are no commercially reasonable determinants of value as of that date, then the damages will be measured on the earliest subsequent date or dates for which such measures are available. If there is disagreement concerning the timing, then the complaining party has the burden to show that the date selected is not appropriate.

The second new section required its own definition. “Master netting agreement” is newly defined in Section 101(38A) as an agreement for the exercise of certain rights in connection with a financial contract, including the right of setoff, liquidation, termination, acceleration, close out and, of course, netting. It also includes any security arrangement, credit enhancement or guarantee related to any of such contracts. New Section 561 of the Bankruptcy Code treats such a master netting agreement in the same manner as the underlying financial contracts to which it relates, so that no order may be entered under the Bankruptcy Code that can affect the rights of a beneficiary under such an agreement to enforce its terms regarding a financial contract.

The legislation is not entirely perfect from the perspective of the securities industry. A provision to protect securitization vehicles was eliminated, while netting across affiliates never made it in. There were no last-minute technical amendments to the legislation, perhaps because its sponsors felt that any amendments, no matter how trivial or reasonable, would open the door for the bill's opponents to once again defeat its passage.

However, taken together with conforming changes to the automatic stay provisions of Section 362, the set-off provisions of Section 553 (which now excepts financial contracts from the prohibition in Section 553(a)(3)(C) against acquiring claims for the purpose of effectuating an offset), and the limitations on avoidance actions of Section 546, it would appear that both regulators and financial market participants have achieved a level of safety and liquidity in the face of a counterparty's insolvency that has made the tortured path to passage of this legislation well worth the wait.

Esoteric and arcane, the financial contract provisions of the new Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 — those dealing with repurchase agreements, securities contracts, swap agreements, forward and commodity contracts — have been given short shrift by a mainstream media focused on the more “newsworthy” consumer provisions of that legislation. However, to bankruptcy practitioners focusing on larger commercial cases or involved in the capital markets, these amendments are important and deserve a close look.

Although generally described as simply adding netting provisions to the Bankruptcy Code, the amendments, which are set forth in Sections 901 through 911 of the legislation, do much more. They build upon and expand the network of safe-harbor protections previously granted in the Bankruptcy Code to qualifying parties in qualifying financial transactions from time to time since the Bankruptcy Code became law in 1978. Netting is one element of this expansion. Both the existing provisions and these new amendments are consistent with the long-espoused goals of financial regulators, such as the Federal Reserve and the SEC, to eliminate potential risks to the international financial system that would otherwise result from the collapse of a major market participant. The amendments update and expand existing law in recognition of the continued evolution of the capital markets since the last significant change to these safe harbors over 10 years ago.

Good Intentions v. Reality

What the financial regulators hope to achieve — continued liquidity and transparency in the international financial system — are arguably inapposite to the goals of the U.S. reorganization process, as are the special rights offered market participants under these provisions. Qualifying transactions trump two fundamental pillars of the U.S. reorganization process: 1) a breathing space for the debtor in the form of an automatic stay; and 2) equality of treatment of similarly situated creditors, enforced in part through the estate's ability to avoid and recover circumscribed pre-bankruptcy transfers for the benefit of all creditors. Even prior to these amendments, parties to financial contracts under the Bankruptcy Code had an ability to terminate pre-petition contracts, liquidate collateral, and apply or offset proceeds notwithstanding the automatic stay. They are insulated from preference and even fraudulent conveyance claims (absent actual fraud committed within a year of the petition date). As a result, these provisions have never been popular with the relatively few bankruptcy courts that have encountered them, since judges are forced to balance the abstract greater good of the international financial system against the reality of the reorganization case in front of them. Accordingly, a good portion of the amendments are devoted to “clarifying” existing law to make it as difficult as possible for an otherwise well-meaning court to find ambiguities in the statute and then interpret around them.

The original safe harbor provisions in the Bankruptcy Code when it was enacted in 1978 resulted from a decision under the former Bankruptcy Act, Seligson v. New York Produce Exchange , 394 F. Supp. 125 (S.D.N.Y. 1975), which concerned a fraudulent conveyance claim resulting from a margin payment received in a commodity broker's insolvency. With additional provisions and wording clarifications added from time to time, prior to the present legislation the financial contract provisions had a hodgepodge quality that created uncertainty as to which transactions were entitled to safe harbor treatment, an uncertainty that added risk and cost to market transactions. This legislation seeks to reduce such uncertainty and harmonize the various protections between and among financial products and those parties eligible to benefit from them, and to make those protections as consistent as possible with similar, simultaneous changes made to the Federal Deposit Insurance Act (FDIA) and the Federal Credit Union Act.

Repos

One form that this harmonization takes is the expansion of the various definitions of safe harbored products and parties. Qualifying repurchase agreements, for example, were previously limited to transactions of a year or less, and the subject of the repo had to be obligations of the United States or agencies of the United States, or guaranteed by the United States or agencies of the United States. Section 101(47). Although the 1-year limitation remains, the subject matter of a qualifying repo has been expanded to include the obligations of enumerated foreign governments (making the statute consistent with prior regulations promulgated under the FDIA in the case of a bank failure) as well as certain mortgage-related securities, mortgage loans, or interests in mortgage-related securities or mortgage loans (but not a repo embedded in a participation agreement in a commercial mortgage loan, although a repo of participations in commercial mortgage loans does qualify). The amendment makes clear that master agreements, such as the Bond Market Association's standard industry form, qualify as repos, although not those transactions entered into under the master, which don't themselves qualify. Options to enter into repos or any combination of permitted transactions are also permitted. The definition of repo extends to security agreements, other credit enhancements and even guarantees “in connection with” any qualifying transaction, subject to a calculations of damages described in a new Section 562 discussed below. The old definition of “repo participant” in Section 101(46), which was broad to begin with, is further expanded by removing a condition as to the timing of the transaction. Finally, the legislative history confirms existing case law that repos which meet the definitions of other safe harbored financial contracts (and vice-versa), such as securities contracts or commodities contracts, are entitled to safe harbor treatment under those provisions even if they do not qualify as repurchase agreements under Section 101(47).

Securities Contracts

The definition of “securities contract” set out in Section 741(7) is expanded and clarified by the addition of specific language extending the definition to, among other things, contracts for the purchase, sale or loan of mortgage loans or interests in mortgage loans “including an interest therein or based on the value thereof” or related options, but, as with repos, excluding any purchase, sale or obligation to repurchase any participation in a commercial mortgage loan. “Securities contract” specifically includes repos and reverse repos on “securities,” as that term is defined, and also includes options entered into on a national securities exchange relating to foreign currencies, margin loans, guarantees by or to securities clearing agencies, any agreement or transaction similar to those enumerated, and any combination, or option respecting any of the foregoing, and, like repos, any master agreement, security agreement, other credit enhancement or guarantee subject, once again, to the damage calculation in new Section 562.

Although the Bankruptcy Code definition of “securities contract” historically has been much broader than that of “repurchase agreement,” this was balanced by the fact that only a stockbroker, financial institution or securities clearing agency could be party to a securities contract, while any “entity,” that broadest of parties in the bankruptcy definitional spectrum, could be party to a repurchase agreement.

Financial Institution

This has changed. Although the definition of “financial institution” at Section 101(22) has been modified to include a federally insured credit union or its successor receiver, liquidating agent or conservator, the definition of “securities clearing agency” at Section 101(48) has been slightly modified to make clear that to qualify, such an agency need not be registered if an SEC order states it need not be, and the definition of “stockbroker” at Section 101(53A) has been modified not at all; the statute introduces a new qualifying entity, the “financial participant” in a new Section 101(22A). This important change was intended to give safe harbor rights to active market participants that do not fit into other protected classes, and could include, on a case-by-case basis, such entities as hedge funds, major corporations, and affiliates of investment banks that do not meet the test to be a “stockbroker.”

Financial Participant

Except with respect to clearing organizations, status as a “financial participant” is purely a function of financial market activity. To meet the test, an entity must have: 1) a total of not less than $1 billion in notional or actual outstanding financial contracts; or 2) gross mark-to-market positions of not less than $1 million (aggregated across counterparties, including the debtor, but not including such entity's own affiliates) on any day within a 15-month period prior to the counterparty's bankruptcy filing date. A party meeting either test is a financial participant for Bankruptcy Code purposes.

Swap Contracts

Swap contracts were not protected under the Bankruptcy Code until 1990, when swaps were still in their infancy. The new amendments reflect not only the exponential growth in the uses of swap and similar derivative products in succeeding years, but also attempt to cover new permutations and uses of the swaps and derivatives as well as those not yet contemplated. This was done in rewriting Section 101(53B) by specifying a large number of swap types, while at the same time broadening already broad language concerning what should be considered a swap for bankruptcy purposes in the future. Illustrative products specifically enumerated, some of which arguably did not fall within the prior definition in Section 101(53B), include the addition of certain types of precious metals agreements, equity and equity index swaps, debt index or debt swaps, total return, credit spread or credit swaps, commodity index or commodity swaps, or weather swaps, derivatives or options as well as any other arrangement similar to those specified which in the future becomes the subject of recurrent dealings in the swap markets and is a forward swap future or option.

Additionally, new Section 101(53B) contains similar protections to those given in the repo and securities provisions for master agreements, security agreements, other credit enhancements and guarantees, with the same limitations as well. It is made clear that the definition given to swaps in the Bankruptcy Code is for bankruptcy purposes only, and has no application under any other statute, regulation or rule.

One cautionary note: Because swaps and derivative products are adaptable to a variety of uses, there was a concern that they could be used to document ordinary commercial transactions. The legislative history indicates that “swap agreement” should not be interpreted to permit parties to document “[t]raditional commercial arrangements, such as supply agreements, or other non-financial market transactions, such as commercial, residential or consumer loans” as swap transactions and get safe harbor protection. It will be interesting to see how the courts will interpret “swap agreement” in light of this admonition.

'Forward Contracts'

The definition of “forward contracts,” at Section 101(25), and “commodity contracts,” at Section 761(7), are both expanded to include conforming language regarding master agreements, security agreements, other credit enhancements and guarantees, with any damages subject to the limitations of new Section 562.

Those who can be party to a forward contract, ie, a “forward contract merchant” defined in Section 101(26), have been expanded to include, among others, a Federal Reserve bank, an estate, trust or governmental unit.

New Sections

The legislation adds two completely new sections to the Bankruptcy Code. The first, Section 562, referred to several times above, creates rules for the timing and measurement of damages in the event that the debtor or trustee rejects, or the non-debtor counterparty exercises its rights to terminate or accelerate a financial contract. In such circumstances, damages will be measured from the earlier of the date of rejection or the date or dates of liquidation, termination or acceleration. If there are no commercially reasonable determinants of value as of that date, then the damages will be measured on the earliest subsequent date or dates for which such measures are available. If there is disagreement concerning the timing, then the complaining party has the burden to show that the date selected is not appropriate.

The second new section required its own definition. “Master netting agreement” is newly defined in Section 101(38A) as an agreement for the exercise of certain rights in connection with a financial contract, including the right of setoff, liquidation, termination, acceleration, close out and, of course, netting. It also includes any security arrangement, credit enhancement or guarantee related to any of such contracts. New Section 561 of the Bankruptcy Code treats such a master netting agreement in the same manner as the underlying financial contracts to which it relates, so that no order may be entered under the Bankruptcy Code that can affect the rights of a beneficiary under such an agreement to enforce its terms regarding a financial contract.

The legislation is not entirely perfect from the perspective of the securities industry. A provision to protect securitization vehicles was eliminated, while netting across affiliates never made it in. There were no last-minute technical amendments to the legislation, perhaps because its sponsors felt that any amendments, no matter how trivial or reasonable, would open the door for the bill's opponents to once again defeat its passage.

However, taken together with conforming changes to the automatic stay provisions of Section 362, the set-off provisions of Section 553 (which now excepts financial contracts from the prohibition in Section 553(a)(3)(C) against acquiring claims for the purpose of effectuating an offset), and the limitations on avoidance actions of Section 546, it would appear that both regulators and financial market participants have achieved a level of safety and liquidity in the face of a counterparty's insolvency that has made the tortured path to passage of this legislation well worth the wait.