How Safe Is the Harbor?

However, in 1982, the Bankruptcy Code was amended technically to clarify and substantively to modify the statute “to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.” See H.R. REP. NO. 97-420, at 1 (1982) as reprinted in U.S.C.C.A.N. 583, 583.

In other words, there was concern that the failure of a securities firm or commodity firm to meet its payment obligations might have a domino or ripple effect on other market participants ' a concept better known as systemic risk. The ultimate consequence of systemic risk was perceived to be global bankruptcy. Thus, the 1982 amendments added ” 555 and 556 to the Bankruptcy Code to include exemptions from the automatic stay for securities contracts, commodities contracts and forward contracts.

However, despite the good intentions of Congress, the scope of these exemptions under the 1982 amendments was quite narrow. The definition of a securities contract was limited only to contractual rights set forth in a rule or bylaw of a national securities association or a securities clearing association, and such rights could only be enforced by a narrow group defined to include stockbrokers, securities clearing agencies, commodity brokers or forward contract merchants.

Adding Section 559

By 1984, Congress, still concerned about the increasing complexity of financial transactions, added ' 559 to the Bankruptcy Code to provide a safe harbor for repurchase agreements. What was particularly unique about this amendment was that the term contractual right was defined much more broadly to include any right “whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice.”

Adding Section 560

In 1990, ' 560 was added to the Bankruptcy Code to include the newly developed swap agreement “to ensure that the swap and forward contract financial markets are not destabilized by uncertainties regarding the treatment of their financial instruments under the Bankruptcy Code.” See H.R. REP. NO. 101-484, at 1 (1990), as reprinted in 1990 U.S.C.C.A.N. 223, 223. This amendment extended safe harbor protection to interest rate and foreign currency rate swap agreements, including combinations of swap agreements, options to enter into swap agreements and any master agreement that includes a swap agreement. The amendment also prohibited a bankruptcy trustee from avoiding transfers under the strong arm powers made under a swap agreement or any setoff in connection therewith. Further, the amendment modified definitions of forward contracts to comply with standard financial practice.

2005 Amendment

In 2005, Congress realizing that the Bankruptcy Code was still inadequate to address systemic risk due to among other things the lack of ability to net different transactions against each other, amended the Bankruptcy Code effective for cases commenced on or after Oct. 17, 2005, to expand the definitions of forward contracts, repurchase agreements and swap agreements, to add safe-harbor protection for master netting agreements (' 561), to broaden the definition of contractual rights, to cover termination and acceleration of contracts, and to broadly expand protection for a financial participant, a catch-all category derived from and quite similar to Regulation EE, issued in 1994 to expand the definition of financial institution used in the netting provisions contained in ” 401-407 of the Federal Deposit Insurance Corporation Improvement Act of 1991.

Five Protected Categories

There are now five protected categories: securities contracts, commodities contracts, forward contracts, repurchase agreements and swap agreements. However, certain financial transactions, especially as a result of the wide scope of underlying agreements that can be use to qualify such transactions for safe harbor treatment, can easily qualify transactions to fit within the definition of more than one of these protected categories, leading to potential uncertainties as to their treatment.

The classes of protected counterparties include commodity brokers, forward contract merchants, stockbrokers, securities clearing agencies, repo participants, swap participants, financial institutions, master netting participants and financial participants. Two things to remember about counterparties are that the definitions of these terms in the Bankruptcy Code do not necessarily correspond to trade usage and that certain protected transactions may not include all types of counterparties.

Finally, Congress passed the Financing Netting Improvements Act of 2006, which contains some technical amendments to ' 561 of the Bankruptcy Code. The Act makes technical and conforming amendments to the Code's definitions of financial institution, financial participant, forward contract and swap agreement. Further, the rights under various financial contracts now include contractual netting rights. Finally, the safe harbors from avoidance actions were amended to include transfers made to or for the benefit of a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant or securities clearing agency in connection with any securities, commodities or forward contracts. These amendments are effective in cases commenced on or after Dec. 12, 2006.

To summarize, the history behind amendments to the Bankruptcy Code relating to special treatment of financial transactions evidences Congress' strong intent to allow for prompt closing out, termination or liquidation of open accounts upon the commencement of a bankruptcy case. In effect, these safe harbor provisions provide an exception to general rule that the automatic stay provisions of ' 362 (a) of the Bankruptcy Code prevents any act that affects property of the estate and overrides the prohibition contained in ' 365(e)(1) of the Bankruptcy Code with respect to enforcement of ipso facto clauses that are tied to the commencement of a bankruptcy case. Whether this goal has been accomplished remains to be seen.

Case Law Developments

Metavante

In a recent bench decision in In re Lehman Brothers Holdings Inc. et al., Case No. 08-13555 (JMP) (Bankr. S.D.N.Y.), Judge James M. Peck held that a non-debtor out of the money swap counterparty (“Metavante“) under a pre-petition interest-rate swap agreement was required to perform its payment obligations notwithstanding a bankruptcy filings by the counterparty, Lehman Brothers Special Financing, Inc. (“Lehman”) and Lehman Brothers Holdings Inc, the credit support provider (“Holdings”). The swap transaction was controlled by a 1992 ISDA Master Agreement (“Master Agreement”).

Floating and fixed-rate payments were netted and the difference was to be paid on scheduled payment dates. Events of default included a bankruptcy filing by the counterparty or its credit support provider. Other terms included the right, but not obligation, to terminate in the event of a default and the right to withhold performance upon an event of default that is continuing under ' 2(a)(iii) of the Master Agreement.

Due to declining interest rates the value of Metavante's position under the swap (which was based on a fixed interest rate) was out of the money. Stated differently, termination of the Master Agreement would result in a significant multi-million dollar payment to Lehman. Consequently, Metavante did not want to terminate the swap and pay a substantial termination fee ' choosing simply to suspend payment. Lehman commenced an adversary proceeding to compel payment (which at the time had reached $6 million), together with interest at the contract default rate.

Metavante, relying on Section 2(a)(iii) of the Master Agreement, argued: 1) that the commencement of Lehman's bankruptcy case and that of its parent Lehman Brothers Holdings, Inc. constituted a default that excused its payment performance; and 2) that pursuant to ' 560 of the Bankruptcy Code it had the right to terminate the swap agreement at any time before maturity.

The bankruptcy court disagreed with Metavante, finding that: 1) the Master Agreement was an executory contract; 2) the safe harbor under ' 560 of the Bankruptcy Code did not allow Metavante to withhold performance ' noting Metavante's conduct of riding the market for the period of one year, while taking no action whatsoever, was simply unacceptable and contrary to the spirit of these provisions of the Bankruptcy Code; 3) Metavante did not have an open-ended contractual right to terminate the swap; and 4) its failure to exercise that right after one year constituted a waiver of that right ' meaning that the right to decide the fate of the Master Agreement shifted to Lehman, which could now choose to either assume or reject the swap agreement under ' 365 of the Bankruptcy Code. This case has recently been settled, but nevertheless raises a substantial number of unresolved issues and creates uncertainty in the market.

Hutson

In re Hutson v. E.I. Dupont De Nemours & Co. et al. (In re National Gas Distributors LLC) 556 F 3d 247 (4th Cir. 2009) involved the physical delivery of a commodity ' natural gas. The circuit court held that a physically settled “commodity forward agreement” may qualify for safe harbor treatment as a “swap agreement” under ' 560 of the Bankruptcy Code, notwithstanding that these over-the-counter transactions are: 1) settled by physical delivery of a commodity; 2) assignable; or 3) not traded on a financial market or exchange. The key protection included in the safe harbor provision under ' 560 of the Bankruptcy Code in this case was the exemption of such transactions from a trustee's avoidance powers under ' 5488 of the Bankruptcy Code. relating to fraudulent transfers.

In Hutson, the trustee sought to avoid certain natural gas forward contracts as fraudulent transfers arguing that the debtor sold the gas to counterparties for less than fair market value at the time when the debtor was presumably insolvent. The Fourth Circuit's decision was one of first impression with respect to whether physically settled commodity forward contracts fall within the definition of “swap agreement,” and thus are protected under the safe harbor provisions of ' 560 of the Bankruptcy Code. The bankruptcy court, which was reversed by the Court of Appeals, held that commodity forward agreements were “agreements by a single end-user to purchase a commodity” (in other words a supply contract) and not a swap agreement, noting that a swap agreement contemplates that it be “regularly the subject of trading in financial markets” and must be settled by financial exchanges of differences in commodity prices.

The Court of Appeals rejected the analysis of the bankruptcy court, noting that: 1) every “forward contract” is a “forward agreement”; and the term “contract“ is included within the broader definition of agreement, a term used in the statute; and 2) commodity contracts can be privately negotiated and do not have to be traded in a financial market.

On this latter point, the Court of Appeals did focus on the fact that the contracts in question were part of a hedging program by the counterparties that involved other securities that were traded in financial markets. The court also rejected the notion that a “commodity forward agreement” had to be cash settled, noting that forward agreements can be physically settled as well as forward commodity contracts. The case was remanded to the bankruptcy court for further proceedings consistent with its decision. This case is an example of how the broad definitions given to safe harbor transactions under the Bankruptcy Code allows courts, rightly or wrongly, to characterize transactions in ways that may or may not qualify them for safe-harbor treatment.

One potential criticism about Hutson is whether the court should have determined qualification of the agreement in question as a swap agreement under the pain meaning of ' 101(53B) of the Bankruptcy Code, or as the court did, to inquire about the economic attributes of the transaction and possibly the motivation of the parties. See In re American Home Mortgage, infra.

American Home Mortgage

In 2008, the scope of a repurchase agreement was addressed in Calyon New York Brach v. American Home Mortgage Corp., 379 B.R. 503 (Bankr. D. Del. 2008). The bankruptcy court held that the agreement between the parties to purchase and sell mortgage loans was a repurchase agreement because ' 559 of the Bankruptcy Code defined a repurchase agreement as including the transfer of “mortgage related securities, mortgage loans [and] interest in mortgage related securities or mortgage loans.“

However, the bankruptcy court severed the loan servicing portion of the repurchase agreement from the safe harbor protection, finding that the servicing of the loans was retained and not released by the debtor under the repurchase agreement. This decision clarified the treatment of repurchase agreements involving mortgages and servicing rights and creates welcomed clarity as to this category of financial transactions.

One other aspect of this case worth noting is the bankruptcy court's view as to the plain meaning of the statute, which says:

Succinctly stated, if the definition of “repurchase agreement” is met, the section 559 safe harbor protections apply, period. Similarly, if the definitions “securities contract” and “financial institution” are met, the section 555 safe harbor applies, period. This conclusion is compelled by the plain meaning of the statute and is consistent with the policy and legislative history underlying the relevant provisions of the Bankruptcy Code. Id. at 516-17.

Some Unresolved Issues

A number of questions about the safe harbor provisions contained in ' 560 of the Bankruptcy Code remain unresolved as a result of the Metavante decision. First, how long does a counterparty have to exercise its rights before those rights are waived? Second, if the counterparty continues to perform, can the counterparty wait until just before maturity before exercising its rights to terminate? Does the resolution of either of these issues depend on the complexity of the transactions involved, the ability to find reliable substitute counterparties, or how specifically the counterparty as a business practice chooses to address risk management? Drilling down even further, if one of more of these factors are relevant, what weight or other (equitable) considerations should be given to each of them, or is a totality of circumstances the correct analysis? What if refusal to perform by the non-debtor counterparty is based on defaults other than the filing of bankruptcy such as fraud or misrepresentation? Is there a different result?

Final Thoughts

What have we learned? First, the rights of the non-defaulting swap counterparty to liquidate, terminate and accelerate the transaction and to net out the resulting payments under safe-harbor provisions have time limitations. Second, safe harbors relating to swap agreements do not excuse performance by the non-defaulting counterparty. Third, safe harbors in swap agreements do not allow the non-defaulting counterparty to play the market once a default have occurred, strongly suggesting that a counterparty act promptly to exercise its rights to liquidate, terminate or accelerate the transaction in question or risk having a court find that these rights have been waived.

We have also learned that payments made under commodity forward contracts can be treated and protected as a swap agreement under the safe harbor of ' 560 of the Bankruptcy Code whether they are physically or cash settled and therefore not be subject to attack as fraudulent transfers. The factors considered by the Fourth Circuit in Hutson provide analysis as to how commodity supply contracts that are tied to hedging strategies of the purchaser may qualify for safe harbor protection as a swap agreement.

According to Hutson, the commodity supply agreement must involve a commodity with its cost being substantially tied to the commodity itself and not to ancillary packaging, marketing transportation or service charges. Second, it must be a forward contract with delivery of more than two days. Third, the agreement has to set price, time and quantity for delivery. And last, there must be some relationship to the financial markets such as a hedging feature so as to cause the transaction to fall within a safe harbor. In other words, where a commodity forward agreement specifically sets forth prices and quantities at the time the contract is entered, the agreement has hedging features similar to forward contracts that are financially settled in the market, then they can be treated as swap agreements, and protected against fraudulent transfer attack. Such an analysis of the economic attributes of the transaction or the motivation of the parties. transactions, however, may not be universally accepted practice by other courts who favor a plain meaning approach.

Finally, we learned that repurchase agreements involving mortgage-related securities do have safe-harbor protection, which provides greater certainty in the market place and presumably reduces systemic risk for these types of financial transactions.

Just how safe are the harbors? The safe harbors contained in the Bankruptcy Code certainly are not perfect, and indeed may even be too pervasive so as to have unintended consequences. The process to reconciled these issues is ongoing. However, as this process unfolds less sophisticated and smaller counterparties who become subject to safe-harbor statutes designed to protect against systemic risk also need to be protected in a different way. In other words, there can be unintended consequences of causing the failure of a smaller financial player who, but for the modification of the stay authorized under safe harbor provisions, could have survived and reorganized. There is a need to weigh and balance the potential consequences of systemic risk against the fundamental purpose of allowing debtors to reorganize under the Bankruptcy Code. Further tweaking of the statute seems to be required to create this balance. And, despite such a modification and as reasonably anticipated other clarifying amendments, the ever-changing complexity of financial transactions suggests that these safe harbors may never be completely safe.

Robert W. Dremluk, a member of this newsletter's Board of Editors, is a partner in the New York office of Seyfarth Shaw LLP. His work focuses on diverse interests in federal and bankruptcy court litigation and advice and risk assessment regarding transactional matters, including asset purchases and structured finance transactions. He may be reached at [email protected].

This article: 1) summarizes the evolution of safe harbor protections for financial transactions under the Bankruptcy Code; 2) briefly reviews case law developments involving ” 559 and 560 of the Bankruptcy Code; 3) identifies some key unresolved issues; and 4) concludes with some thoughts about whether or not these Bankruptcy Code safe-harbor provisions have some unintended consequences and can adequately address systemic risk in an environment of ever-changing complex financial transactions.

The Evolution of Safe-Harbor Protections

Some historical background will be helpful to understand the evolution that has occurred under the Bankruptcy Code with respect to treatment of financial transactions. When the Bankruptcy Code was enacted in 1978, it only provided for special treatment for transactions involving securities and commodities markets.

However, in 1982, the Bankruptcy Code was amended technically to clarify and substantively to modify the statute “to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.” See H.R. REP. NO. 97-420, at 1 (1982) as reprinted in U.S.C.C.A.N. 583, 583.

In other words, there was concern that the failure of a securities firm or commodity firm to meet its payment obligations might have a domino or ripple effect on other market participants ' a concept better known as systemic risk. The ultimate consequence of systemic risk was perceived to be global bankruptcy. Thus, the 1982 amendments added ” 555 and 556 to the Bankruptcy Code to include exemptions from the automatic stay for securities contracts, commodities contracts and forward contracts.

However, despite the good intentions of Congress, the scope of these exemptions under the 1982 amendments was quite narrow. The definition of a securities contract was limited only to contractual rights set forth in a rule or bylaw of a national securities association or a securities clearing association, and such rights could only be enforced by a narrow group defined to include stockbrokers, securities clearing agencies, commodity brokers or forward contract merchants.

Adding Section 559

By 1984, Congress, still concerned about the increasing complexity of financial transactions, added ' 559 to the Bankruptcy Code to provide a safe harbor for repurchase agreements. What was particularly unique about this amendment was that the term contractual right was defined much more broadly to include any right “whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice.”

Adding Section 560

In 1990, ' 560 was added to the Bankruptcy Code to include the newly developed swap agreement “to ensure that the swap and forward contract financial markets are not destabilized by uncertainties regarding the treatment of their financial instruments under the Bankruptcy Code.” See H.R. REP. NO. 101-484, at 1 (1990), as reprinted in 1990 U.S.C.C.A.N. 223, 223. This amendment extended safe harbor protection to interest rate and foreign currency rate swap agreements, including combinations of swap agreements, options to enter into swap agreements and any master agreement that includes a swap agreement. The amendment also prohibited a bankruptcy trustee from avoiding transfers under the strong arm powers made under a swap agreement or any setoff in connection therewith. Further, the amendment modified definitions of forward contracts to comply with standard financial practice.

2005 Amendment

In 2005, Congress realizing that the Bankruptcy Code was still inadequate to address systemic risk due to among other things the lack of ability to net different transactions against each other, amended the Bankruptcy Code effective for cases commenced on or after Oct. 17, 2005, to expand the definitions of forward contracts, repurchase agreements and swap agreements, to add safe-harbor protection for master netting agreements (' 561), to broaden the definition of contractual rights, to cover termination and acceleration of contracts, and to broadly expand protection for a financial participant, a catch-all category derived from and quite similar to Regulation EE, issued in 1994 to expand the definition of financial institution used in the netting provisions contained in ” 401-407 of the Federal Deposit Insurance Corporation Improvement Act of 1991.

Five Protected Categories

There are now five protected categories: securities contracts, commodities contracts, forward contracts, repurchase agreements and swap agreements. However, certain financial transactions, especially as a result of the wide scope of underlying agreements that can be use to qualify such transactions for safe harbor treatment, can easily qualify transactions to fit within the definition of more than one of these protected categories, leading to potential uncertainties as to their treatment.

The classes of protected counterparties include commodity brokers, forward contract merchants, stockbrokers, securities clearing agencies, repo participants, swap participants, financial institutions, master netting participants and financial participants. Two things to remember about counterparties are that the definitions of these terms in the Bankruptcy Code do not necessarily correspond to trade usage and that certain protected transactions may not include all types of counterparties.

Finally, Congress passed the Financing Netting Improvements Act of 2006, which contains some technical amendments to ' 561 of the Bankruptcy Code. The Act makes technical and conforming amendments to the Code's definitions of financial institution, financial participant, forward contract and swap agreement. Further, the rights under various financial contracts now include contractual netting rights. Finally, the safe harbors from avoidance actions were amended to include transfers made to or for the benefit of a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant or securities clearing agency in connection with any securities, commodities or forward contracts. These amendments are effective in cases commenced on or after Dec. 12, 2006.

To summarize, the history behind amendments to the Bankruptcy Code relating to special treatment of financial transactions evidences Congress' strong intent to allow for prompt closing out, termination or liquidation of open accounts upon the commencement of a bankruptcy case. In effect, these safe harbor provisions provide an exception to general rule that the automatic stay provisions of ' 362 (a) of the Bankruptcy Code prevents any act that affects property of the estate and overrides the prohibition contained in ' 365(e)(1) of the Bankruptcy Code with respect to enforcement of ipso facto clauses that are tied to the commencement of a bankruptcy case. Whether this goal has been accomplished remains to be seen.

Case Law Developments

Metavante

In a recent bench decision in In re Lehman Brothers Holdings Inc. et al., Case No. 08-13555 (JMP) (Bankr. S.D.N.Y.), Judge James M. Peck held that a non-debtor out of the money swap counterparty (“Metavante“) under a pre-petition interest-rate swap agreement was required to perform its payment obligations notwithstanding a bankruptcy filings by the counterparty, Lehman Brothers Special Financing, Inc. (“Lehman”) and Lehman Brothers Holdings Inc, the credit support provider (“Holdings”). The swap transaction was controlled by a 1992 ISDA Master Agreement (“Master Agreement”).

Floating and fixed-rate payments were netted and the difference was to be paid on scheduled payment dates. Events of default included a bankruptcy filing by the counterparty or its credit support provider. Other terms included the right, but not obligation, to terminate in the event of a default and the right to withhold performance upon an event of default that is continuing under ' 2(a)(iii) of the Master Agreement.

Due to declining interest rates the value of Metavante's position under the swap (which was based on a fixed interest rate) was out of the money. Stated differently, termination of the Master Agreement would result in a significant multi-million dollar payment to Lehman. Consequently, Metavante did not want to terminate the swap and pay a substantial termination fee ' choosing simply to suspend payment. Lehman commenced an adversary proceeding to compel payment (which at the time had reached $6 million), together with interest at the contract default rate.

Metavante, relying on Section 2(a)(iii) of the Master Agreement, argued: 1) that the commencement of Lehman's bankruptcy case and that of its parent Lehman Brothers Holdings, Inc. constituted a default that excused its payment performance; and 2) that pursuant to ' 560 of the Bankruptcy Code it had the right to terminate the swap agreement at any time before maturity.

The bankruptcy court disagreed with Metavante, finding that: 1) the Master Agreement was an executory contract; 2) the safe harbor under ' 560 of the Bankruptcy Code did not allow Metavante to withhold performance ' noting Metavante's conduct of riding the market for the period of one year, while taking no action whatsoever, was simply unacceptable and contrary to the spirit of these provisions of the Bankruptcy Code; 3) Metavante did not have an open-ended contractual right to terminate the swap; and 4) its failure to exercise that right after one year constituted a waiver of that right ' meaning that the right to decide the fate of the Master Agreement shifted to Lehman, which could now choose to either assume or reject the swap agreement under ' 365 of the Bankruptcy Code. This case has recently been settled, but nevertheless raises a substantial number of unresolved issues and creates uncertainty in the market.

Hutson

In re Hutson v. E.I. Dupont De Nemours & Co. et al. (In re National Gas Distributors LLC) 556 F 3d 247 (4th Cir. 2009) involved the physical delivery of a commodity ' natural gas. The circuit court held that a physically settled “commodity forward agreement” may qualify for safe harbor treatment as a “swap agreement” under ' 560 of the Bankruptcy Code, notwithstanding that these over-the-counter transactions are: 1) settled by physical delivery of a commodity; 2) assignable; or 3) not traded on a financial market or exchange. The key protection included in the safe harbor provision under ' 560 of the Bankruptcy Code in this case was the exemption of such transactions from a trustee's avoidance powers under ' 5488 of the Bankruptcy Code. relating to fraudulent transfers.

In Hutson, the trustee sought to avoid certain natural gas forward contracts as fraudulent transfers arguing that the debtor sold the gas to counterparties for less than fair market value at the time when the debtor was presumably insolvent. The Fourth Circuit's decision was one of first impression with respect to whether physically settled commodity forward contracts fall within the definition of “swap agreement,” and thus are protected under the safe harbor provisions of ' 560 of the Bankruptcy Code. The bankruptcy court, which was reversed by the Court of Appeals, held that commodity forward agreements were “agreements by a single end-user to purchase a commodity” (in other words a supply contract) and not a swap agreement, noting that a swap agreement contemplates that it be “regularly the subject of trading in financial markets” and must be settled by financial exchanges of differences in commodity prices.

The Court of Appeals rejected the analysis of the bankruptcy court, noting that: 1) every “forward contract” is a “forward agreement”; and the term “contract“ is included within the broader definition of agreement, a term used in the statute; and 2) commodity contracts can be privately negotiated and do not have to be traded in a financial market.

On this latter point, the Court of Appeals did focus on the fact that the contracts in question were part of a hedging program by the counterparties that involved other securities that were traded in financial markets. The court also rejected the notion that a “commodity forward agreement” had to be cash settled, noting that forward agreements can be physically settled as well as forward commodity contracts. The case was remanded to the bankruptcy court for further proceedings consistent with its decision. This case is an example of how the broad definitions given to safe harbor transactions under the Bankruptcy Code allows courts, rightly or wrongly, to characterize transactions in ways that may or may not qualify them for safe-harbor treatment.

One potential criticism about Hutson is whether the court should have determined qualification of the agreement in question as a swap agreement under the pain meaning of ' 101(53B) of the Bankruptcy Code, or as the court did, to inquire about the economic attributes of the transaction and possibly the motivation of the parties. See In re American Home Mortgage, infra.

American Home Mortgage

In 2008, the scope of a repurchase agreement was addressed in Calyon New York Brach v. American Home Mortgage Corp. , 379 B.R. 503 (Bankr. D. Del. 2008). The bankruptcy court held that the agreement between the parties to purchase and sell mortgage loans was a repurchase agreement because ' 559 of the Bankruptcy Code defined a repurchase agreement as including the transfer of “mortgage related securities, mortgage loans [and] interest in mortgage related securities or mortgage loans.“

However, the bankruptcy court severed the loan servicing portion of the repurchase agreement from the safe harbor protection, finding that the servicing of the loans was retained and not released by the debtor under the repurchase agreement. This decision clarified the treatment of repurchase agreements involving mortgages and servicing rights and creates welcomed clarity as to this category of financial transactions.

One other aspect of this case worth noting is the bankruptcy court's view as to the plain meaning of the statute, which says:

Succinctly stated, if the definition of “repurchase agreement” is met, the section 559 safe harbor protections apply, period. Similarly, if the definitions “securities contract” and “financial institution” are met, the section 555 safe harbor applies, period. This conclusion is compelled by the plain meaning of the statute and is consistent with the policy and legislative history underlying the relevant provisions of the Bankruptcy Code. Id. at 516-17.

Some Unresolved Issues

A number of questions about the safe harbor provisions contained in ' 560 of the Bankruptcy Code remain unresolved as a result of the Metavante decision. First, how long does a counterparty have to exercise its rights before those rights are waived? Second, if the counterparty continues to perform, can the counterparty wait until just before maturity before exercising its rights to terminate? Does the resolution of either of these issues depend on the complexity of the transactions involved, the ability to find reliable substitute counterparties, or how specifically the counterparty as a business practice chooses to address risk management? Drilling down even further, if one of more of these factors are relevant, what weight or other (equitable) considerations should be given to each of them, or is a totality of circumstances the correct analysis? What if refusal to perform by the non-debtor counterparty is based on defaults other than the filing of bankruptcy such as fraud or misrepresentation? Is there a different result?

Final Thoughts

What have we learned? First, the rights of the non-defaulting swap counterparty to liquidate, terminate and accelerate the transaction and to net out the resulting payments under safe-harbor provisions have time limitations. Second, safe harbors relating to swap agreements do not excuse performance by the non-defaulting counterparty. Third, safe harbors in swap agreements do not allow the non-defaulting counterparty to play the market once a default have occurred, strongly suggesting that a counterparty act promptly to exercise its rights to liquidate, terminate or accelerate the transaction in question or risk having a court find that these rights have been waived.

We have also learned that payments made under commodity forward contracts can be treated and protected as a swap agreement under the safe harbor of ' 560 of the Bankruptcy Code whether they are physically or cash settled and therefore not be subject to attack as fraudulent transfers. The factors considered by the Fourth Circuit in Hutson provide analysis as to how commodity supply contracts that are tied to hedging strategies of the purchaser may qualify for safe harbor protection as a swap agreement.

According to Hutson, the commodity supply agreement must involve a commodity with its cost being substantially tied to the commodity itself and not to ancillary packaging, marketing transportation or service charges. Second, it must be a forward contract with delivery of more than two days. Third, the agreement has to set price, time and quantity for delivery. And last, there must be some relationship to the financial markets such as a hedging feature so as to cause the transaction to fall within a safe harbor. In other words, where a commodity forward agreement specifically sets forth prices and quantities at the time the contract is entered, the agreement has hedging features similar to forward contracts that are financially settled in the market, then they can be treated as swap agreements, and protected against fraudulent transfer attack. Such an analysis of the economic attributes of the transaction or the motivation of the parties. transactions, however, may not be universally accepted practice by other courts who favor a plain meaning approach.

Finally, we learned that repurchase agreements involving mortgage-related securities do have safe-harbor protection, which provides greater certainty in the market place and presumably reduces systemic risk for these types of financial transactions.

Just how safe are the harbors? The safe harbors contained in the Bankruptcy Code certainly are not perfect, and indeed may even be too pervasive so as to have unintended consequences. The process to reconciled these issues is ongoing. However, as this process unfolds less sophisticated and smaller counterparties who become subject to safe-harbor statutes designed to protect against systemic risk also need to be protected in a different way. In other words, there can be unintended consequences of causing the failure of a smaller financial player who, but for the modification of the stay authorized under safe harbor provisions, could have survived and reorganized. There is a need to weigh and balance the potential consequences of systemic risk against the fundamental purpose of allowing debtors to reorganize under the Bankruptcy Code. Further tweaking of the statute seems to be required to create this balance. And, despite such a modification and as reasonably anticipated other clarifying amendments, the ever-changing complexity of financial transactions suggests that these safe harbors may never be completely safe.

Robert W. Dremluk, a member of this newsletter's Board of Editors, is a partner in the New York office of Seyfarth Shaw LLP. His work focuses on diverse interests in federal and bankruptcy court litigation and advice and risk assessment regarding transactional matters, including asset purchases and structured finance transactions. He may be reached at [email protected].