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Derivatives

The Financial Contract Provisions Of The Bankruptcy Abuse Prevention & Consumer Protection Act Of 2005

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which became law on April 20, 2005, significantly revises many provisions of the U.S. Bankruptcy Code.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which became law on April 20, 2005, significantly revises many provisions of the U.S. Bankruptcy Code. While most of the press discussion of the Act has focused on the impact it will have on the ability of individuals to eliminate debts under Chapter 7 of the Code, the Act also significantly affects the rights of debtors and non-debtor parties in business bankruptcy cases. Among other things, the Act clarifies and expands the rights of parties to various financial contracts and transactions in the event of a party's bankruptcy. The provisions of the Act relating to financial contracts will apply to bankruptcy cases commenced on or after October 17, 2005.


Current Law


In a series of steps ending in 1990, Congress created bankruptcy safe harbors for a variety of financial transactions in order to limit the systemic disruption that might be caused by the bankruptcy of a significant financial-markets participant. The Code's existing safe harbors protect the rights of parties to securities contracts, commodities contracts, forward contracts, repurchase agreements and swap agreements to liquidate such agreements in the event of the bankruptcy of a counterparty. The Code exempts these transactions from its automatic stay, which would otherwise prevent non-debtor parties from liquidating a contract and exercising rights of setoff. These exemptions allow the non-debtor party to the contract to net the losses and gains under that contract and close out the contract notwithstanding the pending bankruptcy case. In addition, the Code insulates these transactions from avoidance (i.e., revocation or unwinding) as preferential or fraudulent transfers unless the transaction was made with actual intent to hinder, delay or defraud creditors of the debtor.


The Need For Reform


Since the 1990s some practitioners have argued the Code's existing provisions relating to financial transactions should be updated to address the reality that a greater number and variety of participants are engaging in a broader range of financial transactions. As a result, these new parties and transactions, which are not clearly addressed by the existing provisions of the Code, are subject to uncertainty regarding their rights and obligations in the event of a bankruptcy. To address these issues and to bring greater certainty to financial markets, the Act updates, expands and clarifies a number of Code provisions to specifically permit termination, close-out, setoff and netting of a broader array of financial contracts.


Highlights Of The Act[1]


Broadened Definitions

The Act significantly expands the Code's definitions of a commodity contract, forward contract, repurchase agreement, securities contract and swap agreement. The revisions are intended to broaden the types of contracts and transactions that benefit from the safe harbor and other protections of the Code and to insure the Code automatically covers new and changing transactions as they evolve. For example, the definition of swap agreement has been revised extensively to enumerate in detail the various types of swap agreement covered by the Act. Examples of types of transactions that were not explicitly described in the pre-Act definition include equity and credit derivatives. These are now specifically included.

The expanded definitions also now cover a combination of agreements or transactions and any options to enter into them, master agreements, security agreements and other credit enhancement related to them. The Act allows for future innovation in transactions by covering "any agreement or transaction that is similar to any other agreement or transaction referred to in this paragraph[2] and that is of a type that has been, or in the future becomes, the subject of recurrent dealings in the swap markets . . . and is a forward, swap, future, or option on one or more rates, currencies, commodities, equity securities, [sic] or other equity instruments, debt securities or other debt instruments, quantitative measures associated with an occurrence, extent of an occurrence, or contingency associated with a financial, commercial, or economic consequence, or economic or financial indices or measures of economic or financial risk or value."


Netting

The Act strengthens the existing safe harbor for the exercise of contractual rights under swap agreements by adding liquidation and acceleration to termination as protected rights. Furthermore it adds, as permissible sources of such contractual rights, the rules, bylaws and resolutions of a derivatives clearing organization, a national securities exchange, a national securities association (such as the NASD), a securities clearing agency, a designated contract market, a registered derivatives transaction execution facility or a board of trade.

As a result of the Act, the Code will permit multiple-transaction, multiple-contract and cross-product netting. Thus, the broad netting that the International Swaps and Derivatives Association 1992 and 2002 Master Agreement forms permit if the parties elect "Multiple Transaction Payment Netting" would become enforceable in a U.S. bankruptcy case. The Act adds a definition for "master netting agreement," which is defined as "an agreement providing for the exercise of rights, including rights of netting, setoff, liquidation, termination, acceleration or close out," under or in connection with one or more securities contracts, commodities contracts, forward contracts, repurchase agreements or swap agreements. A master netting agreement will be effective to protect qualifying transactions even if it also covers some transactions or agreements that do not qualify for protection.

The Act adds new Section 561, which, with exceptions relating primarily to commodities contracts, creates a safe harbor to protect the exercise of contractual rights (broadly defined, as described above) "to cause the termination, liquidation, or acceleration of or to offset or net termination values, payment amounts, or other transfer obligations arising under or in connection with one or more" swap agreements or master netting agreements from prior restraint or subsequent avoidance by the Code, a bankruptcy court or an administrative agency. The Code as amended would, it thus appears, permit the full implementation of early termination for bankruptcy or insolvency and close-out netting under the ISDA 1992 and 2002 Master Agreement forms.


Exceptions From Automatic Stay & Avoidance Powers

The Act modifies the Code's automatic stay to exempt broader rights of setoff against payments due under swap agreements and master netting agreements. Also, because the Code's financial contract definitions are being revised to include related security and other credit enhancement agreements, the enforcement of such agreements would now also be more clearly exempt from the automatic stay.

The Act adds limitations upon and exceptions to the various avoidance power provisions of the Code to insulate from avoidance in bankruptcy pre-bankruptcy transfers made under a master netting agreement and to better insulate transfers made under a swap agreement. Transfers by a debtor that were made with actual intent to hinder, delay or defraud creditors will remain subject to possible avoidance.

These changes will allow a party to a financial contract to realize the benefits and control its exposure even as its counterparty is teetering on the verge of bankruptcy without concern that the transactions occurring in the months preceding a bankruptcy filing will be scrutinized and avoided by a bankruptcy trustee in the absence of actual intent to defraud.


Damage Measurement Timing

The Act adds Section 562 to the Code to address the timing of the measurement of damages following the rejection, liquidation, termination or acceleration of a commodities contract, forward contract, repurchase agreement, securities contract, swap agreement or master netting agreement. Damages will be measured as of the earlier of (i) the date of rejection of the agreement by the trustee or (ii) the date or dates of liquidation, termination or acceleration of the agreement. If there are not any "commercially reasonable determinants of value" as of such dates, damages must be measured "as of the earliest subsequent date or dates on which there are commercially reasonable determinants of value." Any security agreement, guarantee, reimbursement agreement or other credit enhancement related to a swap transaction will be considered a "swap agreement" entitled to the benefits of the Code's newly expanded safe harbors only to the extent that it secures damages as calculated in accordance with new Section 562.

Under another new provision of the Code added by the Act, any damage claim against the debtor remaining after all permissible netting is to be treated as if it had arisen immediately prior to the filing of the bankruptcy case. As a result, any such claim will be treated as a general (i.e., non-priority) claim in bankruptcy.


Conclusion


The Act significantly expands and clarifies a party's setoff, netting, termination and close-out rights upon the bankruptcy of a counterparty. In addition, the Act provides greater certainty regarding the types of financial contracts that will receive safe-harbor protection, thus improving the certainty with which parties will be able to structure and document their transactions. For example, they will now be able to elect Multiple Transaction Payment Netting with great assurance that it will be enforceable in bankruptcy. In addition, they will be able to deal with troubled counterparties with much greater assurance that their actions on the eve of bankruptcy will be immune from attack in bankruptcy and exercise remedies after the commencement of the bankruptcy case that previously required leave of the Bankruptcy Court.


This week's Learning Curve was written by David Dykhouse, partner, and Alexander Lewis and Michael Handler, associates, at Patterson, Belknap, Webb & Tyler in New York.


[1]This note is intended only as a summary of certain provisions of the Act as it relates to financial contracts. A document showing the changes to each of the relevant provisions of the Code is available online at www.pbwt.com. [2]Which is a laundry list of existing transactions.

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