Treatment of Securities and Derivatives Transactions in Bankruptcy Part I
What Is a Derivative?
A derivative is a risk-shifting agreement, the value of which is derived from the value of some underlying asset (e.g., a currency, security or commodity), reference rate (e.g., LIBOR), stock or other market index (e.g., Standard & Poor's Composite Index) or any other tradable or measurable instrument or phenomenon upon which two parties can agree to measure.
Derivatives fall into two general categories. One category consists of standardized, exchange-traded contracts known as futures. A commodity contract as defined in the Code is an exchange-traded instrument and, thus, is considered a future.1 The other category of derivatives consists of customized, privately negotiated contracts known as OTC derivatives. The most common types of OTC derivatives are forward contracts and swaps, although there are numerous variations within each of these two broad product types. From an OTC-derivatives perspective, a forward contract can be any agreement to exchange any type of asset at a specified future date and at an agreed-upon price. A swap agreement can be defined, in general nonbankruptcy terms, as an agreement between two parties to exchange (swap) cash flows at specified intervals or payment dates during an agreed-upon term based on the value of some underlying asset, rate or index that is expected to change over time. The terms "forward contract" and "swap agreement" are separately defined in the Code.
Other than how they are traded (i.e., on or off exchange), OTC derivatives differ from exchange-traded futures in several respects. First, the terms of a futures contract are standardized for each type of contract. While organizations such as the International Swaps and Derivatives Association (ISDA) have worked to create standardized forms for many types of OTC derivatives transactions, the same characteristics that are standardized for futures are subject to negotiation by the parties to an OTC derivative contract. Second, standardization allows futures contracts to be freely transferable. For OTC derivatives, transfer or assignment is usually limited by contract. Third, futures markets have a fixed location and are generally subject to the single regulatory regime of the applicable exchange. OTC derivatives are primarily governed by contract law, and the governing law can be chosen by the parties. Fourth, parties to a futures transaction assume exposure by default only to the exchange's clearinghouse. For OTC derivatives, each party to the contract assumes the risk of default by its counterparty. Finally, credit-risk mitigation measures, such as regular marking-to-market and margining, are automatically required for futures, but optional for OTC derivatives.2
In many so-called "cash settled" OTC derivatives transactions, the asset is notional or hypothetical and is never actually traded; one party will simply pay an amount that is somehow derived by reference to the notional asset (e.g,. by application of an interest rate or by measuring a change in value). For example, in an interest rate swap, cash flows are calculated by multiplying the applicable interest rates on each payment date by a notional principal amount of some currency (e.g., $10 million). In a simple interest rate swap, one party (the fixed-rate payor) agrees to pay an amount equal to the interest that would accrue at a fixed rate (e.g., 8 percent) on the notional amount, while the other party (the floating rate payor) agrees to pay an amount equal to the interest that would accrue on the notional amount based on a rate that fluctuates over time (e.g., LIBOR plus some margin). Fixed-rate payors often enter into interest rate swaps in conjunction with obtaining a variable rate commercial loan as a way to hedge against rising interest rates. In addition, by matching the swap terms as closely as possible with the commercial loan terms, the fixed-rate payor/borrower can engineer fixed-rate financing that might not otherwise be available from a single commercial lender.3
In the interest rate swap example above, if the interest rate based on the fluctuating LIBOR rate rises and is greater than 8 percent on an interest payment date, the payment the fixed-rate payor/borrower will have to make to the floating rate payor will be less than the payment he or she would receive from the floating-rate payor. In almost all instances, the parties agree to "net" their mutual payment obligations, thereby dispensing with the need to actually exchange payments. The party with the net payment obligation (in this case, the floating-rate payor) is considered "out of the money" and must pay the difference between the two cash-flow payments. If, in our example, the swap terms are matched to our fixed-rate payor/borrower's commercial loan, the payment received under the swap would offset the increased cost of borrowing under the variable-rate loan.
Unlike futures, which are almost always cash-settled instruments, OTC derivatives often contemplate or provide for the option of "physical settlement." For example, a physically settled forward contract would require the selling party to actually deliver the agreed-upon type and quantities of the asset (e.g., natural gas) on the future settlement date or dates specified in the contract. Companies that require significant amounts of a particular product or commodity to operate their businesses may enter into forward contracts in order to ensure a steady supply of the product or commodity, to lock in a favorable price or to obtain cost certainty for budgeting purposes. If the forward contract was cash-settled, the "out-of-the-money" party (i.e., the seller if the price goes up, and the buyer if the price goes down) would only be required to pay the counterparty the difference between the contract price and the market price for the notional type and quantity of the product or commodity agreed to in the contract.
As noted above, OTC derivatives transactions are increasingly becoming common financial market transactions. In 1990, the OTC derivatives market consisted primarily of commodity forwards and basic interest rate and currency swaps. Since then, however, derivatives transactions have expanded into a wide range of commodity, interest rate, currency, credit, debt, equity and even weather-derivative products. During the same period, the growth of the OTC derivatives markets in terms of dollars has exploded. In 1990, ISDA estimated that $1 trillion in notional principal amount of interest rate swaps were outstanding. As of the end of 2004, ISDA estimated the notional amount of interest-rate swaps outstanding at more than $183 trillion. These figures are significant. On numerous occasions, Federal Reserve Board Chairman Alan Greenspan has commented on the phenomenal growth of the OTC derivatives markets and their impact on financial markets worldwide.4
Bankruptcy Code Provisions
Congress has long accorded special treatment to transactions involving the securities and derivatives markets. This special treatment has been justified by concerns that the insolvency of one market participant might spread to other participants in a so-called "ripple effect" that could, in turn, lead to the collapse of an affected market.5 As originally enacted in 1978, the Code provided limited protection to commodity brokers by providing that certain margin payments could not be avoided as preferential transfers. However, concerns over the stability of established and expanding markets prompted Congress over time to provide additional and broader protections for a variety of financial markets.
In 1982, Congress amended the Code by inserting special provisions relating not only to commodity contracts, but also securities and forward contracts. Since then, as new financial instruments have developed, Congress has expanded the reach of these protective provisions. As part of the Bankruptcy Amendments and Federal Judgeship Act of 1984, Congress inserted provisions essentially mirroring the 1982 amendments for repurchase agreements. In 1990, Congress again amended the Code to insert provisions with respect to swap agreements. As noted above, BAPCPA inserted additional provisions and amended various existing provisions (together, collectively referred to hereinafter as the "Financial Market Provisions").6
While contained in a fairly complex web of definitions and substantive provisions scattered throughout the Code, the basic structure of the Financial Market Provisions is rather straightforward. The provisions generally operate to exempt a number of routine financial market payments and transfers from the Code's automatic stay and avoidance provisions. The exempt payments and transfers are afforded special treatment because the timely completion of these types of transactions (without the risk that they may be subsequently undone) is considered critical to the stability and smooth operation of the financial markets.
To be exempt, a payment or transfer must constitute either a margin, settlement or other similar payment (a "protected payment") made with respect to a securities or derivatives transaction, or more specifically, a securities contract,7 commodity contract,8 swap agreement,9 forward contract10 or a repurchase agreement11 (each a "protected contract" and, collectively, the "protected contracts"). The payments or transfers must also typically be made by or to certain types of market participants specifically identified in the various Financial Market Provisions (the "protected participants").
Specific Exemptions from the Automatic Stay and Avoidance Provisions
The Financial Market Provisions provide for three sets of substantive protections or exemptions. First, setoffs by protected participants on account of a protected payment due from the debtor under a protected contract are excepted from the automatic stay provisions of §362(a). Claims for protected payments may be set off against any cash, securities or other property due from, held by or pledged to a protected participant.12 BAPCPA further provides that the exercise of the setoff rights excepted from the automatic stay cannot be stayed by an order of the bankruptcy court in any proceeding under the Code.13
Second, various subsections of §546 limit the ability of a trustee or a DIP to avoid a pre-petition transfer that might otherwise be treated as a preference or constructively fraudulent transfer if such transfer constitutes a protected payment made by or to a protected participant under a protected contract.14 The Financial Market Provisions do not limit avoidance of a transfer determined to be intentionally fraudulent. However, §548(d)(2) of the Code essentially establishes one of the two prongs of the "good-faith transferee for value" defense to a fraudulent transfer action15 by providing that a protected participant is deemed to have taken "for value" to the extent it received a protected payment under a protected contract.16
Third, §§555, 556, 559, 560 and 561 provide exceptions to both the automatic stay and the general rule of §365(e)(1) against enforcement of ipso facto clauses by allowing a protected participant to enforce a contractual right to close out, terminate and accelerate all amounts owing under a protected contract on account of the grounds set forth in §365(e)(1)—i.e., the debtor's insolvency or financial condition, the commencement of the bankruptcy case or the appointment of a trustee in a bankruptcy case.17 These provisions also further limit or prohibit a bankruptcy court from issuing any order under §105(a) of the Code that would stay the enforcement of such contractual rights.
With respect to this last set of exemptions, it is important to note that these provisions also limit a protected participant's termination rights to the specific conditions specified in §365(e)(1). For instance, a protected participant cannot, without violating the automatic stay, terminate an agreement simply because the protected contract is no longer a good deal for the nondebtor party. The conventional wisdom with respect to §§555, 556, 559 and 560 is that if the nondebtor party decides not to terminate the protected contract upon, or reasonably close in time to, the filing of the debtor's bankruptcy petition, it does so at its own risk since, with the passage of time and absent the appointment of a trustee, it may become difficult to establish that its subsequent attempt to terminate was grounded upon the debtor's bankruptcy filing, insolvency or financial condition.18
The substantive protections of the Financial Market Provisions apply only to the five types of protected contracts identified above. Thus, a threshold determination in any case is whether one of the foregoing types of protected contracts exists or existed between the debtor and a nondebtor party.
The definitions for each of the protected contracts in the Code, however, are quite expansive and were made even more so by BAPCPA. These definitions appear to have been intentionally drafted to overlap with one another so that various types of financial market contracts will fall within two or more categories of protected contracts. For instance, under the protected contract definitions as modified by BAPCPA, a securities option could be considered both a securities contract and a swap agreement, and an equity forward (like the contract involved in the Enron I case discussed in Part II) could be considered a forward contract, a securities contract and a swap agreement.19
In addition, four of the five protected contract definitions20 include catch-all language that would incorporate "any similar agreement" not specifically listed or described in the definitions. The purpose of the catch-all language is to incorporate into the definitions additional financial contracts that either are not specifically listed or do not yet exist, but that may exist in the future as markets for various financial products evolve.21 Finally, each of the protected contract definitions specifically incorporates within its terms separate security agreements, third-party guarantees and other credit enhancements (such as letters of credit) that might be provided in connection with a protected contract.
It is useful to emphasize that physically settled OTC derivatives transactions can qualify as protected contracts. Based on a narrow reading of the legislative history of the Financial Market Provisions, some litigants have argued that physically settled forward contracts that are not traded on an exchange are not the type of "financial market" transactions that Congress intended to include within the protective sweep of the Financial Market Provisions.22 In the Olympic Natural Gas case, the U.S. Court of Appeals for the Fifth Circuit rejected this argument. The court held that the definition of "forward contract" in the Code makes no distinction between "financial" cash-settled forward contracts and the physically settled forward contracts the appellant described as "ordinary purchase and sale" contracts.23 Indeed, there does not appear to be any good reason to assume that a physically settled forward contract is not "financial" in character.
The substantive protections afforded with respect to protected contracts are only available to, or with respect to transactions involving, the protected participants specifically identified in the various Financial Market Provisions. The terms used to describe each protected participant are defined in the Code.
Several of the protected participant terms are defined in a manner that associates the term directly with a type of protected contract (i.e., "commodity broker" with "commodity contract"). With respect to repurchase agreements and swap agreements, a person is a protected participant simply by virtue of being a party to a protected contract with the debtor.24 However, with respect to securities contracts, commodity contracts and forward contracts, the categories of protected participants are more narrowly defined in terms of regular participation in the applicable markets.
For example, a "forward contract merchant" is defined in terms of an entity whose business consists in whole or in part of entering into forward contracts.25 BAPCPA took this concept a step further by including within the new definition of "financial participant" (applicable to all categories of protected contracts) an entity that, on any day within 15 months before either the petition date or the date it enters into a protected contract, has entered into one or more protected contracts with a total gross dollar value of not less than $1 billion in notional or actual principal amount outstanding, or gross mark-to-market positions of not less than $100 million aggregated across all counterparties.26
Whether a person is a protected participant should be determined on a case-by-case basis. Some courts have recently held that in order to be protected as a protected participant, the person or entity claiming such protection must be acting as a protected participant in the relevant transactions with the debtor.27 Thus, if a nondebtor party to a protected contract obtains a pre-petition payment under the protected contract that is not in the ordinary course but by means of more typical debt-collection efforts, courts may determine that in obtaining the payment, the nondebtor party was not acting as a protected participant but as an ordinary creditor.28
As noted above, to be exempt, a payment or transfer must constitute either a margin, settlement or other similar payment made by or to a protected participant with respect to a protected contract. For securities contracts, commodity contracts, forward contracts and repurchase agreements, the protected payments are "margin payments" or settlement payments."29 These terms are defined in the Code; however, their definitions are quite circular. For example, for purposes of the forward contract provisions, "margin payment" is defined as a "payment or deposit of cash, a security or other property, that is commonly known in the forward contract trade as original margin, initial margin, maintenance margin or variation margin, including mark-to-market payments or variation payments."30 "Settlement payment," for purposes of the forward contract provisions, is defined as "a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, a net settlement payment or any other similar payment commonly used in the forward contract trade."31
These circular definitions ultimately force courts to look to the relevant market to determine how these terms are used in the industry.32 The Code seems to explicitly recognize this market-based meaning approach by providing separate, slightly different versions of the definitions for use with respect to specific types of protected contracts. Thus, "settlement payment" is defined twice in the Code; one definition is used in connection with forward contracts33 and the other for securities contracts.34 The term "margin payment" has three similar but separate definitions for forward contracts,35 securities contracts36 and commodity contracts.37
Given these imprecise definitions, disagreements as to the meaning of the terms are inevitable. Not surprisingly, as will be discussed in Part II of this article, what actually constitutes a settlement payment under the Code has been the subject of much litigation.
4 See, e.g., Federal Reserve Chairman Alan Greenspan, Remarks at Lancaster House, London (Sept. 25, 2002) available at http://www.federalreserve.gov/boarddocs/speeches/2002/, and Remarks to the Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank Structure, Chicago (via satellite) (May 5, 2005) available at http://www.federalreserve.gov/boarddocs/speeches/2005/. Return to article
5 See H.R. Rep. No. 97-420 at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, available at 1982 WL 25042 and H.R. Rep. No. 101-484 at 2 (1990), reprinted in 1990 U.S.C.C.A.N. 233 at 224, available at 1990 WL 92539. Return to article
18 See In re Amcor Funding Corp., 117 B.R. 549, 551 (Bankr. D. Ariz. 1990) (construing §555). Cf. In re Mirant Corp., 314 B.R. (Bankr. N.D. Tex. 2004) (nondebtor party's termination of a swap agreement seven weeks after the petition date was permitted under §560 and not a violation of the automatic stay where court found that the debtor actively discouraged the nondebtor party from terminating by pointing to certain benefits under a court order, only later to deny that the nondebtor party was entitled to the benefits). Return to article
22 See Williams v. Morgan Stanley Capital Group Inc. (In re Olympic Natural Gas Co.), 294 F.3d 737, 742 (5th Cir. 2002). See, also, Campbell, Rhett G., "Energy Future and Forward Contract, Safe Harbors and the Bankruptcy Code," 78 Am. Bankr. Law J. 1, 9-12 (Winter 2004) (outlining the argument). Return to article
27 Mirant Amerigas, 310 B.R. at 569. See, also, Newhouse v. Texas Eastern Transmission Corp., (In re Aurora Natural Gas LLC), 316 B.R. 481 (Bankr. N.D. Tex. 2004); GPR Holdings L.L.C. v. Duke Energy Trading and Mktg. L.L.C. (In re GPR Holdings L.L.C.), 316 B.R. 477 (Bankr. N.D. Tex. 2004). Return to article
32 See Kipperman v. Circle Trust (In re Grafton Partners L.P.), 321 B.R. 527, 538 (B.A.P. 9th Cir. 2005); Jackson v. Mishkin (In re Adler, Coleman Clearing Corp.), 263 B.R. 406, 475 (S.D.N.Y. 2001). Return to article