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As the corporate world becomes increasingly more complex and competitive, companies have sought innovative techniques to manage the risks and costs associated with conducting business. To that end, companies frequently employ "hedging programs," which seek to make advanced contractual arrangements in order to safeguard against loss from market fluctuations and provide business certainty. Out of these hedging programs and other risk management techniques have emerged five types of financial contracts that Congress has recognized serve an important role in managing an individual company's risks, and, consequently, helping to ensure stable financial markets. Because of their unique purposes and characteristics, Congress has excluded these stabilizing financial contracts from the rules otherwise applicable to executory contracts 1 under the Bankruptcy Code in order to protect the benefits of these risk management tools.
The Enumerated Financial Contracts
The following types of executory financial contracts are given special treatment under the Bankruptcy Code: (1) securities contracts, (2) commodity or forward contracts, (3) repurchase agreements, (4) swap agreements, and, as recently added under BAPCPA, 2 (5) master netting agreements (collectively, the "Enumerated Financial Contracts"). 3 The Enumerated Financial Contracts receive special treatment because Congress has sought to relieve "systemic risk" from the market place - the risk that a default by one counterparty may cause widespread difficulties within other industry participants, other market segments, or the financial system as a whole ( i.e., a domino effect).
The Safe Harbor Provisions
The Bankruptcy Code provides for the special treatment of the Enumerated Financial Contracts under sections generally referred to as the "safe harbor" provisions. These safe harbor provisions seek to (i) exclude the Enumerated Financial Contracts from certain restrictions in the Bankruptcy Code or (ii) grant qualifying counterparties to an Enumerated Financial Contract certain affirmative rights that are not otherwise available to them.
With few exceptions, a debtor can elect to assume or reject an executory contract at any time between the petition date and the confirmation of the debtor's plan, which may be several years. This waiting period can be economically risky for the non-debtor counterparty, because the market price of the commodity or other item upon which the value of the Enumerated Financial Contract is based could move significantly against the debtor's interests, leaving the financially fragile debtor unable to pay for potentially extensive losses that the non-debtor counterparty may not be able to absorb (creating a cascade of defaults). To address this "hostage counterparty" issue, Congress has provided that counterparties to an Enumerated Financial Contract are not prohibited by the automatic stay from exercising a "contractual right" to cause the termination, liquidation, or acceleration of an Enumerated Financial Contract based on a counterparty's bankruptcy, notwithstanding the Bankruptcy Code's general prohibition against the enforceability of termination clauses. 4
Furthermore, the automatic stay does not prohibit a counterparty to an Enumerated Financial Contract from exercising a contractual right to "setoff" a claim owed by the debtor for a "margin payment" or "settlement payment" against "cash, securities or other property" held by the counterparty as security. 5 As a result, a qualifying counterparty can quickly terminate an Enumerated Financial Contract and offset any qualifying claims against posted security without having to seek relief from the automatic stay, tremendously reducing the delay and uncertainty associated with seeking court approval.
To incorporate the addition of master netting agreements to the Enumerated Financial Contracts, BAPCPA amended Section 553(a) of the Bankruptcy Code to provide that if a counterparty acquired setoff rights against the debtor from an entity other than the debtor ( i.e., an affiliate of the counterparty) in connection with an Enumerated Financial Contract, any transfer related thereto cannot be avoided as a preference. Prior to BAPCPA, if a counterparty acquired setoff rights against the debtor that were transferred by an entity other than the debtor within 90 days of the bankruptcy filing ( i.e., were transferred by an affiliate of the counterparty pursuant to a newly executed master netting agreement with the debtor), any setoff related thereto was probably avoidable and recoverable as a preference.
Similarly, BAPCPA amended Section 553(b) of the Bankruptcy Code to prohibit the recovery of any setoff that was executed within 90 days of the debtor filing for bankruptcy protection, if such setoff was pursuant to an Enumerated Financial Contract. Consequently, post BAPCPA, the acquisition and execution of contractual setoff rights under an Enumerated Financial Contract, including those acquired pursuant to a master netting agreement, are not avoidable under Section 553.
Section 546 of the Bankruptcy Code sets out certain limitations on the avoidance powers generally afforded to either the trustee or debtor under chapter 5 of the Bankruptcy Code. Specifically, if a "margin payment" or "settlement payment" is transferred pre-petition to a qualifying counterparty, such payment may not be avoided as a preference or fraudulent transfer absent proof that the transfer was made with the "actual intent to hinder, delay or defraud creditors." 6 BAPCPA extended this avoidance protection to include qualifying transfers made pursuant to master netting agreements.
Qualifying for the Safe Harbors
To enjoy the benefits of the safe harbor provisions, an Enumerated Financial Contract counterparty must satisfy three primary elements. First, a counterparty must show that the contract in question qualifies as one of the specifically defined Enumerated Financial Contracts ( i.e., it is a "forward contract"). Second, a counterparty must establish that it qualifies under the counterparty requirements that are dictated by the Bankruptcy Code ( i.e., is a "forward contract merchant"). Lastly, a counterparty must prove either (i) with respect to preference or fraudulent conveyance immunity, that the transfer sought to be avoided was a "settlement payment," a "margin payment," or a "setoff," or (ii) with respect to exceptions to the automatic stay, that the counterparty had a "contractual right" to terminate, liquidate or accelerate the Enumerated Financial Contract, and to offset any qualifying claims related thereto. As with any definition, there is significant litigation related to the exact parameters of the qualifying contracts, counterparties and transfers afforded special treatment under the safe harbors.
Of course, an Enumerated Financial Contract counterparty is not required to exercise its safe harbor rights and terminate the contract immediately upon the debtor filing a bankruptcy petition. A counterparty may chose to be treated as a counterparty to a normal executory contract, and wait to see if the debtor will assume the contract and "cure" all defaults ( i.e., make payment in full). 7 Under this scenario, if the debtor subsequently decides to reject the contract, the counterparty is entitled to rejection damages.
Under BAPCPA, Section 562 was added to the Bankruptcy Code to address the timing for assessing damages in connection with the rejection of an Enumerated Financial Contract. New Section 562 provides that damages related to an Enumerated Financial Contract should generally be measured as of the date of rejection of the contract. Under the prior law, rejection damages were generally calculated as of the petition date, thereby capping a counterparty's damages at the onset of the case and allowing the debtor to watch the market move before determining whether to assume or reject the contract.
The Enumerated Financial Contracts have become bedrock risk management tools for businesses in their attempts to reduce risks and provide greater business certainty. The safe harbor provisions provide valuable tools to protect non-debtor counterparties. Understanding the fundamental mechanics of the safe harbor provisions and the benefits that they provide can result in significantly increased recoveries for clients who are counterparties to an Enumerated Financial Contract.
1 See 11 U.S.C. § 365 (2006).
2 The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA").
3 See 11 U.S.C. §§ 555, 556, 559, 560, and 561 (2006)
4 Compare, e.g., 11 U.S.C. § 556 with 11 U.S. C. § 365(e).
5 See, e.g., 11 U.S.C. § 362(b)(6).
6 11 U.S.C. § 546.
7 A creditor must be careful not to wait an unreasonably long amount of time after the bankruptcy filing to determine whether it will exercise its safe harbor rights to terminate the contract because such delay may be seen as a waiver of its contractual right to terminate.
About the Author
Mr. Worden practices with Fulbright & Jaworski L.L.P. ("Fulbright") in Houston, Texas. His practice focuses primarily on debtor and creditor rights and related litigation under the "Bankruptcy Code," 11 U.S.C. § 101, et seq. (2006).
Special thanks to Evelyn Biery, a partner at Fulbright, and Johnathan Bolton, a senior associate at Fulbright, for their assistance in editing this paper.