Chapter 15 Deciphering Derivatives in Bankruptcy

• Jurisdiction: United States

15. Deciphering Derivatives in Bankruptcy

Written by:

Nicholas M. McGrath

K&L Gates LLP; Boston

Ji Hun Kim

GrayRobinson PA; Miami

Derivative contracts are afforded special treatment under the Bankruptcy Code, which contains provisions (the "safe-harbor provisions") that allow derivatives to be exempted from the automatic stay,¹ certain avoidance actions² and the unenforceability of ipso facto clauses.³ In the 2008 financial crisis, this treatment of derivative contracts played a special role.⁴ Just before and after Lehman Brothers' chapter 11 filing, parties rushed to close out their derivatives with the investment bank. Bigger players terminated all of their contracts with Lehman, leaving one "net" claim.⁵ Some parties who had collateralized their obligations could cover their claims with this collateral.⁶ New trades were entered into to hedge any losses, new collateral was bought and sold, and the derivatives markets experienced turbulence.⁷

Derivative contracts also contributed to AIG's financial deterioration.⁸ Parties that had entered into derivatives contracts with AIG knew that their demands for increasing amounts of collateral could never be questioned if AIG had to file for bankruptcy.⁹ AIG also knew that a filing would lead to the dismemberment of its firm.¹⁰ This article will first provide an overview of derivative contracts, then describe the most common types of derivatives. Safe-harbor provisions and the reasoning behind them will be detailed next, concluding with a summary of recent case law involving derivatives and the Bankruptcy Code.

A. Overview of Derivatives

A derivative is a risk-transfer agreement, the value of which is derived from the value of an underlying asset.¹¹ The underlying asset could be a physical commodity, an interest rate, a company's stock, a stock index, a currency or any other tradable instrument upon which two parties can agree.¹²

Derivatives can be used to hedge against financial risk, or for speculative purposes.¹³ Companies may want to hedge their risks to avoid the adverse effects of future spikes in the price of a needed commodity or sudden change in the value of payments the corporation receives from sales abroad.¹⁴ As an example, a company wanting to avoid adverse spikes in the prices of a needed commodity may enter into an option.¹⁵ With an option, the holder has the right, but not the obligation, to buy the specified commodity or asset for a specified price at an agreed upon date.¹⁶ If Company X purchases an option to buy 100 gallons of gas as $100 per gallon in three months, this right has value¹⁷ because in three months, a gallon of gas could sell for $200, in which case, the holder of the option is ahead by $100 per gallon.¹⁸

B. Types of Derivatives

The most common types of derivatives are forward contracts, repurchase agreements, swaps, future contracts and options. A forward contract is an agreement in which a party commits to buy (or sell) an asset at a specified future date and at an agreed-upon price.¹⁹ In a repurchase agreement, the borrower promises to transfer security to a lender for a sum of money. The security will then be repurchased later at a fixed price.²⁰

Another type is a swap agreement, which is between two parties to exchange cash flows at specified intervals or payment dates during an agreed-upon term based on an assumed value of some underlying asset, rate or index that is expected to change over time.²¹ A popular example of a swap agreement is the credit-default swap, which is a private contract that transfers credit risk from a credit-protection buyer to a protection seller.²² A protection buyer can use a credit-default swap to unbundle and hedge the credit risks associated with a particular entity, a group of entities or even an entire industry.²³

Future contracts are similar to forward contracts, with an agreement between two parties to buy and sell a particular asset, at some future date, at a predetermined price.²⁴ The last type is an option, which is a contract that gives an individual or entity the right, but not the obligation, to buy, sell or lease an item, or to enter into or renew a contract at a specified price within a specified time.²⁵

C. Derivatives and the Code

As mentioned, the Code provides derivative contracts with three main forms of substantive protections or exemptions. First, termination of a derivative contract is exempt from the automatic stay provision of § 362(a).²⁶ Usually, when a firm files a bankruptcy petition, it immediately receives the advantage of the automatic stay, which prevents creditors from taking measures to collect debts, seize assets or exercise control over property of the debtor's estate, but this is not the case when derivatives are involved. Even if a firm enters bankruptcy, nondebtor counterparties can enforce a contractual right to close out, terminate and accelerate all amounts owed under a derivative contract. Likewise, collateral provided as part of a derivative transaction can be foreclosed upon. Bankruptcy courts are also prohibited from issuing any order under § 105(a) that would stay the enforcement of such contractual rights.²⁷

Second, derivatives are exempt from the general rule of § 365(e)(1) against enforcement of ipso facto clauses by allowing nondebtor counterparties to enforce a contractual right to close out, terminate and accelerate all amounts owed under a derivative contract on account of the debtor's insolvency or financial condition.²⁸ Third, § 546 limits the ability of a trustee or debtor in possession to avoid pre-petition transfers that might otherwise be treated as preferences or constructively fraudulent transfers.²⁹

Congress' reason in providing derivative contracts with these protections was to promote stability within the financial sector.³⁰ It decided that this treatment was necessary to counter the concern of a systemic risk in the financial markets, and was concerned that if participants in certain financial activities were unable to enforce their rights to terminate financial contracts with an insolvent entity in a timely manner, or to offset or net their various contractual obligations, the resulting uncertainty and potential lack of liquidity could wreak havoc in the financial markets.³¹ Without the safe-harbor provisions, counterparties to derivative contracts would be subject to the automatic stay for extended periods. They would thus be unable to liquidate volatile contracts and thereby limit their exposure to market movements.³²

D. Recent Decisions

1. Limitations of Foreign Security-Based Swap Agreements

On Dec. 30, 2010, the U.S. District Court for the Southern District of New York dismissed two...