Chapter 9 Swap Agreements

• Jurisdiction: United States

Chapter 9 Swap Agreements

The term "swap agreement" is defined in § 101(53)(B) of the Bankruptcy Code. Unfortunately, the Bankruptcy Code's definition is somewhat circular; it lists types of swaps and other agreements without further explanation or definition. A commonly used description of a swap is "a contract between two parties ('counterparties') to exchange ('swap') cash flows at specified intervals, calculated by reference to an index. Parties can swap payments based on a number of indices including interest rates, currency rates and security or commodity prices."¹⁰³

Another way to think about a swap is as a protection against some negative outcome, such as interest rate increases, loan defaults, currency fluctuations, equity value loss, etc. Once the swap contract is terminated, a formula in the contract determines which party suffers a loss (usually based on market activities) in the protected set of transactions, and one party then pays the other to cover the loss.

A. The Example of an Interest Rate Swap

One common use of swaps is in connection with floating-rate loan facilities to manage the risk posed by fluctuations in interest rates. As explained by the U.S. Court of Appeals for the Ninth Circuit:

The "plain-vanilla" interest rate swap, the simplest and most common type of swap contract, obligates one counterparty (Counterparty A) to make payments equal to the interest which would accrue on an agreed hypothetical principal amount ('notational amount'), during a given time period, at a specified, fixed interest rate. The other counterparty (Counterparty B) must pay an amount equal to the interest which would accrue on the same notational amount, during the same period, but at a floating interest rate defined by reference to an index. If the interest calculated using the fixed rate exceeds the interest calculated using floating rate, then Counterparty A must pay to Counterparty B an amount equal to the difference between the two rates multiplied by the notational amount, for the specified interval. Conversely, if interest calculated at the floating rate exceeds interest calculated at the fixed rate, then Counterparty B must pay Counterparty A the difference. The agreed hypothetical or 'notational' amount provides the basis for calculating payment obligations, but it does not change hands.¹⁰⁴

Using a more specific example, suppose Counterparty A obtains a $1 million loan with a five-year term that accrues interest at the per annum floating rate of LIBOR plus 2%. Counterparty A is comfortable with a floating rate as long as its effective rate does not exceed 5% (i.e., LIBOR peaks at 3%). To manage the risk that LIBOR could rise above 3%, Counterparty A enters into a five-year swap agreement with Counterparty B with a notational amount of $1 million. Counterparty A agrees to make semiannual payments of interest to Counterparty B calculated at 5% on the notational amount, and Counterparty B agrees to make semiannual payments of interest to Counterparty A calculated at LIBOR + 2% on the same notational amount.

Counterparty A ------> Counterparty B
[Interest on $1 million over 5 years at 5%]

Counterparty A [Interest on $1 million over 5 years at LIBOR + 2%]

As illustrated below, if LIBOR rises to 4%, Counterparty B would be obligated to pay Counterparty A $30,000 (calculated as $1,000,000 x (6/100) x (6/12)), and Counterparty A would be obligated to pay Counterparty B $25,000 (calculated as $1,000,000 x (5/100) x (6/12)). In practice, the parties would net their obligations, with the result that Counterparty B would pay $5,000 to Counterparty A (calculated as $1,000,000 x ((4 + 2-5)/100) x (6/12)).

Counterparty A ------> Counterparty B
$1,000,000 x (5/100) x (6/12) = $25,000

Counterparty A $1,000,000 x (6/100) x (6/12) = $30,00
Net: Counterparty B pays $5,000 to Counterparty A

In contrast, if LIBOR falls to 1%, then Counterparty A would be obligated to pay Counterparty B $25,000 (calculated as $1,000,000 x (5/100) x (6/12)), and Counterparty B would be obligated to pay Counterparty A $15,000 (calculated as $1,000,000 x (3/100) x (6/12)). After netting the obligations, Counterparty A would pay $10,000 to Counterparty B.

Counterparty A ------&gt...