March 26, 2020
The economic effects of the Coronavirus (Covid-19) pandemic likely will include increased risk of defaults between counterparties in the $640 trillion global OTC derivatives market.* With the possibility of more economic disruption ahead, it is reasonable to assume that many out-of-the-money counterparties (including entities with exposure to oil & gas, travel, retail, and commercial real estate) will seek bankruptcy relief under the United States Bankruptcy Code, 11 U.S.C. §§ 101 et seq. In this context, the following update provides a brief overview of the issues that may arise in bankruptcy cases where the debtor is a counterparty to derivatives contracts.
The Bankruptcy Code provides counterparties to certain protected transactions with debtors (e.g., securities contracts, forward contracts, commodities contracts, swaps, repurchase agreements, etc., all referred to herein as “Protected Transactions”) with three primary protections (the “Safe Harbors”) that are not available to other creditors in bankruptcy cases:
First, counterparties to Protected Transactions can exercise their contractual rights to terminate, liquidate, or accelerate their Protected Transactions with the debtor according to so-called ipso facto or bankruptcy default clauses. See, e.g., 11 U.S.C. §§ 555 (securities contracts), 556 (commodities contracts and forward contracts), 559 (repurchase agreements), 560 (swaps), and 561 (master netting agreements). Outside the derivatives context, such ipso facto clauses are generally unenforceable in bankruptcy. See 11 U.S.C. § 365(e).
Second, counterparties to Protected Transactions can exercise certain contractual rights against the debtor’s collateral notwithstanding the “automatic stay,” a broad statutory injunction that otherwise protects the debtor’s property from creditor actions absent relief from the bankruptcy court. See, e.g., 11 U.S.C. § 362(b)(6) (pertaining to commodities contracts, forward contracts, and securities contracts); (7) (pertaining to repurchase agreements); (17) (pertaining to swaps); and (27) (pertaining to master netting agreements).
And third, certain transfers made to or for the benefit of counterparties to Protected Transactions are not subject to avoidance as preferences and fraudulent transfers. See 11 U.S.C. § 546(e), (f) and (g). Generally, only transfers to creditors in Protected Transactions that involve actual fraud are subject to avoidance by the bankruptcy trustee (including the debtor-in-possession).
The Bankruptcy Code’s Safe Harbors are often the subject of litigation because of the size and complexity of some Protected Transactions, and also because of the natural tension between the debtor’s interest in preserving its assets and the creditor’s asserted right to payment. Safe Harbor disputes typically boil down either to the parties’ competing views on the specific provisions and definitions in the Bankruptcy Code, or to their competing views of their contractual rights as set forth in the underlying documents. Many such disputes likely will turn on the parties’ intent as stated in the four corners of their agreements, often including the ISDA master agreement, schedule, confirmation, and collateral support documents (if any).**
The Bankruptcy Code provides rules for the timing and calculation of damages in connection with the trustee’s (including the debtor-in-possession’s) rejection of Protected Transactions or the counterparty’s liquidation, termination, or acceleration of the same. See 11 U.S.C. § 562. Despite these rules, disputes regarding the amount of close-out damages have led to litigation, often when no commercially reasonable determinants of value exist. Moreover, master netting agreements may prevent trustee’s from “cherry picking” which Protected Transactions to assume or reject, a subject that has been litigated as well.
One issue that may be litigated soon is whether the effects of the Covid-19 pandemic constitute a “force majeure” under the ISDA Master Agreement, which provides the industry-standard terms of many Protected Transactions. Generally, force majeure clauses address circumstances outside the counterparty’s control that prevent the counterparty’s performance under the contract. In particular, the 2002 ISDA Master Agreement contains a force majeure provision as a termination event, assuming the parties have not agreed otherwise in their trading documentation. In the case of “force majeure or act of state,” the Master Agreement provides that the out-of-the-money counterparty has a waiting period of eight (8) local business days to make agreed-upon deliveries or payments. If the waiting period expires but the force majeure event is continuing, then either party can declare an early termination date according to the procedures set forth in the Master Agreement. The counterparties then must calculate and, in the case of the out-of-the-money counterparty, pay the close-out amount owed under the contract. How these rules may interact with the Bankruptcy Code has not yet been litigated in the context of the Covid-19 pandemic.
As was the case after Lehman Brother’s collapse in 2008, it is possible that regulators or trade organizations will issue special guidelines along the lines of ISDA’s “2008 Lehman CDS Protocol” regarding the settlement of derivatives contracts in connection with potential market disruption involving the Covid-19 pandemic. Derivatives counterparties should consult with counsel and monitor developments on ISDA’s website, isda.org, for timely information regarding any changes to standard settlement or close-out practices.
Moses & Singer’s bankruptcy team has advised numerous financial institutions and other market participants in a variety of Safe Harbor disputes, including litigation in the Orange County, Enron, and Lehman Brothers bankruptcy cases. Please contact Patrick J. Trostle or Alan Gamza with your questions.
*$640 trillion is the approximate notional amount of all OTC derivatives in 2019. The gross market value of such trades is approximately $12.1 trillion. See Bank of International Settlements (BIS) OTC Derivatives Statistics 2019. Exchange traded derivatives account for additional trillions of dollars of notional principal and market value.
**ISDA is the International Swaps and Derivatives Association, a leading trade organization for derivatives.