Derivatives Treatment in Bankruptcy Proceedings Minimizing Risks When a Counterparty Becomes Insolvent

Transcription

1 presents Derivatives Treatment in Bankruptcy Proceedings Minimizing Risks When a Counterparty Becomes Insolvent A Live 90-Minute Audio Conference with Interactive Q&A Today's panel features: Willa Cohen Bruckner, Partner, Alston & Bird, New York William S. Sugden, Attorney, Alston & Bird, Atlanta Thursday, September 10, 2009 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions ed to registrants to access the audio portion of the conference. CLICK ON EACH FILE IN THE LEFT HAND COLUMN TO SEE INDIVIDUAL PRESENTATIONS. If no column is present: click Bookmarks or Pages on the left side of the window. If no icons are present: Click View, select Navigational Panels, and chose either Bookmarks or Pages. If you need assistance or to register for the audio portion, please call Strafford customer service at ext. 10

2 DERIVATIVES TREATMENT IN BANKRUPTCY PROCEEDINGS September 10, 2009 Willa Cohen Bruckner

3 OVERVIEW OF DERIVATIVES DOCUMENTATION Derivatives contracts are generally governed by an ISDA Master Agreement or documents based on the ISDA master agreement. Three versions of ISDA Master Agreement 1987, 1992, Most agreements use 1992 or 2002 version version is not used for new contracts, but some existing agreements use that version or were individually drafted. - 1

4 1992 and 2002 have same basic structure, but differ in a few key areas: Grace periods for events of default reduced in Method for calculating termination values 1992 uses Market Quotation or Loss, 2002 uses Close-out Amount. Force majeure termination event added to Specified Transactions include repos and securities lending transactions in added a change of control clause to Credit Event Upon Merger and a setoff provision

5 Bankruptcy / insolvency event of default Key trigger events include: insolvency; commencement of bankruptcy proceedings (voluntary or involuntary); appointment of administrator, receiver, or liquidator. Occurrence of trigger event with respect to a party, its credit support provider, or any of its specified entities constitutes an event of default. Event of default gives non-defaulting party right to terminate all (but not less than all) outstanding transactions. Different treatment for voluntary vs involuntary bankruptcy proceedings: cure period applies for involuntary bankruptcy

6 Automatic early termination Under automatic early termination, transactions are terminated immediately upon bankruptcy without further action by non-defaulting party. Automatic early termination used to be the norm to allow liquidation and/or netting before application of the automatic stay. With changes in bankruptcy law and the adoption of safe harbors for derivatives, parties opted out of automatic early termination

7 Credit Support May be in the form of a guaranty or in the form of collateral held by the secured party. Credit support in the form of collateral is usually governed by the Credit Support Annex (New York law version for collateral held in New York). Collateral is generally in the form of cash or Treasuries. Components of collateral calculation: Exposure (mark to market value of transaction), Independent Amount, Threshold Amount

8 Secured Party usually has the right to rehypothecate collateral. Credit Support Annex provides that upon default by a party, the non-defaulting party can: net obligations owed by the defaulting party against collateral pledged to non-defaulting party. net obligations owed by the non-defaulting party against collateral pledged to the defaulting party

9 LESSONS LEARNED FROM THE LEHMAN BANKRUPTCY Counterparty credit risk Counterparty credit risk is present, even in the good times. Particularly so if the transactions will be long term. Protections against counterparty credit risk: Reevaluate counterparty credit risk periodically, and renegotiate Master Agreement if necessary. Bilateral collateral

10 Collateral instead of (or in addition to) guaranty. Parent and subsidiary may both be insolvent. Events of default and/or termination events which relate to loss of strong capital and reserve positions or strong regulatory rating

11 Safe harbor protections under the Bankruptcy Code do not create a general priority status for derivatives counterparties. What the safe harbors do Protect right to terminate derivatives transactions and net termination amounts, even after commencement of bankruptcy/insolvency proceedings. Protect counterparty s right to net obligations against collateral. Protect counterparty from claim that transfers in connection with derivatives before commencement of bankruptcy proceedings are preferential

12 Treatment of derivatives under bank insolvency law is similar to treatment under the Bankruptcy Code. Key differences from the Bankruptcy Code: If bank is in receivership, receiver has one day to transfer derivatives contacts before non-defaulting party s right to terminate can be exercised. If bank is in conservatorship, non-defaulting party may not terminate transactions. Requirement for bank records regarding board approval. FDICIA ensures enforceability of bilateral netting contracts between financial institutions, whether the institutions are ongoing or failed

13 Claim for return of excess collateral held by the insolvent entity under the typical arrangement is likely to be an unsecured claim. Most agreements allow for rehypothecation, which means collateral may be commingled with assets of the secured party. Dealers and some counterparties (particularly hedge funds) want the right to rehypothecate because they want to use the collateral in other parts of their business

14 Minimize risk that excess collateral won t be returned by: Requiring collateral be held in a protected account, not commingled, preferably at a third party. Third party custodial arrangements may be more work operationally and will entail additional fees. Not posting Independent Amount

15 Claim for payment of obligations in excess of collateral posted by the defaulting party will be an unsecured claim. Miminize risk of undercollateralization by: Setting collateral Threshold for the other party at zero. Minimizing transfer time for delivery of collateral

16 Legal developments lag behind business developments. Structures not contemplated at the time laws are put in place are fodder for challenge by creative bankruptcy counsel. Role of debtor s counsel is to get as much as possible into the bankruptcy estate. Evaluate treatment of new transaction structure under all bankruptcy scenarios

17 Major dealers and their trading relationships are global when times are good but segregated when things unravel. Different affiliates are used for booking particular types of transactions, so a counterparty may face several members of the dealer s worldwide group. The dealer will want netting and setoff across the full relationship, which protects the dealer upon counterparty insolvency by allowing the dealer to reduce its overall exposure to the counterparty

18 If the dealer becomes insolvent, the counterparty may be involved in multiple bankruptcy proceedings in several jurisdictions. Counterparty may have to defend netting arrangements in several proceedings, with no assurance of consistent treatment across proceedings. Bankruptcy proceedings among jurisdictions are not necessarily coordinated. Courts may not work towards a global solution

19 Address the risk of segregated unwind by: Putting in place a master netting agreement. Confirm it is enforceable in all relevant jurisdictions. Adhere to the processes established in the agreement who is notified, which entity posts collateral and to whom collateral is returned. Traders and operational units may modify or try to streamline processes set out in the agreement. > Provide a template for communication with dealer affiliates. > Review compliance with terms of the agreement periodically and obtain approval from all parties for variations

20 Where are the funds? Dealers may engage in derivatives transactions outside the regulated broker entity, so customer protection rule (Rule 15c3-3) doesn t apply. No regulatory requirement for banks to segregate collateral. Funds may be transferred outside the dealer organization and/or outside the country. Risk management may be best accomplished by diversifying across numerous trading counterparties so not all operational funds are hung up upon insolvency of a major dealer

21 Many market participants expected a softening of credit requirements by the major dealers in the aftermath of Lehman. That has not materialized. Many out-of-the money counterparties to Lehman did not terminate transactions upon Lehman bankruptcy (so as not to trigger a termination payment obligation), but did not continue to make periodic payments because of the condition precedent in Section 2(a)(iii) of the ISDA Master Agreement. One 2003 Australian case (Enron Australia v TXU Electricity) upheld that course of action by the nondefaulting party. Some market participants include a provision in Master Agreements requiring a non-defaulting party to terminate quickly or lose its right to withhold periodic payments

22 The process for determining termination payments under the 1992 version of the ISDA Master Agreement has led to some difficult results. Market Quotation approach was developed when transactions were much simpler. Quotations on plain vanilla, liquid contracts are likely to be close. Outliers are addressed through the ISDA process by excluding the high and low quotations. Obtaining quotations on structured transactions in times of financial crisis may prove difficult if not impossible

23 With greater complexity of transactions, it is more likely the parties will disagree whether quotations obtained (if any) are commercially reasonable. The size of transactions and therefore the size of potential discrepancies in the parties views about appropriate termination payments mean a greater likelihood of challenge. There is very little case law on interpreting the calculation of termination values under the ISDA Master Agreement. It is likely that litigation will come out of the Lehman bankruptcy

24 Legislation and regulation of the over-the-counter derivatives will impact risk management of market participants. Broad themes of legislation/regulation likely to include central clearing, increased capital and margin requirements, greater oversight and regulation of major market participants. Balance between business advantage and legal risk in derivatives is complex and should be monitored and reevaluated frequently

25 Willa Cohen Bruckner Alston & Bird LLP 90 Park Avenue New York, NY Atlanta One Atlantic Center 1201 West Peachtree Street Atlanta, GA Charlotte Bank of America Plaza 101 South Tryon Street, Suite 4000 Charlotte, NC Dallas Chase Tower 2200 Ross Avenue, Suite 3601 Dallas, TX Los Angeles 333 South Hope Street 16th Floor Los Angeles, CA New York 90 Park Avenue New York, NY Research Triangle, NC 3201 Beechleaf Court, Suite 600 Raleigh, NC Silicon Valley, CA Two Palo Alto Square 3000 El Camino Real, Suite 400 Palo Alto, CA Ventura County, CA 2801 Townsgate Road Suite 215 Westlake Village, CA Washington, DC The Atlantic Building 950 F Street, NW Washington, DC

26 Bankruptcy Safe Harbors for Derivatives and Lehman Presented By: Willa Bruckner and Will Sugden Alston & Bird LLP Privileged Attorney-Client Communication

27 Overview What bankruptcy related items are we covering today? Very brief overview of some of the major bankruptcy safe harbors for derivatives transactions. Some of the challenges and difficulties facing derivatives counterparties in the Lehman Brothers bankruptcy proceeding: Challenges in bespoke transactions. Challenges in plain vanilla transactions. General difficulties facing all counterparties. 2

28 Overview of Bankruptcy Safe Harbors The bankruptcy safe harbor for derivatives protect (i) certain rights of (ii) certain kinds of parties to (iii) certain kinds of contracts. Kinds of protected contracts: Swaps Repos Securities contracts Certain grain contracts Master netting agreements Forward contracts Legislative history and statute make clear that the definitions are intended to be broad and self-defining. There is flexibility for them to change over time as the industry evolves. 3

29 Overview of Bankruptcy Safe Harbors Kinds of protected parties: Swap participants Repo participants Commodity brokers Forward contract merchants Stock brokers Securities clearing agencies Financial institutions Financial participants (a catch all covers parties with total gross dollar value of subject transactions of not less than $1,000,000,000 in notional or actual principal amount outstanding (aggregated across counterparties) at the date of the bankruptcy filing or on any day within 15 months of the bankruptcy filing, or has gross mark-to-market positions of not less than $100,000,000) 4

30 Overview of Bankruptcy Safe Harbors Kinds of rights protected: Liquidation Termination Acceleration Offset Setoff Exercise of other remedies Protections from preference and other kinds of avoidance actions (except in case of actual fraud) 5

31 Overview of Bankruptcy Safe Harbors Some initial thoughts on the coverage of the statute: Broadly defines protected contracts. Fairly broadly defines parties entitled to protection under the safe harbor (particularly with the inclusion of the financial participant provision). More narrowly defines protected rights. There is no catch-all for non-enumerated activities as there is with protected contracts and protected parties. The safe harbors are being interpreted by bankruptcy judges who tend to bring a perspective to judging that can be focused on reorganizing or otherwise maximizing the value of the debtor s estate. The Lehman Brothers bankruptcy presents a very significant challenge or test case for the safe harbors. The parties running the Lehman Brothers liquidation are attempting to limit the scope and coverage of the safe harbors (or otherwise have them interpreted in a narrow way) to maximize the recovery for the Lehman Brothers bankruptcy estate. 6

32 Challenges to Bespoke Transactions Bespoke transactions are generally structured transactions developed for a particular transaction with a particular counterparty. They generally involve a safe harbor agreement (often a swap agreement) embedded within a broader transaction. In many cases, these transactions include priority of payment provisions that subordinate a swap counterparty s priority of payment if the swap counterparty defaults under the swap agreement. 7

33 Challenges to Bespoke Transactions Lehman has challenged these subordination provisions in a number of instances. The instance most publicly discussed is the so-called Ballyrock litigation. In Ballyrock, the Lehman parent (LBHI) filed for bankruptcy, triggering a default and termination under the embedded swap agreement. The swap was terminated prior to the swap counterparty s (LBSF) bankruptcy filing. The trustee sought to pay out proceeds in accordance with the indenture, which included a subordination of LBSF s interest because of the bankruptcy filing of LBHI. Lehman asserts that if the priority of payment provision is not enforced it would be entitled to first priority of payment, which would lead to approximately $400 million in additional funds for its estate. 8

34 Challenges to Bespoke Transactions Lehman has several challenges to the subordination provision in the priority of payment section: The subordination provision is unenforceable under nonbankruptcy clause because it amounts to a penalty rather than a liquidated damages provision The subordination provision is unenforceable under bankruptcy law because it effects a taking of property of the estate and is an unenforceable ipso facto provision. 9

35 Challenges to Bespoke Transactions More on the bankruptcy challenge: The priority of payment provision that Lehman is challenging is located within the indenture agreement, not the swap agreement. Lehman is arguing that the provisions of the indenture impose additional limitations on the exercise of the termination right under the swap. Generally, in bankruptcy, for non-safe harbor transactions, termination provisions that are triggered upon a bankruptcy filing are unenforceable. Lehman is therefore trying both to engraft additional requirements on the swap termination as well as limit the ability to terminate the swap. 10

36 Challenges to Bespoke Transactions Status of the Ballyrock litigation Presently, the defendants have filed a motion to dismiss the complaint. Lehman is opposing the motion to dismiss. A hearing is scheduled for September

37 Challenges to Plain Vanilla Transactions Plain vanilla transactions are standard swap transactions between two or more counterparties that are not embedded within larger transactions. Issue #1: Withholding payments pending determination to terminate. Metavante was a counterparty to an interest rate swap with Lehman. Since the bankruptcy filing, Metavante has not terminated but has withheld payments it would otherwise owe to Lehman. Lehman filed a motion to compel Metavante to resume making payments, arguing that the withholding of payments amounted to a modification of the contract and also that the withholding of payments was not protected by any safe harbor. Metavante argues that no payments are due because of the default (Lehman s bankruptcy filing) and Metavante is entitled to time the market on termination because it is not a defaulting party. No final ruling on this. The judge appears to be quite skeptical of Metavante s position. His comment was that they should have to pay to play. 12

38 Challenges to Plain Vanilla Transactions Other issues: Lehman has taken very aggressive positions on what appear to be largely straightforward issues. In one case, a Lehman counterparty that was a party to a master netting agreement with two Lehman entities exercised remedies against collateral posted by one entity to satisfy the other entity pursuant to the terms of the master netting agreement. Lehman has challenged the efficacy of this. The counterparty has had to initiate a declaratory judgment in the Lehman bankruptcy court for a determination of rights. The action is in its very beginning stages. 13

39 Other Difficulties Faced by All Derivatives Counterparties In addition to specific challenges in specific transactions, the Lehman bankruptcy has exposed numerous areas in which a derivatives counterparty will be subject to and have to monitor the bankruptcy. Motion to assign in the money contracts: In late 2008, Lehman sought and received authority to assign its nonterminated in the money contracts. Challenges for the counterparty: Forced to deal with a new counterparty not of your choice. Have to monitor the bankruptcy carefully to determine if your contract is going to be subject to this treatment. 14

40 Other Difficulties Faced by All Derivatives Counterparties Issue #2 The Claims Bar Date Procedure For in the money counterparties, significant burdens are posed by the claims bar date procedure. In addition to a standard proof of claim form, derivatives counterparties are required to fill out online questionnaires that require the counterparty to provide significantly more information than would ordinarily be provided in a proof of claim form. These same claims will be subject to a standard claims reconciliation procedure. These procedures have been and will continue to be significant burdens on certain counterparties. In the money counterparties without collateral (or sufficient collateral) are therefore stuck to the bankruptcy for the duration. 15

41 Other Difficulties Faced by All Derivatives Counterparties Issue #3 The alternative dispute resolution procedure Lehman has stated that it has disputes with at least 250 different counterparties (and potentially thousands) regarding various issues related to the termination of their contracts. To expedite the resolution of these disputes, Lehman proposed ADR that was originally quite one-sided. Counterparties had to monitor the case and object. In total about 56 did object. This motion impacted all counterparties, not just in the money or out of the money counterparties. The Court is going to hold a continued hearing on this motion on September 15, and so the issues implicated by it have not been finally decided. 16