NATIONAL BANKRUPTCY CONFERENCE REPORT OF THE COMMITTEE ON THE CAPITAL MARKETS AND THE UCC March 2, 2009 The Committee on the Capital Markets and the UCC (the Committee ) makes this report to the National Bankruptcy Conference (the Conference ) for the March 2009 mid-year meeting of the Conference in Dallas, Texas. Since the 2008 annual meeting in Washington, D.C., the Committee has (a) incorporated comments of the Conference into drafts of proposed changes to the financial contract safe harbor provisions of the Bankruptcy Code to exclude safe harbor recourse to collateral that is not financial collateral and to permit recoveries of fraudulent transfer settlement payments on securities from ultimate beneficial holders of the securities, (b) considered the advisability and possible ways further to narrow the full reach of the financial contract safe harbor provisions, (c) considered broader changers to the Bankruptcy Code relating to systemic risk in the capital markets, (d) monitored case law developments affecting financial markets, (e) monitored certain federal legislative developments affecting capital markets and (f) monitored proposed revisions to Article 9 of the Uniform Commercial Code. A report on each of these subjects is set forth below. I. DRAFTS OF PROPOSED CHANGES TO THE FINANCIAL CONTRACTS SAFE HARBOR PROVISIONS A. Financial Collateral Attached here as Exhibit A is a revised draft of the suggested amendments to the Bankruptcy Code to confine recourse to collateral under the financial contracts safe harbor provisions of the Bankruptcy Code solely to collateral that is financial collateral as defined in the draft. The draft is designed to exclude from the safe harbors transactions secured by a debtor s operating assets on the theory that the transactions are likely abusive ones, i.e. transactions that in economic effect are ordinary commercial transactions but are structured as derivative transactions merely to benefit from the safe harbors. In the Committee s view, these abusive transactions do not implicate systemic risk and should be excluded from the safe harbors. The following, taken from the Conference s proposed testimony in early March before the House Judiciary Committee, provides further background for the proposed change: The current special protections contain no limitation on the types of collateral against which a non-debtor counterparty may exercise contractual rights. Therefore, a non-debtor counterparty to a protected contract, such as a swap agreement, may exercise
its secured party rights against the collateral posted for such agreement free from any bankruptcy stay, regardless of whether such collateral is cash or securities (as would be common for a swap agreement) or the debtor s principal plants, equipment and other operating assets (which would be quite uncommon for a legitimate swap agreement). Indeed, the use of uncommon collateral in what is otherwise facially a protected contract may be a strong indicator that the transaction is, in fact, a secured loan or commercial arrangement that has been documented to appear to be a protected contract. The unfettered exercise of secured party rights against operating assets could end the debtor s prospects for reorganization, and thus likely lead to the termination of its employees and the loss of going concern values to other creditors and stakeholders. Where collateral is cash, securities or other fungible financial assets not used in the operation of the debtor s business, affording a non-debtor counterparty the right to realize on such collateral free from stay, should not deprive the debtor of its reorganization prospects. In contrast, where the collateral is operating assets which can often be unique or practically irreplaceable not only does the type of collateral raise serious issues as to the bona fides of the transaction as a protected contract, but the loss of the stay can be fatal to the debtor s reorganization prospects. Therefore, the Conference has been focusing on limiting the special protections related to the exercise of contractual rights against collateral to financial assets of types that are usual for legitimate protected contracts and do not present as high a level of risk to reorganization prospects. The revisions to the draft generally reflect comments made at the 2008 annual meeting. However, the Committee did not make the change suggested that the collateral, to qualify as financial collateral, must be in the sole possession or control of the debtor. The Committee tried to develop language along those lines, but it became too difficult adequately to define what possession or control meant in the context of financial collateral. The Committee believes that the language property sold or to be sold in the performance of such contracts adequately addresses the concerns raised. B. Settlement Payments Attached here as Exhibit B is a revised draft of the suggested amendments to 546 and 550 of the Bankruptcy Code to permit recourse to the beneficial holder of a security on which a settlement payment is made if the settlement payment otherwise constitutes a constructive fraudulent transfer. The following, taken from the Conference s proposed testimony before the House Judiciary Committee in early March, provides the background for the proposed change: Bankruptcy Code 546(e) was designed to protect prepetition transfers under securities contracts from avoidance as preferential transfers or fraudulent transfers. For example, a mark-to-market margin payment under a securities purchase agreement, securities loan, margin loan, clearing advance or other securities contract might be subject to avoidance as a preferential transfer absent 546(e) protection. Similarly, 546(e) protects intermediaries in the national securities clearance process from avoidance exposure with respect to the transfers for which they act as intermediaries. 2
There has been disagreement among the courts as to the scope of the 546(e) protection with respect to payments to shareholders in connection with leveraged buyouts and similar transactions. Absent 546(e), shareholders who received payouts for their stock in connection with a leveraged buyout that rendered the target company insolvent may be vulnerable to recovery of their payouts as constructive fraudulent transfers by the target company s bankruptcy estate. The recovered amounts would be available to repay the target company s unpaid creditors. Some (but not all) courts have interpreted 546(e) sufficiently broadly as to immunize shareholders from such recoveries if they received their payouts through the national securities clearance or payment system, even though no securities contract was implicated and they are not themselves securities intermediaries. The Conference believes that this result is unfair and unnecessary to protect the securities markets. The revisions reflect comments made at the 2008 annual meeting, in particular, the elimination of recourse to a bank or securities intermediary that receives and retains the transfer while preserving recourse to the beneficial holder of the security in respect of which the transfer was made. II. FURTHER NARROWING OF THE FINANCIAL CONTRACT SAFE HARBOR PROVISIONS The Committee has not reached a consensus as to whether a narrowing of the reach of financial contract safe harbor provisions is advisable and, if it is, how that may made be done. Of particular concern, as mentioned above, is the breadth of the safe harbor provisions as they might be applied to ordinary commercial transactions, such as loan and supply transactions. Nevertheless, Conferee Westbrook has offered one suggestion in the memorandum attached as Exhibit C. The suggestion is that the protections should not apply to debtors who would fail to qualify as protected parties if they were non-debtor counterparties. The suggestion has the support of some members of the Committee. Those members of the Committee supporting the proposal believe that, because the safe harbor provisions were designed to address major systemic risks in the financial markets, their applicability to debtors should be confined to major market participants. In this way, there would be less of an opportunity for the safe harbor provisions to infect ordinary commercial transactions with small and middle market companies that are not major participants in the financial markets. Other members of the Committee are concerned that limiting the application of the safe harbor provisions to major market participants will too broadly undermine certainty in the capital markets for derivative contracts with a broad range of counterparties,\ by leaving to other Bankruptcy Code sections and non-bankruptcy law such questions as whether netting is enforceable and when rejection damage claims are measured. In addition, some members of the Committee believe that major concerns about the safe harbor provisions infecting ordinary commercial transactions would be largely, but not entirely, addressed by limiting recourse to collateral under the safe harbor provisions exclusively to financial collateral as proposed in Exhibit A. They admit, though, that the financial 3
collateral proposal will not in and of itself address the concern that ordinary supply contracts may qualify as forward contracts or swap agreements. See Part IV.A below. III SYSTEMIC RISK The Committee has not reached a consensus as to whether to recommend more aggressive reforms to address system risk. The current thinking of the Committee is reflected in the memorandum attached as Exhibit D prepared by Conferee Morrison. The memorandum reflects a discussion of the imperfections of the safe harbor provisions in addressing systemic risk issues and offers a strategy for a broader approach to systemic risk within the Bankruptcy Code. IV. CASE LAW DEVELOPMENTS A. Forward Contracts The Committee believes that the financial contract safe harbor provisions should be amended to exclude ordinary commodity supply contracts to end-users. However, the Committee has been unable so far to develop a proposal to accomplish this result without also affecting supply contracts that impact on capital markets. The recent case of In re National Gas Distributors, LLC, F.3rd, 2009 WL 325436 (4th Cir. 2009), illustrates the problem. In that case the Fourth Circuit found that a natural gas supply contact may qualify as commodity forward agreement and therefore a swap agreement under Bankruptcy Code 101(53B) even though the contract was with a single end-user, involved a physical delivery and was not traded on a market or exchange. Based on that finding, the court remanded the case to the bankruptcy court to determine if the supply contract qualified as a commodity forward agreement. In doing so, the court admitted that little guidance is provided in the Bankruptcy Code as to the meaning of that term. The case did not address whether the contract was a forward contract within the meaning of Bankruptcy Code 101(25) since the end-user did not claim to be a forward contract merchant. B. Contractual Rights to Net Bankruptcy Code 555, 556, 559. 560 and 561 provide that contractual rights of certain parties to financial contracts to terminate the financial contracts and, in some cases, to net amounts owing on termination may not be limited by any other provisions of the Bankruptcy Code. The full reach of these anti-limitation provisions has not been fully explored by the Committee. The issue has arisen on a motion for a bankruptcy court to reconsider its decision that Bankruptcy Code 553(a) does not permit a contractual triangular setoff even if the setoff would otherwise be permitted under applicable nonbankruptcy law. In In re SemCrude L.P., B.R., 2009 WL 68873 (Bankr. D. De. 2009), the debtor agreed to buy certain commodities and services from and to provide certain commodities and services to counterparties that were affiliated with each other. The contract contained a provision (a so-called contractual triangular 4
setoff provision) permitting a counterparty owing amounts to the debtor to reduce those amounts by offsetting amounts owing by the debtor to another counterparty. The bankruptcy court denied the counterparties motion for relief from the automatic stay to exercise their contractual triangular setoff rights. In doing so, the court concluded that Bankruptcy Code 553(a) preserves setoff for only mutual debts owing between two parties and that contractual triangular setoff, by its nature encompassing three parties, does not involve mutual debts. The counterparties moved for reconsideration on the ground that the affected transactions were forward contracts entitled to the benefit of the Bankruptcy Code s safe harbor provisions for financial contracts and that, accordingly, contractual rights to net may not be limited by Bankruptcy Code 553(a). At the time of this report, the motion for reconsideration has not been decided. V. FEDERAL LEGISLATIVE DEVELOPMENTS Congress continues to consider legislation to address the residential mortgage crisis. The Conference has already taken a position that the Bankruptcy Code should be amended to permit modifications of mortgages on primary residences. If, as expected, that legislation passes, the legislation may affect the value of residential mortgage-backed securities issued by some issuers even for the holders of the highest tranches of securities issued by the issuer. That is because of a number of residential mortgage-backed securities structures spread bankruptcy losses above a certain level ratably among all tranches rather than allocate the losses solely to the lower tranches. The rationale for the pro rata allocation provision is that, since bankruptcy losses above the agreed level are considered a force majeure type event, the losses should be shared by all investors. Action, whether by legislation or regulation, is also being considered to address mortgage loan modifications that can be accomplished outside of bankruptcy in order to avoid borrowers having to resort to bankruptcy. The action under consideration is directed to servicers of residential mortgages for issuers of residential mortgage-backed securities and to investors in the issuers as a way to encourage them to make modifications to residential mortgages beyond what the current documents governing the programs permit. For example, the President s Homeowner Affordability and Stability Plan contemplates that the federal government would pay to a servicer a fee for modifying a residential mortgage within prescribed guidelines and also a success fee for each year that passes without the borrower going into default on the modified loan. In addition, legislation is being considered to regulate over-the-counter derivative transactions. Being closely watched is The Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) which, among other things, would require the maintenance of records of derivatives transactions available for inspection by the Commodities Futures Trading Commission (the CFTC ), limit access to trading on foreign boards of trade not approved by the CFTC, impose trading limits on positions on physically delivered commodities, require that settlements of over-the-counter derivative trades be made through approved regulated derivative clearing organizations and give the CFTC authority to suspend trading in credit default swaps with the concurrence of the President. 5
VI. UNIFORM COMMERCIAL CODE DEVELOPMENTS A joint review committee formed by the American Law Institute and the Uniform Law Conference has been considering discrete revisions to Article 9 of the Uniform Commercial Code. The charge to the joint review committee is not to effect a major re-write of Article 9 but rather to address specific issues that have arisen in practice or which are the subject of proliferating state non-uniform amendments. The primary focus of the joint review committee is to address amendments to the filing provisions proposed by the International Association of Commercial Administrators and by Uniform Commercial Code Committee of the Business Law Section of the Texas Bar Association. Texas has already adopted non-uniform filing provisions as have a few other states. Of particular concern is the question of what name for the debtor should be provided on a financing statement if the debtor is an individual. A number of bankruptcy courts have set aside a security interest where the financing statement, filed to perfect the security interest, failed to provide a name for the debtor that the bankruptcy court later determined to be the debtor s name. Often the financing statement provided a nick name for the debtor instead of what the court viewed to be the debtor s name as reflected on legal documents including the bankruptcy petition itself. Several proposals have been made to address this issue. One proposal is that, if the debtor has a driver s license or state identification card, the financing statement may, as a safe harbor, provide the debtor s name on the driver s license or state identification card. Another proposal is that, if the debtor has a driver s license or state identification card, the financing statement must provide the debtor s name on the driver s license or state identification card. If a search of the records of the filing office under the debtor s name on the driver s license or state identification card does not disclose the financing statement, the financing statement will be ineffective. The joint review committee is also considering addressing the case of In re Commercial Money Center, Inc., 350 B.R. 465 (9th Cir. BAP 2006), by comment. The case was discussed in the Committee s October 2007 report to the Conference. The comment would suggest that equipment lease rentals remain chattel paper, even if the rentals are arguably sold separately from the chattel paper, and are not separately characterized as payment intangibles. A list of other issues being considered by the joint review committee may be obtained from Conferee Edwin Smith at edwin.smith@bingham.com. 6