International Insolvency Institute Introduction to Derivatives and Insolvency

International Insolvency Institute Introduction to Derivatives and Insolvency Edwin E. Smith Bingham Mc. Cutchen LLP

Background • Many insolvency laws generally provide exemptions for certain transactions involving qualified financial contracts that favor the nondebtor counterparties 2

Background • Qualified financial contracts • Swap agreement • Payments against reference asset or index • Hedging • • Interest rate swap Foreign exchange swap Commodity swap Weather swap • Transfer of other risk • Credit default swap • Total return swap 3

Background • Qualified financial contracts • Securities contract • Contract to buy, sell or loan a security • Margin loan • Loan for clearance or settlement of securities transactions • Option contracts 4

Background • Qualified financial contracts • Repurchase agreement • Sale of property with an obligation by the buyer to sell back the property on a day certain • The repurchase price is usually the purchase price plus an interest factor • The property must be of a particular type, typically a security, certificate of deposit or mortgage note 5

Background • Qualified financial contracts • Commodity contract • Commodities traded on an exchange • Forward contract • Agreement to purchase a commodity at a later date 6

Protected Parties • In some cases the non-debtor counterparty may need to be a “protected party” such as a financial institution or a “major participant” in financial contract markets • UNIDROIT Principles on the Operation of Close-Out Netting Provisions refer to an “eligible party” and “qualified financial market participant” 7

Protections • Exemptions or “safe harbors” for derivative transactions • Ability to enforce based on an insolvency default clause • No insolvency tribunal stay on enforcement • Or very limited stay in some situations (e. g. , SIFIs) • Right to exercise any contractual or similar right to terminate, accelerate and liquidate position • Close-out netting 8

Protections • Exemptions or “safe harbors” for derivative transactions • Right to look to collateral in the possession or control of the non-debtor counterparty • Exemption from avoidance of preferential or suspicious transfers or undervalued transactions except perhaps for an intentional fraudulent or other voidable transaction • Pre-commencement payments, transfers and termination payments • Pre-commencement provision of additional margin • Close-out netting 9

Justification • Justification is to minimize system risk to the financial system if a major bank, broker or other major capital markets participant should fail • The concern is the so-called “ripple effect” of one counterparty’s failure causing another counterparty’s failure, especially where there are back to back transactions • Securities lending example • Volatility risk of rapid changes in values 10

Other Issues • Other issues on financial contracts • Recharacterization risk • Repurchase agreement • Collateral security and other support arrangements • Determination of termination amounts owing 11

Other Issues • Other issues on financial contracts • Netting • “Cherry picking” concern • Netting vs. setoff • Netting is arguably broader – mutual debts need not be of the same kind or already be due and payable • Bi-lateral single product netting • Bi-lateral cross-product netting • Cross-affiliate netting • “Walkaway clauses” 12

Historical Acceptance • Insolvency law exemptions have been historically accepted by insolvency law community • UNCITRAL Legislative Guide on Insolvency • UNIDROIT Principles on the Operation of Close-Out Netting Provisions 13

Current Concerns in the Insolvency Community • Are the exemptions justified as an abstract matter at all? • Even if the exemptions are justified, are they justified in relation to their costs? • Lehman example where value was arguably loss • Forced sales depressing markets 14

Current Concerns in the Insolvency Community • Even if the exemptions are justified in relation to their costs, • Do the exemptions need to be modified for SIFIs? • Especially global SIFIs • UNIDROIT Principles on the Operation of Close-Out Netting Provisions, Principle 8 • Are they too broad? • Examples of opportunistic structurings of ordinary commercial transactions to fit within the exemptions 15

Opportunistic Structurings • Clear advantage to the non-debtor counterparty to structure a normal commercial transaction to fit within an exemption without changing the economics of the transaction • Clear disadvantage to other creditors in the case 16

Repurchase Agreement • Original Transaction: Lender extends credit to a mortgage originator secured by real estate mortgage notes • Restructured Transaction: Lender purchases the real estate mortgage notes under a repurchase agreement, with the seller having an obligation to buy them back • Bevill, Bresler & Schulman Asset Mgmt. Corp. v. Spencer S&L Ass'n. (In re Bevill, Bresler & Schulman Asset Mgmt. Corp. ), 878 F. 2 d 742 (3 d Cir. 1989). 17

Swap Agreement • Original Transaction: Lender makes a loan to Debtor at a fixed rate. • Restructured Transaction: • Lender makes a loan to Debtor at a floating rate. • Lender and Debtor enter into an interest rate swap by which floating rate interest payments above the fixed rate are made by Lender to Debtor and floating rate interest payments below the fixed rate are made by Debtor to Lender. • Thrifty Oil Co. v Bank of Am. Nat’l Trust, 322 F. 3 d 1039 (9 th Cir. 2002). 18

Securities Contract • Original Transaction: Lender extends term credit to Debtor under a loan agreement • Restructured Transaction: Lender purchases a private placement note from Debtor • Enron Creditors Recovery Corp. v. Alfa, S. A. B. (In re Enron Creditors Recovery Corp. ), 651 F. 3 d 329 (2 d Cir. 2011). • Official Committee of Unsecured Creditors of Quebecor World (USA) Inc. v. American United Life Insurance Company, et. al. (In re Quebecor World (USA) Inc. ), 2013 U. S. App. LEXIS 11615 (2 d Cir. June 10, 2013) 19

Securities Contract • Original Transaction: Lender extends term credit to Debtor under a loan agreement secured by Debtor’s accounts • Restructured Transaction: Lender purchases a private placement note from Debtor secured by Debtor’s accounts 20

Securities Contract • Original Transaction: Lender extends credit to Debtor to redeem equity in Debtor from Debtor’s equity holders • Restructured Transaction: Lender extends credit to Debtor to redeem equity in Debtor from Debtor’s equity holders. Redemptions are effected through a bank or broker 21

Securities Contract • U. S. Bankruptcy Code Section 546(e) • Brandt v. B. A. Capital Co. (In re Plassein Int'l Corp. ), 366 B. R. 318 (Bankr. D. Del. 2007), aff'd, 590 F. 3 d 252 (3 d Cir. 2009); Mervyn's, LLC v. Lubert-Adler Group IV, LLC (In re Mervyn's Holdings, LLC), 426 B. R. 488 (Bankr. D. Del. 2010). • But see Geltzer v. Mooney (In re Mac. Menamin’s Grill LTD. ), 450 B. R. 414 (Bankr. S. D. N. Y. 2011). • Does Section 546(e) reach state law fraudulent transfer claims abandoned by the trustee? • See, e. g, In re Tribune Company Fraudulent Conveyance Litigation, No. 11 MC 2296 (RJS) (S. D. N. Y. Sept. 23, 2013) 22

Forward Contract • Original Transaction: Lender makes a one-year term loan to Debtor secured by Debtor’s gold. • Restructured Transaction: Lender buys the gold effective (e. g. , with title to pass) in one year. Lender prepays for the gold at the beginning of the year. At the end of the year, Debtor delivers gold to Lender with a value equal to the prepayment plus an amount equal to interest or, alternatively, pays to Lender the value of the gold to be delivered. 23

Forward Contract • Original Transaction: Seller sells gas to Buyer 30 days net. • Restructured Transaction: Seller commits to sell gas to Buyer on the first day of each month with Buyer to pay for the goods on the last day of the month • Williams v. Morgan Stanley Capital Grp. , Inc. (In re Olympic Natural Gas Co. ), 294 F. 3 d 737 (5 th Cir. 2002). 24

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