The recent disruptions in financial markets have caused many of our clients to assess their counterparty exposure to troubled financial institutions. This article summarizes the key principles governing swap participants' rights in bankruptcy proceedings to assist the reader in working through the current turmoil in financial markets.
The recent chapter 11 filing of Lehman Brothers Holdings Inc. (Lehman) has caused organizations around the world to assess their exposure (particularly counterparty risk) to Lehman and other potentially troubled financial institutions.
The Automatic Stay
The filing of a chapter 11 petition gives rise to an automatic stay under §362 of the Bankruptcy Code. Generally speaking, the automatic stay prohibits creditors from taking action to enforce their rights under contracts entered into with the debtor before the bankruptcy filing. However, to facilitate risk management, the movement of capital, and market certainty, the Code provides an exception to the automatic stay for many financial contracts, including securities contracts, swap agreements, repurchase agreements, commodity contracts, forward contracts, and master netting agreements. Subject to certain limitations, counterparties to these types of agreements can liquidate, terminate, or accelerate the agreement in accordance with its terms without violating the automatic stay. The discussion that follows focuses on the exception to the automatic stay applicable to swap agreements.
Exceptions to the Automatic Stay for Swap Agreements
Sections 560 and 362(b)(17) of the Code permit counterparties to exercise contractual rights in connection with a "swap agreement" without violating the automatic stay. The definition of "swap agreement" under the Code includes "any security agreement or arrangement or other credit enhancement" related to a swap agreement. 11 U.S.C. § 101(53B)(a)(vi).
Section 560 of the Code protects only contractual rights of liquidation, termination, and acceleration of nondebtor counterparties that are triggered by ipso facto clauses or bankruptcy defaults. Accordingly, if the swap agreement provides that the bankruptcy of the swap counterparty or the swap guarantor is an event of default giving rise to a right to terminate the swap agreement, §560 permits the swap participant to terminate the swap agreement. Section 560 also permits a swap participant to exercise a contractual right to "offset or net out any termination values or payment amounts arising under or in connection with the termination..." of a swap agreement.
Pursuant to §362(b)(17), a swap participant retains all of its contractual rights under any credit enhancement related to a swap agreement. This exception to the automatic stay applies to a common swap arrangement in which a swap participant enters a swap agreement with a counterparty, and the parent of the counterparty guarantees the obligations of the counterparty under the swap agreement. In such a scenario, if the swap guarantor becomes a chapter 11 debtor-in-possession, §362(b)(17) permits the swap participant to exercise its contractual rights under the guaranty without violating the automatic stay. These rights are likely to include the ability to terminate the swap agreement and offset or net positions under a master netting agreement. Section 362(b)(17) also protects a swap participant's contractual right "to offset or net out any termination value, payment amount, or other transfer obligation arising under or in connection with [one] or more [swap] agreements, including any master agreement for such agreements." If the nondebtor swap participant is owed money under the swap agreement, it could look to collateral pledged (if any), collect from any non-debtor counterparty, and file a proof of claim in the bankruptcy proceeding of the debtor guarantor.
Review of Specific Terms of Swap Agreement is Critical
Subject to certain limitations, swap participants can liquidate, terminate, or accelerate a swap agreement in accordance with its terms without violating the automatic stay. Whether the swap participant should exercise its contractual right to terminate the swap agreement due to the bankruptcy of a swap counterparty or swap guarantor will depend upon the particular circumstances of the parties (i.e., whether the swap participant is "in the money" or not and how the swap participant expects the future to unfold). However, for most purposes, the swap participant can proceed to exercise its rights in accordance with the swap agreement, regardless of the bankruptcy of the swap counterparty or swap guarantor.
We have repeatedly emphasized the importance of referring to the terms of the particular agreement because the goal of the Code in providing these exceptions to the automatic stay was to minimize the impact of bankruptcy on counterparties' negotiated contractual rights, not to modify those rights or create new ones. Acccordingly, reviewing the swap agreement at issue (typically consisting of the ISDA Master Agreement, the related schedule, and any Credit Support Annex or other credit support enhancements and confirmations) is critical. Once the financial implications of termination or enforcement have been evaluated, the swap participant must act in accordance with the rights set forth in the swap agreement (e.g., carefully comply with the termination provisions). If the decision is made to terminate the swap agreement, the swap participant may still have claims against the bankrupt swap counterparty or guarantor. Section 562 of the Code provides that, if a swap participant liquidates, accelerates, or terminates a swap agreement, damages are measured as of the date of such liquidation, acceleration, or termination.