Enron Bankruptcy: Counter-Party Rights Under Derivative Contracts
The bankruptcy filing by Enron Corp. and several of its subsidiaries, including its principal energy trading subsidiary, creates a number of issues for our clients, including those clients who are in the exploration and production business and who have entered into financial and physical swaps, puts and other derivative contracts with Enron or one of its subsidiaries.
A bankruptcy filing presents three immediate issues for companies that have contractual relationships with an Enron entity that has filed or may file for bankruptcy protection. As discussed below, certain types of derivative contracts receive special treatment in bankruptcy.
- The automatic stay. The automatic stay in bankruptcy will have two important consequences on your contractual relationships with a bankrupt debtor. First, it will prohibit you from terminating your contracts with the debtor for reasons related to the debtor’s insolvency or financial condition without bankruptcy court approval. Second, it will prohibit you from off-setting amounts incurred before the bankruptcy with amounts incurred after bankruptcy without court approval.
- Preferences and fraudulent conveyances. A preference payment under the bankruptcy code is a payment made to a creditor on an pre-existing debt within 90 days of the bankruptcy filing. Preference payments must be returned to the bankrupt debtor, and the person who received the preference payment becomes a creditor in the bankruptcy. Similarly, a fraudulent conveyance is a transfer by a debtor where reasonably equivalent value is not received by the debtor, if the debtor is or is rendered insolvent or certain other conditions are met. Fraudulent conveyances may be avoided in bankruptcy.
- Rejection. A debtor in bankruptcy may petition the bankruptcy court to reject contracts. If a contract is rejected, the other party to the contract has a claim in the bankruptcy case against the debtor’s estate. Rejection of a contract does not automatically terminate the contract, and there may be proactive steps that you can take to avoid or reduce the consequences of rejection of a contract.
The bankruptcy code contains provisions which provide special treatment for different types of derivative contracts. For example, the bankruptcy code defines a swap contract broadly to include most commodity, currency and interest rate swaps. Swap contracts receive the following special treatment under the bankruptcy code:
- Exemptions from the automatic stay. The bankruptcy code exempts swap contracts from the provisions of the automatic stay prohibiting termination based on the financial condition of the counter-party to the swap. You will therefore be able to exercise whatever contractual rights you have to terminate a swap contract without court approval. In addition, the bankruptcy code exempts swap contracts from the provisions of the automatic stay which prevents the offset of debts incurred prior to bankruptcy with amounts incurred after bankruptcy.
- Exemption from preference and fraudulent conveyance provisions. Generally, amounts you received prior to a bankruptcy filing under swap contracts will not be preferences. Also, subject to certain exceptions, such amounts should not be subject to challenge under the fraudulent conveyance provisions of the code.
Your ability to recover amounts from Enron or a subsidiary will depend on a number of factors, including the following:
- Which Enron entity filed for bankruptcy. The protections afforded to debtors under the bankruptcy laws apply only to the legal entity which files for bankruptcy. Enron Corp., the parent, publicly traded corporation, has filed for bankruptcy, as has Enron North America Corp., its principal trading subsidiary. However, if the counter-party to your derivative contract has not filed, the bankruptcy filings by its affiliates will not affect its obligations to make payments under your contracts or your ability to terminate the contracts pursuant to their terms. We have listed the Enron entities that filed for bankruptcy on Schedule A, although these entities may have conducted business under different names in the past.
- The terms of your contracts with the Enron entity. Most derivative contracts with Enron entities entered into over the last several years use the ISDA Master Swap Agreement. Earlier derivative agreements frequently used a swap form prepared internally by Enron. Both the ISDA Master Agreement and the in-house forms were frequently customized for different hedge counter-parties. The terms of your contracts will be important in determining the amount of damages to which you are entitled, and may provide for steps, such as notice or demand for collateral, required to terminate the swap or otherwise protect your rights.
- Whether your contracts with Enron are “swap contracts.” As discussed above, the bankruptcy code provides for special treatment of swap contracts, defined to include a broad array of derivative products. However, not all contracts entered into for the purpose of hedging risk will be swap contracts. The bankruptcy code also provides special treatment for several other types of contracts used to hedge exposure to fluctuations in commodity prices, currency exchange rates and interest rates that may, in limited circumstances, provide additional remedies.
If you are a counter-party to a swap contract with an Enron entity, you should identify each of your master agreements and confirmations and have them carefully reviewed to determine the following:
- The identity of the Enron entity that is the counter-party;
- Your rights to terminate the agreements;
- The procedures you must follow to terminate the agreements; and
- The measure of damages for termination of the agreements.
For most companies party to swap contracts with Enron or a bankrupt subsidiary, the best course of action may be to terminate the swap contracts, offset the in-the-money contracts with the out-of-the-money contracts to the extent permitted, and file proof of claims with the bankruptcy court for the net amount owed to you. For most swap contracts, you will be a general unsecured creditor for the net amounts owed to you. There may, however, be limited situations in which you should not terminate swap contracts. A careful analysis of the possible courses of action may result in effective strategies for dealing with your Enron derivative contracts.
In addition, you should have your current hedge policies, bank loans and other credit documents reviewed in light of the probability that you will not be fully paid under your contracts with Enron and its bankrupt affiliates. Your hedge policies may indicate that additional hedges should be established, and bank credit agreements may require that a certain percentage of production be hedged with credit worthy counter-parties.
We suggest that our public company clients consider the following additional steps:
- Disclosure. A substantial number of companies have disclosed their “exposure” to an Enron bankruptcy. The appropriate disclosure will depend on your relationship with the Enron entity and the amount of information previously disclosed. For example, if you have not disclosed your 2002 hedging positions, it may not be necessary to disclose anything about your exposure to an Enron bankruptcy.
- Understand the accounting treatment. Hedge accounting can be complex and confusing. The accounting treatment resulting from a bankrupt counter-party or a termination of the hedge, and the creation of reserves for non-payment of the loss incurred be early termination, should be reviewed with your auditors, and disclosed.
- Regulation FD. Regulation FD will continue to apply to questions from analysts. If the information regarding a default by a counter-party to a hedge is material, disclosure to analysts and the other parties identified in Regulation FD should be avoided until public disclosure is made.
- Trading in securities prior to disclosure. If the information about exposure to a default by an Enron entity is material, the company and other persons in possession of this information should not trade in company securities.
Enron Metals & Commodity
Enron North America Corp.
Enron Power Marketing, Inc.
Smith Street Land Company
Enron Broadband Services, Inc.
Enron Energy Services Operations, Inc.
Enron Energy Marketing Corp.
Enron Energy Services, Inc.
Enron Energy Services L.L.C.
Enron Transportation Services Company
BAM Leasing Company
ENA Asset Holdings, L.P.
For additional information, please contact one of the attornyes listed at the top of this page.