Derivative Exposure and Counterparty Insolvency: Lessons Learned in the Current Market

09/11/2009

Almost all large (and many small) companies in today’s economy use derivatives in one way or another to hedge against future risk. Hedging allows a business to limit potential exposure to market fluctuation upfront (for a price) and instead focus on its strengths and core competencies. In the past, parties entering into derivative contracts faced the risk of the counterparty filing for bankruptcy protection and effectively blocking the non-defaulting counterparty from terminating the derivative contract and/or collecting the underlying collateral. Realizing the potential ripple effect that could result throughout the financial markets, Congress sought to provide security to derivative market participants by exempting certain transactions from the reach of the “automatic stay” and avoidance provisions of the United States Bankruptcy Code (the “Bankruptcy Code”).

In 2005, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “BAPCPA”) which took effect on October 17, 2005. On December 12, 2006, the President signed into law the Financial Netting Improvements Act of 2006 (the “Act”). The amendments set forth in BAPCPA and the Act (referred to together as the “Amendments”) materially affected the Bankruptcy Code’s treatment of securities and derivatives transactions through broad substantive modifications and expansive definitional amendments. Specifically, Congress sought to clarify and, in certain respects, expand upon the protections already accorded to derivative transactions in the Bankruptcy Code. The overall effect of the Amendments was to extend the Bankruptcy Code’s preexisting “safe harbor” provisions to additional parties and additional types of financial market contracts by expanding the Bankruptcy Code’s definitions to include new kinds of derivatives and new types of transactions encompassed in derivatives.

The protections provided by the safe harbor provisions are substantial. While all other creditors must sit by and wait for administration of the debtor’s bankruptcy estate, these “protected parties” can simply continue with business as usual and, in some instances, terminate the contract and foreclose on the underlying collateral. Additionally, the “protected parties” can keep payments from the debtors without worry of future preference litigation from the trustee or debtor-in-possession. It is up to a company seeking to hedge (and its lawyers) to ensure that the company and its contracts fit neatly within the safe harbor language of the Code in order to take full advantage of the protections afforded therein. Derivative contracts must be thoroughly negotiated and meticulously drafted on the front-end so that when a counterparty files for bankruptcy, the non-defaulting counterparty is able to act swiftly and with confidence in terminating the derivative and/or foreclosing on underlying collateral.

Presented to The 8th Annual Gas and Power Institute, September 11, 2009.

To read the full presentation, click on the PDF below. 

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