For the past several years, low interest rates and higher commodity prices have resulted in generally favorable financial conditions in the energy sector, keeping energy bankruptcy activity to a minimum. With the recent sharp decline of prices in numerous commodities and forecasts of higher interest rates in the near future, there is a likelihood that the financial condition of some companies in the energy and commodities sectors could deteriorate significantly. The time to begin contingency planning is now; steps taken in the weeks and months before a bankruptcy can often provide the best protection against significant losses in trading contracts. Discussed below, however, are the steps that non-defaulting parties should take after a bankruptcy filing by one of their counterparties.
The first inquiry should be whether the non-defaulting counterparty is able to terminate its trading contracts. This inquiry entails an analysis of the contractual provisions concerning default and termination. The right to terminate may arise not only from the counterparty’s insolvency, but also from the insolvency of a guarantor or an affiliate (e.g., a Specified Entity designated under an ISDA Master Agreement). In some cases, termination is triggered automatically on the occurrence of the insolvency; in others, the non-defaulting party must expressly terminate the contract. Even if the counterparty has the right to terminate, it should analyze the agreement’s close-out provisions to determine whether and when it is desirable for it to exercise those rights. The timing of the termination should be relatively soon after the bankruptcy filing that created the default, and the counterparty should take care to ensure that it adheres to the notice requirements under the contract.
After termination, the counterparty must closely heed the provisions concerning the calculation of a termination payment. The counterparty should make its calculations as quickly as possible and then convey those calculations to the debtor entity.
Upon a bankruptcy filing, the Bankruptcy Code generally imposes an automatic stay, enjoining most actions against the debtor in bankruptcy and its property. For generic creditors, the automatic stay prohibits the exercise of contractual rights of termination, liquidation, acceleration or setoff. In many instances, however, trading counterparties that exercise their rights under derivatives contracts are exempted from the automatic stay. As a result, derivatives counterparties may still be entitled to exercise those contractual rights under the Bankruptcy Code’s safe harbor provisions.
Nevertheless, counterparties should use caution before exercising their contractual rights, because bankruptcy courts often read the safe harbor provisions narrowly. If the contemplated action does not fall clearly within the permitted actions in the safe harbors, courts will generally rule that the automatic stay continues to apply. For example, although the safe harbors permit the enforcement of termination, liquidation or acceleration rights based on a bankruptcy default, any other modification of contractual rights triggered by the bankruptcy is prohibited.
Courses of Action
If the counterparty is owed money by the debtor in bankruptcy, then it likely has several separate courses of action to consider:
- If the counterparty believes that the debtor is holding excess collateral that should not be property of the bankruptcy estate, then the counterparty will likely need to commence a legal action to recover the excess collateral. The time frame for the resolution of such a proceeding will be determined by the court, but it is unlikely to lead to any immediate access to the excess collateral. The counterparty’s prospects of recovering the excess collateral depend on various external facts, but there is a chance it will be left with only an unsecured claim.
- If the debtor simply owes a termination payment or other payment under the relevant agreements, then the counterparty should file a proof of claim. In chapter 11 cases, the bankruptcy court will generally set a deadline for the filing of claims; in chapter 7 cases, the deadline is automatically set by law. The first three pages of a proof of claim must be on an official form, but the counterparty should attach as much supporting documentation as is necessary to demonstrate the amount owed. Separate claims should be filed against each separate debtor entity that may owe some obligation, including under a guaranty.
- If the non-defaulting party is holding collateral, the Bankruptcy Code will generally allow it to exercise bilateral setoff rights under a derivatives contract. Thereafter, if the counterparty is still owed additional money, it should file a proof of claim for the balance. If, on the other hand, the counterparty holds excess collateral after the offset, then it may face legal actions seeking to have those funds returned to the bankruptcy estate.
After Filing the Proof of Claim
Larger debtors will often retain a claims agent, which will accept and record all proofs of claim. After filing a proof of claim, the counterparty will likely face a prolonged wait before it realizes any payments. Debtors have an initial 120-day period to file a plan of reorganization, and that period may be extended to a maximum of 18 months from the bankruptcy filing. Thereafter, there is an additional period of time before the bankruptcy court can confirm the plan. After plan confirmation, there is often a short delay before the plan becomes effective; and even once effective, distributions on some claims will be sent only in incremental amounts over a number of months.
In the interim between the counterparty’s filing of the claim and the ultimate payout, the debtor will review the amounts and validity of the claims filed against it. If it agrees with the amounts claimed, then it will take no action. After a certain amount of time passes without an objection filed, the claim would become an “allowed claim.” Only allowed claims are eligible for distributions. If, on the other hand, the debtor disagrees with the amount or basis for any given claim, then it may file an objection to that claim. A claim objection commences a contested matter that represents a condensed version of litigation. If the parties are unable to reach an agreement, then the court would hold an evidentiary hearing and make a final determination on whether the claim should be an allowed claim and in what amount.
Protection from Avoidance Actions
One way in which bankruptcy law attempts to maximize the funds available for distribution to creditors is through the prosecution of avoidance actions. In those lawsuits, the bankruptcy estate seeks to avoid and recover certain types of transfers – usually preferences or fraudulent conveyances – for the benefit of the estate. For trade creditors, the prospect of being sued in an avoidance action after failing to be paid in full is often a maddening occurrence. Except in cases of actual fraud, however, counterparties under derivatives contracts are generally shielded from avoidance actions.
The summary above provides a high-level summary of the bankruptcy procedure facing counterparties to trading contracts. Each counterparty will likely face individualized issues based on its unique set of facts. Any specific actions to be taken should be based on a thorough review of the applicable contracts and underlying transactions, all of which could modify the general observations provided above.