As noted in a previous Sutherland Legal Alert, the American Bankruptcy Institute has formed a Commission to Study the Reform of Chapter 11 (the Commission). To further its goal of proposing changes to modernize the Bankruptcy Code, the Commission formed a number of advisory committees, including one named the Financial Contracts, Derivatives and Safe Harbors Committee (the Committee).
The Committee consists of a diverse group of bankruptcy academics and professionals who, on the surface, appear to span an ideological spectrum. As a whole, however, the group appears to skew towards a preference for limiting the scope of the Bankruptcy Code’s safe harbor provisions. Likewise, a disproportionate number of the witnesses called by the Committee to date appear to favor legislation narrowing the safe harbors.
The Committee has held a number of meetings, and its agenda is beginning to take shape in the form of recommendations from its subcommittees. There is no guarantee that the Committee will ultimately adopt those recommendations, nor that the Commission will act upon any proposals from the Committee. Nonetheless, it is becoming increasingly clear that changes are on the horizon with respect to the interplay between U.S. bankruptcy law and derivatives contracts.
From the outset, the Committee identified several general topics worthy of review. They included:
- Assumption or rejection of qualified financial contracts (QFCs)
- Avoidance power safe harbors for QFCs
- Realization on collateral and netting
- Bank holding companies, broker-dealers, commodity brokers, and other financial debtors
- Claims with respect to QFCs
- Delays in the exercise of safe harbor termination rights
- One-way payment provisions
The Committee’s work on the topics above has progressed at varying paces. Certain subcommittees have already issued their recommendations, while other subcommittees still have works in progress. The following is a summary of likely proposals from the Committee, in order of specificity, available to date.
Narrowing the Safe Harbor Exemption for Avoidance Actions
One frequent topic at Committee meetings has been the scope of protection under section 546(e) of the Bankruptcy Code. Several subsections to section 546 provide exemptions from avoidance actions, such as preference and fraudulent transfer suits, instituted by a trustee or debtor-in-possession. Although there is some variation from subsection to subsection, the exemption generally arises if the defendant is a participant in the financial or commodity markets, and the transfer at issue occurred under certain types of financial or commodity contracts.
Observers commonly agree that the section 546 exemptions exist for the purpose of creating certainty for market participants – in other words, traders need to know that their settlement payments or transfers of collateral will not be reversed by a later clawback action. The language of section 546(e), however, has led to its frequent application in a context that was likely unforeseen by Congress when it drafted the statute. Section 546(e) is often used as a defense to the avoidance of any transfers associated with failed leveraged buyouts – which otherwise fit the traditional model of a fraudulent transfer. There is some logic to applying section 546(e) in cases involving publicly held securities and market participants that are the ultimate beneficiaries of the transaction. On the other hand, cases involving small transactions with privately held securities and limited involvement of market participants have generated more controversy.
With that recent history as a backdrop, the Committee posed the question: “Should the protections of Section 546(e) be narrowed to exclude certain types of transactions and certain ultimate transferees?” In response to that question, a subcommittee has already issued a preliminary and a revised report on the scope of section 546(e). The report reflects unanimous support on the subcommittee for retaining the exemption for market participants that act as conduits in transactions involving either publicly-held or privately-held securities. The subcommittee also unanimously supported withdrawing the exemption for ultimate beneficial owners of privately-traded securities. There remains an open issue with respect to ultimate beneficial owners of publicly traded securities.
The subcommittee’s work thus far reflects a measured approach. Striking the section 546(e) exemption from beneficial owners of privately held securities would address the apparent absurdity of the 2011 case, In re MacMenamin’s Grill, in which safe harbor protections were extended to a small-scale leveraged buyout of three shareholders.
New Rule on Walkaway Clauses Likely
For many years, parallel insolvency statutes like the Federal Depository Insurance Act (FDIA) have included provisions rendering walkaway clauses unenforceable. Title II of the Dodd-Frank legislation, which creates the Orderly Liquidation Authority, follows the FDIA model of denying enforcement of walkaway clauses.
Walkaway clauses are generally understood to be contractual provisions that nullify the benefit to an “in the money” defaulting party. The “First Method” under Section 6(e) of the 1992 ISDA Master Agreement is a quintessential example of a walkaway clause.
The relevant subcommittee has recommended that the Bankruptcy Code render walkaway clauses unenforceable when triggered by a bankruptcy-related default. The subcommittee bases that recommendation on the benefit of aligning the Bankruptcy Code with other insolvency regimes. The subcommittee appears to be considering the breadth of its proposal and how to define the term, “walkaway clause.” Although it considered including flip clauses and extinguisher provisions, those types of contractual provisions do not appear to be within the scope of the subcommittee’s report.
Supply Contracts in Limbo
Dating at least as far back as the Fifth Circuit’s Olympic Natural Gas decision in 2002, the application of safe harbors to physical supply contracts has been a lightning rod. Although the Courts of Appeals have regularly reinforced the availability of the safe harbor protections with regard to supply contracts, lower courts and academics have frequently balked at the concept. In response, a subcommittee addressed the question of whether supply contracts should constitute QFCs and, if they should, whether their safe harbor protections should be limited.
A general consensus appears to favor retaining the application of safe harbors to some degree – but only when a dealer is involved in the transaction. One obvious follow-up question is what will constitute a dealer, particularly in the commodity markets.
Other important issues related to supply contracts are still lingering. One idea under consideration is to limit safe harbor protections under physical supply contracts to prevent immediate close-out. The subcommittee has addressed nuances related to forward contracts as hedge transactions, and their occasional use of options for settlement without delivery, but it has not reached a conclusion on those issues.
On the positive side, it appears likely that the subcommittee will recommend enactment of a provision stating that electricity is a good. That amendment would eliminate one brand of litigation that has been commonplace since the enactment of section 503(b)(9) in 2005.
Away From the Commission, Similar Pressures
Congress has also been investigating whether the Bankruptcy Code should be amended to improve the intersection of insolvency law and financial/commodity markets. On December 3, 2013, the House Judiciary Subcommittee held a hearing to address those issues. In that hearing, a Harvard law professor delivered testimony that included the comment that the safe harbors are “too wide.” The professor concluded with proposals that Congress should:
- Provide for a limited application of the automatic stay with respect to derivatives contracts;
- Narrow the safe harbor exemption from preference actions;
- Limit the scope of the Bankruptcy Code provisions on netting;
- Require each Circuit to name one bankruptcy judge with expertise in financial markets to be “on call” for issues related to failing financial institutions
From a big-picture view, it is certainly gratifying to see capable and serious minds gather to discuss potential legislative improvements. Because of the collective credibility of the Commission and its various committees, Congress will likely be forced to give credence to whatever proposals ultimately emerge. That may be troubling from the perspective of firms that trade in the financial and commodity markets, however. Those traders have entered into transactions with the expectation of certain treatment under the bankruptcy laws, which may now change significantly. Traders – especially those that engage in physical supply contracts – would be well-advised to monitor developments closely, and to be ready to voice their opinions when the proposals eventually make their way to Congress.