This alert describes issues to consider when a derivatives dealer counterparty becomes insolvent.We address below issues involving termination of a master agreement, close-out netting of underlying trades and collateral. Even though this alert focuses on the bankruptcy of a dealer, many of the issues would also arise in connection with the bankruptcy of most non-dealer counterparties.
1. Existence of an Event of Default and Termination
a. Existence of an Event of Default
Parties to an ISDAMaster Agreement (the “Master Agreement”) first will need to determine whether the bankruptcy (“Bankruptcy”) of their dealer counterparty (the “Counterparty”) or one of its affiliates constitutes an event of default under the applicable Master Agreement, enabling the non-defaulting party to terminate the Master Agreement (or whether an automatic termination will be deemed to have occurred).
When the Counterparty itself files for bankruptcy, an event of default occurs under the Master Agreement. If the dealer entity that files for bankruptcy is not also the Counterparty to the Master Agreement, but is named as a guarantor (Credit Support Provider) or as a Specified Entity under the applicable Master Agreement in connection with the Bankruptcy event of default, then an event of default under the Master Agreement also occurs even if the Counterparty itself is not insolvent.
If an event of default has occurred, the non-defaulting party has the right to terminate the Master Agreement entirely, thereby triggering the termination of all underlying trades. A termination of only a subset of all of the underlying trades is not permitted. If, however, the parties have specified Automatic Early Termination to be applicable in the applicable Master Agreement, the Master Agreement will terminate automatically upon the occurrence of a Bankruptcy event of default.
b. Procedure to effect termination
If Automatic Early Termination applies under the applicable Master Agreement, the Master Agreement will terminate without the need for the parties to take any action and an Early Termination Date (on which the underlying derivative trades will be valued) in respect of all outstanding transactions will occur immediately upon or as of the time immediately preceding the occurrence of the applicable Bankruptcy event of default (such as the filing of a voluntary petition, as was the case in connection with the recent filing by Lehman Brothers Holdings Inc. and various of it subsidiaries).
Note that U.S. counterparties to a Master Agreement rarely select automatic termination because of the protection granted under U.S. bankruptcy laws to close-out netting. Automatic termination is typically used when there are doubts as to whether close-out netting is legally enforceable in the countries in which a financial institution operates, as local laws (especially bankruptcy laws) may preempt the ability of the parties to effectuate close-out netting.
Assuming that the parties did not select Automatic Early Termination, the non-defaulting party has the right to terminate immediately the Master Agreement if the event of default is continuing, by delivering a termination notice that specifies the relevant event of default and designates an Early Termination Date in respect of all outstanding transactions underlying the terminated Master Agreement. The Early Termination Date cannot be earlier than the date that the notice is effective and cannot be later than 20 days from such date.
However, once the Counterparty has filed for bankruptcy, the Bankruptcy Code will protect the nondefaulting party’s right to terminate only if it is based on certain events specifically listed in the safe harbor provisions of the Bankruptcy Code and relating to the Bankruptcy filing or the financial condition of the Counterparty. A right to terminate on account of other events of default (such as the prior bankruptcy of a Credit Support Provider) may not be protected under the safe harbor provisions. Courts have also examined the circumstances surrounding the termination of Master Agreements following the Bankruptcy to determine whether the termination was in fact premised on a debtor’s Bankruptcy. In light of these limitations, non-defaulting parties may wish to terminate their Master Agreement with the Counterparty as soon as practicable after the Counterparty files for Bankruptcy to establish, as an evidentiary matter, that the reason for the termination was the Bankruptcy filing and not other, non-protected, events.
c. Other Financial Agreements
Other master agreements, such as the Global Master Repurchase Agreement published by the Securities Industry and FinancialMarkets Association (SIFMA) and the International CapitalMarkets Association (ICMA) and the Global Master Securities Lending Agreement published by the International Securities Lending Association (ISLA) (collectively, the “Other Financial Agreements”) also provide for similar termination rights in connection with the Bankruptcy of a counterparty.
d. Should the non-defaulting party terminate?
Even if a non-defaulting party has the right to terminate a Master Agreement based on an event of default, it should consider whether it wishes to exercise that right. This is particularly relevant if outstanding transactions are net out-of-the-money to the non-defaulting party because such party would owe a termination payment to the defaulting party immediately upon termination of the Master Agreement. In such a case, the non-defaulting party may decide to hold such out-of-themoney trades open (by not terminating the Master Agreement) and withhold scheduled payments under such trades during the pendency of the event of default.
e. Unsettled Trades
What happens if a trade was in settlement at the time of the bankruptcy event of default?
Under the Master Agreement, the amounts to be paid and deliveries to be made by the parties under such unsettled trades will be taken into account in the computation of damages.
With respect to trades negotiated on a one-off basis, a transaction in settlement will become executory when the Counterparty files for Bankruptcy. As a result, the Counterparty can either assume or reject the contract. In the former case, the transaction will be completed according to its terms. In the latter case, assuming damages occur, the non-defaulting party will have a claim against the Counterparty to recover such damages.
2. Close-out Netting
Upon termination of the Master Agreement, a process known as close-out netting will occur, as follows:
(i) open transactions between the parties to the Master Agreement are terminated;
(ii) each terminating transaction is valued by the non-defaulting party (as of the Early Termination Date) pursuant to the applicable methodology reflected in the Master Agreement (Market Quotation or Loss under the 1992 ISDA Master Agreement or Close-Out Amount under the 2002 Master Agreement); and
(iii) all the termination values, together with unpaid amounts are reduced to a single net amount owed by one party to the other.
The Other Financial Agreements also include close-out netting procedures which vary depending on the form of master agreement, but the basic common concept is to reduce exposure across all transactions governed by the applicable master agreement to a single net exposure.
If the parties entered into a master netting agreement, the non-defaulting party may be able to effectuate close-out netting across Master Agreements and Other Financial Agreements by offsetting positive balances of master agreements with negative balances of others, thereby reducing its exposure to the Counterparty. Also, the non-defaulting party may be entitled to set-off amounts owed to it by the Counterparty (and, as the case may be, the Counterparty’s affiliates) against amounts due to the non-defaulting party (and, as the case may be, the non-defaulting party’s affiliates) if set-off rights are included as part of the arrangement between the parties.
a. Initial and Variation Margin
When counterparties enter into derivative trades, they will transfer to each other collateral (usually in the form of cash or treasury securities) to collateralize their obligations under such trades.
There are two types of collateral: (i) initial margin (called “Independent Amount” under the Credit Support Annex (security agreement) to the Master Agreement), which is an amount typically paid by a counterparty to the other without regard to the mark-to-market value of the underlying trades to account for the expected volatility of a particular transaction and credit concerns relating to one or both counterparties and (ii) variation margin, which is collateral that will be transferred by the parties to each other depending on the daily net mark-to-market value of the underlying trades.
Secured parties typically have the right to use (including to invest, lend, pledge, sell or rehypothecate) the funds and securities posted as collateral as they are commingled with their other assets. In other words, the secured party may treat the collateral as though it were its own.
c. Rights upon termination
Upon termination, the non-defaulting party is entitled immediately to the return of any collateral held by the Counterparty in excess of amounts owed to the Counterparty.
If the non-defaulting party is net out-of-the-money (it owes money to the Counterparty across all trades governed by the Master Agreement), there may be a substantial amount of excess collateral (as the non-defaulting party may have posted initial margin without regard to the fact that the trades moved in its favor) and the non-defaulting party will be entitled to set-off amounts owed to the Counterparty against the collateral. If, after exercising such set-off, excess collateral remains with the Counterparty and the collateral has not been segregated (a protection that will apply only if negotiated and agreed to by the parties), the non-defaulting party generally will be left with an unsecured claim equal to the amount of such excess collateral.
If the non-defaulting party is net in-the-money (it is owed money by the Counterparty across all trades governed by theMaster Agreement), the variation margin will probably have been reduced to zero but the Counterparty may still hold initial margin posted by the non-defaulting party. If the Counterparty fails to return the posted collateral immediately and assuming that such collateral has not been segregated, the non-defaulting party will be left with an unsecured claim equal to the amount of such collateral plus the net in-the-money value of the trades and other amounts receivable by the nondefaulting party under the Master Agreement.
d. Segregation of Collateral
If the collateral posted is commingled with the Counterparty’s other assets (for instance because the Counterparty has a right to invest, lend, pledge, sell or rehypothecate the collateral), the nondefaulting party will have the status of a general unsecured creditor in a bankruptcy proceeding in respect of such posted collateral.
Instead, if the parties agreed in the Credit Support Annex that the collateral posted is to be held in a segregated account with the Counterparty, the non-defaulting party will have a claim against the Counterparty’s estate for any amount owed to it, secured up to the value of such collateral.
Similarly, in some cases, the parties may have appointed a third party custodian to hold any collateral posted. In such a case, the non-defaulting party may be able to expedite the return of its collateral.
4. Bankruptcy Safe Harbors
The Bankruptcy Code contains several provisions aimed at protecting parties’ rights and remedies under, inter alia, swap agreements. Yet, parties should be aware that these provisions do not protect all contractual rights that may exist under the applicable Master Agreement; instead, the protected rights are narrowly tailored and limited to a handful of categories: (i) the right to terminate the Master Agreement will not be affected by the automatic stay imposed by the Bankruptcy Code if termination is on account of the debtor’s bankruptcy or insolvency; (ii) the right to setoff any net loss against collateral posted in connection with the Master Agreement will not be affected by the automatic stay; (iii) transfers made pursuant to a Master Agreement may not be avoided as preferential transfers or constructive fraudulent transfers; they may only be avoided upon a showing of intentional fraud; and (iv) cross-product netting under a master netting agreement is permitted in order to determine termination damages.