T he recent surge in activity in the claims trading market in the wake of Lehman Brothers and other high-profile bankruptcies has created a backlog of open trades and heightened price volatility. This is a perilous combination. The lack of standardized trading documentation and uniform trading conventions, as well as the dramatic influx of new counterparties into the claims market, are factors that have contributed to longer settlement timeframes and increased uncertainty in the market. Currently, settlement delays arise primarily from (i) the complexity of the underlying claims and the bankruptcy proceedings within which the claims will be resolved and (ii) the difficulty of efficiently negotiating and settling a claims purchase agreement acceptable to both buyer and seller. Even trade confirmations—short-form documents confirming the terms of specific trades— often remain unsigned until the final settlement date. For extended periods, the parties to a claims trade may be bound only by the oral promise to sell or to buy the claim that was made over the telephone on the trade date.
Against this background of documentation uncertainty and price volatility, market participants should understand the rules governing enforceability of oral agreements and take steps to protect themselves from broken trades.
This memorandum summarizes the relevant statutory framework in New York, describes the special challenges that exist in the claims trading market, and sets forth some practical recommendations for market participants.
As a general rule, oral contracts are enforceable provided that there is sufficient evidence of the parties’ intent to be bound. For public policy reasons, however, the New York Statute of Frauds provides that certain classes of oral contracts are unenforceable unless reduced to a writing. These include, among others, contracts in consideration of marriage, contracts for the sale of an interest in land, contracts which cannot be performed within one year, and contracts for the sale of goods for $500 or more. In the past, the application of the Statute of Frauds meant that oral, undocumented debt and claims trades could not be enforced.
A modern exemption to New York’s Statute of Frauds changed this rule. The “qualified financial contract” (“QFC”) exemption, enacted in 1994 with support from the financial industry, permits the enforcement of an oral agreement for certain types of sophisticated financial transactions between institutions. This carve-out originally applied to options, swaps, and certain other derivative transactions. In 2002, with input from the Loan Syndications and Trading Association, Inc. (“LSTA”), the legislature extended the QFC exemption to the Statute of Frauds to cover debt and claims trades as well.
As a result, it is possible today to enforce an oral trade against a recalcitrant counterparty, provided certain conditions are met.
THE QFC EXEMPTION
Under New York General Obligations Law (“NYGOL”) § 5-701, an oral trade that is valid in other respects will be enforceable, even in the absence of fully executed trade documentation, if such trade qualifies as a “qualified financial contract” and either (i) there is “sufficient evidence” to indicate that a contract has been made or (ii) the parties, by means of a prior or subsequent written contract, have agreed to be bound by the terms of such qualified financial contract.
What is a “qualified financial contract?”
A qualified financial contract includes any agreement “as to which each party thereto is other than a natural person” and that is, inter alia, “for the assignment, sale, trade, participation or exchange of indebtedness or claims relating thereto arising in the course of the claimant’s business or profession (including but not limited to commercial and/or bank loans. . .)[.]”
As reflected in the language above, the QFC exemption covers both bank debt and claims trades.
What is “sufficient evidence?”
Section 5-701(b)(3) of NYGOL provides that there is “sufficient evidence” that a contract has been made if, among other things:
- there is evidence of electronic communication (e.g., e-mails or recorded telephone calls) sufficient to indicate that in such communication a contract was made between the parties (§ 5-701(b)(3)(a));
- a written confirmation sufficient to indicate a contract has been made between the parties and sufficient against the sender is received by the party against whom enforcement is sought no later than the fifth business day after such contract is made, and the sender does not receive, on or before the third business day after such receipt, written objection to a material term1 of the confirmation (§ 5-701(b)(3)(b)); or
- there is other writing sufficient to indicate that a contract has been made, signed by the party against whom enforcement is sought or its agent (§ 5-701(b)(3)(d)). In addition, § 5-701(b)(3) states that an electronic communication or written confirmation may be “sufficient evidence” of a contract even if it omits or incorrectly states one or more agreed-upon material terms as long as such evidence provides a reasonable basis for concluding that a contract was made.
“Safe harbor” of § 5-701(b)(3)(b)
As noted above, NYGOL § 5-701(b)(3)(b) provides a “safe harbor” whenever a trade confirmation is received within five business days after the trade date and the sender does not receive an objection to a material term thereof within three business days of such confirmation’s receipt.
If a counterparty does respond within three business days with changes to the trade confirmation, the issue becomes whether the changes pertain to material or non-material terms. Objections to non-material terms of the confirmation should have no effect on the general rule and the sender would still be able to rely on the safe harbor of § 5-701(b)(3)(b). If a written objection is received to a material term of the confirmation, on the other hand, the sender will no longer be able to rely on such safe harbor (although the sender may still be able to establish that there is “sufficient evidence” apart from the confirmation to demonstrate that a contract has been formed, including a prior or subsequent written contract evidencing that the parties agreed to be bound by the terms of such QFC).
ISSUES UNIQUE TO THE CLAIMS TRADING MARKET
Over the past few years, the loan trading market, with guidance from the LSTA, has developed a stable framework to take advantage of, and enhance, the protections afforded by the QFC exemption. Brokerdealers and other active market participants have designed procedures with the QFC exemption in mind. Most broker-dealers have policies requiring prompt documentation of new trades via blotters or trade recaps and distribution of trade confirmations within two to three business days of the trade. Furthermore, the standardized nature of the LSTA trading documentation, coupled with the prevalence of relatively experienced market participants, minimizes the amount of negotiation necessary and reduces the volume of unsigned trade confirmations.
In conjunction with the 2002 legislation, the LSTA published revised forms of loan trading confirmations that specifically contemplated the QFC exemption and paved the way for electronic execution of documents. (Since that date, the LSTA has periodically issued revised loan trading confirmations, all of which are intended to take advantage of the QFC exemption.) For example, market participants executing LSTA distressed loan trading confirmations agree to be bound to all prior and subsequent oral trades on “distressed terms” upon reaching agreement (whether by telephone or otherwise) to the terms thereof. This is intended to support the “prior or subsequent written contract” framework introduced by NYGOL § 5-701(b)(1)(b). The statutory exemption provided under § 5-701(b)(1)(b) and the revised trade confirmation together provide a savings feature for situations in which one party fails to sign.
In contrast, the claims trading market does not yet have the kind of well-developed architecture available in the loan trading market. Various broker-dealers have different documentation standards and institutionspecific requirements. In addition, market participants are much more likely to face counterparties transacting in the market for the first time, usually resulting in more extensive negotiations, prolonged delays in executing trade confirmations and a heightened risk of broken trades. While market participants should recognize that the QFC exemption covers claims trades to the same extent it does loan trades, they should continue to design and implement appropriate procedures in order to take full advantage of the exemption and strengthen their position in the event of a dispute over a trade that is not fully and formally documented.
Overall, the more specific one is from the start with a counterparty—whether in oral or written confirmations— the better position one will be in later to prove the terms of a trade that was never formally documented but yet falls within the QFC exemption.
Market participants may want to consider taking the following steps:
- Traders should, to the extent practicable, ask specific questions upfront regarding material terms that would create challenges if the counterparty were to attempt to change them later. For example, the trader might ask from the start whether the ultimate counterparty will be different from the legal entity with whom the trader is dealing with over the phone and, if so, who it will be. Similarly, traders should discuss upfront other issues, such as diligence items and conditions to closing that may affect the settlement process.
- Traders should reach express oral agreement as to material terms at the time of the trade and should set forth those material terms in their confirmations or trade recaps.
- To better prove oral confirmations of such specific material terms, market participants should review procedures for creating “sufficient evidence” of the trade on the trade desk. Blotters, e-mails, Bloomberg messages and trader's notes are all sources of evidence supporting contract formation. Market participants should design operational processes to capture and preserve such evidence.
- To the extent that certain counterparties are “repeat offenders” who often try to change terms of the trade after the confirmation has gone out, it may be prudent to shorten the time in which such counterparties must either object to material terms of the confirmation or be deemed to have countersigned the confirmation, as the governing time period can be amended by written agreement of the parties.
The rapid evolution of the bankruptcy claims trading market will no doubt spur development of trading conventions and documentation standards. The obvious analogue is the development of conventions and standards in the secondary loan market over the past 15 years. Until such standards are tailored, developed and widely used in the trade claims market, counterparties will continue to need to understand the rules governing enforceability of oral agreements and take practical steps to protect themselves from broken trades.