In the wake of the recent financial crisis, the legal system continues to sort out rights and obligations of financial market participants. This is especially true for participants in the over-the-counter derivatives markets.
The tremendous growth of that largely unregulated market has been accompanied by the development of sophisticated contractual frameworks and specific bankruptcy legislation expressly intended to reduce uncertainty around the amount and type of claims that could ultimately be asserted by market participants following bankruptcy of a derivative counterparty.
As a general rule, the insolvency of a swap counterparty entitles the remaining solvent counterparty to terminate all derivatives transactions between the parties. A robust contractual netting process, honored in bankruptcy, allows the parties to determine the final amount owed to or owed by the insolvent party.
As discussed below, a claim for amounts owed by an insolvent swap counterparty – the “swap termination claim" – will generally be considered an unsecured claim on the estate of such party.2 Parties holding swap termination claims may want to monetize those claims before the conclusion of an insolvent counterparty's bankruptcy. Swap termination claims, like other types of unsecured claims, constitute an asset class that can be traded during the course of the bankruptcy. Swap termination claims have been actively traded in several recent U.S. bankruptcies, including Lehman, Enron and ASARCO, and will be actively traded in any bankruptcy of a financial institution with a significant number of over-the-counter derivatives transactions.
Sellers and buyers of swap termination claims take on unique economic and legal risk that can be managed through appropriate legal documentation. This memorandum briefly describes how (i) swap termination claims are calculated, (ii) unsecured bankruptcy claims are traded, and (iii) customary claims trading documentation should be modified when swap termination claims are purchased and sold.
SWAP TERMINATION CLAIMS
Unlike exchange-traded futures and other derivatives products, over-the-counter derivatives products have to date traded without a central clearing system and therefore parties are exposed directly to the credit risk of their counterparties.3 In order to mitigate counterparty credit risk, most parties enter into a master agreement (“Master Agreement”), in a form prepared by the International Swaps and Derivatives Association (“ISDA”), to govern over-the-counter derivatives transactions.
One of the pillars of the Master Agreement is a detailed contractual close-out netting process. Upon the default (including bankruptcy) of one party, the non-defaulting party can (i) terminate all transactions subject to the Master Agreement, (ii) designate an early termination date for purposes of calculating the value of the terminated transactions, and (iii) calculate a net amount owed to or owed by the insolvent party under the terminated transactions (the “swap termination amount”).4
The non-defaulting party must deliver a notice to the insolvent party showing the calculation of the swap termination amount. The swap termination amount owed by either party may generally be set off by the non-defaulting party against amounts owed to the defaulting party outside of the Master Agreement. As a general rule, payment obligations arising upon early termination are secured by any collateral posted5 pursuant to the credit support annex to the Master Agreement (“Credit Support Annex”).6
A non-defaulting party’s swap termination claim can arise in two ways: (i) if the swap termination amount is owed by the insolvent party, the collateral posted by the insolvent party may be less than that amount, or (ii) if the swap termination amount is owed to the insolvent party, the insolvent party may fail to return excess collateral posted by the non-defaulting party.
If the swap termination amount is owed by the insolvent party, the non-defaulting party may exercise all rights and remedies of a secured party under the Credit Support Annex and use the collateral posted by the insolvent party to satisfy the insolvent party’s payment obligations. If the swap termination amount exceeds the posted collateral, then the non-defaulting party has an unsecured claim against the insolvent party for the deficiency.
If the swap termination amount is owed to the insolvent party,7 the insolvent party may exercise its rights and remedies as a secured party with respect to collateral posted by the non-defaulting party under the Credit Support Annex. However, if the collateral posted by the non-defaulting party exceeds the swap termination amount, as a practical matter the non-defaulting party will likely receive only an unsecured claim for the excess collateral, and not the return of the excess collateral itself.
TRADING UNSECURED CLAIMS
A trading market for unsecured bankruptcy claims has developed over the past twenty years.8 In most cases, claims trading in a bankruptcy case will begin after the debtor in the case publishes its schedule of liabilities and will continue through plan confirmation.
Claims purchased early in a bankruptcy case, e.g., shortly after the debtor releases its schedule of liabilities, involve greater uncertainty around the amount, treatment and status of the claims than claims purchased subsequently, after being allowed in a bankruptcy case by stipulation or court order. Claims purchased early in the case generally will be traded on buyer-friendly documents containing more fulsome representations, warranties and indemnities intended to provide recourse to buyer in the event such representations and warranties are breached or the indemnities triggered.9 Claims purchased after a final order allowing the claim has been entered in the bankruptcy case will be considered more certain and will trade on streamlined, seller-friendly documentation.
The claims trading market does not use form documentation prepared by a market association such as ISDA or the Loan Syndications and Trading Association, Inc. (“LSTA”).10 However, to some extent an accepted range of “customary” documentation has emerged in the claims trading market. The documents contain detailed seller representations and warranties customized to address the specific claim being traded, and generally follow a pattern of risk allocation between buyer and seller that is accepted in the market.
Because the amount of the claim that ultimately will be allowed by the bankruptcy court is uncertain, parties must allocate the risk that the final allowed claim amount will be less than the amount originally purchased. As a general rule, the purchase price allocable to any portion of the claim that is disallowed by final order is returned to buyer with interest. This is referred to as the “disallowance” remedy, which is generally triggered when the claim is reduced in whole or in part by the bankruptcy court. But the disallowance remedy is effective only if seller of the claim is solvent at the time of the disallowance and financially able to return the purchase price to buyer. To reduce counterparty risk, buyer may "hold back" a portion of the purchase price until the claim is allowed by final order in the bankruptcy case. In a customary trade, the parties may also allocate the risk that the allowed claim amount will be greater than the amount purchased by buyer under the transfer document.11
Rule 3001(e) of the Federal Rules of Bankruptcy Procedure sets forth the mechanism for recording the transfer of claim on the bankruptcy court’s records. The procedure is straightforward, but substantial delay and confusion (which may impair future liquidity of the claim) can result if this procedural matter is not dispatched promptly and accurately.
MODIFICATIONS FOR TRADING SWAP TERMINATION CLAIMS
Swap termination claims require modification of the documentation used to trade unsecured claims. Most importantly, given the complex nature of derivative transaction close-out netting under the Master Agreement, claim buyers generally conduct focused legal (and business) due diligence on the underlying swap transactions between the insolvent party and the non-defaulting party that gave rise to the swap termination claim. This due diligence will help test the valuation for the swap termination amount. The diligence is always conducted wearing the "debtor's hat" with the goal of anticipating objections and challenges to the specific claim that would likely be raised by the debtor's estate.
Information regarding terminated derivatives transactions, calculation of the swap termination amount and the valuation method employed by the nondefaulting party will be crucially important when defending the swap termination claim in the bankruptcy proceeding. It is important to note that the case law in this area is evolving rapidly, primarily due to the Lehman bankruptcy. A prudent buyer should require seller to provide – and represent as to the completeness of – all information relevant to the termination of the swap termination amount. Buyer should also require seller to represent that the swap termination amount was calculated in accordance with the terms of the relevant Master Agreement and that the amount includes all of the amounts owing to the non-defaulting party from the insolvent party under the Master Agreement and the non-defaulting party has no remaining obligations under or in connection with the Master Agreement.12
Buyer should ensure that the non-defaulting party under the Master Agreement is required to maintain all documentation relating to the underlying swap transactions and to make these documents available to buyer (or buyer's designee) upon request.13
Importantly, the standard "no setoff" representation found in most documents used in trading unsecured claims should be reviewed in light of the facts surrounding a particular swap termination claim. Because the Master Agreement expressly authorizes the non-defaulting party to set off the amount owed by the defaulting party under the Master Agreement against any other amount owed by the non-defaulting party to the defaulting party, and vice versa, it is likely that setoff will have occurred and should be considered in calculating the size of the swap termination claim. Any "no setoff" representation should be adjusted to include appropriate exceptions for the Master Agreement's explicit right of setoff, but most importantly, buyer should understand and agree with any setoff exercised by the non-defaulting party in determining the swap termination claim. That calculation can be confirmed by seller through representations and warranties in the purchase documentation, but a prudent buyer will want to evaluate the worst case – the non-defaulting party’s setoff being held invalid (resulting in reinstatement of the non-defaulting party’s liability to the defaulting party), an increase in the size of the claim (which, under some documents, may trigger buyer’s obligation to purchase additional claims) and a delay on the distributions for the claim pending non-defaulting party’s payment of amounts owed to the debtor.
The disallowance remedy contained in claims trading documentation forms an adequate starting point for trading swap termination claims and often will not need substantial modification. To the extent that a swap termination claim is disallowed in whole or in part, the disallowance remedy will return the relevant portion of the purchase price plus interest to compensate buyer for the disallowance. Care should be taken to ensure that the disallowance remedy will be triggered by appropriate events, for example, a settlement or stipulation of the claim that fixes the amount of the claim at a lower level, in addition to the standard trigger of a court order allowing the claim at a lower level. Parties also need to ensure that any purchase price "hold back" agreements are accurately reflected in the disallowance provisions.
Finally, buyer should be sure to purchase from seller all rights of the non-defaulting party against any ”Credit Support Provider” for the insolvent party under the Master Agreement. Depending upon the terms of the credit support, buyer may be able to assert a separate and independent claim against the Credit Support Provider (generally a parent or operating affiliate of the counterparty). If the Credit Support Provider is insolvent, buyer will need to prosecute a parallel claim in the bankruptcy proceeding of the Credit Support Provider.
Swap termination claims have received increased attention in the unsecured claims trading market because of current market conditions (including, most importantly, the Lehman bankruptcy) and the large notional amount of existing derivative exposure. The traditional market in unsecured claims has generated customary and comprehensive trading documentation that can form a starting point for swap termination claims, but modifications will be necessary to reflect the history and origin of the particular claim (including setoff) and to confirm the correct calculation of the swap termination amount under the Master Agreement. As a more liquid market for swap termination claims continues to develop, appropriate and efficient trading conventions and documentation will continue to evolve.