22 October 2008

Practical Considerations For Contract Counterparties Regarding Recent Market Events

McDermott Will & Emery


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Companies trading derivatives and commodities with or through entities that are currently undergoing corporate changes should review these possible actions, alternatives and note their legal implications.
United States Corporate/Commercial Law
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Companies trading derivatives and commodities with or through entities that are currently undergoing corporate changes should review these possible actions, alternatives and note their legal implications.

Every day seems to bring more news of bankruptcies, bailouts, rescues and acquisitions in U.S. financial markets. The journalists' cliché that "Wall Street will never be the same again" is on the front page of every periodical. In a span of only a few weeks in September 2008, a number of Wall Street entities and U.S. financial institutions have merged, sold significant stakes to U.S. or international buyers, become semi-nationalized by the federal government, changed their primary regulator or filed for bankruptcy court protection. When the dust settles, the U.S. federal government may end up spending close to $1 trillion of tax-payers' money on bailout loans and the repurchases of troubled assets. This action will almost certainly serve as a stimulus to change the U.S. legal landscape and the existing regulatory regime of U.S. financial services in the near future. However, before these regulatory changes are implemented, companies that have trading relationships with entities that are undergoing corporate restructurings, mergers, reconstitution for regulatory purposes, or that are in distress, need to know how they should react and what they can and cannot do in the immediate term.

This article briefly discusses some of the alternatives and legal implications that should be considered by those trading derivatives and commodities with or through the entities that are currently undergoing corporate changes. This article is not meant to serve as a blueprint for action for a contract administrator, but rather as "food for thought" in light of recent events. Of course, each specific derivative and commodity trading contract should be analyzed specifically for available remedies' provisions and in the context of a specific market or counterparty event.

Legal Characterization of Recent Market Events

Although the facts characterizing each company's situation are somewhat different, from the perspective of a counterparty's legal rights, recent events can generally be grouped into four main conceptual categories: (a) bankruptcy (either a voluntary or an involuntary filing for bankruptcy court protection, which may also include an insolvency); (b) change of control (such as a merger, acquisition or any other corporate restructuring event); (c) downgrade (an adverse change in a credit rating by one or more of the credit rating agencies); and (d) material adverse change or market disruption event (generally, any event that has an adverse effect on the operations of a company that is material enough to either call into question the continued operation of the company in the ordinary course of business or that frustrated the purpose of any given transaction or contract).

After a determination has been made that any of these events has occurred, a counterparty must carefully consider how to respond in light of whether its trading counterparty is an unregulated entity (e.g., a hedge fund or an energy trader), a bank (e.g., an unregulated investment bank or a regulated bank or financial holding company), or a regulated broker dealer or an adviser (e.g., a futures commission merchant, a securities broker dealer or a commodity trading advisor).

There are various contract responses available to counterparties, as well as several alternatives to consider.

Termination Generally

In most cases, depending upon the terms of trading contracts, if a company determines that an event of default has occurred and is continuing with respect to one of the trading counterparties, a company may terminate the agreement or contract pursuant to the terms thereof. For example, under the International Swaps and Derivatives Association, Inc. (ISDA) Master Agreement, bankruptcy (including insolvency and other related events) is an event of default. Upon notice and designation of a date for early termination, a party may terminate and liquidate its transactions under the ISDA Master Agreement. In addition, a terminating party generally may take into account all collateral posted under the agreement, and, if the ISDA Master Agreement is also a master netting agreement (as defined by the U.S. Bankruptcy Code) collateral posted with respect to other agreements or annexes (be they for physical or financial trading only). Other standard U.S. master trading agreements, including the NAESB, EEI and WSPP, use similar procedures.

Note that the U.S. Bankruptcy Code allows for the termination of certain derivatives contracts (such as swaps, forwards, options and other transactions under master netting agreements) upon the occurrence of bankruptcy without regard to its automatic stay provisions, provided that the contract that is being terminated allows for such termination.

Automatic Early Termination (AET)

Because it is not standard market practice to include the AET provisions, the decision to terminate likely is not automatic and other alternatives may be considered (unless, of course, the AET provisions are included in the contract, in which case the termination will happen automatically). For example, if there is the likelihood that the company will come out of bankruptcy, a company may be better off continuing the existing business relationship. Likewise, the trading counterparty in bankruptcy may be purchased by a solvent and more creditworthy entity, in which case a company may benefit by continuing the relationship.

Bankruptcy of a Regulated Entity

In the case of a futures commission merchant (FCM) bankruptcy, the Commodity Exchange Act requires that all customers' accounts must be transferred to a solvent FCM. This transfer should be relatively straightforward because the Commodity Exchange Act requires FCMs to segregate customer accounts from the accounts and assets of the FCM. That said, it could become complicated if the FCM has impermissibly commingled assets of customers, or in the case of certain customers' funds that are not clearly identified by the U.S. Commodity Futures Trading Commission (CFTC) as subject to mandatory segregation. Similar procedures apply with respect to insolvencies of securities broker dealers.

The insolvencies of U.S. national or state-chartered commercial banks are conducted under a different system, although as a practical matter the same event of default contractual provisions generally apply. Now that the remaining major investment banking entities have been transformed either into commercial banks or have become subsidiaries of bank holding companies or financial holding companies, counterparties should analyze the effect of U.S. banking laws on their affiliates and trading counterparties, and on applicable transactions with them.

Participation in Specific Industry Termination/Workout Scheme

In addition, industry organizations, such as ISDA, may establish an ad hoc protocol for the uniform settlement of certain counterparty obligations that were documented under the ISDA Master Agreement (e.g., see the ISDA uniform settlement agreement CDS protocol). Also, futures exchanges may have additional protocols for unwinding futures trades (e.g., see the Chicago Mercantile Exchange's order regarding block trades).

Additional Termination Events

Finally, a contract may be terminated if certain termination events are specified (e.g., illegality, force majeure, tax event, tax event upon merger, credit event upon merger or any other specific additional termination events). For example, the U.S. Securities and Exchange Commission (SEC) prohibition on short selling of securities or the State of New York Insurance Department position on credit default swaps as insurance products may call into question the legality of individual transactions that may have to be terminated.

Change of Control

General Considerations – Industry Standard and Bespoke Agreements

Under most industry standard trading agreements, if a surviving entity assumes the obligations of the merged or acquired entity, and the credit rating of the surviving entity is the same or better than that of the original counterparty, the change of control will not constitute an event of default or an additional termination event (e.g., Credit Event Upon Merger under the 2002 ISDA Master Agreement). Also, most industry-standard trading agreements allow for the assignment of all or substantially all of a counterparty's assets without the other party's consent and without triggering an event of default.

Some agreements may, however, provide that any change of control is an event of default or a termination event. These provisions are more likely to be found in service-specific agreements where counterparties rely on service from a particular entity (e.g., agreements with pipelines, gas storage facilities, refineries, power plants and other similar facilities). Because some of the entities in distress may own these facilities, it is imperative to read the relevant contracts and, if applicable, the confirmations thereunder very closely. Also, given that many energy-related agreements are bespoke (i.e., are not industry standard and individually drafted between the parties for a specific transaction at hand), close review of such contracts and confirmations thereunder becomes imperative.

Regulated Commodities Considerations

Note that the CFTC and many futures exchanges and clearing houses require that any substantial change of control (i.e., more than 10 percent) must be reported for aggregation purposes if the combined futures positions of the acquired and the surviving entity exceed the statutory or exchange trading limits. Accordingly, if a target entity and an acquiring entity have positions on a futures exchange, such positions may be aggregated for CFTC reporting purposes. Likewise, if any of the affiliates of the target entity are FCMs, commodity trading advisors or commodity pool operators, they will need to update their registration and reporting forms. If a counterparty deals with any of these entities, it may have to re-execute its brokerage or investment advisory agreements, or will be required to provide additional representations and warranties.

Bank Holding Company Issues

Although strictly speaking the reconstitution of an investment bank into a bank holding company or a financial holding company does not qualify in and of itself as a change in control, such event may have significant implications on how business is conducted by these companies. For example, many of the representations and warranties may need to be revised, and some activities conducted in the ordinary course of business by an investment bank prior to reconstitution may have to be approved for bank or financial holding company purposes. In addition, after applicable grace periods after the reconstitution expire, the new bank or financial holding companies may have to divest some of their assets.


Downgrades and Exposure

A credit downgrade usually serves as a trigger for requesting additional collateral. Because collateral typically is posted in the form of cash or letters of credit, calls for additional collateral usually come at the worst possible time for an entity in distress that is already experiencing liquidity problems. Downgrade clauses are drafted in a variety of forms, ranging from very specific, such as a rating grid stating the amount of callable collateral per each credit rating, to the most general, such as adequate assurances clauses pursuant to which a party may request additional collateral if it identified that it has reasonable grounds for insecurity of its counterparty's future performance under a contract. In addition to downgrade clauses, of course, a counterparty can ask for additional collateral if an agreement includes a mechanism for calculating marked-to-market exposure and requesting collateral if such exposure exceeds a certain threshold level.

Bankruptcy Code Considerations

As with other clauses, care should be taken when calling for additional collateral under the downgrade clauses. Although the U.S. Bankruptcy Code allows calling and posting additional collateral prior to and upon bankruptcy, the agreement in question must allow counterparties to ask for additional collateral contractually. Similarly, adequate assurances clauses (that do not have hard downgrade thresholds) should not be treated as a carte blanche for calling collateral in any situation—a counterparty must have clearly articulated, reasonable grounds for insecurity and should not exercise this clause for any other reasons (e.g., to trigger cross-defaults with other affiliates of an entity in distress). The counterparty must act in a commercially reasonable manner and make sure that the relevant agreement does not provide for alternative remedies (e.g., with respect to reliance on the gap-filler Uniform Commercial Code adequate assurance rights).

Material Change

Material Adverse Change and Market Disruption Events

As with calling for adequate assurances, one must use material adverse change clauses reasonably. This is especially important if a material adverse change event serves as grounds for termination (as an event of default or an additional termination event), or as a reason for calling additional collateral. Likewise, declaration of a force majeure event must be made also in strict compliance with the provisions of the relevant agreement (e.g., with respect to qualification of events as force majeure events, form and timing of notice and specific description of force majeure events). Similarly, application and declaration of market disruption events must be made in strict compliance with the language of the given contract, and the applicable definitions (e.g., ISDA 2005 Commodity Definitions).

Regulatory Changes

Since the beginning of September 2008, we have witnessed unprecedented regulatory activity by the Federal Reserve System, the CFTC, the SEC some state regulators (e.g., New York Department of Insurance with respect to credit default swaps), and, of course, the U.S. Congress and the U.S. Treasury. These regulatory changes that have already happened and those likely to follow may affect the status quo of existing transactions. Accordingly, counterparties should reassess their existing contractual relationships to ensure their continued legality.

In sum, there is no recipe for response that would work equally well for all market participants and each situation must be assessed by individual legal, business and credit departments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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