2005 Bankruptcy Code Amendments Affecting Financial Contracts

On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Reform Act"). Although principally a measure to guard against consumer bankruptcy abuse, the Reform Act clarifies, expands, and adds provisions to title 11 of the United States Code (the "Bankruptcy Code") dealing with financial transactions. Notwithstanding the Reform Act’s broader scope, this discussion is limited to those portions of the Reform Act bearing on financial transactions. The amendments discussed below will take effect on Monday, October 17, 2005, and will not apply to cases commenced prior to that date.

Sections 555, 556, 559, and 560 of the Bankruptcy Code currently provide special protections to transactions involving financial markets. Without these provisions, a non-debtor party to a protected financial contract would be stayed pursuant to section 365(e)(1) of the Bankruptcy Code from taking immediate action to protect itself upon the bankruptcy of its contract counterparty. By enacting these provisions, Congress recognized that financial markets can change significantly in a matter of days and a non-bankrupt party to certain types of complex financial transactions may face heavy losses unless the transactions are promptly and finally closed out and resolved. The Reform Act contains modifications to sections 555, 556, 559, and 560 of the Bankruptcy Code to expand and clarify the protections afforded with regard to "securities contracts," "forward contracts," "repurchase agreements" and "swap agreements" under the Bankruptcy Code and adds new sections 561 and 562 to the Bankruptcy Code to provide protections with regard to master netting agreements and to define the timing of the measure of damages under such agreements, respectively. Set forth below is a summary of the relevant amendments to the Bankruptcy Code pertaining to financial transactions.

One of the most important changes in the Reform Act is that it broadens the class of parties protected by the Bankruptcy Code’s financial transactions provisions. Specifically, protected parties now include all "financial participants," which is essentially defined to include most clearing organizations as well as any entity which, on any day during the 15-months immediately preceding the commencement of the case under the Bankruptcy Code has had securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements or master netting agreements involving non-affiliates with a total gross dollar value of not less than $1 billion in notional or actual principal amount outstanding or had gross mark-to-market positions of not less than $100 million (aggregated across counterparties). The complete definition of "financial participant" (as well as other relevant definitions and the revised text of sections 555, 556, 559 and 560) is set forth in the statutory appendix annexed hereto.

The Reform Act also provides that neither filing for protection under the Securities Investor Protection Act of 1970 nor any court order or decree obtained by the Securities Investor Protection Corporation may act as a stay of any contractual right to "liquidate, terminate, or accelerate a securities contract, commodity contract, forward contract, repurchase agreement, swap agreement, or master netting agreement," to offset or net termination payments or other obligations arising under such agreements, or to foreclose on cash collateral. In contrast, such an application, order or decree may still operate as a stay of any foreclosure or other disposition of securities collateral pledged by a debtor.

The Reform Act clarifies sections 555, 556, 559 and 560 by providing that the liquidation of a qualifying securities contract also encompasses termination and acceleration. In addition, the Reform Act broadens the definition of "contractual right" to include a right set forth in a bylaw of a derivative clearing organization, a multilateral clearing organization, a national securities exchange, a national securities association, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act or a board of trade or in a resolution of the governing board thereof, and a right (whether or not in writing) arising under common law, merchant law, or by reason of normal business practice.

The Reform Act also expands the definitions of sections 555 (securities contracts), 556 (commodity or forward contracts), 559 (repurchase agreements) and 560 (swap agreements) of the Bankruptcy Code as follows:

The Reform Act expands the definition of "securities contract" to include, most significantly, any contact for the purchase, sale or loan of a mortgage loan or interest in a mortgage loan and options on any of the foregoing, including repurchase or reverse repurchase transactions. More specifically, the revised definition of "securities contract" explicitly includes, among other things: (a) a contract for the purchase, sale, or loan of a security, a certificate of deposit, a mortgage loan or any interest in a mortgage loan, a group of index of securities, certificates of deposit or mortgage loans or interests therein or options on any of the foregoing; (b) the guarantee by or to any securities clearing agency of a settlement of cash, securities, certificates of deposit, mortgage loans, or interests therein, group or index of securities, or mortgage loans or interests therein or option of any of the foregoing; (c) any margin loan; and (d) (i) any other agreement or transaction that is similar to an agreement or transaction referred to above, (ii) any combination of agreements or transactions referred to above, (iii) any option to enter into any agreement or transaction referred to above, (iv) a master agreement that provides for an agreement or transaction referred to above, and (v) a security agreement or arrangement, or other credit enhancement related to any agreement or transaction referred to therein but not to exceed the damages in connection with any such agreement or transaction measured in accordance with section 562. However, the definition of "securities contract" explicitly excludes any purchase, sale, or repurchase obligation under a participation in a commercial mortgage loan.

Under section 761(4) of the Bankruptcy Code prior to enactment of the Reform Act, a "commodity contract" was defined as (a) with respect to a futures commission merchant, a contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade; (b) with respect to a foreign futures commission merchant, a foreign future (as defined in section 761); (c) with respect to a leverage transaction merchant, a leverage transaction (as defined in section 761); (d) with respect to a clearing organization, a contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade that is cleared by such clearing organization, or commodity option traded on, or subject to the rules of, a contract market or board of trade that is cleared by such clearing organization; or (e) with respect to a commodity options dealer, a commodity option (as defined in section 761).

The Reform Act expands the definition of a "commodity contract" to include, among other things, (i) any other agreement or transaction that is similar to an agreement or transaction referred to above, (ii) any combination of agreements or transactions referred to above, (iii) any option to enter into any agreement or transaction referred to above, (iv) a master agreement to the extent that it provides for an agreement or transaction referred to above, and (v) a security agreement or arrangement, or other credit enhancement related to any agreement or transaction referred to above but not to exceed the damages in connection with any such agreement or transaction measured in accordance with section 562.

Under section 101(25) of the Bankruptcy Code prior to enactment of the Reform Act, a "forward contract" was defined as a contract (other than a commodity contract) for the purchase, sale, or transfer of a commodity or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade, or product or byproduct thereof, with a maturity date more than two days after the date the contract is entered into, including, but not limited to, a repurchase transaction, reverse repurchase transaction, consignment, lease, swap, hedge transaction, deposit, loan, option, allocated transaction, unallocated transaction, or any combination thereof or option thereon.

Under the Reform Act, the ambiguous reference to "any combination thereof or option thereon" is deleted and replaced with "any other similar agreement." The following clauses are then added to the definition: (i) any combination of agreements or transactions referred to above, (ii) any option to enter into an agreement or transaction referred to above, (iii) a master agreement to the extent that it provides for an agreement or transaction referred to above, and (iv) a security agreement or arrangement, or other credit enhancement related to any agreement or transaction referred to herein but not to exceed the damages in connection with any such agreement or transaction measured in accordance with section 562.

Under section 101(47) of the Bankruptcy Code prior to enactment of the Reform Act, repurchase agreements were narrowly defined as agreements that provide "for the transfer of certificate of deposits, eligible bankers’ acceptances or securities that are the direct obligations of, or that are fully guaranteed as to the principal or interest, by the United States" or any agency thereof with a simultaneous agreement by the transferee to transfer to the original transferor a certificate of deposit or other similar obligation either on demand or at a date certain not later than one year after the transfer.

The Reform Act expands the definitions of "repurchase agreement" and "reverse repurchase agreement" to include mortgage-related securities (as defined in the Securities Exchange Act of 1934, commonly referred to as "SMMEA Securities"), mortgage loans, interests in mortgage-related securities or mortgage loans and qualified foreign government securities (defined as a security that is a direct obligation of, or that is fully guaranteed by, the central government of a member of the Organization for Economic Cooperation and Development).

A "repurchase agreement" expressly would not include a repurchase obligation under a participation in a commercial mortgage loan (such as recourse obligations). However, a repurchase agreement involving the transfer of participations in commercial mortgage loans with a simultaneous agreement to repurchase the participation on demand or at a date certain one year or less after such transfer would constitute a "repurchase obligation."

The Reform Act’s definition of a "swap agreement," found in section 101(53B) of the Bankruptcy Code, enumerates various types of swaps and includes options, futures and forward agreements including (a) a rate floor, rate cap, rate collar, cross-currency rate swap and basis swap, (b) spot, same day-tomorrow, tomorrow-next, forward, or other foreign exchange or precious metal agreement, (c) currency swap, (d) equity index or equity swap, (e) debt index or debt swap, (f) total return, credit spread or credit swap, (g) commodity index or commodity swap, or (h) weather swap,weather derivative or weather option. The prior definition was more general and did not include as specific a list of agreements. Moreover, under the Reform Act, the definition contains an open-ended provision that would include as a "swap agreement," among other things, any agreement that is similar to any other agreement or transaction referred to in the expanded definition and that is "presently, or in the future becomes, the subject of recurrent dealings in the swap market and is a forward, swap, future or option on one or more rates, currencies, commodities, equity securities, or other equity instruments, debt securities or other debt instruments, or economic indices or measures of economic risk or value." A "rule of construction" in the Reform Act provides, however, that an arrangement fitting within the Bankruptcy Code definition of "swap agreement" does not necessarily constitute a swap agreement under other federal statutes, such as the Securities Act of 1933, the Securities Exchange Act of 1934, and other federal statutes, rules and regulations.

The Reform Act adds two new sections to the Bankruptcy Code relating to financial contracts: (a) protections with regard to master netting agreements (section 561); and (b) a definition for the timing of the measure of damages under swap agreements, securities agreements, forward contracts, commodity contracts, repurchase agreements and master netting agreements (section 562). Both of these two new sections are discussed below.

The Reform Act adds a new Bankruptcy Code definition for a "master netting agreement," meaning "an agreement providing for the exercise of rights, including rights of netting, setoff, liquidation, termination, acceleration or closeout," or any security agreement or arrangement or other credit enhancement related to one or more of the foregoing. It also adds a definition for "master netting agreement participant," meaning "an entity that, at any time before the date of the filing of the petition, is a party to an outstanding master netting agreement with the debtor."

The Reform Act adds section 561 to the Bankruptcy Code, which provides a general prohibition against staying, avoiding, or otherwise limiting a non-debtor counterparty’s ability to exercise rights under the various types of financial contracts covered by master netting agreements. This protection is supported by amendments to the definitions of "forward contract," "repurchase agreement," "swap agreement,""securities contract" and "commodity contract" to include within the scope of each such definition crossproduct master agreements, to the extent that transactions or agreements under the master agreement otherwise meet the applicable definition. "Netting" refers to the aggregate payments that become due to a swap participant when the agreement is terminated, for example, by a counterparty filing for bankruptcy. Upon termination, the non-defaulting party has the right to set off and liquidate the amount owed by the other party under a master netting agreement, regardless of whether or not the various transactions under the master netting agreement involve the same type of financial product.

Under the Reform Act, section 362(b) of the Bankruptcy Code is conformed to provide that setoff by a master netting agreement participant is an exception to the automatic stay. Section 546 of the Bankruptcy Code,which limits a trustee’s avoiding powers under certain circumstances, is also amended by the addition of a new subsection 546(j), which provides that in the absence of actual intent to defraud creditors,"the trustee may not avoid a transfer made by or to a master netting agreement participant under or in connection with any master netting agreement or any individual contract covered thereby that is made before the commencement of the case, except under section 548(a)(1)(A) and except to the extent that the trustee could otherwise avoid such a transfer made under an individual contract covered by such master netting agreement." Section 548(a)(1)(A) of the Bankruptcy Code allows a trustee to avoid a transfer made with an actual intent to hinder, delay or defraud a creditor.

Section 562 is new and provides that damages under a swap agreement, securities contract, forward contract, commodity contract, repurchase agreement, or master netting agreement will be measured as of the earlier of the date of (a) rejection by the trustee or (b) liquidation, termination or acceleration of such contract or agreement by a forward contract merchant, stockbroker, financial institution, securities clearing agency, repo participant, financial participant, master netting agreement participant, or swap participant. The Reform Act makes a corresponding change to section 502(g) to provide that claims for damages under section 562 will be prepetition claims.

Section 101(22A) – The term "financial participant" means – (A) an entity that, at the time it enters into a securities contract, commodity contract, swap agreement, repurchase agreement, or forward contract, or at the time of the date of the filing of the petition, has one or more agreements or transactions described in paragraph (1), (2), (3), (4), (5), or (6) of section 561(a) with the debtor or any other entity (other than an affiliate) of a total gross dollar value of not less than $1,000,000,000 in notional or actual principal amount outstanding on any day during the previous 15-month period, or has gross mark-to-market positions of not less than $100,000,000 (aggregated across counterparties) in one or more such agreements or transactions with the debtor or any other entity (other than an affiliate) on any day during the previous 15-month period; or

Section 101(25) – The term "forward contract" means –

(A) a contract (other than a commodity contract) for the purchase, sale, or transfer of a commodity, as defined in section 761(8) of this title, or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade, or product or byproduct thereof, with a maturity date more than two days after the date the contract is entered into, including, but not limited to, a repurchase transaction, reverse repurchase transaction, consignment, lease, swap, hedge transaction, deposit, loan, option, allocated transaction, unallocated transaction, or any other similar agreement;

(B) any combination thereof or option thereon; of agreements or transactions referred to in subparagraphs (A) and (C);

Section 101(38A) – The term "master netting agreement" –

Section 101(47) – The term "repurchase agreement" (which definition also applies to a reverse repurchase agreement) means –

(A) means – (i) an agreement, including related terms, which provides for the transfer of one or more certificates of deposit, mortgage related securities (as defined in section 3 of the Securities Exchange Act of 1934), mortgage loans, interests in mortgage related securities or mortgage loans, eligible bankers’ acceptances, qualified foreign government securities (defined as a security that is a direct obligation of, or that is fully guaranteed by, the central government of a member of the Organization for Economic Cooperation and Development), or securities that are direct obligations of, or that are fully guaranteed as to principal and interest by, the United States or any agency of the United States against the transfer of funds by the transferee of such certificates of deposit, eligible bankers’ acceptances, or securities, mortgage loans, or interests, with a simultaneous agreement by such transferee to transfer to the transferor thereof certificates of deposit, eligible bankers’ acceptances, or securities as described above acceptance, securities, mortgage loans, or interests of the kind described in this clause, at a date certain not later than one 1 year after such transfers or on demand, against the transfer of funds;

Section 101(53B) The term "swap agreement" means

(A) an agreement (including terms and conditions incorporated by reference therein) which is a rate swap agreement, basis swap, forward rate agreement, commodity swap, interest rate option, forward foreign exchange agreement, spot foreign exchange agreement, rate cap agreement, rate floor agreement, rate collar agreement, currency swap agreement, (I) an interest rate swap, option, future, or forward agreement, including a rate floor, rate cap, rate collar, cross-currency rate swap agreement, currency option, any other similar agreement (including and basis swap;

(iv) any option to enter into any of the foregoing); an agreement or transaction referred to in this subparagraph;

(B) any combination of the foregoing; or

(C) a master agreement for any of the foregoing together with all supplements;

Section 741(7) is revised as follows:

(7) "securities contract"—

(A) means –

(i) a contract for the purchase, sale, or loan of a security, including an option for the purchase or sale of a security, a certificate of deposit, or a mortgage loan or any interest in a mortgage loan, a group or index of securities, certificates of deposit, or mortgage loans or interests therein (including any interest therein or based on the value thereof), or option on any of the foregoing, including an option to purchase or sell any such security, certificate of deposit, mortgage loan, interest, group or index, or option, and including any repurchase or reverse repurchase transaction on any such security, certificate of deposit, mortgage loan, interest, group or index, or option:

(ii) any option entered into on a national securities exchange relating to foreign currencies, or the guarantee of any settlement of cash or securities by or to a securities clearing agency;

Section 761(4) is revised as follows:

(4) "commodity contract" means—

(A) with respect to a futures commission merchant, contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade;

(B) with respect to a foreign futures commission merchant, foreign future;

(C) with respect to a leverage transaction merchant, leverage transaction;

(D) with respect to a clearing organization, contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade that is cleared by such clearing organization, or commodity option traded on, or subject to the rules of, a contract market or board of trade that is cleared by such clearing organization; or

(E) with respect to a commodity options dealer, commodity option;

Section 555 is amended as follows:

The exercise of a contractual right of a stockbroker, financial institution, financial participant, or securities clearing agency to cause the liquidation, termination or acceleration of a securities contract, as defined in section 741 of this title, because of a condition of the kind specified in section 365(e)(1) of this title shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title unless such order is authorized under the provisions of the Securities Investor Protection Act of 1970 or any statute administered by the Securities and Exchange Commission. As used in this section, the term "contractual right" includes a right set forth in a rule or bylaw of a derivatives clearing organization (as defined in the Commodity Exchange Act), a multilateral clearing organization (as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991), a national securities exchange, a national securities association, or a securities clearing agency, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act, or a board of trade (as defined in the Commodity Exchange Act), or in a resolution of the governing board thereof, and a right, whether or not in writing, arising under common law, under law merchant, or by reason of normal business practice.

Section 556 is amended as follows:

The contractual right of a commodity broker, financial participant, or forward contract merchant to cause the liquidation, termination or acceleration of a commodity contract, as defined in section 761 of this title, or forward contract because of a condition of the kind specified in section 365(e)(1) of this title, and the right to a variation or maintenance margin payment received from a trustee with respect to open commodity contracts or forward contracts, shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by the order of a court in any proceeding under this title. As used in this section, the term "contractual right" includes a right set forth in a rule or bylaw of a clearing organization or contract market derivatives clearing organization (as defined in the Commodity Exchange Act), a multilateral clearing organization (as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991), a national securities exchange, a national securities association, a securities clearing agency, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act, or a board of trade (as defined in the Commodity Exchange Act) or in a resolution of the governing board thereof and a right, whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice.

Section 559 is amended as follows:

The exercise of a contractual right of a repo participant or financial participant to cause the liquidation, termination or acceleration of a repurchase agreement because of a condition of the kind specified in section 365(e)(1) of this title shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title, unless, where the debtor is a stockbroker or securities clearing agency, such order is authorized under the provisions of the Securities Investor Protection Act of 1970 or any statute administered by the Securities and Exchange Commission. In the event that a repo participant or financial participant liquidates one or more repurchase agreements with a debtor and under the terms of one or more such agreements has agreed to deliver assets subject to repurchase agreements to the debtor, any excess of the market prices received on liquidation of such assets (or if any such assets are not disposed of on the date of liquidation of such repurchase agreements, at the prices available at the time of liquidation of such repurchase agreements from a generally recognized source or the most recent closing bid quotation from such a source) over the sum of the stated repurchase prices and all expenses in connection with the liquidation of such repurchase agreements shall be deemed property of the estate, subject to the available rights of setoff. As used in this section, the term "contractual right" includes a right set forth in a rule or bylaw, applicable to each party to the repurchase agreement, of of a derivatives clearing organization (as defined in the Commodity Exchange Act), a multilateral clearing organization (as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991), a national securities exchange, a national securities association, or a securities clearing agency, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act, or a board of trade (as defined in the Commodity Exchange Act) or in a resolution of the governing board thereof and a right, whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice.

Section 560 is amended as follows:

The exercise of any contractual right of any swap participant or financial participant to cause the liquidation, termination, or acceleration of a one or more swap agreements because of a condition of the kind specified in section 365(e)(1) of this title or to offset or net out any termination values or payment amounts arising under or in connection with any the termination, liquidation, or acceleration of one or more swap agreements shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title. As used in this section, the term "contractual right" includes a right set forth in a rule or bylaw of a derivatives clearing organization (as defined in the Commodity Exchange Act), a multilateral clearing organization (as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991), a national securities exchange, a national securities association, a securities clearing agency, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act, or a board of trade (as defined in the Commodity Exchange Act) or in a resolution of the governing board thereof and a right, whether or not evidenced in writing, arising under common law, under law merchant, or by reason of normal business practice.

Section 561 is new and provides:

(a) Subject to subsection (b), the exercise of any contractual right, because of a condition of the kind specified in section 365(e)(1), to cause the termination, liquidation, or acceleration of or to offset or net termination values, payment amounts, or other transfer obligations arising under or in connection with one or more (or the termination, liquidation, or acceleration of one or more) —

Section 562 is new and provides:

(a) If the trustee rejects a swap agreement, securities contract (as defined in section 741), forward contract, commodity contract (as defined in section 761), repurchase agreement, or master netting agreement pursuant to section 365(a), or if a forward contract merchant, stockbroker, financial institution, securities clearing agency, repo participant, financial participant, master netting agreement participant, or swap participant liquidates, terminates, or accelerates such contract or agreement, damages shall be measured as of the earlier of—

This article has been prepared by Sidley Austin Brown & Wood LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Readers should not act upon this without seeking professional counsel.