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From: SandPUtil@StandardAndPoors.Com [mailto:SandPUtil@StandardAndPoors.Com]
Sent: Thursday, December 20, 2001 10:17 AM
To: Rohauer, Tanya
Subject: Commodities Futures and Swaps Contracts: Set-Off and Bankruptcy



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Commodities Futures and Swaps Contracts: Set-Off and Bankruptcy

 

 

Publication date:

 

10-Dec-2001

Analyst:

 

Sabine Zerarka, Esq. , New York (1) 212-438-6610; James Penrose, Esq. , New York (1) 212-438-6604 

 

 

Standard & Poor's regularly receives inquiries on the treatment of certain types of financial contracts, such as commodity swaps and commodity futures contracts, in the event of bankruptcy of one of the parties thereto. These sorts of financial contracts are often used to hedge, or insure against, future financial liabilities of at least one of the parties. Financial contracts take many forms. Many are executed pursuant to a master agreement, which provides for amounts owed from each party to the other to be deducted, or "set-off," so that a single amount will be owed by one party to the other. As "risk transfer" mechanisms, financial contracts are an important source of market liquidity. Consequently, certain special types of financial contracts have special protection under the U.S. Bankruptcy Code.   

In general, a bankruptcy filing triggers an "automatic stay" that restrains creditors from taking actions against the debtor or its property. As a result of the automatic stay, creditors in general cannot exercise contractual remedies, such as the exercise of set-off and close-out rights, without the permission of the bankruptcy court. Because of the importance of financial contracts, however, Congress provided that the liquidity of the swap and commodity markets would not be disrupted by the bankruptcy of participants by exempting certain qualifying financial contracts from the automatic stay. In appropriate cases, therefore, the nonbankrupt party's contractual right to set off amounts owed to it under a particular financial contract against cash, securities, or other property of the bankrupt party held by or due from the nonbankrupt party is protected notwithstanding the bankruptcy of the counterparty.   

Business dealings, of course, often result in more complicated issues than can be addressed by a straightforward application of black-letter law. The following are some of the questions that investors have asked about set-off and netting of liabilities under financial contracts:   

Q: What types of financial contract can be set-off or netted?   

A: Financial contracts that qualify as protected contracts under the Code can be netted. Financial contracts must fall within certain definitions in the Code to qualify as protected contracts. The Code also requires that such contracts must be between particular types of entities, such as commodities brokers, financial institutions, stockbrokers, etc., in order for the financial contract to be protected under the Code.   

Q: In a situation where Party "A" and Party "B" have entered into several different financial contracts with each other, can Party A net its "in the money" obligations against its "out of the money" obligations if Party B goes bankrupt?   

A: With respect to financial contracts that are protected contracts under the Code definitions (and which by their terms permit termination and liquidation), Party A may terminate the contract, liquidate collateral, and net out any termination values. Pursuant to Code sections 555, 556, 559, and 560, these rights are not subject to the automatic stay, and cannot be avoided or otherwise limited under the Code or by the bankruptcy court in a reorganization or a liquidation.   

Furthermore, Code section 362, which establishes the automatic stay, creates specific exceptions from the stay for set off of mutual claims under commodity contracts and set off of mutual claims under swaps that constitute the set off of a claim against the debtor for a "margin payment" or "settlement payment". However, the stay does apply to "cross-product" set-offs--swap claims against commodity contracts claims, for example. For cross-product set-offs, Code section 553 provides that set-off rights are not affected by bankruptcy but are subject to the automatic stay. Permission from the bankruptcy court, therefore, is necessary before Party B could exercise its contractual set-off rights across different types of financial contracts. Set-off, in other words, is not automatic in these circumstances. Although cross-product netting may not be protected from the automatic stay, Party B is still treated as a secured creditor to the extent of its set-off rights.   

Q: In what circumstances could a bankruptcy court rescind a netting of swap or commodities claim?   

A: Grounds for contesting set-off may include the failure of a particular financial contract to qualify as a protected contract under the Code, or the failure of a particular financial contract to permit set-off.   

Q: Aside from any netting benefits realized by Party A against Party B, where does Party A stand with respect to amounts owed to it under the financial contract that have not been realized through set-off?   

A: After termination, liquidation, and set-off, Party A will have an unsecured claim against Party B.   

Q: Are payments made by a debtor prior to bankruptcy under swaps or commodity contracts at risk of being clawed back as a preferential transfer or fraudulent conveyance?   

A: Generally, no. Code section 546 provides that the bankruptcy trustee may not avoid any prepetition margin or settlement payment made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, or securities clearing agency; or any prepetition transfer under a swap agreement made by or to a swap participant as a preferential transfer or fraudulent conveyance, except where such payments are made with actual intent to hinder, delay, or defraud creditors.   

Q: In a situation where Party B goes bankrupt and there are financial contracts between Party A and Party B, where Party B is in the money; between Party B and Party C where Party C is in the money; and between Party C and Party A where Party A is in the money, can Party C set off its payment to Party A to the extent of its claim against Party B?   

A: No. Set-off in bankruptcy is only possible where "mutuality" exists (i.e., one party must owe a debt to another party); that other party must owe a debt to the first party. As a result, Party A's claim will belong to the bankruptcy estate of Party B while Party C will be a general creditor of Party B. No set-off will be permitted in these circumstances.   

 

 

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