derivatives in bankruptcy
DESCRIPTION
Continuing Legal Education for the Boston Bar AssociationTRANSCRIPT
Derivatives in Bankruptcy
Presented at the Boston Bar AssociationApril 14, 2009
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Overview
Introduction
Structure of Derivatives Transactions
What Happens If Your Counterparty Fails?– Termination Process– Bankruptcy Code Safe Harbors– Close-out Valuations
Lessons Learned
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“Baseball is the only field of endeavor where a man can succeed three times out of ten and be considered a good performer.”
- Ted Williams
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What is a Derivative?
A Derivative derives its value from the value/outcome/ movement of another instrument/index/reference (called the underlying)
Derivatives can be used to adjust risk profile of an underlying– Interest Rates– Credit Rating / Credit Events– Commodities– Foreign Exchange Rates
Varying levels of complexity
Opaque pricing and market conventions
Most liquid markets are interest rate and foreign exchange, but others (credit, commodity) are also very large
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Common Types of Derivatives:
Option Products – The right but not the obligation– Protects against a worst case scenario but provides upside– Purchased (payment is usually at inception)– Will not become a liability– Examples:
Interest Rate CapFX Call
Lock Products – Fix a price or rate today– Removes the uncertainty associated with the underlying– Price/Rate is set at inception– Can become an asset or liability depending upon changes in the underlying– Examples:
Interest Rate SwapForward FX Contract
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What is a Hedge?
Derivatives have been blamed for many adverse, high-profile events. However, not all derivatives are hedges.
Derivatives can be used in two ways– To make a leveraged bet or increase risk: Speculation– To hedge a financial position or decrease risk: Hedging
A derivative that is used to hedge is always one-half of a good news / bad news story. Consider a hedge of the interest rate risk of ananticipated future financing:
Good NewsLower Rate on Fixed Rate Financing
Good NewsLower Rate on Fixed Rate Financing
Bad News
Pay Cash on Hedge Termination
Bad News
Pay Cash on Hedge Termination
Bad News
Higher Rate on Fixed Rate Financing
Bad News
Higher Rate on Fixed Rate Financing
Good NewsReceive Cash on Hedge Termination
Good NewsReceive Cash on Hedge Termination
Rates Go Up
Impact on Loan(at Rate Fixing)
Impact on Hedge(at Hedge Termination)
Rates Go Down
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ISDA Documentation Structure
ISDA Master Agreement(2002 or 1992)
Schedule to the Master Agreement
Credit Support Annex
Trade Confirmations
Events of Default
Termination Events
Eligible Collateral
Threshold & Calculations
Legal Terms
Economic Terms
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Schedule to the Master Agreement: ISDA Documents Structure
The “boilerplate” part, but…
Governs all trades between parties
Legal Provisions, not trade-specific details
Currently 2 versions in use (1992 & 2002)
Changes negotiated in– ISDA Schedule (default terms)– Credit Support Annex (collateral)
ISDA Master Agreement(2002 or 1992)
Schedule to the Master Agreement
Credit Support Annex Trade Confirmations
Events of Default
Termination Events
Eligible Collateral
Threshold & Calculations
Legal Terms
Economic Terms
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Schedule to the Master Agreement: ISDA Documents Structure
The negotiated part
Terms reflect credit/default risk
Key negotiated issues– Events of Default– Termination Events
ISDA Master Agreement(2002 or 1992)
Schedule to the Master Agreement
Credit Support Annex Trade Confirmations
Events of Default
Termination Events
Eligible Collateral
Threshold & Calculations
Legal Terms
Economic Terms
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Events of Default and Termination Events
Events of Default
Failure to Pay or Deliver
Breach of Agreement
Credit Support Default
Misrepresentation
Default under Specified Transaction
Cross Default
Bankruptcy
Merger without Assumption
Termination Events
Illegality
Force Majeure (2002)
Tax Event
Tax Event Upon Merger
Credit Event Upon Merger
“Additional Termination Events”
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Credit Support AnnexISDA Documents Structure
ISDA Master Agreement(2002 or 1992)
Schedule to the Master Agreement
Credit Support Annex Trade Confirmations
Events of Default
Termination Events
Eligible Collateral
Threshold & Calculations
Legal Terms
Economic Terms
Outlines Collateral Terms (if any)– Independent Amount– Threshold Amount– Minimum Transfer Amount
Eligible Collateral Types– Cash– Treasuries– Other Securities– Letter of Credit
Beware of rehypothecation!
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Trade ConfirmationsISDA Documents Structure
Basic terms of a single transaction
Legal terms– References ISDA, or– Incorporate ISDA provisions– May add new trade-specific provisions
Economic Terms– Specific trade details– Caution…dealers can make mistakes!
ISDA Master Agreement(2002 or 1992)
Schedule to the Master Agreement
Credit Support Annex Trade Confirmations
Events of Default
Termination Events
Eligible Collateral
Threshold & Calculations
Legal Terms
Economic Terms
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What Happens When Your Counterparty Fails?
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What Happens When Your Counterparty Fails?
Whether and When to Terminate?
How To Terminate – Affected Party, Defaulting Party, Calculation Agent– Notices– Termination Date/Settlement Date– Close Out Amount Calculation
Second Method/Market QuotationLoss
U.S. Bankruptcy Code Safe Harbor Protections
What is Commercially Reasonable?
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High LevelDecision Tree
*Considerations if client chooses not to terminate:• Client may not have an economic hedge if counterparty
can’t pay or receive payments• The amount of the liability will fluctuate until termination• Public company may have concern with disclosing active
trades with bankrupt bank and could affect accounting
The net position for Client isa net liability
Client must contact their Lender & counsel first
The net position for Client is a net asset
Wait*
Is an Event of Default
Triggered?
Is the hedge
required?
Is the net position an asset
or liability?
Y
N
Y
Y
N
Can Client submit Protective Claim in
Guarantee’s Bankruptcy?
Determine if Market Quotation or Close-out Amount can be
calculated in Commercially Reasonable method.
Client should involve their counsel and financial advisor
Is collateral being posted?
Check if ISDA Schedule specifies Market Quotation, Loss or Close-
out Amount. Line up dealer counterparties that are willing to
quote including credit.
Identify the amount of collateral posted, including any Independent Amounts
Wait*
Check if ISDA Schedule specifies Market Quotation, Loss or Close-out Amount. Line up dealer counterparties that are
willing to quote including credit.
Decide to send Notice of Default
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How the ISDA Operates Upon a Bankruptcy “Event of Default”
Step 1: Section 5(a) – Event of Default– Under ISDA Master Agreement Event of Default § 5(a)(vii) (Bankruptcy),
when a counterparty to a qualified financial contract--or its credit support provider or specified entity--is insolvent (filing a bankruptcy petition is just once of the many measure of insolvency), an Event of Default exists and all transactions may be terminated
Step 2: Section 6(a) – Designation of Early Termination Date– Pursuant to ISDA Master Agreement § 6(a), upon an Event of Default, the
non-Debtor party has the right to elect to designate an Early Termination Date by written notice (the date can be as early as the date of the notice itself, but not more than 20 days later) by hand delivery
– The designation of an Early Termination Date causes the close-out of all transactions under the same ISDA Master Agreement, and provides for netting of all such transactions to determine the amount and recipient of any Early Termination Payment
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How the ISDA Operates Upon a Bankruptcy “Event of Default”
Step 3: Section 6(d)(i) - Statement– Computation of the Early Termination Payment is made as of the Early
Termination Date, according to the methodology selected in the Schedule or Confirmation
– The non-defaulting party must deliver a statement setting forth the early termination payment calculation as soon as “reasonably practicable”
– This statement must be delivered--by hand--to trigger the right to payment as well as set-off and foreclosure on collateral pledged to and held by the non-Debtor counterparty
Step 4: Section 6(d)(ii)– Payment is due when demand is effective (comply with local business day
and time); follow-up by exercising rights to set-off and foreclose
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U.S. Bankruptcy Code Safe Harbors
U.S. Bankruptcy Code applies to bankruptcy filings by corporate entities and investment banks (but not insurance companies, FDIC insured banks, or most stock and commodity brokers each of which is the subject of other types of insolvency proceedings)
The Bankruptcy Code provides special “Safe Harbor” rights for a broadrange of financial instruments including: Swap Agreements (i.e., currency, interest, FX, credit, forwards, futures), Repurchase Agreements, Forward Contracts and Commodities Contracts
Excepts certain financial participants and contracts from provisions of the Bankruptcy Code, i.e., the automatic stay
Allows the non-Debtor counterparty to defined transactions to terminate, or “close-out” derivative agreements with the Debtor, apply netting and set-off as applicable, determine whether an early termination payment amount is due and to whom, and to foreclose on posted collateral
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Limits on Safe Harbor Protections
Waiver risks – Failure to act quickly on contractual rights to terminate transactions may be
deemed by a Court to be a waiver of the Safe Harbor protections--need to be balanced with the time needed to set up a replacement hedges
Unsecured Claim For Deficiency – If demand for payment exceeds the value of the collateral pledged and
posted, balance of the demand will be treated as an unsecured claim and subject to its pro rata distribution under the Bankruptcy Code‘s priority scheme
Thus far, Safe Harbors apply to the situation of a counterparty’s bankruptcy, not to that of its Credit Support Provider/Specific Entity (guarantor)
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Key Bankruptcy Code Sections
Exceptions to the Automatic Stay and the Ipso Facto clause– Right to Liquidate, Terminate or Accelerate.
Bankruptcy Code § 556 – Commodities or Forward ContractsBankruptcy Code § 559 – Repurchase AgreementsBankruptcy Code § 560 – Swap Agreements
– Right to off-set or net termination values or payment amounts, under master netting agreements
Bankruptcy Code § 361 – Offset under Master Netting AgreementsBankruptcy Code § 362(b)(17) – Offset And Netting
– Foreclosure on collateral: Bankruptcy Code §§ 362(b)(6)&(7), 362(d)
Protection from Preference and Fraudulent Transfers– Exception for Margin or Settlement Payments
Bankruptcy Code §§ 546(e), (f), (g) & (j) – NOTE: Trustee may not avoid transfers made pre-petition by or to a non-Debtor counterparty under a swap, unless transfer was made with actual intent to hinder, delay or defraud creditors of Debtor counterparty)
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Bankruptcy Courts Can and Do Interpret the Agreements
Court’s Discretion– If there is a dispute, Court remains free to determine whether the
transaction is of the type protected or is merely a supply or other contract that should not benefit from the Safe Harbor provisions
– Safe Harbors safeguard rights but do not create liquidity or rewrite contracts--need to know what documents provide
– Agreements are not protected simply because they are titled or documented in form of swaps; must show nexus with/impact on financial market
Recent Key Decisions– Physically Settled Gas Forwards - Hutson v Smithfield Packing Co. (In re
National Gas Distributors, LLC), 4th Cir. Court of Appeals– Triangular Set-off – In re SemCrude, U.S. Bankruptcy Court District of
Delaware– Procedures for Assignment or Settlement of Derivatives – In re Lehman
Bros. Holdings, Inc. et al, U.S. Bankruptcy Court SDNY
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Close Out Valuation: Market Quotation
What would a market maker charge (negative) or pay (positive) toenter into a Replacement Transaction that would replicate the Terminated Transaction?
– If there are 3 or more Market Quotes, take the arithmetic mean– If there are 2 or fewer Market Quotes, the method of calculation reverts to
Loss
What is a Replacement Transaction?– The same economic terms– The same ISDA terms– The same collateral terms
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Market Quotation Examples
Ask 6 Banks for Bids to Take Assignment of TradeAssume 4 Give Quotes:
– Bank 1 would pay $2.0mm -- Bank 3 would pay $2.2mm– Bank 2 would pay $2.8mm -- Bank 4 would pay $2.5mm
Average of the Four Quotes = $2,375,000Assignment can still be done with Bank 2
Ask 4 Banks for Bids to Take Assignment of Trade. Assume 2 Give Quotes:
– Bank A would pay $2.2mm– Bank B would pay $2.0mm
Three Banks would not provide Market Quotation, therefore the method of calculation reverts to Loss
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Close Out Valuation: Loss
An amount a party reasonably determines in good faith to be its total losses and costs (or gain, in which case expressed as a negativenumber)
– Economic Loss– Loss of bargain– Cost of funding– Cost of terminating or reestablishing a hedge or trading position
Must be calculated in a commercially reasonable manner
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Close Out Valuation: Loss Example
Original Swap Rates Notional Amount Effective Date Maturity Date
5.0000% $100,000,000 11-Jul-08 11-Jul-13
DV01
Replacement Mid-Market Swap
RateMark to Market
Value$35,000 3.0000% ($7,000,000)
Loss CalculationEnter into swap at Market Rate 3.00%Plus credit charge assessed on Replacement Swap 0.25%Replacement swap rate 3.25%
Cost of the credit charge 875,000
Independent Amount (5% of Notional) 5,000,000 Cost of funds 15.00%Number of months remaining in the swap 52 Opportunity cost = PV (cost of funds * collateral * yrs of hedge) 2,400,000
Chatham Transaction Fee and Legal Fees 50,000
Loss Calculation
Loss Amount Owed (3,675,000)
Mark-to-market liability of the current swap less the value of the credit charge for entering the new trade, less the economic cost to post collateral, less expenses, and less legal fees
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Underlying Methodology for Derivatives Valuation
Build a Strong Legal Case for the Process That You Followed– ISDA Master and Schedule provides the procedure for terminating
transactions, governed by ISDA, and it must be followed exactlyMarket QuotationLossClose out Amount
– If it is determined that transactions are governed by law other than ISDA, assertions must be documented as process is followed exactly
Build a Strong Economic Case for the Valuation– Indicative quotes from bidders as acceptable market quotations may not
reflect true market conditions and current creditworthiness of each party. A court may therefore deem the quotes not “commercially reasonable.”
– Sparse case law underscores the need to be able to justify the unwind value calculation. This is much more complex than simply obtaining indicative quotes from dealers based on their pricing models.
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Lessons Learned
Know Your Documents: Trade Tickets/Confirms
Monitor Counterparty Credit. Recognize the warning signs of counterparty credit risk. Develop Counterparty Guidelines
Monitor Value of Pledged Collateral and Make Prompt Demands for Return/Addition
Implement Third party custodian to hold collateral
Include in the Schedule as an ATE, and in the CSA as a trigger for certain collateral rights: (i) a credit rating decline of Counterparty or its Credit Support Provider and/or (ii) Counterparty on a credit watch list
Maximize opportunities to reduce your exposure through contract modification and enforcement of your rights
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Conclusion
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Contact Information
Chatham Financial – Kennett Squarewww.ChathamFinancial.com235 Whitehorse LaneKennett Square, PA 19348T: 610.925.3120
Phil WeeberDerivatives [email protected]
T: 484.731.0241F: 610.925.3125
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Our Company
Founded in 1991
Focus: – Interest Rate and Foreign Currency Hedging– Defeasance – Equity and Debt Advisory– Comprehensive FAS 133, 157, 159, IAS 39
Hedge Accounting– Debt Management & Valuation Systems
Client Sectors:- Opportunity Funds– Private Developers– Pension Funds– Public Real Estate/REITs- Private Equity- Corporates- Structured Finance - Regional Banks– Community Banks
Chatham advises on approximately $1.3bn in hedging transactions daily