(PRWEB) June 14, 2005
Thirty bankers and derivatives counsel came to hear Ellen H. Clark, a New York-based derivatives lawyer with Salans international law firm, speak on Tuesday, June 7th, about the recently adopted Bankruptcy Act of 2005 signed into law by President Bush on April 20, 2005. Although the Act was meant in large part to curb abuses by profligate debtors, buried in its 185 pages is a long-awaited, change-making section called Title IX on "financial contracts" which has turned the heads of derivatives specialists.
Title IX provides the long sought-after holy grail of derivatives attorneys: legal certainty in bankruptcy for netting, termination and collateral arrangements of hybrid swaps.
"The new Financial Contract legislation under Title IX of the Act has brought the U.S. Bankruptcy Code into the 21st Century," explains Clark, "and more importantly for U.S. market participants, it provides a level playing field to compete with many foreign counterparties for deals unhampered by our legal tar-baby called the automatic stay."
Before the International Swaps and Derivatives Association, the derivative industry trade association leader (ÂISDAÂ), along with a coterie of legal experts in the derivatives area, petitioned for change in the existing U.S. bankruptcy legislation more than 15 years ago, derivative contracts were treated like any other payment obligation under the Bankruptcy Code. In order to provide a bankrupt debtor with breathing room to start business afresh, certain provisions of the Code, still in place today, were set up to stay actions by creditors seeking to recover amounts due to them. Debtors' contracts with creditors could be avoided altogether by the bankruptcy trustee. A bankruptcy court could also postpone obligations for a period of time. Fair enough for the individual debtor, but for creditors of an insolvent corporate entity involved in complex swap or derivatives trades, the bankruptcy "automatic stay" or contract avoidance measure meant market disaster.
In 1990, ISDA succeeded in bringing about the first set of amendments to the Bankruptcy Code to exempt swap contracts from the automatic stay provisions by creating a "safe harbor" especially for these types of financial contracts. "But the solution was short-lived," explains Clark. ÂBy 2005, the world of derivatives trades had developed beyond recognition, and bankruptcy legislation just hadn't kept up."
That is where the Bankruptcy Act comes in. ISDA and its advisers again took the lead, along with The Bond Market Association and government officials at the FDIC, in proposing legislation that would amend not only the Bankruptcy Code, but also the Federal Deposit Insurance Act and Federal Deposit Insurance Corporation Improvement Act which govern the insolvency of banks. The amendments, which took more than ten years to bring to fruition, have greatly expanded the scope of the original Bankruptcy Code amendments that provided the original safe harbor for swaps.
"Three major changes came about this spring," Clark explained to her audience. "The scope of financial contracts covered by the safe harbor was greatly expanded. Now everything from debt and equity swaps to weather swaps are exempt from the automatic stay in bankruptcy. Second, the scope of covered counterparties able to seek relief under the safe harbor was extended to a broader category of market-makers. Third, the ability to net payment amounts among different product types, from hybrid swaps to repos and forwards to security arrangements, is expressly permitted under the bankruptcy law to occur automatically without stay or avoidance or any other court interference."
This last item, cross-product netting, is a tremendous source of relief for derivatives market makers. "However, I don't think the Bankruptcy Act went far enough", pointed out Drew Phillips, a derivatives attorney at Bank of Tokyo - Mitsubishi. "Until netting is permitted among affiliates of a bankrupt entity, a lot of the gaming that we have seen in the pre-petition phase will continue to occur." Indeed, according to Kimberly Summe, General Counsel at ISDA, there are many leading financial institutions that would support further legislative refinements to include cross-affiliate netting, but not all regulators agree. "The bottom line", says Clark, "is market certainty, where the law is clear and the outcome known. Even if the new law is not all things to all people, it has come a long way in the right direction."
Ellen H. Clark, Esq. is a derivatives and structured finance attorney in New York. She currently practices at Salans law firm where she is head of their structured products group representing international financial organizations and private equity investors. Her offices are at 620 Fifth Avenue, New York, New York, 10020. She can be reached by telephone at (212) 632-8375.
Ellen H. Clark