On May 28, 2015, the United States District Court for the Central District of California affirmed a bankruptcy court order finding that a post-termination assignee of remaining rights under an interest rate swap with a debtor was not a “swap participant” under the Bankruptcy Code (the “Bankruptcy Code”) and, therefore, was not entitled to the safe harbors from the automatic stay provisions of the Bankruptcy Code.[1]
In 2006, the debtors and U.S. Bank, N.A. (the “Bank”) entered into an interest rate swap, as well as a cross-collateralization agreement under which the debtors’ swap obligations were secured by collateral pledged under certain loan agreements. The swap was governed by the terms of an ISDA Master Agreement, including a Schedule thereto, under which the parties elected New York governing law.[2] In June 2012, the Bank notified the debtors that a default had occurred under the swap agreement, and designated an early termination date. The Bank thereafter notified the debtors that it had determined that $527,384.59 was payable to the Bank in connection with the termination.[3] The Bank did not exercise any remedies in connection with this amount but, rather, added it to the loan balance due to the debtors.
The terms of the swap agreement permitted a party to transfer all or any part of its interest in any amount payable to it from a defaulting party, but otherwise prohibited the assignment of the swap agreement or any interest in or obligation under the swap agreement, except in connection with a merger or similar event.[4] A62 Equities LLC (“A62”) asserted that the Bank assigned to A62 the Bank’s rights in the swap agreement, and sold to A62 its interests in the documents securing the swap. According to the district court, it was undisputed that the debtors did not consent to any of these transfers.
On June 6, 2014, the debtors filed a bankruptcy petition under Chapter 11 of the Bankruptcy Code, in which they asserted that A62 intended to conduct a foreclosure sale of bankruptcy estate assets on July 16, 2014. The bankruptcy court heard the debtors’ motion on an expedited basis, finding that “A62 did not acquire an interest in a swap agreement because the [d]ebtors did not consent [sic] any alleged assignment.” The bankruptcy court therefore ordered that the automatic stay applied to A62’s claims. A62 appealed to the district court.
Under Section 362 of the Bankruptcy Code, the filing of a bankruptcy petition results in an automatic stay, which prohibits actions such as the enforcement of liens against a debtor’s property and actions to obtain possession of a debtor’s property.[5] However, there is an exception to the automatic stay, sometimes referred to as the “safe harbor,” that allows “the exercise by a swap participant . . . of any contractual right (as defined in section 560) under any security agreement . . . forming a part of or related to any swap agreement.”[6] In turn, Section 560 of the Bankruptcy Code provides that “[t]he exercise of any contractual right of any swap participant . . . to cause the liquidation, termination or acceleration of one or more swap agreements because of [the filing of a bankruptcy petition, among other reasons] . . . shall not be stayed, avoided, or otherwise limited by operation of this title or by order of a court or administrative agency in any proceeding under this title.”[7] Under the Bankruptcy Code, a “swap participant” is defined as “an entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor.”[8]
The district court’s decision focused on whether A62 constituted a “swap participant” for purposes of Section 560. The court first noted that the definitions of “swap participant” and “swap agreement” were too circular and ambiguous to provide sufficient guidance. The court acknowledged that the swap initially entered into by the debtors and the Bank constituted a “swap agreement,” but then examined whether the purported assignment conferred “swap participant” status on A62. , The court held that at the time of the purported assignment, the only right that the Bank could validly assign was its right to collect the early termination amount payable by the debtor under the terms of the swap agreement. Therefore, the Bank did not transfer an interest in a swap agreement, and so, A62 was not a “swap participant” within the meaning of the Bankruptcy Code. As a result, the assignment of the Bank’s right to payment did not include the assignment of any right the Bank may have had to invoke the exception to the automatic stay contained in Sections 362(b)(17) and 560.
In arriving at its decision, the district court examined the legislative history of the safe harbor, noting that Congress was concerned with minimizing volatility in financial markets. In particular, the court noted that Congress enacted the safe harbor for swap agreements to protect against the risk that a non-bankrupt counterparty would be exposed to market volatility if it were not able to terminate a swap agreement promptly upon the occurrence of a bankruptcy filing, as well as the risk that a non-bankrupt counterparty would be prejudiced by the debtor cherry-picking the portions of the agreement that were advantageous to the debtor and rejecting the remaining provisions.[9] The court concluded that Congressional intent would not be served by allowing an assignee such as A62 under the present circumstances to qualify as a “swap participant” and avail itself of the safe harbor. The court reasoned that an assignee is not exposed to risk of market fluctuations because the termination payment is fixed before the assignment is entered into and the assignee can assess its risk of repayment before entering into the assignment. If the assignee were protected by the safe harbor, the safe harbor would be protecting the assignee from the risk of counterparty default and not from the risk of market volatility. Finally, the court highlighted the risk that providing the protections of the safe harbor to an assignee “would create substantial risk or arbitrage,” whereby persons could “accumulate ‘super-priority’ debt by speculatively obtaining assignments of interests in swap agreement termination damages.”[10]
[1] In re Chohan, 532 B.R. 130 (C.D. Cal. 2015).
[2] It is not clear from the decision whether this agreement was a 1992 ISDA Master Agreement or 2002 ISDA Master Agreement. However, certain provisions quoted by the court suggest that the parties entered into a 2002 agreement.
[3] The district court’s opinion did not address the validity of the reason for the termination, the process undertaken by the Bank taken in connection with the termination or the calculation of the early termination amount determined by the Bank.
[4] According to the district court, the assignment documents were not part of the record. However, the standard assignment provisions set forth in Section 7 of the swap agreement were not disputed. The court held, relying on a 1952 New York state court decision, that the restrictions on assignability were enforceable. The court did not discuss, and perhaps the parties did not address, whether the provisions of Sections 9-406 through 9-408 of the New York Uniform Commercial Code invalidated the restrictions on assignment and overruled the holding of the New York state court.
[5] 11 U.S.C. § 362(a).
[6] 11 U.S.C. §362(b)(17) (emphasis added).
[7] 11 U.S.C. § 560 (emphasis added).
[8] 11 U.S.C. § 101(53C) (emphasis added). The term “swap agreement” is broadly defined to include interest rate swaps and security agreements relating to such swaps. 11 U.S.C. §§ 101(53B)(A)(i), (vi).
[9] 532 B.R. at 138.
[10] 532 B.R. at 139.