Derivatives and Bankruptcy

An End User’s Practical Guide to the QFC Stay Rules

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The Board of Governors of the Federal Reserve System (Board), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) adopted rules (together, the QFC Stay Rules) in 2017 requiring amendments to certain qualified financial contracts (QFCs). The compliance dates for these rules depend on the type of QFC counterparty facing a “covered entity” (as defined below), and are being phased in beginning on January 1, 2019 and ending on January 1, 2020.[1] Notwithstanding this compliance phase-in, dealers subject to the QFC Stay Rules have been requesting that all of their counterparties, including end users, take action to facilitate compliance as though the initial compliance date, January 1, 2019, applied to all types of QFC counterparties. This article is intended to help buy-side participants navigate the compliance process, with emphasis on describing (i) the various types of contracts that constitute “covered” QFCs subject to the rules and (ii) the various alternative methods for compliance.

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Smart Contracts That Violate the Commodity Exchange Act: What Parties Are Liable?

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In recent years, the U.S. Commodity Futures Trading Commission (CFTC) has devoted significant resources to addressing how the requirements of the Commodity Exchange Act (CEA) and the regulations thereunder apply to transactions involving Bitcoin and other virtual currencies.[1] The CFTC has not adopted any rules specific to virtual currencies, but rather has made clear that derivatives contracts based on a virtual currency are subject generally to the same CFTC regulations that apply to other types of derivatives contracts that have traditionally been within the CFTC’s jurisdiction.[2] Additionally, the CFTC has noted that derivatives contracts are susceptible to automation through smart contracts and distributed ledger technology (DLT) and “[e]xisting law and regulation apply equally regardless what form a contract takes . . . [even to] contracts [or parts of contracts] that are written in code[.]”[3]

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Getting Smarter: CFTC Publishes Smart Contracts Primer

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An Orrick lawyer authored an article titled “Getting Smarter: CFTC Publishes Smart Contracts Primer,” addressing LabCFTC’s recently released “Primer on Smart Contracts.” The Primer provides (i) a high-level overview of smart contract technology and applications, (ii) a discussion of the potential role of the CFTC in smart contract regulation and (iii) a discussion of the unique risks and governance challenges posed by smart contracts. The article is available here.

Novo Banco and CDS – A Post-Mortem

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In 2014, the International Swaps and Derivatives Association, Inc. (“ISDA”), published the 2014 ISDA Credit Derivatives Definitions (the “Definitions”), which updated the 2003 ISDA Credit Derivatives Definitions.[1]

One of the most significant changes in the Definitions was the inclusion of a new credit event for “Governmental Intervention.”[2]  This credit event was intended to address concerns expressed in the market that the credit event for “Restructuring” may not cover certain measures actually taken by governments to support struggling entities, especially banks.  Governmental Intervention[3] is generally defined to include actions or announcements by a “Governmental Authority”[4] that result in, inter alia, the reduction in the rate or amount of interest payable by a reference entity, an expropriation or other event which mandatorily changes the beneficial holder of the relevant obligation, or a mandatory cancellation, conversion or exchange.  This event is similar to Restructuring in certain respects (for example, the reduction in the rate or amount of interest of an obligation may trigger both events).  However, unlike Restructuring, deterioration in creditworthiness is not required to trigger a Governmental Intervention.

It did not take long for this new credit event to be probed and tested by a set of straightforward, but unusual, facts that apparently were not specifically considered by the drafters. In August 2014, Banco de Portugal, the central bank of Portugal, applied resolution measures to Banco Espírito Santo, S.A. (“BES”), a bank organized in Portugal that was experiencing distress.  These measures included a €4.9 billion rescue package for BES, and the transfer of numerous assets, liabilities and deposit-taking operations from BES to a new “good bank,” Novo Banco, S.A. (“Novo Banco”).  However, on December 29, 2015, Banco de Portugal announced the re-transfer of five senior Euro-denominated bonds (having almost €2 billion in principal) from Novo Banco back to BES.[5]  This re-transfer resulted in significant losses to bondholders, up to 90% in secondary market trading.

It was clear that Banco de Portugal constituted a “Governmental Authority” and that it had taken a binding action pursuant to its resolution law. However, irrespective of the undeniable losses suffered by creditors,[6] there was an issue as to whether the re-transfer of the bonds at issue from BES to Novo Banco affected creditors’ rights in one of the ways specified in Section 4.8(a) of the Definitions.

In accordance with the standard practice in the credit default swap (“CDS”) market, purchasers of protection asked the relevant 15-member Determinations Committee (the “Committee”) to determine whether the central bank’s actions amounted to a Governmental Intervention, hence triggering protection payments under CDS contracts.  Under the relevant rules, an 80% supermajority (12 of 15 members) is required for a Committee to decide whether or not a credit event has occurred.[7]   The Committee fell just short of the required percentage, with 11 members voting that there was no Governmental Intervention.  Although the Governmental Intervention event was generally intended to protect investors from governmental actions negatively affecting the value of obligations, the majority of the Committee concluded that the transfer of debt to another institution did not constitute a “mandatory cancellation, conversion or exchange” and did not have “an analogous effect” to the events specifically enumerated in the definition of Governmental Intervention.

Nevertheless, without the required supermajority, pursuant to the relevant rules governing Committees, the matter was referred for “external review.”[8]  External reviews of Committee decisions are quite rare and entail at least three “experts” nominated by Committee members deciding the issue.  A unanimous decision is needed to override the Committee’s original “No” vote where, as here, over 60% of Committee members voted against the occurrence of a credit event.  On February 15, 2016, the external review panel released a unanimous decision to uphold the negative determination.  In short, the panel decided that the central bank’s transfer did not constitute a mandatory cancellation, conversion or exchange of the obligations, and was not analogous to those types of event.[9]  On the latter point, the panel stated that taking a broader review of the word “analogous” would result in this clause “dominat[ing] the whole of the definition, which is inconsistent with [the] careful and detailed drafting” of the definition.[10]

In addition to seeking a determination that a Governmental Intervention had occurred, protection buyers pursued one more potential avenue for payout under the Definitions: seeking a determination that a “successor” event had occurred with respect to CDS naming Novo Banco as reference entity. A successor event occurs under the Definitions if, generally, more than 25% of the relevant obligations of a reference entity are transferred to another entity and more than 25% of the relevant obligations of the reference entity remain with the reference entity.[11]  The Committee sought additional information from Banco de Portugal and Novo Banco to determine whether this threshold had been exceeded.  After receiving this additional information, the Committee unanimously decided on March 3, 2016 that a successor event did not occur.[12]

Many industry participants believed that the Governmental Intervention was designed to protect against precisely the type of result that precipitated from Banco de Portugal’s actions.  Nevertheless, the Committee concluded, and the external review panel agreed, that the actions of Banco de Portugal did not align with the requirements of the Definitions.  Thus, one lesson from this situation is that Determinations Committees may take a formalistic view of requirements under the Definitions, regardless of the scope of losses incurred by creditors or the spirit or purpose of the language in the Definitions.  CDS purchasers should take note and not overlook the precise words of the Definitions.

[1] The implementation date for the updated Definitions was September 22, 2014.

[2] For a more complete description of the changes to ISDA Credit Derivatives Definitions, click here.

[3] “Governmental Intervention” is defined in full, as follows:

(a) “Governmental Intervention” means that, with respect to one or more Obligations and in relation to an aggregate amount of not less than the Default Requirement, any one or more of the following events occurs as a result of an action taken or an announcement made by a Governmental Authority pursuant to, or by means of, a restructuring and resolution law or regulation (or any other similar law or regulation), in each case, applicable to the Reference Entity in a form which is binding, irrespective of whether such event is expressly provided for under the terms of such Obligation:

(i) any event which would affect creditors’ rights so as to cause:

(A) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals (including by way of redenomination);

(B) a reduction in the amount of principal or premium payable at redemption (including by way of redenomination);

(C) a postponement or other deferral of a date or dates for either (I) the payment or accrual of interest, or (II) the payment of principal or premium; or

(D) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation;

(ii) an expropriation, transfer or other event which mandatorily changes the beneficial holder of the Obligation;

(iii) a mandatory cancellation, conversion or exchange; or

(iv) any event which has an analogous effect to any of the events specified in Sections 4.8(a)(i) to (iii).

Definitions, §4.8(a) (emphasis added).

[4] The term “Governmental Authority” includes, inter alia, any de facto or de jure government (or agency, instrumentality, ministry or department thereof), any court, tribunal administrative or other governmental, inter-governmental or supranational body and any authority or other entity designated as a resolution authority or charged with the regulation or supervision of the financial markets of the “reference entity” or some or all of its obligations.  Definitions, §4.9(b).

[5] It appears from Banco de Portugal’s announcement of the measure that it specifically selected these bonds because they were “intended for institutional investors.” See Banco de Portugal, Banco de Portugal approves decisions that complete the resolution measure applied to BES (December 29, 2015) (available at: https://www.bportugal.pt/en-US/OBancoeoEurosistema/ComunicadoseNotasdeInformacao/Pages/combp20151229-2.aspx). Among other things, the central bank stated that “[t]he selection of the above-mentioned bonds was based on public interest and aimed to safeguard financial stability and ensure compliance with the purposes of the resolution measure applied to Banco Espírito Santo, S.A. This measure protects all depositors of Novo Banco, the creditors for services provided and other categories of unsecured creditors.” Id.

[6] Some US$430 million in net protection payments would be triggered if it was determined that a credit event had occurred.

[7] ISDA supported a decision of a Governmental Intervention having occurred, arguing that the re-transfer of the bonds at issue constituted a “conversion or exchange” or had “an analogous effect” to an exchange, and that a negative determination “would lead to an illogical outcome.” See ISDA Determinations Committee Request, Has a Governmental Intervention Credit Event occurred with respect to Novo Banco, S.A.? (December 30, 2015) (available at http://dc.isda.org/documents/2016/01/novo-banco-pai-3.pdf). Specifically, ISDA argued as follows:

A decision that a Governmental Intervention has not occurred would lead to an illogical outcome where holders of the Transferred Bonds suffer a near complete economic loss for the arbitrary reason that they are institutional investors, but this loss is not mitigated by their CDS protection despite paying a higher premium for protections against the risk of governmental interventions.  This outcome will further diminish CDS’s efficacy as a tool to hedge credit risk and further erode confidence in the product. . . .  This action is taken under the “bail in” regime that the European banking regulators seek to implement, and is precisely the type of governmental intervention risk that the Definitions were designed to cover.

[8] Specifically, Section 4.1(a) of the 2014 ISDA Credit Derivatives Determinations Committees Rules (available at http://dc.isda.org/wp-content/files_mf/1414437004ICM2319997111v10DC_Rules_2014.pdf) provides that “[a]ny DC Question relating to DC Resolutions to be made by Supermajority under . . . 3.1(c) (Credit Event Resolution) . . . shall be referred to the external review process described in this Section 4 (External Review) . . . if a Convened DC . . . holds a binding vote on, but is unable to Resolve by a Supermajority, such DC Question.”

[9] Among other things, the panel pointed to the use of the word “transfer” elsewhere in the Definitions and concluded that “it would seem . . . that the draftsman has deliberately decided not to include the expression of ‘transfer’ as an event within the definition of a [Governmental Intervention].”  Novo Banco External Review; Decision and Analysis of the External Review Panel of the ISDA EMEA Determinations Committee with respect to DC issue Number 2015123002 pursuant to Section 4 of the 2016 ISDA Credit Derivatives Determination Committees Rules, at 4 (February 15, 2016) (available at http://dc.isda.org/documents/2016/02/nb-er-decision.pdf).

[10] Id. at 6.

[11] Definitions, at §2.2(a). More specifically, in this case, if the Committee concluded that BES succeeded to more than 25% of Novo Banco’s relevant obligations but more than 25% of relevant obligations remained with Novo Banco, then the CDS would be divided accordingly into new CDS transactions with each of BES and Novo Banco, respectively, as the reference entity. See id. at §2.2(a)(iv) and 2.2(n).

[12] See ISDA EMEA Credit Derivatives Determinations Committee, Statement (March 3, 2016) (available at: http://dc.isda.org/documents/2016/03/emea-dc-meeting-statement-3-march-2016.pdf). It appears that, in addition to Novo Banco’s €7.35 billion of outstanding senior debt, the European Central Bank had provided Novo Banco with some €7 billion in loans. Therefore, €2 billion of re-transferred bonds constituted less than 25% of Novo Banco’s aggregate obligations at the time.

District Court Holds that Assignee is Not Entitled to Safe Harbor Protections

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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] READ MORE →

Exploring Temporary Stays of Early Termination Rights

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Under the Bankruptcy Code (Title 11, U.S.C., §§ 101 et seq., the “Bankruptcy Code”) non-debtor counterparties to qualified financial contracts generally are not subject to the automatic stay under section 362 and the prohibition on ipso facto clauses under section 365(e).  As a result, upon the commencement of a bankruptcy case under the Bankruptcy Code, counterparties are able to exercise their contractual right to cause the liquidation, termination or acceleration of the transactions under qualified financial covenants.

The same is not necessarily true when a bank, insurance company or other similar regulated entity becomes insolvent.  Such entities are not eligible to be debtors under the Bankruptcy Code.[1] While the insolvency regimes for such entities do not provide for an automatic injunction barring creditor remedies, the insolvency regime will provide a brief stay preventing counter-parties to qualified financial contracts with such entity from terminating, liquidating or accelerating a qualified financial contract during such period.

The American Bankruptcy Institute recently released its Chapter 11 Reform Report.  The Reform Report proposed a number of revisions to Chapter 11 related to confirmation, valuation, financing and asset sales, among others.  The Reform Report also proposed a number of revisions to the safe harbor protections, which were discussed in Part II of Orrick’s Restructuring Team’s summary and analysis of the Reform Report.  As mentioned in the summary of the proposed changes to the safe harbor protections,  the Commission considered, but rejected, incorporating a temporary stay on the exercise by a non-debtor counterparty of its contractual rights to terminate and liquidate qualified financial contracts.  Read More.

English Court Addresses Derivatives Close-outs

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On July 29th, the High Court of Justice, Queen’s Bench Division, Commercial Court, issued an opinion[1] that addressed several issues regarding the calculation of early termination amounts under a standard derivatives master agreement, as well as the calculation of default interest under the master agreement.

In the case at issue, Lehman Brothers Finance S.A. (“LBF”) claimed that Sal. Oppenheim Jr. & Cie, KGAA (“Oppenheim”) had improperly calculated the early termination amount payable to LBF in connection with the termination of transactions governed by a 1992 ISDA Master Agreement under which “Market Quotation” had been selected as the payment measure. The transactions at issue were equity puts and calls that referred to the Nikkei 225 Stock Average Index (the “Index”). Pursuant to the terms of the master agreement between the parties, all transactions thereunder automatically terminated upon the bankruptcy filing of LBF’s parent, Lehman Brothers Holdings Inc. (“LBHI”), at 1:44 a.m. New York time on Monday, September 15, 2008. LBF itself went into liquidation in December 2008. READ MORE →

Major Banks Agree to Protocol “Staying” Exercise of Termination Rights

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On October 18, the International Swaps and Derivatives Association, Inc. (“ISDA”) announced that eighteen major global banks had agreed to sign a protocol (the “Protocol”) that imposes a stay on cross-default and termination rights under standard derivatives contracts governed by an ISDA master agreement. The terms of the Protocol, which was developed in close coordination with regulators to facilitate cross-border resolution efforts and to address risks associated with the disorderly unwind of derivatives portfolios, would apply where one of the Protocol signatories becomes subject to resolution action in its jurisdiction. READ MORE →

Lehman Court Finds Safe Harbors Protect Damage Calculation Provisions In Swap

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An important opinion involving swaps was issued recently in the Lehman litigation.  Specifically, this opinion protects a non-debtor counterparty’s right to rely on a contractually agreed methodology for damages calculations upon the liquidation of a safe harbored swap agreement, even if the debtor’s bankruptcy triggers the provision.  For a summary of this opinion and its implications, click here.