Central banks in the past 18 months have injected a flood of money into financial markets. This liquidity in the system has allowed many marginal companies to issue bonds and avoid looming bankruptcy. So we have seen a lull the filing of major bankruptcy cases, particularly those affecting the energy industry. But the headlines also have included reports of some relatively large players with financial difficulties.
Rumors often fly in advance of a major bankruptcy. Even if the bankruptcy filing itself is not a certainty, traders usually have enough warning to begin their contingency planning prior to the bankruptcy. Often, those that are caught unprepared may have missed a prior opportunity to have better protected themselves.
So, leveraging the lull, energy companies may want to consider prophylactic measures to safeguard against a bankruptcy filing by a major counterparty. Dealing with a counterparty bankruptcy should include both the right steps in the first days of the bankruptcy case and proactive steps before the case is filed.
The best protections reside in the contractual framework agreed upon by the parties. The ideal framework must be determined on a case-by-case basis, but a few general principles are likely to apply:
- First, a wide range of events of a default may give greater flexibility to a company to terminate before a bankruptcy filing.
- Second, the agreement should allow the parties to terminate the contract and all underlying transactions after a default.
- Third, if the counterparty will consent, provisions requiring the segregation of collateral can provide some beneficial protections. Alternatively, the agreement should allow for a prompt return of collateral if the market moves in favor of the pledgor.
- Fourth, it is generally worth seeking expansive rights of setoff or cross-affiliate netting. While one bankruptcy court has arguably limited the enforceability of such rights in bankruptcy, the breadth of that ruling is not yet known. Expansive setoff rights may still be useful in the event of nonbankruptcy defaults and negotiations outside the courtroom.
At this stage, traders should focus heavily on their posted collateral and related contractual rights. Trading contracts usually do not require collateral to be segregated, which generally results in any surplus collateral becoming exposure to the counterparty. Thus, if a counterparty files bankruptcy at a time when it is overcollateralized, then its obligation to return excess collateral likely will be converted into an unsecured claim in the bankruptcy. The best practice is to pay close daily attention to whether a return of any collateral is warranted.
The Dodd-Frank Act further complicates collateral issues. "Over-the-counter" (OTC) swaps have historically been used to hedge against market price volatility, but the new law requires many of those transactions to be cleared on exchanges. Some traditional energy companies are likely to be treated as "end-users" under the law, but that classification may give only some protection. End-users likely will still be required to post cash "margin" to support their cleared swaps, and the margin requirements will probably be considerably higher than their OTC market equivalents. End-users also likely will need to post collateral for uncleared swaps. Other energy companies that do not qualify as "end-users" will be subject to an even greater regulatory burden.
Documenting agreements is another area where Dodd-Frank will cause complications. Most traders are accustomed to using form agreements, such as the ISDA Master Agreement, that feature heavy negotiation over key terms. Dodd-Frank’s requirement of cleared swaps will force most traders to use an entirely different set of contracts, such as a Futures Account Agreement and a Cleared Derivatives Transaction Addendum, both with the trader’s futures commission merchant. These documents are considerably less bilateral in nature and may provide traders with a decreased ability to negotiate key terms to protect against bankruptcy issues. So traders may have less control over their contractual provisions governing events of default, ability to terminate, and assignability.
Throughout the period before bankruptcy, commercial decisions will likely be made on the basis of the pending bankruptcy. Both sides will likely delay deliveries and payments until the last possible moments. One common issue concerns whether to accept a payment from a counterparty in financial difficulty, considering the possibility of a preference action if the counterparty enters bankruptcy. It is usually advisable to accept the payment. One reason is based on the range of things that can happen after the receipt of the transfer: the counterparty might avoid bankruptcy, or the records of the transaction may be lost before a trustee can pursue the transfer. Also, the creditor has the time value of money on its side. The general advice in favor accepting a preference has even more value in the energy trading context, because transfers under energy trading contracts will often be exempt from preference actions under the Bankruptcy Code’s safe harbor provisions.
It may also be useful in the pre-petition stage to analyze agreements for any bases for termination, independent of a bankruptcy filing. Parties might request adequate assurances of future performances, and then proceed to termination if the counterparty fails to provide the adequate assurances. Cross-defaults, breaches of representations, or credit support defaults might also provide unexpected rights of termination. Some contracts may even allow for the counterparty to be "bankrupt" before it has actually filed a bankruptcy petition, by virtue of a definition that incorporates other forms of financial distress. In any event, this exercise will be particularly useful for parties that will not qualify for the safe-harbor provisions of the Bankruptcy Code, because those parties may be stayed from exercising their contractual termination rights once the case begins.
Once a major counterparty has filed its bankruptcy petition, there are several steps to take in the immediate term. First, obtain reports from relevant departments concerning exposure and physical deliveries. Answers to these questions will likely drive the strategic decisions in the first days of the case:
- Are we in-the-money or out-of-the-money?
- What is the status of our collateral or letters of credit or both?
- If there is a guarantor, is it also in bankruptcy?
- Have physical deliveries (either by us or to us) been completed?
Traders should then begin evaluating their contractual rights. They must ensure that their contracts include a bankruptcy filing as an event of default, and that they allow for termination upon such a default. If so, then the firm’s lawyers should determine whether the Bankruptcy Code’s safe harbor provisions—ensuring the ability to terminate, liquidate, and accelerate certain protected classes of contracts—will apply. Once it is clear about the safe harbor provisions, the trader can start to terminate its transactions with the bankrupt counterparty and determine the valuation of its terminated trades, paying particular attention to the contractual methods for determining the values. Throughout this phase, the trader should heed the notice requirements—for example, proper addresses and means of transmission—in the relevant contracts.
If the safe harbor provisions do not apply, the automatic stay will prohibit the trader from exercising termination and setoff rights. The determination of whether safe harbor statutes apply is crucial, not only because of the scope of their protections, but also because debtors may seek to hold an entity that wrongly terminates its contracts in contempt and impose sanctions. In recent years, debtors have become more aggressive in their attempts to narrow the scope of safe harbor rights. So traders should be vigilant, understanding that they may face risks difficult to forecast.
In the early stages of a bankruptcy case, a company that previously sent physical deliveries to the debtor should prepare reclamation requests. The Uniform Commercial Code (UCC) provides the reclamation remedy; the Bankruptcy Code provides some additional guidance. When bankruptcy is not a factor, the UCC allows a seller of goods to reclaim any goods that an insolvent customer received on credit, as long as the seller makes its demand within 10 days after the delivery. The Bankruptcy Code preserves that general framework for reclamation but slightly alters the requirements, imposing time limits for action and offering some definitions of priorities for reclamation.
If a terminated contract calls for market quotations as the measure of termination damages, the nonbankrupt counterparty must obtain that information from brokers. Worksheets with the needed information and scripts for the traders to read when they make calls to the brokers may be helpful. The exact information needed varies, but the traders will need to know the number of quotes that they need, and to obtain all quotes for the same day that they are requested. Unless the contracts dictate otherwise, lawyers should advise the traders to ask for the bid/offer for each transaction and to get quotes for the actual volumes. The traders should know that they do not need to enter into any transactions based on the quotes. Finally, they should avoid mentioning defaults or bankruptcy, accepting indicative quotes, or engaging in any unrelated discussions with the broker.
In addition to implications revolving around collateral, the new federal Dodd-Frank law creates other layers of uncertainty for the energy industry. For example, the new law creates an "Orderly Liquidation Authority" (OLA), aimed at addressing the insolvency of an entity that is "too big to fail." While the OLA statute appears to contemplate the insolvency of a financial company, it could also apply to a large energy company heavily involved in derivatives transactions (think Enron). If an energy company (or a bank that entered into trades with energy company counterparties) were liquidated under the OLA, there are some important differences in the counterparty’s safe harbor rights. While similar to that of the Bankruptcy Code, a small number of provisions give a poorer treatment of traders’ contractual rights under the OLA. These create risk management difficulties. Lawyers and other in-house professionals will have trouble evaluating risks if they do not know which regime will govern.
But uncertainty is a hallmark of bankruptcy and considerably more so with the addition of Dodd-Frank to the legal landscape. Traders will never be able to eliminate that uncertainty altogether. With careful planning and smart execution, however, they may be able to mitigate the uncertainty—as well as their losses.