Derivatives In Bankruptcy

Derivatives in Bankruptcy

Presented at the Boston Bar AssociationApril 14, 2009

2Chatham Financial - Proprietary and Confidential - All Rights Reserved

Overview

Introduction

Structure of Derivatives Transactions

What Happens If Your Counterparty Fails?– Termination Process– Bankruptcy Code Safe Harbors– Close-out Valuations

Lessons Learned


“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


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


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


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


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


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)



Credit Support Annex Trade Confirmations

Events of Default

Termination Events

Eligible Collateral


Legal Terms

Economic Terms


Schedule to the Master Agreement: ISDA Documents Structure

The negotiated part

Terms reflect credit/default risk

Key negotiated issues– Events of Default– Termination Events




Events of Default

Termination Events

Eligible Collateral


Legal Terms

Economic Terms


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”


Credit Support AnnexISDA Documents Structure




Events of Default

Termination Events

Eligible Collateral


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!


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!




Events of Default

Termination Events

Eligible Collateral


Legal Terms

Economic Terms


What Happens When Your Counterparty Fails?


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?


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


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


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


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


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)


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)


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


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


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


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


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


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.


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


Conclusion


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


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