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Web posted and Copyright © October 1, 2000, American Bankruptcy Institute.

This month's Update contains excerpts from the House committee report on H.R. 1161, the Financial Contract Netting Improvement Act of 2000. The bill, a major priority of the bond market community, was favorably reported by the House Committee on Banking on Sept. 7. A similar bill is included in the pending omnibus bankruptcy reform bill (H.R. 833/S. 625). The full text of the bill can be found at http://thomas.loc.gov.

Financial Contract Netting Improvement Act of 2000

PURPOSE AND SUMMARY

H.R. 1161, the Financial Contract Netting Improvement Act of 2000 (Act), is based on legislative proposals forwarded to Congress by the nation's financial regulators in order to guard against systemic risk to the nation's financial system. The major provisions of this Act come from recommendations made by the President's Working Group on Financial Markets following a review of current statutory provisions governing the treatment of qualified financial contracts and similar financial contracts upon the insolvency of a counter party. The Working Group for these recommendations consisted of the Securities and Exchange Commission; the Commodity Futures Trading Commission; the Federal Deposit Insurance Corporation (FDIC); the Department of the Treasury, including the Office of the Comptroller of the Currency; the Board of Governors of the Federal Reserve System; and the Federal Reserve Bank of New York. The recommendations of the Working Group were transmitted to Congress on March 16, 1998.

The provisions forwarded by the Working Group amend the U.S. Bankruptcy Code; the Federal Deposit Insurance Act (FDIA), as amended by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA); the payment system risk reduction and netting provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA); and the Securities Investor Protection Act of 1971 (SIPA). These amendments address the treatment of certain financial transactions following the insolvency of a party to such transactions.

BACKGROUND AND NEED FOR LEGISLATION

Since its adoption in 1978, the Bankruptcy Code has been amended several times to afford different treatment for certain financial transactions upon the bankruptcy of a debtor, as compared with the treatment of other commercial contracts and transactions. These amendments were designed to further the policy goal of minimizing the systemic risk potentially arising from certain interrelated financial activities and markets. Similar amendments have been made to the FDIA and FDICIA, and both the FDIC and the Securities Investor Protection Corporation (SIPC) have issued policy statements and letters clarifying general issues in this regard.

Systemic risk is the risk that the failure of a firm or disruption of a market or settlement system will cause widespread difficulties at other firms, in other market segments or in the financial system as a whole. If participants in certain financial activities are unable to enforce their rights to terminate financial contracts with an insolvent entity in a timely manner, or to offset or net their various contractual obligations, the resulting uncertainty and potential lack of liquidity could increase the risk of an inter-market disruption.

Congress has taken steps in the past to ensure that the risk of such systemic events is minimized. For example, both the Bankruptcy Code and the FDIA contain provisions that protect the rights of financial participants to terminate swap agreements, forward contracts, securities contracts, commodity contracts and repurchase agreements following the bankruptcy or insolvency of a counter party to such contracts or agreements. Furthermore, other provisions prevent transfers made under such circumstances from being avoided as preferences or fraudulent conveyances (except when made with actual intent to defraud). Protections also are afforded to ensure that the netting, set off and collateral foreclosure provisions of such transactions and master agreements for such transactions are enforceable.

In addition, FDICIA was enacted in 1991 to protect the enforceability of close-out netting provisions in 'netting contracts' between 'financial institutions.' FDICIA states that the goal of enforcing netting arrangements is to reduce systemic risk within the banking system and financial markets. In simple terms, netting occurs when money payments, entitlements, or obligations arising under one or more contracts or a clearing arrangement are all offset against each other, leaving one net amount.

The orderly resolution of insolvencies involving counter parties to such contracts also is an important element in the reduction of systemic risk. The FDIA allows the receiver of an insolvent insured depository institution the opportunity to review the status of certain contracts to determine whether to terminate or transfer the contracts to new counter parties. These provisions provide the receiver with flexibility in determining the most appropriate resolution for the failed institution and facilitate the reduction of systemic risk by permitting the transfer, rather than termination, of such contracts.

In summary, the insolvency provisions of the Act are designed to clarify the treatment of certain financial contracts upon the insolvency of a counter party and to promote the reduction of systemic risk. These provisions further the goals of prior amendments to the Bankruptcy Code and the FDIA on the treatment of those financial contracts and of the payment system risk reduction provisions in FDICIA. The insolvency provisions of the Act have four principal purposes:

  • To strengthen the provisions of the Bankruptcy Code and the FDIA that protect the enforceability of termination and close-out netting and related provisions of certain financial agreements and transactions.
  • To harmonize the treatment of these financial agreements and transactions under the Bankruptcy Code and the FDIA.
  • To amend the FDIA and FDICIA to clarify that certain rights of the FDIC acting as conservator or receiver for a failed insured depository institution (and in some situations, rights of SIPC and receivers of certain uninsured institutions) cannot be defeated by operation of the terms of FDICIA.
  • To make other substantive and technical amendments to clarify the enforceability of financial agreements and transactions in bankruptcy or insolvency.

Section 8. Bankruptcy Code Amendments

Subsection (a)(1) specifies that repurchase obligations under a participation in a commercial mortgage loan do not make the participation agreement a 'repurchase agreement.' Such repurchase obligations embedded in participations in commercial loans (such as recourse obligations) do not constitute a 'repurchase agreement.' However, a repurchase agreement involving the transfer of participations in commercial mortgage loans with a simultaneous agreement to repurchase the participation on demand or at a date certain one year or less after such transfer would constitute a 'repurchase agreement.'

The definition of 'swap agreement,' in conjunction with the addition of 'spot foreign exchange transactions' that was added to the definition in 1994, will achieve contractual netting across economically similar over-the-counter products that can be terminated and closed out on a mark-to-market basis.

The definition of 'swap agreement' originally was intended to provide sufficient flexibility to avoid the need to amend the definition as the nature and uses of swap transactions matured. For that reason, the phrase 'or any other similar agreement' was included in the definition. To clarify this, subsection (a)(1) expands the definition of 'swap agreement' to include 'any agreement or transaction similar to any other agreement or transaction referred to in [subsection (a)(1)] that is presently, or in the future becomes, regularly entered into in the swap market [...] and is a forward, swap, future, or option on one or more rates, currencies, commodities, equity securities or other equity instruments, debt securities or other debt instruments, or economic indices or measures of economic risk or value.' Subsection (a)(1) specifies that this definition of swap agreement applies only for purposes of the Bankruptcy Code and is inapplicable to the other statutes, rules and regulations enumerated in that section.

The definition also includes any security agreement or arrangement, or other credit enhancement, related to a swap agreement. This ensures that any such agreement, arrangement or enhancement is itself deemed to be a swap agreement, and therefore eligible for treatment as such for purposes of termination, liquidation, acceleration, offset and netting under the Bankruptcy Code and the FDIA. Similar changes are made in the definitions of 'forward contract,' 'commodity contract' and 'repurchase agreement.' An example of a security arrangement is a right of setoff; examples of other credit enhancements are letters of credit, guarantees, reimbursement obligations and other similar agreements.

Subsections (a)(2) and (a)(3) amend the Bankruptcy Code definitions of 'securities contract' and 'commodity contract,' respectively, to conform them to the definitions in the FDIA, and also to include any security agreements or arrangements or other credit enhancements related to one or more such contracts. Subsection (a)(2), like the amendments to the FDIA, amends the definition of 'securities contract' to encompass options on securities and margin loans. The inclusion of 'margin loans' in the definition is intended to encompass only those loans commonly known in the securities industry as 'margin loans' and does not include other loans utilizing securities as collateral, however documented.

Subsection (a)(2) also specifies that purchase, sale and repurchase obligations under a participation in a commercial mortgage loan do not constitute 'securities contracts.' While a contract for the purchase or sale or a participation may constitute a 'securities contract', the purchase, sale or repurchase obligation embedded in a participation agreement does not make that agreement a 'securities contract.'

Subsection (b) amends the Bankruptcy Code definitions of 'financial institution' and 'forward contract merchant.' The definition for 'financial institution' includes Federal Reserve Banks and the receivers or conservators of insolvent depository institutions.

Subsection (b) also adds a new definition of 'financial participant' to limit the potential impact of insolvencies upon other major market participants. This definition will allow such market participants to close-out and net agreements with insolvent entities under sections 362(b)(6), 546, 548, 555, and 556 even if the creditor could not qualify as, for example, a commodity broker. The new subsection preserves the limitations of the right to close-out and net such contracts, in most cases, to entities who qualify under the Bankruptcy Code's counter party limitations. However, where the counter party has transactions with a total gross dollar value of at least $1 billion in notional principal amount outstanding on any day during the previous 15-month period, or has gross mark-to-market positions of at least $100 million (aggregated across counter parties) in one or more agreements or transactions on any day during the previous 15-month period, the new subsection and corresponding amendments would permit it to exercise netting rights irrespective of its inability otherwise to satisfy those counter party limitations. This change will help prevent systemic impacts upon the markets from a single failure.

Subsection (c) adds to the Bankruptcy Code new definitions for the terms 'master netting agreement' and 'master netting agreement participant.' The definition of 'master netting agreement' is designed to protect the termination and close-out netting provisions of cross-product master agreements between parties.

 

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