December 1999

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New York

Special Comment

The Status Of Swap Agreements Under The U.S. Bankruptcy Code

Phone 1.212.553.1653

Jeremy Gluck William L. May

The Status Of Swap Agreements Under The U.S. Bankruptcy Code

Introduction
In the process of disseminating our rating analysis of derivative product companies, Moodys has received a number of questions from investors regarding the status of swap agreements under the U.S. Bankruptcy Code (the Code). These questions have ranged from Does netting really work? to inquiries about exactly what benefits the Code confers on swap participants that are not enjoyed by other types of creditors. These issues have, of necessity, been explored by counsel for the derivative product companies rated by Moodys. Accordingly, this Special Comment should be viewed as a summary of the knowledge we have derived from discussion and review of the opinions rendered on behalf of the derivative product companies. The purpose of this Special Comment is therefore to describe briefly how swap agreements are treated under the Code and to focus attention on what are, in our view, the three most important advantages conferred on swap participants: the enforceability of termination and netting provisions; exemption from the automatic stay and limitations on the avoidance powers of the trustee in bankruptcy.

Special Comment

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Author William L. May

Production Associate John Tzanos

Copyright 1999 by Moodys Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN IS COPYRIGHTED IN THE NAME OF MOODYS INVESTORS SERVICE, INC. (MOODYS), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODYS PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODYS from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided as is without warranty of any kind and MOODYS, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODYS have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODYS or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODYS is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODYS IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODYS hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODYS have, prior to assignment of any rating, agreed to pay to MOODYS for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.

Moodys Special Comment

Code Eligibility
The question of which entities are eligible to be considered a debtor in a case commenced under the Code is addressed by Section 109 of the Code. In general, only a person that resides or has a domicile, a place of business, or property in the United States, or a municipality, may be a debtor under the Code. Entities that are specifically excluded from Code eligibility include domestic and foreign insurance companies and various types of banks and savings and loan institutions. The legislative history indicates that these institutions were excluded from Code eligibility because provision for their liquidation had been made under various other regulatory schemes. The U.S. derivative products subsidiaries to which Moodys has assigned Aaa ratings do not fit within the description of the excluded entities (nor do their respective sponsors) and are thus Code eligible entities.1

Termination and Netting Rights

In June 1990, legislation amending the Code specifically to deal with swap agreements was signed into law. Section 560 of the Code expressly provides that The exercise of any contractual right of any swap participant to cause the termination of a swap agreement because of a condition specified in section 365(e)(1) of this title [i.e. insolvency, commencement of a bankruptcy case or appointment of a custodian or trustee] or to offset or net out any termination values or payment amounts arising under or in connection with any swap agreement shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency.... Besides specifically making enforceable termination and netting provisions (such as those contained in an ISDA Master Agreement2), Section 560 overrides Section 365(e) of the Code which would otherwise prevent a nonbankrupt party from using the filing of the bankruptcy petition as a basis for termination of the swap contract pursuant to the typical termination provisions contained in the contract. In other words, the non-defaulting party may terminate a swaps contract for precisely the reasons other creditors are forbidden to use in terminating their contracts with the bankrupt entity. To take advantage of Section 560 the non-defaulting party must be a swap participant and the contract must constitute a swap agreement. Section 101(56) of the Code defines a swap participant as an entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor. Section 101(55) of the Code defines a swap agreement as: (A) an agreement (including terms and conditions incorporated by reference therein) which is a rate swap agreement, basis swap, forward rate agreement, commodity swap, interest rate option, forward foreign exchange agreement, rate cap agreement, rate floor agreement, rate collar agreement, currency swap agreement, cross-currency rate swap agreement, currency option, any other similar agreement (including any option to enter into any of the foregoing); (B) any combination of the foregoing; or (C) a master agreement for any of the foregoing together with all supplements. Although there is no legislative history on the matter, the any other similar agreement reference in paragraph (A) apparently was intended to bring over-the-counter derivatives transactions that have characteristics similar to the ones enumerated in paragraph (A) within the aegis of the special protections afforded swap agreements. For example, such instruments as total-rate-of-return swaps, which have become fairly common in the world of structured finance, would presumably fall into the category of nonenumerated agreements that enjoy the protections given to the enumerated swaps agreements.

1 The exception to this fact is Credit Lyonnaiss Derivatives Program. The Credit Lyonnais Derivatives Program exists at the New York branch of the French bank Credit Lyonnais and its insolvency would be governed by the New York Banking Law and enforced by the New York State Superintendent of Banks. 2 This Special Comment assumes that the swap participants use either ISDA Master Agreement, that New York law is the governing law and that both parties have acted in good faith.

Moodys Special Comment

Protection for Collateral

The Status Of Swap Agreements Under The U.S. Bankruptcy Code
One of the most important protections enjoyed by a swap participant transacting with a Code eligible entity is the right to foreclose against posted collateral despite the automatic stay generally imposed by Section 362(a) of the Code. Section 362(b)(14) of the Code permits a swap participant to set off its claim under a swap agreement against any cash, securities, or other property of the debtor held by or due from such swap participant to guarantee, secure or settle any swap agreement. In addition, Section 553(b)(1) prevents a bankruptcy trustee from recovering amounts offset by virtue of the exemption expressed in Section 362(b)(14). This exemption places the swap participant in a better position than the ordinary secured creditor whose foreclosure and set-off rights are suspended by the automatic stay.

Protection from Avoidance Powers

Section 546(g) of the Code limits the powers of a bankruptcy trustee to avoid transfers made under a swap agreement, by or to a swap participant, before the commencement of a case. For example, under Section 547(b) of the Code a trustee can ordinarily claw back as a preference any transfer of the debtors property made to a creditor within 90 days of the filing of the bankruptcy petition. Section 546(g) expressly abrogates this avoidance power with respect to transfers made under a swap agreement. The bankruptcy trustees avoidance powers will obtain, however, whenever a transfer of the debtors property is made with actual intent to hinder, delay or defraud any entity.... (Section 548(a)(1))

Summary
We have provided a brief synopsis of the status of swap agreements under the U.S. Bankruptcy Code. The amendments to the Code passed by Congress in June of 1990 provide significant advantages to the swaps participant that is transacting with a Code eligible entity using a standard ISDA Master Agreement. The most important of these advantages are the black-letter affirmation of termination and netting provisions, the exemption from the automatic stay and the curbing of a bankruptcy trustees avoidance powers. For the alert swaps participant making diligent use of such features as termination provisions and the posting of collateral, the Code provides in large measure the comfort and certainty of result that Congress intended to provide by passing the 1990 amendments. For the swaps participant that finds itself transacting in a swaps agreement with a counterparty that has become bankrupt, without having secured sufficient collateral to cover its exposure to that bankrupt counterparty, the situation is somewhat different. The solvent swaps participant will still be able to avail itself of any termination and netting provisions in order to minimize its losses, but the solvent swaps participant will then have to join the other unsecured creditors in terms of priority for realizing the remainder of its claim.

Special Comment

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Moodys Special Comment