Vol 11 (2014) - Issue 4

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The Method of Liquidation of a Swap Agreement is Enforceable in Bankruptcy

In Michigan State Housing Development Authority v Lehman Brothers Derivative Products, Inc. et al., 502 B.R. 383 (Bankr. S.D.N.Y. 2013), the Bankruptcy Court for the Southern District of New York held that contractually prescribed procedures for liquidating a swap agreement, and not just the termination thereof, fall within the U.S. Bankruptcy Code safe harbour protections.

1. Swap agreements in the United States
Swap agreements are contracts to exchange (swap) cash flows at certain predetermined intervals, calculated by reference to an index, including interest rates, currency rates and security or commodity prices. As such, swaps are normally tied to an underlying loan, but they are legally independent obligations. The simplest subgroup are interest rate swaps, in which parties exchange payments tied to a certain interest rate to hedge against the risk of changes in interest rates. For example, a party with a floating rate loan may prefer a fixed rate loan, and can enter into a floating-to-fixed interest rate swap agreement to ensure a fixed net financing cost.
Swaps are customized contracts and are traded overthe- counter (OTC). As of February 2014, the size of the U.S. swap market was estimated at USD 395 trillion. In light of their importance to the overall financial market, qualifying swap agreements (and certain other derivative instruments) enjoy special treatment under the provisions of the Bankruptcy Code, commonly referred to as safe harbour provisions. These rules favour non-debtor counterparties and help to prevent market disruption in three main ways: they (i) allow non-debtor counterparties to enforce contractual rights without having to seek a bankruptcy court order to lift the automatic stay; (ii) exempt counterparties from avoidance powers of a trustee, who may recover certain prepetition payments made by the debtor (preferences and constructive fraudulent transfers); (iii) permit setoff and netting; and (iv) allow counterparties to enforce termination rights in the event of bankruptcy, which are otherwise unenforceable ipso facto clauses.