In the United States, in a typical plain vanilla lending arrangement, if a counterparty files for bankruptcy, an automatic stay of enforcement actions is imposed that would prevent a lender from (i) foreclosing on the property of the debtor, (ii) terminating contracts with the debtor, (iii) commencing or continuing certain enforcement actions against the debtor or its property and/or (iv) setting off amounts owed under such arrangements (in each case unless a motion is filed and granted in the related bankruptcy case). In addition, provisions in lending contracts that allow for the termination or modification of a contract based on the debtor’s bankruptcy or financial condition (also known as “ipso facto clauses”) are prohibited from being enforced.
However, if a contract is a “protected contract” as designated under Title II of the United States Code, as amended, (the “Bankruptcy Code”), and the party seeking enforcement is a “protected party” (e.g., in the case of securities contracts, a financial institution or a financial participant as defined within the Bankruptcy Code), then the contract will receive “safe harbor” protections that allow the qualifying party to liquidate and close out the protected contract when the counterparty becomes the subject of a bankruptcy case and to do so free from the automatic stay and certain other significant restrictions of the Bankruptcy Code. Specifically, ipso facto clauses, which would not otherwise be enforceable in a typical lending arrangement, can be enforced, and the actions taken by the protected party to enforce the protected contract are not subject to the automatic stay. The safe harbor provisions, therefore, enable counterparties to terminate their financial contracts and exercise contractually agreed-on rights of liquidation, termination and acceleration (e.g., enforcement through the netting and setoff of then outstanding obligations) promptly upon the bankruptcy of the debtor. Additionally, each of the Bankruptcy Code’s protected contract provisions makes clear that a protected party can freely exercise its rights under any security agreements, guarantees, reimbursement agreements or other credit enhancements that relate to the central protected contract and that those related contracts are each eligible, in their own right, for treatment as protected contracts. As a result, enforcement actions by the protected parties of these related protected contracts are exempt from the automatic stay and can be undertaken without prior approval of the bankruptcy court.
In addition, the Bankruptcy Code shields protected parties from a variety of avoidance powers that are generally available to a bankruptcy trustee (or debtor-in-possession) with respect to transactions engaged in by the debtor prior to commencement of the case. Critically, with respect to securities contracts, under section 546(e) of the Bankruptcy Code, certain payments and other transfers received by the protected party from the debtor in connection with a Repurchase Facility, prior to commencement of the case, may not be avoided. Likewise, because the Bankruptcy Code permits the close-out of the Repurchase Facility, those post-bankruptcy actions also cannot be “avoided” by the trustee (or the debtor-in-possession).
As a consequence, enabled to have more certainty in contract enforcement when a debtor is bankrupt, the counterparty is able to undertake a different calculus in determining the necessary resources to recover on a claim against the bankrupt debtor, the amount recoverable, the timeframe in which the recovery can be achieved and, equally important, the ability to retain the recovery once achieved. As a result of these changes to the protected counterparty’s “calculus,” better pricing as compared to a typical asset-level lending arrangement may be achievable.
Protected contracts entitled to safe harbor treatment under the Bankruptcy Code include commodity contracts, forward contracts, master netting agreements, swaps, repurchase agreements and securities contracts. Repurchase Facilities (as defined below) are the most similar to lending arrangements and can be used as an alternative to a typical lending arrangement if certain characteristics are met.
In a repurchase facility, the “buyer” provides liquidity by “purchasing” certain portfolio assets with an obligation of the “seller” to “repurchase” these same assets on a specified date in the future (each, a “Repurchase Facility”). A Repurchase Facility is similar to a lending facility in that the buyer (or lender) provides financing to the seller (or borrower) for a period of time and expects to receive a rate of return on the amount provided to the seller. The rate of return is typically described as the “price differential” or “spread” and, similar to interest on a loan, is commonly payable periodically prior to repurchase of the applicable asset(s) by the buyer. In addition, Repurchase Facilities are usually treated as loans for accounting and tax purposes by sellers and buyers.
Unlike most other secured lending arrangements, Repurchase Facilities are considered protected contracts under the Bankruptcy Code and are afforded the safe harbor protections described above. However, not every lending contract can be a repurchase agreement. In fact, in order to fit into the “repurchase agreement” definition under the Bankruptcy Code, an agreement must:
[provide] for the transfer of one or more certificates of deposit, mortgage related securities . . . mortgage loans, interests in mortgage related securities or mortgage loans, eligible bankers’ acceptances, qualified foreign government securities (defined as a security that is a direct obligation of, or that is fully guaranteed by, the central government of a member of the Organization for Economic Cooperation and Development), or securities that are direct obligations of, or that are fully guaranteed by, the United States or any agency of the United States against the transfer of funds by the transferee of such certificates of deposit, eligible bankers’ acceptances, securities, mortgage loans, or interests, with a simultaneous agreement by such transferee to transfer to the transferor thereof certificates of deposit, eligible bankers’ acceptance, securities, mortgage loans, or interests of the kind described in this clause, at a date certain not later than 1 year after such transfer or on demand, against the transfer of funds . . . .
In sum, the underlying asset subject to a Repurchase Facility must be (a) a security or mortgage loan or an interest therein and (b) sold with an automatic obligation to resell such asset within one year.
In addition, there are other protected contracts that can be utilized in a manner similar to secured lending arrangements. “Securities contracts” under the Bankruptcy Code are similar to repurchase contracts, with the notable exception that there is no requirement to transfer the asset back to the counterparty. However, the counterparty to a “securities contract” must be a stockbroker, securities clearing agency, financial institution or financial participant. In other words, such entity must be:
an entity that, at the time it enters into a securities contract, commodity contract, swap agreement, repurchase agreement, or forward contract, or at the time of the date of the filing of the petition, has one or more [securities contracts, commodity contracts, repos, swaps or master netting agreements] with … any entity (other than an affiliate) of a total gross dollar value of not less than $1,000,000,000 in notional or actual principal amount outstanding (aggregated across counterparties) at such time or on any day during the 15-month period preceding the date of the filing of the petition, or has gross mark-to-market positions of not less than $100,000,000 (aggregated across counterparties) in one or more such agreements or transactions with the debtor or any other entity (other than an affiliate) at such time or on any day during the 15-month period preceding the date of the filing of the petition … or is a clearing organization (as defined in section 402 of the Federal Deposit Insurance Corporation Improvement Act of 1991).
Consequently, while under the Bankruptcy Code a “securities contract” is more broadly defined than a “repurchase agreement,” the universe of qualifying “buyer” counterparties to a securities contract may be more limited. Regardless, structuring asset-level financing as a “protected contract” (whether a repurchase agreement or securities contract under the Bankruptcy Code) benefits both counterparties by providing the buyer with safe harbor provisions for the enforcement of remedies in connection with a bankruptcy of the seller, and accordingly may provide the seller with more favorable economic terms.
As the market continues to mature, financial institutions will continue to explore new and innovative ways to obtain liquidity from existing pools of assets including obtaining asset-level leverage (particularly for mortgage loans). Since Repurchase Facilities and securities contracts provide yet another cost-effective method for satisfying liquidity needs and optimizing returns for investors, we expect to see continued growth of these financing arrangements in the coming years.