We need to go forward and get bankruptcy reform legislation into conference
and completed so we can improve this area in the law, so the law will be clearer for
all those interested, and so we can send it to the President for his signature.

Remarks of Senate Majority Leader Trent Lott during debate on the Bankruptcy Reform Act of 2000 in the Senate, March 22, 2000.

For presentation at the American Bankruptcy Institute

New York City Bankruptcy Conference

May 15, 2000

The Bankruptcy Reform Act of 2000 (the "Act") is viewed principally as a measure to reform consumer bankruptcy issues and stem perceived abuses by individual debtors. However, the Act also has provisions addressing other important areas of bankruptcy law, including tax and international insolvency cases. Title X of the Act, entitled "Financial Contracts Provisions," proposes amendments to the Bankruptcy Code to clarify, expand and add new provisions dealing with financial contracts such as securities contracts, commodities and forward contracts, repurchase agreements and swap agreements. These provisions in the Act represent a long, difficult history of efforts during the past several years to pass legislation improving the rights of non-defaulting parties to financial transactions and maintaining the integrity of financial markets in general when participants in those markets become debtors in cases under the Bankruptcy Code.

Certain of the Financial Contracts provisions of the Act were part of early drafts of the Bankruptcy Reform Act of 1994, but ultimately were abandoned in the final version of the bill as enacted. Four years later the Senate introduced the Business Bankruptcy Reform Act of 1998 which included a comprehensive section on financial contracts nearly identical to Title X of the Act. That bill was never presented to the full Senate.

The bankruptcy bill which has now become the Act was passed in the House of Representatives on May 5, 1999 by a vote of 313 to 108, and in the Senate on February 2, 2000 by a vote of 83 to 14. The next step toward enactment ordinarily would be for Congress to convene a conference committee comprised of House and Senate members for the purpose of reconciling differences between the two versions of the bill, and then presenting a uniform bill to the President. However, since the Senate vote in February, the legislation has been mired in scuffles between House and Senate members mostly on matters unrelated to bankruptcy. The current impasse originated when House members complained that a tax relief provision in the Senate bill violated the Constitutional requirement that tax legislation originate in the House.

In the meantime, members of the House and Senate reportedly have been exchanging views on the Act in an effort to short-cut, or perhaps circumvent altogether, a formal reconciliation process. In early May, the House offered to propose a compromise on the tax issue with the hope of thereby allowing the legislation to proceed to conference. On May 11, 2000, the House compromise was delivered to the Senate. Reports of the compromise offer indicate that there are still substantial differences that would need to be resolved before a final bill can be sent to the President.

For purposes of this paper, it is worthwhile to note that the House and Senate versions of the Financial Contracts provisions of the respective bills are in all material respects nearly, if not completely, identical and there have been no reports of any need to reconcile those provisions.

The provisions of the Act addressing financial transactions expand the existing protections under the so-called "safe harbor" provisions of the Bankruptcy Code. The safe harbors, as currently enacted, generally protect non-defaulting parties to certain types of financial transactions by permitting such parties to exercise contractual rights upon a bankruptcy of the other party notwithstanding the automatic stay, trustee avoidance powers and other Bankruptcy Code provisions that generally restrict creditor actions. Simply stated, the purpose of the safe harbors is to maintain the integrity and fluidity of capital and financial markets in the event of the insolvency or bankruptcy of participants in those markets. The Act builds upon these protections by clarifying and expanding existing Bankruptcy Code provisions and adding new provisions increasing the types of market participants and financial transactions that would come within the scope of safe harbor protection.

The Act also includes provisions addressing asset-backed securitization which are discussed separately at the end of this paper.

The Act proposes to amend existing Bankruptcy Code provisions to clarify and improve safe harbor protections, as well as add whole new provisions and definitions that are designed to bolster the existing framework and further reduce the risk to non-defaulting financial participants and, thus, to financial markets in general.

The Act includes several new definitions and operative Code sections that would give safe harbor protection to financial participants and transactions not currently within the explicit language of the safe harbor provisions. It would add new provisions for measuring damages under financial contracts and protecting the priority of any shortfall, unsecured claims of non-debtor counterparties to financial contracts.

The Act would add a definition to the Bankruptcy Code for the term "financial participant," meaning an entity that, at the time it enters into a financial contract or at the time the bankruptcy case is commenced, has one or more agreements or transactions:

The term "financial participant" is used in the Act to allow such entities to exercise rights under a securities, commodity, or forward contract (1) to setoff claims by and against the debtor as an exception to the automatic stay (§362(b)(6)), and (2) to liquidate, terminate or accelerate such contracts under the relevant safe harbor provisions for such contracts (§§555 and 556). The term would also be used in section 546(e) of the Bankruptcy Code to prevent a bankruptcy trustee or debtor-in-possession from avoiding prepetition margin payments or settlement payments made to a financial participant.

The new definition would therefore increase the types of entities that would be protected under the existing safe harbor provisions.

Two new definitions proposed in the Act are "master netting agreement" and "master netting agreement participant." Netting, which is not defined in the Code or the Act, refers generally to the process of combining and offsetting gains and losses between particular counterparties across two or more transactions. A master agreement, also not defined, is essentially an agreement that sets forth terms and conditions between the parties that are intended to govern various transactions entered into between them from time to time. The standard form of master agreements widely used in financial transactions generally permit parties to incorporate netting provisions. When such provisions are used, these agreements would likely qualify as master netting agreements under the definition proposed in the Act.

One issue that arises under current law is whether a master agreement that covers transactions which do not fall within the safe harbors as well as others that do, is nevertheless eligible for safe harbor protection. In other words, does the presence of non-protected transactions "taint" the protected ones? The Act seeks to resolve this issue in favor of protecting the safe harbored transactions by limiting the exercise of contractual rights to only those transactions that would otherwise be entitled to safe harbor protection, and excluding from the exercise of such rights other, non-protected transactions that are within the same master agreement.

The Act defines master netting agreement as "an agreement providing for the exercise of rights, including rights of netting, setoff, liquidation, termination, acceleration, or closeout" under one or more securities, commodities or forward contracts, or repurchase or swap agreements. The definition further provides that if the master netting agreement covers transactions that are not one of the types enumerated, it "shall be deemed to be a master netting agreement only with respect to those agreements or transactions" that are enumerated. Thus, the presence of non-safe harbor transactions in the master netting agreement will not "taint" the protected transactions and thereby render the entire agreement ineligible for safe harbor treatment as a master netting agreement.

By the same token, including non-safe harbor transactions under a master netting agreement with transactions that are safe harbored does not bestow protection on the otherwise unprotected transactions.

The definition of "master netting agreement participant" is simply "an entity that, at any time before the filing of the petition, is a party to an outstanding master netting agreement with the debtor."

The Act would also add new section 561 to the Bankruptcy Code as the operative safe harbor provision for master netting agreements. Proposed section 561(a) would provide that, with certain exceptions noted below, the exercise of any contractual right arising from the bankruptcy of a counterparty "to cause the termination, liquidation, or acceleration of or to offset or net termination values, payment amounts or other transfer obligations arising or in connection with one or more" securities, commodity, or forward contracts, or repurchase, swap, or master netting agreements, "shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by any order of a court or administrative agency in any proceeding under this title."

There are two limitations to the master netting agreement safe harbor. The first, consistent with the definition noted above, would protect safe harbor transactions under master netting agreements that also contain non-safe harbor transactions. Section 561(b)(1) would provide that,

The second exception applies if the debtor is a commodity broker. It limits the ability to set off claims against the debtor to the extent necessary to protect the customer priority under the Commodities Exchange Act. Because neither securities nor other brokerage customers are entitled to a statutory priority such as that given to commodities customers, proposed section 561 prohibits setting off across commodities and non-commodities transactions.

Conforming amendments would be made to sections 362(b) (exceptions to the automatic stay), 546 (limitation on avoidance powers) and 548 (fraudulent transfers). New section 362(b)(31) would provide that the automatic stay does not apply to the setoff by a master netting agreement participant with one or more master netting agreements or any contract or agreement subject to a master netting agreement to the extent each such contract or agreement is otherwise excepted from the operation of the stay under existing subsections of section 362(b), namely 362(b)(6) for securities, commodities and forward contracts; (b)(7) for repurchase agreements; and (b)(17) for swap agreements.

New section 546(j) would provide that the trustee may not avoid a prepetition transfer made to a master netting agreement participant under a master netting agreement or any individual contract covered under the agreement unless the transfer was made with actual intent to defraud creditors or to the extent that a transfer under an individual contract covered by the master netting agreement is otherwise subject to avoidance. In other words, as in other provisions where master netting agreements appear, transfers under non-safe harbor transactions do not obtain safe harbor protection merely by being included in a master netting agreement along with qualifying transactions.

New subsection (E) would be added to section 548(d)(2) which defines "value" for purposes of constructively fraudulent transfers made under various types of transactions. A master netting agreement participant would be deemed to have received a transfer for value "to the extent of such transfer, except, with respect to a transfer under any individual contract covered thereby, to the extent such master netting agreement participant otherwise did not take (or is otherwise not deemed to have taken) such transfer for value."

The Act would delete and completely replace the existing definition of swap agreement. The swaps market has experienced tremendous growth in the past decade fueled to a large part by the innovation and ingenuity of financial engineers. The existing definition enacted in 1990 was intended to be broad enough to include types of swaps that were not yet known. It includes certain enumerated types of swaps (interest rate, forward, commodity, foreign exchange, etc.) plus "any other similar agreement." It is likely that any list of enumerated swap transactions, even one that includes "similar" transactions, would soon be rendered obsolete by advances in the market.

The Act provides a complete overhaul of the definition, building upon the basic existing framework by substantially enlarging the list of enumerated transactions and providing a veritable "kitchen sink" of derivatives including same day-tomorrow, tomorrow-next, precious metals, debt index, and credit spread transactions. The existing "any similar agreement" clause is expanded and more detailed under the Act as a separate subsection in which the definition of swap agreement would include "any agreement or transaction similar to any other agreement or transaction referred to in this paragraph that — is presently, or in the future becomes, regularly entered into in the swap market."

While the Act represents an improved effort to accommodate innovation in the swap markets, the use of the phrase "regularly entered into" may be read as limiting the otherwise expansive language. It is not clear, for example, whether an agreement that would otherwise qualify as a swap agreement but has as its underlying measure of value a novel or unusual index, or one that has not previously been used, would be deemed to be "regularly entered into" in the swap market.

If one of the purposes of a new definition for swap agreements is to include transactions that are not currently used or known, the standard ought to depend not on being similar to known transactions, but rather on whether the measure of value used in the transaction (whether similar to others or not) is vulnerable to market fluctuations such that the same systemic risks sought to be avoided by the safe harbor provisions justify protecting the transaction at issue.

The Act also proposes a provision for measuring damages in connection with financial contracts. Under proposed section 562, if the debtor rejects a financial contract (presumably one in which the counterparty either does not have a contractual right to close out or is in the money and has elected not to), or if the counterparty liquidates, terminates, or accelerates the contract, "damages shall be measured as of the earlier of — (1) the date of such rejection; or (2) the date of such liquidation, termination, or acceleration." This amendment would make the Bankruptcy Code consistent with provisions related to the timing of the calculation of damages for "qualified financial contracts" under the Federal Deposit Insurance Act.

Proposed section 767 would provide that notwithstanding any other provision of the Bankruptcy Code, the exercise of rights by "a forward contract merchant, commodity broker, stockbroker, financial institution, securities clearing agency, swap participant, repo participant, or master netting agreement participant" under the Bankruptcy Code "shall not affect the priority of any unsecured claim it may have after the exercise of such rights." Presumably, this is intended, at a minimum, to provide a statutory defense to subordination claims based on the termination and liquidation of financial contracts.

It is also worth noting that the Act would amend section 901 of the Code which sets forth the Code sections applicable in municipal bankruptcy cases commenced under chapter 9. Currently, the operative safe harbor provisions — sections 555, 556, 559 and 560 — are arguably not applicable in chapter 9 cases. The Act would make these and the new safe harbor provisions — sections 561 and 562 — expressly applicable in municipal bankruptcy cases.

In addition to adding the new provisions described above, the Act would amend certain existing definitions and operative provisions concerning financial contracts and safe harbor protections.

The Act would expand the current definitions of "securities contract," "commodity contract," "forward contract," "repurchase agreement," and "swap agreement" to include (where the current definition does not):

1. an option to enter into the particular type of contract;

2. a master agreement that provides for the type of contract, whether or not it also provides for other types of contracts;

3. any combination of agreements or transactions of the type of contract;

4. security agreements or other credit enhancements related to the type of contract; and

5. any other agreement or transaction that is similar to the type of agreement or transaction.

Along with these definitional changes, the Act would amend the individual operative safe harbor provisions. As currently drafted, sections 555, 556, 559 and 560 of the Code permit non-defaulting parties to exercise their contractual right "to cause the liquidation" of the contract upon the bankruptcy of the counterparty notwithstanding the automatic stay, trustee avoidance powers, or any other law. Although the right to liquidate necessarily requires the liquidating party to first close out open positions in order to determine the net amount owing to or from the debtor, the safe harbors as currently drafted do not explicitly authorize closing out the debtor’s open positions. The Act would clarify this right by permitting the exercise of contractual rights to "cause the liquidation, termination, or acceleration" of the contract.

The operative safe harbor provision for securities contracts would also be amended to make the internal definition of "contractual right" in section 555 consistent with the definition of that term in the safe harbor provisions for commodities and forward contracts, and repurchase and swap agreements. It would amend section 555 to define contractual rights as, among other things, "a right, whether or not in writing, arising under common law, under law merchant, or by reason of normal business practice.

The definition of certain particular financial contracts would be amended under the Act to include transactions in the secondary mortgage markets. For example, under the current definition of repurchase agreement, safe harbor protection is limited to transactions in which the underlying property is certificates of deposit, bankers acceptances or government securities. The Act would amend this definition to include mortgage-related securities, mortgage loans, and interests in mortgage-related securities or mortgage loans. Similarly, a securities contract qualifies for safe harbor protection under the current Code if it is a contract for the purchase, sale or loan of securities, certificates of deposit and groups or indexes of securities. The Act would amend the definition of securities contracts to include mortgage loans or any interest in mortgage loans and groups or indexes of mortgage loans or interests in mortgage loans.

These amendments would permit repurchase agreements and securities contracts in which the underlying assets are mortgage-related securities such as residual certificates, whole loans, or pools of whole loans, to be eligible for safe harbor treatment under, respectively, sections 555 and 559 of the Code.

The Act includes a comprehensive set of amendments to section 541 of the Bankruptcy Code which defines property of the bankruptcy estate. These amendments are specifically designed to uphold the validity of asset-backed securitization transactions.

In a securitization, assets are transferred from one entity (the originator) to a special purpose entity which may itself issue securities backed by the cash flow from the assets, or transfer the assets to another entity that issues such securities. Securitizations are structured to reduce the risk that in a bankruptcy case of the originator, the transferred assets (and their attendant cash flows) would be deemed to be property of the debtor’s bankruptcy estate under section 541(a) of the Code, thereby making them unavailable to the holders of the securities.

As a condition to consummating a securitization transaction, issuer’s counsel ordinarily is required to deliver a so-called "true sale" opinion which, in effect, concludes that in a bankruptcy of the originator, the transferred assets would not be deemed to be property of the debtor’s bankruptcy estate.

In 1993, the United States Court of Appeals for the Tenth Judicial Circuit held that assets transferred in a "true sale" nevertheless remained property of the debtor’s bankruptcy estate. The decision relied on a strained interpretation of the Uniform Commercial Code and has been roundly criticized, including by the Permanent Editorial Board which drafts the official commentary to the U.C.C. On the heels of that decision, provisions similar to those in the Act were almost included in the Bankruptcy Reform Act of 1994, but were stripped from the legislation prior to the time it became law.

The asset-backed securitization provisions of the Act are based principally upon a definitional scheme that starts with proposed new subsection (5) of section 541(b) which would provide that property of the estate does not include:

As in other Bankruptcy Code exceptions to avoidable transfers, the reference to sections 550 and 548(a) would allow the trustee to avoid transfers, even under an asset-backed securitization, if its was made with actual intent to defraud creditors.

The definitional scheme requires a reference back to several of the operative terms used in proposed section 541(b)(5) — "eligible asset," "asset-backed securitization," and "transferred" — some of which in turn contain other definitional hurdles. For example, an eligible asset is defined as cash, securities, and:

An eligible entity is defined as an "issuer" or :

Perhaps the most critical definition in the scheme is the one for the term "transferred" which is defined in the Act to mean,

1. whether the debtor directly or indirectly obtained or held an interest in the issuer or in any securities issued by the issuer;

2. whether the debtor had an obligation to repurchase or to service or supervise the servicing of all or any portion of such eligible assets; or

3. the characterization of such sale, contribution, or other conveyance for tax, accounting, regulatory reporting, or other purposes.

If enacted, these provisions may effectively foreclose parties from challenging the true sale treatment of assets transferred in a securitization, whether or not the transfer would withstand analysis under state law, if the appropriate representations and warranties are made within the meaning of the proposed Bankruptcy Code provision.

The Act provides that the Financial Contracts provisions of Title X would take effect on the date of enactment, and that the amendments made by the provisions would apply with respect to cases commenced after the date of enactment but would not apply to cases commenced before the date of enactment.