Restructuring

Co-Authored by Sunny Singh and Adam Lavine
In section IV.E of its report and recommendations of reforms to chapter 11 of the Bankruptcy Code, the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 (the “Commission”) considered changes to the Bankruptcy Code’s “safe harbor” provisions. Generally, the filing of a bankruptcy case immediately triggers the application of the automatic stay and other protections that prohibit collection efforts and the enforcement of contractual rights against the debtor, including contractual rights of termination. The Bankruptcy Code’s safe harbor provisions exempt (as their colloquial name implies) certain financial and derivatives contracts from sections 362 and 365(e)(1), which, respectively, impose the automatic stay and prohibit the enforcement of ipso facto clauses – i.e., a contractual clause that is triggered upon the debtor’s bankruptcy filing – to the extent those sections would prevent certain counterparties from exercising certain contractual rights to terminate, liquidate or accelerate safe harbored contracts. Additionally, the safe harbors prevent debtors from avoiding certain prepetition transfers made in connection with safe harbored contracts as preferential or constructively fraudulent. Generally, safe harbored contracts are swap agreements, securities contracts, forward contracts, commodities contracts and repurchase agreements.
Since the 2008 financial crisis, the scope and application of the safe harbor provisions have been rigorously tested due to the failures of large financial firms such as Lehman Brothers, MF Global, Madoff and American Home Mortgage. With the benefit of this experience, the Commission proposes scaling back some of the safe harbors, while leaving certain safe harbors as is. The Commission indicates that its recommendations are generally guided by the original and familiar policy rationale underlying the safe harbor provisions: market stability.   The premise is that without the safe harbors, the insolvency of one commodities or securities firm allegedly would spread to other market participants and threaten the collapse of the relevant market.
The Commission’s proposals – which are relatively moderate – regarding the safe harbor provisions can be summarized as follows (don’t worry, we do a deeper dive below):

• Section 546(e) and Leveraged Buyouts: eliminate safe harbor protection for avoidance claims against a debtor’s former equity holders who received the proceeds of a prepetition leveraged buyout (or LBO) investment, but only to the extent that such equity holders held privately issued securities.
• Section 562 and “Commercially Reasonable Determinants of Value”: refer to the prepetition contract for the definition of “commercially reasonable determinants of value” or, in the absence of such determinants of value, commercially reasonable market prices.
• Mortgage-Related Repurchase Agreements: eliminate safe harbor protections for mortgage loans and mortgage-related securities, or, at a minimum, eliminate disguised mortgage warehouse facilities from safe harbors.
• Walkaway Clauses: expressly declare walkaway clauses to be unenforceable to the extent they are safe harbored.
• Temporary Stay of Safe Harbors: do not adopt short stay of enforcement of safe harbor rights in order to provide debtors brief opportunity to assume safe harbored contracts.
• Ordinary Supply Contracts: expressly exclude physical supply contracts of nondealers, such as contracts for the supply of natural gas and electricity, from the safe harbors.

Deep Dive
546(e) and LBOs
To illustrate the proposed changes to section 546(e) of the Bankruptcy Code, consider the following hypothetical of a typical LBO transaction, albeit a simplified one. A private equity firm approaches a privately owned company and offers to acquire the company. The privately owned company has just a handful of shareholders, all of whom are company insiders. A deal is reached pursuant to which the private equity firm will finance the buyout of the insiders with a combination of significant debt placed on the company and a limited equity investment. Upon closing, the insiders exchange their shares in the company for a sizeable payment funded by the borrowed money and the equity investment.
Soon thereafter, a downturn in the company’s business prevents the company from servicing its new debt obligations. The company commences a bankruptcy case. The chapter 11 debtor or trustee seeks to avoid the payments to insiders as fraudulent transfers and alleges that the LBO rendered the company insolvent. Under existing law, the payments made to the insiders would potentially fall within the safe harbor in section 546(e) of the Bankruptcy Code, which exempts “settlement payments” from avoidance actions that may be asserted under the Bankruptcy Code.
The Commission proposes removing safe harbor protection for payments to the beneficial owners of securities in LBOs, but only in respect of privately issued securities. Thus, the payments to the insiders in the above hypothetical may be avoidable. Numerous courts have struggled to reconcile the plain language of section 546(e), which does not distinguish between privately issued and publicly issued securities, with the purported policy rationale behind section 546(e): insulating the securities transfer system from avoidance actions so that a major bankruptcy does not negatively impact the functioning of the public securities markets. In light of this tension, this proposed change is hardly surprising.
Section 562 and “Commercially Reasonable Determinants of Value”
Section 562 governs the timing of the measurement of damages under safe harbored contracts. It provides that damages under a safe harbored contract shall be measured as of the earlier of the date that the debtor rejects the contract or the counterparty liquidates, terminates or accelerates the contract. If no “commercially reasonable determinants of value” exist as of that date, then damages are measured as of the earliest subsequent date or dates on which there are commercially reasonable determinants of value.
The term “commercially reasonable determinants of value” is not defined in the Bankruptcy Code and may be critical to the measurement of damages arising under a safe harbored contract. In American Home Mortgage Holdings Inc., the Third Circuit addressed the circumstance where there may be more than one commercially reasonable determinant of value (see our coverage of the Third Circuit’s American Home decision). In that case, the American Home debtors argued that even though market prices of a loan portfolio under a repurchase agreement may not have been commercially reasonable in late 2007, a discounted cash flow (or DCF) valuation was available and appropriate. Under DCF, the counterparty’s damages were substantially lower, resulting in a lower deficiency claim against the debtor, even though the counterparty could not recover that value in the market. The counterparty in that case argued that the loans must be valued as of the date the market or sale price for the loans was available. The Third Circuit sided with the debtors.
The Commission questioned this result and proposes to define “commercially reasonable determinants of value” based upon the agreed-upon valuation methodology provided for in the parties’ contract, unless that methodology is manifestly unreasonable. If the contract is silent or provides for a methodology that is manifestly unreasonable, the Commission proposes that the assets should be valued as of the earliest date on which market prices are available. The Commission states that its proposal is grounded in policies of promoting market stability and respecting prepetition bargains whenever possible.
Repurchase Agreements and Disguised Mortgage Warehouse Facilities
Sections 555 and 559 of the Bankruptcy Code grant certain parties the ability to liquidate, terminate or accelerate “securities contracts” or “repurchase agreements,” and to enforce other remedies against a debtor (like setoff), without first having to seek relief from the automatic stay. Under existing law, these safe harbors apply to, among other types of contracts, mortgage loans, interests in mortgage loans, mortgage-related securities, and interests in mortgage-related securities. These mortgage-related contracts were afforded safe harbor protections pursuant to the 2005 amendments to the Bankruptcy Code.
The Commission proposes removing these types of mortgage-related transactions from safe harbor protection. Alternatively, the Commission recommends that, at a minimum, Congress amend the Bankruptcy Code to explicitly exclude from safe harbor protection mortgage loan repurchase facilities that are essentially disguised mortgage warehouse facilities, which are not protected by the safe harbors.
Under a typical mortgage warehouse facility, a mortgage originator borrows from a lender to finance mortgages, pledges those mortgages or other assets to the lender in exchange for the loan and then transfers the financed mortgages to a buyer or securitization pool.  The proceeds of these transfers are then used by the originator to repay the secured lender.  Recently, to obtain safe harbor protections under section 559 of the Bankruptcy Code, lenders and originators have begun to structure these secured financings as repurchase agreements.  That is, the originator (borrower) sells mortgages to the lender and agrees to repurchase those mortgages for a premium at a later date.  The borrower’s repurchase obligations are secured by the underlying mortgages. The mortgages are then sold to a securitization pool.  The proceeds of that sale are used to repurchase the mortgages from the lender and release the lender’s liens.
By structuring the deal as a repo as opposed to a secured financing, the “lender” gains the protection of the safe harbors in the event that the originator files for bankruptcy before the mortgage is sold to the securitization pool. For example, under existing law, if an originator files for bankruptcy, the repo “lender” can immediately liquidate the mortgages that it holds and seek damages against the debtor for any deficiency. In contrast, under an ordinary warehouse mortgage facility, the secured lender must seek relief from the automatic stay to exercise remedies against the collateral, exposing itself to greater market risk if the value of the mortgages deteriorates while the lender is subject to the automatic stay.
Commentators have questioned whether bankruptcy law should countenance the mass liquidation, termination and acceleration of mortgage-related contracts held by a debtor in the mortgage industry (such as a large originator). Commentators have alleged that mortgages are illiquid assets and, therefore, fall outside the main justification for the safe harbors: the preservation of liquidity in the financial markets. The Commission appears to have agreed and proposes to exclude such mortgage-related contracts from safe harbor protection.
Walkaway Clauses
The Commission considered whether “walkaway” clauses in safe harbored contracts that allow the nondefaulting party to limit or avoid (i.e., walk away from) its performance obligations upon termination should be enforceable to the extent they are safe harbored. For example, the safe harbored contract may provide that a nondefaulting party is not required to make a termination payment to the defaulting party if the defaulting party has filed for bankruptcy. Naturally, these provisions, if enforceable, can have a significant impact on a debtor’s bankruptcy estate and could deprive it of enormous value. Not surprisingly, such clauses are not enforceable in contracts that are not safe harbored.
The Bankruptcy Code does not specifically address the enforceability of walkaway clauses in safe harbored contracts, other than in the context of repurchase agreements under section 559. Although it is debatable whether walkway clauses are enforceable under the existing safe harbors (other than in the situation addressed in section 559 of the Bankruptcy Code), the Commission proposes to expressly preclude the enforcement of walkaway clauses in safe harbored contracts in chapter 11 cases. The Commission noted that other laws, such as the Federal Deposit Insurance Act, as well as the Orderly Liquidation Authority, which could apply to systemically important financial institutions, render walkaway clauses unenforceable.
Temporary Stay of Safe Harbors
The safe harbors’ exemptions from the automatic stay and ipso facto prohibitions typically result in the prompt termination of safe harbored contracts by counterparties upon a debtor’s bankruptcy filing or shortly thereafter. As a result, even if the debtor is “in the money” under the contracts or may be able to continue to perform or assign the contracts, it rarely has the ability to assume, or assume and assign, its safe harbored contracts prior to their termination. Some commentators have argued against this result and in favor of a short stay — one to two business days — that would allow the debtor some ability to assume or assign its qualified financial contracts. This approach would be similar to the ones taken by the Orderly Liquidation Authority and the Federal Deposit Insurance Act, which briefly enjoin counterparties from terminating, liquidating or accelerating safe harbored contracts.
After considering pros and cons, the Commission decided not to propose a similar stay in chapter 11. The Commission questioned the feasibility of a debtor reviewing and making assumption or assignment decisions in a meaningful manner in such a short time frame. On balance, the Commission concluded that imposing a stay of safe harbor protections would not enhance a debtor’s rehabilitation efforts sufficiently to outweigh the potential negative effect that could be caused to the markets by such a stay.
Ordinary Supply Contracts
According to the Commission, an ordinary supply agreement (e.g., a contract for the supply of natural gas or electricity in the ordinary course of business) could be drafted to meet the Bankruptcy Code’s technical definition of “forward contract” and/or “swap agreement.” Indeed, in 2012, the Fifth Circuit held that a particular electric supply agreement was a “forward contract” and, as a result, protected the supplier from preference liability under the safe harbors.
The Commission has recommended an amendment to the Bankruptcy Code to expressly exclude physical supply contracts of nondealers from the safe harbors. In proposing this recommendation, the Commission noted that such supply contracts fall outside of the public policy justification for the safe harbors: a desire to protect market stability.
Conclusion
Time will tell if these and other proposals by the Commission will make their way into the Bankruptcy Code. Although these recommendations would only very moderately improve the rights of most debtors vis-à-vis safe harbored contracts, we wouldn’t be surprised if lenders and financial institutions pushed back on these proposals in an effort to preserve every aspect of the safe harbors that currently benefit them.