United States: Wounded Knight Raises Questions About Bankruptcy Risks

The ongoing financial peril of Knight Capital provides an opportunity to reflect on steps investors should consider whenever a financial intermediary or counterparty encounters financial difficulties. The issues clients face in such a case depend very much on the facts: for example, some intermediaries are execution-only brokers, some are prime brokers, others are derivatives counterparties. But we have found that there are a number of steps clients might take that can be effective in many if not all of these fact patterns. Here is a brief, representative list of steps you might want to consider when confronted by an intermediary in financial distress.

  • Who am I doing business with? – Almost all large financial intermediaries have myriad affiliates, and you may well have exposure to many of them. The nature and number of those affiliates can have a substantial effect on your credit exposure. You should take the time to know the various affiliates you are dealing with, the lines of business you have with them, and how much. Bankruptcy and insolvency regimes in the US and foreign jurisdictions differ greatly, and you should keep in mind that the steps you may need to take, and your ultimate legal and financial position, can depend very much on the jurisdiction where you are required to bring your claim.
  • Where are the documents? – Take the time to find and catalog all of the deal documents you have in place with the intermediary and its affiliates.
  • How do I contact the intermediary? – Review the documentation carefully to determine where you need to send close-out or default notices, or other communications you might need to send quickly in the coming days or hours.
  • Think hard before sending money – When an intermediary begins to teeter, this is not business as usual. You will obviously need to think hard about how to meet your contractual obligations to the intermediary, but you need to consider carefully the credit implications of sending/wiring any money or securities to the intermediary – including by way of mark-to-market collateral. And you will want to make certain you send/wire the money or securities to the right entity – because once the intermediary goes into bankruptcy, it can be difficult, if not impossible, to get back money or securities sent in error to the wrong affiliate.
  • DvP Settlement – If you are required to settle a transaction with the intermediary, take all possible steps to effect settlement on a true delivery vs. payment ("DvP") basis. That means that you don't release money or securities to the intermediary until you know that you will receive securities or money in return. This is more easily done in some contexts than others, and you will need to work closely with your clearing broker or custodian, but a true "DvP" payment or delivery can reduce or eliminate much credit exposure. If possible, accelerate settlement periods to minimize the length of time you take settlement credit risk.
  • Overcollateralization/free credit balances – Take whatever steps you can to move away from the intermediary any assets that don't have to be there, including any assets serving to overcollateralize your obligations to the intermediary, or any free credit balances. You will very likely end up as a general unsecured creditor for those assets in a bankruptcy.
  • Offset – Common law and contractual rights of netting and offset generally work even after a bankruptcy filing. So you should take the time to determine the amount of your obligations to the financial intermediary and each of its affiliates (separately), and the offsetting obligations of the financial intermediary and each of its affiliates (separately) to you. If there is time, it may be possible to optimize your netting and offset position by transferring or assigning among your affiliates any rights or obligations to/from the financial intermediary and its affiliates, on the one hand, and you and your affiliates, on the other. (If you are an investment manager acting for managed accounts, your ability to move rights or obligations among accounts will, however, likely be limited.)
  • Close-out may not be the best option – You will want to think hard about whether closing out a transaction before the financial institution goes into bankruptcy proceedings is the best course. For example, if you close out a futures contract immediately before a bankruptcy, you may be an unsecured creditor for cash in the intermediary's proceeding; it might be worth taking the chance of leaving the contract open in the expectation that it will be assigned to another FCM with your collateral account. These determinations can obviously be highly subjective, and may involve choosing what is perceived to be the least of various evils.
  • Hedges – Keep in mind that the insolvency of an intermediary with which you have a hedge on will effectively undermine the hedge and it may not be possible, or it may be prohibitively expensive, to replace the hedge. It is never too early to think about alternative hedging strategies.
  • All of these steps can be challenging and involve a detailed assessment of credit and legal risk, and you would be well advised to take financial and legal advice. We would, of course, be happy to assist you with any pre-insolvency planning so that you may optimize your position.

In the event you are confronted with a financial intermediary that has entered into U.S. bankruptcy proceedings, there are the basic distinctions that may apply when the distressed entity is a broker-dealer or clearing house:

Limitations on the Automatic Stay

The automatic stay triggered by a bankruptcy filing typically imposes various restrictions on actions that may be taken by a non-debtor regarding a debtor. Absent court-approved relief from the stay, lawsuits may not be commenced or continued, and contract counterparties are precluded from exercising various contract rights against a debtor, including the right to terminate a defaulted contract. These restrictions are frequently extremely burdensome on non-debtors. For example, when a contract does not mature for many years, the debtor may essentially be afforded the opportunity to cease making payments pending its decision whether to assume or reject the contract, while the counterparty is required to honor its contractual obligations. In appreciation of the burdens this inequality of power imposes on certain types of contract counterparties, the Bankruptcy Code exempts certain contractual relationships from these rules. These exceptions are referenced as "safe harbor" provisions.

In particular, exempted from the automatic stay are certain entities that have specific categories of financial contracts with a debtor: these safe harbor exemptions apply to "commodity contracts," "forward contracts," "securities contracts," "repurchase agreements," "swap agreements," and "master netting agreements." These, so-called, "safe harbor contracts" are not subject to the automatic stay, and as such, a party's contractual right "to cause the liquidation, termination, or acceleration of or to offset or net termination values, payment amounts, or other transfer obligations arising under or in connection with" a safe harbor contract "shall not be stayed, avoided, or otherwise limited by operation" of any other provision of the Bankruptcy Code. Moreover, swap counterparties are explicitly not precluded from exercising "any contractual right . . . to offset or net out any termination value, payment amount, or other transfer obligation arising under or in connection with one or more such agreements." The benefit of these protections is clear: a counterparty is entitled to exercise its contractual right to close out its contract, calculate damages, and eliminate continuing exposure to the debtor under the contract.

Beneficiaries of these safe harbor provisions must satisfy two requirements. First, the applicable financial contract must fall within the Bankruptcy Code definitions of "commodity contracts," "forward contracts," "securities contracts," "repurchase agreements," "swap agreements," and "master netting agreements." Second, after determining that the financial contract is protected, the particular counterparty must qualify as one of the eligible types of parties; namely, a "financial institution," "financial participant," or "swap participant." As is often the case regarding complex legal rules, when considering whether a particular contract or particular party is eligible for the safe harbor protections, the defined terms do not exactly match their plain meaning. Careful review is, thus, necessary to confirm a party's eligibility to benefit from the safe harbor provisions. This caution is particularly compelled by the fact that violations of the automatic stay by a counterparty ineligible for safe harbor benefits may subject such counterparty to severe sanctions.

Claims Process

Particularly for parties eligible to take advantage of the safe harbor provisions, it is critical to be familiar with the steps necessary to exercise these rights. Such forethought mitigates the burden and risk of the claims process, and reduces the likelihood of subsequent disputes with the debtor. For example, counterparties in recent bankruptcy cases discovered that they would have benefitted from understanding all the contractual provisions that govern termination before exercising their rights, including when calculating any close-out amounts, such as soliciting market quotations to value a terminated swap agreement. Each action taken and correspondence made should be well documented in anticipation of possible disputes with the debtor that may actually take place years later during the claims process.

Customer Status in a Broker-Dealer or FCM Bankruptcy:

Rights of a bankrupt's claimants, including their priority in any distributions from the bankruptcy estate, are governed by a series of rules, including both their contractual rights and rights granted by law. A unique and significant distinction between types of claimants is particularly applicable in the event of a bankruptcy filing by a broker-dealer or futures commission merchant. Certain claimants of these types of bankrupts may not be considered merely a creditor, but rather be categorized as having "customer" status. This "customer" status entitles the claimant to possible distribution priority, and applies to a party which had entrusted its securities, cash, or commodities positions to be held by the debtor. Since customers are entitled to the return of their securities, or some measure of their equivalent, ahead of the bankrupt's general creditors, members of the "customer" class generally receive a higher rate of recovery than general unsecured creditors. Whether a counterparty qualifies as a "customer" depends not only on contractual language, but also on nuances of the actual relationship with the bankrupt and the nature of their transactions. Disputes occasionally arise regarding a party's entitlement to "customer" status. Creditors asserting "customer" status are usually required to submit to the debtor customer claim and account details very soon after a bankruptcy filing. It is, therefore, prudent to review the nature of your relationship with the potential broker-dealer or FCM debtor in anticipation of its bankruptcy filing.

Exchange Traded Funds

Knight Capital currently serves as an authorized participant of certain ETFs, in some cases, the lead market maker. Although ETFs are unlikely to have significant credit exposure to their authorized participants, they may wish to enter into authorized participant agreements with other firms in order to reduce the possibility that a bankruptcy of existing authorized participants might disrupt trading in the ETFs' shares.

Looking Ahead

Recent examples of financial distress among market participants serve as a reminder that it is best to be prepared for such circumstances. All of the issues discussed in this alert should be considered when clients are entering into or renegotiating agreements with financial intermediaries and counterparties. We would be happy to assist you with a review of your existing agreements with such parties and with an analysis of ways to strengthen your existing practices and procedures in connection with your entry into new relationships.

www.ropesgray.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions