United States: Using The Bankruptcy Code 'Safe Harbors'

Chapter 11 bankruptcy cases can be both fraught with peril and rich in opportunity. Nowhere is this more apparent than the energy sector, where special "safe harbor" provisions turn typical bankruptcy rules upside down. For potential debtors, creditors and distressed-asset purchasers, failing to understand the safe harbors can result in the evaporation of a contract's value or the loss of crucial supply and sale contracts. But, when properly understood, such parties can utilize the safe harbors to preserve asset value when facing financial distress or mitigate risk when contract counterparties hit the skids.

The Bankruptcy Code is very protective of a debtor. The "automatic stay" is a primary example. Section 365(e)(1) is equally helpful preventing counterparties from terminating contracts due to the debtor's insolvency (i.e., it invalidates "ipso facto" clauses).

On the other hand, recognizing the volatile nature and systemic importance of the financial and commodities markets and the risk of one firm's insolvency triggering a "domino effect" that spreads a financial contagion throughout the broader economy, Congress enacted safe harbor provisions that render numerous typically bedrock bankruptcy principles inapplicable to certain commodity and financial contracts. Most significantly, certain qualified parties to such contracts can enforce ipso facto clauses and contractual rights to liquidate, accelerate and setoff obligations.

However, absent careful planning and forethought, such safe harbor provisions may offer little utility and, in fact, present often unforeseen dangers. As such, when a company's bankruptcy looms on the horizon, parties must diligently evaluate their contracts to avoid shipwreck in the bankruptcy storm.

As a preliminary matter, a company must determine whether its contracts fall within the safe harbors, which require satisfaction of two preconditions. First, the contracts must fit within the Bankruptcy Code's definition of "commodity contract," "forward contract," "securities contract," "swap agreement," "repurchase agreement," or "master netting agreement." Second, the party must qualify as a "commodity broker," "forward contract merchant," "swap participant," "financial participant," "repo participant" or "master netting agreement participant." Crucially, extreme care must be taken when analyzing whether a particular contract and party fit within the Bankruptcy Code's safe harbor definitions because such definitions do not precisely comport with the terms' colloquial meanings. Moreover, a company enforcing its right and terminating a contract under the mistaken perception that the safe harbors apply faces severe liability, including punitive damages.

In addition, unique issues arise depending on whether a company anticipates becoming a debtor or counterparty in the potential bankruptcy proceeding. For counterparties, considerations differ depending on whether the contract is "in-the-money" or "out-of-the-money." For debtors, termination provisions must be analyzed carefully, lest the company enter bankruptcy seeking to reorganize, only to have crucial contracts terminated and value potentially destroyed.

Qualified counterparties to an "in-the-money" safe harbor contract can terminate the contract and potentially eliminate any related exposure to the debtor. This tack is often attractive when collateral fully secures the debtor's obligations. Conversely, when a debtor's obligations are unsecured or under-secured, a counterparty faces a more difficult decision, namely: (i) terminate the contract, receive a general unsecured claim for the amount by which its claim exceeds the value of its interest in the collateral, and potentially enter another contract with a third party, or (ii) continue performing under the contract, realize any appreciation in the value of the collateral and run the risk of the debtor rejecting the contract, or, worse, watch its unsecured exposure increase. In final analysis, such decision is highly fact-specific, varies depending on the party's appetite for risk, and should be made in consultation with experienced counsel.

Counterparties to an "out-of-the-money" safe harbor contract can likewise terminate the contract, but such termination could trigger a payment obligation or the debtor's contractual setoff rights. Notably, however, unlike a counterparty to an in-the-money contract, a counterparty to an "out-of-the-money" contract typically need not worry about the debtor rejecting the contract (because such contracts benefit the estate). And, although the debtor could assign such contract to a third party, assignment is impermissible absent cure of all contractual defaults and the provision of adequate assurance of future performance.

As for potential debtors, perhaps the greatest risks of safe harbor contracts relate to termination provisions. First, for debtors with "in-the-money" contracts containing "one-way termination payment provisions" (i.e., such that a defaulting party does not receive a termination payment), which are notably common in 1992 ISDA Master Agreements and bilateral forward contracts, commencing a bankruptcy case could allow a counterparty to terminate the agreement and avoid termination payment obligations. Second, failing to analyze termination provisions of supply and sale agreements could result in the termination of such agreements and severe disruptions to the debtor's business. In other words, a company that files for bankruptcy without conducting proper due diligence could not only see the value of its in-the-money contracts evaporate, but could see crucial contracts terminated causing severe disruption to its operations.

Although the safe harbor provisions pose significant risks for the unwary, all hope need not be lost. For the savvy, even the most pernicious traps of the safe harbor provisions can be side-stepped. For instance, potential debtors (or purchasers of their assets) can avoid the risks posed by safe harbor contracts with one-way termination payment provisions by selling such contracts before filing for bankruptcy. Likewise, all parties can limit the fallout of a bankruptcy proceeding by evaluating the liquidation, termination, acceleration, setoff, and ipso facto provisions of their contracts and entering bankruptcy "with their eyes open." Although there is no substitute for the advice of experienced counsel, by proactively addressing the unique risks posed by the Bankruptcy Code safe harbor provisions, you can help your company weather any bankruptcy storm.

This article was originally published in Daily Bankruptcy Review on July 10, 2013.

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.

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