Treatment of Hedge Fund Counterparties under House Legislation Resolution Authority Concerns Industry

This story appeared in Jim Hamilton's World of Securities Regulation.

The hedge fund industry has some concerns with the treatment of OTC derivatives in the event a hedge fund’s counterparty is liquidated under the resolution authority established by the House Wall Street Reform and Consumer Protection Act, HR 4173. While the protections afforded swap participants under the Act are substantially similar to those provided under the Bankruptcy Code, noted the Managed Funds Association in a letter to Treasury, the FDIC’s broad authority under the Act to make business decisions on behalf of the troubled firm is a concern.

The House legislation and the Bankruptcy Code grant substantially similar rights to swap participants, noted the MFA, with two notable exceptions. Like the Code, the Act provides that a counterparty cannot be prohibited from exercising a right it has under a qualified financial contract, which HR 4173 defines as including a swap agreement. Further, the Act’s definition of swap agreement is identical to the definition of swap agreement under section 101(53B) of the Code. In this respect, the Act allows a counterparty to a swap transaction the same rights of setoff or net out of any termination value, payment amount, or other transfer obligation arising under a qualified financial contract as is allowed by the Bankruptcy Code under section 362(b)(17).

However, the Act affirmatively limits the rights and remedies of counterparties to a qualified financial contract in two ways that differ from the Code: First, HR 4173 states that walkaway clauses that suspend or terminate the obligation of a party to make a payment under a contract solely because a receiver has been appointed with respect to the counterparty to the contract are not enforceable. Second, the House measure suspends payment obligations due under the qualified financial contract until the earlier of the time such party receives notice that the contract has been transferred; or 5:00 p.m. on the business date following the date of the appointment of the FDIC as receiver

The House legislation defines a walkaway clause as any provision in a qualified financial contract that suspends, conditions, or extinguishes a payment obligation of a party or does not create a payment obligation of a party that would otherwise exist, solely because of the party's status as a non-defaulting party in connection with the insolvency of a covered financial company that is a party to the contract or the appointment of or the exercise of powers by a receiver, and not as a result of a party's exercise of any right to offset or net contractual obligations.

The legislation also provides the FDIC with avoidance powers similar to those available to a bankruptcy trustee under sections 547 and 548 of the Code. However, as to payments made under qualified financial contracts, the general avoidance powers do not apply, and the FDIC, as receiver, is prohibited from recovering such payments unless they were made with actual intent to hinder, delay, or defraud the company, its creditors, or any receiver appointed for such company. The primary difference between this portion of the reform Act and the Bankruptcy Code is the absence of a limitation period. Section 548 of the Bankruptcy Code provides for a two-year look-back period for fraudulent transfers.

In the view of the MFA, it could be argued that this provision of the House measure permits a perpetual look-back period because, in section 1609(a)(12)(A) of the Act, Congress did provide for a five-year limitation period for fraudulent transfers. Thus, with respect to a qualified financial contract, the FDIC does not have general authority to avoid preferential transfers, but the FDIC is empowered to avoid transfers made with the actual intent to defraudm perhaps without a limitation period.

In addition, the Act authorizes the FDIC to stay any proceedings regarding creditor's claims, including any case filed under the Bankruptcy Code. Therefore, even though the Act grants parties to qualified financial contracts substantially similar rights to those of a swap participant under the Code, the Act affords the FDIC broad authority to determine the value, allowance, and disallowance of claims. Similarly, the House measure caps the FDIC's liability at that which would have been allowed if the company had been liquidated under the Code. Finally, while the reform legislation does provide for judicial review of the FDIC’s claim determinations, the review is by a federal district court and could lead to unpredictable results because bankruptcy court jurisprudence will not be dispositive. Likewise, judicial review of the FDIC’s claims determinations may be subject to the broad Chevron deference provided to administrative agencies.