Appendix VII: Safe Harbors for Contracts under the Bankruptcy Code:
On the filing of a bankruptcy petition, the Code provides for an
automatic stay, or freeze, of any action by creditors to recover
assets from the debtor in possession. A debtor-in-possession (DIP) or
trustee, as the case may be, may, subject to the court's approval and
certain provisions in the Code, assume or reject any executory
contracts or unexpired leases, and may "avoid" any prepetition
preferential payments given to creditors within 90 days of the
filing.[Footnote 162] However, the DIP or trustee may not use any
"cash collateral," such as cash, securities, documents of title, or
other cash equivalents, without the consent of secured creditors and
the court. Secured creditors of the debtor receive payment from the
proceeds of the collateral, and if the collateral is insufficient to
pay the claim in full the balance becomes an unsecured claim.
Certain contracts, sometimes referred to as qualified financial
contracts (QFC), receive "safe harbor" protections from the automatic
stay by allowing counterparties to choose whether or not to terminate,
or "close-out," contracts underlying QFC transactions with a debtor.
If a collateralized QFC counterparty closes-out a contract, it can
remove and liquidate the collateral used to secure the transaction
before that collateral becomes part of the bankruptcy estate. Also,
the counterparty has the option, but is not obligated, to apply the
proceeds of the collateral liquidation to any amounts owed to the
debtor, a process called "netting." After netting, if the counterparty
is owed money by the debtor, it awaits payment under a reorganization
plan with the unsecured creditors. If it owed money to the debtor
after netting, the debtor would collect what it was owed and include
those funds in the estate for payment to creditors according to the
established order of priority.
In addition, the safe harbor for QFCs allows the QFC counterparty to
keep prepetition preferential payments, which can be understood by the
example of a CDS. A CDS is generally a contract between two parties
where the first party promises to pay the second party if a third
party experiences a credit event such as failing to pay a debt. If the
third party suffers a credit event, then the first party would be
required to post increased collateral to assure the second party that
it could meet its contractual obligation. On a bankruptcy filing of
the first party, without the safe harbor, the second party would
normally be required to return the increased collateral to the first
party's estate as a prepetition preferential payment. Instead, under
the safe harbor, the second party could close-out the CDS, liquidate
the collateral, and net the proceeds against its debts to the first
party.
AI
