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-----Original Message----- From: SandPUtil@StandardAndPoors.Com [mailto:SandPUtil@StandardAndPoors.Com= ] Sent: Thursday, December 20, 2001 10:17 AM To: Rohauer, Tanya Subject: Commodities Futures and Swaps Contracts: Set-Off and Bankruptcy Standard and Poor's RatingsDirect Link <http://www.ratingsdirect.com/img/r= dl.gif< This report was reproduced from Standard & Poor's Web-based credit ratings = and research service, RatingsDirect. Click here to get a FREE 30-day trial! <http://www.standardandpoors.com/rat= ingsdirect/eme104/< Your Connection to Standard & Poor's Utilities, Oil & Gas, and Project Finance Ratings Team Standard & Poor's is pleased to provide ongoing service to the investment c= ommunity. Research: <http://rd-digex.ratings.com/cgi-= bin/gx.cgi/AppLogic+GetArticle?Article_id=3D222929&fullGraphics=3Dtrue&Prin= t=3DYes< =20 <Javascript:enterLivePerson('standardandpoors','default','Research','')< Commodities Futures and Swaps Contracts: Set-Off and Bankruptcy =20 =20 Publication date: =20 10-Dec-2001 Analyst: =20 Sabine Zerarka, Esq. , New York (1) 212-438-6610; James Penrose, Esq. , New= York (1) 212-438-6604=20 =20 =20 Standard & Poor's regularly receives inquiries on the treatment of certain = types of financial contracts, such as commodity swaps and commodity futures= contracts, in the event of bankruptcy of one of the parties thereto. These= sorts of financial contracts are often used to hedge, or insure against, f= uture financial liabilities of at least one of the parties. Financial contr= acts take many forms. Many are executed pursuant to a master agreement, whi= ch provides for amounts owed from each party to the other to be deducted, o= r "set-off," so that a single amount will be owed by one party to the other= . As "risk transfer" mechanisms, financial contracts are an important sourc= e of market liquidity. Consequently, certain special types of financial con= tracts have special protection under the U.S. Bankruptcy Code. =20 In general, a bankruptcy filing triggers an "automatic stay" that restrains= creditors from taking actions against the debtor or its property. As a res= ult of the automatic stay, creditors in general cannot exercise contractual= remedies, such as the exercise of set-off and close-out rights, without th= e permission of the bankruptcy court. Because of the importance of financia= l contracts, however, Congress provided that the liquidity of the swap and = commodity markets would not be disrupted by the bankruptcy of participants = by exempting certain qualifying financial contracts from the automatic stay= . In appropriate cases, therefore, the nonbankrupt party's contractual righ= t to set off amounts owed to it under a particular financial contract again= st cash, securities, or other property of the bankrupt party held by or due= from the nonbankrupt party is protected notwithstanding the bankruptcy of = the counterparty. =20 Business dealings, of course, often result in more complicated issues than = can be addressed by a straightforward application of black-letter law. The = following are some of the questions that investors have asked about set-off= and netting of liabilities under financial contracts: =20 Q: What types of financial contract can be set-off or netted? =20 A: Financial contracts that qualify as protected contracts under the Code c= an be netted. Financial contracts must fall within certain definitions in t= he Code to qualify as protected contracts. The Code also requires that such= contracts must be between particular types of entities, such as commoditie= s brokers, financial institutions, stockbrokers, etc., in order for the fin= ancial contract to be protected under the Code. =20 Q: In a situation where Party "A" and Party "B" have entered into several d= ifferent financial contracts with each other, can Party A net its "in the m= oney" obligations against its "out of the money" obligations if Party B goe= s bankrupt? =20 A: With respect to financial contracts that are protected contracts under t= he Code definitions (and which by their terms permit termination and liquid= ation), Party A may terminate the contract, liquidate collateral, and net o= ut any termination values. Pursuant to Code sections 555, 556, 559, and 560= , these rights are not subject to the automatic stay, and cannot be avoided= or otherwise limited under the Code or by the bankruptcy court in a reorga= nization or a liquidation. =20 Furthermore, Code section 362, which establishes the automatic stay, create= s specific exceptions from the stay for set off of mutual claims under comm= odity contracts and set off of mutual claims under swaps that constitute th= e set off of a claim against the debtor for a "margin payment" or "settleme= nt payment". However, the stay does apply to "cross-product" set-offs--swap= claims against commodity contracts claims, for example. For cross-product = set-offs, Code section 553 provides that set-off rights are not affected by= bankruptcy but are subject to the automatic stay. Permission from the bank= ruptcy court, therefore, is necessary before Party B could exercise its con= tractual set-off rights across different types of financial contracts. Set-= off, in other words, is not automatic in these circumstances. Although cros= s-product netting may not be protected from the automatic stay, Party B is = still treated as a secured creditor to the extent of its set-off rights. = =20 Q: In what circumstances could a bankruptcy court rescind a netting of swap= or commodities claim? =20 A: Grounds for contesting set-off may include the failure of a particular f= inancial contract to qualify as a protected contract under the Code, or the= failure of a particular financial contract to permit set-off. =20 Q: Aside from any netting benefits realized by Party A against Party B, whe= re does Party A stand with respect to amounts owed to it under the financia= l contract that have not been realized through set-off? =20 A: After termination, liquidation, and set-off, Party A will have an unsecu= red claim against Party B. =20 Q: Are payments made by a debtor prior to bankruptcy under swaps or commodi= ty contracts at risk of being clawed back as a preferential transfer or fra= udulent conveyance? =20 A: Generally, no. Code section 546 provides that the bankruptcy trustee may= not avoid any prepetition margin or settlement payment made by or to a com= modity broker, forward contract merchant, stockbroker, financial institutio= n, or securities clearing agency; or any prepetition transfer under a swap = agreement made by or to a swap participant as a preferential transfer or fr= audulent conveyance, except where such payments are made with actual intent= to hinder, delay, or defraud creditors. =20 Q: In a situation where Party B goes bankrupt and there are financial contr= acts between Party A and Party B, where Party B is in the money; between Pa= rty B and Party C where Party C is in the money; and between Party C and Pa= rty A where Party A is in the money, can Party C set off its payment to Par= ty A to the extent of its claim against Party B? =20 A: No. Set-off in bankruptcy is only possible where "mutuality" exists (i.e= ., one party must owe a debt to another party); that other party must owe a= debt to the first party. As a result, Party A's claim will belong to the b= ankruptcy estate of Party B while Party C will be a general creditor of Par= ty B. No set-off will be permitted in these circumstances. =20 =20 =20 RatingsDirect Link is a FREE service provided by Standard & Poor's. If you = do not wish to receive further E-mails related to this topic only, please s= end a blank E-mail to leave-utility@ratingslist.standardandpoors.com <mailt= o:leave-utility@ratingslist.standardandpoors.com<.=20 If you do not wish to receive further E-mails on any topic, please click he= re <mailto:ratings_customerrelations@standardandpoors.com?subject=3Dunsubsc= ribe%20ALL%20RD-L< or send an E-mail with the subject "Unsubscribe" to rati= ngs_customerrelations@standardandpoors.com <mailto:ratings_customerrelation= s@standardandpoors.com< =20 If you would like to be added to this list, please send an E-mail to join-u= tility@ratingslist.standardandpoors.com <mailto:join-utility@ratingslist.st= andardandpoors.com<. 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