DATE DOWNLOADED: Sun Sep 24 00:55:32 2023

SOURCE: Content Downloaded from HeinOnline

Citations:
Please note: citations are provided as a general guideline. Users should consult their preferred
citation format's style manual for proper citation formatting.

Bluebook 21st ed.

John C. Dugan, Derivatives: Netting, Insolvency, and End Users, 112 BANKING L.J. 638
(1995).

ALWD 7th ed.

John C. Dugan, Derivatives: Netting, Insolvency, and End Users, 112 Banking L.J. 638
(1995).

APA 7th ed.

Dugan, J. C. (1995). Derivatives: netting, insolvency, and end users. Banking Law
Journal, 112(7), 638-659.

Chicago 17th ed.

John C. Dugan, "Derivatives: Netting, Insolvency, and End Users," Banking Law Journal
112, no. 7 (July-August 1995): 638-659

McGill Guide 9th ed.

John C. Dugan, "Derivatives: Netting, Insolvency, and End Users" (1995) 112:7 Banking
LJ 638.

AGLC 4th ed.

John C. Dugan, 'Derivatives: Netting, Insolvency, and End Users' (1995) 112(7)
Banking Law Journal 638

MLA 9th ed.

Dugan, John C. "Derivatives: Netting, Insolvency, and End Users." Banking Law
Journal, vol. 112, no. 7, July-August 1995, pp. 638-659. HeinOnline.

OSCOLA 4th ed.

John C. Dugan, 'Derivatives: Netting, Insolvency, and End Users' (1995) 112 Banking
LJ 638 Please note: citations are provided as a general guideline.
Users should consult their preferred citation format's style manual for proper
citation formatting.

Provided by:
Available Through: Pontificia Universidad Catolica de Chile

-- Your use of this HeinOnline PDF indicates your acceptance of HeinOnline's Terms and
Conditions of the license agreement available at
https://heinonline.org/HOL/License
-- The search text of this PDF is generated from uncorrected OCR text.
-- To obtain permission to use this article beyond the scope of your license, please use:
Copyright Information
 DERIVATIVES: NETTING, INSOLVENCY,
AND END USERS

John C.Dugan*

This article, targeted not to swap dealers, but to

relatively unsophisticated end-users of derivatives and
their counsel, is intended to provide a simple, "plain
English" explanation of one very important but very
technical aspect of the risk of using derivatives, that is,
the ability to enforce a close-out netting agreement
againsta counterpartythat defaults and becomes insol-
vent. The article also suggests a practical,step-by-step
method for determining the degree to which such legal
risk is involved with different types of counterparties
and different types ofderivative instruments.

Institutions are increasingly using swaps and other over-the-

counter financial derivatives to manage various forms of risk.
However, as a number of events in the last year have demonstrated,
these derivatives (collectively called "swaps" for purposes of this
article) may themselves expose an institution to risks that must be
managed. One such risk that has been less well-publicized is the so-
called "legal risk" that the contractual agreement underlying a
set of derivatives transactions between two parties-the "swap
agreement" -will not be enforced in the event of the insolvency of
one of the parties. The focus of concern is with certain provisions
in the swap agreement that govern the practice of "netting" or
"setting off" payments that swap counterparties owe to each other.
The issue is whether a swap user could be precluded under U.S.
bankruptcy law from exercising a "close-out netting" provision if
the swap counterparty were insolvent at the time of the default. If
so, the swap user could be exposed to substantial losses.
In general, this type of legal risk has been greatly reduced by
recent amendments to U.S. law. Nevertheless, it is still possible
* Partner, Covington & Burling, Washington, D.C.

638
 DERIVATIVES

that a close-out netting provision would not be enforced with

respect to certain types of swap agreements or certain types of
counterparties, or that such enforcement would be delayed or would
fail to produce a single net amount due or owed.'
Accordingly, this article discusses the enforceability of swap
netting provisions under U.S. law. Its principal focus is not on swap
dealers, who are generally very much aware of the legal risk
involved with netting agreements. Instead, the purpose of the article
is to familiarize the so-called "end-users" of swaps, particularly
those who have used these instruments only sparingly, with both
the legal risk involved and the means for minimizing such risk.
The article first provides additional background concerning
the circumstances that may give rise to potential losses from the
inability to exercise a close-out netting provision and then provides
a brief overview of relevant U.S. law. The article concludes with a
"checklist" that end-users may employ in a variety of circumstances
to determine whether a close-out netting provision could be exer-
cised against an insolvent counterparty under U.S. law.

Background
In general, the two counterparties to a swap agree to exchange
two different payment streams. For example, in one typical type of
interest rate swap, one party agrees to pay its counterparty a floating
rate of interest on a hypothetical or "notional" amount of principal
for a specified period of time; in return, it receives from its
counterparty a fixed rate of interest on the same amount of notional
principal for the same period of time. The two counterparties,
however, do not actually pay the full amount of each payment
stream to each other. Instead, because of the swap agreement's
netting provision, the counterparties will periodically net their
obligations against each other so that only the net amount due from
one party to the other actually changes hands. Moreover, because
counterparties often enter into a number of different swap transac-

The risk of unenforceability may be significantly greater if the insolvent counterparty is foreign,
because U.S. bankruptcy law likely would not apply. This same risk would apply if the swap
agreement is not governed by U.S. law. Indeed, commercial banks may be required to obtain legal
opinions as evidence of the enforceability of netting provisions that involve foreign counterparties.
See, e.g., Office of the Comptroller of the Currency, "Questions and Answers for BC-277: Risk
Management of Financial Derivatives," OCC Bull. 94-31, Q&A 46 (May 10, 1994).

639
BANKING LAW JOURNAL

tions with each other, they frequently enter into a single "master
agreement" covering all such transactions. Such a master agreement
typically includes a netting provision that produces a single net
payment due or owed at particular points in time with respect to all
payment obligations arising from all transactions covered by the
master agreement.
Finally, a swap master agreement usually includes "early
termination" and "close-out netting" provisions. The early termi-
nation provision permits a party to terminate the master agreement
and all related swap trades based upon a counterparty's default (and
under certain other circumstances). The close-out netting provision
then permits the healthy counterparty to calculate a single net
amount payable to or owed by the insolvent counterparty at the time
of the termination in connection with all transactions covered by
the agreement. The purpose of the provision is to make this single
net amount the sole measure of all payments due or owed by the
counterparties to each other.
The legal risk arises when the defaulting counterparty is
insolvent or bankrupt; the issue under U.S. law is whether "auto-
matic stay" provisions of the U.S. Bankruptcy Code, U.S. federal
banking laws, or any other law would prevent the exercise of the
early termination or close-out provisions. If so, there might be no
cross-netting of amounts due or owed under individual swaps
covered by the swap agreement. This in turn might permit a
bankruptcy trustee for the insolvent counterparty to engage in
"cherry-picking," that is, honoring net payments due for only those
swaps where the insolvent counterparty was owed money, while
"staying" all net payments due on swaps where the healthy counter-
party was owed money (these "stayed" obligations of the insolvent
party would be subject to the normal liquidation/distribution of
claims process). In short, even if the healthy counterparty were
owed money on a net basis at the time of termination, it might be
forced to pay substantial sums to its insolvent counterparty with
possibly little or no prospect of receiving in return the even greater
sums it would be owed. Alternatively, even if a close-out netting
provision were ultimately enforced, the insolvency process might
result in costly delays in reaching a single amount due or owed.
Because of the large potential losses involved, it is obviously
critical to determine the enforceability under U.S. law of early

640
 DERIVATIVES

termination and close-out netting provisions against an insolvent

counterparty.2

Overview of U.S. Law

As a contractual agreement between two parties, swap termina-
tion and netting provisions governed by U.S. law normally would
be enforceable under basic principles of contract law. Before 1989,
however, there was uncertainty about whether such provisions
would be enforced against an insolvent counterparty, especially
where the agreement covered different types of transactions. In
these circumstances, the receiver for an insolvent counterparty
typically had broad authority to invoke "automatic stay" provisions
under applicable U.S. laws to prevent the enforcement of particular
contractual claims against the insolvent company.
However, the stability of the swap market depends on the
enforceability of netting provisions in virtually all circumstances,
including insolvencies. Accordingly, Congress has significantly
amended U.S. law on three separate occasions in recent years to
ensure that swap netting provisions will nearly always be enforced,
even against insolvent counterparties.
The first amendment was to the federal banking laws to prevent
an automatic stay when the insolvent counterparty is a federally-
insured depository institution. The second amendment was the
addition of similar language to the U.S. Bankruptcy Code to
prevent an automatic stay when the insolvent counterparty is a U.S.
corporation other than a bank or an insurance company. The third
amendment was an attempt to ensure that netting provisions are
enforced in a number of situations not specifically covered by the
first two amendments.
2 Moreover, commercial banking organizations have an important additional reason for making

this determination; that is, it may reduce their required level of regulatory capital. In general, a bank
must hold capital against any amount due to it from a swap counterparty (just as it must hold capital
against outstanding loans). Because the net amount due from a swap conterparty will nearly always
be lower than the gross amount due, a bank would much prefer to have its capital requirement
calculated on a net basis rather than a gross basis. The bank regulators have recently adopted
regulations to permit exactly this practice, but only where the swap's netting provision is clearly
enforceable in all relevant jurisdictions. See, e.g., Risk-Based Capital Standards; Bilateral Netting
Requirements, 59 Fed. Reg. 66,645, 66,651-66,653 (1994) (to be codified at 12 CFR Pt. 3 and Pt.
567) (Dec. 28, 1994) (Office of the Comptroller of the Currency and Office of Thrift Supervision
regulations applying to national banks and savings associations, respectively). To establish this
enforceability, a bank must obtain a written legal opinion to that effect and satisfy other documentation
requirements. Id.

641
BANKING LAW JOURNAL

These three amendments to federal law have made virtually all

swap netting provisions enforceable against insolvent counterparties
(provided, of course, that enforceability is governed by U.S. law).
Nevertheless, it is still possible that a particular swap agreement
with a particular counterparty would not be governed in whole or
in part by any of these amendments. The close-out netting provisions
in such agreements therefore might be subject to the automatic stay
provisions of the federal banking laws, the U.S. Bankruptcy Code,
or even state law, or they might be subject to delayed or partial
enforcement.
A discussion of the three different amendments to federal law
and a brief discussion of state law follow.

Federal Banking Laws

The Federal Deposit Insurance Act (FDIA) governs the insol-
vency of U.S. insured depository institutions.' These include na-
tional banks, state banks, savings associations, and U.S. branches
of foreign banks, so long as their deposits are insured by the
Federal Deposit Insurance Corp. (FDIC). The FDIA does not cover
insolvencies of uninsured branches of foreign banks. (Most foreign
branches operating in the United States are not federally insured.)
A more detailed list of institutions covered by the FDIA is attached
as Appendix A. 4
In 1989, Congress amended the FDIA to clarify that its
automatic stay provision would not apply to swap agreements., A
"swap agreement" is defined as:

"12 USC §§ 1812-1832 (1988). It should be observed that, in rare cases, the FDIC may not act
as the conservator or receiver of a failed state depository institution. In such a case, state law would
determine whether a netting provision would be subject to an automatic stay.
' Unlike insolvencies governed by the U.S. Bankruptcy Code, only bank regulators may place a
bank into receivership or conservatorship. Thus, a third party may not force a bank into receivership
or conservatorship; nor may the bank place itself into receivership or conservatorship without the
FDIC's consent. In a receivership, the bank effectively ceases operations. In a conservatorship, the
bank continues to do business under FDIC control until it is placed into receivership. Thus,
receivership is the rough equivalent of a Chapter 7 liquidation under the Bankruptcy Code, and
conservatorship is the rough equivalent of a Chapter 11 reorganization under the Bankruptcy Code.
The FDIA lists specific conditions under which a bank can be placed in receivership or conservatorship.
These include, for example, instances when the bank has insufficient assets to meet its obligations to
creditors and others, the bank consents to placement in receivership or conservatorship, or the bank
fails to meet certain capital adequacy standards required under the federal banking laws.
5 12 USC § 1821(e)(8).

642
 DERIVATIVES

any agreement, including the terms and conditions incorporated by refer-

ence in any such agreement, which is a rate swap agreement, basis swap,
commodity swap, forward rate agreement, interest rate future, interest
rate option purchased, forward foreign exchange agreement, rate cap
agreement, rate floor agreement, rate collar agreement, currency swap
agreement, cross-currency rate swap agreement, currency future, or cur-
rency option purchased or any other similar agreement.6

The term also includes any combination of such agreements and the
option to enter into any such agreement. In addition, any master
agreement that permits separate transactions of the kind set forth in
the definition will be treated as a single swap agreement. This means
that a netting provision in a master agreement would be enforced
with respect to a series of individual swap transactions covered by
the master agreement; it would not be necessary to have separate
netting provisions for each covered transaction.
This definition of swap agreement is quite broad and therefore
clearly would apply to standard interest rate and foreign currency
swap agreements modeled after the International Swap and Deriva-
tives Ass'n (ISDA) standard agreements. Moreover, the reference
in the definition to "any other similar agreement" provides flexibil-
ity for the inclusion of other types of swap or derivative agreements
that are not specifically mentioned. For additional information on
the scope of the definition, see the chart included as Appendix B.
Nevertheless, until specific determinations are made by U.S.
regulators or courts, there will remain some uncertainty as to
whether a close-out netting provision would be subject to the FDIA's
automatic stay provision if it involved swaps or derivatives that are
not specifically mentioned in the statutory definition of "swap
agreement."I These would include, for example, an equity or equity
index swap, equity or equity index option, bond option, or spot
foreign exchange agreement. The same uncertainty also would exist
for a netting provision in a master agreement that covers transactions
in different types of instruments, some of which clearly fall within
the swap definition, and some of which do not.
This uncertainty would be mitigated if the instruments not
covered by the exemption for "swap agreement" were separately
612 USC § 182 1(e)(8)(D)(vi).
7Legislation has been proposed to expand the definition of "swap agreement" in the FDIA. See
HR 20, 104th Cong., Ist Sess., § 301 (1995).

643
BANKING LAW JOURNAL

covered by the exemptions for "forward contracts" or "securities

contracts" under the FDIA. While this may well be the case for a
number of instruments that have securities or forward characteris-
tics, the analysis is complicated and the outcome not yet certain.
Moreover, even if covered by separate exemptions, issues arise
concerning the ability to enforce a single net amount from separate
net amounts due or owed under each individual exemption from the
automatic stay.
It should also be observed that there are limited circumstances
in which a party to a swap agreement may be prevented from
exercising an early termination provision against the FDIC. First,
where the FDIC is appointed the receiver of a failed bank, it appears
that a counterparty may not exercise an early termination provision
until the day after the appointment.' During this period, the FDIC
may transfer the institution's swap agreements to a third party, but
only if all of the institution's "qualified financial contracts,"
including all "swap agreements," are so transferred.' This require-
ment prevents the FDIC from "cherry-picking" particular swaps
for transfer to a third party in order to maximize gains for the
receivership and maximize losses for the receivership's counter-
party. 0
Second, if a failed bank counterparty were placed in conserva-
torship rather than receivership, and the FDIC continued to satisfy
the terms of the swap agreement while acting as a conservator, a
healthy counterparty could not exercise an early termination provi-
sion merely because the bank had been placed in conservatorship."
If the conservatorship were to default for any other reason, however,
such as by failing to make timely payments, its counterparty could
then exercise the early termination provision and engage in close-
out netting.
U.S. Bankruptcy Code
The U.S. Bankruptcy Code applies to the insolvencies of
virtually all U.S. corporations other than insurance companies and
' See 12 USC §§ 1821(e)(8)(A), 1821(e)(10); FDIC Statementsof Policy 5113 (Dec. 12, 1989).
9 A "qualified financial contract" is defined as "any securities contract, commodity contract,
forward contract, repurchase agreement, swap agreement, and any similar agreement that the [FDIC]
determines by regulation to be a qualified financial contract." 12 USC § 182 1(e)(8)(D)(i).
1n 12 USC § 1821(e)(9).

"12 USC § 1821(e)(8)(E).

644
 DERIVATIVES

banks.12 Such corporations include commercial and manufacturing

companies as well as financial companies like stock and commodity
brokers.' Appendix A provides additional information about the
types of companies covered by the Bankruptcy Code.
In 1990, Congress adopted amendments to the Bankruptcy
Code that were very similar to the FDIA amendments discussed
above. These amendments provide that the Bankruptcy Code's
automatic stay provision does not apply to swap agreements. 4
Moreover, the Bankruptcy Code definition of "swap agreement"
is virtually identical to the FDIA's definition, with the following
exceptions. 5 The Bankruptcy Code definition expressly covers spot
foreign exchange agreements,' 6 but the FDIA definition does not.
However, the FDIA definition expressly covers interest rate futures
and currency futures, while the Bankruptcy Code does not. For
additional information on the definitions, see the chart included as
Appendix B. 7
Again, as in the FDIA, the swap agreement definition in the
Bankruptcy Code is broad enough to cover standard ISDA-style
interest rate or currency swap agreements. However, the same
uncertainty also exists with respect to agreements that cover instru-
ments not specifically identified in the statute; it is at least possible
that close-out netting provisions with respect to such agreements
would be subject to the automatic stay. Likewise, the same uncer-
tainty would exist for a netting provision in a master agreement that
covers transactions in different types of instruments, some of which
clearly fall within the swap definition, and some of which do not.
As with the FDIA, this uncertainty would be reduced to the extent
that such instruments fall within the Bankruptcy Code's separate
exemptions from the automatic stay for "securities contract" or
2 The Bankruptcy Code also may apply to a foreign bank, provided that it is not engaged in
business in the United States, but only holds assets or maintains accounts in the United States.
' Stockbrokers and commodity brokers are eligible debtors only for so-called "liquidation"

bankruptcy under Chapter 7 of the Bankruptcy Code, but not "reorganization" under Chapter 11 of
the Bankruptcy Code. The automatic stay provisions, including the exemption for swap agreements,
apply equally to Chapter 7 and Chapter 11 filings.
" 11 USC § 362(b)(14).
11 USC § 101(55).
6 "Spot foreign exchange agreement" was added to the definition of "swap agreement" in
Section 216 of the recently-enacted Bankruptcy Reform Act of 1994. H.R. 5116, 103d Cong., 2d
Sess. (1994).
'7 As with the FDIA definition, legislation has been proposed to expand the definition of "swap

agreement" in the Bankruptcy Code. See H.R. 20, 104th Cong., Ist Sess., § 306 (1995).

645
BANKING LAW JOURNAL

"forward contract." Again, however, while strong arguments

may be made that those separate exemptions would apply to a
number of different instruments, the outcome is not yet certain;
moreover, even if separate exemptions were applicable, complex
cross-netting issues and costly delays could very well arise."
Finally, it should also be observed that, unlike insolvencies
governed by the federal banking laws, there are no narrow excep-
tions that would prevent a counterparty from terminating or netting
a swap agreement or exercising a close-out netting provision when
the other party begins formal bankruptcy proceedings or becomes
insolvent. Although Section 365(e) of the Bankruptcy Code gener-
ally prevents a party from terminating an agreement solely because
the agreement has a provision that allows the party to terminate if
the other party begins bankruptcy proceedings, this rule does not
apply to swap agreements. A swap counterparty may enforce its
contractual rights to terminate and to net obligations under the swap
agreement, even if the other party files for bankruptcy.20

FDICIA Provision
Even after the amendments to both the FDIA and the Bank-
ruptcy Code, it remained possible that close-out netting provisions
in agreements covering certain types of derivatives, as discussed
previously, would be subject either to the automatic stay provisions
of those laws or to delays and complex cross-netting issues. It was

" See 11 USC §§ 101(25) (definition of "forward contract"), 362(b)(6) (exemption provision
that may be applicable), and 741(7) (definition of "securities contract").
" A question that arises under both the Bankruptcy Code and the federal banking laws is whether
exercising a netting provision before the swap agreement counterparty begins bankruptcy proceedings
or is placed in conservatorship or receivership is an avoidable preference. Both the Bankruptcy Code
and the federal banking laws protect swap agreement counterparties from this possibility.
Section 546(g) of the Bankruptcy Code provides that a bankruptcy trustee is not entitled to reclaim
property that was transferred to a swap creditor before commencement of the bankruptcy case. 11
USC § 546(g). The only exception to this rule is if the transfer was made with actual intent to defraud
other creditors. 11 USC § 548(a)(1).
The FDIA contains similar protections. It provides that the FDIC, whether acting as a conservator
or receiver of a failed bank, may not avoid any transfer of money or property in connection with a
"qualified financial contract," including a swap agreement, unless the transfer was made with actual
intent to defraud the bank, other creditors, or the FDIC. 12 USC § 1821(e)(8)(C). This protection is
somewhat broader than the protection provided under the Bankruptcy Code. Under the FDIA, all
"qualified financial contracts" are covered, which includes swap agreements, securities contracts,
repurchase agreements, and certain other types of financial instruments. 12 USC § 1821(e)(8)(D).
Under the Bankruptcy Code, only swap agreements are covered.
20 11 USC § 560.

646
 DERIVATIVES

also possible that swap agreements with certain types of insolvent

counterparties, such as insurance companies, would be governed
by state law rather than the FDIA or the Bankruptcy Code. In this
latter situation, the enforceability of netting provisions could vary
from state to state, depending upon the applicability of automatic
stay provisions in the relevant jurisdiction.
In the Federal Deposit Insurance Corporation Improvement
Act of 1991 (FDICIA), Congress attempted to address these gaps,
particularly with respect to institutions that are significant partici-
pants in swap markets. However, to achieve this goal, Congress
took an entirely different approach. The FDICIA provision does
not focus on the FDIA and the Bankruptcy Code or their definitions
of "swap agreement." Instead, the provision focuses exclusively
on the netting agreement itself and the nature of the counterparties
to the agreement.
Put simply, under the FDICIA rule, if a netting provision
qualifies as a "netting contract," and if the counterparties qualify
as "financial institutions," then the netting provision will be en-
forced-regardless of the type of financial agreement, and regardless
of the FDIA, the Bankruptcy Code, or any other federal or state
law. 2 Thus, the FDICIA rule is potentially much broader than the
earlier amendments to the FDIA and the Bankruptcy Code.22
To qualify as a "netting contract," the netting provision must
"provide[] for netting present or future payment obligations or
payment entitlements (including liquidation or close-out values
relating to the obligations or entitlements) among the parties to the
agreement."'23 The netting provision in most swap agreements would
satisfy this condition.
Qualifying as a "financial institution," however, is somewhat
more complex. First, it is important to note that both counterparties
must qualify as "financial institutions," unlike the provisions in
the FDIA or the Bankruptcy Code, which apply only to the insolvent

12 USC §§ 4403, 4405.

* Indeed, it is possible that the FDICIA provision may be interpreted as overriding the FDIA's
narrow limitation on the ability of a counterparty to engage in close-out netting against the FDIC
during the one-day period following the appointment of a receiver for a failed institution. On the
other hand, it may also be argued that the FDICIA override does not apply to the FDIC's ability to
stay an early termination provision during this period, which would mean that close-out netting would
never come into play.
2 12 USC §4402(14)(A).

647
BANKING LAW JOURNAL

counterparty. Second, the term "financial institution" has both a

statutory definition and a regulatory definition. An institution may
qualify as a "financial institution" by satisfying either the statutory
definition or the regulatory definition.
FDICIA Statutory Definition. The FDICIA statutory definition
refers to particular types of institutions. These consist of securities
brokers and dealers, futures commission merchants, and depository
institutions. The term "depository institution" is more broadly
defined in the FDICIA statutory definition than in the FDIA. The
FDIA primarily covers federally-insured depository institutions,
like national banks, state banks, and savings associations; the
FDICIA statutory definition covers these depository institutions,
but also covers uninsured branches or agencies of foreign banks,
Edge Act Corporations, and Agreement Corporations (the latter
two are typically subsidiaries of U.S. banks that operate outside the
United States). A more detailed list of institutions expressly covered
by the FDICIA statutory definition is included in Appendix A.
FDICIA Regulatory Definition. The FDICIA provision also
permits the Federal Reserve to designate additional "financial
institutions" by regulation. Pursuant to this authority, the Federal
Reserve has issued a regulation that includes a broad "activity-
based" definition of other institutions that qualify as "financial
institutions."24 Unlike the statutory definition, the regulatory defini-
tion does not focus on a particular type of financial institution.
Instead, any person or legal entity may qualify, regardless of status-
whether it is foreign or domestic, or whether it is a corporation,
partnership, governmental unit, or any other kind of legal entity.
This is obviously a broad definition, and plainly would cover
insurance companies, as well as any commercial corporation.
However, unlike the statutory definition, the regulatory defini-
tion of "financial institution" also requires that the person be
a significant dealer in financial markets. More specifically, the
regulatory definition requires an institution to satisfy two activity-
based criteria.
First, it must represent that it will engage in "financial con-

24 Netting Eligibility for Financial Institutions, 59 Fed. Reg. 4780, 4784 (1994) (to be codified at

12 CFR §231).

648
 DERIVATIVES

tracts" as a counterparty on both sides of one or more financial

markets-in other words, it must hold itself out to the market as a
dealer of such contracts. A financial contract is defined as a
"qualified financial contract" under the FDIA, which in turn is
defined as "any securities contract, commodity contract, forward
contract, repurchase agreement, swap agreement, and any similar
agreement that the [FDIC] determines by regulation to be a qualified
financial contract."25 (The term "swap agreement" in the FDIA
picks up the definition discussed above.)
Second, the party must either (1) have had one or more financial
contracts of a total gross dollar value of at least $1 billion in notional
principal amount outstanding on any day during the past fifteen
months with unaffiliated counterparties, or (2) have had total gross
mark-to-market positions of at least $100 million in one or more
financial contracts on any day during the past fifteen months. While
these numbers may appear large at first glance, as a practical matter
the threshold likely will be met by a wide range of participants in
the financial markets.
The regulatory definition also provides that, if a counterparty
qualifies as a "financial institution" at the time it enters into a
netting agreement, the netting agreement will be enforceable under
the FDICIA provision even if the counterparty subsequently ceases
to be a "financial institution" because of a subsequent decline in
market participation. Likewise, a netting provision under a master
agreement entered into when the counterparty qualified as a "finan-
cial institution" under the regulatory definition would continue to be
protected even if the counterparty engages in individual underlying
transactions after it ceases to qualify as a "financial institution."
In sum, the FDICIA provision is the most expansive of the
three amendments to federal law that were intended to ensure the
enforceability of close-out netting provisions. It applies to more
types of agreements and more types of counterparties, and preempts
all conflicting state or federal law. If the regulatory definition of
"financial institution" proves in fact to be a relatively easy test to
satisfy, then the FDICIA standard will provide the most certainty
of the enforceability of close-out netting provisions than any other
U.S. law.

5 12 USC § 182 1(e)(8)(D)(i).

649
BANKING LAW JOURNAL

State Law
In the rare cases in which neither the FDIA, the Bankruptcy
Code, nor the FDICIA provisions apply, state law would generally
determine whether a netting provision found in a swap agreement
would be subject to an injunction or stay that would prevent the
netting provision from being exercised. The institutions most likely
to receive state law treatment would be insurance companies,
especially ones that are not significant dealers in financial contracts.
This is so because the insolvencies of insurance companies are not
governed by either the FDIA or the Bankruptcy Code, and, if they
are not significant dealers of financial contracts, they would not
qualify as "financial institutions" under the FDICIA provision.
Thus, the enforceability of netting provisions against insolvent
insurance companies could vary from state to state.

Checklist
The general legal principles discussed previously may be
applied to specific fact patterns by using the four-part checklist set
forth below. This checklist is also presented as a flowchart in
Appendix C.

Step 1: Applicability of U.S. Law

Determine whether the agreement is governed by federal law
or the law of any state in the United States. Most agreements will
include an express "choice-of-law" provision that expresses the
intent of the parties as to which law should govern, and such
provisions are generally honored by courts. If there is no express
choice-of-law provision, general choice-of-law principles would be
applied. Apart from choice-of-law issues, if a counterparty is
foreign, there is a substantial likelihood that foreign law would
govern its insolvency as it relates to all obligations, including swap
obligations. Obviously, if United States law does not apply, there
is no reason to examine the effect of other provisions of U.S. law.

Step 2: Applicability of FDICIA Provision

Assuming U.S. law governs, determine whether the FDICIA
provision applies before examining the applicability of the FDIA
or the Bankruptcy Code. Examine the FDICIA provision first

650
 DERIVATIVES

because it applies the most broadly of any other applicable U.S.

law.
The FDICIA analysis has two parts: (1) determining whether
the netting provision is the type governed by FDICIA, and (2)
determining whether both parties to the agreement are "financial
institutions.
Nature ofNetting Provision. To qualify for the exemption from
automatic stays, the netting provision must "provide[ ] for netting
present or future payment obligations or payment entitlements
(including liquidation or close-out values relating to the obligations
or entitlements) among the parties to the agreement."' 2 Most swap
netting provisions would satisfy this requirement.
Determinationof "FinancialInstitution". Determine whether
both parties to the agreement are "financial institutions" under
either (1) the FDICIA statutory definition or (2) the FDICIA
regulatory definition.
FDICIA Statutory Definition. The FDICIA statutory definition
of "financial institution" consists of securities brokers and dealers,
futures commission merchants, U.S.-insured depository institu-
tions, uninsured branches or agencies of foreign banks, and other
institutions listed in Appendix A. (Obviously, commercial firm end-
users could not satisfy the statutory definition.) An institution that
meets this statutory definition does not have to satisfy the activity-
based regulatory definition, that is, it does not have to be a significant
participant in any financial market to qualify as a "financial institu-
tion."
FDICIA Regulatory Definition. If either party to the agreement
does not clearly satisfy the statutory definition, determine whether
such party satisfies the Federal Reserve's regulatory definition. The
regulatory definition requires a party to satisfy two criteria.
First, the party must represent that it will engage in "financial
contracts" as a counterparty on both sides of one or more financial
markets. Thus, an end-user that fails to satisfy the statutory defini-
tion would be required to make such a representation. If it is the
end-user's counterparty that fails to satisfy the statutory definition,
16 12 USC § 4402(14)(A).

651
BANKING LAW JOURNAL

then it would be necessary for the end-user to ask for and receive
the representation from the counterparty (which the counterparty
should have no trouble providing it if is a swap dealer, as it likely
would be). The Federal Reserve has stated that it is permissible to
rely on a party's representation for purposes of satisfying the
definition. It is not necessary to actually prove that the party is such
a financial market participant. (Appendix D is a sample letter to
a potential counterparty that requests various representations to
demonstrate that the counterparty is a "financial institution" under
the FDICIA regulatory definition. Question 2 of the letter requests
the specific representation by the counterparty that it will engage as
a counterparty on both sides of one or more financial contracts.)
Second, the party must either (1) have had one or more financial
contracts of a total gross dollar value of at least $1 billion in notional
principal amount outstanding on any day during the past fifteen
months with unaffiliated counterparties, or (2) have had total gross
mark-to-market positions of at least $100 million in one or more
financial contracts on any day during the past fifteen months. To
determine whether a counterparty satisfies this second criterion, an
end-user should ask for and receive a representation from the
counterparty that it does in fact satisfy either of these quantitative
criteria. The counterparty's response should include supporting
documentation to verify the quantitative representations, including
publicly available documents such as an annual report. (The sample
letter in Appendix D specifically requests this information.) If any
doubt remains after examining the response to the request, it may
be prudent for an outside auditor to verify the reports.
In sum, if the FDICIA provision is applicable because the
netting provision is a "netting contract," and the two parties to
the swap agreement are "financial institutions," then the netting
provision will be enforced even if the counterparty becomes insol-
vent. In such circumstances, there is no need to proceed to any of
the additional steps set forth below in the checklist. On the other
hand, if the FDICIA provision does not apply, proceed to the third
step in the checklist."
" As a practical matter, a commercial firm end-user is unlikely to be able to take advantage of the
FDICIA provision because it is unlikely to qualify under either the statutory or regulatory definition
of "financial institution." However, a financial firm end-user, such as a smaller depository institution
or the branch of a foreign bank, could very well take advantage of the provision; it would qualify
under the statutory definition of "financial institution," and the swap dealer that would be its likely
counterparty would almost certainly qualify under the regulatory definition of "financial institution."

652
 DERIVATIVES

Step 3: Determination of Governing U.S. Insolvency Law

If the FDICIA provisions do not clearly apply, determine
which U.S. insolvency law would govern if the U.S. counterparty
became insolvent and defaulted-the FDIA, the Bankruptcy Code,
or state law.28 This determination depends on the type of institution
involved.
FDIA. If the insolvent institution is an insured depository
institution, such as a national bank, a state bank, or a savings
association, the FDIA will apply. Remember, however, that foreign
banks and uninsured branches of foreign banks operating in the
United States would not be covered. For a more detailed list, see
Appendix A.
Federal Bankruptcy Code. If the insolvent counterparty is a
U.S. corporation, other than a bank or an insurance company, the
Bankruptcy Code would likely apply to its insolvency. For a more
detailed list, see Appendix A.
State Law. If neither the FDIA nor the Bankruptcy Code
would govern the insolvency of a potential counterparty, then state
insolvency law would apply. For example, if the counterparty in
this category were an insurance company, state insolvency law for
insurance companies would apply.
Determining which state law would apply will depend generally
on the place of incorporation of the counterparty.
Step 4: Applicability of Stay Provisions Under Specific Laws
Once it has been decided whether the FDIA, the Bankruptcy
Code, or state law would govern the agreement in question, deter-
mine whether the stay provisions of that law, if any, would apply to
the agreement.
Applicability of Stay Provisions Under U.S. Banking Law. If
governed by federal banking law, determine whether the exemption
from the automatic stay provisions applies to this kind of contract.
As discussed earlier, the exemption applies to a "swap agreement,"
which is defined as:
28 An insolvency involving a pension plan would likely be governed by the Employee Retirement
Income Security Act of 1974 (ERISA) or state pension and insolvency laws. Analysis of the relevant
provisions of these laws is beyond the scope of this article.

653
BANKING LAW JOURNAL

any agreement, including the terms and conditions incorporated by refer-

ence in any such agreement, which is a rate swap agreement, basis swap,
commodity swap, forward rate agreement, interest rate future, interest
rate option purchased, forward foreign exchange agreement, rate cap
agreement, rate floor agreement, rate collar agreement, currency swap
agreement, cross-currency rate swap agreement, currency future, or cur-
rency option purchased or any other similar agreement.29

The term includes any combination of such agreements and the

option to enter into any such agreement. In addition, any so-called
"master agreement" that permits separate transactions of the kind
set forth in the definition will be treated as a single swap agreement.
For further details, see Appendix B.
Remember, while the swap definition is quite broad, there is
some question about whether an equity or equity index swap, equity
or equity index option, bond option, or spot foreign exchange
transaction qualifies as a swap agreement. In addition, 'when a
master agreement is involved, it is important to determine whether
all of the specific transactions contemplated by the master agreement
would qualify as "swap agreements."
If the agreement is clearly a swap agreement as defined by the
statute, no further analysis is needed; the netting provision will be
exempt from the automatic stay. If the exemption does not apply,
then it is possible that other exemptions may apply (although the
applicability of separate exemptions could give rise to delays and
complex cross-netting issues). In the alternative, it is also possible
that the automatic stay may prevent the exercise of the netting
provision.
Applicability of Stay Provisions Under the U.S. Bankruptcy
Code. If the insolvent counterparty is a U.S. corporation, other than
a depository institution or an insurance company, the Bankruptcy
Code is likely to apply. (Appendix A contains a more complete list
of eligible debtors under the Bankruptcy Code.) As with the FDIA,
the Bankruptcy Code's automatic stay provision does not apply to a
"swap agreement." The definition of swap agreement is virtually
identical to the definition in the FDIA, except that the Bankruptcy
Code definition expressly covers spot foreign exchange agreements,
which are not mentioned in the FDIA, while the FDIA definition

29 12 USC § 182 1(e)(8)(D)(vi).

654
 DERIVATIVES

expressly covers interest rate futures and currency futures, which

are not mentioned in the Bankruptcy Code. See Appendix B for a
detailed list of agreements that would qualify as "swap agree-
ments."
Again, as with the FDIA, if a swap agreement satisfies the
definition, it will be exempt from the automatic stay; if it does not
satisfy the definition, it may be subject to other exemptions, which
may give rise to delays and complex cross-netting issues, or it may
be subject to the automatic stay.
Applicability of State Law. Finally, if state law applies rather
than the FDIA or the Bankruptcy Code-as would be the case with
insurance companies-examine the laws of the particular state in
question to determine whether an automatic stay would apply.

655
BANKING LAW JOURNAL

0 0 cC

.22 E , E~
.S L .2

0 0 >*0
Ulm. i
S c0 o cc M=0
to M c 00

-S.E w E~

FaE 0) '7 CCIS

0 E r~ 0CT
C
C l C
(D CM
0
~ ~ o
D 10
0.
(1)
z m
0< vaoc So g.- 0)
0 ' I
L
.r Ca W*-
8 ~( ~( ,) - c 0>
0 -0 o .2 -EO-2
0 c~ -
.0 ad -1 15~ C0. CL
o _cn,.a ti
Ld C - 0 0o
-E x o .0 2 8
10 No 0
C O coo~ 00
cc 00 0
ao co
ZCOMSLLflLL.W
cm-(M J- 'a - zw
0
.- ,0 ~ ~ - 0 0

V~coo -(D .0

0
a.0
-J0
M 0 0-6 -
CoL
- - =E--
-
IVou CC v

JC .0 O08 0 00 z
w 22 5

aa
oz0 U! ~C om : M-
08 M
5 0 ~ EfsOr o E m- =u 0
0
0 - cc 0 o
I- F 8 Co 0 > so
C-. M r-) 0 t
10E " 00 . = '
0 0) (a < B ;;F2 tg c EE
E -00 ~0=C
- K
zz ~ ~ MC.'- C D M.

0
ELO8
z 3 G)0U '-'
Co
'- 0 ;
.0300
CC 0 S , C DCO-5ECO M0a
.0 .)
M~ Sig 0 o.90
8 T-0 0
Et0
on
I
-e C C
U
0C <M M C 00 c
0
E-C0-, ~ ~ a .

IL o. 0
C )0 C M 00 0 Mw%
C.3 (aCO OU
,
00 5.
. O)5()r
LW0
C)
000

656
 DERIVATIVES

C'n
z
0

U-

i0

02~

o-E

zo
>.a .0
0

z15
.

Co a
00

<C
-C

U-
0,

E, E
Vl
cO

657
BANKING LAW JOURNAL

APPENDIX C
SWAP AGREEMENT CHECKLIST

658
 DERIVATIVES

APPENDIX D
SAMPLE INQUIRY LETTER
[Date]
[Name of Counterparty]
[Address]
Re: Proposed [Name of Swap Agreement] Between
[Name of end-use] and [Name of Counterparty]

The [name of end-user] and [name of counterparty] contemplate entering into

a [name of contract] (the "Agreement"). [Name of end-user] wishes to ensure that
the proposed Agreement would enjoy certain protections under provisions of the
U.S. banking and bankruptcy laws should [name of counterparty] become insol-
vent. Accordingly, we would appreciate your providing the following information:
1.Do you qualify as a "financial institution" as that term is defined under
FDICIA, 12 USC § 4402, or its enabling regulation, 12 CFR Part 231?
2. Please provide us with a letter representing that you will engage in financial
contracts as a counterparty on both sides of one or more financial markets for pur-
poses of 12 CFR Part 231.
3.Please advise us whether either of the following istrue:
(a) [Name of counterparty) had one or more financial contracts of a total
gross dollar value of at least $1 billion in notional principal amount outstanding on
any day during the previous fifteen-month period prior to the effective date of the
Agreement with counterparties that are not its affiliates; or
(b)[Name of counterparty] had total gross mark-to-market positions of at
least $100 million (aggregated across counterparties) in one or more financial
contracts on any day during the previous fifteen-month period prior to the effec-
tive date of the Agreement with counterparties that are not its affiliates.
If either (a) or (b)is true, please provide us with supporting documentation,
preferably publicly available reports (such as an annual report), which verifies this
information.
Very truly yours,

[Name of end-user]
By:
Title:

659