The commencement of a bankruptcy case is a common event of default under executory contracts. To allow debtors to retain contract rights necessary to consummate an effective reorganization, however, the Bankruptcy Code prohibits the enforcement of a default based upon the bankruptcy filing—so called ipso facto defaults—with limited exceptions. These exceptions, or “safe harbors,” allow non-debtor counterparties to certain types of executory financial contracts, including swap agreements, to exercise rights after the commencement of a bankruptcy case to terminate, liquidate or accelerate the contracts that are triggered by a bankruptcy filing and apply any collateral against any outstanding obligations. In addition, transfers made under or relating to safe-harbored contracts are protected from avoidance claims, like preference recoveries. These safe harbors reflect Congress’ decision to balance bankruptcy goals (fostering reorganization and creditor recoveries) and financial market goals (providing stability and certainty).
Early last year, Brazos Electric Power Cooperative Inc. (Brazos), the largest electricity co-op in Texas, filed for bankruptcy after the state experienced severe winter storms that left many homes without power for days and froze the company’s power generation equipment and natural gas pipelines. The company blamed its bankruptcy filing on the Electric Reliability Council of Texas, after it briefly set the wholesale electricity price at $9,000 per MWh and billed Brazos more than $2.1 billion for electricity—an amount due within days after the bill.
The bankruptcy filing triggered ipso facto defaults under fixed-for-floating interest rate swap agreements (Swap Agreements) Brazos had separately entered into with four financial institutions (together, the Dealers) pursuant to which Brazos was to pay fixed interest payments to the Dealer in exchange for floating interest payments from the Dealer. Each Swap Agreement was documented under the 1992 ISDA Master Agreement published by the International Swaps and Derivatives Association (ISDA), a trade association that develops market standards for the over-the-counter derivatives industry. The 1992 ISDA Master Agreement contains standardized terms that govern the parties’ relationship, including terms regarding close-out netting, which allows a non-defaulting party to determine the net termination value owed by a defaulting party and close-out existing positions.
Under each Swap Agreement, the parties had elected “market quotation” as the method for calculating the amount payable upon termination of the Swap Agreement following an event of default. Under this methodology, when the non-defaulting party terminates the agreement after a default, the non-defaulting party must solicit quotations from market dealers to enter into a transaction with the non-defaulting party to preserve the economic equivalent to the non-defaulting party of the payment or delivery obligations that would have been required had the event of default not occurred. If the Dealer obtains at least three market quotations, the Swap Agreement directs it to disregard the highest and lowest market quotations and choose the intermediate quote (or average of the intermediate quotes).
The difference between the intermediate quote and the original Swap Agreement, if it is economically disadvantageous to the non-defaulting party, constitutes the non-defaulting party’s loss. If two or fewer market quotations are obtained, the Dealer must use the “loss” method to calculate damages, which is simply “an amount that [the Dealer] reasonably determines in good faith to be its total losses and costs … including any loss of bargain.” A non-defaulting party may “determine its loss by reference to quotations of relevant rates or prices from one or more leading dealers in the relevant markets.” Notably, the 2002 ISDA Master Agreement replaced “market quotation” with “closeout calculation,” which may result in different damage calculations following termination of the Swap Agreement.
The 1992 definition of market quotation requires that, in determining a market quotation, the leading market dealer must consider “any existing Credit Support Document with respect to the obligations of [the party requesting the quotation].” As discussed below, this provision of the market quotation definition is a lynchpin to the dispute between Brazos and the Dealers over the calculation of their damages claims.
As noted, the Brazos bankruptcy filing constituted an event of default under each Swap Agreement which led each Dealer to terminate its Swap Agreement, designate an early termination date and calculate their respective damages. All the Dealers, except one, obtained at least three market quotations, selected the intermediate quote and asserted claims against Brazos based on the intermediate quote. Two of the Dealers discounted their respective intermediate quote to account for collateral posted by Brazos, while another Dealer’s (together, the MQ Dealers) intermediate quote was not discounted for any posted collateral. Unlike the MQ Dealers, one Dealer (non-MQ Dealer) received two market quotations and thus applied the loss method by averaging the two quotes it received to calculate damages.
Objections and Responses to Interest Rate Swap Termination Claims
Each Dealer filed proofs of claim against Brazos for their respective interest swap termination claim, which, in the aggregate, totaled approximately $133 million. Brazos objected to the claims, arguing that each was overstated. In total, Brazos contended that the Dealers’ aggregate claims should be reduced by about 36% to a total of approximately $85.7 million.
In its objection, Brazos claimed that the MQ Dealers’ market quotation process was tainted because they failed to send a copy of a “Credit Support Document” between Brazos and the MQ Dealer to the market dealer. This omission, according to Brazos, caused the MQ Dealers to inflate their claims by soliciting pricing for a fully collateralized transaction rather than an under-collateralized transaction, which usually would attract lower bids. Similarly, Brazos argued that the non-MQ Dealer’s claim was overstated and made in bad faith because the two market quotations it relied on to calculate damages under the loss method failed to account for the “creditworthiness” of the defaulting party (i.e., Brazos).
Each Dealer responded, arguing that Brazos’ interpretation of the market quotation methodology was wrong. According to the MQ Dealers, Brazos’ obligations to post collateral were irrelevant because they read the definition of “market quotation” to require market dealers to consider only the collateral obligations of the dealer requesting the quotation and not the defaulting party. Likewise, the non-MQ Dealer argued that the creditworthiness of Brazos was not a factor in determining its loss and that the loss method definition under the Swap Agreements expressly permitted it to rely on the two market quotations it received to calculate damages.
The Dealers’ claim calculations were supported by ISDA and the Securities Industry and Financial Markets Association (SIFMA), another significant trade association that represents, among others, broker-dealers. Both associations criticized Brazos’ interpretation of the damage methodology under the Swap Agreements as inconsistent with their plain meaning, and ISDA, as the effective author of the Swap Agreements, argued that Brazos’ interpretation was inconsistent with the intended meaning of the Swap Agreements. According to ISDA and SIFMA, the Dealers “scrupulously” followed the market quotation process and the loss methodology set forth in the Swap Agreements. Both associations warned that Brazos’ interpretation, if adopted, would create enormous uncertainty and destabilize financial markets, which the safe harbor provisions (including those related to swap agreements) under the Bankruptcy Code were enacted to prevent.
The economic difference between the Dealers’ calculation of their claims and Brazos’ position would have had a significant impact in the Brazos case. Unsecured creditors in Brazos expect to receive distributions of at least 89 cents on the dollar. As a result, the ultimate pay out on the Dealers’ claims under their damage calculation would be approximately $120 million, and under Brazos’ damage calculation, it would only be approximately $76 million, a meaningful $44 million (approximately 37%) difference.
On November 14, 2022, the U.S. Bankruptcy Court for the Southern District of Texas, Case No. 21-30725, approved a settlement of the Dealers’ filed claims which reduces them, in the aggregate, by approximately $800,000, for a total amount of approximately $132.2 million.
Non-debtor counterparties to safe-harbored transactions who “scrupulously” comply with close-out and damage calculation terms have very strong positions in disputes over their loss damage claims in and out of bankruptcy, especially, if all information related to the calculation of damages is properly preserved. They also, as Brazos demonstrates, should get the support of ISDA and SIFMA, each of which has an institutional imperative to defend ISDA Master Agreements, where there is not yet controlling law on this issue.