Treatment of Repo Transactions Under the Bankruptcy Code

The Bankruptcy Code limits in many ways the rights of nondebtors under contracts with a debtor in bankruptcy. There are, however, some crucial exceptions, which Congress deemed important for the orderly function of the securities markets. In particular, agreements governing securities repurchase (or repo) transactions involving a financial institution may be terminated and liquidated notwithstanding the bankruptcy filing of the repo seller. This article navigates the various provisions of the Bankruptcy Code that allow the termination and liquidation of typical repo contracts, and preclude avoidance of pre-filing transfers thereunder, notwithstanding the pendency of a bankruptcy proceeding.
 
The Basics of a Repo Transaction

Repo transactions are a form of secured financing. A repo arrangement typically involves a seller of securities, a buyer of the securities that effectively provides the seller with secured credit, a master agreement between the parties, and a custody agreement between the buyer and an institutional custodian. 

The master agreement contemplates that seller and buyer will from time to time enter into transactions whereby (i) the seller will sell to the buyer one or more securities identified in confirmations, and (ii) the seller will repurchase the securities from the buyer on a later repurchase date at a specified repurchase price. 

The master agreement typically provides that upon the occurrence of a seller bankruptcy (i) the seller’s obligation to repurchase all purchased securities becomes immediately due and payable; (ii) any pending sale transactions that have not occurred are canceled; and (iii) the buyer may sell in a recognized market or otherwise in a commercially reasonable manner any purchased securities, and apply the proceeds to the repurchase price, or elect to retain the purchased securities and give the seller credit for their value against the repurchase price.

Under the terms of the custody agreement, the buyer engages the custodian to maintain a custodial account for the purpose of depositing the securities that are the subject of the repo transactions. The custody agreement typically also provides that the custodian will act as agent for the buyer with respect to the right to terminate, liquidate, accelerate, net and offset transactions, and otherwise exercise remedies available to the buyer under the relevant repo agreement. 

The Automatic Stay, Ipso Facto and Avoidance Features of the Bankruptcy Code

The commencement of a bankruptcy case triggers the automatic stay of Section 362 of the Bankruptcy Code, which enjoins most actions against the debtor and any of the debtor’s property on account of any claims that arose prior to the date the petition was filed.

Section 365(e)(1) of the Bankruptcy Code prohibits the termination or modification of a contract with the debtor, or of any right or obligation under such contract, at any time after the commencement of the case solely on the basis of provisions conditioned on the insolvency or financial condition of the debtor, the commencement of a bankruptcy case or the appointment of a bankruptcy trustee. Such provisions are referred to as “ipso facto” provisions.

Sections 544 and 548 of the Bankruptcy Code allow trustees and debtors-in-possession to avoid or cut off certain claims against a debtor’s property, such as unperfected security interests, and to avoid certain transfers of property by the debtor. 

Some Definitions

As discussed below, the Bankruptcy Code affords special treatment to certain types of financial instrumental and parties thereto, including “securities contracts” and “master netting agreements” involving a “financial institution.”

— The Bankruptcy Code’s Definition of “Securities Contract”

Section 741(7) of the Bankruptcy Code defines a “securities contract” to mean, inter alia,

“a contract for the purchase, sale, or loan of a security,” including “any repurchase or reverse repurchase transaction on any such security ... (whether or not such repurchase or reverse repurchase transaction is a ‘repurchase agreement,’ as defined in section 101).”

Securities contract also includes “a master agreement that provides for [a securities contract].” Courts construing the definition of securities contract have generally enforced it broadly based on the plain meaning of the statutory language.¹ The terms of a typical repo agreement align with the plain meaning of several components of the definition of “securities contract” in Section 741(7). 

— The Bankruptcy Code’s Definition of “Master Netting Agreement”

Section 101(38A)(A) of the Bankruptcy Code, in relevant part, defines “master netting agreement” as

“an agreement providing for the exercise of rights, including the rights of netting, setoff, liquidation, termination, acceleration or close out, under or in connection with one or more [securities] contracts. ...”

Repo master agreements comport with the plain meaning of “master netting agreement” under Section 101(38A), as they typically provide for the exercise of setoff rights and the netting of amounts owed across transactions.

— The Bankruptcy Code’s Definition of “Financial Institution”

A “financial institution” is defined in Section 101(22)(A) of the Bankruptcy Code as

“a Federal reserve bank, receiver, liquidating agent, conservator or entity [when it] is acting as agent or custodian for a customer ... in connection with a securities
contract. ...”

Under Section 101(22)(A), the term “financial institution” also includes a customer of a financial institution, if such financial institution acts as “agent or custodian” for that customer. There is no case law addressing the meaning of “customer” for purposes of Section 101(22)(A), but it is reasonable to interpret the term as used in Section 101(22)(A) in accordance with its common usage. For example, a buyer who has a bank account, including a custody account, with a bank is commonly referred to as the bank’s customer. Accordingly, where the custodian acting for a buyer in a repo transaction is a “commercial or saving bank, industrial savings bank, savings and loan association, trust company, [or] federally-insured credit union,” the buyer should also be a financial institution.

The “Safe Harbors” for Securities Contracts and Master Netting Agreements

— Exceptions to the Automatic Stay and the Ipso Facto Prohibition for Securities Contracts

Section 555 of the Bankruptcy Code provides an exception to the automatic stay that otherwise applies under Section 362, and the prohibition on giving effect to ipso facto provisions that otherwise applies under Section 365(e), in respect of securities contracts. Specifically, Section 555 provides that

“[t]he exercise of a contractual right of a ... financial institution ... to cause the liquidation, termination, or acceleration of a securities contract ... shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency. ...”

Section 362(b)(6) of the Bankruptcy Code also limits the effect of the automatic stay when a financial institution exercises a contractual right to offset termination amounts owed in connection with one or more securities contracts. That section provides that the filing of a petition in bankruptcy shall not operate as a stay of

“the exercise by a ... financial institution ... of any contractual right ... under any security agreement or arrangement or other credit enhancement forming a part of or related to any ... securities contract, or of any contractual right ... to offset or net out any termination value, payment amount, or other transfer obligation arising under or in connection with 1 or more such contracts, including any master agreement for such contracts. ...”

A buyer’s acceleration of a seller’s obligation to pay the repurchase price for purchased securities under a repo agreement, as well as the buyer’s liquidation of the purchased securities transferred to the buyer and the cancellation of repo transactions that have not yet occurred, should be protected by the safe harbors of Section 555 and Section 362(b)(6).²

— Exceptions to the Automatic Stay and Ipso Facto Prohibition for Master Netting Agreements

Section 362(b)(27) of the Bankruptcy Code precludes the application of the automatic stay to the exercise of any contractual right of a “master netting agreement participant” to offset or net out any termination amount in connection with one or more master netting agreements. A “master netting agreement participant” is defined under Section 101(38B) of the Bankruptcy Code as “an entity that, at any time before the date of the filing of the petition, is a party to an outstanding master netting agreement with the debtor.” 

Section 561(a) of the Bankruptcy Code likewise provides an exception to the automatic stay and the non-enforceability of ipso facto provisions that would otherwise apply to the termination, liquidation, or acceleration of one or more securities contacts and master netting agreements.

Accordingly, the exceptions to the automatic stay and anti-ipso facto provisions of the Bankruptcy Code should also apply to repo transactions to the extent they are conducted pursuant to customary master agreements.

Safe Harbor From Avoidance Powers for Securities Contracts

— Safe Harbor From Avoidance Powers for Securities Contracts

Section 546(e) of the Bankruptcy Code limits the power to avoid certain transfers made pursuant to securities contracts and other financial contracts that might otherwise be avoidable by a trustee or debtor as a preference or a constructively fraudulent transfer. In pertinent part, Section 546(e) provides that

“the trustee may not avoid a transfer ... that is a transfer made by or to (or for the benefit of) a ... financial institution ... in connection with a securities contract ... that is made before the commencement of the case. ...” ³

Transfers made by a seller to a buyer prior to a bankruptcy filing in connection with a repo transaction should be eligible for the limitations on avoidance powers provided by
Section 546(e) of the Bankruptcy Code, because the buyer would be considered a financial institution, and the repo agreement would be a securities contract. ⁴

— Safe Harbor From Avoidance Powers for Master Netting Agreements

Section 546(j) of the Bankruptcy Code similarly precludes the avoidance of transfers made

“by or to (or for the benefit of) a master netting agreement participant under or in connection with any master netting agreement or any individual contract covered thereby. ...” ⁵  

Section 546(j) is thus an independent basis for shielding a repo transaction from the avoidance provisions of the Bankruptcy Code, to the extent the transaction is being conducted pursuant to a customary master agreement.

Conclusion

Multiple bases exist in the Bankruptcy Code to assure that repo transactions can unwind in accordance with their terms upon the occurrence of a bankruptcy of the securities seller. The avoidance provisions of the Bankruptcy Code should similarly be inapplicable to repo transactions that unwind on the eve of bankruptcy. The formulation of the relevant safe harbor provisions, and the references there to securities contracts, master netting agreements and financial institutions, comfortably accommodate these types of transactions as they are typically conducted.

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¹ See In re Bernard L. Madoff Inv. Sec. LLC, 773 F.3d 411, 420 (2d Cir. 2014); Lehman Bros. Holdings v. JPMorgan Chase Bank, N.A. (In re Lehman Bros. Holdings), 469 B.R. 415 (Bankr. S.D.N.Y. 2012); Am. Home Mortg. Corp., 379 B.R. 503, 517-19 (Bankr. D. Del. 2008); In re Am. Home Mortg. Holdings, Inc., 388 B.R. 69, 85 (Bankr. D. Del. 2008).

² A buyer’s liquidation, termination or acceleration under a repo agreement must be based solely on the occurrence of events triggering the right to enforce the ipso facto provisions in the repo agreement. See In re Enron Corp., 306 B.R. 465, 473 (Bankr. S.D.N.Y. 2004). Also, a buyer’s liquidation, termination or acceleration under the repo agreement must take place promptly after commencement of the bankruptcy proceedings. See In re Lehman Brothers Holdings Inc., et al., Case No. 08-13555 (JMP) (Bankr. S.D.N.Y.) [Sept. 15, 2009 Hr. Tr. at Dkt. No. 5261], citing In re Enron Corp., Case No. 01 B 16034, 2005 WL 3874285, *4 (Bankr. S.D.N.Y. Oct. 5, 2005).

³ Section 546(e) has an exception of transfers made with actual fraudulent intent, dealt with in Section 548(a)(1)(A) of the Bankruptcy Code, which are not likely to be relevant in the context of repo agreements.

⁴ Earlier this year, the Supreme Court agreed to hear a case concerning Section 546(e) of the Bankruptcy Code, FTI Consulting, Inc. v. Merit Mgmt. Grp., LP, 830 F.3d 690 (7th Cir. 2016), cert. granted, 137 S. Ct. 2092, 197 L. Ed. 2d 894 (2017). While the outcome of that case could have broad ramifications for the application of Section 546(e) and, potentially, the safe harbors generally, the conclusions in this article regarding the application of Section 546(e) to repo agreements are unlikely to change.

⁵ Section 546(j) similarly has an exception for actual intent to defraud.