FYI: An Update on Emerging Issues in Banking

Adjusting the Rules: What Bankruptcy Reform 

Will Mean for Financial Market Contracts

October 11, 2005

On April 20th, President Bush signed into law the Bankruptcy Abuse Prevention and 

Consumer Protection Act of 2005 (Bankruptcy Act of 2005). These revisions to the 

Bankruptcy Code and other laws are the most far-reaching changes to U.S. 

insolvency laws in more than 20 years. Many commentators have argued the 

merits of the consumer bankruptcy provisions of the Bankruptcy Act of 2005 and 

the effect these changes will have on the use of bankruptcy as an opportunity for a 

fresh start after financial difficulties or as a tool to avoid financial responsibility. 

What is safe to say is that many of these provisions make bankruptcy less 

attractive for consumers and that the interpretation of the new law will engage the 

courts for some time to come. Although the application and effects of the 

Bankruptcy Act of 2005 remain to be determined, it is likely that creditors, including 

bankers and the Federal Deposit Insurance Corporation (FDIC) when appointed 

receiver for failed banks, may benefit from the improved ability to collect on 

banking assets. 

While much has been written about the consumer bankruptcy parts of the 

Bankruptcy Act of 2005, other key parts of the bill have received little attention. For 

example, Title VIII adopts a new chapter 15 of the Bankruptcy Code that should 

make the administration of international bankruptcies much more predictable and 

effective. Title VIII, however, is probably not the most significant non-consumer part 

of the Act. That label better applies to Title IX and its restructuring of U.S. 

insolvency laws governing the financial markets. 

What is Title IX? In short, Title IX updates, clarifies, and strengthens the existing 

laws that determine what happens to financial market contracts when a market 

participant fails. Title IX accomplishes four key goals. First, it comprehensively 

harmonizes all of the principal laws that could come into play in insolvencies of 

market participants, including banks, thrifts, credit unions, broker-dealers, 

investment banks, and other companies. Second, it updates and modernizes those 

laws to accommodate innovations in the markets. Third, it expands the availability 

of the risk-reduction benefits of financial contract netting by ensuring that market 

participants can net across different types of contracts. Finally, Title IX strengthens 

and clarifies the powers of the FDIC to preserve asset value and to limit market 

disruptions by fashioning a flexible resolution of a failing bank or thrift. The power 

to transfer derivative contracts to another financial institution allows the FDIC the 

flexibility to choose a strategy to maximize the value of a portfolio of QFCs through 

an immediate sale or a more gradual resolution. The statutory balance between 

market participants' contractual rights to terminate and net their exposures and the 

FDIC's need for flexible resolution strategies could be crucial in periods of market 

disruption. 

The resilience of a financial system is measured by how well it deals with adversity. 

As financial markets have become more complex and interrelated, legal certainty 

about how derivatives and other financial contracts will be netted and settled in an 

insolvency has become a prerequisite for dealing effectively with financial distress. 
Greater legal certainty on these issues has far-reaching effects in the economy by 

allowing banks and other financial market participants to better assess and more 

effectively manage their risks which provides a more stable and resilient market 

environment. The new Bankruptcy Act of 2005 is a landmark in this respect, 

marking the culmination of a more than 20-year legislative trend to reduce the risk 

of systemic crises in financial markets by defining rules for the prompt settlement 

and netting of claims. This paper summarizes how the Act harmonizes 

counterparty rights and insolvency procedures, and reaffirms the special flexibilities 

the FDIC would have to minimize the systemic disruptions arising from a bank 

failure. While some inconsistencies do remain, the trend towards statutory 

harmonization also is reflected in the legislative proposals to create a new regulator 

for government sponsored enterprises, which include provisions parallel to those in 

the FDI Act. 

Background

To better explain why these changes are so significant, it is helpful to examine the 

interconnections between the role of derivatives in managing risk and the laws 

governing how these contracts will be handled in the event of an insolvency of a 

derivatives counterparty. Not only are these rules vital in the case of an actual 

insolvency, but even in the absence of an insolvency they determine, in large part, 

how market participants manage credit and market risks. The rapid and 

accelerating growth and innovation in the financial markets over the past two 

decades has placed a new impetus on the drive for clearer insolvency rules. 

A financial derivative is a contract whose value derives from the value of an 

underlying asset, such as a cash instrument, or an underlying reference rate or 

index. Derivative transactions are typically traded either through established 

exchanges or as over-the-counter (OTC) transactions. Although different types of 

derivatives bear a variety of labels, the basic building blocks of all of these 

contracts are options and forwards. An option is a contract in which the buyer pays 

a certain amount or premium to the seller to obtain the right, but not the obligation, 

to buy (in a call) or sell (in a put) a specific asset at an agreed price at or before a 

certain time. The buyer pays the premium at inception and has no further financial 

obligation unless the option is exercised. A forward is a sales contract between a 

buyer (holding the long position) and a seller (holding the short position) for an 

asset with delivery deferred until a future date. The buyer agrees to pay a fixed 

price at the agreed future date and the seller agrees to deliver the asset. A swap

can be defined as a custom forward contract to exchange cash flows for a specific 

time based on a notional amount. A common example is the interest rate swap 

which, in a simple form, may involve a swap of fixed-rate cash flows for variablerate cash flows. Futures contracts are standardized forward contracts traded on 

organized exchanges. 

Why have these investment and hedging vehicles grown so rapidly as risk 

management tools for banks and corporations? In short, derivatives offer the 

opportunity to construct innovative asset and liability structures that achieve a 

combination of risk and return that would be unavailable through more traditional 

financial instruments, such as bonds and equity securities. Like more traditional 

financial instruments such as bonds and certificates of deposit, derivatives can be 

used to control a business risk by hedging or taking a countervailing position in the 

market. However, unlike traditional bonds and equity securities, an institution 

seeking the hedge does not need to purchase a cash instrument; it can simply pay 

a premium to replicate the cash flows desired. A common derivative hedge 

employed by banks is the interest rate swap, which permits a bank lending at a 

fixed rate to hedge against the risk of adverse interest rate movements by 
exchanging its fixed interest rate payments on those loan assets for floating rate 

payments. Thus, the interest rate swap simply fixes a portion of the risk of adverse 

interest rate movements through hedging with floating rate payments. 

Nonetheless, these benefits do not come without a cost. As the past difficulties of 

Long-Term Capital Management, Barings, and Bankers Trust illustrate, both the 

dealer and end user of financial derivative investments must take care to manage 

the risks to avoid the descent from prudent hedging to speculative losses. For 

these reasons, the risks posed by financial derivatives have been the subject of 

Congressional hearings, review by international banking supervisors and careful 

study by United States' banking, securities, and commodities regulators. 

As with other financial instruments, including bonds and equity securities, 

derivatives pose credit, market, liquidity, operating, legal, settlement, and 

interconnection risks. One of the primary ways to reduce the risks to individual 

parties in derivative or other financial contracts is the ability to settle the 

transactions by payment of a single net amount. Netting is simply taking what I owe 

you and what you owe me and subtracting to yield a single amount that should be 

paid by one of us. Netting can be a valuable credit risk management tool in all 

multiple transaction relationships by reducing the credit and liquidity exposures by 

eliminating large funds transfers for each transaction in favor of a smaller net 

payment. 

Close-out netting, or the ability to terminate financial market contracts, determine a 

net amount due, and liquidate any pledged collateral, is a valuable tool to protect 

against credit and market risks in cases of default. This is particularly important in 

the financial markets because, unlike loans or many other financial contracts, the 

value of derivatives and other financial market contracts are based principally on 

their fluctuating market value. If one of the parties to a derivative or other financial 

market contract is placed into bankruptcy or receivership, the normal stays on 

termination of contracts and liquidation of collateral could create escalating losses 

due to changes in market prices. As a result, the ability to terminate the contract 

and net exposures quickly can be crucial to limit the losses to the non-defaulting 

party because such contracts can change in value rapidly due to market 

fluctuations. 

In response to questions about the adequacy of regulation for the derivatives 

markets, the President's Working Group on Financial Markets began a review of 

derivatives instruments and the legal framework for netting and the insolvency 

treatment of such instruments during the mid-1990s. This review indicated a 

growing need to update the insolvency laws governing the financial markets and 

the potential for problems in risk management, creditor strategies, regulatory 

responses, and market responses from ambiguities and inconsistencies in the laws 

for banks and other market participants. As a result, under the auspices of the 

President's Working Group on Financial Markets, representatives of the Treasury 

Department, the Federal Reserve, the Office of the Comptroller of the Currency, 

the Commodities Future Trading Commission, the Securities and Exchange 

Commission, the Federal Reserve Bank of New York, and the FDIC worked to craft 

statutory proposals to address these issues. An important part of that work was a 

close collaboration with legal and industry experts, such as the International Swaps 

and Derivatives Association (ISDA) and the Bond Market Association, to ensure 

that any new proposals responded to the needs of the markets while ensuring 

effective regulatory action. Finally, in February 1998, then-Treasury Secretary 

Robert Rubin submitted proposed amendments to Congress. While final enactment 

did not occur until 2005, the amendments always had the support of the industry, 
key Congressional committees, and regulators. The delay in final enactment was 

solely the result of the many issues presented by other provisions of the larger 

bankruptcy legislation. 

Understanding Insolvency Rules

A full appreciation of the improvements in Title IX requires an understanding of the 

normal rules that affect contracts in insolvency proceedings and the special 

protections provided under prior law for certain financial contracts. In general, 

American insolvency laws seek to either rehabilitate or liquidate the insolvent 

entity's affairs through a restructuring of business operations to establish a 

productive business if a rehabilitation is possible or, if not, to equitably distribute 

losses to creditors. Fundamental principles under either approach are to stop the 

accrual of new claims, preserve the value of existing contracts and assets, resolve 

claims, and distribute available money to creditors. The Bankruptcy Code and the 

insolvency laws for banking and other credit institutions, such as the FDI Act, 

include similar procedures to achieve these goals. In this article, for simplicity I will 

focus on the specific rights and duties under the FDI Act for insured banks and 

thrifts. 

Under the FDI Act, the FDIC may be appointed receiver of any federally insured 

depository institution. As receiver, the FDIC has statutory authority to marshal the 

failed institution's assets, determine its liabilities, and resolve its affairs in order to 

pay creditors. First, there are a number of statutory powers that allow the receiver 

to retain valuable contract rights and eliminate unneeded agreements. While there 

is no automatic stay, most contracts with the failed bank or thrift cannot be 

terminated or accelerated by the other party based solely on the appointment of a 

conservator or receiver for the bank.1 As a result, the clauses common in many 

leases and other contracts that accelerate payments or terminate the contract upon 

insolvency are unenforceable. Finally, the receiver also has the power to repudiate 

or disaffirm burdensome contracts, such as leases for unneeded branches, if that 

promotes the orderly resolution of the failed bank or thrift.2

Second, the FDI Act allows the receiver to avoid pre-insolvency transfers made 

with "the intent to hinder, delay or defraud" the bank, the FDIC as conservator or 

receiver, or other regulators.3 The Bankruptcy Code also grants a trustee the power 

to avoid fraudulent transfers, but includes more expansive powers to avoid other 

pre-bankruptcy payments or other transfers and requires the return of the 

transferred property to the bankruptcy estate. For example, the Bankruptcy Code, 

although generally permitting the set-off or netting of pre-petition mutual debts, 

bars set-off during the 90-day period preceding bankruptcy if the creditor improved 

its position by the set-off compared to its claim in bankruptcy.4 These provisions 

are all designed to protect the rights of creditors of the bankruptcy estate from 

dilution through special arrangements with certain creditors. 

Third, the FDI Act includes detailed procedures that require creditors of the failed 

institution to file claims with the receiver before filing litigation.5 This allows the 

receiver an opportunity to resolve competing claims, cut off claims that are not 

pursued within the statutory process, and more effectively administer the resolution 

process. 

Fourth, the FDI Act includes a priority for payment for deposit claims in a 

receivership. As a result, unsecured creditors of the bank are subordinated to 

deposit claims and generally cannot set off their claims against the failed bank. In 

most cases, unsecured, non-deposit creditors often receive very little for their 

claims.6 This underscores one of the major differences between the FDI Act and 
the Bankruptcy Code—the emphasis in the FDI Act on protecting depositors and 

the deposit insurance funds managed by the FDIC. 

Insolvency Rules for Financial Contracts

In order to reduce systemic risks, however, both the Bankruptcy Code and the FDI 

Act have long provided exceptions from many of these restrictions for certain 

defined financial contracts—securities contracts, commodity contracts, forward 

contracts, repurchase agreements and swap agreements. In the FDI Act, these 

contracts are defined as qualified financial contracts, or QFCs. The statutory safe 

harbors allow parties to these contracts, with some exceptions, to terminate and 

net their exposures and liquidate any pledged collateral to protect them from losses 

that could result from market fluctuations if the counterparties were subject to 

lengthy insolvency proceedings. 

Under the FDI Act and other U.S. insolvency laws, a party to a derivative contract 

has four key rights after commencement of insolvency proceedings. First, the 

counterparty can exercise contractual rights to terminate the derivative contract 

and offset or net out any termination values, payment amounts, or other transfer 

obligations under the agreement. Subject to certain limitations, this right is 

immediate under the Bankruptcy Code.7 Under the FDI Act, the only limitation on 

this right is that the counterparty must wait until the business day after appointment 

of the receiver to exercise its contractual netting rights.8 Second, the receiver or 

conservator may not avoid any transfer of money or other property in connection 

with the derivative contract, unless the transferee had actual intent to hinder, delay 

or defraud the institution, the creditors of the institution or any receiver or 

conservator of the institution.9 Third, if the receiver is to transfer any QFCs to a 

third party, the receiver must transfer all QFCs with the same counterparty 

(including its affiliates) to one depository institution transferee and notify the QFC 

counterparty of transfer by a specific deadline on the business day after 

appointment of the receiver.10 Finally, the damages available if the receiver 

repudiates a QFC are more expansive than those allowed for other contracts.11 If a 

QFC is repudiated, damages accrue to date of repudiation, rather than to date of 

appointment of receiver, and damages include normal and reasonable costs of 

cover or other reasonable measures of damages utilized in the industries for such 

contract claims. 

Within these similar approaches, however, before the Bankruptcy Reform Act of 

2005 there were a few key differences between the Bankruptcy Code and the FDI 

Act. While any counterparty under the FDI Act or any "financial institution" under 

FDICIA can exercise contractual rights to terminate and net its positions, the 

Bankruptcy Code limits these rights to specific types of counterparties for securities 

contracts, commodity contracts, and forward contracts. 

In addition, the definitions of the contracts that can be terminated and netted upon 

insolvency differed between the FDI Act and the Bankruptcy Code. Both statutes 

define five types of contracts that receive special treatment—repurchase 

agreements, securities contracts, commodity contracts, forward contracts, and 

swap agreements—but the Bankruptcy Code does not include some agreements 

that are included within the FDI Act definitions. The FDI Act includes mortgage 

loans, interests in mortgage loans, and mortgage-related securities in its definitions 

for repurchase agreements and securities contracts. In addition, the broader 

netting rights provided by the FDICIA provisions have created some ambiguity 

about whether termination and netting rights are limited to the five types of 

contracts enumerated in the FDI Act and Bankruptcy Code. Perhaps most 

importantly, the financial contracts traded in the markets of 2005 have evolved new 
forms that, while "similar agreements" to those contained in the statutory listings, 

were not clearly encompassed within those 1980s-era definitions. 

Finally, while the FDI Act permits the receiver for a failed insured bank or thrift to 

transfer QFCs to new counterparties or to disaffirm the contracts and, thereby, limit 

the liability of the receivership estate, the Bankruptcy Code does not provide any 

similarly effective rights to a bankruptcy trustee. The immediate transfer and 

repudiation rights provided to the FDIC as receiver for a failed bank or thrift give 

receivers greater flexibility and allows the FDIC to capture the value in a derivatives 

portfolio. While these powers are crucial to reduce losses to the deposit insurance 

funds and implement the least costly resolution strategy, they also can reduce the 

risks of market disruptions by providing a mechanism to maintain ongoing hedge 

transactions or other derivatives that continue to benefit the solvent counterparties 

as well as the receivership. This distinction between the FDI Act and the 

Bankruptcy Code could be significant in the insolvency of a major participant in the 

financial markets during times of market instability because the risk of market 

disruption could be greater from a failing non-bank participant since its 

counterparties would have no option but to immediately liquidate their contracts 

and dump collateral on the markets.12 This difference remains after Title IX. 

Another statute bears mentioning because it both illustrates the possible interplay 

between different laws affecting derivatives and netting and emphasizes the need 

for clarity. In 1991, the Federal Deposit Insurance Corporation Improvement Act 

became law. Among its provisions were the additional protections for netting. 

FDICIA confirmed the enforceability of the netting of payment obligations among 

"financial institutions" under a "netting contract."13 FDICIA was particularly 

significant because it (unlike the FDI Act and the Bankruptcy Code) was not linked

to specific types of contracts. As a result, it could be interpreted to provide broader 

netting rights than either the Bankruptcy Code or the FDI Act. 

The breadth of FDICIA's protection for netting contracts, however, could have been 

interpreted as impairing the FDIC's power to repudiate QFCs and to require 

counterparties to delay netting until after the business day following appointment of 

the receiver. While the FDIC took the informal position that it retained its 

receivership powers because the FDI Act is the more specific statute governing 

insured bank and thrift receiverships, the breadth of FDICIA's language—

"[n]otwithstanding any other provision of law"—created questions. 

Benefits of Title IX 

Since the Bankruptcy Code and FDI Act safe harbor provisions were enacted 

during the 1980s, the financial markets have grown tremendously in importance, 

size and concentration. While the relevant laws were broadly consistent, there 

were inconsistencies and gaps in application of the protections for netting that 

could create unnecessary confusion. Title IX of the Bankruptcy Act of 2005 

addresses these issues. In summary, the new rules of the game accomplish four 

key goals: 

1. Harmonize the key statutes governing the insolvency of financial market 

participants so that all participants in the markets will be able to better 

assess and manage risks. 

2. Update and expand the definitions of the protected contracts to 

accommodate developments in the marketplace. 

3. Expand the availability of cross-product netting under the FDI Act and the 
Bankruptcy Code. 

4. Clarify the powers of the FDIC as conservator or receiver for a failed bank 

to maximize the value of the QFC portfolio and, where appropriate, 

minimize the impact on other market participants by transferring QFCs to 

open institutions or to a bridge bank. 

Harmonization of Insolvency Laws 

One of the principal goals of Title IX was to create an insolvency system that 

provided similar rights under derivative contracts irrespective of whether you were 

dealing with a bank, a corporation, and any other debtor. The more harmonious 

insolvency system provided by Title IX will promote more effective risk 

management and provide a more level playing field. This goal is achieved through 

uniform definitions of the protected contracts and greater consistency in the 

availability of close-out netting.

After Title IX, the statutory definitions for securities contracts, swap agreements, 

repurchase agreements, commodities contracts, and forward agreements are 

virtually identical in the FDI Act, the Bankruptcy Code, and the Federal Credit 

Union Act (FCUA). To provide a common approach to these transactions, these 

new definitions are incorporated into the insolvency laws governing uninsured 

national banks, uninsured federal branches and agencies, certain uninsured state 

banks that are members of the Federal Reserve System, and Edge Act 

Corporations. As a result, the safe harbors contained in federal insolvency law will 

have the same basic coverage. One remaining difference between the FDI Act and 

Bankruptcy Code definitions is that the FDIC's Board will retain its authority to 

expand the definition of qualified financial contract by regulation, resolution or 

order. 

The most significant remaining difference between most other federal insolvency 

laws and the Bankruptcy Code are the counterparty limitations contained in the 

Bankruptcy Code. Before Title IX, any counterparty under the FDI Act and 

generally any "financial institution" under FDICIA could exercise contractual rights 

to terminate and net its positions. However, under the pre-Title IX Bankruptcy Code 

these rights were limited to specific types of counterparties for securities contracts, 

commodity contracts, and forward contracts. As a result, some uncertainty existed 

about the ability of some counterparties to exercise close-out netting in a 

bankruptcy. 

Title IX significantly reduces these differences. The new amendments to the 

Bankruptcy Code allow netting by a new type of counterparty, a "financial 

participant," which is defined as any party with transactions with a total gross dollar 

value of at least $1 billion in notional or actual principal amount outstanding on any 

day during the previous 15-month period, or has gross mark-to-market positions of 

at least $100 million (aggregated across counterparties) in one or more 

agreements or transactions on any day during the previous 15-month period. 

"Clearing organizations" under FDICIA also are included as "financial participants." 

In addition, Title IX expanded the availability of netting by protecting parties to 

master netting agreements through a new definition for "master netting agreement 

participant." Combined with an expanded definition of financial institution, these 

changes will allow any significant market participant to exercise close-out netting 

rights with bankrupt debtors' entities even if the creditor could not qualify as, for 

example, a commodity broker.14 These changes will reduce systemic risk by 

providing greater clarity to the rights available to larger participants in the markets. 

Modernization and Expansion of Netting Protection 
Title IX also modernizes the netting rules to accommodate the significant changes 

to the marketplace in recent years. An important Working Group goal was to 

ensure that U.S. law kept pace with the increasing statutory protection for netting 

around the world. A quick overview of some of the changes will illustrate two 

countervailing principles—netting protection should be assured for significant 

components of the market which are subject to its risks, but netting protection does 

not extend to normal lending or credit transactions no matter how documented. 

The definition of swap agreement in Title IX includes a number of additional types 

of agreements, such as "spot, same day-tomorrow, tomorrow-next, forward or other 

foreign exchange agreement[s]," weather derivatives, equity swaps, and debt 

swaps. Perhaps the most significant addition to the category of swap agreements 

are "total return, credit spread or credit swap, option, future, or forward 

agreements" in view of the rapid expansion of the credit derivatives market in 

recent years. Overall, the swap agreement definition rearranges the prior definition 

by ordering the references to swap transactions in a sequence of related types of 

swaps, options, futures, and forwards, such as interest rate transactions and credit 

transactions. 

Similarly, the definition of securities contract clarifies the treatment of several 

transactions and components of transactions actively traded in the financial 

markets. Perhaps the most significant addition to the already broad definition of 

securities contract is the addition of "repurchase or reverse repurchase 

transactions" if the transaction is based on the types of agreements otherwise 

forming a securities contract.15 This is significant because the definition of 

repurchase agreement is subject to some specific limitations on the underlying 

assets and on the length of the agreement. However, the market has developed a 

significant volume of repos on other types of assets and, to a lesser degree, for 

terms longer than one year. Now, under Title IX a "repurchase or reverse 

repurchase transaction" on a "security, certificate of deposit, mortgage loan, 

interest, group or index, or option" may be a QFC as a securities contract even if it 

does not fall within the definition of repurchase agreement. Despite these 

expansions, the repurchase agreement definition remains significant because, 

under the Bankruptcy Code, certain rights to terminate and net repurchase 

agreements are limited to "repo participants" unless the counterparty is a "financial 

participant" or "master netting agreement participant."16

The securities contract definition also includes margin loans. Such loans have 

become significant in financing market operations for a variety of participants. 

However, there are clear limitations to what can be legitimately defined as margin 

loans. Throughout Title IX, the governing principle has been to encompass only 

those agreements that are important parts of the financial markets and are subject 

to the market risks in those markets. The changes are not intended to include 

normal credit transactions. For example, an agreement that is documented as a 

swap, but which involves a commercial transaction, such as a supply agreement, 

or another non-financial market transaction will not be treated as a swap 

agreement or QFC simply because the transactions are documented or labeled as 

swaps. Similarly, defining margin loans as securities contracts does not 

encompass all loans that happen to be secured by securities collateral. As used in 

the new definition, margin loans is intended to include only those loans commonly 

known in the industry as margin loans, which extend credit for the purchase, sale, 

carrying or trading of securities. From the FDIC's perspective, it is important that 

the QFC definitions not embrace the normal lending and credit transactions that 

form the backbone of the traditional banking business.17
An important part of the protection of netting rights is the protection of the right to 

liquidate collateral or gain payment through other credit enhancements to pay any 

net amount due. Some examples of securities arrangements and credit 

enhancements are pledging of collateral, guarantees, rights of set-off, letters of 

credit, and similar agreements. Collateral or other credit enhancements are a 

widely used technique to reduce effective credit exposures. Title IX extends this 

protection by defining such credit enhancements as part of the protected contract. 

In addition, an amendment to FDICIA ensures that such credit enhancements are 

enforceable under bilateral and clearing house netting agreements.18

Title IX's modernization of the prior statutory protections for netting financial 

contracts would not have been complete without some mechanism for 

accommodation of legitimate innovation in the markets. The pre-existing definitions 

for several of the contracts included the phrase "or any other similar agreement" in 

order to permit such innovation. The Working Group similarly included this phrase 

in the definition for forward contracts and the phrase "similar to any agreement or 

transaction referred to" in the definitions for securities contract, swap agreement, 

and commodity contract. An important caveat for the safe harbor available for 

innovative swap agreements is the requirement that the "similar" agreement must 

be "of a type that has been, is presently, or in the future becomes, the subject of 

recurrent dealings in the swap markets" and relates to the types of transactions 

already identified in the definition. This caveat is designed, as noted above, to 

avoid claims that all transactions that can be documented as swaps suddenly 

become swaps protected by the safe harbors. As the final report from the House 

Financial Services Committee makes clear, "[t]raditional commercial arrangements, 

such as supply agreements or other non-financial market transactions, such as 

commercial, residential or consumer loans, cannot be treated as ‘swaps' under the 

FDIA, the FCUA, or the Bankruptcy Code simply because the parties purport to 

document or label the transactions as ‘swap agreements.'" These cautions are 

important safeguards for the principles of shared losses embodied in U.S. 

insolvency laws and the priority for protection of depositors, and the deposit 

insurance funds, codified in the FDI Act. 

Enhanced Protection for Cross-Product Netting 

Another important part of Title IX is the expanded protection provided to crossproduct netting under the FDI Act and the Bankruptcy Code. Cross-product netting

simply allows a bank or other market participant to reduce their credit exposures by 

netting all QFCs, such as interest rate swaps, repos, and securities contracts, 

under a single master agreement. The use of ISDA master agreements covering 

most types of financial market contracts to expand the benefits of netting has 

grown rapidly in recent years. Title IX simply ensures that the risk-reduction 

benefits of this development is legally protected under U.S. insolvency laws. 

Protection for cross-product netting is provided by including within the definitions of 

the component contracts "a master agreement" for QFCs. Title IX then includes a 

new definition of master agreement under the FDI Act and master netting 

agreement under the Bankruptcy Code.19 These definitions ensure that all QFCs 

may be documented and netted under a single master agreement. In addition, the 

definitions enhance protection for cross-product netting by defining "any 

combination" of the listed transactions and a master agreement for those 

transactions as QFCs. Finally, to address the issues created by some of the 

counterparty limitations contained in the Bankruptcy Code, Title IX also adds a new 

definition of "master netting agreement participant." 

The effect of these revisions of current law is to confirm that the availability of 
cross-product netting under the FDI Act extends to all QFCs. Before Title IX, FDI 

Act protections for netting across products under master agreements formally 

extended only to swap agreements.20 However, preexisting FDI Act provisions did 

not draw distinctions between types of QFCs in authorizing close-out netting of 

individual QFCs (which was defined to include all five types of component 

agreements) under section 11(e)(8)(A). The FDI Act's authorization for netting of "1 

or more contracts and agreements" defined as QFCs probably already permitted 

cross-product netting. 

Under the Bankruptcy Code, these changes will significantly expand the availability 

of cross-product netting. In the past, netting across different types of contracts, 

such as repurchase agreements, swap agreements and other contracts, under a 

master netting agreement was limited under the Bankruptcy Code. Both the 

counterparty limitations and the specific netting exemptions from the automatic stay 

called into question the enforceability of such cross-product netting agreements in 

bankruptcy.21 The new definitions of master netting agreement and master netting 

agreement participant will protect the ability to close out cross-product contracts 

both for master agreements across contracts and for master agreements across 

separate master agreements. 

These provisions, however, do not provide QFC treatment to non-QFC agreements 

simply because they might be covered by the master agreement. If the master 

agreement includes such non-QFC agreements, then the master agreement 

receives QFC treatment only for those agreements that would otherwise be QFCs. 

This limitation will prevent bundling of non-QFC agreements under a master 

agreement in order to provide special QFC treatment to those agreements. 

Clarification of the FDIC's Powers 

As receiver or conservator, the FDIC has a variety of statutory powers to assist it in 

resolving failing insured banks and thrifts in a manner that minimizes the costs to 

the deposit insurance funds as well as disruption to depositors and other 

customers. Like FIRREA, the new provisions carefully balance the importance of 

close-out netting for counterparties with the maintenance of market stability through 

a responsive resolution process and the reduction of losses for the deposit 

insurance funds. Title IX clarifies and strengthens the FDIC's powers to resolve the 

derivatives held by a failed insured bank or thrift by retaining valuable QFCs held 

by an institution in a conservatorship, selling or transferring QFCs to another 

financial institution or a FDIC-owned bridge bank, or terminating unneeded QFCs 

in a receivership. The FDIC's ability to retain the value in a derivatives portfolio and 

fashion a flexible resolution strategy could be a crucial element in limiting the

potential market disruption from a bank's failure during a period of market 

instability.22

Title IX clarifies the powers of conservators and receivers in five key ways. First, 

Title IX eliminates some ambiguities in prior law that could be used to argue that 

counterparties could terminate agreements and destroy any value to a receiver. 

One key provision bars the use of walkaway clauses that could eliminate remaining 

value in a QFC portfolio. Walkaway clauses would suspend or extinguish a net 

payment right or otherwise allow an institution's counterparty to avoid any net 

payment solely because of the status of the failed insured bank or thrift as a 

defaulting party under the contract. If used against a bank or thrift placed into 

receivership or conservatorship, these clauses would destroy any net value due to 

the institution and increase losses to the insurance funds—in effect, shifting all net 

obligations onto the insurance funds. This was recognized as bad public policy and 

the regulators and industry agreed that such clauses should be unenforceable 
against a conservator or receiver. The clear intent of new section 1821(e)(8)(G) is 

to make unenforceable any clause of a financial market contract that would have 

the effect of denying to the FDIC as receiver or conservator a net payment 

otherwise available solely because the bank or thrift was the defaulting party. 

Second, Title IX confirms that the FDIC continues to have the power to repudiate or 

transfer QFCs within one business day after the failure. Title IX confirms that "no 

provision of law shall be construed as limiting the right or power of the Corporation" 

to transfer or repudiate any QFC.23 While this has always been the FDIC's 

interpretation, the FDICIA language: "Notwithstanding any other provision of law," 

12 U.S.C. §§ 4403, 4404, created some ambiguity. Title IX specifically makes the 

bilateral and clearing organization netting rights provided by FDICIA subject to the 

sections of the FDI Act, the Federal Credit Union Act, Securities Investor Protection 

Act of 1970, and the Bankruptcy Code governing QFCs.24 Similarly, Title IX 

includes a provision confirming that rights to terminate, liquidate or net out cannot 

be exercised solely due to appointment of a conservator.25

Third, the amendments expand the potential transferees of QFCs after the FDIC is 

appointed receiver in several significant ways. Title IX allows the FDIC to transfer 

QFCs to banks, as under prior law, and to all "financial institutions," which are 

defined to include broker-dealers, future commission merchants or other 

institutions defined as financial institutions by the FDIC through a regulation, 

resolution, or order. In addition, Title IX includes provisions ensuring that the FDIC 

may transfer QFCs to a bridge bank or an institution in conservatorship.26 Similarly, 

Title IX provides the FDIC with some flexibility in transferring QFCs to foreign 

banks and in transferring QFCs subject to the rules of a clearing house. The FDIC 

can transfer QFCs to a foreign bank or to the branch or agency of a foreign bank if 

the contractual rights of the parties to those QFCs are enforceable "substantially to 

the same extent" as under the FDI Act after the transfer. The FDIC also could 

transfer QFCs subject to clearing house rules to non-clearing house members, but 

the transfer would not require the clearing house to accept the transferee as a 

member. 

Fourth, the new provisions prohibit the enforcement of rights of termination or 

liquidation that arise solely because of the insolvency of the institution or are based 

on the financial condition of the depository institution in receivership or 

conservatorship. Contractual rights to declare a default based on credit 

downgrades or other facts reflecting the financial condition of the failed institution 

or incidental to the appointment of a conservator or receiver are unenforceable. 

This also would apply to cross-defaults if the original default was based on such 

unenforceable contractual provisions. Thus, Title IX bars a premature termination 

of the QFC if incidental to the appointment or if based on the "insolvency or 

financial condition of the depository institution." In addition, the new FDI Act bars 

termination of an agreement which purports to be for a ground other than 

appointment of the conservator or receiver if the termination is based upon the 

exercise of rights or powers of the conservator or receiver.27 This latter provision is 

a significant strengthening of the receiver's protection from arguments that 

contracts can be terminated despite the transfer of the QFCs to a purchasing bank 

or to a bridge bank. This does not mean, however, that a bank or thrift in 

receivership or conservatorship can refuse to make required payments or collateral 

calls or meet other contractual requirements. If the default is based on such failures 

to meet the contractual terms, it should not be deemed to be based solely on 

financial condition for purposes of this provision and would remain enforceable. 

These changes help confirm the ability of the FDIC to complete an orderly 
resolution of the institution. 

Fifth, the new amendments give the FDIC somewhat greater flexibility in providing 

notice of any transfer of QFCs in conformity with the FDIC's December 12, 1989 

statement of policy, which sought to correct errors in the FDI Act. Thus, Title IX, 

allows the FDIC until 5:00 p.m. (Eastern Time), rather than by 12:00 noon, on the 

business day following the date of the appointment of the FDIC to provide notice of 

the transfer. In addition, the notice will be deemed sufficient if the FDIC has taken 

steps to notify the counterparty "reasonably calculated to provide notice" by the 

deadline. This could be an important clarification to allow the FDIC the flexibility to 

use the communication tools most appropriate under the circumstances that could 

exist shortly after a closing. 

Implications of Title IX 

The growing interrelationships between banks, securities brokers, insurers, and 

other financial market participants as well as the development of financial products 

that do not fit neatly within traditional descriptions of banking, insurance, or 

securities have changed our financial system. The myriad connections between 

firms involved in the markets allow both greater diversification of risks and greater 

risks of contagion. When the initial Bankruptcy Code provisions protecting closeout netting were adopted in the early 1980s and the first bank insolvency 

protections were enacted in 1989, the financial markets were far smaller and 

played a less important role in the financial services industry. Today, financial 

market contracts are used by many insured banks and thrifts, agribusinesses, 

exporters, insurers, and other companies for their valuable hedging and risk 

management features. While the end-users of derivatives are diverse and 

widespread, the market is concentrated in a handful of very large investment and 

commercial banking firms. 

Together these developments have focused even greater industry and regulatory 

attention on effective risk management and the use of risk-reduction techniques, 

such as close-out netting. Title IX of the Bankruptcy Reform Act of 2005 is a 

response to those growing connections and to the need for an updated and more 

harmonious set of insolvency rules to cover all participants in the financial markets. 

The new amendments to the U.S. insolvency laws provide a common set of rules 

for the failure of a derivatives counterparty and will help all market participants 

better manage their risks by allowing participants to exercise a virtually uniform 

right to terminate and close-out net their exposures to an insolvent contracting 

party. A more uniform approach to netting, irrespective of whether the counterparty 

is a bank, broker-dealer, manufacturer, or some other type of company, recognizes 

the role of the many different players in the markets. 

Equally important, Title IX clarifies and expands the availability of close-out netting 

to accommodate rapidly growing components of the financial markets, such as 

credit derivatives, and future market innovations. A vital aspect of this clarification 

of existing law is the enhanced protection of the ability to recover net claims 

through collateral and other credit enhancements. Clearer protection for crossproduct netting is an additional significant accomplishment for Title IX because it 

allows market participants to maximize the risk-reduction benefits of close-out 

netting across QFCs with counterparties, thereby reducing payments flows and the 

resultant credit and operational risks. 

Finally, Title IX reconfirms that the FDIC can use its powers to fashion a flexible 

resolution for a bank with derivatives. The FDIC's power to transfer QFCs to 

another open bank or to an FDIC-owned bridge bank within a business day after 
appointment of the FDIC as receiver allows the FDIC the flexibility to choose a 

resolution strategy that may retain the value in a portfolio of QFCs or maximize its 

value through more gradual sale. In addition, a transfer of QFCs to another bank or 

to a bridge bank also may avoid the potential market disruption that could result 

from an immediate liquidation of a large portfolio. This flexibility is one way in which 

the FDI Act continues to differ with the Bankruptcy Code, which allows 

counterparties the immediate right to terminate and close-out net their financial 

market contracts. This difference reflects the importance that U.S. law has on 

flexibility in bank resolutions principally to limit the losses to depositors and the 

deposit insurance funds, but also to reduce the potential for disruption caused by 

bank failures. 

Title IX is a significant advance in the protection provided by U.S. insolvency laws 

for close-out netting of financial market contracts. By providing netting protection 

comparable to other major derivatives trading nations, Title IX ensures that 

American markets and banks can fully benefit from the reduced risks and improved 

risk management available from netting. Title IX also preserves and strengthens 

the flexibility available under the FDI Act to limit disruption from bank failures to the 

value of a failed bank's QFC portfolios and to the markets. 

Endnotes

1

See 12 U.S.C. § 1821(e)(12). The Bankruptcy Code imposes an "automatic stay" 

that immediately bars a wide variety of actions and activities that could affect the 

ownership or value of the bankrupt's assets once a bankruptcy petition is filed. See 

11 U.S.C. § 362. 

2

See 12 U.S.C. § 1821(e)(1). 

3

See 12 U.S.C. §1821(d)(17). As conservator or receiver, the FDIC also can use 

other state or federal fraudulent conveyance powers. See 12 U.S.C. §§ 

1821(c)(2)(B) and (3)(B). 

4

See 12 U.S.C. § 548(a). 

5

See 12 U.S.C.§§ 1821(d)(5) – (13). 

6

See 12 U.S.C. § 1821(d)(11). The Bankruptcy Code also contains a priority order 

for payment of claims focused on distinctions between different types of unsecured 

claims. See 11 U.S.C. §507. Under both systems, secured claims are paid from the 

collateral to the extent of the collateral. 

7

See 11 U.S.C. §§ 362(b)(6), (7), and (17); 555; 556; 559; and 560. 

8

See 12 U.S.C. § 1821(e)(9), (10). A December 12, 1989, FDIC Policy Statement 

on QFCs provided the FDIC interpretation of the statutory provisions. The new 

Bankruptcy Reform Act of 2005 incorporates this interpretation and extends the 

deadline for notice until 5:00 p.m. on the business day after appointment of the 

receiver. 

9

See 12 U.S.C. § 1821(e)(8)(C)(i), (ii). This section specifically overrides 12 U.S.C. 

§1821(e)(11), which gives the receiver the right to avoid a security interest taken in 
contemplation of insolvency. If a transfer was made or a security interest was 

created with intent to hinder, delay or defraud the institution or the creditors of the 

institution the receiver could avoid the transfer or security interest. Analogous rights 

are provided by the Bankruptcy Code, but those rights are somewhat more limited. 

For example, the limitation on the trustee's avoidance powers requires, in part, that 

the transfer qualify as a "margin payment" or "settlement payment" to specified 

recipients. See 11 U.S.C. §§ 546(e) and (f); see also 11 U.S.C. §§ 546(g); 

548(d)(2). 

10See 12 U.S.C. §§ 1821(e)(9) and (10). 

11See 12 U.S.C. § 1821(e)(3)(A)(ii)(II) and (C). 

12See The President's Working Group on Financial Markets, "Hedge Funds, 

Leverage, and the Lessons of Long-Term Capital Management," appendix E at E-6 

to E-7 (April 1999). 

13These terms are broadly defined. A "financial institution" includes broker-dealers, 

depository institutions, future commissions merchants, and other entities 

recognized by Federal Reserve regulation. On March 7, 1994, the Federal Reserve 

expanded the definition of "financial institution" to include most significant 

participants in the financial markets. See Regulation EE, 12 C.F.R. Part 231. 

14See 11 U.S.C. §§ 101(22), (22A), (26), and (38B), as amended or added by Title 

IX, section 907(b) and (d). 

15The definition of "forward contract" already included repurchase transactions and 

reverse repurchase transactions based on the purchase, sale or transfer of a 

commodity. See 11 U.S.C. § 101(25). 

16See 11 U.S.C. §§ 548(d)(2)(C), 559, and 753, as amended by Bankruptcy Act of 

2005, Title IX, section 907. 

17See House Report accompanying H.R. 685. 

18See Title IX sections 901, 906(b) and 907. 

19See Title IX, sections 905 and 907(c), codified at 12 U.S.C. § 1821(e)(8)(D)(vii) 

and 11 U.S.C. § 101(38A), respectively. 

20See 12 U.S.C. § 1821(e)(8)(D)(vii) (treating all swap agreements under a master 

agreement as "1 swap agreement"). 

21Prior to Title IX, Bankruptcy Code sections 362(b)(6), 362(b)(7), and 362(b)(17), 

probably allowed enforcement of a single net agreement for commodity contracts, 

forward contracts, and securities contracts between the same parties. However, 

sections 362(b)(7) and 362(b)(17) treated swap agreements and repurchase 

agreements separately and included no provisions indicative of a right to net 

across those contracts. 

22Compare this with the President's Working Group on Financial Markets, "Hedge 

Funds, Leverage, and the Lessons of Long-Term Capital Management," appendix 

E at E-6 (April 1999). The President's Working Group's report describes the 
difficulties of controlling the impact on the markets of the liquidation of large 

positions in a bankruptcy proceeding. 

23New subparagraph (F) to 12 U.S.C. § 1821(e)(8), as amended by Title IX, section 

902(a)(1). 

24See 12 U.S.C. §§ 1821(e)(10)(B), 4403 and 4404, as amended by Title IX, 

section 903(a)(3) and 906, respectively. 

25See 12 U.S.C. § 1821(e)(12), as amended by Title IX, section 903(a)(3). 

26See 12 U.S.C. § 1821(e)(10)(C), as amended by Title IX, section 903(a)(3). 

27See 12 U.S.C. §§ 1821(e)(10)(B) and 1821(e)(12)(A), as amended by Title IX, 

sections 903 and 902, respectively. 

About FYI

FYI is an electronic bulletin summarizing current information about the trends that 

are driving change in the banking industry, plus links to the wide array of other 

FDIC publications and data tools. 

Disclaimer

The views expressed in FYI are those of the authors and do not necessarily reflect 

official positions of the Federal Deposit Insurance Corporation. Some of the 

information used in the preparation of this publication was obtained from publicly 

available sources that are considered reliable. However, the use of this information 

does not constitute an endorsement of its accuracy by the Federal Deposit 

Insurance Corporation. 

Last Updated 10/11/2005