Since its inception, the interest rate swap agreement has been an increasingly popular and integral portion of the derivatives market in the United States. Specifically, many borrowers and other financial market participants use interest rate swaps as a way to protect against fluctuating interest rate exposure in lending transactions. The most common interest rate swap agreement obligates one party “to make payments equal to the interest which would accrue on an agreed hypothetical principal amount (‘notional amount’), during a given period, at a specified fixed interest rate.”¹ In return, the other party “must pay an amount equal to the interest which would accrue on the same notional amount, during the same period, but at a floating interest rate.”² Although the notional amount on which the payments are

made never changes hands, the practical effect is the parties trade a variable rate for a fixed interest rate and vice versa. Typically, interest rate swaps are documented with a standard form agreement (a “master agreement”) prepared by the International Swaps and Derivatives Association (ISDA).³

With the expected (albeit delayed) future increase in bankruptcy filings due to COVID-19-pandemic-induced economic fallout in the United States, parties to interest rate or other swap agreements inevitably will seek bankruptcy protection. How are those agreements impacted by bankruptcy? Specifically, are interest rate swap agreements considered executory contracts which a bankrupt debtor can assume or reject under §365 of the U.S. Bankruptcy Code and what rights does a non-debtor counterparty have to modify or terminate a swap agreement after the bankruptcy filing?

Typical interest rate swap agreements obligate the counterparties to continuing performance, which meets both the case law and the functional definition of an “executory contract.” Thus, these agreements can likely be assumed or rejected by a debtor party under §365 of the bankruptcy code. However, an interest rate swap agreement is also subject to termination or liquidation by a non-debtor party in bankruptcy under §560 of the bankruptcy code, the “safe harbor” provision created by Congress to protect swap agreement counterparties from the bankruptcy code’s prohibition on enforcement of contractual ipso facto clauses.

To begin, interest rate agreements likely fall under the definition of executory contracts for purposes of §365 of the bankruptcy code. An executory contract is one “on which performance is due to some extent on both sides.”⁴ More precisely, a contract is executory where “the obligations of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other.”⁵ Generalization about executory contracts is difficult because they are highly fact-specific. At a high level, however, at least two rules apply. First, the contract must exist at the commencement of the bankruptcy case.⁶ Second, the payment of money is not typically an obligation-triggering executory contract status.⁷

Typical interest rate swap agreements using the standard ISDA master agreement meet the definition of executory contracts because each counterparty to a swap has a continuing obligation to make payments based on the notional amount.⁸ A failure of either party to make its payments would materially breach the swap agreement. Although an obligation to make a monetary payment is typically excluded from contractual duties pushing an agreement into executory territory, in a swap agreement, such payments form an ongoing transaction rather than repayment for a loan that has already occurred. Therefore, interest rate swap agreements are likely to be rejected or assumed by a debtor under §365 of the bankruptcy code. This could create a significant benefit to a bankrupt party to a swap agreement, as the debtor can assume or reject the agreement based on the market at the time, preserving an economically positive interest rate swap or rejecting an economically negative one.

On the flip side, despite the bankruptcy code’s general prohibition on the enforcement of ipso facto clauses,⁹ non-debtor counterparties to a swap agreement are permitted to modify or terminate an executory contract solely due to the other party’s bankruptcy filing under the statutory carve-out provided by §560 of the bankruptcy code.¹⁰ The prohibition on ipso facto clauses under the bankruptcy code creates an asymmetry between a bankrupt debtor, which, as set forth earlier, can “assume or reject any executory contract,”¹¹ and a non-bankrupt counterparty, which cannot. As such, a non-bankrupt counterparty is exposed to significant risk.¹² However, in 1990, as swap agreements grew in popularity and significance within the finance industry, Congress amended the bankruptcy code to “immunize the swap market from the legal risks of bankruptcy.”¹³ As a result, swap agreements are now explicitly granted a “safe harbor” under §560 of the bankruptcy code, whereby parties to a swap agreement may terminate, liquidate or accelerate their contracts under an otherwise unenforceable ipso facto clause.¹⁴

In summation, although filing for bankruptcy likely provides a bankrupt party to an interest rate swap agreement the power to assume or reject the agreement as an executory contract under §365, the filing itself may be grounds for the non-debtor party to terminate, liquidate or accelerate the swap agreement under §560, negating any advantage to the debtor party created by the bankruptcy filing and preserving the rights of the non-debtor party. Either way, an increase in bankruptcy filings should not have a chilling effect on the derivatives market, but post-petition termination or liquidation of an interest rate swap by non-debtor parties might significantly impact the economic outcome of bankruptcy cases.

¹Thrifty Oil Co. vs. Bank of America Nat. Tr. & Sav. Ass’n, 322 F.3d 1039, 1042 (9th Cir. 2003).
²Id.
³Thrifty Oil Co., 322 F.3d at 1042.
⁴NLRB vs. Bildisco & Bildisco, 465 US 513, 522 n.6 (1984); In re Wegner, 839 F.2d 533, 536 (9th Cir. 1988) (adopting this definition).
⁵In re Wegner, 839 at 536; In re Penn Traffic Co., 524 F.3d 373, 379 (2d Cir. 2008) (same).
⁶In re Windmill Farms, Inc., 841 F.2d 1467, 1469 (9th Cir. 1988).
⁷See In re Chateaugay Corp., 102 B.R. 335, 345 (Bankr. S.D.N.Y. 1989); H.R. Rep. No. 595, 95th Cong., 1st Sess. 347 (1977), U.S. Code Cong. & Admin. News 1978, pp. 6303–04 (“A note is not usually an executory contract if the only performance that remains is repayment. Performance on one side of the contract would have been completed and the contact is no longer executory.”)
⁸See In re Lehman Bros. Holdings Inc., 422 B.R. 407, 416 (Bankr. S.D.N.Y. 2010) (“The language and structure of the ISDA master agreement that forms a central part of the swap agreement demonstrate that these contracts are executory.”)
⁹See, e.g., 11 U.S.C. § 365(e)(1) (prohibiting the termination or modification of a contract with a bankrupt debtor if such action is conditioned upon a provision in a contract conditioned the insolvency of the debtor, the commencement of the bankruptcy filing or the appointment of a bankruptcy trustee or other custodian, commonly called an ipso facto clause).
¹⁰In re Lehman Bros. Holdings Inc., 970 F.3d 91, 100 (2d Cir. 2020).
¹¹Id. at §365(a).
¹²In re Lehman Bros. Holdings Inc., 970 F.3d 91, 102 (2d Cir. 2020).
¹³Thrifty Oil, 322 F.3d at 1050; see also Lehman Bros. Holdings, 970 F.3d at 99-100 (“[S]ection 560 was meant to protect the stability of swap markets and to ensure that swap markets are ‘not destabilized by uncertainties regarding the treatment of their financial instruments under the bankruptcy code.’”) (citing H.R. Rep. No. 101-484, at 1 (1990), as reprinted in 1990 U.S.C.C.A.N. 223, 223; and 136 Cong. Rec. S7534-01 (daily ed. June 6, 1990) (statement of Sen. DeConcini) (asserting that the “potential for disruption in the financial markets justified the creation of an exclusion for these contracts from the usual powers of a bankruptcy trustee.”)).
¹⁴See 11 U.S.C. §560; Lehman Bros. Holdings, 970 F.3d at 100 (Congress amended section 560 as part of BAPCPA in 2005 to broaden the definition of “swap agreement” to include virtually all derivatives and “clarif[y] that a swap participant’s contractual right to liquidate and accelerate a swap agreement — in addition to its right to terminate the swap — are protected under the safe harbor provision.”)

Jill Perrella is a partner at Snell & Wilmer in Tucson, AZ. As a member of the firm’s bankruptcy and reorganization group, she represents creditors, debtors and other interested parties in complex commercial bankruptcy matters and related litigation. She can be reached at  [email protected].

Steven Jerome is a partner at Snell & Wilmer in Phoenix. His practice primarily focuses on assisting clients (both debtors and creditors) with solving problems pertaining to insolvency and potential insolvency situations. He can be reached at [email protected].