Volume 4, Number 35, Page 2

Brazil: Derivatives in Bankruptcy: Netting & Cherry Picking

by Levy Salomao Advogados

Common types of derivatives include options, swaps, and futures operations to be liquidated by difference in quotations. In these latter operations, a financial institution is typically one of the involved parties, buying and selling futures in successive transactions with the same client.
The laws of many countries provide that each sale and purchase contract be considered separately. Consequently, in cases of bankruptcy of the other party, the financial institution must pay the bankrupt estate the difference in the latter’s favor arising from pending agreements. On the other hand, the financial institution must file a claim in bankruptcy relating to all individual contracts where there are differences in its favor, rendering it subject to the uncertainties of the bankruptcy. This fortuitous advantage afforded to the bankrupt debtor, enabling it to make the best of the bankruptcy situation, is known in market practice as “cherry picking.”

Two kinds of initiatives have been taken in an attempt to eliminate the effects of cherry picking. First, governments such as France and the United States have recently approved legislation allowing compensation for the differences in favor of and against the bankrupt debtor — referred to as “netting” — thereby making the financial institution the creditor or debtor only of the final balance. The second initiative was private in character: the International Swap Dealers Association, Inc. (ISDA) proposed and drafted a standard model agreement, known as the ISDA Master Agreement, the last version of which was issued in 1992. This agreement attempts to cover all futures transactions between a given institution and an identified client; one of its main clauses allows netting.

There is currently no specific legislation in Brazil to address this problem. Article 1.009 of the Brazilian Civil Code, however, allows set-off among reciprocal credits if such are already matured and of determined amounts. This principle is reaffirmed in general terms in Article 46 of Decree-Law No. 7.661 of June 21, 1945 (the “Bankruptcy Law”).

The operative rule in a bankruptcy is as follows: in cases of futures agreements to be liquidated by difference of quotations, this difference must be calculated based on the difference between the quotation on the day of the agreement and that in effect at the time of liquidation (Article 44, Section V of the Bankruptcy Law). This could render the amount to be paid by the estate or the other party indeterminate from the moment of bankruptcy until the date stipulated for liquidation.
With regard to a bundle of futures contracts with reciprocal positions, there would be no problem if the settlement date of the agreements which imply debts against the estate were prior to the settlement date of the individual agreements with positions in their favor. In such a case, the financial institution would set off the debts of the bankrupt estate already liquidated against its own, as these latter mature.

In the opposite case, and with the existence of a bundle of futures agreements still in mind, our understanding is that the financial institution could legitimately fail to honor the differences against it until the differences in its favor are liquidated. In fact, a reduction in assets of one of the parties which casts doubts on its capacity to comply with its obligations would be grounds for the other party to refuse to make payments which it is legally bound to make in the first place (Article 1.092 of the Brazilian Civil Code). At any rate, if the financial institution bundles its individual futures contracts in an ISDA Master Agreement, its legal position will be reinforced.

The law firm of Levy & Salomão Advogados is located in São Paulo, Brazil. Its practice areas include international banking, contracts, taxes, litigation and corporations.