FRB: Annual Report 2005, The Board of Governors and the Government Performance and Results Act

Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Bankruptcy Act of 2005). Title IX of the act contains provisions designed to reduce systemic risk in the banking system and the financial markets when parties to certain types of financial transactions become bankrupt or insolvent, by allowing expeditious termination or netting of certain types of financial transactions. In addition, the Bankruptcy Act of 2005 makes several important amendments to the Truth in Lending Act.

Financial Contract Provisions

Treatment of Swaps and QFCs

The Bankruptcy Act of 2005 amends the definitions of several terms that appear in the Federal Deposit Insurance Act (FDI Act) and the Federal Credit Union Act (FCUA) to make them consistent with the definitions in the Bankruptcy Code and to reflect the enactment of the Commodity Futures Modernization Act of 2000 (CFMA). Of particular importance, the act updates the definition of "swap agreement" to include types of transactions that have recently entered the market. Under the FDI Act, the FCUA, and the Bankruptcy Code, swap agreements are eligible for termination, liquidation, acceleration, offset, and netting. The amended definition includes combinations of the listed agreements or transactions and permits contractual netting across economically similar transactions that are the subject of recurring dealings in swap agreements.

In addition, the Bankruptcy Act of 2005 clarifies that the FDI Act and the FCUA expressly protect rights under securities agreements, arrangements, or other credit enhancements related to qualified financial contracts (QFCs). The act also clarifies that no provision of federal or state law relating to the avoidance of preferential or fraudulent transfers may be invoked to avoid a transfer made in connection with any QFC of an insured depository institution in conservatorship or receivership, absent actual fraudulent intent on the part of the transferee.

Cross-Product Netting

The Bankruptcy Act of 2005 also promotes cross-product netting through master agreements for QFCs. The act specifies that under the FDI Act and the FCUA, a master agreement for one or more securities contracts, commodity contracts, forward contracts, repurchase agreements, or swap agreements is to be treated as a single QFC, but only with respect to the underlying agreements that are themselves QFCs. This provision ensures that cross-product netting pursuant to a master agreement, or pursuant to an umbrella agreement for separate master agreements between the same parties, will be enforceable under the FDI Act and the FCUA. Cross-product netting permits the netting of a wide variety of financial transactions between two participants, thereby maximizing the present and potential future risk-reducing benefits of the netting arrangement between the parties.

The Bankruptcy Act of 2005 similarly promotes cross-product netting through amendments to the Bankruptcy Code. The act adds definitions for "master netting agreement" and "master netting agreement participant" to the Bankruptcy Code in order to protect the termination and close-out netting provisions of cross-product master agreements between parties. These agreements may be used (1) to document a wide variety of securities contracts, commodity contracts, forward contracts, repurchase agreements, and swap agreements or (2) as umbrella agreements for separate master agreements between the same parties, each of which is used to document a discrete type of transaction. The act also adds a new section 561 to the Bankruptcy Code designed to expressly protect the contractual rights of a master netting agreement participant to enforce any rights of termination, liquidation, acceleration, offset, or netting under a master netting agreement.

"Financial Participants" under the Bankruptcy Code

The Bankruptcy Act of 2005 adds a new definition for "financial participant" and allows such market participants to close out and net agreements with insolvent entities under the Bankruptcy Code. These changes are designed to limit the potential effect of insolvencies on major market participants. "Financial participant" is defined by the act to include entities having contracts of a total gross dollar value of not less than $1 billion in notional or actual principal amount outstanding or having gross mark-to-market positions of not less than $100 million (aggregated across counterparties). Clearing organizations are also expressly included in the definition and may take advantage of these expanded protections. This amendment is intended to further the goal of promoting the clearing of derivatives and other transactions as a way of reducing systemic risk. The act also makes several amendments to the Bankruptcy Code to reflect current market practice and to conform certain definitions to the FDI Act.

FDICIA Netting Protections

The Bankruptcy Act of 2005 also extends the protections afforded to netting arrangements by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). FDICIA provides that a netting arrangement will be enforced pursuant to its terms, notwithstanding the failure of a party to the agreement. The act extended FDICIA's protections of netting arrangements to

multilateral clearing organizations,
uninsured national and state member banks,
foreign banks and their branches and agencies,
netting arrangements governed by the laws of a foreign country, and
netting arrangements between clearing organizations.

Authority of FDIC and NCUAB

The Bankruptcy Act of 2005 provides that no provision of law may be construed to limit the power of the FDIC or the National Credit Union Administration Board (NCUAB) to transfer, or to disaffirm or repudiate, any QFC in accordance with its powers under the FDI Act or the FCUA, respectively. Moreover, the act denies enforcement of "walkaway" clauses in QFCs. The act defines a walkaway clause as a provision that, after calculation of the value of a party's position or an amount due to or from one of the parties upon termination, liquidation, or acceleration of the QFC, either (1) does not create a payment obligation for the party or (2) extinguishes a payment obligation of the party in whole or in part solely because of the party's status as a non-defaulting party.

The Bankruptcy Act of 2005 also amends the FDIA and the FCUA to expand the receivership authority of the FDIC and the NCUAB, respectively, to permit transfers of QFCs to "financial institutions." The amendment allows the FDIC and the NCUAB, when acting as receiver for an insolvent depository institution, to transfer QFCs to a non-depository financial institution, provided the transferee institution is not subject to bankruptcy or insolvency proceedings. In transferring QFCs, the receiver may not split the QFCs and related interests between the depository institution in default and a particular counterparty; rather, either the receiver must transfer all such QFCs to a single person or it may not transfer any of the QFCs for that particular counterparty. The act's amendments also permit transfers to an eligible financial institution that is a non-U.S. person, or the branch or agency of a non-U.S. person, or a U.S. financial institution that is not an FDIC-insured institution if, following the transfer, the contractual rights of the parties would be enforceable substantially to the same extent as under the FDI Act and the FCUA. The act similarly limits the disaffirmance and repudiation authorities of the FDIC and NCUAB with respect to QFCs so as to make those authorities consistent with the agencies' transfer authority. The act requires that a conservator or receiver must either disaffirm or repudiate all QFCs between the depository institution in default and a particular counterparty or disaffirm or repudiate none of such QFCs. This requirement limits the ability of the FDIC and the NCUAB to "cherry pick" the QFCs between a depository institution in default and a particular counterparty. The amendment is consistent with the FDIC's policy not to repudiate or disaffirm QFCs selectively. The unified treatment is fundamental to the reduction of systemic risk.

The Bankruptcy Act of 2005 also limits the enforcement of rights of termination, liquidation, or netting that arise solely because of the insolvency of a depository institution or that are based on the "financial condition" of the institution in receivership or conservatorship. However, any payment, delivery, or other performance-based default, or a breach of a representation or covenant putting in question the enforceability of the agreement, will not be deemed to be based solely on the financial condition of the institution. The amendment does not prevent counterparties from taking all actions permitted and recovering all damages authorized upon repudiation of any QFC by a conservator or receiver.

The Bankruptcy Act of 2005's amendments also permit the FDIC and the NCUAB to transfer QFCs of a failed depository institution to a bridge bank or a depository institution organized by the FDIC or NCUAB for which a conservator is appointed either (1) immediately upon the organization of such institution or (2) at the time of a purchase and assumption transaction between the FDIC or NCUAB and the institution. These institutions are not to be considered financial institutions that are ineligible to receive transfers of QFCs under the FDI Act.

TILA Amendments

The Bankruptcy Act of 2005 also includes several provisions that amend the Truth in Lending Act (TILA). These provisions deal principally with open-end (revolving) credit accounts and require new disclosures on periodic statements and on credit card applications and solicitations. The Board is required to issue regulations implementing most of the new provisions, and the new provisions generally will not become effective until twelve months after the regulations are finalized.

Minimum-Payment Warnings

The Bankruptcy Act of 2005 requires creditors to provide, on each periodic statement for open-end credit, a clear and conspicuous disclosure that making only the minimum payment will increase the interest the consumer pays and the time it takes to repay the balance. The statute also requires that the disclosure include

a hypothetical example of how long it would take to pay off a specified balance with a 17 percent annual percentage rate and
a toll-free telephone number that consumers can call to obtain an estimate of how long it will take to pay off their own balance if only minimum payments are made.

The Bankruptcy Act of 2005 contains an exemption from these disclosure requirements for a creditor that maintains a toll-free telephone number for the purpose of providing customers with the actual number of months that it will take to repay the customer's outstanding balance. To standardize the information provided to consumers, the act directs the Board to develop a "table" that creditors may use in responding to consumers. The Board and the FTC must establish their own toll-free telephone numbers for use by customers of small banks and non-depository institution creditors, respectively. ¹

Introductory Rate Offers

Credit card issuers that offer discounted introductory interest rates are required, under the Bankruptcy Act of 2005, to disclose clearly and conspicuously on the application or solicitation for the credit card the expiration date of the offer, the rate that will apply after that date, and an explanation of how the introductory rate could be lost (for example, by making a late payment).

Internet Solicitations

The act requires that credit card offers on the Internet must include the same disclosure table--commonly known as the "Schumer box"--that now is required to be included in applications or solicitations for credit cards that are sent by direct mail.

Late Fees

For open-end credit, the Bankruptcy Act of 2005 requires creditors to disclose, on each periodic statement, the earliest date on which a late payment fee may be charged, as well as the amount of the fee.

High Loan-to-Value Mortgage Credit

For home-secured credit that may exceed the home's fair market value, the act requires creditors to disclose in the application and in advertisements that the interest on the portion of the loan that exceeds the home's fair market value is not tax deductible.

Account Termination

Creditors are prohibited under the Bankruptcy Act of 2005 from terminating an open-end credit account before its expiration date solely because the consumer has not incurred finance charges on the account.

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Post-Employment Restrictions on Senior Examiners

In December 2004, Congress imposed a new federal post-employment restriction applicable to senior examiners of the federal banking agencies, as part of the Intelligence Reform Act. ² Under this provision, an officer or employee of a federal banking agency or a Federal Reserve Bank who acts as the "senior examiner" for a particular depository institution may not, within one year after terminating employment with the agency or Reserve Bank, knowingly accept compensation as an officer, director, employee, or consultant from that depository institution or any company (including a bank holding company) that controls the depository institution. A similar post-employment restriction is imposed on an officer or employee who acts as the senior examiner of a particular bank holding company or savings and loan holding company; in these circumstances, the post-employment restrictions apply to relationships with the bank holding company or savings and loan holding company and any depository institution subsidiary of the holding company. These post-employment restrictions are in addition to any other conflict of interest and ethics rules and restrictions that may apply to examiners under applicable federal law or the internal codes of conduct established by the agency or Reserve Bank.

Under the statute, an officer or employee of an agency or a Reserve Bank is considered to be the "senior examiner" of a particular depository institution or depository institution holding company only if the examiner has "continuing, broad responsibility" for the examination or inspection of that depository institution or holding company. In addition, to be subject to these new post-employment restrictions, the officer or employee must have served as the senior examiner for the relevant institution or holding company for two or more months during the final twelve months of his or her employment with the agency or Reserve Bank. If a senior examiner violates the one-year post-employment restrictions, the appropriate agency must initiate proceedings to impose an order of removal and prohibition or a civil money penalty on the former senior examiner, and may seek both remedies.

In November 2005, the Board and the other federal banking agencies jointly adopted rules implementing these new post-employment restrictions. See 70 FR 69,633 (November 17, 2005).