How the Bankruptcy Code Should Treat All Derivatives

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The American Bankruptcy Institute released a report on Chapter 11 laws.Credit

The American Bankruptcy Institute released its anticipated report on Monday on how Chapter 11 laws should be reformed and updated.

I was part of an earlier advisory committee that struggled with the special treatment of derivatives and related securities trades in Chapter 11 cases. The so-called safe harbor provisions excuse derivatives from much of the normal operation of the bankruptcy code. Normally, a debtor has some time to decide which contracts it wants to keep and which it no longer needs. But with derivatives, the choice moves to the non-bankruptcy parties, which get to decide whether they will allow the debtor to keep the contract or whether they will terminate the deal instead.

The advisory committee passed on several recommendations to the American Bankruptcy Institute’s larger Chapter 11 Reform Commission. Thus, I turned with great anticipation to the “safe harbors” portion of the report.

The report recommends four basic changes:

¶ A narrowing of Section 546(e)’s applicability to leveraged buyouts. Section 546(e) protects “settlement payments,” which, some have argued, protects any challenge to a leveraged buyout if the money passed through a financial institution.

¶ A narrowing of the repo safe harbors especially with regard to mortgage financing. Repos involve a sale of a security with a promise to buy it back at a slightly higher price. Short-term repo trades have a long tradition in banking, but in recent years the broad repo safe harbor has arguably allowed things that formerly were called secured loans to be recast as repos.

¶ Conforming the bankruptcy code to the Federal Deposit Insurance Act and the Dodd-Frank Act’s Orderly Liquidation Authority standards with regard to “walkway” clauses, which impose penalties on the bankrupt party to a derivatives trade. Under those two laws, such clauses are not enforceable. But under the bankruptcy code, they are.

¶ Making it clear that the safe harbors should not apply to ordinary supply contracts that don’t involve financial institutions.

All sensible changes, although really only a small step in the right direction.

The big issue that the commission dodged was whether real companies in bankruptcy should have the same rights that financial institutions have under the Dodd-Frank Act. Namely, should an operating company – imagine an airline with jet fuel hedges – have the ability to keep those hedges in place if it can continue to perform on those contracts after filing for bankruptcy?

Financial institutions can keep their derivatives books in place through a combination of the provisions of Dodd-Frank and new industry agreements that provide that an insolvency proceeding of a holding company will not disrupt the trades of an operating subsidiary, despite provisions in the contracts to the contrary.

Unfortunately, the bankruptcy institute’s commission did not seek similar changes for real economy debtors, even though the justification for the safe harbors – systemic risk – is even less tenable for nonfinancial institutions.

This, of course, is an area where consensus on how to make a change would be challenging. Most derivatives traders would agree, in a moment of candor, that a debtor that can truly perform on its trades should be allowed to keep them in bankruptcy.

But the status quo works well for traders. Any change potentially exposes them to the risk that a debtor will feign an ability to perform, and thus expose its counterparties to loss. Thus, staying with the cozy, familiar rules seems quite prudent.

Nonetheless, if Chapter 11 is going to work (and “working” here means preserving going concern value), it needs to preserve the value of all of the going concern. In a modern business, that has to include derivative contracts.