A Consensus Begins to Emerge on Derivatives in Bankruptcy

Derivatives are contracts, but they are not treated like other contracts when one party enters an insolvency proceeding.

The banking sector – broadly defined to include the shadow banks – has largely argued that the special treatment is vital. Without the special treatment, the derivatives market would shrink, and the cost of hedging would balloon. Liquidity would evaporate. The skies would darken.

O.K., maybe not that last one.

On the restructuring side, the special treatment of derivatives – commonly referred to as the “safe harbors,” although really they should just be called exemptions – leads to an equal amount of face-pulling. In short, the exemptions destroy “going concern” value, and prefer one set of creditors over another, in violation of the general rule of equity. Financing decisions are distorted by the exemptions, and then the very purpose of Chapter 11 is thwarted when creditors don’t have to incur costs associated with the communal system that Chapter 11 entails. Chapter 11 is admired the world over, yet these sorts of special provisions are slowly destroying it.

There is not a lot of common ground here.

That’s why it was so surprising that something like a consensus seemed to emerge at a roundtable last week in Washington on this issue. At the roundtable, which was sponsored by the American Bankruptcy Institute and the World Bank, the participants – me included – seem to agree on two basic points:

1. Sometimes derivatives do deserve special treatment in insolvency, because they are unlike many other contracts. And the broader question of whether such contracts should exist, and to what degree, is probably best addressed by laws outside the insolvency system.

2. The current exemptions suffer from overbreadth, but fixing that problem by direct redrafting efforts won’t be easy. Maybe bankruptcy judges should have more power to police abuses of the exemptions, as they do in other areas.

It’s a start toward a more sensible policy in this regard. Now, the banking side was represented at the conference mostly by governmental types – I suspect actual industry participants will be much more hesitant to change the status quo. But it’s still a start.

As I argue in a recent paper, it certainly is time to move beyond the binary debate about whether or not the “safe harbors” should be repealed.