Too Much Protection for Derivatives in Bankruptcy

I have written before about my opinions regarding the “safe harbors” in the bankruptcy code. These are the provisions that exempt derivatives and repo contracts from the automatic stay, the prohibition on termination of contracts with the debtor, the prohibition on constructively fraudulent transfers and the prohibition on obtaining preferential treatment on the eve of bankruptcy.

In general, I think the current safe harbors are too broad and amount to little more than a subsidy to the derivatives industry. Similar provisions protect “securities contracts,” and open up the argument that any transaction that occurs in the general vicinity of a broker-dealer is immune from the normal rules of bankruptcy.

Maybe Congress wants to subsidize the industry, but it probably should stop pretending that these provisions are vital to protect mom, apple pie and the American economy from systemic risk. You could do that with narrower provisions, as I have shown.

My latest concern with regard to the safe harbors is not so much the statutory provisions, but the role that courts have come to play in expanding the provisions beyond their already broad statutory language.

These sorts of expansions come in two forms. First, there is the expansion that comes from seeming inattention. A recent example can be found in Judge Jed S. Rakoff’s opinion dismissing virtually all of the Madoff trustee’s preference and fraudulent transfer claims against the owners of the New York Mets.

The judge assumes the applicability of the safe harbor provisions with little analysis. The apparent basis of the ruling was Bernard L. Madoff’s registration as a stockbroker. But the bankruptcy code does not define stockbrokers by registration, instead referring to stockbrokers as persons “engaged in the business of effecting transactions in securities.”

One might wonder whether Mr. Madoff actually qualified under that test, but the opinion does not discuss it and simply presumes the answer.

Then there is the expansion that comes from an effort to embrace the apparent aims of Congress and run with it.

Kind of like a young person who is a bit too eager to please, these courts find a Congressional intention and take it to places even Congress might not have wanted to go.

A nice example of the latter is a recent decision by the United States Court of Appeals for the Fifth Circuit in Lightfoot v. MXEnergy Electric Inc. The court ruled that a requirements contract for the delivery of electricity was a protected “forward contract” under the bankruptcy code. Yet the contract did not specify any quantity or a delivery date.

Instead, the putative contract provided that the debtor’s “full electricity requirements” would be met and the debtor would be charged based on metered usage. If that is a forward contract, any contract involving a commodity (itself a rather vague term, since its includes “or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade”) that does not provide for immediate performance upon execution becomes a forward contract, and thus is not subject to the normal rules of bankruptcy.

The Fifth Circuit acknowledged this risk, but basically said it was bound by terms that Congress had given it. A court acting like a robot is cute, but it is a basic rule of interpretation that you define provisions in the context in which they are used.

Practically every corporate finance text you look at defines a forward contract as an agreement between two people for the delivery of an asset at a negotiated price on a set date in the future.

The Fifth Circuit Court’s certainty that Congress wanted Section 101(25)(A) of the bankruptcy code to change that normal understanding seems like more than a bit of a stretch.