Amending the Flaws in the Safe Harbors of the Bankruptcy Code: Guarding Against Systemic Risk in the Financial Markets and Adding Stability to the System
| Publication year | 2015 |
Amending the Flaws in the Safe Harbors of the Bankruptcy Code: Guarding Against Systemic Risk in the Financial Markets and Adding Stability to the System
Peter Marchetti
This Article discusses derivative transactions in bankruptcy. Generally, the parties to these transactions are major participants in the financial markets. On a worldwide basis, the estimated outstanding notional amounts of derivative transactions are approximately $693 trillion. Certain provisions of derivative trading contracts get special exemptions under the Bankruptcy Code. This Article will refer to these exemptions as the "Safe Harbors." Congress enacted the Safe Harbors to prevent systemic risk, i.e., to prevent a domino effect of bankruptcy filings among financial institutions. The Safe Harbors seek to accomplish this goal by permitting a party to a derivative trading contract to quickly terminate and liquidate its positions. Thus, these parties are, for the most part, not subject to the normal bankruptcy process that applies to other types of contracts.
Several recent disputes in the Lehman Brothers bankruptcy proceedings raise new issues that illustrate that the precise parameters of the Safe Harbors remain unclear. This lack of clarity adversely affects the ability of market participants to accurately perform credit risk analyses with respect to their derivative trading counterparties and may adversely impact the ability of certain market participants to prepare Living Wills, as required by the recently
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enacted Dodd-Frank Act. Similarly, it adversely affects the ability of a party to reorganize under the Bankruptcy Code. This Article argues that Congress should amend the Safe Harbors to address these issues to mitigate systemic risk.
Several academics have argued that the Safe Harbors should be repealed. Other recent proposals have argued that a short stay should apply before the Safe Harbors could be used against certain large financial institutions that file for bankruptcy protection. Congress, however, has not repealed the Safe Harbors. This Article argues that the Safe Harbors should be amended. Specifically, Congress should amend the Bankruptcy Code so that it is clear that Payment Suspension Clauses, Walkaway Clauses, and Flip Clauses are not enforceable against a debtor that has filed for bankruptcy where a party seeks to enforce such clauses based on that debtor's financial condition or bankruptcy filing or the financial condition or bankruptcy filing of any one of such debtor's affiliates. Furthermore, Congress should amend the Bankruptcy Code and Title II of the Dodd-Frank Act so that it is clear that Triangular Setoff Clauses are enforceable where either affiliated entities both agree to the Triangular Setoff or those affiliated entities guarantee each other's liabilities. Such amendments would both increase efficiency in credit risk analyses and in the drafting of Living Wills and mitigate systemic risk.
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During the past decade, the use of derivatives transactions has exploded.1 According to a recent survey, more than 94% of the world's largest corporations use derivatives for hedging purposes.2 Generally, the parties to these transactions are major participants in the financial markets, such as large banks, broker-dealers, commodity traders, large corporations, and hedge funds. The current estimated outstanding amount of such transactions on a worldwide basis is approximately $693 trillion.3 Certain provisions of derivative trading contracts get special treatment under the Bankruptcy Code (the "Code") and are exempted from some of its very important provisions.4 These exemptions
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are commonly referred to as the derivative safe harbor provisions of the Code (the "Safe Harbors").5
Congress enacted the Safe Harbors to prevent systemic risk, i.e., to prevent a domino effect of bankruptcy filings among financial institutions.6 The Safe Harbors seek to accomplish this goal by permitting a party to a derivative trading contract to quickly terminate and liquidate its positions thereunder.7 Thus, parties to derivative trading contracts are, for the most part, not subject to the ordinary bankruptcy process that applies to parties to other types of contracts. Several academics have criticized the Safe Harbors and argue that they should be repealed.8 These academics argue that the Safe Harbors do not
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accomplish their goal of preventing systemic risk.9 Similarly, more recently, some academics have proposed that a short stay apply to a party's ability to utilize the Safe Harbors against certain large financial institutions that file for bankruptcy protection.10 Despite these arguments, and despite significant financial reforms in the recent Dodd-Frank Wall Street Reform and Consumer
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Protection Act (the "Dodd-Frank Act"), Congress refused to repeal the Safe Harbors.11
As Congress has refused to repeal the Safe Harbors, this Article takes a different course than prior scholarship and focuses on clarifying the Safe Harbors. Indeed, several recent disputes that took place during Lehman Brothers' bankruptcy proceedings regarding issues of first impression illustrate that the precise parameters of the Safe Harbors remain unclear. This lack of clarity adversely affects (1) the ability of financial institutions and other market participants to accurately perform credit risk analyses with respect to their derivative trading counterparties; (2) the ability of a party to a derivative trading contract that files for bankruptcy protection (a "Debtor") to reorganize its business affairs under the Code;12 and (3) the ability of certain financial institutions that are required by the Dodd-Frank Act to formulate "Resolution Plans" or "Living Wills."13 The result is an increase in systemic risk and an increase in the lack of stability in our financial system. This Article argues that Congress should amend the Safe Harbors to address these issues so that systemic risk can be mitigated. Specifically, Congress should amend the Code so that it is clear that Payment Suspension Clauses, Walkaway Clauses, and Flip Clauses are not enforceable against a Debtor where a party seeks to enforce such clauses based on the Debtor's financial condition or bankruptcy filing or the financial condition or bankruptcy filing of any one of the Debtor's affiliates.14 Furthermore, Congress should amend the Code and Title II of the Dodd-Frank Act so that it is clear that Triangular Setoff Clauses are enforceable where either (1) affiliated entities agree to the Triangular Setoff or
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(2) those affiliated entities guarantee each other's liabilities. Such amendments would increase efficiency in credit risk analyses and mitigate systemic risk.15
First, this Article will present a brief overview of derivative transactions and the players involved in such transactions. That overview will briefly discuss certain contractual provisions commonly contained in the most widely-used derivative trading contract in the world—the International Swaps and Derivatives Association ("ISDA") Master Agreement.16 Similarly, that section will discuss the ambiguities surrounding the enforceability of such provisions in the bankruptcy context. Second, this Article will present an overview of the ISDA Master Agreement, focusing on the provisions that are crucial in the bankruptcy or insolvency context. Third, this Article will present a brief overview of the Safe Harbors and certain other provisions of the Code that are vital to an understanding of how the Code intersects with these various provisions of the ISDA Master Agreement.17 Fourth, this Article will briefly discuss certain provisions of the recently enacted Dodd-Frank Act that relate to
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the issues discussed in this Article. Next, this Article will discuss and analyze recent litigation that sent reverberations throughout the multi-trillion dollar derivatives markets involving issues of first impression with respect to the intersection of these provisions of the ISDA Master Agreement and the Code.18
This Article will conclude that Congress should further legislate to resolve some of the ambiguities that continue to exist with regard to the Safe Harbors. Failure to do so will have an adverse effect on the market because absent such legislation, financial institutions and other market participants lack the ability to precisely analyze their credit risk with regard to potential counterparties. Furthermore, for those financial institutions that are required by the Dodd-Frank Act to formulate Living Wills, this lack of clarity may impact their ability to effectively do so. Such a lack of clarity and predictability injects significant uncertainty in any credit risk analysis in the context of derivatives transactions and, as a result, seriously hampers parties' ability to conduct sound credit risk analysis. Clarifying legislation would not only afford market participants increased ability to conduct credit analysis, but also would inject increased certainty regarding such issues into the chapter 11 process, because a chapter 11 debtor would have certainty regarding its rights with respect to its various derivative counterparties.
A. Overview of Derivative Transactions and the Players Involved
Derivatives encompass various types of products including, among others, interest rate swaps, interest rate collars, interest rate caps, forward contracts involving commodities, currency swaps, equity derivatives, options, and credit default swaps.19 Generally, the value of many derivative transactions such as
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interest rate swaps and currency swaps change over time so that, on a particular date, the value of a particular derivative transaction may be "in the money" or an...
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