Custodian or Not: Scrivener's Error in a Bankruptcy Code Safe Harbor

• Jurisdiction: United States,Federal
• Citation: Vol. 38 No. 1
• Publication year: 2022

Custodian or Not: Scrivener's Error in a Bankruptcy Code Safe Harbor

Thomas E. Plank

CUSTODIAN OR NOT: SCRIVENER'S ERROR IN A BANKRUPTCY CODE SAFE HARBOR

Thomas E. Plank^*

Abstract

This Article analyzes a drafting error in the United States Bankruptcy Code that remained latent for 36 years until 2020. This drafting error limits a safe harbor that Congress enacted in 1984 and expanded in 2005 to protect an important segment of the securities and mortgage loan markets.

When a person becomes a debtor in bankruptcy, the Bankruptcy Code imposes an automatic stay on substantially all actions by creditors and other entities against the debtor or the debtor's bankruptcy estate. It also abrogates contractual provisions, known as ipso facto clauses, that otherwise permit a party to terminate a contract because its counterparty filed a bankruptcy petition. In most cases, these rules produce a net benefit. Congress, however, has determined that, because of the nature and importance in the financial markets of certain qualified financial contracts, the costs imposed by these rules outweigh their benefits. In particular, Congress enacted specific safe harbor provisions for "securities contracts," which are contracts for the purchase and sale of securities and mortgage loans. These safe harbors permit a financial institution (a) to liquidate, terminate, or accelerate the securities contract immediately if the counterparty became a debtor in bankruptcy and (b) notwithstanding the automatic stay, to exercise immediately its rights under any security agreement or its rights of set off and netting.

A financial institution as defined includes not only a banking institution or trust company but also includes a customer of a banking institution or trust company that acts as a custodian for the customer. Congress intended to extend the safe harbor to customers who used a banking institution or trust company as a custodian in the ordinary sense of the word—a person holding securities or mortgage loans for another. Unfortunately, the drafters of the safe harbor were

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not aware that the Bankruptcy Code had already given the term "custodian" a narrow and misleading definition— a "Humpty-Dumpty definition." As defined, a "custodian" is, in the words of the legislative history, a prepetition liquidator such as an assignee for the benefit of creditors or other receiver or trustee appointed to liquidate the property of a borrower that later becomes a debtor in bankruptcy.

The use of this misleading Humpty-Dumpty definition of a prepetition liquidator in the definition of financial institution produces an absurd result. It nullifies the intended extension of the securities contract safe harbor to a customer that uses a banking institution or trust company as a custodian of the securities or mortgage loans. This use of this misleading defined is a true scrivener's error that permits courts to ignore the plain language of the statute. This Article argues that courts should ignore this misleading definition of "custodian" in the definition of financial institution. Instead, they should give the term "custodian" its commonly understood, ordinary meaning. They can easily add a simple judicial amendment comparable to other Bankruptcy Code definitions that specify the ordinary meaning of a defined term as an exception to an express technical meaning.

Table of Contents

Introduction...............................................................................................53

I. Securities contracts under the Bankruptcy Code..................58

A. The Limitations of the Bankruptcy Code .................................... 58
B. The Bankruptcy Code Safe Harbors........................................... 63

II. Legislative History: Custodian Versus Financial Institution........................................................................................66

A. The Definition of Custodian ....................................................... 67
B. The Addition of the Safe Harbors for Financial Institutions ...... 70

1. The 1982 Legislation: Safe Harbors for Stockbrokers under Securities Contracts ............................................................. 71
2. The 1984 Legislation: Safe Harbors for Repurchase Agreements and for Financial Institutions under Securities Contracts .............................................................................. 72
3. The Role of a Custodian for Non-Financial Participants .... 75

III. Plain Language and Scrivener's Error: A Custodian is not Always a Custodian.......................................................................84

A. The Absurdity from Applying the Definition of Custodian to Financial Institutions .................................................................. 87
B. An Easy Fix ................................................................................ 95

Conclusion...................................................................................................95

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Introduction

This Article analyzes a drafting error in the definition of "financial institution" in the United States Bankruptcy Code.¹ This drafting error limits the safe harbors that congress enacted to protect an important segment of the securities and mortgage loan markets.

Under the Bankruptcy Code, a financial institution may immediately terminate a contract for the purchase and sale of securities or mortgage loans— a "securities contract"² —if a party to the contract becomes a debtor in bankruptcy.³ A financial institution may also immediately exercise its rights under any security agreement or its rights of set off and netting, and it is exempt from the bankruptcy trustee's power to avoid prepetition preferential or constructively fraudulent transfers.⁴ These advantages arise from specific exemptions in the Bankruptcy Code—safe harbors—from the application of three provisions of the Bankruptcy Code that generally affect non-debtor parties in a transaction: (i) the abrogation of ipso facto clauses, which are provisions in a contract or law that permit the termination or modification of rights of a party if that party becomes a debtor in bankruptcy, (ii) the automatic stay of most acts against the debtor and the debtor's bankruptcy estate, and (iii) the bankruptcy

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trustee's power to avoid specific prepetition transfers of interests in property by the debtor.⁵

One important type of securities contract is known in the marketplace as a "repurchase agreement." Under a market repurchase agreement, an entity that owns securities or mortgage loans sells the securities or mortgage loans to a buyer for a price and promises to repurchase the securities or mortgage loans at a future date for a repurchase price equal to the initial purchase price plus interest.⁶ If the seller becomes a debtor in bankruptcy, a financial institution, whether acting for itself as buyer or pursuant to authorization from the buyer, may immediately liquidate, terminate, or accelerate the securities contract and sell the transferred securities or mortgage loans to third parties or to itself and apply the liquidation proceeds to the repurchase price. The seller is entitled to any surplus from the liquidation and is obligated to pay the buyer any deficiency in recovering the repurchase price. The financial institution is entitled to the benefit of the safe harbors for securities contracts.

A narrower form of market repurchase agreement, defined in the Bankruptcy Code as a "repurchase agreement," also enjoys safe harbors similar to those for securities contracts. The use of the defined term "repurchase agreement" for this narrower type of market repurchase agreement is unfortunate. It creates confusion between what the market considers a repurchase agreement and what the Code defines as a repurchase agreement.⁷ Specifically a "repurchase agreement" as defined under the Code is an agreement for the transfer of federal government securities, certain other specific obligations, and mortgage loans, with a simultaneous agreement by the transferee to transfer to the transferor those assets within one year after the transfer or upon demand.⁸ To differentiate

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this narrower type of repurchase agreement from securities contracts, I will refer to the defined repurchase agreement as a "Code repurchase agreement."

Although encompassing a narrower range of transactions, a Code repurchase agreement has one advantage over a securities contract. Any entity that is a party to a Code repurchase agreement—a "repo participant"—has the benefit of the safe harbors for Code repurchase agreements. Accordingly, the definition of financial institution is not relevant to Code repurchase agreements. Nevertheless, I also discuss the Code repurchase agreement because Congress added the definition of financial institution, extended the safe harbors under securities contracts to financial institutions, and added the full safe harbors for Code repurchase agreements in the same legislation—the Bankruptcy Amendments and Federal Judgeship Act of 1984⁹ —for the same reasons.

In 2005, Congress added mortgage loans and interests in mortgage loans to the assets that were entitled to safe harbor treatment under securities contracts¹⁰ and Code repurchase agreements.¹¹ This addition made sense because of the large size of the market for mortgage loans, which are generally sold at least once and often more frequently. For example, as of December 2005, there were approximately $9.4 trillion of single-family mortgage loans outstanding and $12.1 trillion of total mortgages loans (home, multifamily, commercial and farm) outstanding.¹²

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This volume was significantly larger than the outstanding balance of marketable U.S. Treasury securities ($4.4 trillion).¹³ It was also significantly larger than the outstanding balance of bonds of non-financial corporations ($3.0 trillion) and bonds of domestic financial entities ($4.7 trillion), although a...