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Erik correctly sensed my wariness regarding the treatment of derivatives under the U.S. Bankruptcy Code and the new resolution authority granted the federal government under the Dodd-Frank Act. (By the way Erik, great job posing thoughtful questions and fostering additional discussion in the forum; thanks!) In my previous post, I noted that both resolution schemes contain exceptions (a/k/a “safe harbors”) for derivatives and counterparty obligations, and I provided a link to Mark Roe’s article concerning potential issues with that treatment. Accordingly, Erik posed the following question:

Michelle: What do you think of Mark Roe’s argument that providing various exemptions in Ch. 11 (from the automatic stay) for derivative counterparties exacerbated the crisis? Did these exemptions warp the incentives of derivatives counterparties to monitor and discipline debtors? Is this a hole in Dodd-Frank?

I generally agree with Mark Roe’s characterization of the derivative exceptions and the need to remedy this problem under the Bankruptcy Code. As it stands, counterparties have the ability basically to dismantle a financial institution by invoking netting, liquidation, termination and other rights under their derivative contracts as that financial institution becomes more distressed and even after it files for bankruptcy. As Erik’s comment implies, the automatic stay, the prohibition against the enforcement of ipso facto clauses and the threat of avoidance actions in bankruptcy generally do not apply to counterparties. As a result, counterparties can protect their economic interests at the direct expense of the debtor and its other stakeholders.

The Dodd-Frank Act incorporates similar exceptions for counterparties and allows counterparties to exercise many of their contractual rights after a short grace period (one business day). Nevertheless, the Act does impose some limitations on counterparties that are uncertain under the Bankruptcy Code (see, e.g., here). For example, the Act restricts the enforcement of walkaway provisions—i.e., provisions that allow the nondefaulting party to suspend obligations owed to the defaulting party or forego any payments due to the defaulting party upon termination of the contract. So perhaps the Act recognizes some of the vast inequality created by the derivative exceptions, but I do not think it goes far enough.

From my perspective, inequality and the resulting consequences are the real reasons for concern. One of the bedrock principles of the Bankruptcy Code is similar treatment for similarly-situated creditors; it helps protect both the debtor and its stakeholders by, for example, ensuring that creditors are not rewarded for high-pressured tactics immediately before bankruptcy and providing some incentive for creditors to work together to maximize their collective return. The derivative exceptions undercut this principle and grant counterparties far greater rights than ordinary secured or unsecured creditors. I recognize that counterparties face challenging issues in a bankruptcy or liquidation scenario, but I do not believe that the burden of those issues should be placed on the shoulders of the debtor and its other stakeholders.

As to Erik’s other questions, I am uncomfortable grading the legislation as I view it as largely incomplete. The extent of its success (and it could be successful at the end of the day) depends so heavily on things yet unknown—e.g., who writes the rules; the content of the rules; and if and how they are enforced. Would I have voted for the legislation? It depends (yes, the dreaded lawyer answer). Analyzing a piece of legislation as an academic versus a politician requires similar yet very different considerations. Among other things, it would depend on the interests of my constituents and what I thought was best for my district. And finally, I will absolutely incorporate the legislation into my fall courses. I think it is important for our students to understand the import not only of this piece of legislation, but also the legislative process more generally, for businesses and consequently their future clients.

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Erik correctly sensed my wariness regarding the treatment of derivatives under the U.S. Bankruptcy Code and the new resolution authority granted the federal government under the Dodd-Frank Act. (By the way Erik, great job posing thoughtful questions and fostering additional discussion in the forum; thanks!) In my previous post, I noted that both resolution schemes contain exceptions (a/k/a “safe harbors”) for derivatives and counterparty obligations, and I provided a link to Mark Roe’s article concerning potential issues with that treatment. Accordingly, Erik posed the following question:

Michelle: What do you think of Mark Roe’s argument that providing various exemptions in Ch. 11 (from the automatic stay) for derivative counterparties exacerbated the crisis? Did these exemptions warp the incentives of derivatives counterparties to monitor and discipline debtors? Is this a hole in Dodd-Frank?

I generally agree with Mark Roe’s characterization of the derivative exceptions and the need to remedy this problem under the Bankruptcy Code. As it stands, counterparties have the ability basically to dismantle a financial institution by invoking netting, liquidation, termination and other rights under their derivative contracts as that financial institution becomes more distressed and even after it files for bankruptcy. As Erik’s comment implies, the automatic stay, the prohibition against the enforcement of ipso facto clauses and the threat of avoidance actions in bankruptcy generally do not apply to counterparties. As a result, counterparties can protect their economic interests at the direct expense of the debtor and its other stakeholders.

The Dodd-Frank Act incorporates similar exceptions for counterparties and allows counterparties to exercise many of their contractual rights after a short grace period (one business day). Nevertheless, the Act does impose some limitations on counterparties that are uncertain under the Bankruptcy Code (see, e.g., here). For example, the Act restricts the enforcement of walkaway provisions—i.e., provisions that allow the nondefaulting party to suspend obligations owed to the defaulting party or forego any payments due to the defaulting party upon termination of the contract. So perhaps the Act recognizes some of the vast inequality created by the derivative exceptions, but I do not think it goes far enough.

From my perspective, inequality and the resulting consequences are the real reasons for concern. One of the bedrock principles of the Bankruptcy Code is similar treatment for similarly-situated creditors; it helps protect both the debtor and its stakeholders by, for example, ensuring that creditors are not rewarded for high-pressured tactics immediately before bankruptcy and providing some incentive for creditors to work together to maximize their collective return. The derivative exceptions undercut this principle and grant counterparties far greater rights than ordinary secured or unsecured creditors. I recognize that counterparties face challenging issues in a bankruptcy or liquidation scenario, but I do not believe that the burden of those issues should be placed on the shoulders of the debtor and its other stakeholders.

As to Erik’s other questions, I am uncomfortable grading the legislation as I view it as largely incomplete. The extent of its success (and it could be successful at the end of the day) depends so heavily on things yet unknown—e.g., who writes the rules; the content of the rules; and if and how they are enforced. Would I have voted for the legislation? It depends (yes, the dreaded lawyer answer). Analyzing a piece of legislation as an academic versus a politician requires similar yet very different considerations. Among other things, it would depend on the interests of my constituents and what I thought was best for my district. And finally, I will absolutely incorporate the legislation into my fall courses. I think it is important for our students to understand the import not only of this piece of legislation, but also the legislative process more generally, for businesses and consequently their future clients.

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