Lehman’s Derivative Portfolio

By Stephen Lubben, Seton Hall University School of Law

Derivatives themselves were likely at most a secondary cause of the Lehman’s collapse, and played a more central role in other firms caught up in the financial crisis, like AIG. But the late Harvey Miller suggested that derivatives were responsible for a massive loss in value suffered by Lehman post-bankruptcy. Bryan P. Marsal, the Lehman estate administrator, likewise asserted that as much as $75 billion in value was destroyed, largely as a result of the sudden termination of Lehman’s derivatives book.

The singular losses caused by Lehman’s derivative portfolio to Lehman’s bankruptcy estate come from these safe harbors and the system of closeout netting the safe harbors support. While the safe harbors have been thoroughly studied and debated in the abstract, a close look at Lehman’s experience provides important insights for the future.

In particular, the largest part of Lehman’s derivative portfolio shows how financial institutions will suffer when resolution is attempted in the traditional bankruptcy system, despite the Dodd-Frank Act’s professed preference for “normal” bankruptcy process over specialized insolvency regimes like the new “Orderly Liquidation Authority.”

And the abrupt closeout of Lehman’s cleared derivatives portfolio by CME, which Lehman’s examiner noted as the source of several obvious losses to the bankruptcy estate, also provides important insights, especially given Dodd-Frank’s strong preference for central clearing going forward.

My paper Lehman’s Derivative Portfolio, written as a chapter for a forthcoming book, looks at both issues, and suggests that the continuation of the safe harbors “as is” renders chapter 11 nonviable for larger financial institutions, and recent contractual attempts to work around the safe harbors are insufficient to solve the problem, while the increased role of clearinghouses in financial institution failures will force regulators to confront difficult choices. In short, the regulators will have to balance two competing systemic risks: the risk of an unruly resolution of the financial institution, balanced against increased risk to the clearinghouse.

The Roundtable has previously posted multiple items on the derivatives safe harbors: on selling Lehman’s derivatives portfolio, systemic risk issues, the safe harbors’ history, two posts on the ISDA derivatives stay protocols (here and here), and on congressional testimony.

House Judiciary Committee Approves Bill to Amend Chapter 11 for Financial Institution Bankruptcies

On February 11, 2016, the House of Representatives Judiciary Committee approved H.R. 2947—the Financial Institution Bankruptcy Act (FIBA)—which would amend the Bankruptcy Code to accommodate more smoothly the resolution of systemically important financial institutions (SIFIs). Introduced in July 2015, the current bill is essentially identical to an earlier version that passed the House in December 2014 (discussed in a Roundtable post here).

Like two pending Senate proposals, FIBA focuses on facilitating the recapitalization of a SIFI through a “single point of entry” (SPOE) approach similar to the strategy the FDIC has developed for implementing the Orderly Liquidation Authority (OLA) created in Title II of the Dodd-Frank Act. During an SPOE resolution, most of the failing SIFI’s assets would be transferred to a non-debtor bridge holding company to continue operations, leaving long-term debt and equity behind in the original holding company to be liquidated. (For a previous Roundtable post describing SPOE, click here.) Although both the House and the Senate bills would adapt the Bankruptcy Code to support recapitalization, FIBA differs from the Senate proposals in some important ways.

First, unlike the Senate proposals, FIBA does not repeal the OLA’s regulatory resolution process. FIBA would eliminate some of the major differences between the OLA and the current Bankruptcy Code to make bankruptcy a more viable route for failing SIFIs, but the OLA would remain an option for regulators.

Second, FIBA does not address either private or public financing for the bridge company. The Senate Judiciary Committee’s proposal, on the other hand, explicitly prohibits federal government funding. The bill pending in the Senate Banking, Housing, and Urban Affairs Committee also prohibits financing by Federal Reserve banks.

At the same time, FIBA and the Senate bills both impose a 48-hour stay on the exercise of contractual rights to terminate, liquidate, and offset qualified financial contracts to allow their transfer to a bridge company. At present, safe harbors in the Bankruptcy Code exempt such contracts from the automatic stay, and even the OLA imposes a stay of only one business day.

The full text of FIBA may be found here.

(This post was authored by Rebecca Green, J.D. ’17.)

Testimony before House Judiciary Committee on Financial Institution Bankruptcy Act

By Stephen E. Hessler, Kirkland & Ellis LLP

hesslerCongress is again advancing legislation to amend the Bankruptcy Code to add specific provisions for administering the case of a major financial institution.  The belief that the Chapter 11 filing of Lehman Brothers was a key cause of the Great Recession led Congress to enact in 2010, as part of the Dodd-Frank Act, Title II, which provided “orderly liquidation authority” to the federal government to wind down insolvent financial companies whose failure would have “serious adverse effects on financial stability in the United States,” in proceedings administered by the FDIC.  Although there has never been a Title II proceeding, Dodd-Frank has been significantly criticized for creating a new resolution framework that imbues politically-sensitive regulators with broad and untested discretion to liquidate a major bank.

In further response, the House of Representatives last year passed the Financial Institution Bankruptcy Act of 2014, but the Congressional session expired without consideration of the bill by the Senate.  In July 2015, the House Judiciary Committee held another hearing on H.R. 2947, the reintroduced Financial Institution Bankruptcy Act of 2015.  This bill, which is substantively identical to last year’s iteration, proposes to amend the Bankruptcy Code by adding a new Subchapter V within current Chapter 11.  The central feature of Subchapter V is referred to as the “single point of entry” approach that allows a debtor to separate quickly upon filing “good” from “bad” assets through a near-immediate postpetition transfer of “good” assets to a nondebtor bridge company whose equity is held by a trust that is managed by a special trustee for the benefit of creditors of the chapter 11 estate.  The “bad” assets would then be liquidated within the chapter 11 case.  Critically, both the proposed transfer and liquidation transactions are subject to Bankruptcy Court approval.

For a further exploration of the legislation and these issues, my testimony before the House Judiciary Committee in 2015 is available here and my testimony before the House Judiciary Committee in 2014 is available here. Please note the views expressed in my testimony are solely my own, and are not offered on behalf my firm, any client, or other organization.

For a previous Roundtable post on the Financial Institution Bankruptcy Act see here.

Financial Experts in Chapter 11 Bankruptcies: Unique Situations from Common Assignments

By Allyn Needham, Shipp, Needham & Durham, LLC

needhamWhen disagreements arise in Chapter 11 bankruptcies, debtor and/or creditors’ counsel may seek financial experts to provide information relative to their positions. While engagements of economic experts may cover a broad spectrum of analyses, these engagements generally fall into two areas: determining the appropriate interest rate for the repayment of a secured claim and the liquidation and/or fair market value of certain assets or the bankrupt business as a whole.

The assessment of interest rates and appraising the value of a business are assignments not limited to bankruptcy work alone. Most financial experts are familiar with the methods required to perform these tasks. However, even in the application of these basic analyses, Chapter 11 bankruptcy may present unusual assignments.

This article discusses two unique situations that may arise from common assignments. The first is the application of the cramdown interest rate model when a creditor makes an 1111(b) election. An 1111(b) election allows an under secured creditor to be paid its total allowed claim (both secured and unsecured). This impacts the interest rate and its application toward retirement of the claim. The second considers the concept that the “highest bidder may not be the best bidder” when selling a bankrupt business. The best bid may not be the highest bid due to differing prices, terms, contingencies and impact on the local economy (e.g. closing a business or location) in the competing bids.

To read the full article see here.

Bankruptcy Code With No Repo Safe Harbor — An Evaluation

By Jeffrey Murphy and Lee Smith of Dentons

The ABI Reform Commission recommended that the safe harbors under Section 555 and 559 of the Code be revised to return to their pre-2005 contours and, specifically, that the safe harbors exclude mortgage warehousing, which is a short-term revolving credit facility extended by a financial institution to the loan originator. We believe that excluding mortgage warehousing transactions from the safe harbors will increase “contagion risk” and also reject the Commission’s assertion that mortgages, in comparison with other safe-harbored asset types, are “illiquid” investments based upon our experience with mortgage loan trading.  The largest banks, and ever increasingly, the largest investment funds, are major participants in the mortgage markets as originators, buyers, and market makers (the same cannot be said of, say, municipal bonds), and the financial crisis started with a subset of the mortgage markets: subprime mortgages.

We are not persuaded that repo financing contributed to the excesses of the credit boom of the mid-2000s, nor do we believe that the Bankruptcy Code safe harbors for the liquidation, termination or acceleration of repurchase agreements are to be indicted for causing “runs” on debtors that knowledgeable market actors will not restructure.  To the contrary, mortgage repos are a crucial component of healthy housing markets, and fairness requires that debtors relieved of their margin call obligations by a bankruptcy filing not have options to satisfy their obligations while the repo buyers are exposed to all the market risk.

For our full analysis of the ABI recommendation, please see here.

Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio

By Mark J. Roe, Harvard Law School, and Stephen D. Adams, Ropes & Gray LLP

adams-stephen-200 Roe 124Lehman Brothers’ failure and bankruptcy led to the deepest part of the 2008 financial crisis. Yet, while Congress reformed financial regulation in hopes of avoiding another crisis, bankruptcy rules, such as those that governed Lehman’s failure, have persisted unchanged. When Lehman failed, it lost perhaps tens of billions of dollars of further value when its contracting counterparties terminated their financial contracts with Lehman.

Bankruptcy must be able to market salable parts of the failed institution’s financial contracts portfolio at other-than-fire-sale prices. Current law prevents this marketing, however. It allows only two polar choices: sell the entire portfolio intact (currently impossible in bankruptcy and only narrowly viable under Dodd-Frank) or allow for the liquidation of each contract, one-by-one (which worked poorly in Lehman). Bankruptcy needs authority, first, to preserve the failed firm’s overall portfolio value, and, second, to break up and sell along product lines a very large portfolio that is too large to sell intact.

Congress and the regulators favor bankruptcy for financial resolution. Yet, bankruptcy law has neither been fixed nor even updated here since the financial crisis. We here outline one critically needed fix: authorizing bankruptcy to break up a large derivatives portfolio by selling its constituent product lines, one-by-one, instead of a Lehman-style close-out of each contract, one-by-one.

This article is forthcoming in 32 Yale Journal on Regulation. A full draft of the article can be found here.

For related pieces discussing safe harbors, see here and here.

The ISDA 2014 Resolution Stays Protocol and the Bankruptcy Code Safe Harbors

By David Geen and Samantha Riley of the International Swaps and Derivatives Association (ISDA)

The International Swaps and Derivatives Association (“ISDA”) recently published the 2014 Resolution Stay Protocol (the “Protocol”). Developed by a working group comprised of both dealer and buy-side market participants in consultation with regulators from France, Germany, Switzerland, Japan, the United Kingdom and the United States, the Protocol has been hailed by the Financial Stability Board as a “crucial element[] of the policy framework to end too-big-to-fail.” In addition to addressing the failure of systemically important financial institutions (“SIFIs”) under special resolution regimes, such as the Orderly Liquidation Authority provisions of the Dodd-Frank Act or the EU Bank Recovery and Resolution Directive, Section 2 of the Protocol also addresses the failure of SIFIs under the U.S. Bankruptcy Code (the “Code”).

Section 2 of the Protocol was developed to support SIFI resolution strategies under the Code where operating companies, such as banks and broker dealers, are kept out of insolvency proceedings altogether, while affiliates, such as a parent holding company, are restructured through Chapter 11 proceedings. Section 2 introduces a short, temporary stay on the exercise of default rights that arise because of the parent’s or other affiliate’s entry into bankruptcy proceedings to enable the SIFI to take actions to preserve the operating companies as going concerns. If the actions taken satisfy the conditions established by the Protocol, the termination rights that arose as a result of the SIFI entering bankruptcy proceedings would be permanently overridden.

Naturally, questions have arisen as to the interplay between Section 2 of the Protocol and the safe harbors for swap agreements under the Code. The Code stays, and safe harbors, default rights that arise because a counterparty to an ISDA Master Agreement subject to the Protocol enters proceedings under the Code; it does not stay (and therefore does not need to safe harbor) contracts between non-debtor affiliates and their counterparties. The Protocol only addresses the affiliate contracts, and thus does not alter the scope or application of the safe harbors.

To help interested parties better understand the Protocol, ISDA has developed a detailed FAQ. The full text of the Protocol can be found on ISDA’s website.

ISDA Resolution Stay Protocol: A Brief Overview

On November 12, 2014, the International Swaps and Derivatives Association (“ISDA”) officially released the ISDA 2014 Resolution Stay Protocol (the “Protocol”), a mechanism that contractually imposes a stay on certain default rights in ISDA contracts between adhering parties during the resolution of a significantly important financial institution (SIFI) counterparty or one of its affiliates.

The first section of the Protocol—addressing default rights under Special Resolution Regimes (“SRRs”) (e.g., the U.S.’s OLA and FDIA)—is relatively uncontroversial. It merely ensures that adhering cross-border counterparties will be bound by the preexisting stay provisions of a foreign SRR, even if the jurisdictional limitations of the SRR would normally exempt such cross-border counterparties. This section went into affect for the 18 adhering banks on January 1, 2015.

The second section of the Protocol—addressing default rights under the U.S. Bankruptcy Code—has been met with significantly more contention. This section confines, to a limited extent, the use of currently existing “safe harbors” in the Code, by contractually limiting certain cross-default rights in ISDA contracts in the case of a counterparty’s affiliate’s bankruptcy, so that the affiliate is not also forced into bankruptcy, where close-out rights are safe-harbored. Significantly, this section will not go into effect until further regulations are promulgated by the Federal Reserve and other U.S. regulators. The concept behind the Protocol’s second section is that a failure of one part of a SIFI should not necessarily lead to defaults and close-outs of derivatives and repos sitting in affiliates of the SIFI, if the affiliate is still performing on its obligations.

The HLS Bankruptcy Roundtable has focused on the Code’s safe harbors previously. Click here for an analysis of the effect of the safe harbors on systemic risk; click here for an argument for narrowing the safe harbors for repos.

Congress is also currently considering the issue of the safe harbors in the case of a SIFI failure. Click here and here for previous coverage of currently pending legislation, the Financial Institution Bankruptcy Act, which would impose a short stay on financial contracts in the case of a SIFI resolution under the Bankruptcy Code.

For a full discussion of the Protocol, please see Mayer Brown’s Legal Update, here.

(This post was drafted by Stephanie Massman, J.D. ’15.)

House Passes Financial Institution Bankruptcy Act

On December 1, 2014, the House of Representatives passed, with bipartisan support, H.R. 5421—the Financial Institution Bankruptcy Act of 2014 (FIBA), a bill that would amend the Bankruptcy Code to better allow for the resolution of systemically important financial institutions (SIFIs). FIBA (previously discussed in Roundtable posts here and here) is similar in many respects to the bankruptcy amendments proposed in another bill introduced in the Senate (previously covered here) and to the “chapter 14” proposal from the Hoover Institution, but there are some key differences among these proposals.

First of all, the Senate version would entirely repeal the Orderly Liquidation Authority (OLA), the current regulatory receivership alternative to traditional bankruptcy (and to some, the only current viable option) to resolve failed SIFIs. Both FIBA and the Hoover Institution’s version, however, would keep the OLA in place as an alternative.

Additionally, each proposal takes a different approach to the issue of federal funding in a SIFI resolution, which is provided in an OLA resolution. The Hoover Institution’s version does not explicitly provide for such federal funding, but it does contemplate it and condition it upon a showing that no private funding is available. FIBA is silent on the matter, and the Senate version explicitly prohibits it.

Lastly, both FIBA and the Senate proposal solely focus on facilitating a single-point-of-entry (SPOE) resolution of a SIFI, whereas the Hoover Institution’s proposal seeks to accommodate both an SPOE recapitalization and a conventional reorganization of a SIFI. An SPOE recapitalization would make debt and equity at the financial holding company take the brunt of losses, while substantially all of the holding company’s assets would be transferred to a new bridge institution and cash would be pushed down into shaky subsidiaries to prevent their bankruptcy. A conventional reorganization (or liquidation) of a SIFI would largely track traditional bankruptcy approaches, with the troubled subsidiaries entering bankruptcy.

These and other differences among the proposals are some of the most debated aspects in the SIFI resolution reform discussion. Moreover, which version (if any) ultimately passes through both houses of Congress and is signed by President Obama may set significant precedent in resolution regimes worldwide.

For previous HLS Bankruptcy Roundtable coverage of the viability and limits of an SPOE approach in bankruptcy, click here and here.

This post was composed by Stephanie Massman (J.D. ’15)

Derivatives and Collateral: Balancing Remedies and Systemic Risk

By Steven L. Schwarcz, Duke University School of Law

schwarczProfessor Schwarcz examines whether the bankruptcy “safe harbor” for derivatives is necessary or even appropriate to protect against systemic risk—such protection being the safe harbor’s articulated justification. The article examines the most important function of the safe harbor: allowing derivatives counterparties to exercise their contractual enforcement remedies against a debtor or its property notwithstanding bankruptcy law’s stay of enforcement actions. A threshold question is whether there is anything inherently risky about derivatives that might cause a systemic failure.

The standard answer is volatility. But, the article observes, regulation could reduce that potential for systemic risk in a more limited fashion. The article next addresses the safe harbor from the standpoint of its impact on avoiding contagion. The safe harbor is supposed to enable large derivatives dealers to enforce their remedies against a failed counterparty, thereby minimizing the dealer’s losses and reducing its chance of collapse. There are, however, several flaws in the safe harbor’s design to accomplish that. First, the safe harbor incentivizes systemically risky market concentration by enabling dealers and other parties to virtually ignore counterparty risk. Second, the safe harbor operates independently of the size of the counterparty or its portfolio. The article then examines how the Lehman bankruptcy might inform the safe harbor debate. The article offers a final caution: To the extent the safe harbor might amplify, rather than protect against, systemic risk, its negative impact would transcend the traditional derivatives market.

The full version of this article is forthcoming from the University of Illinois Law Review and is available in draft form here.

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