Rolling Back the Repo Safe Harbors

Authors: Edward R. Morrison, Mark J. Roe, and Hon. Christopher S. Sontchi

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Recent decades have seen substantial expansion in exemptions from the Bankruptcy Code’s normal operation for repurchase agreements. These repos, which are equivalent to very short-term (often one-day) secured loans, are exempt from core bankruptcy rules such as the automatic stay that enjoins debt collection, rules against prebankruptcy fraudulent transfers, and rules against eve-of-bankruptcy preferential payment to some creditors over other creditors. While these exemptions can be justified for United States Treasury securities and similarly liquid obligations backed by the full faith and credit of the United States government, they are not justified for mortgage-backed securities and other securities that could prove illiquid or unable to fetch their expected long-run value in a panic. The exemptions from baseline bankruptcy rules facilitate this kind of panic selling and, according to many expert observers, characterized and exacerbated the financial crisis of 2007–2009, leading to a bailout of the repo market and the institutions supporting mortgage-backed securities. The exemptions from normal bankruptcy rules should be limited to United States Treasury and similarly liquid securities, as they once were. The more recent expansion of the exemption to mortgage-backed securities should be reversed.

This article is forthcoming in The Business Lawyer, and a draft is available here.

The Case in Brief Against Chapter 14

Author: Bruce Grohsgal, Pachulski Stang Ziehl & Jones, LLP

Grohsgal-BruceResolution of a distressed financial company under Dodd-Frank Title II is a last – but crucial – resort.  Dodd-Frank, Title I, requires each large financial enterprise to file a “living will” that provides for its orderly resolution under the Bankruptcy Code.  Dodd-Frank Title II may only be used to liquidate a failing financial company that would “pose a significant risk to the financial stability of the United States” if resolved in a bankruptcy proceeding or under other federal or state law.  The FDIC must conduct a Title II resolution “in a manner that mitigates such risk and minimizes moral hazard.”  Dodd-Frank also expressly prohibits both a taxpayer-funded bailout and the Federal Reserve’s lending to a failing or failed financial firm.

Dodd-Frank has drawn fire, nonetheless, as encouraging, rather than preventing, bailouts.  Detractors urge repealing Title II of Dodd-Frank and amending the Bankruptcy Code to include a new Chapter 14 in its place.

The proposed Chapter 14’s central flaw is that it does nothing to reconcile Dodd-Frank’s purposes of mitigating systemic risk and minimizing moral hazard with the Bankruptcy Code’s starkly contrasting aims of reorganizing troubled companies, preserving going concerns and maximizing payments to creditors.

This article briefly summarizes Dodd-Frank’s orderly resolution regime and then addresses some of the core proposals for a new Chapter 14.  It concludes that the proposed Chapter 14 will not mitigate systemic risk, minimize moral hazard, or improve on Dodd-Frank’s prohibitions against bailouts, which are the primary purposes of Title II of Dodd-Frank.

The article is available here.

The Chapter 14 Proposal in the Senate

Author: Stephen D. Adams*

[This week the Roundtable looks at the Chapter 14 proposal in the Senate.  This post provides an overview of Chapter 14 as background to Bruce Grohsgal’s thoughtful piece from the ABI Journal available here.]

The Taxpayer Protection and Responsible Resolution Act of 2014 (S. 1861), commonly known as “Chapter 14”, aims to “end ‘too big to fail’ by repealing Dodd-Frank’s Title II” and “replacing it with a bankruptcy process” capable of safely resolving a Systemically Important Financial Institution.

The Chapter 14 proposal envisions a number of changes to the bankruptcy process, grouped into a new bankruptcy chapter (hence “Chapter 14”, a previously unused chapter) that would be available to bank holding companies. Chapter 14 would be run by a special group of financially experienced district judges, could allow for the FDIC to be appointed as trustee, and would have no period of plan exclusivity. In order to effect a quick sale similar to the FDIC’s single point of entry strategy for Title II, the Senate bill would add a two-day stay to bankruptcy’s swap safe harbors to give the trustee a chance to transfer the entire swap portfolio to a new company that is solvent. Repos, however, are treated like secured debt, but with the ability to immediately sell off high quality collateral (though not non-agency Mortgage-Backed Securities).

The Senate Bill draws on work from the Hoover Institution’s Resolution Project that proposed the original Chapter 14 in 2009 and 2010 and updated it recently.

Documents related to the original Chapter 14 proposal work, including proponents’ descriptions of the case for a new Chapter 14, can be found here. The text of S. 1861 can be found here. Professor Thomas Jackson’s Congressional testimony about Chapter 14 in 2014 can be found here.

*Editor, Harvard Law School Bankruptcy Roundtable, and Research Director, Harvard Law School Bankruptcy and Corporate Restructuring Project.

Another Court of Appeals Broadly Reads Settlement Payment Safe Harbor

By Michael L. Cook, Schulte Roth & Zabel LLP

The Courts of Appeals, with few exceptions, have broadly read the safe harbor defense contained in Bankruptcy Code §546(e) over the past 24 years.  It insulates a “settlement payment” or “margin payment” on a “securities contract,” “commodity contract” or “forward contract” from a trustee’s fraudulent transfer or preference claims unless the debtor makes the payment with “actual intent to hinder, delay or defraud creditors.”  Despite policy arguments by lower courts, trustees, creditors and commentators, the appellate courts have claimed to rely on the Code’s “plain language” to deny recovery.  In this Article, we discuss a recent Seventh Circuit decision that (a) reversed a district court’s “policy” decision purporting to divine Congress’s intent as to the proper application of the safe harbor provision; (b) rejected decisions by the Fifth and Ninth Circuits that refused to apply the safe harbor in the context of a Ponzi scheme; and (c) followed recent decisions of the Second and Fourth Circuits.

We discuss the Seventh Circuit’s close reading and application of the statutory language, “clearly and predictably using well established principles of statutory construction.”  Citing Supreme Court precedent, the court refused to rely on legislative history that was “neither passed by a majority of either House nor signed into law.”  Instead, the court explained why the safe harbor in the case before it yielded a sensible result, avoiding instability and uncertainty in the securities business.

We also review recent conflicting decisions in the lower courts that have resulted from imaginative attempts by lawyers to avoid application of the safe harbor defense.  Finally, we discuss another case pending in the Second Circuit that pushes the safe harbor defense to its outer limits.  That case asks (a) whether an intermediary is required in a safe harbor case, and (b) whether the defendant must show an adverse effect on financial markets.

Schulte Roth & Zabel Client Alert, April 3, 2014:  http://www.srz.com/Seventh_Circuit_Reads_Bankruptcy_Safe_Harbor_Broadly_to_Insulate_Preferential_Settlement_Payment_to_Commodity_Broker/

Practitioners, Academics, and a Judge Testify about Safe Harbors before Congress

Author: Stephen D. Adams

The House Judiciary Subcommittee on Regulatory Reform, Commercial, and Antitrust Law has held two sets of hearings in recent months on the bankruptcy safe harbors for repos and derivatives from the automatic stay, from preference and fraudulent conveyance law, and from the limitations on ipso facto clauses.

This past Wednesday, March 26, Judge Christopher Sontchi, Seth Grosshandler, Jane Vris, Thomas Jackson, and Michelle Harner testified. Last December, Jeffrey Lacker, Donald Bernstein, and Mark Roe testified.

Judge Sontchi argued that the 546(e)’s exception for all settlement transactions is too broad and also urged Congress to narrow the safe harbors for repos. Seth Grosshandler, of Cleary Gottlieb, reported on the work of the ABI safe harbors advisory committee (which includes both Judge Sontchi and Prof. Roe) and warned that the safe harbors are complex and potentially costly to alter.  Jane Vris, representing the National Bankruptcy Conference (NBC), and Thomas Jackson, professor at the University of Rochester, testified on bankruptcy of SIFIs as an alternative to Dodd Frank resolution of bail-out.  Michelle Harner, professor at University of Maryland School of Law, testified in her role as the Reporter to the ABI Commission on Bankruptcy Reform about the Commission.

Mark Roe, professor at Harvard Law School, testified that the safe harbors facilitate excessive short-term funding of financial institutions and impede effective resolution of large financial failures, like that of Lehman in 2008.  Donald Bernstein, of Davis Polk, a member of the ABI bankruptcy commission, testified about the bankruptcy adjustments needed to adapt bankruptcy law to the FDIC’s Single Point of Entry resolution mechanisms.  Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, testified about the importance of bankruptcy reform to reduce the problem of too-big-to-fail and reduce reliance on short-term debt.

The written testimonies are linked above, and the video of the oral testimonies for the March 26th hearing will be found here once it has been posted, and is here for the December 3rd hearing.

For more on the bankruptcy safe harbors for derivatives and repurchase agreements, please see the post by Steven L. Schwarcz and Ori Sharon summarizing their recent paper, The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, and the post by Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, and John Thompson, entitled Lehman Bankruptcy Court Issues Safe Harbor Decision, summarizing a recent Lehman case decision on the safe harbors, both published Tuesday.

The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis

Authors: Steven L. Schwarcz and Ori Sharon

Bankruptcy law gives creditors in derivatives transactions a “safe harbor” in the form of special rights and immunities. In The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, available on SSRN here, we argue that this safe harbor grew incrementally from industry lobbying, without a rigorous vetting of its consequences. This type of legislative accretion is path dependent, in that its outcome is shaped by its historical path.

Path-dependent legislation is not necessarily bad; but if it’s not fully vetted, its significance and utility should not be taken for granted. For example, advocates of the safe harbor contend that the collapse of a highly connected derivatives counterparty might systemically disrupt the derivatives market, impacting the broader financial system. But there’s little evidence to support this.

Scholars also seriously question the safe harbor, estimating that the net exposure of the major derivatives dealers to their counterparties is small. They also argue that the safe harbor may not be focused on the right parties because it operates independently of the size of the counterparty and applies to non-financial firms. Thus a bank that makes a secured loan cannot enforce its collateral against a bankrupt borrower, but an ordinary company can enforce its collateral against a bankrupt derivatives counterparty. The safe harbor is also overly broad, tempting parties to try to document ordinary financial transactions as derivatives transactions.

Because the derivatives safe harbor has important consequences for systemic risk, there should be a more fully informed discussion of its merits.

[Editor’s note: Please stay tuned for a special post later this week on hearings on bankruptcy reform, financial institution insolvency, and derivatives in front of the U.S. House of Representatives Subcommittee on Regulatory Reform, Commercial, and Antitrust Law.]

Lehman Bankruptcy Court Issues Safe Harbor Decision

Authors: Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, John Thompson

On December 19, 2013, Judge James M. Peck of the United States Bankruptcy Court for the Southern District of New York issued his latest decision in the Lehman Brothers cases addressing the scope of the safe harbor provisions of the Bankruptcy Code.  Michigan State Housing Development Authority v. Lehman Brothers Derivatives Products Inc. and Lehman Brothers Holdings Inc. (In re Lehman Brothers Holdings Inc.).  Judge Peck’s decision confirms that the contractual provisions specifying the method of calculating the settlement amount under a swap agreement are protected by the Bankruptcy Code’s safe harbors.  The decision follows the reasoning of the amicus brief filed by the International Swaps and Derivatives Association (“ISDA”), which was prepared by Cadwalader.  For a full discussion of the case and argument, please continue reading here.

 

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