Senator Reed Introduces Study Bill to Assess Systemic Risk Impact of “Bankruptcy-for-Banks” Reforms

On December 6, Senator Jack Reed introduced a bill aimed at establishing a more informed basis for regulatory and policymaking action on financial institution bankruptcies. The bill would mandate bi-annual reports by financial regulators on key issues in the resolution of financial companies under the Bankruptcy Code, such as potential reforms to the safe harbors for repos and derivatives, strategies for mitigating the systemic impact of financial company bankruptcies, risks embedded in the “single point of entry” strategy (particularly if it is tried and fails), and sources of liquidity for a financial company in bankruptcy. Overall, the bill calls for regulators to make a big picture assessment of how various bankruptcy reforms would affect systemic risk, drawing attention to weaknesses in some of the policy proposals in this area.

The bill also would also amend bankruptcy court procedure for financial firm bankruptcies. Most notably, it would revise the Bankruptcy Code to give the Federal Reserve and other regulators standing to be heard in financial company bankruptcies. Additionally, the bill would provide for the Federal Reserve and the FDIC, jointly, to propose five potential trustees for the financial company, with the United States trustee selecting the final appointee from this list. Finally, the bill would require the Supreme Court to issue a rule establishing a procedure for appointing a bankruptcy or district court judge with appropriate expertise to preside over the bankruptcy resolution of a financial company.

The Roundtable’s full update on the bill is available here.

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


Related posts on legislative reform proposals are available here and here. The Roundtable has also posted previously on policy issues surrounding “bankruptcy for banks” reforms. For example, see Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“; Roe & Adams, “Restructuring Failed Financial Firms in Bankruptcy“; and Lubben & Wilmarth, “Too Big and Unable to Fail.”

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.

United States Court of Appeals for the Second Circuit Holds That Claims Arising from Securities of a Debtor’s Affiliate Must Be Subordinated to Senior or Equal Claims of the Same Type as the Underlying Securities

posted in: Cramdown and Priority | 0

By Fredric Sosnick, Douglas P. Bartner, Joel Moss, Solomon J. Noh and Ned S. Schodek of  Shearman & Sterling LLP

 

Lehman Brothers Inc. (“LBI”) was lead underwriter for unsecured notes issued by Lehman Brothers Holdings Inc., LBI’s affiliate and parent. A Master Agreement Among Underwriters governed the relationship between LBI and the offering’s junior underwriters, and created among them a right of indemnification for liabilities resulting from securities fraud claims related to the offerings.

 

Following the bankruptcy of Lehman Holdings and the SIPA proceeding of LBI, investors filed securities fraud lawsuits alleging material misstatements and omissions in the offering documents, and asserted claims for contribution against LBI. The SIPA trustee objected, arguing that the claims were subject to mandatory subordination under § 510(b) of the Bankruptcy Code. The underwriters argued that because Lehman Holdings, not LBI, issued the securities, § 510(b) did not apply to the underwriters’ claims.

 

The Second Circuit held that claims arising from securities of a debtor’s affiliate must be subordinated to all claims senior or equal to claims of the same type as the underlying securities. As a result, the claims for contribution and reimbursement for losses incurred in the course of defending and settling securities fraud lawsuits brought by investors in securities issued by LBI’s affiliate were subordinated to the claims of LBI’s general unsecured creditors pursuant to § 510(b).

 

This Court of Appeals’ decision was based on precedent, textual support and legislative history, and it clarifies the appropriate classification of claims in the affiliate-securities context.

 

For the full memo is available 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.

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.

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.