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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