Amending the Flaws in the Safe Harbors of the Bankruptcy Code: Guarding Against Systemic Risk in the Financial Markets and Adding Stability to the System

31 EMORY BANKR. DEV. J. 305 (2015)

70 Pages Posted: 1 Aug 2016

See all articles by Peter Marchetti

Peter Marchetti

Texas Southern University - Thurgood Marshall School of Law

Date Written: June 1, 2015

Abstract

This Article discusses derivative transactions in bankruptcy. Generally, the parties to these transactions are major participants in the financial markets. On a world-wide basis, the estimated outstanding notional amounts of derivative transactions are approximately $693 trillion. Certain provisions of derivative trading contracts get special exemptions under the Bankruptcy Code. This Article will refer to these exemptions as the “Safe Harbors.” Congress enacted the Safe Harbors to prevent systemic risk, i.e., to prevent a domino effect of bankruptcy filings among financial institutions. The Safe Harbors seek to accomplish this goal by permitting a party to a derivative trading contract to quickly terminate and liquidate its positions. Thus, these parties are, for the most part, not subject to the normal bankruptcy process that applies to other types of contracts. Several recent disputes in the Lehman Brothers bankruptcy proceedings raise new issues that illustrate that the precise parameters of the Safe Harbors remain unclear. This lack of clarity adversely affects the ability of market participants to accurately perform credit risk analyses with respect to their derivative trading counterparties and may adversely impact the ability of certain market participants to prepare Living Wills, as required by the recently enacted Dodd-Frank Act. Similarly, it adversely affects the ability of a party to reorganize under the Code. This Article argues that Congress should amend the Safe Harbors to address these issues to mitigate systemic risk.

Several academics have argued that the Safe Harbors should be repealed. Other recent proposals have argued that a short stay should apply before the Safe Harbors could be used against certain large financial institutions that file for bankruptcy protection. Congress, however, has not repealed the Safe Harbors. This Article argues that the Safe Harbors should be amended. Specifically, Congress should amend the Bankruptcy Code so that it is clear that Payment Suspension Clauses, Walkaway Clauses and Flip Clauses are not enforceable against a debtor that has filed for bankruptcy where a party seeks to enforce such clauses based on that debtor’s financial condition or bankruptcy filing or the financial condition or bankruptcy filing of any one of such debtor’s affiliates. Furthermore, Congress should amend the Bankruptcy Code and Title II of the Dodd Frank Act so that it is clear that Triangular Setoff Clauses are enforceable where either affiliated entities both agree to the triangular setoff or those affiliated entities guarantee each other's liabilities. Such amendments would increase efficiency in credit risk analyses and in the drafting of Living Wills and mitigate systemic risk.

Keywords: Swaps, Derivatives, ISDA Master Agreement, Bankruptcy, Safe Harbors of Bankruptcy Code, Dodd-Frank Act, Clearning, Walkaway Clause, Flip Clause, Triangular Setoff, Cross-Affiliate Netting, Credit Analysis, Lehman Brothers

JEL Classification: G33, K12, K10, K20, K22, G10, G20, G30, G33, E50, G10, G20, G30, M20, N20

Suggested Citation

Marchetti, Peter, Amending the Flaws in the Safe Harbors of the Bankruptcy Code: Guarding Against Systemic Risk in the Financial Markets and Adding Stability to the System (June 1, 2015). 31 EMORY BANKR. DEV. J. 305 (2015), Available at SSRN: https://ssrn.com/abstract=2809811

Peter Marchetti (Contact Author)

Texas Southern University - Thurgood Marshall School of Law ( email )

3100 Cleburne Street
Houston, TX 77004
United States
617-270-3143 (Phone)

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