In 1978 the Bankruptcy Act of 1898 was thoroughly revised. The revised Act granted special privileges to both commodity brokers and forward contract merchants in the event of a customer bankruptcy.[1] Commodity brokers dealt in exchange traded derivative contracts and had been subject to regulation since the Commodities Exchange Act of 1936. Forward contract merchants, by contrast, did not trade in derivatives; they traded in goods where the contract had a settlement date in the future – that is they traded in commercial contracts for future delivery. [2]
The privileges granted by the 1978 Bankruptcy Code to commodity brokers and forward contract merchants were the following: they were exempt from the automatic stay that prevents creditors from seizing and liquidating collateral, they were protected from the bankruptcy trustee’s power to avoid recent pre-bankruptcy transactions and they were permitted to offset claims against debts. Thus, they were allowed to seize margin funds (i.e. collateral), close out customer positions and net the value of margin against the customer’s holdings.[3]
Overall the effect of the 1978 Bankruptcy Code was to give special protection to two categories of contracts: exchange traded commodity contracts and commercial contracts for future delivery. In order to understand why these privileges were granted, we need to understand how these markets operated.
An exchange sets rules for a market to ensure that every trader can honor his obligations. Typically the value of every position is calculated on a daily basis in a process called mark to market, and traders are required to post margin sufficient to cover their obligations under the contract at current prices. Since the margin posted against exchange traded contracts is the property of the trader who posted it, in the absence of special bankruptcy procedures these margin payments could easily be tied up in bankruptcy proceedings. Furthermore, the obligations of a bankrupt party are frozen at the date bankruptcy is declared, so standard bankruptcy procedure disrupts the process of marking and margining contracts.
Another complication is that exchanges are central counterparties. Thus, all trade on the market is trade with the exchange. Because the exchange is backed by a partnership of the largest dealers in the market, everyone can trade on the market with confidence that every contract will almost certainly be honored.
Standard bankruptcy procedure can easily impose significant losses on the exchange, particularly if a large trader fails and triggers the failure of a few smaller traders. To minimize the possibility that large losses could destabilize an exchange the 1978 bankruptcy law allows brokers to close out a bankrupt’s position, seize any margin posted and determine the net obligation without delay. In this way, bankruptcy law validates the process of marking and margining contracts, by permitting the margin funds to be used to settle the debts against which they have been posted in a timely manner. Sometimes these provisions of the Bankruptcy Code are called “safe harbor” provisions.
While these rights were only written into the bankruptcy code in 1978, the fact that exchanges were self regulatory organizations (SROs) may well have served as an informal mechanism protecting margin payments from inclusion in bankruptcy estates in earlier years: as long as no claim was made on a bankruptcy court, there may have been no obligation to resolve margin payments through bankruptcy. This view is supported by the fact that in 19th century Britain the law viewed the resolution of a defaulter’s Stock Exchange accounts as determined by the rules of the Stock Exchange and thus protected from the trustee of the bankruptcy estate.[4] It seems plausible that a similar system may have been in effect in the United States prior to the 1978 law. If this speculation is correct, we may also speculate that commercial contracts for future delivery were granted the same treatment because there was a tradition of allowing forward contract merchants to seize and liquidate the margin posted by bankrupt counterparties in a timely manner.
In 1982 safe harbor privileges were also granted to securities brokers and clearing agencies, thus expanding the bankruptcy exemptions to securities-based derivatives. The 1982 amendment was careful to specify that the exemption from the automatic stay only applied to contractual rights “set forth in a rule or bylaw of a national securities exchange, a national securities association or a securities clearing association.”[5] In other words, the 1982 amendment was designed to protect practices sanctioned by the rules of self regulatory organizations, not the terms of individually negotiated contracts.[6]
In short, after 1982 derivatives subject to regulation by self regulatory organizations and commercial contracts for future delivery, as well as the margin payments related to these contracts, were formally excluded by acts of Congress from resolution in bankruptcy court. It is possible that this represented nothing more than the codification of existing norms. Whether this special treatment was a continuation of past procedures or not, the fact that it was written into the law may have encouraged the growth of exchange-traded derivatives.
[1] Note that forward contracts were carefully defined in the Commodities Exchange Act to include only transactions where future delivery is intended (i.e. they are commercial rather than financial transactions).
[2] Karen Ramdhanie, 1999, “Derivatives Contracts of Insolvent Companies” 18 NY Law School J of Intl and Comp Law, p. 277. If the intent of a contract was to exchange in cash the difference between the spot price on the settlement date and the contracted price, the contract did not qualify as a forwards contract. In fact, such contracts were unlawful under the terms of the Commodity Exchange Act.
Because the meaning of the term “forward contract” has changed, I am going to adopt the modern usage in this paper. Thus, from this point on the contracts referred to as “forward contracts” in the 1978 law will be called “commercial contracts for future delivery,” and the term “forward contract” will be reserved for a derivative contract that may be settled in cash.
[3] Ramdhanie, p. 284 – 288.
[4]The settlement of debts incurred on an exchange separately from the settlement of a bankruptcy estate was upheld under the law in 19th c. Britain. Ex parte Grant re Plumbly (1880) is explained in The Law Relating to Betting, Time-bargains and Gaming, George Herbert Stutfield, Waterlow & Sons, 1884, p. 78 – 79.
[5] Jonathan Hance, 2008, “Derivatives at Bankruptcy: Lifesaving knowledge for the small firm” 65 Washington & Lee Law Review p. 741.
[6] The Securities Exchange Act of 1934 recognized that self regulatory organizations played an essential role in American markets and made them the partners of the SEC.
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