The No Derivative Left Behind Act of 2005 #1-5

With the 1998 failure of Long Term Capital Management the major derivatives dealers realized that there were still many limitations on their ability to keep derivatives transactions out of bankruptcy court.  In particular, the safe harbor privileges had been granted in separate laws and thus for each type of contract (i.e. futures, forwards, securities, repurchase agreements and swaps) there was a distinct right to offset a bankrupt individual’s margin against his obligations. Clearly safe harbor protections would be stronger if it were possible to offset the positions in the various derivative contracts against each other.  Thus an important purpose of the financial contracts section of the Bankruptcy Act of 2005 was to guarantee the right to set off obligations across different types of derivative contracts.

Protection for cross-product netting was achieved by adding master netting agreements to the list of contracts granted safe harbor.  Master agreements permit counterparties “to document a wide variety of securities contracts, commodities contracts, forward contracts, repurchase agreements and swap agreements” in a single contract.[1]

The fact that somewhat different protections were offered to each different type of derivative contract could also interfere with smooth operation of a cross-product netting process.  For this reason the Bankruptcy Act of 2005 broadened the specific safe harbor protections granted to the different contracts so that they would be uniform.  For example, the contractual rights that were exempt from bankruptcy were expanded for futures, forwards and securities to include the broader rights that had been granted to repos and swaps, that is, rights arising “under common law, under law merchant, or by reason of normal business practice.”[2]

Another obstacle that could interfere with cross-product netting was the development of new derivatives.  The financial industry was concerned that the law would always be a step behind the process of financial innovation and thus that yet-to-be-developed derivatives would be left out of the cross-product netting regime.  For this reason, two clauses in the 1990 definition of a swap contract that made it very broad were added to the definitions of commodities, forward, repurchase and securities contracts.  Thus, the definition of each contract incorporates “any other agreement or transaction that is similar to an agreement or transaction referred to” in the definition and “any combination of the agreements or transactions referred to” in the definition. [3]

The 2005 Bankruptcy Act also expanded the safe harbor protections for repurchase agreements dramatically.  Recall that since 1984 safe harbor had been granted only to repos on Treasuries, Agencies, CDs and bankers’ acceptances.  Now, any repo on a stock, bond, mortgage or other securities contract is defined to be a securities contract and thus eligible for safe harbor as a securities contract.[4] Furthermore, the definition of a repurchase agreement was expanded to include repos on “mortgage related securities”.  This latter revision makes repos on synthetic mortgage assets – in other words repackaged swaps that reference one or more mortgages – eligible for safe harbor.

While each of the individual changes to the categories of derivatives exempt from the bankruptcy code appeared minor, in aggregate the changes are dramatic.  Prior to 2005, safe harbor for securities was only available if the contractual right in question was granted by the rules and bylaws of a self regulating organization.  After 2005 any right negotiated bilaterally in a securities contract was granted safe harbor and the term securities contract was redefined to include the purchase and sale of residential mortgages and repurchase agreements on stocks, bonds and mortgages.  These changes granted safe harbor to huge swathes of over-the-counter transactions that had never before had this protection including:  cash CDOs, mortgage backed securities and repurchase agreements on securities contracts.  The breadth of the definitions made it easy to develop new financial products that would also be protected from the bankruptcy code.  Furthermore, because the term repurchase agreement was redefined to include mortgage related assets, even repos on synthetic mortgage backed securities and synthetic CDOs with mortgage exposure were granted safe harbor.  The House report on the bill gives no indication that Congress understood that safe harbor was being expanded to repos on synthetic assets.

Pause for a moment to think about the implications of these changes.  Repurchase agreements are a standard component of any broad measure of the money supply.  It is now possible for a bank to write a swap that functions like an insurance contract on the returns of a mortgage security, to package that swap into a synthetic security and then to use the synthetic security as collateral to borrow money in a repurchase agreement.  Thus, the 2005 law encourages the monetization of synthetic and cash securities in repo markets, because if the bank goes bankrupt, then the repo counterparty’s claim has far greater privileges in bankruptcy than that of a bondholder – with careful management of collateral the repo counterparty can be all but certain of being paid in full.  It isn’t clear that anybody in Congress gave much thought to the consequences of monetizing derivatives contracts – or for that matter of monetizing junk bonds.

It’s unfortunate that no statistics are collected on the size of the private sector repo market, because it seems likely that the market grew at an astounding pace after the 2005 Bankruptcy Act was passed, granting safe harbor protections to repos on over-the-counter securities and synthetic assets.

The breadth of the expansion of safe harbor in 2005 cannot be understated.  For example, the definition of securities contract now includes “any margin loan.”  This is explicated in the House report as follows:

The inclusion of “margin loans” in the definition is intended to encompass only those loans commonly known in the securities industry as “margin loans,” such as … arrangements where a financial intermediary—a stockbroker, financial institution, financial participant, or securities clearing agency—extends credit in connection with the purchase, sale, carrying, or trading of securities.  “Margin loans” do not include, however, other loans that happen to be secured by securities collateral. [5]

Notice that the only distinction between a “margin loan” that qualifies for safe harbor and an economically equivalent loan that does not qualify is the terminology used by the securities industry.  In other words, Congress has ceded to members of the financial industry the right to determine which secured contracts qualify for exemption from bankruptcy laws.  We find a similar problem with swaps.

The 2005 Act clarified the definition of a swap agreement by explicitly including equity, credit and total return swaps.  Presumably others noticed that the definition of a swap was quite broad, because the text that read “or any other similar agreement” was deleted and replaced with the following:

[Swap agreement means]… any agreement or transaction that is similar to any other agreement or transaction referred to in this paragraph and that (I) is of a type that has been, is presently, or in the future becomes, the subject of recurrent dealings in the swap markets … [and (II) has a value that depends on a future rate, price or other contingency.][6]

The simple fact is that all financial contracts involve some kind of future payment and thus all of them have a value that can be viewed as contingent on future money market rates.  Given that total return swaps, for example, can mimic the returns of any financial asset, it is unlikely that any financial asset will fail to be “similar” to some kind of swap.  And we are left with a single criterion to distinguish a swap agreement from any other financial asset:  whether it is the “subject of recurrent dealings in the swap market”.  In the 2005 Bankruptcy Act definition of a swap, the dealer-banks have been granted the authority by Congress to exempt from the bankruptcy laws just about any financial contract.  The only requirements are that they call the contract a swap and that there are enough interested dealers to make a market in it.[7]

The House report on the bill shows some recognition that the definition of a swap is overbroad.

The definition of “swap agreement” in this subsection should not be interpreted to permit parties to document non-swaps as swap transactions. Traditional commercial arrangements, such as supply agreements, or other non-financial market transactions, such as commercial, residential or consumer loans, cannot be treated as “swaps” under … the Bankruptcy Code because the parties purport to document or label the transactions as “swap agreements.”[8]

It is remarkable, however, that the only concern evidenced in the report is that the swap definition could be used to exempt non-financial market transactions from the bankruptcy code.  The fact that the biggest players in the financial industry will be able to exempt whatever transactions they so choose from bankruptcy is apparently acceptable to Congress.

Based on this evidence, Michael Krimminger, Senior Policy Advisor to the FDIC, concludes that “since the purpose of the special protections is to prevent systemic risk from the interconnected nature of actively traded markets, … the substance of the transaction – whether the agreement is a financial market contract rather than a commercial or normal credit transaction – matter[s] in defining protected contracts.”[9] Setting aside the unusual use of the term “substance” in a manner that ignores the economic substance of the transaction,[10] Krimminger makes it clear that there is a population of individuals who think that policy should exempt financial market contracts from bankruptcy law.  What is most interesting about this approach is that it is completely inconsistent with the purpose of the initial 1978 bankruptcy exceptions.  Special protections were granted to exchange traded derivatives and commercial contracts for future delivery.  Forward contracts were included precisely because they were not financial in nature.  In fact, at the time the 1978 bankruptcy law was passed, financial contracts for future delivery had to be traded on an exchange; otherwise they violated the terms of the Commodities Exchange Act.

We have transitioned over a period of thirty years from an environment where over the counter trade in financial contracts for future delivery was illegal to an environment where the same contracts are granted privileged status under the Bankruptcy Code.  What motivated this change?

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[1] Hance, p. 756 quoting the House Report on BAPCPA, H R Rep no 109-31, p. 131.

[2] House Report on BAPCPA, H R Rep no 109-31, p. 133.

[3] The Bankruptcy Code with revisions marked is available here:  http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/code-01.htm#101.50
http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/code-07.htm#741.7

[4] Note that forward contracts included repos on commodities before the 2005 amendment.  The House Report (No 109-31, p. 130) indicates that the stated purpose of the incorporation of repos into securities contracts was to eliminate any doubt “as to whether a repurchase or reverse repurchase transaction is a purchase and sale transaction or a secured financing”.  The comments do not reflect the fact that this is a dramatic expansion of safe harbor protections.

[5] H R Rep No 109-31 p. 130  http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/house-report-109-31-001-010.htm

[6] Available here:  http://www.law.ttu.edu/lawlibrary/library/research/BAPCPA_Library/code-01.htm#101.50
Quoted in Hance, p. 755.

[7] Others have noted this problem:  From Edward Morrison and Joerg Riegel, 2005, “Financial Contracts and the New Bankruptcy Code,” 13 American Bankruptcy Institute Law Review, p. 664:  “Equally important, the amendments limit judicial discretion to assess the economic substance of financial transactions, even those that resemble ordinary loans or that retire a debtor’s outstanding debt or equity.”  Kettering, p. 1712 states “Read literally this language cedes the content of the definition to the players in the market.”

[8] H R Rep No 109-31 p. 128-129, cited in Hance, p. 755 and in Kettering, p. 1712.

[9] Michael Krimminger, 2006, “The evolution of US insolvency law for financial market contracts”, p. 21.  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=916345

[10] Other commentators describe this differently:  “Judges are discouraged from engaging in ‘substance over form’ analysis. The new definitions are pure form; they protect transactions that fit within formal definitions developed in the marketplace. The role of the judge is to identify these industry definitions. If the contract fits the form, it’s protected.”  (Edward Morrison and Joerg Riegel, 2005, “Financial Contracts and the New Bankruptcy Code,” 13 American Bankruptcy Institute Law Review, p. 664.)

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