How the 2005 bankruptcy reforms guarantee unfair returns to derivatives counterparties (and our largest banks)

The effects of the derivatives safe harbors in bankruptcy that protect financially sophisticated creditors at the expense of the bankrupt company’s other creditors (and were greatly expanded by the no-derivative-left-behind act of 2005 — a.k.a. BAPCPA) are demonstrated by this Lehman Brothers lawsuit.

The former purpose of the bankruptcy process was to guarantee that all creditors receive no more than they are due under the law given that the bankrupt debtor is unable to meet all of its obligations.  The modern bankruptcy process allows derivative and repo counterparties to foreclose on any collateral posted to them. While theoretically they must demonstrate that the collateral they have taken was no more than was owed to them, the imprecision inherent in the process of marking complex assets to market clearly gives these counterparties the upper hand. In the event that discussion fails to result in the return of improperly seized collateral, the bankrupt debtor must sue the counterparty to get what is due the other creditors, as the Lehman lawsuit aptly illustrates.

It is a trivial matter to show using economic analysis that the costs to the bankrupt debtor of suing will guarantee that the vast majority of derivative and repo counterparties will be able to keep more collateral than they are due (unless they were undercollateralized at the date of default). In short the bankruptcy process now favors financially sophisticated creditors over trade creditors and debt-holders, not only because the financially sophisticated are able to negotiate more favorable contracts before bankruptcy, but also because they are able to take more than they are due under the law once a company enters bankruptcy.

Update 5-8-13: Matt Levine has done the yeoman’s job of reading some Lehman-related legal complaints and appears to reach similar conclusions.

Update 5-15-13: This article leaves the impression that that best targets for a lawsuit regarding the closing of a derivative contract are those who can’t afford expensive legal advice.

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1 thought on “How the 2005 bankruptcy reforms guarantee unfair returns to derivatives counterparties (and our largest banks)”

  1. The world banking system has a heart transplant in process, so we put a band aid over our eyes and “scalpel, scalpel, now!”- thus we hurry. Perhaps we can connect the markets better with hard assets and real development, making jobs and consumerism. Brick and morter, granite and steel; the mother of all downtown high rise Madison Ave. and Wall St. Let’s work. We know what to do. Got gum?

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