The First Safe Harbor Exemptions #1-2

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.


The Legal Foundations of Financial Collapse (Intro) #1-1

As economists, financiers, journalists and many others struggle to understand the financial crisis with which the 21st century opened, derivatives inevitably enter the conversation.  Unfortunately derivatives – especially those that are traded only through dealers on what are called “over the counter” markets – are not well understood outside the financial industry.  Perhaps, the fact that regulators and legislators permitted the development of markets that they did not understand is an important cause of the crisis.

Starting in the early 80s, the financial industry lobbied aggressively for legislation that favored youthful markets in repurchase agreements and derivatives.  Initially the industry was supported by the Federal Reserve, because the financial system was already fragile and there was genuine concern that losses in these new markets could be destabilizing.  In later years, the industry was careful to frame its requests for special privileges under the law in the same terms:  the stability of the financial system could only be ensured if these privileges were granted.  Neither regulators nor legislators were willing to challenge the expertise of the financiers.[1]

In 1984, in 1990 and in 2005 Congress passed laws exempting certain financial contracts from the standard provisions of the bankruptcy code.  In each case, the effect of the law was to protect collateral securing the contract from those provisions of the bankruptcy code that allow a judge to review the claims of secured creditors and to protect the interests of other creditors whenever necessary.  By granting derivative counterparties special treatment under the law, these exceptions guarantee that no contract is more secure than a repurchase agreement or an over the counter derivative – this guarantee comes at the expense of other secured creditors and bondholders.  In short, in modern bankruptcies, there is one class of claimant that doesn’t even need to show up in court to prove its claim – the counterparties to collateralized derivative contracts.

The introduction of inequitable treatment into the bankruptcy code would be acceptable, if in fact the financial contract exemptions worked to protect the stability of the financial system.   Recent experience indicates, however, that the special treatment granted to repurchase agreements and over the counter derivatives tends to reduce the stability of the financial system by encouraging collateralized interbank lending and discouraging careful analysis of the credit risk of counterparties.  The bankruptcy exemptions also increase the risk that creditors will run on a financial firm and bankrupt it.  Thus, the bankruptcy code has been rewritten to favor financial firms and this revision of the law has had a profoundly destabilizing effect on the financial system.

Introduction to the Bankruptcy Code

The Bankruptcy Code is designed to distribute the assets of a firm that cannot meet all of its obligations as equitably as possible across the firm’s creditors.  Thus, as soon as a firm files for bankruptcy, creditors are prohibited from collecting on the firm’s debts, and recent payments made by the firm may be recalled by the trustee of the estate.  The principle is that the trustee needs to take the time to realize the value of the firm’s assets and evaluate the full extent of creditor claims.  Only after the trustee has the whole picture of assets and liabilities can the bankrupt estate be distributed fairly to creditors.  Because payments made just prior to bankruptcy can potentially have the effect of favoring one creditor over another, the trustee has broad powers to void such transactions.

The prohibition against collecting on a bankrupt firm’s debts is called the automatic stay.  The trustee’s power to cancel recent transactions is called avoidance.  Prior to the special exemptions enacted by Congress over the counter derivatives were subject to the same treatment in bankruptcy as all other contracts.  The automatic stay ensured that netting of offsetting derivatives and termination of derivatives could only take place after receiving the approval of the bankruptcy court.  Furthermore, collateral that had been posted against derivative contracts over the last 90 days was subject to avoidance – and could thus be reclaimed as the property of the estate.  Collateral that had been posted over the previous year could be avoided if the transaction had an adverse effect on the equitable distribution of the estate.

In general, the purpose of the bankruptcy exemptions enacted by Congress was to ensure that participants in the markets for over the counter derivatives and repurchase agreements were not subject to the automatic stay or to the avoidance powers of the trustee.  The bankruptcy exemptions guarantee that over the counter derivatives and repurchase agreements can be netted and terminated instantly when bankruptcy is declared.  Any collateral can be seized and sold, free and clear of encumbrances.  Effectively under current law once collateral is posted against a derivative or repurchase agreement, it cannot be touched by a bankruptcy trustee – unless the recipient of the collateral was aware that the transfer was fraudulent.

Before examining the effects of these changes to the bankruptcy code, we will outline the history of the changes and then analyze why the exemptions were put in place.  Understanding the reasoning behind these bankruptcy provisions is essential to any discussion of the role that derivatives and repo markets played in destabilizing the financial system.

[1] There were exceptions amongst the regulators, such as Brooksley Born.  They were, however, unsuccessful in their endeavors.