The Long and Short of It: Financial Engineering Meets Chapter 11 was one of the more esoteric presentations at the conference with an unusual lineup of panelists. The group included New York Bankruptcy Judge James Peck, investment banker David Barse, Professor Edward Janger, Dr. Riz Mokal from the World Bank and Edward Murray, an English solicitor. They discussed the effect of safe harbors granted to certain financial contracts under sections to 555 to 562 of the Code. These sections were extensively re-written by BAPCPA.
Certain financial contracts, such as swaps and repos are granted safe harbors under the Bankruptcy Code. These contracts can be liquidated, terminated or accelerated notwithstanding the Bankruptcy Code. They are also exempt from recovery under preference and fraudulent transfer theories. According to the panelists, this was done to protect the interest of sophisticated parties and avoid the risk of financial contagion. The rationale was that if one party went down, that the transaction could not be unwound and pull down the counter-party. Additionally, the ability to do close-out netting under a contract allows parties to reduce their risk.
One problem with these provisions is that, even with the extensive re-writing of definitions in 2005, the definitions are still imperfectly drawn. Section 555 applies to securities contracts and was intended to protected intermediaries. However, as written, it could apply to a transaction with Bernie Madoff’s Ponzi scheme.
Prof. Janger suggested that these provisions may have “done exactly the opposite of what they were supposed to do” in the 2008 financial crisis. He said that when a Bear Stearns or a Lehmann Brothers files bankruptcy, their hands are tied and they can’t reorganize. The drafters did not anticipate that large entities would be filing bankruptcy.
The panel debated whether the immunities granted to financial contracts increase the risk of transactions. Dr. Mokal noted that the provisions were put in the Code in 2005 and the financial crisis followed three years later.
Ed Murray described the immunities as a “safety net” and said that they did not eliminate incentives to monitor credit risk. He said that parties want to make good transactions and noted that “credit officers are a pain” regardless of the immunities.
David Barse was much more direct. He said, “If we don’t get comfort, we don’t participate. If secondary parties don’t participate, then primary can’t participate.” He described the protections as providing a “comfort zone” and said that “providing great clarity is very important.” He added that “the practical answer is that two parties to a contract should be allowed to play it out and shouldn’t be regulated.”
Dr. Mokal stated that the safe harbors are an important part of a sophisticated insolvency system. He said that in other countries, there are not sophisticated bankruptcy regimes and that there is “no certainty about the court’s ability to understand or apply sophisticated rules or statutes.” He said that this was “unlike in this country where courts understand exactly what Congress intended,” a comment which drew chuckles from the audience.
The panel also discussed how financial contracts could be used to commit mischief in the bankruptcy system. Prof. Janger discussed the problems of empty voting and the empty creditor where there is a separation of the economic interest from the ownership interest and separation of the economic interest from governance rightst in bankruptcy and workout situations. He said that creditors can go short and bet against a company’s reorganization and then cause trouble. He analogized the problem to a secured creditor voting its deficiency claim to sink the reorganization and acquire the asset. He said that the tools available to bankruptcy judges to combat this problem included disclosure under Rule 2019, designating ballots and subordination.
Mr. Barse said that this was a big problem. He said that creditors using ever more sophisticated tools can drive decisions on corporate governance. He said that while his firm doesn’t use these tools to drive corporate governance that they could be used by corporate raiders. He also added that “Derivatives are tools of destruction. We don’t really know what they do.”