Academic journal article Stanford Journal of Law, Business & Finance

Swap Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis

Academic journal article Stanford Journal of Law, Business & Finance

Swap Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis

Article excerpt

The bankruptcy code exempts a class of financial contracts from key provisions, such as the automatic stay. The primary rationale for these safe harbors, as they are called, has been that delayed terminations at major firms might transfer distress to their creditors, creating systemically risky contagion. The resolution assumptions behind Dodd-Frank's Title II, the Orderly Liquidation Authority (OLA) (and its derivative, the Single Point of Entry protocol), which was designed to resolve systemically important financial institutions (SIFIs), are in tension with the systemic risk reduction method behind the safe harbors. This Article identifies this tension and demonstrates not only that the OLA reduces the chances of systemically risky contagion, but also that the safe harbors may reduce the effectiveness and efficiency of the OLA in ways that may create new kinds of systemic costs and risk. The Article describes efforts to narrow the safe harbors and evaluates a more radical alternative, the bankruptcy-enabled Orderly Winddown, that Dodd-Frank's Title VII may eventually make more attractive.

I. Introduction

A large amount of bankruptcy scholarship since the financial crisis has focused on a previously insignificant part of the bankruptcy code: the swap and repurchase agreement exemptions (called safe harbors in the trade), and particularly the possibility they had a role in aggravating the distress of financial institutions, complicating the Lehman bankruptcy, and causing the bailout of AIG.1 This view even influenced the Dodd-Frank Act, but the decision to include a bankruptcy alternative in that Act, Title II or the Orderly Liquidation Authority (OLA), rather than amend the current bankruptcy code has added even more heat to the debate about the relationship between bankruptcy and systemic risk.2 But despite the flood of criticism and defenses and related scholarship, how the Dodd-Frank Act changes the debate over the swap safe harbors has not yet been examined.3 This Article fills that gap and argues that the assumption that Title II replaces the need to develop procedures for large financial bankruptcies is mistaken.

The original advocates for the swap safe harbors in bankruptcy argued that normal bankruptcy rules would create systemic risk upon the bankruptcy of a major financial institution, specifically, credit contagion, a kind of systemic risk that occurs when enough distress moves from a debtor to a creditor to threaten that creditor's solvency. The OLA targets the most susceptible firms, so-called Systemically Important Financial Institutions (SIFIs), and reorganizes them under special accelerated rules to contain forms of systemic risk like severe credit contagion. Has the need for the swap safe harbors diminished then? This Article argues so, and suggests that the bankruptcy code should return to its basic principles of protecting the common pool of assets and safeguarding the out-of-bankruptcy bargained-for positions of creditors. The question now is not whether the bankruptcy code can afford to take the risk, but whether the bankruptcy code will take the opportunity provided by the OLA to return to fulfilling its role.

In addition, the swap safe harbors create two structural problems when joined with the OLA that could reduce the accuracy and efficiency of financial resolutions. Specifically, although OLA decisionmakers may prefer to allow a SIFI to file bankruptcy before they intervene for a variety of valid reasons (and Dodd-Frank envisioned this possibility), the safe harbors may undercut the OLA's ability to restrain systemic risk and reorganize a SIFI, thus forcing OLA decisionmakers to intervene prematurely.4 The distortions premature interventions make, including the incentive for potentially insolvent companies not to plan effectively for bankruptcy, are discussed in more depth below. The view that Title II makes bankruptcy reform unnecessary is thus doubly wrong.

This Article develops as follows. …

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