The Evolution of U.S. Insolvency Law for Financial Market Contracts
U.S. Federal Deposit Insurance Corporation (FDIC)
June 13, 2006
The enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was the most significant change to the United States' insolvency laws for the financial markets in more than fifteen years. Unlike all prior laws defining how financial market contracts would be treated in bankruptcy or a bank insolvency, the new comprehensively updated and harmonized all of the principal laws that could come into play in insolvencies of market participants, including banks, thrifts, credit unions, broker-dealers, investment banks, and other companies.
The 2005 Bankruptcy Reform Act, however, was not a new direction in American law. The special protections provided to termination and close-out netting for capital markets contracts in the new amendments simply continued an evolutionary process in American insolvency law that started with the enactment of the new Bankruptcy Code in 1978. Once the foundation for protection of the liquidity of financial market contracts had been established by 1991, American law provided the basis for effective risk management by market participants. The task of the past fifteen years has been to secure those benefits, clarify the interrelationships between different insolvency laws, and define the scope of flexibility to accommodate market developments.
It must be recognized, however, that these protections are a departure from the pari pasu principle inherent in equitable insolvency laws. Nonetheless, this principle has never meant that all creditors should receive the same proportional share. Insolvency law has always recognized that creditors should be able to benefit from some characteristics of the bargain they made with the debtor before its failure. As illustrated in the article, the fundamental goal of those special protections is the prevention of the risks to the stability of the financial system that could result from a cascade of interrelated defaults if normal insolvency processes prevented termination and settlement of pending trades. As a result, there are limits to the further expansion of those protections if they are to remain consistent with the underlying public policy that supports them.
This article examines the evolution of the special protections for financial market contracts under U.S. insolvency law (including the Bankruptcy Code and the Federal Deposit Insurance Act's protection for "qualified financial contracts") and the public policy goals underlying those protections, looks at the continuing course of that evolution in the Bankruptcy Reform Act, and provides an overview of what this evolution means for bank and non-bank insolvencies of financial market participants.
Number of Pages in PDF File: 25
Keywords: Insolvency, bankruptcy, derivatives, securities, Bankruptcy Reform Act of 2005, QFCs, qualified financial contracts, bank resolution
JEL Classification: E50, E53, G21, G28, G33, G38, K10, K12working papers series
Date posted: July 17, 2006
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