Bankruptcy Boundary Games

Abstract

For the past several decades, Congress has steadily expanded the exclusion of securities market operations from core bankruptcy protections. This Article focuses on three of the most important of these issues: the exclusion of brokerage firms from Chapter 11; the protection of settlement payments from avoidance as preferences or fraudulent conveyances; and the exemption of derivatives from the automatic stay and other basic bankruptcy provisions. In Parts I, II and III of the Article, I consider each of the issues in turn, showing that each has had serious unintended consequences. Both Drexel Burnham and Lehman Brothers evaded the brokerage exclusion, for instance; and the settlement provision has been invoked in several high profile contexts that do not fit neatly within the core cases for which it was designed. The application of the special derivatives provisions has also raised even more questions, once again most prominently in the Lehman bankruptcy.

In the final part of the Article and in a brief conclusion, I explore the implications of the awkward interaction between bankruptcy and securities law. I begin by speculating about how bankruptcy courts will handle each of these issues if Congress does not alter the current rules. I then consider how Congress might intervene in these areas to address some of the problems that have arisen. I focus most extensively on the most complex of the issues, bankruptcy’s special protections for derivatives and other financial contracts. After surveying possible alternatives to the existing framework, I propose and defend two strategies for reform: under the first and more novel, the stay would apply in cases involving systemically important firms but not in other cases; and the second would simply remove the existing exemptions, imposing the stay in all cases. I argue that the choice between the two approaches depends on the overall structure of financial services regulation.

Keywords: Bankrupt brokerage houses, corporate reorganization, securities law, derivative contracts, financial services, overlap between bankruptcy and securities law, automatic stay, exemptions from bankruptcy protection

JEL Classification: G24, G33, K22