The Bankruptcy Code Without Safe Harbors

Abstract

In prior work I have argued that the derivative “safe harbors” in the Bankruptcy Code should be either repealed, or at least greatly reduced in scope. This argument is based on the mismatch between the safe harbors and their stated goal – reducing systemic risk.

But upon repeal of the safe harbors, what happens next? Is it sufficient to remove the safe harbors from the Bankruptcy Code, or must the Code be further adapted to reflect the prevalence of derivatives throughout the economy? And if repeal is not enough, what kinds of issues should the Bankruptcy Code legitimately accommodate, and what issues are simply disguised versions of the general plea of all creditors to be excused from the normal consequences of default?

This short paper examines these and other related questions, and begins to sketch a roadmap for reforming the Code’s handling of financial contracts.

Keywords: Chapter 11, safe harbors, derivatives, Lehman, AIG, bankruptcy, systemic risk, financial reform, SIVs, repos

JEL Classification: K22, G28, G33, G38, K20, K23, G34, G32, G33