Transaction Consistency and the New Finance in Bankruptcy

Abstract

Prior to the enactment of the Dodd-Frank Act last summer, derivatives and repurchase agreements (“repos”) were largely unregulated outside of bankruptcy, and also were exempted from core bankruptcy provisions such as the automatic stay, which prevents creditors from seizing collateral or attempting to collect what they are owed. The Dodd-Frank Act now extensively regulates derivatives outside of bankruptcy, but it left their special treatment in bankruptcy completely untouched. There is a gap in the debate over this special treatment. To date, neither scholars nor the derivatives industry have fully analyzed the key counterfactual: what would happen if derivatives and repos were subject to the same treatment as other contracts? This Article tries to fill the gap, and to develop a more general theory about the importance of “transaction consistency” in the bankruptcy laws. Our findings are surprising. Contrary to the dire warnings of the repo industry, the effect of transaction consistency on repos would be limited, because repos would automatically be terminated as of the bankruptcy filing and thus could not be reinstated by the debtor. Derivatives have more at stake, but the nondebtor’s right of setoff would reduce many of the adverse effects. We do not argue that the special treatment should simply be removed, however. Given the distinctive attributes of these contracts, we argue that repo lenders should be able to immediately sell some kinds of collateral and that the automatic stay should be limited to three days for derivatives. We also explain how transaction consistency can be integrated with the Dodd-Frank Act. We believe that that the reforms we propose would strongly enhance bankruptcy’s efficacy, and make Dodd-Frank resolution unnecessary in all but the most extraordinary cases.

Keywords: derivatives, repurchase agreements, repos, Dodd-Frank, bankruptcy

JEL Classification: K20, K23, G33