Implementing Symmetric Treatment of Financial Contracts in Bankruptcy and Bank Resolution

29 Pages Posted: 26 Sep 2016 Last revised: 2 Nov 2016

Edward J. Janger

Brooklyn Law School

John A. E. Pottow

University of Michigan Law School

Date Written: March 1, 2016

Abstract

Financial contracts, such as swaps, repos, and options, are excepted from the Bankruptcy Code’s automatic stay by the so-called derivative “safe harbors.” The bankruptcy of Lehman Brothers in 2008 provides a graphic illustration of how these safe harbors make it almost impossible for a non-bank financial firm, or other firm with significant derivative exposure, to restructure in chapter 11. Without the restraint of the automatic stay, non-debtor counterparties enjoying safe harbor protection may exercise early termination rights, demand payment, and offset obligations. The effect mimics a bank run, where value is drained from the struggling debtor in a destructive rush.

The resolution regime for banks takes a different approach. It does not include such safe harbors. Instead, it imposes a short stay on financial contract termination to permit the orderly transfer of a failed bank’s derivative portfolio intact to a solvent bank. This approach has been used for decades to preserve the value of financial contracts and to minimize the systemic disruption occasioned by a bank failure.

In this Article, we offer a road-map for translating and generalizing the “short-stay” regime used for banks into chapter 11. The key to this synthesis is the bankruptcy concept of “adequate assurance of future performance,” and the mechanism for providing that assurance is bankruptcy’s commonplace debtor-in-possession financing. This financing can backstop the debtor’s timely performance of its financial obligations. We note that our approach would facilitate the “Single Point of Entry” strategy for restructuring financial firms contemplated by the Dodd-Frank Act. Our approach also would, we contend, bring greater stability to financial markets, preserve otherwise evaporating value for insolvent debtors with a significant book of derivatives, and ultimately make it possible for many more firms to restructure in bankruptcy.

Keywords: Financial, Banking, Financial Crisis and Regulation, Capital Markets, Derivatives, Legal, Bankruptcy, Contract & Commercial

Suggested Citation

Janger, Edward J. and Pottow, John A. E., Implementing Symmetric Treatment of Financial Contracts in Bankruptcy and Bank Resolution (March 1, 2016). U of Michigan Law & Econ Research Paper No. 16-020; U of Michigan Public Law Research Paper No. 521; Brooklyn Law School, Legal Studies Paper . Available at SSRN: https://ssrn.com/abstract=2841956 or http://dx.doi.org/10.2139/ssrn.2841956

Edward J. Janger

Brooklyn Law School ( email )

250 Joralemon Street
Brooklyn, NY 11201
United States
718-780-7995 (Phone)
718-780-0376 (Fax)

John A. E. Pottow (Contact Author)

University of Michigan Law School ( email )

625 South State Street
Ann Arbor, MI 48109-1215
United States
734-647-3736 (Phone)

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