The Long and Short of It: Financial Engineering Meets
Chapter 11 was one of the more esoteric presentations at the conference with an
unusual lineup of panelists. The group included New York Bankruptcy Judge James
Peck, investment banker David Barse, Professor Edward Janger, Dr. Riz Mokal
from the World Bank and Edward Murray, an English solicitor. They discussed the
effect of safe harbors granted to certain financial contracts under sections to
555 to 562 of the Code. These sections were extensively re-written by BAPCPA.
Certain financial contracts, such as swaps and repos are
granted safe harbors under the Bankruptcy Code. These contracts can be
liquidated, terminated or accelerated notwithstanding the Bankruptcy Code. They
are also exempt from recovery under preference and fraudulent transfer
theories. According to the panelists, this was done to protect the interest of
sophisticated parties and avoid the risk of financial contagion. The rationale
was that if one party went down, that the transaction could not be unwound and
pull down the counter-party. Additionally, the ability to do close-out netting
under a contract allows parties to reduce their risk.
One problem with these provisions is that, even with the
extensive re-writing of definitions in 2005, the definitions are still
imperfectly drawn. Section 555 applies to securities contracts and was intended
to protected intermediaries. However, as written, it could apply to a
transaction with Bernie Madoff's Ponzi scheme.
Prof. Janger suggested that these provisions may have
"done exactly the opposite of what they were supposed to do" in the 2008
financial crisis. He said that when a Bear Stearns or a Lehmann Brothers files
bankruptcy, their hands are tied and they can't reorganize. The drafters did
not anticipate that large entities would be filing bankruptcy.
The panel debated whether the immunities granted to
financial contracts increase the risk of transactions. Dr. Mokal noted that the
provisions were put in the Code in 2005 and the financial crisis followed three
Ed Murray described the immunities as a "safety net" and
said that they did not eliminate incentives to monitor credit risk. He said
that parties want to make good transactions and noted that "credit officers are
a pain" regardless of the immunities.
David Barse was much more direct. He said, "If we don't
get comfort, we don't participate. If secondary parties don't participate, then
primary can't participate." He described the protections as providing a
"comfort zone" and said that "providing great clarity is very important." He
added that "the practical answer is that two parties to a contract should be
allowed to play it out and shouldn't be regulated."
Dr. Mokal stated that the safe harbors are an important
part of a sophisticated insolvency system. He said that in other countries,
there are not sophisticated bankruptcy regimes and that there is "no certainty
about the court's ability to understand or apply sophisticated rules or
statutes." He said that this was "unlike in this country where courts
understand exactly what Congress intended," a comment which drew chuckles from
The panel also discussed how financial contracts could be
used to commit mischief in the bankruptcy system. Prof. Janger discussed the
problems of empty voting and the empty creditor where there is a separation of
the economic interest from the ownership interest and separation of the
economic interest from governance rightst in bankruptcy and workout situations.
He said that creditors can go short and bet against a company's reorganization
and then cause trouble. He analogized the problem to a secured creditor voting
its deficiency claim to sink the reorganization and acquire the asset. He said
that the tools available to bankruptcy judges to combat this problem included
disclosure under Rule 2019, designating ballots and subordination.
Mr. Barse said that this was a big problem. He said that
creditors using ever more sophisticated tools can drive decisions on corporate
governance. He said that while his firm doesn't use these tools to drive
corporate governance that they could be used by corporate raiders. He also
added that "Derivatives are tools of destruction. We don't really know what they
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