Bankruptcy

Resolution Authority -- Part 1 (Safe Harbors)

By Stephen Lubben

This is the first of a series of posts commenting on the resolution authority as it currently appears in the Dodd bill.

The present draft of the bill includes ?safe harbors? that excuse derivatives from the normal operation of the resolution authority ? with a vague suggestion that the safe harbors might be suspended for five days while the receiver tries to transfer assets to a buyer, although no indication if termination provisions can be enforced once the derivatives are in the hands of the buyer. And the draft does not address the safe harbors already in the Bankruptcy Code, even though the resolution authority contemplates that all but the largest institutions will proceed under the Code.

Every legal academic that has considered the ?safe harbors? that excuse derivatives from the normal operation of the Bankruptcy Code has determined that these provisions increase systemic risk. In a recent paper I show how the intersection of derivatives and insolvency could be better addressed with narrowly targeted amendments to the Code, rather than safe harbors.

Safe harbors are typically justified in terms of systemic risk. The systemic risk argument for the safe harbors is based on the belief that the inability to close out a derivative position because of the automatic stay would cause a daisy chain of failure amongst financial institutions. The problem with this argument is that it fails to consider the risks created by the rush to close out positions and demand collateral from distressed firms. Not only does this contribute to the failure of an already weakened financial firm, by fostering a run on the firm, but it also has consequent effects on the markets generally, as parties rush to sell trades with the debtor and buy corresponding positions with new counterparties.

Solution:  Safe harbor provisions should be removed from the bill and from the Bankruptcy Code. These statutes can be slightly modified to account for the reality of derivatives in modern finance (e.g., allow ?mark to market? collateral adjustments to continue until the derivative is assumed or rejected).

Full post as published by Credit Slips on April 22, 2010 (boomark / email).