Sen. Elizabeth Warren (D-Mass.), among others, has introduced “The 21st Century Glass-Steagall Act,” which primarily seeks to restore the bank regulatory barriers that existed before 1999, when the original Glass-Steagall Act’s ban on commercial banks owning investment banks was repealed.[1] However, tacked onto the end of the bill is a provision that would repeal §§ 555, 559, 560, 561 and 562 of the Bankruptcy Code.[2]
Most of the listed sections create “safe harbors” for financial institutions exercising their post-petition remedies under securities contracts (§ 555), repurchase (“repo”) agreements (§ 559), swaps (§ 560) and master netting agreements (§ 561), while § 562 deals with the calculation of damages. Curiously, § 556 (which pertains to commodity contracts and forward contracts) was left off the list of sections to be repealed, which is perplexing because the overlap of the various definitions could enable many of the other types of contracts to squeeze in under § 556 and avoid the effect of the repeal.
In general, the effect of these safe harbors is that if a party to these types of contracts becomes a debtor in bankruptcy, counterparties may then exercise their remedies without obtaining relief from the automatic stay, and any action to avoid the rights of the counterparties under the trustee’s strong-arm powers will fail. For example, § 555 allows a stockbroker or other financial institution to terminate and liquidate its position under a securities contract with the debtor based upon breach of a bankruptcy ipso facto clause, and prohibits the court from staying such action unless the stay is authorized by the Securities Investor Protection Act of 1970 (SIPA) or by any statute administered by the Securities and Exchange Commission. The repo and swap provisions are similar. The master netting agreement safe harbor also specifically mentions rights of set off.
These provisions were designed to give these types of contracting parties an advantage that other creditors do not enjoy; the most obvious of which is an exemption from the automatic stay. In reality, however, because these provisions are safe harbors, repealing them does not necessarily mean that any substantive part of the law would change. Obviously, the counterparty would need to take the procedural step of seeking relief from the stay, but from a substantive standpoint, what repeal would mostly mean is additional litigation as financial institutions seek to fit their particular arrangements within other Bankruptcy Code provisions, including those pertaining to set off, secured claims, executory contracts, preference defenses and the like. In addition, financial institutions would likely redraft their contracts to reduce the risk that a court would find the remedies unenforceable in bankruptcy.
Institutions might find that certain financial products that they previously provided simply cannot be offered at all, or if so, the pricing must be higher to account for the greater risk. For example, it may be that repos would lose popularity inasmuch as the § 559 safe harbor is a large part of the allure of a repo.
A repo is best explained by example. Assume that a company owns a lot of mortgages and wants to borrow against those mortgages. It could give the bank a security interest in the mortgages to secure the loan. If the company becomes a debtor in bankruptcy, the bank must obtain relief from the stay before liquidating the collateral. A repo is an alternative arrangement where the company sells the mortgages to the bank, and agrees to repurchase them at a later date for a pre-agreed upon price that includes a profit component analogous to interest. In theory, the bank becomes the owner of the mortgages. If the company files for bankruptcy, then the bank need not seek relief from the automatic stay to enforce its rights because the mortgages are not property of the estate.[3]
However, without the safe harbor, the bank would be well advised to seek relief from the automatic stay before enforcing its rights because the court might recharacterize the repo as a secured claim and treat the mortgages as property of the estate. The loss of certainty resulting from repeal of the safe harbor might eliminate the benefit of these transactions, and the repo might lose its popularity.
One could say, so what? Why should the bank be exempt from the stay? It is a good question, but one must also ask what is accomplished by imposing a stay. The mortgages are not likely to be key assets in a bankruptcy, and the short delay occasioned by the bank’s motion for relief from the stay is not likely to result in any significant benefit to the estate.
Although all of these different types of contracts cannot simply be lumped together in analyzing the safe harbors, it is usually difficult to see how the assets affected by such contracts could be important to reorganization. In most cases, we are talking about intangible collateral such as treasury bills, securities and rights of set off. The debtor is often unable to perform its obligations so it is difficult to see how those assets could be made available to the estate. Most likely, a repeal would mean additional litigation and expense, but little else. This was at least the thinking at the time that the safe harbors were enacted.
The bill states that its general purpose is to reduce systemic risk in the financial sector, but it does not explain how repeal of these safe harbors achieves this purpose. Adding burden to the enforcement of a financial institution’s rights might increase risk, particularly if it involves repealing a safe harbor designed to provide certainty. However, the safe harbors have come under attack recently from a number of different sources, including some of the members of the ABI Commission to Study the Reform of Chapter 11.[4]
Proponents of amending or repealing these safe harbors argue that they increase risk in the financial sector by eliminating the breathing space a debtor has upon filing a bankruptcy and encouraging a race to liquidate the debtor’s assets.[5] In the article cited in footnote 5, the author uses AIG as the “poster boy,” arguing that the automatic stay would have given AIG an opportunity to cherry pick its winning derivatives, possibly stopping its collapse. Of course, AIG was an insurance company and not eligible for bankruptcy anyway. Although it is possible for a too-big-to-fail financial institution operating in the derivatives industry to become a debtor in bankruptcy (e.g., Lehman Bros.), the likely forum for such insolvencies (particularly after Dodd-Frank Act) is the Federal Deposit Insurance Corp. (FDIC), SIPA or state regulatory authorities. Large financial institutions dealing in derivatives are more likely to be beneficiaries of the safe harbors, and debtors in bankruptcy are more likely to be their customers or creditors of their customers.
Even if the next AIG could file for bankruptcy and use the automatic stay to arrest its collapse, the benefit that it could receive would be achieved at the expense of its customers (mostly other financial institutions). It is not obvious that would reduce systemic risk overall; it might actually transfer risk to the rest of the financial sector. In the case of the insolvency of a large institution operating in the derivatives industry, the systemic risk is not so much that the insolvent institution will be dismembered by counterparties as it is that the counterparties will be undersecured, and will end up absorbing the losses. This is a problem not cured — and possibly aggravated — by eliminating the safe harbors.
A cynic might suggest that the movement to repeal the safe harbors is motivated more by a desire to deter the use of derivatives and complex securities contracts, which some see as a contributing factor in the 2008 financial collapse. If so, then one wonders why the Bankruptcy Code was selected as the battlefield, rather than the agencies that are directly responsible for regulating those contracts. Nevertheless, it appears that the movement to repeal or modify the bankruptcy safe harbors is growing, and the 21st Century Glass-Steagall Act might be the vehicle that brings this issue before Congress.
[1] S. 1282, 113th Cong. (2013-2014).
[2] 11 U.S.C. §§ 555-562.
[3] Actually, the compromise that § 559 makes is that the stay does not apply, but the excess proceeds from liquidation are nevertheless property of the estate. Thus, the safe harbor benefits the debtor to some degree.
[4] Learn more about the Commission at commission.abi.org.
[5] See Stephen J. Lubben, “Repeal the Safe Harbors,” ABI Law Review, Vol. 18 (Spring 2010), available at lawreview.abi.org/content/2009-legislative-symposium-repeal-safe-harbors.