Expect TV news shows to feature plenty of unhappy people behind bill-strewn kitchen tables this month when the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 kicks in. Tough on consumers, the act was a big win for the banks that issue their credit cards and loans. The new law cracks down hard on corporate debtors, too, but the lack of a clear-cut populist angle has kept mainstream media coverage to a minimum. The most widely reported of the nonconsumer provisions tend to squeeze corporate debtors to the benefit of groups such as utilities and landlords (bankrupt companies, for example, must decide more quickly whether to keep or shed leases).
In fact, banks are big winners on the nonconsumer side, too. But you won't see that on the news — the biggest boon comes from esoteric provisions that even now are little known or understood outside Wall Street. These changes, which essentially shield derivatives and other complex financial contracts from the slow grind of bankruptcy proceedings, are intended to boost the financial system's immunity to serious shocks. Less clear, however, is the impact such changes may have on corporate users of these instruments. Some argue that the changes will lower risk, and therefore cost, but others fret that the new provisions put additional pressure on companies facing insolvency.
Without a Net
That the banking industry had a heavy hand in rewriting the bankruptcy code was most evident in a self-serving change to the nonconsumer provisions. The code has long defined individuals whose conflicts of interest prohibit them from acting as advisors to bankrupt companies. The 2005 act carefully deletes the words "investment banker" — five times — from that definition.
That's a clear lobbying success for bankers looking for an extra source of advisory fees. But for years, a far more important industry goal — keeping derivative contracts out of court when one party goes bankrupt — proved elusive. Despite universal support from U.S. banking and securities regulators, passage of many of these so-called safe-harbor protections has — until now — been tied to bankruptcy bills that sank under the controversial weight of their consumer provisions, or in one instance, a political battle over abortion.
Because derivative contracts often involve offsetting positions between counterparties, they are typically settled by netting — that is, the amount each counterparty owes is netted against the other, and a single payment is made by whichever party owes more. This eliminates large fund transfers in both directions. Counterparties also usually agree to "closeout netting," which means that in the event that one of them defaults, the other may terminate the contracts, mark to market their remaining value, and then seize any net amount that is owed.
In most cases, however, default goes hand in hand with a bankruptcy filing. And before the latest act became law, closeout netting often conflicted with bankruptcy's automatic stay, which prevents creditors from seizing collateral or terminating contracts once a company has filed for Chapter 11 protection.
True, the bankruptcy code has long allowed set-off rights — the right of a creditor to subtract from its obligations what its debtor owes. A bank, for example, may seize the contents of a company's disbursement account as partial payment for a defaulted loan. But such actions require a judge's approval, explains Rhett Campbell, an attorney in the Houston office of law firm Thompson & Knight LLP. That can mean anywhere from a 30- to 90-day delay, observes Campbell, not to mention "the chance that some nutty judge wouldn't allow you to do it."
In the fast-moving, multiparty, big-money world of derivatives, such delays are untenable. Without netting, a solvent party could be required to make a large funds transfer to the debtor's estate and stand in line with other creditors to claim the offsetting amount. When a counterparty with the size and leverage of Long-Term Capital Management (LTCM) is the insolvent player, this creates a risk of a widespread market failure. Derivative contracts typically settle for a fraction of the absolute amounts owed by both parties, but if each side of the contract had to be settled independently through a bankruptcy proceeding, the out-of-pocket expense for a creditor would be high — conceivably even as much as the notional amount.
"Without a safe harbor from automatic stay, many participants in the financial markets could be at risk from a default by one big derivative counterparty," notes Anthony Nolan, who heads the securitization and derivatives practice in the New York office of Boston-based law firm Goodwin Procter LLP.
Realizing this, Congress has been writing exemptions allowing closeout netting for various types of derivatives since 1982. But legislators have been hard-pressed to keep pace with Wall Street's latest inventions. "By 2002, you were starting to see some very funky instruments — energy derivatives, emissions contracts, weather derivatives — these are really bizarre things. And nobody was quite sure if they were covered by the existing statute," explains Nolan.
Even before then, the near collapse of hedge fund LTCM in 1998 highlighted both the risk that one major player could pose and the fact that the law only allowed netting between the same types of derivatives. That prompted support for amending the bankruptcy code to include both broader definitions and "cross-product netting" by the President's Working Group on Financial Markets, a blue-ribbon panel of banking and securities regulators.
Finally passed last April, the new bankruptcy act "covers every conceivable instrument," says Nolan, as well as language intended to anticipate future Wall Street innovations. Moreover, the act allows cross-product netting — meaning, for example, an interest-rate swap can be netted against a commodity swap. (Cross-product netting was standardized as a market practice in 1999 by the International Swaps and Derivatives Association.) The act also ensures that such provisions apply even in the case of international insolvencies (had LTCM not been bailed out, it would likely have filed for bankruptcy in the Cayman Islands). All of these changes "stem almost directly from the failure of LTCM and the President's Working Group report," says Campbell. "They are trying to prevent the systemic failure of the world financial system."
A Philosophical Question?
Given that lofty goal, the new netting provisions have been widely praised by the financial industry as reducing systemic risk. And most observers agree that less risk means lower costs for corporate buyers of derivatives. "I think the net result will be to make pricing somewhat more favorable, because dealers won't have to worry about what will happen if a counterparty goes bankrupt," says Nolan.
"It's a very good bill for banks and investment banks," says attorney Jeffrey Murphy, a partner in the structured finance practice at New York–based Thacher, Proffitt & Wood LLP, "and it's a very good bill for the capital markets to the extent that it causes corporate borrowing rates to be reduced." Indeed, says Murphy, when it comes to the netting and safe-harbor provisions, "I'm not aware that there was any opposition on the planet."
Still, banks did not get everything they wanted. For example, Enron highlighted the tendency of both banks and their corporate counterparties to deal in derivatives through multiple subsidiaries. And while cross-affiliate netting is a standard market practice, Congress stopped short of freeing cross-affiliate netting from the automatic stay. (After all, it would be contradictory for the bankruptcy code to recognize arms-length affiliates and bankruptcy-remote entities for some purposes, yet allow derivatives users to consolidate similar entities in order to short-circuit bankruptcy's automatic stay.) Moreover, to ensure smooth passage of netting provisions, the financial industry abandoned a multiyear effort to win similar safe-harbor protection for securitization (see "True or False?" below).
Unlike the rest of the bankruptcy reform act, which changes the very tenor of bankruptcy by shifting more of the onus to debtors, these changes don't represent a dramatic change in philosophy. There have, after all, been various efforts to protect derivatives going back to 1982.
Nonetheless, there was opposition on the grounds that the netting provisions, however necessary to world financial order, erode the underlying premise that bankruptcy affords equal treatment to all creditors. "The expansion of these provisions would take us farther down the path of allowing sophisticated parties to opt out of bankruptcy," testified University of Chicago law professor Randal Picker, of the American Bankruptcy Conference, during a congressional hearing.
"It is a fair question to ask, 'If the safe harbors are good policy, why do they only apply to a certain class of monetary asset?'" observes Thompson & Knight's Campbell. "The only reason is that they are so big and so important to the world financial system that they cannot be tied up in bankruptcy."
Indeed, in testimony before Congress in 1999, then-FDIC general counsel William F. Kroener III, explaining the netting provisions then in force, noted that "the FDI Act and the bankruptcy code grant those who have entered into financial derivative contracts with parties that subsequently become insolvent greater rights than these statutes grant those who enter into most contracts."
Campbell says he is undecided on whether or not that's good policy. However, in a recent paper for the American Bankruptcy Law Journal, Campbell cited Picker's testimony, and added, "A cynic might argue that the financial safe harbors are indeed a 'bankruptcy opt-out clause' for a certain class of capitalists because their money is more important than everyone else's. Does that mean that Chapter 11 reorganization rules apply to the average company but not to those that deal in sophisticated financial instruments?"
Right or wrong, the answer to that question is clearly yes — and more so now. The question, then, is does this matter to the average company? These rules, after all, were put in place to address the problems created by giant hedge funds such as LTCM.
One reason it might matter is that corporations are offered derivative-based contracts more often these days, and not just for simple interest-rate or FX swaps. "Financial markets have become incredibly reliant on a wide range of derivatives, including, most recently, credit derivatives," notes Goodwin Procter's Nolan. "There are a lot of transactions that are done synthetically with derivatives that five years ago would have been done by traditional loans."
Most companies, of course, don't enter into financial contracts thinking about what will happen if they default. "I don't think these changes to the bankruptcy code are going to surface in a CFO's mind as he is negotiating a transaction," says Campbell. But what happens once a company is in financial distress? In the past, he notes, it might take a bank 30 to 90 days after a Chapter 11 filing to get permission to unwind its transaction. That not only gave CFOs of troubled companies some wiggle room but also made banks more likely to come to their aid.
"But when you have a relationship that deals with these kinds of instruments, the bank will be able to pull the plug on the first day," Campbell says. "So now, as the CEO and CFO think through their options, one of those options has changed."
A case in point was the 2003 bankruptcy of Atlanta-based energy firm Mirant Corp. Although the case predates the recent bankruptcy act, the bankruptcy code allowed safe-harbor netting for the various types of derivative contracts that Mirant relied on for the delivery of gas and energy. On the day it filed, Mirant petitioned the court to approve a package of assurances and incentives demanded by its counterparties. Without them, Mirant told the court, "there is a high likelihood that many of the counterparties to [Mirant's] trading contracts would exercise their rights under the safe-harbor provisions of the bankruptcy code to terminate and liquidate the contracts, . . . jeopardizing the ability of the debtors to continue the trading activities that are necessary and prudent to ensure the continued operation of their power plants."
Mirant warned that without the court's help, "the reliability of the electric power grid may be threatened." And, ironically, Mirant warned that its "inability to continue at or near historical levels of operations could cause a domino effect within the fragile energy sector, triggering other financially distressed energy merchants to fail." In other words, the same safe-harbor provisions intended to prevent a systemic failure in the financial sector very nearly caused one in the energy sector.
Tim Reason is a senior editor at CFO.
Securitization Still Lacks a Safe Harbor
True or False?
Despite years of maneuvering, the financial industry ultimately abandoned efforts to get a safe-harbor provision for asset-backed securitization into the new bankruptcy law. Such a provision would have guaranteed that the transfer of receivables or other assets in a securitization was a "true sale" and shielded it from creditor challenges or bankruptcy court review.
While safe-harbor netting provisions for derivatives encountered little resistance other than philosophical objections, the securitization safe harbor became a lightning rod after LTV Steel tried to reclaim its securitized assets in bankruptcy in 2001. That got the attention of the AFL-CIO. "In the interest of getting the larger bill done, particularly the netting provisions," proponents scrapped the securitization safe harbor, says Mike Williams, the Bond Market Association's vice president for government affairs.
Ironically, the bankruptcy act still may be a boon to the securitization world, says Jack Williams, director of BDO Seidman Financial Recovery Services and a law professor at Georgia State University in Atlanta. "At worst, it's neutral for the securitization market. At best, it may be quite favorable," he says. That's because the new consumer provisions push individual debtors away from Chapter 7, which used to absolve them of debt, and into a revamped Chapter 13, which requires that they dedicate their disposable income to pay off creditors over a five-year period. Williams expects credit-card companies in particular will bundle up those payment streams and — you guessed it—securitize them. "From an academic perspective," he says, "it's a wonderful thing. Rarely do you get to see a new financial asset created." — T.R.
Cutting energy company Mirant's contracts under safe-harbor rules might have caused:
- An inability to fuel or operate "must run" plants in California
- Blackouts or brownouts in San Francisco and other major cities
- Failure of other distressed energy merchants
- Energy-market liquidity and power shortages
Source: Affidavit of Mirant chief risk officer Cameron Bready, July 2003