Safe Harbor for Derivatives in Bankruptcy: Overstayed Its Welcome?

The safe harbor for derivatives in bankruptcy has developed over the course of the last four decades into a very powerful tool for derivatives counterparties. The safe harbor’s overall effect is to allow counterparties to terminate their derivatives instruments and immediately collect their collateral upon the debtor’s initiation of a bankruptcy. This effect flies in the face of the Bankruptcy Code’s overarching principles, which are to ensure debtor rehabilitation and equality of distribution amongst creditors. By allowing derivatives counterparties to immediately terminate and close out their positions while the other creditors are stayed, both the debtor and other creditors are severely harmed. As the safe harbor contravenes the purpose of the Bankruptcy Code, it is important to consider why it was enacted into the law. This paper begins with a detailed look at the creation of the safe harbor over time. It all began with the enactment of the Bankruptcy Code in 1978, which contained a narrow safe harbor for certain derivatives instruments. Amendments to the Bankruptcy Code in 1982, 1984, and 1990 all served to dramatically increase the breadth, scope, and power of the safe harbor provisions. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 as well as the Financial Netting Improvements Act of 2006 were the final modifications to the safe harbor, and continued the pattern of enlarging its power. Overall, the safe harbor has consistently grown over time as the derivatives market increased in size and complexity. The paper next takes a detailed look at the legislative history over the decades to ascertain the purposes behind the safe harbor provisions. The legislative history paints a relatively consistent picture over all of the various amendments to the safe harbor about why this legal regime was created. The primary purpose behind the safe harbor provisions is, and has always been, to eliminate systemic risk. There has long been a fear that the size, complexity and interconnectedness of the derivatives market were so great that without special treatment it would all eventually come crashing down. However, there is also a discernible secondary purpose behind the safe harbor provisions, which is to clarify the protections for all market participants and create consistent, settled expectations for all so that the market may function effectively. As derivatives developed in complexity over time, industry participants clamored for legislation to clarify what protections extended to these new instruments and players, and Congress acquiesced to their requests. Having deduced the purposes behind the safe harbor, the next step is to determine whether those purposes were fulfilled in relation to the Financial Crisis of 2007-09. Substantial evidence from the collapses of Bear Stearns, Lehman Brothers, AIG, and the entire residential mortgage-backed securities market suggests that not only did the safe harbor fail to achieve its stated goal of reducing systemic risk, but actually backfired and increased systemic risk, and thereby worsened the financial crisis. In light of this evidence, the paper ends by discussing two routes for reform. The first option is to repeal the safe harbor in light of the creation of the Orderly Liquidation Authority under the Dodd-Frank Act. The Orderly Liquidation Authority is a financial resolution system created specifically for the largest institutions capable of producing systemic risk. However, this paper supports the second option, which is less drastic and the one less likely to upset settled expectations. That second option proposes to narrow the safe harbor provisions in various ways so that they are more appropriately targeted at achieving their goal of reducing systemic risk.