The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis

Table of ContentsI. Introduction 1716II. Background 1718III. The Concept of Path Dependence 1721A. Defining Path Dependence 1721B. Legal Path Dependence 1722IV. Evolution of the Bankruptcy-Law Safe Harbor for Derivatives 1724A. The 1978 Bankruptcy Code 1724B. The 1982 Amendment 1727C. The 1984 Amendment 1728D. The 1990 Amendment 1729E. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 1731F. The Financial Netting Improvements Act of 2006 1736V. Is the Derivatives Safe Harbor Path Dependent? 1737VI. Reassessing the Derivatives Safe Harbor 1742A. Does Market Concentration Justify the Safe Harbor? 1743B. Is the Safe Harbor Focused on the Right Parties? 1746C. Possible Unintended Consequences 1747VII. Conclusions 1753I. IntroductionBankruptcy law in the United States, which serves as an important precedent for the treatment of derivatives under insolvency law worldwide,2 provides unique protections to creditors in derivatives transactions. Unlike other creditors of a debtor,3 derivatives counterparties have special rights and immunities in the bankruptcy process, including virtually unlimited enforcement rights against the debtor (hereinafter, the "safe harbor"). This Article shows that these rights and immunities accreted over time, primarily due to industry lobbying and without a systematic and rigorous vetting of the consequences.This type of legislative accretion process is not uncommon. It is a form of path dependence-a process in which the outcome is shaped by its historical path. Because the resulting legislationin our case, the safe harbor-is not fully vetted, its significance and utility should not be taken for granted.This Article first provides background on U.S. bankruptcy law and derivatives transactions.4 Thereafter, it explains the concept of path dependence, including legal path dependence.5 The Article then reviews the evolution of the safe harbor for derivatives6 and shows why that evolution has been largely path dependent.7 Finally, the Article reviews the scholarship that substantively engages the merits of the safe harbor.8 That scholarship suggests there is a serious question whether the benefits of the safe harbor exceed its costs, and that the safe harbor may even have unintended harmful consequences.II. BackgroundBroadly speaking, bankruptcy law, which in the United States is governed by the federal Bankruptcy Code,9 favors derivatives (including repurchase agreements) counterparties in three main ways.10 Most prominently, it allows derivatives counterparties to exercise their contractual enforcement remedies against a debtor or its property-including closing out, netting, and setting off their derivatives positions and liquidating collateral in their possession-notwithstanding the automatic stay of enforcement actions.11 Secondly, bankruptcy law exempts derivatives counterparties from the so-called "[trustee-]avoiding powers," such as preference rules and constructively fraudulent transfers, regarding any payments and collateral received prior to the bankruptcy.12 For example, a derivatives counterparty that receives a preferentially large repayment from an insolvent debtor shortly before the debtor's bankruptcy will not have to return it.13 Lastly, bankruptcy law allows derivatives counterparties to enforce bankruptcy-termination ipso facto clauses14 and to net all existing derivatives contracts with the debtor.15 This effectively exempts derivatives contracts from a debtor's ability to terminate unfavorable contracts.16To fully grasp the significance of these exemptions, we must first discuss the rationales underlying bankruptcy law's debtor protections. …