Transaction consistency and the new finance in bankruptcy

Columbia Law Review

Volumn 112, Issue 1, 2012, Pages 152-202

  Skeel Jr , David A ^a   Jackson, Thomas H ^b  

^a UNIVERSITY OF PENNSYLVANIA LAW SCHOOL   (United States)

^b UNIVERSITY OF ROCHESTER   (United States)

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[No Author keywords available]

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EID: 84856251219     PISSN: 00101958     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (261)

1. Chief among these are the automatic stay and the executory contract assumption provisions. The automatic stay forbids creditors from seizing or selling collateral, terminating contracts, or engaging in any other "act to obtain possession of property of the estate." 11 U.S.C. § 362 (2006). Similarly, 11 U.S.C. § 365 outlines permissible contract assumption, giving the debtor the ability to assume valuable executory contracts even if the debtor is in default at the time it files for bankruptcy.
2. This is the consequence of the so-called absolute priority rule, 11 U.S.C. §§ 725, 726, as implemented in Chapter 11's reorganization rules, 11 U.S.C. §§ 1123, 1126, 1129, which require that higher-priority creditors be paid before lower-priority creditors and shareholders unless the higher-priority creditors consent to different treatment.
3. Thomas Jackson, The Logic and Limits of Bankruptcy Law 8-17 (1986) [hereinafter Jackson, Logic and Limits].
4. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 210(a)(11)(a)-(b), 124 Stat. 1376, 1470-71 (2010) (to be codified at 12 U.S.C. § 5390) (incorporating bankruptcy-like fraudulent conveyance and preference provisions).
5. See id. §§ 201-217, 124 Stat. at 1442-1520 (to be codified in scattered sections of 12 U.S.C.) (codifying resolution rules).
6. See id. § 202(e), 124 Stat. at 1448-49 (to be codified at 12 U.S.C. § 5382) (providing for bankruptcy study by Comptroller and Administrative Office of U.S. Courts)
7. id. § 216, 124 Stat. at 1519 (to be codified at 12 U.S.C. § 5394) (providing for study by Federal Reserve and Administrative Office of U.S. Courts).
8. The major forms of swaps include credit default swaps, interest rate swaps, and currency swaps.
9. See 11 U.S.C. § 101(53B) (defining "swap agreement"). A credit default swap functions like insurance, with one party (the protection seller) promising the other party (the protection buyer) a payment in the event that a third party (the reference entity) that is the subject of the contract experiences a "credit event" such as default or bankruptcy. With an interest rate swap, one party agrees to pay one form of interest (such as a fixed interest rate) and the other pays a different rate (such as an interest rate that varies based on the prime rate). With a currency swap, one party agrees to pay a specified amount of one currency (such as dollars) and the other promises a different currency (such as euros). In each case, the obligations are usually netted out at the end of the contract, and one party pays the other the difference.
10. In a repurchase or "repo" transaction, one party sells securities to the other and promises to buy them back at a specified time in the future.
11. See id. § 101(47) (defining "repurchase agreement"). Repos are generally used for financing and are very similar to a secured loan with securities as collateral.
12. In its most common form, structured finance, or "securitization," involves a sale by the issuer of assets such as mortgages or credit card receivables to a new entity. Investors in the new entity receive securities issued by the new entity, and the funds they contribute are used by the entity to purchase its assets.
13. See, e.g., Steven L. Schwarcz, The Future of Securitization, 41 Conn. L. Rev. 1313, 1315-17 (2009) (outlining and explaining securitization).
14. See Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, app. E, 114 Stat. 2763A-365 (codified as amended in scattered sections of 7 U.S.C.). The Commodity Futures Modernization Act of 2000 excluded a broad range of derivatives transactions from the jurisdiction of both the CFTC and the SEC, leaving them unregulated by the federal government.
15. Noah L. Wynkoop, Note, The Unregulables? The Perilous Confluence of Hedge Funds and Credit Derivatives, 76 Fordham L. Rev. 3095, 3099 (2008).
16. 11 U.S.C. § 362(a).
17. The most famous endorsement came from former Federal Reserve Chairman Alan Greenspan, who credited derivatives with easing the effects of the Enron and WorldCom collapses. Alan Greenspan, Chairman, Fed. Reserve, Remarks to the Federal Reserve Bank of Chicago's Forty-First Annual Conference on Bank Structure: Risk Transfer and Financial Stability (May 5, 2005), available at http://www.federalreserve.gov/Boarddocs/Speeches/2005/20050505/default.h tm (on file with the Columbia Law Review) (attributing "the remarkable resilience of the banking system, which had [by the time of earlier remarks by Greenspan in 2003] recently shrugged off severe shocks to the economy and the financial system" to derivatives and sophisticated risk management).
18. See infra Part II (analyzing how repos and derivatives would be treated if subject to same core bankruptcy policies as other contracts, and citing other works by each of the authors on these issues).
19. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 723, 124 Stat. 1376, 1675-82 (2010) (to be codified at 7 U.S.C. § 2) (discussing clearing requirement). Technically, the clearinghouse is a principal to both parties, becoming a buyer to every seller and a seller to every buyer. The effect is similar to a guaranty, and this term will be used throughout the Essay.
20. See id. (discussing exchange requirement).
21. Most importantly, bank regulators are authorized to limit the amount of shortterm debt that a systemically important financial institution is permitted to have in its capital structure.
22. Id. § 165(g), 124 Stat. at 1429 (to be codified at 12 U.S.C. § 5365). For structured finance, the legislation requires that the originator retain at least 5% of the credit risk of the structured finance entity.
23. Id. § 941, 124 Stat. at 1891-92 (to be codified at 15 U.S.C. § 78o-11).
24. This Essay's particular concern is with repos and derivatives. The current treatment of structured finance is less problematic, as it treats securitization transactions as true sales, and thus, as remote from the issuer's bankruptcy, except in egregious circumstances.
25. Special treatment may prevent other distortions. The Essay considers these benefits when discussing the effect that removing the special treatment would have. See infra text accompanying note 22. 19. To call this principle "transaction consistency" may seem heretical (or unnecessary) to some bankruptcy insiders. It bears an unmistakable family resemblance to the "equality of creditors" principle, a longstanding staple of bankruptcy that says similarly situated creditors should be treated as equivalently wherever possible.
26. Thomas H. Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors' Bargain, 91 Yale L.J. 857, 859-68 (1982) (discussing idea of creditor equality). Despite the familiarity of the "equality of creditors" principle, we prefer "transaction consistency" for several reasons. The first is that the traditional term is so familiar that it has lost much of its content in practice. In addition, the two terms have different connotations. Equality of creditors connotes fairness, and assuring fairness was its historical objective: In the nineteenth century, sophisticated creditors were often discriminated against, as debtors favored friends and local creditors. Fairness is still an issue, but transaction consistency gives a better sense of the distortions created by deviations, which are the primary concern of this Essay. 20.
27. See 11 U.S.C. § 365(c)(2) (2006) (excepting from power to assume or assign "a contract to make a loan, or extend other debt financing or financial accommodations").
28. The key provision here is 11 U.S.C. § 553, which honors prebankruptcy setoff rights.
29. With many derivatives contracts, the parties are required to post "initial margin"-which is the value corresponding to a portion of any potential obligations under the contract-as well as "variation margin"-additional margin payments to reflect changes in the current value of the contract.
30. This recognition comes in part from our own experience. Both of us were involved in numerous discussions with Congressional staff of both parties, and in other ways, during the legislative debates that led to the Dodd-Frank Act. While we would like to think that we made a tiny contribution to the removal of a dedicated $50 billion fund from the original version of the Dodd (Senate) bill
31. see Restoring American Financial Stability Act of 2010, S. 3217, 111th Cong. (2010) (as introduced in Senate, Apr. 15, 2010), our own influence on the final legislation was essentially nil. With this Essay, we are going back to the drawing board.
32. An ipso facto clause is a provision that defines the debtor's bankruptcy or insolvency as an event of default and thus as grounds for terminating the contact. The rules that invalidate so-called ipso facto clauses for ordinary contracts can be found in 11 U.S.C. §§ 365(e), 541(c). Derivatives and repos are exempted from these rules. Id. §§ 559, 560, 561 (exempting repos, swaps, and netting agreements, respectively).
33. Id. §§ 362(a), 547 (outlining automatic stay and preference provisions, respectively).
34. Id. § 547(b)(4). The reach back is extended to one year if the recipient of the transfer is an insider. Id.; see also id. § 101(31) (defining "insider").
35. See, e.g., Jackson, Logic and Limits, supra note 3, at 125 (explaining normative underpinnings of preference law).
36. For the chronology and other details
37. see Edward R. Morrison & Joerg Riegel, Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges, 13 Am. Bankr. Inst. L. Rev. 641, 644-45 (2005) (describing progression of congressional protections available to counterparties).
38. If Buyer did not pay for the stock immediately or bought it on credit, the payment could be construed as a payment "on account of an antecedent debt," which would thus be subject to challenge as a preference. 11 U.S.C. § 547(b)(2). As the initial transferee of the payment, Broker theoretically could be asked to turn over $100, even if Broker was really just a conduit.
39. See, e.g., 11 U.S.C. § 550(a)(1) (authorizing trustee to recover from "initial transferee," even if this transferee is not "entity for whose benefit the payment is made").
40. "If a firm or a clearing organization had to return margin payments received from a debtor when he had already transmitted those funds to others in the clearing chain," a witness testified in 1981, "its finances would be seriously undermined to the point where it also might be driven into bankruptcy." Bankruptcy of Commodity and Securities Brokers: Hearings before the Subcomm. on Monopolies & Commercial Law of the H. Comm. On the Judiciary, 97th Cong. 165 (1981) (statement of Edmund R. Schroeder, Attorney, Barrett Smith Schapiro Simon & Armstrong, New York, N.Y., appearing for New York Cocoa Clearing Association and New York Sugar Clearing Association).
41. Id. at 167 (statement of Stephen F. Selig, Esquire, Baer, Marks, & Upham, New York, N.Y., appearing for Comex Clearing Association, Commodity Exchange, Inc., Kansas City Board of Trade, Bache, Bear Stearns, Dean Witter Reynolds, and Merrill Lynch Commodities). Securities and Exchange Commission Commissioner Bevis Longstreth sounded this theme in the same hearing, opining that the application of ordinary preference law to securities transactions "creates uncertainty which is incompatible with the efficient working of the national clearance and settlement system."
42. Id. at 240 (statement of Bevis Longstreth, Comm'r, Sec. & Exch. Comm'n).
43. A slightly wider range of views emerged in the early discussion of repos than with derivatives. The Department of the Treasury opined in the early 1980s that it might not be necessary to exempt repos from the automatic stay. Letter from Paul A. Volcker, Chairman of the Fed. Reserve, to Senator Robert J. Dole, Chairman, Subcomm. on Courts, Comm. On the Judiciary (Sept. 29, 1983). Although the Federal Reserve disagreed, they initially were willing to consider minor limitations on the special treatment. In 1984, Representative Peter Rodino stated that then-Federal Reserve Chair Paul Volcker had "stated in written correspondence to this committee that amendments that limit protection to repo transactions of $1 million or more" would be sufficient, and would "'avoid major exceptions to existing bankruptcy law.'" Bankruptcy Law and Repurchase Agreements: Hearing on H.R. 2852 and H.R. 3418 Before the Subcomm. of Monopolies & Commercial Law of the H. Comm. on the Judiciary, 98th Cong. 61 (1984) [hereinafter 1984 House Hearing] (statement of Rep. Peter W. Rodino, Jr., Chairman, H. Comm. on the Judiciary).
44. Lombard-Wall Inc. v. Bankers Trust Co. (In re Lombard-Wall, Inc.), 23 B.R. 165 (Bankr. S.D.N.Y. 1982). Lombard-Wall was a securities firm that dealt with government securities. Shortly after Lombard-Wall filed for bankruptcy in August 1982, the bankruptcy court held that its repos would be treated as secured loans rather than sales and that they would be subject to the automatic stay. The court issued a temporary restraining order forbidding the repo buyers from selling the collateral absent court approval and subsequently confirmed its ruling despite protests that the repo buyers' inability to sell their collateral would reduce the liquidity of the repo market.
45. Id. at 166 (requiring repo buyers to turn over securities to estate and holding that "[u]nless Lombard is able to obtain and use the Securities immediately. Lombard will be forced to stop its operations, leaving the estate and its creditors facing financial disaster"). For a good discussion of the Lombard-Wall default and the push for bankruptcy protection
46. see Kenneth D. Garbade, The Evolution of Repo Contracting Conventions in the 1980s, 12 Fed. Res. Bank N.Y. Econ. Pol'y Rev. 27, 35-36 (2006). Lombard-Wall's failure came three months after the collapse of another securities dealer, Drysdale Government Securities, had rattled the government securities markets.
47. Id. at 32-34 (discussing Drysdale failure and shift to recognition of accrued interest that followed).
48. See 1984 House Hearing, supra note 34, at 19 (statement of Del. Walter Fauntroy).
49. Id. at 83 (statement of Robert Brown, Chairman of the Board of Directors of the Public Securities Association). Witnesses predicted that the market would flourish, on the other hand, if repo protections were expanded. Even years later, this reasoning for expansive repo protections was solidly in place. According to Seth Grosshandler of Cleary, Gottlieb, Steen & Hamilton, testifying in 1999: "Market participants could. enter into. [repo] transactions with greater confidence that they will be easily enforceable, improving the liquidity and cost of financing for the underlying instruments. " Bankruptcy Reform Act of 1999 (Part III): Hearing on H.R. 833 Before the Subcomm. On Commercial & Admin. Law of the H. Comm. on the Judiciary, 106th Cong. 388 (1999) [hereinafter 1999 House Hearing] (statement of Seth Grosshandler, Esquire, Partner, Cleary, Gottlieb, Steen & Hamilton LLP).
50. Commenting on market concerns about the Lombard-Wall decision, Federal Reserve Chairman Paul Volcker told Congress: "[I]f the repo market were to become less attractive, its usefulness as an instrument of monetary policy would decline." 1984 House Hearing, supra note 34, at 71 (quoting Letter from Paul A. Volcker, Chairman, Fed. Reserve, to Senator Robert J. Dole, Chairman, Subcomm. on Courts, Comm. on the Judiciary (Jan. 20, 1983)). For a lengthy exegesis on the importance of repo financing to the nation's financial markets and Federal Reserve policymaking activities, see In the Matter of Bevill, Bresler & Schulman Asset Mgmt. Corp., 67 B.R. 557, 566-71 (D.N.J. 1986).
51. See, e.g., John C. Dugan, Derivatives: Netting, Insolvency, and End Users, 112 Banking L.J. 638, 640 (1995) (emphasizing "cherry-picking" concern).
52. For criticism of this argument, see Stephen J. Lubben, Derivatives and Bankruptcy: The Flawed Case for Special Treatment, 12 U. Pa. J. Bus. L. 61, 68-73 (2009) ("The Bankruptcy Code does not change [the calculations of an insolvent company], as the power to reject under section 365 is precisely the same as the power to breach when insolvent. The 'cherry picking' argument then loses much of its force.").
53. See 1999 House Hearing, supra note 37, at 352 (prepared statement of Oliver Ireland, Associate General Counsel, Board of Governors of the Federal Reserve System) ("The right to terminate or close-out protects [financial institutions]. on an individual basis, and by protecting both supervised and unsupervised market participants, protects the markets from systemic problems of 'domino failures.'").
54. See, e.g., Michael H. Krimminger, Adjusting the Rules: What Bankruptcy Reform Will Mean for Financial Market Contracts, FYI: An Update on Emerging Issues in Banking, FDIC (Oct. 11, 2005), http://www.fdic.gov/bank/analytical/fyi/2005/101105fyi.html (on file with the Columbia Law Review) (noting "[i]f [a counter-party]. is placed into bankruptcy or receivership, the normal stays on termination of contracts and liquidation of collateral could create escalating losses" and "as a result, the ability to terminate the contract and net exposures quickly can be crucial to limit the losses to the non-defaulting party").
55. William D. Cohan, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street 66-67 (2010) (describing consultation of Bear Stearns top executives).
56. See, e.g., Kate Kelly, Fear, Rumors Touched Off Fatal Run on Bear Stearns, Wall St. J., May 28, 2008, at A1 (noting discussion among Geithner, Paulson, and Bernanke concerning likely fallout from allowing Bear Stearns to collapse).
57. David Wessel, In Fed We Trust: Ben Bernanke's War on the Great Panic 166-68 (2009) ("The Fed pushed for the Treasury to promise to 'indemnify' the Fed if mortgagelinked securities ultimately weren't worth the $30 billion.").
58. The possibility that the special treatment in bankruptcy could subsidize use of derivatives as compared to other forms of financing was first identified by Franklin Edwards and Ed Morrison. See Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 Yale J. on Reg. 91, 121 (2005) [hereinafter Edwards & Morrison, Derivatives and the Bankruptcy Code] (noting "the Code may unintentionally alter the debt structure of firms towards a greater reliance on derivatives by favoring derivatives counterparties over other creditors").
59. See Mark J. Roe, The Derivatives Market's Payment Priorities as Financial Crisis Accelerator, 63 Stan. L. Rev. 539, 552 (2011).
60. See David Skeel, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences 28-29 fig.2.3 (2010) [hereinafter Skeel, New Financial Deal].
61. Report of Anton R. Valukas, Examiner at 732, In re Lehman Bros. Holdings Inc., Bankr. No. 08-13555 (JMP), 2011 WL 4071995 (Bankr. S.D.N.Y. Sept. 14, 2011) [hereinafter Valukas Report], available at http://lehmanreport.jenner.com/ (on file with the Columbia Law Review) (concluding repos were used to "create materially misleading picture of the firm's financial condition"). Spurred by the Examiner's report, the New York Attorney General has sued Lehman's accountants, Ernst & Young, alleging that they were aware of Lehman's manipulations and failed to disclose them.
62. See Complaint, Cuomo v. Ernst & Young LLP, No. 0451586 (N.Y. Sup. Ct. filed Dec. 21, 2010), available at http://www.ag.ny.gov/media_center/2010/dec/ErnstYoungComplaint.pdf (on file with the Columbia Law Review).
63. Valukas Report, supra note 49, at 739. 51. For a discussion of the question of whether repos are lending transactions or sales, see infra Parts II.B.1-2.
64. See supra notes 35-38 and accompanying text (discussing Lombard-Wall case). 53.
65. See, e.g., Darrell Duffie, The Failure Mechanics of Dealer Banks, 24 J. Econ. Persp. 51, 67-68 (2010) [hereinafter Duffie, Failure Mechanics] (describing J.P. Morgan interventions).
66. See, e.g., Susanne Craig & Robin Sidel, Crisis on Wall Street: J.P. Morgan Made Dual Cash Demands, Wall St. J., Oct. 8, 2008, at C2 (recounting pressures J.P. Morgan put on Lehman).
67. See, e.g., Debtor's Motion for Entry of an Order Pursuant to Sections 105 and 365 of the Bankruptcy Code to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivative Contracts at 4, In re Lehman Bros. Holdings, Inc., Bankr. No. 08-13555 (JMP) (Bankr. S.D.N.Y. Nov. 13, 2008) ("[T]he Debtors are party to approximately 930,000 Derivative Contract transactions of which approximately 733,000 are purported to have been terminated.").
68. Too Big to Fail: The Role for Bankruptcy and Antitrust Law in Financial Regulation Reform: Hearing Before the Subcomm. on Commercial & Admin. Law of the H. Comm. on the Judiciary, 111th Cong. 9 (2009) (prepared statement of Harvey R. Miller, Weil, Gotshal & Manges, LLP).
69. According to a subsequent report by the Special Investigator General for the Troubled Asset Relief Program (TARP), Federal Reserve and Treasury officials feared a panoply of potential consequences if AIG stopped making payments to counterparties, including "the impact on the American retirement system [because many retirement plans had bought stable value fund contracts from AIG]; the impact of AIG's commercial paper obligations[;] the broader effect on the already frozen credit markets and money market mutual funds; and the considerable systemic risk to the global financial system." Office of the Special Inspector Gen. for the Troubled Asset Relief Program (SIGTARP), SIGTARP-10-003, Factors Affecting Efforts to Limit Payments to AIG Counterparties 9 (2009) [hereinafter SIGTARP Report], available at http://www.sigtarp.gov/reports/audit/2009/Factors_Affecting_Efforts_to_L imit_Payments_to_AIG_Counterparties.pdf (on file with the Columbia Law Review).
70. See generally Gretchen Morgenson & Louise Story, Testy Conflict with Goldman Helped Push A.I.G. to Precipice, N.Y. Times, Feb. 7, 2010, at A1 (describing AIG's difficulties retrieving alleged collateral overpayments from Goldman Sachs).
71. Compare 11 U.S.C. § 362(a) (2006) (providing for general stay), with id. § 362(b)(17) (providing exception for swaps).
72. Compare id. § 547(b) (describing transfers, including transfers of collateral, within ninety days of bankruptcy avoidable as preferences), with id. § 546(g) (outlining special treatment of swaps).
73. See, e.g., Carrick Mollenkamp & Serena Ng, Report Rebuts Goldman's Claim on AIG: TARP Audit Suggests AIG Collapse Could Have Resulted in Big Losses, Wall St. J., Nov. 18, 2009, at C1 (questioning Goldman's claim that they were fully protected and thus did not need bailout).
74. See, e.g., SIGTARP Report, supra note 57, at 9 (reciting Federal Reserve Chairman Ben Bernanke's testimony identifying "global banks and investment banks that had $50 billion in exposure to losses on loans, lines of credit and derivatives" as reason for intervention).
75. See, e.g., David A. Skeel, Jr., Bankruptcy Boundary Games, 4 Brooklyn J. Corp. Fin. & Com. L. 1, 18, 20 (2009) [hereinafter Skeel, Bankruptcy] (describing monitoring effect); see also Roe, supra note 47, at 556-60 (exploring monitoring issue in detail). 64. James Sprayregen, a leading bankruptcy attorney who was consulted when AIG threatened to collapse, has recalled that bankruptcy was briefly considered as a possible option, but rejected precisely because bankruptcy would not stay the termination of AIG's derivatives.
76. see also Roe, supra note 47, at 556-60 (exploring monitoring issue in detail).
77. James Sprayregen, a leading bankruptcy attorney who was consulted when AIG threatened to collapse, has recalled that bankruptcy was briefly considered as a possible option, but rejected precisely because bankruptcy would not stay the termination of AIG's derivatives
78. See E-mail from James H.M. Sprayregen, Partner, Kirkland & Ellis LLP, to David Skeel (Jun. 9, 2011, 1:48 PM EST) (on file with the Columbia Law Review). Sprayregen further elaborated on this idea in discussions with the authors at the Richmond and Philadelphia Federal Reserve Banks' Workshop: Financial Firm Bankruptcy held on July 26, 2011. The new Dodd-Frank resolution rules counteract this to some extent for the companies to which they apply by providing for a temporary suspension of ipso facto clauses.
79. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 210(C)(10)(B), 124 Stat. 1376, 1491 (2010) (to be codified at 12 U.S.C. § 5390). But derivatives are still likely to be bailed out by regulators in practice.
80. See infra Part III.
81. See, e.g., Edwards & Morrison, Derivatives and the Bankruptcy Code, supra note 46, at 121 (noting substitution effect). 66.
82. See, e.g., Stephen J. Lubben, The Bankruptcy Code Without Safe Harbors, 84 Am. Bankr. L.J. 123, 138 (2010) (suggesting changes to Bankruptcy Code may have encouraged use of mortgage-backed securities as repo collateral).
83. This comparison is a central feature of Gary Gorton's recent work. In an article with Andrew Metrick, he argues that "the core problem in the financial crisis was a run on repos," which occurred when nervous repo buyers increased the amount of the "haircut"-that is, the difference between the value of the collateral and the amount the repo buyer pays in the initial sale. Gary Gorton & Andrew Metrick, Regulating the Shadow Banking System, Brookings Papers on Econ. Activity, Fall 2010, at 261, 264, 279, available at http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010_fall_bpea_p apers/2010fall_gorton.pdf (on file with the Columbia Law Review). "An increase in a repo haircut," Gorton and Metrick argue, "is tantamount to a withdrawal from the issuing bank."
84. Id. at 279.
85. See, e.g., Kenneth Ayotte & David A. Skeel, Jr., Bankruptcy or Bailouts?, 35 J. Corp. L. 469, 495 (2009) [hereinafter Ayotte & Skeel, Bailouts] (making this argument).
86. See Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973) (defining executory contract as "a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other");
87. 11 U.S.C. § 365(c)(2) (2006). This prohibition on assumption or assignment also applies to contracts to issue a security of the debtor, id., or where applicable law "excuses a party. from accepting performance from or rendering performance to an entity other than the debtor."
88. This Essay focuses on the treatment of these contracts in bankruptcy in terms of (a) their valuation, (b) their ability to be assumed and/or assigned, and (c) their protection (in the case of contracts backed by security interests). This Essay later addresses other issues involving such contracts, such as the application of preference law to payments received within ninety days of bankruptcy.
89. See infra Part II.E (explaining that preference and fraudulent rules are waived off for repos, derivatives, and other financial contracts).
90. see also Jackson, Logic and Limits, supra note 3, at 105-18 (discussing special nature of executory contracts in bankruptcy).
91. See 11 U.S.C. § 726(a)(5) (noting, in such circumstances all unsecured claimants will receive "interest at the legal rate from the date of the filing of the petition").
92. See id. §§ 361, 362(d)(1) (stating what constitutes "adequate protection" and when it is required).
93. See Douglas G. Baird & Thomas H. Jackson, Cases, Problems, and Materials on Bankruptcy 278 (2d ed. 1990) (describing parties' incentives during this period).
94. In the situations we just noted, the other party's major remedy is to seek a court order requiring the debtor to assume or reject the contract. 11 U.S.C. § 365(d)(2).
95. See, e.g., Thompson v. IFG Leasing Co. (In re Thompson), 788 F.2d 560, 563 (9th Cir. 1986) (holding when debtor used property prior to rejection, the "fair and reasonable value" of property is an administrative expense).
96. 11 U.S.C. § 365(d)(3).
97. We have to assume the debtor is in fact using the coverage, as indeed would be the case prior to a rejection. If the building is insured, and there is no fire, the debtor would, at the end of the coverage period, reject the contract; if, however, there was a fire, the debtor would, at that point, assume the contract. Given that, it is clear that, in reality, the debtor is "using" the coverage during that interregnum.
98. This tension was revealed with the question of whether a natural gas distributor's supply contracts with its customers should be characterized as swaps for purposes of bankruptcy's special rules. Hutson v. Smithfield Packing Co. (In re Nat'l Gas Distribs. LLC), 369 B.R. 884, 900 (Bankr. E.D.N.C. 2007), rev'd sub nom., Hutson v. E.I. du Pont de Nemours & Co. (In re Nat'l Gas Distribs. LLC), 556 F.3d 247 (4th Cir. 2009). Analytically, it is both a standard commodities contract and a hedge, and it would be strange to have this characterization turn on the "primary purpose" or some such thing.
99. As we discuss in more detail below, in the event that a swap is embedded in, or used as, a loan, it should be treated as a financial accommodation.
100. See infra notes 123-125 and accompanying text (discussing loan-like swaps).
101. See Valukas Report, supra note 49, at 732-1053. As noted earlier, Ernst & Young has been charged with having known about the Repo 105 transactions and having acquiesced in them.
102. See supra note 49. Press coverage was immediate.
103. See, e.g., Jacob Goldstein, Repo 105: Lehman's 'Accounting Gimmick' Explained, NPR (Mar. 12, 2010, 11:55 AM), http://www.npr.org/blogs/money/2010/03/repo_105_lehmans_accounting_gi.ht ml (on file with the Columbia Law Review).
104. See supra text accompanying notes 49-50 (describing use of repos to reduce Lehman's reported debt).
105. See Valukas Report, supra note 49, at 754-57 (discussing Lehman's use of Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 140 ("SFAS 140") to characterize Repo 105 transactions as sales). Repos are ordinarily treated as loans for accounting purposes. But SFAS 140 allows the repo seller to characterize a report as a sale if specified criteria are met. See Fin. Accounting Standards Bd., Statement of Financial Accounting Standards No. 140: Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities ¶ 98 (2000). Lehman's interpretation of this was that a sale characterization would be appropriate if the securities conveyed to the buyer were worth at least 105% of the cash paid by the buyer.
106. According to the Lehman examiner, Lehman used $38.6 billion in Repo 105s in fourth quarter 2007, $49.1 billion in first quarter 2008, and $50.38 billion in second quarter 2008. The transactions reduced its reported leverage from an actual ratio of 17.8 dollars of debt for every dollar of equity to a reported debt-to-equity ratio of 16.1; 17.3 to 15.4; and 13.9 to 12.1 in these three quarters.
107. Valukas Report, supra note 49, at 748.
108. For a nice analysis of this point from early in the evolution of the repo market
109. see Gary Walters, Note, Repurchase Agreements and the Bankruptcy Code: The Need for Legislative Action, 52 Fordham L. Rev. 828, 838-40 (1984) (noting repo transactions are like loans in that buyers generally pay less than securities' market value and sellers usually receive securities' interest or other distributions). The leading article in this area takes the opposite view.
110. See Jeanne L. Schroeder, Repo Madness: The Characterization of Repurchase Agreements Under the Bankruptcy Code and the U.C.C., 46 Syracuse L. Rev. 999, 1018 (1996) [hereinafter Schroeder, Repo Madness] (arguing repos do not qualify as secured transactions since they lack tangible "res"). It may be worth noting, however, that the author, a top commercial law scholar, starts from the premise that the "repo market is simply too enormous and important" to run the risk that repos might be recharacterized as loans, and sets out to find a strong argument for this conclusion.
111. Id. at 1014.
112. U.C.C. § 9-109(a) (2011). In a much discussed recent case, a bankruptcy judge determined that the characterization of repos should turn on the parties' "objective intent," and that this created an issue of material fact, in part because the repo buyer was required to "transfer the same, not merely equivalent, securities." In re Criimi Mae, Inc., 251 B.R. 796, 800-05 (Bankr. D. Md. 2000).
113. Sales of accounts are defined as secured transactions and brought within Article 9 by U.C.C. § 9-109(a)(3).
114. In a securitization, a firm sells accounts receivable or other assets to a new entity created for the purposes of the transaction, often as a means of generating financing for the firm's business. If the transaction is not a "true sale," it could be recharacterized as a secured loan and the assets treated as part of the bankruptcy case if the firm later files for bankruptcy. So long as it is a true sale, on the other hand, the transaction will be "bankruptcy remote."
115. See Kenneth C. Kettering, Securitization and Its Discontents: The Dynamics of Financial Product Development, 29 Cardozo L. Rev. 1553, 1564 (2008) (discussing bankruptcy remote, securitization, and some of the controversy securitization has engendered);
116. see also Edward J. Janger, The Costs of Liquidity Enhancement: Transparency Cost, Risk Alteration and Coordination Problems, 4 Brooklyn J. Corp. Fin. & Com. L. 39, 44 (2010) ("[C]ertainty that the assets have been subject to a true sale has been hard to come by.").
117. Many of the standard terms of repo contracts underscore this intention. The repo seller, rather than the buyer, is typically entitled to any interest payments or other proceeds of the securities during the pendency of the contract.
118. See, e.g., Jeanne L. Schroeder, A Repo Opera: How Criimi Mae Got Repos Backwards, 76 Am. Bankr. L.J. 565, 571 (2002) [hereinafter Schroeder, A Repo Opera] ("[R]epos typically provide that the repo seller is the owner of all interest and other distributions made on the underlying security pending the repurchase.");
119. see also Bond Mkt. Ass'n & Int'l Capital Mkt. Ass'n, Global Master Repurchase Agreement (2000) [hereinafter Global Master Repurchase Agreement], available at http://www.icmagroup.org/ICMAGroup/files/25/25561a36-72bc-439d-8538-039a 3a979b03.pdf (on file with the Columbia Law Review) (providing standard master agreement for repo transactions based on English law).
120. See, e.g., U.C.C. § 2A-103(1)(j) (defining "lease" as "a transfer of the right to possession and use of goods for a term in return for consideration," but excluding without defining "a sale, including a sale on approval or a sale or return, or retention or creation of a security interest").
121. A nominal repurchase price suggests that the transaction really is a loan. For a survey of cases that had arisen under Article 2A as of the early 1990s, see generally Robert D. Strauss et al., Leases, 47 Bus. Law. 1545 (1992).
122. Repo sellers like Lehman recognize that their repo transactions are loans and regularly treat them as such for accounting purposes. The Lehman examiner highlighted this fact in his criticism of Lehman's Repo 105 transactions. "Like other large investment banks," he reported, "Lehman engaged, on a daily basis, in tens of billions of dollars of repo transactions in its normal course of business for financing purposes."
123. Valukas Report, supra note 49, at 751. In contrast with its Repo 105s, "Lehman accounted for these ordinary repo transactions as financing transactions."
124. See, e.g., Global Master Repurchase Agreement, supra note 96, ¶ 3(f) (requiring return of "equivalent securities" on repurchase date);
125. see also Schroeder, A Repo Opera, supra note 96, at 571 ("[T]he repo buyer. is typically entitled to deal with the security and is only required to sell back an equivalent security.").
126. The absence of clearly identifiable collateral is the central plank in Jeanne Schroeder's argument that repos are best treated as sales rather than secured loans. See Schroeder, Repo Madness, supra note;
127. see also supra note 92 (discussing Schroeder's argument and counterarguments).
128. See, e.g., In re Criimi Mae, Inc., 251 B.R. 796, 803-04 (Bankr. D. Md. 2000) (finding ambiguity as to whether repo at issue was sale or secured transaction, and emphasizing requirement that specific collateral be returned weighed in favor of treating it as secured transaction).
129. Kimberly Summe has argued that repos and derivatives would present insoluble valuation issues. Kimberly Anne Summe, Lessons Learned from the Lehman Bankruptcy, in Ending Government Bailouts as We Know Them 59, 94 (Kenneth E. Scott, George P. Shultz & John B. Taylor eds., 2010) ("Complex derivatives such as credit default swaps on asset-backed securities or collateralized debt obligations presented a major challenge for valuation when markets began to fall apart."). This, however, is a necessary part of any termination; Summe suggests it is a reason to reconsider whether complex derivatives are suitable for a mark-to-market model.
130. See 11 U.S.C. §§ 361, 362(d)(1) (2006) (stating what constitutes adequate protection and when it is required).
131. See id. § 362(a)(7) (providing that filing of petition operates as stay of "the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor"). The right of setoff is expressly recognized and is generally treated as the equivalent of a secured claim that existed at the time of the filing of the bankruptcy petition. Id. § 553. If the off-set arises out of the same transaction, it has been considered a "recoupment," not a "setoff," and is thus not subject to § 553 or § 362(a)(7).
132. See In re Holyoke Nursing Home, Inc., 372 F.3d 1, 4 (1st Cir. 2004) (holding transaction was recoupment rather than setoff and "[a]s such, it was neither a voidable preference nor a violation of the automatic stay").
133. This is particularly so in the wake of the 2008 crisis, which has prompted a shift back to cash-like collateral for derivatives and sharply diminished repos based on mortgage-backed securities and other less liquidate collateral.
134. See, e.g., Adam Copeland, Antoine Martin & Michael Walker, The Tri-Party Repo Market Before the 2010 Reforms 46 (Fed. Reserve Bank of N.Y. Staff Reports, Staff Report No. 477, Nov. 2010), available at http://www.ny.frb.org/research/staff_reports/sr477.pdf (on file with the Columbia Law Review) ("The composition of assets used as collateral has changed somewhat, with more liquid collateral being substituted for less liquid collateral. The amount of Non Fed-eligible collateral more than halved between July 2008 and July 2009, falling from $600 billion to less than $300 billion.").
135. The debtor's need for liquidity, particularly acute for a financial institution that hopes to reorganize, does not undermine this conclusion. This is so because liquidity needs do not make cash or cash-like collateral "firm-specific." Rather, liquidity needs should be addressed through debtor-in-possession financing. While not the subject of this Essay, both authors are participants in (and Jackson is principal drafter for) a Hoover Institution working group that has formed a proposal for the bankruptcies of the largest financial
136. See Thomas H. Jackson et al., Resolution of Failed Financial Institutions: Orderly Liquidation Authority and a New Chapter 14 (April 25, 2011) [hereinafter Jackson, et. al., Chapter 14 Proposal] (unpublished manuscript), available at http://media.hoover.org/sites/default/files/documents/Resolution-Project -Booklet-4-11.pdf (on file with the Columbia Law Review). Requiring a counterparty in possession of cash or cash-like collateral to turn it over to the debtor is, as a matter of both principle and existing procedures, extremely dubious as a source of liquidity. A hearing would be necessary prior to transfer under § 542(e) and/or before the collateral could be used by the debtor per § 363(a) and (c)(2). 11 U.S.C. §§ 363(a), 363(c)(2), 542(e). Moreover, upon turn-over, the counterparty would have to be given adequate protection, id. § 361, which effectively is the requirement for senior-most debtor-in-possession financing. Id. § 364(d). In every other situation, such financing can only be used if "the trustee is unable to obtain such credit otherwise." Id. § 364(d)(1)(A). For these reasons, liquidity needs of financial institutions are not a reason to deviate from the idea that cash and cash-like collateral in the possession of a counterparty should not be subject to the automatic stay.
137. For a discussion on recoupment doctrine and its implications for repos and derivatives below
138. see infra notes 150-154 and accompanying text. 109. For a discussion of the application of preference law and other trustee avoidance powers,
139. see infra Part II.E. It is worth noting that the prices even of cash-like collateral may be volatile under extraordinary market conditions, as with some Treasury bonds in 2008.
140. See, e.g., Stan Luxenberg, After a Rollercoaster Year, Are TIPS Attractive?, Registered Rep. (Apr. 5, 2010, 3:31 PM), http://registeredrep.com/investing/fixedincome/tips_little_inlation_yet0 403/ (on file with the Columbia Law Review) (describing volatility of Treasury Inflation-Protected Securities). This still would not call for a stay, however, because the value at any given time still is less likely to be subject to uncertainty than with more opaque or firm-specific collateral.
141. We thus part ways with the analysis of Mark Roe, whose fine article we are otherwise in full accord with, on this point.
142. See Roe, supra note 47, at 541 (arguing special treatment reduced incentive of repo lender to monitor debtor).
143. See supra notes 34-38, 41-42 and accompanying text (discussing motives for special treatment, including elimination of delay).
144. See supra notes 48-52 and accompanying text (examining Lehman's 105 transactions).
145. Where a repo is recharacterized as a secured transaction, as we argue it should be, U.C.C. § 9-309(10) provides automatic perfection.
146. See U.C.C. § 9-309(10) (2011).
147. It would not alter the ease of perfecting the security interest, because U.C.C. § 9-309(10) would continue to provide automatic perfection. For an argument that repos should be subject to a filing requirement if their special bankruptcy treatment is retained,
148. see Enrico Perotti, Systemic Liquidity Risk and Bankruptcy Exceptions 4 (Ctr. for Econ. Policy Research, Policy Insight No. 52, 2010), available at www.cepr.org/pubs/policyinsights/policyInsight52.pdf (on file with the Columbia Law Review).
149. As our friend and colleague Darrell Duffie has repeatedly reminded us.
150. See supra note 68 and accompanying text (presenting this argument). 117. Money market funds, for instance, are limited to investments that can be liquidated quickly.
151. Money market funds, for instance, are limited to investments that can be liquidated quickly
152. See generally Adam Copeland, Darrell Duffie, Antoine Martin & Susan McLaughlin, Policy Issues in the Design of Tri-Party Repo Markets 20 (Hoover Inst., Working Paper No. 55, Jul. 2011), available at http://www.darrellduffie.com/uploads/working/CopelandDuffieMartinMcLaugh lin_Working_July%2023_2011.pdf (on file with the Columbia Law Review) (noting "revisions of Rule 2a7 of the Investment Company Act, designed to lower risks to money market funds, push those funds into shorter-term assets").
153. The proposal outlined in the text could easily be coordinated with Acharya and Oncu's recent proposal to establish a resolution authority for repos that are collateralized by opaque collateral. Viral V. Acharya & T. Sabri Oncu, The Repurchase Agreement (Repo) Market, in Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance 319, 345-46 (Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson & Ingo Walter eds., 2010). Under their proposal, a new authority would make initial payments to a debtor's repo counterparties and would subsequently liquidate the collateral. Id. A stay on seizing or selling the collateral would facilitate this process.
154. For an in-depth description of rehypothecation as well as an account of the historical context and an analysis of current patterns, see generally Kenneth C. Kettering, Repledge Deconstructed, 61 U. Pitt. L. Rev. 45 (1999).
155. See, e.g., Schroeder, Repo Madness, supra note 92, at 1023 (using security interest in grain in which secured creditor is not required to give back grain as example of inventory loan). A standard repo contract with fungible securities-such as treasury bonds-is quite similar.
156. See U.C.C. §§ 8-502, 8-510(a) (2011);
157. see also Christian A. Johnson, Derivatives and Rehypothecation Failure: It's 3:00 PM, Do You Know Where Your Collateral Is?, 39 Ariz. L. Rev. 949, 980 (1997) (concluding any party that expressly permits rehypothecation "has in substance subordinated its rights in the posted collateral to the third party").
158. See, e.g., Benn Steil, Op-Ed., Enron and Italy: Parallels Between Rome's Efforts to Qualify for Euro Entry and the Financial Chicanery in Texas, Council on Foreign Relations (Feb. 21, 2002), http://www.cfr.org/italy/enron-italy-parallels-between-romesefforts-qual ify-euro-entry-financial-chicanery-texas/p4455 (on file with the Columbia Law Review) (describing transaction and comparing it to transactions used by Enron).
159. The London Interbank Offered Rate is the interest rate at which banks lend to one another.
160. There obviously was no guaranty that the swap would retain its value for J.P. Morgan, given the inevitable fluctuations in the value of the lira and LIBOR. But J.P. Morgan could lock in the value by hedging against the fluctuations if it wished to protect itself.
161. 11 U.S.C. § 365(c)(2) (2006).
162. See supra text accompanying note 21 (noting "debtor's ability to pick the good swaps and abandon the bad ones").
163. See infra Part II.D.
164. See 11 U.S.C. § 365(d)(4) (setting time limit to 120 days). There are also time limits for such a decision on residential real property or personal property in Chapter 7. Id. § 365(d)(1).
165. Summe, supra note 103, at 82 (footnote omitted).
166. It is the case that interest rate swaps are, in fact, diminished in importance in bankruptcy, since (for the most part) debtors do not make interest payments, on prepetition debt at least, during the bankruptcy case. Ayotte & Skeel, Bailouts, supra note 68, at 496 n.136. Even so, to the extent they have value, because of a hedge that is "in the money," it is an element bargained for by the debtor, and hence, analytically, a proper asset of the estate.
167. Given that the original derivatives contract was a hedge, the probability (or risk) of an assumption or rejection would logically be directly related to the relative values of the currencies, interest rates, or other underlying factor on which the original derivatives contract was based. Because of that direct correlation, it would seem entirely possible to hedge against the possibility of either assumption or rejection (or both).
168. The counterparty can minimize risk by "limiting its exposure to any given debtor,. and. sell[ing] a duplicative hedge to a third party. Moreover, the uncertainty could be reduced under a rule that required the debtor to make prompt decisions on assumption, much as bank regulators do in a bank insolvency." Skeel, Bankruptcy, supra note 63, at 17-18 n.84.
169. See supra note 75 and accompanying text (describing protection given to secured creditors after bankruptcy filing against any diminution in value of collateral during subsequent bankruptcy proceedings).
170. See supra notes 68-69, 116 and accompanying text. 135. Although this would be difficult if there were a long stay, because a counterparty's collateral would need to cover potentially large post-bankruptcy shifts in the values of the contracts, it is less problematic if the stay is short.
171. See infra Part III.A.
172. See, e.g., Ayotte & Skeel, Bailouts, supra note 68, at 494-95 (discussing potential consequences of bankruptcy filing).
173. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 210(c)(10)(B)(i)(I), 124 Stat. 1376, 1491 (2010) (to be codified at 12 U.S.C. § 5390).
174. A proposal drafted by one of us (Jackson) for a working group coordinated by the Hoover Institution calls for a similar three-day stay.
175. See Jackson et al., Chapter 14 Proposal, supra note 107, at 2-27. In addition to its temporary restriction on ipso facto clauses, the Dodd-Frank Act also invalidates "walkaway" clauses that permit a counterparty to cancel a contract without making any payment to the debtor, even if the debtor is in the money. Dodd-Frank Act § 210(c)(8)(F), 124 Stat. at 1488 (to be codified at 12 U.S.C. § 5390). Walkaway clauses should also be invalidated in bankruptcy.
176. See Dodd-Frank Act § 165(d), 124 Stat. at 1426-27 (to be codified at 12 U.S.C. § 5365) (requiring wind-down plans). As explored below, Dodd-Frank also pushes towards a regime in which most swaps would be traded on an exchange or "swap execution facility" and cleared on a clearinghouse.
177. See infra notes 168-180 and accompanying text. Such a move would almost certainly permit apid valuations of swaps, again facilitating the ability to make decisions regarding such swaps within a three-day stay period.
178. See, e.g., Duffie, Failure Mechanics, supra note 53, at 57-58 (noting that both parties to over-the-counter derivatives are frequently dealers).
179. ISDA is the principal trade and lobbying group for the derivatives industry. See ISDA, http://www.isda.org (last visited Oct. 9, 2011). It supplies the standard form contracts that are used (as customized by the parties) in most derivatives transactions. For an example of a master agreement,
180. see ISDA Master Agreement and Schedule Between Comerica Bank and Rackspace US, Inc. dated Sept. 26, 2007, Exhibit 10.32, in Rackspace, Inc. Registration Statement (Form S-1) (Apr. 25, 2008), available at http://www.sec.gov/Archives/edgar/data/1107694/000119312508091225/dex103 2.htm (on file with the Columbia Law Review).
181. See, e.g., 11 U.S.C. § 101(53B) (2006) (defining "swap agreement" to include a master agreement); id. § 560 (exempting netting under swap agreement); id. § 561 (exempting netting across multiple swap and other financial market contracts and master agreements).
182. Netting is the practice of offsetting cross-cutting obligations. If counterparty owes debtor $50 on one derivative, for instance, while debtor owes counterparty $30 on another derivative, counterparty's "net" obligation to debtor is $20. If netting is not permitted, on the other hand, the parties' combined exposure would be $80. Netting can be seen as significantly reducing overall exposure, and as a result overall risk, in the derivatives markets. ISDA has warned that removing the special provisions protecting netting rights in bankruptcy could have dire effects. See David Mengle, The Importance of Close-Out Netting 6-7 (ISDA Research Notes No. 1, 2010), available at http://www2.isda.org/attachment/MTY4MQ==/Netting-ISDAResearchNotes-1-201 0.pdf (on file with the Columbia Law Review) (arguing unenforceability of netting will result in increased credit exposure, shortfalls of collateral and capital, increased risk and uncertainty, and inability to hedge). For a more equivocal assessment of the impact of netting
183. see Robert R. Bliss & George G. Kaufman, Derivatives and Systemic Risk: Netting, Collateral, and Closeout, 2 J. Fin. Stability 55, 56 (2006) ("[I]t is not clear whether the netting and collateral provisions when combined with closeout. decreases the potential for economic damage, as is generally claimed in previous work, or indeed increases the risk.").
184. See Mengle, supra note 144, at 3-4 (describing how netting avoids "unwanted exposure to. market risk" and noting "trillions of dollars of derivative notional amounts outstanding are largely the result" of netting).
185. See, e.g., Patrick Bolton, Tano Santos & Jose A. Scheinkman, Is the Financial Sector Too Big? 1-2 (Sept. 8, 2010) (unpublished manuscript) (on file with the Columbia Law Review) (modeling factors that can produce excessive development of financial sector).
186. See 11 U.S.C. § 553(a).
187. The Dodd-Frank Act's resolution regime takes this principle still further, requiring that the FDIC either assume or reject all of its derivatives with a single counterparty, regardless of whether they are part of a single master agreement. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 210(c)(9), 124 Stat. 1376, 1489-90 (2010) (to be codified at 12 U.S.C. § 5390).
188. 11 U.S.C. § 362(a)(7) (providing that stay applies to setoffs of any debt owing to debtor that arose before commencement of case against any claim against debtor).
189. Recoupment is treated as an "equitable exception" to the automatic stay. See, e.g., Thompson v. Bd. of Trs. of the Fairfax Cnty. Police Officers Ret. Sys. (In re Thompson), 182 B.R. 140, 146 (Bankr. E.D. Va. 1995) (explaining rationale and scope of automatic stay doctrine).
190. In Ashland Petroleum Co. v. Appel (In re B&L Oil Co.), 782 F.2d 155 (10th Cir. 1986), a leading recoupment case, B&L Oil executed an oil division order in favor of Ashland Petroleum which granted Ashland the right to purchase oil from B&L. On two occasions Ashland overpaid B&L for the oil.
191. Id. at 156.
192. B&L subsequently filed for Chapter 11 bankruptcy. Id. After filing, Ashland withheld money from payments owed to B&L for subsequent oil deliveries in order to recoup Ashland's pre-petition overpayments. Id. The Tenth Circuit found that recoupment did apply in this instance because the order was a single contract and the overpayments were analogous to advances and overpayments in other cases where application of the doctrine was upheld.
193. Id. at 158-59.
194. Id. at 157 (noting availability of recoupment when debtor and creditor's claims arise from same transaction).
195. For an argument that the nondebtor should have a right of setoff under similar circumstances,
196. see Johnson, supra note 121, at 986 ("[P]ermitting a pledgor to setoff its payment obligation against posted collateral would appear to limit the systemic risk that concerned Congress in the event of the bankruptcy of the secured party.").
197. See, e.g., Tavenner v. United States (In re Vance), 298 B.R. 262, 267-68 (Bankr. E.D. Va. 2003) (describing comparatively capacious "logical relationship" test, and contrasting more restrictive approach requiring that obligations must arise out of "single integrated transaction").
198. One final adjustment: As noted earlier, we also would include language making clear that "walkaway" clauses are not enforceable in bankruptcy, just as they are invalidated in the new Dodd-Frank resolution regime. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 210(c)(8)(F), 124 Stat. 1376, 1488, (2010) (to be codified at 12 U.S.C. § 5390).
199. 11 U.S.C. § 547(b) (2006).
200. Id. § 548(a)(1)(B).
201. Id. § 546(e)-(g).
202. ISDA justifies this exception from preference law as follows: This provision enables market participants to continue to trade with weakening parties immediately prior to any bankruptcy filing (subject to prohibitions against intentionally fraudulent transactions), so as to allow those weakening parties continued access to market accommodations that might help them survive. Without these safe harbor protections, market participants would be extremely reluctant to enter transactions with a weakening party in order to avoid receiving payments or taking collateral within the Code's suspect time periods relating to preferences and fraudulent conveyances. Int'l Swaps & Derivatives Ass'n, Bankruptcy Code Swap Safe Harbor Overview 3 (2010) (on file with the Columbia Law Review). This argument, note, does not apply to new transactions with "weakening parties" within the preference period (as such new transactions would be for new value). Rather, the argument suggests that, prior to the preference period, such contracts will not be entered into as frequently because of the preference risk. Putting aside that this does not distinguish these transactions from any other transactions (all of which are subject to preference risk), the argument ultimately depends on the assumption that "continued access to market accommodations" of "weakening parties" is a good thing. We believe a strong counterargument-that weakening parties should be resolved and financial players with the greatest expertise and monitoring ability are in the best position to stop inevitable delay-is as or more plausible. In any event, the ISDA argument runs counter to the overarching policy of preference law.
203. See supra text accompanying note 134 (outlining Bank of America and Goldman swap hypotheticals).
204. This assumes that the lender has an "after acquired" property clause in its security agreement, as inventory and receivable lenders invariably do.
205. See U.C.C. § 9-204 (2011) (authorizing after acquired property clauses).
206. 11 U.S.C. § 96 (1976) (current version at 11 U.S.C. § 547(b)(2006)). The change was explained in Report of the Commission on the Bankruptcy Laws of the United States, H.R. Doc. No. 93-137, pt. 1, at 209-10 (1973).
207. 11 U.S.C. § 547(c)(5).
208. This stands in notable contrast to the current § 547(c)(5), which can be difficult to apply because of the need to determine the value of the inventory or receivable collateral as of ninety days before bankruptcy, something inherently difficult when it consists of a non-liquid cluster of, say, inventory.
209. The best known case prior to the adoption of 11 U.S.C. § 547(c)(5) in 1976 was Grain Merchants of Ind., Inc. v. Union Bank & Savings Co., 408 F.2d 209 (7th Cir. 1969). In Grain Merchants, the court held that the lender had not received preferences when its security interest attached to new inventory and accounts receivable during the preference period, despite the apparent violation, because the new security interest was a replacement for the lender's interest in prior inventory and accounts.
210. Id. at 218.
211. Under the current § 547, courts might treat the adjustments as contemporaneous exchanges of new value, which are protected by § 547(c)(1). The fit is not perfect, however, because the parties are not substituting new for old collateral, as inventory and receivable lenders do. Rather, they are adding or subtracting collateral as the values under the contract change.
212. If Goldman owes Bank of America, on the other hand, the new swap is not preferential because it simply has the effect of prepaying an obligation that Goldman would otherwise be required to pay later.
213. If a nondebtor incurs an obligation in order to create a right to set off the obligation against an unsecured claim, and affects the setoff prior to bankruptcy, the trustee is authorized to retrieve the amount by which the nondebtor's position is improved. 11 U.S.C. § 553(b) (allowing trustee to recover reduction in insufficiency on date of setoff compared to amount of insufficiency ninety days before filing of petition in bankruptcy). If the nondebtor does not invoke its setoff right until after the bankruptcy is filed, 11 U.S.C. § 553(a)(3) achieves the same effect.
214. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 723(a), 124 Stat. 1376, 1675-76, 1681 (2010) (to be codified at 7 U.S.C. § 2).
215. The guaranty is somewhat qualified. The clearinghouse has the option of paying the defaulting party's obligation or obtaining a substitute contract. If the clearinghouse decides to pay, it determines the appropriate value. We are grateful to Kimberly Summe for pointing this out to us.
216. Dodd-Frank Act § 723(a), 124 Stat. at 1681 (to be codified at 7 U.S.C. § 2).
217. Bank of America could try to replace any hedging transaction that a counterparty terminated, of course, but the costs could be substantial.
218. Under Dodd-Frank's resolution rules, clearinghouses are subject to the standstill, Dodd-Frank Act § 210(c)(10)(B), 124 Stat. at 1491 (to be codified at 12 U.S.C. § 5390), but they are permitted to continue enforcing margin obligations. Id. § 210(c)(8)(G), 124 Stat. at 1489 (to be codified at 12 U.S.C. § 5390). This protection will not have much practical effect because the FDIC will invariably protect all of the institution's derivatives contracts. As noted below, the clearinghouse should not be insulated from the effect of the stay in bankruptcy.
219. The rationale is that cleared derivatives would enjoy slightly superior treatment, because they would not be subject to the automatic stay in the event one of the counterparties later filed for bankruptcy. At the margin, this would encourage parties to use cleared rather than noncleared derivatives.
220. See supra notes 30-31
221. and accompanying text (describing arguments that brokers were simply conduits and should not be subject to preference and fraudulent conveyance rules).
222. This point is made (sarcastically) in Editorial, Another Dodd-Frank Triumph, Wall St. J., Feb. 16, 2011, at A16 (criticizing clearinghouse provisions of Dodd-Frank Act as creating new sources of systemic risk).
223. Adequate collateralization would consist of collateral in the amount of the shortfall from the counterparty that is currently out of the money, plus sufficient collateral to cover possible swings in value during the three-day period of the stay.
224. Somewhat ironically, exempting clearinghouses from the three-day automatic stay would undermine one of the key advantages clearinghouses (and exchanges) provide. The ability to make three-day decisions regarding the assumption or rejection of swaps requires accurate valuation information that is virtually instantaneously available. Swaps cleared on clearinghouses (and therefore traded on exchanges or swap-execution facilities) would have precisely this attribute. If, however, clearinghouses were exempted from the automatic stay, the swaps that would remain subject to the three-day stay proposed here would likely be the ones without accurate and instantaneous pricing information. See supra note 139 and accompanying text (introducing proposed three- business-day truncated stay).
225. While the attention has been on whether clearinghouses should be exempted from bankruptcy's automatic stay, the same reasoning would apply if the issue were whether clearinghouses should be exempted from bankruptcy's preference rules (as adjusted pursuant to the analysis). Although incomplete, preference rules are bankruptcy law's most important effort to address a serious problem that leads bankruptcies to systematically start too late: These rules deny gains from creditors who foresee bankruptcy but avoid, rather than commencing, it. See supra notes 26-27 and accompanying text (introducing concept of preference rules). For that reason, the monitoring argument for counterparties applies equally to their inclusion in the preference rules for swaps.
226. For an argument that Dodd-Frank's one-day standstill would not be enough time to handle the huge number of derivatives for which a clearinghouse is responsible, see Julia Lees Allen, Note, Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis, 64 Stan. L. Rev. (forthcoming 2012).
227. The resolution rules are set forth in Title II of the Dodd-Frank Act, entitled Orderly Resolution Authority (OLA).
228. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, tit. II, 124 Stat. 1376, 1442 (2010)
229. (to be codified at 12 U.S.C. § 5381). Interestingly, there is no requirement that a financial institution be designated as systemically important under section 805 (a category that subjects it to extensive new regulation under Title I) prior to being taken over under the resolution rules. Id. § 805, 124 Stat. at 1809 (to be codified at 12 U.S.C. § 5464). Instead, regulators need only find that it is a "covered financial company" because, among other things, its failure might cause systemic damage.
230. Id. § 202, 124 Stat. at 1444-50 (to be codified at 12 U.S.C. § 5382) (outlining requirements for resolution petition).
231. Id. § 203(a), 124 Stat. at 1450-51
232. (to be codified at 15 U.S.C. § 1583(a)) (requiring recommendation by U.S. Treasury and approval by two-thirds of Federal Reserve Governors and FDIC Board).
233. The analogy between FDIC resolution and the Dodd-Frank resolution rules is criticized at length in Skeel, New Financial Deal,
234. supra note 48, at 117-27 (arguing rationale for FDIC resolution of small- and medium-sized banks does not apply to large financial institutions).
235. Id. at 123-24.
236. Under the new resolution rules, qualified financial contracts (which include repos and derivatives) cannot be terminated until 5 PM of the day after a receiver is appointed.
237. Dodd-Frank Act § 210(c)(10)(B), 124 Stat. at 1491 (to be codified at 12 U.S.C. § 5390).
238. See, e.g., Skeel, Bankruptcy, supra note 63, at 19 (explaining possible benefits of stay only for systemically important institutions).
239. Assistant Treasury Secretary Michael Barr, the Obama Administration's point person for the legislation, assured lawmakers that "bankruptcy proceedings will remain the dominant option for handing the failure of a non-bank financial institution, even very large ones."
240. Too Big to Fail: The Role for Bankruptcy and Antitrust Law in Financial Regulatory Reform (Part I): Hearing Before the Subcomm. on Commercial & Admin. Law of the H. Comm. on the Judiciary, 111th Cong. 23 (2009) (prepared statement of Michael S. Barr, Assistant Treasury Secretary); see also U.S. Dep't of the Treasury, Financial Regulatory Reform: A New Foundation 76-79 (2009), available at http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf (on file with the Columbia Law Review) ("Bankruptcy is and will remain the dominant tool for handling the failure of a [bank holding company], unless the special resolution regime is triggered because of concerns about financial stability.").
241. See, e.g., Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 208, 124 Stat. 1376, 1459-60 (2010) (to be codified at 12 U.S.C. § 1588) (authorizing removal of case from bankruptcy to Dodd-Frank resolution).
242. See supra note 187 and accompanying text (discussing statement of Assistant Treasury Secretary Michael Barr).
243. See supra notes 57-61 and accompanying text (discussing this dilemma with AIG).
244. Moreover, if any large troubled financial institution did start in bankruptcy, even with the extraordinarily rapid (and potentially unconstitutional) ability of the government to remove the institution from bankruptcy and place it within the orderly liquidation authority of Title II of Dodd-Frank, Dodd-Frank Act § 202(a), 124 Stat. at 1444-46 (to be codified at 12 U.S.C. § 5382), absent a brief stay on derivative counterparties in bankruptcy, the stay provided in the orderly liquidation authority of Dodd-Frank may prove to be illusory.
245. See Skeel, New Financial Deal, supra note 48, at 139 (noting constitutional difficulties with process by which orderly liquidation authority is commenced for entity already in bankruptcy).
246. See supra notes 57-61 and accompanying text (describing crisis at AIG).
247. Compare 11 U.S.C. § 541(c)(1)(B) (2006) (invalidating ipso facto clauses), with id. § 559 (allowing ipso facto clauses in repos), and id. § 560 (allowing ipso facto clauses in swaps).
248. See supra Part II.C (describing proposal for swaps and derivatives).
249. See supra Part II.E (proposing rules for preference and fraudulent conveyance).
250. See supra Part III.A (describing Dodd-Frank clearinghouse requirement).
251. In this ideal world, we would, of course, recommend that there be consistency between our proposals for repos and derivatives in bankruptcy and those in Title II of Dodd-Frank, preferably by having Title II of Dodd-Frank mirror the rules we would place in bankruptcy. This idea-consistency between bankruptcy and Title II of Dodd-Frank in the application of substantive rules-would likewise apply to our alternatives as well. We focus in text on bankruptcy reforms, however, believing that issues concerning reopening Dodd-Frank for amendment raise a whole different level of political issues.
252. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 210(c)(10)(B), 124 Stat. 1376, 1491 (2010) (to be codified at 12 U.S.C. § 5390) (preventing invocation of ipso facto clause until 5 PM the day after resolution petition is filed).
253. If a stay were in place, these steps would be prohibited. But they would not be prevented if Congress reinstated bankruptcy's anti-ipso facto provisions while leaving counterparties' exemption from the stay in place.
254. The bankruptcy judge's handling of the Lehman case gives some comfort in this regard. The judge ruled, for instance, that Lehman's counterparties who did not promptly exercise their right to terminate were deemed to have waived this right. Order to Compel Performance of Contract and to Enforce the Automatic Stay at *1, In re Lehman Bros. Holdings, No. 08-13555 (JMP), 2009 WL 6057286 (Bankr. S.D.N.Y. Sept. 17, 2009).
255. In addition to repealing 11 U.S.C. §§ 559, 560 and related provisions, this reform would entail modifications to 11 U.S.C. § 362(b)(7) and 11 U.S.C. § 362(b)(17) reintroducing a three-day stay.
256. See supra Part II.B.1 (discussing characteristics making repos similar to secured loans).
257. The issues are of far more than academic interest alone. The Dodd-Frank Act calls for two different reports on the efficacy of bankruptcy for handling financial institution failures. Dodd-Frank Act § 202(e), 124 Stat. at 1448-49 (to be codified at 12 U.S.C. § 5382) (providing for study by Administrative Office and Comptroller); id. § 216, 124 Stat. at 1519 (to be codified at 12 U.S.C. § 5394) (providing for study by Federal Reserve and Administrative Office). The report by the Board of Governors of the Federal Reserve System was issued in July 2011. Bd. of Governors of the Fed. Reserve Sys., Study on the Resolution of Financial Companies Under the Bankruptcy Code (2011), available at http://www.federalreserve.gov/publications/other-reports/files/bankruptc y-financialstudy-201107.pdf (on file with the Columbia Law Review) (laying out various alternatives, including ones close to those proposed by this Essay, without committing to any one outcome). The treatment of repos and derivatives in bankruptcy will be central to the analysis of these studies.
258. See, e.g., Dodd-Frank Act § 216(a)(2)(D), 124 Stat. at 1519 (to be codified at 12 U.S.C. § 5394) (calling for analysis of whether special treatment of qualified financial contracts-that is, derivatives-in bankruptcy should be amended).
259. Although our particular concern in this Essay has been repos and derivatives, deviations from transaction consistency have created problems in other contexts as well. The most obvious is the special treatment of consumer mortgages. Unlike most other loans, which can be written down to the value of the collateral if the collateral is worth less than the debtor owes, mortgages on primary residences cannot be altered by debtors under Chapter 13.
260. See 11 U.S.C. § 1322(b)(2) (2006) (noting Chapter 13 plan may "modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor's principal residence"). The special treatment of mortgages may have contributed to the distortions in the mortgage market during the real estate bubble, and many commentators (including one of us) believe that removing the special treatment might have hastened homeowners' recovery from the recent economic crisis.
261. See, e.g., David A. Skeel, Jr., Bankruptcy Phobia, 82 Temp. L. Rev. 333, 334-35, 340 (2010) (describing defeat of proposals for reform).