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.
Reader Comments» Post a comment