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Systemic Failure
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?"
Selective Protection
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.
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