Exceptional Derivatives

Bankruptcy rule exceptions exacerbated financial crisis, says Roe

Walter Vasconcelos

Although the sweeping financial reform package that President Obama ’91 signed into law in July contained hundreds of provisions in its 848-page final version, Professor Mark Roe ’75 says it’s still not long enough.

The legislation should have addressed exceptions to normal bankruptcy rules enjoyed by holders of derivatives and similar instruments, says Roe. In an article forthcoming in the Stanford Law Review, “The Derivatives Players’ Payment Priorities as Financial Crisis Accelerator,” he argues that these exceptions undermine market discipline and exacerbated the financial crisis.

Roe observes that while firms in bankruptcy are protected from immediately having to pay their creditors—so that the court has time to assess the bankrupt’s finances before the firm is pulled to pieces—parties that hold derivatives and repurchase agreements can seize and sell off the bankrupt’s collateral immediately. Roe notes that there are bases for a more creditor-friendly bankruptcy in many places in the Bankruptcy Code. But the favorable treatment of parties holding these financial instruments—which became a popular means to raise a large amount of money quickly on Wall Street in recent decades—reduces risk for the failed firms’ trading partners to such a degree that their incentives to monitor the firms’ financial health decline commensurately.

“Normally, markets will adjust to whatever kind of rule Congress puts in place, and having a financing means that’s very safe is usually for the good,” he says. But here we’re not dealing with normal financing. “The [Bankruptcy] Code’s impact [on these instruments] is to transfer risk to the United States as the ultimate guarantor of the [large financial] firms’ solvency, draining financial resiliency,” he writes. “This encourages more knife’s-edge financing, because it’s the U.S. Treasury that picks up the risk of catastrophic failure.” If these firms weren’t financially central, financial markets could, and normally would, adjust. But it’s the presence of the United States as ultimate guarantor that weakens the potential efficacy of financial market adjustments, Roe argues.

The original rationale for the exception was that healthy parties to derivatives contracts might themselves collapse if they are not paid because of the bankruptcy of a derivatives-trading firm, he writes. The fear was that this would lead to a contagion of financial catastrophe throughout Wall Street and all of American finance. But after the financial crisis of 2007-2008, we now know, he says, that it’s equally possible that the bankruptcy favoritism toward derivatives can spur heavy users to collapse, as financial players use the exception to pull cash out of the failing firm quickly and irrevocably.

When AIG, for example, lost its high-quality investment grade rating, derivatives counterparties demanded that the company put up more collateral right away. If normal bankruptcy rules applied, Roe says, “they wouldn’t have been able to pull fresh collateral from AIG so easily on the eve of its failure, so the crisis atmosphere might not have been so severe, and there would have been more time to steady the financial ship.” The contest, he adds, was not between AIG and the creditor demanding new collateral. When the paying up was all done, the collateral was coming from AIG’s other creditors. The special exceptions to normal bankruptcy practice hurt those other creditors, and eventually the U.S. Treasury, as cash and value moved out of the company.

Repealing the wide exceptions, or cutting them back, would motivate the derivatives market players to more carefully consider the risk of their transactions and the financial stability of their trading partners, and would lessen the possibility of another financial meltdown, Roe says.

Roe hopes that the exception will be changed and that his article will help spark debate that eventually leads to a phased-in rollback of several of the derivatives’ special treatment exceptions. “The goal,” he says, “is to figure out how we can use and understand corporate law and bankruptcy law to make business work better and more effectively.”

Derivatives in the Classroom and Beyond

Although the derivatives setup in bankruptcy is new enough not to have generated the judicial decisions that populate law school casebooks, last year Mark Roe devoted several classes in his bankruptcy course to the subject.

One student in the class, Ephraim Mernick ’12 (J.D./M.B.A.), was sufficiently motivated by the discussions to take Roe up on his offer to help place him in the office of Sen. Sheldon Whitehouse, chairman of the Senate Judiciary subcommittee focused on bankruptcy legislation.

The internship was facilitated through the HLS Semester in Washington Clinic, and Mernick says the four months were a highlight of his Harvard Law experience, with practical and academic components. As it turned out, he addressed many issues for the senator’s office—derivatives among them—and he also wrote a paper on the topic, separate from his Senate work.

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