One of the little-emphasized features of the 2005 Bankruptcy Code is a series of amendments designed to insulate the financial markets from the effects of corporate bankruptcy. These changes build upon earlier provisions designed to accomplish the same objective, and continue a more general Congressional policy toward the separation of bankruptcy and securities law dating back to the Chandler Act of 1938.
But are the securities markets and the Bankruptcy Courts better off for this “insulation”? Do the Bankruptcy Code’s various “securities exemptions” truly work as advertised?
That is the question raised by the University of Pennsylvania’s David A. Skeel, Jr.
Skeel, Penn Law School’s S. Samuel Arsht Professor of Corporate Law, explores the intersection between bankruptcy and securities law in a recently-authored Penn Institute for Law and Economics research paper titled “Bankruptcy Boundary Games.” The paper focuses on Bankruptcy Code provisions intended to subordinate corporate bankruptcy protections to the work-a-day operation of securities markets. In particular, Skeel focsuses on three examples of this deference:
- The Chapter 11 “brokerage exclusion” set forth in Bankruptcy Code Section 109(d);
- Section 546(e)’s “avoidance safe harbor” for securities-related “settlement payments;” and
- Special treatment of “derivative transactions” under Section 362(b)(7) and elsewhere in the Code.
According to Skeel, “Debtors have sidestepped the brokerage exclusion from Chapter 11, the settlement safe harbor has been invoked in contexts well outside the transactions it was originally designed to protect, and the exemption from the stay for derivatives and other financial contracts performed much differently than advertised when Bear Stearns, Lehman Brothers and then AIG failed.”
Specifically, Skeel delves into recent case law and Chapter 11 filings to argue:
- Congress’s original contemplation that a Chapter 7 liquidation would be “cleaner” and more efficient than Chapter 11 has been superseded by the current, actual corporate structure of investment banking, which has permitted firms such as Lehman to utilize Chapter 11 and the “363 sale” process to accomplish the same result, more quickly and economically than might occur in a brokerage’s “straight 7.” As a result, this exclusion is largely irrelevant to the realities of present financial markets and their participants.
- Section 546(e)’s “avoidance safe harbor,” hobbled by a circular and virtually useless definition of the key term “settlement payment,” has been inconsistently applied by Bankruptcy Courts faced with challenges made on this ground to avoidance actions. These challenges are often raised in contexts far different from what Congress appears to have originally contemplated. In the context of LBO-related avoidance claims, courts are divided over when – or if – the “safe harbor” applies. In Enron, the “safe harbor” defense was interposed with respect to at least three different types of transactions, and each defense appears to have been resolved on fact-specific grounds – with differing results. Skeel suggests that this “safe harbor” may leave markets insulated, but at the cost of extreme uncertainty regarding specific transactions.
- The exemption of derivatives from the Code’s automatic stay and other provisions were originally implemented in order to avoid a feared “domino effect” in the securities markets created by a corporate Chapter 11 filing. Ironically, however, these exemptions appear to do as much to invite systemic problems in the markets (e.g., runs in the event of financial distress) as they do to avoid them. Among other examples, Skeel argues that Bear Stearns’ 2008 bailout (in lieu of a Chapter 11 filing) was borne of precisely this concern. He suggests these exemptions have, in reality, done little to curb the “spill-over” effects in the securities markets that result from corporate bankruptcies.
In an environment where a great deal of federal securities regulation is up for fresh review, is it time for a legislative re-write of the Bankruptcy Code’s “securities exemptions?”
Perhaps, suggests Skeel.
But “Bankruptcy Boundary Games” also hints at a more immediate and pragmatic approach to reconiling the Code’s provisions with the realities of the market: Creative lawyering and intelligent judging. “Overall,” he writes, “the Bankruptcy Courts have done a relatively good job of handling the fallout from the sweeping protection of securities markets.”
A point well taken.