Bankruptcy and Derivatives: What’s All the Fuss, Anyway?

17 May Bankruptcy and Derivatives: What’s All the Fuss, Anyway?

The esoteric world of credit default swaps and other derivative securities often appears far removed from the everyday practice of Chapter 11.  But the impact of this little-known (and often less-understood) corner of the securities market upon the bankruptcy world has recently garnered considerable academic interest – and is now attracting some legislators’ attention as well.

Several posts on this blog (beginning here) have summarized the intersection between credit default swaps and bankruptcy.  Some academics have explored the potential indirect effect of these securities upon out-of-court netogiations – focusing primariliy on the potential problems of “holdout” creditors and the “empty creditor hypothesis.”  Others (here and here) have offered their preliminary thoughts on the continued usefulness of the Bankruptcy Code’s “securities safe harbors,” originally included to shield financial markets from the effects of large bankruptcy filings – but now perceived as distorting creditor priorities and possibly exacerbating the financial risk created by such events.

Some portions of this debate (such as the true impact of CDS’s on corporate insolvency) continue to play out in the realities of Chapter 11 economics.  Other portions (such as the continued viability of the Bankruptcy Code’s “safe harbor” rules) are beginning to work themselves – albeit slowly – into legislative proposals.

Within the last 30 days, Florida’s Sen. Bill Nelson has offered a brief, 2-page amendment to the proposed financial reform legislation now working its way through the US Senate.  In essence, the amendment would strip the “safe harbors” out of the Bankruptcy Code, ostensibly “leveling the playing field” for all creditors.

For its simplicity, the amendment – which has no co-sponsors – has provoked still further discussion amongst academics.  Seton Hall’s Steve Lubben commends it as a good “first step” toward amending the Bankruptcy Code, but believes further compromise is necessary (his proposed compromises are outlined here).  Harvard’s Mark Roe says, in an updated research paper, that the amendment deserves “central consideration” in connection with financial reform legislation.