Bankruptcy law in the United States, which serves as an important precedent for the treatment of derivatives under insolvency law worldwide, gives creditors in derivatives transactions special rights and immunities in the bankruptcy process, including virtually unlimited enforcement rights against the debtor (hereinafter, the “safe harbor”). The concern is that these special rights and immunities grew incrementally, primarily due to industry lobbying and without a systematic and rigorous vetting of their consequences.
This type of legislative accretion process is a form of path dependence—a process in which the outcome is shaped by its historical path. To understand path dependence, consider Professor Mark Roe’s example of an 18th century fur trader who cuts a winding path through the woods to avoid dangers. Later travelers follow this path, and in time it becomes a paved road and houses and industry are erected alongside. Although the dangers that affected the fur trader are long gone, few question the road’s inefficiently winding route.
Legal path dependence occurs when an initial path effectively blinds lawmakers to alternative paths. Informational and political burdens can cause the blindness. Informational burdens arise when the choice of one legislative path makes it harder to assess other paths. Political burdens are created when groups wield their influence to maintain and perhaps magnify an initial path.
Evolution of the Bankruptcy-Law Safe Harbor for Derivatives
The derivatives safe harbor exemplifies legal path dependence. It is an outcome of decades of sustained industry pressure on Congress to exempt the derivatives market from the reach of bankruptcy law, with each exemption serving as an historical justification for subsequent broader exemptions.
The initial exemptions—which were included in 1977 in the bill that became the Bankruptcy Code—were promoted by a derivatives-industry representative who suggested that Congress grant commodities brokers authority to “close out” an insolvent customer’s account, in order to prevent “a potential domino effect.” He argued such an effect could occur because the commodities futures market is fragile. But as sole evidence of market fragility, he merely cited a court case. And he did not explain why the inability of a commodities broker to freely close out an insolvent customer’s account could cause a domino effect. Nonetheless, Congress followed his suggestion and included several narrow exemptions in the Bankruptcy Code.
These exemptions were later used as precedent to justify broader exemptions, which in turn themselves served as precedent for increasingly broader exemptions. For example, a 1982 amendment to the Bankruptcy Code that further expanded the safe harbor exemptions beyond commodities futures markets was viewed by Congress as merely continuing the goal of preventing systemic risk, with the “potential domino effect” now being termed a “threat of market collapse.” Similarly, in 1990, the International Swaps and Derivatives Association (“ISDA”), a leading industry group, urged Congress to further amend the Bankruptcy Code to exempt its application to swap transactions. ISDA noted that “Congress has for many years recognized the need for certainty and speed in the treatment of securities and other similar financial transactions in bankruptcy,” and that former amendments to the Bankruptcy Code with regard to securities, commodities, and repurchase agreements “worked well in practice and have provided needed certainty.” ISDA argued that the requested new protections “closely paralleled” those provided by earlier amendments.
Perhaps the only expansion of the safe harbor that was not clearly due to path dependence was the 2005 Bankruptcy Code amendment to allow creditors to terminate and net amounts owing under most financial market contracts. This was based on a recommendation in a report by the President’s Working Group on Financial Markets (the “PWG Report”), which studied the near failure of the Long-Term Capital Management hedge fund. The PWG Report argued that if LTCM had defaulted, the ability of counterparties to terminate and net amounts owing under derivatives contracts, free of bankruptcy law’s automatic stay of enforcement actions, would have mitigated counterparty losses and reduced the likelihood of instability in the financial markets. Congress did not appear to take into account opposing views, however, such as those of the estimable National Bankruptcy Conference, which advised that there is “no indication that the absence of” these expanded rights “has led to widespread difficulties or systemic disruptions in the financial markets.” Congress also ignored the Conference’s warning that certain aspects of the “netting could deprive a debtor of much-needed cash collateral, which in some instances may lead to conversion and liquidation to the detriment of other creditors.”
Is the Derivatives Safe Harbor Path Dependent?
The derivatives safe harbor is, at least, largely path dependent. Congress usually assumed that an expanding safe harbor would help protect against systemic risk. With each passing amendment, that assumption became more entrenched as a truth. This reflects an informational blindness, discouraging alternative views. The informational blindness was almost certainly exacerbated by both the complexity of derivatives and uncertainty over how systemic risk is created and transmitted. In the face of complexity, people tend to see what they expect to see, the expectation in this case being driven by lobbyist pressure.
To the extent the 2005 expansion of the safe harbor was recommended by the PWG Report, it might not appear to represent legal path dependence. Nonetheless, that Report does not appear to address opposing views (such as those of the National Bankruptcy Conference). Furthermore, ISDA played a “significant role in the drafting of the relevant provisions of [the 2005 expansion and] worked in close collaboration” with the President’s Working Group on Financial Markets. ISDA “prepared a position paper . . . setting forth the need for [the expansion] and proposing [its] language.” ISDA also “participated in many of the hearings that led up to the eventual adoption of the” expansion. ISDA’s significant influence reflects the fact that as the derivatives industry skyrocketed in size, lobbyists such as ISDA became much more powerful, creating a political burden that discouraged alternative views. Ironically, the increase in the size of the derivatives industry was itself partly fostered by the safe harbor, which encouraged firms to deviate away from traditional financing into exotic derivatives, to avoid application of bankruptcy law. And that, in turn, has made the financial system even more complex, further reinforcing the informational blindness.
Reassessing the Derivatives Safe Harbor
Path-dependent legislation is not necessarily bad. Nonetheless, if the legislation is not fully vetted, its significance and utility should not be taken for granted. Although we have not made an independent analysis of the merits of the derivatives safe harbor, our review indicates that some scholars seriously question whether its benefits exceed its costs. Consider this in the context of the substantive issues surrounding derivatives and systemic risk.
The characteristics of the derivatives market have contributed to the belief that a collapse of a derivative counterparty might precipitate a systemic meltdown. Because the trade in derivatives is concentrated among relatively few major firms, it is feared that the collapse of a single firm, especially a highly connected one, might systemically disrupt the derivatives market, which could then impact the financial system more broadly. But this systemic risk story is far from proved. There is “little actual evidence to support” the story. On the other hand, economists have estimated that the net exposure of the major derivatives dealers to their five largest dealer counterparties is relatively small.
Ironically, the safe harbor itself may be exacerbating the movement toward market concentration of the derivatives industry. The safe harbor enables creditors to ignore counterparty risk because a creditor can terminate derivatives contracts, net amounts owing thereunder, and foreclose on collateral notwithstanding the counterparty’s bankruptcy. That reduces a creditor’s incentive to diversify its counterparties.
The safe harbor may not even be focused on the right parties. Some scholars argue that the fear of derivatives-induced systemic risk is warranted only in the case of an insolvency of a major financial market participant holding a massive derivatives portfolio. The safe harbor’s exemptions, however, operate independently of the size of the counterparty or its portfolio. They also apply to non-financial, as well as to financial, firms. Thus a bank that makes a secured loan cannot enforce its collateral against a bankrupt borrower, whereas an ordinary business firm can enforce its collateral against a bankrupt derivatives counterparty.
Another concern is that the safe harbor, which is now so broad that virtually any ordinary financial transaction can be documented to fall within it, may well have unintended consequences. Because derivatives transactions are exempted from bankruptcy law, parties are tempted to try to document ordinary financial transactions as derivatives transactions in order to benefit from the exemption. Some textbooks are openly encouraging parties to design financing contracts as derivatives transactions, in order to circumvent the Bankruptcy Code’s restrictions.
Because the derivatives safe harbor has important consequences for systemic risk, a more fully informed discussion of its merits—under U.S. bankruptcy law, and under foreign insolvency laws to the extent such laws incorporate similar derivatives exemptions—may well be timely. Our analysis also suggests that heightened informational burdens can increase the influence of interest-group politics. That, in turn, can make complex legislation more vulnerable to legal path-dependency. Further research into the causes and consequences of path-dependency in complex rulemaking may be warranted.
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