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Senate Passes Bankruptcy Bill With Derivatives Netting Provisions

The Senate has passed a bankruptcy reform bill, S.256, providing for the orderly and timely unwinding of derivatives contracts in bankruptcy by a vote of 74-25. The bill now moves to the House, where prompt passage is expected. The bill is strongly backed by the banking and securities industries.

Section 414 of the bill would allow judges to consider investment banks on the same terms as other entities in determining who can advise a company seeking bankruptcy protection. Current law prohibits judges from considering investment banks that have served as underwriters or distributors of securities for a company that subsequently files for bankruptcy. The provision allows the incumbent investment banker to continue advising the debtor company. Current law amounts to an automatic disqualification of the incumbent investment banker, which in turn compels the debtor company to hire a new investment banker that would have to get up to speed on the issues while the debtor is trying to preserve as much of its assets as possible.

Section 1404 of the act amends a provision that was added to the bankruptcy code by the Sarbanes-Oxley Act, which protects victims of securities fraud by making judgments and settlements based on securities law violations non-dischargeable in bankruptcy. Section 903 of Sarbanes-Oxley was designed to prevent corporate wrongdoers from sheltering their assets under the umbrella of bankruptcy. Section 1404 expressly gives pre-petition and post-petition effect to the provision with an amendment whose effective date relates back to the effective date of the Sarbanes-Oxley Act on July 30, 2002.

The derivatives netting measures, which have the strong support of the SEC and the Federal Reserve Board, are designed to minimize the systemic risk that is evident in the financial system. The measures serve to reduce the risk that would occur when a counterparty to a derivatives contract becomes insolvent. The bill would amend the federal securities, banking and bankruptcy laws to allow netting to fulfill the contracts of the financial and over-the-counter derivatives instruments that are often traded among large financial institutions. The availability of cross-product netting arrangements limits counterparty exposure and can help preserve market stability in the event of a failure.

The bill's provisions are based on proposals forwarded to Congress by the financial regulators in order to guard against systemic risk to the nation's financial system. Most of the provisions were included in a 1999 report by the Working Group on Financial Markets, following a review of current statutory provisions governing the treatment of qualified financial contracts upon the insolvency of a counterparty. The working group consisted of the SEC, the CFTC and the federal banking regulators.

Systemic risk has been defined as the risk that a disruption at a firm, in a market segment, or to a settlement system, can cause on a widespread basis to other firms, in other market segments, or in the financial system as a whole. The SEC's director of the Division of Market Regulation, Annette Nazareth, has noted that if participants engaged in financial activities are unable to enforce their rights to terminate financial contracts with an insolvent entity in a timely manner, and are unable to offset or net payment and other transfer obligations and entitlements arising under these contracts, the resulting uncertainty and potential lack of liquidity could increase the risk of market disruption.

S.256 would allow for derivatives contracts to be unwound in an orderly fashion should a company holding large numbers of derivatives contracts become bankrupt, instead of having the derivatives contracts tied up in bankruptcy court. The provision is important because delays in the appropriate handling of these contracts could spread the financial problems of one derivatives firm to other companies, which could be required to make payments on their side of a deal, but be unable to immediately collect on the other side. The provision is also of particular consequence since bankruptcy procedures are frequently lengthy. The derivatives provisions in Title IX of the bill are designed to avoid the situation where the derivatives contracts of a company that declares bankruptcy become tied up on a lengthy basis in bankruptcy court proceedings, which in turn poses a threat that the financial system could be destabilized.