Transaction Simplicity

By: Stephen J. Lubben

David Skeel and Thomas Jackson come at the important question of derivatives in bankruptcy by wondering why the Bankruptcy Code was largely left out of the Dodd-Frank Act.¹ On one level, it is an odd question: Recent experience notwithstanding, the vast bulk of derivative users in bankruptcy are not financial institutions, and financial institutions are the focus of Dodd-Frank. ²

Dodd-Frank itself draws a distinction between financial institutions and real economy companies with regard to derivatives: Financial institutions are subject to extra capital requirements, clearing, and exchange trading mandates with regard to derivatives, while “end-users” are largely exempt.³ This separation reflects the reality that while financial institutions use derivatives for myriad purposes, end-users are almost exclusively hedgers, engaging in derivative trades as an ancillary part of their business.⁴ And while their derivatives portfolios can undoubtedly be quite large in absolute terms, the amount of derivatives held by financial institutions is another matter altogether.⁵ For example, the Office of the Comptroller of the Currency reported in June of this year that Goldman Sachs had the fifth largest derivatives portfolio in the United States, with a total notional amount of more than $50 trillion, and the two largest derivatives traders (JP Morgan Chase and Bank of America) held portfolios of more than $70 trillion each.⁶

Of course, understanding this distinction immediately calls into question the entire foundation for the Bankruptcy Code’s special treatment of derivatives and repos. If a non-financial institution derivative or repo user files for bankruptcy and the filing perturbs the financial markets, it seems more likely that this disruption is the result of a failure of risk management at financial institutions than any systemic risk created by the bankruptcy. After all, a financial institution’s exposure to an “end-user” is a one-way affair, and the actions of a single client should never threaten the viability of the bank. Nonetheless, systemic risk remains the primary justification for the inclusion of the “safe harbors” for financial contracts in the Bankruptcy Code.⁷

Skeel and Jackson thus correctly highlight what this Response argues is the real motivation for special treatment of derivatives and repos under the Bankruptcy Code: subsidy.⁸ Taking these agreements out of the normal bankruptcy process means that counterparties need not incur the cost of the collective process used in this country to resolve financial distress.⁹ While Chapter 11 is generally assumed to be socially efficient, exemption from Chapter 11 allows counterparties to make a socially inefficient but individualistically valuable decision.¹⁰ In short, the special treatment of derivatives and repo agreements under the Bankruptcy Code is a subsidy to the financial industry, and it is time it is recognized as such.

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