COLUMBIA LAW REVIEW

SIDEBAR
VOL. 112 JULY 31, 2012 PAGES 194–205

TRANSACTION SIMPLICITY

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

* Harvey Washington Wiley Chair in Corporate Governance & Business Ethics, Seton Hall
University School of Law, Newark, New Jersey. Thanks to Robert Pickel, Michael Simkovic, and
David Skeel for comments on an earlier draft.
1. David A. Skeel, Jr. & Thomas H. Jackson, Transaction Consistency and the New Finance
in Bankruptcy, 112 Colum. L. Rev. 152, 153–54 (2012).
2. According to a query run in the UCLA-LoPucki Bankruptcy Research Database, of 941
large Chapter 11 cases in the dataset, 38 involved bank holding companies, 20 involved debtors
that owned insurance companies, and six involved broker-dealer holding companies. While some
of these bankruptcies involved companies like Lehman or Drexel Burnham Lambert, the vast
bulk of these filings involved smaller banks and insurance companies. And in all cases these
financial institutions make up just under 7% of all debtors in the database. See UCLA-LoPucki
Bankruptcy Research Database, http://lopucki.law.ucla.edu/bankruptcy_research.asp (on file with
the Columbia Law Review) (last visited May 8, 2012) (with all fields selected in the “First Step”
and “Second Step” of the “Design a Study Page” select “Industry” as the variable in the “Third
Step” and then select “Submit Query” to view relevant data).
3. 7 U.S.C. §§ 1a, 2, 6s (2006). This distinction is especially clear in § 2(h)(7). For a helpful
discussion of central clearing of derivatives, see Anupam Chander & Randall Costa, Clearing
Credit Default Swaps: A Case Study in Global Legal Convergence, 10 Chi. J. Int’l L. 639, 651–
55 (2010).
4. See Sarah Pei Woo, Regulatory Bankruptcy: How Bank Regulation Causes Fire Sales, 99
Geo. L.J. 1615, 1623 (2011) (discussing financial institutions’ increasing usage of “both long and
short positions on the same entity”); see also Erik F. Gerding, Credit Derivatives, Leverage, and
Financial Regulation’s Missing Macroeconomic Dimension, 8 Berkeley Bus. L.J. 29, 37–38
(2011) (reviewing “hedging” derivatives).
194
2012] Transaction Simplicity 195

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.
Whether this subsidy is a good thing is unclear.11 On the one hand,

5. Laurin C. Ariail, The Impact of Dodd-Frank on End-Users Hedging Commercial Risk in

Over-the-Counter Derivatives Markets, 15 N.C. Banking Inst. 175, 191 (2011) (noting, for
example, that financial institutions constitute 91% of “$437.2 trillion market for interest rate
derivatives”).
6. These numbers are gross notional amounts. Office of the Comptroller of the Currency,
OCC’s Quarterly Report on Bank Trading and Derivatives Activities: Second Quarter 2011, at
tbl.2 (2011), http://www.occ.treas.gov/topics/capital-markets/financial-
markets/trading/derivatives/dq211.pdf (on file with the Columbia Law Review) (last visited May
8, 2012).
7. See Kenneth Ayotte & David A. Skeel, Jr., Bankruptcy or Bailouts?, 35 J. Corp. L. 469,
493–96 (2010) (discussing systemic concerns relating to financial contracts in bankruptcy); Bryan
G. Faubus, Note, Narrowing the Bankruptcy Safe Harbor for Derivatives to Combat Systemic
Risk, 59 Duke L.J. 801, 825 (2010) (explaining special treatment of derivatives in bankruptcy to
reduce systemic risk).
8. Skeel & Jackson, supra note 1, at 155.
9. See Kenneth C. Kettering, Securitization and Its Discontents: The Dynamics of Financial
Product Development, 29 Cardozo L. Rev. 1553, 1567–68 (2008) (making similar point with
regard to asset securitization).
10. See In re Nat’l Gas Distributors, LLC, 556 F.3d 247, 259 (4th Cir. 2009) (allowing gas
supply contract to be treated as safe harbored contract).
11. See Colleen M. Baker, Regulating the Invisible: The Case of Over-the-Counter
Derivatives, 85 Notre Dame L. Rev. 1287, 1303–09 (2010) (reviewing benefits and costs of
derivatives to financial markets).
196 COLUMBIA LAW REVIEW SIDEBAR [Vol. 112:194

evasion of the bankruptcy system has obvious costs for unsubsidized creditors
and other stakeholders like employees. Namely, the bankruptcy process is less
useful to these creditors, and they bear more of the bankruptcy system’s cost if
subsidized creditors are allowed to opt out. On the other hand, the loss of the
subsidy would increase the costs of hedging, resulting in either increased cost
or risk to corporations from unviable hedges,12 which itself has a positive
cost.13 How these two costs balance out—and thus the net cost of the safe
harbors—is uncertain and perhaps unknowable.14
Skeel and Jackson spend the bulk of their Essay arguing for the complete
rethinking of derivatives and repos in bankruptcy, a project that they put under
the general heading of “transactional consistency.” In short, they argue that
repos should be treated as sec ured financing, save for where the repo is based
on cash-like collateral.15 Swaps should be treated as regular contracts,
insurance contracts, or financing, depending on their true purpose.16
I am largely sympathetic to the project, having argued myself that straight
repeal of the “safe harbors” is often little more than an unrealistic thought
exercise.17 But I also worry that Skeel and Jackson’s Essay relies too heavily
on these new categories. To some degree they have replaced one set of
exceptions with another. I thus use this short Response to outline these
concerns and suggest a simpler solution to the issue.
I embrace the basic Skeel-Jackson premise that like agreements should be
treated alike under the Bankruptcy Code. But I depart from them insofar as
they engage in a re-sorting of agreements: Repos would be treated one way
under their proposals, swaps another.18 As the recent efforts to draft the
content of the Volcker Rule show, translating financial transactions into
legislative rules is no easy task.19 Moreover, we should never doubt the
creativity at work in financial institutions. Skeel and Jackson address swaps

12. This theory does assume that the derivatives market is price competitive and subsidies
pass through financial institutions to end-users. There are reasons to doubt this proposition
currently holds, although market features introduced by Dodd-Frank—like exchange trading—
might make it so in the future. Cf. Aaron Unterman, Innovative Destruction—Structured Finance
and Credit Market Reform in the Bubble Era, 5 Hastings Bus. L.J. 53, 94 (2009) (advocating
heightened derivatives regulation to ensure “future economic stability”).
13. See Peter H. Huang & Michael S. Knoll, Corporate Finance, Corporate Law and Finance
Theory, 74 S. Cal. L. Rev. 175, 185–86 (2000) (“[H]edging can create value by reducing the costs
of financial distress and bankruptcy.”); see also David B. Spence, Can Law Manage Competitive
Energy Markets?, 93 Cornell L. Rev. 765, 805 (2008) (noting “hedging devices, when used by
retail sellers . . . can go a long way toward protecting retail customers from price volatility”).
14. See Kristin N. Johnson, Things Fall Apart: Regulating the Credit Default Swap
Commons, 82 U. Colo. L. Rev. 167, 199–214 (2011) (discussing benefits and dangers of credit
derivatives).
15. Skeel & Jackson, supra note 1, at 179.
16. Id. at 180–81.
17. See generally Stephen J. Lubben, The Bankruptcy Code Without Safe Harbors, 84 Am.
Bankr. L.J. 123 (2010) [hereinafter Lubben, Without Safe Harbors].
18. E.g., Skeel & Jackson, supra note 1, at 199 (summarizing their proposal).
19. See Peter Schroeder, SEC Head Indicates Slow Going on Volcker Rule, The Hill (March
6, 2012, 1:33 PM), http://thehill.com/blogs/on-the-money/banking-financial-institutions/214395-
sec-head-indicates-slow-going-on-volcker-rule (on file with the Columbia Law Review)
(discussing agencies' inability to meet Volcker Rule implementation deadline).
2012] Transaction Simplicity 197

throughout their Essay, but what of the various combinations of forwards,

options, linear certificates, structured notes, correlation products, and other
instruments that can achieve the same ends?
And their basic project is still largely based on two financial institutions
as counterparties, which may reflect the bulk of the derivatives and repo
markets, but plays a relatively small part in Chapter 11, and is apt to get even
smaller with the creation of the new Orderly Liquidation Authority (OLA).20
I therefore conclude by arguing that two simple changes would better
address the pressing problems of the special treatment of derivatives in
bankruptcy. First, opening the door to judicial recharacterization of putative
derivatives and repos that are really just disguised versions of other
transactions would solve much of the problem associated with the overbroad
safe harbors. A supply contract that is rewritten as a swap should be treated as
a supply contract, and the bankruptcy court should have the power to do just
that. This is a simpler version of transactional consistency.
Second, the Bankruptcy Code should be harmonized with Dodd-Frank.
This revision is the simpler, immediate solution to Skeel and Jackson’s
concerns about financial institutions in bankruptcy, and if we are to take the
financial regulators at their word, we must anticipate that a few financial
institutions will be resolved under Chapter 11. If Chapter 11 is the complement
to the OLA, there should be consistency between the two proceedings.
These are not perfect solutions but rather first steps. They are, however,
steps that should be easily achievable.

I. THE PROBLEM OF DERIVATIVES IN BANKRUPTCY

Derivatives and bankruptcy interact in strange ways, creating strange

laws.21 But one of the most fundamental problems is that discussions of
“derivatives” in this context sweep up the rather distinct issue of repurchase
agreements, which are treated the same as traditional derivatives under the
Bankruptcy Code but are otherwise quite distinct.22
Derivatives are, at heart, contracts.23 Repos, however, are financing.24

20. See Adam J. Levitin, In Defense of Bailouts, 99 Geo. L.J. 435, 487–89 (2011)
(reviewing Dodd-Frank Act’s Orderly Liquidation Authority).
21. Given the space constraints of this short Response, I assume the reader is familiar with
the treatment of derivatives and repos under the Bankruptcy Code, particularly post-2005. If not,
good reading on the topic includes Stephen J. Lubben, Repeal the Safe Harbors, 18 Am. Bankr.
Inst. L. Rev. 319 (2010); Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit
Derivatives, 75 U. Cin. L. Rev. 1019 (2007); Mark J. Roe, The Derivatives Market’s Payment
Priorities as Financial Crisis Accelerator, 63 Stan. L. Rev. 539 (2011); Michael Simkovic, Secret
Liens and the Financial Crisis of 2008, 83 Am. Bankr. L.J. 253 (2009). For something even more
concise, see Mike Konzcal, An Interview About the End User Exemption with Stephen Lubben,
Rortybomb (May 6, 2010), http://rortybomb.wordpress.com/2010/05/06/an-interview-about-the-
end-user-exemption-with-stephen-lubben/ (on file with the Columbia Law Review).
22. See Eleanor Heard Gilbane, Testing the Bankruptcy Code Safe Harbors in the Current
Financial Crisis, 18 Am. Bankr. Inst. L. Rev. 241, 267–70 (2010) (discussing repurchase
agreements and Bankruptcy Code).
23. Stephen J. Lubben, Derivatives and Bankruptcy: The Flawed Case for Special
198 COLUMBIA LAW REVIEW SIDEBAR [Vol. 112:194

Contracts are subject to the debtor’s special power to assume (perform) or

reject (breach).25 Financing, on the other hand, is considered to be among the
special class of agreements, like personal service contracts, that are exempt
from this normal rule.26
By the time of bankruptcy, financing has typically transformed itself into
debt. The corporate debtor that enters Chapter 11 with untapped sources of
liquidity is a rare bird indeed.
Skeel and Jackson spend a good bit of time grappling with these issues,
before ultimately coming to some sensible conclusions regarding swaps.27 But
there are some bigger issues that loom here and some non-problems that also
cloud the Skeel-Jackson analysis.
The basic issue is that contracts of all sorts are subject to default. If an
entire class of contracts is subject to rumors or fears of default, that type of
contract is subject to a run.28 Once a class of contract or debt instrument
becomes subject to a run, it ceases to have value in the market, and is then
termed “illiquid.” Often this is a temporary condition, but it can also be self-
reinforcing.
Based on these simple truths and a semi-plausible argument that
derivatives are especially likely to be subjected to runs and illiquidity, the
derivatives industry persuaded Congress to enact a series of “safe harbors” for
derivatives.29 In particular, financial institutions have large gross exposures to
derivatives and wanted assurances that their net exposures are what really
matter.30
Actually, the argument began with the Federal Reserve and the concern
over the failure of a few repo dealers shortly after the enactment of the current
Bankruptcy Code in 1978.31 The swaps dealers, and their allies in Treasury

Treatment, 12 U. Pa. J. Bus. L. 61, 68–73 (2009) (supporting this principle).

24. Granite Partners L.P. v. Bear, Stearns & Co., 17 F. Supp. 2d 275, 301–02 (S.D.N.Y.
1998) (reviewing repo treatment).
25. 11 U.S.C. § 365 (2006).
26. Id. § 365(c).
27. See Skeel & Jackson, supra note 1, at 185. However, their conclusion that an
International Swaps and Derivatives Association (ISDA) master agreement and all subsidiary
documents must constitute a single agreement, even in the absence of the safe harbors, is not
nearly as clear as they make it out to be. See Rhett G. Campbell, Energy Future and Forward
Contracts, Safe Harbors and the Bankruptcy Code, 78 Am. Bankr. L.J. 1, 44 (2004) (raising
possibility of debtor assuming favorable trades but rejecting others).
28. See Charles K. Whitehead, Reframing Financial Regulation, 90 B.U. L. Rev. 1, 22–23
(2010) (describing collapse of Bear Stearns to illustrate this principal).
29. See Thomas J. Giblin, Financial Markets in Bankruptcy Court: How Much Uncertainty
Remains After BAPCPA?, 2009 Colum. Bus. L. Rev. 284, 288–90 (reviewing these regulatory
changes); Shmuel Vasser, Derivatives in Bankruptcy, 60 Bus. Law. 1507, 1509–11 (2005)
(discussing public policy underlying “safe harbors” for derivatives).
30. See David Mengle, ISDA Research Notes: The Importance of Close-Out Netting (2010),
available at http://www.isda.org/researchnotes/pdf/Netting-ISDAResearchNotes-1-2010.pdf (on
file with the Columbia Law Review) (noting financial institutions’ large gross derivatives
exposure and attempts to reduce credit risk from this exposure).
31. Bevill, Bresler & Schulman Asset Management Corp. v. Spencer S & L Ass’n (In re
Bevill, Bresler & Schulman Asset Mgt. Corp.), 878 F.2d 742, 745–50 (3d Cir. 1989) (reviewing
2012] Transaction Simplicity 199

and the Federal Deposit Insurance Corporation (FDIC), simply used the
preexisting repo safe harbors to gain special treatment for derivatives, too.32
Thus, repo and derivatives became linked together in the world of bankruptcy.
The end result is that both repos and derivatives are exempt from the
normal rules of bankruptcy: There is no automatic stay, there are no avoidance
actions, and the debtor does not get to decide whether to assume or reject
contracts that are still executory upon bankruptcy.33 After 2005 the definitions
of the relevant repos and derivatives were expanded, resolving every possible
doubt in the prior definitions in an industry favorable way, so that now
anything that even “sort of” looks like a covered transaction can arguably be
included within the safe harbors.34
Although I might put the emphasis in different spots—and I doubt that the
safe harbors really had much role to play in Lehman’s infamous “repo 105”—
Skeel and Jackson correctly identify many of the pernicious effects of safe
harbors.35
Because of the subsidy given to repo and derivatives, the debtor’s cost of
capital will be lower if it can finance itself with either of these two classes of
instruments.36 The safe harbors thus encourage overuse, especially since most
of the bad effects of overuse are likely to occur far in the future, in a state of
failure that managers will understandably discount. This overuse becomes
extreme in cases where “normal” contracts become recast as either type of
financial contract.
And while Dodd-Frank has created a new bankruptcy system for financial
institutions, it did not replace the Bankruptcy Code in all instances.37 Indeed,
the FDIC indicates that Chapter 11 remains the primary framework for

this history).
32. Timothy P.W. Sullivan, Comment, Swapped Disincentives: Will Clearinghouses
Mitigate the Unintended Effects of the Bankruptcy Code’s Swap Exemptions?, 80 Fordham L.
Rev. 1491, 1510–12 (2011) (recapping this progression).
33. For example, with regard to swaps, see 11 U.S.C. § 362(b)(17) (2006) (providing
exemption from automatic stay); 11 U.S.C. § 546(g) (providing exemption from certain avoiding
powers); and 11 U.S.C. § 560 (preserving rights of termination including under an ipso facto
clause, close-out netting and swap enforcement).
34. See John J. Chung, From Feudal Land Contracts to Financial Derivatives: The
Treatment of Status Through Specific Relief, 29 Rev. Banking & Fin. L. 107, 130–38 (2009)
(reviewing expansion of derivatives exemption in Bankruptcy Code to “reduce or even eliminate
virtually all exposure losses”); Stephen J. Lubben, Systemic Risk & Chapter 11, 82 Temp. L.
Rev. 433, 443–44 (2009) (crediting broad definition of “swap” with expansion of derivatives
“safe harbors”).
35. For a brief review of Lehman’s “repo 105” see Michael J. de la Merced & Julia
Werdigier, The Origins of Lehman’s ‘Repo 105,’ N.Y. Times DealBook (March 12, 2010, 7:02
AM), http://dealbook.nytimes.com/2010/03/12/the-british-origins-of-lehmans-accounting-
gimmick/ (on file with the Columbia Law Review).
36. I am implicitly assuming that Modigliani & Miller overstated their case, and that the
debtor can avoid paying more to subordinated creditors. See John D. Ayer, The Role of Finance
Theory in Shaping Bankruptcy Policy, 3 Am. Bankr. Inst. L. Rev. 53, 59–60 (1995) (reviewing
Modigliani & Miller’s premise and “ideal” assumptions).
37. Hollace T. Cohen, Orderly Liquidation Authority: A New Insolvency Regime to
Address Systemic Risk, 45 U. Rich. L. Rev. 1143, 1151 (2011).
200 COLUMBIA LAW REVIEW SIDEBAR [Vol. 112:194

resolving financial distress in these institutions.38 In this light, we then need to

worry about the ways in which the safe harbors create runs in repos and
derivatives markets, given the extensive involvement of most financial
institutions.
It is these two problems that are the most pressing issues with regard to
financial contracts in bankruptcy. These problems, and my proposed solutions,
animate the remainder of this short Response.

II. THE PROBLEM OF PRETEND DERIVATIVES

Whatever position one might have regarding the special treatment of

financial contracts under the current Bankruptcy Code, it seems
unquestionably problematic that the definition of a thing like “swap” was left
so open-ended that it could potentially cover relatively mundane contracts.
Consider, for example, a hypothetical debtor: Bogartco, a leading
manufacturer of trenchcoats and fedoras. Bogartco enters a transaction with a
bank whereby the bank gives Bogartco $1 million and Bogartco promises to
repay that sum in ten years. In the interim, Bogartco promises to make periodic
interest payments to the bank. To secure its performance, Bogartco agrees to
provide the bank with a lien on its property, plant, and equipment (PP&E). The
cash flows would look like this:

Risk Free + Spread

Bank Bogartco
$1m (year 1)
$1m (year 10)

This is rather clearly a secured loan. But what if the original deal was modified
as follows:

(2 × Risk Free) + Spread

Bank Risk Bogartco
$1m Free
(year 1)
$1m (year 10)

38. See Does the Dodd-Frank Act End Too Big to Fail?: Hearing Before the Subcomm. on
Fin. Insts. and Consumer Credit of the H. Comm. on Fin. Servs., 112th Cong. (2011) (statement
of Michael H. Krimminger, Gen. Counsel, Federal Deposit Insurance
Corporation), available at http://www.fdic.gov/news/news/speeches/chairman/spjun1411.html (on
file with the Columbia Law Review) (describing mechanisms for resolving financial institutions
through bankruptcy and the OLA).
2012] Transaction Simplicity 201

And replace the security interest with “margin,” represented by the grant of an
interest in Bogartco’s PP&E.
Note that the economics of the transaction have not changed—the
additional risk-free rate payments cancel each other out. Nonetheless, there is
an argument that the second transaction is a swap39—especially if
memorialized under the ISDA form documents used to document derivatives
trades.40
If the payments were made in different currencies, the transaction would
easily fit within the safe harbors, as currency swaps are some of the few
transactions that involve the exchange of principal.41 Bogartco could then be
obligated by the bank to hedge the currency risk in the transaction with another
safe-harbored instrument.
A similar, if somewhat less problematic, situation exists with regard to the
definition of “repurchase agreement” under the Bankruptcy Code.42 The safe
harbor encompasses essentially any loan collateralized by certificates of
deposit, bankers’ acceptances, U.S. or other Organization for Economic Co-
operation and Development government securities, mortgage loans or interests
in the same, including mortgage-backed securities, with less than a one-year
term. In an extreme case, the debtor could grant a security interest in a large
portion of its cash—in the form of a certificate of deposit—which essentially
exposes the lender to no risk so long as it is fully collateralized, yet the loan
will still be exempt from the automatic stay.43
These provisions thus exclude legitimate financial contracts—things we
would think really are swaps, forwards, and repos—from the scope of the
Bankruptcy Code. But they also exclude pretend financial contracts from the
Code, to such a degree that there might not be much left of the debtor to
reorganize once enough contracts get rewritten to take advantage of the
expansion of the safe harbors in 2005.44
While Skeel and Jackson might argue for a reconsideration of the special
treatment of derivatives generally, and I have undeniably done the same in the
past, it seems time to admit that such a broad approach leads to a dead end.
Namely, derivatives have become integrated into the American economy, so
that even a mid-cap manufacturing company will have a portfolio of interest
rate and currency swaps to hedge its loans and foreign operations. Removing
the bankruptcy subsidy to these contracts will result in higher prices for the

39. See 11 U.S.C. § 101(53B)(A)(ii) (2006).

40. See In re Enron Corp., 328 B.R. 58, 70 (Bankr. S.D.N.Y. 2005) (“[E]quity swaps and
credit derivatives should include what the swap market understands to be a swap agreement.”).
41. See Jennifer A. Frederick, Note, Not Just for Widows & Orphans Anymore: The
Inadequacy of the Current Suitability Rules for the Derivatives Market, 64 Fordham L. Rev. 97,
99 n.8 (1995) (explaining currency swaps).
42. 11 U.S.C. § 101(47).
43. Id. § 362(b)(7).
44. The definitions were also expanded in 2006, but for ease I collapse the two changes to
the Code and refer to the “2005 changes” throughout. For a discussion of the 2006 alterations, see
Seth Grosshandler & Kate A. Sawyer, The Financial Netting Improvements Act of 2006 Clarifies
the Bankruptcy Protections and Promotes Netting for Qualifying Derivative Transactions, 124
Banking L.J. 523, 525 (2007).
202 COLUMBIA LAW REVIEW SIDEBAR [Vol. 112:194

hedge.
Maybe the higher prices are outweighed by the net social benefits of not
subsidizing derivatives. However, maybe they are not; this is an essentially
unanswerable empirical question.
But it seems unquestionable that efforts to sneak “regular” contracts into
the financial contracts provisions of the Bankruptcy Code are pernicious, and
could eventually destroy the benefits of Chapter 11. As such, I argue in the
Conclusion for an increase in bankruptcy court power to police the line
between true financial contracts and pretend financial contracts.
But I will first explain the other issue in need of immediate attention: the
impossibility of financial institutions in a bankruptcy case under the
Bankruptcy Code.

III. DODD-FRANK’S PARTIAL SOLUTION TO ORDERLY LIQUIDATION

Dodd-Frank’s Title II creates a new Orderly Liquidation Authority that

potentially replaces Chapter 11 as the resolution tool for bank holding
companies and their non-regulated subsidiaries.45 The OLA could only
potentially displace Chapter 11 because Chapter 11 remains in place unless
financial regulators decide to invoke the OLA,46 through an intricate process
that culminates with the D.C. District Court having twenty-four hours to say
“no” under very controlled circumstances.47
In essence, the OLA expands the FDIC’s bank receivership powers to
cover a greater part of the financial institution.48 This provision allows the
FDIC to conduct a purchase and assumption transaction with regard to non-
depository bank parts of the institution or transfer the institution to a newly
created “bridge bank.”49 The latter option allows the FDIC to split the good
assets from the bad, in a process that is very much like that used in “363 sales”
under Chapter 11, widely publicized by the automotive Chapter 11 cases.50
Importantly, the FDIC is granted a one-day stay on counterparties’ ability
to terminate their derivative contracts.51 This stay obviously facilitates the sale

45. 12 U.S.C. §§ 5381–5394 (2006). See also Stephen J. Lubben, Resolution, Orderly and
Otherwise: B of A in OLA, U. Cin. L. Rev. (forthcoming 2012) (on file with the Columbia Law
Review) (exploring implications of invoking the OLA in hypothetical resolution of Bank of
America).
46. 12 U.S.C. § 5382(c)(1) (“[T]he provisions of the Bankruptcy Code . . . shall apply to
financial companies.”); see id. § 5383(b)(2) (allowing D.C. District Court review of a financial
company’s failure which may have “serious adverse effects on financial stability in the United
States” for purposes of commencing orderly liquidation under 12 U.S.C. § 5382(a)(1)(A)).
47. Id. §§ 5382, 5383.
48. Id. § 5384(b).
49. Id. § 5390.
50. For a discussion of this process, see generally Stephen J. Lubben, No Big Deal: The GM
and Chrysler Cases in Context, 83 Am. Bankr. L.J. 531 (2009). See also Stephanie Ben-Ishai &
Stephen J. Lubben, Sales or Plans: A Comparative Account of the “New” Corporate
Reorganization, 56 McGill L.J. 591 (2011) (comparing “quick sales” under American
reorganization regime to similar proceedings under Canadian law).
51. 12 U.S.C. § 5390(c)(10)(B)(i).
2012] Transaction Simplicity 203

of the debtor financial institution in a way that is lacking under the Bankruptcy
Code, where there are no restraints on counterparties’ ability to terminate
derivatives contracts.52 Similarly, under Dodd-Frank, the FDIC has the ability
to nullify ipso facto clauses in financial contracts between subsidiaries and
counterparties that are triggered solely because of the parent company’s OLA
filing.53
In short, under the OLA, the debtor’s derivatives book can remain intact;
under Chapter 11 it will be pulled to pieces. Nonetheless, the FDIC and
Treasury have asserted that bankruptcy remains the preferred solution for
financial distress in financial institutions.54 The OLA is only to be used when
the debtor’s distress threatens to cause systemic problems.
The reason for the disparity is puzzling, especially if one focuses on
situations where there has been no performance default on the debtor’s
financial contracts. Why should a systemic crisis in particular provide an
occasion for the preservation of going concern value, whereas such value is
destroyed in all other situations?
Moreover, the potential disruption in the derivatives markets caused by
the Chapter 11 case of a financial institution could itself necessitate invoking
the OLA. If the regulatory community is serious about making Chapter 11 the
primary tool for resolving financial distress in this area, that would itself seem
another reason to achieve some degree of parity with regard to financial
contracts.
For the “end-users” of financial contracts, the unequal treatment of
financial contracts is all the starker since by and large these debtors will never
be eligible to reorganize under the OLA.55 The airline that has hedged its fuel
needs might rightly wonder why it must lose its hedges upon bankruptcy,
whereas its counterparty, a major financial institution, can demand the airline’s
continued performance after the FDIC takes over the bank as receiver. This
disparity exposes the one-way direction of the safe harbors, especially after the
advent of Dodd-Frank. 56

52. 11 U.S.C. §§ 546(g), 548(d)(2)(D), 561(a) (2006) (explaining termination of derivatives

contract is exempt from classification as constructive fraudulent transfer or preference).
53. 12 U.S.C. § 5390(c)(16). On March 20, 2012, FDIC issued its Notice of Proposed
Rulemaking setting forth the proposed rule to implement this section. Enforcement of Subsidiary
and Affiliate Contracts by the FDIC as Receiver of a Covered Financial Company, 77 Fed. Reg.
18,127 (proposed Mar. 20, 2012).
54. See Dep’t. of the Treasury, Financial Regulatory Reform–A New Foundation 8 (2009)
(describing bankruptcy as suitable option for distressed financial firms in situations not impacting
“greater financial stability”).
55. I use the term “reorganize” intentionally, despite the OLA’s claimed model of
“liquidation only.” A recapitalized financial institution has been reorganized, whatever the
language of the statute.
56. See Stephen J. Lubben, Financial Institutions in Bankruptcy, 34 Seattle U. L. Rev. 1259,
1261 (2011) (arguing “there are significant gaps in the federal system for resolving financial
distress in a financial firm even after passage of the Dodd-Frank bill”).
204 COLUMBIA LAW REVIEW SIDEBAR [Vol. 112:194

CONCLUSION: SIMPLE SOLUTIONS

In an ideal world, the treatment of derivatives under the Bankruptcy Code,

the Securities Investor Protection Act, the OLA, and other insolvency statutes
would be entirely reconsidered, and these various insolvency systems would be
further integrated.57 The legitimate concerns that support the safe harbors in all
of these statutes could be addressed in a far more narrowly tailored way.58 But
given the larger, difficult empirical questions identified at the outset of this
Response, this discussion is not apt to be easy or quick.
But in the interim, the key problems identified herein could be addressed.
First, the problem of pretend financial contracts could be addressed by a little
faith in judicial discretion—admittedly something Congress showed little
regard for in 2005.59
Nonetheless, in virtually every other context the bankruptcy judge is
empowered to recast a transaction to reflect its true nature.60 This principle has
a long history.61
If the bankruptcy court had such a power with regard to putative financial
contracts, it would give the court the ability to police the boundaries between
the legitimate goals of the safe harbors and their potential, particularly post-
2005, to swallow the whole of the Bankruptcy Code.62 In essence, this power
would amount to an anti-evasion rule, such as are common in many other
corporate statutes63—including recently enacted provisions of Dodd-Frank.64

57. See Brett McDonnell, Don’t Panic! Defending Cowardly Interventions During and After
a Financial Crisis, 116 Penn St. L. Rev. 1, 68–69 (2011) (discussing regulatory agency
reorganization).
58. See generally Lubben, Without Safe Harbors, supra note 17.
59. Lauren E. Tribble, Note, Judicial Discretion and the Bankruptcy Abuse Prevention Act,
57 Duke L.J. 789, 804 (2007) (criticizing replacement of “judicial discretion with a rigid and
formulaic rule” under Bankruptcy Abuse Prevention Act).
60. See, e.g., In re SubMicron Sys. Corp., 432 F.3d 448, 459 (3d Cir. 2006) (applying
“clearly erroneous” standard to review district court’s recharacterization of instruments as debt);
Roth Steel Tube Co. v. C.I.R., 800 F.2d 625, 629–32 (6th Cir. 1986) (applying multi-factor test to
determine whether advances were capital contributions or loans); In re BH S & B Holdings LLC,
420 B.R. 112, 157 (Bankr. S.D.N.Y. 2009), aff’d as modified, 807 F. Supp. 2d 199 (S.D.N.Y.
2011) (discussing multi-factor recharacterization analysis); In re Commercial Loan Corp., 316
B.R. 690, 700–02 (Bankr. N.D. Ill. 2004) (same); see also Robert D. Aicher & William J.
Fellerhoff, Characterization of a Transfer of Receivables as a Sale or a Secured Loan Upon
Bankruptcy of the Transferor, 65 Am. Bankr. L.J. 181, 182–84 (1991) (noting various legal
contexts in which recharacterization issues can arise); Simkovic, supra note 21, at 281 (explaining
that “the Bankruptcy Abuse Prevention and Consumer Protection Act . . . effectively rendered
derivatives immune from recharacterization based on economic substance”).
61. See Home Bond Co. v. McChesney, 239 U.S. 568, 575–76 (1916) (characterizing
contracts as “mere shams . . . to cover loans of money at usurious rates of interest”); James M.
Wilton & Stephen Moeller-Sally, Debt Recharacterization under State Law, 62 Bus. Law. 1257,
1268 (2007) (discussing early twentieth-century state court cases on debt recharacterization).
62. Cf. Shu-Yi Oei, Context Matters: The Recharacterization of Leases in Bankruptcy and
Tax Law, 82 Am. Bankr. L.J. 635, 655 (2008) (discussing application of “economic substance”
doctrine by bankruptcy courts).
63. E.g., Securities Exchange Act of 1934, Pub. L. 73-291, § 30(b), 48 Stat. 881 (codified as
amended at 15 U.S.C. § 78a et seq. (2006)).
64. E.g., 12 U.S.C. §§ 1851(e), 5323(c) (2006).
2012] Transaction Simplicity 205

In this case, the court’s ability to recharacterize would work as a prohibition on

evasion of the Bankruptcy Code.
The great bugaboo of a rogue bankruptcy judge would undoubtedly be
raised against such a move. But financial contracts are most apt to be an issue
in large Chapter 11 cases, the kind that are most likely to be filed in front of
experienced bankruptcy judges.65 It seems farfetched to assume these judges
would not “get it.”
Similarly, regardless of the type of debtor, it seems that if financial
institutions are allowed twenty-four hours to save their financial contracts, real
economy companies should also have this option. Moreover, if financial
institutions are to ever use Chapter 11 as their resolution tool, such a change is
quite obviously necessary.
Thus, the Bankruptcy Code should be amended to allow debtors one day
to assume or reject their swaps and other derivatives before counterparties can
terminate those contracts. If the debtor assumes a swap, only performance-
related defaults would justify termination going forward.
These two practical changes would go a long way toward addressing the
very serious issue of derivatives in bankruptcy.

Preferred Citation: Stephen J. Lubben, Transaction Simplicity, 112 COLUM. L.

REV. SIDEBAR 194 (2012),
http://www.columbialawreview.org/assets/sidebar/volume/112/194_Lubben.pd
f

65. Troy A. McKenzie, Judicial Independence, Autonomy, and the Bankruptcy Courts, 62
Stan. L. Rev. 747, 777–82 (2010) (describing consistent handling of major bankruptcy cases by
sophisticated bankruptcy judges in preferred jurisdictions).