Adjusting the Rules: What Bankruptcy Reform Will Mean for Financial Market Contracts

Abstract

Most of the commentary written on the recent Bankruptcy Reform Act (The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005) has focused on provisions that will make bankruptcy less appealing for individuals. However, the Bankruptcy Act also contains important provisions that determine how financial market contracts are handled when a market participant goes into bankruptcy. These provisions, designed to update, clarify and strengthen the existing laws pertaining to financial contracts, will have far reaching implications for a wide variety of financial market participants, including banks and the Federal Deposit Insurance Corporation (FDIC) itself. The 2005 Bankruptcy Act promises to significantly improve the efficiency of the business bankruptcy process by harmonizing the treatment of financial contracts across the spectrum of bank and non-bank market participants and instruments. It does so by revising and amending a number of previous statutes (including the Bankruptcy Code, FIRREA (1989) and FDICIA (1991)) that currently govern these matters. The most important result of these changes is an improved ability of creditors under certain financial contracts to quickly resolve claims against bankrupt debtors by employing what is known as close-out netting. This ability to terminate financial contracts, determine a net amount due, and liquidate any pledged collateral is a valuable tool in minimizing losses in receivership and reducing the disruptions that result from the bankruptcy process. An equally important feature of the changes is that it clarifies and strengthens the FDIC's ability to resolve a failing bank involved in the financial markets. The past twenty-five years have been marked by a proliferation of new institutional players and ever-increasing complexity in financial instruments. These changes have led to a growing recognition that legal structures governing the disposition of financial market contracts in bankruptcy also needed to be updated. In the past, changes in how such contracts were handled were made in different statutes at different times creating inconsistencies, as well as persistent uncertainties as to how a given instrument might be handled in bankruptcy. By bringing more consistency and certainty to this process, the Bankruptcy Reform Act promises to reduce the risk that a bankruptcy will create systemic instability, which could affect individuals as well as financial institutions. To the extent that these changes allow financial market participants to more effectively manage market risks, they will also help to promote greater efficiency in the operation of U.S. financial markets.