Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges

Abstract

The reforms of 2005 yield important but subtle changes in the Bankruptcy Code's treatment of financial contracts. They might appear only to eliminate longstanding uncertainty surrounding the protections available to financial contract counterparties, especially counterparties to transactions and other derivative contracts. But the ambit of the reforms is much broader. The expanded definitions - especially the definition of swap agreement - are now so broad that nearly every derivative contract is subject to the Code's protection. Instead of protecting particular counterparties to particular transactions, the Code now protects any counterparty to any derivative contract. Entire markets have been insulated from the costs of a bankruptcy filing by a financial contract counterparty. Equally important, the amendments limit judicial discretion to assess the economic substance of financial transactions, even those that resemble ordinary loans or that retire a debtor's outstanding debt or equity. The reforms of 2005 direct judges to apply a formalistic inquiry based on industry custom: a financial transaction is a swap, repurchase transaction, or other protected transaction if it is treated as such in the relevant financial market. The transaction's loan-like features or its effect on outstanding obligations of the debtor are irrelevant, unless they affect the transaction's characterization in financial markets. Absent fraud, form trumps substance - a desirable outcome, we argue, in light of the impossibility of drawing coherent lines between combinations of ordinary financial contracts and loans, dividends, or debt repurchases.