Should Derivatives Be Privileged in Bankruptcy?

Abstract

Derivatives enjoy special status in bankruptcy: They are exempt from the automatic stay and effectively senior to virtually all other claims. We propose a corporate finance model to assess the effect of these exemptions on a firm's cost of borrowing and its incentives to engage in efficient derivative transactions. While derivatives are value-enhancing risk management tools, seniority for derivatives can lead to inefficiencies: It transfers credit risk to debtholders, even though this risk is borne more efficiently in the derivative market. Seniority for derivatives is efficient only if it provides sufficient cross-netting benefits to derivative counterparties that provide hedging services. * Bolton is at Columbia University, NBER, and CEPR. Oehmke is at Columbia University. For helpful comments and suggestions, we thank two anonymous referees, an associate editor, Viral Acharya, Jun Kyung Auh, Ulf Axelson, Ken Ayotte, Mike Burkart, Doug Diamond, Darrell Duffie, Yaniv Grinstein, Oliver Hart, Gustavo Manso, Ed Morrison, David Scharfstein, Ken Singleton (editor), Jeremy Stein, Suresh Sundaresan, Vikrant Vig, Jeff Zwiebel, and seminar participants at Columbia University, the UBC Winter Finance Conference, Temple University, University of Rochester, the Moody's/LBS Credit Risk Conference, LSE, LBS, Stockholm School of Economics, Mannheim, HEC, INSEAD, CEU, the 2011 ALEA meetings, the 4th annual Paul Woolley Conference, the 2011 NBER Summer Institute, ESSFM Gerzensee, the 2011 SITE Conference, ESMT Berlin, Harvard Law School, Harvard Business School, Chicago Booth, University of Amsterdam, EPF Lausanne, Stanford GSB, Berkeley, the NY Fed workshop on the automatic stay, the 2012 WFA meetings, Wharton, and Boston University.Derivative contracts enjoy special status under U.S. bankruptcy law: Derivative counterparties are exempt from the automatic stay, and-through netting, closeout, and collateralization provisionsthey are generally able to immediately collect payment from a defaulted counterparty. 1 Taken together, these special provisions make derivative counterparties effectively senior to almost all other claimants in bankruptcy. The costs and benefits of this special treatment are the subject of a recent debate among legal scholars, policymakers, and regulators. Notably, this debate is characterized by considerable disagreement about the costs and benefits of the special bankruptcy treatment of derivatives, which is reflected in substantial differences in the bankruptcy treatment of derivatives across different jurisdictions. 2 In this paper we provide the first formal analysis of the economic consequences of the privileged treatment of derivative contracts in bankruptcy. The fundamental observation underlying our analysis is that (effective) seniority for derivatives does not eliminate default risk-it transfers default risk from derivative counterparties to other claimholders, particularly creditors. The desirability of seniority for derivatives thus depends on whether default risk is more efficiently bor...

Policy uncertainty, derivatives use, and firm-level FDI

“…Within this framework, Bolton and Oehmke (2015) show that by allowing transfers of cash from world states correlated with high-cash flow realizations to states correlated with low-cash flow realizations, derivative contracts help firms manage uncertainty more effectively.…”

“…Our conjecture is built upon a number of theoretical and empirical studies. In one theoretical study, Bolton and Oehmke (2015) extend the standard incomplete contracts framework in corporate finance, by introducing derivative contracts that allow firms to arrange state-contingent transfers with separate derivative counterparties. Specifically, derivatives allow for payments tied to publicly observable and verifiable events that are correlated with firms' unobservable (or unverifiable) cash flow outcomes.…”

Bank Insolvencies, Priority Claims and Systemic Risk

“…Because the latter have a higher proportion of unsecured and international deposits, they faced a greater risk from the actions of those parties' national governments to protect them. 13 Concerns have also been expressed more recently by Partnoy and Skeel (2007) and Perotti (2010) in response to bankruptcy privileges granted in 2005 11 See Mantripragada (1992) for support of this view from a legal perspective. 12 There is a similarity between this argument and the theoretcal argument put forward by Bolton and Oehmke (2015) related to the role of derivatives.…”

“…13 Concerns have also been expressed more recently by Partnoy and Skeel (2007) and Perotti (2010) in response to bankruptcy privileges granted in 2005 11 See Mantripragada (1992) for support of this view from a legal perspective. 12 There is a similarity between this argument and the theoretcal argument put forward by Bolton and Oehmke (2015) related to the role of derivatives. 13 The 1993 Act placed international deposits very low on the priority ladder in both the US and Europe to overnight secured credit and derivatives that have e¤ectively allowed these lenders to claim priority over all other creditors in case of default.…”

“…However, on the liability side of the balance sheets of banks we …nd other claims by …nancial institutions that are secured and therefore occupy the top step in the hierarchy ladder. Bolton and Oehmke (2015) analyze the seniority status of derivatives. They conclude that while these claims enhance value by providing risk management solutions, their seniority status can lead to ine¢ciencies as it transfers risk to other liabilityholders, such as depositors.…”