Current Safe-Harbor Treatment for Financial Contracts under the Code

Although the automatic stay generally preserves assets and prevents  creditors from taking company assets in payment of debts before a case  is resolved and assets are distributed in a systematic way, it is subject to  exceptions, one of which can be particularly important in a financial  institution bankruptcy. Although experts broadly supported regulatory involvement in financial  company bankruptcies, they said the proposed changes raise several  implementation issues, such as determining the number of days prior to a  bankruptcy that a company would be required to notify regulators and  which regulator(s) to notify. One  expert noted that because large financial companies have many  regulators, before a firm could file for bankruptcy it would be important to  identify in advance which regulators to notify. Experts Considered Fully Secured Federal or Industry Funding Mechanisms Essential for Orderly and Efficient Bankruptcies

Experts at our roundtables emphasized that many of the proposals to  make the bankruptcy process more orderly and effective depend on  having an adequate funding mechanism. As a result, experts at the first  roundtable generally agreed that changing the Code to prevent any  federal funding of these bankruptcies would not be consistent with orderly  and effective resolutions. The industry could create a fund or mechanism for providing liquidity  to firms that needed it. A few of the experts noted that some government guarantees might  facilitate private-sector financing. Experts Had Varying Views on Advantages and Disadvantages of QFC Proposals

Experts at our roundtables evaluated proposals to change the treatment  of certain QFCs relative to criteria for orderly and effective financial  company bankruptcies. For example, with regard to the  safe-harbor exemptions from avoidance actions—trustees’ ability to  “avoid” transfers entered into in the 90 days prior to a bankruptcy if they  are determined to be preferential or up to 2 years prior to a bankruptcy if  they are determined to be fraudulent—some legal experts at the second  roundtable said that the courts were giving preferential treatment to  contracts that in principle should not be receiving it. The expert and others said that it might be useful  to allow a judge to make decisions relative to some contracts. When explicitly asked, some experts responded that limiting the safe  harbors would increase systemic risk, while others responded that limiting  them would reduce it. One  expert at the second roundtable noted that during the early days of the  Lehman Bankruptcy, he thought that the QFC terminations would lead to  a systemic event in derivatives markets, but that did not happen. Roundtable participants also discussed whether a temporary stay for  QFCs would enhance the value of a financial company; however, as  noted earlier, they were split on whether this would contribute or detract  from the overall orderliness and effectiveness of financial company  bankruptcies. FSOC—which was established under the Dodd-Frank Act  to identify and respond to threats to financial stability—has not specifically  considered changes to the role of regulators in bankruptcy or the  treatment of QFCs. Recommendations for Executive Action

To fulfill FSOC’s role under the Dodd-Frank Act to identify and respond to  threats to financial stability, we recommend that the Secretary of the  Treasury, as Chairperson of FSOC, in consultation with other FSOC  members, consider the implications for U.S. financial stability of changing  the role of regulators and narrowing the safe harbor treatment of qualified  financial contracts in financial company bankruptcies. In commenting on our draft report, FSOC said that it shares our concern  that a disorderly financial company bankruptcy could pose risks to  financial stability. Given that preference and FSOC’s charge to identify  and respond to risks to U.S. financial stability, our recommendation—that  FSOC consider the implications for U.S. financial stability of changing the  role of regulators and narrowing safe harbor treatment of QFCs in  financial company bankruptcies—is consistent with its statutory role and  responsibilities. This report, the third in the series, examines the advantages  and disadvantages of certain proposals to modify the Bankruptcy Code  (Code) for financial company bankruptcies. Specifically this report  examines the advantages and disadvantages of proposals (1) to change  the role of financial regulators in the bankruptcy process; (2) affecting the  funding of financial company bankruptcies; and (3) to change the safe- harbor treatment of qualified financial contracts (QFC), including  derivatives and repurchase agreements. These criteria are minimizing systemic  risk, avoiding fire sales, maximizing value; preserving due process, and  minimizing taxpayer liability. QFCs are generally also exempt from avoidance or claw back provisions  under the Code.
Why GAO Did This Study

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) mandates that GAO report on an ongoing basis on ways to make the Code more effective in resolving certain failed financial companies. This report examines advantages and disadvantages of certain proposals, based on those identified in GAO's first report, to revise the Code for financial company bankruptcies--specifically, proposals (1) to change the role of financial regulators in the bankruptcy process; (2) affecting funding of financial company bankruptcies; and (3) to change the safe-harbor treatment of QFCs. For this report, GAO held two expert roundtables in which participants evaluated the proposals using criteria for orderly and effective bankruptcies that GAO developed in earlier reports. The criteria are minimizing systemic risk, avoiding asset fire sales, ensuring due process, maximizing value, and limiting taxpayer liability. GAO identified these criteria by reviewing literature and interviewing government officials, industry representatives, and legal and academic experts.

What GAO Found

Because the Bankruptcy Code (Code) does not specifically address issues of systemic risk, experts have proposed giving financial regulators a greater role in financial company bankruptcies. However, according to experts at a GAO roundtable, such proposals may have limited impact and raise certain implementation issues. For example, a proposal to require notification before bankruptcy depends on when (number of days) notification would be required and with whom (which regulators). Experts noted financial companies may not know that they will declare bankruptcy even a few days before the event and could have many regulators to notify. Experts also noted ways regulators already can compel financial companies to declare bankruptcy, and that changing the Code to allow regulators to place firms in bankruptcy involuntarily could temporarily place a firm in an uncertain legal status, eroding firms' values and endangering market stability. Other options, such as having regulatory standards forcing the firm into bankruptcy, could improve the likelihood of an orderly resolution, according to these experts. Although the proposals reflect the need to minimize systemic effects of financial company bankruptcies, the Financial Stability Oversight Council (FSOC)--charged with responding to threats to financial stability--has not considered changes to the Code. Consideration could improve FSOC's ability to address such threats in a timely and effective manner.
Experts emphasized that funding is needed to facilitate orderly and effective financial company bankruptcies. They generally agreed that prohibiting all federal funding or guarantees of private funding likely would lead to fire sales of assets. They agreed that fully secured funding should be used only to provide short-run liquidity and not for bailouts of insolvent firms' creditors. Experts suggested a private-sector fund could be created for this purpose. Such funds could be collected voluntarily, through routine assessments (before a bankruptcy), or through a facility similar to the one created for the Orderly Liquidation Authority, which allows federal funding at the time of a bankruptcy and later recovery of funds through an industry assessment. Experts noted some difficulties associated with these proposals, including determining whether a firm was insolvent or needed liquidity, and identifying permissible types of collateral.
Generally, experts did not agree on advantages or disadvantages of proposals to change the safe-harbor treatment of qualified financial contracts (QFC). The Code exempts QFCs, such as derivatives, from the automatic stay that generally prevents creditors from taking company assets in payment of debts before a case is resolved. It also exempts QFCs from provisions that allow bankruptcy judges to "avoid" contracts entered into within specified times before a filing. Proposals to change QFC treatment--subjecting all or some contracts to the automatic stay on a permanent or temporary basis and removing the avoidance exemptions--might address issues raised by extensive contract terminations in the early days of financial company bankruptcies. Experts said it was unclear what lessons should be learned from those experiences. Many noted that narrowing the exemptions would reduce the size of derivative markets, but views varied about whether such narrowing would increase or decrease systemic risk. Some experts said that the current safe harbors decrease systemic risk, while others said they increase it by making firms more dependent on less-reliable short-term financing.

What GAO Recommends

FSOC should consider the implications for U.S. financial stability of changing the role of regulators and the treatment of QFCs in financial company bankruptcies. FSOC agreed that a disorderly financial company bankruptcy could pose risks to financial stability, but stated that it would be premature for FSOC to consider proposals to change the Code. GAO reiterated that its recommendation was consistent with FSOCs statutory role and responsibilities.