The collapse of Long Term Capital Management ("LTCM") in Fall 1998 and the Federal Reserve Bank's subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the "automatic stay" and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor's assets. It is commonly believed that the exemption for derivatives contracts helps reduce "systemic risk" in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity. Indeed, Congress is now contemplating reforms that would extend the exemption to include a broader array of financial contracts, all in the name of reducing systemic risk. This is a mistake. The Bankruptcy Code can do little to reduce systemic risk and may in fact exacerbate it, as the experience of L TCM suggests. Risk of a systemic meltdown arose there and prompted intervention by the Federal Reserve precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring.
Franklin R. Edwards & Edward R. Morrison,
Derivatives and the Bankruptcy Code: Why the Special Treatment?,
Yale J. on Reg.
Available at: http://digitalcommons.law.yale.edu/yjreg/vol22/iss1/4