The following is an excerpt of Hughes Hubbard Partner Christopher K. Kiplok’s written statement and testimony to the American Bankruptcy Institute’s Commission to Reform Chapter 11.
The Commission invited Mr. Kiplok to testify regarding the current safe harbor provisions and his recommendations for proposed reforms. Further information regarding the Commission can be found here.
Consideration Should be Given to the Impact of the Safe Harbors on a Debtor Post-Petition; the Benefit of Safe Harbor Protections Should be Tied to an Obligation to Inform the Estate of the Closeout of the Transaction
A laudable goal of the safe harbor provisions is to assist the financial markets by encouraging continued transactions during periods of distress. This goal was to a significant degree met during the worst periods of the financial crisis, as thousands of counterparties continued to do business with struggling institutions, providing transaction flow and liquidity that may have helped prevent additional firm failures.
However, in the event of a failure, particularly a financial firm failure, the safe harbors as currently drafted do little to assist the debtor in understanding the impact of counterparties who exercise their safe harbor rights.
This has been manifest in the liquidations of Lehman Brothers Inc. and MF Global Inc., where several hundred counterparties availed themselves of safe harbor protections on instruments involving tens of billions of dollars.
The unwinding of these financial products – including repurchase and reverse repurchase transactions, securities lending transactions, derivatives transactions, and to-be-announced mortgage transactions – has resulted in well over $4.5 billion in assets marshaled for the two estates. However, with a few exceptions, this process has been arduous and expensive, and the results for the estates come only out of an aggressive and innovative asset collection regime that future estates may not necessarily be in a position to establish, or to fund.
Current law provides little incentive for counterparties to self-report to a debtor and, with perhaps exception for an auditor’s demand to maintain a reserve, few do. At best, counterparties have no reason to report their termination values to the estate and wait for a demand letter, Rule 2004 subpoena, or an adversary proceeding to begin a dialogue. At worst, counterparties frustrate a debtor’s attempt to marshal estate property, by withholding information to gain a financial advantage.
A. The Debtor’s View of a Closeout – Consideration of a Reporting Requirement
A reporting requirement to the exercise of safe harbor rights could help further the policy goals of the safe harbors both pre and post petition, as speeding the return of estate property can only help expedite distributions and therefore return of capital to the marketplace.
In the Lehman Brothers and MF Global liquidations, nearly all the counterparties have been highly sophisticated market participants that engaged in complex transactions worth millions or even billions of dollars and, as such, are fully aware of (i) their rights and obligations regarding the closeout of transactions, and (ii) their financial exposure to the estate resulting from the closeout, including whether an estate receivable or payable exists.
While solvent, functioning counterparties may have this information readily available, in practice estate professionals can be required to expend tremendous effort and expense to determine which counterparties had payables to the estate, send inquiry or demand letters to such counterparties (if not subpoenas), and then conduct the reconciliation of the outstanding accounts. Even then, many of the counterparties can be slow to respond to requests for information or support for their closeout calculation, and subpoenas and/or litigation may be necessary.
It would aid future debtors if, within a period such as the bar date, financial product counterparties were required to provide the debtor, trustee or other liquidator information regarding their terminated transactions, together with summaries setting forth: (i) the trade information, closeout date and amount believed to be owed; (ii) any collateral or other property of the estate being held by the counterparty; (iii) the valuation statements and the methodology employed in calculating valuation; and (iv) the nature and amount of any setoff or other deduction or adjustment the counterparty intends to assert. The Counterparties should also identify any collateral held, and provide a representation that the submission is a complete list as along with copies of supporting contractual documents.
The debtor should in turn provide to financial product counterparties, if possible, and post on its own and others’, such as SIFMA’s, websites: (i) the updated mailing address to which the counterparties should send a copy of their termination notices, valuation statements, notices of default and other correspondence; (ii) the updated bank/securities account(s) information to which counterparties should make payments of cash or transfer of securities, as applicable, and (iii) the name and address of the trustee’s or other liquidator’s legal counsel to whom legal questions should be directed.
A debtor should also (i) implement a standardized format (as determined by the financial/accounting professionals) as to the type of information that should be provided for each financial product, and (ii) require that such reconciliation information, in addition to hard copies, be provided in a modifiable electronic format, e.g., excel format (no pdfs).
B. Special Considerations for Clearing Bodies
Clearing banks hold enormous amounts of collateral which, under current safe harbor provisions, they are able to hold or liquidate with little or no visibility or accountability until well into a bankruptcy. These entities need security and should not be prevented from exercising legitimate rights of secured creditors; however, there should be visibility for the estate and accountability by the clearing entity in contemporaneous fashion.
In the critical early days of the Lehman and MF Global failures, access to data screens at clearing banks was limited or nonexistent. This resulted in each estate expending substantial resources to identify the ownership and interest in securities that were part of trades or other transactions.
To remedy this challenge for future estates, the bilateral information systems on which a broker-dealer relies in conducting business with its clearing bank should maintain visibility to information even if electronic trading access to accounts is cut off or activity in the accounts is frozen.
Future liquidators should be provided with continuous, unimpeded access to systems that monitor activity, and transmission of information by clearing banks should be continued without interruption on the same basis as prior to the bankruptcy. This information flow should include daily reports identifying (i) CUSIP-level detail of securities transactions that will occur post-filing, including trade settlements and unwinds of repurchase transactions, covering both the debtor’s outgoing obligations and anticipated receivables and (ii) securities that the clearing banks have liquidated. Requiring clearing banks to maintain systems visibility will ensure that any actions taken in their capacity as creditors of the estate are done with complete transparency and accountability.