NYTimes Dealbook is reporting that last Friday, when the city of Detroit sought approval to borrow $350 million from Barclays Capital to pay payroll and to pay off their interest rate swap counterparties* Judge Rhodes ignored the Bankruptcy Code’s “Safe Harbor” provisions and sent two bank lenders into a confidential mediation through Christmas Eve so that the swap counterparties could “improve the deal for the city.”

I’m not really following this bankruptcy case, but I would like to think that I am well-versed in the arguments of the role of the “Safe Harbor” provisions of the Bankruptcy Code, or the swaps and derivatives treatment in Bankruptcy court.  If nothing else, I’m very passionate about the safe harbor provisions.

Under the Bankruptcy Code, interest rate swap counterparties are entitled to full payment.  In fact, swaps and derivatives counterparties in a bankruptcy are allowed to (and I’m oversimplifying here) ignore the automatic stay, terminate their derivatives contract, and seize underlying collateral.  No other creditors (that I know of) have such latitude in a bankruptcy case.

In this case, Detroit’s swap counterparties are already taking 70% rather than the full 100% to which they are entitled.  The Judge does not want to allow even 70% because that is too preferential, so he sent them to mediation so that the city can get a better deal.  This means that the counterparties will either: (1) rest on their laurels in the mediation because if they come out with no deal then they can argue that they are entitled to 100% via the Bankruptcy Code; or (2) take a lower payout and risk a shareholder lawsuit.  Under option (1) the Judge will need to use his 105(a) powers or make a bold move that could later be overturned by a higher court.  Obviously, the Judge hopes that the parties will mutually agree to a lower amount without having to defy the Bankruptcy Code in court.**

The reason the “Safe Harbors” exist is to prevent a bankruptcy filing from creating systemic risk, which might happen if the swaps and derivatives counterparties were unable to escape the jaws of a bankruptcy court.  Swaps and Derivatives are regulated outside of bankruptcy courts, and the regulations have been bolstered sharply by Dodd Frank.

Scholars note that derivatives originated as an insurance against default and that the “Safe Harbors” did not pose a problem until the financial industry firms actually started filing Chapter 11 because they were speculating in these swaps and derivatives.  Thus, Lubben concludes that the “Safe Harbors” are not so disruptive unless debtors are financial firms.

There are good cases to be made for for the current treatment of swaps & derivatives in bankruptcy.  The Systemic Risk argument is a good one: if AIG was allowed to fail the systemic risk could have been enormous, costing swap counterparties $180 billion.  Also, how about certainty in bankruptcy courts?  The more judges use their 105(a) powers, the less ability one has in predicting what is a likely outcome in bankruptcy and the more room for human error.  I believe, as do many other very smart people, that the “Safe Harbors” should be upheld in bankruptcy courts.

Of course I could be convinced to the contrary.  The counterarguments, or arguments that the “Safe Harbors” are not necessary are numerous and may have merit.

One common argument brought up is the cherry-picking problem, whereby the Debtor is able to “cherry-pick” which contracts it wants to perform.  The problem with this argument, as it relates to the “safe harbor” provisions, is that a debtor can always choose which executory contracts to assume and which to assign, and which to reject in bankruptcy. Thus, this problem is not unique.

I should probably continue this post and further develop my arguments in another post.

*$230 million would have paid off swap counterparties while the rest of the proceeds from the loan, $120 million, would go to the streetlights, the police, the razing of dilapidated properties and other city services that the residents of Detroit sorely need.

**I don’t really practice Bankruptcy Law, I just really like it.  I do currently have a pending securities litigation case as an adversary proceeding in New York’s Southern District.

Please email Gilbert J. Bradshaw of The Bradshaw Law Group at gil@bradshawlawgroup.com for any questions about securities regulation.

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