The Banker’s Protection Act

What you don't know about the new bankruptcy act won't hurt your company. Unless it gets into trouble.

Expect TV news shows to feature plenty of unhappy people behind bill-strewn kitchen tables this month when the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 kicks in. Tough on consumers, the act was a big win for the banks that issue their credit cards and loans. The new law cracks down hard on corporate debtors, too, but the lack of a clear-cut populist angle has kept mainstream media coverage to a minimum. The most widely reported of the nonconsumer provisions tend to squeeze corporate debtors to the benefit of groups such as utilities and landlords (bankrupt companies, for example, must decide more quickly whether to keep or shed leases).

In fact, banks are big winners on the nonconsumer side, too. But you won’t see that on the news — the biggest boon comes from esoteric provisions that even now are little known or understood outside Wall Street. These changes, which essentially shield derivatives and other complex financial contracts from the slow grind of bankruptcy proceedings, are intended to boost the financial system’s immunity to serious shocks. Less clear, however, is the impact such changes may have on corporate users of these instruments. Some argue that the changes will lower risk, and therefore cost, but others fret that the new provisions put additional pressure on companies facing insolvency.

Without a Net

That the banking industry had a heavy hand in rewriting the bankruptcy code was most evident in a self-serving change to the nonconsumer provisions. The code has long defined individuals whose conflicts of interest prohibit them from acting as advisors to bankrupt companies. The 2005 act carefully deletes the words “investment banker” — five times — from that definition.

That’s a clear lobbying success for bankers looking for an extra source of advisory fees. But for years, a far more important industry goal — keeping derivative contracts out of court when one party goes bankrupt — proved elusive. Despite universal support from U.S. banking and securities regulators, passage of many of these so-called safe-harbor protections has — until now — been tied to bankruptcy bills that sank under the controversial weight of their consumer provisions, or in one instance, a political battle over abortion.

Because derivative contracts often involve offsetting positions between counterparties, they are typically settled by netting — that is, the amount each counterparty owes is netted against the other, and a single payment is made by whichever party owes more. This eliminates large fund transfers in both directions. Counterparties also usually agree to “closeout netting,” which means that in the event that one of them defaults, the other may terminate the contracts, mark to market their remaining value, and then seize any net amount that is owed.

In most cases, however, default goes hand in hand with a bankruptcy filing. And before the latest act became law, closeout netting often conflicted with bankruptcy’s automatic stay, which prevents creditors from seizing collateral or terminating contracts once a company has filed for Chapter 11 protection.

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