A recent ruling by a bankruptcy judge in New York adds to a growing body of opinions that appear to leave the door open for actions under state law that would normally be prohibited in federal bankruptcy proceedings.
The issue concerns the so-called safe harbor provisions of the bankruptcy code, which exempt derivatives and other securities transactions from the usual stay that blocks creditors’ efforts to collect debts. Last week, Judge Robert E. Gerber of Federal Bankruptcy Court in Manhattan ruled in a lingering part of a case involving the Lyondell Chemical Company that the safe harbor provisions applied only to the bankruptcy process.
His decision joined the mini-trend of court opinions that do not extend the exemptions to state courts. That is, while a bankruptcy trustee or debtor might be precluded from bringing a fraudulent transfer action in bankruptcy court, creditors retain their right to do so under nonbankruptcy state law. In the Lyondell case, Judge Gerber refused to dismiss a lawsuit initially brought in New York State court that seeks to claw back $12.5 billion paid to shareholders as part of merger deal.
Given the statutory language of the bankruptcy code, this seems like the right result.
But consideration of the justification for the safe harbors makes this a somewhat more difficult matter.
The safe harbors were created for certain transactions because of the fear of systemic risk â€" if one bankrupt institution failed to make payment, it could quickly bankrupt its trading partners, and they, in turn, might bankrupt their other trading partners, setting off a dangerous domino effect. Namely, the safe harbors are said to be required because financial markets need certainty, or finality, and pesky bankruptcy trustees can upset that.
The primary way that trustees can upset such finality is through “avoidance actions,†which include fraudulent transfer claims, preference actions and perhaps some breach of fiduciary duty claims, too. The sticky issue is, most of these actions can also be brought by creditors under state law.
So it has always been something of a mystery to me why there has never been much of an effort to enact safe harbors at the state level, except for a few put into state insurance receivership statutes, but those simply reflect the fact that insurance companies cannot file for bankruptcy. It is not as if all 50 states would have to get on board, either, because enacting safe harbors in New York would cover the vast bulk of the relevant transactions.
If the uncertainty of a world without safe harbors might create systemic risk, why only address half of the problem?
It leads one to suspect that perhaps systemic risk is not the real issue here and that the safe harbors might instead simply be evidence of Congress favoring derivatives markets over restructuring. Either that or the bankruptcy code as interpreted by Judge Gerber is not quite achieving what it should.
I suspect the former; but I also suspect that most of Lower Manhattan disagrees with me.
Stephen J. Lubben is the Harvey Washington Wiley Chair in corporate governance and business ethics at Seton Hall Law School and an expert on bankruptcy.
