Immediately Repaying Chapter 11

Chapter 11 stops bankrupts from immediately repaying their creditors, so that the court can reorganize the debtor without creditors shredding the bankrupt firm’s business.

Not so for the bankrupt’s derivatives counterparties, who can seize and liquidate collateral, net out gains and losses, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor in ways that favor them over other creditors. Their right to jump to the head of the bankruptcy repayment line, ahead of even ordinary secured creditors, warps their pre-bankruptcy incentives to monitor the pre-bankruptcy debtor and adjust their investments to better account for counterparty risk, since they do well in any resulting bankruptcy. If they bear less risk, other creditors bear more risk and have more incentives to monitor the debtor. But the other creditors — such as the United States of America are poorly positioned to provide that monitoring. Moreover, the policy justification for the super priorities reducing financial contagion risk is difficult to maintain today: contagion is as likely to be propagated by the priorities as it is to stifled, the priorities did not prevent contagion in the 2007-2008 financial melt-down and may have spread it, and we use alternate resolution mechanisms anyway. Bankruptcy policy was made in the erroneous belief that it could contain contagion and that there were no other ways to do so. The best regulatory reaction to this monitoring disconnect is for Congress to repeal the extensive de facto priorities now embedded in chapter 11 for these derivatives counterparties. Repeal would induce the derivatives market to better recognize the risks of counterparty financial failure, which in turn should better stabilize the financial system and dampen the possibility of another AIG/Bear/Lehman financial melt-down, thereby helping to maintain financial stability. Yet the major financial reform packages now in Congress do not contemplate the needed repeal.