LEXIS-NEXIS® Congressional Universe-Document

LEXIS-NEXIS® Congressional

MARCH 18, 1999, THURSDAY

SECTION: IN THE NEWS

LENGTH: 3155 words

HEADLINE: PREPARED STATMENT OF
PROF. RANDAL C. PICKER
LEFFMANN PROFESSOR OF COMMERCIAL LAW
UNIVERSITY OF CHICAGO LAW SCHOOL
BEFORE THE HOUSE JUDICIARY COMMITTEE
SUBCOMMITTEE ON COMMERCIAL AND ADMINISTRATIVE LAW
SUBJECT - H.R. 833, THE "BANKRUPTCY REFORM ACT OF 1999"

BODY:

Summary of Written Statement National Bankruptcy Conference
We highlight two areas of particular concern in Title X of H.R. 833: asset securitization and master netting.
Asset Securitization. Section 1012 would change drastically the rules applicable to asset-backed securitizations. It would amend Section 541 of the Bankruptcy Code to make it possible for companies to isolate assets from bankruptcy by choice, regardless of whether there was an actual true sale of the assets in question. The debtor's say so--a simple representation and warranty--would be enough to remove these assets from the debtor's bankruptcy estate.
True sales that are not otherwise subject to avoidance under the fraudulent transfer provisions should be respected in bankruptcy. This is true whether the sold asset is real estate or a car, securities or accounts receivable. The problem that arises--and here is where asset securitization comes in--is that for some assets, the basic notion of sale can be quite tricky. In some versions, true sales take place, in others, this is much less obvious, and the essential point here is that the basic notion of sale in these contexts is quite difficult to apply.
How should we deal with that uncertainty, that is, the uncertainty about whether the structure of a particular asset securitization is or is not a true sale? Current law appropriately leaves these questions to judges, to be resolved under state law, if and when a particular transaction is challenged. Some uncertainty does exist, but notwithstanding these issues, so far, trillions of dollars of asset- securitization deals have taken place, with only a handful of challenges. Section 1012 would overturn a long tradition in commercial law by allowing the mere say so of the debtor to determine how a transaction is characterized. The National Bankruptcy Conference thus believes that the statute should remain unchanged and that Congress should await further judicial development before legislating in this important area.
Master Netting. Section 1007 of H.R. 833 would permit the setoff or netting of claims arising under different financial products without running afoul of the automatic stay. There is no indication that the absence of such cross-product netting features has led to widespread difficulties or systematic disruptions in the financial markets for such products. In addition, master netting could deprive a debtor of much-needed cash collateral, which in some instances may lead to conversion and liquidation to the detriment of other creditors. For these reasons, the master netting provisions should be deleted. *******************
Mr. Chairman and Members of the Subcommittee on Commercial and Administrative Law, I am Randal C. Picker, the Leffmann Professor of Commercial Law at the University of Chicago Law School. I am offering this testimony on behalf of the National Bankruptcy Conference, as Vice-Chair of its Committee on Legislation, and this testimony does not necessarily represent the views of the University. The Conference is a private organization of bankruptcy judges, practitioners, and law professors formed in 1932 to work on proposed revisions of the Bankruptcy Act of 1898. The Conference has functioned since 1932 to advise Congress with respect to issues regarding bankruptcy legislation and laws. As per House Rule XI, clause 2(g)(4), no federal grant, contract, or subcontract has been received by me or the National Bankruptcy Conference, and I have attached to this testimony as Appendix A a copy of my curriculum vitae.
You have asked me to address Title X of the Bankruptcy Reform Act of 1999, on financial contract provisions. These provisions would make many changes to the relevant areas of law. Some of these are largely technical in nature, and I will have very little to say about them. Other changes might appear "technical," as they are not the stuff of everyday family dinner discussion. It would be a substantial mistake to lump the genuinely technical with the provisions that will make important substantive changes to bankruptcy law. In that connection, I will focus on two particular changes: Section 1012 on asset-backed securitizations and Section 1007, which makes a number of changes, including introducing to the Bankruptcy Code the idea of master netting. Both of these would make it possible for sophisticated entities to exclude assets from the bankruptcy estate. This runs contrary to the general history of our bankruptcy laws which have treated as void against public policy agreements seeking to avoid the application of the bankruptcy laws.
I should indicate as a preliminary matter that, as of this date, the National Bankruptcy Conference does not have comments on the provisions of Title X making amendments to the Federal Deposit Insurance Act regarding the definitions and treatment of various financial contracts.(1) The balance of this written testimony consists of two parts: a general discussion of the asset securitization and master netting issues and a detailed section by section analysis of selected provisions in Title X of H.R. 833.
I. Asset Securitization and Master Netting
We highlight two areas of particular concern in Title X of H.R. 833:
- Asset Securitization. Section 1012 would change drastically the rules applicable to asset-backed securitizations. It would amend Section 541 of the Bankruptcy Code to make it possible for companies to isolate assets from bankruptcy by choice, regardless of whether there was an actual true sale of the assets in question. The National Bankruptcy Conference believes that the statute should remain unchanged and that Congress should await further judicial development before legislating in this important area.
- Master Netting. Through a series of inter-related amendments to the Bankruptcy Code, Section 1007 of H.R. 833 would permit the setoff or netting of claims arising under different financial products (see, e.g., portions of proposed new sections 11 USC '' 561, 362(b)(29)) without running afoul of the automatic stay. There is no indication that the absence of such cross-product netting features has led to widespread difficulties or systematic disruptions in the financial markets for such products. In addition, master netting could deprive a debtor of much-needed cash collateral, which in some instances may lead to conversion and liquidation to the detriment of other creditors. For these reasons, the master netting provisions should be deleted.
I will take these one-by-one.
Asset Securitization. Section 1012 of H.R. 833 would introduce a new provision that would exclude from "property of the estate" assets transferred by the debtor in connection with an asset securitization under which investment grade rated debt has been created. "Eligible assets" would be defined broadly to include cash, securities, and all financial assets.

A transaction essentially would be considered a transfer for asset securitization so long as the transaction documentation deemed it as such. Put differently, so long as the company "selling" the assets "represented and warranted" that the sale was a true sale--so long as the debtor-to-be just said it was a true sale--it would be treated as such for bankruptcy purposes, and the "sold" assets would be excluded from the bankruptcy estate if the company eventually filed for bankruptcy.
The issue can be framed quite generally. Suppose that a company sells an asset--a piece of real estate, for example--in a transaction in which it receives reasonably equivalent value for the asset. Say the real estate is worth around $100,000 and the company receives that amount in exchange for it. The company files for bankruptcy soon thereafter, with a good chunk, say $80,000 of the cash in hand. The company did not have title to the real estate when it filed for bankruptcy, so under the general rules for creating the bankruptcy estate under Section 541, the estate also does not have title to the real estate. Instead, the estate gets whatever the company has in hand that it received in exchange for the sold asset when the company files for bankruptcy, here the $80,000.
All of this is as it should be. True sales that are not otherwise subject to avoidance--undoing--under the fraudulent transfer provisions should be respected in bankruptcy. This is true whether the sold asset is real estate or a car, securities or accounts receivable. The problem that arises--and here is where asset securitization comes in--is that for some assets, the basic notion of sale can be quite tricky. I am owed in one year $10,000 by Smithco. I would like cash today. To raise that cash, I "sell" Smithco's promise to me to Buyer for $9,000. Of course, Buyer may not know Smithco at all, so to allay Buyer's concerns about Smithco's ability and willingness to repay the debt in one year, I agree to make good on the debt, in the full amount of $10,000, if Smithco doesn't pay when it is supposed to do so.
Have I really "sold" the debt to Buyer, or has Buyer merely floated a loan to me for one year? The point of this exercise is not to answer this question, because if you are confident about your answer here, I can add or subtract provisions, wrinkle by wrinkle, until I should be able to get you to the point of uncertainty. Asset securitizations, which are essentially highly-complex variants on the Smithco hypothetical, do exactly this. In some versions, true sales take place, in others, this is much less obvious, and the essential point here is that the basic notion of sale in these contexts is quite difficult to apply.
How should we deal with that uncertainty, that is, the uncertainty about whether the structure of a particular asset securitization is or is not a true sale? One possibility--and this is current law--is just to leave these questions to judges, if and when a particular transaction is challenged. The uncertainty just exists and may create a cloud over some transactions, but we get a resolution of the true sale question only if a challenge is ultimately mounted. This will typically turn on the details of state law. Notwithstanding these issues, so far, trillions of dollars of asset-securitization deals have taken place, and we have had only a handful of challenges. A different approach--and this is the point of Section 1012--would be to allow the seller to just deem a sale a true sale by saying it was one, and making that statement dispositive for bankruptcy purposes. We have generally been reluctant to allow the characterization of a deal by the transacting parties to control, and with good reason. The parties to the deal will ignore the consequences to third parties--unsecured creditors, for example--who have no say in how the deal is characterized. There is a third position that would close the gap between simply leaving current law in place or moving to Section 1012's representation and warranty scheme. The third approach would create a separate federal definition of a true sale that would be applied by a judge, usually in bankruptcy, if a transaction was challenged. This would create greater uniformity in sales law as applied to asset securitizations, at the price of invading an area of law traditionally left to state control.
As should be clear, in its current form, Section 1012 would change drastically the rules applicable to asset-backed securitizations. It would amend Section 541 of the Bankruptcy Code to make it possible for companies to isolate assets from bankruptcy by choice, regardless of whether there was an actual true sale of the assets in question. The National Bankruptcy Conference believes that the statute should remain unchanged and that Congress should await further judicial development before legislating in this important area.
The need for Section 1012 is highly questionable. The current existence of a robust asset-securitization business, coupled with the existence of minimal case law in the area, suggest that special Bankruptcy Code treatment is unnecessary. The broad definition of "transferred" in Section 1012 is likely to cause certain financing arrangements to be treated as sales to prevent the debtors' assets from being considered property of the estate even though they are only pledged as collateral. The proposed provision makes no effort to distinguish those transactions properly characterized as "true sales" from those legitimately subject to characterization as security interests. At the very least, the language should be amended to limit the provision's application to securitizations which are, in economic substance, true sales.
We should be clear on the purpose of securitization. As described by The Committee on Bankruptcy and Corporate Reorganization of The Association of the Bar of the City of New York in its report on "Structured Financing Techniques" in The Business Lawyer of February 1995, "structured financings are based on one central, core principle--a defined group of assets can be structurally isolated, and thus serve as the basis of a financing that is independent as a legal matter, from the bankruptcy risks of the former owner of the assets." Assets that would otherwise be part of the bankruptcy estate had the original transaction been structured as a secured financing are outside of bankruptcy if the transaction structure is respected.
Many believe that securitization is socially useful in that it may reduce the cost of obtaining cash by making it easier for our certain borrowers to access public markets. There is also a general concern that uncertainty about the status of asset securitization prevents deals from going forward, though you would not know it by the number of securitizations that take place. Notwithstanding this, we have had a long-standing policy in this country of not permitting individuals or companies to opt out of bankruptcy. Waivers of the right to file for bankruptcy are seen as void against public policy. Section 1012 obviously does not validate general waivers of the right to file for bankruptcy, but it does make it possible to isolate from bankruptcy assets that would otherwise become part of the bankruptcy estate.
We should tread cautiously here. What is less well understood, or at least less well-publicized, is the possible harm to the bankruptcy estate and other creditors that may result from securitized financings. There is an academic literature that emphasizes that securitization may have the consequence of creating judgment-proof entities. See Lynn M. LoPucki, The Death of Liability, 106 Yale L J 1, 28-29 (1996); Lois R. Lupica, Asset Securitization: The Unsecured Creditor's Perspective, 76 Tex L Rev 595 (1998). This debate is ongoing and is far from unanimous. See James J. White, Corporate Judgment Proofing: A Response to Lynn LoPucki's The Death of Liability, 107 Yale L J 1363 (1998), and the further response by Lynn M. LoPucki, Virtual Judgment Proofing: A Rejoinder, 107 Yale L J 1413 (1998).
These issues are unresolved, because there have been almost no cases addressing the consequences of securitization in bankruptcy. There are a handful of unreported opinions and almost no reported opinions. Usually, judicial development of an area gives us a full sense of the issues raised by any new practice. It is the interaction of case law and legislation that is the genius of the American system. We will artificially truncate this process were Congress to adopt the broad exemption set forth in Section 1012.
The National Bankruptcy Conference thus believes that no change is warranted now and that we should wait additional judicial development to better understand consequences of this financial innovation for bankruptcy. The proposed change might easily hurt creditors and decrease the likelihood that a business can reorganize because the business will have no cash collateral to fund operations. Rating agencies and private parties should not be authorized to make the legal determination of whether an asset is property of a bankruptcy estate. This provision also would invade states right by treating "sales" voidable under state law as effective in bankruptcy.
Master Netting. H.R. 833 contains numerous provisions addressing the bankruptcy treatment of certain financial products and financial transactions. Most of these provisions are unobjectionable, as they seek to protect important financial markets by eliminating inconsistencies in the treatment of these transactions and products and to protect additional counterparties. However, the provisions relating to master netting are objectionable and should be eliminated.
The Bankruptcy Code currently contains a number of special provisions that exempt certain financial transactions from the scope of the automatic stay and from the general rules in Section 365 which ban ipso facto clauses (that is, contractual rights triggered by a bankruptcy filing). These are in Section 362(b) and Section 555 on securities contracts; Section 556 on commodities contracts and forward contracts; Section 559 on repurchase agreements (which includes reverse repurchase agreements); and Section 560 on swap agreements. There are also a series of corresponding definitions in Section 101. These provisions currently create a special exemption for these financial transactions to permit market participants to do with-in product setoff or liquidations. By "within-in product" I mean, for example, that that a swap participant can setoff claims against a debtor relating to the swap agreement against monies owed by the swap participant to the debtor in connection with that swap agreement or can liquidate securities held as collateral to support the debtor's obligations under the swap agreement.
What a market participant cannot do is setoff across products, so- called cross-product netting, or in the language of H.R. 833, master netting. So, a market participant with securities collateral for a swap agreement cannot use the collateral with the benefits of the Section 362(b) exceptions to cover payments under a non-swap agreement, say a securities contract. The precise point of the new provisions in Section 1007 that would add Sections 561 and 362(b)(29), and a definition of a master netting agreement in 101(38B) is to make cross-product netting possible.
There is no indication that the absence of such cross-product netting features has led to widespread difficulties or systematic disruptions in the financial markets for such products. The expansion of these provisions would take us farther down the path of allowing sophisticated parties to opt out of bankruptcy. In addition, cross- product netting could deprive a debtor of much-needed cash collateral, which in some instances may lead to conversion and liquidation to the detriment of other creditors.
For these reasons, the master netting provisions should be deleted.

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