Safe Harbor for Whom, and from What?

All animals are equal, but some animals
are more equal than others.
George Orwell, Animal Farm

In 2005, less than two years before onset of the Global Financial Crisis, “safe harbor” provisions in the U.S. Bankruptcy code were significantly changed. “Safe harbor” sounds like a good thing, but again, this was about making it absolutely certain that secured creditors can take client assets, and that this cannot be challenged subsequently. This was about “safe harbor” for secured creditors against demands of customers to their own assets.

Here are some explanatory excerpts from the online article “The Effect of the new Bankruptcy Code on Safe Harbor Transactions” [20]:

On October 17, 2005, the provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the 2005 act) became effective, amending various provisions of the U.S. Bankruptcy Code … Of particular significance are the provisions of the 2005 act that address the bankruptcy treatment of various “safe harbor” transactions, such as forward contracts, commodity contracts, repurchase agreements and securities contracts.

Historically, under U.S. Bankruptcy Code, a bankruptcy trustee could avoid transfers, i.e. force disgorgement or repayment, if

So now, with the new “safe harbor” provisions, the transfer of customer assets to creditors previously considered to be fraudulent can no longer be challenged. That was exactly the point. Further, it is now quite OK for the transfer of the public’s assets to be made free-of-payment (FoP), as there is no requirement to show that reasonably equivalent value was received.

Stephen J. Lubben is the Harvey Washington Wiley Chair in Corporate Governance & Business Ethics at Seton Hall University and an expert in the field of corporate finance and governance, corporate restructuring, financial distress and debt. Below are some excerpts from his book “The Bankruptcy Code Without Safe Harbors” [21]:

Following the 2005 amendments to the Code, it is hard to envision a derivative that is not subject to special treatment.

The safe harbors cover a wide range of contracts that might be considered derivatives, including securities contracts, commodities contracts, forward contracts, repurchase agreements, and, most importantly, swap agreements.  The latter has become a kind of ‘catch-all’ definition that covers the whole of the derivatives market, present and future …

A protected contract … is only protected if the holder is also a protected person, as defined in the Bankruptcy Code.  Financial participants—essentially very large financial institutions—are always protected.

The safe harbors as currently enacted were promoted by the derivatives industry as necessary measures … The systemic risk argument for the safe harbors is based on the belief that the inability to close out a derivative position because of the automatic stay would cause a daisy chain of failure amongst financial institutions.

The problem with this argument is that it fails to consider the risks created by the rush to close out positions and demand collateral from distressed firms. Not only does this contribute to the failure of an already weakened financial firm, by fostering a run on the firm, but it also has consequent effects on the markets generally … the Code will have to guard against attempts to grab massive amounts of collateral on the eve of a bankruptcy, in a way that is unrelated to the underlying value of the trades being collateralized.

The new safe harbor regime was cemented into case law with the court proceedings around the bankruptcy of Lehman Brothers. In the lead-up to the failure, JP Morgan (JPM) had taken client assets as a secured creditor while being the custodian for these client assets! Under long-standing bankruptcy law this would clearly have been a constructively fraudulent preference transfer benefitting an insider. And so, JPM was sued by clients whose assets were taken.

I will cite the following memorandum filed in defense of JPM by the law firm Wachtel, Lipton, Rosen & Katz, with the U.S. Bankruptcy court of the Southern District of New York [22]:

The purpose of the safe harbors, from their inception, has been to promote stability in large and inherently unstable financial markets by protecting transactions in those markets from being disturbed during a bankruptcy. As explained in the legislative history of the original safe harbor, “the financial stability of the clearing houses, with often millions of dollars at their disposal, would be severely threatened by” exposure to avoidance claims; as well, actions to avoid margin payments made by clearing houses could set off a “chain reaction” of insolvencies among all other market participants, “threatening the entire industry.”

Now here is the decision of the court [23] :


The Court agrees with JPMC that the safe harbors apply here, and it is appropriate for these provisions to be enforced as written and applied literally in the interest of market stability. The transactions in question are precisely the sort of contractual arrangements that should be exempt from being upset by a bankruptcy court under the more lenient standards of constructive fraudulent transfer or preference liability: these are systemically significant transactions between sophisticated financial players at a time of financial distress in the markets—in other words, the precise setting for which the safe harbors were intended. …

The Court first must consider whether JPMC is eligible for protection under section 546(e). That subsection, like the safe harbors generally, applies only to certain types of qualifying entities. …

JPMC, as one of the leading financial institutions in the world, quite obviously is a member of the protected class and qualifies as both a “financial institution” and a “financial participant.

And so, only “a member of the protected class” is empowered to take customer assets in this way. Smaller secured creditors are not similarly privileged.

In the aftermath of the 2007-2008 Global Financial Crisis no executive was convicted of a crime for the use and subsequent loss of client assets. Quite to the contrary! The bankruptcy of Lehman Brothers was used to establish case law precedent that the “protected class” of secured creditors have an absolute priority claim to client assets, and that, potentially and practically, only they will end up with the assets.