Bankruptcy-Remote Structuring: Reallocating Risk Through Law

Bankruptcy-remote structuring – structuring an entity to protect it from internal or external factors that might prevent it from paying its debts as they come due or make it the subject of a bankruptcy case – is crucial to a wide range of important business and financial deals. Investors in securitization, project finance, covered bonds, oil-and-gas and mineral production payments, and other types of structured finance transactions – valued at many trillion of dollars of securities outstanding – require both the entity issuing securities and the transaction itself to be structured as bankruptcy remote. Public service commissions and other regulators also require many utilities and other publicly essential firms to be structured – in this context, sometimes called ring-fenced – as bankruptcy remote by legally separating their risky assets and operations from the public-utility function.

Bankruptcy-remote structuring can provide valuable economic benefits, including optimizing resource utilization by functioning as a risk-allocation device and reducing information asymmetry. Investors in a bankruptcy-remote entity, for example, assume the risks associated with its assets or cash flows but few of the risks associated with the entity’s affiliates or with ordinary business operations. This risk allocation can make the entity more attractive to investors, which reduces its cost of capital.

In reality, though, bankruptcy-remote structuring can sometimes create harmful externalities. Some blame bankruptcy-remote securitization transactions, for example, for triggering the 2007-08 global financial crisis by shifting risk from contracting parties to the public.

In a new article, I undertake a normative analysis of bankruptcy-remote structuring, examining the extent to which parties should have the right contractually to reallocate bankruptcy risk. It is the first article to do so both from the standpoint of public policy – examining how bankruptcy-law policy should limit freedom of contract; and also from the standpoint of cost-benefit analysis – examining how externalities should limit freedom of contract. The article also examines how to reform bankruptcy-remote structuring to reduce its externalities.

Except for certain covered bond transactions, bankruptcy-remote structuring is implemented primarily by contract. By compromising the bankruptcy statutory scheme, that structuring creates a tension between freedom of contract and bankruptcy-law policy. The article analyzes this tension and the need to balance contractual freedom and statutory policies. It finds that bankruptcy-remote structuring should not nullify the purposes of the bankruptcy statutory scheme or thwart its statutory policy. Therefore, from the standpoint of public policy, parties should be allowed to engage contractually in that structuring.

The article then examines whether the externalities of bankruptcy-remote structuring – including its potential to create systemic financial risk – should limit freedom of contract. Abstractly, externalities can limit freedom of contract. However, determining which externalities should count in constraining the ability of parties to contract with each other poses major conceptual problems. For example, corporate risk-taking creates myriad externalities, yet the law only attempts to restrict material externalities. Furthermore, the law generally attempts to restrict material externalities only where the benefits of doing so exceeds its costs.

Although bankruptcy-remote structuring can create material externalities, that should not automatically defeat the enforcement of bankruptcy-remote structures. The merits of permitting bankruptcy-remote structuring should be assessed by a cost-benefit analysis (“CBA”). Traditionally, CBA weighs overall costs and benefits regardless of who pays the costs and who receives the benefits. That model makes sense for a neutral governmental assessment of costs and benefits, such as deciding where to locate a new airport or whether to enact new regulation. In bankruptcy-remote structuring, however, the contracting parties both advocate and significantly stand to gain from the project. The article argues that, from a public policy standpoint, an impartial assessment of these private actions should weigh the socially relevant costs and benefits.

In that weighing, the article first explains why the socially relevant benefits of project finance that is used to facilitate the construction of critical infrastructure projects like powerplants and toll roads, as well as the socially relevant benefits of ring-fencing that is used to protect critical utilities, should exceed the socially relevant costs.

However, for more generic structured finance transactions, like securitization, the CBA weighing is more difficult. These types of bankruptcy-remote transactions have valuable public benefits, including giving firms increased access to capital markets at lower costs and more favorable interest rates and acting as a money multiplier. It is difficult, though, to quantify the value of these public benefits.

Likewise, these types of bankruptcy-remote transactions have social costs that are difficult to quantify. Although the article shows that these transactions do not directly appear to harm third parties, they can indirectly create externalities by increasing systemic financial risk. The article explains in detail the several ways this can occur; for example, these types of transactions can increase moral hazard (and possibly discourage lender monitoring), impair disclosure, and increase the default risk of maturity transformation (the asset-liability mismatch that results from the short-term funding of long-term projects, which is common for structured finance transactions).

Because it is difficult to quantify the public benefits and social costs of generic structured finance transactions, the article merely categorizes those benefits and costs without purporting to conclude how they balance. This approach has important precedent, including for assessing the costs and benefits of the Volcker Rule.

The article next examines how to reform bankruptcy-remote structuring to reduce its externalities, thereby rebalancing the costs and benefits to try to achieve net positive benefits. Among other things, it compares the European Union’s regulatory framework that creates incentives for simple, transparent, and standardized (“STS”) securitization transactions and urges U.S. lawmakers to consider similar reform.

The article then reexamines how to approach bankruptcy-remote-structuring CBA in light of these potential reforms. It does not purport to definitively resolve whether or not these reforms would – or even could – reduce the social costs of bankruptcy-remote structured finance below its level of public benefits. Nonetheless, given the reality that bankruptcy-remote structured finance transactions are widespread and inevitable, it contends that these reforms could save trillions of dollars if they merely reduced the risk of another financial collapse by even 10 percent.

Finally, the article analyzes a related CBA issue: whether any quantitative balancing for bankruptcy-remote-structuring should be a simple inequality, assessing whether the benefits exceed the costs. It argues that because bankruptcy-remote structuring increases the risk of a catastrophic systemic financial collapse, any such quantitative balancing should be modified by requiring some margin of safety – effectively applying a form of precautionary principle to show that the public benefits clearly outweigh the social costs.

This post comes to us from Steven L. Schwarcz, the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law and a senior fellow at the Centre for International Governance Innovation (CIGI). It is based on his recent article, “Bankruptcy-Remote Structuring: Reallocating Risk Through Law,” available here.

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