WRITTEN TESTIMONY OF THE U.S. SECURITIES AND EXCHANGE COMMISSION REGARDING TITLE X OF H.R. 833 FINANCIAL CONTRACT PROVISIONS BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE MARCH 25, 1999 The United States Securities and Exchange Commission (“Commission„) appreciates the opportunity to express its views on Title X of H.R. 833, the “Bankruptcy Reform Act of 1999.„ As a member of the President’s Working Group on Financial Markets (“Working Group„), the Commission supports the original proposal of the Working Group to reduce systemic risk[1] and strengthen investor confidence in the U.S. financial markets. In addition, the Commission also appreciates the opportunity to express its support for the securities-related provisions that improve the laws that permit netting and the termination of certain financial contracts when a counterparty becomes insolvent. I. Background For several years, the Commission, along with the Federal Deposit Insurance Corporation (“FDIC„), the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Commodity Futures Trading Commission, the Office of the Comptroller of the Currency, and the Department of the Treasury, as part of the Working Group, have been developing proposals to improve the laws that form the U.S. insolvency regime in an effort to address inconsistencies among the laws and reduce systemic risk. The current statutory provisions governing the treatment of financial contracts upon the insolvency of a counterparty are found primarily in the Bankruptcy Code (“Code„), the Securities Investor Protection Act of 1970 (“SIPA„), the Federal Deposit Insurance Act (“FDIA„), and the Federal Deposit Insurance Corporation Improvement Act of 1991. Both the Code and the FDIA grant special treatment to financial contracts in insolvency proceedings and provide greater rights to entities that have entered into financial contracts with parties that subsequently become insolvent than those entities who have entered into other types of contracts.[2] For example, counterparties to financial contracts generally are not subject to automatic stay provisions and have greater rights to terminate the contracts and to net or offset their obligations to the debtor against the debtor’s obligations to them. Our insolvency laws provide preferential treatment to counterparties to financial contracts to help maintain the efficient operation of our financial markets. However, these provisions contain significant variations in the definitions of the contracts to which they are applicable and in the potential treatment of counterparties.[3] II. The Working Group’s Proposal On March 16, 1998, the Department of the Treasury on behalf of the Working Group recommended to Congress that it enact the Financial Institution Insolvency Laws Reform Act (“Proposal„). The Proposal was designed to (1) clarify the treatment of certain financial contracts (i.e., securities contracts, commodity contracts, forward contracts, repurchase agreements, and swap agreements) upon the insolvency of one of the counterparties to a transaction and (2) recognize certain netting arrangements in order to reduce the risk that the failure of one entity to pay its obligations will cause other firms to fail to meet their obligations. The Proposal would accomplish these goals by: (1) harmonizing the provisions of the Code and the FDIA so that they provide similar rights to counterparties with regard to financial agreements and transactions; (2) amending the Code and the FDIA to permit cross-product netting; and (3) eliminating the uncertainties surrounding the FDIC’s authority to permit transfers of financial contracts to financial institutions. On August 4, 1998, House Banking Committee Chairman James Leach introduced the Proposal as the “Financial Contract Netting Improvement Act,„ H.R. 4239, which the Commission as part of the Working Group supported.[4] On August 5, 1999, the House Banking Committee did report a substantially similar version of the bill as H.R. 4393. Neither bill was enacted in the last session of Congress. III. H.R. 833 On February 24, 1999, Rep. George Gekas, Chairman of the Judiciary Subcommittee on Commercial and Administrative Law introduced H.R. 833. Title X of H.R. 833 is very similar to H.R. 4393. If enacted, H.R. 833 will provide more consistent and predictable treatment of financial contracts by clarifying the rights of counterparties and the treatment of those contracts if a counterparty becomes insolvent. As a result, market participants will have a better understanding of their rights under the insolvency laws and will be able to more accurately assess and manage the risks arising from financial contracts with an insolvent counterparty. Furthermore, consistent with the Working Group’s Proposal, the exceptions to the general treatment for claims against the insolvent counterparty’s assets contained in H.R. 833 are narrow. Netting would be limited to contexts that further the public policy goal of reducing systemic risk in financial markets. For example, in the definitions of the types of instruments to which these provisions might apply, the Working Group was careful to exclude transactions that are, in substance, commercial loans. The Working Group did not want to create a situation where a transaction that is actually a loan receives preferential treatment. H.R. 833 would clarify that cross-product close-out netting is permitted under the Code and by the FDIA.[5] Thus, under H.R. 833, a master netting agreement would allow obligations arising from securities contracts, commodity contracts, forward contracts, repurchase agreements, and swap agreements to be netted against each other.[6] However, because of the concerns about creating exceptions to the automatic stay (i.e., unless the overriding goal of minimizing systemic risk justifies it), H.R. 833 preserves the limitations on the types of entities that can benefit from the new provisions to those covered by the current Code.[7] Also, H.R. 833 retains the provisions of Subchapter III of Chapter 7 of the Code relating to the liquidation of stock brokers. This provision provides protection for customer property held by a stockbroker. Finally, section 1011 of H.R. 833 modifies SIPA so as to provide an exception to SIPA for netting transactions. However, SIPA would still apply to securities (but not cash) pledged as collateral under a repurchase agreement. This provision would add further protection to a counterparty’s contractual right to close-out financial contracts. The staff of the SIPC has advised the Commission staff that they do not object to the proposal. However, the Commission believes that certain technical corrections should be made to the wording of Section 1011 of H.R. 833. IV. Conclusion Once again, the Commission appreciates the opportunity to express its support for the Working Group’s proposal to reduce systemic risk and strengthen investor confidence in the U.S. financial markets. We look forward to working with Congress on this important legislation. **FOOTNOTES** [1]: Systemic risk has been defined as the risk that a disruption -- at a firm, in a market segment, to a settlement system, etc. -- can cause widespread difficulties at other firms, in other market segments, or in the financial system as a whole. If participants engaged in certain financial activities are unable to enforce their rights to terminate financial contracts with an insolvent entity in a timely manner and are unable to offset or net payment and other transfer obligations and entitlements arising under these contracts, the resulting uncertainty and potential lack of liquidity could increase the risk of an inter-market disruption. [2]: In particular, since its adoption in 1978, the Code has been amended several times in order to provide that, upon the filing of a bankruptcy petition, certain financial transactions are treated differently than other commercial contracts and transactions. For example, in 1982 the Code was amended so that “the exercise of a contractual right of a stockbroker, financial institution, or securities clearing agency to cause the liquidation of a securities contract„ is not subject to the automatic stay provision of the Code. A similar provision also was adopted in 1982 for commodity brokers and forward contract merchants with respect to commodities and forward contracts. In 1984, the exemption from the automatic stay was extended to repurchase agreements and in 1990 to swap agreements. As a general matter, the Code provides the benefits of the last two provisions to all counterparties. [3]: For example, the definition of “securities„ for “securities contract„ purposes under the FDIA is broader than the Code’s definition. The FDIA’s definition includes any mortgage loan, any mortgage-related security (as defined in section 3(a)(41) of the Securities Exchange Act of 1934), and any interest in any mortgage loan or mortgage related security. The FDIA’s list of items that may be used in connection with a repurchase agreement also is broader than the Code. Under the FDIA, the definition of repurchase agreement includes mortgage-related securities, mortgage loans, and any interest in any mortgage loan. However, both definitions exclude participation in commercial mortgage loans. [4]: On April 2, 1998, Senator Grassley introduced S. 1914 the “Business Bankruptcy Reform Act,„ which paralleled H.R. 4239 in many respects. [5]: “Close-out netting„ or “netting by close-out„ relates to the treatment of future obligations between counterparties when a defined event of default occurs (e.g., the appointment of a receiver or SIPC trustee). For a more complete discussion on “netting,„ refer to “Report on Netting Schemes,„ Wayne D. Angell, Chairman Group of Experts on Payment Systems and Member of the Board of Governors, Federal Reserve System, February 1989 at http:/risk.ifci.ch/138820.htm. [6]: Subsection (f) of Section 1007 would amend Section 548(d) of the Code to provide that transfers made under or in connection with a master netting agreement may not be avoided by a trustee except where such transfer is made with an actual intent to hinder, delay or defraud. [7]: The Code permits only certain classes of counterparties to exercise their contractual rights under a securities contract (i.e., stockbrokers, financial institutions, or securities clearing agencies), and under a commodity or forward contract (i.e., commodity brokers or forward contract merchants). 1