By Steven L. Schwarcz (Duke University of Law)
The primary goals of corporate reorganization under Chapter 11 of the federal Bankruptcy Code are to provide a structured, equitable means of resolving a firm’s financial distress while maximizing creditor recoveries. The central provisions of bankruptcy law, which include the automatic stay of enforcement, the trustee avoidance powers, and the debtor’s right to assume favorable contracts and reject unfavorable ones, serve as critical tools to try to safeguard those goals. However, an alleged competing concern—the mitigation of systemic risk in financial markets—has prompted the enactment of amendments to the Bankruptcy Code that exempt derivatives-related contracts from those provisions and other core bankruptcy protections (these exemptions collectively being the “safe harbor”).
Originally narrowly tailored, the safe harbor has expanded significantly over time through intensive industry lobbying, without any real evidence that its exemptions reduce systemic risk. Moreover, the broad statutory language of the exemptions, which include a wide list of contracts and “any agreement or transaction that is similar,” has invited courts to use standard statutory construction norms to widen the exemptions even further. Courts often feel constrained by the sheer breadth of the language, which appears to mandate inclusion rather than allow for exclusion.
Courts that have tried to resist overly broad categorization of ordinary financial contracts as derivatives have been overruled on appeal. In In re National Gas Distributors, LLC, for example, the lower court found that ordinary agreements to purchase commodities should not be treated as derivatives and therefore should not be exempt from bankruptcy law. The court feared a slippery slope: that exempting ordinary contracts as derivatives would disrupt “the overall scheme of the Bankruptcy Code. . . . No public purpose would be served, and the result would be wholly at odds with the established aims and order of bankruptcy proceedings.” On appeal, however, the court’s decision was reversed, given the breadth of the safe harbor language.
In response, lawyers increasingly are reframing standard commercial contracts to fit within the safe harbor exemptions, rapidly multiplying the range of financial transactions that circumvent the application of bankruptcy law. A recent Practising Law Institute guide suggests, for example, that attorneys should try to document financing agreements as securities contracts in order to obtain safe harbor protection. Similarly, various articles and law-firm client alerts indicate that attorneys now believe the safe harbor can and should apply to financial arrangements that are essentially traditional secured loans by framing them as forward contracts or swaps. One leading law firm recommends that clients should characterize many ordinary contracts as swaps or forward contracts even for physically settled commodity transactions. Another top law firm advocates reframing financial and other ordinary business contracts as safe-harbor-covered derivatives, observing that this strategic practice has become normalized.
My Article—Bankruptcy’s Demise: The Flawed Safe Harbor, available at http://ssrn.com/abstract=5390514 and forthcoming in The Business Lawyer (summer 2026)—argues that the virtually unbounded expansion of the safe harbor and the increasing reframing of financing contracts to take advantage of the safe harbor’s exemptions are not only undermining the broader goals of bankruptcy law but also, ironically, potentially exacerbating systemic risk.
The Article argues that the safe harbor should be reformed in at least two ways to protect the integrity of bankruptcy law and the bankruptcy process: by narrowing the scope of the contracts covered by the exemptions and by redesigning the exemption for close-out netting. Close-out netting distorts bankruptcy law by permitting creditors to terminate their outstanding financial contracts with a bankrupt debtor and to calculate net exposures and seize collateral for those amounts. The redesign would impose a limited stay on the ability of creditors to exercise these remedies, giving debtors and bankruptcy judges the opportunity to assess their economic impact. If exercising the remedies could trigger liquidity spirals or otherwise accelerate financial distress, a judge should be able to extend the stay. Neither of these reforms should increase systemic risk. To the contrary, they should reduce that risk by maintaining the integrity of the bankruptcy process.
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