Word of the Day: Safe Harbor

Given our discussion about MF Global with James Koutoulas, the word of the day is Safe Harbor. So what exactly is Safe Harbor? Safe Harbor protections in the Bankruptcy Code include: Provisions that protect nondebtor counterparties from the normal course in bankruptcy. Many transfers of cash or securities made in the final weeks before a bankruptcy, for example transfers used to meet margin calls on OTC derivatives, are not subject to clawbacks, as long as the parties involved claim they had no knowledge of fraud. Let's take a look at one of the ways it has been used: In the case of MF Global, when more than 1.6 billion dollars of customer money went missing from customer accounts, one would assume that the money would go back to the customers once properly discovered right? Not necessarily under the safe harbor provisions. Companies that received hundreds of millions in transfers of MF Global customer funds in their final days may simply get to keep that money! And they would be within their legal right to do so! Also, any collateral MF Global posted with counterparties before the bankruptcy, those counterparties may get to keep! These assets are beyond the reach of creditors. This would be as if you bought a car you didn't know was stolen, and when the owner of the car came to take back the car, the Safe Harbor would be used to protect you from having to return the car to its rightful owner. So, unlike what would happen to ordinary citizens outside of their dealings with banks, creditors and customers can sail into safe harbors when they are dealing with stolen assets by saying they didn't know they were stolen. The Safe Harbor provisions are supposedly intended to avoid a financial ripple effect, where a large firm's bankruptcy infects the market as a whole by providing immunity to other market entities. However if counterparties are not incentivized to perform due diligence on each other, and instead rely on the ability to liquidate the other's collateral upon bankruptcy, a large counterparty failure easily leads to a fire sale of all posted collateral. So much for the systemic risk argument! The provisions were first introduced into the Bankruptcy Code in 1982, in a very limited manner, safe harbors have since been expanded over the years, most recently in 2005 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). The 2005 act extended safe harbor provisions to include repo and swap agreements, in addition to futures contracts and securities agreements. And who were some of the biggest lobbyists for this act? Bank of America, CitiGroup, JP Morgan, Merrill Lynch, and the American Banker's association. These 5 entities spent over 6 million dollars to get this bill passed. The poorly named Bankruptcy Abuse Prevention and Consumer Protection Act arguably neither prevents abuse nor protects consumers. And the big losers today may be customers who are trying to recover funds such as those at MF Global that sunk with the ship and are in a so called safe harbor. And now you know what it is.