FROM THE OFFICE OF PUBLIC AFFAIRS

I appreciate the opportunity to appear before this subcommittee to present the Treasury Department's views on improving the U.S. legal regime governing netting and termination of certain financial contracts in insolvency situations. Improvements in this area can help to reduce systemic risk in financial markets.

The President's Working Group on Financial Markets realized the importance of this issue and directed the staffs of the various agencies involved in the Working Group to develop a legislative proposal. As a result, staffs of the Treasury Department (including Departmental Offices and the Office of the Comptroller of the Currency), the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Securities and Exchange Commission, and the Commodity Futures Trading Commission began an intensive effort, which lasted over two years, to craft a legislative proposal. The goals were (1) to eliminate uncertainty in the interpretation of certain provisions of the law, (2) to harmonize, where appropriate, provisions under the Bankruptcy Code and the bank insolvency laws, and (3) to update laws to reflect changes in the market.

On March 16, 1998, Secretary Rubin, as Chairman of the Working Group, transmitted the agencies' legislative proposal to Congress. In his transmittal letter, Secretary Rubin stated: "The proposed legislation, which amends the banking laws and the Bankruptcy Code, is important to the achievement of systemic risk reduction in our financial markets. The Working Group respectfully urges the Congress promptly to consider and pass this important legislative proposal this year."

The legal regime in the U.S. in this area has in general provided more reassurance to market participants than the regimes in many other countries. This is not to say, however, that important improvements in this highly technical area are not necessary. In fact, general recognition of the need to improve the legal regime in this area was expressed in the G-7 finance ministers' final report to the G-7 heads of state and government in Denver last summer.

The finance ministers agreed "to introduce, where necessary and appropriate, legislative measures to ensure the enforceability of sound netting agreements in relation to insolvency and bankruptcy rules to reduce systemic risk in international transactions." The Working Group's legislative proposal, though initiated before the Denver Summit, is also our fulfillment of this agreement to introduce necessary legislative improvements in this area.

Since its adoption in 1978, the Bankruptcy Code has been amended several times in order to provide that, upon the filing of a bankruptcy petition, certain financial transactions are treated differently from the general treatment for 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. Absent an exception, the automatic stay prohibits the exercise of certain creditors' rights until lifted by a court. A similar provision was also 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, which are an important financing tool in the government securities market, and in 1990, in recognition of the increasing importance of the over-the-counter derivatives market, to swap agreements. The benefits of these last two provisions are effectively not limited to certain types of counterparties.

Creditors who can benefit from these provisions have an obvious advantage over other types of creditors whose contracts and transactions are subject to the automatic stay. In general, the automatic stay not only serves to protect the debtor's estate until matters can be sorted out but also serves to protect creditors from each other. Absent the automatic stay, creditors would all rush to satisfy their claims against the debtor in a situation where not all creditors can be repaid in full. Consequently, it is our view that exceptions to the automatic stay should not be written into the law except when there is an overriding public policy purpose to confer this advantage on certain creditors.

In the case of certain financial contracts, the exception from the automatic stay is justified in order to minimize systemic risk to the financial markets. These markets are vast, have numerous interconnections, and move very quickly. If counterparties to an insolvent entity cannot satisfy the claims arising from financial contracts with that entity, the resulting general uncertainty, particularly the payment difficulties, could have a domino effect on other financial market participants.

In such a situation, the freezing of collateral could result in entities that are fundamentally sound having difficulties making payments they owe because funds they expect to receive are not forthcoming. This disruption could have significant spillover effects on financial markets generally and, hence, on the economy.

The efficient operation of financial markets is extremely important to this country and our economy. It is the government's responsibility to make rules affecting these markets which serve to minimize systemic risk. Therefore, there is an overriding public policy interest in making limited exemptions to the normal treatment of creditors in bankruptcy proceedings in order to protect markets important to the operation of the economy as a whole.

The amendments to the Bankruptcy Code that the Working Group has proposed are designed to minimize further systemic risk by strengthening the provisions of the Code relating to termination and close-out netting and related provisions for certain financial agreements and transactions. Close-out netting results in the monetary obligations stemming from a variety of financial contracts between a particular creditor and the insolvent entity to be reduced to a single amount. In crafting these amendments, we attempted to limit the applicability of these provisions to areas where the public policy goal of reducing systemic risk in financial markets provided the justification for making exceptions to the general bankruptcy treatment. We are seeking to protect markets, not particular types of creditors. For example, in the definitions of the types of instruments to which these provisions might apply, we were careful to exclude transactions that are in substance commercial loans. We do not want to create a situation where what is actually a loan receives special treatment just because the documentation calls the transaction a swap.

One of the most important changes to the Code that our proposal makes is to clarify that cross-product close-out netting for certain financial contracts is permitted. Thus, under our proposal, a master netting agreement would allow positions in securities contracts, commodity contracts, forward contracts, repurchase agreements, and swaps to be netted against each other. However, because of the concerns outlined above about not creating exceptions to the automatic stay unless the overriding goal of minimizing systemic risk justifies it, our proposal preserves the limitations on the types of entities that can benefit from the new provisions, which limitations are contained currently in the provisions relating to securities, commodities, and forward contracts.

Also, the proposal is written to retain the provisions of Subchapters III and IV of Chapter 7 of the Code relating to the protection of customer property held by a stockbroker or commodity broker. These Subchapters concern the liquidation of stockbrokers and commodity brokers.

Another important provision of the proposal clarifies that, in the case of a municipality filing for bankruptcy under Chapter 9 of the Code, the provisions of the Code relating to termination and close-out netting of certain financial contracts are applicable. Whether or not this is current law became a subject of dispute in the Orange County bankruptcy.

Other provisions of our legislative proposal amend the banking laws. These provisions, along with the proposed amendments to the Bankruptcy Code, harmonize the definitions of financial contracts receiving special treatment under the two insolvency regimes. Some of the provisions relating to bank insolvency differ from the Bankruptcy Code regime. Generally, the differences are designed to protect the federal deposit insurance funds which have exposure in the case of a depository institution insolvency. For example, under the proposed amendments, we clarify that the conservator or receiver of a failed insured depository institution has one business day to transfer qualified financial contracts from the failed institution to another financial institution. The right of counterparties to terminate, liquidate, or net qualified financial contracts cannot be exercised during this period.

We believe our legislative proposal will reduce systemic risk in our financial markets and serve to maintain our leadership in the world in providing a legal regime with respect to termination and close-out netting which will provide an example and encouragement for other countries to improve their laws in this area. We are gratified that this subcommittee has addressed the issue, and we are hopeful that the banking committees will consider the portions of our proposal which fall under their jurisdiction. We have met with both majority and minority staff of this subcommittee to discuss S.1914 and the differences between it and the Working Group proposal, and we are very encouraged by these discussions. We look forward to continuing to work on this important matter with this subcommittee.

Mr. Chairman, that concludes my prepared statement and I will be happy to answer any questions you and the other members of the subcommittee might have.