Faculty of law blogs / UNIVERSITY OF OXFORD

Bankruptcy-Remote Structuring

Author(s)

Steven L. Schwarcz
Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law and Senior Fellow of the Centre for International Governance Innovation

Posted

Time to read

2 Minutes

In a new Article, forthcoming at 97 American Bankruptcy Law Journal 1 (2023), I analyze bankruptcy-remote structuring, a legal strategy with potential public policy implications. This type of structuring is crucial both to a range of important financial transactions—including securitization, project finance, covered bonds, oil-and-gas and mineral production payments, and other forms of structured financing—and to the ring-fencing of utilities and other publicly essential firms. In finance, the goal is contractually to reallocate risk by structuring securities-issuing entities that, absent the bankruptcy risks inherent to operating businesses, can attract investments based on specified cash flows. In ring-fencing, the goal is contractually to structure firms to minimize bankruptcy risks, thereby assuring their continued business operations.

            Parties engaging in bankruptcy-remote structuring usually seek to reallocate risk more optimally, including by reducing information asymmetry and assigning higher risk to yield-seeking investors, thereby enabling firms to diversify and lower their costs of capital. In reality, 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.

            The Article undertakes a normative analysis of bankruptcy-remote structuring, examining the extent to which parties should have the right to reallocate bankruptcy risk. It is the first 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 (‘CBA’)—examining how externalities should limit freedom of contract.

            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 whether to enact new regulation. In bankruptcy-remote structuring, however, the contracting parties both advocate and significantly stand to gain from the project. 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 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 that are difficult to quantify. Their social costs are also difficult to quantify. Given these difficulties, the Article merely categorizes the 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.

            Finally, the Article 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 US lawmakers to consider similar securitization reforms.

Steven L. Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law.

This post is based on blog posts previously published in the Harvard Law School Bankruptcy Roundtable and in the Columbia Law School Blue Sky Blog.

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