ABSTRACT
This Chapter considers the implications of using private contracts as public policy tools, or what happens when regulators ‘catch a ride’ on private law instruments to their policy destination. It centres on an episode of creative problem solving after the transatlantic financial crisis of 2007-2009, when wealthy governments pledged to stop bailing out too-big-to-fail global banks and turned to standard-form contracts for help to deliver on their pledge. To convince voters and markets that even megabanks could fail under their new ‘special’ resolution regimes, governments had to contain the costs of failure to economies and financial systems. The prospect of chaotic termination of the banks’ derivatives contracts emerged as a major obstacle in the way of establishing credible resolution regimes and ending bailouts.
Derivatives are among the principal beneficiaries of an effective exemption from corporate and bank insolvency regimes worldwide. Although the start of insolvency proceedings usually halts (stays) claims against the debtor, derivatives contract counterparties may terminate, net bilateral exposures, seize and sell collateral, and take other steps that put them at the head of the debt collection queue. Such generous ‘safe harbour’ treatment reflects pre-crisis policy consensus that derivatives performed critical functions in national and global financial systems; that maximum market liquidity was essential for their ability to perform these functions; and that ensnaring them in bankruptcy would disrupt markets and harm economies.
The Lehman Brothers and AIG failures in 2008 revealed that, instead of treating safe harbours as a guarantee of repayment and staying put, derivatives counterparties could use safe harbours to run on the failing firm. After the crisis, policy makers feared that excluding systemically important contracts from systemically important resolution frameworks would distort incentives and exacerbate turmoil. In the worst-case scenario, an avalanche of panicked terminations could strip the debtor’s balance sheet bare before resolution got under way. Standard derivatives contract terms moreover allowed the failure of an affiliate in one country to trigger claims against every part of a multinational conglomerate, threatening a cascade of failures in different parts of the world. The public (or publics, in cross-border cases) would soon be back to the old choice between suffering spillovers and paying for bailouts.
Meeting the megabank failure challenge under the circumstances entailed more than balancing the costs and benefits of contract enforcement, or weighing pre-crisis and post-crisis perspectives on financial stability. The treatment of derivatives contracts in special resolution regimes implicated politically charged distribution commitments. Contract boilerplate and bankruptcy safe harbours were part of an institutional architecture that allocated losses between failed firms and their counterparties, between failed firms and their governments, and among states. If the safe harbours let contract counterparties run on a bank, its government could come under pressure to bail it out. If the same contracts were stayed, losses would fall on the bank’s counterparties, and could shift the pressure for bailouts onto different governments.
Gelpern, Anna, Boilerplate against Bailouts: A Regulatory Ride Fallacy (March 1, 2025). Published in Hidden Fallacies in Corporate Law and Financial Regulation: Reframing the Mainstream Narratives (Alexandra Andhov, Claire A Hill and Saule T Omarova eds, Bloomsbury Publishing 2025) pp 253-289, DOI: 10.5040/9781509971534.ch-011; Georgetown University Law Center Research Paper Forthcoming.
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