Part One of a Two Part Legal Alert on Bankruptcy Safe Harbors, the CLARITY Act, and Lessons from FTX and Celsius
When a major financial institution collapses, a web of legal protections is supposed to keep the fallout from spreading. For decades, bankruptcy “safe harbors” in the U.S. Bankruptcy Code have served as that safety net for participants in traditional financial markets, offering legal protections to keep the fallout from spreading when a major financial institution collapses. But when the crypto industry experienced its own wave of spectacular failures – most notably FTX and Celsius in 2022 – those protections simply did not apply. The result was billions of dollars in customer losses, years of litigation, and a stark reminder that the law had not kept pace with innovation.
This alert examines the gap between the protections available to participants in traditional financial markets and those available to participants in the digital asset economy, the real-world consequences of that gap, and the methods for closing that gap as illustrated by the proposed CLARITY Act.
Bankruptcy Safe Harbors: The Traditional Safety Net
As the name suggests, the Bankruptcy Code “safe harbor” provisions preserve certain rights that would otherwise exist outside of bankruptcy, even after a bankruptcy case has been filed. While the Code generally imposes an “automatic stay” the moment a company files for bankruptcy, freezing nearly all actions against the debtor, the safe harbor provisions provide that certain transactions, such as those involving derivatives, will not be stayed. For example, Section 362(b)(6) provides that the stay does not operate to prevent the exercise by a commodity broker of “any contractual right under any security agreement or arrangement . . . forming a part of or related to any commodity contract . . . to offset or net out any termination value, payment amount, or other transfer obligation arising under or in connection with 1 or more such contracts . . . .”
Congress recognized that applying the automatic stay and other provisions of the bankruptcy code rigidly to financial markets could be catastrophic, concluding that certain rapid, high-volume financial transactions warrant special treatment so as not to disrupt international capital markets. Commodities futures contracts, for example, are highly price-sensitive, commonly marked to market and margined daily, interconnected through clearing organizations and financial intermediaries, frequently offset through portfolios of related positions, and capable of producing rapidly increasing exposures if they cannot be closed out promptly. If a major commodities futures contract counterparty filed for bankruptcy and its trading partners were suddenly frozen—unable to close out positions, liquidate collateral, or net their exposures—the result could be a chain reaction of defaults spreading across the entire financial system.
To prevent that scenario, Congress enacted safe harbor provisions (primarily Sections 362(b)(6), 546(e), and 555–561 of the Bankruptcy Code) that carve out exceptions for securities contracts, swap agreements, repurchase agreements, forward contracts, and commodity contracts. These safe harbors allow protected counterparties to exercise contractual rights – termination, liquidation, and netting – even during bankruptcy, and shield certain “settlement payments” and “margin payments” from avoidance actions. These protections proved their worth during the 2008 financial crisis: when Lehman Brothers collapsed, its derivative counterparties closed out transactions without fear of later clawback.
A trustee’s “claw back” rights under the Bankruptcy Code (which also has a safe harbor under Section 546(e)) generally will operate hand in hand with the automatic stay safe harbor – preventing a bankruptcy trustee from clawing back payments made shortly before bankruptcy (ordinarily allowed under Section 547) and fraudulent transfers (allowed under Section 548(a)(1)(B)). Here, Congress recognized that it would accomplish little to permit immediate termination and netting after bankruptcy (under the automatic stay safe harbor) if the resulting payments could later be clawed back. Next week’s legal alert will examine how the safe harbor provisions have failed to properly accommodate for the evolving landscape of digital assets such as Bitcoin and Ethereum, often to disastrous effects for customers, and how Congress recently attempted to resolve this ongoing issue.
This advisory does not constitute legal advice. Nothing herein creates an attorney-client relationship between the sender and recipient. If you have any questions, please feel free to contact R. Patrick Quinn at (516) 357-3826 or via email at PQuinn@cullenllp.com, Matthew G. Roseman at (516) 296-9106 or via email at MRoseman@cullenllp.com, Michael H. Traison at (312) 860-4230 or via email at MTraison@cullenllp.com, or Howard Poon at (212) 510-2231 or via email at HPoon@cullenllp.com
About Cullen and Dykman’s Bankruptcy and Creditors’ Rights Practice
Cullen and Dykman’s Bankruptcy and Creditors’ Rights practice offers clients a unique perspective into the issues involved in complex bankruptcy proceedings in a wide range of industries. We have represented secured creditors, debtors, unsecured creditors’ committees, and individual unsecured creditors in Chapter 11 cases filed throughout the country, and we are skilled in resolving issues among various constituencies in complex Chapter 11 proceedings. We also have significant experience in out-of-court workouts, restructurings and bankruptcy litigation, and we have secured favorable results for our clients in complex bankruptcy cases throughout the country.
About Cullen and Dykman’s Distributed Ledger Technology Practice
Cullen and Dykman’s Distributed Ledger Technology practice advises financial institutions, corporate clients, and real asset stakeholders on the legal and regulatory implications of distributed ledger technology (DLT) and digital asset adoption. As blockchain-based infrastructure becomes increasingly integrated into banking, lending, payments, and asset ownership, we help clients implement these technologies within established legal and supervisory frameworks.