Editor’s Note: For more information about the proposed Chapter 14 plan, register for ABI’s July 15th webinar titled “Proposed Chapter 14 and the Future of Large Financial Institution Resolution.” This webinar is being hosted by the Legislation Committee: http://goo.gl/bjid0z.
The 2008 bankruptcy of Lehman Brothers Holdings Inc. and the government bailout of American International Group (AIG) caused federal lawmakers to rethink the financial market’s capacity to self-stabilize.[1] In 2009, then-Treasury Secretary Timothy Geithner cautioned Congress: “The job of the financial system ... is to efficiently allocate savings and risk. Last fall, our financial system failed to do its job, and came precariously close to failing altogether.”[2] Congress subsequently enacted Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),[3] promulgating the Orderly Liquidation Authority (OLA) to help resolve failing non-bank institutions[4] “that pose a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.”[5]
Opponents of the OLA introduced legislation in December 2013 to replace it with a new “Chapter 14” of the Bankruptcy Code that would task bankruptcy courts, rather than federal regulators, with the job of unwinding a failing financial institution.[6] The proposed legislation — the Taxpayer Protection and Responsible Resolution Act (S. 1861)[7] — revives a bankruptcy chapter 14 model previously introduced (but not adopted) in a 2009 House Republican bill (H.R. 3310).[8] Senator John Cornyn (R-Tex.), one of S. 1861’s co-sponsors,[9] asserts that “[o]nce these [large financial] institutions know that the government can and will let them fail, they will be forced to become better stewards of their clients’ resources or risk going out of business, rather than becoming a taxpayer liability.”[10] Senator Cornyn contends that “[i]nstituting a bankruptcy process[] would allow the market to impose discipline on large financial institutions by pricing their risks appropriately.”[11]
Title II of the Dodd-Frank Act and Lessons Learned from the Lehman Bankruptcy
Title II’s OLA vests the Federal Deposit Insurance Corporation (FDIC) with the ability to take over certain defined “covered financial companies”[12] “in a manner substantially similar to the FDIC’s resolution process for depository institutions.”[13] Once the FDIC is appointed receiver, the OLA supplants any pending bankruptcy proceeding and prohibits the covered financial company from receiving the benefit of subsequent bankruptcies[14] or bailouts[15] at any time while the orderly liquidation is pending. The FDIC must then liquidate the covered financial company[16] or transfer assets to an interim “bridge financial company” in a manner that closely resembles a chapter 11 reorganization.[17] The FDIC recently issued a report “examin[ing] how the government could have structured a resolution of Lehman under the [OLA] and how the outcome could have differed from the outcome under bankruptcy.”[18] The FDIC identified three primary benefits to employing the OLA instead of bankruptcy.
First, under the OLA, a bridge financial company could have been used to preserve the going-concern value of Lehman’s assets and business lines.[19] The FDIC doubts that there are “specific parallel provisions in the Bankruptcy Code, and therefore it is more difficult for a debtor company operating under chapter 11 of the Bankruptcy Code to achieve the same result as expeditiously, particularly where circumstances compel the debtor company to seek bankruptcy protection before a wind-down plan can be negotiated and implemented.”[20] The second key advantage to the OLA is the availability of federal funding “to stabilize the key operations of the covered financial company by continuing valuable, systemically important operations.”[21] This taxpayer financing is made available immediately,[22] and the covered financial company is thus immediately able to resume operations.[23] Third, the OLA requires advanced planning; financial institutions, whether failing or not, are now required to periodically submit contingency plans to the Federal Reserve Board of Governors (the “Board”) designed to assist in avoiding or recovering from a financial disaster. In contrast, Lehman was unprepared: The FDIC noted that “senior management discounted the possibility of failure until the very last moment.”[24] Under the Dodd-Frank Act, Lehman would have been required to prepare advance resolution contingency plans. Specifically, the Dodd-Frank Act requires bank holding companies with consolidated assets of $50 billion or more and nonbank financial companies designated for supervision by the Board to periodically provide and update a plan for “rapid and orderly resolution in the event of material financial distress or failure[.]”[25] According to the FDIC, this advance planning “significantly enhances regulators’ ability to conduct advance resolution planning in respect of systemically important financial institutions through a variety of mechanisms, including heightened supervisory authority and the resolution plans[.]”[26] This advance planning is beneficial for both the debtor and the financial markets regardless of whether the covered financial company resolves via the OLA or the Bankruptcy Code.
A Proposal to Replace the OLA with a New Bankruptcy Code “Chapter 14”
S. 1861 would supplant the OLA with a new chapter 14 of the Bankruptcy Code specially designed to resolve large financial companies. Supporters of codifying chapter 14 argue that it can achieve the same result as the OLA without the use of taxpayer dollars and with the benefits of judicial review and a transparent statutory scheme.[27] For example, like the OLA, proposed chapter 14 would afford regulators the power to initiate involuntary bankruptcy proceedings;[28] would transfer failing assets and liabilities to “bridge companies;”[29] would weigh the necessity to “prevent imminent substantial harm to financial stability in the United States” when deciding whether a case should proceed;[30] and would permit federal regulators to file a plan of reorganization for the debtor-in-possession (DIP) at any time after the order for relief is entered.[31] Proponents argue that “[t]he new chapter [14] could be adopted either in addition or as an alternative to the [OLA].” [32] Such a hybrid method might couple the funding and oversight made available under the OLA with the transparency of bankruptcy proceedings by providing “explicit rules, designated in advance and honed through published judicial precedent ... in such a way as to minimize the felt necessity to use the alternative government agency resolution process[.]”[33]
Conclusion
The claimed functions of chapter 14 — increased transparency and decreased government intrusion — advance the discussion to improve the OLA. That said, a regime relying solely on chapter 14, without the OLA, wouldn’t tackle the most prominent concern in resolving a failed financial institution: finding funding for the DIP. Proposed chapter 14 assumes that a modified § 364 of the Bankruptcy Code will allow for private DIP funding.[34] Yet relying on the private DIP financing market to secure a loan for a struggling $50 billion financial company — especially during a financial crisis — seems implausible, if not naïve. Title II’s OLA effectively resolves this funding concern with FDIC financing “to stabilize the key operations of the covered financial company” and temporarily continue operations.[35] While court-based rules in a bankruptcy setting would increase transparency, such a process would stall the speed needed to resolve distressed DIPs and quickly restore stability to the financial markets. Transparency concerns are therefore tempered by the need to act quickly. In short, if bankruptcy is deemed preferable in addressing transparency and free-market interests, future chapter 14 proposals would benefit from adopting funding and timing provisions similar to those contained in the OLA.
[1] For a comprehensive review of the 2008 financial crisis and the federal government response thereto, see John C. Coffee, Jr., The Political Economy of Dodd-Frank: Why Financial Reform Tends to Be Frustrated and Systemic Risk Perpetuated, 97 Cornell L. Rev. 1019, 1047, 1062 (2012) (“In 2008, Congress saw the nation’s largest financial institutions race like lemmings over the cliff and into insolvency.... The 2008 financial crisis crested when, in rapid succession, Lehman failed and AIG was bailed out.”).
[2] Fin. Regulatory Reform Hearing Before the H. Fin. Services Comm., 111th Cong. (2009) (written statement of Treasury Secretary Timothy F. Geithner), available at www.treasury.gov/press-center/press-releases/Pages/tg296.aspx.
[3] Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified in various sections of U.S.C.).
[4] 12 U.S.C. §§ 5381(a)(8), 5383(b) (defining “covered financial company” as a non-depository institution in default or in danger of default whose failure and resolution under otherwise applicable law “would have serious adverse effects on financial stability in the United States”).
[5] 12 U.S.C. § 5384(a).
[6] Press Release, Sen. John Cornyn, Cornyn, Toomey Introduce Bill To End “Too Big To Fail” (Dec. 13, 2013) [hereinafter “Sen. Cornyn Press Release”], available at www.cornyn.senate.gov/public/index.cfm?p=InNews&ContentRecord_id=0ad834a5-fdea-418f-84a7-969d521409c9 (“Under Chapter 14, the failed bank would go bankrupt, leaving its owners and long-term creditors on the hook for its bad decisions, not taxpayers.”).
[7] Taxpayer Protection and Responsible Resolution Act, S. 1861 [hereinafter “S. 1861”], 113th Cong., available at www.gpo.gov/fdsys/pkg/BILLS-113s1861is/pdf/BILLS-113s1861is.pdf.
[8] Consumer Protection and Regulatory Enhancement Act, H.R. 3310, 111th Cong., available at www.gpo.gov/fdsys/pkg/BILLS-111hr3310ih/pdf/BILLS-111hr3310ih.pdf (introduced but not enacted).
[9] S. 1861, supra n.7 (S. 1861 is co-sponsored by Sens. John Cornyn (R-Tex.) and Pat Toomey (R-Pa.)).
[10] Sen. Cornyn Press Release, supra n.6.
[11] Id.
[12] 12 U.S.C. § 5384(a).
[13] Systemically Important Institutions and the Issue of “Too Big to Fail” Before the Fin. Crisis Inquiry Comm’n, 111th Cong. 18 (2010) (statement of Sheila C. Bair, Chairman, FDIC), available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0902-Bair.pdf.
[14] 12 U.S.C. § 5388(a).
[15] 12 U.S.C. § 5394(a) (“No taxpayer funds shall be used to prevent the liquidation of any financial company under this subchapter.”)
[16] Id. (“All financial companies put into receivership under this subchapter shall be liquidated.”)
[17] 12 U.S.C. § 5390(h).
[18] “The Orderly Liquidation of Lehman Brothers Holdings Inc. Under the Dodd-Frank Act,” FDIC Quarterly, Vol. 5, No. 2 (2011) [hereinafter “Lehman Brothers Under Dodd-Frank Act”] at 1, available at www.fdic.gov/bank/analytical/quarterly/2011_vol5_2/lehman.pdf.
[19] Id. at 6.
[20] Id. at 6-7.
[21] Id. at 7.
[22] 12 U.S.C. §§ 5384(d), 5390(n).
[23] Lehman Brothers Under Dodd-Frank Act, supra n.18 at 7.
[24] Id. at 11.
[25] 12 U.S.C. § 5365.
[26] Lehman Brothers Under Dodd-Frank Act, supra n.18 at 10.
[27] Thomas H. Jackson et. al., Resolution of Failed Financial Institutions: Orderly Liquidation Authority and a New Chapter 14, at ii (Apr. 25, 2011) (unpublished manuscript) [hereinafter “The OLA and a New Chapter 14”], available at www.federalreserve.gov/SECRS/2011/June/20110620/OP-1418/OP-1418_061511_81311_544434921739_1.pdf.
[28] S. 1861, supra n.7 at § 1403(a)(2).
[29] Id. at § 1405.
[30] Id. at § 1403(a)(2)(A)(ii).
[31] The OLA and a New Chapter 14, supra n.27 at 2-16.
[32] Id. at 2-2.
[33] Id.
[34] Id. at 2-14 to 2-16.
[35] Lehman Brothers Under Dodd-Frank Act, supra n.18 at 7.