Beyond Common Equity: The Influence of Secondary Capital on Bank Insolvency Risk

By Thomas Conlon (University College Dublin), John Cotter (University College Dublin; UCLA Anderson School of Management); Philip Molyneux (University of Sharjah – College of Business Administration)

Prudential regulation requires banks to hold capital as a buffer in the event of losses and as a means to mitigate risk shifting by shareholders. Under capital regulation, a large menu of securities is permitted to contribute to regulatory capital. While previous studies have predominantly concentrated on the relationship between bank risks and narrow capital measures (such as tier 1 capital or equity capital), we further develop this work by looking at a broader menu of capital components. We examine bank insolvency risk (distance to default) for listed North American and European banks over the period from 2002 to 2014, with a focus on sensitivity to capital other than common equity. Decomposing tier 1 capital into equity and non-core components reveals a heretofore unidentified variation in risk reduction capacity. Greater non-core tier 1 capital is associated with increased insolvency risk for larger and more diversified banks, impairing the risk reducing capacity of aggregate tier 1 capital. Overall, tier 2 capital is not linked with insolvency risk, although a conflicting relationship is isolated conditional on the level of total regulatory capital held. Finally, the association between risk and capital is weakened when the latter is defined relative to risk-weighted assets.

The full article is available here.

A Functional Analysis of SIFI Insolvency

By Stephen J. Lubben (Seton Hall University School of Law)

Since the disgrace of Lehman, the question of how to handle failing SIFIs has been quite vexed.   On the one hand, governmental rescue of shareholders and other investors is beyond annoying, and there is some intuitive sense that if management does a poor job, they and their investor backers should face the consequences, just like any other firm.   That bank managers would have the temerity to pay themselves large bonuses shortly after a taxpayer rescue only emphasizes the point.

On the other hand, there is a widespread understanding that a large bank, or a sufficiently interconnected one, is not quite like Kmart, Enron, or even American Airlines, in that when the bank fails, it tends to take a large chunk of the economy along with it.   Pre-failure regulation can mitigate some of the effects, but by the time we get to insolvency—or “financial distress”—the regulatory string has pretty much played out.   And in the end, we have trouble deciding if we really mean to treat large financial institutions like normal failed firms.

In A Functional Analysis of SIFI Insolvency, I argue that we need to consider what it is that we are trying to achieve in a bank insolvency case, and how that compares with bankruptcy law in general.  Bank insolvency, I submit, is all about special priorities: both ordinal and temporal.  The Bankruptcy Code, on the other hand, takes an “equality is equity” approach to priorities as a baseline, mostly using state law to draw the claim-asset border.

Financial insolvency law expressly rejects this model; it instead is all about protecting some favored group from the effects of insolvency.   There is no equality here, and it was never intended that there would be equality.   And thus it is time to stop pretending SIFI insolvency is “normal” corporate insolvency but bigger.

The full article is available here.

Recent Developments in Bankruptcy Law, April 2018

By Richard Levin (Jenner & Block LLP)

The bankruptcy courts and their appellate courts continue to explore issues of interest to practitioners and academics. This quarterly summary of recent developments in bankruptcy law covers cases reported during the first quarter of 2018.

Most notable were two Supreme Court decisions. Merit Mgmt. Group, LP. v. FTI Consulting, Inc. substantially reduced the scope of the financial contracts avoiding power safe harbor by directing courts to focus on the ultimate recipient of the transfer, rather than on the intermediate financial institutions who participated in the transfer. Village at Lakeridge ducked the substantive bankruptcy law issue of the standard for determining who is a non-statutory insider (although the dissent tackled it) and instead ruled only on the appellate standard of review of such determinations. 

Moving in the opposite direction from the Supreme Court’s reduction of safe harbor protections, the New York district court, on an appeal from the bankruptcy court’s decision, gave a broad reading to the ability of swap counter-parties under section 560 to close out and distribute collateral upon a default. (Lehman Bros.).

The Ninth Circuit took a strong position on the open question in the application of section 1129(a)(10), requiring an impaired consenting class for confirmation, adopting the “per-plan” approach. (Transwest) And the Fourth Circuit gave another boost to reorganizing real estate debtors by permitting a bankruptcy court to value collateral in a partial “dirt-for-debt” plan. (Bates Land).

In a case largely of first impression, the Texas bankruptcy court proposed rules to apply the “single satisfaction” rule of section 550(d) when the trustee settles with some but not all defendants. (Provident Royalties).

During the first quarter, the bankruptcy courts also expanded the reach of chapter 15 and its effectiveness. (Manley Toys, B.C.I. Finances Pty Ltd., Energy Coal S.P.A., Avanti, and Platinum Partners).

The full memo, discussing these and other cases, is available here, and the full (900-page) compilation of all prior editions is available here.

Merit Management v. FTI: Law Firm Perspectives

On February 27, the Supreme Court decided Merit Management Group, LP v. FTI Consulting, Inc., holding unanimously that the § 546(e) safe harbor does not protect allegedly fraudulent transfers “in which financial institutions served as mere conduits.” The Court’s decision resolves a circuit split on the reach of § 546(e). In reaching its conclusion, the Court focused on the “end-to-end transfer” that the trustee seeks to avoid, rather than any “component parts of the overarching transfer.” In FTI, because the overarching transfer was made between two parties not otherwise shielded by the safe harbor, the transfer will now fall outside the safe harbor.

As many law firms recognize, this decision will have wide-ranging implications on the finality of securities transactions effected through financial institutions, especially leveraged buyouts. Mayer Brown notes that as the decision enhances a trustee’s ability to recover fraudulent transfers, it also increases the bankruptcy estate’s leverage against recipients of pre-petition transfers. Cleary observes that “debtors or trustees may strategically frame avoidance actions in order to limit the scope of the safe harbor.” Mayer Brown concludes that the decision may also expose investors, investment funds and similar entities to fraudulent transfer litigation risks.

The bottom line, as Davis Polk notes, is that the § 546(e) safe harbor is no longer a blanket safe harbor for the recipients of transactions that pass through financial institutions. But the safe harbor will still shield financial institutions operating as escrow agents or clearinghouses, as the Court expressly stated that a financial institution under § 546(e) is protected whether the institution acts as a principal or as an intermediary.

Firms have noted that the decision also left open some ambiguities. First, Schulte Roth & Zabel writes that the Court leaves open possible arguments that any “customer” of a “financial institution” is also itself a “financial institution” under § 546(e). Second, Mayer Brown points out that the Court did not address whether the transaction at issue actually qualified as a transfer that is a “settlement payment” or made in connection with a “securities contract” under § 546(e). These ambiguities will draw the attention of defendants in future fraudulent transfer litigation.

Finally, Weil notes that the decision raises the question of how the preemption of state-law creditor remedies under § 546(e) will be applied in light of the Supreme Court’s now-narrow construction of the safe harbor.

By Jianjian Ye, Harvard Law School, J.D. 2018.

The roundtable has posted on FTI before. Some of those posts are: an analysis of the FTI oral argument, the Amici Curiae Brief of Bankruptcy Law Professors, an article by Ralph Brubaker on the meaning of § 546(e), and a roundup of law firm perspectives on the Seventh Circuit’s decision in FTI Consulting, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).

Mandatory Contractual Stay Requirements for Qualified Financial Contracts

By Erika D. White and Donald S. Bernstein of Davis Polk & Wardwell LLP.

The U.S. banking agencies have issued rules that require U.S. G-SIBs and the U.S. operations of foreign G-SIBs to amend their swaps, repurchase agreements and other qualified financial contracts (QFCs) to include certain provisions designed to mitigate the risk of destabilizing close-outs of QFCs in the event the G-SIB enters resolution. The rules are part of a package of reforms implemented by the industry, Congress and the U.S. banking agencies since the financial crisis in an attempt to ensure that the largest financial institutions can be resolved in an orderly manner. Specifically, the rules seek to (1) mitigate the risk that the FDIC’s stay-and-transfer powers with respect to QFCs under Title II of the Dodd-Frank Act and the Federal Deposit Insurance Act may not be recognized and given effect outside of the United States and (2) improve the likelihood of success of a single-point-of entry resolution strategy under the Bankruptcy Code by limiting the ability of counterparties to terminate their QFCs with a solvent and performing operating entity based on cross-defaults triggered by the bankruptcy of the operating entity’s parent or other affiliate. The QFC Stay Rules do not, however, affect the rights of counterparties to terminate QFCs under the safe harbor provisions of the Bankruptcy Code in the event the operating subsidiary itself were to enter bankruptcy proceedings.

 

The full visual memo is available here.

Debt Priority Structure, Market Discipline and Bank Conduct

By Piotr Danisewicz (University of Bristol), Danny McGowan (University of Nottingham), Enrico Onali (Aston University; University of Wales System – Bangor University), and Klaus Schaeck (University of Bristol).

This article explores how changes in debt priority structure affect banks’ funding costs and soundness. We exploit the staggered introduction of depositor preference laws across 15 U.S. states between 1983 and 1993 which confer priority to deposit claims in case of bank liquidation. The laws are exogenous with respect to the outcomes of interest and apply to state-chartered banks but not to nationally-chartered banks, allowing us to isolate causality using difference-in-difference methods.

We document changes in monitoring intensity by various creditors depending on whether creditors move up or down the priority ladder. Enactment of depositor preference reduces deposit interest rates, consistent with the fact that deposit claims are protected in case of bankruptcy thereby reducing depositors’ monitoring incentives. However, non-deposit interest rates increase as these creditors are exposed to greater losses in bankruptcy which leads them to more intensively monitor banks’ conditions.

Subordinating non-depositor claims also reduces banks’ risk-taking and leverage, consistent with market discipline. For example, non-depositors who receive negative signals about project returns may refuse to roll over funds which motivates banks to improve soundness to maintain access to key funding sources such as Fed Funds.

These insights highlight a role for debt priority structure in the regulatory framework, and support recent innovations in banking regulation that reallocate monitoring incentives towards non-depositors.

The full paper can be found here.

FTI Argument Analysis: Justices Dubious About Limiting Bankruptcy Court’s Right to Recover Fraudulently Transferred Assets

By Ronald Mann. Published by SCOTUSblog and re-posted with permission.

Perhaps a week with only two cases on the argument calendar gave the justices more time to prepare than normal. They certainly seemed to come to the argument in Merit Management Group v FTI Consulting with a strong predisposition about how to decide the case.

As I explained in more detail in my preview, the case involves the “avoidance” powers of the bankruptcy court, which generally permit the court to recover (“avoid”) dubious payments that bankrupts make before their bankruptcy filings. The provisions are intricately drafted, with numerous detailed exceptions – excellent terrain for law-school exam questions! This case involves a “safe harbor” exception that protects transactions in the securities industry; that provision bars recovery of any “settlement payment” made under a “securities contract” if the payment is made “by or to” a financial institution. The transaction here involved a transfer of assets between parties that were not themselves financial institutions; to make the transfer, the assets had to pass through a financial institution. The U.S. Court of Appeals for the 2nd Circuit has held for many years that those “conduit” payments are protected from avoidance; the U.S. Court of Appeals for the 7th Circuit in this case disagreed.

From the earliest moments of the argument, it seemed clear that the justices were skeptical of the 2nd Circuit’s position. (…)

The remainder of the post can be found here.


Oral argument took place on November 6, 2017. The transcript is available here. The roundtable previously posted the Amici Curiae Brief of Bankruptcy Law Professors, an article by Ralph Brubaker on the meaning of § 546(e), and a roundup of law firm perspectives on the Seventh Circuit’s decision in FTI Consulting, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016). The Supreme Court granted certiorari to review the Seventh Circuit’s decision on May 1, 2017. Petitioner Merit Management Group, LP’s opening brief was subsequently filed, along with the Respondent’s brief, and Petitioner’s reply. Additional amicus curiae briefs were filed by Opportunity Partners, L.P.Various Former Tribune and Lyondell ShareholdersTribune Company Retirees and Noteholders, and the National Association of Bankruptcy Trustees.

Amicus Brief on the Scope of the Bankruptcy Safe Harbor for Securities Settlement Payments Filed in Merit Mgmt. v. FTI Consulting

By Ralph Brubaker (University of Illinois College of Law), Bruce A. Markell (Northwestern University Pritzker School of Law), Charles W. Mooney, Jr. (University of Pennsylvania Law School), and Mark Roe (Harvard Law School).

Bankruptcy Code § 546(e) contains a safe harbor that prevents avoidance of a securities settlement payment, e.g. as a preferential or constructively fraudulent transfer. This amicus brief was filed in Merit Management Group, LP v. FTI Consulting, Inc., No. 16-784 (U.S.). The brief explains how § 546(e) rationally constrains its scope via the statutory specification that the safe harbor only applies (because it need only apply) if the “transfer” sought to be avoided was allegedly “made by or to (or for the benefit of)” a protected securities market intermediary, such as a stockbroker or a financial institution.

Ascertaining the meaning and function of that determinative scope language requires an understanding of (1) the concept of a “transfer” as the fundamental analytical transaction unit throughout the Code’s avoidance provisions, and (2) the relationship between that avoidable “transfer” concept and the inextricably interrelated concepts of who that “transfer” is “made by or to (or for the benefit of).” By its express terms, § 546(e) only shields a challenged “transfer” from avoidance if (1) that transfer was “made by” a debtor-transferor who was a qualifying intermediary, “or” (2) a party with potential liability—because the challenged transfer allegedly was made “to or for the benefit of” that party—was a protected intermediary. Thus, the transfer of cash to a stock seller and of the stock back to the buyer is not safe-harbored. The delivery of the cash (and the stock) through financial intermediaries, however, is.

The full amicus brief may be found here.


Oral argument took place on November 6, 2017. The transcript is available here. The roundtable previously posted an article by Ralph Brubaker on the meaning of § 546(e) and a roundup of law firm perspectives on the Seventh Circuit’s decision in FTI Consulting, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016). The Supreme Court granted certiorari to review the decision on May 1, 2017. Petitioner Merit Management Group, LP’s opening brief was subsequently filed, along with the Respondent’s brief, and Petitioner’s reply. Additional amicus curiae briefs were filed by Opportunity Partners, L.P.Various Former Tribune and Lyondell Shareholders, Tribune Company Retirees and Noteholders, and the National Association of Bankruptcy Trustees.

Don’t Bank on Bankruptcy for Banks

By Mark Roe (Harvard Law School)

In the next month, the US Treasury Department is expected to decide whether to seek to replace the 2010 Dodd-Frank Act’s regulator-led process for resolving failed mega-banks with a solely court-based mechanism. Such a change would be a mistake of potentially crisis-size proportions.

Yes, creating a more streamlined bankruptcy process can reduce the decibel level of a bank’s failure, and bankruptcy judges are experts at important restructuring tasks. But there are critical factors that cannot be ignored. Restructuring a mega-bank requires pre-planning, familiarity with the bank’s strengths and weaknesses, knowledge of how to time the bankruptcy properly in a volatile economy, and the capacity to coordinate with foreign regulators.

The courts cannot fulfill these tasks alone, especially in the time the proposal under consideration has allotted – a 48-hour weekend. Unable to plan ahead, the courts would enter into the restructuring process unfamiliar with the bank. Moreover, the courts cannot manage the kind of economy-wide crisis that would arise if multiple mega-banks sank simultaneously. And they cannot coordinate with foreign regulators.

The rest of the article is available here.

Recent Roundtable coverage of this subject includes a round-up of op-eds; a summary of a letter submitted to Congress by financial scholars; a summary of a White House memorandum calling for reconsideration of the OLA; and an analysis of recent legislative efforts to address bankruptcy for banks.

The Roundtable has also published commentary on the treatment of insolvent financial institutions; see Jackson & Massman, “The Resolution of Distressed Financial Conglomerates” and Lubben & Wilmarth, “Too Big and Unable to Fail.”

Could Problems at MF Global Have Been Anticipated?

By Hilary Till (J.P. Morgan Center for Commodities, University of Colorado Denver Business School)

In the fall of 2011, futures market participants were caught off-guard when MF Global filed for bankruptcy. Essentially, this episode educated industry participants that customer protections in the U.S. commodity futures markets had been more ambiguous than expected. That said, there are a number of reforms that have been undertaken to help prevent future MF Globals. This article takes the position that a number of red flags existed as far back as 2007, regarding the firm’s financial weakness, which could have served as a warning to those investors relying on MF Global as a fiduciary.

In discussing the MF Global debacle, this article will cover the following seven areas:

(1) a brief background on the firm will be outlined;

(2) warning signs will be identified;

(3) the firm’s final week will be recalled;

(4) the response of regulators and bankruptcy trustees will be noted;

(5) the shortfall in customer segregated funds will be described;

(6) the CFTC’s charges and settlement will be mentioned; and

(7) later reforms will be summarized.

The article concludes that while MF Global’s business model appears not to have been viable after 2007, this observation does not excuse unlawful practices. In particular, the firm effectively (and arguably unlawfully) used customer funds in large-scale proprietary trades that the firm ultimately could not fund, leading to its chaotic bankruptcy.

The article is available here, and is forthcoming in the Fall 2017 issue of the Global Commodities Applied Research Digest.

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