Roundup: Recent Op-Eds on Bankruptcy for Banks

The House of Representatives’ passage first of the Financial Institution Bankruptcy Act (FIBA) and then of the Financial CHOICE Act last Thursday has made bankruptcy for banks and the fate of Dodd-Frank’s Orderly Liquidation Authority (OLA) a live issue again. Both FIBA and the CHOICE Act would add a “subchapter V” to chapter 11 to resolve financial conglomerates in bankruptcy. Unlike FIBA, however, the CHOICE Act would also repeal the OLA, leaving bankruptcy as the only option for handling the failure of a financial conglomerate.

Several academics, former regulators, and practitioners, including several contributors to the Bankruptcy Roundtable, have recently published op-eds weighing arguments for and against replacing the OLA with bankruptcy. Support for adding tools to the Bankruptcy Code is widespread. Commentators differ, however, on whether bankruptcy, by itself, can address the systemic risk concerns that prompted the creation of the OLA and on whether it would be useful to have a bankruptcy procedure more robust than subchapter V.

Stephen Lubben contends that without a mechanism for providing liquidity to financial institutions—the usual providers of funding for companies in chapter 11—the Bankruptcy Code cannot effectively handle a widespread financial crisis. Mark Roe emphasizes that economic stability requires having the OLA and related structures to allow subchapter V to succeed (through regulatory coordination with international authorities and supervision over financial institutions to ensure that they have the capital structures to facilitate a subchapter V resolution). The OLA is also needed in case a subchapter V reorganization fails, as subchapter V is not a general bankruptcy authorization but, instead, a mechanism to use the 48-hour “single-point-of-entry” restructuring strategy in bankruptcy. This point renews some of the arguments Roe and David Skeel expressed earlier on ways subchapter V should be strengthened, such as by the addition of a regulatory trigger and a means to deal with an inability to complete the resolution within 48 hours.

Finally, Sheila Bair and Paul Volcker argue that having the OLA as a backstop for a failed bankruptcy makes government bailouts less likely, as the OLA provides regulators with the tools to wind down a failed financial institution in an orderly fashion. In contrast, Stephen Hessler argues that the Bankruptcy Code, amended along the lines of subchapter V, would promote both market discipline and financial stability. A bankruptcy judge applying well established precedents and rules in a subchapter V case would combat moral hazard more effectively than the OLA, which grants regulators significant discretion to treat similarly situated creditors differently.

(By Rebecca Green, Harvard Law School, J.D. 2017.)


Recent Roundtable coverage of this subject includes posts on a letter submitted to Congress by academics and the Trump administration’s direction to the Treasury to issue a report on the OLA.

Do the Financial Institution Bankruptcy Act and the CHOICE Act Undermine an Effective Restructuring of a Failing Financial Institution?

By Bruce Grohsgal (Delaware Law School, Widener University)

The House recently passed the Financial Institution Bankruptcy Act of 2017 (FIBA). FIBA’s provisions are incorporated into the Financial CHOICE Act of 2017, passed by the House last week, which would repeal Dodd-Frank’s receiverships for failing financial institutions that pose risk to the financial system. The Senate may soon consider both bills.

FIBA creates a subchapter V of chapter 11 for financial institutions. Only the holding company will file. In the first 48 hours of the case, it will transfer certain assets—consisting primarily of its equity in its subsidiaries and its derivatives—to a newly-formed bridge company. It will leave behind pre-designated “bail-in debt,” mostly unsecured term obligations owed to 401ks and pensions and shorter term unsecured trade debt.

In my view, however, FIBA is unlikely to result in an effective restructuring. First, because of FIBA’s 48-hour deadline, individual determinations likely will not be made with respect to the hundreds of thousands, if not millions of repo, derivatives, and other qualified financial contracts. Instead, the entire book of financial contracts—the “bad” along with the “good”—likely will be transferred to the bridge company. The bankruptcy court’s jurisdiction over the bridge company and its property—and the restructuring—ends on the transfers.

Second, the bridge company must assume 100% of the debt secured by any property transferred—without any write down, even if the property is worth less than the claim—and all liabilities owed on the derivatives and repo transferred. These statutory provisions may weaken the bridge company’s balance sheet and imperil its ability to obtain financing.

Though the Federal Reserve’s total loss-absorbing capacity (TLAC) rule includes “clean holding company” requirements to facilitate restructuring, the rule does not adequately address these balance sheet ills that FIBA creates. The clean holding company requirements apply only to eight U.S. global systemically important banks, and do not reach dozens of $50+ billion banks or nearly 5,000 other FIBA-eligible financial institutions. Moreover, TLAC does not prohibit secured borrowing even by those eight bank holding companies, though undersecured borrowings by those eight banks may be limited by TLAC’s regulatory capital requirements. But at a time of declining asset values and a ramp-up to a subchapter V filing, it is likely that many previously fully secured loans will have become undersecured. FIBA will require the bridge bank to either assume the unsecured portion of the debt or lose the collateral to the lender.

FIBA’s bankruptcy proceeding makes a run by the bridge company’s derivatives and repo counterparties more likely. If the bridge company’s balance sheet is weakened by the wholesale assumption of qualified financial contracts and by the assumption of debt above asset value, then the bridge company’s ability to obtain new financing may be diminished. Actions against the bridge company and its assets are not stayed under FIBA. As a result, when repo lenders and other counterparties require post-transfer haircuts and margin payments, and the bridge company is unable to obtain new funding, the run on repo and derivatives will continue.


The text of FIBA is available here. My testimony on FIBA before the House Judiciary’s subcommittee is available here. The text of The Financial CHOICE Act of 2017 is available here. The “clean holding company” requirements of TLAC are at 12 CFR § 252.64, and the TLAC final rule release is available here.

Financial Scholars Submit Letter to Congress Opposing Repeal of Title II

On May 23, bankruptcy and financial scholars submitted a letter to members of Congress opposing the Financial CHOICE Act’s proposed replacement of the Dodd-Frank Act’s Orderly Liquidation Authority (“OLA”) with a new subchapter of the Bankruptcy Code as the exclusive method for resolving failed financial institutions. Like the Financial Institution Bankruptcy Act (“FIBA”), which passed the House earlier this year, the CHOICE Act would add a subchapter V to chapter 11, amending the Bankruptcy Code to facilitate a single point of entry (“SPOE”) resolution strategy for financial institutions. Unlike FIBA, however, the CHOICE Act would also repeal the OLA, making subchapter V the only method for resolving a large, failed financial institution.

The letter noted that a bankruptcy proceeding could provide a useful addition to the financial crisis toolbox but expressed several concerns about FIBA’s capacity to deal effectively with an economy-wide financial crisis. For example, the bankruptcy court’s lack of familiarity with failed institutions could undermine the chances of success for the lightning-fast, 48-hour bankruptcy proceedings envisioned in proposed subchapter V. In contrast, in a proceeding under the OLA, the FDIC would have in-depth knowledge of the financial institution’s operations based on the “living wills” resolution planning process. Moreover, the SPOE resolution strategy at the heart of proposed subchapter V requires a specific kind of capital structure; regulators can verify that this structure is in place in advance, but the bankruptcy courts cannot. In addition, the letter voiced concerns about the lack of international coordination for a subchapter V proceeding, the absence of assured liquidity facilities in bankruptcy, and the general inability of bankruptcy courts to provide a coordinated response to the simultaneous failure of several financial institutions. Based on these weaknesses, the letter emphasized the need to retain the OLA as a backstop for resolving financial institutions in the event of a large-scale economic crisis, as well as the need to plan in advance for a subchapter V SPOE-style bankruptcy.

The letter also enumerated concerns specific to subchapter V itself as included in both FIBA and the Financial CHOICE Act. First, the letter pointed to FIBA’s weakness in giving financial institutions and their executives exclusive control over the initiation of the bankruptcy proceeding. Second, it noted that subchapter V does not provide a backup plan for a resolution that fails to be completed within 48 hours. Finally, it emphasized that existing limits on bankruptcy courts’ legal authority could result in challenges to any proceeding under subchapter V, potentially undermining its efficacy by creating uncertainty.

The full letter is available here.

(By Rebecca F. Green, Harvard Law School, J.D. 2017.)


For previous posts on this topic, see “White House Releases Memorandum on Orderly Liquidation Authority“; Jackson & Massman, “The Resolution of Distressed Financial Conglomerates“; and “Bankruptcy Code Amendments Pass the House in Appropriations Bill.”

White House Releases Memorandum on Orderly Liquidation Authority

On April 21, the White House released a memorandum placing a reconsideration of the Dodd-Frank Act’s Orderly Liquidation Authority (OLA) on the administration’s agenda. The memorandum directs the Secretary of the Treasury, Steven Mnuchin, to review and report on the OLA within 180 days, focusing on whether the OLA might lead to excessive risk-taking by financial institutions, counterparties, and creditors; whether invoking the OLA could lead to losses for the U.S. Treasury; and whether the OLA comports with a February 3 executive order outlining the president’s principles for financial regulation. Additionally, the memorandum calls for an assessment of whether bankruptcy, under a Bankruptcy Code amended to accommodate financial institutions, would be a more effective method of resolving failed financial companies than the OLA.

President Trump’s memorandum parallels congressional efforts to amend the Bankruptcy Code, but it is not structurally identical. Earlier in April, the House passed H.R. 1667, the Financial Institution Bankruptcy Act (FIBA), which would amend the Code to facilitate a single-point-of-entry (SPOE) resolution in which only the top-tier holding company of a financial institution enters bankruptcy, while the operating subsidiaries continue running as normal and receive support from the top-tier holding company. Nearly identical versions of FIBA passed the House in 2016 and 2015. FIBA, as passed by the House, would not repeal title II of the Dodd-Frank Act. It would thus make two resolution systems available for financial institutions.

Representative Jeb Hensarling’s CHOICE Act, a sweeping package of proposed financial reforms, also incorporates the text of FIBA as it currently stands. The CHOICE Act, however, would also repeal title II, leaving FIBA as the single formal structure for resolving financial institutions.

(By Rebecca Green, Harvard Law School, J.D. 2017.)


For previous Roundtable posts on the resolution of financial institutions, see Jackson & Massman, “The Resolution of Distressed Financial Conglomerates“; Lubben & Wilmarth, “Too Big and Unable to Fail“; and “Senator Reed Introduces Bill to Assess Systemic Risk Impact of ‘Bankruptcy-for-Banks’ Reforms.”

The Resolution of Distressed Financial Conglomerates

By Howell E. Jackson (Harvard Law School) & Stephanie Massman (Harvard Law School, J.D. 2015)

One of the most elegant legal innovations to emerge from the Dodd-Frank Act is the FDIC’s Single Point of Entry (SPOE) initiative for resolving the failure of large financial conglomerates (corporate groups with regulated financial entities as subsidiaries), whereby regulators would seize only the top-tier holding company, down-stream holding-company resources to distressed subsidiaries, and wipe out holding-company shareholders while simultaneously imposing additional losses on holding-company creditors. The SPOE strategy is designed to resolve the entire group without disrupting the business of operating subsidiaries (even those operating overseas) or risking systemic consequences for the broader economy.

Although SPOE’s underlying creativity is admirable, the approach’s design raises several novel and challenging questions of implementation, explored in this chapter. For example, the automatic down-streaming of resources raises the so-called pre-positioning dilemma. If too much support is positioned at subsidiaries in advance, there may be inadequate holding-company reserves to support a severely distressed subsidiary. Alternatively, without such pre-positioning, commitments of subsidiary support may not be credible (especially to foreign authorities), and it may become difficult legally and practically to deploy resources in times of distress.

It is easiest to envision SPOE operating in conjunction with the FDIC’s Orderly Liquidation Authority (OLA), established in the Dodd-Frank Act; however, Dodd-Frank’s preferred regime for resolving failed financial conglomerates remains the U.S. Bankruptcy Code, and several complexities could arise if a bankruptcy court had to implement an SPOE resolution today. While many experts are working on legislative proposals to amend the Bankruptcy Code to facilitate SPOE resolutions, this chapter examines some legal levers that federal authorities could deploy under current law to increase the likelihood of a successful SPOE bankruptcy. For example, with appropriate pre-failure planning, section 365(o) of the Bankruptcy Code—which requires the debtor to assume and cure immediately any deficiency under an obligation to federal regulators to maintain the capital of an insured depository institution—could be used to prioritize holding-company commitments to all material operating subsidiaries, including affiliates that are not insured depository institutions. Such priority status would shield the down-streaming of value to operating subsidiaries from possible legal challenges, thereby alleviating some of the difficulty of the pre-positioning dilemma. Additionally, broad-based credit facilities under section 13(3) of the Federal Reserve Act or targeted lending under the Federal Deposit Insurance Act’s systemic risk exception may be available to provide government-sponsored debtor-in-possession financing where no private or other public alternative (like that provided under OLA) is available.

Implementing these strategies would be challenging and would require considerable planning. However, it is important to take steps now to increase the likelihood that bankruptcy represents a viable and credible alternative for effecting SPOE transactions outside of OLA.

The full chapter is available here.


The Roundtable has covered bank resolution and the SPOE strategy previously. For example, see Lubben & Wilmarth, “Too Big and Unable to Fail“; Crawford, “Establishing ‘Credible Losers’“; Roundtable Update, “Bankruptcy Code Amendments Pass the House in Appropriations Bill.”

The Value of Insolvency Safe Harbors

By Philipp Paech (London School of Economics)

“Safe harbor” privileges in insolvency are typically afforded to financial institutions. They are remotely comparable to security interests as they provide a financial institution with a considerably better position as compared to other creditors should one of its counterparties fail or become insolvent. Safe harbors have been and continue to be introduced widely in financial markets. The common rationale for such safe harbors is that the protection they offer against the fallout from the counterparty’s insolvency contributes to systemic stability, as the dreaded “domino effect” of insolvencies is not triggered from the outset. However, safe harbors also come in for criticism, being accused of accelerating contagion in the financial market in times of crisis and making the market riskier. In this article, I submit that the more important argument for the existence of safe harbors is liquidity in the financial market. Safe harbor rules do away with a number of legal concepts, notably those attached to traditional security, and thereby allow for exponentially increased market liquidity. Normative decisions by legislators sanction safe harbors, as modern markets could not exist without these high levels of liquidity. To the extent that safe harbors accelerate contagion in terms of crisis, which in principle is a valid argument, specific regulation is well suited to correct this situation, whereas to repeal or significantly restrict the safe harbors would be counterproductive.

The full article may be found here.


For previous Roundtable posts on the safe harbors, see Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“; Janger & Pottow, “Implementing Symmetric Treatment of Financial Contracts in Bankruptcy and Bank Resolution“; and Lubben, “Lehman’s Derivatives Portfolio.”

Senator Reed Introduces Study Bill to Assess Systemic Risk Impact of “Bankruptcy-for-Banks” Reforms

On December 6, Senator Jack Reed introduced a bill aimed at establishing a more informed basis for regulatory and policymaking action on financial institution bankruptcies. The bill would mandate bi-annual reports by financial regulators on key issues in the resolution of financial companies under the Bankruptcy Code, such as potential reforms to the safe harbors for repos and derivatives, strategies for mitigating the systemic impact of financial company bankruptcies, risks embedded in the “single point of entry” strategy (particularly if it is tried and fails), and sources of liquidity for a financial company in bankruptcy. Overall, the bill calls for regulators to make a big picture assessment of how various bankruptcy reforms would affect systemic risk, drawing attention to weaknesses in some of the policy proposals in this area.

The bill also would also amend bankruptcy court procedure for financial firm bankruptcies. Most notably, it would revise the Bankruptcy Code to give the Federal Reserve and other regulators standing to be heard in financial company bankruptcies. Additionally, the bill would provide for the Federal Reserve and the FDIC, jointly, to propose five potential trustees for the financial company, with the United States trustee selecting the final appointee from this list. Finally, the bill would require the Supreme Court to issue a rule establishing a procedure for appointing a bankruptcy or district court judge with appropriate expertise to preside over the bankruptcy resolution of a financial company.

The Roundtable’s full update on the bill is available here.

(This post was authored by Rebecca Green, J.D. ’17.)


Related posts on legislative reform proposals are available here and here. The Roundtable has also posted previously on policy issues surrounding “bankruptcy for banks” reforms. For example, see Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“; Roe & Adams, “Restructuring Failed Financial Firms in Bankruptcy“; and Lubben & Wilmarth, “Too Big and Unable to Fail.”

Too Big and Unable to Fail

By Stephen J. Lubben (Seton Hall University School of Law) and Arthur E. Wilmarth, Jr. (George Washington University Law School)

Financial regulation after the Dodd-Frank Act has produced a host of new regulatory tools for resolving failures of systemically important financial institutions (SIFIs). The explicit goal of this new “resolution” regime is to enable SIFIs to go bankrupt without a government bailout, just like other businesses. In our paper, forthcoming in the Florida Law Review, however, we express significant doubts about the new regime’s ability to work as advertised.

The “single point of entry” (SPOE) strategy, which focuses all resolution efforts on a SIFI’s parent holding company, addresses a very stylized, even hypothetical sort of failure. We believe that it is unlikely to work during a global crisis that involves multiple failing SIFIs operating thousands of subsidiaries across dozens of national boundaries.

The Federal Reserve’s “total loss absorbing capacity” (TLAC) proposal is closely tied to SPOE. It would require SIFI holding companies to issue large amounts of debt securities that can be “bailed in” (converted into equity) in a resolution proceeding to make the holding company solvent again. In our view, TLAC debt will also create a new, more opaque way to impose the costs of SIFIs’ financial distress on ordinary citizens, because retail investors in brokerage accounts, mutual funds, and pension funds are likely to be the largest TLAC debtholders.

We propose several strategies for forcing SIFIs and their Wall Street creditors to internalize at least some of the costs of the enormous risks they create. Among other things, mutual funds and pension funds that invest in TLAC debt should disclose the bail-in risks to investors and should include in their offering materials “black box” warnings similar to those already used in selling junk bonds to investors. In addition, each SIFI should describe its resolution plan on a web page that also contains a straightforward discussion of the risks TLAC debtholders are taking on—risks that creditors and counterparties of operating subsidiaries are unwilling to assume. Only with such disclosures can the hazards of TLAC debt be appropriately priced by the market.

The full paper can be found here.

 

FTI Roundup

The Seventh Circuit held last July in FTI Consulting, Inc. v. Merit Management Group, LP, 2016 BL 243677 (7th Cir. July 28, 2016), that § 546(e) of the Bankruptcy Code is not a safe harbor for “transfers that are simply conducted through financial institutions.” This decision deepens a circuit split on this issue. While the Second, Third, Sixth, Eighth, and Tenth Circuits have held that the plain language of § 546(e) protects transfers through financial institutions as settlement payments, the Seventh Circuit’s interpretation agrees with the Eleventh Circuit’s older decision in In re Munford, 98 F.3d 604, 610 (11th Cir. 1996). The legislative purpose of § 546(e) was to prevent the insolvency of one financial institution from causing systemic harm to the market as a whole. However, its text also has deep implications for leveraged buyouts that might render target corporations insolvent because payments to selling shareholders almost invariably pass through brokers and clearinghouses that are covered by the safe harbor.

Several law firms have now written memos on the FTI decision. Schiff Harden postulates that debtors will be more likely to forum shop when filing for bankruptcy when they have recently undergone a leveraged buyout. Jones Day makes clear that shareholders selling into a leveraged buyout face differing levels of risk depending on which forums the corporation could legally avail itself of in a bankruptcy proceeding. And Dechert argues that FTI Consulting will result in different treatment for parties selling identical securities in leveraged buyouts: financial institutions, stockbrokers, and the like will remain protected by the safe harbor when they are beneficial owners of stock, but other shareholders will be subject to avoidance action.

Tinkering with Ipso Facto Provisions Could Send Them Sailing out of Safe Harbors

By Maurice Horwitz (Weil, Gotshal & Manges)

Recently, the United States Bankruptcy Court for the Western District of Louisiana considered whether a bankruptcy termination provision in a forward contract continues to be safe harbored under section 556 if its enforcement is conditioned on other factors – in this case, the debtor’s failure to perform under the contract.  Consistent with prior case law, the court held that termination is only safe harbored if it is based solely on a condition specified in 365(e)(1) (i.e., the financial condition of the debtor, bankruptcy, or the appointment of a trustee).

The contract in Louisiana Pellets contained a standard ipso facto provision that permitted either party to terminate the agreement upon commencement of a bankruptcy case by the other party.  But the debtor’s counterparty could only invoke the provision if the debtor was also in breach of its obligations under the agreement.  The counterparty alleged that both requirements of the ipso facto provision – bankruptcy and breach – had been satisfied, and sought to terminate.

The court held that because the ipso facto provision contained an additional condition to enforcement (the debtor’s breach), it no longer fell within the 556 safe harbor.  Thus, even if both conditions were satisfied (bankruptcy and breach), the automatic stay applied and the termination clause could not be exercised absent relief from the automatic stay.

The lesson of Louisiana Pellets is that ipso facto provisions in financial contracts should be drafted carefully so that their enforcement depends solely on one of the conditions specified in Section 365(e)(1) of the Bankruptcy Code.

The full article is available here.

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