Did Bankruptcy Reform Contribute to the Rise in Structured Finance?

By Kandarp Srinivasan

Financial contracts such as repurchase agreements (“repos”) have effective “super-priority” in a bankruptcy situation—they are safe harbored from the automatic stay provision. The common justification for this special treatment is the threat of cascade effects (systemic risk). The 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”) expanded safe harbor provisions for repos collateralized by mortgage-related securities.

This paper highlights an unintended consequence of preferential treatment: Safe harbor exemptions increased incentives for financial institutions to issue complex securitized products. From an economic standpoint, an increase in demand for collateral in repo markets can cause securitized products to become more attractive to issue (Gorton and Metrick (2012)). This theoretical premise has remained untested so far.

Using data from bank holding companies and underwriters of structured mortgage products, this paper finds an increase in mortgage securitization activity in years preceding the financial crisis. Hand-collected data on repo collateral in the tri-party repo market reveals underwriters of securitized products increased use of mortgage-backed repos in the quarters following the law change.

Understanding the securitization “flash flood” is important because regulatory responses during the financial crisis (for example, TARP) were primarily targeted at buying securitized assets. Yet, the Dodd-Frank Act directs little attention to repurchase markets (Acharya (2010)). If safe harbor contributed to the proliferation of securitized products, it renews the debate (Roe (2011), Duffie and Skeel (2012)) on the costs and benefits of preferential treatment of financial contracts in bankruptcy.

For the full article, please click here. The Roundtable has posted work on this topic previously. See Morrison, Roe, and Sontchi, “Rolling Back the Repo Safe Harbors.”

Establishing “Credible Losers” at Systemically Important Bank Holding Companies

By John Crawford, UC Hastings College of Law

Systemically important bank holding companies (“SIBs”) have always had an abundance of creditors that can legally absorb losses in the event of failure. The SIB bailouts of 2008, however, were driven by regulators’ unwillingness to allow losses to fall on these creditors. The Fed has recently proposed a rule requiring SIBs to issue large quantities of “loss-absorbing” long-term debt (“LTD”) out of their parent holding companies. If, however, regulators were averse to haircuts for SIB creditors before, how will creating a new class of debt help? I attempt to answer this question here. First, regulators fear the consequences of loss or delay for SIBs’ short-term creditors. These consequences include, inter alia, the risk of “contagion by simile,” as short-term creditors of other SIBs “run” to avoid a similar fate. This risk does not extend to long-term debt per se. The challenge of imposing losses on long-term debt while protecting short-term debt goes beyond mere repayment priority, however, as involuntary haircuts typically require a bankruptcy or resolution process that creates the risk of uncertainty or delay for all claims—potentially triggering the very contagion dynamics regulators wish to avoid. I nevertheless argue that the combination of a “single point of entry” resolution strategy for SIBs and a set of proposed “clean holding company” requirements plausibly solves the problem for LTD, so that it can absorb losses without creating these risks. In short, LTD may be the “credible loser” that SIBs previously lacked.

 

The full article may be found here.

Bankruptcy Code Amendments Pass the House in Appropriations Bill

On July 7, the House of Representatives passed an appropriations bill (H.R. 5485) that includes a revised version of H.R. 2947, the Financial Institution Bankruptcy Act (FIBA), which passed the House by voice vote earlier this year. This bill, which the Roundtable has covered previously (here and here), would add to Chapter 11 of the Bankruptcy Code a “Subchapter V” to facilitate the bankruptcy resolution of troubled financial institutions. The inclusion of FIBA in the appropriations bill suggests there could be a substantial effort to pass the bankruptcy bill this year.

The version of FIBA included in the appropriations bill is largely the same as the bill that was introduced in the House last July. Importantly, however, the current version of the bill, which passed the House by voice vote this past spring, no longer allows the Board of Governors of the Federal Reserve System (the Board) to force a financial institution into bankruptcy. The role of federal regulators in the initiation and conduct of bankruptcy proceedings has been a controversial issue in debates about how to adapt the Bankruptcy Code to handle failed financial institutions more effectively. As included in the appropriations bill, FIBA permits only the debtor to file for bankruptcy. At the same time, the current bill would still provide for federal financial regulators, including the Board, to appear and be heard in any case under Subchapter V.

Although the bill aims to make bankruptcy feasible for large financial institutions, Subchapter V has been designed to facilitate a two-day, single-point-of-entry (SPOE) resolution strategy. FIBA’s proposed changes to the Bankruptcy Code would not support financial institutions during a lengthier path through bankruptcy. As the two-day bankruptcy resolution of a large, complex firm has no precedent, it is unclear whether the resolution strategy contemplated by Subchapter V would prove workable in practice. Thus, FIBA may not go as far as its proponents claim in making bankruptcy feasible for systemically important financial institutions (SIFIs).

H.R. 5485 is now in the Senate, which will consider it after the summer recess.

For a link to the full text of H.R. 5485, click here.

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

Bankruptcy Court Disagrees with Second Circuit’s Holding in Tribune

By Lee Harrington of Nixon Peabody.

Recently, in In re Physiotherapy Holdings Inc., the Bankruptcy Court in Delaware held that section 546(e) of the Bankruptcy Code did not preempt various state fraudulent transfer actions because the allegedly fraudulent transfers implicated neither the rationale for that section nor preemption generally. The decision is at odds with recent case law, notably: (i) the Tribune litigation, in which the Second Circuit concluded that state law constructive fraudulent transfer claims involving payments in LBO transactions are prohibited under section 546(e); and (ii) a proceeding in which the Southern District of New York concluded that the interest payment at issue, which did not retire the underlying debt, were not “settlement payments” and was thus outside section 546(e).

Section 546(e) precludes certain bankruptcy avoidance actions involving settlement payments made by or to a financial institution and transfers made by or to a financial institution in connection with a securities contract. It is intended to prevent litigation that might have a destabilizing “ripple effect” on the financial markets and provides a defense to constructive fraudulent transfer actions against shareholders receiving LBO payments.

Physiotherapy found that section 546(e) was not intended to shield “LBO payments to stockholders at the very end of the asset transfer chain, where the stockholders are the ultimate beneficiaries of the constructively fraudulent transfers, and can give the money back . . . with no damage to anyone but themselves” without the attendant destabilizing “ripple effect.”

The full memo is available here.

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The Bankruptcy Roundtable has previously covered treatment of 546(e), most recently in our Tribune Fraudulent Conveyance Litigation Roundup.

Developing a New Resolution Regime for Failed Systemically Important Financial Institutions

Stephanie Massman, J.D. 2015, Harvard Law School

 

In the wake of the 2007-2008 financial crisis, criticism surrounded not only the government bailouts, but also the decision to not bail out Lehman Brothers, which led to its lengthy and value-destructive chapter 11 bankruptcy. In response to this criticism, Congress enacted the Orderly Liquidation Authority (“OLA”), a regulatory alternative to bankruptcy for systemically important financial institutions (“SIFIs”), included as Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The OLA, although perceived to be a radical departure from traditional bankruptcy, incorporates many familiar resolution principles. The most significant departures from the Bankruptcy Code are those designed to ensure financial stability in the national and global economies in the event of a SIFI failure; because the Bankruptcy Code does not currently specifically provide for a SIFI failure, it does not address financial stability concerns at all. Furthermore, by banning future government bailouts and imposing new stays on qualified financial contracts, the OLA also seeks to correct skewed market discipline incentives surrounding SIFIs—including those arising due to the “Too Big To Fail” subsidy—which may have caused the “moral hazard” problems that were a contributing factor in the financial crisis. Unfortunately, the prescribed tactics for accomplishing a resolution under the OLA may in fact implicate new moral hazard concerns, which have yet to be addressed by regulators. What further remains to be seen is both the extent to which the regulatory agencies will assume their new statutorily ordained authority to regulate these SIFIs and the extent to which the market will find their regulations credible.

This article examines the current state of development of a resolution process for SIFIs under the OLA and evaluates how effective the OLA is likely to be in preserving financial stability and minimizing moral hazard.

To view the full article, click here.

Tribune Fraudulent Conveyance Litigation Roundup

Recently, in In re Tribune Co. Fraudulent Conveyance Litig., 2016 WL 1226871 (March 29, 2016), the Second Circuit held that 11 U.S.C. § 546(e) preempts state law constructive fraudulent conveyance claims brought by creditors even though the text of § 546(e) mentions only trustees. The court thought it unwise to focus exclusively on § 546(e)’s limitation to trustees in ignorance of its context and legislative history. Using those indicia of meaning, the court concluded that the statute’s purpose is to insulate securities markets from avoidance proceedings, and that allowing creditors to assert state law constructive fraudulent conveyance claims would frustrate that purpose. Accordingly, it held such claims preempted.

Weil Gotshal, Shearman & Sterling and Mintz Levin believe the decision properly forecloses creditors from circumventing § 546(e) by either suing individually under state fraudulent conveyance laws or assigning their claims to the trustee. According to these firms, the decision thus reinforces equitable distributions because it prevents creditors from enhancing their individual recoveries.

Latham & Watkins, on the other hand, believes the decision’s “sweeping” language leaves creditors “stranded at sea” and doubts other circuits will join the Second Circuit’s expansive interpretation. Caplin & Drysdale agrees that the court went too far. “Any untoward consequences threatened by the simultaneous prosecution of claims by a trustee and creditors,” the firm explains, “could be prevented by a Section 105(a) injunction.”

Meanwhile, according to Freshfields, Schulte Roth, and Paul, Weiss, the decision merely reaffirms the Second Circuit’s commitment––announced in Enron and Quebecor––to expansive interpretations of the Bankruptcy Code’s safe harbors.

Failure of the Clearinghouse: Dodd-Frank’s Fatal Flaw?

Stephen J. Lubben

Harvey Washington Wiley Chair in Corporate Governance & Business Ethics, Seton Hall University School of Law.

Clearinghouses reduce risk by acting as a central hub for trades. Each party to a trade faces only the risk of the clearinghouse’s non-performance, rather than the doubtlessly greater risk that the counterparty to the trade will fail to perform.

But the concentration of derivatives trades into a very small number of clearinghouses or central counterparties (CCPs) makes the clearinghouse’s own failure a matter of systemic concern. As such, the recovery and resolution of CCPs becomes vital in the post-crisis financial system.

Given that important context, I argue in my paper—recently published in the Virginia Law & Business Review—that the lack of any obvious resolution mechanism for clearinghouses represents a major flaw in the Dodd-Frank regulatory fabric.

I explain why Dodd-Frank’s new orderly liquidation authority was probably not intended to apply to clearinghouses and would provide little help in the case of a distressed CCP in any event. The Bankruptcy Code is equally unhelpful, in that clearinghouses are forced into Chapter 7 liquidation proceedings, and the “safe harbors” for derivative contracts would make such a filing an exercise in futility.

I also argue that the CCP’s own, internal resolution mechanisms will be unworkable in times of systemic crisis. Most clearinghouse rules state that upon exhaustion of their default fund and any assessment rights they have against members, all contracts will be closed and member positions netted. Given the concentration of certain trades in one or two clearinghouses, the sudden termination of more than half of the index CDS trades—to take but one example—could not help but have systemic effects.

In the paper, I propose that the government should nationalize the clearinghouses upon failure, and that the intention to do so should be made clear ex ante. That is, the government should expressly state clearinghouses that ultimately fail will be nationalized, with specific consequences to investors, and an expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable. This should provide stakeholders in the clearinghouses with stronger incentives to oversee the clearinghouse’s management, and avoid such a fate.

In essence, what I propose is a system of precommitment or “structured bailouts.” Bailouts of clearinghouses seem inevitable. We must specify what would happen today, both to discourage an avoidable situation, and to facilitate an organized response in the event of an essential bailout.

Lehman’s Derivative Portfolio

By Stephen Lubben, Seton Hall University School of Law

Derivatives themselves were likely at most a secondary cause of the Lehman’s collapse, and played a more central role in other firms caught up in the financial crisis, like AIG. But the late Harvey Miller suggested that derivatives were responsible for a massive loss in value suffered by Lehman post-bankruptcy. Bryan P. Marsal, the Lehman estate administrator, likewise asserted that as much as $75 billion in value was destroyed, largely as a result of the sudden termination of Lehman’s derivatives book.

The singular losses caused by Lehman’s derivative portfolio to Lehman’s bankruptcy estate come from these safe harbors and the system of closeout netting the safe harbors support. While the safe harbors have been thoroughly studied and debated in the abstract, a close look at Lehman’s experience provides important insights for the future.

In particular, the largest part of Lehman’s derivative portfolio shows how financial institutions will suffer when resolution is attempted in the traditional bankruptcy system, despite the Dodd-Frank Act’s professed preference for “normal” bankruptcy process over specialized insolvency regimes like the new “Orderly Liquidation Authority.”

And the abrupt closeout of Lehman’s cleared derivatives portfolio by CME, which Lehman’s examiner noted as the source of several obvious losses to the bankruptcy estate, also provides important insights, especially given Dodd-Frank’s strong preference for central clearing going forward.

My paper Lehman’s Derivative Portfolio, written as a chapter for a forthcoming book, looks at both issues, and suggests that the continuation of the safe harbors “as is” renders chapter 11 nonviable for larger financial institutions, and recent contractual attempts to work around the safe harbors are insufficient to solve the problem, while the increased role of clearinghouses in financial institution failures will force regulators to confront difficult choices. In short, the regulators will have to balance two competing systemic risks: the risk of an unruly resolution of the financial institution, balanced against increased risk to the clearinghouse.

The Roundtable has previously posted multiple items on the derivatives safe harbors: on selling Lehman’s derivatives portfolio, systemic risk issues, the safe harbors’ history, two posts on the ISDA derivatives stay protocols (here and here), and on congressional testimony.

House Judiciary Committee Approves Bill to Amend Chapter 11 for Financial Institution Bankruptcies

On February 11, 2016, the House of Representatives Judiciary Committee approved H.R. 2947—the Financial Institution Bankruptcy Act (FIBA)—which would amend the Bankruptcy Code to accommodate more smoothly the resolution of systemically important financial institutions (SIFIs). Introduced in July 2015, the current bill is essentially identical to an earlier version that passed the House in December 2014 (discussed in a Roundtable post here).

Like two pending Senate proposals, FIBA focuses on facilitating the recapitalization of a SIFI through a “single point of entry” (SPOE) approach similar to the strategy the FDIC has developed for implementing the Orderly Liquidation Authority (OLA) created in Title II of the Dodd-Frank Act. During an SPOE resolution, most of the failing SIFI’s assets would be transferred to a non-debtor bridge holding company to continue operations, leaving long-term debt and equity behind in the original holding company to be liquidated. (For a previous Roundtable post describing SPOE, click here.) Although both the House and the Senate bills would adapt the Bankruptcy Code to support recapitalization, FIBA differs from the Senate proposals in some important ways.

First, unlike the Senate proposals, FIBA does not repeal the OLA’s regulatory resolution process. FIBA would eliminate some of the major differences between the OLA and the current Bankruptcy Code to make bankruptcy a more viable route for failing SIFIs, but the OLA would remain an option for regulators.

Second, FIBA does not address either private or public financing for the bridge company. The Senate Judiciary Committee’s proposal, on the other hand, explicitly prohibits federal government funding. The bill pending in the Senate Banking, Housing, and Urban Affairs Committee also prohibits financing by Federal Reserve banks.

At the same time, FIBA and the Senate bills both impose a 48-hour stay on the exercise of contractual rights to terminate, liquidate, and offset qualified financial contracts to allow their transfer to a bridge company. At present, safe harbors in the Bankruptcy Code exempt such contracts from the automatic stay, and even the OLA imposes a stay of only one business day.

The full text of FIBA may be found here.

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

Testimony before House Judiciary Committee on Financial Institution Bankruptcy Act

By Stephen E. Hessler, Kirkland & Ellis LLP

hesslerCongress is again advancing legislation to amend the Bankruptcy Code to add specific provisions for administering the case of a major financial institution.  The belief that the Chapter 11 filing of Lehman Brothers was a key cause of the Great Recession led Congress to enact in 2010, as part of the Dodd-Frank Act, Title II, which provided “orderly liquidation authority” to the federal government to wind down insolvent financial companies whose failure would have “serious adverse effects on financial stability in the United States,” in proceedings administered by the FDIC.  Although there has never been a Title II proceeding, Dodd-Frank has been significantly criticized for creating a new resolution framework that imbues politically-sensitive regulators with broad and untested discretion to liquidate a major bank.

In further response, the House of Representatives last year passed the Financial Institution Bankruptcy Act of 2014, but the Congressional session expired without consideration of the bill by the Senate.  In July 2015, the House Judiciary Committee held another hearing on H.R. 2947, the reintroduced Financial Institution Bankruptcy Act of 2015.  This bill, which is substantively identical to last year’s iteration, proposes to amend the Bankruptcy Code by adding a new Subchapter V within current Chapter 11.  The central feature of Subchapter V is referred to as the “single point of entry” approach that allows a debtor to separate quickly upon filing “good” from “bad” assets through a near-immediate postpetition transfer of “good” assets to a nondebtor bridge company whose equity is held by a trust that is managed by a special trustee for the benefit of creditors of the chapter 11 estate.  The “bad” assets would then be liquidated within the chapter 11 case.  Critically, both the proposed transfer and liquidation transactions are subject to Bankruptcy Court approval.

For a further exploration of the legislation and these issues, my testimony before the House Judiciary Committee in 2015 is available here and my testimony before the House Judiciary Committee in 2014 is available here. Please note the views expressed in my testimony are solely my own, and are not offered on behalf my firm, any client, or other organization.

For a previous Roundtable post on the Financial Institution Bankruptcy Act see here.

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