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.

Financial Experts in Chapter 11 Bankruptcies: Unique Situations from Common Assignments

By Allyn Needham, Shipp, Needham & Durham, LLC

needhamWhen disagreements arise in Chapter 11 bankruptcies, debtor and/or creditors’ counsel may seek financial experts to provide information relative to their positions. While engagements of economic experts may cover a broad spectrum of analyses, these engagements generally fall into two areas: determining the appropriate interest rate for the repayment of a secured claim and the liquidation and/or fair market value of certain assets or the bankrupt business as a whole.

The assessment of interest rates and appraising the value of a business are assignments not limited to bankruptcy work alone. Most financial experts are familiar with the methods required to perform these tasks. However, even in the application of these basic analyses, Chapter 11 bankruptcy may present unusual assignments.

This article discusses two unique situations that may arise from common assignments. The first is the application of the cramdown interest rate model when a creditor makes an 1111(b) election. An 1111(b) election allows an under secured creditor to be paid its total allowed claim (both secured and unsecured). This impacts the interest rate and its application toward retirement of the claim. The second considers the concept that the “highest bidder may not be the best bidder” when selling a bankrupt business. The best bid may not be the highest bid due to differing prices, terms, contingencies and impact on the local economy (e.g. closing a business or location) in the competing bids.

To read the full article see here.

Bankruptcy Code With No Repo Safe Harbor — An Evaluation

By Jeffrey Murphy and Lee Smith of Dentons

The ABI Reform Commission recommended that the safe harbors under Section 555 and 559 of the Code be revised to return to their pre-2005 contours and, specifically, that the safe harbors exclude mortgage warehousing, which is a short-term revolving credit facility extended by a financial institution to the loan originator. We believe that excluding mortgage warehousing transactions from the safe harbors will increase “contagion risk” and also reject the Commission’s assertion that mortgages, in comparison with other safe-harbored asset types, are “illiquid” investments based upon our experience with mortgage loan trading.  The largest banks, and ever increasingly, the largest investment funds, are major participants in the mortgage markets as originators, buyers, and market makers (the same cannot be said of, say, municipal bonds), and the financial crisis started with a subset of the mortgage markets: subprime mortgages.

We are not persuaded that repo financing contributed to the excesses of the credit boom of the mid-2000s, nor do we believe that the Bankruptcy Code safe harbors for the liquidation, termination or acceleration of repurchase agreements are to be indicted for causing “runs” on debtors that knowledgeable market actors will not restructure.  To the contrary, mortgage repos are a crucial component of healthy housing markets, and fairness requires that debtors relieved of their margin call obligations by a bankruptcy filing not have options to satisfy their obligations while the repo buyers are exposed to all the market risk.

For our full analysis of the ABI recommendation, please see here.

Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio

By Mark J. Roe, Harvard Law School, and Stephen D. Adams, Ropes & Gray LLP

adams-stephen-200 Roe 124Lehman Brothers’ failure and bankruptcy led to the deepest part of the 2008 financial crisis. Yet, while Congress reformed financial regulation in hopes of avoiding another crisis, bankruptcy rules, such as those that governed Lehman’s failure, have persisted unchanged. When Lehman failed, it lost perhaps tens of billions of dollars of further value when its contracting counterparties terminated their financial contracts with Lehman.

Bankruptcy must be able to market salable parts of the failed institution’s financial contracts portfolio at other-than-fire-sale prices. Current law prevents this marketing, however. It allows only two polar choices: sell the entire portfolio intact (currently impossible in bankruptcy and only narrowly viable under Dodd-Frank) or allow for the liquidation of each contract, one-by-one (which worked poorly in Lehman). Bankruptcy needs authority, first, to preserve the failed firm’s overall portfolio value, and, second, to break up and sell along product lines a very large portfolio that is too large to sell intact.

Congress and the regulators favor bankruptcy for financial resolution. Yet, bankruptcy law has neither been fixed nor even updated here since the financial crisis. We here outline one critically needed fix: authorizing bankruptcy to break up a large derivatives portfolio by selling its constituent product lines, one-by-one, instead of a Lehman-style close-out of each contract, one-by-one.

This article is forthcoming in 32 Yale Journal on Regulation. A full draft of the article can be found here.

For related pieces discussing safe harbors, see here and here.

The ISDA 2014 Resolution Stays Protocol and the Bankruptcy Code Safe Harbors

By David Geen and Samantha Riley of the International Swaps and Derivatives Association (ISDA)

The International Swaps and Derivatives Association (“ISDA”) recently published the 2014 Resolution Stay Protocol (the “Protocol”). Developed by a working group comprised of both dealer and buy-side market participants in consultation with regulators from France, Germany, Switzerland, Japan, the United Kingdom and the United States, the Protocol has been hailed by the Financial Stability Board as a “crucial element[] of the policy framework to end too-big-to-fail.” In addition to addressing the failure of systemically important financial institutions (“SIFIs”) under special resolution regimes, such as the Orderly Liquidation Authority provisions of the Dodd-Frank Act or the EU Bank Recovery and Resolution Directive, Section 2 of the Protocol also addresses the failure of SIFIs under the U.S. Bankruptcy Code (the “Code”).

Section 2 of the Protocol was developed to support SIFI resolution strategies under the Code where operating companies, such as banks and broker dealers, are kept out of insolvency proceedings altogether, while affiliates, such as a parent holding company, are restructured through Chapter 11 proceedings. Section 2 introduces a short, temporary stay on the exercise of default rights that arise because of the parent’s or other affiliate’s entry into bankruptcy proceedings to enable the SIFI to take actions to preserve the operating companies as going concerns. If the actions taken satisfy the conditions established by the Protocol, the termination rights that arose as a result of the SIFI entering bankruptcy proceedings would be permanently overridden.

Naturally, questions have arisen as to the interplay between Section 2 of the Protocol and the safe harbors for swap agreements under the Code. The Code stays, and safe harbors, default rights that arise because a counterparty to an ISDA Master Agreement subject to the Protocol enters proceedings under the Code; it does not stay (and therefore does not need to safe harbor) contracts between non-debtor affiliates and their counterparties. The Protocol only addresses the affiliate contracts, and thus does not alter the scope or application of the safe harbors.

To help interested parties better understand the Protocol, ISDA has developed a detailed FAQ. The full text of the Protocol can be found on ISDA’s website.

ISDA Resolution Stay Protocol: A Brief Overview

On November 12, 2014, the International Swaps and Derivatives Association (“ISDA”) officially released the ISDA 2014 Resolution Stay Protocol (the “Protocol”), a mechanism that contractually imposes a stay on certain default rights in ISDA contracts between adhering parties during the resolution of a significantly important financial institution (SIFI) counterparty or one of its affiliates.

The first section of the Protocol—addressing default rights under Special Resolution Regimes (“SRRs”) (e.g., the U.S.’s OLA and FDIA)—is relatively uncontroversial. It merely ensures that adhering cross-border counterparties will be bound by the preexisting stay provisions of a foreign SRR, even if the jurisdictional limitations of the SRR would normally exempt such cross-border counterparties. This section went into affect for the 18 adhering banks on January 1, 2015.

The second section of the Protocol—addressing default rights under the U.S. Bankruptcy Code—has been met with significantly more contention. This section confines, to a limited extent, the use of currently existing “safe harbors” in the Code, by contractually limiting certain cross-default rights in ISDA contracts in the case of a counterparty’s affiliate’s bankruptcy, so that the affiliate is not also forced into bankruptcy, where close-out rights are safe-harbored. Significantly, this section will not go into effect until further regulations are promulgated by the Federal Reserve and other U.S. regulators. The concept behind the Protocol’s second section is that a failure of one part of a SIFI should not necessarily lead to defaults and close-outs of derivatives and repos sitting in affiliates of the SIFI, if the affiliate is still performing on its obligations.

The HLS Bankruptcy Roundtable has focused on the Code’s safe harbors previously. Click here for an analysis of the effect of the safe harbors on systemic risk; click here for an argument for narrowing the safe harbors for repos.

Congress is also currently considering the issue of the safe harbors in the case of a SIFI failure. Click here and here for previous coverage of currently pending legislation, the Financial Institution Bankruptcy Act, which would impose a short stay on financial contracts in the case of a SIFI resolution under the Bankruptcy Code.

For a full discussion of the Protocol, please see Mayer Brown’s Legal Update, here.

(This post was drafted by Stephanie Massman, J.D. ’15.)

House Passes Financial Institution Bankruptcy Act

On December 1, 2014, the House of Representatives passed, with bipartisan support, H.R. 5421—the Financial Institution Bankruptcy Act of 2014 (FIBA), a bill that would amend the Bankruptcy Code to better allow for the resolution of systemically important financial institutions (SIFIs). FIBA (previously discussed in Roundtable posts here and here) is similar in many respects to the bankruptcy amendments proposed in another bill introduced in the Senate (previously covered here) and to the “chapter 14” proposal from the Hoover Institution, but there are some key differences among these proposals.

First of all, the Senate version would entirely repeal the Orderly Liquidation Authority (OLA), the current regulatory receivership alternative to traditional bankruptcy (and to some, the only current viable option) to resolve failed SIFIs. Both FIBA and the Hoover Institution’s version, however, would keep the OLA in place as an alternative.

Additionally, each proposal takes a different approach to the issue of federal funding in a SIFI resolution, which is provided in an OLA resolution. The Hoover Institution’s version does not explicitly provide for such federal funding, but it does contemplate it and condition it upon a showing that no private funding is available. FIBA is silent on the matter, and the Senate version explicitly prohibits it.

Lastly, both FIBA and the Senate proposal solely focus on facilitating a single-point-of-entry (SPOE) resolution of a SIFI, whereas the Hoover Institution’s proposal seeks to accommodate both an SPOE recapitalization and a conventional reorganization of a SIFI. An SPOE recapitalization would make debt and equity at the financial holding company take the brunt of losses, while substantially all of the holding company’s assets would be transferred to a new bridge institution and cash would be pushed down into shaky subsidiaries to prevent their bankruptcy. A conventional reorganization (or liquidation) of a SIFI would largely track traditional bankruptcy approaches, with the troubled subsidiaries entering bankruptcy.

These and other differences among the proposals are some of the most debated aspects in the SIFI resolution reform discussion. Moreover, which version (if any) ultimately passes through both houses of Congress and is signed by President Obama may set significant precedent in resolution regimes worldwide.

For previous HLS Bankruptcy Roundtable coverage of the viability and limits of an SPOE approach in bankruptcy, click here and here.

This post was composed by Stephanie Massman (J.D. ’15)

Derivatives and Collateral: Balancing Remedies and Systemic Risk

By Steven L. Schwarcz, Duke University School of Law

schwarczProfessor Schwarcz examines whether the bankruptcy “safe harbor” for derivatives is necessary or even appropriate to protect against systemic risk—such protection being the safe harbor’s articulated justification. The article examines the most important function of the safe harbor: allowing derivatives counterparties to exercise their contractual enforcement remedies against a debtor or its property notwithstanding bankruptcy law’s stay of enforcement actions. A threshold question is whether there is anything inherently risky about derivatives that might cause a systemic failure.

The standard answer is volatility. But, the article observes, regulation could reduce that potential for systemic risk in a more limited fashion. The article next addresses the safe harbor from the standpoint of its impact on avoiding contagion. The safe harbor is supposed to enable large derivatives dealers to enforce their remedies against a failed counterparty, thereby minimizing the dealer’s losses and reducing its chance of collapse. There are, however, several flaws in the safe harbor’s design to accomplish that. First, the safe harbor incentivizes systemically risky market concentration by enabling dealers and other parties to virtually ignore counterparty risk. Second, the safe harbor operates independently of the size of the counterparty or its portfolio. The article then examines how the Lehman bankruptcy might inform the safe harbor debate. The article offers a final caution: To the extent the safe harbor might amplify, rather than protect against, systemic risk, its negative impact would transcend the traditional derivatives market.

The full version of this article is forthcoming from the University of Illinois Law Review and is available in draft form here.

House Advances Bipartisan Financial Institution Bankruptcy Act

By Stephen D. Adams, Editor, HLS Bankruptcy Roundtable

On September 10, 2014, the House Judiciary Committee approved H.R. 5421, the Financial Institution Bankruptcy Act of 2014, in a voice vote with bipartisan support. The bill would amend Chapter 11 of the Bankruptcy Code by adding Subchapter V, targeting large financial institutions.  Subchapter V reflects the principles of the Single Point of Entry framework developed for the Orderly Liquidation Authority, which include the following: 1) an expedited involuntary commencement process that may be initiated by a regulator (in addition to a voluntary process), 2) a special transfer of estate property, including an assignment of executory contracts, leases, swaps and the like, to a new holding company, and 3) a brief but broad automatic stay on a wide variety of instruments in order to enable the special transfer.  As a result, the subsidiaries of the bank holding company are in and out of bankruptcy quickly, but the parent holding company remains.  To enable this special transfer, Subchapter V transfers may assign licenses, permits, and registrations, and are exempt from most avoiding powers.  In addition, the prospective statute empowers judges to consider the effects of their decisions on financial stability, a power strengthened by authorization of the Federal Reserve, the SEC, the OCC, and the FDIC (but not the CFTC, it seems), to be heard on any issue in the case or proceeding.  Finally, the bill would create a special category of judges who would handle these cases.

The approval statement of the House Judiciary Committee is here.  The text of the bill can be found here, and you may track the bill’s progress here.  Previously, the Roundtable covered a draft of the bill in the Senate in connection with Bruce Grohsgal’s discussion of the limits of the proposal, then called Chapter 14.  David Skeel’s post today provides a comparison of an earlier (though substantially similar) proposal with the Single Point of Entry plan for the OLA.

Single Point of Entry and the Bankruptcy Alternative

Author: David A. Skeel, Jr., University of Pennsylvania Law School

dskeel

The Dodd-Frank Act requires systemically important financial institutions to prepare living wills explaining how they could be smoothly resolved in bankruptcy.  Yet Dodd-Frank itself did not do anything to ensure that the bankruptcy laws actually are adequate to the task of handling a major financial institution.  Earlier this month, the House Judiciary committee unanimously approved proposed legislation (known colloquially as “Subchapter V”) that is designed to finish the job.  Subchapter V would mimic the single point of entry strategy that the FDIC has devised for resolution under the Dodd-Frank Act by facilitating a quick sale of the assets and some of the liabilities of the financial institution’s holding company in bankruptcy.

In this Essay (which pre-dates Subchapter V), I consider the risks and benefits of single of entry and the bankruptcy alternative.  The Essay begins with a brief overview of concerns raised by the Lehman Brothers bankruptcy, and points out that the Dodd-Frank Act as enacted left nearly all of them unaddressed.   By contrast, the FDIC’s new single point of entry strategy, which is introduced in the second section, can be seen as addressing nearly all of them.  The third and fourth sections point out some of the limitations of single point of entry, first by highlighting potential pitfalls and distortions and then by explaining that single point of entry does not end the too-big-to-fail problem and would not reduce worrisome concentration in the financial services industry.  The final section turns to bankruptcy, and shows that the single-entry-style strategy can easily be replicated in bankruptcy.  Indeed, the strategy harkens back to the original procedure used to reorganize American railroads well over a century ago.

The full version of the article can be found here.

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