The Dark Side of Bank Resolution: Counterparty Risk through Bail-in

By Wolf-Georg Ringe and Jatine Patel (University of Hamburg – Institute of Law & Economics, University of Oxford)

Bail-in and its supplementary capital requirements have much touted potential. Beyond their promise to reign in financial institutions’ bail-out moral hazard, bail-in intends to stem systemic risk whilst maintaining “critical” banking functions. It seeks to do this by allocating responsibility for recapitalization of banks to their individual creditors, immediately upon resolution, and in a pre-defined manner, for each financial institution individually. Counterparties to banking capital are therefore intrinsic to the current regulatory framework.

In our recent paper, we show, however, that bail-in legislation may have had counterproductive effects. Our key finding is that the introduction of bail-in has led to increased interconnectedness among banks, which involves more rather than less systemic risk. Worse still, increased interconnectedness between banks may jeopardize the effectiveness of the bail-in regime altogether since resolution authorities may be reluctant to exercise bail-in powers in the face of highly interconnected and contagious banks.

Using a difference-in-differences methodology, we provide evidence for this from the introduction of bail-in powers at the Eurozone level on January 1, 2016 when it entered into force under the European legislation known as the Bank Recovery and Resolution Directive, and the corresponding Single Resolution Mechanism (as part of the Banking Union) became effective. Using data from the European Central Bank’s Securities Holdings Statistics, we demonstrate that beginning in early 2016, financial institutions’ investments in securities issued by other financial institutions has been following a markedly increasing rate. What is more, at the same time non-banks have continued to decrease their investments in the same issuances. Put differently, banks’ holdings of securities in each other increased following the introduction of bail-in legislation, while non-banks continued to divest their holdings of bank securities.

We interpret these findings as evidence of a relative cost advantage that financial institutions have in comparison with other investors when investing in banks’ securities. We know from prior literature that increased interconnectedness may stabilize the banking sector for small external shocks (Acemoglu et al. 2015). For large, systemic shocks, in contrast, bank interconnectedness may frustrate any bail-in decision due to the systemic risk it creates (Bernard, Capponi, and Stiglitz 2017).

We subsequently discuss the challenges in regulating this problem, noting that in addition to the incentive problems mentioned above, there are also extensive knowledge and incentive challenges. Those challenges are symptomatic of the same legal and economic difficulties expressed in the literature and evident in recent bail-in cases.

Whilst some aspects of the current regulatory framework, including the Basel III and the TLAC framework, and standardized information disclosure under IFRS 9, indirectly affect those knowledge and incentive issues, they insufficiently address the bail-in counterparty problem especially because those measures address pre-resolution systemic risk perceptions, and not post-resolution systemic risk. More crucially perhaps, they do not facilitate optimization, or the who should hold corollary.

Finally, we explore some potential regulatory supplements to the current framework that may assist in reducing the challenge of knowing who should hold banking issuances, particularly ensuring that markets are better informed and able to allocate banking securities to optimal holders in accordance with principles of portfolio management, as opposed to attempting to prescribe ideal holders. More analysis and further holistic research are required to understand better what combination of regulatory instruments would be appropriate.

The full article is available here.

Financially Distressed Companies, Restructuring and Creditors’ Interests: What is a Director to Do?

By Andrew Keay (University of Leeds)

Out of court restructuring is a popular and, according to many, optimal way of resolving the circumstances of insolvent companies in the UK, and probably more so since the advent in the UK of the Enterprises Act 2002. One concern that some commentators have raised is the fact that the opportunities to engage in such restructuring are likely to be reduced given the way that the courts have approached claims that directors who have initiated restructuring strategies are liable for breach of duty in failing to take into account the interests of company creditors when their company is insolvent or near to it (as applied by section 172(3) of the Companies Act 2006 in the UK). Allied to this is the concern that if directors are not granted freedom to use their discretion in entering into a restructuring process companies might be placed into administration or liquidation when they have some prospect of continuing to trade and to do so profitably, because directors may choose to be risk averse in placing a company into administration or liquidation rather than take the risk of being held liable for breach of the duty if they attempt restructuring. This paper examines whether the aforementioned concerns are realistic, given the law, and, if they are, what directors should be doing to ensure that they do not breach the obligation in relation to creditors. These are important issues as little consideration has been given in the UK to the issue of liability of directors for breach of duty in the wake of a restructuring. The issues are considered in light of section 172(3) of the Companies Act 2006 which makes the director’s duty to promote the success of the company for the benefit of the shareholders (as under section 172(1) and providing for what is known as ‘enlightened shareholder value’) subject to any rule of law that requires directors to consider the interests of creditors. It is a rule of law in the UK (and in many Commonwealth countries and Ireland) that when their company is insolvent or in dire financial distress directors must take into account the interests of creditors.

The paper finds that while directors might be subject to liability in entering into restructuring attempts, this is only going to occur in limited cases and so there should not be particular concern over liability. This is because first of all courts will not hold directors liable if they acted in good faith and took into account the interests of creditors, and regarded these interests as paramount in their considerations. Even if the directors failed to take into account the interests of creditors or failed to make them paramount, they will not be liable where the court finds that the honest and intelligent director, taking into account creditors’ interests, would have entered into the restructuring in any event on the basis that it would benefit creditors. Obviously if directors restructure in such a way as to benefit themselves or specific creditors, or they have improper motives, then liability is more likely to ensue. But, where the directors have acted reasonably then they should be safe from challenge.

The full article is available here.

A New PDVSA? The Transfer of Venezuela’s Oil Assets to a Successor Entity and Fraudulent Conveyance

By Richard Levin (Jenner & Block LLP) and Roland Pettersson (LEC Abogados).

This Working Paper analysis the hypothetical transfer and conveyance of Petróleos de Venezuela, S.A.’s assets to a new state-owned entity by the Venezuelan Government, and the possible creditor responses to such action, on account of the Venezuela’s NOC current financial-distress situation. The study is conducted from the perspective of Venezuelan law, which might provide certain legal remedies under Civil, Commercial and Administrative law—although with somehow little practical success expectations, given other factors and externalities—as well as from the perspective of U.S. law, which is of particular relevance, given (i) significant asset exposure in the U.S., where PDVSA—through CITGO—maintains an important operation, (ii) the contractual terms in the bulk of Venezuela and PDVSA’s financial indebtedness relies on U.S. law and provides for submission to the jurisdiction of NY courts, and (iii) many creditors are actually U.S. persons. Thus, this Working Paper examines the above situation, given the multiple issues and complexities on the case, starting from the very nature of PDVSA as an state-owned entity under Venezuelan law, but with particular emphasis on the creditors’ side of the equation and the theory of fraudulent transfer, which is analyzed both from the standpoint of Venezuelan law, as well as from U.S. insolvency framework and international law in general.

The full working paper is available here.

Restructuring Venezuela’s Debt: An Update

By Mark Walker (Guggenheim Securities)

Lee Buchheit and Mitu Gulati have proposed an innovative and aggressive strategy to facilitate the restructuring of Venezuela’s external debt based on consensual agreement between Venezuela and a supermajority of its broad creditor universe. Borrowing from the United Nations Security Council’s decision (supported by action of the United States) to shield Iraq’s assets from seizure by its creditors in order to promote a restructuring of Iraq’s debts, they propose that the Security Council or (more likely) the President of the United States by Executive Order shield Venezuela’s assets (particularly revenues from the sale of oil into the United States) from legal process. The rationale for their proposal rests on the premises that (1) virtually all of Venezuela’s foreign exchange is generated by sales of oil into the United States, (2) the revenues from exports of oil to the United States are vulnerable to attachment by creditors and therefore a small group of aggressive creditors could strangle the entire economy of the country, (3) existing restructuring techniques are inadequate to the task and (4) the policy of the United States is to promote the restructuring of sovereign debt based on an agreement between the debtor state and a supermajority of its creditors in the context of a process in which all creditors are bound by the vote of a supermajority.

This article argues that (1) a new Venezuelan government (which all agree is a prerequisite to a restructuring) will have substantial means to shield the country’s oil revenues from seizure by creditors, (2) a new government will also be able to expand its foreign exchange earnings to include sale of oil outside the United States, (3) the proposals do not create a mechanism to allow all of Venezuela’s creditors to have a voice in the terms of a restructuring — by supermajority or otherwise — and would treat U.S. and non U.S. creditors differently and (4) the unintended consequences of the proposals advanced by Buchheit and Gulati would negatively affect the ability of emerging market sovereigns, and Venezuela in particular, to fund themselves in the debt markets and would be disruptive of the sovereign debt market generally. Referring to the paper that the author and Richard Cooper wrote one year ago, the author argues that there are tested, market-based mechanisms to achieve the goal of a consensual restructuring arrived at by a supermajority vote of creditors, in particular a restructuring of PDVSA’s debts under a newly enacted Venezuela law that is implemented with the support of a Chapter 15 proceeding under the United States Bankruptcy Code.

The full article is available here.

Crossing The Line In Cross-Border Insolvencies

By Jonathan C. Gordon (Jones Day).

Consider an insolvency proceeding outside the United States. To obtain ancillary relief in the U.S., an authorized representative from that foreign proceeding can file a petition with a U.S. court under chapter 15 of the Bankruptcy Code. In chapter 15, the foreign representative acts as a liaison between the U.S. proceeding and the foreign proceeding. For example, the representative must update the U.S. court of substantial developments in the foreign proceeding.

But what happens when that foreign representative (appointed by a foreign court) commits misconduct in the U.S. proceeding; what can the U.S. court do? As I explain in my paper, courts have struggled with a solution. For one, the Bankruptcy Code does not address this situation (nor does the related UNCITRAL Model Law). And common law is equally unavailing; courts have tried and suggested potential solutions, but those approaches (and others) fall short.

In my paper, I propose a novel solution that is simple yet effective: the U.S. court should request the foreign court to replace the foreign representative. I also analyze legal issues related to the solution’s implementation, such as judicial authority, burden of proof, timing, and interim relief.

The full paper, recently published in the ABI Law Review, can be accessed here.

Debt Restructuring: When Do Loan and Bond Prepayments Pay Off?

By Edwin Fischer and Ines Wöckl (University of Graz)

Many debtholders, whether private households, companies, or states, are caught up in high-interest long-term loans. At the same time, economic developments in the Eurozone over the past few years have created a low-interest environment in which prepaying an existing loan and simultaneously refinancing into a new loan can be advantageous from the borrower’s point of view. By redeeming an existing loan before maturity and refinancing into a loan with a lower interest rate, the amount of interest owed to the lender can be reduced significantly. Intuitively debt restructuring seems advantageous whenever the nominal interest rate of the new loan is lower than that of the old loan. However, prepayment considerations are more complex since debt restructuring entails transaction costs. These include a possible penalty for the early redemption of the existing loan, called a prepayment penalty, as well as credit charges and a possible loan disbursement fee for taking out a new loan. We use the method of differential investment to analyze under which circumstances loan and bond prepayments make sense for debtholders. We provide an exact solution concept as well as an easy-to-use approximation for calculating the critical upper limits for the nominal interest rate of the new loan up to which prepayment and subsequent refinancing is optimal. The calculations address both fixed and variable rate loans and consider whether the debt agreement is repaid at maturity or in annuities.

The full article is available here.

Transplanting Chapter 11 of the US Bankruptcy Code into Singapore’s Restructuring and Insolvency Laws: Opportunities and Challenges

By Gerard McCormack (University of Leeds) and Wai Yee Wan (Singapore Management University – School of Law)

In 2017, Singapore introduced wide-ranging reforms to its insolvency and restructuring laws with a view to enhancing its attractiveness as an international centre for debt restructuring. A key theme of the reforms is the transplantation (with modification) of certain provisions from Chapter 11 of the US Bankruptcy Code including the automatic moratorium, cross-creditor cram-down, rescue financing and pre-packs. These provisions are engrafted into the existing scheme of arrangement framework, which in turn has its roots in the United Kingdom (UK).

In our paper, relying on the US experience and the reactions to similar reform proposals in the European Union (including the UK), we critically evaluate the effectiveness of the legal transplantation and discuss the possible unintended consequences of such transplantation.

We raise three issues. First, the new cross-class cram-down provisions could lead to valuation disputes and satellite litigation, such as whether the directors and scheme managers have properly discharged their duties. Second, the 2017 reforms shift power from the creditors to the management of the debtor company. This may prove to be disadvantageous to creditors in Singapore (and many other Asian countries) where the majority of the companies, including publicly listed companies, have concentrated shareholdings, and managers owe their existence to those who are in control. Finally, there remains the question whether the Singapore schemes will be recognised overseas, which will be important if the scheme proposes to modify debt obligations that are governed by non-Singapore law.

The full article is available here. The article is recently published in Journal of Corporate Law Studies.

 

How Specialized Courts Changed the Chinese Bankruptcy System

By Bo Li (Tsinghua University – PBC School of Finance) and Jacopo Ponticelli (Kellogg School of Management – Department of Finance)

In the last decade, China experienced a massive increase in corporate debt and, more recently, in corporate bankruptcies. Despite the mounting pressure on its insolvency resolution system, little is known about how bankruptcy works in China and the role played by the government.

China’s bankruptcy system experienced two recent changes: the reform of the bankruptcy code in 2007, and the introduction of specialized courts between 2007 and 2017. Before the introduction of specialized courts, bankruptcy cases were filed in local civil courts. Characterized by limited expertise and long delays, local courts tend to operate under the influence of local politicians, who have strong incentives to keep financially distressed state-owned companies alive to reduce unemployment and boost their political career. Thus, even though  the 2007 reform aligned Chinese bankruptcy law with those in the US and Europe, timely resolution of state-owned firms in financial distress remains a problem due to the influence of local governments.

Recently, China’s central government promoted the introduction of courts specialized in bankruptcy, which are modeled on US courts and run by insolvency professionals. In this paper, we study the impact of the introduction of specialized courts across Chinese provinces a on bankruptcy resolution and credit markets. The introduction of specialized courts led to an increase in the share of liquidations of state-owned firms and a faster speed of processing in court. In addition, state-owned firms operating in jurisdictions with specialized courts experienced a decrease in the size of new bank loans, lower access to new loans, and lower investment in physical capital relative to privately-owned firms.

The full article is available here.

 

Piercing the Corporate Veil: Historical, Theoretical and Comparative Perspectives

By Cheng-Han Tan, Jiangyu Wang, Christian Hofmann (National University of Singapore Law School)

Corporate personality is not absolute and this paper aims to compare and critically examine the circumstances under which veil piercing takes place against the objectives of incorporation. The countries examined are a mix of common law and civil law countries, including China, England, Germany, Singapore and the United States. We note that English and German courts have in recent years adopted a more restrictive approach to veil piercing, with Singapore courts appearing to be sympathetic to the current English position. On the other hand, courts in the United States and especially China seem to accept a more expansive approach to piercing even while recognising its exceptional nature. One reason for this is because veil piercing has been used loosely in instances which seem inappropriate and where the matters could have been determined by other legal principles.

We suggest that this is sub-optimal and that a narrower approach to veil piercing is preferable. For one, the need to look beyond the corporation is usually only necessary where insolvency has intervened. Direct claims by creditors against shareholders or management therefore potentially risk undermining the collective insolvency framework within which creditors are to have their claims adjudicated. Another reason is that veil piercing potentially overlaps with other legal doctrines, particularly the law of torts. As tort law is principally engaged with the issue of when civil wrongdoing arises, it will often provide a superior framework for determining whether shareholders or management should be directly responsible for alleged wrongdoing to a creditor.

The full article is available here.


The Roundtable will be off for two weeks. We’ll be back early after the New Year.

Repo Markets Across the Atlantic: Similar but Unalike

By Songjiwen Wu (University of Heidelberg) and Hossein Nabilou (Universite du Luxembourg – Faculty of Law, Economics and Finance)

The vulnerabilities in the wholesale funding and in particular short-term (overnight) repurchase agreement (repo) markets were significant sources of systemic risk in the Global Financial Crisis. Numerous studies have investigated the role of repos in the crisis, but only a few scholars have explored why the European repo markets have weathered the crisis better than their US counterparts. With a focus on the underlying legal and structural features of repo markets across the Atlantic, our paper sets out to explain such a different outcome. In doing so, it sketches the key differences in the EU and the US repos by focusing on three main aspects of repo markets that are pivotal to highlighting potential vulnerabilities. First, it highlights the differences in the legal framework governing repos, such as legal construction of repo contracts, special bankruptcy treatment—the reform of which has been a key controversial issue across the Atlantic—and legal treatment of the reuse of collateral. Second, it discusses the composition, structure, and organization of the repo markets, such as differences in the composition of repo participants, maturity of repos, and the composition of the underlying collateral in repo contracts. Finally, it investigates the differences in the issues related to the market infrastructure of repo markets such as differences in the clearing and collateral management stages. The findings of our paper suggest that multiple legal and regulatory divergences, which could still pose challenges to the short-term funding markets, exist in repo markets across the Atlantic.

The full article is available here.


For previous Roundtable posts on repo markets, see Ganduri, “Repo Regret?“, and Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“.

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