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.

How Absolute is the Absolute Priority Rule in Bankruptcy? The Case for Structured Dismissals

By Bruce Grohsgal (Widener University School of Law)

A structured dismissal in a chapter 11 bankruptcy case is a court-approved settlement of certain claims by or against the debtor followed by the dismissal of the case. Courts have held that a bankruptcy court cannot approve a settlement unless it complies with the absolute priority rule, paying senior claims in full before any distribution to junior stakeholders.

The Supreme Court will consider structured dismissals this fall in In re Jevic Holding Corp. The question before the Court is: “Whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme.”

The argument that a structured dismissal always must follow the absolute priority rule, even when a chapter 11 plan is not confirmable, overstates the current statutory reach of the rule. The rule reached its zenith by judicial launch in 1939 in Case v. Los Angeles Lumber, when the Supreme Court construed the statutory term “fair and equitable” to be synonymous with “absolute priority.” Congress has circumscribed the rule repeatedly since: in 1952 under the Bankruptcy Act, in 1978 with enactment of the Code, and in 1986 and 2005.

As a result of these enactments, the absolute priority rule is a special, limited rule that does not pervade the current Code. Indeed, the very reorganization plan—a consensual chapter 11 plan—that the Supreme Court held was not confirmable in Los Angeles Lumber would be confirmable under the current Code.

My article, forthcoming and available here, concludes that Congress has authorized the bankruptcy court to approve a structured dismissal in chapter 11 when it is in the best interest of creditors—such as when a plan is not confirmable—even if distributions do not follow the absolute priority rule. Accordingly, the Supreme Court should resolve the current circuit split by affirming Jevic.

The Case in Brief Against Chapter 14

Author: Bruce Grohsgal, Pachulski Stang Ziehl & Jones, LLP

Grohsgal-BruceResolution of a distressed financial company under Dodd-Frank Title II is a last – but crucial – resort.  Dodd-Frank, Title I, requires each large financial enterprise to file a “living will” that provides for its orderly resolution under the Bankruptcy Code.  Dodd-Frank Title II may only be used to liquidate a failing financial company that would “pose a significant risk to the financial stability of the United States” if resolved in a bankruptcy proceeding or under other federal or state law.  The FDIC must conduct a Title II resolution “in a manner that mitigates such risk and minimizes moral hazard.”  Dodd-Frank also expressly prohibits both a taxpayer-funded bailout and the Federal Reserve’s lending to a failing or failed financial firm.

Dodd-Frank has drawn fire, nonetheless, as encouraging, rather than preventing, bailouts.  Detractors urge repealing Title II of Dodd-Frank and amending the Bankruptcy Code to include a new Chapter 14 in its place.

The proposed Chapter 14’s central flaw is that it does nothing to reconcile Dodd-Frank’s purposes of mitigating systemic risk and minimizing moral hazard with the Bankruptcy Code’s starkly contrasting aims of reorganizing troubled companies, preserving going concerns and maximizing payments to creditors.

This article briefly summarizes Dodd-Frank’s orderly resolution regime and then addresses some of the core proposals for a new Chapter 14.  It concludes that the proposed Chapter 14 will not mitigate systemic risk, minimize moral hazard, or improve on Dodd-Frank’s prohibitions against bailouts, which are the primary purposes of Title II of Dodd-Frank.

The article is available here.