Don’t Bank on Bankruptcy for Banks

By Mark Roe (Harvard Law School)

In the next month, the US Treasury Department is expected to decide whether to seek to replace the 2010 Dodd-Frank Act’s regulator-led process for resolving failed mega-banks with a solely court-based mechanism. Such a change would be a mistake of potentially crisis-size proportions.

Yes, creating a more streamlined bankruptcy process can reduce the decibel level of a bank’s failure, and bankruptcy judges are experts at important restructuring tasks. But there are critical factors that cannot be ignored. Restructuring a mega-bank requires pre-planning, familiarity with the bank’s strengths and weaknesses, knowledge of how to time the bankruptcy properly in a volatile economy, and the capacity to coordinate with foreign regulators.

The courts cannot fulfill these tasks alone, especially in the time the proposal under consideration has allotted – a 48-hour weekend. Unable to plan ahead, the courts would enter into the restructuring process unfamiliar with the bank. Moreover, the courts cannot manage the kind of economy-wide crisis that would arise if multiple mega-banks sank simultaneously. And they cannot coordinate with foreign regulators.

The rest of the article is available here.

Recent Roundtable coverage of this subject includes a round-up of op-eds; a summary of a letter submitted to Congress by financial scholars; a summary of a White House memorandum calling for reconsideration of the OLA; and an analysis of recent legislative efforts to address bankruptcy for banks.

The Roundtable has also published commentary on the treatment of insolvent financial institutions; see Jackson & Massman, “The Resolution of Distressed Financial Conglomerates” and Lubben & Wilmarth, “Too Big and Unable to Fail.”

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.

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.”