The Resolution of Distressed Financial Conglomerates
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By Howell E. Jackson (Harvard Law School) & Stephanie Massman (Harvard Law School, J.D. 2015)

One of the most elegant legal innovations to emerge from the Dodd-Frank Act is the FDIC’s Single Point of Entry (SPOE) initiative for resolving the failure of large financial conglomerates (corporate groups with regulated financial entities as subsidiaries), whereby regulators would seize only the top-tier holding company, down-stream holding-company resources to distressed subsidiaries, and wipe out holding-company shareholders while simultaneously imposing additional losses on holding-company creditors. The SPOE strategy is designed to resolve the entire group without disrupting the business of operating subsidiaries (even those operating overseas) or risking systemic consequences for the broader economy.

Although SPOE’s underlying creativity is admirable, the approach’s design raises several novel and challenging questions of implementation, explored in this chapter. For example, the automatic down-streaming of resources raises the so-called pre-positioning dilemma. If too much support is positioned at subsidiaries in advance, there may be inadequate holding-company reserves to support a severely distressed subsidiary. Alternatively, without such pre-positioning, commitments of subsidiary support may not be credible (especially to foreign authorities), and it may become difficult legally and practically to deploy resources in times of distress.

It is easiest to envision SPOE operating in conjunction with the FDIC’s Orderly Liquidation Authority (OLA), established in the Dodd-Frank Act; however, Dodd-Frank’s preferred regime for resolving failed financial conglomerates remains the U.S. Bankruptcy Code, and several complexities could arise if a bankruptcy court had to implement an SPOE resolution today. While many experts are working on legislative proposals to amend the Bankruptcy Code to facilitate SPOE resolutions, this chapter examines some legal levers that federal authorities could deploy under current law to increase the likelihood of a successful SPOE bankruptcy. For example, with appropriate pre-failure planning, section 365(o) of the Bankruptcy Code—which requires the debtor to assume and cure immediately any deficiency under an obligation to federal regulators to maintain the capital of an insured depository institution—could be used to prioritize holding-company commitments to all material operating subsidiaries, including affiliates that are not insured depository institutions. Such priority status would shield the down-streaming of value to operating subsidiaries from possible legal challenges, thereby alleviating some of the difficulty of the pre-positioning dilemma. Additionally, broad-based credit facilities under section 13(3) of the Federal Reserve Act or targeted lending under the Federal Deposit Insurance Act’s systemic risk exception may be available to provide government-sponsored debtor-in-possession financing where no private or other public alternative (like that provided under OLA) is available.

Implementing these strategies would be challenging and would require considerable planning. However, it is important to take steps now to increase the likelihood that bankruptcy represents a viable and credible alternative for effecting SPOE transactions outside of OLA.

The full chapter is available here.

The Roundtable has covered bank resolution and the SPOE strategy previously. For example, see Lubben & Wilmarth, “Too Big and Unable to Fail“; Crawford, “Establishing ‘Credible Losers’“; Roundtable Update, “Bankruptcy Code Amendments Pass the House in Appropriations Bill.”

Developing a New Resolution Regime for Failed Systemically Important Financial Institutions
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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.

ISDA Resolution Stay Protocol: A Brief Overview
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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
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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)

Chapter 22 Roundtable in the WSJ Bankruptcy Beat
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Last week, the Wall Street Journal’s Bankruptcy Beat posted several pieces on the causes and consequences of so-called “Chapter 22” repeat bankruptcy filings. In the first three posts of the series, bankruptcy experts offered a range of views on the topic.

In the first post, Harvey Miller, of Weil, Gotshal & Manges, said that increased recidivism in Chapter 11 filings was largely due to distressed debt and securities investors, who effectively gain control of the debtor and its plan formulation process and do all that is necessary to expedite the plan confirmation. Because nobody in this coordinated effort will challenge the plan’s feasibility and because the judge is not well placed to independently investigate, feasibility issues may go unaddressed.

Marshall Huebner, of Davis Polk & Wardwell LLP, in the second post, noted other factors that could trigger subsequent Chapter 11 filings, including a company’s underestimation of the broader industry’s decline, creditor pressure on the debtor to remain overleveraged, and a debtor’s inability to shed legacy liabilities.

In the third post, Mark Roe, professor at Harvard Law School reasoned that, regardless of the cause, recidivism is both not that common—less than 20% of Chapter 11 debtors—and not that bad of a trade-off if it stems from getting companies through the bankruptcy process quickly, as long as most of them recover and grow. Enforcing a strict zero-tolerance feasibility standard could do more damage to debtors by keeping them in bankruptcy longer.

Visit the Bankruptcy Beat website to see the rest of the experts’ views on Chapter 22 filings.

Visit the HLS Bankruptcy Roundtable’s prior coverage of Ed Altman’s study of the frequency and nature of Chapter 22 filings, posted in June, here.

This summary was drafted by Stephanie Massman (J.D. 2015)