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Bankruptcy Not Bailout
A Special Chapter 14
By Kenneth E. Scott, John B. Taylor
Hoover Institution PressCopyright © 2012 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
A Guide to the Resolution of Failed Financial Institutions
Dodd-Frank Title II and Proposed Chapter 14
Kenneth E. Scott
The "Resolution Project" began in August 2009, in the midst of the financial crisis, to consider how best to deal with the failure of major financial institutions. The members of the group, assembled from institutions across the country, were Andrew Crockett, Darrell Duffie, Richard Herring, Thomas Jackson, William Kroener, Kenneth Scott (chair), George Shultz, Kimberly Summe, and John Taylor, later joined by David Skeel. A number of meetings and discussions led to papers and then a conference in December 2009, followed by a book: Ending Government Bailouts as We Know Them.
The heated debate in Congress over the proper response continued until July 2010, culminating in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. 111–203). This massive statute runs for 848 pages, contains 16 titles, requires 386 more agency rulemakings, and mandates 67 studies. Most of it was a collection of assorted changes to the financial system that various groups had been advocating for some time, unrelated to the causes of the panic.
A popular conception, in the press and Congress, of the cause of the panic was that when the investment bank Lehman Brothers failed in September 2008, it had to be put into bankruptcy reorganization because (unlike commercial banks) it could not be taken over by the Federal Deposit Insurance Corporation (FDIC). Whatever its merits, that view provided much of the impetus for the enactment of Titles I (Financial Stability) and II (Orderly Liquidation Authority) of the Dodd-Frank Act, which were intended to prevent the failure of systemically important (nonbank) financial institutions (SIFIs) and, if that was unsuccessful, provide for a new failure procedure whereby the Secretary of the Treasury could institute the takeover of a SIFI with the FDIC becoming the receiver.
Title I created a new Financial Stability Oversight Council composed of the heads of various financial regulatory agencies, which is to collect data about financial companies and financial risks and to identify financial companies that could pose a threat to U.S. financial stability. Such companies would be supervised by the Federal Reserve Board (the "Fed") and subjected to a list of more stringent prudential standards and requirements.
Title II authorizes the Secretary of the Treasury, upon recommendation by the Fed and FDIC, to determine that a financial company is in default or in danger of a default that would have serious adverse effects on U.S. financial stability, and then to petition the DC district court to appoint the FDIC as receiver to "liquidate" the company. Title II, and not the Bankruptcy Code, would govern the receivership.
The Resolution Project group turned its focus to the development of a supplemental proposal for a modified bankruptcy law, denominated as a new Chapter 14,3 designed exclusively for major financial institutions. This paper is written for a moderately knowledgeable audience and is intended to identify and compare the major differences in the Dodd-Frank Title II and Chapter 14 procedures and to outline the reasons why the group believes the latter to be preferable. Sections 202 and 216 of the Dodd-Frank Act (the "Act") called for an inquiry on bankruptcy resolution to be conducted by the Government Accountability Office (GAO), the Federal Reserve System (FRS) Board of Governors, and the Administrative Office of the United States Courts, and one of the Resolution Project's goals was to make a contribution to that analysis and its consideration by the Congress.
II. OBJECTIVES OF RESOLUTION LAW FOR MAJOR INSOLVENT FINANCIAL FIRMS
Any failure law for business firms has a number of objectives, not always fully consistent. One is to provide a mechanism for collective action by creditors to realize on the assets of the firm in an orderly manner, as opposed to an individual scramble for whatever could be seized and sold first, and apply the proceeds to claims in accordance with the contractual priorities for which they had bargained and charged. An efficient procedure for maximizing recoveries, involving notices and hearings, contributes to meeting expectations and reducing losses, and hence to lower costs of capital for the carrying on of all business enterprises.
A second objective, which could be seen as an adjunct to the first, is to retain the "going-concern value" of any parts of the business that can still be operated at a net profit through a "reorganization" of the firm, as opposed to the liquidation sale of its various assets. This is particularly significant for financial firms, much of whose value lies in the organization, knowledge, and services of its personnel and their relationships to clients, rather than in separately salable assets like inventory, real estate, buildings, and machinery.
A third objective, perhaps uniquely so for "systemically important financial institutions," is to avoid a breakdown of the entire financial system. What this means and what it entails is considered toward the end of this chapter. So we turn next to an examination of the differences between the Act and Chapter 14, necessarily limiting it to central concepts and omitting a host of (not at all unimportant) details.
III. FINANCIAL INSTITUTIONS COVERED
The Act excludes from its coverage banks and (notably) government-sponsored entities (such as Fannie Mae and Freddie Mac), and includes in its coverage companies predominately (on the basis of either assets or revenues) engaged in financial activities. From the large universe of financial companies, the Fed is supposed to give especially intensive supervision to all bank holding companies with more than $50 billion in consolidated assets and those financial companies that the Financial Stability Oversight Council has selected as potentially posing a threat to U.S. financial stability in the event of its financial distress. But whether or not so predesignated or supervised, any financial company that the Secretary of the Treasury determines to be in danger of default with serious adverse effects on financial stability may be seized and put into FDIC receivership by petition to the DC district court. Financial companies that are not so chosen would remain under the existing Bankruptcy Code. In other words, application of Title II of the Act is left to administrative discretion, defined only by "findings" that the agency itself makes at the time of action, and counterparties have no way of knowing in advance which law will apply.
B. Chapter 14
The new Chapter applies to all financial companies and their subsidiaries with more than $100 billion in consolidated assets. Counterparties would generally not be left in doubt as to which companies will be subject to a special resolution procedure and which ones will be dealt with under the Bankruptcy Code provisions. Uncertainty in financial transactions increases risk and costs for everyone, and is to be minimized wherever possible.
IV. COMMENCEMENT OF PROCEEDINGS
The Act creates an elaborate and potentially cumbersome bureaucratic process for triggering seizure of a financial company. The Fed and FDIC (or other primary federal regulator) jointly make a recommendation to the Treasury Secretary, based upon consideration of a list of factors that includes the reason why proceeding under the Bankruptcy Code is not appropriate. The Treasury Secretary then must make seven findings, including that the firm is a financial company projected to be in danger of a default (because of insufficient capital or ability to pay its obligations when due) that, if handled under the Bankruptcy Code, would have serious adverse effects on U.S. financial stability.
The Secretary thereupon files a petition in the DC district court to appoint the FDIC as its receiver (unless the company's board consents). The statute mandates that within 24 hours: (1) there is a closed and secret hearing in which the Secretary presents all the accumulated documentation underlying the agency recommendations and his conclusions, (2) the company can try to present a rebuttal as to its portfolio asset valuations and capital or access to liquidity, (3) the judge considers all the conflicting evidence (but only on two of the seven mandatory determinations), and (4) the court issues either an order authorizing the receivership or a written opinion giving all reasons supporting a denial of the petition. If the district court cannot accomplish all that within 24 hours, the petition is granted by operation of law.
Apart from the obvious impossibility of an effective rebuttal by the company — much less of findings of fact and a reasoned decision by the court — within such a truncated time frame, any appeal to a higher court would be limited to that one-sided, one-day record, and any stay of the liquidation is prohibited. This summary procedure raises substantial constitutional problems under the Due Process Clause, which could invalidate the entire Title II mechanism.
B. Chapter 14
To the involuntary procedure in current bankruptcy law, initiated by unpaid creditors, there is added authority for the financial institution's primary regulator to commence a case both on the grounds applicable to other involuntary petitions as well as on the ground of "balance sheet" insolvency: its assets are less than its liabilities or it has unreasonably small capital. This is analogous to the "in default or in danger of default" concept in Dodd-Frank, but the company has an actual opportunity in a court to challenge the assertion (in closed and secret hearing, should the judge deem appropriate), without a truncated time frame, if it really disputes the adverse judgments on its financial soundness or believes the administrative valuations of its illiquid (nontraded) assets are demonstrably erroneous.
Chapter 14 retains the ability of the management of a firm to itself initiate a voluntary proceeding in lieu of having to go into FDIC receivership. If the management sees the firm's financial position as becoming untenable, it does not have to wait for balance sheet insolvency or default on obligations, but can inaugurate a reorganization to try to salvage in part its business and retain its jobs. Much recent history indicates the tendency of banking regulators for various reasons not to take over prior to complete insolvency (as the FDIC Improvement Act of 1991 authorized them to do) but to wait until losses to the deposit insurance fund have become substantial despite its supervisory powers and stake as the primary creditor. The Dodd-Frank seizure procedure was designed to require a consensus of a set of government agencies before taking action. The history of voluntary bankruptcy, conversely, is replete with examples of preemptive action in which asset values are written down, there is a negotiation to allocate losses among claimants (with stockholders being the first to go), and a reduced business continues in successful operation, sometimes under existing management (which, as explained subsequently, Dodd-Frank makes very unlikely). Incentives for management to act in a fashion more timely than receivership liquidation are socially valuable.
V. THE RESOLUTION PROCEDURE
A. Dodd-Frank: FDIC as Receiver
One of the reasons stressed in Congress for enactment of Title II was the FDIC's long experience in liquidating failed commercial banks. But the SIFIs with which the Act is primarily concerned are giant firms — hundreds of billions or even trillions of dollars in size, with any commercial bank as only one part of the complex. The FDIC's experience has been in dealing with numerous small and medium-sized banks, in which it is by far the biggest creditor through the deposit insurance fund, and for which there are often obvious — and larger — institutions ready to take over; only in the last several years has it encountered a few very large ones, with a wider variety of assets and claimants. And in the case of a common reassessment type of systemic event (see section VI.A of this chapter), the FDIC might have to take on a number of such institutions at the same time — a situation for which no one has experience or existing capacity.
The Act mandates that the seized financial company shall be liquidated; it may not be reorganized, and the management "responsible" must be immediately removed. It is evident that the mandate was intended to be more punitive than value enhancing. There may be indirect ways to avoid its needless value destruction, but it is certainly not conducive to efficient resolution, a process that the Act recognizes could take more than five years to complete.
More troubling is the power of the receiver to operate without transparency and not observe standard bankruptcy rules intended to adhere to absolute priority of claims and equal treatment of claimants in the same category. (Although many of the relevant Title II provisions have been imported from the Bankruptcy Code, provisions for judicial hearings, management participation, and creditor votes were not.) The Act authorizes the FDIC, as it sees fit, to transfer assets and liabilities to a "bridge" institution where they are fully protected, and depart from equal treatment of unsecured receivership claimants if it decides that would be good for the receivership estate. If those dealing with a large financial institution have to calculate the risk they are assuming not only on the basis of business assessments but also on predictions of the exercise of legally unreviewable political discretion rather than on reasonably settled legal rules, a major cost and burden is imposed on the operation of financial markets.
B. Chapter 14
Bankruptcy judges have been handling the liquidation and reorganization of very large and complicated companies for decades. Nonetheless, it should be recognized that giant financial firms pose some particular issues. Therefore, Chapter 14 contemplates the development of a small (hopefully, cases will be few and infrequent) and specialized panel of district and bankruptcy court judges and special masters that would oversee these cases. Like the FDIC, this panel would have to develop some special expertise with giant SIFIs over time. The details are spelled out in chapter 2.
In a typical Bankruptcy Code proceeding, management (as the "debtor-in-possession" or "DIP") remains in control of ordinary business operations, and has an exclusive period in which to file a plan of reorganization. Upon creditor petition, the bankruptcy court may turn control over to a bankruptcy "trustee." Under Chapter 14, the financial company's primary federal regulator could initiate the proceeding, and could petition to have the FDIC appointed as a trustee. The FDIC would then function under Chapter 14 and therefore have the option (lacking in Title II of the Act) to pursue openly a traditional reorganization to maximize the business's value for benefit of creditors, rather than being forced to liquidate it in a formal sense to satisfy § 214. In addition, there would be no period of exclusivity in Chapter 14 in which only management could propose a plan of reorganization; both the FDIC and a creditor's committee would be given concurrent rights to file such a plan.
Whoever is in charge, resolution under Chapter 14 would be conducted under established (Chapters 11 and 7) bankruptcy rules about absolute priority, avoiding powers, transfers, and preferences (except as noted in section VI.C herein). Dispositions of cash and of assets outside the ordinary course of business require creditor notice and opportunity for hearing, particularly on the value being received. Plans of reorganization, with their allocation of losses among claimant classes, are subject to approval votes and judicial oversight. The resolution would proceed in the open, unlike present FDIC practices.
These requirements constitute safeguards against not only erroneous administrative judgments but also political manipulation and favoritism of selected interests. That such concerns are not merely speculative is illustrated by the way the government managed the Chrysler bankruptcy under the current Bankruptcy Code to avoid creditor voting rights. This defect is partially addressed in the new Chapter 14 through the provisions entrusting this category of cases to Article III judges with life tenure. In addition, other broader safeguards are included to ensure that sales under Section 363 of the Bankruptcy Code do not, sub rosa, avoid the safeguards of voting under plans of reorganization and protection of dissenting creditors.
VI. SYSTEMIC RISK — BREAKDOWN OF THE FINANCIAL SYSTEM
A. Concepts of Systemic Risk — What Exactly Is the Scenario?
Systemic risk is much referred to but typically not defined operationally or modeled in any generally accepted form. At least three different (if at times overlapping) notions can be found. All describe paths to the failure, or failure to function, of a large number of major financial institutions and a breakdown of the system for allocating financial credit.
Excerpted from Bankruptcy Not Bailout by Kenneth E. Scott, John B. Taylor. Copyright © 2012 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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Table of Contents
Preface John B. Tayhr ix
Part A A New Bankruptcy Approach
1 A Guide to the Resolution of Failed Financial Institutions: Dodd-Frank Title II and Proposed Chapter 14 Kenneth E. Scott 3
2 Bankruptcy Code Chapter 14: A Proposal Thomas H. Jackson 25
Part B Lehman and "Orderly Liquidation"
3 Comment on Orderly Liquidation under Title II of Dodd-Frank and Chapter 14 William F. Kroener III 73
4 An Examination of Lehman Brothers' Derivatives Portfolio Postbankruptcy: Would Dodd-Frank Have Made a Difference? Kimberly Anne Summe 85
Part C Liquidation and Reorganization
5 A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements Darrell Duffie David Skeel 133
6 The Going-Concern Value of a Failed SIFI: Dodd-Frank and Chapter 14 Kenneth E. Scott Thomas H. Jackson 175
7 Dodd-Frank: Resolution or Expropriation? Kenneth E. Scott 199
8 Regulatory Reform: A Practitioner's Perspective Kevin M. Warsh 207
9 A Macroeconomic Perspective: "Dealing with Too Big to Fail" Andrew Crockett 217
About the Authors 227
About the Hoover Institution's Working Group on Economic Policy 233