In a recent post,[1] I summarized my forthcoming article critiquing the financial industry’s plan for resolving failed megabanks under Title II of the Dodd-Frank Act.[2] My article describes the industry’s “single point of entry” (SPOE) strategy for recapitalizing and reorganizing failed megabanks. I argue that the industry’s SPOE strategy is designed to provide full protection for Wall Street creditors of failed megabanks while imposing the costs of rescuing those banks on ordinary investors and/or taxpayers.
The financial industry has also proposed a new “Chapter 14” of the Bankruptcy Code, which would authorize federal bankruptcy courts to adopt an SPOE approach for reorganizing insolvent financial holding companies.[3] Under the industry’s Chapter 14 proposal, a bankruptcy court could authorize an insolvent financial holding company to transfer all of its operating subsidiaries to a newly-created “bridge financial company” (BFC). The transfer of the operating subsidiaries to the BFC would be accomplished within 48 hours by means of an accelerated “Section 363 sale.” Similar transfers were made in the emergency bankruptcy reorganizations of Chrysler and General Motors (GM).[4]
Under the financial industry’s strategy, the result of a Chapter 14 SPOE reorganization would be a cleaned-up megabank, as would also be true in an SPOE resolution under Title II of Dodd-Frank. The BFC would be converted into a new financial holding company, which would inherit the operating subsidiaries previously owned by the parent holding company of the insolvent megabank. The operating subsidiaries would kept open for business, and all of their creditors (including Wall Street creditors) would be fully protected.
The Chapter 14 proposal – like the industry’s SPOE plan under Title II – would impose losses on the shareholders and long-term bondholders of the old parent holding company.[5] For reasons I have discussed in my article, most of those long-term bondholders would probably be ordinary individuals with investments in pension funds or mutual funds.[6] Thus, if the financial industry’s SPOE strategy is adopted under either Chapter 14 or Title II, ordinary investors would likely shoulder the greatest share of the losses when a failed megabank is resolved. Meanwhile, as indicated above, Wall Street creditors of the failed megabank would be shielded from any losses.
The proposed Chapter 14 would include a temporary stay on “qualified financial contracts” (QFCs), including derivatives and securities repurchase agreements, in order to prevent holders of those instruments from terminating their contracts and seizing their collateral when a megabank enters Chapter 14. Such a stay would represent a significant exception to the current “safe harbors” for QFCs under the Bankruptcy Code, and it would be similar to the temporary stay for QFCs that is already mandated under Title II of Dodd-Frank.[7]
A major challenge for the Chapter 14 proposal is to identify a source of “debtor in possession” (DIP) financing that could support the reorganization of an insolvent megabank. Dodd-Frank finances resolutions of failed megabanks under Title II by authorizing the Treasury Department to make loans from the Orderly Liquidation Fund (OLF) to the Federal Deposit Insurance Corporation (FDIC).[8] During a financial crisis, it is very unlikely that private-sector lenders would be willing to provide DIP financing for resolutions of insolvent megabanks under Chapter 14. The unavailability of private credit during a crisis was demonstrated in September 2008, when federal regulators could not persuade leading financial institutions to help in saving either Lehman Brothers or AIG.[9]
To fill this crucial gap, the financial industry has proposed that the Federal Reserve (Fed) should play the role of DIP lender when a megabank enters Chapter 14 by either (i) using the Fed’s authority to make discount window loans, or (ii) obtaining a statutory change that would restore the Fed’s authority to make emergency loans to individual megabanks under the pre-Dodd-Frank version of Section 13(3) of the Federal Reserve Act. [10] In addition, the Fed could conceivably use its authority under the post-Dodd-Frank version of Section 13(3) to create a “widely available” emergency lending facility similar to the Primary Dealer Credit Facility, which the Fed set up in 2008.[11]
For at least three reasons, the financial industry’s proposed Chapter 14 strategy should not be adopted in its current form because it would have consequences that are even worse than the industry’s SPOE plan under Title II of Dodd-Frank. First, when a megabank is placed in receivership under Title II, Section 206(4) compels the FDIC to remove executives and directors who were responsible for the megabank’s failure. In contrast, the financial industry’s Chapter 14 proposal does not contain any similar requirement.[12] Thus, Chapter 14 would allow the same executives and directors who contributed to a megabank’s failure to remain in charge of the cleaned-up megabank after it emerges from a Chapter 14 reorganization.
Second, a Title II receivership would be supervised by the FDIC, but a bankruptcy court would exercise broad control over a Chapter 14 reorganization. The Fed would have a limited degree of influence in a Chapter 14 proceeding, while the FDIC would play a very minor role.[13] Similarly, as indicated above, the FDIC would control the extent to which a failed megabank could obtain OLF loans under Title II, but DIP financing would be available from the Fed under proposed Chapter 14. Thus, the financial industry’s Chapter 14 proposal appears to be consciously designed to minimize the FDIC’s role while enlisting the Fed to support the work of bankruptcy judges.
It is not surprising that the financial industry would attempt to sideline the FDIC and to strengthen the Fed’s role in reorganizing insolvent megabanks. The FDIC has generally taken a significantly stricter supervisory approach compared to the Fed. The two agencies’ differences in supervisory philosophy reflect their distinct missions. The FDIC is primarily concerned with protecting depositors and maintaining the solvency of the deposit insurance fund. That mission does not encourage the FDIC to look kindly on excessive risk-taking by megabanks. In contrast, the Fed focuses much of its efforts on preserving financial stability. That objective strongly inclines the Fed to support large financial institutions and to avert any potentially disruptive failures.
In addition, the FDIC enjoys a substantial degree of structural independence from industry influence. The FDIC’s monopoly position as deposit insurer and its status as an independent public agency give it a relatively high degree of political insulation. In contrast, the Fed’s hybrid private-public ownership and governance structure – in which banks own shares in regional Federal Reserve Banks and elect two-thirds of Reserve Bank directors, who in turn nominate Reserve Bank Presidents – has tended to encourage a cozy relationship between the industry and the Fed.[14] Accordingly, there are good reasons for the financial industry to expect that the Fed would provide DIP financing on relatively lenient terms under Chapter 14, while the FDIC would impose more demanding conditions for OLF loans under Title II of Dodd-Frank
Third, there are strong reasons to doubt whether federal bankruptcy judges would be as insulated from political pressures in overseeing Chapter 14 reorganizations as the FDIC would be in overseeing Title II resolutions. Several scholars have criticized the emergency reorganizations of Chrysler and GM as politically charged transactions, in which federal officials pressured bankruptcy judges to give better treatment to creditors whom the federal government favored (e.g., claimants under union pension and health benefit plans) compared with other creditors (e.g., bondholders, tort plaintiffs, and terminated car dealers).[15] In contrast to the potentially vulnerable and isolated position of a bankruptcy judge, the FDIC has a well-known status as the guardian of our nation’s deposits, which provides that agency with a natural platform to rally public support against the financial industry’s political influence. In the past, the FDIC’s leaders have used their public standing to push back against political pressure, as former FDIC Chairmen Sheila Bair and William Seidman demonstrated during their respective tenures.[16]
In my forthcoming article, I argue that Title II of Dodd-Frank should be reformed in order to (i) prevent the financial industry from using the SPOE strategy to create disguised bailouts for Wall Street creditors, and (ii) compel megabanks and their executives to bear a significant share of the losses when a financial giant fails.[17] Those reforms should also be included in any legislation that would create a new Chapter 14 of the Bankruptcy Code.
Three additional reforms are needed to ensure that the Chapter 14 proposal does not provide unwarranted protection for megabank executives and Wall Street creditors. First, the bridge financial company created in Chapter 14 (and any successor holding company) should obtain the joint approval of the FDIC and the Fed before employing any individuals who served as executives, directors, or consultants for the insolvent megabank. That joint approval requirement would create a much-needed parallel to Section 206(4) of Dodd-Frank, cited above.
Second, the bankruptcy court should provide at least 48 hours’ notice to the Treasury Department, the FDIC and the Fed before approving any “Section 363 sale” or similar transfer of assets under Chapter 14. During that period, the Treasury (with the concurrence of the FDIC and the Fed) should be authorized to place the insolvent megabank in a receivership under Title II. Confirming the Treasury’s authority to establish a Title II receivership would prevent an insolvent financial giant from commencing a Chapter 14 proceeding for the purpose of preempting the federal government’s ability to resolve the megabank under the more closely supervised procedures contained in Title II. That authority would also enable the Treasury, the Fed and the FDIC to block a “Section 363 sale” that the agencies find to be overly generous to insiders and Wall Street creditors, contrary to Dodd-Frank’s declared purpose of ending bailouts.[18]
Third, the Fed should be required to obtain the concurrence of the Treasury and the FDIC before it provides emergency loans to support a Chapter 14 reorganization. The FDIC is currently required to obtain the Treasury’s and Fed’s joint agreement before providing extraordinary assistance to protect uninsured creditors of a failed systemically important bank.[19] To maintain the same degree of political accountability for megabank rescues, the three agencies should be required to agree on emergency Fed support for Chapter 14 resolutions. In addition, to ensure appropriate public review, any emergency Fed loans under Chapter 14 should be reported to Congress and should be subject to an audit by the Government Accountability Office under the same procedures that apply to extraordinary FDIC assistance for failed megabanks.[20]
ENDNOTES
[1] http://clsbluesky.law.columbia.edu/2015/09/08/the-financial-industrys-plan-for-resolving-failed-megabanks-will-ensure-future-bailouts-for-wall-street/
[2] Arthur E. Wilmarth, Jr., The Financial Industry’s Plan for Resolving Failed Megabanks Will Ensure Future Bailouts for Wall Street (GWU Leg. Stud. Res. Paper No. 2015-36, June 30, 2015), 50 Ga. L. Rev. (forthcoming), available at http://ssrn.com/abstract=2648572.
[3] For descriptions of the financial industry’s Chapter 14 proposal, see Statement of Randall D. Guynn before the Subcomm. on Financial Institutions & Consumer Protection of the Senate Comm. on Banking, Housing, & Urban Affairs (July 29, 2015) [hereinafter Guynn Testimony], available at http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=93762f4b-5364-47fc-b0e6-dd763f32978c; Statement of Thomas H. Jackson before the Subcomm. on Financial Institutions & Consumer Protection of the Senate Comm. on Banking, Housing, & Urban Affairs (July 29, 2015) [hereinafter Jackson Testimony], available at http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=e68e1981-46a6-4fe2-98bc-a2ea6a6553fc; Too Big to Fail: The Path to A Solution: A Report of the Failure Resolution Task Force of the Financial Regulatory Reform Initiative of the Bipartisan Policy Center (May 2013) [hereinafter BPC Report] (a report co-authored by Messrs. Guynn and Jackson along with John Bovenzi), available at http://bipartisanpolicy.org/wp-content/uploads/sites/default/files/TooBigToFail.pdf.
[4] See BPC Report, supra note 3, at 33-35, 70-72.
[5] See Guynn Statement, supra note 3, at 4-6, 9-10, 19-20 & Exh. A at A-9 (fig. 7); Jackson Statement, supra note 3, App. at 9-12, 17-20; BPC Report, supra note 3, at 33-34, 70-71.
[6] Wilmarth, supra note 2, at 15-20.
[7] See Guynn Statement, supra note 3, at 19-20; BPC Report, supra note 3, at 34, 72.
[8] Wilmarth, supra note 2, at 20-22.
[9] David Wessel, In Fed We Trust: Ben Bernanke’s War on the Great Panic 16-20, 189-91 (2009); The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States 331-37, 347-49 (Fin. Crisis Inquiry Comm’n, Jan. 2011).
[10] See Guynn Statement, supra note 3, at 12-13, 20-22; BPC Report, supra note 3, at 34, 71-72. For an insightful analysis that compares the financial industry’s SPOE proposals under Title II and the proposed Chapter 14, and that also discusses the DIP financing issues under Chapter 14, see David A. Skeel, Jr., The New Synthesis of Bank Regulation and Bankruptcy in the Dodd-Frank Era (U. Penn. Instit. Law & Econ. Res. Paper No. 15-22, May 18, 2015), available at http://ssrn.com/abstract=2628694.
[11] Skeel, supra note 9, at 33, 36.
[12] See Jackson Statement, supra note 3, at 21; see also id. App. at 32 (stating that “the management, at least originally, of the bridge company is very likely to be the management of the entity that filed for bankruptcy”).
[13] See Jackson Statement, supra note 3, at 20 (stating that the new holding company formed under Chapter 14 would not be “subject to ‘control’ by a government agency, such as the FDIC, whereas the bridge company created in the SPOE process [under Title II] is effectively run, for a while at least, by the FDIC”); id. App. at 21-25 (describing the limited roles that the Fed and the FDIC would play in a Chapter 14 reorganization).
[14] See Arthur E. Wilmarth, Jr., The Financial Services Industry’s Misguided Quest to Undermine the Consumer Financial Protection Bureau, 31 Rev. Banking & Fin. L. 881, 941-50 (2012), available at http://ssrn.com/abstract=1982149.
[15] See, e.g., David Skeel, The New Financial Deal 33-39, 170-73 (2011); Mark J. Roe & David Skeel, Assessing the Chrysler Bankruptcy, 108 Mich. L. Rev. 727, 729-31, 761, 765, 770-71 (2010); but see Stephen J. Lubben, No Big Deal: The GM and Chrysler Cases in Context, 83 Am. Bankruptcy L. J. 531, 536-47 (2009) (defending the Chrysler and GM transactions against criticism by several academics, including Professors Skeel and Roe).
[16] See Sheila Bair, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself (2012); L. William Seidman, Full Faith and Credit: The Great S&L Debacle and Other Washington Sagas (1993).
[17] Wilmarth, supra note 2, at 26-38 (presenting proposed reforms).
[18] Dodd-Frank Wall Street Reform and Consumer Protection Act, 124 Stat. 1376 (preamble) (declaring that Dodd-Frank is designed “to protect the American taxpayer by ending bailouts”).
[19] See 12 U.S.C. § 1823(c)(4)(G)(i).
[20] Id. § 1823(c)(4)(G)(iv), (v).
The preceding post comes to us from Arthur E. Wilmarth, Jr., Professor of Law at the George Washington University Law School.