Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) represents a singular development in U.S. resolution law.  It provides a new regime, the so-called Orderly Liquidation Authority, for use in the event that a systemically important U.S. financial company encounters severe financial distress.[1]  Like other provisions in the Dodd‑Frank Act, Title II was designed as a response to perceived inadequacies in U.S. legal and regulatory regimes during the financial crisis.  Title II is intended to be available as an alternative to and substitute for a bankruptcy process, because a bankruptcy process was seen as inadequate to handle the failure of a systemically important financial company at the time of the crisis.

In proposing the Orderly Liquidation Authority in 2009, the Obama Administration said that the events of the financial crisis had demonstrated that when a systemically important financial company encountered financial distress, there were only two options for the company:  (1) obtain funding from the federal government, as in the case of AIG; or (2) file for bankruptcy and undergo a “disorderly” failure that threatened the stability of the U.S. financial system, as in the case of Lehman Brothers.  The Obama Administration concluded that the government needed another option: a resolution authority that replicated the speed and flexibility of the longstanding resolution authority for insured banks in the Federal Deposit Insurance Act (the “FDIA”).  Title II essentially replicates the provisions in the FDIA for application to systemically important nonbank financial institutions.  The proponents of Title II believe it is an essential element in addressing the too-big-to-fail problem.  They cite several distinguishing features in Title II that are critical to an orderly resolution of a large financial firm.  The first is the availability of a bridge financial company (similar to the bridge bank feature in the FDIA) to facilitate a speedy transfer of systemically important parts of the failed firm to a successor entity.  The second feature is a temporary stay on the close-out and netting rights of counterparties on derivatives and other financial market contracts.  The stay would facilitate the transfer of the portfolio of such contracts to the bridge financial company, avoiding the acceleration and liquidation of the contracts and the fire sale of collateral underlying the contracts.  The third and perhaps most important feature is the availability of short-term funding support for the bridge company from the Federal Deposit Insurance Corporation (the “FDIC”) and Treasury Department.[2]  This special funding mechanism would substitute for debtor-in-possession financing in a bankruptcy proceeding, which it is assumed would not be available from the private sector to support the orderly resolution process of a large financial firm.

Since the enactment of Title II, the FDIC, as the administrator of the Title II resolution process, has spent commendable time and resources developing the operational underpinnings of that process.  The FDIC’s work to date, particularly in respect of the single-point-of-entry (“SPOE”) strategy, has broken new ground in resolution planning and has taken Title II itself in directions that could not have been foreseen when Title II was enacted.[3]  The SPOE strategy envisions that a resolution under Title II would occur only at the top-tier holding company, avoiding to the greatest extent possible the need for the initiation of resolution proceedings at the level of the operating subsidiaries.  This approach minimizes the complexities and conflicts that would invariably arise if multiple resolution proceedings in the United States and foreign jurisdictions had to be commenced at the level of the operating subsidiaries.  It is also designed to reduce the risk of runs on the operating subsidiaries by their depositors and other short-term creditors.  This approach envisions that losses incurred at the level of the operating subsidiaries would be absorbed by holders of the top-tier holding company’s long-term debt.[4]  The SPOE strategy appears to offer an elegant solution to many of the most vexing problems presented by the failure of a global financial institution.

Title II was controversial at the time of its enactment and remains controversial today.  In a two-part article published last year, I surveyed the arguments for and against the use of Title II and analyzed the House and Senate versions of legislation intended to enhance the Bankruptcy Code as an alternative to Title II.[5]  Opponents of Title II assert that, contrary to the arguments of the proponents, Title II has actually reinforced the too-big-to-fail phenomenon and that use of Title II would result in the bail-out of large financial firms that encounter financial difficulty.[6]  Republican legislators have regularly urged that Title II be repealed and that instead an enhanced form of the Bankruptcy Code process be adopted for large financial companies.

The idea of amending the Bankruptcy Code to make it a better alternative for handling the failure of a large financial firm is also driven by the operation of another important provision in the Dodd-Frank Act.  As a corollary to the creation of the new resolution regime in Title II, Title I of the Dodd-Frank Act imposed heightened prudential requirements on systemically important bank holding companies and other non-bank financial companies designated as systemically important.  One of these prudential provisions requires these companies to prepare a plan for a “rapid and orderly resolution in the event of material financial distress or failure.”[7]  (The more sepulchrally minded initially referred to this as a “funeral plan” requirement, but that phrase quickly gave way to the more vibrant phrase, “living will” requirement.)  The Title I provision requires that the resolution plan be evaluated against the Bankruptcy Code, not Title II, reflecting the legislative judgment that resolution under the Bankruptcy Code should be preferred over resolution under Title II.  Under this provision, the FDIC and the Federal Reserve Board must determine whether the plan proposed by the company is credible and would facilitate an orderly resolution of the company under the Bankruptcy Code.[8]  If the FDIC and Federal Reserve Board jointly determine that the plan is not credible or would not facilitate an orderly resolution, these regulators may impose more stringent regulatory requirements or other restrictions on the company’s operations and ultimately may order the company to divest operations.  The resolution plan requirement has proven to be one of the most demanding Dodd-Frank Act requirements.  Large financial firms have been required to make significant structural and operational changes in an attempt to facilitate their orderly resolution under the provisions of the current Bankruptcy Code.

In addition to changes in structure and operations made by individual companies, changes to the Bankruptcy Code would assist the process of designing plans that would more readily facilitate the orderly resolution of a large financial company in bankruptcy.  Bankruptcy practitioners and academicians have taken up the cause of developing amendments to the Bankruptcy Code to make it a more viable alternative to Title II for resolving large financial firms.  Legislative proposals to amend the Bankruptcy Code have been introduced in the Senate and the House in the last several years.  The House passed a Bankruptcy Code enhancement bill in 2014, 2015 and 2016.  The version of the legislation passed by the House (H.R. 2947) adds a new Subchapter V to Chapter 11 of the Bankruptcy Code for large financial companies.  It incorporates certain provisions paralleling those in Title II.  For example, it provides for a temporary stay on close-out and netting rights on derivative and other “qualified financial contracts” similar to that in Title II.  It also provides for the use of a bridge company and for a “quick sale” process to transfer assets and liabilities of the failed firm to a bridge company over a “resolution weekend.”  These and other provisions in Subchapter V are intended to make an SPOE strategy in bankruptcy more competitive with the SPOE option under Title II.[9]  Of course, amendments to the Bankruptcy Code cannot provide a funding option that is competitive with the federal funding option under Title II.  This remains a crucial difference between resolution approaches under Title II and a revised Bankruptcy Code.

Another factor has overshadowed the efforts to adopt enhancements to the Bankruptcy Code:  fear that such enhancements would be coupled with, or otherwise pave the way for, a repeal of Title II.  The proposed version of a Bankruptcy Code enhancement bill in the Senate, for example, includes a repeal of Title II.  Many of the witnesses who testified on the Senate and House versions supported the enhancements but specifically opposed the repeal of Title II.  In June 2016, Representative Jeb Hensarling, chairman of the House Financial Services Committee, proposed a broad-ranging bill to revise and in some instances repeal provisions in the Dodd-Frank Act.  The bill incorporates the enhancements to the Bankruptcy Code reflected in H.R. 2947.  It also includes a repeal of Title II.  The election results have strengthened Hensarling’s proposal – and prospects for a Title II repeal.

In my article, I weighed the advantages and disadvantages of a Bankruptcy Code approach as an alternative to a Title II approach and concluded that the proposed changes to the Bankruptcy Code should be adopted, even though significant questions remain as to whether a resolution of a systemically important financial institution over a resolution weekend could actually be achieved under the Bankruptcy Code.  I cautioned against according too much weight to such an option for two principal reasons.  First, many commentators have questioned whether it would fly with foreign regulators and resolution authorities, whose acceptance and cooperation would be essential to an orderly resolution of a global financial institution.  The prospects for cooperation are likely to be higher if the U.S. and foreign regulatory authorities have engaged in joint planning and confidence building, as Title II envisions and promotes.[10]

Second, many bankruptcy commentators have questioned the viability of a Bankruptcy Code approach in the absence of a government backup liquidity facility.  The National Bankruptcy Conference has been particularly forceful in its comments on the proposed bankruptcy legislation on the need for some form of a lender-of-last resort facility.[11]  Although the largest banking firms have made significant strides in building internal liquidity buffers in their most recent resolution plans, the availability of a backup liquidity facility to support the resolution of those firms is still advisable.

The overriding conclusion that emerges from an analysis of the proposed Bankruptcy Code approaches is that Title II should be retained as a backup, even if an enhanced Bankruptcy Code option is enacted.  Enthusiasm for either a Title II or an enhanced Bankruptcy Code approach must also be tempered by the realization that the solution to a systemic financial crisis will not be found in Title II or the Bankruptcy Code but in broad-based government liquidity programs to support the financial system.  Ironically, the Dodd-Frank Act imposed additional restrictions on the ability of the federal government to provide liquidity support to the financial system in a crisis.[12]  Chairman Hensarling’s bill seeks to impose further restrictions on the ability of the federal government to respond to a financial crisis.  Future events may prove the imposition of such restrictions to have been particularly unwise.

ENDNOTES

[1] Pub. L. No. 111-203, Title II, 124 Stat. at 1442-1520 (2010) (codified at 12 U.S.C. §§ 5381-5394).

[2] Repayment of such funding is given a top priority in the Title II receivership process.  If there were to be a shortfall in repaying the Treasury from the receivership process, it would be made up by a special assessment on bank holding companies with $50 billion or more in total assets, nonbank financed companies designated under Title I of the Dodd-Frank Act, and other financial companies with $50 billion or more of total assets.  This assessment provision is intended to ensure that taxpayers will not ultimately bear any losses from the provision of Treasury funding to the resolution process.

[3] See Federal Deposit Insurance Corporation, Resolution of Systemically Important Financial Institutions:  The Single Point of Entry Strategy, 78 Fed. Reg. 76614 (Dec. 18, 2013).  An early critic of Title II has described the development of the SPOE strategy by the FDIC as a “rare illustration of a happy unintended consequence” of the Dodd-Frank Act.  David A. Skeel, Jr., Single Point of Entry and the Bankruptcy Alternative, in Across the Great Divide:  New Perspectives on the Financial Crisis 313 (Martin N. Baily & John B. Taylor eds., 2014).  This critic had originally faulted the drafters of Title II for limiting the FDIC to the single option of liquidation under Title II.  David Skeel, The New Financial Deal:  Understanding the Dodd-Frank Act and Its (Unintended) Consequences 149 (2011).

[4] The losses at the operating subsidiaries would in effect be transmitted to and absorbed by the top-tier holding company through the conversion of debt owed by the operating subsidiaries to the holding company (internal loss-absorbing debt) into equity of the operating subsidiaries.  This internal loss-absorbing debt amounts to a form of bail-in debt at the operating subsidiary level.  The top-tier holding company would itself have to have outstanding a large amount of external long-term debt to cover the losses at the holding company and the operating subsidiaries.

[5] Bankruptcy Alternatives to Title II of the Dodd-Frank Act – Part I, 132 Banking L.J. 437 (2015) & Part II, 132 Banking L.J. 503 (2015).

[6] See, e.g., Peter Wallison, The error at the heart of the Dodd-Frank Act (Sept. 6, 2011), http://www.aei.org/publication/the-error-at-the-heart-of-the-dodd-frank-act; Failing to End “Too Big to Fail”:  An Assessment of the Dodd-Frank Act Four Years Later, Report Prepared by the Republican Staff of the Committee on Financial Services, U.S. House of Representatives, 113^th Cong. (July 2014).

[7] Dodd-Frank Act, § 165(d)(1) (codified at 12 U.S.C. § 5365(d)(1)).

[8] Dodd-Frank Act, § 165(d)(4) (codified at 12 U.S.C. § 5365(d)(4)).

[9] Hearing on the “Financial Institution Bankruptcy Act of 2014”:  Hearing Before the Subcomm. On Regulatory Reform, Commercial and Antitrust Law of the H. Comm. on the Judiciary, 113^th Cong. 39 (2014) (statement of Thomas H. Jackson, Professor & President Emeritus, University of Rochester, and principal draftsman of a Bankruptcy Code enhancement bill).

[10] See, e.g., Michael S. Helfer, We Need Chapter 14 – And We Need Title II, in Across The Great Divide:  New Perspectives On The Financial Crisis (Martin N. Bailey & John B. Taylor eds., Hoover Institution Press 2014).

[11] Letter from the National Bankruptcy Conference to Hon. Tom Marino, Hon. Hank Johnson, Hon. Chuck Grassley & Hon. Patrick J. Leahy (June 18, 2015), available at http://www.nationalbankruptcyconference.org/images/NBC_Ltr_to_Cong_re_SIFI_Bills.pdf.

[12] See, e.g., Glenn Hubbard & Hal Scott, A Financial System Still Dangerously Vulnerable to a Panic, Wall St. J. (March 1, 2015).

This post comes to us from Paul L. Lee, of counsel to Debevoise & Plimpton LLP and a member of the adjunct faculty of Columbia Law School.  It is based on his two-part article, “Bankruptcy Alternatives to Title II of the Dodd-Frank Act,” available here and here.