Bailing out big financial institutions during the financial crisis was unpopular from the beginning. It was done in part because the bankruptcy code provision for the resolution of big institutions was widely considered inadequate to preserve the nation’s financial stability.[1] Congress approved Title II of Dodd-Frank in 2010 to provide better safeguards by enhancing the FDIC’s authority and creating the Orderly Liquidation Fund. However, the changes remain unpopular in the financial world.[2] Title II opponents in Congress now propose amending the bankruptcy code to include a new Chapter 14 to create special provisions for the bankruptcy of large financial firms.[3] This article compares the proposed Chapter 14 and Title II on four core issues:

• Covered Companies: Title II qualifies any financial company for FDIC receivership regardless of the company’s designation and supervision status. The main criterion is whether the secretary of the treasury concludes that the company’s failure would undermine financial stability.[4] Existing bankruptcy code provisions would continue to be used for the other companies. However, only financial companies and subsidiaries that hold more than $100 billion in consolidated assets would qualify for the special resolution procedure of Chapter 14.
• Regulators, Judges, and Financial Stability: The role of bankruptcy judges under Title II and Chapter 14 differs. Under Title II, a federal judge becomes involved only when the Treasury Department files a petition to appoint the FDIC as the receiver. The FDIC is then responsible for the resolution process. Under Chapter 14, the bankruptcy judge would oversee the case. However, Chapter 14 would prohibit bankruptcy judges from making decisions based on either a need to reduce systemic risk or minimize moral hazard. Although Chapter 14 would permit the Fed to be heard on matters of financial stability, regulators’ roles would be limited and subject to the judge’s discretion.
• Reorganization: Is it Necessary? Title II requires the FDIC to liquidate the failing company to mitigate risk and remove moral hazard, but prohibits the agency from reorganizing the insolvent firm for the profit of the creditors. Furthermore, it mandates that decisions by the Fed and FDIC to liquidate a firm’s assets and to transfer them to a bridge institution should be solely based on financial stability concerns. In contrast, reorganization would be the main feature of resolution under Chapter 14. Furthermore, the receiver would openly seek to maximize the business’ value for the profits of creditors.[5]
• Potential for Bailouts: The Dodd-Frank Act forbids the Fed to bail out insolvent companies. However, when Title II is triggered, FDIC can finance the resolution of the covered company through the Orderly Liquidation Fund. Under Chapter 14, the practice of Debtor-In-Possession Financing (DIP loans) would allow the main regulator to finance the claim of “critical” creditors at the beginning of the case.[6]

To conclude, there is a philosophical difference between Title II and Chapter 14 on how to best achieve the “orderly resolution” of big financial companies. Title II explicitly has the financial stability of the U.S. as its primary goal,[7] and to accomplish that, it provides a mechanism for an orderly liquidation of financial companies. Title II’s secondary goal is to ensure that creditors and other counterparties bear the proportionate risks of their investments. In contrast, Chapter 14 maintains as its focal point the Bankruptcy Code’s existing goal of reorganizing to protect creditors. Its objective is to provide a charter for an orderly bankruptcy of large firms to cover creditors’ claims according to their contractual priorities.

ENDNOTES

[1] Chapter 11 is the chapter in the bankruptcy code employed by large companies to reorganize their debts and continue their business.

[2] The Orderly Liquidation Fund is a segregated fund at the U.S. Department of the Treasury to finance the resolution of covered financial companies by the FDIC. It has been characterized by its critics as paving the way for future bailouts.

[3] The Taxpayer Protection and Responsible Resolution Act of 2014 is commonly known as “Chapter 14.” The “Chapter 14″ proposal was originally put forth by the Hoover Institution.

[4] The main exceptions are government-sponsored entities (most notably Fannie Mae and Freddie Mac), broker-dealers and insurance companies.

[5] The court could appoint the FDIC as a trustee with an authority to reorganize or liquidate the failing company.

[6] DIP loans are a special form of loan. They are provided for distressed companies especially during restructuring under corporate bankruptcy law.

[7] It also aims to reduce moral hazard and end the use of U.S. Treasury resources upon the failure of a systemically important financial company.

This post comes to us from Dr. Elham Saeidinezhad, a research economist in international finance and macroeconomics at the Milken Institute.