Following the financial crisis of 2008, large bank resolution has drawn much attention and prompted innovative ideas from regulators. Many of the ideas are intended to solve what is widely believed to be the inadequacy of existing bankruptcy law in the context of systemically important financial institutions (“SIFI”). However, an improved Bankruptcy Code, building upon the existing structure in the United States, could support Dodd-Frank’s efforts to improve resolution and stability and reconcile an apparent contradiction in the act.
The demand for legislation on big bank resolution was driven by the idea that these institutions are “too big to fail.” This catch-phrase conflates the beliefs that (1) the systemic consequences of the failure of such a financial institution would be so severe that regulators believe they have no choice but to “rescue” the institution; and (2) we need to have loss-bearing mechanisms that would allow one of them to fail without triggering nationwide systemic consequences.
Out of the first grew proposals for reducing the size and complexity of these institutions. Out of the second grew proposals for mechanisms that would separate financial failure (assets exceeding liabilities or serious cash-flow problems) from an underlying economic failure (no matter how restructured, the assets would be better deployed elsewhere). It has been a given that the solutions must avoid a government-funded bailout (although there continues to be disagreement about what that might mean in practice).
Through generations, bankruptcy law has increasingly been honed as a device to effectively separate financial failure from economic failure. Far from its origins as a device to punish debtors, starting with equity receiverships for railroads, continuing through Chapters X and XI of the 1938 Chandler Act, and further refined in Chapter 11 of the Bankruptcy Code of 1978 (and thereafter made even more useable through “going concern sales” under Section 363 and “prepackaged plans”), U.S. bankruptcy law was generally thought to be unusually effective at dealing with the consequences of financial failure without inducing economic failure and liquidation by providing for an understanding of loss-bearing in advance through the precise application of the absolute priority rule.
During and after the 2008 crisis, however, U.S. bankruptcy law was thought to be wholly inadequate to deal with the failure, and resulting systemic consequences, of a large financial institution. This conclusion was the result of several underlying beliefs—some correct, some less so: the bankruptcy process is too slow and cumbersome; it is conducted before a judicial officer who doesn’t have the requisite economic or financial expertise to consider systemic consequences; and bankruptcy has too many exclusions to deal effectively with a complex financial group (depository banks and insurance companies are wholly excluded; stockbrokers and commodity brokers are relegated to a specialized provision under Chapter 7). Also, a series of amendments to the Bankruptcy Code, originally driven by the International Swaps and Derivatives Association and the Federal Reserve Board, had increasingly immunized counterparties on qualified financial contracts from the major consequences of bankruptcy, prominently including bankruptcy’s automatic stay under Section 362.
Bankruptcy law could and should be improved to deal with some, if not all, of these deficiencies, but there was a consensus that bankruptcy law, as it stood, was not up to the task.
The Current Disconnect Between Bankruptcy Law and Title II of the Dodd-Frank Act
The Dodd-Frank Act displays contradictory attitudes toward bankruptcy law. On the one hand, bankruptcy is framed as the process of first-resort for distressed large financial institutions. And Title I’s resolution plans require a focus on using bankruptcy as the standard against which their effectiveness will be measured. On the other hand, Title II is specifically designed to have the FDIC handle, often under bankruptcy-like procedures, the financial failure of distressed large financial institutions—on the precise assumption that a bankruptcy proceeding has been found wanting.
This notion that Title II is a last-resort option, however, creates a tension between the purposes of bankruptcy law and the announced purposes of a Title II proceeding. Bankruptcy law intends to separate financial failure from liquidation: if a firm’s assets are worth more together than apart, then they should be held together. The result of that financial failure—liabilities exceeding assets—should be handled by a recapitalization of the firm in Chapter 11, with the losses being born by equity first, according to the absolute priority rule. But Title II of the Dodd-Frank Act has elements, starting with the name itself—“Orderly Liquidation Authority”—that suggest a firm, and its managers, should be punished for a financial failure and not allowed to continue. That is, elements of Title II seem to conflate the idea that “failure” means appropriate loss-bearing, separated from the best use of the assets, with a wholly distinct idea that “failure” should result in liquidation.
The Single-Point-of-Entry Breakthrough and Its Use in Bankruptcy
In retrospect, the discussion of systemically important financial institutions that led up to the passage of Dodd-Frank centered on how to handle the financial failure of operating entities. Certainly, the Hoover Institution’s Resolution Project—of which I am a member—focused on improving bankruptcy law to handle operating entities. And, though legislative intent may not be fully known, it appears that the Dodd-Frank Act was enacted with the same perspective.
Innovative thinking and work continue. Two dominant—and very similar—proposals have emerged, one in Europe, the other from the FDIC. Both employ a “single-point-of-entry” (“SPOE”) approach that handles resolution at the holding company level. Europe has focused on a “one-entity” recapitalization via bail-in while the FDIC has focused on a “two-entity” recapitalization. Under the FDIC’s approach, a SIFI holding company (the single point of entry) is effectively “recapitalized” virtually overnight by the transfer of its assets and liabilities, except for certain long-term unsecured liabilities, to a new bridge institution. The bridge institution then forgives intercompany liabilities or contributes assets to recapitalize its operating subsidiaries. Both models involve a subordination of the long-term unsecured debt—the major difference is that in the European bail-in model the SIFI holding company before and after the recapitalization is the same entity (thus, the one-entity recapitalization), whereas in the FDIC’s proposal, the “recapitalized” bridge institution is legally different than the original holding company (thus, the two-entity recapitalization).
The SPOE approach is a significant breakthrough, most prominently because, in a very short period, it promises the ability to accomplish both the substantive and the informational: recapitalization makes the holding company (or its replacement) solvent again, and the market can recognize, and react to, the resulting entity’s solvency. To work effectively—and putting aside incredibly important, but distinct, cross-border issues—it requires several key features, which I will discuss later.
The SPOE strategy also carries with it a couple of problems. One is political and due to Title II’s reliance on the language of “liquidation.” The other is more substantive. If resolution plans, as demanded by Title I, are focused on “resolution” under the Bankruptcy Code, and current bankruptcy law cannot easily handle the reorganization of a SIFI, those plans—contrasted with SPOE under Title II—may be found to be inadequate despite all reasonable efforts to make them adequate. The ultimate effect of their constant regulatory rejection would likely lead either to a presumptive default use of Title II—which seems to be no one’s preferred outcome—or regulatory demands for financial institutions to become smaller and much less complex. Whether that latter outcome is desirable is debatable, but it seems odd to bring back the “too big” question into an exercise in “how to fail.”
The most useful Title I resolution plans will be those that provide guidance to either the bankruptcy process or the use of Title II, and this requires convergence between the two processes, acknowledging that one will ultimately be judicial-based while the other will ultimately be administrative-based.
A Proposed Chapter 14 of the Bankruptcy Code
A natural question is whether bankruptcy law could be revised so as to make it a sensible alternative to SPOE under Title II—and thus bring about substantial convergence in the processes.
In the United States, the “bones” of a response are already embedded in bankruptcy law and practice. Section 363 of the Bankruptcy Code, permitting the “sale” of assets, may not have been envisioned in 1978 as a mechanism for a going-concern sale of some or all of a business, but it has become such a mechanism over time—most recently with the Chrysler and GM bailouts (though these are not ideal models in my view). It doesn’t fit perfectly, but it has been used, repeatedly, as a way of continuing a business outside of bankruptcy while the claimants, left behind, wind up as the owners of the estate of the former business entity. A bankruptcy solution modeled on this idea of a going-concern sale can form the basis of an effective alternative to SPOE under Title II. To be credible as such, however, several important changes and clarifications are essential:
- Sufficient loss-absorbency must be built into the capital structure of the holding company. That is, there must be debt, known in advance, that can be “left behind” in any going-concern sale to a new entity, and thereby effectively converted into a potentially equity-like claim against the residual value of that new entity. This requires legal or regulatory rules that will require such loss-absorbency capital.
- In any Section 363 “recapitalization sale,” not just assets, but also executory contracts, debts (other than those scheduled to be “left behind”), and operating licenses and permits must be transferable to the new company notwithstanding ipso facto clauses, anti-assignment clauses, change-of-control provisions, and the like—and those same rules must apply to comparable assets, liabilities, and rights of subsidiaries that are not in bankruptcy but are “assets” of the holding company transferred in the recapitalization sale. This particularly requires changes in the existing Bankruptcy Code provisions regarding qualified financial contracts.
- There needs to be a mechanism, known in advance, to ensure that this Section 363 recapitalization sale occur within a very short period, such as within 48 hours of the filing of the petition.
- A more controversial change is the ability of either the government or the Orderly Liquidation Fund to be a “lender of last resort” for the new entity during its early days. This change may not be necessary if (1) the immediate recapitalization of a new company would be obvious, and thus market-based lenders would provide necessary liquidity, and (2) we are satisfied that, in the unusual event of a system-wide liquidity-lending crisis, the new entity can rely on access to an existing secured lender-of-last-resort facility from the Federal Reserve under a Section 13(3) “program or facility with broad-based eligibility.” This change evokes a palpable belief among some that any government-backed liquidity, even if fully secured and otherwise meeting the ordinary standards for liquidity versus capital, is itself (in reality or in perception) a government bailout.
This summary description only touches on the major points. There are many other important details, as well as other provisions, that would be nice but not necessary. And, if legislation to enable such changes is proposed, it may be valuable to look at the reorganization ideas embodied in the 2012 Hoover Institution Resolution Project’s proposal regarding Chapter 14 pre-SPOE, so as to make Bankruptcy Code revisions for financial institutions comprehensive at both the holding company and at the operating subsidiary level.
These changes would make bankruptcy a viable alternative to SPOE under Title II of the Dodd-Frank Act, and that would have several salutary effects. First, it would lessen the need to invoke Title II—and the political second-guessing that would likely result were the FDIC to do anything that had the appearance of “preserving” a “failed” SIFI. Second, it would harmonize the resolution plans of Title I with the procedures of Title II, if and when they should ever need to be invoked. Third, it would provide as much assurance as possible under our current system that the “rule of law” is being followed—as the applicable rules and priorities would be known in advance and applied by the judiciary.
There are several salient differences between bankruptcy in the manner I outline above and Title II’s SPOE process:
- The new company formed in the Section 363 recapitalization sale is neither (1) subject to the jurisdiction of a bankruptcy court nor (2) subject to “control” by a government agency, such as the FDIC, whereas the bridge company created in the SPOE process is effectively run, for a while at least, by the FDIC. In bankruptcy, it is market-discipline first and foremost; in Title II, there inevitably is a heavier layer of regulatory overlay and control.
- The Chapter 14 process envisions the possibility that the market can determine the equity value of the new company (and thus the amount to be distributed to the creditors and old equity interests “left behind”), whereas the FDIC’s SPOE proposal relies on expert valuations for those distributions.
- The FDIC’s focus on limiting its discretion is commendable, but a reason for keeping Title II is that there may be emergency circumstances, with serious systemic consequences, where having some discretion may be preferable to following rules formed in advance, which in that instance seem like they won’t work. (I hope these occasions would be somewhere between “extremely rare” and “never.”)
I applaud the creative thinking that has gone into the FDIC’s SPOE proposal—and, indeed, I borrow some of its best ideas in service of a notion that bankruptcy law can be improved in immense ways to make it “work” for SIFIs. Doing so would accomplish some of the key meta-goals of the Dodd-Frank Act: making Title I’s resolution plans as effective as possible and making Title II—in reality and not just in rhetoric—a process of last resort. These proposed changes to bankruptcy law probably won’t end debates over “too big” or whether all government-provided liquidity is a “bailout”—but those issues are contentious and complex enough to be debated without having to mix into the equation the general concern that bankruptcy law is not up to the task.