Imagine a repeat of the darkest moments of the Great Recession, and major banks are failing quickly, as exemplified by Lehman Brothers’ bankruptcy filing in September 2008. If this happens again, Congress has ensured the next time will be different – and potentially worse.
James H M Sprayregen and Stephen E Hessler of Kirkland & Ellis LLP share their thoughts on 'too big to fail' banking structures.
Global economic contagion may result when the biggest financial companies slide towards insolvency and prompt counterparties to take destabilising actions to save themselves. In the aftermath of the collapse of Lehman, the United States Congress mandated in the Dodd-Frank Act that distressed “systemically important” institutions must be liquidated in a regulatory proceeding administered by the Federal Deposit Insurance Corporation (FDIC), outside the established legal landscape of the Bankruptcy Code as applied by bankruptcy courts.
The Federal Reserve, as required by Dodd-Frank, is presently studying the efficacy of the Act’s “orderly liquidation authority” as compared with the Bankruptcy Code’s regime. We submit that the hallmark of any restructuring regime must be clear rules administered by an impartial tribunal. In stark contrast, the wide-ranging and ill-defined discretion granted to regulators by Title II will promote the moral hazard and the uncertainty that Dodd-Frank was intended to combat.
Moral hazard results when commercial parties are incentivised to take increasingly speculative risks, believing they will enjoy significant gains if an investment succeeds, but the government will shield them from excessive losses if it fails. Dodd-Frank authorises the FDIC to make dissimilar distributions to creditors in similar situations. Further, the Treasury Department may loan the FDIC the funds necessary to administer liquidation, with repayment to come from asset sale proceeds, but any shortfall will be remedied by assessments on third-party financial companies. In other words, Dodd-Frank gives the FDIC the discretion (and latitude) to provide some (but not all) creditors par recoveries, if necessary to stabilise the economy, according to prevailing political and regulatory priorities.
Too much discretion generates uncertainty, which is especially problematic for markets attempting to divine the likely actions of political institutions. As the distress of a financial company deepens, politically powerful investors, convinced they can leverage their influence with government officials, may hold or even increase their positions. But less connected, or even politically unpopular, counterparties may perceive they are at risk of dissimilar treatment and rush to unwind or protect their position (such as by demanding more collateral be posted). It is ironic that the spectre of intervention by the FDIC, whose mission is to ensure public confidence in the safety of retail deposits, may trigger a classic run on the banks by putting enormous pressure on distressed financial companies.
That said, Congress should enact relatively discrete modifications to the Bankruptcy Code to liquidate or reorganise systemically important financial companies more effectively. Regulators should be permitted to appear and advance their oversight responsibilities. Courts should be authorised to consider the “public interest” when reviewing a financial company’s reorganisation decisions. And certain experienced bankruptcy judges should be the arbiters of financial company resolutions.
The Bankruptcy Code already provides that, upon a filing, contract counterparties are automatically stayed from terminating their agreements with the debtor – except for counterparties to most derivatives, which are generally exempt from the stay. Congress should eliminate most, if not all, of these exceptions, which dissuade management from contemplating bankruptcy while value erodes and reorganisation options diminish. And if a filing does occur, there may be chaos as the outset, as derivatives counterparties terminate and enforce their rights in the debtor’s assets.
Lastly, Dodd-Frank does contain some helpful measures that should be incorporated into the Bankruptcy Code. The distinct size and need for capital of financial companies may mean that the US government is the only lender with a balance sheet large enough to provide debtor-in-possession (DIP) financing. Dodd-Frank permits the Treasury Department to loan the FDIC the amounts needed to administer an orderly resolution. The Bankruptcy Code should be modified for the special circumstances of the government as DIP lender and a failed financial company as borrower.
Dodd-Frank also allows for immediate distributions to creditors, to mitigate the systemic impact of delayed recoveries. Bankruptcy courts sometimes permit advance payments to creditors under the judicially created “doctrine of necessity.” But explicitly authorising the practice within the Code may provide valuable reassurance to short-term creditors and guard against a bankruptcy causing contagion.
With these reforms to the Bankruptcy Code, Congress can further improve the reorganisation (or, if necessary, liquidation) regime that is already the most tested and effective in the world and further restore the responsible functioning of financial companies by repealing Dodd-Frank’s “orderly liquidation authority” or minimising any possibility of its invocation.