Making Failure Feasible

How Bankruptcy Reform Can End Too Big to Fail

Thomas H. Jackson, Kenneth E. Scott, John B. Taylor, Thomas H. Jackson, Kenneth E. Scott, John B. Taylor

• Publisher: Hoover Institution Press
• Year: 2015
• ISBN:
  9780817918866
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Regierung & Wirtschaft

In 2012, building off work first published in 2010, the Resolution Project proposed that a new Chapter 14 be added to the Bankruptcy Code, exclusively designed to deal with the reorganization or liquidation of the nation's large financial institutions. In Making Failure Feasible, the contributors expand on their proposal to improve the prospect that our largest financial institutions—particularly with prebankruptcy planning—could be successfully reorganized or liquidated pursuant to the rule of law and, in doing so, both make resolution planning pursuant to Title I of Dodd-Frank more fruitful and make reliance on administrative proceedings pursuant to Title II of Dodd-Frank largely unnecessary. This book highlights the problems of dealing with large financial institutions in distress, and Chapter 14's responses to those twin issues. The contributors first outline the basic features of Chapter 14 and point to their continuation as well as additional features to ensure the quick resolution of large financial institutions that would not depend on government discretion and would mesh with emerging ideas about cross-border resolution. The remaining chapters provide the context for reform and show how Chapter 14, as envisioned in this book, would be a substantial advance on administrative-focused resolution procedures.

CHAPTER 1

The Context for Bankruptcy Resolutions

Kenneth E. Scott

Introduction

Any process for resolving the affairs of failed financial institutions other than banks, whether under Title II of the Dodd-Frank Act of 2010 or the Resolution Project’s proposed new version of a Chapter 14 of the Bankruptcy Code, takes as its starting point a firm whose organizational form and financial structure have been determined by a complex set of statutory and regulatory requirements. At this writing, many of those requirements are still being developed, important aspects are uncertain, and terminology is not set.

A note on terminology: the phrase “systemically important financial institution” or SIFI is nowhere defined (or even used) in the Dodd-Frank Act, though it has come into common parlance. I will use it here to refer to those financial companies whose distress or failure could qualify for seizure under Title II and Federal Deposit Insurance Corp. (FDIC) receivership, as threatening serious adverse effects on US financial stability. Presumably they come from bank holding companies with more than $50 billion in consolidated assets and nonbank financial companies that have been designated for supervision by the Federal Reserve Board.

Revised Chapter 14 2.0, at places, makes assumptions about pending requirements’ final form, and may have to be modified in the light of what is settled on. It also contains recommended changes in the application of stays to QFCs (qualified financial contracts), which are also relevant to a separate chapter in this volume by Darrell Duffie on the resolution of central clearing counterparties.

The Resolution Project’s original proposal (Chapter 14 1.0) contemplated resolving a troubled financial institution through reorganization of the firm in a manner similar to a familiar Chapter 11 proceeding, with a number of specialized adjustments. Subsequently, the FDIC has proposed that the failure of those large US financial institutions (mostly bank holding company groups) that are thought to be systemically important (SIFIs) and not satisfactorily resolvable under current bankruptcy law will be handled by (1) placing the parent holding company under the control of the FDIC as a Title II receiver and (2) transferring to a new “bridge” financial company most of its assets and secured liabilities (and some vendor claims)—but not most of its unsecured debt. Exactly what is to be left behind is not yet defined, but will be here referred to as bail-in debt (BID) or capital debt. (Any convertible debt instruments—CoCos—that the firm may have issued are required to have been already converted to equity.) The losses that created a fear of insolvency might have occurred anywhere in the debtor’s corporate structure, but the takeover would be of the parent company—a tactic described as a “single point of entry” (SPOE).

The desired result would be a new financial company that was strongly capitalized (having shed a large amount of its prior debt), would have the capacity to recapitalize (where necessary) operating subsidiaries, and would have the confidence of other market participants, and therefore be able to immediately continue its critical operations in the financial system without any systemic spillover effects or problems. But all of that depends on a number of preconditions and assumptions about matters such as: the size and locus of the losses, the amount and terms of capital debt and where it is held, the availability of short-term (liquidity) debt to manage the daily flow of transactions, and agreement on priorities and dependable cooperation among regulators in different countries where the firm and its subsidiaries operate—to name some of the most salient.

If the failed financial institution is not deemed to present a threat to US financial stability, even though large, it is not covered by Title II but would come under the Bankruptcy Code. Chapter 14 2.0 is our proposal for a bankruptcy proceeding that is especially designed for financial institutions and includes provisions for the use of SPOE bridge transfers where desired, and it too will be affected by the regulatory regime in force—especially as it relates to BID.

Not all of these matters are, or can be, determined by Dodd-Frank or in the Bankruptcy Code. But they can be affected for better or worse by regulations still being proposed or adopted. This paper represents my attempt, for readers not unfamiliar with these topics, to highlight some of the problems and Chapter 14’s responses, and to recommend some other measures that would facilitate successful resolutions.

Capital Debt

Definition

1) In FDIC’s proposal, the debt that is not to be transferred (and thus fully paid) is not precisely specified. It is suggested that accounts payable to “essential” vendors would go over, and “likely” secured claims as well (at least as deemed necessary to avoid systemic risk), but not (all?) unsecured debt for borrowed funds. Unless ultimately much better specified, this would leave a high degree of uncertainty for creditors of financial institutions, with corresponding costs.

There are some specifics that have been suggested—for example, that capital debt be limited to unsecured debt for borrowed money with an original (or perhaps remaining) maturity of over a year. That would imply a regulatory requirement that a SIFI hold at all times a prescribed minimum amount of such debt—at a level yet to be determined but perhaps equal to its applicable regulatory capital requirements and buffers, giving a total loss absorbing capacity (TLAC) of as much as 20 percent to 25 percent of risk-weighted assets

Would that total amount be sufficient to cover all losses the firm might encounter, and enough more to leave it still well capitalized? That depends on the magnitude of the losses it has incurred. In effect, the debt requirement becomes a new ingredient of required total capital (beyond equity), and impaired total capital could trigger resolution (but not necessarily continuance of operations, unless a grace period of a year or more for restoration of the mandated TLAC were included). The operative constraint is the mandated total amount of regulatory capital plus BID; the exact split between the two is less significant, and could be a matter for management judgment. Until such requirements are actually specified and instituted, however, their effectiveness is hard to analyze.

The definition of bail-in debt continues to be controverted. Is it a species of unsecured bonds for borrowed money, with specified staggered maturities? Is it all unsecured liabilities, with an extensive list of exceptions? Whatever the category, does it apply retroactively to existing liabilities? Will investors realize their risk status? Should disclosure requirements be spelled out? (It is hard to see why it is not defined simply as newly issued subordinated debt, without any cumbersome apparatus for conversions or write-downs or loss of a priority rank.)

2) A capital debt requirement would function the same way in Chapter 14, but without discretionary uncertainty. Section 1405 provides for the transfer to a bridge company of all the debtor’s assets (which should include NOL [net operating loss] carry-forwards) and liabilities (except for the capital debt and any subordinated debt); in exchange, the debtor estate receives all of the stock in the new entity. And the external capital debt is given a clear definition: it must be designated unsecured debt for borrowed money with an original maturity of one year or more. To be effective, minimum capital debt requirements (an issue outside of bankruptcy law) would again need to be specified.

It should be noted that Chapter 14 applies to all financial companies, not just SIFIs that pose systemic risk and not just to resolution through a bridge. The firm may go through a familiar Chapter 11 type of reorganization, following on a filing by either management or supervisor after losses have impaired compliance with whatever are the total capital plus BID (TLAC) requirements then in force. In that case, the BID is not “left behind” but should all automatically (under the provisions of its indenture) either be written down or converted to a new class of senior common stock, or to preferred stock or subordinated debt with similar terms. (If conversion were to a security on a parity with outstanding common stock, there would be immediate time-consuming and disputable issues about how to determine asset valuations and losses and the possible value of existing common shares. These are avoided by simply converting instead to a new class with a priority above outstanding common and below ordinary liabilities.)

3) What is the locus of the capital debt? The question is central to whether subsidiaries necessarily continue in operation. The FDIC proposal seems to contemplate that it is issued by a parent holding company (or, in the case of a foreign parent, its intermediate US holding company), and thus removed from the capital structure of the new bridge company, which is thereby rendered solvent.

But what if the large losses precipitating failure of the US parent were incurred at a foreign subsidiary? There have been suggestions that the new bridge parent would be so strongly capitalized that it could recapitalize the failed subsidiary—but who makes that decision, and on what basis? The supervisory authorities of foreign host countries have understandably shown a keen interest in the answer, and it is high on the agendas of various international talks.

A core attribute of separate legal entities is their separation of risk and liability. Under corporation law, the decision to pay off a subsidiary’s creditors would be a business judgment for the parent board, taking into account financial cost, reputational cost, future prospects, and the like—and the decision could be negative. In a Title II proceeding, perhaps the FDIC, through its control of the board, would override (or dictate) that decision—and perhaps not.

The clearest legal ways to try to ensure payment of subsidiary creditors would be (1) to require parents to guarantee all subsidiary debt (which amounts to a de facto consolidation) or (2) to have separate and hopefully adequate “internal” capital debt (presumably to the parent) requirements for all material subsidiaries. Again, at time of writing it is an issue still to be resolved, and perhaps better left to the host regulators and the firm’s business judgment in the specific circumstances.

Coverage

1) The FDIC’s SPOE bridge proposal seemingly applies only to domestic financial companies posing systemic risk (currently, eight bank and three or four non-bank holding companies are so regarded, although more may be added, even at the last minute), not to the next hundred or so bank holding companies with more than $10 billion in consolidated assets, or to all the (potentially over one thousand) “financial companies” covered by Dodd-Frank’s Title I definition (at least 85 percent of assets or revenues from financial activities). Will the capital debt requirement be limited to those dozen SIFIs, or will it be extended to all bank holding companies with more than $250 billion or even $50 billion in consolidated assets (though posing no threat to US financial stability)? That will determine how failure resolutions may be conducted under the Bankruptcy Code, as they must be for all but that small number of SIFIs that Title II covers.

2) Resolution under Chapter 14 (in its original version) can take the form essentially of a familiar Chapter 11 reorganization of the debtor firm (often at an operating entity level). Where systemic risk or other considerations dictate no interruptions of business operations, it may (in its current version 2.0) take the form of transfers to a new bridge company (usually at the holding company level—thus leaving operating subsidiaries out of bankruptcy). Therefore, any capital debt requirement should apply explicitly to both situations, and Chapter 14 would accommodate both options.

3) What triggers the operation of the capital debt mechanism? A filing of a petition under Chapter 14, for which there are two possibilities. The management of a firm facing significant deterioration in its financial position can...

Table of contents

• Contents
• List of Figures and Tables
• Preface
• CHAPTER 1
• CHAPTER 2
• CHAPTER 3
• CHAPTER 4
• CHAPTER 5
• CHAPTER 6
• CHAPTER 7
• CHAPTER 8
• CHAPTER 9
• About the Contributors
• About the Hoover Institution’s Working Group on Economic Policy
• Index