Section 165(d) of the Dodd-Frank Act requires companies designated as systemically important financial institutions to produce a plan that details how they could be resolved in a rapid and orderly fashion in the event of material financial distress or failure. These resolution plans have come to be known as "living wills."
The Federal Reserve and Federal Deposit Insurance Corp. recently issued a notice of proposed rulemaking on this provision, with comments due by June 10, 2011.
The provision and the proposed rule will have several serious practical consequences that may not be immediately obvious.
Supervisory impact: The living-will requirement involves a new method of supervision of complex financial institutions. Regulation will no longer involve responding to the question "What are you doing?" but rather "What will you do if … ?" In other words, regulators will expect covered companies to have an enterprisewide understanding of the impact of a range of hypothetical situations and develop a credible response plan for the event that such situations actually occur.
Planning criteria: Regulators will have to determine whether a company's living will demonstrates that it could be resolved under the Bankruptcy Code in a way that would not pose systemic risks to the financial system. While neither the FDIC nor the Fed has significant experience with the Bankruptcy Code, covered companies will have to understand it and be cognizant of the regulators' interpretations in order to produce satisfactory resolution plans. In the end, making a successful case will be far different from an appearance in the bankruptcy court.
Distressed circumstances: Companies must also confront the fact that the overall economic and financial circumstances in which their hypothetical failure "occurs" are not knowable at the time a plan is written. Without such information, they will have to make many assumptions about future conditions. They will have to justify those assumptions to the regulators, and, depending on how the question of confidentiality turns out, they may have to justify those assumptions to existing and potential creditors and counterparties. Those parties' reactions could have significant regulatory and economic consequences.
Impact on strategic planning: Systemically important financial institutions will be required to amend their plans to reflect material changes that will have an impact on strategic planning. Companies will have to consider their strategies before undertaking major initiatives. Because of the potential that regulatory uncertainty might spark market uncertainty, covered companies would be prudent to obtain some form of prior approval for their post-transaction resolution plans. While it is unclear what process the Fed and FDIC would choose for pre-approval, it is certain that Section 165's requirements will add to the list of regulatory issues that must be considered before closing a deal.
Impact on acquisitions: The requirement for a living will also complicates the acquisition courtship process and the effort to "sell a deal." Quite likely, while the chief executive is touting the transaction, the company will be simultaneously preparing its plan to dispose of the asset or business line. It is unclear how the market will react to such contradictory messages. It also remains to be seen what types of disclosures will be required under the securities laws.
Data management: Developing a living will would require more extensive and granular information than commonly maintained in most financial and value at-risk systems. For example, an SIFI will need to know the terms as well as the amount of its exposures to other SIFIs and market participants, in order to determine how they could be resolved in a bankruptcy proceeding. Any living will is therefore likely to require a expansion of legacy data systems and an array of new inputs.
Due diligence review: Acquisition due diligence will have to be fairly robust and extensive in order to meet the demands for information under the proposed rules and to enable the acquirer to prepare the necessary plan within the mandated time frame. Also, the seller will need to clearly understand how its business will be conducted going forward, including under circumstances of deep distress, and whether the benefits of the transaction will be realized.
Confidential treatment: A final concern is the need for ensuring that resolution plans and the regulators' treatment of them are accorded confidential treatment. Disclosure of regulatory actions may be misinterpreted by the marketplace. Again, how this process is treated for securities law purposes will be important.
Implementation of a living will would impose some of the most difficult regulatory burdens on the covered financial organizations and the supervisory regulators. The difficulty complying with the living-will regulatory framework is great and will be even greater at the nonbank SIFI, which is for the first time coming under a prudential supervisory regime.
