WASHINGTON – While supporters of the Dodd-Frank Act are hopeful a new resolution regime for financial giants will prove better than the traditional bankruptcy process, regulators are under pressure to prove it will at least be no worse.
The Federal Deposit Insurance Corp. is planning how the agency, as required by the financial reform bill, will ensure creditors receive at least as much in a resolution as they would otherwise in a Chapter 7 bankruptcy.
"The FDIC will probably put in place a rule that provides more details about how the provision will be applied and then defines the process for a creditor to contest whether they got at least what they would have gotten under Chapter 7," said Michael Krimminger, a former FDIC general counsel and now a partner at Cleary Gottlieb Steen & Hamilton LLP.
Dodd-Frank put a large asterisk on bankruptcies for large companies. The law allows the government in certain cases to sidestep traditional reorganizations and subject failing financial behemoths to a special wind-down process meant to limit effects on the broader financial system.
But many in the debate over the reform law argued bankruptcy should not be tinkered with too dramatically, and whatever new process is put in place should resemble the bankruptcy code to give creditors comfort they would face similar treatment under the two systems.
"It was important that creditors and investors understand that they would not be disadvantaged under a Title II resolution so that the potential for a FDIC resolution would not affect the value placed on a company's debt or equity," Krimminger said.
As a result, the law included what is known as a "minimum recovery" section, saying the FDIC – authorized to pay certain creditors more than they would normally get in a bankruptcy – must not pay any creditor less than what they would have received in a liquidation.
But in the many months since the reform law, observers have urged the FDIC to discuss implementing the provision in a rulemaking, both in terms of how it would calculate the minimum relief afforded under the bankruptcy code and the process for creditors to challenge the FDIC's calculation.
"Assuring markets that creditors would be no worse off in a liquidation under OLA is a critical step towards making orderly liquidation a credible option for resolving a failing financial company and ensuring that OLA is effective in reducing systemic risk," Seth Grosshandler, a Cleary Gottlieb attorney, said in a letter to the agency last year on behalf of several institutions. "Without such assurance, creditors will pull short-term funding from and refuse to trade with a systemically important financial institution at the first sign of trouble due to the specter of harsh treatment under OLA.
"Despite the importance of this provision" in Dodd-Frank, he added, "no means were provided for determining creditors' minimum recoveries or for contesting the FDIC's determination thereof."
Among the issues is how the agency could estimate recoveries in a bankruptcy reorganization that will not occur. Commenters noted the agency has not raised the issue in earlier proposals for carrying out the resolution regime.
"Although creditors are assured of such a minimum recovery, it is not clear under the Act or the Proposed Rules as to how such a recovery would be calculated," said Gus Sauter, managing director and chief investment officer for Vanguard, said just two months after passage of the law. "Understanding this process will be critical to the ability of market participants to accurately evaluate how creditors will be treated under the FDIC's orderly liquidation framework."
Krimminger, who left the FDIC this past May, said the FDIC could approach the test in two different ways.
"There are a couple of options for doing that. One is the FDIC could produce a finding during a resolution of what a Chapter 7 minimum would be, and then a creditor could challenge that finding," he said. "Or, if there is a challenge that the creditor did not receive value equivalent to what it would have gotten under Chapter 7, then the FDIC could respond to that challenge to demonstrate that the credit did receive at least that recovery."
There are signals the FDIC may weigh in on the issue soon. A report earlier this month by banking policy analyst Karen Shaw Petrou included the FDIC's "bankruptcy-equivalence test" as one of its remaining to-do items in implementing the resolution regime.
"The FDIC is working on a minimum-recovery protocol to be proposed shortly in regulatory form to address this important issue," according to the report, released by Petrou's Federal Financial Analytics Inc.
A Government Accountability Office report in July similarly said the agency had begun work on a rule to "clarify how creditors would receive no less than they would under a Chapter 7 bankruptcy."