WASHINGTON — For weeks, Republicans have argued that creditors would benefit if lawmakers granted government regulators the power to unwind companies that pose a threat to the financial system.
But as the House prepares to vote on a massive regulatory reform bill this week, creditors oppose the measure, arguing that the existing bankruptcy process is clearer, allows them to negotiate payments and includes an independent judicial review.
They are also fearful that the legislation would give the Federal Deposit Insurance Corp. considerable leeway in deciding how and whether creditors of a failed institution get paid.
"Bankruptcy code has a hierarchy of parties," said Harvey Miller, a partner at Weil, Gotshal & Manges LLP who handled the Lehman Brothers bankruptcy. "Under resolution authority, there is no hierarchy. Almost everything is left to the FDIC receivership. That's the problem. There is no accountability."
The House Financial Services Committee debated a systemic-risk bill off and on for three weeks before finally passing it on Dec. 2. The measure will be rolled into a broader reform package that the House is expected to start debating Wednesday.
Republicans are likely to continue to argue this week that the existing bankruptcy process is preferable to giving the government resolution powers.
"The only way to end the bailouts is to resolve all failed nonbank financial firms through bankruptcy," said Rep. Spencer Bachus, the lead Republican on the financial services panel. "We need to end the uncertainty over which politically favored creditors will get paid off in a government-managed bailout and which will not."
But creditors do not think they would be favored. They say the bankruptcy process is designed to protect them while this new resolution authority attempts to preserve assets and guard against risks to the overall financial system.
For example, current bankruptcy law dictates in what order creditors should be paid, starting with securitized debt first, then unsecured senior debt, subordinated debt, preferred stock and finally common stock.
Under the systemic resolution bill, the FDIC would have a similar priority payout — with some key differences. Funds would be paid first to the FDIC for its expenses as receiver, then the government, for any amounts owed it. After that point, the FDIC would pay general or senior liabilities, subordinated debt and preferred and common stock.
But under bankruptcy, creditors can negotiate their payout in court, whereas under receivership, the FDIC decides the payout. Judicial review would occur only after the resolution is completed. Bankruptcy advocates said it is also unclear how the FDIC would treat contingent claims, guarantees and indemnities that have not been drawn on.
Creditors and their representatives argue the current process provides better clarity along with the ability to negotiate contracts.
"You want as much predictability for how creditors are treated because the more uncertainty, the more systemic instability," said Phil Corwin, a partner at Butera & Andrews.
But many other observers argue that, though the resolution process may disadvantage creditors, it is a much better way to protect against systemic collapse. "The reality is, there is a reason large financial firms have not been allowed to fail — because no one has had enough confidence in the bankruptcy code to handle it," said Michael Krimminger, a special adviser for policy to the chairman of the FDIC.
He pointed to the Lehman bankruptcy, which more than a year later is still being worked out in court. "Lehman was an example of why bankruptcy doesn't work for the largest financial firms because it did create systemwide consequences," Krimminger said. "It's now taken over a year, and we still have a backlog of unresolved derivatives contracts at Lehman. We must have a process that can close the largest financial firms without creating a systemic crisis. And I don't know anyone who thinks Lehman did not create a problem in the market."
The FDIC and others argue a government resolution process would be faster and provide more certainty to investors. "Bankruptcy … tends to be cumbersome and doesn't tend to have the flexibility to act rapidly and make instantaneous decisions," said John Douglas, a partner at Davis Polk & Wardwell and a former general counsel of the FDIC. "The FDIC should have more sensitivity to the economy and markets than a bankruptcy court might."
But Miller, the Weil Gotshal partner, argued that the FDIC would not have handled Lehman any better. "I don't think any court or agency could have taken care of Lehman as expeditiously as bankruptcy court did," he said.
He also said that a judicial review of the FDIC's actions after the fact would take too long.
"The FDIC operates without any sunshine," Miller said. "Under the FDIC you can file a complaint under the administrative procedures act, but that is a death-defying act and takes a long time."
Obama administration officials emphasize that the resolution process is better for the system as a whole. "The bankruptcy system in general is not set up to deal with externalities, with costs that are imposed outside the firm," said Michael Barr, the Treasury assistant secretary for financial institutions. "The bankruptcy process is about protecting creditors and winding down firms in a way that protects creditors. Resolution is about protecting Americans. It is not about protecting creditors. It is for a fundamentally different purpose. It is designed to provide stability to the financial system as a whole while winding down major firms in an orderly fashion."
Creditors continue to mistrust the FDIC, particularly after it championed an amendment to the House bill that would let it impose a 20% haircut on secured creditors when resolving a systemic institution. Rep. Brad Miller, D-N.C., who co-authored the amendment, said last week that the amendment would only apply to short-term creditors who demand more collateral as a troubled institution is failing.
But industry representatives see a much wider application and worry that it would raise the cost of debt for the largest institutions and spread uncertainty in the market. "We think that is a very bad idea that will increase systemic risk, not decrease it," said Tim Ryan, the president and chief executive officer of Securities Industry and Financial Markets Association. "If the marketplace thinks this will become law, we believe the intraday short-term credit markets will reprice and the repo markets will reprice to consider this 20% haircut. The next time we have a financial crisis, we'll have a situation where a number of institutions will be considered to be at risk, and secured creditors will get concerned they will be at risk because of this 20% haircut. Short-term credit will evaporate very quickly."