WASHINGTON — Although creditors could lose money in the wind-downs of large firms that are authorized by the Dodd-Frank Act, many of them may own a piece of the startup that emerges from the failed company's ashes.

The Federal Deposit Insurance Corp., tasked by Dodd-Frank to run the resolution facility, has discussed preserving certain healthy operations of a failed firm in a new private company.

But for that to work, some bondholders of the failed company would get a consolation prize of sorts instead of their limited repayment: stock in the new company. Similar to how creditor claims are resolved in bankruptcy, those bondholders would get equity no greater in value than what they otherwise would have received. Yet that value could grow if the startup succeeded.

"If a debt for equity swap is used, the creditor could be offered equity in a new company with the same value as the expected cash payment, but now he or she could anticipate potential upside — and downside — risk as a shareholder in the new company," said Michael Krimminger, a former FDIC general counsel and now partner at Cleary Gottlieb Steen & Hamilton LLP.

The process of divvying up the remains of a failed firm to unsecured claimants under the new resolution regime is complex—and not all the pieces are clear.

Initially, the FDIC would create a "bridge" entity to hold the firm's healthy operations and subsidiaries while the agency determines how much claimants can receive. Essentially, different classes of creditors — based on their ranking in a strict hierarchy — would be repaid different amounts via different types of instruments.

As the FDIC rolled functioning parts of the bridge into a new successor company, the agency would pay certain claimants their allotted share with new equity or debt in the private startup company. Since shareholders of the original failed firm would likely have been wiped out, the debt-to-equity conversions in turn would help establish a capital base for the new institution without utilizing public funds. (Claimants preferring cash upfront could sell their instruments in the secondary market.)

"It requires that there be enough debt in the holding company level to cover losses … and be able to recapitalize it," said John Bovenzi, a partner in Oliver Wyman's financial services practice and formerly the FDIC's chief operating officer.

Some experts said while converting a bond into equity does not offer any more coverage than if the FDIC simply wrote the creditor a check, it would afford that creditor at least a limited opportunity as a shareholder to help influence the direction of the new company. However, they may face certain limits on the amount of equity they own, and therefore the amount of influence they wield.

"They're not going to get any more than they would have gotten in the liquidation," but "it will be their responsibility to pick their own CEO and president and board of directors and to continue on with the operations," said Mitchell Glassman, formerly head of the FDIC's bank resolutions division, who is now a director at Deloitte Consulting.

Debt-to-equity swaps are a more common route in bankruptcy than in FDIC resolutions. But both the agency and industry leaders appear to be embracing the conversions -- combined with the launch of a successor company -- for closing a systemically important financial institution without upending the market.

"In typical reorganizations, it's reasonably common to have unsecured or less-secured debt converted into equity," said Gregory Lyons, a partner at Debevoise & Plimpton LLP. "It is a logical system and I think it would honestly work in many circumstances and has proven to be a viable system in standard bankruptcy reorganization."

A joint paper last year by The Clearing House Association and Securities Industry and Financial Markets Association backed a version of the idea, which the groups called "recapitalization." They suggested such a resolution strategy would provide some comfort to creditors of a troubled institution, who may otherwise run if they feared the FDIC would simply liquidate the company in a resolution.

"Resolving SIFIs by recapitalizing the systemically important or other viable parts of their businesses should reduce the incentive of creditors to run at the first sign of trouble, while ensuring that any and all losses are ultimately borne by shareholders and creditors rather than taxpayers," they said.

JPMorgan Chase & Co. also endorsed the idea in hypothetical planning for its own failure. In the public summary of its so-called "living will" — submitted to the FDIC and Federal Reserve Board as part of other requirements in Dodd-Frank — the company said, "The FDIC would distribute the stock of the bridge entity to the Firm's creditors, both long-term debt holders under indentures and others, in order of priority in satisfaction of the claims against the Firm not assumed by the bridge entity."

Krimminger said another benefit of swapping debt for equity is that the newly created company avoids having to sell one giant firm to another.

"Given that the failed holding company was a large SIFI, using the swap helps prevent further concentration in the industry because it avoids having to sell one failed SIFI to another large company that would then be even larger," he said.

But other observers said debt-to-equity conversions as a method for large-firm resolutions do not appear today to be a slam dunk.

Thomas Vartanian, a partner at Dechert LLP, noted the complexity and potential legal proceedings that could ensue as a result of so many creditor claims.

"While getting from A to Z may sound easy conceptually, getting from B to Y may often be a rocky path littered with litigation," he said. "Since every private party will have significant value at stake, there could be litigation on every single aspect of resolving the claims."

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