WASHINGTON — The Federal Deposit Insurance Corp. is set Monday to begin a Herculean task: creating a resolution procedure for large, systemically important firms that improves on the bankruptcy process but still resembles it enough that it does not unsettle the marketplace.
Although the bankruptcy system was largely discredited by the resulting chaos after the fall of Lehman Brothers, for creditors, it is the devil-they-know, compared with a new, untested system in the early stages of formation.
"If it looks like something completely new and different, which is unpredictable, then you have a problem," said Mark Ellenburg, a partner at Cadwalader, Wickersham & Taft. "Without predictability, creditors are hesitant to transact business. While you never want the person you're dealing with to end up in bankruptcy, you always have planned for it."
The agency's board meeting is the first step in its plan to implement the unprecedented resolution scheme, which gives the government the ability to clean up systemically risky banks and nonbanks the same way it does commercial banks. The board is also expected to finalize a much-awaited rule on what conditions securitizers must follow to enjoy exemptions from FDIC seizures.
The Dodd-Frank regulatory reform law, which would permit the government to place certain large firms in receivership, sets clear parallels between a new regime and the bankruptcy code, and FDIC officials have said the order of claims will follow the bankruptcy model.
"We want to make it very clear that the claims priority that we will be following will be what's in the statute — pretty much the same thing that's … followed in bankruptcy," FDIC Chairman Sheila Bair said at a recent agency roundtable on the issue.
But the law also aims to create a regime that can take down a company without the systemic shocks that resulted from Lehman's collapse.
Unlike bankruptcy, where a judge oversees the process, the FDIC can try to act in the government's interest, selling off assets and preventing systemic fallout. For instance, Dodd-Frank says the FDIC can "realize upon the assets of the covered financial company, in such manner as the Corporation deems appropriate, including through the sale of assets" and "the transfer of assets to a bridge financial company."
Most observers said having the FDIC preside over a firm's dismantling rather than a judge will mean a very different process. "I guess the FDIC, you could say, is a neutral party, but is it? It's not a judge. It has an interest," said Ron Glancz, a partner at Venable LLP.
Still, observers expressed hope the new FDIC regime will mirror bankruptcy as close as possible. Many said they would also welcome a model closely resembling the FDIC's current system for resolving failed banks — another known system — which was established by the Federal Deposit Insurance Act. "It would be important for the FDIC to create a system that has a number of the procedural protections that mimic the bankruptcy code," said Stephen Mertz, a partner at Faegre & Benson. "The biggest concern is unfamiliarity with a new process."
FDIC officials insisted creditors need not worry. Michael Krimminger, the FDIC chairman's deputy for policy, said while the resolution process will have new elements, it will be designed to largely track existing models.
"Creditors care less about the process than about getting comparable returns and comparable treatment between bankruptcy and another liquidation process," Krimminger said. "But, they want to have a clear process. They want to have a fast process. They want something with comparable protections for creditors as you get under bankruptcy. That's what this process does."
He said that a new resolution system could be more efficient than the extended court proceedings central to bankruptcy.
"A court reviewing everything before it can be done means you can't have a fast process," he said.
But not everyone is so confident. John H. Cochrane, professor of finance at the University of Chicago Booth School of Business, said regulators are making a mistake in trying to craft new rules instead of altering existing ones.
"There are hundreds of years of experience going into bankruptcy law," he said. "But people were unhappy with how that worked for big financial institutions, so we're going to invent something from scratch. Good luck."
Cochrane also said making a system that is mostly like bankruptcy appears harder than just changing the bankruptcy system itself. "Why couldn't we just have bankruptcy?" he said. "If we're going to do it just like bankruptcy court, well, there is a bankruptcy court. If you thought there were problems with bankruptcy, figure out what they are and fix them."
Under the law, bankruptcy would still be the process for the vast majority of companies. But in isolated scenarios, the Treasury Department would subject large financial firms — including bank holding companies and nonbank companies — to a new resolution process designed to prevent systemic fallout.
Ellenberg said that kind of discretion will prove tricky for market participants, who will want to plan for the worst-case scenario of a company's failure, but will not be sure which resolution model will apply. "Prior to Dodd-Frank, you knew what regime your entity was governed by — if it was a bankruptcy code filer, if it was an FDIA filer, or if it was under some other regime," he said. "To the extent an entity could conceivably be within the Dodd-Frank definition of a systemically important entity, then you don't know for sure what regime you're under."
Krimminger said the rule unveiled Monday, which is subject to approval by the FDIC's board and could be revised at future meetings, is only a start in the implementation process. It will include certain technical definitions, while also providing questions for comment to help guide future regulations.
Monday's interim rule is intended "to start the process of putting in place regulations that will help define how this process will work so that the marketplace, which is not as familiar with the FDIC receivership process, will get more clarity … so they can make their own judgments," he said.
Ellenberg and others said a system resembling the FDIC's current processes for resolving insured institutions would also reassure creditors. "The ideal thing would be for them to closely follow that model, because people know what that is and they're familiar with it," Ellenberg said.
Tom Vartanian, a partner at Dechert LLP, said while the bankruptcy model is the first choice for many, a model resembling more traditional FDIC receiverships is a "second choice."
"At least it's a second choice that people understand," he said. "Obviously, a third choice would be to create a different system that draws from both, and that probably would cause some anguish in the marketplace."