The ability of regulators to seize and unwind a failing large company — the very heart of the Dodd-Frank Act — is caught in a crossfire.

It's the mega financial companies on one side, Republican lawmakers and academics on the other.

Stuck in the middle? The Federal Deposit Insurance Corp.

Barbara A. Rehm

The agency's staff is working on a policy statement or perhaps even a regulation that would provide both sides with more detail about how systemically important financial companies would be resolved under Orderly Liquidation Authority.

Title II of the 2010 reform law extended the FDIC's liquidation authority to any mega financial firm. In other words, what failing banks have been subject to for decades — the Friday-night seizure that ends careers and wipes out shareholders followed by a sale or a shutdown — will now apply to any financial company deemed systemically important.

Whatever policy statement or rulemaking the FDIC staff settles on would need to be approved by the agency's board and put to public comment before it could be adopted. That could take a year, but the staff aims to get something before its board by yearend.

The FDIC is more concerned about mitigating its litigation risks than appeasing the big banks or mollifying critics in Congress and academia who want to repeal Title II and replace it with a special form of bankruptcy they are calling Chapter 14.

By putting out a policy statement or a rulemaking, the FDIC would create a point of deference for judges who will hear the lawsuits sure to be filed by creditors who suffer losses when a large bank fails. The FDIC staff is looking to cover two main areas: how an OLA resolution would unfold and more specifically what creditors can expect. On this latter point, the FDIC wants creditors to know that their claims may not be settled in cash. They may need to accept an equity stock certificate.

The FDIC began vetting its plans in January and acting FDIC Chairman Martin Gruenberg unveiled the OLA program in May with a speech hosted by the Federal Reserve Bank of Chicago.

In a nutshell, Gruenberg said that when a large financial firm fails, the FDIC will seize its holding company, wipe out shareholders, replace management and the board of directors and set up a bridge bank. The bridge will have all of the company's assets and none of its liabilities. Losses exceeding shareholder equity will be absorbed by subordinated and unsecured debtholders and any remaining creditor claims will be converted to ownership stakes in the new bridge bank.

It was a fine speech, but it was still just a speech. The agency is aiming for something more formal but may opt for a policy statement, which is easier to adjust than a rulemaking.

While large-bank executives understand the FDIC's need for flexibility — failures often present surprises that force regulators to go off script — they want the agency to lay out how and when OLA will be used.

Michael Helfer, a vice chairman at Citigroup who is married to former FDIC Chairman Ricki Helfer, treaded lightly but definitely got his point across in a recent speech.

"I believe it would be very useful for all concerned, including the industry, policymakers, and foreign regulators, if, when it is ready to do so, the FDIC proposes and, after notice and public comment, adopts a regulation or policy statement describing more precisely the circumstances in which it would invoke Title II and how a Title II resolution would work," Helfer told an audience gathered by Bretton Woods, the University of Maryland and Deloitte.

Randy Guynn, the head of Davis Polk & Wardwell's financial institutions group in New York, was more blunt. "The market needs more certainty," he says. "So somehow you have to balance the FDIC's desire for discretion and the market's need for certainty."

The industry supports OLA because it's viewed as faster and simpler than bankruptcy as well as more likely to preserve the value of a firm's assets.

JPMorgan Chase has hit the road with a presentation that shows in great detail how the $2 trillion-asset company could be resolved under the new liquidation authority.

"Anything the FDIC can do to clarify that we really have ended 'too big to fail' … and dissuade the market from thinking it will get bailed out, that tells creditors they are at risk is a good thing," says Greg Wilson, an independent industry consultant. "And now is probably a good time to do it, in this period of relative calm, for the FDIC to say 'Here is our new policy statement' or 'here is our new reg, creditors are at risk in the following ways. You are now officially on notice.' Such a step might finally lead creditors to impose more discipline on the financial giants."

And that's exactly what the other side is pushing for.

The advocates for scrapping OLA, including House Republicans like Paul Ryan and Spencer Bachus, want to replace it with a new form of bankruptcy. Critics worry OLA simply gives the FDIC too much leeway to protect favored creditors, including other large financial institutions.

The intellectual firepower behind a lot of this rests at Stanford University, where experts like Ken Scott, Thomas Jackson and John Taylor have been working on an alternative to OLA since before it was even enacted. They have a book coming out at the end of the month, "Bankruptcy, Not Bailout: A Special Chapter 14." Much of the research that went into the book can be found here.

A new Chapter 14 would combine liquidation features of Chapter 7 and reorganization features of Chapter 13. It would be "designed and exclusively tailored to large financial institutions," Scott says. Special judges would administer the new chapter, which would be speedier than other forms of bankruptcy.

Lawmakers who oppose Title II object to the fact that taxpayer dollars could be used to bail out a megabank. The law does allow the FDIC to tap the Treasury, and liquidity needs might indeed trigger a borrowing. But Dodd-Frank also requires the FDIC to pay any borrowed funds back and, if necessary, requires the agency to assess fines on all the other systemically important firms to raise the funds.

Scott says he and his colleagues define "bailout" differently. They are much less worried about a short-term loan from the Treasury than about creditors being protected from losses.

"What constitutes a bailout in our view is a discretionary process in which some creditors are selected to receive more or all of their claims than they would receive in a normal bankruptcy," Scott says. "What you get is a very discretionary process where the people running the show … will determine there are certain creditors that they don't want to see fail and will therefore pay off their claims in the bridge bank to a greater degree than they would receive" under bankruptcy.

"Almost by definition these creditors are other large financial institutions," Scott says. "They are also the counterparties of the failed institutions who are the most knowledge about what's going on, they have the most at stake, and they would be the most effective and powerful monitors of each other if they were not protected so that they didn't have to."

This echoes one of the iconic political outrages of the 2008 crisis: Goldman Sachs and other large financial company creditors being repaid in full by the failed AIG.

Scott says it is crucial that these creditors believe they are subject to losses.

"Without this, you are removing the primary source of market discipline," he says.

No one expects such a fundamental change to Dodd-Frank is on the near-term horizon, but it's possible the momentum behind Chapter 14 could affect how the FDIC writes its OLA rule book.

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