Banking and Finance Law Daily Treasury report calls for restricting, not abolishing, orderly liquidation authority
Wednesday, February 21, 2018

Treasury report calls for restricting, not abolishing, orderly liquidation authority

By Richard A. Roth, J.D.

A report by the Treasury Department says that the federal government’s power to take over and resolve insolvent large nonbank financial companies should be subject to stricter limits but not entirely revoked. The orderly liquidation authority, which was created by the Dodd-Frank Act, should be available only if extraordinary circumstance would render a new bankruptcy code chapter inadequate, Treasury says. Changes to the OLA itself also are called for.

The report’s recommendations rely heavily on benefits from Dodd-Frank Act and other post-financial crisis reforms, including required higher capital and liquidity levels and resolution plans.

Using the OLA. The Dodd-Frank Act created the OLA to address a problem revealed by the financial crisis—the inability of the government to prevent the disorderly failure of large, complex financial companies other than insured banks and securities broker-dealers. The OLA gives the Federal Deposit Insurance Corporation the power to take over and resolve such companies outside of the ordinary bankruptcy process. The Treasury report notes that bankruptcy is the preferred resolution method and that the OLA can be implemented only if four distinct hurdles first are cleared:

  1. Two thirds of the serving Federal Reserve Board governors must concur that the OLA should be invoked.
  2. The FDIC or Securities and Exchange Commission, as appropriate, then must make the same recommendation, again by a two-thirds vote.
  3. The Treasury Secretary, in consultation with the President, must determine that the OLA should be invoked.
  4. The Treasury Secretary must seek the consent of the company’s board of directors and, if they do not consent, petition a federal district court to approve the action.

OLA powers. The report also describes restrictions on the FDIC’s powers. The FDIC must create an orderly liquidation plan, which must be approved by the Treasury. If resolving the company requires funding to preserve the value of parts of the company that remain viable, the FDIC can borrow from the Treasury and lend to the bridge company; however, the funding advances require Treasury approval, including approval of the financial terms—the amount, maturity, and interest to be paid on the loans.

The failed company’s managers must be replaced, and they are subject to compensation clawbacks. A new bridge company, managed by individuals hired from the private sector, is to be created. The losses that result from the failure are to be passed to the company’s shareholders and creditors and are not to be imposed on taxpayers, according to the report.

The FDIC has settled on a "single point of entry" resolution strategy, the report says. This strategy calls for the assets of the failed company, including the ownership of its solvent subsidiaries, to be transferred to the bridge company. The claims of most unsecured creditors, and of the company’s shareholders, would be liabilities of the receivership and satisfied, to the extent possible, by securities issued by the bridge company. The agency assumes that this process will wipe out any shareholders’ value.

Criticism of OLA. Critics of the OLA claim that the ability of the FDIC to borrow from the Treasury constitutes a bailout. They also claim the Dodd-Frank Act allows the FDIC to treat similarly situated creditors differently, and they want stronger judicial protection for companies. The Treasury’s recommendations are intended to address these concerns.

Bankruptcy code. The centerpiece of the Treasury’s recommendations is that Congress should pass a new Chapter 14 of the bankruptcy code that would be used specifically for large, complex financial institutions. Under the law, the failing company would file for bankruptcy court approval of the creation of a bridge company and the transfer of most of the failing company’s assets, and some of its liabilities, to the bridge company within the next 48 hours. This would allow the entire process to occur over a single weekend, the report says, so that the bridge company could open for business on Monday morning.

The new law would include "a clear, predictable allocation of losses," according to the report. The claims of shareholders and of "capital structure debt" creditors would remain in the failed company. The securities initially issued by the bridge company would be held by a special trustee for the benefit of these persons and eventually would be distributed as directed by the bankruptcy court.

The report asserts that Dodd-Frank Act changes have increased the amount of liquidity that financial companies must have, so the bridge company would not need as much financing as might be expected. Also, the bankruptcy version of the SPOE strategy would create a financially sound bridge company with access to private capital. Treasury also notes that the living wills that the Dodd-Frank Act requires these companies to create calls on them to calculate and hold enough liquidity to sustain their subsidiaries in the event of a company’s failure.

In order to take advantage of all available expertise, the new bankruptcy code chapter would require that the case be assigned to one of a small number of previously-designated judges. Also, the federal financial industry regulators would have the right to participate in the bankruptcy proceeding.

OLA reforms. As noted, the Treasury does not want the OLA to be abolished. It should remain available as "an emergency tool," but with changes. Recommended changes include:

  • ensuring that creditors could determine, in advance, where their claims would stand in the payment hierarchy and that similarly-situated creditors be treated the same;
  • empowering the bankruptcy court to adjudicate claims against the receivership;
  • specifying more clearly when a company is deemed to be "in default or in danger of default," which is the standard for invoking the OLA authority;
  • repealing the bridge company tax-exempt status, a status Treasury says would give that company an "enormous advantage" over its competitors;
  • permitting advances to the bridge company only for a short term of fixed duration;
  • using guarantees and premium interest rates to induce bridge companies to begin relying on private capital as quickly as possible;
  • requiring that advances to bridge companies be secured;
  • if an advance could not be repaid by a bridge company, requiring that the industry be assessed for an orderly liquidation fund to cover the advance as quickly as possible; and
  • strengthening the judicial review of a decision to invoke the OLA.

The FDIC needs to adopt a final SPOE strategy, the report adds.

Disappointed House leader. House Financial Services Committee Chairman Jeb Hensarling (R-Texas) was quick to express his dissatisfaction with the Treasury report. According to Hensarling, the report’s failure to call for the complete abandonment of the OLA is inconsistent with President Trump’s previously announced principle of avoiding all possible taxpayer bailouts.

Hensarling asserted that the FDIC’s ability to borrow from the Treasury to support a bridge company amounts to a bailout that puts taxpayers at risk, even though the Dodd-Frank Act requires that any draw always will be repaid by either the bridge company or the orderly liquidation fund. Trump asked the Treasury for a report on how to achieve the no-taxpayer-bailout goal, and the failure to call for the repeal of OLA means the report fell short, Hensarling said.

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