Abstract
Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (shortly called as the Dodd-Frank Act) was enacted with the objective of preventing the repetition of the financial crisis followed by the collapse of Lehman Brothers in 2008 as an aftermath of the economic downturn. Use of bankruptcy has been found to involve extensive costs and high attorney’s fees in the case of Lehman Brothers. Title II has provided for the creation of an “Orderly Liquidation Authority” (OLA). OLA is a structure created exclusively to handle the insolvency of the financial companies in a proper manner, so that their collapse does not affect the economy of the United States largely. Title II provides for the appointment of the Federal Deposit Insurance Corporation (FDIC) as the authority under the Act responsible for carrying out the process of insolvency of the troubled financial companies. The Act has provided for enormous powers to FDIC to carry out this responsibility. This paper analyzes the salient provisions of the Act and compares the provisions with those of the Bankruptcy Code for better understanding.
Introduction
This research seeks to analyze the impact of the provisions of Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) on the creation of “Orderly Liquidation Authority” on the rights and interests of the counterparties of troubled financial companies and compares it with the provisions of the Bankruptcy Code. This paper analyses the significant implications of the provisions of new Act of Title II of the Dodd-Frank Act 2010 on creditors, directors and management. It will also state the differences and the similarities between both the new Title II of Dodd Frank and The Bankruptcy Code with regard to insolvency of corporations in the financial sector in the United Sates. This paper argues that there are varied consequences from application of different insolvency laws. Moreover, it is important for the creditors to be aware of the consequences of the application of Title II of Dodd Frank, because Orderly Liquidation Authority might affect the creditors’ rights to some extent. Thus, arguments about legal aspects of both of the laws in regulating the legal relationships between the concerned company, (debtor), creditor, and the authority (the Federal Deposit Insurance Corporation or the Court) will be presented in this research report by undertaking a secondary research and a review of several professional journal articles and other research papers on the topic.
Dodd-Frank Act has been considered as “the strongest financial reform, this country has considered since the Great Depression.” Title II an addition/ amendment to the Dodd-Frank Act and provide a set of new rules legislation. This legislative measure was an aftermath of the financial crisis of 2008, which crippled the U.S. economy. After the financial turmoil of 2008, the need for an effective framework for the reorganization of financial companies, which are in financial distress, was strongly felt. It was apprehended that the failure of large financial companies is likely to lead to systemic failures, which in turn might harm the entire economy as a whole. Because it was critical to prevent any possible recurrences of the events of 2008 and prior, enactment of Title II was considered as a protective framework. The objective of Title II of the Dodd-Frank Act was to avoid the reoccurrence of the undesirable financial events, which were witnessed as aftermath of the collapse of Lehman Brothers in 2008. Another objective of the enactment was to monitor the “bailouts” planned for large financial institutions. An “Orderly Liquidation Authority” (OLA) is created under Title II. OLA is a structure developed for restructuring or liquidating some of the nonbanking financial entities. Title II contains provisions regarding the federal receivership proceedings. In respect of the liquidation process of the non banking financial entities Federal Deposit Insurance Corporation (FDIC) will act as the authority to conduct the insolvency proceedings. “The purpose of Title II is to improve financial stability, mitigate risk, end “too big to fail” and protect taxpayers by “ending bailouts.”” In this context, this research analyzes the various provisions of Title II on the creation of the OLA and its implications for board of directors and management of nonbank financial companies.
Appointment of FDIC as Receiver
FDIC does not get appointed as the OLA under all circumstances, in which the failure of a financial company is evident. It is necessary that federal and government agencies governing the economic system of the United States must be persuaded that there is the need for creating an authority for conducting the liquidation process in respect of the identified companies. Title II has prescribed a specific process, which outlines the appointment of FDIC as receiver. This receivership is granted in respect of a failing financial company covered under the Dodd-Frank Act. The granting of the authority to FDIC to act as OLA can happen only when the federal agencies regulating the financial system recommends to Secretary of Treasury about such appointment. The Secretary in turn appoints the receiver in consultation with the President of the United States. Several situations have been prescribed for the consideration of the Secretary to decide on the appointment of FDIC as receiver. Considering brevity, this paper does not describe these circumstances.
Entities covered under the Act – Financial Companies
Although there are four different categories of insolvency laws, which govern the liquidation proceedings of different types of companies operating in the United States, certain business entities becoming debtors under the Bankruptcy Code are directed to be placed into federal receivership by the Dodd-Frank Act. According to the Act, these companies are classified as “financial companies.” The definition of the term “financial companies” under the Act provides for different categories of companies.
In respect of these companies, new rules have been evolved providing for the framework under which FDIC is allowed to “seek recoupment of senior executives and director compensation” of a covered financial company. The rules also provide for the ranking of unsecured creditors for settlement of their claims and the manner in which creditors of bridge financial companies need to be treated. The “administrative claims and judicial review procedures” are an integral part of the legislation introduced under Title II. To the extent the Act and Rules have prescribed the process of liquidation, the new Act can be said to be meticulous in its approach.
Orderly Liquidation Authority
Orderly liquidation authority is the process of liquidation prescribed by Title II in respeat of financially troubled financial companies It is the argument of some of the scholars that the provisions of Bankruptcy Code, which deal with the financial contracts, have led to the increase of systemic risk in the system. The purpose of the regulations under Title II of the Dodd-Frank Act is to provide the power and authority essential to carry out the insolvency proceedings of financial companies, which face difficulties in conducting their businesses and because of this might cause serious risk to the economic stability of the United States. The process of liquidation under the Act is expected to take place in a manner, which will minimize the risk and increase the value of the dissolving firm. The legislation provides specifically for the losses to be borne by the counterparties of the companies brought under liquidation. The Act has established a priority covering the expenses as well as claims that remain unsecured against a financial company covered by the provisions of the Act. The creditors are also provided with certain level of protection under the Act. The Act provides for the settlement of the creditors of a company brought under liquidation of an amount, which would have otherwise been received by the claimants, had the company followed the procedure under Chapter 7 of the Bankruptcy Code for the winding up of the company. Title II of Dodd-Frank Act provides for these provisions.
FDIC is of the opinion that orderly liquidation of a financial company covered under the Act is dependent upon its ability to “continue necessary operations”. Under the legislation covering the orderly liquidation, FDIC is allowed to continue necessary operations of the companies brought under liquidation. Under the provisions, FDIC can create a bridge company. This bridge company will act as the receiver for conducting the affairs of the company brought under OLA process. The newly created bridge company is empowered to undertake the settlement of the liabilities and purchase the assets of a company brought to liquidation under Title II. The bridge company also has the powers to carry on any other operations for the time being on behalf of the company brought under liquidation, which the FDIC deems appropriate. By establishing the bridge company, the FDIC will be able to continue to conduct the major operations of a covered financial company and thereby maximize the value in liquidation. A bridge company is a beneficial tool in the hands of the FDIC, as the bridge company can hold the assets of the covered financial company until the time the assets could fetch maximum value. It has been made explicit that the contracts transferred to the bridge company cannot be subject to termination because of the reason that bridge company has assumed the execution of the contracts. For carrying on the important functions of the company brought under liquidation or of the bridge company, FDIC is authorized to consider creditors having the same standing under different positions for executing their claims. However, under the provisions of Dodd-Frank Act, FDIC can take a decision to treat the creditors differently only for the purpose of obtaining maximum benefits for the company placed under liquidation.
Orderly Liquidation Authority – Creditor’s Perspective
It is observed that a majority of debate covering the OLA focuses on the appropriateness and general ability of Title II to reduce systematic risk and ensure protection of taxpayers from contributing to any future bailouts. However, this enactment has a significant consequence on the rights and interests of creditors of the financial companies covered under the Act. Hardee based on a comparison of the language of the provisions of Title II and that of the Bankruptcy Code argues that OLA cannot be considered as protective of the interests and rights of the creditors. On the other hand, Bankruptcy Code provisions appear to provide for greater protection of the rights and interests of the creditors. Hardee suggests that the creditors must evaluate the riskiness of their loans and whether the lending is made to a potential covered financial company. One cannot rule out the possibility that once a financial company becomes a covered one and placed under the receivership of FDIC, the OLA will follow an administrative procedure with enormous discretionary powers granted to the FDIC. In contrast the proceedings under Bankruptcy Code involve a judicial procedure with the creditors represented by their respective counsels. The decisions are appealable providing an opportunity to the creditors to put forth their cases. Further, under Chapter 11 proceedings the management of the company and the creditors retain the control over the affairs of the company including its assets.
Counterparty Risk and Orderly Liquidation Authority
In exercise of the powers under Title II, FDIC has prescribed certain rules for the implementation of OLA. Under these rules FDIC is empowered to treat similarly situated creditors in different priorities for settlements. These circumstances are:
- which will work to enhance the value of assets of the troubled company to the maximum,
- to continue the operations of the company in an effective manner for implementing the receivership,
- to realize maximum present value for the assets of the troubled company
- to reduce the loss on sale of the assets of the troubled company to the minimum. In short, the process of liquidation is expected to be conducted in a most advantageous manner to the financial company facing liquidation.
The construction of the provisions of the Act has large impact on the rights and interests of counterparties. Under the Act, FIDC has identified three categories of claimants who may not qualify and meet the requirements of the Act to receive payments. “The first category of claimants who cannot receive additional payments are holders of long-term senior debt.” Long-term senior debt is covered by a separate definition under the Act. “Senior debt issued by the covered financial company to bondholders or other creditors that has a term of more than 360 days” but excludes “partially funded, revolving or other open lines of credit that are necessary to continuing [essential] operations.”
In comparison, trade creditors who provide essential services to the company would get priority in getting additional payments. “Holders of subordinated debt are the second category of claimants who cannot receive additional payments under the FDIC’s Proposed Rule.” Other counterparties, who are considered having ownership interest in the company under liquidation, are included in the third category.
Process of Risk Determination
Title II of Dodd-Frank Act provides for whether the insolvency of a particular company presents a systematic risk on the economy of the country. However, simply because a company is a financial company, it does not become eligible for being placed under federal receivership under the Dodd-Frank Act. For becoming eligible, the company must satisfy the definition of a “covered financial company” under the Act. A covered financial company is one respect of which the authorities identified under the Act has made a “systematic risk determination.” The process of determination begins when the FDIC and the Board of Governors recommends the placing of the company under orderly liquidation authority. These authorities make the recommendation in respect of finance companies other than a covered broker or dealer. Securities Exchange Commission (SEC) and the Board of Governors decide about a covered broker or dealer as to whether such dealer or broker has to be brought under the purview of orderly liquidation.
The authorities have been mandated to make an extensive evaluation of the financial status of company to the effect that whether the default of the financial company would have significant impact on the financial stability of the United States. The evaluation must also cover the chances of evolving a different method to resolve the issue. The process of systematic risk determination is so detailed that it also covers whether the bankruptcy procedure is the appropriate course of action for the financial company. Because the evaluation covers the effects of orderly liquidation on creditors, counterparties and shareholders of the covered financial company, Title II appears to consider the rights and interests of all connected with the company.
Basic Elements of the Process of Liquidation
“Once the FDIC is appointed receiver of a covered financial company, it assumes virtually complete control over the liquidation process, the role of the courts in the core receivership process ends, and only limited avenues exist for challenging the various ancillary decisions that the FDIC may make in pursuing the liquidation.” Only very few avenues are available for challenging the decisions of FDIC, which are taken in the process of following the liquidation. Role of federal receivership under Title II is similar to the role it takes during the process of insolvency proceedings of federal banks and savings and loans and similar to the role of the state insurance commissioner in the bankruptcy proceedings of insurance companies. However, this role of federal receivership in orderly liquidation is different from that of a receiver appointed under Chapter 11 of the Bankruptcy Code for the reorganization of an entity under insolvency. Under Chapter 11 proceedings, “debtor’s board and management stay in place, the debtor remains in possession of its business, and the normal rules of corporate governance and decision making continue to apply (subject to the requirement that transactions outside the ordinary course of business require advance court approval.”
Once FDIC is appointed as a receiver for a covered financial company, the powers and privileges of the company are vested with the authority. “The FDIC succeeds to all rights, titles, powers and privileges of the covered financial company and its assets, and of any stockholder, member, officer or director of such company.” FDIC is authorized to wind up the affairs of the company in any manner the authority might consider fit. FDIC may take any action including selling of the assets of the covered company or transferring the assets to a bridge company. The authority may also exercise any other right or privilege granted to it in achieving the orderly distribution of the assets of the covered financial company. For example, FDIC may provide for the merger of the financial company with any other company on its own motion. It may also transfer other assets or liabilities of the company, without the approval of the stakeholders.
Although Title II has provided enormous powers to FDIC in the matter of controlling the operations of a covered financial company, it has also specified several guidelines in the conduct of the proceedings by FDIC. For instance, when the authority decides to dispose off some of the assets of the financial company, FDIC is expected to take into account the possibilities of obtaining the maximum returns and incurring minimum losses. At the same time, FDIC must also eliminate the potential for any serious impact on the financial system. FDIC is obligated to take into account the economic and financial stability of the country rather than protecting the company, while taking decisions on the desired courses of action. FDIC must ensure that the dues of the shareholders are settled finally after every other due is paid off. The unsecured creditors must undertake the losses of the company. It is obligatory on the part of FDIC to not to undertake an equity interest in the company under financial distress or become a shareholder thereof.
The powers conferred on FDIC are equivalent to the powers granted to the same authority under the insolvency proceedings in respect of thrifts under the FDIA and the powers granted to SIPC trustees covering the insolvency proceedings of broker-dealers under the provisions of SIPA. The powers are also consistent with the powers conferred on bankruptcy trustees for conducting the liquidation process under Chapter 7 of the Bankruptcy Code. FDIC’s powers can be discussed in three categories – “resolution and payment of claims; disposition of existing contracts and similar obligations; and recovery of pre-receivership fraudulent conveyances and preferential transfers.”
Process of Creation of a Restructured Successor
One of the objectives of this Act, as well as the Bankruptcy Code and FDIA is to obtain the maximum value for the assets of the business so that there can be maximum repayment against the amounts advanced by the creditors. This is achieved mostly by undertaking some form of restructuring of the business of the company, which is facing the financial struggle. Title II also includes the mechanisms for achieving this. It is to be noted that these mechanisms are more similar to those prescribed under the FDIA and the Bankruptcy Code in connection with the insolvency of banks and savings and loans.
More specifically, FDIC has the power to arrange for the selling of particular assets of the troubled company to one or more private acquirers. Of course, such sale is subject to the anti-trust and other regulations as they apply to any other general transactions. Similarly, FDIC may also arrange for the acquisition or takeover of the company brought under liquidation by any private party or parties, again subject to anti-trust and other regulatory obligations cast on the troubled entity and the proposed acquirers. One of the significant aspects of Title II is that FDIC is under no obligation to provide any advance intimation of such sale or other arrangement to any of the creditors, shareholders or other counterparties of the troubled company. Moreover, any party interested in any of the transactions does not have the right to challenge any of such transaction on the ground that such transaction represents a fraudulent conveyance. This is because of the operations of the provisions of the Act in prohibiting the courts to admit any actions for restraining such transactions. However, this approach of Title II is in contrast to the proceedings under the provisions of the Bankruptcy Code. Under the Bankruptcy Code, a troubled company has the option of selling its ongoing business to any interested party. Free and clear of certain specified liabilities. In addition, the company has to notify all the stakeholders of its intention to sell the business. The stakeholders must be provided an opportunity to be heard in this connection. The troubled company can sell the undertaking or any part thereof after obtaining an order from the bankruptcy court, approving the transaction as in the best interests of beneficial winding up.
Under the Bankruptcy Code, a troubled company is given an opportunity to restructure its operations and liabilities under a scheme of reorganization. However, the company is under an obligation to provide a detailed disclosure statement to the affected stakeholders, which describes the scheme of reorganization. The stakeholders must be given an opportunity to vote n favor of the scheme or they may vote to reject to it. The stakeholders may also raise objection to some parts of the scheme. It is also necessary that the bankruptcy court finds the scheme of reorganization meets with the number of requirements put forth by the Bankruptcy Code, which have been designed to ensure that such reorganization schemes are really beneficial to the affected stakeholders and that such scheme is really fair and feasible. This discussion leads to the point that FDIC is given wide powers under Title II in respect of introducing any scheme of reorganization and in the matter of selling the undertaking of the troubled companies.
A reasonable explanation can be found for the enormous powers given to the FDIC under Title II. The main reason behind the grant of powers is that the businesses, which are brought under the purview of OLA, are financial services businesses, which are fragile entities. These enterprises do not contain “bricks and mortar” structure and they also do not sell any physical goods. These businesses mainly are comprised of people, who sell advices generated out of their ideas and expertise. Mutual trust and confidence form the basis of this business. The nature of these businesses is such that they cannot withstand the delays, which are common to the insolvency proceedings under the Bankruptcy Code. Accordingly, if a troubled company has to have the opportunity of salvaging its core business undertaking for the benefit of the impaired stakeholders, the decision as to the sale or transfer of any asset or liability has to be taken swiftly and subject to the expert guidance and supervision of a capable authority. It is also essential that this authority is provided with maximum powers to conclude the transactions at shorter notices, to make them beneficial to all concerned. The processes described above are in contrast to some of the provisions of the Bankruptcy Code, as the Code does not provide much flexibility to the bankruptcy courts for an expedient conduct of the insolvency cases. The Code reflects minimum standards of due process only and contains provisions relating to the serving of advance notices and providing opportunities to be heard, which act to delay the process of liquidation.
Although the Act has provided broad and enormous powers to FDIC, it has placed some restrictions covering the transfer of assets or liabilities of a troubled company. First, FDIC is obligated to treat the similarly placed creditors equally, in the matter of transfer of assets or liabilities of a troubled company in favor of a bridge company. This is a general obligation. However, the FDIC may choose not to comply with this direction, if in the opinion of FDIC, unequal treatment of the similarly placed creditors is likely to enhance the value and returns from such transfer or it would minimize the losses likely to occur. Secondly, when the FDIC has established a bridge company to deal with the undertaking of a troubled broker-dealer, it is under the obligation to transfer all the customer accounts to the bridge company.
A bridge company created by FDIC cannot enjoy perpetual existence. The purpose of establishing a bridge company is to facilitate the acquiring of the troubled financial company by another private entitiy. In order to ensure reasonableness of the transaction, the bridge company has been mandated to terminate in two years after its charter is created. Under special circumstances, FDIC may decide to extend the life of the bridge company up to additional periods of three one year. Similarly the existence of a bridge company will come to an end when the bridge company is merged with another company or majority of its assets is sold to another company, which is not a bridge company. However, FDIC is given the power under the Act to deicide to terminate the bridge company at any point of time as it may deem fit. While the bridge company is in operation, the FDIC need not subject itself to the direction of any government department or agency for conducting the affairs of the bridge company or for disposing the assets and liabilities of the bridge company.
With regard to the expenses of the process of liquidation, the Act provides that no part of the liquidation process could be carried out using taxpayer funds and the Act specifically provides that the creditors and shareholders are under the obligation to bear all the looses in connection with the liquidation of a troubled company.
Provisions Covering Derivatives
The provisions of Dodd-Frank Act, deals with the transfer and cancellation of contracts and leases and they also relate to the rights and interest of various counterparties and stakeholders in the event of a financial company being brought under the purview of OLA. Under the Act, special protections are available to derivative agreements and special provisions have been enacted to protect the rights of derivative counterparties. These protections are not available in connection with other agreements. In this respect, the provisions of Title II are similar to those under FDIA and Bankruptcy Code, which deal with derivative contracts.
All of these legislations extend special protections to the derivative contracts classifying them as “qualified financial contracts.” These contracts include “repurchase agreements, cross-netting provisions, credit swaps, interest rate swaps, and margin loans among other arrangements.” In each of these instances, the respective legislations specify the counterparties involved in the transactions. It is to be noted that the Act, the Bankruptcy Code and the FDIA contain similar definitions of each of these categories of agreements as wells as the counterparties covered by the agreements. These legislations provide that certain non-debtor counterparties relating to these agreements are entitled to execute their contractual obligations to repudiate, close out and liquidate their positions in the instance of the insolvency of the counterparties connected with the respective contracts. It must be noted that this allowance to the counterparties is the reversal of the general rule governing the fate of all other agreements in the event of insolvency of a financial company. According to the general rule, termination of an agreement based on the financial status of the troubled company or after the commencement of the insolvency proceedings becomes unenforceable.
Implications for Directors and Management
The Bankruptcy Code places certain restrictions on the payment of compensation and retention payments to insiders of a troubled company, by placing limitations on such payments on occasions that are unlikely to occur. Despite these limitations, the Bankruptcy Code provides for the existence of the board and management of a troubled company so that the company could reorganize its operations effectively. In the same way as the Bankruptcy Code, Dodd-Frank Act treats certain settlements as fraudulent transfers, if such settlement is in favor of an insider. The settlement needs to be nullified even it is a settlement to the employees, which was of an extraordinary business nature.
The above provision intends to prohibit the excessive provision of severance payments contemplated to be made to the executives. As provided by the Bankruptcy Code, the Act extends a limited priority for unpaid claims made by the employees of the troubled company in respect of “wages, salaries, commissions and other benefits.” However, the provisions of the Act are different from those of the Bankruptcy Code, in which there is express subordination of any claims made by senior executives and directors to general unsecured claims.
“The Act outlines the circumstances under which culpable management may be banned from the financial services industry for a term of at least two years.” The management may be debarred under the Act, when FDIC is of the opinion that the management has violated any of the regulations covering the employment of personnel whether directly or indirectly and by reason of such violation, the management has received certain gains. FDIC may also initiate such action if it is of the opinion that such violation exhibits personal dishonesty.
The above measures are meant to provide the necessary motivation to the boards and management to terminate the services of culpable executives. The provisions also encourage the managements to extend the required cooperation for undertaking pre-receivership negotiations, aimed at reorganizing a troubled company. However, these provisions may also act to the detriment of the troubled company, in that the troubled companies may have difficulty in attracting and retaining talents required to maximize the value of the company in reorganization. The executives, who are otherwise competent, might be wary of the prospect of being removed from their positions, notwithstanding their best efforts to improve the financial standing of the company and avoid the liquidation.
Conclusion
Rosner points out a fundamental flaw in the creation of OLA, as it leads to two different regimes – Bankruptcy Code and the OLA for winding up a financial firm. This analysis threw light on several important provisions of Title II of the Dodd-Frank Act, in so far they apply to troubled financial companies on the verge of insolvency. Sprayregen and Hesslerare of the opinion that there is a fundamental flaw in Title II and it cannot work as it is intended. The authors point out that the Act has been premised on an improper assessment of the recent financial crisis and therefore it only provides a misguided solution for the prevention of the reoccurrence of the financial crisis. Title II provides that once a financial company is identified to be financially sick and it is to be liquidated, the liquidation shall have to be proceeded with under the provisions of Title II. No provisions of Bankruptcy Code will apply to the liquidation process of such a company. It is to be noted that the financial companies not identified to be liquidated under Title II have to follow the process specified in the Bankruptcy Code. This is a serious anomaly. In addition, Title II precludes the use of any public money for the winding up of the troubled companies. This focus of Title II in preventing the taxpayers’ funds to be used in saving major banks has only weak justification in displacing the provisions of Chapter 7 and Chapter 11 of the Bankruptcy Code.
Under situations of crisis of a financial company, the lenders are concerned more with the safety and repayment of their funds rather than worrying whether the borrowing company is saved or whether their money is repaid by public or private funds. To this extent Title II can offer only a superficial protection against any future occurrences of financial crisis. The Act has provided extensive powers to FDIC, in connection with the conduct of the affairs of a financial company, which is a potential candidate of bankruptcy. The paper compared the provisions of the Act with those of the Bankruptcy Code and found many similarities and differences as well. The powers of FDIC under Orderly Liquidation Authority include the ability of the authority to control the undertaking of the troubled company including the formation of a bridge financial company. FDIC is also given extensive powers under the Act to transfer assets to the bridge company and to merge the troubled company with another entity. The authority under OLA is empowered to prevent fraudulent transfers and preferences in addition to repudiating certain contracts. The Act has provided for special treatments in respect of derivative contracts, categorizing them as qualified financial contracts. The provisions of the Act have serious implications for the boards and management to the extent that they place serious limitations on the payment of excessive compensation to the senior executives and also provide for removal of culpable management personnel. The provisions act to extend a potential limitation on the enthusiasm of otherwise competent managerial personnel because of potential prospects of being removed from their positions, notwithstanding their best efforts to save the company from insolvency.
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