Does “Too Big to Fail” Mean “Too Big for Bankruptcy”?
The market collapse of 2008 and resulting financial crisis have led to significant reflection on a number of systemic features of our financial markets and on the stability of institutions that play significant roles in their function.
That reflection has produced a fresh round of legal scholarship on what role – if any – the federal Bankruptcy Code should play in addressing the financial difficulties of these institutions. In a recent paper, Columbia’s Harvey R. Miller Professor of Law Edward R. Morrison asks, “Is the Bankruptcy Code an Adequate Mechanism for Resolving the Distress of Systemically Important Institutions?”
The issue, at least as put by Professor Morrison in the opening paragraphs of his paper, is framed as follows:
The President and members of Congress are considering proposals that would give the government broad authority to rescue financial institutions whose failure would threaten market stability. These systemically important institutions include bank and insurance holding companies, investment banks, and other “large, highly leveraged, and interconnected” entities that are not currently subject to federal resolution authority. Interest in these proposals stems from the credit crisis, particularly the bankruptcy of Lehman Brothers.
That bankruptcy, according to some observers, caused massive destabilization in credit markets for two reasons. First, market participants were surprised that the government would permit a massive market player to undergo a costly Chapter 11 proceeding. Very different policy had been applied to other systemically important institutions such as Bear Stearns, Fannie Mae, and Freddie Mac. Second, the bankruptcy filing triggered fire sales of Lehman assets. Fire sales were harmful to other, non-distressed institutions that held similar assets, which suddenly plummeted in value. They were also harmful to any institution holding Lehman’s commercial paper, which functioned as a store of value for entities such as the Primary Reserve Fund. Fire sales destroyed Lehman’s ability to honor these claims.
Lehman’s experience and the various bailouts of AIG, Bear Stearns, and other distressed institutions have produced two kinds of policy proposals. One calls for wholesale reform, including creation of a systemic risk regulator with authority to seize and stabilize systemically important institutions. Another is more modest and calls for targeted amendments to the Bankruptcy Code and greater government monitoring of market risks. This approach would retain bankruptcy as the principal mechanism for resolving distress at non-bank institutions, systemically important or not.
Put differently, current debates hinge on one question: Is the Bankruptcy Code an adequate mechanism for resolving the distress of systemically important institutions? One view says “no,” and advances wholesale reform. Another view says “yes, with some adjustments.”
Morrison’s paper sets out to assess this debate, and concludes by advocating [again, in his words] “an approach modeled on the current regime governing commercial banks. That regime includes both close monitoring when a bank is healthy and aggressive intervention when it is distressed. The two tasks – monitoring and intervention – are closely tied, ensuring that intervention occurs only when there is a well-established need for it.” As a result of the close relationship between the power to intervene and the duty to monitor, however, any proposed legislation “is unwise if it gives the government power to seize an institution regardless of whether it was previously subject to monitoring and other regulations.”
Elsewhere in the Empire State, at the University of Rochester, Distinguished Professor Thomas H. Jackson proposes “Chapter 11F: A Proposal for the Use of Bankruptcy to Resolve (Restructure, Sell, or Liquidate) Financial Institutions.” According to Jackson:
Bankruptcy reorganization is, for the most part, an American success story. It taps into a huge body of law, provides certainty, and has shown an ability to respond to changing circumstances. It follows (for the most part) nonbankruptcy priority rules – the absolute priority rule – with useful predictability, sorts out financial failure (too much debt but a viable business) from underlying failure, and shifts ownership to a new group of residual claimants, through the certainty that can be provided by decades of rules and case law.
Notwithstanding its success, bankruptcy reorganization has a patchwork of exceptions, some perhaps more sensible than others. Among them are depository banks (handled by the FDIC), insurance companies (handled by state insurance regulators), and stockbrokers and commodity brokers (relegated to Chapter 7 and to federal regulatory agencies). In recent months, there has been a growing chorus to remove bankruptcy law, and specifically its reorganization process, from “systemically important financial in-stitutions (SIFIs),” with a proposed regulatory process substituted instead, run by a designated federal agency, such as the Federal Reserve Board or the Securities and Exchange Commission.
Putting aside political considerations, behind this idea lie several perceived objections to the use of the bankruptcy process. First, it is argued, bankruptcy, because it is focused on the parties before the court, is not able to deal with the impacts of a bankruptcy on other institutions – an issue thought to be of dominant importance with respect to SIFIs, where the concern is that the fall of one will bring down others or lead to enormous problems in the nation’s financial system. Second, bankruptcy – indeed, any judicial process – is thought to be too slow to deal effectively with failures that require virtually instant attention so as to minimize their consequences. Third – and probably related to the first and second objections – even the best-intentioned bankruptcy process is assumed to lack sufficient expertise to deal with the complexities of a SIFI and its intersection with the broader financial market.
Jackson’s response to this growing chorus of objections is to propose amending existing Chapter 11 legislation. Again, in his words:
The premise of [Jackson's] “Chapter 11F” proposal, which [he] flesh[es] out [in his paper], is that, assuming the validity of each of these objections, they, neither individually nor collectively, make a case for creating yet another (and very large) exception to the nation’s bankruptcy laws and setting up a regulatory system, run by a designated federal agency, that operates outside of the predictability-enhancing constraints of a judicial process. Rather, bankruptcy’s process can be modified for SIFIs – [Jackson's] Chapter 11F – to introduce, and protect, systemic concerns, to provide expertise, and to provide speed where it might, in fact, be essential. Along the way, there is probably a parallel need to modify certain other existing bankruptcy exclusions, such as for insurance companies, commodity brokers, stockbrokers, and even depository banks, so that complex, multi-faceted financial institutions can be fully resolved within bankruptcy.
With views as divergent as these, one might be tempted to look for a fundamental assessment of the differences between the banking regulatory system and the Chapter 11 process. And that assessment is, in fact, available from the Congressional Research Service – which last April provided its own comparison of “Insolvency of Systemically Significant Financial Companies: Bankruptcy v. Conservatorship / Receivership.” As summarized by its author, Legislative Attorney David H. Carpenter:
One clear lesson of the 2008 recession, which brought Goliaths such as Bear Sterns, CitiGroup, AIG, and Washington Mutual to their knees, is that no financial institution, regardless of its size, complexity, or diversification, is invincible. Congress, as a result, is left with the question of how best to handle the failure of systemically significant financial companies (SSFCs). In the United States, the insolvencies of depository institutions (i.e., banks and thrifts with deposits insured by the Federal Deposit Insurance Corporation (FDIC)) are not handled according to the procedures of the U.S. Bankruptcy Code. Instead, they and their subsidiaries are subject to a separate regime prescribed in federal law, called a conservatorship or receivership. Under this regime, the conservator or receiver, which generally is the FDIC, is provided substantial authority to deal with virtually every aspect of the insolvency. However, the failure of most other financial institutions within bank, thrift, and financial holding company umbrellas (including the holding companies themselves) generally are dealt with under the Bankruptcy Code.
In March of 2009, Treasury Secretary Timothy Geithner proposed legislation that would impose a conservatorship/receivership regime, much like that for depository institutions, on insolvent financial institutions that are deemed systemically significant. In order to make a policy assessment concerning the appropriateness of this proposal, it is important to understand both the similarities and differences between insured depositories and other financial institutions large enough or interconnected enough to pose systemic risk to the U.S. economy upon failure, as well as the differences between the U.S. Bankruptcy Code and the FDIC’s conservatorship/receivership authority.
[Carpenter's] report first discusses the purposes behind the creation of a separate insolvency regime for depository institutions. The report then compares and contrasts the characteristics of depository institutions with SSFCs. Next, the report provides a brief analysis of some important differences between the FDIC’s conservatorship / receivership authority and that of the Bankruptcy Code. The specific differences discussed are: (1) overall objectives of each regime; (2) insolvency initiation authority and timing; (3) oversight structure and appeal; (4) management, shareholder, and creditor rights; (5) FDIC “superpowers,” including contract repudiation versus Bankruptcy’s automatic stay; and (6) speed of resolution. This report makes no value judgment as to whether an insolvency regime for SSFCs that is modeled after the FDIC’s conservatorship/receivership authority is more appropriate than using (or adapting) the Bankruptcy Code. Rather, it simply points out the similarities and differences between SSFCs and depository institutions, and compares the conservatorship/receivership insolvency regime with the Bankruptcy Code to help the reader develop his/her own opinion.
Fascinating reading . . . and an awful lot of it.
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