On March 25, Treasury Secretary Geithner proposed the “Resolution Authority for Systemically Significant Financial Companies Act of 2009,” which would grant the FDIC the authority to provide assistance to and to put into receivership or conservatorship “systemically significant financial companies” that fall outside of the FDIC’s existing resolution regime. The proposed authority would constitute a substantial expansion of the FDIC’s power and, if invoked, would effectively replace the Bankruptcy Code as the framework for “resolving” claims and restructuring and liquidating assets of a broad range of systemically important financial institutions.
Upon a determination that a “financial company” poses a “systemic risk” to the United States economy, the proposed resolution authority would grant the FDIC the power to provide assistance to the company (through loans or equity investments or by purchasing or guaranteeing assets) or to appoint itself as conservator or receiver for the company. The object of conservatorship would be to restore the company’s solvency and preserve its assets, whereas the object of receivership would be to wind the company down. The FDIC’s powers as a conservator or receiver would substantially (though not identically) track its existing authority under Section 11 and part of Section 13 of the Federal Deposit Insurance Act (“FDIA”) with respect to insured depository institutions. Treasury maintains that the expanded authority is needed because the federal government’s current options for non-insured institutions are only to extend substantial aid but without meaningful control (as Treasury did with AIG) or let the firm fail (as it did with Lehman Brothers).
The proposed resolution authority constitutes one component of the Administration’s plan to address systemic risk in the financial system—the others being: (i) a single independent regulator with responsibility over systemically important firms and payment and settlement systems; (ii) higher standards on capital and risk management for systemically important firms; (iii) registration requirements for hedge fund and private equity fund advisers with assets under management above a certain threshold (which we described in our March 26 Alert); (iv) a framework of oversight, protections and disclosure for the over-the-counter derivatives market; and (v) requirements for money market funds to reduce the risk of rapid withdrawals.
Secretary Geithner sent the draft legislation to Congress on March 25 and discussed the proposed authority in an appearance before the House Committee on Financial Services on March 26. No further committee meetings have yet been scheduled.
Proposed Resolution Authority
Definition of “Financial Companies.” The proposed resolution authority would allow the FDIC to provide assistance to or take over non-regulated U.S. holding companies and subsidiaries of regulated U.S. financial institutions. Specifically, a “financial company” would be defined as any U.S. entity that is:
- a bank holding company;
- a financial holding company as defined by the Bank Holding Company Act of 1956, as amended;
- a savings and loan holding company;
- a holding company of an insurance company;
- a holding company of a registered broker or dealer;
- a holding company of a futures commission merchant or commodity pool operator; or
- any subsidiary of companies described in (i) through (v)1 (other than (A) an insured depository institution or any subsidiary thereof, (B) any registered broker or dealer that is a member of the Securities Investor Protection Corporation or (C) an insurance company).
Systemic Risk Determination; Choice of Actions. Before any measures are taken by the FDIC, there must be a threshold determination that the failure of the financial company would pose a systemic risk to the U.S. economy. First, the members of the Federal Reserve Board and the commission serving as the financial company’s “Appropriate Federal Regulatory Agency” (the agency that regulates the largest financial entity with which the financial company is affiliated) must recommend, by a two-thirds vote of each, that the Secretary of the Treasury take the actions provided for in the proposed authority. Second, the Secretary must determine that (i) the financial company is insolvent or in danger of becoming insolvent, (ii) the insolvency of the financial company and its resolution under otherwise applicable law would have serious adverse effects on financial stability or economic conditions in the United States and (iii) taking any actions provided for in the proposed resolution authority would avoid or mitigate those adverse effects. Upon the Secretary making such determination, the financial company becomes a “covered financial company” and the Secretary and the FDIC must determine what form of assistance to provide, including whether to appoint the FDIC as the covered financial company’s conservator or receiver.
Key Powers as Conservator or Receiver. As a conservator or receiver of a covered financial company, the FDIC would have nearly identical powers to those it possesses when it becomes a conservator or receiver of an insured depository institution. It would become a successor to the company’s assets and have the authority to conduct the company’s business in the company’s name, replace the company’s board, merge the company with another company or transfer any or all of the company’s assets or liabilities. As receiver, it would have the power to transfer any or all of the covered financial company’s assets to a newly organized “bridge financial company”—in short, the “good bank” in a “good bank/bad bank” strategy—which the FDIC would operate for up to five years and then either sell or wind down.
The FDIC would also have the extraordinary powers it currently possesses under the FDIA with respect to insured depository institutions. Among other powers, it would have the authority to:
- disaffirm or repudiate contracts it determines to be “burdensome” and whose disaffirmance or repudiation it believes will promote the administration of the covered financial company;
- enforce any contract, other than a director’s or officer’s liability insurance or a qualified financial contract (discussed below), notwithstanding any contractual provision that authorizes the termination, default, acceleration or exercise of other rights upon the financial company’s insolvency or placement into conservatorship or receivership (a socalled “ipso facto clause”);
- avoid fraudulent transfers by any director, officer, employee, controlling stockholder or agent of the covered financial company made within five years of the FDIC’s appointment if the transfer was made to hinder, delay or defraud the covered financial company or the FDIC; and
- avoid legally enforceable or perfected security interests taken “in contemplation of the covered financial company’s insolvency.”
Just as under the FDIA, the proposed authority would require the FDIC to pay damages in respect of the contracts it repudiates. Such damages would be limited to actual direct compensatory damages (and exclude punitive damages or damages for lost profits or pain and suffering) and would be calculated as of the date of repudiation, in the case of qualified financial contracts, and the date of the appointment of the conservator or receiver, in the case of all other contracts.
Qualified Financial Contracts. Qualified financial contracts, which comprise securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements and other similar agreements, receive special treatment under both the FDIA and the proposed authority. In the case of receivership, before 5:00 p.m. on the first day after the FDIC is appointed receiver, the FDIC must decide—for each counterparty of the covered financial company in a qualified financial contract—whether (i) to transfer to a solvent financial institution (which a bridge financial company is deemed to be) all qualified financial contracts between the covered financial company and such counterparty or its affiliates, all claims relating to such qualified financial contracts and all property securing such contracts or claims or (ii) to transfer none of such contracts, claims or property. Only after such deadline (or after such transfer occurs), may the counterparty exercise its contractual rights to terminate or liquidate qualified financial contracts that are triggered by the covered financial company’s insolvency or the FDIC’s appointment as receiver. In the case of conservatorship, a counterparty is prohibited from exercising contractual rights to terminate or liquidate qualified financial contracts that are triggered by the appointment of a conservator or the covered financial company’s insolvency or financial condition prior to such appointment.
Differences from FDIC’s Current Authority. There are several differences between the proposed authority and the FDIC’s current authority with respect to insured depository institutions, including the following:
- The FDIA allows the FDIC to put an insured depository institution into conservatorship or receivership without the threshold interagency determination of systemic risk required by the proposed authority.
- Under the FDIA, the FDIC’s maximum liability for damages in respect of a repudiated contract is the amount it would have paid had the insured depository intuition been liquidated through the FDIA process; the FDIC’s maximum liability under the proposed authority is the amount it would have paid had the covered financial company been liquidated pursuant to Chapter 7 of the Bankruptcy Code, the Securities Investor Protection Act (“SIPA”) and applicable state law.
- While the FDIA allows the FDIC to treat similarly situation claimants differently provided they receive at least as much as they would have under an FDIA liquidation, the proposed authority allows the FDIC to treat similarly situated claimants differently provided they receive at least as much as they would have received through a Chapter 7, SIPA or state law liquidation process.
- Whereas under the FDIA the FDIC may recoup its losses by tapping the depository insurance fund, the FDIC may not access the depository insurance fund to cover losses resulting from its assistance under the proposed authority. Rather, to fund its initial assistance, the FDIC will be appropriated funds by the Treasury. Such amounts will constitute “amounts owed to the United States,” which the covered financial company must repay after administrative expenses of the receiver but prior to any unsecured claims. To the extent that the FDIC’s losses remain unrecouped, the FDIC must make “emergency special assessments” on financial companies, taking into account whatever considerations the FDIC deems appropriate.
Policy Issues and Open Questions
As currently drafted, the proposed resolution authority would bring about a structural change in the regulation of U.S. financial entities, and one which will result in both foreseeable and unforeseeable consequences. We consider the following to be key questions at this point.
Uncertainty as to when the proposed authority would be invoked. The first striking feature of the proposed authority is that it is uncertain under what circumstances it will ever be invoked. Whether a particular financial company poses a sufficiently systemic risk to the U.S. economy to justify measures under the proposed authority may be decided at a future time by a collective body based on broadly drafted criteria—such as whether the company “is likely to incur” substantial losses or whether the company’s failure would have “serious adverse effects” on U.S. financial stability. Until the systemic risk determination is made, creditors would be uncertain as to whether the Bankruptcy Code or the FDIC’s authority would govern their claims. And unlike the proposed authority, the Bankruptcy Code provides for certain limits on the unenforceability of ipso facto clauses, prohibits unequal treatment of similarly situated claimants, allows a debtor to reject only executory contracts (as opposed to all “burdensome contracts”) and does not limit the termination of qualified financial contracts. Such uncertainty, combined with uncertainty regarding the priority of claims introduced by the funding provision (discussed below), could result in higher borrower costs. As an alternative, Treasury and the FDIC could determine ex ante which financial companies would be subject to the proposed authority—either (i) by publishing, and periodically reviewing, a list of such companies, (ii) pursuant to an announced set of criteria concerning firm size or assets under management, (iii) through an “opt-in” system, whereby firms would choose to be subject to the proposed authority (perhaps to provide greater comfort to their creditors) or (iv) or with some combination thereof.
Limited scope of proposed authority. The restructuring or liquidation of a large financial firm with diversified businesses is affected by a patchwork of legal regimes, including the FDIA, SIPA, state insurance and insolvency laws and foreign statutes, to name a few. This would continue to be the case with the enactment of the proposed authority, as the proposed authority would directly impact only those entities that are not otherwise regulated. The possibility of conservatorship or receivership for such entities may ultimately increase recoveries, but creditors whose interests are collateralized by multiple entities will still have to endure a long and complex resolution process when a firm fails.
Impact of the “funding” provisions. As noted, when a covered financial company enters receivership, “amounts owed to the United States” must be repaid before all other unsecured claims (other than administrative fees). This effectively converts any equity or preferred equity investment previously made by the FDIC into a senior unsecured loan when receivership occurs; it thus prevents the FDIC from offering pre-receivership assistance to a covered financial company without impairing all unsecured creditors. Even more troubling is the requirement that the FDIC make special assessments on financial companies—including those for which no systemic risk assessment has been made—if its losses are not recouped. The definition of “financial company” encompasses not only financial holding companies, but also all unregulated subsidiaries of such holdings companies. How such assessments would be made on unrelated companies is unclear; so, too, are what steps financial firms will take to shield their holding companies and subsidiaries from such potential liability.