The Board of Directors of the Federal Deposit Insurance Corporation, or FDIC, voted on Friday, October 8, 2010, to approve a proposed rule clarifying how the agency would treat certain creditor claims under the new orderly liquidation authority established under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The notice of proposed rulemaking, or NPR, was the subject of a briefing and board discussion during the FDIC open board meeting on September 27th, 2010.

Title II of the Dodd-Frank Act provides a mechanism for the appointment of the FDIC as receiver for a financial company where the failure of the company and its liquidation under the Bankruptcy Code or other insolvency procedures would pose a significant risk to the financial stability of the United States.

Among the issues addressed in the NPR is the availability of additional payments to creditors under the authority of the Dodd-Frank Act. These provisions parallel the FDIC’s longstanding authority under the Federal Deposit Insurance Act and must be narrowly construed consistent with the Congressional intent. Pursuant to the Dodd-Frank Act, the NPR proposes to absolutely bar any additional payments to holders of long-term senior debt, subordinated debt, or equity interests that would result in those creditors recovering more than other creditors entitled to the same priority of payments under the law. Additional payments to holders of long-term senior debt, subordinated debt, or equity interests do not meet the statutory test that the payments must maximize the value of the assets or recoveries, minimize losses or be essential to implementation of the receivership or any bridge financial company. The NPR also proposes to clarify that all creditors, must expect to absorb losses in any liquidation. Under the NPR, no creditor can receive any additional payment unless the FDIC Board of Directors has determined, by recorded vote, that the payments meet the statutory standards. In addition, such payments are subject to recoupment if ultimate recoveries are insufficient to repay any temporary government liquidity support provided as part of the orderly wind-down. This recoupment must occur before imposition of a general industry assessment to cover any shortfalls. In no event may taxpayer money be used to cover losses associated with the failure of a large financial firm.

The NPR also provides that secured creditors will only be protected to the extent of the fair value of their collateral. To the extent that any portion of the claim is unsecured, it will absorb losses along with other unsecured creditors. Secured obligations collateralized with US government securities will be valued at par. The FDIC believes this provision should create additional incentives for market participants to use highly liquid and easy to value collateral such as US government obligations to collateralize short term debt. The use of illiquid collateral to secure short term liabilities was a major contributor to the freezing of credit markets during the financial crisis.