About a year ago, before the full onset of the current financial crisis, the Treasury Department issued a blue print for a broad overhaul of financial services regulation. See Regulatory Watch: Treasury Recommends A Massive Reconstruction of Financial Regulation, 21st Century Money, Banking & Commerce Alert® (Mar. 31, 2008). Drawing on the experience over the past several months, including experience gained from AIG and Lehman Brothers, Secretary Geithner has outlined several reforms to the current regulatory framework with the goal of providing the federal government with, among other things, new tools to resolve large nonbank financial institutions in severe distress that pose a systemic risk to the US financial markets and the broader economy.
The Treasury Department released on March 26, 2009, legislation that would provide the Federal Deposit Insurance Corporation (“FDIC”) with wide-ranging powers to take control of, and provide assistance to, systemically significant financial companies whose failure may have a severe adverse effect on the financial system or the US economy. Under the Treasury’s legislation, the FDIC, with the approval of the Secretary of the Treasury (“Secretary”), would be empowered to appoint itself as conservator or receiver for failed or failing financial institution holding companies and certain of their subsidiaries, as well as to provide a broad range of financial assistance to such companies and their subsidiaries. The shift to seizure of a holding company may seem subtle, but it is a sea change from what institutions and markets have been accustomed to.
The resolution authority forms one of six proposals outlined by the Treasury regarding comprehensive reform of the financial regulatory system. Other proposals outlined by the Treasury include: (i) the creation of a single independent regulator with responsibility over systemically important firms and critical payment and settlement systems; (ii) higher standards on capital and risk management for systemically important firms; (iii) registration and reporting requirements with respect to hedge fund advisers and hedge funds; (iv) a comprehensive regulatory framework for the credit-default swaps and over-the-counter derivatives market; and (v) new requirements for money market funds to reduce the risk of rapid withdrawals.
This proposal raises significant capital market issues largely because of the enormous shift it would create with regard to the handling and failure of systemically significant financial companies. These issues include:
- If the rules that govern the FDIC in its capacity as conservator or receiver differ from those that are applicable under federal bankruptcy laws, how would a potential seizure of an entire company – the holding company and its subsidiaries – impact financial relationships of the parent and its subsidiaries with their investors, creditors, counterparties, vendors and trading partners?
- If certain financial institution holding companies and certain of their subsidiary companies could be determined to pose a systemic risk at any time, how would that possibility impact those financial relationships? How would those parties and the markets deal with this uncertainty?
- Lenders and bondholders generally understand and are comfortable with the well-established rights of parties within a Chapter 11 bankruptcy case. While the differences in the rules of the game between a Chapter 11 bankruptcy case and an FDIC receivership or conservatorship under this proposal would need to be clarified, they would likely be significant (e.g., priorities among creditors, claim resolution process, ability to pursue avoidance actions, ability of a company to assume or reject contracts, obtain financing, etc.). In that respect, would the prospect of an FDIC receivership or conservatorship and the related uncertainty make it difficult to convince market participants to lend to a distressed company that may be subject to this legislation?
- How would the proposed resolution authority be interpreted given language contained within existing indentures and financial instruments? For example, would an FDIC conservatorship fit within bankruptcy default provisions? What impact could be expected on the pricing and trading of debt instruments of potentially systemically significant financial companies in light of their contractual provisions? What practices would develop in future financial instruments to allocate risks between issuers and investors?
- Would this new resolution authority lead to some subsidiaries (such as federally insured banks) being supported by the holding company and its other subsidiaries, and how would that impact those companies?
New Resolution Authority Over An Expanded Range of Financial Companies and Subsidiaries
Under the Treasury’s proposal, receivership and conservatorship authority would apply to “financial companies” a term broadly defined to include: bank and savings and loan holding companies (including those qualifying as financial holding companies); holding companies of insurance companies, SECregistered brokers or dealers, futures commission merchants, and commodity pool operators that are incorporated or organized under US law; and certain financial and non-financial US subsidiary companies of such holding companies. The proposed resolution authority would not, however, extend to non-US incorporated financial companies or their US or non-US subsidiaries.
Systemic Risk Determination
The proposed receivership and conservatorship authority would only apply to financial companies that the Treasury determined created a systemic risk. Until a systemic risk determination was made by the Treasury in a particular case, it would not be possible to identify with certainty whether a particular financial institution would or would not be subject to the proposed resolution process. This potential difference in treatment may cause significant uncertainty within the financial and capital markets, which may translate into added costs for companies considered to be in the zone of being determined to create a systemic risk.
A systemic risk determination would be made by the Treasury (in consultation with the President) following the receipt by the Treasury of a written recommendation for such determination by the Federal Reserve Board and the appropriate federal regulatory agency that described the effect that the default of the financial company would have on economic conditions or financial stability in the United States, and the nature and the extent of assistance or actions that should be provided or taken by the FDIC regarding the financial company.
Following the receipt of such a written recommendation, the Treasury would determine whether:
- the financial company is in default or is in danger of default;
- the failure of the financial company and its resolution under otherwise applicable federal or state law would have “serious adverse effects” on financial stability or economic conditions in the United States; and
- any actions or assistance under the resolution process would avoid or mitigate such adverse effects.
The circumstances in which a financial company may be deemed to be in “default” or in “danger of default” are broadly defined. They include situations in which (i) a case has been, or likely will promptly be, commenced with respect to the financial company under federal bankruptcy laws; (ii) the financial company is critically undercapitalized; (iii) the financial company has incurred, or is likely to incur, losses that will deplete all or substantially all of its capital and there is no reasonable prospect for the company to avoid such depletion without assistance by the FDIC; (iv) the financial company is insolvent; or (v) the financial company is, or is likely to be, unable to pay its obligations in the normal course of business.
If the Treasury determines that a financial company poses a systemic risk, the company would become a “covered financial company” and would be subject to a wide-range of actions and resolution assistance. The proposed legislation would require the Secretary to notify Congress within 30 days of such determination, and the Government Accountability Office would be required to review the determination and submit a report to Congress regarding the determination.
Resolution Assistance for Covered Financial Companies
The FDIC, with the approval of the Secretary, would have a wide range of tools at its disposal to stabilize a covered financial company. In choosing among various forms of resolution assistance, the FDIC would be required to take into account the cost to the general fund of the Treasury and the potential to increase moral hazard on the part of creditors and shareholders in such covered financial company. Within its arsenal, the FDIC would have the power to, among other things:
- make loans to the covered financial company or any subsidiary;
- purchase assets of the covered financial company or any subsidiary;
- assume or guarantee obligations of the covered financial company or any subsidiary;
- acquire any type of equity interest or security of the covered financial company or any subsidiary;
- take a lien on any or all assets of the covered financial company or any subsidiary; and
- appoint itself as conservator or receiver of the covered financial company.
FDIC Powers as a Conservator or Receiver
Under the proposal, the FDIC could place a failed or failing covered financial company into conservatorship or receivership. The FDIC’s receivership and conservatorship authority would be expanded well beyond its current parameters. The FDIC currently has such power only with respect to limited situations involving insured depository institutions, but not with respect to bank or savings and loan holding companies or other financial institution holding companies that would be subject to the new regime. Any receivership and conservatorship authority over bank and savings and loan holding companies in this respect would represent a fundamental shift in the power of the federal government over such companies. Under current law, bank and savings and loan holding companies have substantial leverage to protect the interests of their shareholders and creditors, relative to the demands of bank regulators with respect to the interests of subsidiary insured depository institutions. The proposed legislation would significantly alter the current balance in this regard.
The FDIC’s powers as conservator or receiver under the proposal are modeled on current law applicable to the FDIC’s resolution of failed banks and savings associations and, more recently, the Federal Housing Finance Agency’s powers as conservator and receiver with respect to Freddie Mac, Fannie Mae, and the Federal Home Loan Banks. In its capacity as conservator, the FDIC, in effect, gains complete control over the operations of the covered financial company in conservatorship, which continues its day-to-day operations. In its capacity as a receiver, the FDIC would undertake to liquidate a failed covered financial company, subject to purchase and assumption transactions that would distribute its assets and liabilities. The proposed legislation would largely track the FDIC’s current receivership claims process for claims relating to a failed institution, including the receiver’s authority to repudiate contracts with third parties, including, under certain circumstances, executive compensation arrangements.
Preemption of Bankruptcy Proceedings
The proposed legislation would create a unique circumstance where a company potentially could be subject, at any given time, to either federal bankruptcy proceedings or FDIC receivership. Under current law, as a general matter, institutions are not subject to potentially conflicting federal insolvency jurisdiction. Under the proposed legislation, the appointment of the FDIC as conservator or receiver for a covered financial company would result in the immediate termination of any federal bankruptcy proceedings with respect to that covered financial company and would prohibit the commencement of any such proceedings with respect to such company while the FDIC acts as conservator or receiver for such company.
Current Status of Proposed Legislation
The House Financial Services Committee (“Committee”) held a hearing on financial regulatory reform on March 26, 2009, in which Secretary Geithner outlined his proposals for reform of the financial services industry, including draft legislation discussed above for new resolution authority over financial institution holding companies. Federal Reserve Chairman Bernanke backed Secretary Geithner’s proposals in testimony before the Committee. It is expected that the Committee will vote on the draft legislation shortly.