President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act") into law on July 21, 2010. Title II of the Reform Act ("Title II") creates a new "orderly liquidation authority" ("OLA") that provides the Federal Deposit Insurance Corporation (the "FDIC") with the power to seize control of certain non-bank financial companies ("covered financial companies") if the Secretary of the Treasury determines that they are in default or in danger of default and that the bankruptcy of such entity would threaten the financial stability of the United States.1 Please see the SNR Denton client alert dated September 2, 2010 (the "September 2, 2010 OLA Client Alert") for more information regarding the content of Title II.
As noted in the September 2, 2010 OLA Client Alert, lawmakers left many of the important details of Title II to regulation2 and on October 19, 2010 the FDIC published a notice of proposed OLA rulemaking (the "Proposed Rule")3 in order to provide greater clarity, transparency and certainty as to how certain components of Title II would be implemented. On December 29, 2010 the then Acting General Counsel of the FDIC issued a letter addressing the treatment of preferential and fraudulent transfers under Title II (the "Transfer Avoidance Letter").4 On January 14, 2011 the then Acting General Counsel of the FDIC issued a letter addressing the repudiation powers of the FDIC under Title II (the "Repudiation Letter").5 On January 18, 2011 the Board of Directors of the FDIC (the "Board") adopted6, and on January 25, 2011 the FDIC published, an interim final rule7 (the "Interim Final Rule")8 updating and revising the Proposed Rule in response to comments received.
In the Supplementary Information to the Interim Final Rule (the "Supplementary Information") the FDIC describes that prior to the enactment of the Reform Act, there was no common statutory scheme for the orderly liquidation of a covered financial company whose failure could adversely affect the financial stability of the United States. Instead, different types of entities were subject to differing insolvency regimes, including:
- Federal Deposit Insurance Act (‘‘FDIA’’) based, FDIC-administered receivership for insured depository institutions;
- insolvency proceedings under the laws of individual States for insurance companies;
- Chapter 7 of Title 11 of the United States Code (the "Bankruptcy Code") and proceedings under the Securities Investor Protection Act for registered brokers and dealers; and
- becoming a debtor under the Bankruptcy Code for other companies (including but not limited to the parent company of one or more insured depository institutions or other financial companies).
Given the limitations of, and lack of coordination among, these differing liquidation schemes, the Federal Government in some cases viewed financial support for a company at risk of imminent failure as the sole option available to it for containing the harmful national economic consequences that would follow in the wake of such a failure.
The Supplementary Information explains that Title II was included in the Reform Act in order to create an alternative option for containing such harmful national economic consequences. Section 204(a) of the Reform Act states that "it is the purpose of this title to provide the necessary authority to liquidate failing financial companies that pose a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard."
In order to mitigate potential adverse effects of OLA, Title II provides that ‘‘creditors and shareholders will bear the losses of the financial company’’9 and that the FDIC shall:
- liquidate the covered financial company in a manner that maximizes the value received from the sale of the company’s assets;
- minimize any loss from the resolution;
- mitigate the potential for serious adverse effects to the financial system;
- ensure timely and adequate competition and fair and consistent treatment of offerors; and
- prohibit discrimination on the basis of race, sex or ethnicity.10
The Supplementary Information goes on to explain that it is often vital to continue the essential operations and functions of a company if the value of the assets of such company are to be maximized through an orderly liquidation thereof. Given the importance in these cases of continuing the company’s key services, Title II also provides the FDIC with the ability to establish newly formed bridge financial companies which the FDIC can utilize to continue performing such functions without being burdened by the shareholders, debt, senior executives, bad assets or unprofitable operations that may have contributed to the covered financial company’s failure.
FDIC General Counsel Transfer Avoidance Letter
On December 29, 2010 Michael H. Krimminger, the then Acting General Counsel of the FDIC,11 issued the Transfer Avoidance Letter to the Securities Industry and Financial Markets Association ("SIFMA") and the American Securitization Forum ("ASF"). The Transfer Avoidance Letter addresses inquiries made in letters by SIFMA12 and ASF13 relating to inconsistencies between Title II and the Bankruptcy Code regarding the authority of the FDIC, as the receiver of a covered financial company, to use section 210(a)(11) of the Reform Act to avoid certain fraudulent, preferential or unauthorized transfers of property that would not have been able to be avoided under the Bankruptcy Code. This issue is of import to SIFMA and ASF because, unlike under the Bankruptcy Code, if the security interest in the collateral of an issuing entity in a securitization of a covered financial company is perfected by a UCC filing, rather than by possession through the delivery of such collateral to the applicable trustee or custodian, the FDIC as a bona fide purchaser under Title II could have the ability to trump the securitization’s lien on such collateral. Consequently, the SIFMA and ASF letters requested clarification from the FDIC as to whether it would interpret section 210(a)(11) of the Reform Act in a manner consistent with the treatment of fraudulent, preferential or unauthorized transfers under the Bankruptcy Code.
The Transfer Avoidance Letter provides that since the Reform Act was "intended to harmonize to the extent possible with otherwise applicable insolvency laws, including the Bankruptcy Code" the proper reading of section 210(a)(11) should "take into consideration the similar provisions of the Bankruptcy Code in order to achieve this intended harmonization and avoid unnecessary disparities in creditor treatment." Consequently, the Transfer Avoidance Letter concludes that the treatment of preferential and fraudulent transfers under section 210(a)(11) of the Reform Act should be interpreted in a manner consistent with the related provisions under the Bankruptcy Code. Specifically, the Transfer Avoidance Letter states that the correct interpretation of section 210(a)(11)(H)(i)(II) of the Reform Act is as follows:
- the avoidance provisions in section 210(a)(11) would apply the bona fide purchaser construct only in the case of fraudulent transfers alleged under subparagraph (A) and preferential transfers of real property (other than fixtures) alleged under subparagraph (B);
- the avoidance provisions in section 210(a)(11)(B) would apply the hypothetical lien creditor construct as applied under section 547(e)(1)(B) of the Bankruptcy Code to any alleged preferential transfers of personal property and fixtures; and
- the avoidance provisions in section 210(a)(11)(B) would apply the 30-day grace period as provided in section 547(e)(2) of the Bankruptcy Code.
The Transfer Avoidance Letter goes on to state that, in order to eliminate any remaining uncertainty in this regard, Mr. Krimminger will recommend to the Board that it adopt a regulation through notice and comment rulemaking under section 209 of the Reform Act to the above effect.
FDIC General Counsel Repudiation Letter
On January 14, 2011 Mr. Krimminger issued theRepudiation Letter to the ASF. The Repudiation Letter addresses inquiries made by the ASF with respect to whether:
- the FDIC would exercise its repudiation14 power under section 210(c) of the Reform Act to repudiate contracts of an entity if it had not been appointed receiver for such entity and the separate existence of such entity had not been disregarded under other applicable law;
- there are any provisions of the Reform Act that impact the ongoing enforceability of subordination agreements, non-petition covenants or other contractual provisions intended to ensure the bankruptcy-remote nature of special purpose entities established in connection with structured finance transactions; or
- the FDIC would repudiate contracts that transferred assets from a covered financial company in order to seize such assets even if such assets would not be treated as property of the estate under the Bankruptcy Code.
These questions are important to the ASF since they could result in the FDIC having the power to seize assets that had previously been sold into securitizations.
With respect to the first inquiry above, the Repudiation Letter provides that the repudiation provisions set forth in section 210(c) of the Reform Act are based upon the similar provisions in the FDIA and that a key prerequisite for the FDIC to have the power to repudiate contracts under the FDIA (and as a result under Title II as well) is that they are contracts of the entity in receivership. For this reason, the Repudiation Letter states that the FDIC as receiver for a covered financial company "cannot repudiate a contract or lease unless it has been appointed as receiver for that entity or the separate existence of that entity may be disregarded under other applicable law."
With respect to the second inquiry above, the Repudiation Letter confirms that there are no provisions of the Reform Act that alter the enforceability of subordination agreements, non-petition covenants or other contractual provisions intended to ensure the bankruptcy-remote nature of special purpose entities established in connection with structured finance transactions.
With respect to the final inquiry above, the Repudiation Letter quotes the Reform Act in stating that "[t]he liquidation rules of Title II are designed to create parity in the treatment of creditors with the Bankruptcy Code."15 Consequently, the Repudiation Letter states that until such time as the Board adopts regulations addressing the application of section 210(c) of the Reform Act, the FDIC will only exercise its repudiation powers under Title II in a manner consistent with the Bankruptcy Code. The Repudiation Letter goes on to provide that this interpretation will remain in effect until at least June 30, 2011.
The Repudiation Letter gives significant comfort with respect to securitizations and structured financings by entities that are not insured depository institutions ("non-IDIs"). The Repudiation Letter provides this comfort by indicating that the FDIC will not use its repudiation powers to reclaim assets that were sold by non-IDIs in transactions that are respected as legal true sales under the Bankruptcy Code and precedents thereunder. This is in stark contrast to the FDIC’s treatment of securitizations by insured depository institutions ("IDIs") pursuant to the FDIC's final rule on the treatment of financial assets transferred by IDIs in connection with securitizations as published on September 30, 2010 (the "Legal Isolation Safe Harbor").16 Under the Legal Isolation Safe Harbor, transfers into securitizations are treated by the FDIC as secured financings (and the assets so transferred as within the receivership or conservatorship) if they are financings under generally accepted accounting principles ("GAAP"), even if such transfers would be viewed as legal true sales. While the Legal Isolation Safe Harbor does provide specific protections to certain transfers by IDIs into securitizations, whether treated as sales or as financings under GAAP, these protections are available only if the securitization meets a number of stringent conditions, which conditions are not referenced in the Repudiation Letter with respect to transfers into securitizations by non-IDIs.
The Interim Final Rule
The Interim Final Rule updates and revises the Proposed Rule in response to comments received. The following is a summary of certain key provisions of the Interim Final Rule:
Section 380.1 of the Interim Final Rule gives bridge financial company, Corporation, covered financial company, covered subsidiary and insurance company the same meanings as they have in the Reform Act.
Treatment of Similarly Situated Creditors
While the Reform Act requires that no creditor receive less than they would under the Bankruptcy Code or other insolvency law that would apply to the covered financial company outside of Title II17, the Reform Act does permit the FDIC to treat certain similarly situated creditors differently than under Chapter 7 by making additional payments to them if the Board believes such payments are necessary in order to:
- maximize the value of the assets;
- initiate and continue operations essential to the implementation of the receivership or any bridge financial company;
- maximize the present value return from the sale or other disposition of the assets;
- minimize the amount of any loss on sale or other disposition;18 or
- minimize the losses to the FDIC as receiver from the orderly liquidation of the covered financial company.19
With respect to these potential additional payments, section 380.2 of the Proposed Rule and Interim Final Rule specify certain categories of creditors that will not receive any such additional payments without the Board making a special exception. These categories of creditors excluded from potential additional payments include:
- holders of unsecured senior debt with a term of more than 360 days;
- holders of subordinated debt; and
- shareholders or other equity holders.
The FDIC received a number of comments on the above provision voicing concerns that this structure would result in a bias toward short-term financing for potential covered financial companies if the short-term debt holders of such entities received such preferential treatment by the receiver.
The FDIC justifies the potential for differing creditor treatment in the Supplementary Information to the Interim Final Rule by citing the benefits of maintaining essential operations in order to minimize losses and maximize recoveries. The FDIC goes on to emphasize that creditors not excluded from additional payments would only be entitled to such additional payments if the Board determines that such payments satisfy the above statutory requirements. Consequently, the FDIC argues that in virtually all cases creditors with short-term claims will receive the same pro rata share of their claim as is provided to creditors with long-term claims and as a result potential credit providers will have no expectation of differing treatment regardless of whether they lend for periods under or over 360 days.
The Interim Final Rule also clarifies that while secured claims will be paid first to the extent of their collateral, any portion of an otherwise secured claim in excess of the fair market value of the applicable collateral20 will be treated as an unsecured claim and paid in accordance with regular priority established in section 210(b)(1) of the Reform Act.
Personal Services Agreements
Section 380.3 of the Interim Final Rule provides guidance with respect to the treatment of personal services agreements.21 While the FDIC confirms that it can repudiate personal services agreements should it determine them to be burdensome, the Interim Final Rule gives the FDIC the ability to utilize the services of employees who have personal services agreements with the covered financial company unless and until the FDIC decides to so repudiate. Further, unless alternative contractual arrangements have been agreed to by any given employee(s), if the FDIC utilizes the services of such employee(s) prior to repudiating the related personal services agreement, the employee(s) should be paid pursuant to the terms of such personal services agreement either by the bridge financial company or as administrative expenses of the receiver.
The Interim Final Rule states that no entity acquiring a covered financial company or any operational unit, subsidiary or assets thereof from the receiver or a bridge financial company shall be bound by any personal services agreement unless the acquiring party expressly assumes it.
Section 380.3(e) of the Interim Final Rule provides that the rules concerning personal services agreements do not apply to senior executives or directors of a covered financial company and do not limit the ability of the FDIC as receiver to recover compensation22 previously paid to such senior executives or directors.23
Section 380.4 of the Interim Final Rule affirms that holders of contingent claims should receive no less than the amount they would have been entitled to in a Chapter 7 proceeding and that the FDIC will not disallow a claim solely because it is based on a liability that was contingent as of the date the FDIC became the receiver. In order to assign a value to a contingent claim, the FDIC will determine an estimated value based on the likelihood that such contingent obligation will become fixed and the likely size of the obligation were it to become fixed.24
If the FDIC repudiates a contingent obligation consisting of a guarantee, letter of credit, loan commitment or similar credit obligation, it will base its determination as to the actual, direct, compensatory damages for repudiation on the same estimated likelihood that such contingent obligation will become fixed and the likely size of the obligation were it to become fixed.
Insurance Company Subsidiaries
Section 380.5 of the Interim Final Rule was not revised from the Proposed Rule and states that the FDIC as receiver of direct or indirect subsidiaries of insurance companies that are not themselves insurance companies will distribute the value received from the liquidation, transfer or sale of such companies solely in accordance with section 210(b)(1) of the Reform Act.
Liens of Insurance Company Assets
Section 380.6 of the Interim Final Rule recognizes that the orderly liquidation of a covered financial company that is an insurance company or an affiliate or subsidiary thereof (each, a "Covered Insurer") should not supersede the rights of the policyholders thereof. Consequently, if the FDIC makes funds available to a Covered Insurer or otherwise enters into a transaction with a Covered Insurer, the FDIC will only take liens on the assets of the Covered Insurer if it determines that taking any such lien is necessary for the orderly liquidation of the Covered Insurer and that taking such lien will not unduly impede or delay the liquidation or rehabilitation of such Covered Insurer or the recovery by its policyholders of amounts due.
The Interim Final Rule goes on to clarify that section 380.6 is not intended to restrict the ability of the FDIC to take a lien on the assets of a Covered Insurer in order to secure financing provided by the FDIC or receiver in connection with the sale of the Covered Insurer or its assets.
Request for Comments
The FDIC requests comments on any aspect of the Interim Final Rule be received by no later than March 28, 2011.
As the next stages of financial regulatory reform move forward, we will continue to provide additional alerts on key developments.