On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”). This alert focuses specifically on the powers of the Federal Deposit Insurance Corporation (the “FDIC”) to liquidate large, systemically important financial companies and the liquidation plans of such companies. This liquidation power is aimed to prevent the type of disorder caused by, for example, Lehman Brothers’ bankruptcy in 2008. Although the failure of another financial company vital to the American economy may not be imminent, the Reform Act seeks to create a blueprint for future liquidations of systemically important financial companies, such that the FDIC may issue rules to ensure that its new authority is in place, effective and streamlined and such that the marketplace has clarity and confidence as to the terms of such liquidation authority.
II. Orderly Liquidation Authority
A.What Companies Are Affected?
The FDIC’s orderly liquidation authority (the “Liquidation Authority”) is not limited to any fixed class of companies. Instead, the Liquidation Authority may apply to any financial company if certain determinations are made. The new law is largely set forth in Title II of the Reform Act. A financial company (“Financial Company”) is a company that is:
- a bank holding company, as defined by the Bank Holding Company Act (the “BHC Act”);
- a nonbank financial company that the Financial Stability Oversight Council (the “Council”) determines to be systemically important (“Systemically Important Nonbank Financial Company”), and therefore subject to the supervision of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board");
- any company predominantly engaged (generally 85% or more of the total consolidated revenues of the company) in activities that are financial in nature or incidental thereto under Section 4(k) of the BHC Act; or
- any subsidiary of any company set forth above that is predominantly engaged in activities that the Board of Governors of the Federal Reserve System ("Federal Reserve Board") has determined are financial in nature or incidental thereto for purposes of Section 4(k) of the BHC Act.
Fannie Mae, Freddie Mac, any Federal Home Loan Bank and any governmental entity are not Financial Companies for the purposes of the Liquidation Authority.
2.Covered Financial Company
The FDIC will be appointed as a receiver of a Financial Company only if, at any time, including on the eve of bankruptcy, the Treasury Secretary makes the following determinations, upon recommendation of not fewer than two-thirds of the members of each of the Federal Reserve Board and the board of directors of the FDIC and in consultation with the President, and either: (i) the U.S. District Court for the District of Columbia finds that the Treasury Secretary’s determination was not arbitrary or capricious and orders such appointment, or (ii) the Financial Company consents to such appointment:
- the company is a Financial Company;
- the company is not an insured depository institution;
- the company is in “default” or “in danger of default,” as described below;
- the failure of the company would have serious adverse effects on the financial stability of the U.S.;
- no viable private sector alternative is available to prevent the default of the Financial Company;
- any effect on the claims or interests of creditors, counterparties, shareholders or other market participants would be appropriate given the beneficial impact of using the Liquidation Authority on U.S. financial stability;
- the use of the orderly liquidation authority would avoid or mitigate the adverse effects of the otherwise applicable insolvency law; and
- a federal regulatory agency ordered the company to convert all of its convertible debt instrument
A Financial Company as to which the foregoing conditions and determinations apply is referred to under the Reform Act as a covered financial company (“Covered Financial Company”).
3.Application to Broker-Dealers and Insurance Companies
If the Financial Company is a broker-dealer or an insurance company, the designation must be approved by two-thirds of the members of the Securities and Exchange Commission or the newly-created Federal Insurance Office, respectively, and two-thirds of the members of the Federal Reserve Board, provided that the FDIC is consulted.
4.Determination of “Default” or “Danger of Default
The Treasury Secretary may find a Financial Company in default or danger of default (“Default or Danger of Default”) if any one of the following conditions exists:
- a case has been or will or likely will be promptly commenced under the Bankruptcy Code;
- the company has incurred or is likely to incur substantial losses that will deplete all or substantially all of its capital and there is no reasonable prospect to avoid such depletion;
- the assets of the company are or are likely to be less than its obligations to creditors and others; or
- the company is or is likely to be unable to pay its obligations in the normal course of business.
The Treasury Secretary must obtain an order from the U.S. District Court for the District of Columbia before appointing the FDIC as receiver of any Covered Financial Company. The court’s review is limited to whether the Secretary’s determination that the Financial Company is in Default or Danger of Default is not arbitrary or capricious. The order is appealable to the U.S. Court of Appeals for the DC Circuit and then to the U.S. Supreme Court. However, the Treasury Secretary is not required to obtain an order if the Financial Company’s board or directors (or equivalent governing entity) acquiesces or consents to the FDIC’s appointment as receiver.
B.FDIC as Receiver
The Reform Act imposes a three-year time limit on the duration of the FDIC’s role as a receiver, with the possibility of two one-year extensions. Another extension is permissible solely for the purpose of completing ongoing litigation in which the FDIC as receiver is a party.
2.Purpose of the Orderly Liquidation
The purpose of the orderly liquidation of Covered Financial Companies is to provide the necessary authority to liquidate failing Financial Companies that pose a significant risk to the financial stability of the U.S. The Liquidation Authority will be exercised so that:
- creditors and shareholders bear the losses of the Financial Company;
- management responsible for the condition of the Financial Company will not be retained; and
■all parties (including responsible management, directors and third parties) bear losses consistent with their responsibility, including actions for damages, restitution and recoupment of compensation.
3.Mandatory Terms and Conditions for All Orderly Liquidation Actions
In exercising the Liquidation Authority, the FDIC must:
- determine that such action is necessary for the financial stability of the U.S., and not for the purpose of preserving the Covered Financial Company;
- ensure that the shareholders of a Covered Financial Company do not receive payment until after all other claims and the Liquidation Fund (discussed in Section II.C below) are fully paid;
- ensure that unsecured creditors bear losses in accordance with the priority of claims set forth in the Reform Act;
- ensure that responsible management and members of the board of directors (or equivalent governing body) are removed; and
- not take an equity interest in or become a shareholder of any Covered Financial Company.
4.Director, Officer and Executive Liability
The Reform Act expressly provides that members of the board of directors (or equivalent governing body) of a Covered Financial Company are not liable to the shareholders or creditors thereof for consenting in good faith to the appointment of the FDIC as receiver. Although a director or officer of a Covered Financial Company may be held personally liable for monetary damages in any civil action with respect to actions for gross negligence, or a greater disregard of a duty of care.
The FDIC may recover any compensation received during the two-year period prior to the date the FDIC is appointed as receiver from any current or former senior executive or director substantially responsible for the failed condition of a Covered Financial Company. In the case of fraud, no such time limit will apply.
The FDIC may prohibit a senior executive or director of a Covered Financial Company from participating in the conduct of the affairs of any Financial Company for a period of time of not less than two years if it determines that the senior executive or director, among other things, violated any law or regulation, engaged or participated in an unsafe or unsound practice in connection with any financial company; or breached his or her fiduciary duty and such breach contributed to the failure of the company and such breach involved personal dishonesty or demonstrated a willful disregard for the safety and soundness of such company.
5.Applicable Insolvency Laws
In regard to Covered Financial Companies, the FDIC will apply provisions of the Liquidation Authority instead of provisions of the Bankruptcy Code and rules. In the case of a Covered Financial Company that is a broker-dealer and a member of the Securities Investor Protection Corporation (the “SIPC”), the FDIC must appoint the SIPC as receiver. In the case of a Covered Financial Company that is an insurance company, the appropriate state regulator under applicable state law will be appointed as receiver. If the appropriate state regulator does not assume its duties as receiver in a timely manner, the FDIC may step in as receiver.
6.Dismissal and Exclusion of Other Actions
Effective as of the date of the appointment of the FDIC or the SIPC as receiver, any case or proceeding commenced under the Bankruptcy Code or the Securities Investor Protection Act of 1970 will be dismissed, and no such case or proceeding may be commenced while the orderly liquidation is pending.
7.FDIC’s Powers As Receiver
If the FDIC is appointed receiver of a Covered Financial Company, it succeeds to all of the rights, titles, powers and privileges of the company and its stockholders, members, officers and directors, subject to the provisions of the Liquidation Authority. Once appointed as receiver, the FDIC may:
- take over the assets of and operate the company;
- collect all obligations and money owed to the company;
- perform all functions of the company in the name of the company;
- manage the company’s assets and property to maximize value of the assets in the context of an orderly liquidation; and
- provide by contract for assistance in fulfilling any function, activity, action, or duty of the FDIC as receiver.
The FDIC’s powers are largely modeled on its powers as receiver of insured depository institutions under Sections 11 and 13 of the Federal Deposit Insurance Act (the “FDIA”). The FDIC’s powers as receiver of a Covered Financial Company include, but are not limited to, the power to:
- transfer all or any portion of the assets or liabilities of a company to a third party at fair value. If a third party buyer cannot be found at fair value, the FDIC has the authority to establish a temporary bridge financial company to hold any part of the business worth preserving until it can be sold to a third party at fair value or otherwise liquidated in an orderly fashion;
- decide which creditors receive what assets, and in what order; and
- provide a wide range of financial assistance for the resolution of a Covered Financial Company, including making loans to, or purchasing debt, purchasing assets, assuming or guaranteeing obligations, taking liens on assets, and selling or transferring assets or liabilities of, the Covered Financial Company.
Further, the FDIC’s powers as receiver of a Covered Financial Company differ from its powers as a receiver of an insured depository institution under the FDIA in several ways. Specifically, when the FDIC acts as receiver of a Covered Financial Company:
- the Liquidation Authority does not include a priority for any deposit claims over the claims of other general creditors, because a Covered Financial Company, by definition, cannot be an insured depository institution;
- the Reform Act adopts the treatment of contingent claims under the Bankruptcy Code. It defines the term “claim” to include contingent claims, provided that no creditor may receive less in a receivership proceeding than it would have received in a liquidation proceeding under Chapter 7 of the Bankruptcy Code;
- the Liquidation Authority retains an absolute prohibition on oral contracts, but will treat any written agreement as enforceable so long as it was duly executed or confirmed in the ordinary course of business as demonstrated by the counterparty to the satisfaction of the receiver;
- the Liquidation Authority retains the power to repudiate any contract or lease to which a company is party if the FDIC determines that such contract or lease was burdensome (with exceptions regarding debt-obligations and post-appointment interest);
- qualified financial contracts (“QFCs”) such as securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements and master agreements all receive nearly identical treatment under the Liquidation Authority with a few minor exceptions;
- the Reform Act adopts the treatment of security interests and preferential and fraudulent transfers under the Bankruptcy Code, which provides that a security interest or other transfer of property may be set aside if it amounts to a preferential or fraudulent transfer on account of pre-existing debt that improves the position of the creditor. Security interests taken in return for new value cannot be set aside, even if taken on the eve of insolvency. However, under the FDIA, except in the case of a secured QFC, an otherwise perfected security interested may be set aside if it was taken with knowledge of the company’s insolvency. The FDIA does not distinguish between security interests used to secure pre-existing or new debt; and
- the Reform Act adopts the treatment of setoff rights under the Bankruptcy Code with an important modification. The Reform Act provides that setoff rights are expressly recognized, with some qualifications, to permit the FDIC to transfer liabilities to a third party or bridge financial company even if the transfer destroys the mutuality of offsetting claims. Further, a creditor’s setoff rights which have been destroyed in this manner is given priority over the claims of other general unsecured creditors. On the other hand, the FDIA through silence on the issue, permits the FDIC to transfer liabilities to a third party or bridge bank even if the transfer destroys the mutuality of offsetting claims.
C.Orderly Liquidation Fund and Assessments
The Reform Act authorizes the Treasury to establish an orderly liquidation fund (the “Liquidation Fund”), from which the FDIC may borrow funds to carry out its responsibilities under the Liquidation Authority. Amounts received by the FDIC, including assessments received, proceeds of debt securities issued to the Treasury Secretary, interest and other earnings from investments, and repayments to the FDIC by Covered Financial Companies, will be deposited into the Liquidation Fund. The FDIC may not use any of its funding as receiver for any Covered Financial Company unless and until it submits an orderly liquidation plan for such company that is acceptable to the Treasury Secretary (as discussed in Section III below). The FDIC and the Treasury Secretary must reach an agreement that provides a specific plan and schedule for the repayment of any borrowings from the Treasury.
If necessary to pay in full the obligations issued by the FDIC to the Treasury Secretary, the FDIC will impose assessments on any claimant that received additional payments or amounts from the FDIC, except for payments or amounts necessary to initiate and continue operations essential to implementation of the receivership or any bridge financial company, to recover on a cumulative basis any excess benefits that such claimant received in the receivership over what such claimant was entitled to receive in a liquidation under Chapter 7 of the Bankruptcy Code or in a SIPC proceeding. If the amounts to be recovered on a cumulative basis above are insufficient to allow the FDIC to repay its obligations to the Treasury within 60 months or such longer period as approved by the Treasury, the FDIC shall impose assessments on:
- any bank holding company with total consolidated assets equal or greater than $50 billion (a “Large Bank Holding Company”) and
- any Systemically Important Nonbank Financial Company.
It should be noted that, with regard to the assessments to be imposed on Large Bank Holding Companies, while technically such provisions of the Reform Act apply only to bank holding companies and not to savings and loan holding companies, we believe that the implementing regulations will address this anomaly.
The FDIC will impose assessments on a graduated basis, with Financial Companies having greater assets and risk being assessed at a higher rate. In imposing assessments, the FDIC will take into account:
- economic conditions generally affecting Financial Companies;
- any assessments imposed on the Financial Company or an affiliate of such company that is an insured depository institution to fund deposit insurance, a broker-dealer to fund SIPC insurance, an insured credit union assessed pursuant to the Federal Credit Union Act or an insurance company for a state insurance guarantee fund;
- the risks presented by the Financial Company to U.S. financial stability;
- the extent to which the company received, benefitted, or likely would benefit, from the orderly liquidation of a Covered Financial Company;
- any risks presented by the Financial Company during the 10-year period immediately prior to the appointment of the FDIC as receiver that contributed to the failure of the Covered Financial Company; and
- other factors that the FDIC or the Council deems appropriate.
D.Unenforceability of Certain Agreements
The FDIC may deem unenforceable any term contained in any existing or future standstill, confidentiality, or other agreement that, directly or indirectly:
- affects, restricts, or limits the ability of any person to offer to acquire or acquire;
- prohibits any person from offering to acquire or acquiring; or
- prohibits any person from using any previously disclosed information in connection with any such offer to acquire or acquisition of,
all or part of any Covered Financial Company.
E.Reports and Studies
The Liquidation Authority also provides for a number of studies and reports on:
- Reports to Congress and the Public
- the FDIC must file a report with Congress setting forth a Covered Financial Company’s financial condition, description of the plan to wind down the Covered Financial Company and the expected costs of the liquidation;
- Judicial and Bankruptcy Processes
- reports regarding the effectiveness and efficiency of the U.S. District Court for the District of Columbia and studies on the bankruptcy and the effectiveness of the liquidation or reorganization processes for financial companies under Chapters 7 and 11 of the Bankruptcy Code;
- International Coordination
- studies regarding the liquidation of financial companies under the Bankruptcy Code and applicable foreign law, mechanisms and structures facilitating international coordination thereof;
- Implementation of Prompt Corrective Action Measures
- studies of the implementation of prompt corrective action by federal banking agencies and resolving insured depository institutions with the least possible cost; and
- Secured Creditor Haircuts
- a study regarding whether a “haircut” on secured creditors of a Covered Financial Company could improve market discipline and protect taxpayers.
III. Resolution Plans
Systemically Important Nonbank Financial Companies and Large Bank Holding Companies must prepare extensive orderly resolution plans (“Resolution Plans”), which must be approved by the Federal Reserve Board and the FDIC. Resolution Plans are nonbinding on bankruptcy courts, receivers or similar authorities. The requirement to prepare Resolution Plans will not be effective until three years after the enactment of the Reform Act.
Each Resolution Plan must include:
- information regarding the extent to which any insured depository institution affiliated with the company is adequately protected from risks arising from the activities of any nonbank subsidiaries of the company;
- descriptions of the company’s ownership structure, assets, liabilities and contractual obligations;
- identification of the cross-guarantees tied to different securities, major counterparties and a process for determining to whom the collateral of the company is pledged; and
- any other information that the Federal Reserve Board and the FDIC jointly require.
The FDIC and the Federal Reserve Board will review a company’s Resolution Plan to determine whether it would facilitate an orderly resolution under the Bankruptcy Code. If the Resolution Plan is found to be deficient, the company must resubmit its Resolution Plan. If a company fails to adopt an acceptable Resolution Plan, the FDIC and the Federal Reserve Board may impose more stringent capital, leverage, or liquidity requirements, or restrictions on growth, activities or operations. After having imposed other requirements, the FDIC and Federal Reserve Board may require a company to divest assets if the company’s Resolution Plan is deficient and a suitable Resolution Plan is not resubmitted within two years.
IV. Unprecedented Rulemaking Effort Required
As is often the case with respect to landmark legislation, lawmakers left many of the key details of financial reform to regulation. Various industry experts have estimated that the new law will require federal banking regulators to enact over 200 new regulations. Others have asserted that the rulemaking effort required to implement the Reform Act will be unprecedented in its scope and complexity and will exceed the efforts required to implement the post-September 11th measures and the Sarbanes-Oxley Act. As a result, U.S. regulatory agencies will be compelled to enact numerous regulations implementing the Reform Act and, in doing so, will have the opportunity to shape the ultimate effect of financial reform in many critical areas.
In each of these areas, the implementation of the Reform Act is in large part left to federal banking regulators in general and particularly to the FDIC and the Federal Reserve Board. Institutions therefore may have to wait for federal regulators to propose and enact regulations before they will know the ultimate impact that regulatory reform will have on them and their operations.
Now that the Reform Act has become law, the regulatory implementation phase has begun. While a few of the Reform Act’s provisions became effective immediately, many provisions of the Reform Act will become effective in stages over the next 6 to 24 months as the U.S. regulatory agencies issue the implementing regulations required under the Reform Act. To find out more information about the Reform Act’s effective dates and regulatory deadlines, please visit Sonnenschein's interactive Reform Act timeline. This timeline was designed to help our clients gain a better understanding of the many steps required to effectively navigate the regulatory implementation process.
As the next stage of financial regulatory reform moves forward, we will provide additional alerts on key developments.