Can Bankruptcy Cure the Too Big to Fail Problem?

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By Stephanie Cumings

July 29 — There is “no chance” foreign regulators would cooperate if a large financial firm went into bankruptcy, even if Congress amends the Bankruptcy Code to better accommodate such bankruptcies, according to one witness who testified July 29 before the Senate Committee on Banking, Housing and Urban Affairs.

But another witness claimed this argument was a “red herring” because the reforms being contemplated to the Bankruptcy Code would allow a big financial firm to go through bankruptcy in such a way that the cooperation, or lack thereof, of foreign regulators would be irrelevant.

Sens. Pat Toomey (R-Pa.) and John Cornyn (R-Tex.) introduced the Taxpayer Protection and Responsible Resolution Act (S. 1840) on July 22, which would add a new chapter to the Bankruptcy Code specifically designed for large financial institutions. But the bill would also repeal the Orderly Liquidation Authority (OLA) in Title II of the Dodd-Frank Act, which grants the Federal Deposit Insurance Corporation the authority to resolve failed systemically important financial institutions. Many of the witnesses agreed it would be prudent to retain the OLA as a last resort option.

Sen. Elizabeth Warren (D-Mass.) criticized the bill at the hearing for not addressing the issue of “moral hazard” because it would allow the “CEO and the management team of the bank to keep their jobs and all of their past compensation,” and she questioned whether this would encourage senior managers to “take on big risks that threaten the entire financial system.”

While the Senators and witnesses generally agreed a “taxpayer bailout” should be avoided if at all possible, they disagreed on whether or not some form of government funding would be appropriate or even necessary to facilitate bankruptcies and stave off systemic risk.

Bankruptcy on Steroids

Witnesses at the hearing, which was entitled “The Role of Bankruptcy Reform in Addressing Too-Big-to-Fail,” generally agreed that the current Bankruptcy Code isn't prepared to handle another larger financial institution bankruptcy and that such a bankruptcy would likely result in fallout similar to that which occurred following the Lehman Brothers bankruptcy in 2008.

Randall D. Guynn, a partner and head of the financial institutions group at Davis Polk, New York, testified that the “single point of entry” strategy (SPoE), which was originally developed for Title II of Dodd-Frank, should be added to the Bankruptcy Code for large financial institutions. Under the SPoE approach, a top-tier parent company is put into bankruptcy and any subsidiaries, including foreign subsidiaries, would continue to operate outside of bankruptcy. This approach would create a bridge company, to which the debtor's assets, including ownership interests in subsidiaries, would be transferred. This approach, Guynn said, would mitigate any systemic damage to the larger financial system.

“Think of this approach as Section 363 on steroids,” Prof. Thomas H. Jackson of the University of Rochester said at the hearing. Section 363 of the Bankruptcy Code is used to conduct sales of bankrupt companies as going concerns. Jackson said that reforms to the Bankruptcy Code are needed so that the SPoE process can be conducted with the necessary speed to prevent systemic reverberations throughout the global economy.

Fighting Foreign Regulators

Prof. Simon Johnson of the MIT Sloan School of Management questioned whether creating a special form of bankruptcy for large financial institutions was a sound approach. Johnson argued that financial firms should be smaller and less complex so that they can utilize the Chapter 11 process that already exists.

Johnson also warned that foreign regulators who don't understand the U.S.'s bankruptcy process aren't likely to cooperate in the event of a large financial institution bankruptcy, even if reforms are instituted, and will likely freeze assets in foreign subsidiaries. Johnson said he didn't think the reforms contemplated by Toomey's bill would prevent the kind of chaos that followed in the wake of the Lehman bankruptcy.

Retaining Title II of Dodd-Frank

Johnson also noted that foreign regulators are more likely to be placated by the OLA of Title II, which they better understand. While the other witnesses generally agreed that bankruptcy was preferable to the OLA, they also agreed that the OLA should be retained as a backstop.

Sen. Jeff Merkley (D-Ore.) submitted into the record a letter from the National Bankruptcy Conference which called for retaining the OLA even if the Bankruptcy Code is amended. The National Bankruptcy Conference is a non-profit organization comprised of lawyers, professors, and judges that advises Congress on bankruptcy law and reforms.

A similar bill, the Financial Institution Bankruptcy Act (H.R. 2947), was introduced in the House July 7 by Rep. David A. Trott (R-Mich.). Trott's bill would also reform the Bankruptcy Code to help facilitate rapid but orderly bankruptcies for large financial institutions.

However, the House bill wouldn't repeal Title II of Dodd-Frank and would instead preserve the OLA as a last resort in cases where bankruptcy isn't deemed feasible.

To contact the reporter on this story: Stephanie Cumings in Washington at

To contact the editor responsible for this story: Jay Horowitz at

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