Big Bank Bankruptcy Bill Back on Table; Will It Prevent Meltdown?

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By Diane Davis

Bankruptcy protections tailored to large financial institutions in crisis are back on the agenda in Congress, but using Chapter 11 in these situations has its drawbacks, some scholars and practitioners say.

Bipartisan legislation passed by the House and now wrapped into a larger appropriations measure may improve its chances in the Senate if it should get there. It would enable mega banks to restructure in bankruptcy should they run aground. It would create a new sub-chapter in Chapter 11 for financial institutions with assets of at least $50 billion, which would include institutions such as JPMorgan Chase, Bank of America, Wells Fargo & Co., and Citigroup Inc.

Proponents say the Financial Institution Bankruptcy Act (FIBA) of 2017 (H.R. 1667) would help ensure financial market stability in the event of a major bank failure. That occurred in 2008 amid the global financial crisis when Lehman Brothers went bankrupt.

There’s some optimism in the House that the plan will make it to the other side of the Capitol as early as this summer, where a similar bill died in 2016. But there is disagreement among bankruptcy scholars and practitioners as to whether bankruptcy, by itself, can address systemic risk concerns.

No Repeal of Liquidation Authority

The Federal Deposit Insurance Corporation (FDIC) is empowered under the 2010 Dodd-Frank Act, also known as the Wall Street reform law, with “orderly liquidation authority.” That empowers the regulatory agency to wind down financial institutions if they run into severe trouble.

The House spending bill contains several dozen Republican-led policy provisions included in the Financial Choice Act of 2017, H.R. 10, that aim to roll back Dodd-Frank. But it doesn’t include the repeal of the liquidation authority under Title II of the Dodd-Frank law. The Financial Institution Bankruptcy Act would be in addition to the FDIC authority.

Many bankruptcy scholars and industry experts said the bankruptcy legislation is a good start for handling systemically important financial institutions, or SIFIs. These are financial institutions whose collapse could severely impact the U.S. economy. But others believe the legislation needs to be more robust.

Support for keeping FDIC Title II authority in place is widespread within the bankruptcy community because the economy and the financial system would still need orderly liquidation authority to make FIBA work, if it became law.

A ‘Helpful Addition’

Some bankruptcy practitioners view FIBA as an additional tool to manage a financial crisis.

“FIBA represents a helpful and needed addition to Chapter 11,” Stephen E. Hessler, a restructuring partner at Kirkland & Ellis LLP, New York, told Bloomberg BNA July 18.

“It will facilitate the more effective restructuring of major financial institutions under the Bankruptcy Code, by providing for expedited and transparent proceedings before experienced bankruptcy court judges applying established precedent,” Hessler said.

“Any legislative steps that move FIBA closer to enactment and implementation is a welcome development,” he said.

Hessler, who has testified before the House Judiciary Committee three times in support of the bill, said that the bankruptcy legislation in and of itself isn’t controversial. The controversy arises when the repeal of Title II of Dodd-Frank is added to the discussion, he said.

Including the bankruptcy bill as an amendment to the spending legislation greatly increases the likelihood that the Senate will consider the measure, especially since it doesn’t contain the Title II repeal controversy, Hessler said.

Bankruptcy Alone Not Enough

Mark J. Roe, a professor at Harvard Law School, believes so strongly that bankruptcy alone can’t handle a financial crisis from collapsed banks that he and co-author Jeffrey Gordon of Columbia Law School wrote congressional leaders. Their May 23 letter was endorsed by 120 financial market and bankruptcy academics.

It explains how the Financial Choice Act of 2017, H.R. 10, would have replaced the orderly liquidation authority with FIBA as the exclusive means for addressing SIFIs.

“To repeal OLA and its supporting provisions would be a dangerous error,” Roe and Gordon state in the letter.

FIBA in its current state, however, doesn’t repeal OLA.

One of the main problems with FIBA is that it “doesn’t allow the regulators to start the bankruptcy,” Roe told Bloomberg BNA July 14.

Only bank management can initiate a bankruptcy and they have a reason to “gamble for resurrection” and put off a day of reckoning, Roe said. That delay, according to Roe, could be fatal in a crisis.

“A stronger regulatory involvement is needed,” Roe said.

For megabanks with global operations, American regulators need to coordinate with counterparts abroad, Roe said. Even if bankruptcy courts can quickly restructure a U.S. bank’s failed operations, creditors on the bank’s London subsidiaries might still have a run on those banks and take down U.S. operations no matter what the bankruptcy judge does, he said.

Roe said there is no back up plan or safety net if it doesn’t work, he said.

‘Crisis’ Testing

Another problem is that the proposed legislative remedy wouldn’t get tested until a crisis.

“If they turn out to be inadequate, the risks of a taxpayer-funded bailout are increased rather than reduced,” Edward Janger, a bankruptcy professor at Brooklyn Law School, New York, told Bloomberg BNA July 17.

Title II of Dodd-Frank provided an “administrative back-stop,” Janger said in support of the FDIC authority.

Janger said he was “concerned about the bankruptcy court’s ability to deal effectively with financial institution bankruptcies.” Problems are “compounded” when you add in the special attributes of SIFIs, which “might have global systemic consequences,” Janger said.

Edward R. Morrison, the Charles Evans Gerber Professor of Law, Columbia Law School, New York, told Bloomberg BNA via email July 14 that “OLA and its related regulatory machinery are the right response” to risks of and in a financial crisis.

“Bankruptcy judges are not able to ensure that financial institutions adopt capital structures that facilitate orderly resolution, to provide short-term liquidity to institutions whose collapse would endanger the economy, to quickly hammer out understandings for international cooperation, and to resolve the distress of a massive, economy-endangering institution within a matter of hours,” Morrison said.

“This is a tall order just for full-time regulators,” Morrison said. “Don’t get me wrong. Implicit within FIBA is a desire to strengthen the bankruptcy laws to provide a mechanism for resolving failing financial institutions. That’s a good ambition, but stronger bankruptcy laws should complement, not displace OLA,” he said.

Increase Likelihood of Bailout

Some bankruptcy scholars just don’t think FIBA is the answer to fix everything in the event of a major bank failure.

“Hobbling the OLA on the unfounded optimism that ‘bankruptcy can fix everything’ is not only half-baked whimsy but dangerous shooting from the hip that likely increases the chances of a taxpayer bailout in the event of a subsequent financial crisis,” John Pottow, a bankruptcy professor at the University of Michigan Law School, Ann Arbor, Mich., told Bloomberg BNA via email July 14.

Pottow and Adam Levitin, a bankruptcy professor at Georgetown University, Washington, are currently involved in writing a second letter to congressional leaders that says nothing positive about financial institution bankruptcy.

“Bankruptcy is a great process for dealing with main street businesses, but it is just not built to deal with large financial firms,” Levitin told Bloomberg BNA via email July 14.

“An adversarial process like bankruptcy cannot move fast enough, and there’s no way any failed firm could get adequate debtor-in-possession financing to keep operating in bankruptcy, so there’ll be huge and unnecessary loss of value by using bankruptcy,” he said.

“It’s an ideological pipe dream to think that bankruptcy will work well for a large financial institution,” Levitin said.

Going Nuclear?

He likens a large financial institution’s failure to a fire in a nuclear plant.

“You don’t want the local volunteer fire brigade to deal with that fire,” Levitin said. “You want to bring in specialists who have the right training and equipment. Otherwise you risk a catastrophic meltdown,” he said.

“OLA authorizes that specialist crew; legislation like FIBA and the CHOICE Act mandate using the local fire department while taking away their hoses and pumps and asking them to work with buckets,” Levitin said.

To contact the reporter on this story: Diane Davis in Washington at DDavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at JHorowitz@bna.com

For More Information

Full text of the bill as included in House spending bill: http://src.bna.com/qPL

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