REORGANIZATION OF FAILING FINANCIAL FIRMS: A CAPITAL STRUCTURE SOLUTION.

• Author: Gjerstad, Steven

The underlying rationale of joint-stock companies is that equity holders bear the largest proportional risk of an enterprise, and are rewarded with the most control over the firm and all of its upside risk. Equity owners are lowest in the debt hierarchy: their claims come after all other legitimate claimants of a defaulted enterprise. However, they are the highest in the hierarchy of control: in principle they select the directors of the enterprise who in turn select its management. This article argues that the rationale behind equity owner control should be extended in the debt and control hierarchies at least one more level. The unsecured debt of a firm should have a junior-most tranche, and control of the firm should devolve on the owners of drat debt automatically and immediately upon the failure of the firm. Although the reorganization proposal described in this article would function effectively for any failing enterprise, this article considers the important and challenging problem of restructuring a failing systemically important financial institution (SIFI).

Legal Aspects of Existing and Proposed Legislation

Currently, there are two approaches to the reorganization of a SIFI in the United States--both mandated under the Dodd-Frank Wall Street Reform and Consumer Protection Act--and a proposed modification to these approaches in the Financial CHOICE Act of 2017, passed by the House of Representative in June 2017. (1)

Title I of the Dodd-Frank Act requires each systemic-ally important bank to develop detailed plans--"living wills"--that specify procedures for its own resolution if it is about to collapse. The resolution strategies submitted to the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) to date rely primarily on either (1) a holding company that will spin off its subsidiaries while the holding company itself files for bankruptcy protection or (2) a "bridge bank" that will receive the high-quality assets of the failing firm and many of its liabilities, leaving most impaired assets and the remainder of its liabilities behind with the parent firm that enters bankruptcy. These two approaches are known jointly as the single-point-of-entry (SPOE) approach. (2)

The more complex banks, with numerous subsidiaries, will be structured with a bank holding company that would enter bankruptcy in the event of a failure. The resolution plans specify that subsidiaries should be well-capitalized, with sufficient liquid assets and with strong balance sheets, prior to a bankruptcy filing by the parent holding company. During bankruptcy proceedings the bank's major subsidiaries would continue operations until they are sold off and the proceeds of the sales are returned to the estate of the bankrupt holding company. The second approach would be to form a bridge bank that would receive most of the high-quality assets of the failing bank and a portion of its liabilities. The impaired assets of a failing bank and the remainder of its liabilities would be left behind in the bankrupt firm. Both of these approaches are at odds with a fundamental precept of American bankruptcy law: similarly situated creditors should be treated similarly in the settlement of the bankrupt Finn's affairs.

Under the holding company structure, the creditors of the subsidiaries that are sold off will have claims on going concerns with positive net values, so their claims will unimpaired. On the other hand, the holding company will be bankrupt, and it will absorb all of the losses of the institution. Similarly, creditors of a bridge bank would have claims against a going concern, while the creditors whose claims are assigned to the parent firm will have claims against a bankrupt firm. The creditors of the bankrupt parent company, unlike the creditors of subsidiaries or a bridge bank, will be required to absorb all of the losses. Unequal treatment of similarly situated creditors is likely. The only way to avoid it would be to place all of the unsecured debt of the firm in the bankruptcy estate. Nothing in the Dodd-Frank Act requires or suggests that this will be done, and nothing would prevent the firm from distributing its unsecured debt to subsidiaries or a bridge company according to its own preferences. This opens the door to both unequal treatment of similarly situated creditors and to favoritism toward some creditors by the management of the firm in the lead-up to its collapse.

If the resolution process devised by the company in compliance with Title I, Section 165(d) of the Dodd-Frank Act is not implemented successfully and in a timely manner, Title II requires the FDIC to take control of the firm in receivership. (3) Title II vests almost unlimited authority in a receiver appointed by the FDIC. (4) Criticism has been leveled at the Dodd-Frank Act for its harshness (5) and for its subversion of constitutionally guaranteed protections. (6) Other legal arguments could be mounted against Dodd-Frank, such as those developed in Hamburger (2014) and in Lawson (2015), to address the expansive authority of administrative agencies. Hamburger (2014) argues that agencies frequently combine legislative functions in their rulemaking, executive functions in their oversight and enforcement, and judicial functions with their administrative law judges. One of Hamburger's primary arguments is that agencies violate the separation of powers, remove legislative functions from elective bodies, and eliminate review by an independent judiciary. For example, Hamburger (2014: 257) argues that

administrative procedure ... is justified on the ground that the courts are the real target of constitutional guarantees of due process and other procedural rights. It is not plausible, however, to suggest that administrative tribunals are less confined by procedural guarantees than the courts, or that administrative process satisfies the due process of law. Procedural rights developed ... precisely to bar extralegal adjudication. And the growth of administrative adjudication only confirms the importance of procedural rights as limits on extralegal power. Rather than satisfy the due process of law, administrative process is exactly what the guarantee of due process forbids. These arguments clearly have relevance to agency authority in Dodd-Frank, which is extensive and operates explicitly without even the administrative law review provided by other agencies, such as the SEC, the FDIC, the NLRB, the FAA, the EEOC, and dozens of other federal agencies. Recent cases, such as Bandimere v. SEC in the 10th Circuit Court of Appeals and Burgess v. FDIC in the 5th Circuit Court of Appeals, indicate a growing discomfort within the judiciary toward quasi-judicial review within an administrative agency of that agency's own...