Financial Institutions in Bankruptcy
| Publication year | 2011 |
Introduction
Consistent with the broader theme of the deregulatory era,(fn1) the past few decades have seen a growing divide between banking and bankruptcy.(fn2) Through deregulation, banking and financial institutions have been increasingly held to different standards than other types of corporations in the bankruptcy setting. This divide between banking and financial institutions on the one hand and all other types of corporations on the other essentially excepted banking and financial institutions from the normal rules of corporate law and corporate failure.(fn3) That is, finance became excused from bankruptcy.
The divide had long existed, fostered by the unique nature of a class of debtors with a large group of government-insured creditor-depositors. But the past decades saw the banking community move away from the bankruptcy system, and chapter 11 in particular, with a vigor nearing revulsion.(fn4) The only way bankers would be involved in bankruptcy was as creditors. The collapse of Bear Stearns seems to confirm the special place that bankers held in the order. Bear Stearns and its stakeholders were not subjected to the same fate as mundane insolvent companies, with bondholders and, even more importantly, shareholders receiving a buyout on claims that were likely worthless.
And then Lehman. Bankers faced the cold reality that the growth of "shadow banking" had moved finance out of the comfortable realm of the OCC, the FDIC, and the Federal Reserve.(fn5) The government rescue of AIG can be seen as a desperate attempt to regain control.(fn6) The subsequent treatment of Citibank and Merrill Lynch, contrasted with the treatment of Lehman, reaffirms this interpretation.
The Dodd-Frank Act formalizes this attempt to restore the old order.(fn7) Under the Act, all large bank holding companies will be subject to a new resolution regime-essentially a glorified receivership process- controlled by the FDIC and initiated by the Treasury Secretary and the Federal Reserve. The new system will cover the large banks as well as the former investment banks, such as Goldman Sachs, and many other important institutions with more than 85% of their activities in "finance."(fn8)
But by developing a new system for addressing financial distress, instead of integrating the new system into the existing structure of the Bankruptcy Code, the financial reform act simply recreates the prior problem in a new place while also creating new problems. The future Lehmans and AIGs will be covered by the new procedure, but other firms that have 84% of their activities in finance will not. In short, the disconnect between bankruptcy and banking has moved to a different group of firms. And we may have done nothing but protect ourselves against an exact repeat of the financial crisis.(fn9)
This change will reduce the overall risks to the financial system to the extent that the size of Lehman, AIG, Bear Sterns, and others was the key problem in the recent financial crisis. But if instead the problem was the interconnected nature of these firms, the difference between 84% and 85% is unimportant.(fn10)
And in focusing on the biggest of the big, the recent financial reform bill has left behind the banking industry's detritus in the bankruptcy system.(fn11) For example, derivatives will now get special treatment in bankruptcy only in those cases where it is least needed to protect the banking industry, even though these provisions were originally justified based on their application to the financial system.(fn12)
Expecting that the financial reform bill is not the last piece of legislation in this area, I explore the divide between banking or finance and bankruptcy.(fn13) As with any other industry, bankruptcy is of limited import to the financial industry in normal times, save for its role in general debtor-creditor law. But even here, bankruptcy rules are a vital part of every financing contract, operating to make claims consistent across similarly situated creditors and discouraging runs on the assets of the firm.
In times of general financial stress, the content of these rules and their strength becomes ever more vital. And if the rules are unclear or their application uncertain, the risk to the financial system becomes acute. This is especially true in the financial industry, where the horizontal connections between firms go far beyond those found in any other industry.
In this Article, I argue that there are significant gaps in the federal system for resolving financial distress in a financial firm even after passage of the Dodd-Frank bill. These gaps represent potential sources of systemic risk-that is, risk to the financial system as a whole. They must be fixed. But I should make clear at the outset that I do not argue that these gaps must be filled with the Bankruptcy Code.(fn14) Rather, the point is that the various systems for resolving financial distress among financial firms must be integrated so that the result of financial distress is clear and predictable. Integrating all under the Bankruptcy Code is an option, but not the only way to achieve such clarity.
The first Part of this Article sketches the several existing systems for resolving financial distress in financial firms, including the new resolution authority(fn15) created by the Dodd-Frank Act. By my count, there are at least six systems at work here, not counting state-by-state variations. Part II examines the coverage of these systems and the uncertainty created by the interaction of the same. For example, under current law, a large hedge fund might be "resolved" under chapter 11 of the Bankruptcy Code, or it might not be. The decision rests with the systemic risk counsel. Therefore, the fund's counterparties will be unable to determine ahead of time which set of rules is incorporated into their contracts with the hedge fund. Undoubtedly, both will be priced with a further discount for the uncertainty. That is unlikely to be the optimal solution.
Part III of the Article then considers the ways in which the divide between finance and bankruptcy could be narrowed, if not eliminated. Ultimately, I doubt the plausibility of solving these issues with some grand solution like drafting a unified bankruptcy law. The political realities involved in getting a major piece of legislation through Congress are so daunting nowadays that it is something of a wonder that even Dodd-Frank, with all its limitations, passed. A unified system of financial distress, which would implicate both state and federal interests, seems almost more unlikely. Given this reality, I suggest incremental ways to move the myriad existing systems together. These suggestions exploit the new Financial Stability Oversight Counsel's power to recommend changes in regulation to fill gaps left by the Dodd-Frank Act.(fn16)
It is important throughout to maintain a realistic approach; blind regulation will more often than not simply encourage new innovation, often in ways that are apt to be even more inefficient, less transparent, or both. But only by overcoming the divide between banking and bankruptcy will the systemic risks presented by the existing patchwork be ameliorated. Ultimately, this is a matter that will require coordination between the alienated worlds of banking and bankruptcy.
I. Resolution Regimes
Historically, the United States has taken an inconsistent approach to the division between banking and bankruptcy, in part reflecting vague notions that banks were unlike other businesses, and also reflecting the tension between those who argued for local creation of banks and those, lead initially by Alexander Hamilton, who favored integration of the national economy at the federal level. For example, the 1841 Bankruptcy Act(fn17) applied to bankers and those who underwrote insurance policies.(fn18) But while the statute initially included banks-the entity as opposed to the individual-and all other corporations among those who could file bankruptcy, the provision was removed on "states' rights" grounds before the Act received final approval.(fn19) The 1867 Bankruptcy Act(fn20) split the difference; federally chartered banks could not file under the Act, while state-chartered banks and insurance companies could and did.(fn21)
By the time of the first permanent American bankruptcy law in 1898,(fn22) it was widely accepted that banks and insurance companies were sufficiently different from other companies that they should be excluded from the normal bankruptcy process.(fn23) Of course, most big business was excluded from the Bankruptcy Act,(fn24) so the exclusion of financial companies was consistent with the broader tendency to specialize the law of large enterprise.(fn25)
More recently, the key bankruptcy mechanism for dealing with large corporations is chapter 11 of the Bankruptcy Code. In addition, the United States has a number of different specialized insolvency regimes, including the Federal Deposit Insurance Act of 1950 (FDIA) provisions that apply to banking organizations and the Securities Investor Protection Act (SIPA) provisions that apply to broker-dealers.(fn26)
Furthermore, insurance regulation is entirely exempted from federal regulation. This exemption resulted from the McCarran-Ferguson Act of 1945, which was Congress's response to the Supreme Court's...
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