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From Securities Regulation Daily, December 2, 2014

House updates Bankruptcy Code to deal with failed financial firms

By Jim Hamilton, J.D., LL.M.

The House approved bi-partisan Bankruptcy Code legislation to provide a first alternative to putting failed and failing financial firms into the orderly liquidation authority of Title II of the Dodd-Frank Act. The Financial Institution Bankruptcy Act, H.R. 5421, which passed by voice vote, is a bipartisan, balanced approach that increases transparency and predictability in the resolution of a financial firm. The legislation creates a court-supervised, orderly mechanism that will be guided by the regulators.

H.R. 5421. The chief sponsor of H.R. 5421, Regulatory Reform Subcommittee Chair Spencer Bachus (R-Ala) noted that two points of consensus emerged after careful expert consideration of why the Bankruptcy Code was not used to resolve failing firms during the financial crisis. The first point is that a single point of entry is the best way to resolve a failing firm; and the second point is that the current Bankruptcy Code cannot accommodate a single point of entry. Rep. Bachus also said that the current Bankruptcy Code does not provide the tools to resolve a large complex financial firm that deals in new financial instruments such as credit default swaps and straddles. Put simply, the Bankruptcy Code had not been updated to address derivatives, hence, the need for the legislation.

A co-sponsor of the bill, Judiciary Committee Chair Bob Goodlatte (R-Va), said that the Bankruptcy Code must better facilitate the resolving of a failing finance firm. The bill is calibrated to provide a single point of entry approach to resolving financial firms. The measure will provide transparency, predictability, and judicial oversight to a process that must be executed quickly and in a manner that is responsive to potential systemic risks. A growing consensus of experts in public and private industry believes that single point of entry is the most effective and feasible method to resolve a financial institution that has a bank holding company.

Chairman Goodlatte added that the development of the legislation has been a collaborative effort that included the financial and legal community as well as the Democratic staff. This collaboration has continued through a broader circulation of the bill including to, among others, the Federal Reserve, the FDIC, the courts, and Treasury.

Amplifying the deep bi-partisan support for the bill, the Ranking Member of the Committee, and a bill co-sponsor, John Conyers (D-Mich), noted that the goal of the legislation is to position the Bankruptcy Code so that it can better facilitate the resolution of failing financial firms. Dodd-Frank posits the Bankruptcy Code as the first alternative for resolving a failed financial firm.

Title II. Title II of the Dodd-Frank Act establishes a mandatory administratively driven resolution process to wind down large financial institutions. While Title II is a critical enforcement tool for regulators to facilitate compliance with the Act’s heightened regulatory requirements for large companies, noted Rep. Conyers, nevertheless Dodd-Frank clearly recognizes that bankruptcy should be a first resort and that Title II’s orderly liquidation process should be a last resort.

The Financial Institution Bankruptcy Act makes several improvements to the Bankruptcy Code in order to enhance the prospect of an efficient resolution of a financial firm through the bankruptcy process. The bill allows for a speedy transfer of the operating assets of a financial firm over the course of a weekend. This quick transfer allows the financial firm to continue operating in the normal course, which preserves the value of the enterprise for the firm’s creditors without having a significant impact on the firm’s employees, suppliers, and customers.

The measure also requires an expedited judicial review by judges designated in advance and selected by the Chief Justice of the Supreme Court for their experience, expertise, and willingness to preside over these complex cases. Furthermore, the legislation provides for key input from the financial institution’s regulators during the process.

H.R. 5421 allows the debtor holding company that sits atop the financial firm’s corporate structure to transfer its assets, including the equity in all of its operating subsidiaries, to a newly-formed bridge company over a single weekend. The debt and equity held at the holding company will remain in the bankruptcy process and absorb the losses of the financial institution. Identifying the debt and equity to remain in the bankruptcy process allows existing creditors of the debtor to price appropriately their dealings and investment with the debtor prior to any bankruptcy proceeding.

Allowing a failing financial institution to transfer its assets to a newly-formed bridge company over a single weekend will promote confidence in the financial marketplace. The firm’s equity and debt will remain in the bankruptcy case to be administered by a trustee under court supervision. As a result, valuable assets will be maximized for the benefit of creditors, and the marketplace will be stabilized.

Furthermore, the single point of entry approach allows all of the financial institution’s operating subsidiaries to remain out of the bankruptcy process. Keeping these entities out of an insolvency proceeding is particularly helpful for multinational firms that otherwise could be required to comply with multiple, and potentially, conflicting insolvency jurisdictions.

H.R. 5421 also includes provisions designed to deal with the types of transactions that financial institutions engage in routinely, namely derivative and similarly-structured transactions. Currently, the Bankruptcy Code contains exemptions for counterparties to derivative and similarly-structured transactions to collect on outstanding debts notwithstanding the commencement of a Chapter 11 case and the consequent automatic stay. This exemption stands in contrast to the treatment of other contracts and debts under the Bankruptcy Code, which typically requires creditors to wait until a Chapter 11 plan is approved before they receive a recovery on account of their relationship with the debtor.

H.R. 5421 overrides the exemption for derivative and similarly-structured transactions contained in the Bankruptcy Code for two days to allow for the effective transfer of the financial institution’s operations to a bridge company. Without overriding the existing exemptions, counterparties to derivatives and similarly-structured transactions could terminate their relationships with the debtor upon the commencement of a bankruptcy case, which likely would endanger the successful transfer and continued operation of the bridge company and potentially threaten other entities within the broader financial system.

MainStory: TopStory DoddFrankAct

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