|FDIC—wild card in financial company insolvencies|
January 28, 2011
By Brian W. Smith, Robert J. Rosenberg, Melissa R. H. Hall, Christopher D. Blickley
Since its creation, the Federal Deposit Insurance Corporation has acted in two main regulatory capacities – the insurer of deposits and the conservator or receiver of failed financial institutions. There was no role of the FDIC in bankruptcy proceedings except as receiver or conservator of a failed depository institution. The financial crisis of the past few years and the passage of the Dodd-Frank Act in July 2010 have significantly altered and expanded the role of the FDIC as a constituent in the bankruptcy of bank holding companies and certain significant financial companies. The complications presented by FDIC involvement in bank holding company bankruptcies are likely to be compounded by the orderly liquidation authority (OLA) powers granted to the FDIC under Title II of Dodd-Frank to resolve complex financial companies.
Orderly liquidation authority explained
Under its OLA powers FDIC can be appointed receiver of certain financial companies that have failed or are in danger of failing and whose failure is determined to present a significant risk to the financial stability of the United States (a “covered financial company”). Appointment of the FDIC is a multi-step process.
First, under Title II, the appropriate federal regulator or regulators need to determine that the FDIC should be appointed as receiver of a covered financial company, and subsequently request the Treasury Secretary to make such an appointment. Dodd-Frank lists several specific factors that need to be addressed in conjunction with making this recommendation. These include: whether the financial company is in default or in danger of default; the effect such a default would have on the financial stability of the United States; the likelihood of a private sector alternative to prevent default of the financial company; an evaluation of why it would not be appropriate for the case to be or remain under Title 11 of the United States Code (the Bankruptcy Code); and an evaluation of the effect on creditors, counterparties and shareholders of the financial company and other market participants.
Next, the Treasury Secretary, after consultation with the President of the United States, must reach a number of conclusions before determining a company is deemed a covered financial company and appointing the FDIC as receiver. These include: that the financial company is in default or danger of default; the failure of the company and its resolution under other applicable law would have serious adverse effects on the financial stability of the United States; there is no private sector alternative to prevent default of the financial company; and the effect, if any, on the claims or interests of creditors, counterparties and shareholders of the financial company and other market participants is appropriate.
Upon determining that a financial company is a covered financial company subject to OLA, the Treasury Secretary is required to notify the FDIC and the company. If the company does not consent to the appointment of the FDIC as receiver, the Treasury Secretary is obligated to request an order authorizing such appointment from the United States District Court for the District of Columbia. Once the FDIC has been appointed as receiver for a covered financial company, it will have the authority to appoint itself as receiver of any U.S.-organized subsidiary of the financial company, other than an insured depository institution, covered broker or dealer, or insurance company.
Under Title II, the FDIC is required to exercise its orderly liquidation authority subject to the following mandates and principles:
1. creditors and shareholders will bear the losses;
2. management responsible for the condition of the company is to be removed; and
3. the FDIC shall take all necessary and appropriate steps (along with other appropriate regulators) to assure that all parties (including management, directors and third parties) having responsibility for the condition of the company will bear the losses consistent with their responsibility, including possible actions for damages, restitution and recoupment and compensation and other gains not compatible with such responsibility.
The stated intention of the FDIC’s OLA authority, according to Dodd-Frank, is to “liquidate failing financial companies that pose a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.”
Title II empowers the FDIC to issue rules and regulations with respect to the powers it is granted under Dodd-Frank with respect to orderly liquidation. Section 209 of Dodd-Frank requires the FDIC, in consultation with the Financial Stability Oversight Council, to “seek to harmonize applicable rules and regulations promulgated under this section with the insolvency laws that would otherwise apply to a covered financial company.” Furthermore, in the FDIC’s first Notice of Proposed Rulemaking under Title II, the FDIC specifically notes that “parties who are familiar with the liquidation of insured depository institutions under the FDI Act or the liquidation of companies under the Bankruptcy Code will recognize many parallel provisions in Title II.” The FDIC’s intention is to create a set of rules and procedures governing the liquidation of a covered financial institution that parallels the set of rules and procedures set forth in the Bankruptcy Code, although the FDIC’s OLA rules and procedures likely will not be a mere duplication of the Bankruptcy Code. Therefore, although Title II is effective immediately, it will take some time before the parameters of how the FDIC’s liquidation authority will work in practice to emerge and to what extent its process will differ from the Bankruptcy Code.
Complicating the FDIC’s liquidation authority are the provisions in Title II that involve the possible participation of the Security Investors Protection Corporation (SIPC) and state insurance regulators. If a covered financial institution has a subsidiary that is a broker or dealer, Title II requires that SIPC be appointed as trustee for the liquidation of the broker or dealer under SIPC’s current statutory mandate. If a covered financial institution has an insurance company subsidiary, then the appropriate state insurance regulator is responsible for the liquidation of the insurance company in accordance with applicable state law. If a covered financial institution has an insured depository institution subsidiary, then the FDIC is to exercise its traditional powers as receiver of banks and savings associations in liquidating the depository institution.
It is important to note that the designation of a company as a systemically significant nonbank financial company (SSNF) by the Financial Stability Oversight Counsel (FSOC) under the powers granted under Title I of Dodd-Frank is not technically related to whether a company in danger of failure will be subject to FDIC’s new OLA powers. Designation as an SSNF is based on whether material financial distress of the company could pose a threat to the financial stability of the U.S. resulting in increased supervision of the going concern, while a determination that a financial company should be subject to OLA is based on imminent danger of failure of the company and a determination that the failure of the company would have serious adverse effects on the financial stability of the U.S.
From a practical standpoint, it would be highly unusual for a company that is deemed to be an SSNF under Title I not to be deemed to be a covered financial company under Title II. Contemplating the inverse may be useful. One could envision a scenario where an institution was not deemed an SSNF, but as the institution approaches failure, the regulators become concerned that such failure would have serious adverse effects on financial stability in the United States and seek to designate that institution a covered financial company under Title II of Dodd-Frank.
Issues presented in BHC bankruptcies
Although Title II of Dodd-Frank empowers the FDIC with significant new authority with respect to failing financial companies, the FDIC is not unfamiliar with the bankruptcy process. However, the FDIC’s involvement in bankruptcy proceedings has been limited to its role as receiver of failed depository institution whose holding company subsequently entered bankruptcy and an interested party in the holding company bankruptcy. The financial crisis of the past few years has placed the FDIC in a unique role with respect to bank holding company bankruptcies. Until recently, the typical pattern was that a bank failed, was placed into FDIC receivership, and the bank holding company, facing the loss of its primary asset, shortly thereafter would file a bankruptcy petition, usually under Chapter 11. Over the past couple of years there have been numerous (and high-profile) cases where a bank holding company entered Chapter 11 for one reason or another but its subsidiary depository institution remained a going concern or did not enter FDIC receivership for several months. In a recent and interesting variation on the theme, some bank holding companies have filed for Chapter 11 protection in order to recapitalize themselves or to orchestrate a sale of their subsidiary bank to a new investment vehicle, free of holding company obligations and debt (including trust preferred securities) which are left to be resolved by the bankruptcy court. Such a bankruptcy filing also serves to protect the bank holding company from lawsuits by holders of trust preferred securities who are often set to receive pennies on the dollar on their holdings.
Whether the subsidiary depository institution survives after the parent company files for bankruptcy protection or its regulators close the bank and appoint the FDIC receiver, the parties in the bankruptcy will interact with banking regulators in one capacity or another and the bank regulators’ presence can have an important impact on the bankruptcy proceedings. Significantly, the banking regulators may assert claims on the debtor holding company’s estate. These claims have the potential to be very large and can drastically change other creditors’ likelihood of getting paid at all.
Capital Maintenance Agreements
When a bank experiences financial difficulties, the holding company’s regulators frequently will require the holding company to enter into a capital maintenance agreement, in which the holding company commits to ensuring that its subsidiary bank has adequate capital, as defined by the federal regulator seeking the agreement. Furthermore, the commitment will extend to certain minimum capital ratios which likely include Tier 1 capital-to-assets leverage ratio and adequate allowances for loan and lease losses. The size of the capital commitment undertaken by a bank holding company will depend on a number of factors, including the type of institution, the regulator requesting the capital commitment and the size of the subsidiary bank.
A prepetition capital maintenance agreement between a bank holding company and a banking regulator qualifies as a “commitment by the debtor to a Federal depository institutions regulatory agency … to maintain the capital of an insured depository institution” under Section 365(o) of the Bankruptcy Code. Claims under this Section are entitled to a high level of priority against the bankruptcy estate under Section 507(a)(9) of the Bankruptcy Code. Therefore, when a bank holding company files for bankruptcy under Chapter 11, the regulator’s claim against the bankruptcy estate receives the priority provided to claims by a federal regulator according to the provisions of the Bankruptcy Code.
A claim asserted in a Chapter 11 bankruptcy proceeding by a banking regulator in conformity with a capital maintenance agreement could play a significant role in the administration of the bankruptcy estate. The size of the claim will probably be large in absolute terms (the claim has the potential to be in the hundreds of millions of dollars depending on the size of the bank, and will almost certainly be large in relative terms). The bank holding company’s regulator’s claim will likely be one of the largest claims asserted against the bankruptcy estate, if it is not the largest. Furthermore, the high level of priority accorded to the regulator’s claim means that the claim will likely be paid before any secured or unsecured creditors’ claims. A large payment to the regulator results in fewer assets remaining in the bankruptcy estate to satisfy the claims of the secured and unsecured creditors. The regulator has a much higher likelihood of being paid in full than the remaining creditors and, if the regulator isn’t paid in full, it probably means that the creditors will not receive any payment at all.
Limitations on the ongoing activities of the bank
If a bank holding company ends up in bankruptcy, chances are that its subsidiary bank is experiencing financial difficulties and is subject to formal or informal enforcement actions with its regulators. These agreements (written agreements, cease and desist orders or consent orders) typically impose a variety of restrictions on the activities of the bank or banks. These may include restrictions or prohibitions on the declaration of dividends, golden parachute payments, material growth in business, accepting brokered deposits, and/or certain types of lending.
The restrictions placed on the subsidiary bank may complicate the administration of the bankruptcy estate. The terms of these formal or informal enforcement actions may compel the creditors of the holding company to interact and negotiate with the regulators. The regulator has an interest in keeping the bank alive and in preserving the value of the bank for bank’s shareholders. The creditors of the holding company, on the other hand, are likely to prefer to maximize the value of the estate of the holding company at the expense of the value of the bank. Occasionally, the preservation of the value of the bank will result in preserved value at the holding company level; however, the creditors of the holding company will frequently not derive the full benefit of an increase in value of the subsidiary bank. Because of this, the interests of the regulator and the creditors of the holding company will sometimes diverge.
Overlapping Boards of Directors
Bank holding companies and banks will frequently share many of the same directors. This gives rise to certain issues in the context of a holding company bankruptcy. When a holding company files for bankruptcy but its subsidiary bank remains solvent, the interests of the two entities are not entirely consonant.
A dispute over a commitment owed by the holding company to the bank or by the bank to the holding company might place the director in the difficult position of owing conflicting fiduciary obligations to two different entities. A financially distressed holding company will attempt to retain or collect as much money as possible even at the expense of the bank. A holding company might assert, for example, that it has satisfied all its capital contribution commitments to its subsidiary bank while the bank might argue the opposite, that it is owed money by the holding company.
A federal regulator may require directors to resign from the board of the bank or the holding company so that the boards no longer overlap. Such a requirement from the regulators will eliminate the conflict of interest that existed because of the overlapping boards. A forced resignation of directors will resolve the problem of conflicting fiduciary obligations faced by the overlapping directors. However, it may give rise to a different problem the exchange of information between the entities.
Confidential information related to the bank
Once a holding company files for bankruptcy, the creditors of the holding company, the debtors themselves, and their respective counsel will frequently find it difficult to obtain certain information about the subsidiary bank. Examination reports prepared by the regulator (and sometimes responses to such reports and operating and condition reports that the bank delivers to its regulator) are property of the regulator and typically cannot be shared with the holding company or creditors without regulatory approval. The banking regulators differ in their interpretation of the scope of the confidentiality of exam reports and materials arising out of the examination (and the confidentiality regulations slightly vary among regulators), but banks facing distress are typically reluctant to risk raising the ire of their regulators by sharing any materials that could be deemed to fall under the umbrella of confidential exam materials.
As mentioned above, holding companies and their subsidiary banks oftentimes have overlapping boards and, in the ordinary course of business, the exchange of information contained in examination reports between those entities isn’t problematic. Once the holding company files for bankruptcy and, especially in the case where the regulator forces the holding company and subsidiary bank boards to be completely independent of one another, the transmission of examination report information from the bank to the holding company becomes severely restricted. Creditors committees and debtors find that they cannot access the reports or copies thereof or communications between the bank and its regulators. The dearth of information about the bank makes it extremely difficult for the holding company and its creditors to assess the health and value of the bank that is oftentimes the holding company’s most valuable asset, and also for the holding company to determine whether to provide financial support to the bank in order to preserve the value of the bank as a going concern.
FDIC claims and extraordinary powers
If a subsidiary bank of a bankrupt holding company that was solvent at the time the holding company filed for bankruptcy has subsequently failed and is placed into receivership, the parties-in-interest in the holding company bankruptcy should expect the FDIC to assert enormous claims. The FDIC’s mandate is to maximize recovery of the receivership at the least cost to the deposit fund. In exercising its mandate, the FDIC has become increasingly aggressive with respect to claims it will assert in holding company bankruptcies. The FDIC will likely assert large claims regarding monies it is owed from the holding company as receiver of the subsidiary bank, including, among others, claims under capital maintenance agreements, shared services agreements and tax sharing agreements. The powers given to the FDIC under Dodd-Frank will likely further aggregate these issues, both for bank holding companies and for non-bank holding companies of financial companies.
•••Thanks to Dodd-Frank, the FDIC has moved from an insurer of deposits and a receiver or conservator of failed banks to a significant new role as the potential receiver of large, complex financial institutions. It remains to be seen how, in practice, the FDIC will administer this new role, how it will parallel and overlap with proceedings under the Bankruptcy Code, and whether some of the extraordinary powers that the FDIC enjoys in Chapter 11 proceedings as receiver of depository institutions will be incorporated in some fashion into the FDIC’s orderly liquidation authority. It will take months if not years before there is clarity on the OLA process, although financial institutions should start thinking about whether they are likely to be covered by Title II if they were in financial distress.
[This article was posted on January 28, 2011, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2011 by the American Bankers Association.]
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