Treasury recommends preserving OLA for 'extraordinary' situations, while creating a new bankruptcy Chapter 14 to handle most large-bank failures

On February 21, 2018, the Treasury Department released another in a series of reports on financial regulation required by presidential executive orders issued last year. This report responds to a memorandum from the President on April 21, 2017, requesting that Treasury evaluate how the "orderly liquidation authority" (OLA) regime established by the 2010 Dodd-Frank Act aligns with the president's "core principles" for financial reform, and whether an improved bankruptcy process would be a better alternative. As outlined by Dodd-Frank Title II, OLA empowers the FDIC to wind down a large, failing institution through a process intended to avert the "contagion" and runs on deposits seen after the Lehman Brothers bankruptcy in 2008, and permits Treasury to extend a line of credit to the failing company to keep it operating through the resolution process; taxpayers would ultimately be repaid via a fee on financial firms.

Attached with this Alert please find PDFs of the Treasury report (57 pages) and a press release from Treasury on the report. Those materials are also posted here.

Broadly, the report recommends retaining an improved version of OLA to be used in "extraordinary circumstances" — a conclusion that was criticized by some conservatives, including House Financial Services Committee Chairman Jeb Hensarling (R-TX, see below) — while creating a new bankruptcy Chapter 14 designed to resolve larger, failing banks in most situations. "While bankruptcy must be the presumptive option, the bankruptcy of large, complex financial institutions may not be feasible in some circumstances, including when there is insufficient private financing," according to the report's executive summary. "In those cases, a reformed OLA process — with predictable, clear allocation of losses to shareholders and creditors — is a far preferable alternative to destabilizing financial contagion or ad hoc government bailouts." The report also finds that if OLA were to be repealed altogether, "foreign regulators would be more likely to impose immediate new requirements on foreign affiliates of U.S. bank holding companies, raising their costs of business and harming their ability to compete internationally."

In a statement released by Treasury, Secretary Steven Mnuchin said the report's recommendations "seek to ensure that our financial system is resilient while protecting taxpayers and promoting market discipline. The bankruptcy reforms that we propose will make the shareholders, management and creditors of a financial company bear any losses from its failure. The policy of this administration is clear: we will not tolerate taxpayer-funded bailouts."

Chapter 14 Bankruptcy. In its press release, Treasury says the proposal for a new bankruptcy framework "would preserve the key advantage of the existing bankruptcy process — clear, predictable, impartial adjudication of competing claims — while adding procedural features tailored to the unique challenges posed by large, interconnected financial companies." Together these would make the prospect of having to use the OLA regime "remote." The report's Chapter 14 proposal is partly drawn from HR 1667, which the House passed by voice vote on April 17, 2017, as well as the House-passed Financial CHOICE Act (HR 10) and a Senate bill (S. 1861) offered in the 113th Congress by Sens. John Cornyn (R-TX) and Pat Toomey (R-PA).

As outlined by the report, the new Chapter 14 would be "an expedited process that leaves operating subsidiaries open for business … to reassure the market and limit the risk of financial contagion." Treasury proposes a "two-entity recapitalization model" in which "a financial company could file for bankruptcy and petition the court for approval to transfer within 48 hours most of its assets and certain liabilities to a newly formed bridge company. The assets to be transferred to the bridge company would include the ownership interests of operating subsidiaries, allowing these entities to continue their operations." The process would provide for a temporary delay on the ability of counterparties to derivatives and other financial contracts to "reactively" exercise their rights to terminate or liquidate immediately when bankruptcy is initiated, "pending the potential transfer of qualified financial contracts to the bridge company."

In addition, Chapter 14 would provide that "predetermined obligations of the financial company would be 'left behind' rather than transferred to the bridge company. Those left behind would include all shareholders of the debtor financial company as well as holders of … unsecured long-term debt held at the holding company level." Equity in the new bridge company "would be held by a special trustee for the sole benefit of the left-behind shareholders and creditors," according to the summary.

Changes to OLA

The report proposes a series "significant reforms" to Dodd-Frank Title II's orderly liquidation authority, "to correct serious problems in its original design." First, Treasury would curtail what it calls "excessively broad discretion" given to the FDIC in several areas. These changes would:

— Eliminate the FDIC's authority to treat similarly situated creditors differently on an ad hoc basis. "Both the initial transfer of liabilities to the bridge company under OLA and the subsequent administration of claims on the estate of the failed firm should follow established Bankruptcy Code principles," the report says.

— Require a bankruptcy court to be responsible for adjudicating claims. "The FDIC would have standing to participate in the proceedings, but the impartiality and procedural protections of a bankruptcy court would improve the fairness and regularity of the process."

— Repeal the tax-exempt status of the bridge company.

— Require the FDIC to clarify its commitment to use the "single point of entry" (SPOE) resolution strategy that it has developed over the years since Dodd-Frank's enactment. "The FDIC should also identify the circumstances, if any, in which SPOE would not be used," the report says.

Restrictions on use of the OLF. Both Dodd-Frank and the Treasury report hold that the taxpayer-funded Orderly Liquidation Fund (OLF) should be used to keep a failing financial company afloat only in the most dire of circumstances. The report says that if the OLF is used, "loan guarantees of private funding should be preferred over direct lending" that would be "more likely to reintroduce the bridge company to the private funding markets earlier … Treasury should use its authority to set the terms of any OLF advances to ensure that the FDIC only lends funds or provides loan guarantees if it charges an interest rate or guarantee fee set at a significant premium."

The report further recommends that the FDIC should lend from the OLF only "on a secured basis, and Treasury should advance funds to the OLF only on those terms. The FDIC should seek high-quality assets as collateral, and publish a list of assets eligible to serve as collateral for an OLF loan." The duration of OLF loans should be "limited to a fixed term that is only as long as necessary to meet liquidity needs," and the backstop assessment levied on the financial industry to repay Treasury "should be imposed as soon as reasonably possible," preferably well before the five-year window stipulated by Dodd-Frank.

Stronger judicial review. Finally, the report recommends "strengthening judicial review of the decision to invoke OLA, while preserving regulators' ability to act swiftly in the event of a financial crisis … the reviewing court should instead be permitted to review the entire seven-point statutory determination under the 'arbitrary and capricious' standard."

Reaction

House Financial Services Chairman Hensarling was critical of the report's conclusions, saying they contradicted President Trump's stated opposition to bailouts of financial institutions in his "Core Principles" executive order. "Although I have been pleased or even excited about Treasury's previous reports, this one disappoints," Hensarling said in a statement. "Although today's report from the Treasury Department makes a number of positive recommendations … it regrettably does not recommend repealing OLA. On its face, this is inconsistent with the President's core principle. Dodd-Frank's Orderly Liquidation Authority expressly enables taxpayer-funded bailouts; it does not prevent them. It is therefore difficult to square today's report with the President's clear guidance on this issue. Taxpayers must never be forced to pay the price when big banks fail. Encouraging economic growth, strong capital, and market discipline, not the arbitrary discretion of federal regulators, is the only way to maintain vibrant and healthy financial markets."

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ATTACHMENTS

OLA Report

Press Release