Financial Reform Legislation: The Trampling of Creditors' Rights
On May 20, 2010 the Senate passed the Restoring American Financial Stability Act of 2010 (the "Senate Bill") 59-39, only hours after the cloture vote ended debate on the bill. The House passed its version—the Wall Street Reform and Consumer Protection Act of 2009 (the "House Bill")—in December 2009. The primary stated focus of the Senate and House Bills is to prevent the failure of the "too big to fail" institutions and to avoid government (taxpayer) bailouts in the future.
Both the Senate Bill and House Bill are in excess of 1500 pages. While a great deal has been written about the heightened regulation of financial companies and the ability to liquidate such companies, there has been little focus to date on how the liquidation provisions of the proposed legislation affect the rights of bondholders and other creditors of the failing institutions.
It is beyond the scope of this Update to discuss whether overall financial reform legislation is needed and whether the Senate Bill and the House Bill are generally appropriate or go too far. However, we do believe that the receivership provisions affecting the rights of bondholders and other creditors are inappropriate and substantially overreaching. Simply stated, the FDIC will become the judge and the jury in financial institution receiverships with little or no court oversight, including the ability to override the rights of similarly-situated creditors, expropriate 20% of the value of secured claims without compensation to the secured creditor and sell assets without consent or approval of any kind.
1. You may be surprised to find you are a creditor of a regulated financial company
The financial reform legislation affects not only banks and bank holding companies, but also insurance companies and other non-bank financial companies that have been deemed to require "stricter prudential regulation." Generally a company (a "Financial Company") will be held to "stricter prudential regulation" if the relevant regulatory authority determines that material financial distress at the company could pose a threat to the financial stability of the economy. Since this analysis is constantly evolving and largely influenced by the then-current economic situation, there is no certainty about what companies may or may not be subject to the legislation now or in the future. This means that investors may unknowingly already be, or become in the future, creditors of a Financial Company.
2. A new chapter from a different book
Under current law, failing depository banks are subject to receivership proceedings rather than Chapter 11. As a result, Washington Mutual Bank—the largest failed savings and loan in history—was placed into FDIC receivership by the Office of Thrift Supervision. However, Washington Mutual Bank's parent company, Washington Mutual Inc., was able to commence Chapter 11 proceedings because the receivership provisions only extend to operating banks themselves, not their holding companies. Similarly, Lehman Brothers Holdings, Inc. is the best-known example of a failing investment bank parent company that filed for Chapter 11 protection.
The proposed legislation does not remove the Chapter 11 option for parent and holding companies. However, under both the Senate Bill and the House Bill, the relevant regulatory entities and the Secretary of the Treasury have the authority to place the Financial Company into receivership even if there is already a Chapter 11 case pending (once placed into receivership, the Financial Company is referred to as a "Covered Financial Company"). In connection with such a determination, the regulators take into consideration whether (1) the Financial Company is in default or in danger of being in default, (2) the failure of the Financial Company would have serious adverse effects on the financial stability of the economy, and (3) a liquidation of the Financial Company would avoid or mitigate some of those adverse effects.
In a split between the two versions of the legislation, the House Bill provides that the Secretary of the Treasury must initiate liquidation proceedings and appoint the FDIC as the receiver if the above criteria are met. The Senate Bill, in contrast, requires the Secretary of the Treasury to obtain either the Financial Company's consent or the approval of the United States District Court for the District of Columbia, which must evaluate on very short notice whether the Secretary's determination that the Financial Company is "in default or in danger of default" is supported by "substantial evidence". Each of the Bills define "in default or in danger of default" as including when a Chapter 11 case has commenced or is likely to commence. The practical effect is that any Financial Company that has initiated a Chapter 11 case will automatically be eligible for a superseding receivership, and if the relevant authorities do commence a receivership, the Chapter 11 case will immediately be terminated, regardless of the stage of the proceedings and without the need for the bankruptcy court's approval.
3. The FDIC, as judge and jury, can turn equal into unequal and secured into unsecured
A hallmark of Chapter 11, as well as of FDIC receiverships for failed banks, is that similarly situated creditors must generally receive the same treatment. For example, senior bondholder claims and liquidated tort claims are generally entitled to equal and ratable treatment. Remarkably, this may or may not be the case under the new legislation, because it gives the FDIC as receiver the right to treat similar claims differently if such treatment would further financial stability or the US economy.
First, under both the Senate and House Bills, the FDIC as receiver is authorized to make additional payments to some equal priority creditors but not others if such additional payments would "minimize losses to the [FDIC] as receiver from the orderly liquidation of the covered financial company." Additionally, under the House Bill, the FDIC may also make disparate payments to equal priority creditors if such payments would "prevent or mitigate serious adverse effects to financial stability or the United States economy."
Second, under the House Bill, but not the Senate Bill, if estate funds are insufficient to pay in full "any amounts owed to the United States or the Fund," the FDIC has the authority to treat a secured claim as unsecured up to 20% of the claim amount and may use such funds to pay the United States or the Fund. Essentially the government steps into the shoes of the secured creditor and takes the benefit of up to 20% of the value of the secured creditor's security interest, no matter when such security interest was perfected. Similar to all other discretionary sections in the House Bill, the language is extremely broad and there is no clarity or limitations on what "amounts owed to the United States" entails. However, because "amounts owed to the United States" are in addition to "amounts owed to the Fund," one can easily speculate that taxes, underfunded pension obligations, environmental liabilities and other obligations owed or reimbursable to the government are included within this surcharge provision.
Incredibly, there is no judicial review of a determination by the FDIC to decrease the amount of a creditor's secured claim for the benefit of the United States or the Fund. Notably the Senate Bill does not have a similar provision, however, both Bills are now at the conference stage of the legislative process for reconciliation of the differences between each, so there is a chance that the final version as presented to the President for signature may include this or a similar provision.
4. The FDIC, as judge and jury, decides whether an asset sale price is fair
Both versions of the legislation authorize the FDIC as receiver to sell assets of a Covered Financial Company. So far, so good, but the legislation does not stop there. The FDIC is specifically empowered to sell assets "without obtaining any approval, assignment, or consent" and there is no requirement to implement a sale process that would maximize the value of the assets (i.e. there is no "go-shop" requirement). In the context of a bank receivership, where the FDIC often needs to sell the bank's assets quickly following commencement of the receivership, the necessity for swift action is purportedly justified by the need to protect depositors of the bank and minimize losses to the federal deposit insurance fund caused by payments to depositors. However, in the case of many other Covered Financial Companies, there is no similar depositor or creditor insurance fund to protect, yet no consent for asset sales is required even if the assets are subject to a security interest or are associated with any trust or custody business of the Covered Financial Company.
5. Beware the FDIC in sheep's clothing
There are a number of logical reasons why both the Senate Bill and the House Bill expand the applicability of receiverships to more Covered Financial Companies and place the FDIC in charge of the receiverships. However, the Senate and the House would do well to consider the receivership of Washington Mutual Bank ("WaMu") as a cautionary tale. WaMu was stripped by the FDIC of all of its assets within minutes of the commencement of its receivership for only $1.9 billion, even though at the time WaMu had capital in excess of the regulatory standards for "well capitalized" institutions and was unquestionably solvent on a fair valuation basis. All that was left behind was $13 billion of public senior and subordinated bonds.
In normal receiverships of whatever nature, it is black letter law that the receiver owes a fiduciary duty to the beneficiaries of the receivership to maximize the value of the receivership estate. This does not guarantee full recovery to creditors, of course, but it does provide comfort that the estate representative will do its best to obtain the best recovery under the circumstances.
However, according to the FDIC in WaMu, black letter receivership law does not apply to the FDIC. As a result, the FDIC has systematically subordinated the interests of WaMu's bondholders in order to achieve the FDIC's own objectives of obtaining litigation releases for the FDIC. The truly remarkable result of the FDIC's conduct is that the creditors of WaMu's bank holding company will receive a far better recovery than the creditors of the operating bank itself.
If the financial reform legislation passes in a form that is similar to either the Senate Bill or the House Bill, the FDIC will no longer even need to engage in the debate about where its duties as receiver lie. Both versions of the legislation make it clear that the FDIC will be free to act however it wants, without the risk of being second-guessed in a court of law even if it grossly discriminates among similarly-situated creditors and even if it takes away 20% of a secured creditor's value without just compensation. This may (or may not) be good policy for the financial stability of the US economy as a whole, but it surely comes at the expense of the bondholders and other creditors who provided capital to a Covered Financial Company. If the legislation passes with such provisions intact, it is by no means clear that bondholders and creditors will be quite so likely to provide capital to financial institutions going forward. And if that is the result that entails, query whether the legislation will have made worse the systemic damage that the legislation seeks to remedy.