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New Chapter 14 Bankruptcy Code Recommended by the United States Treasury Department

Would Handle Liquidation of Failing Financial Firms and Limit the Use of Orderly Liquidation Funds as Established in the Dodd-Frank Act

In February 2018, the United States Treasury Department issued the Orderly Liquidation Authority and Bankruptcy Reform Report (the “Report”) advocating for the enhancement of the Bankruptcy Code, specifically as it applies to financial institutions.  This report is in stark opposition to the CHOICE Act proposed by a conservative group of lawmakers in the U.S. House of Representatives that seeks to undo much of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and fully repeal the orderly liquidation authority (“OLA”) established in Dodd-Frank.

Under Dodd-Frank, the Federal Deposit Insurance Corporation (“FDIC”) is authorized to control the assets of a failing financial institution that has the risk of disrupting the United States financial markets.  The OLA provides the FDIC with funds generated from fees on financial institutions to be used to break apart the assets of the banks taken over by the FDIC.  Proponents support this structure because it uses bank fees instead of taxpayer dollars to handle the disassembly of failing banks and reduce the impact to financial markets.  Opponents of OLA argue that risky bank behavior is incentivized by essentially providing a guarantee fund.

The CHOICE Act has failed to muster support in the Senate while Dodd-Frank reforms established for the benefit of community and regional banks are moving forward in the current term under the Economic Growth, Regulatory Relief, and Consumer Protection Act and maintain wide bi-partisan support although it does not address the OLA.  The Report, rather than proposing elimination of the OLA, suggests limiting the use of OLA in only the most distressed cases.  The position advocated by the Report could gain traction in future proposed legislation because it limits the use of OLA which is advocated by many conservatives and does not eliminate OLA from Dodd-Frank which could draw political support from more liberal members of Congress.

The Treasury Report has called for Congress to expand the Bankruptcy Code so that banks can dissolve without causing a market-wide credit freeze.  This would “…narrow the path to OLA by building a more robust, effective bankruptcy process for financial companies.”  Treasury’s solution is the creation of a new Chapter to the Bankruptcy Code—Chapter 14.  Under the new Chapter 14 model, “…a covered financial corporation filing for bankruptcy would petition the court for approval of a transfer within 48 hours of most of its assets and some of its liabilities to a newly formed bridge company. A court would permit the transfer if the court determines, based upon a preponderance of the evidence, that the transfer satisfies certain conditions, including that the transfer is necessary to prevent serious adverse effects on financial stability in the United States and that the bridge company is likely to satisfy the obligations of any debt, executory contract, or [Qualified Financial Contracts] transferred to it.”

Similar to the OLA, the 48-hour stay period would allow the bankruptcy case to proceed over a “resolution weekend,” thereby “allowing the operating subsidiaries to open for business on Monday with minimal market disruptions.”    Chapter 14 would also provide for a stay on termination rights of parties who are involved in derivatives contracts with the failing financial institution, and the financial liability would rest with the company’s shareholders, management and certain creditors. Treasury also recommended ending FDIC’s ability to prioritize claims of similar situated creditors, requiring a bankruptcy court to determine the distribution of assets and limiting the time and extent that OLA fund money is provided to the bridge company.

Treasury stated in the Report that, “We conclude unequivocally that bankruptcy should be the resolution method of first resort. Our reason is simple: market discipline is the surest check on excessive risk-taking, and the bankruptcy process reinforces market discipline through a rules-based, predictable, judicially administered allocation of losses from a firm’s failure.”

The Report from Treasury did not call for the elimination of the OLA, however, its support of a new Chapter 14 would clearly establish the OLA under Dodd-Frank as a last resort with respect to failing financial firms.

This blog post was drafted by Matthew Wine, an attorney in the Spencer Fane LLP Kansas City, MO office. For more information, visit spencerfane.com.