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United States Government Accountability Office:
GAO:
Report to Congressional Committees:
July 2011:
Bankruptcy:
Complex Financial Institutions and International Coordination Pose
Challenges:
GAO-11-707:
GAO Highlights:
Highlights of GAO-11-707, a report to congressional committees.
Why GAO Did This Study:
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act) created the Orderly Liquidation Authority (OLA) that can be
used to resolve failed systemically important financial institutions.
However, questions continued to be raised about the effectiveness of
the U.S. Bankruptcy Code (Code) and current mechanisms for
international coordination in bankruptcy cases. The Dodd-Frank Act
requires GAO to report on the effectiveness of the Code in resolving
certain failed financial institutions on an ongoing basis. Among its
objectives, this report addresses (1) the effectiveness of Chapters 7
and 11 of the Code for facilitating orderly resolutions of failed
financial institutions; (2) proposals for improving the effectiveness
of liquidations and reorganizations under the Code; and (3) existing
mechanisms that facilitate international coordination under the Code
and barriers to coordination of financial institution bankruptcies.
GAO reviewed laws, judicial decisions, regulations, data, and academic
literature on resolutions, and spoke with relevant government
officials, industry representatives, and experts from the legal and
academic communities about the effectiveness of the Code.
GAO makes no recommendations in this report. GAO provided a draft for
comment to the Administrative Office of the United States Courts, the
Treasury, and the federal financial regulators, among others. All
provided technical comments that GAO has incorporated as appropriate.
What GAO Found:
The effectiveness of the Bankruptcy Code in resolving failed complex
financial institutions is unclear for several reasons, including that
criteria are not well-developed, a paucity of data, and the complex
activities and organizational structures of financial institutions.
Experts agreed that maximizing asset values and minimizing systemic
impacts are potential criteria for judging effectiveness, but the Code
does not directly address systemic factors in bankruptcies. Even if
criteria were established, few complex financial institutions have
filed for bankruptcy, and those that have, have done so recently,
making measuring effectiveness difficult. Nonetheless, experts
generally agreed that certain attributes of complex financial
institutions—highly liquid funding sources; use of derivatives;
complex legal structures, including regulated and unregulated
entities, that do not correspond to integrated, interconnected
operating structures; and international scope of operations—complicate
bankruptcy proceedings.
Financial, legal, and regulatory experts have made proposals to modify
the Code, but they do not agree on specifics. These proposals
generally focus on or combine several types of actions: (1) increasing
opportunities for bankruptcy planning, (2) providing for regulatory
input in the bankruptcy process, (3) modifying the safe harbor for
certain financial contracts, (4) treating firms on a consolidated
basis, and (5) improving court expertise on financial issues. For
example, experts generally agree that changes need to be made
regarding the safe harbor treatment of certain financial contracts.
The Code exempts these contracts from the automatic stay that, in a
bankruptcy, preserves assets and generally prevents creditors from
taking company assets in payment of debts before a case is resolved
and assets are distributed in a systematic way. However, the experts
do not agree on whether the types of contracts receiving this safe
harbor treatment need to be changed or whether, as with regulatory
processes, a temporary stay should be adopted.
Efforts to improve international coordination continue, but existing
mechanisms are not comprehensive, and international coordination
generally is limited—often because national interests can play a
determining role in resolution outcomes. For example, Chapter 15 of
the Code promotes coordination between U.S. bankruptcy courts and
foreign jurisdictions when the debtor in a U.S. bankruptcy proceeding
is a company with foreign operations. However, national interests and
other factors limit its effectiveness during bankruptcies of financial
institutions. When national interests are aligned, even during a
financial crisis, courts and regulators find ways to coordinate, but
when they diverge, the need to safeguard those interests takes
priority. Variations in countries’ insolvency laws, differences in
definitions and factors that trigger insolvencies, and limits on
information sharing also constrain international coordination.
Proposals have been made to improve international coordination for
financial institution resolutions, but most efforts focus on
regulatory, rather than judicial, processes.
View [hyperlink, http://www.gao.gov/products/GAO-11-707] or key
components. For more information, contact Alicia Puente Cackley at
(202) 512-8678 or cackleya@gao.gov.
[End of section]
Contents:
Letter:
Background:
D.C. District Court Has Issued Rules to Implement Required Judicial
Review under the Orderly Liquidation Authority:
The Effectiveness of the Bankruptcy Code in Resolving Complex and
Internationally Active Financial Institutions Is Unclear:
Bankruptcy Proposals Address Some Financial Institution Challenges,
but There Is No Consensus on Specifics:
Courts and Regulators Have Mechanisms for International Coordination,
but National Interests and Other Factors Limit Coordination:
Agency Comments and Our Evaluation:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Local Civil Rule 85:
Appendix III: CIT Group Bankruptcy:
Appendix IV: Lehman Bankruptcy:
Appendix V: Washington Mutual Bankruptcy:
Appendix VI: Other Financial Institution Failures:
Appendix VII: Safe Harbors for Contracts under the Bankruptcy Code:
Appendix VIII: Some Characteristics of Insolvency Systems in Selected
Countries:
Appendix IX: Organizational Affiliations of Experts:
Appendix X: GAO Contact and Staff Acknowledgments:
Related GAO Products:
Tables:
Table 1: Chapter 11 Mega Bankruptcy Filings, by Total Filings and
Financial Institution Filings, 2000-2009:
Table 2: Thirty of the Largest International Financial Institutions
(Ranked by Size) and Their Subsidiaries and Branches:
Table 3: Timeline of Selected Events Related to the CIT Bankruptcy,
from April 2007 through December 2009:
Table 4: Timeline of Selected Events Related to the Lehman Bankruptcy,
from September 2008 through April 2011:
Table 5: Timeline of Selected Events Related to the Washington Mutual,
Inc. Bankruptcy, from September 2008 through July 2011:
Table 6: Repayment Rankings of Selected Countries:
Figure:
Figure 1: Chapter 11 Bankruptcy Process for a U.S.-Headquartered
Financial Institution as of June 2011:
Abbreviations:
ABN AMRO: ABN AMRO Holding, NV:
AOUSC: Administrative Office of the United States Courts:
AIG: American International Group, Inc.
BIA: Bankruptcy and Insolvency Act:
BHC Act: Bank Holding Company Act:
BCCI: Bank of Credit and Commerce International:
BIS: Bank of International Settlement:
BNY: Bank of New York Mellon Corporation:
Herstatt: BankHaus Herstatt:
Barclays: Barclays PLC:
BNY trustee: BNY Corporate Trustee Services Limited:
CDIC: Canada Deposit Insurance Corporation:
CDIC Act: Canada Deposit Insurance Corporation Act:
CIT: CIT Group, Inc.
CCCA: Companies' Creditors Arrangement Act:
Co-Co: contingent convertible bonds:
CDS: credit default swap:
DIP: debtor-in-possession:
Dodd-Frank Act: Dodd-Frank Wall Street Reform and Consumer Protection
Act:
Drexel: Drexel Burnham Lambert Group, Inc.
EU: European Union:
FDI Act: Federal Deposit Insurance Act:
FDIC: Federal Deposit Insurance Corporation:
FRBNY: Federal Reserve Bank of New York:
Federal Reserve: Board of Governors of the Federal Reserve System:
Fortis: Fortis Bank, SA/NV:
G10: Group of Ten:
G20: Group of 20:
IMF: International Monetary Fund:
ISDA: International Swaps and Derivatives Association:
JPMC: JPMorgan Chase and Co.
LBF: Lehman Brothers Finance:
LBHI: Lehman Brothers Holdings, Inc.
Lehman: Lehman Brothers Holdings, Inc. and subsidiaries:
LBI: Lehman Brothers, Inc.
LBIE: Lehman Brothers International Europe:
LBSF: Lehman Brothers Special Financing, Inc.
LTCM: Long-Term Capital Management:
MOU: memorandum of understanding:
Nordea: Nordea Group:
Nortel: Nortel Networks, Inc.
NAFTA: North American Free Trade Agreement:
NPR: notice of proposed rulemaking:
OTS: Office of Thrift Supervision:
OLA: Orderly Liquidation Authority:
Perpetual: Perpetual Trustee Company Limited:
P&A agreement: Purchase and Assumption Agreement:
QFC: qualified financial contracts:
Saphir: Saphir Finance Public Limited Company:
Section 23A: Section 23A of the 1913 Federal Reserve Act:
SEC: Securities and Exchange Commission:
SIPA: Securities Investor Protection Act:
SIPC: Securities Investor Protection Corporation:
Swedbank: Swedbank AB:
TLGP: Temporary Liquidity Guarantee Program:
TARP: Troubled Asset Relief Program:
UK: United Kingdom:
UNCITRAL: United Nations Commission on International Trade Law:
Code: U.S. Bankruptcy Code:
D.C. District Court: U.S. District Court for the District of Columbia:
Washington Mutual: Washington Mutual, Inc.
WMPF: Washington Mutual Preferred Funding LLC:
WURA: Winding Up and Restructuring Act:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
July 19, 2011:
Congressional Committees:
The recent financial crisis and its attendant bailouts and
bankruptcies of complex financial institutions led lawmakers and other
government officials to question the adequacy of the then existing
U.S. and international frameworks for resolving complex financial
institutions and addressing systemic risk. In response, Congress
created a new Orderly Liquidation Authority (OLA) in the Dodd-Frank
Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),
enacted in July 2010, that can be used when certain insolvent
financial companies pose a risk to the financial stability of the
United States.[Footnote 1] Under certain circumstances, the Dodd-Frank
Act authorizes the Secretary of the Treasury to appoint the Federal
Deposit Insurance Corporation (FDIC) as a receiver, and requires FDIC
to liquidate such financial companies so as to maximize the value of
the company's assets, minimize losses, mitigate systemic risk, and
minimize moral hazard. Since the passage of the Dodd-Frank Act, FDIC
has not been appointed receiver of any failing financial company as
part of OLA; OLA has not yet been tested.
Leading up to the passage of the Dodd-Frank Act, some members of
Congress and some legal and financial experts had raised (and continue
to raise) questions about the effectiveness of the U.S. Bankruptcy
Code (Code) in providing for orderly liquidations or reorganizations
of financial institutions that qualify as debtors under the Code.
[Footnote 2] In addition, the Lehman bankruptcy proceedings, which
began in September 2008 and included the bankruptcy of Lehman Brothers
Holdings, Inc. and a number of its subsidiaries, have highlighted
inconsistencies in laws and regulations across countries and
limitations on the ability of countries to coordinate effectively
during the reorganization or liquidation of a financial institution
that operates across national borders.
Consequently, the Dodd-Frank Act requires that GAO report on issues
relating to OLA's judicial review process, the effectiveness of the
Bankruptcy Code, and international coordination in bankruptcies of
financial companies. As required under section 202 of the Dodd-Frank
Act, this report examines (1) actions taken by the U.S. District Court
for the District of Columbia (D.C. District Court) in response to the
judicial review provision of the OLA; (2) the effectiveness of
Chapters 7 and 11 of the Code in facilitating orderly liquidations or
reorganizations of financial institutions; (3) proposals for improving
the effectiveness of liquidations and reorganizations under the Code;
and (4) mechanisms that facilitate international coordination and any
barriers to coordination of financial institution bankruptcies.
[Footnote 3]
To address these objectives, we reviewed a rule issued by the U.S.
District Court under the OLA judicial review provision. We also
monitored proposed rules issued by U.S. regulators charged with
implementing OLA and legal developments in selected other countries.
To assess the effectiveness of the Code, the strengths and weaknesses
of proposals, and the extent of international coordination, we
reviewed laws, judicial decisions, regulatory proceedings, and
academic literature. During that review, we focused on identifying
potential criteria for determining the effectiveness of bankruptcy
proceedings, factors that complicate or facilitate bankruptcies, or
those that limit or facilitate coordination during bankruptcies or
insolvencies of internationally active institutions. Also, we
interviewed experts including law professors, practicing attorneys,
bankruptcy judges, economists, and regulators both in the United
States and in selected other countries and the European Union (EU).
The countries included Canada, Germany, Mexico, the Netherlands,
Switzerland, and the United Kingdom (UK) and were chosen because of
their importance to the U.S. financial system and their geographic
scope. To supplement these activities, we developed information from
court documents, including examiner and Securities Investor Protection
Act (SIPA) Trustee reports, and interviews about the three largest
financial institution bankruptcies in the United States--CIT Group
(CIT), Lehman Brothers Holdings, Inc. and its subsidiaries (Lehman),
and Washington Mutual, Inc. (Washington Mutual). In addition, we
collected information from prior GAO reports, court and regulatory
documents, and academic studies on a number of other financial
institution failures or near failures. Finally, we analyzed available
data on U.S. bankruptcies and determined that they were sufficiently
reliable to provide some background information on the number of large
financial institution bankruptcies that occurred between 2000 and
2010. See appendix I for more information on our objectives, scope,
and methodology for this report.
We conducted this performance audit from August 2010 to July 2011, in
accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.
Background:
Bankruptcy is a federal court procedure conducted under rules and
requirements of the U.S. Bankruptcy Code. The goal of bankruptcy is to
give individuals and businesses a "fresh start" from burdensome debts
by eliminating or restructuring debts they cannot repay and help
creditors receive some payment in an equitable manner through
liquidation or reorganization of the debtor. The filing of a
bankruptcy petition operates as an "automatic stay" that stops
lawsuits, foreclosures, and most other collection activities against
the debtor. Under the Code, secured creditors--those with liens or
other secured claims against the debtor's property--are more likely to
get some portion of their debt repaid than unsecured creditors. In
addition, creditors typically receive payment of their debts before
shareholders receive any return of their equity.
Business debtors that are eligible for protection under the Code may
qualify for liquidation, governed by Chapter 7 of the Code, or
reorganization, governed by Chapter 11. A Chapter 7 proceeding is a
court-supervised procedure by which a trustee takes over the assets of
the debtor's estate, reduces them to cash, and makes distributions to
creditors, subject to the rights of secured creditors to the
collateral securing their loans to the debtor. Debtors that are
commercial enterprises desiring continuation of some or all of the
debtor's operations ordinarily seek to reorganize under Chapter 11 as
a way to satisfy creditor claims. Under Chapter 11, typically the
debtor remains in control of its assets, and is therefore called a
debtor-in-possession (DIP). If, however, the bankruptcy court
determines that this is not in the best interest of creditors, the
court can appoint a trustee to oversee the debtor. The reorganization
is consummated when the reorganization plan developed by the debtor
(or other interested party) is confirmed by the court. The plan sets
forth the means by which it will be implemented, including disposition
or retention of property, mergers, and issuance of securities.
[Footnote 4] The plan also, among other things, divides creditors into
classes and sets forth the manner in which the creditor classes will
be paid. The debtor also can terminate burdensome contracts and
leases, recover assets, and rescale its operations in order to return
to profitability. Chapter 11 proceedings often involve financing under
what is called DIP financing.[Footnote 5] Proceedings under both
Chapters 7 and 11 can be voluntary (initiated by the debtor) or
involuntary (generally initiated by at least three creditors and
infrequent).[Footnote 6] Since 2001, the courts have overseen nearly
350,000 Chapter 7 and Chapter 11 business cases (those with primarily
business debt). Almost all of the debtors that were larger businesses--
those with assets of at least $100 million--initially filed under
Chapter 11; however, because smaller businesses often file under
Chapter 7, Chapter 7 cases made up almost 75 percent of all business
filings.
The U.S. bankruptcy system involves multiple federal entities.
Bankruptcy courts are located in 90 federal judicial districts;
however, the Southern District of New York (which includes Manhattan)
and the District of Delaware adjudicate a majority of larger corporate
or business bankruptcy cases, many of which constitute "mega cases"
involving companies with assets of at least $100 million and at least
1,000 creditors.[Footnote 7] The Judicial Conference of the United
States serves as the judiciary's principal policymaking body and
recommends national policies and legislation on all aspects of federal
judicial administration.[Footnote 8] In addition, the Administrative
Office of the United States Courts (AOUSC) serves as the central
administrative support entity for the Judicial Conference and the
federal courts, including bankruptcy courts. For example, AOUSC
provides administrative, legal, financial, management, and information
technology functions for the federal courts. The Federal Judicial
Center is the education and research agency for the federal courts and
assists bankruptcy courts with reports and assessments relating to the
administration and management of bankruptcy cases. Finally, the U.S.
Department of Justice's Trustee Program and the Bankruptcy
Administrator Program oversee bankruptcy trustees and promote
integrity and efficiency in the bankruptcy system by overseeing the
administration of bankruptcy estates.[Footnote 9]
Financial Institutions and the Bankruptcy Code:
Large financial institutions operating in the United States engage in
a broad range of financial services including commercial banking,
investment banking, and insurance.[Footnote 10] Many of them are
organized as holding companies with a variety of subsidiaries,
including regulated subsidiaries such as depository institutions,
insurance companies, broker-dealers, and futures commission merchants,
as well as other nonregulated subsidiaries that engage in a wide
variety of financial activities. Many of these businesses have
centralized business functions that may be housed in the holding
company. Smaller banking institutions also are organized as holding
companies, but many of these hold few, if any, assets outside a
depository institution and generally engage in a narrower range of
activities.
Certain financial institutions, specifically insured depositories,
domestic insurers, and branches and agencies of foreign banks may not
file as debtors under the U. S. Bankruptcy Code, and other entities
face special restrictions in using the Code. These institutions are
resolved through regulatory processes or face some restrictions, as
follows:
* Under the Federal Deposit Insurance Act (FDI Act), FDIC serves as
the conservator or receiver for insured depository institutions placed
into conservatorship or receivership under applicable law.[Footnote
11] FDIC, as receiver, is charged with liquidating these failed
depository institutions' assets. Often, FDIC will arrange for all or
part of the assets and liabilities of the failed depository
institution to be purchased and assumed by a single or several other
financial institutions. To the extent such a purchase and assumption
is not possible or the assuming institution or institutions do not
purchase all of the assets of the failed depository institution, FDIC
will liquidate such assets over time.
* Insurers are generally subject to oversight by state insurance
commissioners, who have the authority to place them into
conservatorship, rehabilitation, or receivership.
* Broker-dealers can be liquidated under SIPA or under a special
provision of Chapter 7 of the Code. However, broker-dealers may not
file for reorganization under Chapter 11.[Footnote 12] Similarly,
commodity brokers, also known as futures commission merchants, are
restricted to using only a special provision of Chapter 7 for
bankruptcy relief.
* Covered financial companies--those financial companies that the
Secretary of the Treasury determines meet the conditions specified
under OLA, including that their failure would pose a threat to the
financial stability of the United States--are to be resolved under an
FDIC receivership, generally similar to that currently used to resolve
insured depositories.[Footnote 13] Under this receivership, FDIC can
create a bridge financial institution and can divide the company's
assets so they can be sold, liquidated, or transferred to such a
bridge institution.
Other financial institutions that have not been determined to pose a
threat to the financial stability of the United States may qualify as
debtors under the Code. These would include holding companies that own
insured depository institutions or other firms, such as broker-
dealers, that are not permitted to be debtors under Chapter 11. Large
complex financial institutions that are eligible to file for
bankruptcy generally file under Chapter 11 of the Code. A financial
institution going through a Chapter 11 bankruptcy generally will pass
through several stages, ranging from the filing of a petition and
implementation of the automatic stay, through "first-day motions," to
submission of a written disclosure statement and judicial approval of
a reorganization plan, as shown in figure 1.[Footnote 14] The most
common first-day motions relate to the continued operation of the
debtor's business and involve matters such as requests to use cash
collateral--liquid assets on which secured creditors have a claim--and
obtaining DIP financing, if any. The disclosure statement filed after
the filing of the bankruptcy petition must include information on the
debtor's (financial institution's) assets, liabilities, and business
affairs sufficient to enable creditors to make informed judgments
about the debtor's plan of reorganization.[Footnote 15] Creditors need
to understand the reorganization plan because the court may not
confirm the plan unless, among other things, a sufficient proportion
of allowed creditors has either accepted the plan or is not impaired
by the plan.[Footnote 16] The court's approval also depends on whether
or not there are dissenting classes of creditors. The possible
outcomes of a Chapter 11 bankruptcy, which can be used in combination,
include liquidating the assets of the company with the approval of the
court (as opposed to liquidation by a bankruptcy trustee under Chapter
7), sale of the company, in whole or in part, which is sometimes
called a section 363 sale because that is the section of the Code that
applies to sales that are free and clear of creditor claims, and
actual reorganization of the company in which it emerges from
bankruptcy with new contractual rights and obligations that replace or
supersede those it had before filing for bankruptcy. During the
bankruptcy proceeding, the debtor, or one or more creditors with an
allowed claim, and other interested parties, may initiate adversary
proceedings--in effect, a lawsuit within the bankruptcy case. Debtors
initiate adversary proceedings to preserve or recover money or
property for the estate; for example, property that may have been
transferred in the resolution of a regulated entity such as an insured
depository. Creditors may initiate adversary proceedings to
subordinate a claim of another creditor to their own claims or for
other similar reasons.
Figure 1: Chapter 11 Bankruptcy Process for a U.S.-Headquartered
Financial Institution as of June 2011:
[Refer to PDF for image: illustration]
Holding company:
1) Unregulated legal entities:
Chapter 11 bankruptcy;
Debtor voluntarily files for bankruptcy; or:
Creditors initiate involuntary bankruptcy.
Automatic stay for all assets except qualified financial contracts
(QFC); (Closing and netting of QFCs).
Ancillary proceedings:
Adversary proceeding (U.S. debtor and creditor, two U.S. creditors,
etc.);
Chapter 15 proceeding;
First day motions;
Disclosure statement;
Confirmation of plan:
Ladder of unsecured creditor priorities:
- DIP financers;
- Taxing authorities;
- Unsecured creditors;
- Shareholders.
Potential outcome(s) (any single one or combination is possible):
Assets liquidated;
Company sold in 363 sale;
Company reorganized.
2) Broker-dealer:
SIPA proceeding or special provision of Chapter 7;
Commodity broker:
Special provision of Chapter 7.
3) Foreign subsidiary:
Insolvency or regulatory process (varies by location);
A foreign proceeding may be tied to a U.S. proceeding through a
Chapter 15 filing.
4) Insured depository institution:
FDIC process.
5) Insurance company:
State resolution process.
Source: GAO analysis of U.S. Court information
Note: Qualified Financial Contracts are contracts specified in the
Bankruptcy Code as exempt from the automatic stay. These contracts are
discussed in more detail throughout the body of this report and in
appendix VII. Chapter 15, which is also discussed throughout this
report, governs judicial cross-border coordination and foreign
subsidiaries may be engaged in Chapter 15 cases. 363 sales are denoted
as such because they are governed by section 363 of the Bankruptcy
Code.
[End of figure]
As shown in table 1, only a few large financial institutions--those
with assets of at least $100 million and at least 1,000 creditors or
more--actually filed for bankruptcy under Chapter 11 from 2000 through
2009.
Table 1: Chapter 11 Mega Bankruptcy Filings, by Total Filings and
Financial Institution Filings, 2000-2009:
Year: 2000;
Chapter 11 mega filings: Total number of filings: 63;
Chapter 11 mega filings: Number of financial institution filings: 2.
Year: 2001;
Chapter 11 mega filings: Total number of filings: 101;
Chapter 11 mega filings: Number of financial institution filings: 1.
Year: 2002;
Chapter 11 mega filings: Total number of filings: 88;
Chapter 11 mega filings: Number of financial institution filings: 2.
Year: 2003;
Chapter 11 mega filings: Total number of filings: 73;
Chapter 11 mega filings: Number of financial institution filings: 1.
Year: 2004;
Chapter 11 mega filings: Total number of filings: 54;
Chapter 11 mega filings: Number of financial institution filings: 0.
Year: 2005;
Chapter 11 mega filings: Total number of filings: 31;
Chapter 11 mega filings: Number of financial institution filings: 2.
Year: 2006;
Chapter 11 mega filings: Total number of filings: 25;
Chapter 11 mega filings: Number of financial institution filings: 0.
Year: 2007;
Chapter 11 mega filings: Total number of filings: 13;
Chapter 11 mega filings: Number of financial institution filings: 4.
Year: 2008;
Chapter 11 mega filings: Total number of filings: 79;
Chapter 11 mega filings: Number of financial institution filings: 4.
Year: 2009;
Chapter 11 mega filings: Total number of filings: 118;
Chapter 11 mega filings: Number of financial institution filings: 6.
Year: Total;
Chapter 11 mega filings: Total number of filings: 645;
Chapter 11 mega filings: Number of financial institution filings: 22.
Sources: GAO analysis of AOUSC and New Generations Research, Inc. data.
[End of table]
Financial Institutions Can Be Parties to Contracts That Receive Safe
Harbor Protection:
Although the automatic stay is one of the central provisions of the
Code, it is subject to exceptions, one of which can be particularly
important in a financial institution bankruptcy.[Footnote 17] Commonly
referred to as a "safe harbor," this exception pertains to certain
financial and derivative contracts, often referred to as "qualified
financial contracts" (QFC), that are defined in the Code.[Footnote 18]
They include derivative financial products, such as futures contracts
and swap agreements that financial institutions, as well as
individuals and nonfinancial institutions, use to hedge against losses
from other transactions or to speculate on the likelihood of future
economic developments. Repurchase agreements, collateralized
instruments that provide short-term financing for financial
institutions and others, also receive safe harbor treatment.
Under these provisions, counterparties that entered into a transaction
with the debtor that qualifies for safe harbor treatment under the
Code may exercise their contractual rights even if doing so would
otherwise violate the automatic stay.[Footnote 19] Typically these
contractual rights are described in an ipso facto clause, which gives
the parties to a contract the right to terminate it or modify its
terms upon a counterparty's insolvency or the commencement of
bankruptcy proceedings.[Footnote 20] Such an occurrence constitutes a
default, and the nondefaulting party may liquidate, terminate, or
accelerate the contract, and may offset (net) any termination value,
payment amount, or other transfer obligation arising under the
contract when the debtor files for bankruptcy.[Footnote 21]
As with the Code, the FDI Act and the Dodd-Frank Act permit QFC
counterparties to move quickly to enforce their contractual rights,
notwithstanding the appointment of a receiver.[Footnote 22] After its
appointment as receiver, FDIC has three options in managing the
institution's QFC portfolio. FDIC can retain the QFCs in the
receivership; transfer the QFCs to another financial institution; or
repudiate (reject) the QFCs. Subject to some requirements described
below, FDIC can apply different options to QFCs with different
counterparties.
FDIC's first option is similar to the safe harbor provisions under the
Code. If FDIC retains QFCs in the receivership, the counterparty may
terminate the contract and exercise any contractual right to net any
payment the counterparty owes to the institution against the payment
the institution owes to the counterparty on a different QFC.[Footnote
23] While this right is immediate under the Code's safe harbor, the
QFC counterparty generally cannot exercise it against a failed insured
depository institution in FDIC receivership until after 5:00 p.m.
(eastern standard time or eastern daylight time) on a normal business
day following the date of appointment of FDIC as receiver.[Footnote
24] Because bank regulators almost always close depository
institutions on Fridays, the stay remains in effect until 5:00 p.m.
the following Monday. The second option involves FDIC's transfer of
QFCs to another financial institution or permissible entity. If FDIC
transfers a QFC to another financial institution, the counterparty
cannot exercise its contractual right to terminate the QFC solely as a
result of the transfer, the insolvency, or the appointment of the
receiver.[Footnote 25] Under the third option, FDIC may repudiate
(reject) a QFC, within a reasonable period of time, if FDIC determines
that the contract is burdensome.[Footnote 26] However, FDIC must pay
actual direct compensatory damages, which may include the normal and
reasonable costs of cover or other reasonable measure of damages used
in the industry for such claims, calculated as of the date of
repudiation. If FDIC decides to transfer or repudiate (reject) a QFC,
all other QFCs entered into between the failed institution and that
counterparty, as well as those QFCs entered into with any of that
counterparty's affiliates, must be transferred to the same financial
institution or repudiated at the same time.[Footnote 27]
Safe harbor treatment was first added to the Code in 1982 for forward
contracts, commodity contracts, and security contracts, and over time
the Congress has expanded the types of contracts and counterparties
covered.[Footnote 28] The most recent changes to the treatment of safe
harbor contracts under the Code in 2005 and 2006 expanded the safe
harbor treatment to contracts related to mortgage-backed securities
and repurchase agreements, an overnight source of funding used by
financial institutions, and included provisions to strengthen and
clarify the enforceability of such contracts.[Footnote 29] According
to legislative history and FDIC regulations, the purpose of these safe
harbors and the QFC provisions in the FDI Act is to maintain market
liquidity and reduce systemic risk, which we define as the risk that
the failure of one large institution would cause other institutions to
fail or that a market event could broadly affect the financial system
rather than just one or a few institutions.[Footnote 30]
Chapter 15 of the Bankruptcy Code Governs Judicial Cross-Border
Coordination:
In 2005, the United States adopted Chapter 15 of the U.S. Bankruptcy
Code.[Footnote 31] Chapter 15 is based on the United Nations
Commission on International Trade Law (UNCITRAL) Model Law on Cross-
Border Insolvency, which is intended to promote coordination between
courts in different countries during insolvencies and has been adopted
in 19 jurisdictions.[Footnote 32] Over 450 Chapter 15 cases have been
filed since its adoption, with over half filed in the Southern
District of New York and the District of Delaware.
Promoting cooperation between U.S. and foreign parties involved in a
cross-border insolvency case, providing for a fair process that
protects all creditors, and facilitating the rescue of a distressed
firm, are among the stated objectives of Chapter 15.[Footnote 33] In
pursuit of these goals, Chapter 15 authorizes several types of
coordination including:
* U.S. case trustees or other authorized entities operating in foreign
countries on behalf of a U.S. bankruptcy estate;
* foreign representatives having direct access to U.S. courts,
including the right to commence a proceeding or seek recognition of a
foreign proceeding; and:
* U.S. courts communicating information they deem important,
coordinating the oversight of debtors' activities, and coordinating
proceedings.
Chapter 15 excludes the same financial institutions that are generally
not eligible to file as debtors under the Code (such as insured
depository institutions and U.S. insurance companies), with the
exception of foreign insurance companies. It also excludes broker-
dealers that can be liquidated under SIPA or a special provision of
Chapter 7 of the Code and commodity brokers that can be liquidated
under a different special provision of Chapter 7. Based on the
UNCITRAL model law, Chapter 15 contains a public policy exception that
allows a U.S. court to refuse cooperation and coordination if doing so
would be "manifestly contrary to the public policy of the United
States."[Footnote 34]
D.C. District Court Has Issued Rules to Implement Required Judicial
Review under the Orderly Liquidation Authority:
OLA provisions establish a process for judicial review when a
financial company's board of directors (or the functional equivalent)
does not accept the appointment of FDIC as receiver following a
determination by the Secretary of the Treasury.[Footnote 35] Under
OLA, the Secretary is to make the determination, in consultation with
the President, based on seven factors, three of which are that the
company is a financial company, its insolvency would pose a threat to
the financial stability of the United States, and it is or is likely
to be "in default or in danger of default" (insolvent).[Footnote 36]
After making this determination, the Secretary must appoint FDIC as
receiver for the company unless the company refuses to "acquiesce or
consent" to the appointment. In that case, the Secretary must file a
petition with the D.C. District Court for an order authorizing the
Secretary to appoint FDIC as receiver.[Footnote 37] The court has 24
hours to review the petition and provide an opportunity for a hearing.
The court may decide only whether the Secretary acted arbitrarily or
capriciously in finding either that the company was a financial
company under OLA or that the company was in default or in danger of
default. The law does not authorize the court to review other aspects
of the Secretary's determination, such as whether the company posed a
threat to the financial stability of the United States (the systemic
risk determination). Although the D.C. District Court's decision can
be appealed on an expedited basis to the U.S. Court of Appeals for the
District of Columbia Circuit and thereafter to the Supreme Court, the
District's decision is not subject to any stay or injunction while any
appeal is pending.
The judicial review provision requires the D.C. District Court to
establish rules and procedures "as may be necessary" to ensure the
orderly conduct of the proceeding and to publish them and transmit
them to specific Congressional Committees--the Senate Committees on
the Judiciary and on Banking, Housing, and Urban Affairs and the House
Committees on the Judiciary and Financial Services--within 6 months of
the enactment of the Dodd-Frank Act.[Footnote 38] On January 19, 2011,
the D.C. District Court issued a rule (Local Civil Rule 85) in
response to this requirement, which is printed in its entirety in
appendix II of this report. Generally the rule reiterates the
procedural requirements in the Dodd-Frank Act. It provides for a 24-
hour review, during which the financial institution has the right to
oppose the Secretary's petition. The rule also defines the possible
outcomes. If the court does not rule on the petition within the 24-
hour period, or rules in favor of the Secretary, the receivership goes
forward immediately. If the judge rules that the Secretary's
determination was arbitrary and capricious with respect to one of the
two elements, the Secretary has the right to amend the petition and
file it again. The rule also acknowledges that the receivership will
go forward immediately even if the financial company decides to take
its opposition to it to a higher court, such as the U.S. Court of
Appeals. However, the rule also contains a mechanism not specified in
the law that may make the process more efficient and effective. It
requires the Secretary of the Treasury to notify the D.C. District
Court under seal at least 48 hours before the filing of a petition,
which would give the court time to prepare for the review. However, in
March 2011, FDIC and Treasury sent letters to the D.C. District Court
expressing concern that the 48-hour requirement would be impossible to
meet and could threaten U.S. financial stability. As of June 2011, the
D.C. District Court was considering comments on the rule.
The court has not yet tested the effectiveness of the rule because, as
of the time of FDIC's March 23, 2011, notice of proposed rulemaking
(NPR) the Secretary had not yet appointed FDIC as receiver, and FDIC
said that it did not have any expectation that it would be appointed
as receiver for any covered financial company in the near future.
[Footnote 39] Additionally, FDIC remains engaged in a rulemaking
relating to whether an institution is a financial company subject to
OLA, which the court might consider during its judicial reviews. FDIC
addressed the definition of a financial company for OLA purposes in
its March 23, 2011 NPR. Under Title II of the Dodd-Frank Act, the
definition of a financial company includes a bank holding company, a
nonbank financial company supervised by the Board of Governors of the
Federal Reserve System (Federal Reserve), and a company that receives
at least 85 percent of its consolidated revenues from activities that
are financial in nature or incidental under the BHC Act. In the March
NPR, FDIC proposed to rely primarily on the consolidated financial
statements of a company over a 2-year period to determine if 85
percent of revenues in either year came from financial activities. As
stated in the Dodd-Frank Act, the consolidated revenues are to include
revenues from subsidiary depository institutions, which are excluded
from the definition of covered financial companies. The comment period
for this NPR closed on May 23, 2011. As of July 8, 2011, FDIC had not
proposed rules to further define insolvency. However, under the Dodd-
Frank Act, a financial company shall be considered to be in default,
or in danger of default, if the company has filed or is likely to file
promptly for bankruptcy, has depleted or is likely to deplete its
capital, has assets that are less than or likely to be less than its
liabilities, or is or is likely to be unable to pay its debts.
[Footnote 40]
The Effectiveness of the Bankruptcy Code in Resolving Complex and
Internationally Active Financial Institutions Is Unclear:
Potential Criteria for Judging Effectiveness Include Maximizing Asset
Value but Not Minimizing Duration of Bankruptcy:
Most experts we interviewed agreed that maximizing asset values was
the most important criterion for judging the effectiveness of the
bankruptcy process. Under Chapter 7, in which a bankruptcy trustee
liquidates the debtor's assets and disperses the proceeds according to
a strict ladder of creditor and shareholder priorities, experts told
us that maximizing the return for creditors was the most important
criterion for judging the effectiveness of the process. Under Chapter
11, in which the debtor and its creditors negotiate a reorganization
plan, experts agreed that the goal is to maximize the value of a
business as a going concern, or a functioning entity. In either case,
having to sell assets at "fire sale" prices--below the asset's
fundamental value--would reduce returns to creditors and going concern
values.[Footnote 41] However, as we have noted in a previous report, a
substantially lower asset price may be consistent with the fundamental
value of that asset.[Footnote 42]
Various stages of the bankruptcy process can affect the ultimate value
of the debtor's assets. Some experts told us that having a plan for
proceeding with a bankruptcy is important; the time and resources
spent planning for the possibility of bankruptcy could increase
returns to creditors and thus improve the effectiveness of the
process. Some experts with whom we spoke highlighted the importance of
prebankruptcy planning by noting the bankruptcy of CIT--a bank holding
company engaged in small business lending and leasing. In the CIT
case, CIT reached an agreement with creditors before filing the
bankruptcy petition, which led to what some experts considered an
orderly bankruptcy process and reorganization. On July 5, 2011, CIT
was valued at $9.0 billion. In contrast, some experts described the
Lehman bankruptcy as disorderly, in part, because the institution did
not plan sufficiently for the possibility of bankruptcy.[Footnote 43]
Attorneys in the Lehman bankruptcy said management did not seriously
consider bankruptcy until about a week before filing, and an official
of the Securities and Exchange Commission (SEC) told us that Lehman
did not try to arrange for the sale of various components of the
institution until the week before its collapse. In part because of
Lehman's rush to sell certain assets, Lehman later claimed that the
buyer underpaid for those assets and sought additional compensation.
See appendixes III and IV for more information about the CIT and
Lehman bankruptcies, respectively.
Bankruptcy experts also told us that the automatic stay frees debtors
from creditor actions that could further deplete a firm's asset
values. The stay allows parties to gain control over the distribution
of assets. In a Chapter 7 bankruptcy, the bankruptcy trustee has full
control over the liquidation of the firm's assets. Legal experts told
us that, although control may be dispersed among different parties
under Chapter 11, the process is still considered predictable because
it follows a long-standing legal tradition, transparent because it
occurs under judicial review, and equitable because assets are
distributed either according to a strict ladder of creditor priorities
or through negotiated settlements in which all parties can
participate. Some legal experts stated that control over assets in a
bankruptcy is similar to that gained when a regulator--FDIC or a state
insurance commissioner--becomes the receiver of a depository
institution or insurer. However, some legal experts said that FDIC's
processes are less predictable and less transparent than the
bankruptcy processes, because FDIC resolutions do not operate under
court supervision.
Because a debtor's estate faces costs--such as attorneys' fees--during
a bankruptcy, the longer the company spends in bankruptcy, the higher
the costs are likely to be, reducing the value of a firm's estate.
However, the experts with whom we spoke generally agreed that
minimizing the overall time spent in bankruptcy was not an important
criterion for judging the effectiveness of a bankruptcy. Some
bankruptcies of financial institutions take a long time to resolve,
but a longer bankruptcy can lead to increased creditor recoveries. For
example, Bank of Credit and Commerce International (BCCI), a
multinational financial institution that failed in 1991, had not been
fully resolved as of June 2011. Despite this 20-year process,
creditors have benefited from increasing recoveries. Some experts we
interviewed also said that professional costs are likely too high, and
debtors' estates pay not only the fees of professionals assisting the
estate but also for attorneys and other professionals used by
creditors' and shareholders' committees. Nonetheless, an expert said
that these costs were relatively small compared with the overall value
of the assets at stake in a bankruptcy. This view that the overall
time in the bankruptcy may not be an important criterion for judging
the effectiveness of the process is supported by a study conducted by
research staff at the Federal Reserve. The study found that the value
of creditors' claims (bonds) in a bankruptcy tended to increase over
time up to a point and then tended to decrease.[Footnote 44] However,
this study did not specifically address financial institution
bankruptcies or consider a time of financial crisis when the time
frames for resolving insolvent financial institutions could be of
greater importance. Experts also noted that complex companies that
rushed through the bankruptcy process might file for bankruptcy again
if their reorganizations were not well conceived. As a result, experts
said that the total length of time of a bankruptcy should not be a
main focus in judging the Code's effectiveness.
Potential Criteria for Judging Effectiveness Also Include Systemic
Impacts, Which the Code Does Not Directly Address:
Systemic impacts are one reason that regulators supervise financial
institutions and have often been the rationale for providing
government assistance for certain markets or failing financial
institutions. Certain financial institutions--sometimes designated as
systemically important financial institutions--play a central role in
key financial markets and thus affect general credit availability or
have an effect on credit availability through their impact on other
financial institutions. For example, the Lehman failure affected
credit availability by lowering values in the commercial paper market,
which is used by employers throughout the economy to finance
payrolls.[Footnote 45] According to researchers at the Federal Reserve
Bank of New York (FRBNY), market participants saw the failure of
Lehman, an active commercial paper issuer, as a signal that the risks
of what had been perceived as a relatively safe, low-cost investment
had increased and no longer was consistent with the low interest rates
offered by issuers.[Footnote 46] The Lehman bankruptcy also had an
impact through its effect on money market funds. Because money market
funds hold large quantities of commercial paper, Lehman's bankruptcy
led the Reserve Primary Fund, a large money market fund with $65
billion of assets under management, to lose $785 million in holdings
of Lehman commercial paper and, for the first time, caused a retail
money market fund's shares to fall below one dollar. This caused
investors in money market funds to lose confidence and begin to remove
their money from this and similar funds. In response, the Department
of the Treasury extended a temporary government guarantee to eligible
participating money market funds. In addition, the Federal Reserve
authorized the Commercial Paper Funding Facility and the Asset-Backed
Commercial Paper Money Market Mutual Funding Liquidity Facility.
[Footnote 47]
As noted, the government often has provided assistance to offset or
prevent systemic effects and has also taken action to prevent firms
whose failure might have systemic effects from filing for bankruptcy.
For example, in 1998, Long-Term Capital Management (LTCM)--a hedge
fund that held $1.4 trillion in derivatives whose largest creditors
and counterparties were major domestic and foreign banking
institutions and investment firms--faced major liquidity problems.
Thus, its failure likely would have had a broad impact on other
financial institutions and the availability of credit throughout the
economy. As a result, FRBNY called together 14 of LTCM's
counterparties, and these industry participants organized a gradual
liquidation of LTCM outside of the bankruptcy process.[Footnote 48] At
the time, Federal Reserve officials expressed concern that the rapid
closing out of derivative contracts with LTCM would have led not only
to LTCM's insolvency but possibly to the insolvency of other firms as
well. More recently, after noting that the American International
Group, Inc. (AIG) faced the imminent prospect of declaring bankruptcy,
the Federal Reserve authorized the extension of emergency credit to
AIG, citing that its failure would have been disorderly and likely to
have systemic effects on already fragile financial markets.[Footnote
49]
Economists and regulators have expressed the view that systemic
factors--such as the extent to which a financial institution's failure
has an impact on other firms' asset values or on broader economic
stability--should be used to judge the effectiveness of the bankruptcy
process. Some economists with whom we spoke explained that, if failed
financial institutions were forced to sell assets at fire sale values,
the market value of those assets would decrease. Under current mark-to-
market accounting rules, which require that firms change the value of
the assets on their balance sheets to reflect changes in the market
prices of the assets, other financial institutions holding similar
assets could be forced to mark down their asset values as well. The
Department of the Treasury also has noted that during the financial
crisis, asset sales made in a highly leveraged environment led to a
vicious cycle in which declining asset prices triggered further
deleveraging and reductions in market liquidity, which in turn led to
further asset price declines.[Footnote 50] However, as noted earlier,
lower asset prices may be consistent with the prevailing fundamental
values of those assets. Those in the legal community that are involved
in financial institution bankruptcies, and those working with
economists and others on proposals to improve the Code's ability to
handle financial institutions, also recognized the importance of
considering systemic factors in judging the effectiveness of the Code
in facilitating the orderly liquidation or reorganization of financial
institutions. The Congress also recognized the importance of systemic
factors when it adopted OLA, which includes minimizing systemic risk
as one of its goals.
Nevertheless, the Code does not directly address systemic risks.
According to some legal experts, the practice of bankruptcy courts is
to deal only with the matters before them; systemic issues are not
considered. When asked about the impact of a bankruptcy on other
firms, legal experts who did not have significant experience with
financial institutions said that they did not think it relevant to
judging the effectiveness of a bankruptcy. However, the Code does
address systemic risks indirectly by providing safe harbor treatment,
such as protection from the automatic stay, for certain contracts--
QFCs--widely used by financial institutions (see app. VII). Financial
and legal experts have noted that to offset some systemic factors,
such as those associated with the LTCM failure, safe harbor treatment
was expanded in 2005 to include additional types of contracts--such as
repurchase agreements.
Several Factors Add to the Difficulty of Measuring Effectiveness of
the Code for Resolving Failures of Complex, Internationally Active
Financial Institutions:
Measuring the effectiveness of the Code for facilitating orderly
liquidations or reorganizations of complex and internationally active
financial institutions is difficult because few of these firms have
filed for bankruptcy and many of the more complex and global
institutions have filed only recently.
Few large-scale bankruptcies. The paucity of complex or
internationally active financial institutions among large-scale
bankruptcies has resulted, in part, from (1) alternative resolution
requirements and (2) governmental assistance to complex and
internationally active financial institutions. Depository institutions
and insurance companies cannot file for bankruptcy protection, and
broker-dealers cannot file for reorganization under Chapter 11, as
noted earlier. In addition, the government often has provided
financial or other assistance, such as facilitating industry action,
to complex financial institutions, such as LTCM and AIG, that
otherwise might have declared bankruptcy, because they posed systemic
risks. Assessing the bankruptcies that have occurred is also
difficult, because many of the most complex cases are recent, and
their outcomes are still unclear. One bankruptcy expert told us that
if a firm still were operating effectively 2-3 years after emerging
from bankruptcy, he would say the proceedings had been successful. The
two largest financial institution bankruptcy cases in the United
States--Washington Mutual and Lehman--still are ongoing, so it is
difficult to provide a definitive assessment of the effectiveness of
these cases at this time.
Lack of data. For those financial institutions that have declared
bankruptcy, data are not readily available for evaluating the
effectiveness of the Code. AOUSC has collected some data on bankruptcy
outcomes, such as the closing date for large cases. But it neither
specifically collects information on cases involving financial
institutions, nor does it track the value of creditor returns or the
value of firms emerging from bankruptcy. The bankruptcy courts only
collect data on the type of business in which an institution is
engaged if the data are pertinent to provisions of the Code. Thus, the
court tracks whether a bankruptcy involves a broker-dealer because it
needs to know whether the bankruptcy courts would be operating under
SIPA or specific provisions of the Code relative to liquidating broker-
dealers. It does not track financial institutions beyond those cases
because no special legal considerations arise. In addition, because
data come directly from filings by the firms' attorneys, the courts
generally rely on self-reported data, and AOUSC staff said they would
do the same for other potential data that could be collected such as
whether the firm is a financial institution. AOUSC staff said that,
while they generally rely on self-reported data, they do perform
certain data checks, including looking for outliers. Some
organizations and researchers have taken the court data and augmented
it with other kinds of data that might allow users to identify
financial institutions, but researchers have not used these data to
study how bankruptcies of financial institutions differ from other
types of bankruptcies or how a systemic market event could impact the
effectiveness of the bankruptcy process. However, researchers have
studied the impact of certain factors on the effectiveness of
bankruptcies, including the Federal Reserve study of the impact of
time and studies of the effect of filing in particular courts on the
effectiveness of bankruptcies.[Footnote 51]
Government involvement. Even when the government does not step in to
prevent complex financial institutions from filing for bankruptcy,
evaluating the bankruptcy process is difficult. Even in cases where
financial institutions have declared bankruptcy, the government often
has provided assistance either before or during the bankruptcy. In two
of the three largest bankruptcies of financial institutions--CIT and
Lehman--the government provided financial assistance. In the case of
CIT, the debtor was able to emerge as a going concern and come through
reorganization quickly (within 1 month), which some said indicated a
successful resolution. However, the success of this bankruptcy was, in
part, facilitated by CIT receiving government assistance in the form
of Troubled Asset Relief Program (TARP) funding. Although CIT received
this funding 10 months before declaring bankruptcy, and at a time when
it hoped to avoid doing so, the funding allowed CIT the time to more
effectively plan for the bankruptcy, including time to negotiate with
its creditors to develop an acceptable restructuring plan. Because
TARP assistance was structured in a way that gave the government low
priority in case of a bankruptcy, it received no repayment in the
bankruptcy process.[Footnote 52] Similarly, the Federal Reserve
authorized FRBNY to provide assistance to broker-dealers through its
Primary Dealer Credit Facility. Under that facility, FRBNY extended
$28 billion in credit to Lehman Brothers, Inc. (LBI), the broker-
dealer and commodity broker subsidiary of Lehman Brothers Holding,
Inc. (LBHI), on September 15, 2008, the same day the parent company
filed for bankruptcy.[Footnote 53] However, the terms of the facility
provided FRBNY with a position as a secured creditor of the firm,
giving it higher priority in the event of a bankruptcy. LBI continued
to borrow under the Primary Dealer Credit Facility for 2 more days,
and, on September 18, 2008, the day before Barclays PLC assumed many
of LBI's accounts, Barclays borrowed more than $47 billion through the
same facility.[Footnote 54] This additional liquidity allowed LBI, the
broker-dealer subsidiary, to remain a going concern until some of its
assets and liabilities could be sold to Barclays and, thus, affected
the value of the estate more broadly. The remaining parts of LBI are
the subject of a SIPA proceeding. According to the Federal Reserve,
LBI and Barclays repaid their overnight loans with interest.
Complex Financial Institutions Pose Challenges for Liquidations or
Reorganizations:
Our review of literature on bankruptcies and financial institutions,
as well as interviews with experts in these fields, identified several
characteristics of complex financial institutions that pose challenges
for liquidations and reorganizations. Some of the legal and economic
experts we interviewed told us that large financial institutions would
not necessarily be any more difficult than other large firms to take
through bankruptcy. Complex financial institutions, regardless of
their size, were viewed as more difficult because of the nature of
their businesses and their interconnected organizational structures.
Specifically, the characteristics of complex financial institutions
that make their liquidation or resolution through bankruptcy difficult
include the highly liquid nature of financial institutions' funding
sources, their use of derivatives and other financial contracts not
subject to the Code's automatic stay, and institutions' separate yet
interconnected legal structures (separate entities often created to
gain tax and regulatory advantages) that are not congruent with their
integrated operational structures.
Funding Sources and Use of Derivatives:
Some financial institutions are dependent on short-term, highly liquid
funding sources to finance assets that have longer-term maturities and
are not easy to sell. When depositors, lenders, counterparties, or
investors lose confidence in an institution, the institution may be
subject to a run--a sudden removal of its liquid funding sources--that
will force the institution to sell assets at fire sale prices,
impairing its solvency in a way that could ultimately lead to its
failure. The existence of runs in retail depository institutions has
long been acknowledged, but the 2008 financial crisis demonstrated
that complex financial institutions that lend money to other financial
institutions in what is referred to as the wholesale market also are
subject to runs. Although deposit insurance is designed to limit these
runs, for larger institutions, runs continued to play a role during
the 2008 crisis. Runs created by the loss of depositor confidence
contributed, in part, to the failures of IndyMac, FSB, and Washington
Mutual Bank, and fear of a depositor run was one of the reasons the
government cited for providing assistance to Citigroup Inc. during the
crisis. Similarly, in 2008, uncertainty about the financial condition
and solvency of financial institutions caused other financial
institutions to raise the prices they charged for short-term funds in
wholesale markets, and interbank lending slowed substantially. For
example, in 2008 after Bear Stearns and Co.--an investment firm
participating in wholesale markets--failed, the then-SEC Chairman
noted that the firm failed when many lenders, concerned that the firm
would suffer greater losses in the future, stopped providing funding,
even on a fully secured basis with highly-rated assets as collateral.
[Footnote 55] Lehman also faced a liquidity crisis when banks refused
to lend money for its brokerage and other services. An official
familiar with Lehman's bankruptcy proceedings said that just before
the institution declared bankruptcy, Lehman had to roll over borrowing
of about $100 billion dollars every day to pay off maturing commercial
paper and other commitments.
Complex financial institutions are principal users of derivative
contracts, and this is another factor that makes their bankruptcy
proceedings more challenging. The exemption from the automatic stay
for these QFCs was designed to help ensure that financial markets and
institutions remained liquid during bankruptcies. The concern is that,
if these markets froze, credit would not be available in the economy
generally. However, when a financial institution itself is the debtor,
the exemption can negatively affect it and lead to a number of
adversary proceedings related to the safe harbor treatment. For
example, a bankruptcy attorney familiar with the Lehman bankruptcy
case told us that much of the value in Lehman declined after the
institution's counterparties used the safe harbor to terminate
contracts where they stood to gain (and Lehman lose) and keep those
alive where they would have experienced losses (and Lehman gains).
Approximately 80 percent of the derivative counterparties to Lehman's
primary U.S. derivatives entity terminated their contracts within 5
weeks of Lehman's bankruptcy filing. Questions have also arisen over
the course of the bankruptcy about the setoff rights of QFC
counterparties. For example, Swedbank AB, a Swedish bank, that was a
creditor of Lehman Brothers Holdings, Inc., sought to offset Lehman's
payment obligations under prepetition swaps with deposits Lehman had
made at Swedbank after filing for bankruptcy. The Bankruptcy Court of
the Southern District of New York ruled against Swedbank, concluding
that offset rights under the Code only exist when, among other things,
"mutuality" exists. That is, mutuality would exist when the debtor's
claim against the creditor and the debt owed to the creditor are
mutual, as determined under principles of bankruptcy and contract law.
However, the court held that no mutuality existed because the funds in
the Swedbank account were deposited after the bankruptcy petition was
filed, while Lehman's payment obligations under the swaps arose before
the petition was filed.[Footnote 56] In another proceeding involving
the Lehman bankruptcy, a lender, Bank of America, seized the debtor's
account funds, which were unrelated to any safe harbor transaction.
The court ruled that the bank's use of the funds to set off the
transactions violated the automatic stay.[Footnote 57] Also, experts
have noted that the exemption from the stay could weaken market
discipline because creditors do not stand to lose as much from
bankruptcy as they would with other types of financing.
Organizational Structures and Interconnectedness:
Financial institutions often have complex legal structures that do not
reflect their operational and strategic alignment and include both
regulated and unregulated subsidiaries.[Footnote 58] To the extent
that institutions' operating structures increase their value through
economies of scope and scale, splitting them up by legal entity likely
would lower their value. However, the complex arrangement of the legal
entities and various regulatory insolvency processes can pose
significant challenges in bankruptcy, as judges and regulators must
attempt to resolve pieces of an interconnected institution separately.
These challenges are especially evident when regulators become
involved in the resolution of nonregulated entities.
The organizational structure, including the number and types of
subsidiaries in a financial institution, usually develops over time
for different business reasons, but it typically does not coincide
with the institution's operational or strategic business functions, as
economists, government officials, and financial institution executives
have noted.[Footnote 59] Instead, the legal entities often are set up
to benefit from tax or regulatory differences or to obtain higher
credit ratings. For example, institutions obtain tax advantages by
setting up a holding company structure that allows subsidiaries to
transfer tax savings to the parent company.[Footnote 60] And, at some
failed institutions, regulatory advantages were gained by placing
subprime mortgage assets that had been securitized in an off-balance
sheet vehicle that was not subject to regulatory capital adequacy
requirements imposed on the consolidated entity, although the entity
retained significant risk.[Footnote 61] Institutions also set up legal
entities called special purpose vehicles, legally separate from the
parent entity, to issue specific structured finance products such as
asset backed securities. As a result, rating agencies could rate
products higher than the parent institution's debt.[Footnote 62]
Because the financial institution usually operates its businesses
without regard for the legal separateness of these entities, breaking
it up along legal entity lines for the purposes of bankruptcy likely
would lower the value of the consolidated entity.
Although some bankruptcy cases are administered together in what is
called procedural consolidation, the courts still must separate assets
so that creditors of a given legal entity receive payouts only on the
basis of that entity's assets. For example, in the Lehman bankruptcy,
many legal entities in the United States filed separate cases, which
have been procedurally consolidated under a single judge in the
Southern District of New York. However, the complex interrelationships
among Lehman's entities have to be unwound so that the claims of
creditors of the different entities can be addressed. Reports by the
Lehman bankruptcy examiner and SIPA trustee reports document the many
ways in which the parent company--Lehman Brothers Holdings, Inc.--and
its subsidiaries were linked.[Footnote 63] For example, the examiner
had to map Lehman's centralized cash management system to determine
which legal entities were entitled to claim certain assets.
In unusual cases, the interconnectedness of the debtor's estate with
related entities can lead to a bankruptcy court's use of a doctrine
known as "substantive consolidation." The doctrine, developed by case
law, permits a court in a bankruptcy case involving one or more
related corporate entities to disregard the separate identities of
entities and to consolidate and pool their assets and liabilities in
order to treat them as though held and incurred by one entity. The
process creates a single estate for the benefit of all creditors for
all the consolidated corporations and combines the creditors into one
consolidated body.[Footnote 64] For example, in the early 1990s, the
court applied the doctrine in confirming the Chapter 11 reorganization
plan of Drexel Burnham Lambert Group, Inc. (a holding company for an
investment group) and certain of its eligible subsidiaries.[Footnote
65] In the Lehman bankruptcy, some creditors maintain that because the
parent company guaranteed the trades for different entities,
distributions should be made across all parties equally, according to
the ladder of creditor priorities. Other creditors argue that there is
no legal rationale for not respecting the separate corporate status of
the individual Lehman debtors. On June 29, 2011, the holding company
provided a new plan, agreed to by the creditors, which includes a
compromise on substantive consolidation. The plan's settlement takes
into account the different outcomes that would occur if either the
proconsolidation or anticonsolidation plans were approved, and
subsequent litigation that would likely follow if one of those plans
were adopted. (For more detail on these issues, see appendix IV).
The complexity of a liquidation or reorganization of a consolidated
financial institution likely would be even greater if the institution
has regulated subsidiaries that do not qualify as a debtor under the
Code, such as depository institutions or state-regulated insurance
companies. When these regulated entities fail and are liquidated by
regulators, the prospects for reorganization of their holding
companies may be limited. In cases where the holding company's main or
major assets consist of one or more regulated subsidiaries, the
holding company likely will be forced to declare bankruptcy when the
subsidiary fails. The subsidiaries' insolvencies, which are resolved
outside of the bankruptcy process, leave fewer assets available for
the holding company's creditors to recover in liquidation or for use
in reorganizing the remaining parts of the firm. For example, after
its primary asset--Colonial Bank--was placed into FDIC receivership,
Colonial BancGroup--the parent holding company--reported liabilities
of $380 million and assets of only $45 million in its bankruptcy
filing. In the case of Washington Mutual, legal practitioners familiar
with the case told us that holding company executives were generally
unaware that FDIC was being appointed as receiver of their subsidiary
until the day the announcement was made and, within hours, the
depository institution, Washington Mutual Bank, was transferred to a
third party, leaving the holding company unprepared to file for
bankruptcy.
For some complex financial institutions with regulated subsidiaries,
the regulator may become a creditor in the bankruptcy proceedings.
FDIC is often a creditor in bank holding company bankruptcies when
FDIC seeks to recover amounts associated with its role in resolving
the depository institution subsidiary.[Footnote 66] Issues can arise
over the ownership of assets (i.e., whether assets such as tax refunds
belong to the depository institution or the holding company) and the
status of FDIC's claim as a creditor. Additionally, an issue can arise
concerning the parent's financial responsibility, if any, for the
bank. The Washington Mutual bankruptcy is an example of disputes over
the ownership of the assets. In that proceeding, the debtor has sued
FDIC to regain certain of its deposits that had been placed at the
depository institution before they were transferred to JPMorgan Chase
and Co. (JPMC). As of June 2011, the parties had reached an agreement
over these and other assets, but shareholders have not accepted the
agreement, and the judge is continuing to hear their claims before
approving a final reorganization plan.[Footnote 67] In the other two
cases at which we looked in depth--CIT and Lehman--the holding
companies and some affiliates have gone through bankruptcy while their
subsidiary depository institutions continued to operate.[Footnote 68]
Experts familiar with these cases said the estates have worked with
FDIC to show that keeping insured depositories open and well-
capitalized was a lower-cost solution than placing them in
receivership. Officials at FDIC said that it was not common for a
holding company to declare bankruptcy while its depository institution
subsidiaries continued to operate. They said that, in the case of the
CIT and Lehman depositories, FDIC used cease and desist orders to
insulate the institutions it oversees from the bankruptcies of their
respective holding companies.[Footnote 69] The cease and desist orders
required prior FDIC approval for any affiliate transactions, the
declaration or payment of dividends, and any other payment
representing a reduction in capital.
Broker-dealers may file a petition for liquidation under Chapter 7 of
the Code or may be subject to proceedings under SIPA for the
protection of customers. Their parent companies and eligible
affiliates may qualify for reorganization under Chapter 11; however,
the interrelationships among affiliates in complex financial
institutions complicates these cases. In the case of Lehman's broker-
dealer, for example, determining whether affiliates of the broker-
dealer were entitled to SIPA protections has posed substantial
challenges for the SIPA trustee.[Footnote 70] In addition, when
affiliates of a broker-dealer or its holding company file for
bankruptcy, the broker-dealer is likely to experience some negative
impacts as well and may need to be liquidated. For example, when
Drexel Burnham Lambert Group declared bankruptcy in the 1990s, market
participants and creditors lost confidence in Drexel's solvent
subsidiaries, including its large broker-dealer, and were unwilling to
enter into new transactions. Following that, SEC and other regulators
transferred the broker-dealer's customer accounts and wound it down.
Internationally Active Financial Institutions Pose Additional
Challenges for the Bankruptcy Process:
Financial institutions can have assets and customers throughout the
world. Similar to domestic institutions, they may locate subsidiaries
in particular countries to gain tax and regulatory advantages. As a
result, subsidiaries, assets, and creditors may be subject to separate
insolvency regimes in various countries. Differences in laws and
insolvency systems and the national interests of the countries add to
the complexity of bankruptcy proceedings. Several legal experts
pointed out that even one contract, such as a derivative, may be
written in New York and hedged in London so that a bankruptcy pulls
the two-sided contract apart and subjects it to two different legal
regimes--that of the United States and of England. Many of the
complexities in the Lehman bankruptcy have come about because Lehman
operated subsidiaries in 21 countries. These complexities included (1)
having all of the cash in New York when its bankruptcy was declared,
leaving foreign subsidiaries with no cash to retain employees needed
to help liquidate or reorganize subsidiaries in those countries; (2)
the failure to share needed information across countries; and (3)
different decisions being rendered in the United States and England
regarding the same securities. Similarly, in assessing the problems at
AIG, economists faced challenges understanding how and to what extent
its myriad U.S. and foreign subsidiaries were viable.[Footnote 71] At
the end of 2008, AIG comprised at least 223 companies and had
operations in over 130 countries and jurisdictions worldwide.[Footnote
72] Table 2 documents the extent to which large international
financial institutions operate across international borders.
Table 2: Thirty of the Largest International Financial Institutions
(Ranked by Size) and Their Subsidiaries and Branches:
Dollars in thousands (U.S.):
Financial institution[A]: BNP Paribas SA;
Total assets, year end 2010: $2,680,292,421;
Country of headquarters: France;
Number of countries with operations, most recent available: More than
80.
Financial institution[A]: Deutsche Bank AG;
Total assets, year end 2010: $2,556,177,062;
Country of headquarters: Germany;
Number of countries with operations, most recent available: 74.
Financial institution[A]: HSBC Holdings plc;
Total assets, year end 2010: $2,454,689,000;
Country of headquarters: UK;
Number of countries with operations, most recent available: 87.
Financial institution[A]: Barclays PLC;
Total assets, year end 2010: $2,332,673,035;
Country of headquarters: UK;
Number of countries with operations, most recent available: More than
50.
Financial institution[A]: Royal Bank of Scotland Group plc;
Total assets, year end 2010: $2,276,191,669;
Country of headquarters: UK;
Number of countries with operations, most recent available: 39.
Financial institution[A]: Bank of America Corporation;
Total assets, year end 2010: $2,264,909,000;
Country of headquarters: United States;
Number of countries with operations, most recent available: More than
41.
Financial institution[A]: Mitsubishi UFJ Financial Group, Inc.;
Total assets, year end 2010: $2,183,944,247;
Country of headquarters: Japan;
Number of countries with operations, most recent available: More than
40.
Financial institution[A]: Crédit Agricole SA;
Total assets, year end 2010: $2,137,530,516;
Country of headquarters: France;
Number of countries with operations, most recent available: 70.
Financial institution[A]: JPMorgan Chase & Co.;
Total assets, year end 2010: $2,117,605,000;
Country of headquarters: United States;
Number of countries with operations, most recent available: More than
60.
Financial institution[A]: Mizuho Financial Group, Inc.;
Total assets, year end 2010: $1,671,913,220;
Country of headquarters: Japan;
Number of countries with operations, most recent available:
Approximately 30.
Financial institution[A]: Citigroup Inc.;
Total assets, year end 2010: $1,913,902,000;
Country of headquarters: United States;
Number of countries with operations, most recent available: 160.
Financial institution[A]: ING Groep N.V.;
Total assets, year end 2010: $1,667,128,102;
Country of headquarters: Netherlands;
Number of countries with operations, most recent available: 49.
Financial institution[A]: Banco Santander SA;
Total assets, year end 2010: $1,633,133,042;
Country of headquarters: Spain;
Number of countries with operations, most recent available: 28.
Financial institution[A]: Lloyds Banking Group plc;
Total assets, year end 2010: $1,554,083,934;
Country of headquarters: UK;
Number of countries with operations, most recent available: More than
30.
Financial institution[A]: Société Générale SA;
Total assets, year end 2010: $1,518,540,577;
Country of headquarters: France;
Number of countries with operations, most recent available: 83.
Financial institution[A]: UBS AG;
Total assets, year end 2010: $1,410,932,948;
Country of headquarters: Switzerland;
Number of countries with operations, most recent available: More than
50.
Financial institution[A]: Wells Fargo & Company;
Total assets, year end 2010: $1,258,128,000;
Country of headquarters: United States;
Number of countries with operations, most recent available: 36.
Financial institution[A]: UniCredit SpA;
Total assets, year end 2010: $1,246,797,525;
Country of headquarters: Italy;
Number of countries with operations, most recent available:
Approximately 50.
Financial institution[A]: Credit Suisse Group AG;
Total assets, year end 2010: $1,105,403,813;
Country of headquarters: Switzerland;
Number of countries with operations, most recent available: More than
50.
Financial institution[A]: Commerzbank AG;
Total assets, year end 2010: $1,011,802,817;
Country of headquarters: Germany;
Number of countries with operations, most recent available: 50.
Financial institution[A]: AXA Group;
Total assets, year end 2010: $981,425,889;
Country of headquarters: France;
Number of countries with operations, most recent available: 60.
Financial institution[A]: Goldman Sachs Group, Inc.;
Total assets, year end 2010: $911,332,000;
Country of headquarters: United States;
Number of countries with operations, most recent available: 34.
Financial institution[A]: Intesa Sanpaolo SpA;
Total assets, year end 2010: $883,644,534;
Country of headquarters: Italy;
Number of countries with operations, most recent available: 39.
Financial institution[A]: Allianz Group;
Total assets, year end 2010: $838,289,738;
Country of headquarters: Germany;
Number of countries with operations, most recent available: 70.
Financial institution[A]: Morgan Stanley;
Total assets, year end 2010: $807,698,000;
Country of headquarters: United States;
Number of countries with operations, most recent available: 28.
Financial institution[A]: Nordea Bank AB;
Total assets, year end 2010: $779,126,761;
Country of headquarters: Sweden;
Number of countries with operations, most recent available: 14.
Financial institution[A]: Dexia SA;
Total assets, year end 2010: $760,207,914;
Country of headquarters: Belgium;
Number of countries with operations, most recent available: 34.
Financial institution[A]: Banco Bilbao Vizcaya Argentaria SA;
Total assets, year end 2010: $741,432,036;
Country of headquarters: Spain;
Number of countries with operations, most recent available: More than
30.
Financial institution[A]: MetLife, Inc.;
Total assets, year end 2010: $730,906,000;
Country of headquarters: United States;
Number of countries with operations, most recent available: More than
60.
Financial institution[A]: Royal Bank of Canada;
Total assets, year end 2010: $712,665,358;
Country of headquarters: Canada;
Number of countries with operations, most recent available: 52.
Financial institution[A]: Average;
Total assets, year end 2010: $1,532,063,476;
Number of countries with operations, most recent available:
Approximately 53.
Sources: GAO analysis of SNL Financial and publicly available company
information.
[A] Because of their specialized function and treatment, Fannie Mae
and Freddie Mac are not included in this list. The source also does
not include financial institutions in certain countries such as China.
[End of table]
Whether the Bankruptcy Code Is More or Less Effective Than
Alternatives Is Also Unclear:
Whether resolving financial institutions through bankruptcy would be
more or less effective--that is, maintain asset values and minimize
systemic risk--than resolving institutions through other processes
such as FDIC receivership under OLA is not clear. Both the bankruptcy
courts and FDIC have had some experience addressing the failures of
complex, internationally active financial institutions and have dealt
with fluctuating numbers of failures, which could be important during
a financial crisis. The bankruptcy courts have a long-standing
tradition of administering bankruptcy cases including a number of
complex cases, such as those of Enron Corp. and WorldCom, Inc. In
addition, the courts have dealt with variation in the volume of
bankruptcies over economic cycles (see table 1). Because FDIC has been
resolving insured depositories over a long period of time, it also has
some experience addressing the issues posed by financial institutions
and is familiar with the dramatic variation in failure rates brought
on by market events. For example, FDIC dealt with the large number of
failures during the savings and loan crisis in the 1980s and1990s and
has handled more than 300 depository failures since 2007, following a
period from 2004 to 2007 when failures had fallen to zero.[Footnote 73]
However, both the bankruptcy courts and FDIC lack experience in
handling failures of large numbers of complex, internationally active
institutions during a financial crisis. As noted earlier, bankruptcy
courts have not dealt with a large number of bankruptcies involving
such institutions for a number of reasons. These reasons include the
government's ability and willingness to provide assistance to
systemically important financial institutions, a practice that the
Dodd-Frank Act restricts, and the majority of the assets in these
institutions sometimes being in regulated subsidiaries subject to
regulatory resolution processes. Similarly, while FDIC has resolved
large numbers of small institutions, it has had limited experience
resolving institutions with foreign subsidiaries and often has
resolved a depository institution by selling it to another
institution--a solution that may be less practical when large, complex
financial institutions fail, especially when they fail in a short time
span. Some legal experts and policymakers have noted that these
acquisitions create even larger institutions, making future
insolvencies more difficult to resolve. Although FDIC has not been
appointed receiver for any institution under OLA, it has analyzed how
it would have handled the Lehman failure under OLA. FDIC's analysis
includes more effective planning by Lehman leading up to a resolution
and Barclays' willingness to buy Lehman's distressed assets.[Footnote
74] However, critics have noted that both of these options were
available under the Code and that the analysis does not acknowledge
the widespread weakness in financial markets that affected many
financial institutions during the financial crisis. Because FDIC has
not yet dealt with an actual failure under OLA, it might not be
appropriate to compare its analysis of Lehman with the actual
experience under the Code. However, in commenting on this report, FDIC
officials noted that the OLA has several advantages over the current
Code that likely would have preserved Lehman's value including the
requirement to plan for a resolution and FDIC's ability to transfer
QFCs to a bridge entity.
Bankruptcy Proposals Address Some Financial Institution Challenges,
but There Is No Consensus on Specifics:
Questions about the effectiveness of the bankruptcy process for
liquidating or reorganizing financial institutions have prompted some
financial and legal experts--sometimes working in interdisciplinary
groups--as well as government officials to propose changes to the
Code, or to the supervisory process leading up to a bankruptcy filing.
These proposals generally focus on or combine several types of
actions: (1) increasing opportunities for bankruptcy planning, (2)
providing for regulatory input in the bankruptcy process, (3)
modifying safe harbor exceptions to the automatic stay for QFCs, (4)
treating firms on a consolidated basis, and (5) improving court
expertise on financial issues. Experts sometimes agree on the need for
a particular type of action to address challenges posed by financial
institutions, but they often do not agree on the effectiveness of
specific proposals.
Improving Bankruptcy Planning May Help Maintain Going Concern Value or
Avoid Bankruptcy:
Many of the experts with whom we spoke noted that a lack of planning
in the Lehman bankruptcy contributed to its disorderliness and that
better planning would improve the effectiveness of liquidations and
reorganizations under the Code. Better planning would lessen the
likelihood of precipitous declines in asset values and thus might
increase the returns to creditors, enhance the likelihood that a
financial institution could be successfully reorganized, and lessen
the systemic impact of a financial institution bankruptcy.
Nonetheless, there was little consensus on specific actions needed to
achieve these desired outcomes.
The Dodd-Frank Act has created a process for the prudent supervision
of large financial institutions that regulators believe will
facilitate resolution planning for those institutions. Large bank
holding companies and nonbank financial companies supervised by the
Federal Reserve now must formulate and submit a resolution plan known
as a "living will."[Footnote 75] Financial institutions with the
potential to be systemically important are required to submit and
maintain resolution plans, as well as other periodic reports, in order
to allow for the rapid and orderly resolution of the company. The
Federal Reserve and FDIC issued a joint proposed rule on the
requirements for the plans on April 22, 2011; according to agency
officials, the agencies expect to issue the final rule by January 21,
2012.[Footnote 76] Under the proposal, companies subject to the rule
would have to submit a resolution plan within 180 days of the
effective date of the final rule; however, this may change as a result
of comments on the rule. As described in the preamble, the proposed
rule would require a strategic analysis by the covered company of how
it could be resolved under Title 11 of the U.S. Code in a way that
would not pose systemic risk to the financial system. According to
some experts, one purpose of these resolution plans is to guide
regulators and institutions through the complex legal structures of
large, complex financial institutions in the event of financial
distress. The plans also may be used to encourage or require financial
companies to simplify their legal structures and business lines so
that any resolution in case of failure would be more orderly. Some
regulatory and industry experts contend that effective resolution
planning will help ensure the continuance of companies' critical
functions, which would maintain the company's value and reduce
disruptions to the wider economy. Additionally, a Pew Research report
setting out standards for the plans has acknowledged that these plans
might be useful in a bankruptcy case itself.[Footnote 77] However,
some experts have noted that the plans themselves have drawbacks, and
when facing an actual bankruptcy, might be of limited use.
Institutions and trade associations have responded to the planning
requirements by noting that breaking up institutions or otherwise
changing their structure would decrease their value. In addition, some
financial and legal experts said that although resolution plans might
help institutions and regulators increase their understanding of the
complexities of financial institutions, the plans (which would
generally be revised annually or within 45 days of a material event)
might not be as helpful as hoped during times of financial distress
because so much of a company's contracts, assets, and liabilities
could change dramatically from day to day.
Two related proposals, which could improve planning, and perhaps avoid
bankruptcy, are to either allow or require firms to hold contingent
convertible capital. Contingent convertible bonds, sometimes known as
"Co-Cos," are bonds that convert to equity at a contractually
determined trigger point, typically when a company falls below capital
requirements or otherwise experiences some measure of financial
distress. The required version of the proposed convertible bond
instruments, sometimes called "bail-ins," convert from debt to equity
when a regulatory triggering event occurs. The purpose of requiring
systemically important financial institutions to hold these
instruments is to create a class of bondholders that share the burden
of rescuing a company in financial distress and give these creditors
an incentive to push a distressed financial institution to make
changes, such as replacing management, before the trigger event.
Financial experts suggest that contingent convertible capital bonds
could provide a financial cushion that would give financial
institutions facing bankruptcy more time to recover from their
difficulties or to prepare for bankruptcy. Some institutions in
Europe--Credit Suisse Group AG and Lloyds Banking Group plc--have
introduced such bonds, and European regulators are considering
requiring institutions to hold contingent capital for regulatory
purposes. Critics of Co-Cos and bail-ins question who would purchase
such instruments or whether they could be sold only at a premium (high
interest rates). Some experts noted that the most likely holders of
these securities would be insurance companies, but insurance
regulators may require conservative regulatory treatment of these
investments or, in some cases, may prohibit their purchase. However,
experts expect that the holders of these debt securities likely would
be other financial institutions. As a result, weaknesses at one
financial institution may be transmitted to others, and this would be
particularly problematic during a financial crisis, when having many
institutions converting debt to equity at the same time could have a
widespread systemic impact.
Another proposed action to improve planning is to require failing
financial institutions to notify regulators at least 10 days before
filing a petition for bankruptcy. This notice period is intended to
provide the regulator with some time to facilitate actions to minimize
the systemic impact of the bankruptcy. During this time, the regulator
may be able to find ways to maintain critical functions, facilitate an
asset sale, or identify potential creditors that would provide
financing for the debtor during the bankruptcy proceeding--DIP
financing. This extra time for preparation could help to maintain the
going concern value of the institution and reduce disruptions to the
wider economy. However, during the rapidly developing financial
crisis, some institutions' financial conditions deteriorated so
rapidly that a 10-day notification would not have been possible. For
example, the senior management of Bear Stearns gave FRBNY a 1-day
notification when they said that Bear Stearns would file for
bankruptcy protection the following day unless it received an
emergency loan.
Actions to Increase the Role of Regulators May Better Account for
Systemic Risk in the Bankruptcy Process:
The Code does not explicitly address systemic risk. As a result, legal
and financial experts have proposed bringing regulators or other
government officials who are currently outside the court system into
the bankruptcy process to address issues related to systemic risk.
However, some legal experts believe that such a move could weaken the
role of debtors and creditors in the bankruptcy process.
Proposed actions to increase the role of regulators in the bankruptcy
process include allowing a financial institution's primary regulator
to file an involuntary petition for bankruptcy and to do so prior to
actual insolvency. Currently, only creditors can initiate an
involuntary petition for bankruptcy.[Footnote 78] Some regulatory and
legal experts suggest that early intervention by regulators such as
allowing regulators to file for bankruptcy would help to place the
institution into bankruptcy before its value was depleted and thus
help to preserve its going concern value. In addition, providing
regulators with this authority would thereby allow them to take into
account the potential disruption to other companies, and the economy
as a whole, that would be caused by the timing of the decision to file
for bankruptcy. Currently the debtor or creditors of a financial
institution only take into account the value of the firm or the risk
to creditors in the decision to file for bankruptcy. If a regulator
was to have standing, despite its lack of creditor status, and the
debtor institution was reluctant to file for bankruptcy, the regulator
could choose to file an involuntary petition if a later bankruptcy
filing would pose a greater threat to the greater economy or the going
concern value of the institution. Some bankruptcy experts said this
would weaken the role of debtors and creditors in the bankruptcy
process, and some experts have also noted that regulators have not
always been able to determine when financial institutions are likely
to fail or have a systemic impact.
A second proposal to increase the bankruptcy role of government
officials currently outside the court system would be to allow the
government to provide DIP financing by serving as a lender to the
estate. DIP financing for large systemically important financial
institutions in bankruptcy necessarily would be substantial, and few
outside the government may have adequate resources. Allowing the
government to provide DIP financing might make filing for bankruptcy a
more viable option for systemically important financial institutions.
In addition, depending on the nature of the financing, as a DIP
financer, the government would have super priority--it would be near
the top rung of the creditor priority ladder--for any assistance
provided, and would therefore be among the creditors receiving the
first repayment of their loans. This contrasts with the assistance
provided to CIT, where the government received no repayment. However,
the assistance to CIT was part of widespread government assistance to
financial institutions aimed at maintaining financial stability, not
assistance narrowly aimed at a specific institution, and therefore
might not be strictly comparable. Some experts have suggested that
allowing the government to provide DIP financing ultimately would
minimize the costs to taxpayers of a financial institution failure,
because an adequately funded debtor in bankruptcy would have less
systemic impact than an underfunded one. However, following the
financial crisis, there has been widespread opposition to adopting
resolution mechanisms that would place the government at risk of
future financial losses.
One group of experts also has proposed allowing regulators, in
addition to debtors and creditors, to propose plans of reorganization.
They argue that, in the case of financial institutions, those who were
managing the institution before the bankruptcy usually have been
replaced by firms specializing in resolution management and, as a
result, the institution no longer has an interest in continuing as a
going concern. In addition, a regulatory plan could better take
account of systemic factors. However, in this system, as opposed to a
purely regulatory system, the judge in the case also would consider
proposals by the creditors, preserving their due process. Because this
proposal was not made until recently, other experts have not yet
commented on it.
Proposals to Modify the Safe Harbor Treatment for QFCs May Affect
Systemic Risk and Market Discipline:
Legal and financial experts have made a number of proposals to change
the treatment of QFCs. These contracts are exempt from the automatic
stay in bankruptcy and allow counterparties access to posted
collateral, including cash, as soon as the debtor defaults or declares
bankruptcy. This safe harbor treatment can create significant losses
to the debtor's estate, particularly for financial institution debtors
that often are principal users of these financial products. In
addition, a variety of experts expressed concern about counterparties
not imposing market discipline, such as monitoring the
creditworthiness of their counterparties, or signatories on certain
contracts, because they are less likely to suffer the consequences of
a bankruptcy.
Proposed actions to modify safe harbor treatment for QFCs include
changing the types of exempted contracts and protected counterparties.
These proposals vary greatly and include retaining protections for
contracts backed by the most liquid collateral assets, excluding
certain types of counterparties, or eliminating all QFC exceptions and
subjecting each contract's protection to judicial discretion. Some
experts with whom we spoke suggested that modifying the safe harbor
treatment may help to avoid or mitigate the precipitous decline of
assets typical in financial institution bankruptcies. For example,
some have suggested that the treatment of QFCs in the Lehman
bankruptcy contributed to a significant and rapid loss of asset values
to the estate. Some experts also suggested that the current treatment
contributes to systemic risk and lessens market discipline because it
removes the incentive for fully collateralized counterparties to
monitor each other's risk-taking behavior. However, some experts said
determining which counterparties or contracts should be protected
would be difficult. In addition, some experts argued that modifying
the current exceptions would exacerbate systemic risk when a financial
institution enters bankruptcy. These experts assert that subjecting
any QFCs to the automatic stay in bankruptcy would freeze many assets
of the counterparties of the failed financial institution, causing a
chain reaction and subsequent systemic financial crisis. Officials at
the Commodity Futures Trading Commission also noted that the safe
harbor provisions uphold market discipline through margin, capital,
and collateral requirements. They said that the requirement for
posting collateral limits the amount of risk counterparties are
willing to undertake.
A second proposal to modify safe harbor treatment for QFCs would
preserve current exceptions for financial institutions deemed
systemically important and remove all such exceptions for other
companies. Some experts suggest that the nondefaulting counterparties
of systemically significant financial institutions also are likely to
be systemically significant. Thus, to avoid spreading losses from one
financial institution to another and ultimately to the rest of the
economy, these counterparties need the safe harbor protections. These
experts further assert that nonfinancial and nonsystemic financial
institutions do not need this same safe harbor protection, because
their being subject to the automatic stay would not have an effect on
credit markets throughout the economy. However, other financial
experts argue that preserving safe harbor treatments for certain
financial institutions only raises equity concerns, giving an unfair
advantage to systemically important financial institutions that could
lead to those institutions gaining even larger shares of the market
for financial services.
A third proposed action to modify safe harbor treatment for QFCs would
provide a limited stay for these contracts. The length of these
proposed stays varies, from 1 day to 30 days. Imposing a limited stay
for QFCs in bankruptcy would align this resolution process with other
regulatory insolvency processes. For example, the new OLA and the
resolution process for banks under the FDI Act use a 1 business-day
stay.[Footnote 79] One legal expert has noted that providing a limited
stay would allow debtors enough time to determine which contracts to
assume and which to terminate and this would, in part, effectively
reverse advantages that nondefaulting counterparties now have over the
debtor. Other experts have argued, however, that it is difficult to
determine how long a stay may be necessary to make these
determinations, and that any stay for these contracts would cause
considerable market disruption and increase the cost, and reduce the
availability, of capital.
Although Proposals to Treat Institutions on a Consolidated Basis in
Bankruptcy May Improve Efficiency, Challenges Exist:
As noted throughout this report, large financial institutions are
legally, structurally, and financially complex, and they often operate
both regulated and unregulated subsidiaries in multiple jurisdictions.
To the extent that these structures increase value through economies
of scope and scale, splitting them up likely will lower their value.
As a result, proposals have been made to treat firms on a more
consolidated basis to better address the significant challenges faced
in bankruptcies, where judges and regulators currently attempt to
resolve only one piece of an interconnected institution. The proposals
are as follow:
Eliminate existing exclusions. Proposed options to treat financial
institutions on a consolidated basis include eliminating existing
bankruptcy exclusions for insured depositories, insurance companies,
broker-dealers, or commodity brokers. As discussed previously, insured
depositories and insurance companies have separate and distinct
resolution processes--FDIC resolves insured depositories, and state
insurance regulators resolve domestic insurance companies. Broker-
dealers may be debtors only in Chapter 7 or SIPA liquidations, while
commodity brokers can be debtors only under Chapter 7. By eliminating
these exclusions under the Code for systemically important financial
institutions, a financial institution could enter bankruptcy as one
consolidated entity, and a judge with appropriate authority could
involve the corresponding regulators and regulatory procedures under
his or her authority. For example, one proposal says that, to the
extent possible, insurance policyholders should be treated in the same
way they are treated under regulatory resolution practices. In
addition, this proposal calls for maintaining SIPC and the Commodity
Futures Trading Commission's ability to participate in the bankruptcy
proceeding. Some experts suggested that eliminating these exclusions
could reduce the potential for conflicts among different resolution
authorities with competing interests. However, regulatory experts
expressed doubt that the resolution of their jurisdictional entities
under a bankruptcy judge would remain as effective. In addition, some
regulatory experts expressed concern about the ability of a bankruptcy
process to protect bank depositors, insurance policyholders, and
customers of commodity brokers, who have special protections under
current processes. U.S. insurance regulators specifically noted that
insurance policyholders rely on state insurance commissioners'
abilities to wall off insurer's assets from bankruptcy claims so they
can be used to meet policyholders' claims rather than those of other
unsecured creditors. They said that eliminating these assurances would
likely disrupt insurance markets.
Require procedural consolidation. A second proposed option is to
require procedural consolidation, which currently may be ordered by
the court for cases pending in the same court. Procedural
consolidation, also known as joint administration, involves assembling
together all bankruptcy proceedings for each entity within a financial
institution for administrative purposes, so that one judge ultimately
has authority over all such related cases. Under the Federal Rules of
Bankruptcy Procedure, the court may order consolidation of cases if
two or more petitions "by or against the same debtor" are pending in
the same court. Also, if a joint petition, or two or more petitions,
are pending in the same court against a debtor and an affiliate, the
court may order joint administration of the estates.[Footnote 80] Some
experts suggest that mandating procedural consolidation for financial
institutions predetermined as systemically important would minimize
the cost of the proceeding.
Substantive consolidation. A third proposed option is to treat
financial institution groups on a consolidated basis through
substantive consolidation. Unlike procedural consolidation, in
substantive consolidation, the intercompany liabilities of related
companies are eliminated, the assets of these companies are pooled,
and the companies' liabilities to third parties are satisfied from the
single pool of assets. No direct statutory authority exists for
substantive consolidation; the courts have developed the doctrine
through case law. The courts have stated that this doctrine should be
used rarely, and only in specific instances--when, prior to a
bankruptcy filing, the institution acted on an integrated basis that
led creditors to assess risks across legal entities or after a
bankruptcy filing, the assets and liabilities of the legal entities
were so intermingled that separating them would be prohibitive and
hurt all creditors. Although pooling assets could increase the value
of the consolidated entity and encourage creditors to assess
consolidated risks, legal and economic experts said that creditors can
and do monitor the risk being taken by individual legal entities. And,
they said, consolidating assets in a bankruptcy likely would drive up
the cost of capital because creditors would be less willing to provide
funds to financial institutions if they could not distinguish the
legal entities receiving the funds from other more risky entities in
the consolidated institution. Substantive consolidation has been
proposed in the Lehman case, where one of the two creditors'
reorganization plans proposes it; other creditors have filed a
competing plan. On June 29, 2011, the debtor issued a new plan based
on an initial agreement with the competing creditors. The agreement,
which lays out the factors that support consolidated supervision and
those that argue against it, may be modified. Nonetheless, the plan
asserts that although the majority of the factors indicate that Lehman
operated as a centralized business, certain critical factors, such as
the ease of segregating the assets and liabilities of each entity,
argue against substantive consolidation.
Measures to Improve Court Expertise Have Been Proposed, but Some
Experts Said They Are Not Necessary:
Some experts contend that bankruptcy courts require more expertise to
conduct financial institution bankruptcy proceedings than they
currently have. As we discussed earlier in this report, the complex
legal structures, innovative products, regulatory requirements, and
internationally active business lines of systemically important
financial institutions pose considerable challenges for the bankruptcy
process. If court officials do not have specialized knowledge related
to financial institutions, the time needed to acquire that knowledge
could be especially detrimental in a financial institution case
because assets may lose value quickly.
Proposed options to improve court expertise on financial issues
include creating a specialized panel of judges or a standing group of
financial experts. Some academic and legal experts have suggested
establishing a special panel of judges technically trained on both
bankruptcy and financial institution issues, although opinions vary on
the process for assigning cases and what effect their rulings should
have on other courts. These experts contend that the limited number of
systemically important financial institution bankruptcies warrant a
dedicated group of special masters who would best understand how to
equitably and efficiently resolve such complex financial institutions.
However, other experts with whom we spoke expressed concerns that the
rare occurrence of these bankruptcies would prevent such special
masters from gaining or utilizing their expertise. In addition,
experts commented that some current complex financial bankruptcies are
in courts with highly qualified judges. A related proposal would
create a standing group of financial experts to serve the court during
a financial institution bankruptcy case. Some experts noted that
courts already have the right to appoint examiners as they did in the
Washington Mutual and Lehman cases. As with the proposal for a special
panel of judges, the rare occurrence of these bankruptcies may argue
against creating such a standing group.
Another proposal would grant special standing to regulators to be
parties or otherwise participate in bankruptcy court proceedings on
matters relevant to regulatory issues. While regulators currently may
be involved in bankruptcies--such as FDIC's role in Chapter 11
bankruptcies of bank holding companies--no regulator has a special
role in these bankruptcies. Experts contend that regulated
institutions have more complicated legal structures and products than
others. Thus, having regulatory expertise would provide more timely
information to the judge and could lead to resolutions that better
preserve asset value. Some legal experts expressed doubt that the
bankruptcy process required further financial expertise. A few
bankruptcy judges stated that increasing court expertise is
unnecessary. Although financial institutions do present unique issues
in bankruptcy, they explained that the judge's role is to hear the
facts of the case as presented by both sides before entering judgment
and, ultimately, the burden of educating the judges as to the unique
issues of the institution's structure or products falls on the
attorneys representing the debtors, creditors, shareholders, or any
other parties in the case.
These proposals generally aim to address some potential criteria for
assessing the effectiveness of the Code, including maximizing asset
values and minimizing the impact of one type of systemic event.
However, we (and others) have identified at least two types of events
that could have a systemic impact on the financial system and thus
destabilize the U.S. economy. First, the failure of a single financial
institution could have a systemic impact on other institutions that
are counterparties or creditors of the failing institution. Second, a
market event, such as the crisis in the subprime mortgage market, can
have a systemic impact by threatening the stability of a large number
of financial institutions at a point in time. The proposals described
here address primarily the first type of systemic event, even though
the recent financial crisis that generated these proposals is
associated more broadly with the second type of event--a market event
that affects many financial institutions and markets at the same time.
Some government officials and industry participants have also noted
that OLA is not likely to address fully a widespread financial crisis
involving the possible failure of multiple institutions.[Footnote 81]
In addition, a group of law professors and economists who have created
a proposal for a new chapter of the Code told us that this new chapter
would be designed to address the first type of systemic event but not
the second type. They told us that their group may consider proposals
to address widespread systemic impacts caused by market events after
it addresses another difficult issue encountered in resolving
systemically important financial institutions--the global nature of
those institutions.
Courts and Regulators Have Mechanisms for International Coordination,
but National Interests and Other Factors Limit Coordination:
In a prior report on assistance provided to financial and other
companies during the recent financial crisis, we noted that widespread
financial problems, such as those that occurred in the crisis, require
comprehensive, global actions that must be closely
coordinated.[Footnote 82] Efforts to improve international
coordination in the resolution of financial institutions continue, but
coordination mechanisms are not currently comprehensive, and
international coordination generally is limited--often because
national interests can play a determinant role in resolution outcomes.
Differences in countries' insolvency and resolution systems also can
limit coordination. These include diverse terminologies, disparate
treatment of contracts, limits on information sharing, and the
exclusion of various types of financial institutions from judicial
bankruptcy proceedings. These differences were evident in a number of
financial institution failures during the crisis. Proposals for
improving coordination call for harmonizing definitions, insolvency
triggers, and other aspects of judicial and regulatory systems.
However, most of the efforts to promote harmonization following the
2008 financial crisis have centered on activities that could be
undertaken outside a judicial system.
Countries' Insolvency or Regulatory Systems Combine Models:
Countries often differ in the extent to which their insolvency or
regulatory systems combine universalism or territorialism. In a
universal system, all the operations of a company would be subject to
the legal process and resolution system of the country in which the
company is headquartered. In a bankruptcy proceeding, the debtor's
home country would consolidate the debtor's worldwide assets into a
single pool and treat creditors from any country equally under the
home country's priority scheme. Similarly, in a universal system, a
financial institution would be regulated under its home country's
rules regardless of asset or customer location. By contrast, in a
territorial system, each country would segregate or "ring fence"
companies' assets in its country, regardless of the headquarters'
location. Then, if a company declared bankruptcy, each country in
which it operated would reserve the assets located there for that
country's creditors. Similarly, each country would use its own rules
to regulate financial institution activities occurring there
regardless of company structure. Territorial systems sometimes require
financial institutions headquartered abroad to set up separate legal
entities to operate in their country.
The EU's method for overseeing and resolving banking institutions and
their branches follows a universal system. Any institution with a
banking license in an EU country can operate branches in other
countries while following the rules of its home country. Thus, if the
institution fails, the institution, including its branches in other EU
countries would be resolved under the home country's rules; however,
branches in non-EU countries may be subject to territorial systems in
those countries. In contrast, in the United States, which some experts
consider more territorial, the State of New York may seize a local
branch of a financial institution headquartered in another country and
all of its assets if the foreign parent becomes insolvent.[Footnote
83] Most internationally active financial institutions headquartered
abroad maintain branches in New York because of its importance as a
financial center. Similarly, a U.S. subsidiary of a financial
institution headquartered abroad has to maintain assets sufficiently
in excess of liabilities or it risks FDIC resolution. For example,
when a UK institution, the Royal Bank of Scotland, failed and was
partially nationalized, its U.S. depository subsidiary, Citizens Bank,
was able to continue operations in the United States because it was
well-capitalized independently of its UK parent.
Mechanisms to Coordinate Internationally during Insolvencies Are Not
Comprehensive:
Because institutions can operate across these divergent legal and
regulatory models, nations, and their regulators have adopted
different mechanisms, such as the UN Model Law, in an attempt to
facilitate international coordination on bankruptcies. The UNCITRAL
Model Law on Cross-Border Insolvency is one of the main mechanisms
governing such coordination. Chapter 15 of the Code incorporates the
Model Law.[Footnote 84] Generally, under Chapter 15, U.S. court
officials may communicate directly with foreign court officials to
obtain information or assistance. To facilitate coordination, the
courts also may appoint personnel, communicate information by any
appropriate means, coordinate administration and supervision of the
debtor, approve or implement coordination agreements, and coordinate
concurrent proceedings. Chapter 15 cases allow foreign representatives
to sue or be sued in a U.S. court and apply for relief such as a stay
against U.S. creditors seizing the assets of a foreign debtor in a
U.S. court. In addition, foreign representatives can apply to a U.S.
court to have a foreign proceeding recognized as the main case--the
foreign case would take precedence over a U.S. case.
Chapter 15 was used in the Lehman Bankruptcy. For example, in February
2009, administrators for Lehman Brothers Finance (LBF) filed for
dismissal of a Chapter 11 proceeding in the Southern District of New
York and petitioned under Chapter 15 for recognition of an ongoing
insolvency proceeding in Switzerland. The administrators argued that
LBF's registered office was in Switzerland, and it had no offices or
employees in the United States. In March 2009, the U.S. Bankruptcy
Court recognized the Swiss proceeding as a foreign main proceeding and
dismissed the Chapter 11 proceeding. The court noted that this would
promote the efficient administration and maximization of LBF's assets.
[Footnote 85]
[Side bar:
A Chapter 15 proceeding is available in one of four circumstances: (1)
when a bankruptcy proceeding is taking place in a foreign country, a
representative of that country’s legal system or courts may apply to a
U.S. court for assistance in obtaining assets held in the United
States, or when an issue in the case involves a U.S. creditor; (2)
when a party in the United States seeks assistance from a foreign
court in connection to a U.S. bankruptcy case; (3) when a foreign and a
U.S. bankruptcy case concern the same debtor; or (4) when foreign
parties seek to participate in a U.S. bankruptcy case. 11 U.S.C. §
1501. End of side bar]
The typical Chapter 15 case begins when a foreign representative files
a petition for recognition.[Footnote 86] Recognition is the entry of
an order conferring status on the foreign representative to proceed
before the U.S. court.[Footnote 87] Once the court grants recognition,
that representative may commence a bankruptcy case under the U.S.
Bankruptcy Code. In such a case, foreign creditors would have the same
rights as U.S. creditors. Foreign representatives can intervene in any
proceeding, state or federal, in which the debtor is a party. Under
Chapter 15, a court may authorize a person from the United States,
such as a trustee or examiner participating in a U.S. bankruptcy case,
to operate as a representative of the debtor's estate in a foreign
country under that country's laws.[Footnote 88] In August 2009, the
U.S. Bankruptcy Court authorized the debtors' estate of the parent
company of Lehman, LBHI, to act as foreign representatives for that
estate in the UK. As a result, debtors could seek recognition of their
U.S. Chapter 11 case in the UK and request that the UK courts assist
in protecting LBHI's assets.
Some experts from the legal community here and abroad told us that
Chapter 15 and the Model Law have had a positive impact on
international coordination. One legal expert said that, before several
countries adopted the Model Law, international recognition did not
really exist. A foreign court official also told us that Chapter 15
has allowed him to operate effectively in U.S. bankruptcy courts.
Several experts pointed to the bankruptcy of Nortel Networks, Inc.
(Nortel), a telecommunications company headquartered in Canada, which
filed for bankruptcy along with 14 of its subsidiaries in January
2009, as a successful Chapter 15 case. The U.S. courts recognized the
Canadian proceeding as a foreign main proceeding under Chapter 15. In
June 2009, the U.S. courts also recognized a petition by a
representative of a UK subsidiary to have the English proceeding for
that subsidiary recognized as a foreign main proceeding. However, the
Nortel bankruptcy was still ongoing as of June 2011.
Some legal experts believe that the international framework based on
the Model Law has some drawbacks, especially as it relates to
financial institutions.[Footnote 89] Among those countries that have
adopted the Model Law, some experts said that determining the home
country or center of main interest for a financial institution that
has subsidiaries in a number of countries is difficult and can reduce
the effectiveness of the Model Law.[Footnote 90] For example, in the
Lehman case, there are multiple centers of main interest, each
determined by the home country of the various subsidiaries. For the
parent and many of the subsidiaries that filed for bankruptcy in the
Southern District of New York, the United States is the center of main
interest. For Lehman Brothers Finance, Switzerland is the center of
main interest. The effectiveness of Chapter 15 for financial
institutions is further limited because it exempts many companies
engaged in financial activities, including U.S. state-regulated
insurance companies, U.S.-insured depositories, foreign banks that
have branches in the United States, entities subject to a SIPA
proceeding, broker-dealers, and commodity brokers. In addition, an
academic expert told us that since the Model Law had not been widely
adopted, its effectiveness is limited worldwide. Only 19 countries
have adopted the Model Law. For instance, Germany, France, and the
Netherlands--significant financial centers with strong connections to
U.S. financial markets--have not implemented the Model Law.[Footnote
91]
[Side bar:
The American Law Institute guidelines state that if there is an
insolvency proceeding in one of the NAFTA countries, all NAFTA
countries should recognize that proceeding and once the courts
recognize the proceeding, they should impose a stay on creditors in
the other countries. The guidelines also state that all parties should
disclose information about insolvency cases, allow foreign
representatives the same rights to obtain information as domestic
representatives, and have courts communicate directly with each other or
through administrators. The guidelines further advise courts not to
discriminate against foreign representatives when seeking possession
of debtors’ assets or when seeking to transfer those assets to another
country. General Principle 3, Procedural Principle 4. End of side bar]
Courts overseeing a bankruptcy with international components can
augment coordination by permitting adoption of insolvency protocols.
[Footnote 92] Protocols aim to promote certainty, clarify
expectations, reduce disputes, prevent jurisdictional conflict,
facilitate restructuring, reduce costs, and maximize value. For
instance, they could assign court responsibility for certain matters
to avoid duplication of effort or address the sharing of information.
Guidelines exist for drawing up effective protocols. Some experts
directed us to the American Law Institute's guidelines for
facilitating coordination in the North American Free Trade Agreement
(NAFTA) country bankruptcies.[Footnote 93] The Lehman Brothers Cross-
Border Insolvency Protocol and Order issued by the U.S. Bankruptcy
Court for the Southern District of New York includes approval and
adoption of the American Law Institute's "Guidelines for Court-to-
Court Communications in Cross-Border Cases."[Footnote 94]
However, experts disagreed on the effectiveness of insolvency
protocols. Some experts pointed out that protocols have been used
successfully to coordinate proceedings, allow communication between
courts, and conduct joint proceedings. In addition, a group of legal
experts said that protocols could be more useful in facilitating
coordination than Chapter 15 because they do not require that the
courts determine a main proceeding. As a result, financial
institutions, which encompass many different subsidiaries and business
lines, may benefit more from protocols than from proceedings under
Chapter 15. Other experts were skeptical about the effectiveness of
protocols. One court official told us that aside from the sharing of
information they were ineffectual. In his experience entities may
refuse to participate in a protocol due to legal differences or only
if they seek to maximize returns for creditors in their country. If a
protocol is not comprehensive--all of the important countries do not
participate--its usefulness will likely be limited.
Official representatives from nine countries involved in the Lehman
bankruptcy have signed a protocol to cover issues that arise from the
international nature of the Lehman case.[Footnote 95] The protocol's
goals include facilitating the coordination of the proceedings and
enabling cooperation in the administration of the various estates.
Among other things, the protocol gives representatives the right to
appear in all proceedings and states that the representatives should
keep each other informed of all relevant information. Beginning in
July 2009, the official representatives from these countries have held
regular meetings. Initially, the intent of these meetings was to
discuss broad issues of administering estates, sharing information
such as private client information, and how to deal with intercompany
claims. A legal expert told us that, currently, these meetings focus
on the Chapter 11 reorganization plan in the United States. However,
the effectiveness of the protocol is limited because London-based
Lehman Brothers International Europe has not signed on to the
protocol. Instead, this London-based unit is opting to participate in
bilateral agreements with individual affiliates. Many of the creditors
from nations that signed the protocol dealt primarily with Lehman
Brothers International Europe, which entered insolvency administration
in the UK.
In addition to the mechanisms discussed above, regulators have signed
various memorandums of understanding (MOU) to promote international
coordination. A number of federal U.S. regulators have MOUs with their
counterpart agencies in other countries. For example, the Commodity
Futures Trading Commission and SEC both have MOUs with several
countries important to the U.S. financial system, such as Canada,
China, France, Germany, Japan, the Netherlands, Switzerland, and the
UK. According to officials at the Federal Reserve, these MOUs have
typically dealt with information sharing; however, more recently they
have focused on crisis management and resolution of institutions. For
example, regulators from Sweden, Denmark, Norway, and Finland have
signed an MOU specifically designed for the resolution of Nordea Group
(Nordea)--a universal bank with branches and subsidiaries in multiple
Nordic countries. The MOU specifies how supervisors may share
sensitive or confidential information and grants Swedish authorities
leadership responsibilities among the supervisors. The MOU directs
authorities to monitor the potential for a crisis in their countries,
plan for a crisis situation, and facilitates close cooperation during
a crisis.
However, experts generally felt that MOUs were not effective
mechanisms for international insolvency coordination because they
would break down in a crisis. According to a report on international
insolvency by the Basel Committee on Banking Supervision, supervisors
generally enter MOUs with the goals of cooperating and sharing
information during the course of their regular oversight roles rather
than to resolve an entity.[Footnote 96] An expert familiar with the
Nordea MOU further cautioned that, although the Nordic countries have
similar legal regimes, national interest provisions in the MOU still
might impede its effectiveness in a crisis.
National Interests May Take Precedence over Efforts to Coordinate in a
Bankruptcy:
Although the importance of international coordination is generally
recognized, national interests may take precedence over coordination
during resolutions of insolvent financial companies and often did
during the recent financial crisis. For example, when an international
financial institution fails, regulators in each country generally look
to protect entities in their own countries and focus on minimizing
losses to their citizens and legal entities, as well as preventing
national economic instability. During the recent global economic
instability, countries took actions to mitigate impacts in their own
countries. For instance, under EU laws, Iceland had full authority to
resolve its banks that failed in 2008 (including UK branches) as a
single entity. However, the UK government invoked antiterrorism laws
that allowed it to seize and ring fence assets in UK branches of the
Icelandic banks for the benefit of local depositors, local creditors,
and UK commitments for deposit insurance.
The Fortis Bank, SA/NV (Fortis) failure further illustrates the
difficulty of overcoming national interests in a financial institution
failure. According to an academic expert, the Dutch and Belgians had
good relations, including a strong relationship between their central
banks, before the 2008 economic crisis. However, when Fortis--a
financial institution with operations in Belgium, the Netherlands, and
Luxembourg--nearly failed during the 2008 crisis, national interests
kept regulators and other officials from cooperating to maintain the
value of the bank. Belgian and Dutch officials both considered Fortis
to be systemically important in their countries and proposed
conflicting resolution plans. According to a report by the
International Centre for Monetary and Banking Studies on the failure,
the Belgians favored a joint solution that would keep Fortis as a
consolidated entity, headquartered in Belgium. [Footnote 97] However,
Fortis recently had participated in a joint acquisition of the Dutch
financial institution, ABN AMRO Holding, NV (ABN AMRO). The Dutch
wanted ABN AMRO operations to remain in country and favored a solution
that split the company. In the end, Fortis was broken up, with the
Dutch nationalizing 100 percent of the Dutch banking subsidiaries, and
the Belgians initially nationalizing the Belgian banking subsidiary
and, ultimately, selling 75 percent of it to French bank BNP Paribas.
An expert familiar with the Fortis failure said that the ultimate cost
might have been lower under a consolidated solution. See appendix VI
for more information about the Fortis failure.
However, when national interests align, authorities find ways to
coordinate. When Dexia faced a liquidity crisis in 2008, Belgium and
France, with minor participation by Luxembourg, orchestrated a
coordinated rescue by establishing a joint guarantee mechanism. Dexia
was a key provider of municipal finance, especially in France, and was
a key depository in Belgium. Thus, it was in France's interest to
ensure continued finance for local governments and in Belgium's
interest to prevent the failure of an important financial institution.
As a result, Dexia emerged from the crisis relatively intact.
According to experts with whom we spoke, insolvency laws in some
countries limit the ability of bankruptcy estate administrators to
cooperate. These experts noted that bankruptcy administrators in some
countries could be found liable for malpractice if they did not
attempt to ring fence or otherwise protect domestic creditors while
resolving subsidiaries of companies headquartered in other countries.
Experts familiar with the Lehman case said that the UK had not signed
the Lehman insolvency protocol because Lehman Brothers International
Europe administrators had certain duties under UK law that limited
their participation. As a result, parties in other countries said they
could not obtain needed information because Lehman Brothers
International Europe maintained the books and records for European and
Asian operations. Nonetheless, in a recent SIPA trustee report, the
trustee noted that Lehman Brothers International Europe had provided
him with vast amounts of information.
Furthermore, national laws and regulations may restrict supervisors
from sharing information with foreign entities. While there may be
good reasons for the restrictions, they can prevent the timely sharing
of information. Additionally, other national rules, such as privacy
laws, can limit agreements to share information. Some supervisors'
resolution systems also may not empower them to share information or
may allow them to share information that does not have the specific
details needed to coordinate the resolution of a large, global
financial institution. Regulators also may not want to share bad or
embarrassing news with foreign entities. For example, foreign
regulators discovered that a trader in the New York office of a
foreign firm lost $1.2 billion over the course of a decade due to
improper actions, but they did not promptly share that information
with U.S. regulators.
Differences in Insolvency Systems, such as Definitions and Priority
Structures, Also Limit International Coordination:
In addition to national interests, differences between insolvency
systems can limit international coordination of bankruptcies or
resolutions. This includes differences in the mandated
responsibilities of various actors involved in the proceedings;
payment rankings for creditors; definitions of certain terms;
treatment of contracts; and the extent to which judicial bankruptcy
codes cover certain financial institutions.[Footnote 98] Differences
in legal traditions can also limit coordination. Civil law systems
tend to rely on codes and not on case law, as in common law systems,
such as in the United States.[Footnote 99] Thus, judges may play a
different role in insolvency proceedings depending on the legal system
of the country. A legal expert explained that the effectiveness of
international coordination mechanisms and agreements is limited in
Mexico, a civil law country, due to its legal tradition that
discourages courts from coordinating. In the Netherlands and Germany
(civil law countries), judges are less active than in the United
States and Canada (common law countries), leaving the resolution of
the company to court-appointed administrators. A German court official
said that a U.S. judge probably would have to coordinate with an
administrator in Germany. These differences may complicate efforts to
coordinate during insolvency proceedings, in particular proceedings in
which time is critical. In another example, ladders of priority in
insolvency proceedings differ. In the United States, wage claims
generally rank below secured creditors, while in some European
countries, such as Luxembourg and France, employee wage claims rank
ahead of secured creditors. In France, employee wage claims are
prioritized ahead of any other class. See table 6 in appendix VIII for
more information on countries' payment priorities.
Differences in definitions and standards for commencing insolvency or
resolution proceedings between countries also can limit coordination.
Different countries may have different definitions for terms such as
debtor, center of main interest, proceeding, and relief. The following
are some of the examples given by experts. The Dutch system does not
have a term that means "relief" as exists in the U.S. bankruptcy
system. The closest equivalent to the U.S. "stay" is the idea of a
"cooling off period." Only recently could a debtor apply for an ad hoc
"stay" similar to the U.S. automatic stay. In other parts of Europe,
what might be a "liquidator" in one country is an "administrator" in
another. Different countries may have different thresholds for when to
take action to resolve a failing bank. Some countries intervene when a
bank is no longer solvent or liquid. In other countries, such as the
United States, regulators can intervene before a bank technically is
considered insolvent. Countries also define banks differently. In the
United States, the term "bank" often refers only to an insured
depository institution, but in European countries with universal
banks, the term would apply to an institution offering insurance,
broker-dealer, and other investment firm services as well.
Provisions of contracts between creditors and debtors often dictate
how issues are to be resolved in a bankruptcy; however, contract law
differs across countries. An English case related to the Lehman
bankruptcy proceeding illustrates how these differences can play out
in a bankruptcy case. One London-based Lehman subsidiary, Lehman
Brothers International Europe, had issued a series of notes under
Saphir Finance Public Limited Company (Saphir), a special purpose
legal entity. Saphir was also counterparty to a series of swap
agreements. Another Lehman subsidiary, Lehman Brothers Special
Financing (LBSF), was the other counterparty for the series of notes
in question. Normally, the contracts were written to give the swap
counterparty, LBSF, priority to the collateral over the noteholder,
Perpetual. However, a special clause in the contracts, sometimes
called a flip clause, specified that if LBSF, the swap counterparty,
defaulted, the priorities would flip so that Perpetual, the
noteholder, would have rights to the collateral ahead of LBSF.
Following LBSF's bankruptcy filing in October 2008, the English courts
ruled that the flip clause was valid and in effect. However, the U.S.
Bankruptcy Court ruled that the flip clause was unenforceable because
it violated U.S. bankruptcy law.[Footnote 100] In his ruling, the U.S.
bankruptcy judge stated that the English courts appeared not to take
into account principles of U.S. bankruptcy law and that those courts
understood that the outcome of the dispute might be different under
U.S. law. Observing that the "courts will not extend comity to foreign
proceedings when doing so would be contrary to policies or prejudicial
to the interests of the United States," the judge noted that the
United States has a strong interest in having U.S. bankruptcy courts
resolve issues of bankruptcy law. However, the judge also recognized
the uncertainty created by conflicting U.S. and English rulings, and
he recommended that given the complexity of the case, it would be
better if all parties involved could find a way to harmonize and
reconcile the decisions. On December 16, 2010, the U.S. court approved
a settlement between the parties. For more information on these cases
see appendix IV.
All of these limitations are only relevant to the extent that
financial institutions are resolved under a judicial code. Whether
this is the case or not varies across countries. As noted earlier, in
the United States, insured depositories and state-regulated insurance
entities are exempt from the Code, and broker-dealers cannot file
under Chapter 11. In addition, the United States has now adopted OLA,
which, if triggered, will exempt certain systemically important
companies from the bankruptcy process. Similarly, Canadian law
provides separately for the reorganization or restructuring of
federally insured depository institutions and for the resolution of
insolvent financial institutions.[Footnote 101] Some countries have
not traditionally exempted financial institutions from their corporate
insolvency systems, but in response to the 2008 crisis the UK and
Germany have increased the role of regulators and regulatory processes
in the resolution of certain financial institutions. For example, UK
regulators now can resolve depository institutions in ways that are
similar to FDIC's rules in the United States. However, any assets
remaining after a purchase and sale agreement or the creation of a
bridge bank would be resolved under corporate bankruptcy laws. The UK
is considering extending these rules to investment firms. In addition,
the UK government can temporarily take ownership of certain financial
institutions if, among other factors, it is necessary to resolve or
reduce a serious threat to the stability of the financial systems of
the UK. Germany's special resolution regime grants regulators several
options when dealing with a distressed bank. At first, the regulator
can facilitate voluntary debt restructuring or the provision of new
financing. If that does not work, the regulator can put the bank
through a judicial process similar to Chapter 11. Finally, the
regulators can take the bank into conservatorship.
Experts Have Proposed Harmonized Standards and Use of Existing
Supervisory Coordination Mechanisms to Improve International
Coordination:
In response to the financial crisis, a number of international
organizations--those addressing economic and regulatory issues, as
well as those addressing judicial issues--have been considering
regulatory reforms that include improving international coordination
during insolvencies. Some of these organizations have established
general principles for improving international coordination, and some
have proposed harmonizing specific standards for resolving
institutions, such as insolvency triggers, and have also proposed
using existing coordination mechanisms, such as colleges of
supervisors, in resolving these institutions. The experts with whom we
spoke agreed that these were key elements for improving coordination.
For example, they noted that having a few key countries, such as the
United States, UK, Germany, France, and Japan, adopt similar
procedures might be sufficient to create meaningful coordination.
In support of the Group of 20 (G20) countries, the Financial Stability
Board has released a set of high-level principles for international
coordination for future financial crises.[Footnote 102] The principles
include developing common tools for crisis management, having
authorities meet regularly to discuss possible resolutions of specific
firms, sharing information across countries on specific firms, and
having firms develop resolution plans. The work of the Financial
Stability Board is part of a larger G20 financial reform agenda that
seeks to establish a new financial regulatory framework, including new
bank capital and liquidity standards, as well as measures to better
regulate and effectively resolve systemically important financial
institutions. For example, the G20 stated in September 2009, and again
in November 2010, that internationally active, systemically important
institutions should be subject to a sustained process of international
recovery and resolution planning that includes institution-specific
crisis cooperation agreements developed within crisis management
groups.
In addition, the United States and the EU have worked on the
convergence of U.S. and international accounting systems through the
ongoing U.S.-EU dialogue and could work within the dialogue or other
forums to harmonize certain insolvency and regulatory resolution
features. This would likely be successful only if the EU managed to
harmonize features within the EU through directives that create
minimum standards for its member countries. Although the EU hopes
eventually to create a single European Resolution Authority, its
shorter-term goal is to harmonize resolution powers across EU
countries. As a first step in promoting harmonization, it has released
consultation papers. A foreign expert said that European reform is
moving at two speeds. While the EU has been moving more slowly on its
reports and proposals, some member states have been moving more
quickly. For example, Germany, the Netherlands, and the UK all have
enacted new special resolution regimes for financial institutions.
Specific proposals for harmonization of judicial systems have focused
on a few key areas, such as similar treatment of creditors and
financial collateral and common triggers for, or definitions of,
insolvency. Through colloquia held by INSOL, judicial experts also
have begun to consider whether and how to modify the Model Law to make
it more useful when dealing with corporations that have subsidiaries
in a number of different countries.[Footnote 103] UNCITRAL has
recommended that insolvency laws recognize the existence of
consolidated corporate entities, which it calls "enterprise groups,"
and allow for courts to coordinate enterprise group insolvencies in
the same manner as insolvencies of a single, international debtor
entity. As noted earlier in this report, having multiple main
proceedings can create conflicting rulings and otherwise limit
coordination. Judicial experts also pointed to the International
Insolvency Institute's draft guidelines on enterprise groups.[Footnote
104] These guidelines suggest that courts allow all parts of an
enterprise group, such as subsidiaries incorporated in various
countries, and other affected parties to be heard in determining the
group's center of main interest. The court can choose to determine the
"coordination center" and recognize a coordination center
representative who will have standing in any matter involving the
group.
Experts also recommended harmonization of any special resolution
regimes for financial institutions, whether combined or separate from
the judicial system. However, most of the efforts to promote
international harmonization following the 2008 financial crisis have
centered on activities that could be undertaken outside a judicial
system. The proposals generally specify a number of activities that
government officials should be allowed to undertake, including:
* intervening prior to actual insolvency as with the prompt corrective
action in the United States,[Footnote 105]
* establishing a bridge institution,[Footnote 106]
* ensuring that creditors receive at least the compensation they would
have had if the institution had failed and been liquidated instead of
resolved,
* restructuring an institution's capital structure or merging it with
another entity,
* transferring certain assets and liabilities to other entities,
* nationalizing an institution temporarily, and:
* imposing a temporary stay on the termination of financial contracts.
The principles the G20 and others have been establishing, as well as
the opinions of experts with whom we spoke, stressed the importance of
having regulatory authorities coordinate on financial institution
resolution before crisis situations developed because the value of
such institutions deteriorates rapidly during insolvencies, leaving no
time to set up structures for coordinating. For example, experts such
as officials at the International Monetary Fund (IMF) have recommended
building on the framework created under the Basel Committee on Banking
Supervision, in which supervisors from various countries meet
regularly to better coordinate supervision of an ongoing financial
institution.[Footnote 107] And some have recommended a college of
resolution authorities that would use companies' required resolution
plans to develop a more cohesive plan, promote effective coordination,
and determine how the burden of financing such actions would be shared
across countries. However, some legal experts were concerned that
financial and regulatory officials have not been relying on court
insolvency officials who are more familiar with existing bankruptcy
proceedings and unnecessarily have been creating duplicative systems.
Both international organizations focusing on judicial issues and those
focusing on economic and regulatory issues continue to work on
improving international coordination regarding the resolution of
insolvent firms operating across national borders. However, much of
the specific focus on financial institutions has taken place in those
organizations focusing on economic and regulatory, rather than
judicial, issues. Some experts noted that there is a tradition for
agreeing voluntarily to regulatory harmonization that was established
originally at Basel. However, after the passage of the Dodd-Frank Act,
which intended to limit assistance to individual financial
institutions, there is continued debate as to whether governments will
individually provide assistance to specific failing financial
institutions or will ring fence assets when possible insolvencies
threaten the stability of their national economies. And, countries
such as the UK, continue to provide for the possibility of such
assistance through a temporary public ownership provision in their
recently enacted banking laws. Although some experts told us that a
comprehensive treaty would help to ensure that countries have
coordination mechanisms that are strong enough to withstand another
global financial crisis, prospects for a treaty in this area appear
limited.
Agency Comments and Our Evaluation:
We provided a draft of this report to the AOUSC, Commodity Futures
Trading Commission, Departments of the Treasury and State, Federal
Deposit Insurance Corporation, Federal Judicial Center, Federal
Reserve, National Association of Insurance Commissioners, SEC, and
SIPC for review and comment. We received technical comments from the
AOUSC, Commodity Futures Trading Commission, Departments of the
Treasury and State, Federal Deposit Insurance Corporation, Federal
Judicial Center, Federal Reserve, National Association of Insurance
Commissioners, SEC, and SIPC, which we incorporated as appropriate. We
also requested comments and received technical comments and
perspectives on drafts of the case studies from relevant legal experts
and the judges associated with the cases, which we incorporated as
appropriate.
We are sending copies of this report to the appropriate congressional
committees, Director of the Administrative Office of the U.S. Courts,
the Chairman of the Commodity Futures Trading Commission, the
Secretary of the Treasury, the Secretary of State, the Chairman of the
Federal Deposit Insurance Corporation, the Director of the Federal
Judicial Center, the Chairman of the Board of Governors of the Federal
Reserve System, the Chief Executive Officer of the National
Association of Insurance Commissioners, the Chairman of the Securities
and Exchange Commission, and the Chairman of the Securities Investor
Protection Corporation, and other interested parties. The report also
is available at no charge on the GAO Web site at [hyperlink,
http://www.gao.gov].
If you or your staff members have any questions about this report,
please contact Alicia Puente Cackley at (202) 512-8678 or
cackleya@gao.gov. Contact points for our Offices of Congressional
Relations and Public Affairs may be found on the last page of this
report. Major contributors to this report are listed in appendix X.
Signed by:
Alicia Puente Cackley:
Director, Financial Markets and Community Investment:
List of Committees:
The Honorable Tim Johnson:
Chairman:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Patrick Leahy:
Chairman:
The Honorable Charles E. Grassley:
Ranking Member:
Committee on the Judiciary:
United States Senate:
The Honorable Spencer Bachus:
Chairman:
The Honorable Barney Frank:
Ranking Member:
Committee on Financial Services:
House of Representatives:
The Honorable Lamar Smith:
Chairman:
The Honorable John Conyers, Jr.
Ranking Member:
Committee on the Judiciary:
House of Representatives:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
As required under section 202 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act), this report examines (1)
actions taken by the U.S. District Court for the District of Columbia
(D.C. District Court) in response to the judicial review provision of
the Orderly Liquidation Authority (OLA) of the Dodd-Frank Act; (2) the
effectiveness of Chapters 7 and 11 of the U.S. Bankruptcy Code (Code)
in facilitating orderly liquidations or reorganizations of financial
institutions; (3) proposals for improving the effectiveness of
liquidations and reorganizations under the Code; and (4) mechanisms
that facilitate international coordination and any barriers to
coordination of financial institution bankruptcies.[Footnote 108]
To address all of our objectives, we reviewed relevant laws such as
the Code and the Dodd-Frank Act as well as GAO reports that addressed
bankruptcy issues and financial institution failures. We also reviewed
economic and legal research on bankruptcies, especially bankruptcies
of financial institutions. As part of this review, we conducted two
literature searches, one on federal government documents, and one on
published research on bankruptcy effectiveness, especially as related
to financial institutions. The latter search relied on Internet search
databases (including EconLit and Proquest) to identify studies
published or issued after 2000. We reviewed these articles to further
determine the extent to which they were relevant to our engagement,
that is, whether they discussed criteria for effectiveness of the
bankruptcy process, key features of the bankruptcy process, proposals
for improving the bankruptcy process, or international coordination.
The search of the published research databases produced 106 articles.
A little over half of these documents were relevant to our objectives.
Specifically, among the documents written by authors we did not
interview, 15 documents discussed issues related to criteria for
judging effectiveness, 11 discussed issues related to the treatment of
qualified financial contracts and proposals for modifying the Code, 10
discussed issues related to international coordination, and 4
discussed the Lehman bankruptcy. We augmented this research with
articles provided by those we interviewed or obtained from
conferences. In addition, we reviewed a number of prior GAO reports
related to bankruptcy issues, financial institutions, and the
financial crisis. These are listed in "Related GAO Products" at the
end of this report.
To provide explicit examples throughout our report, we conducted in-
depth reviews of three bankruptcy cases of financial institutions and
developed some information on the bankruptcies or failures of another
11 companies. We chose three companies for in depth reviews--CIT
Group, Inc. (CIT), Lehman Brothers Holdings, Inc. and subsidiaries
(Lehman), and Washington Mutual, Inc.--on the basis of their size and
the variety of experiences and structures such as the types of
businesses in which they engaged, amount of planning for bankruptcy,
their organizational structures included regulated subsidiaries, the
extent of their international operations, and their having entered
bankruptcy after 2005 when the Code was revised. These cases represent
the three largest financial institution bankruptcies as measured by
consolidated asset levels in their most recent 10-K filing before
filing for bankruptcy.[Footnote 109] They also represent a range of
company types and experiences. For example, CIT, which became a bank
holding company only in 2008, provided commercial lending and leasing
products, management advisory services, and small and mid-market
business finance. Lehman provided a range of investment banking and
broker-dealer services that involved it in a number of contracts that
received safe harbor treatment under bankruptcy law. Washington Mutual
was a thrift holding company whose major holdings were insured
depository institutions. The companies also had a range of bankruptcy
experiences--CIT was a prepackaged bankruptcy, while Lehman and
Washington Mutual had engaged in little planning before their filings.
In addition, the Lehman bankruptcy involved extensive activities in
other countries.[Footnote 110] The Lehman and Washington Mutual cases
also help to elucidate the role of the special resolution regimes for
broker-dealers and insured depositories. We did not include a company
that was engaged primarily in insurance activities because few holding
companies with extensive insurance operations have gone through the
bankruptcy system in recent years. For these case studies, we reviewed
judicial proceedings including examiner reports, confirmation
opinions, and disclosure statements, and conducted interviews with
experts familiar with the cases. We concluded that the quantitative
information in these sources were sufficiently reliable for our
purposes. Appendixes III, IV, and V cover these cases in detail.
In addition to these case studies, we chose a number of financial
institution failures or near failures that provided examples of
specific aspects of the bankruptcy process or other aspects of
financial institution failures. These were examples provided by those
we interviewed or had been used in research articles. The examples
include American International Group, BankHaus Herstatt, Bank of
Credit and Commerce International, Bernard L. Madoff Investment
Securities, Colonial Bancgroup, Drexel Burnham Lambert Group, Inc.,
Dexia SA, Fortis Bank SA/NV, the Icelandic banking crisis, Long Term
Capital Management, and Nextbank. Appendix VI includes information on
these examples that we use throughout the report.
During our review, we conducted structured interviews with private
sector experts, including practicing attorneys, law professors,
economists, accountants, and trade associations, who have expertise on
bankruptcy and financial institutions (see app. IX for the
organizational affiliations of those we interviewed). These experts
were chosen because they best met certain criteria--they had published
multiple articles on relevant issues, made proposals to modify the
Bankruptcy Code, been involved in the bankruptcies we chose for our
case studies, testified before Congress, and been recommended by
agency officials. We also conducted similar in-depth interviews with
U.S. and foreign government officials, including regulators, judges,
and other court officials. Specifically, we met with officials at the
Administrative Office of the U.S. Courts (AOUSC), Commodity Futures
Trading Commission, Federal Deposit Insurance Corporation (FDIC),
Board of Governors of the Federal Reserve System (Federal Reserve),
Federal Judicial Center, National Association of Insurance
Commissioners, SEC, Securities Investor Protection Corporation, U.S.
Department of State, and U.S. Department of the Treasury, and at the
Southern District of New York and Delaware District Bankruptcy Courts.
We conducted in-depth interviews with these officials and with
practicing attorneys, economists, and law professors to help develop
criteria for effectiveness, determine critical factors in the
bankruptcy system, determine what company characteristics complicate
bankruptcies, identify mechanisms for and limitations on international
coordination, and collect views on proposals to change the bankruptcy
process and improve international coordination. Because each of the
experts with whom we spoke had differing experiences with bankruptcy
and resolution of failed financial institutions, we generally did not
aggregate their responses. Because the Dodd-Frank Act mandated AOUSC
and the Federal Reserve to conduct reviews similar to those we were
conducting, we met regularly with these agencies throughout the
engagement.
We also undertook a number of activities specific to each objective:
To address the first objective to examine the actions taken by the
D.C. District Court under section 202 of the Dodd-Frank Act, we met
regularly with AOUSC. We contacted staff of the relevant congressional
committees to determine whether they had received the D.C. Federal
District Court's rule under the Dodd-Frank Act provision requiring
publication and submission of the rule to the Congress.[Footnote 111]
We also searched the Federal Register and monitored the Web sites of
FDIC and the Federal Reserve to determine whether relevant rules--
those that defined financial companies and those that defined the
conditions for default--had been issued. During this process we also
observed industry roundtables held by FDIC to help develop rules to
implement OLA.
To address the second objective, we analyzed the results of the
literature review and expert interviews to determine criteria for
effectiveness of the Code, key elements in the bankruptcy process that
pose issues for financial institutions, and characteristics of
financial institutions that pose challenges for the bankruptcy
process. We also collected and analyzed available data on financial
institution bankruptcies to determine if the data were useful for
assessing the effectiveness of financial institution liquidations or
reorganizations. We collected data from the AOUSC and New Generations
Research, Inc. a company that takes data from the U.S. bankruptcy
filings and augments it with industry-specific data, and from a law
professor at the University of California, Los Angeles who also
collects bankruptcy data. The AOUSC provided lead case data on mega
cases (involving assets of more than $100 million and more than 1,000
creditors) that included date and location of filing and some
information on how closed cases were concluded (such as by sale,
liquidation, or reorganization). By matching data from the New
Generations with the AOUSC-provided data, we were able to provide some
context on the number of Chapter 11 mega cases that represented
financial institutions, and we decided the data were sufficiently
reliable for that purpose. However, as noted in the report, we found
that the data were not sufficient for measuring the effectiveness of
the bankruptcy process for liquidating and reorganizing financial
institutions because they did not provide information on returns to
creditors. In addition, only a small proportion of mega cases were
financial institutions. To show the extent to which large financial
institutions operate across national borders, we developed information
from SNL Financial and publicly available company information on 30
large financial institutions relative to their size and international
operations. We concluded that these data were sufficiently reliable
for our purposes.
To address the third objective, we reviewed the literature, as
described earlier, to determine the range of proposals that had been
made to reform the bankruptcy process for financial institutions. We
categorized some of the proposals into groups, such as those that
included a role for the regulators or modified the treatment of
qualified financial contracts and then asked the experts looking at
these categories and these specific proposals to tell us which they
considered had merit and should be included for further consideration
and why. We also discussed their opinion on any additional proposals.
Another academic group--including some of the experts we had
previously contacted--that had a multipart proposal for reforming the
bankruptcy process contacted us about their proposal when interviewed
by another GAO team. This occurred after we had completed our expert
interviews. To the extent that this proposal for reforming the
bankruptcy process included new elements, these were not included in
our earlier expert interviews. We analyzed the results of the academic
research and our expert interviews to determine whether the proposals
addressed the criteria specified in our second objective and to
determine reasons for adopting or not adopting the various proposals.
To address the fourth objective, we supplemented our domestic
interviews by interviewing international experts on resolving failed
financial institutions, including economists, attorneys, court
officials, and regulators from Canada, Germany, the European
Union(EU), Mexico, the Netherlands, Switzerland, and the UK. We also
reviewed information they provided on some key characteristics of the
bankruptcy processes in 10 countries, detailed in appendix VIII. We
chose these countries because of their importance to the U.S.
financial system and their geographic scope. We did not independently
analyze these laws or procedures; instead, we relied on assessments
provided by international legal experts and country court and
regulatory officials.
We conducted this performance audit from August 2010 to July 2011, in
accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.
[End of section]
Appendix II: Local Civil Rule 85:
United States District Court For The District Of Columbia:
Voting: Judges Kollar-Kotelly, Kennedy, Roberts, Huvelle, Walton,
Bates, Hogan, Urbina, Friedman and Kessler.
It is this 19th day of January, 2011 ordered that effective
immediately that Local Civil Rule 85 has been adopted by the Court.
LCvR 85:
Filings Under The Dodd-Frank Wall Street Reform & Consumer Protection
Act:
This rule governs petitions by the Secretary of the Treasury
("Secretary") under the Dodd-Frank Wall Street Reform and Consumer
Protection Act ("Act"), Pub.L. No. 111-203, 124 Stat. 1376, 1444 (Jul.
21, 2010), 12 U.S.C. § 5382(a)(1), for orders authorizing the
Secretary to appoint the Federal Deposit Insurance Corporation as
receiver for financial companies.
(a) Filing Of The Petition:
A petition under this Act must contain all relevant findings and
recommendations under the Act, and must be filed under seal. The
original and one copy of the petition and a PDF version on a CD-ROM
shall be tendered to the Clerk. The original and copy of the petition
and all related documents shall be submitted securely in an
envelope/box appropriate to accommodate the documents. The
envelope/box containing such documents shall have a conspicuous
notation as follows: "Document Under Seal."
(6) Notice To The Court:
At least 48 hours prior to filing the petition, the Secretary shall
provide written notice under seal to the Clerk of the Court that a
petition will likely be filed with the Court.
(c) Notice To The Financial Company:
A petition shall be accompanied by a certificate of counsel or other
proof satisfactory to the Court, stating (1) that actual notice of the
time of filing the petition, and copies of all papers filed to date or
to be presented to the Court at any hearing, have been furnished to
the financial company; or (2) the efforts made by the Secretary to
give such notice and furnish such copies. The certificate shall also
contain the name and contact information of the individual at the
financial company to whom notice was given and upon whom service was
effected.
(d) Opposition To The Petition:
(e) The financial company named in the petition may file an opposition
to the petition under seal and may appear at a hearing to oppose the
petition. The opposition shall be served on the Secretary by the most
expeditious means available.
(e) Proposed Order:
Each petition and opposition shall be accompanied by a proposed order.
(f) Assignment Of The Petition:
The petition shall be assigned to the Chief Judge or Acting Chief
Judge.
(g) Consideration Of Petition: Notification Of Decision:
In considering a petition, the Court shall, on a confidential basis
and without public disclosure, determine whether the Secretary's
decision that the covered financial company (1) is in default or in
danger of default and (2) satisfies the definition of a financial
company under the Act is arbitrary and capricious.
(1) Upon a finding that the Secretary's determination is not arbitrary
and capricious, the Court shall issue an order immediately authorizing
the Secretary to appoint the Corporation as receiver of the covered
financial company.
(2) Upon a finding that the Secretary's determination is arbitrary and
capricious, the Court shall provide immediately for the record a
written statement of each reason supporting the determination of the
Court, and shall provide copies thereof to the Secretary and the
covered financial company, and must afford the Secretary an immediate
opportunity to amend and refile the petition.
(h) Timing Of Decision:
The Court shall attempt to rule on a properly filed petition within
twenty-four (24) hours of receipt of the petition. In the event that
the Court does not do so, the petition is deemed granted by operation
of law under the Act.
(I) Maintaining Petitions And Subsequent Filings Under Seal:
The petition and subsequent filings must be maintained under seal
pending further order of the Court. Upon the granting of a petition,
the Secretary shall promptly notify the Court of the appointment of
the receiver. The Court shall then issue an Order to Show Cause to the
Secretary as to why the proceedings, or any part thereof, shall not be
unsealed.
(j) Stay Pending Appeal:
The decision of the Court on a petition shall not be subject to a stay
or injunction pending appeal.
For The Court:
Royce C. Lamberth:
Chief Judge:
[End of section]
Appendix III: CIT Group Bankruptcy:
This appendix describes selected aspects of the CIT bankruptcy. The
items discussed here provide more detail on certain aspects of the
bankruptcy than we cover in the main body of the report. This appendix
does not attempt to summarize the case or fully capture its
complexities. Table 3 provides a timeline of selected events related
to the CIT bankruptcy.
Background:
Before filing for bankruptcy, CIT--a 100-year old, New York-based
lender--had changed its business focus. According to CIT's filings
with the SEC, CIT had been involved in consumer finance before 2008,
when losses in mortgage-related businesses caused it to change its
business model to focus exclusively on its core businesses of
commercial lending and leasing products, management advisory services,
and small and mid-market-business finance. At that time, CIT was
active in more than 30 industries and 50 countries. In the first
quarter of 2007, CIT reported record quarterly earnings of $271.4
million or $1.37 per common share. The market capitalization of the
common shares of the company peaked in February 2007 at $12.17
billion. CIT relied extensively on both secured and unsecured debt
capital markets for funding. The company had accessed global capital
markets issuing notes denominated in euros, British pounds, Canadian
dollars, and Swiss francs as well as borrowing directly from a bank in
Japanese yen. In December 2008, CIT received approval from the Federal
Reserve to become a bank holding company. CIT's bank holding company,
CIT Group, Inc., was incorporated in Delaware. At that time, CIT
Group, Inc. had a bank subsidiary, CIT Bank, and more than 400 nonbank
subsidiaries, including special purpose entities and other regulated
subsidiaries in the United States and abroad. CIT Bank, based in Salt
Lake City, Utah, had been a state-chartered, industrial loan company
but changed its charter to a state-chartered commercial bank in 2008.
CIT Bank is subject to regulation by both FDIC and the Utah Department
of Financial Institutions.
From the second quarter of 2007 through the third quarter of 2009, CIT
lost money in every quarter for a total of $6.3 billion. According to
the company's filings with SEC, disruptions in the credit markets
combined with the global economic deterioration that began in 2007
materially worsened CIT's liquidity situation. Successive downgrades
by the rating agencies of debt issued by CIT to below investment grade
in 2008 and 2009 compounded CIT's problems, leaving the company
without access to unsecured debt markets. According to CIT's SEC
filings, during the period of 2008 through its bankruptcy, CIT
obtained interim secured financings, such as the senior credit
facility detailed below, and reduced its financing needs through
balance sheet contraction.
Because CIT had changed its structure to that of a bank holding
company--upon receiving approval from the Federal Reserve on December
22, 2008--it was eligible to participate in the Capital Purchase
Program under the Troubled Asset Relief Program (TARP). On December
31, 2008, CIT received $2.33 billion from TARP. In exchange, the
Office of Financial Stability in the Department of the Treasury
received preferred equity stock and a warrant to purchase CIT's common
stock.
According to CIT's filings with SEC, as part of its overall plan to
transition to a bank-centric business model, CIT had applied to
participate in FDIC's Temporary Liquidity Guarantee Program (TLGP).
Participation in this program would have enabled CIT to issue up to
$10 billion in government-guaranteed debt. However, CIT did not
receive approval to issue TLGP backed debt. CIT also applied for
exemptions under Section 23A of the 1913 Federal Reserve Act (Section
23A) and the Federal Reserve's implementing regulation to transfer a
significant portion of its U.S. assets to its subsidiary, CIT Bank.
This transfer enabled CIT to generate liquidity by leveraging the
deposit-taking capabilities of CIT Bank. In April 2009, the Federal
Reserve granted CIT a partial waiver from Section 23A requirements,
which govern transactions between affiliated bank and nonbank
companies, to transfer $5.7 billion of government-guaranteed student
loans to CIT Bank.[Footnote 112] In connection with this transaction,
CIT Bank assumed $3.5 billion in debt and paid $1.6 billion in cash to
CIT Group, Inc. On July 15, 2009, CIT was advised that there was no
appreciable likelihood of receiving additional government support in
the near term, either through participation in TLGP or further
approvals of asset transfers under its remaining pending Section 23A
exemption request. Following this announcement, CIT experienced higher
customer usage of prior financing commitments, accelerating the
degradation of its liquidity position. This liquidity situation, its
continued portfolio deterioration, and the generally weak economic and
credit environment all weighed heavily on CIT's financial performance.
To meet its near-term liquidity needs, CIT entered into a $3 billion
senior secured term loan facility on July 20, 2009--which was amended
and restated on August 3, 2009--provided by a syndicate comprised of
certain of CIT's preexisting creditors. By August 4, 2009, CIT had
drawn the entire $3 billion in financing under this senior credit
facility. Both CIT Group, Inc. and certain subsidiaries were borrowers
under this facility. CIT Group, Inc. and all of its U.S.-based, wholly
owned subsidiaries--with the exception of CIT Bank and other regulated
subsidiaries, such as wholly owned banks in Brazil, France, Germany,
Sweden, and the UK, special purpose entities, and immaterial
subsidiaries--were guarantors of this senior credit facility. At the
same time as announcing this facility, CIT announced that it was
beginning to attempt to restructure its liabilities to improve its
liquidity and capital position. This involved an offer by which
certain senior notes maturing in August would be repaid by CIT at a 20
percent discount on the face value with a 2.5 percent premium payable
to those who agreed to these terms by the end of July. This offer was
subject to approval by holders of 90 percent of the $1 billion in
these notes outstanding. On August 3, 2009, CIT announced that only
64.97 percent of the debt holders agreed to the tender offer. Then,
CIT increased the offered payout to 87.5 percent while lowering the
minimum debt holder approval hurdle to 58 percent. Debt holders with
59.8 percent of the outstanding notes agreed to the tender offer and
were paid out the discounted amount. The remaining 40 percent of debt
holders were paid the full face value on their notes.
The Bankruptcy:
By the end of the third quarter of 2009, CIT was negotiating with a
group of its largest creditors to secure interim financing and develop
a restructuring plan that included a plan to exchange debt on a
voluntary basis or to serve as a prepackaged bankruptcy plan,
according to an expert involved in the negotiations.[Footnote 113] The
restructuring plan would need approval from almost all the creditors,
while a prepackaged bankruptcy plan would need approval only from a
majority of the creditors, which would in turn provide it with
emergency financing. CIT also adopted a strategy to help ensure that
it would be able to preserve the deferred tax assets associated with
the more than $6 billion in operating losses it had borne over the
prior two and a half years. On October 1, 2009 CIT announced its
restructuring plan had been approved by a steering committee of the
company's creditors. The plan included a series of voluntary exchange
offers where existing debt holders would exchange their existing notes
for a series of five newly issued securities. The plan was then
presented to CIT creditors to be voted on pursuant to securities laws.
Eligible creditors were asked to vote on the exchange offer and a
prepackaged bankruptcy plan. The exchange offer included voluntarily
replacing certain unsecured notes with secured notes at 70 cents on
the dollar. The prepackaged bankruptcy plan which has a lower
threshold for approval than an exchange plan, was offered in the event
that creditors did not vote for the exchange offer in a high enough
percentage to be binding. For the vote, creditors and equity holders
were organized into 18 classes. Only Classes 6 through 13
(representing lower-priority creditors) were entitled to vote and they
were subject to a partial impairment of the debt owed to them by CIT.
Classes 1 through 5 and Class 17, representing senior creditors and
secured creditors, as well as some unsecured creditors, holders of
guarantees by CIT and CIT entities owed money by other CIT entities,
were not entitled to vote; the plan called for paying their claims in
full so they were deemed to have accepted the plan. Classes 14 through
16 and Class 18 primarily representing preferred and common equity
shareholders were not entitled to vote and were deemed to reject the
plan and received no payment. In addition, the new common equity
shares in CIT were to be distributed to those creditors that were
scheduled to receive principal payback less than full par value.
CIT did not receive adequate approval for the exchange plan; however,
it received approval from 92 percent of the 83 percent (based on the
principal balance owed) of creditors that voted on the prepackaged
bankruptcy plan for a restructuring framework. CIT Group and one other
financing subsidiary filed for Chapter 11 protection on November 1,
2009, in the bankruptcy court of the Southern District of New York.
CIT requested that the prepetition vote be deemed a vote on a Chapter
11 plan pursuant to section 1126(b) of the Code, which provides that a
prepetition vote may be binding in a prepackaged Chapter 11 if the
solicitation of the vote were applicable and in compliance with
securities law. CIT's plan guaranteed significant recoveries to
creditors and canceled or extinguished all of the existing equity
classes, including the U.S. Treasury's preferred shares acquired
through its $2.33 billion TARP capital injection. Holders of equity
interests were not entitled to retain any property or interest in the
new company. On December 10, 2009, CIT canceled and deregistered its
old common stock, which had been delisted from the New York Stock
Exchange on November 2, 2009, but had continued to trade. On December
11, 2009, CIT issued 200 million shares of new stock to debt holders
and other creditors and began trading on the New York Stock Exchange
under the old CIT ticker symbol. CIT had effectively reduced its debt
by approximately $12.5 billion (from $64.1 billion to $51.6) at the
end of the third quarter of 2009. In addition, it preserved its
deferred tax assets that stemmed from prebankruptcy losses. Its
depository institution, CIT Bank, had preserved its well-capitalized
status, and it and other operating subsidiaries continued to conduct
business throughout the bankruptcy. There were no new adversary
proceedings filed after November 2009. Several adversary proceedings
were voluntarily dismissed.[Footnote 114]
Table 3: Timeline of Selected Events Related to the CIT Bankruptcy,
from April 2007 through December 2009:
Key date: Apr. 18, 2007;
Event or activity: CIT reports record earnings of $271.4 million or
$1.37 a share for the first quarter of 2007.
Key date: Dec. 22, 2008;
Event or activity: CIT receives approval on its application to become
a bank holding company from the Federal Reserve.
Key date: Dec. 31, 2008;
Event or activity: CIT receives Capital Purchase Program investment of
$2.3 billion from U.S. Treasury.
Key date: July 15, 2009;
Event or activity: CIT is advised by regulators that there is no
appreciable likelihood of receiving any further government assistance.
Key date: July 20, 2009;
Event or activity: Initial CIT Restructuring Announcement.
Key date: Oct. 1, 2009;
Event or activity: Exchange offer announced, prepackaged plan
announced.
Key date: Oct. 29, 2009;
Event or activity: Exchange offer closed.
Key date: Nov. 1, 2009;
Event or activity: Voluntary petition for bankruptcy filed.
Key date: Nov. 2, 2009;
Event or activity: New York Stock Exchange delists common and
preferred stock.
Key date: Dec. 7, 2009;
Event or activity: Debtors file Modified Second Amended Prepackaged
Reorganization Plan.
Key date: Dec. 8, 2009;
Event or activity: Plan confirmed.
Key date: Dec. 9, 2009;
Event or activity: Registration of 600,000 new CIT common shares and
100,000 new preferred shares.
Key date: Dec. 10, 2009;
Event or activity: CIT files disclosure statement and emerges from
Chapter 11 deregisters old stock.
Key date: Dec. 11, 2009;
Event or activity: New stock starts trading on the New York Stock
Exchange at $29.64 per share.
Sources: GAO review of SEC filings, CIT bankruptcy filings, regulatory
filings, and other official company documents.
[End of table]
[End of section]
Appendix IV: Lehman Bankruptcy:
This appendix describes selected aspects of the Lehman bankruptcy. The
items discussed here provide more detail on certain aspects of the
bankruptcy that we cover in the main body of the report. This appendix
does not attempt to summarize the case or fully capture its
complexities. Table 4 provides a timeline of selected events related
to the Lehman bankruptcy.
Background:
Lehman was an investment banking institution that offered equity,
fixed-income, trading, investment banking, asset management, and other
financial services. According to the bankruptcy examiner appointed by
the bankruptcy court, Lehman originated mortgages, securitized them,
and then sold the securitized assets. Although headquartered in New
York, Lehman operated globally. Lehman had $639 billion in total
assets and $613 billion in total debts as of May 31, 2008, the date of
its last audited financial statements. According to Lehman's 2007
annual 10-K filing with SEC, the firm had 209 registered subsidiaries
in 21 countries. Lehman included several regulated entities including
Lehman Brothers, Inc (LBI), a broker-dealer subject to SEC oversight,
and one state-chartered bank and one federally chartered thrift whose
primary regulators at the federal level were the FDIC and the Office
of Thrift Supervision, respectively.[Footnote 115] Until it filed for
bankruptcy, Lehman also was subject to SEC supervision at the
consolidated level.[Footnote 116] Although Lehman comprised numerous
subsidiaries, it operated as an integrated entity.
Investment banks such as Lehman generally rely on short-term financing
and engage in derivative activities. Much of what constituted Lehman's
borrowings was secured with collateral, including securities.
According to a legal expert, even before the financial crisis Lehman
needed to refinance about $100 billion on a daily basis. According to
the Lehman bankruptcy examiner's report, as of August 31, 2008, Lehman
had a net receivable (asset) of $46.3 billion and a liability of $24.2
billion arising from its derivatives activity.[Footnote 117] Its
derivative position represented a net positive of $22.2 billion.
However, according to a legal expert, Lehman also was the guarantor to
the majority of International Swaps and Derivatives Association (ISDA)
derivatives contracts--an association of derivative market
participants--with about 1.7 million trades and more than 10,000
counterparties.[Footnote 118]
The examiner attributes Lehman's decline and bankruptcy to aggressive
investing in areas such as commercial real estate and to exceeding
internal risk controls. Starting in 2006, Lehman invested the firm's
capital in real estate lending and began holding mortgages on its
balance sheet rather than selling the loans to other investors. In
February 2007, Lehman stock traded at a record high of $85 per share,
and its market capitalization exceeded $45 billion; however, according
to the examiner's report, by September 2008 the stock had lost around
95 percent of its value. And, in the months leading up to its
bankruptcy filing, Lehman faced liquidity strains, worsened by
increased collateral requirements from its clearing banks. For
example, JPMC required Lehman to post additional collateral, also
called a margin, worth more than the money it received from the bank.
In February 2008, JPMC began increasing Lehman's margin requirements.
By June 2008, JPMC required Lehman to post an additional $5 billion.
On September 9, 2008, JPMC requested another $5 billion. Lehman agreed
to post $3 billion the next day. JPMC also requested that Lehman agree
to a new arrangement giving JPMC increased authority to request and
seize collateral. On September 11, JPMC again requested $5 billion.
The Bankruptcy:
The Bankruptcy Filings:
After government officials and those in the industry were unable to
find a private-sector solution to Lehman's likelihood of defaulting on
its obligations, Lehman Brothers Holdings, Inc (LBHI) filed for
Chapter 11 bankruptcy on the morning of September 15, 2008. According
to experts on the case, the abruptness of Lehman's filing contributed
to many of the ensuing issues raised by creditors. According to its
petition, LBHI had more than 100,000 creditors, with the largest being
Citibank, N.A., which as indenture trustee for LBHI's senior notes
held an unsecured claim of approximately $138 billion, and the Bank of
New York Mellon Corporation (BNY), which had claims of approximately
$12 billion and $5 billion as indenture trustee of LBHI's subordinated
debt and junior subordinated debt, respectively. Between LBHI's
bankruptcy filing on September 15 and September 17, LBI continued to
borrow funds from the New York Federal Reserve Bank.[Footnote 119]
Between September 16 and October 5, 2008, several other Lehman
subsidiaries filed for Chapter 11 bankruptcy. On October 16, the
Bankruptcy Court procedurally consolidated 15 subsidiaries into the
main case.[Footnote 120] In the ruling, the court explicitly declined
consideration of substantive consolidation at that time, which would
have pooled the assets and liabilities of each subsidiary or other
legal entity into one fund. The procedural consolidation was intended
to reduce duplication of effort. For example, the court would not have
to maintain separate dockets and files, and the debtors would not have
to file redundant documents.
Reorganization Plans:
On March 15, 2010, the Lehman debtors (the debtors) filed their
proposed Chapter 11 plan. On December 15, 2010, an ad hoc group of
LBHI senior creditors (the ad hoc group) filed an alternative plan
based upon a substantive consolidation of the debtors' cases. On
January 25, 2011, the debtors filed their first amended joint Chapter
11 plan. On April 25, 2011, a group of creditors opposed to that plan
and the ad hoc group plan (the nonconsolidation creditors) filed an
alternative counterplan (the nonconsolidation plan). On April 27,
2011, the ad hoc group filed an amended second counterplan. At issue
was the amount of substantive consolidation of the various debtors'
assets and liabilities under each plan. The debtors' plan rejected
complete substantive consolidation; instead claims against specific
debtors would be "satisfied primarily" by that debtor's assets and
compromises among creditors would satisfy additional claims. The
nonconsolidation plan rejected the debtors' compromise plan and the
complete substantive consolidation of the ad hoc group.
Nonconsolidation creditors argued that no legal rationale exists for
not respecting the separate corporate status of the individual Lehman
debtors. They stated that LBHI "expressly advised its creditors of…
corporate separateness." The ad hoc group's plan was based on
judicially ordered substantive consolidation. The group stated that
creditors considered Lehman to be a unified economic entity and that
Lehman operated as a single business entity in global markets.
On June 29, 2011, Lehman filed a disclosure statement that set out the
plan for distribution of assets to the claimants of 23 Lehman debtor
entities. This plan was made after extensive negotiations with
representatives of major creditor groups including those that
supported substantive consolidation and those that did not. The plan
asserts that although Lehman operated as a centralized business
enterprise, certain critical factors such as the ease of segregating
each individual entity's assets and liabilities support an argument
against substantive consolidation. It should be noted that although
representatives of the major constituencies believe that they have
reached an agreement in principle to the terms of this plan, as of
June 29, 2011, there were still conditions under which the plan could
be amended. The plan separated the claims against each of the 23
debtor entities and the shareholders of each debtor into classes based
on the nature of the claims and the claimants' related legal rights.
Allowed claims across the 23 entities totaled $361 billion. The estate
estimates that recovered assets will total nearly $84 billion prior to
total administrative expenses of $3.2 billion, amounts due to
intercompany entities of nearly $2.9 billion, and operating
disbursements of approximately $1.9 billion for a net distributable
amount of $76.3 billion or a claim payout ratio of 21.1%. It should be
noted that the plan estimates that 7 of the 23 entities will fully pay
all of their claims and have remaining funds for their shareholders.
These include two separately capitalized AAA rated subsidiaries
through which Lehman conducted fixed income derivatives transactions.
Recoveries to general unsecured derivatives creditors of three Lehman
subsidiaries through which Lehman conducted equity derivatives,
commodity and energy derivatives, and foreign exchange forward
contracts and options business will receive payouts of 29.6 percent
(equity), 50.8 percent (commodity), and 35.8 percent (foreign
exchange). Creditors of the holding company, LBHI, will receive 16
percent of their claims.
Table 4: Timeline of Selected Events Related to the Lehman Bankruptcy,
from September 2008 through April 2011:
Key date: Sept. 15, 2008;
Event or activity: LBHI files for bankruptcy.
Key date: Sept. 17, 2008;
Event or activity: Motion to sell LBI to Barclays, PLC (Barclays)
filed.
Key date: Sept. 19, 2008;
Event or activity: Liquidation of LBI under Securities Investor
Protection Act (SIPA) commences.
Key date: Sept. 20, 2008;
Event or activity: Sale of certain assets and liabilities of LBI to
Barclays authorized.
Key date: Sept. 22, 2008;
Event or activity: Sale of certain assets and liabilities of LBI to
Barclays closed.
Key date: Oct. 3, 2008;
Event or activity: Lehman Brothers Special Financing (LBSF) files for
bankruptcy along with Lehman Brothers OTC Derivatives, Inc. and Lehman
Brothers Commodity Services, Inc.
Key date: Oct. 5, 2008;
Event or activity: Nine other Lehman entities file for bankruptcy.
Key date: Oct. 16, 2008;
Event or activity: Procedural consolidation of Lehman case.
Key date: May 12, 2009;
Event or activity: Lehman insolvency protocol signed.
Key date: Sept. 22, 2009;
Event or activity: Bar Date for claims against the Debtors.
Key date: Mar. 11, 2010;
Event or activity: Lehman Examiner's Report filed.
Key date: Aug. 25, 2010;
Event or activity: Securities Investor Protection Act Trustee's
preliminary report released.
Key date: Jan. 25, 2011;
Event or activity: Debtors file the first amended joint Chapter 11
plan.
Key date: Apr. 25, 2011;
Event or activity: Nonconsolidation creditors file Chapter 11 plan.
Key date: Apr. 27, 2011;
Event or activity: Ad hoc group files amended Chapter 11 plan.
Sources: Judicial filings and decisions from the U.S. Bankruptcy Court
of the Southern District of New York.
[End of table]
Liquidation of Lehman Broker-Dealer:
On September 19, 2008, Lehman's broker-dealer, LBI, was placed into
liquidation under the SIPA in the Southern District of New York. The
court appointed a SIPA trustee to oversee the liquidation of LBI's
estate.[Footnote 121] According to the trustee, his main role was to
"maximize the return of customer property to customers of LBI as
defined by the law, while at the same time maximizing the estate for
all creditors."
The LBI resolution is the largest in SIPA history. As of April 22,
2011, the trustee handled approximately 125,000 customer claims
involving potentially $180 billion. Nearly 10,000 claims were
investigated, denied customer status, and closed. More than 110,000
claims, worth over $92 billion, were resolved through account
transfers to other entities, including Barclays and Neuberger Berman,
a Lehman subsidiary. Another 10,000 claims, worth about $46 billion,
were resolved by SIPC. The amount of intercompany claims revealed the
level of interconnectedness in Lehman. The other Lehman entities filed
630 claims worth about $19.9 billion against LBI. These claims came
not only from LBHI and Lehman Brothers International Europe (LBIE) but
also from entities in Bermuda, the Dutch Antilles, Germany, Hong Kong,
India, Japan, Luxembourg, the Netherlands, Singapore, Switzerland, and
the UK. More than 14,000 claims with a face value of over $88 billion
remained unresolved as of April 22, 2011, including 1,143 claims by
clients of LBIE for over $22 billion.
Selected Proceedings:
The following cases are not intended to represent a complete legal
history of the Lehman bankruptcy but to highlight certain issues
presented in this report. The Lehman Brothers Special Financing (LBSF)
case illustrates how a conflict between U.S. and UK law can create
uncertainty. The Barclays case highlights the issues that can arise
from a hurried financial institution bankruptcy. Finally, the Swedbank
AB case illustrates the limits of safe harbors for qualified financial
contracts.
Lehman Brothers Special Financing Case:
At issue were competing payment priorities between Perpetual Trustee
Company Limited (Perpetual), an Australia-based asset management
company, and LBSF regarding collateral held by BNY Corporate Trustee
Services Limited (BNY trustee). The cases were heard in U.S. and
English courts. On November 6, 2009, the English Court of Appeal
upheld a lower court decision in favor of Perpetual. On January 25,
2010, the U.S. court ruled in favor of LBSF and called for all parties
to work together to reach an agreement.[Footnote 122]
In 2002, LBIE had begun to issue a series of structured notes.
Perpetual had bought two series of the notes, issued by Saphir Finance
Public Limited Company (Saphir)." The two series of notes were issued
in the UK and written so that English law would govern their dealings.
Each note was backed by collateral and included a swap agreement with
LBSF, which was guaranteed by LBHI and also backed by collateral. The
collateral was held by BNY trustee as a trustee for Saphir. Normally,
LBSF as the swap counterparty would have priority rights to the
collateral over Perpetual. However, a "flip" clause in the contracts
specified that, if LBSF defaulted, the priorities would flip, and
Perpetual would have rights to the collateral ahead of LBSF.
LBSF filed for bankruptcy on October 3, 2008. On December 1, 2008,
Saphir exercised its termination rights on the swap agreements with
LBSF. On May 20, 2009, LBSF filed a complaint against the BNY trustee
for the collateral in U.S. Bankruptcy Court claiming that the flip
clause was unenforceable. The U.S. Bankruptcy Code prohibits clauses
(called ipso facto clauses) that modify a contract based on a
bankruptcy filing. LBSF argued that the flip clause violated the Code
because it modified the payment structure based on LBSF's default. The
BNY trustee countered that the contracts were agreed to and valid
under English law, and the U.S. courts should defer to the English
courts. The BNY trustee further argued that even if the flip clause
normally would be unenforceable, safe harbor provisions (that is, the
Code's exemptions of qualified financial contracts from an automatic
stay) protected the agreement. The BNY trustee also argued that the
flip clause was a "subordination agreement" and enforceable under the
Code.[Footnote 123]
At the same time, Perpetual filed suit in the UK against the BNY
trustee for the collateral to enforce the flip clause. On November 6,
2009, the English court ruled that the flip clause was valid and in
effect. The court ruled that LBSF's claim on the collateral was
"always limited and conditional" and no reason existed to override the
contract. On January 25, 2010, the U.S. court ruled that the flip
clause was an unenforceable ipso facto clause. In his ruling, the
judge noted that U.S. courts were not obligated to recognize a foreign
court's decisions and that the English court did not take into account
the Bankruptcy Code in making its decision. He added that courts did
not have to extend recognition to a foreign court when doing so would
be contrary to U.S. policy. The U.S. court also ruled that the safe
harbor provisions of the Code did not apply to the flip clause,
reasoning that the provisions referred to the "acceleration" of
rights, not the "alteration" of rights; thus, they did not protect the
priority changes of the flip clause. Finally, the U.S. court ruled
that, even as a subordination agreement, the flip clause was
unenforceable. Under normal circumstances LBSF could agree to have its
priority rights subordinated to another party and this would be
enforceable. However, since the subordination was triggered by a
bankruptcy filing it still represented an ipso facto clause and
remained unenforceable.
Further, the U.S. court noted the complex and international nature of
the case. It noted that the BNY trustee was in an unfavorable position
since the English courts ruled for Perpetual's rights to the
collateral while the U.S. ruled for LBSF. The U.S. court recommended
that given the complexity of the case it would be better if all
parties could settle the dispute. On December 16, 2010, the U.S. court
approved a settlement.
Barclays Sale Case:
The Barclays sale case illustrates the difficulties and complexities
of an expedited sale of a large financial institution during
bankruptcy and the finality of sale orders under the Code. At issue
was Lehman's sale of LBI to Barclays on September 22, 2008. LBHI and
the committee of unsecured creditors (the committee) moved to have
parts of the sale invalidated. On February 22, 2011, the U.S.
Bankruptcy Court denied the motion to invalidate the sale order.
[Footnote 124]
In the week following its bankruptcy filing, Lehman wanted to sell
assets, including LBI, to Barclays. Barclays had been in talks to
acquire all of Lehman before the bankruptcy. On September 20, 2008,
the court approved a sale of LBI to Barclays and the order was
finalized on September 22. As part of the sale, the parties agreed to
a "clarification letter" that clarified certain aspects of the sale
and made some modifications to the agreement.
LBHI and the committee argued that this sale order should be
overturned, and Barclays should be liable for multibillion dollar
claims for underpayments. They argued that Barclays withheld critical
information from the court: a multibillion dollar discount in
financial assets or that Barclays would not assume LBI's obligations
to the Federal Reserve Bank of New York. Furthermore, they argued that
certain executives were not acting in the interests of the company and
were operating on behalf of Barclays as Barclays had made job offers
to key decision makers. Due to these factors, the Lehman estate
claimed that Barclays unfairly took advantage of LBHI and bought the
assets at well below their fair value. Barclays countered that it gave
the court all the information it needed. Barclays further argued that
LBHI and the committee were happy to accept the deal at the time, but
now regretted the sale, but that this regret was not grounds for
overturning the sale order.
On February 22, 2011, the court ruled that LBHI and the committee had
not established a right to relief. The new information about the deal
structure, while important, would not have changed the court's
previous decision allowing the sale order. The court stated that it
recognized that Barclays was the only buyer available to LBHI at the
time given the uncertainty in financial markets and that since LBHI
was in an unfavorable bargaining position compared to Barclays, it was
not unreasonable to assume that Barclays would get the better end of
the deal. The sale, while profitable to Barclays, also was needed to
potentially stave off further financial disaster. Furthermore, the
court ruled that the Lehman estate did not prove that former Lehman
executives were acting in bad faith due to future employment prospects
at Barclays.
In another aspect of the Barclays Sale case, the SIPA Trustee (the
trustee) disputed Barclays' claim to certain classes of assets, the
15c3-3 assets, the margin assets, and the clearance box assets.
[Footnote 125] The trustee argued that Barclays' claims for additional
assets held by LBI, and the retention by Barclays of assets obtained
as a result of the transfers of accounts and acquisition by Barclays
of certain Lehman businesses, would reduce protection of LBI customers
under applicable laws. Specifically, the trustee argued that $769
million in assets held by LBI in the special account maintained
pursuant to SEC Rule 15c3-3, known as the "Customer Protection Rule,"
and $507 million in assets held at the Options Clearing Corp., (these
assets formed part of LBI's regulatory customer reserve formula) must
be available to LBI to satisfy claims of LBI's customers, rather than
provided to Barclays. In addition, the trustee argued that the terms
of the Asset Purchase Agreement did not provide Barclays the right to
acquire certain margin assets estimated to value $3.5 billion, or
assets valued at approximately $1.9 billion held in LBI's clearance
box account at the Depository Trust & Clearing Corporation. Barclays
disputed the trustee's interpretation of the Asset Purchase Agreement
and demanded all of the above assets in addition to those already
obtained.
The court ruled that the trustee was entitled to relief regarding the
$769 million in assets held in LBI's 15c3-3 account, and the $507
million held at the Options Clearing Corp, and that the trustee was
entitled to the significant margin assets valued at approximately $3.5
billion. With regard to the 15c3-3 account and reserve formula assets
held at the Options Clearing Corp, the court ruled that Barclays'
"self-interested construction of the language" runs counter to the
deal's specific terms that such asset transfer be effected "to the
extent permitted by applicable law," and that the trustee's
interpretation of the deal was consistent with the broad principles
underlying SIPA and its objective of giving priority treatment to
customers. With regard to the margin assets, the court ruled that the
specific terms of the Asset Purchase Agreement excluded these assets,
and that representations made to the court at the Sale Hearing were
unambiguous in meaning that no such margin assets were acquired by
Barclays. As to the clearance box assets held at Depository Trust &
Clearing Corporation, the court agreed with Barclays that despite
conflicting language in the controlling documentation of the deal, the
balance of the evidence favored that transfer of these assets to
Barclays.
Swedbank AB Case:
The Swedbank AB (Swedbank, a Swedish financial institution) case
illustrates the limits of safe harbors for qualified financial
contracts in bankruptcy. At issue was a dispute over a deposit account
LBHI had at Swedbank and whether Swedbank could exercise set-off
rights (essentially, rights to balance mutual claims between parties)
in connection with its liability as a derivatives guarantor against
LBHI's funds in the account. On May 5, 2010, the U.S. Bankruptcy Court
ruled for LBHI granting its motion for an enforcement of the automatic
stay against Swedbank. On January 26, 2011, the U.S. district court
upheld the Bankruptcy Court's decision.[Footnote 126]
LBHI and Swedbank were counterparties in several financial derivative
transactions under various ISDA master agreements. LBHI also had a
regular deposit account at Swedbank's Stockholm branch. On September
15, 2008, LBHI had 2.1 million Swedish Kronor or approximately
$310,000 in the Swedbank account. Once LBHI filed for bankruptcy, the
account was frozen by Swedbank, thus preventing LBHI from withdrawing
any funds. However, LBHI and other entities were able to deposit
additional funds into the account. By November 12, 2009, LBHI had
deposited an additional 82.8 million Swedish Kronor or approximately
$10 million.
Provisions in the ISDA master agreements into which LBHI and Swedbank
had entered allowed for certain rights in case one party defaulted.
Specifically, the master agreements could be terminated, and the
nondefaulting party could set off mutual obligations. Swedbank claimed
that LBHI owed it approximately $13.9 million or 97.5 million Swedish
Kronor. On November 27, 2009, Swedbank announced that it would set off
the obligations LBHI owed it with the money in the Swedbank account.
The Lehman debtors contested this decision and filed suit on January
22, 2010, to force Swedbank to return the funds to the Swedbank
account.
The main issue was whether the setoff violated the Code. More
specifically, whether the safe harbor provisions in sections 560 and
561 permitted Swedbank to set off according to the master agreement or
whether the mutuality provision in section 553 prohibited Swedbank's
action. LBHI argued that Swedbank violated the automatic stay because
it seized money LBHI had deposited after filing for bankruptcy. As
such, the deposits lack mutuality with LBHI's prebankruptcy debts.
Swedbank argued that the setoff rights in the master agreement, and
the safe harbors in the Bankruptcy Code provided an exemption from the
automatic stay in this case.
The Bankruptcy Court ruled that for Swedbank to set off debts with the
deposits in the Swedbank account, the amount owed by LBHI to Swedbank
had to be a "prepetition debt," LBHI's claim on Swedbank also had to
be prepetition, and the two claims had to be mutual. The court ruled
that because the funds in the Swedbank account were postpetition while
the LBHI obligation to Swedbank was prepetition, no mutuality existed.
Swedbank countered that even if no mutuality existed, it still could
set off due to safe harbor protections in the Code. However, the court
ruled that safe harbor provisions did not allow Swedbank to bypass the
mutuality requirement. The court found no support to the claim that
safe harbor provisions were intended to override the mutuality
requirement, or any other underlying requirement, for setoff.
Therefore, the court ruled that Swedbank had to return all funds
deposited after the bankruptcy filing.
[End of section]
Appendix V: Washington Mutual Bankruptcy:
This appendix describes selected aspects of the Washington Mutual,
Inc. (Washington Mutual) bankruptcy. The items discussed here provide
more detail on certain aspects of the bankruptcy than we cover in the
main body of the report. This appendix does not attempt to summarize
the case or fully capture its complexities. Table 5 provides a
timeline of selected events related to the Washington Mutual
bankruptcy.
Background:
Washington Mutual was a thrift holding company that had 133
subsidiaries. These subsidiaries included Washington Mutual Bank,
which was the largest savings and loan association in the United
States prior to its failure, with more than 2,200 branches and $188.3
billion in deposits, according to the confirmation opinion of the U.S.
Bankruptcy Court of the District of Delaware.[Footnote 127] Washington
Mutual Bank conducted most of Washington Mutual, Inc.'s primary
banking activities. Washington Mutual Bank had more than $300 billion
in assets at the time of its failure and a large subsidiary of its
own, called Washington Mutual Bank, FSB.[Footnote 128] The Office of
Thrift Supervision (OTS) was the primary regulator for Washington
Mutual Bank and Washington Mutual Bank, FSB.[Footnote 129] Washington
Mutual also had several nonbanking subsidiaries, including two captive
reinsurers, several mortgage companies, and several real estate
companies. At the time of filing, Washington Mutual had approximately
$32.9 billion in total assets and total debt of approximately $8.1
billion. Washington Mutual's common stock was listed on the New York
Stock Exchange and traded at its highest level of $46.55 per share in
January 2006 for a total market capitalization at that time of $44.9
billion.
Washington Mutual Bank was the largest bank failure in U.S. history.
According to the joint report of the Offices of Inspectors General for
the Department of the Treasury and FDIC on regulatory oversight at
Washington Mutual Bank, Washington Mutual Bank had weak risk
management and pursued a strategy to pursue growth through
originating, acquiring, securitizing, and servicing nontraditional
loan products and subprime loans.[Footnote 130] This strategy broke
down when housing and mortgage markets began to collapse in mid-2007.
Until late 2007, Washington Mutual Bank remained profitable, but loan
losses caused earnings to decrease 73 percent from the second to third
quarter of 2007. Further loan losses and chargeoffs caused Washington
Mutual Bank to post $1 billion in losses in both the fourth quarter of
2007 and the first quarter of 2008.
In March 2008, Washington Mutual began seeking additional capital.
According to the report of the court-appointed examiner for the
bankruptcy case and the Inspectors General's report, the holding
company received a capital infusion of about $7 billion from TPG
Capital (formerly known as the Texas Pacific Group) in April 2008,
part of which went to Washington Mutual Bank and part of which was
used to pay down Washington Mutual's debt.[Footnote 131] However,
Washington Mutual Bank continued to suffer from significant depositor
withdrawals as the housing market further deteriorated and IndyMac,
FSB failed in July 2008. Washington Mutual Bank was a member of the
Federal Home Loan Bank of San Francisco, which also began to limit
Washington Mutual Bank's borrowing capacity.[Footnote 132] Following
company share price declines, Washington Mutual appointed a new chief
executive officer on September 7, 2008. However, after the collapse of
Lehman on September 15, 2008, Washington Mutual Bank had a net deposit
outflow of $16.7 billion (or more than 9 percent of total deposits)
and experienced a second liquidity crisis. According to the Inspectors
General's report, the bank was further hindered by its borrowing
capacity limits, share price decline, portfolio losses, and other
restrictions tied to the $7 billion capital investment.
By September 23, 2008, OTS had found that Washington Mutual Bank had
$4.6 billion in cash to meet its liquidity obligations, and its
expected earnings would be insufficient to supplement its cash base.
OTS began preparations to take over Washington Mutual Bank and appoint
FDIC as the receiver. FDIC opened its Web site for potential bids for
the bank. On September 24, JPMorgan Chase and Co. (JPMC), Citigroup,
Inc., and Wells Fargo & Company each submitted bids to purchase
Washington Mutual Bank, but both Citigroup's and Wells Fargo's bids
did not meet FDIC's bid requirements. At the same time, the holding
company's management was pursuing other alternatives to gain liquidity
without a buyout, including using other assets to pledge as collateral
to receive funding from the San Francisco Federal Home Loan Bank and
the Federal Reserve Bank of San Francisco, according to the examiner's
report. On September 24, Washington Mutual staff presented these
alternatives to OTS but did not get a response. On Thursday, September
25, OTS found Washington Mutual Bank to be unsafe and unsound and
appointed FDIC as receiver. FDIC then sold substantially all of
Washington Mutual Bank's assets to JPMC through a purchase and
assumption agreement for $1.88 billion.[Footnote 133]
The Bankruptcy:
On September 26, 2008, Washington Mutual, Inc. filed a petition for
relief pursuant to Chapter 11 of the Code. The filing for bankruptcy
was completed the day after the closure of Washington Mutual Bank.
Washington Mutual filed for bankruptcy to receive automatic stay
protection against the seizure or dissipation of the holding company's
remaining assets. The holding company's representatives maintain that
they did not know which assets were transferred to JPMC when the bank
was sold because they did not have access to the purchase and
assumption agreement between FDIC and JPMC, so they wanted to maintain
control over the remaining assets. The holding company's subsidiary
WMI Investment Corp. also filed for Chapter 11 protection on September
26, and these cases were administratively consolidated into one case.
After filing its bankruptcy petition in September 2008, Washington
Mutual's estate sought to recover $4 billion in deposits and other
assets from FDIC that it said were on deposit with a subsidiary of
Washington Mutual Bank (Washington Mutual Bank, FSB). FDIC denied all
of Washington Mutual, Inc.'s claims in a letter dated January 23,
2009. The holding company sued FDIC to return its deposits, among
other reasons, while JPMC also sued Washington Mutual, seeking
judgment that the funds (and other disputed assets) belonged to them
as a cash infusion the holding company made to the bank to maintain
the depository institution's capital levels. When the depository
institution and holding company became eligible for more than $5
billion in tax refunds as the result of a change in federal tax law
related to the carrying forward of more than $14 billion in past
losses, Washington Mutual, JPMC, and FDIC were able to come to an
agreement in 2010 on how to split those proceeds, which would provide
the holding company with value from the refunds.[Footnote 134] This
agreement is discussed in greater detail later in this appendix.
Nevertheless, Washington Mutual's shareholders were not satisfied with
the settlement and sought review by a court-appointed examiner. The
shareholders expressed disapproval of the global settlement plan and
raised concerns about the failure of Washington Mutual Bank, including
whether it was improperly assessed as unsafe and unsound or sold to
JPMC for less than fair market value. In January 2010, the U.S.
Trustee's Office appointed the official Committee of Equity Security
Holders. In April 2010, the committee filed a motion for the
appointment of an examiner because the debtors and the creditors'
committee refused to provide equity holders with information. On July
28, 2010, the bankruptcy court approved the appointment of an
examiner, selected by the U.S. Trustee's office, to investigate the
claims of various parties that were addressed by the global
settlement. The examiner's report reviewed key issues related to the
global settlement agreement including the disputed assets as part of
the sale and was issued on November 1, 2010. While the examiner's
findings supported a determination that the settlement agreement was
fair and reasonable, the Bankruptcy Court for the District of Delaware
did not allow the report as evidence because the judge found the
report to be based mostly on hearsay, and officials commenting in the
report were not available to testify.[Footnote 135]
In January 2011, the bankruptcy judge in the Washington Mutual
proceeding entered an order denying confirmation of the proposed plan
of reorganization, which incorporated the global settlement.[Footnote
136] Although finding that the global settlement of claims was fair
and reasonable and provided a basis for confirmation, the judge
concluded that the plan did not adequately address the terms of a
global settlement of various claims by creditors and some
shareholders. The judge also found that the plan was not confirmable
unless certain deficiencies were corrected. After the order was
issued, the interested parties pursued a revised plan. Confirmation
hearings in the case have been repeatedly delayed, but could take
place as early as July 2011.
Table 5: Timeline of Selected Events Related to the Washington Mutual,
Inc. Bankruptcy, from September 2008 through July 2011:
Key date: Sept. 25, 2008;
Event or activity: OTS finds Washington Mutual Bank to be unsafe and
unsound and appoints FDIC as receiver. FDIC facilitates the sale of
Washington Mutual Bank to JPMC for $1.8 billion and assumption of
liabilities.[A]
Key date: Sept. 26, 2008;
Event or activity: Washington Mutual, Inc. files for bankruptcy
protection in the U.S. Bankruptcy Court in Delaware.
Key date: Oct. 3, 2008;
Event or activity: First day of bankruptcy court hearing.
Key date: Dec. 30, 2008;
Event or activity: Washington Mutual, Inc. files proof of claim with
FDIC related to the Washington Mutual Bank receivership.
Key date: Jan. 23, 2009.;
Event or activity: FDIC denies all of the debtors' claims.
Key date: Mar. 20, 2009;
Event or activity: Washington Mutual (debtor) files suit in the D.C.
District Court against FDIC regarding $4 billion in assets FDIC
transferred to JPMC.
Key date: Mar. 24, 2009;
Event or activity: JPMC files suit against Washington Mutual in U.S.
Bankruptcy Court in Delaware over disputed assets in an adversary
proceeding.
Key date: Nov. 6, 2009;
Event or activity: Enactment of the Worker Homeownership and Business
Assistance Act of 2009 permits businesses to use 2008 net operating
losses to receive refunds on taxes paid in prior years.[B]
Key date: Mar. 12, 2010;
Event or activity: Washington Mutual, FDIC, and JPMC announce that
they have reached a settlement regarding the disputed property and
claims (called the global settlement).
Key date: Apr. 12, 2010;
Event or activity: Parties displeased with the global settlement
(which included allocation of the tax refunds) file an adversary
proceeding in the U.S. Bankruptcy Court in Delaware.
Key date: May 21, 2010;
Event or activity: Washington Mutual, Inc. files amended plan of
reorganization and disclosure statement reflecting agreements reached
with FDIC and JPMC.
Key date: July 6, 2010;
Event or activity: Parties displeased with the global settlement file
a different adversary proceeding in the U.S. Bankruptcy Court in
Delaware (known as the Trust Preferred Securities adversary
proceeding).
Key date: July 28, 2010;
Event or activity: The U.S. Bankruptcy Court in Delaware approves the
U.S. Trustee's selection of an examiner to conduct an investigation
into the merits of the various claims of the estate, JPMC, and FDIC
which were being resolved by the global settlement. The examiner
completed his report on November 1, 2010.
Key date: Oct. 6, 2010;
Event or activity: Modification of global settlement plan.
Key date: Jan. 7, 2011;
Event or activity: Denial of summary motion April 12, 2009, adversary
proceeding.
Key date: Mar. 30, 2011;
Event or activity: Approval of disclosure statement and solicitation
procedures for revised plan.
Key date: July 13, 2011;
Event or activity: Scheduled date of confirmation hearing for plan.
Sources: Judicial filings and decisions from the U.S. Bankruptcy Court
of the District of Delaware, FDIC, and OTS.
[A] The sale resulted in a closed bank transaction with no losses to
the deposit insurance fund.
[B] Pub. L. No. 111-92 § 13 (2009) allows firms to apply losses in
2008 and 2009 to their taxable income for up to 5 prior years (with a
limited amount for the fifth prior year), instead of the 2 years
otherwise generally allowed.
[End of table]
Adversary Proceedings:
Washington Mutual, Inc. and JPMC:
Shortly following the sale of Washington Mutual Bank to JPMC,
Washington Mutual filed a proof of claim with FDIC as receiver to
recover about $4 billion in deposits allegedly held by the holding
company in a subsidiary of Washington Mutual Bank. According to
representatives of the holding company, the holding company was the
largest creditor for the receivership and followed timelines for an
appeal of FDIC's decision to transfer the holding company's assets.
FDIC denied the claim in a letter dated January 23, 2009, and
Washington Mutual then sought an appellate review.
As discussed earlier, on March 20, 2009, Washington Mutual filed suit
in D.C. District Court against FDIC, asserting that FDIC: (1) should
review its denial of Washington Mutual's claims; (2) wrongfully
dissipated Washington Mutual Bank's assets; (3) took Washington
Mutual, Inc.'s property without just compensation; (4) should convert
Washington Mutual, Inc.'s property back to the holding company; and
(5) should void its prior disallowance of Washington Mutual, Inc.'s
claim to the deposits. This filing became known as the WMI action.
Representatives of the holding company told us the holding company
took a portion of the funds it raised in April 2008 and put it in a
deposit account at a subsidiary of Washington Mutual Bank, called
Washington Mutual Bank FSB, which also was seized by regulators. By
the end of the second quarter of 2008, $5 billion of the funds from
TPG Capital went into Washington Mutual Bank. Representatives of
Washington Mutual told us they filed in the D.C. District Court
because FDIC's main office is located there, and the challenged action
occurred there.
Four days later, JPMC filed a complaint in bankruptcy court against
Washington Mutual, Inc. (known as the JPMC adversary proceeding)
seeking a declaratory judgment that JPMC owned the deposited funds
contested by Washington Mutual, Inc. JPMC maintained that the funds
were a capital contribution to the bank rather than a deposit.
[Footnote 137] JPMC and FDIC further questioned whether the deposits
were a fraudulent transfer.[Footnote 138] On May 29, 2009, Washington
Mutual, Inc. filed an answer and counterclaims to this adversary
proceeding asserting ownership of the disputed assets in the deposits
made to Washington Mutual Bank. Additional claims and counterclaims
were made during this period both in D.C. District Court and in the
Bankruptcy Court (District of Delaware). In the meantime, Washington
Mutual, Inc.; JPMC; and FDIC entered into discussions on a settlement
to resolve the distribution of assets.
In November 2009, the Congress passed the Worker Homeownership and
Business Assistance Act of 2009, which allowed companies like
Washington Mutual to use their losses in 2008 to offset income on
which taxes had been paid in the prior five years.[Footnote 139] As a
result, the bank was entitled to receive refunds from federal income
taxes paid in 2001-2008 of approximately $5 billion. There were
competing claims to these tax refunds; however, on March 12, 2010,
Washington Mutual, Inc., JPMC, and FDIC announced that they had
reached a settlement of all the issues regarding the disputed property
and related claims (known as the global settlement).[Footnote 140] The
plan set forth the allocation of the tax refund among all of the
parties: up to $2.2 billion to the holding company, up to $2.2 billion
to JPMC (new owner of the bank), up to $850 million to FDIC, and $335
million to the bank's bondholders.
Other Adversary Proceedings:
Two other groups filed adversary proceedings claiming that the
transfer of certain assets under the global settlement to JPMC free
and clear of all claims was improper. First, holders of trust
preferred securities, issued in private placements from a holding
company subsidiary called Washington Mutual Preferred Funding LLC
(WMPF) and based on portfolios of home mortgage loans, filed an
adversary proceeding against Washington Mutual, Inc. and JPMC on July
6, 2010.[Footnote 141] The bankruptcy court ruled against the trust
preferred securities holders.[Footnote 142] The second adversary
proceeding stems from holders of litigation tracking warrants--
securities that track and pay-off based on outcomes of litigation--
from the proceeds of an ongoing lawsuit of one of Washington Mutual,
Inc.'s former subsidiaries.[Footnote 143] The court denied the motion
for summary judgment for the litigation tracking warrants holders
because of disputed issues of material fact.
[End of section]
Appendix VI: Other Financial Institution Failures:
This appendix describes a number of international and domestic
financial institution failures and near failures that were chosen due
to their historic significance, as well as their usefulness in
illustrating the complications in resolving financial institution
insolvencies.
International Failures and Near Failures:
BankHaus Herstatt. The 1974 failure of BankHaus Herstatt (Herstatt),
which was based in Cologne, Germany, is cited as a major catalyst to
several developments in international banking regulation and
infrastructure.[Footnote 144] Although ranked only the thirty-fifth
largest bank in Germany (by total assets), Herstatt was active in
foreign exchange markets, where it had large and risky positions,
according to Bank of International Settlement (BIS) reports. Further,
according to these reports, German regulators forced it into
liquidation on June 26, 1974, after the 3:30 p.m. German close of
business. At that time (10:30 a.m. in New York), Herstatt's New York
correspondent bank suspended outgoing U.S. dollar payments from
Herstatt's account to Herstatt's counterparties that had already
delivered the corresponding German currency to Herstatt. There were
reports of similar difficulties with a correspondent bank in London.
In part due to the Herstatt failure, the Group of Ten (G10) central
bank governors in December 1974 established the Basel Committee on
Banking Regulations and Supervisory Practices.[Footnote 145] The
failure also stimulated other enhancements to the international
payments system, including moving to same day settlement.
Drexel Burnham Lambert Group, Inc. The 1990 failure of the Drexel
Burnham Lambert Group (Drexel) provides an example of a bankruptcy of
a complex financial institution that was relatively orderly, resulted
in significant recoveries to creditors, and was completed within a
relatively short time frame. Drexel was an investment bank that
operated with a holding company structure that had subsidiaries
including a large securities affiliate and broker-dealer (Drexel
Burnham Lambert, Inc.) that had been active in the leveraged buy out
and junk bond markets in the 1980s. Drexel filed for Chapter 11
bankruptcy protection in February 1990 after experiencing severe
liquidity strains. This was the result of legal issues during the late
1980s, which culminated in it pleading guilty to six counts of
securities and mail fraud and having to pay large civil disgorgement
and penalty payments in the year prior to its bankruptcy filing. The
unsecured creditors of Drexel Burnham Lambert, Group, Inc. organized
into a committee with 18 members within 2 weeks of the bankruptcy
filing.
Subsequent to Drexel's bankruptcy filing, market participants and
creditors lost confidence in Drexel's solvent subsidiaries, including
Drexel Burnham Lambert, Inc. and were unwilling to enter into new
transactions with the firm. As a result, according to the estate's
disclosure statement, the Drexel bankruptcy estate, with assistance
from SEC, National Association of Securities Dealers (now the
Financial Industry Regulatory Authority), and the Federal Reserve Bank
of New York (FRBNY), transferred the customer accounts of Drexel
Burnham Lambert, Inc., its securities affiliate and broker-dealer
subsidiary, to other broker-dealers. This was necessary due to the
legal prohibition against a stockbroker filing under Chapter 11 of the
Bankruptcy Code. A stockbroker is defined as an entity that has
customers and executes transactions either for the accounts of other
securities industry participants or for the general public. As a
stockbroker (or broker-dealer) the alternative would have been to use
a SIPC process for liquidation. However, Drexel believed this would
have created greater losses for Drexel and its creditors because the
SIPC trustee would have liquidated the assets very quickly. Once
Drexel Burnham Lambert, Inc.'s customer accounts were transferred, it
effectively ceased being a stockbroker. Drexel, Burnham Lambert, Inc.
then was able to file for Chapter 11 reorganization on May 29, 1990.
Also in May 1990, another Drexel subsidiary, Drexel Burnham Lambert
Trading Corporation, was forced into bankruptcy by creditors. Separate
creditor committees formed for each of the two additional cases.
The bankrupt entities--Drexel and its two subsidiaries--had 13
additional legal entity subsidiaries, but the cases were procedurally
consolidated into a single case. As a result, the creditor and equity
committees worked with the bankruptcy estates and the court to
negotiate and draft a single plan for distributing the assets of the
three bankrupt entities. The plan called for the creditor and equity
classes to be substantively consolidated across the bankrupt entities.
This led to the creation of three new asset pools with a total of 25
creditor and equity classes. In January 1992, this plan was
distributed to creditors for a vote by the end of February. In early
March 1992, upon approval by the majority of the creditors and less
than 25 months after Drexel's initial filing, the judge confirmed the
plan that detailed the payments to be made on claims to all creditor
classes and resulted in warrants being given to equity class members
in a successor entity named New Street Capital, which emerged from
bankruptcy as a going concern.[Footnote 146]
Bank of Credit and Commerce International. The 1991 failure of the
Bank of Credit and Commerce International (BCCI) illustrates how the
complicated organizational structure of a financial institution with
multiple entities based in different sovereign jurisdictions can slow
the resolution process. BCCI failed on July 5, 1991, affecting more
than a million depositors across the world, many in developing
countries in which deposit insurance was not available. At the time of
its demise, BCCI was a London-based branch of a Luxembourg-
incorporated bank headquartered in Abu Dhabi (United Arab Emirates).
Its majority shareholder was the government of Abu Dhabi, with another
principal bank subsidiary incorporated in the Cayman Islands. BCCI had
branches in at least 69 countries, including the United States.
Specifically, BCCI secretly controlled seven commercial banks in six
states and the District of Columbia through a bank holding company
structure. U.S. and state regulators seized certain of these banks on
July 5, 1991. The causes of BCCI's failure were significant accounting
fraud discovered by an external auditor, poor performance, and
substantial nonperforming loans made to large shareholders and
employees. Also in July 1991, the Bank of England triggered the
liquidation of the Luxembourg-based bank in a petition to the UK High
Court, which appointed a liquidator. Later in the month, a receiver
was appointed for the Cayman Islands bank by the Grand Court of the
Cayman Islands. In the United States, FDIC mitigated its losses by
ringfencing the assets of several of BCCI's U.S.
subsidiaries.[Footnote 147] Doing so allowed FDIC to pay domestic
creditors, including uninsured depositors, in full. For example,
Independence Bank of Encino California was placed into receivership
with FDIC in January 1992 upon discovery that BCCI management had
fraudulently and secretly acquired ownership and control over the bank
along with First American Bankshares, which was also a subsidiary of
Independence Bank's holding company (First American Corporation, based
in Washington, D.C.). To avoid a run on the deposits of the larger
First American Bankshares, FDIC paid off more than 33,000 Independence
Bank domestic creditor accounts the next day, including insured and
uninsured depositors. Ultimate payouts totaled more than $500 million,
of which at least $21 million were to uninsured depositors.
On an international level, the liquidation for the four main BCCI
entities was to a certain extent consolidated, with a pooling
agreement and cost and recovery sharing agreements put in place by
1993 covering entities in seven different countries. The view was that
the affairs of BCCI's principal companies were intermingled to such an
extent that it would have been impracticable to determine their
respective assets and liabilities without considerable expense and
delay. These agreements set out the proportions of the costs to be
borne and recoveries to be received by the English, Luxembourg,
Japanese, Cypriot, Bahraini, United Arab Emirates, and Chinese
estates. The UK-based liquidators since have made recoveries through
successful legal claims against parties that either previously failed
to repay loans owed to BCCI entities, committed fraud against BCCI, or
been negligent in the discharge of professional duties to BCCI. As of
January 2011, the BCCI liquidation still was active and had collected
a total $8.6 billion since July 1991 compared with total claims of
$8.5 billion (creditors were entitled to make claims through March
2010). The liquidators expect that processing claims will take several
more years. However, as of January 2011, $6.5 billion had been paid
out to secured and unsecured creditors in a series of seven dividends
between December 1996 and December 2008. According to a February 2011
report issued by the BCCI liquidators, the liquidating company is
committed to making at least one additional payment and currently
expects the final recovery amount to reach nearly 90 percent of all
nominal claims, with the potential for further recoveries beyond this
level. Total costs to the estate were $1.7 billion through January
2011.
Long-Term Capital Management. The 1998 near collapse of Long-Term
Capital Management (LTCM) illustrates coordinated private-sector
action in response to the threat of failure of a relatively small, but
systemically interconnected, financial institution. This potential
systemic failure led to a Federal Reserve Bank of New York-organized,
private sector-funded solution. In 1998, LTCM was one of the largest
U.S. hedge funds, which specialized in arbitrage--"market-neutral"
fixed-income trades--intended to take advantage of what it viewed as
market inefficiencies to make money, regardless of the direction of
the broader markets.[Footnote 148] As we have previously reported,
LTCM's strategy used leverage or borrowing to amplify its arbitrage
returns.[Footnote 149] Prior to its crisis, LTCM held $1.4 trillion in
notional value of off-balance-sheet derivatives contracts of which
$500 billion were traded on futures exchanges, and at least $750
billion were over the counter derivatives. In August 1998, following
the announcement of the Russian debt moratorium, investors began to
seek superior credit quality and higher liquidity, and credit spreads
widened in markets around the world, creating losses for LTCM. It soon
lost 90 percent of its capital. FRBNY officials said they became aware
of LTCM's problems in early September 1998 through their routine
market surveillance activities, which included discussions with
industry officials about current market conditions and developments.
On September 18, 1998, LTCM officials contacted FRBNY officials about
their financial problems and invited a team to visit LTCM to discuss
the situation. During the resulting September 20, 1998, visit, LTCM
officials informed FRBNY and Department of the Treasury
representatives of the extent of LTCM's problems and the size and
scope of its positions in markets around the world.
Concerned about potential systemic implications if a rapid and
potentially disruptive liquidation of LTCM were to occur, FRBNY
officials said they invited Goldman Sachs Group, LP; Merrill Lynch &
Co. Inc; and JPMC--the three firms the FRBNY believed had the greatest
knowledge of the situation--to their office to discuss LTCM's
situation and possible ways to resolve it. This core group of three
was later expanded to include UBS AG. Ultimately, the discussions were
expanded to include 12 of LTCM's other major creditors and
counterparties. Bear Stearns and Co. and Credit Agricole were included
in these discussions, but they later declined to participate in the
recapitalization consortium.
On September 23, 1998, 14 major domestic and foreign banks and
securities firms agreed to recapitalize LTCM through the creation of a
consortium. On September 28, 1998, they contributed about $3.6
billion, representing 90 percent of the net asset value of the fund on
that date leaving 10 percent of the equity with the LTCM partners. The
14 firms were Chase Manhattan Corporation; Goldman Sachs Group, LP;
Merrill Lynch & Co. Inc.; JPMC; Morgan Stanley Dean Witter & Co.;
Salomon Smith Barney (Travelers Group); Credit Suisse First Boston
Company; Barclays PLC; Deutsche Bank AG; UBS AG; Bankers Trust
Corporation; Société Generale; BNP Paribas AB; and Lehman. These firms
appointed a smaller group of employees from several of the firms to
manage LTCM's resolution. The portfolio was slowly wound down with
oversight from a committee representing the 14 institutions. According
to an announcement that was made in early 2000, LTCM closed down and a
final payment of $925 million was distributed to the 14 institutions.
American International Group. The 2008 American International Group,
Inc. (AIG) near-failure illustrates the complications presented by the
prospect of the failure of an extremely complicated global financial
firm. These complications include regulatory and international issues
accentuated by the complexities posed by dealing with a large and
opaque derivatives portfolio. The Federal Reserve authorized FRBNY to
extend credit to AIG after determining that AIG faced the imminent
prospect of declaring bankruptcy, according to the minutes of a
Federal Reserve meeting on September 16, 2008, the date it approved
the initial Federal Reserve extension of credit to AIG. The Federal
Reserve determined that a failure would have been disorderly and would
be likely to have systemic effects on financial markets that already
were experiencing a significant level of fragility. AIG, a
multinational insurer that was a major participant in the financial
derivatives market, ran into significant financial difficulty during
the severe market disruptions of the first 2 weeks of September 2008.
[Footnote 150] As we have reported previously, these difficulties
arose from two sources: securities lending and credit default swaps
(CDS), which are insurance-like contracts that offer credit protection
against specified credit events. AIG had been an active seller of CDS
with large exposures to complex, structured securities and had written
CDS contracts with a large number of counterparties, including
domestic and foreign-based financial institutions. According to
FRBNY's bankruptcy counsel, in a bankruptcy, the CDS contracts would
have been treated as qualified financial contracts (QFC) because they
would have been considered "swap agreements" as defined under the
Bankruptcy Code. Thus, according to FRBNY's bankruptcy counsel,
following a bankruptcy of either AIG or the subsidiary through which
it conducted its CDS business, counterparties would have had the right
to liquidate, terminate, or accelerate each of the CDS contracts. And
according to the International Swaps and Derivatives Association,
counterparties could determine the early termination amount AIG owed.
This amount was subject to the determination of the appropriate date
("early termination date") for calculating the market value of the
contract. The counterparty would have been able to choose either the
bankruptcy filing date or any other date thereafter for determining
the closeout payment AIG owed. However, as occurred with Lehman
Brothers Holdings, Inc., had AIG filed for bankruptcy protection, it
likely would not have been able to pay the aggregate mark-to-market
early termination amounts for all its positions due to the aggregate
size of its derivatives exposures. Counterparties that had collateral
agreements likely would have fared better than those without such
agreements. Those counterparties that did not have collateral
agreements that entitled them to instant payment would likely have
been treated as creditors in the bankruptcy process and faced delayed
payments. Considering the number and geographic diversity of AIG's
counterparties and ongoing disruptions in credit markets worldwide,
these delays might have posed systemic problems.
FRBNY's bankruptcy counsel identified an additional complication that
could have arisen under an AIG bankruptcy scenario: the likely
commencement of legal insolvency proceedings against non-U.S.
subsidiaries in overseas jurisdictions. As of the end of 2007, 37
percent of AIG's consolidated assets were located outside of the
United States and Canada in approximately 100 different countries.
Within the United States, AIG had wholly owned subsidiaries in at
least 25 states as well as Puerto Rico. Because many overseas
jurisdictions have laws that prohibit "trading while insolvent," the
filing of bankruptcy proceedings would have had implications for the
ability of subsidiaries in these countries to continue operations as
going concerns, which in turn could have had a significant negative
impact on the ability of management to maximize the value of the
estate. According to the FRBNY's bankruptcy counsel, it is not
uncommon for the non-U.S. subsidiaries and the U.S. parent to become
adversaries in legal proceedings. Each has a duty to maximize the
value of its own estate, notwithstanding the many and complex inter-
company transactions and arrangements and different treatments across
international jurisdictions. AIG had material intercompany accounts
and transactions. Further complicating the insolvency according to
experts with whom we spoke, the state-regulated insurance subsidiaries
likely would not have been included in the bankruptcy.
Fortis Bank SA/NV. The 2008 nationalization of Fortis is an example of
how differences in national interests can limit international
coordination even between closely linked nations. In 2008 at the time
of its crisis, Fortis was a financial institution with banking and
insurance subsidiaries and significant operations in Belgium, the
Netherlands, and Luxembourg, nations that had a long history of
economic cooperation dating to at least the 1950s.
According to our analysis of the company's annual report to investors
and a report on Fortis by the Bank of International Settlements,
Fortis's problems were precipitated by a combination of factors. The
first was excessive leverage, which Fortis gained as one of three
partners in the large acquisition of Dutch banking group ABN AMRO
Holding NV (ABN AMRO) in October 2007. In addition, Fortis held a
large portfolio of structured credit spread products, asset-backed
securities, and collateralized debt obligations that experienced
significant drops in market value during the financial crisis in
2008.[Footnote 151] These factors and the general deterioration in
global financial conditions led to a liquidity crisis for Fortis in
September 2008 as clients began to withdraw large deposits, and the
overnight interbank lending market, which is essential to short-term
bank financing, stopped dealing with Fortis.
The legal segregation of ABN AMRO into three parts by Fortis and the
UK and Spanish banks that had joined it in the acquisition complicated
an effective international regulatory resolution; the acquisition was
not scheduled to be completed until the second half of 2009, and the
integration of ABN AMRO into Fortis was not near completion when
Fortis started experiencing problems. In September 2008, the
Netherlands, Belgium, and Luxembourg (viewing the pieces of Fortis in
their jurisdictions as systemically important) separately injected
capital--but only into their regulated subsidiaries of the larger
holding company. In October, somewhat coordinated action between the
Dutch and Belgian governments led to 100 percent nationalization of
the Dutch banking subsidiaries and the nationalization and subsequent
sale of 75 percent of the Belgian banking subsidiary to French bank
Paribas. Fortis also sold 100 percent of its Belgian insurance company
to the same French bank. These moves left Fortis, the holding company,
with (1) Fortis Insurance International; and (2) a 66 percent share in
an entity set up to hold the problematic structured credit portfolio,
with a 24 percent interest going to Paribas, and the remaining 10
percent held by the Belgian government. Fortis shareholders
successfully challenged the sales agreement for the Belgian banking
subsidiary in a Belgian court. They claimed Belgian law required their
approval for the sale to proceed. The transaction was renegotiated to
more favorably treat Fortis equity holders before being allowed to
close. Fortis, the holding company, subsequently changed its name to
Ageas N.V. However, Ageas continues to have ongoing legal issues
related to the seizure. They include cases involving ABN AMRO Group NV
and its owner, the Dutch government, as well as cases brought by
Fortis shareholders.
Fortis was ultimately bailed out by the French, Belgian, and
Luxembourg states, but the initial lack of coordination and inward-
looking response by the respective national authorities point to the
limits of current cross-border resolution mechanisms, and the reality
that complexities of cross-border organizational structures and
differences in national laws can impede orderly and effective
resolution of systemically important financial institutions. In
addition, according to European experts with whom we spoke, even in a
case of two countries with strong regulatory relationships and closely
aligned national interests, small divergences in these interests
dominated, preventing a coordinated solution. Prior to Fortis being
split up, Belgium, the Netherlands, and Luxembourg all provided
financial support but only to the parts that were in their country.
This illustrates the countries' willingness to support the company in
a coordinated, although national, manner. However, Dutch concern over
ABN AMRO, (which was still the brand name for many Dutch retail bank
branches of Fortis at the time of its nationalization) prevented a
consolidated solution. A report by the Basel Committee on Banking
Supervision concluded that Fortis demonstrated that the complexity of
the international financial groups and national resolution systems led
to fragmentation and break downs along national lines.[Footnote 152]
Dexia SA. The 2008 Dexia example illustrates how aligned national
interests and joint exposure by entities domiciled in more than one
country can help facilitate cooperation. Dexia, a bank headquartered
in Belgium, had significant operations in Belgium, France, and
Luxembourg. It specialized in providing financing to local governments
globally but concentrated in France and other European countries.
Dexia also had a New York branch and a U.S.-based monoline bond
insurance subsidiary.[Footnote 153] Dexia faced significant liquidity
stress in 2008 arising from issues with its longer-term bond
investments, nonperforming loans, and as a bond insurer. In order to
strengthen its capital, the Belgian, French, and Luxembourg
governments coordinated in September 2008 a nearly €10 billion capital
infusion and replaced the Chairman and Chief Executive of Dexia. When
these actions did not result in an improvement in market sentiment
about the bank, the three nations coordinated the creation of a joint
guarantee mechanism whereby the governments of Belgium, France, and
Luxemburg guaranteed 60.5 percent, 36.5 percent and 3 percent,
respectively, of Dexia's obligations in excess of the bank's ability
to fulfill them up to €150 billion. The nations' shares of the
guarantee were based on the proportional share of the company's equity
and debt held by institutional investors residing in the three
countries. In 2008, Dexia drew only €12.3 million under this
guarantee. This example of coordination in order to avoid an
international insolvency was driven by the unique nature of the
company's business and shareholder base. In France, Dexia was a key
provider of municipal finance. In Belgium, the bank was a key
depository institution. Thus, the governments could reach a joint,
coordinated solution that served the interests of France, which was
able to ensure that municipalities were able to keep a key provider of
funds, and those of Belgium, which avoided the costly and systemically
risky failure of one of its key banks. This coordinated action allowed
Dexia time to access financing and gave the bank time to sell certain
operations and shrink others and avert bankruptcy.
Icelandic banking crisis. The United States was not greatly affected
by the Icelandic banking crisis, but the issues it raised point to the
difficulties in resolving systemically significant financial
institutions with large international relationships. The three largest
Icelandic banks, which accounted for 85 percent of the nation's
banking system, collapsed in early October 2008 after growing
exponentially over the past decade to have total assets peak at more
than 1,000 percent of Iceland's gross domestic product. Part of this
growth was funded by deposits raised in at least nine other European
countries, of which both Great Britain and the Netherlands were large
contributors. The crisis led to investors and depositors pulling
assets out of Icelandic banks simultaneously with a 70 percent
depreciation in the krona (Icelandic currency) in which most of the
bank's assets were priced. Those assets included significant equity
stakes in other Icelandic banks, which were further impaired as the
local stock market lost 80 percent of its value. As the three big
Icelandic banks and their European branches and subsidiaries had
significant liabilities denominated in euros and British pounds, the
declines in asset values overwhelmed the banks' equity and the banks
were not able to meet the huge demand for deposit withdrawals in the
panic. The Icelandic government then guaranteed all domestic Icelandic
deposits but did not extend the same protection to depositors in other
countries. The subsequent insolvencies led to losses being borne by
foreign creditors and initially by British and Dutch depositors, as
the Icelandic government was unable to make them whole. Both the
British and Dutch governments became involved in attempts to force the
Icelandic government to make depositors in their countries whole at
the same time as paying depositors some portion of their guaranteed
deposits. The British government later decided to pay out all retail
depositors in whole, although commercial depositors only received the
guaranteed portion of the account. In order to freeze Icelandic bank
assets, the UK government invoked provisions of the Antiterrorism,
Crime and Security Act of 2001 stating the move was done to prevent
harm to the UK economy. This move was not well received in Iceland and
complicated subsequent efforts to resolve the dispute about who should
repay the depositors. Nevertheless, the UK was able to transfer the
bulk of the deposits to a Dutch bank. Agreements were eventually
concluded between the Icelandic and both the UK and the Netherlands
governments detailing Iceland's repayment to the governments for the
amount of losses borne by their respective deposit schemes. These
agreements were approved by the Icelandic parliament, but the
President of Iceland refused to sign the bill into law unless it
passed a referendum. On two occasions, most recently in April 2011,
Icelandic voters have voted against ratifying these agreements to pay
back the full amounts. Multilateral efforts to resolve the crisis have
been slowed and complicated by differences of opinion about who bears
the responsibility for the losses.
Bernard L. Madoff Investment Securities. The still active 2008 Bernard
L. Madoff Investment Securities, LLC (BLMIS) case demonstrates the
complications that can arise from the presence of fraud, especially in
an international context. BLMIS, an internationally active broker-
dealer, had three principal lines of business: market making,
proprietary trading, and investment advisory services. BLMIS filed for
bankruptcy protection on December 15, 2008, after the founder revealed
that his investment management firm was in fact a Ponzi scheme through
which he had stolen customer funds for years. As part of this scheme,
the founder had sent fraudulent statements to clients falsely claiming
that their invested assets had grown in value, as detailed in reports
by the BLMIS bankruptcy and SIPA trustees. At the time of failure,
BLMIS customers believed that they had an aggregate of $65 billion in
assets managed by BLMIS. BLMIS was a member of SIPC pursuant to its
registration as a broker-dealer. BLMIS led to losses to investors of
invested capital of at least $17 billion. This amount excludes "gains"
that investors falsely believed their investments had earned due to
the fraudulent account statements. In addition to his own investment
advisory business, Madoff had utilized a global network of "feeder
funds" to collect "investments" from wealthy individuals around the
globe.[Footnote 154] Several of these feeder funds also were forced
into liquidation with the individuals in charge of liquidating these
funds filing claims against the BLMIS estate. On the same day as the
bankruptcy filing, the broker-dealer was placed into liquidation under
the Securities Industry Protection Act, and a SIPA trustee was
appointed to resolve claims. The bankruptcy court later combined the
processes for resolving the BLMIS estate with the SIPA process,
placing them under the direction of the SIPA trustee. Since his
appointment, the trustee has located assets in the Bahamas, Bermuda,
the British Virgin Island, Canada, the Cayman Islands, England,
Gibraltar, Ireland, Italy, Luxembourg, Panama, Spain, and Switzerland.
As of July 15, 2011, the trustee reported a total of 16,518 claims had
been made to the trustee, and 2,414 of these claims for a total of
$6.9 billion had been allowed. Of these 2,414 claims, SIPC coverage of
$500,000 per account (including up to $250,000 for cash) resulted in
claims of $795 million. Due to the nature of the fraud, over the
years, certain customers had withdrawn funds from their accounts that
were greater than their initial investments with the firm. The trustee
in the case chose to pursue claims against at least eight such
investors to recover funds that could be distributed to other victims
of the fraud. As of May 2011, the trustee had made $13.7 billion in
such claims against various feeder funds, friends, and family of the
founder, and other related parties. In May 2011, an agreement was
reached between the largest feeder fund and the BLMIS trustee to align
their interests and jointly pursue recovery of billions of dollars in
claims against the owners and management of this failed feeder fund.
According to the trustee, as of May 4, 2011, the trustee had recovered
more than $7.6 billion. However, more than $5 billion of these
recoveries were not available for distribution to BLMIS customers
pending the outcome of appeals by claimants of significant settlements
the trustee had made with some of the customers of BLMIS, who had
withdrawn funds in excess of their capital contributions, leaving $2.6
billion available for customers. Of this amount, the trustee expects
to distribute $272 million to the defrauded holders of 1,224 customer
accounts in the near term.
Domestic Case Studies:
Colonial BancGroup, Inc. (Colonial). The Colonial proceeding is
significant due to the issues raised regarding the holding company's
financial responsibility for an insolvent insured depository
institution. Colonial was a bank holding company that owned Colonial
Bank. On August 14, 2009, the Alabama State Banking Department closed
Colonial Bank and appointed FDIC as the bank's receiver. FDIC, in its
corporate capacity and as receiver of Colonial Bank, then executed a
Purchase and Assumption Agreement (P&A agreement) with Branch Banking
and Trust Company (BB&T), under which BB&T purchased substantially all
of Colonial Bank's assets, and assumed all of its deposit accounts.
This left Colonial (the bank holding company) with less than 1 percent
of the consolidated assets. Colonial filed for Chapter 11 bankruptcy
in the Bankruptcy Court for the Middle District of Alabama (Alabama
Bankruptcy Court), on August 25, 2009. Colonial Bank was closed
following a liquidity crisis caused by poor management of credit risk
related to an over-concentration in commercial real estate,
nonperforming loans, and fraudulent conduct by some of the officers in
its mortgage warehouse lending unit, which provided short-term funding
to mortgage originators for loans that would be sold into the
secondary market.
In connection with Colonial's bankruptcy, FDIC filed a motion seeking
a court order allowing FDIC's $905 million capital maintenance claim
as a priority claim and requiring Colonial to cure the claim under 11
U.S.C. § 365(o), or convert the case to a case under Chapter
7.[Footnote 155] FDIC based its claim on the amount of capital
necessary for Colonial Bank to comply with its capital requirements at
the time it was closed. FDIC also based its claim on the following
prepetition agreements entered into by Colonial with its regulators: a
memorandum of understanding (MOU) with the Federal Reserve Bank of
Atlanta and the Alabama Banking Department, an agreement with the
Federal Reserve Bank of Atlanta and the Alabama Banking Department and
a Cease and Desist Order with the Federal Reserve and the Alabama
Banking Department. Although these agreements referred to Colonial
Bank's separate agreements with its regulators, Colonial Bank was not
a party to the agreements. The Bankruptcy Court denied FDIC's motion
because it found that the language contained in the agreements entered
into by Colonial with its regulators did not obligate Colonial to
maintain the capital of Colonial Bank within the meaning of 11 U.S.C.
§ 365(o).[Footnote 156]
FDIC also filed a separate motion for relief from the automatic stay
to exercise its rights under the P&A agreement to exclude Colonial's
deposit accounts from the definition of "Assumed Deposits" and setoff
its claims against Colonial's deposit accounts, which had been
transferred to BB&T under the P&A agreement. The bankruptcy court
denied FDIC's motion, holding that FDIC could not exercise its rights
after Colonial filed for bankruptcy, and, therefore, FDIC did not have
mutuality for setoff purposes.[Footnote 157] FDIC has appealed the
decision.
NextBank. The 2002 failure of NextBank, NA, and its subsequent
resolution is an example of how the failure of a relatively simple
bank can lead to complex legal questions that take many years to
resolve even outside of the bankruptcy context. In addition,
NextBank's resolution points to how the way a holding company is
structured can lead to challenges for FDIC in resolution. NextBank was
a Phoenix, Arizona-based, Internet only credit-card bank that failed
on February 7, 2002, with total assets of approximately $700 million
and deposits of $554 million. FDIC lost between $300 million and $350
million on the failure, while 2,075 depositors that held $29.4 million
in uninsured deposits were subject to losses. FDIC's seizure of the
bank left NextBank's parent, NextCard, Inc., with assets on its
balance sheet of only 25 percent of their preseizure size. Due to
NextBank's unique corporate structure, the workers who supported
NextBank's credit card servicing were employees of NextCard. After the
failure, NextCard and FDIC agreed that NextCard would provide certain
administrative services, licenses to NextCard's intellectual property,
and give FDIC access to NextCard's proprietary systems while FDIC
looked for a purchaser of NextBank's credit card portfolio. In
addition, 465 of NextCard's 610 employees were transferred to a third-
party contractor working for FDIC to service the credit card
portfolio. FDIC agreed to reimburse NextCard for these services. When
these services terminated with the transfer of receivables and closure
of credit card accounts (discussed later), NextCard was unable to find
any viable business prospects and on November 14, 2002, NextCard filed
for Chapter 11 in the Delaware Bankruptcy Court.
In July 2002, FDIC sold $190 million of NextBank's credit card
receivables that had not been securitized but were held wholly on
NextBank's balance sheet. They then closed credit card accounts with
outstanding balances of $1.4 billion in credit card receivables that
had been securitized and were still being serviced by NextBank at the
time of failure. While these securitized accounts were closed, the
cardholders still were responsible for paying off their balances at
the original terms. The securitizations had four classes of
noteholders (A-D), with each lower level (B-D) exposed to increasing
levels of risk. Before the receivership, the stream of cardholder
payments (monthly principal, interest, and fee payments) were used to
make interest payments on the notes first with all remaining cash
divided into two accounts. One was for "collateral," which would pay
principal on the notes according to the priority schedule that had
been set forth in the securitization's prospectus, and the other was
for "transferor interest," which would pay NextBank as servicer and
then, after the bankruptcy, FDIC. However, the credit performance on
the closed accounts was poor. FDIC, as servicer, and Bank of New York
the trustee in the securitization, applied all delinquent payments to
the collateral account, thus depriving bondholders of principal
payback, while all payments received from cardholders went to the
transferor interest to which FDIC, now the owner of NextBank, was
entitled.[Footnote 158] But, the securitization offering documents
stated that, in the event of a receivership, noteholders were entitled
to accelerated payment of principal compared with the slower schedule
without a receivership. While the Class A and B noteholders were paid
in full, the Class C noteholders stopped receiving principal payments
and the Class D noteholders never received any principal as of the
start of litigation in June 2003.
The Bank of New York (now BNY), as trustee, sued FDIC in the District
of Columbia federal district court (a nonbankruptcy court) on behalf
of the Class C and D noteholders, claiming that FDIC was not entitled
to the transferor interest because the receivership was an ipso facto
trigger for the accelerated payment of principal and this took
priority over the payments of the transferor interest to FDIC.
[Footnote 159] After some claims were dismissed by the court and
others were dismissed pursuant to a settlement, the D.C. Court ruled
against BNY on its remaining claim that FDIC had violated federal
banking law and unlawfully converted funds that should have been paid
to note holders. Despite this and several subsequent judicial
proceedings in both D.C. and New York, not all of the claims
associated with NextBank were settled. Following disposition of the
D.C. Court proceedings, certain Class C and D noteholders demanded
that BNY turn over transferor interest assets for principal repayment.
BNY, in its capacity as a trustee, instituted a lawsuit in New York,
known as an "interpleader" action, so that competing claims to assets
it held in trust could be resolved by a court. Applying principles of
contract law, the U.S. District Court for the Southern District of New
York held that the noteholders, and not FDIC, were entitled to the
money held in the transferor interest account.[Footnote 160] FDIC
appealed. In June 2010, the U.S. Court of Appeals for the Second
Circuit upheld the Southern District Court ruling.[Footnote 161]
[End of section]
Appendix VII: Safe Harbors for Contracts under the Bankruptcy Code:
On the filing of a bankruptcy petition, the Code provides for an
automatic stay, or freeze, of any action by creditors to recover
assets from the debtor in possession. A debtor-in-possession (DIP) or
trustee, as the case may be, may, subject to the court's approval and
certain provisions in the Code, assume or reject any executory
contracts or unexpired leases, and may "avoid" any prepetition
preferential payments given to creditors within 90 days of the
filing.[Footnote 162] However, the DIP or trustee may not use any
"cash collateral," such as cash, securities, documents of title, or
other cash equivalents, without the consent of secured creditors and
the court. Secured creditors of the debtor receive payment from the
proceeds of the collateral, and if the collateral is insufficient to
pay the claim in full the balance becomes an unsecured claim.
Certain contracts, sometimes referred to as qualified financial
contracts (QFC), receive "safe harbor" protections from the automatic
stay by allowing counterparties to choose whether or not to terminate,
or "close-out," contracts underlying QFC transactions with a debtor.
If a collateralized QFC counterparty closes-out a contract, it can
remove and liquidate the collateral used to secure the transaction
before that collateral becomes part of the bankruptcy estate. Also,
the counterparty has the option, but is not obligated, to apply the
proceeds of the collateral liquidation to any amounts owed to the
debtor, a process called "netting." After netting, if the counterparty
is owed money by the debtor, it awaits payment under a reorganization
plan with the unsecured creditors. If it owed money to the debtor
after netting, the debtor would collect what it was owed and include
those funds in the estate for payment to creditors according to the
established order of priority.
In addition, the safe harbor for QFCs allows the QFC counterparty to
keep prepetition preferential payments, which can be understood by the
example of a CDS. A CDS is generally a contract between two parties
where the first party promises to pay the second party if a third
party experiences a credit event such as failing to pay a debt. If the
third party suffers a credit event, then the first party would be
required to post increased collateral to assure the second party that
it could meet its contractual obligation. On a bankruptcy filing of
the first party, without the safe harbor, the second party would
normally be required to return the increased collateral to the first
party's estate as a prepetition preferential payment. Instead, under
the safe harbor, the second party could close-out the CDS, liquidate
the collateral, and net the proceeds against its debts to the first
party.
[End of section]
Appendix VIII: Some Characteristics of Insolvency Systems in Selected
Countries:
As insolvency and resolution is primarily handled at the national
level, different countries will have different approaches. We
interviewed experts and reviewed publications regarding aspects of
insolvency and resolution systems in Canada, China, the EU, France,
Germany, Luxembourg, the Netherlands, Switzerland, and the UK. This
appendix illustrates some of the differences across these
jurisdictions' systems, but it is not a comprehensive examination of
them.
Netting of Financial Obligations:
Generally, counterparties are allowed to close out and net financial
contracts when one of the parties becomes insolvent. As described
earlier in this report, in the United States, netting is allowed as
determined by the safe harbor provisions of the U.S. Bankruptcy Code.
According to experts we interviewed, all the jurisdictions we examined
allowed for netting of mutual financial obligations. However, the
exact treatment may differ across countries as follows:
* Under Canadian insolvency law, derivatives generally qualify as
"eligible financial contracts" and receive special treatment under the
Winding-Up and Restructuring Act (WURA), the Companies' Creditors
Arrangement Act (CCCA), and the Bankruptcy and Insolvency Act (BIA).
[Footnote 163] According to a legal expert, the treatment of
derivative contracts under Canadian insolvency law is similar to that
in the United States. Under the CCCA and BIA, which apply to entities
other than federally insured depository institutions and certain other
specialized entities, and the WURA, which governs the restructuring or
reorganization of federally insured depository institutions, eligible
financial contracts counterparties may terminate the contracts and net
amounts payable to or by the insolvent debtor.
* According to a legal expert, netting of financial obligations is
allowed in China.
* Under Articles 7 and 8 of the EU Directive on Financial Collateral,
the enforceability of close-out netting arrangements is explicitly
protected notwithstanding the insolvency of the parties to the
arrangement. Further, EU members are prohibited from applying their
national insolvency rules to the arrangements. A regulatory expert
told us that the EU is considering incorporating a temporary stay on
close-outs and netting in the proposal resolution procedures in a
manner similar to the provisions of the Orderly Liquidation Authority
(OLA) created in the Dodd-Frank Act.[Footnote 164] The stay would be
48 hours rather than the 24-hour stay under OLA.
Special Resolution Regimes for Financial Institutions:
Some countries have special resolution regimes for certain financial
institutions, similar to those employed by FDIC. Some countries have
recently proposed or enacted such regimes as a result of the 2008
crisis. Canada, France, Germany, Japan, Luxembourg, the Netherlands,
Switzerland, and the UK all have special resolution regimes. China and
the EU are currently considering some type of regime for their
jurisdictions.
* In Canada, several laws can apply to the resolution of insolvent
financial institutions. Similar to the United States, Canadian
resolution laws differentiate between banks, insurance companies and
other specialized financial institutions on the one hand, and other
types of entities, which include the holding companies of those
specialized institutions. Generally, most business entities are
subject to the Bankruptcy and Insolvency Act (BIA) and, if the
aggregate amount of claims is large enough, the Companies' Creditors
Arrangement Act (CCAA). Depository institutions insured by Canada's
federal government are subject to restructuring and/or reorganization
by the Canada Deposit Insurance Corporation (CDIC) under the Canada
Deposit Insurance Corporation Act (CDIC Act). Provincial loan and
trust corporations whose deposits are CDIC-insured also may be subject
to the act if the relevant province has entered an agreement with the
federal government. WURA applies to federal and provincial banks, loan
companies, and insurance corporations. The WURA in effect provides a
liquidation regime for these financial institutions. According to a
paper written by a Canadian law professor, WURA allows the Canadian
court to appoint a liquidator, who can take control of the firm.
[Footnote 165] This liquidator has broad powers to resolve the company
and distribute proceeds to the creditors.
* According to a legal expert, China is considering an FDIC-like
regime for its banks. Under the Enterprise Bankruptcy Law, the Chinese
bankruptcy regime allows creditors, debtors, and the regulatory body
of financial institutions to file a bankruptcy application. The
regulatory body may also require reorganization proceedings. The
Enterprise Bankruptcy Law also allows the state flexibility to
implement more detailed regulations, if necessary. According to a
legal expert, the regulatory body generally places a problematic
financial institution in a trusteeship and monitors the institution.
[Footnote 166] If the regulatory body determines that an institution
can be saved, the body may petition the court to suspend bankruptcy
proceedings. However, the expert said that, since the government
already owns the banks, it has a wide range of options available in
case of insolvency.
* The EU is working on a new resolution regime for financial
institutions, including developing a European Supervisory
Authority.[Footnote 167] A legal expert told us that the first stage
would be to establish a general resolution and recovery framework. The
EU may consider a uniform set of liquidation policies in the future.
* According to a foreign court official, until recently in Germany
financial institutions were resolved under standard insolvency law.
Following the 2008 crisis, the German government approved the German
Act on the Orderly Restructuring and Liquidation of Banks ("Bank
Reorganization Act"), the German Act on the Establishment of a Bank
Restructuring Fund, and the German Act for the Extension of Time
Limitations Barring Management Liability (collectively, the "Bank
Restructuring Act"). The laws provide for two types of reorganization
procedures and a conservatorship procedure, both through BaFin, the
German supervisory body.[Footnote 168] The conservatorship allows the
government to transfer the systemically important parts of the firm to
a bridge institution.[Footnote 169]
* According to an academic expert, the Netherlands recently enacted a
new resolution regime in the wake of the financial crisis. The new
regime includes liquidation and reorganization procedures, as well as
an "emergency plan" provision for financial institutions to be used
prior to liquidation. The regime allows for the appointment of a
formal trustee, who can transfer assets and clients' accounts to a
bridge institution. [Footnote 170]
* The UK made changes to its insolvency system following the failure
of Northern Rock. The Banking Act of 2009 provides for a special
resolution regime. According to a regulatory expert, in the case of a
financial institution failure, authorities now can transfer assets,
establish a bridge bank, and, as a last resort, assume "temporary
public ownership" of an institution. The special resolution regime
only will apply to institutions with "eligible" or insured deposits. A
firm that does not have any insured deposits will continue to be
resolved under the regular insolvency system.
Liability for Corporate Managers:
Some countries can impose liabilities on corporate officers if their
firm becomes insolvent, as follows:
* According to French legal practitioners, in France, a court may
determine that the corporate officers have committed an "actionable
fault," which leads to an insolvency. In this case, the officers may
be liable for the amount of liabilities in excess of the amount of
assets.
* According to a foreign court official, in Germany, corporate
officers must file for insolvency promptly. Otherwise, the officers
face civil and possibly criminal liability. The officers also may be
liable for any payments made to creditors while insolvent.
* According to a legal analysis, in Luxembourg, the court can order
the officers liable for the company's debts if the insolvency is due
to "gross negligence."
* According to a report by a group of international insolvency
experts, in the Netherlands, corporate officers can face liability if
their actions were "severely reproachable."
* According to a report by a group of international insolvency
experts, in the UK, corporate officers can face liability for
transactions made prior to an imminent insolvency filing.
Insolvency Definitions and Triggers:
Countries can have different definitions of "insolvency" and thus
different triggers to commence insolvency proceedings. Some countries
use a "cash-flow" test, in which insolvency would mean an inability to
pay debts as they come due. Others use a "balance-sheet" test, in
which insolvency would mean that liabilities exceed assets. Countries
can use either or both to trigger resolution or insolvency
proceedings. The U.S. Bankruptcy Code defines "insolvent" as a
"financial condition such that the sum of such entity's debts is
greater than all of such entity's property, at a fair valuation."
* According to Canadian practitioners, under Canadian insolvency law,
a company is insolvent if it has acknowledged its inability to pay its
debts. Once a company is insolvent, a court also can commence a
proceeding if the shareholders passed a resolution requiring the
company to be resolved or if the court opined that it is "just and
equitable" that the company be resolved. As discussed previously,
insolvency proceedings for financial institutions are governed by the
WURA.
* In China, a debtor must be both balance-sheet insolvent and cash-
flow insolvent before it can file for insolvency.
* In France, cessation of payment, meaning the inability to make
payments with available assets as they become due, triggers court-
supervised procedures for companies in financial difficulty.
* In Germany, the law defines three types of insolvency, "over-
debtedness," inability to pay debts, and "imminent illiquidity." If
one of the two first types is met, the directors must file for
insolvency. In the third situation, management may file for
insolvency, but it is not required.
* In Japan, insolvency is defined as an excess of liabilities over
assets. However, insolvency proceedings are triggered by the inability
to pay debts.
* In Luxembourg, insolvency proceedings begin when a debtor is both
unable to pay its debts as they come due and unable to raise credit.
* In the Netherlands, a debtor can apply for insolvency protection
when it determines it cannot pay its debts as they come due. The
Netherlands District Court can also declare the debtor bankrupt if it
has ceased to pay debts. The Netherlands does not have a balance-sheet
test.
* In Switzerland, a company may file for insolvency protection if (1)
it cannot pay its debts, (2) it has ceased to pay its debts, or (3)
its liabilities exceed its assets.
* In the UK, both the cash-flow and balance-sheet tests are used to
determine insolvency.
Payment Priorities:
The order in which creditors are repaid from an insolvent estate
varies among various countries. These repayment rankings can represent
the social and political priorities of the jurisdiction. The rankings
in table 6 are general rankings and may not apply in all bankruptcy
cases.
Table 6: Repayment Rankings of Selected Countries:
United States:
1. Secured claims.
2. Claims for debts to spouse or children for court-ordered support.
3. Administrative expenses of the bankruptcy.
4. Unsecured, postpetition claims in an involuntary case.
5. Wage claims of employees and independent salespersons up to $10,000
per claim.
6. Unpaid contributions to employee benefit plans up to $10,000 per
employee.
7. Claims of grain farmers and fishermen against debtors operating
storage or processing facilities.
8. Layaway claims of consumers who did not get the item on which the
deposit was made.
9. Taxes outside of bankruptcy.
10. Debtor's commitment to maintain capital of a federally insured
depository institution.
11. Claims for death or personal injury from a motor vehicle that
occurred while the debtor was driving it and was intoxicated.
Canada:
1. Secured creditors.
2. Funeral and testamentary expenses.
3. Administrative expenses.
4. Superintendent expenses.
5. Unpaid wages for services rendered during bankruptcy.
6. Municipal taxes owed.
7. Rent owed.
8. Fees and costs associated with process against the bankrupt's
property.
9. Workers' compensation, unemployment insurance, or taxes.
10. Claims resulting from injuries to employees of the bankrupt not
covered by workers' compensation.
11. Claims of the Crown not mentioned above.
China:
1. The creditor's right with guaranty on the debtor's particular assets.
2. The wages, subsidies for medical treatment and disability and
comfort and compensatory funds as defaulted by the debtor, fundamental
old-age insurance premiums, fundamental medical insurance premiums
that shall have been transferred into the individual accounts of
employers, as well as the compensation for the employees as prescribed
by the relevant laws and administrative regulations.
3. Social insurance premiums and taxes as defaulted by the debtor.
4. The common creditor's right.
France:
1. Employee wage claims.
2. Legal costs including court appointees.
3. Priority for "new money," in which a party brings in money or
provides goods or services without demanding cash payment after the
commencement order.
4. Secured creditors.
5. Wage claims of employees arising after the commencement order.
6. Claims arising from current contracts, in which the party has
agreed to defer receipt of payment for its services.
7. Amounts advanced by the wage guarantee fund.
8. Claims arising after the commencement order.
9. Claims arising prior to the commencement order and secured by
general liens.
10. Claims arising before the commencement order.
11. Unsecured creditors.
Germany:
1. Estate obligations:
* the costs of the proceedings;
* those obligations created by activities of the administrator or the
temporary administrator to whom the debtor's right to transfer was
vested;
* obligations under mutual contracts, if their performance either is
claimed by the administrator or has to take place after the opening of
the proceedings, and;
* obligations due to unjust enrichment of the estate.
2. Normal insolvency claims.
3. Lower-ranking claims:
* the interest accruing on the insolvency claims from the opening of
the proceedings;
* costs incurred by creditors due to their participation in the
proceedings;
* fines and similar claims, and;
* claims to the debtor's gratuitous performance.
Luxembourg:
1. Receiver's fee.
2. Liquidation expenses.
3. Employee wage claims.
4. Social security contributions.
5. Outstanding taxes.
6. Lower-ranking privileges.
7. Secured creditors.
8. Unsecured creditors.
Netherlands; General principle: paritas creditorum, by which all
creditors have an equal right to payment and proceeds of the estate
shall be distributed in proportion to the size of their claims,
applies to all creditors except secured creditors and creditors who
have a preference under the Dutch Civil Code or other relevant act;
1. Secured creditors (paritas creditorum does not apply).
* creditors who hold a mortgage;
* creditors who hold a right of pledge;
2. Preferred creditors (paritas creditorum does not apply).
* creditors who have a statutory priority;
* creditors who have a nonstatutory priority;
3. Unsecured creditors (paritas creditorum applies).
Switzerland:
1. Secured creditors.
2. Class 1:
* salary claims of employees before the bankruptcy ruling;
* claims resulting out of obligatory accident insurance;
* claims resulting out of nonobligatory pension plans;
* claims of pension funds for premiums against employers;
* alimony claims of dependants and partners;
3. Class 2:
* certain claims of marital partners;
* premiums for social security insurance;
* premiums for accident insurance;
* premiums for unemployment benefits insurance;
* premiums and contributions to health insurance;
* contributions to family burdens equalization fund;
4. Class 3:
* all other debts.
UK:
1. Return of deposit on petition;
2. Payment of petition costs.
3. Distribution to preferential creditors.
4. Dividend to ordinary unsecured creditors.
5. Payment of statutory interest to ordinary unsecured creditors.
6. Deferred creditors; for example, payment of any spouse's or civil
partner's claim in respect of "credit provided".
Sources: GAO analysis of country bankruptcy laws and analysis provided
by legal experts we interviewed.
[End of table]
[End of section]
Appendix IX: Organizational Affiliations of Experts:
During the course of our work, we interviewed experts from the
following organizations:
Administrative Office of the U.S. Courts:
Allen & Overy LLP:
Alvarez & Marsal:
American Bankruptcy Institute:
American Bar Association:
American Council of Life Insurers:
American Insurance Association:
American International Group:
Cleary Gottlieb Stein & Hamilton LLP:
Commodity Futures Trading Commission:
Congressional Research Service:
Davis Polk & Wardwell LLP:
Department of the Treasury:
Department of State:
Duisenberg School of Finance:
European Commission:
Federal Deposit Insurance Corporation:
Federal Judicial Center:
Federal Reserve Board:
Financial Services Roundtable:
Financial Stability Board:
HM Treasury (UK):
Hoover Institution, Stanford University:
Hughes Hubbard & Reed LLP:
Institute of International Bankers:
Institute of International Finance:
International Insolvency Institute:
International Monetary Fund:
International Swaps and Derivatives Association:
Jenner & Block LLP:
Nabarro LLP:
PricewaterhouseCoopers:
National Association of Insurance Commissioners:
New York University:
Reinsurance Association of America:
Securities and Exchange Commission:
Securities Industry and Financial Markets Association:
Securities Investor Protection Corporation:
University of California, Los Angeles:
University of Pennsylvania:
University of Texas:
U.S. Bankruptcy Court:
Wake Forest University:
Weil, Gotshal & Manges LLP:
[End of section]
Appendix X: GAO Contact and Staff Acknowledgments:
GAO Contact:
Alicia Puente Cackley, (202) 512-8678 or cackleya@gao.gov:
Staff Acknowledgments:
In addition to the individual named above, Debra Johnson, Assistant
Director; Nancy S. Barry; Rudy Chatlos; Phil Curtin; Kate Bittinger
Eikel; Nate Gottfried; Dean Gudicello; Marc Molino; Tim Mooney;
Barbara Roesmann; Susan Sawtelle; and Paul Thompson made key
contributions to this report. William Jenkins, Thomas Melito, and
Thomas McCool also made contributions to this report. Technical
assistance was provided by JoAnna Berry, Joyce Evans, David Martin,
Jena Sinkfield, and Cynthia S. Taylor.
[End of section]
Related GAO Products:
Bank Regulation: Modified Prompt Corrective Action Framework Would
Improve Effectiveness. [hyperlink,
http://www.gao.gov/products/GAO-11-612]. Washington, D.C.: June 23,
2011.
Troubled Asset Relief Program: Update of Government Assistance
Provided to AIG. [hyperlink, http://www.gao.gov/products/GAO-10-475].
Washington, D.C.: April 27, 2010.
Federal Deposit Insurance Act: Regulators' Use of Systemic Risk
Exception Raises Moral Hazard Concerns and Opportunities Exist to
Clarify the Provision. [hyperlink,
http://www.gao.gov/products/GAO-10-100]. Washington, D.C.: April 15,
2010.
Troubled Asset Relief Program: The U.S. Government Role as Shareholder
in AIG, Citigroup, Chrysler, and General Motors and Preliminary Views
on Its Investment Management Activities. [hyperlink,
http://www.gao.gov/products/GAO-10-325T]. Washington, D.C.: December
16, 2009.
Troubled Asset Relief Program: Status of Government Assistance to AIG.
[hyperlink, http://www.gao.gov/products/GAO-09-975]. Washington, D.C.:
September 21, 2009.
Financial Regulation: Financial Crisis Highlights Need to Improve
Oversight of Leverage at Financial Institutions and across System.
[hyperlink, http://www.gao.gov/products/GAO-09-739]. Washington, D.C.:
July 22, 2009.
Federal Bankruptcy Judges: Measuring Judges' Case-Related Workload.
[hyperlink, http://www.gao.gov/products/GAO-09-808T]. Washington,
D.C.: June 16, 2009.
Federal Financial Assistance: Preliminary Observations on Assistance
Provided to AIG. [hyperlink, http://www.gao.gov/products/GAO-09-490T].
Washington, D.C.: March 18, 2009.
Financial Regulation: A Framework for Crafting and Assessing Proposals
to Modernize the Outdated U.S. Financial Regulatory System.
[hyperlink, http://www.gao.gov/products/GAO-09-216]. Washington, D.C.:
January 8, 2009.
Bankruptcy: Judiciary Should Take Further Steps to Make Bankruptcy
Data More Accessible. [hyperlink,
http://www.gao.gov/products/GAO-09-28]. Washington, D.C.: December 18,
2008:
Financial Marker Regulation; Agencies Engaged in Consolidated
Supervision Can Strengthen Performance Measurement and Collaboration.
[hyperlink, http://www.gao.gov/products/GAO-07-154]. Washington, D.C.:
March 15, 2007.
Financial Regulation; Industry Changes Prompt Need to Reconsider U.S.
Regulatory Structure. [hyperlink,
http://www.gao.gov/products/GAO-05-61]. Washington, D.C.: October 6,
2004.
Long-Term Capital Management: Regulators Need to Focus Greater
Attention on Systemic Risk. [hyperlink,
http://www.gao.gov/products/GAO/GGD-00-3]. Washington, D.C.: October
29, 1999.
Bankruptcy Administration: Case Receipts Paid to Creditors and
Professionals. [hyperlink,
http://www.gao.gov/products/GAO/GGD-94-173]. Washington, D.C.: July
13, 1994:
Bankruptcy Administration: Justification Lacking for Continuing Two
Parallel Programs. [hyperlink,
http://www.gao.gov/products/GAO/GGD-92-133]. Washington, DC: September
28, 1992:
[End of section]
Footnotes:
[1] OLA may be used when, among other things, a financial company is
in "default or in danger of default," a condition we refer to in this
report as "insolvent." See Dodd-Frank Act, Pub. L. No. 111-203 § 203.
[2] As discussed later in this report, insured depository institutions
and insurance companies may not be debtors under the Code, and broker-
dealers qualify for liquidation, but not reorganization.
[3] Pub. L. No. 111-203 §§ 202(e), (f). The mandate requires that we
report on the judicial review for OLA and the effectiveness of the
Code annually for 3 years after the passage of the act and every fifth
year thereafter. The Administrative Office of the U.S. Courts is also
required to address Pub. L. No. 111-203 § 202(e), and the Board of
Governors of the Federal Reserve System (Federal Reserve) has mandates
to address issues similar to those GAO is addressing in Pub. L. No.
111-203 §§ 216, 217.
[4] See 11 U.S.C. § 1123.
[5] DIP financing is available under 11 U.S.C. § 364.
[6] Voluntary cases are permitted under 11 U.S.C. § 301. Involuntary
cases are subject to 11 U.S.C. § 303.
[7] The Administrative Office of the U.S. Courts defines a "mega"
Chapter 11 case as a single case or set of jointly administered or
consolidated cases that involve $100 million or more in assets and
1,000 or more creditors. See GAO, Federal Bankruptcy Judges: Measuring
Judges' Case-Related Workload, GAO-09-808T (Washington, D.C.: June 16,
2009).
[8] See [hyperlink,
http://www.uscourts.gov/FederalCourts/JudicialConference.aspx].
[9] See [hyperlink,
http://www.justice.gov/ust/eo/ust_org/about_ustp.htm]. The program
covers 84 of the 90 bankruptcy courts and consists of the Executive
Office for U.S. Trustees, which provides general policy and legal
guidance, oversees operations, and handles administrative functions;
the program includes 95 field offices and 21 U.S. Trustees-
-federal officials charged with supervising the administration of
federal bankruptcy cases. Bankruptcy Administrators, who are employees
of the federal judiciary, perform the functions of the U.S. Trustees
in the remaining six bankruptcy courts, located in Alabama and North
Carolina.
[10] Section 201(a)(11) of the Dodd-Frank Act defines a financial
company as an entity organized under federal or state law that is (1)
a bank holding company as defined in the Bank Holding Company Act of
1956, as amended (BHC Act); (2) a nonbank financial company supervised
by the Federal Reserve, as defined in section 102(a)(4)(D) of the Dodd-
Frank Act: (3) any company (other than a bank holding company or
nonbank financial company supervised by the Federal Reserve)
predominantly engaged in activities the Federal Reserve has determined
to be financial in nature or incidental thereto under the BHC Act; or
(4) any subsidiary (other than an insured depository institution or an
insurance company) of one of the three types of entity if the
subsidiary is predominantly engaged in such financial activities. To
be "predominantly engaged" in financial activities, the company's
revenues from those activities must constitute 85 percent or more of
its total consolidated revenues, as FDIC, in consultation with the
Department of the Treasury, establishes by regulation. Insured
depositories, federally chartered Farm Credit System institutions, and
certain other governmental or regulated entities are not financial
companies for purposes of OLA. Throughout this report we use the term
financial institutions to refer more broadly to institutions engaged
in financial activities.
[11] 12 U.S.C. § 1821(c).
[12] The limitation of stockbrokers and commodity brokers to Chapter 7
proceedings is set forth at 11 U.S.C. § 109(d) of the Bankruptcy Code.
Chapter 7 contains special provisions for the liquidation of stock
brokers and commodity brokers. 11. U.S.C. §§ 741-753 (Stockbroker
Liquidation), 753, 761-767 (Commodity Broker Liquidation). Under SIPA,
the Securities Investor Protection Corporation (SIPC) initiates a
liquidation proceeding, the primary purpose of which is to protect
investors against financial losses arising from the insolvency of
their brokers. Once a protective decree has been applied under SIPA,
any other pending bankruptcy proceeding involving the debtor
stockbroker is stayed, and the court where the application is filed
has exclusive jurisdiction of that stockbroker. SIPC participation can
displace a Chapter 7 liquidation pending the SIPA liquidation, but
provisions of the Code apply in a SIPA liquidation to the extent they
are consistent with SIPA. See 15 U.S.C. §§ 78eee(b)(2)(B), 78fff(b).
Because many of the stockbrokers discussed in this report are also
dealers registered with the Securities and Exchange Commission as
broker-dealers, we generally use the term broker-dealer rather than
stockbroker in this report. The Code contains special provisions for
commodity broker liquidation (11 U.S.C. §§ 753, 761-767), and the
Commodity Futures Trading Commission's rules relating to bankruptcy
are set forth at 17 C.F.R. Part 190.
[13] See Dodd-Frank Act, Pub. L. No. 111-203 §§ 204, 210. FDIC's
receivership authority is set forth mainly at 12 U.S.C. §§ 1821, 1822,
and 1823.
[14] Financially distressed firms seeking to restructure may file
prepackaged bankruptcies or conduct out-of-court restructurings. In a
prepackaged bankruptcy, the firm files a plan of reorganization at the
same time as its Chapter 11 petition, with the reorganization plan
negotiated out-of-court. The plan is subject to the court's approval.
[15] Requirements for the content of a disclosure plan filed after the
filing of a bankruptcy petition are set forth at 11 U.S.C. § 1125. A
debtor generally has an exclusive right to file a plan of
reorganization within 120 days of filing the petition, with the
possibility of extending the period up to 18 months. After this
exclusivity period has ended, creditors may file plans as well.
Generally, the debtor has 180 days after the petition date to obtain
acceptance of its plan from certain creditors; however, the court may
extend (up to 20 months) or reduce this acceptance period for cause.
See 11 U.S.C. § 1121(b) and (d).
[16] 11 U.S.C. § 1129(a). An entire class of claims, such as secured
creditors, unsecured creditors, or shareholders, is deemed to accept a
reorganization plan if it is accepted by claimants that hold at least
two-thirds in amount and more than one-half in number of the allowed
claims in the class. See 11 U.S.C. § 1126(c) and (d).
[17] The automatic stay provision is 11 U.S.C. § 362.
[18] These safe harbors are primarily located in the following
sections of the Code, which list types of contracts and instruments
exempt from the automatic stay: 11 U.S.C. §§ 362(b)(6), (b)(7),
(b)(17), 546, 556, 559, 560. Related definitions are set forth in 11
U.S.C. § 101. This same class of contracts is defined in the FDI Act
(and FDIC regulations, see 12 C.F.R. 360.5) and under the OLA
authority as "qualified financial contracts." See 12 U.S.C. §
1821(e)(8)-(10) (FDI Act); Dodd-Frank Act, Pub. L. No. 111-203 §
210(c)(8)-(10). Financial industry participants typically refer to
these instruments generally as QFCs. Because safe harbor contracts and
QFCs generally refer to the same types of contract, in the remaining
discussion we use the term "QFC" to refer both to contracts under the
safe harbor provisions of the Code and to the instruments defined as
QFCs under the FDI Act and the Dodd-Frank Act. Although a specific
type of instrument might not be covered under both sets of provisions,
this general reference is consistent with industry practice.
Additionally, the FDI Act and the Dodd-Frank Act treat QFCs in an
analogous manner to the Code, with one notable exception--the ability
of FDIC to prevent the termination of these QFCs by transfer within 1
business day--this will be discussed later in this report.
[19] The Code defines the types of entities that can benefit from the
safe harbor ("counterparty limitations"). See 11 U.S.C. §§ 362(b),
101(22A), (46), (53C).
[20] Ordinarily, an ipso facto clause in an executory contract is
unenforceable against a debtor in bankruptcy due to the automatic
stay, and the exercise of the right to recover property or act against
the property of the debtor is prohibited by the automatic stay. 11
U.S.C. §§ 365(e), 362. In bankruptcy, an executory contract is one in
which both parties to the contract have future performance obligations
that, if unperformed by either party, would result in a material
breach. See Regen Capital I, Inc., v. Halperin, 547 F.3d 484 (2d Cir.
2008); Olah v. Baird, 567 F.3d 1207 (10TH Cir. 2009).
[21] An offset provision enables the nondefaulting party to offset
(net) obligations owed against collateral pledged to the debtor. 11
U.S.C. § 553. The safe harbors include "master netting agreements" for
cross-product netting. 11 U.S.C. §§ 101(38A), (38B), 362(b)(27),
546(j), 561. The debtor and the counterparty presumably would arrive
at a net sum owed either to or from the debtor.
[22] As discussed previously, the Code does not apply to insured
depository institutions. The OLA provisions of the Dodd-Frank Act
state that "the provisions of this title shall exclusively apply to
and govern all matters relating to . . ." an institution placed into
receivership under the OLA authority. Pub. L. No. 111-203 § 202(c)(2).
For QFCs involving a bank in receivership, see 12 U.S.C. § 1821(e)(1),
(8); for those involving an institution in OLA receivership, see Pub.
L. No. 111-203 § 210(c)(1), (8).
[23] See e.g., 12 U.S.C. §§ 1821(c)(8)(E), 4403, concerning the
netting of bilateral netting rights between financial institution
counterparties.
[24] See FDI Act, 12 U.S.C. § 1821(e)(8)-(10); Dodd-Frank Act, Pub. L.
No. 111-203 § 210(c)(8)-(10).
[25] 12 U.S.C. § 1821(e)(10)(B)(i)(II). Under the Code, the assignment
and assumption of QFCs not terminated by their counterparties may be
assigned if approved by the court. See, e.g., In re Lehman Brothers
Holdings, Inc., (Bankr. S.D.N.Y. 08-13555(JMP)) "Order Approving
Consensual Assumption and Assignment of Prepetition Derivative
Contracts," Jan. 28, 2009.
[26] See FDI Act, 12 U.S.C. § 1821(e)(11); see also Dodd-Frank Act,
Pub. L. No. 111-203 § 210(c)(11).
[27] 12 U.S.C. § 1821(c)(9),(11); see also Dodd-Frank Act, Pub. L. No.
111-203 § 210(c)(9), (11).
[28] See H.R. Rep. No. 97-420 at 2 (1982), 1982 U.S.C.C.A.N. 583, 584-
85; H.R. Rep. No. 101-484 (1990), reprinted in 1990 U.S.C.C.A.N. 223.
[29] Bankruptcy Abuse Prevention and Consumer Protection Act (2005),
Pub. L. No. 109-8 (BAPCPA); Financial Netting Improvements Act of
2006, Pub. L. No. 109-390; see H.R. Rep. No. 109-648, pt. 1 at 2
(2006). Because safe harbor contracts and QFCs generally refer to the
same types of contract, in the remaining discussion we use the term
"QFC" to refer both to contracts under the safe harbor provisions of
the Code and to the instruments defined as QFCs under the FDI Act and
the Dodd-Frank Act. Although a specific type of instrument might not
be covered under both sets of provisions, this general reference is
consistent with industry practice.
[30] See, e.g., H.R. Rep. No. 101-484 at 1-3 (1990) (regarding Code
safe harbor); see 73 Fed. Reg. 78162 (Dec. 22, 2008) (FDIC depiction
of purpose of pertinent QFC provisions in FDI Act).
[31] BAPCPA, Pub. L. No. 109-8.
[32] See, H.R. Rep. No. 109-31, pt. 1 at 105-07 (2005). As of the end
of 2010, legislation based upon the UNCITRAL Model Law had been
enacted in Australia (2008); the British Virgin Islands (2003); Canada
(2009); Colombia (2006); Eritrea (1998); Greece (2010); Japan (2000);
Mauritius (2009); Mexico (2000); Montenegro (2002); New Zealand
(2006); Poland (2003); the Republic of Korea (2006); Romania (2003);
Serbia (2004); Slovenia (2008); South Africa (2000); UK (2006), and
the United States (2005).
[33] 11 U.S.C. § 1501(a).
[34] 11 U.S.C. § 1506.
[35] Dodd-Frank Act, Pub. L. No. 111-203 § 203(b),(c)(4). The OLA
defines a company subject to the determination as a "covered financial
company."
[36] The factors to be addressed are set forth in section 203(b) of
the Dodd-Frank Act. Before the Secretary of the Treasury, in
consultation with the President, makes a decision to appoint FDIC as
receiver of a covered financial company, at least two-thirds of those
serving on the Board of Governors of the Federal Reserve System and at
least two-thirds of those serving on the Board of Directors of FDIC
must vote to make a written recommendation to the Secretary of the
Treasury to appoint FDIC as receiver. In the case of a broker-dealer,
the recommendation must come from the Federal Reserve and the
Securities and Exchange Commission, in consultation with FDIC, and in
the case of an insurance company from the Federal Reserve and the
Director of the Federal Insurance Office, in consultation with FDIC.
[37] Dodd-Frank Act, Pub. L. No. 111-203 § 202(a). The Secretary of
the Treasury must file the petition under seal to ensure
confidentiality.
[38] Dodd-Frank Act, Pub. L. No. 111-203 § 202(b).
[39] FDIC's proposed rule sets standards for determining whether a
company is "predominantly engaged in activities that are financial in
nature or incidental thereto." 76 Fed. Reg. 16324 (Mar. 23, 2011).
[40] Dodd-Frank Act, Pub. L. No. 111-203 § 203(c)(4).
[41] See appendixes III-VI for additional information about many of
the financial institutions discussed in this objective and information
on other failed financial institutions.
[42] GAO, Financial Markets Regulation: Financial Crisis Highlights
Need to Improve Oversight of Leverage at Financial Institutions and
across System, [hyperlink, http://www.gao.gov/products/GAO-09-739]
(Washington, D.C.: July 22, 2009).
[43] By contrast, some academics disagreed that the Lehman bankruptcy
was disorderly and believed instead that difficulties in the markets
during the fall of 2008 were the result of government actions.
[44] Daniel M. Covitz, Song Han, and Beth Ann Wilson, "Are Longer
Bankruptcies Really More Costly?" Federal Reserve Working Paper No.
2006-27 (Washington, D.C.: February 2006).
[45] Commercial paper is a promissory note with a term of 270 days or
less issued in the open market that represents the obligation of the
issuing corporation. Large corporations (financial and nonfinancial)
with strong credit ratings issue commercial paper as an alternative to
bank borrowing. To pay off holders of commercial paper, issuers
generally use the proceeds obtained by selling new commercial paper.
Most commercial paper is issued by financial institutions and mutual
funds purchase a large amount of the commercial paper issued.
[46] Adrian, Tobias, Karin Kimbrough, and Dina Marchioni, "The Federal
Reserve's Commercial Paper Funding Facility," Economic Policy Review
17, no.1 (May 2011): 25-39.
[47] GAO, Federal Reserve System: Opportunities to Strengthen Policies
and Processes for Managing Emergency Assistance, [hyperlink,
http://www.gao.gov/products/GAO-11-696] (forthcoming).
[48] For more information on the failure of LTCM, see GAO, Long-Term
Capital Management: Regulators Need to Focus Greater Attention on
Systemic Risk, [hyperlink, http://www.gao.gov/products/GAO/GGD-00-3]
(Washington, D.C.: Oct. 9, 1999).
[49] See GAO, Troubled Asset Relief Program: Status of Government
Assistance to AIG, [hyperlink, http://www.gao.gov/products/GAO-09-975]
(Washington, D.C.: Sept. 21, 2009).
[50] Treasury, Public-Private Investment Program, $500 Billion to $1
Trillion Plan to Purchase Legacy Assets, White Paper.
[51] See Covitz et al.
[52] Under TARP, the Department of the Treasury assisted institutions
holding troubled assets by purchasing preferred shares in those
institutions. As a shareholder, the government would rank below
secured and unsecured creditors during a bankruptcy proceeding.
Existing shareholders rarely receive any compensation in a bankruptcy.
[53] [hyperlink, http://www.gao.gov/products/GAO-11-696].
[54] See [hyperlink,
http://www.federalreserve.gov/newsevents/files/pdcf.xls] (listing of
all borrowers under the Primary Dealer Credit Facility by name, date,
amount, and other information).
[55] See Senate Committee on Banking, Housing and Urban Affairs,
Testimony Concerning Recent Events in the Credit Markets (testimony of
Christopher Cox, Chairman, Securities and Exchange Commission, 110th
Cong., 2d sess., Apr. 3, 2008); and SEC Office of Inspector General,
SEC's Oversight of Bear Stearns and Related Entities: Broker-Dealer
Risk Assessment Program, Report No. 446-B (Washington, D.C.: Sept. 25,
2008).
[56] In re Lehman Bros. Holdings, Inc., 2010 WL 1783395 (Bankr. S.D.
N.Y. May 5, 2010) ("Memorandum Decision Granting Debtors' Motion
Pursuant to Sections 105(a) and 362 of the Bankruptcy Code for an
Order Enforcing the Automatic Stay Against and Compelling Payment of
Post-Petition Funds by Swedbank AB").
[57] Bank of America, N.A. v. Lehman Brothers Holdings, Inc., 439 B.R.
811 (Bankr. S.D. N.Y. 2010).
[58] We have been highlighting this feature of financial institutions
for some time. See for example GAO, Financial Regulation: A Framework
for Crafting and Assessing Proposals to Modernize the Outdated U.S.
Financial Regulatory System, [hyperlink,
http://www.gao.gov/products/GAO-09-216] (Washington, D.C.: Jan. 8,
2009); GAO, Financial Regulation: Industry Changes Prompt Need to
Reconsider U.S. Regulatory Structure, [hyperlink,
http://www.gao.gov/products/GAO-05-61] (Washington, D.C.: Oct. 6,
2004).
[59] See, for example, C. Cumming and R. Eisenbeis, "Resolving
Troubled Systemically Important Cross-Border Financial Institutions:
Is a New Corporate Organizational Form Required?" Working paper:
February 8, 2010.
[60] Pretax dividends transferred from subsidiary banks can be used by
bank holding companies to pay debts, so that corporate taxes would not
have to be paid on those funds.
[61] US-headquartered bank and financial holding companies are subject
to capital adequacy requirements at the holding company level for on-
balance sheet assets. By moving assets into off-balance sheet
vehicles, the capital requirement for the consolidated entity is lower.
[62] These special purpose entities are called "bankruptcy remote"
because if the parent company failed, neither trustees, debtors-in-
possession, nor creditors could gain access to the assets contained in
the vehicle, providing a safer (and higher-rated) investment for
bondholders.
[63] In re Lehman Brothers Holdings, Inc., Case No. 08-13555, Report
of Anton Valukas, Examiner; In re Lehman Brothers, Inc., Case No. 08-
01420. Trustees Preliminary Investigation Report and Recommendations.
[64] See In re Drexel Burnham Lambert Group, Inc., 138 B.R. 723, 764
(Bankr. S.D. N.Y. 1992) (citation omitted).
[65] In the Drexel proceeding, referenced above, the court listed the
substantive consolidation factors established under case law,
observing that they "must be evaluated within the larger context of
balancing the prejudice resulting from the proposed consolidation
against the effect of preserving separate debtor entities." 138 B.R.
at 764-65 (citations omitted).
[66] Section 13 of the FDI Act, authorizes FDIC to undertake various
actions or provide assistance to a failing institution. FDIC is
obligated to pursue a course of resolution that is the least costly to
the insurance fund, except in cases involving systemic risk. 12 U.S.C.
§ 1823(c). See GAO, Bank Regulation: Modified Prompt Corrective Action
Framework Would Improve Effectiveness, [hyperlink,
http://www.gao.gov/products/GAO-11-612] (Washington, D.C.: June 23,
2011) for more information.
[67] See In re Washington Mutual, Inc, 442 B.R. 314 (Bankr, D. Del.)
(2011) (although the global settlement of claims was fair and
reasonable and provided a basis for confirmation, modifications were
found necessary before confirmation would be granted).
[68] See In re: CIT Group, Inc., Case No. 09-16565, Findings of Fact,
Conclusions of Law and Order (confirming reorganization plan) (Bankr.
S.D. N.Y. Dec. 8, 2009); In re: Lehman Brothers Holdings, Inc., 08-
13555 (S.D. N.Y.) (pending).
[69] FDIC issued cease and desist orders for one of Lehman's
institutions and CIT's bank. The Office of Thrift Supervision also
issued a cease and desist order for Lehman's thrift.
[70] See, e.g., In re Lehman Brothers Inc., No. 08-01420 SIPA.
"Trustee's Third Interim Report for the Period November 12, 2009
through May 10, 2010."
[71] See Cumming and Eisenbeis.
[72] [hyperlink, http://www.gao.gov/products/GAO-09-975].
[73] [hyperlink, http://www.gao.gov/products/GAO-11-612].
[74] FDIC, "The Orderly Liquidation of Lehman Brothers Holdings Inc.
under the Dodd-Frank Act," FDIC Quarterly 5, no. 2 (May 2011).
[75] Dodd-Frank Act, Pub. L. No. 111-203 § 165(d). This provision
requires each nonbank financial company supervised by the Federal
Reserve and each bank holding company with total consolidated assets
of $50 billion or more to submit periodically to the Federal Reserve
or FDIC, respectively, and to the Financial Stability Oversight
Council a plan for the company's rapid and orderly resolution in the
event of material financial distress or failure. Such a company also
must submit a report on the nature and extent of credit exposures the
company has to significant bank holding companies and significant
nonbank financial companies and the same types of exposures such
companies have to the reporting company.
[76] 76 Fed. Reg. 22648 (Apr. 22, 2011). The comment deadline was June
10, 2011.
[77] Pew Financial Reform Project, Standards for Rapid Resolution
Plans (Washington, D.C.: May 2011).
[78] See 11 U.S.C. § 303.
[79] Under the OLA and the FDI Act, in the case of an FDIC
receivership, a QFC counterparty generally cannot exercise a right to
terminate or offset under an "ipso facto" provision until after 5:00
p.m. (eastern standard time or eastern daylight time) following the
date of appointment of FDIC as receiver. Dodd-Frank Act, Pub. L. No.
111-203 § 210 (c)(8)(F); 12 U.S.C. § 1821(e)(10)(B)(i)(II). This
allows FDIC to transfer the QFCs so as to prevent their termination by
the counterparty.
[80] Fed. R. Bankr. P. 1015(a), (b).
[81] See, for example, Office of the Inspector General for the
Troubled Asset Relief Program, Quarterly Report to Congress, January
26, 2011 (Wash., D.C.).
[82] GAO, Financial Assistance: Ongoing Challenges and Guiding
Principles Related to Government Assistance for Private Sector
Companies, [hyperlink, http://www.gao.gov/products/GAO-10-719]
(Washington, D.C.: Aug. 3, 2010).
[83] See, e.g., In the Matter of the Liquidation of the New York
Agency and Other Assets of Bank of Credit and Commerce International,
S.A. 683 N.E. 2d 756 (1997).
[84] H.R. Rep. No. 109-31, pt. 1 at 105-07 (2005).
[85] In re Lehman Brothers Finance, AG, in Liquidation, Case No. 09-
10583; In re: Lehman Brothers Holdings, Inc., Case No. 08-13555, Order
Dismissing Chapter 11 Case of Lehman Brothers Finance AG, (Bankr. S.D.
N.Y. 2009).
[86] 11 U.S.C. § 1504. The Code defines a "foreign representative" as
a person or body "authorized in a foreign proceeding to administer the
reorganization or the liquidation of the debtor's assets or affairs or
to act as a representative of such foreign proceeding." 11 U.S.C.
§101(24).
[87] 11 U.S.C. § 1502(7). The Code permits a foreign representative to
make a limited appearance in an involuntary case without being
submitted to the U.S. court's jurisdiction. 11 U.S.C. § 306. Also, the
Code permits a bankruptcy court to dismiss a case, after notice and a
hearing, if, among other things, recognition of a foreign proceeding
has been granted under Chapter 15. 11 U.S.C. § 305.
[88] 11 U.S.C. § 1505.
[89] 11 U.S.C. §§ 1525, 1526.
[90] Section 1516 of the Code states that "in the absence of evidence
to the contrary, the debtor's registered office is presumed to be the
center of the debtor's main interests." 11 U.S.C. § 1516(c). However,
this presumption has been contested, and courts look to credible
indicators of the center of main interest. See Louise DeCarl Adler,
"Managing the Chapter 15 Cross-Border Insolvency Case," A Pocket Guide
for Judges (Federal Judicial Center: 2011).
[91] Note that eight of the largest financial institutions listed in
table 2 are located in these countries.
[92] An informative discussion of protocols and other aspects of cross-
border insolvency cooperation can be found in the United Nations,
UNCITRAL Practice Guide on Cross-Border Insolvency Cooperation (New
York: 2010).
[93] American Law Institute, Transitional Insolvency: Cooperation
among the NAFTA Countries, Principles of Cooperation among the NAFTA
Countries (Philadelphia, Pa: 2003).
[94] In re Lehman Brothers Holdings, Inc., Docket No. 08-13555, Order
Approving The Proposed Cross-Border Insolvency Protocol For the Lehman
Brothers Group of Companies (June 17, 2009). See American Law
Institute, Guidelines Applicable to Court-to-Court Communications in
Cross-Border Cases (Washington D.C.: 2000).
[95] "Cross-Border Insolvency Protocol for The Lehman Brothers Group
of Companies," execution copy, as of May 12, 2009.
[96] Basel Committee on Banking Supervision, Report and
Recommendations of the Cross-border Resolution Group (Basel,
Switzerland: March 2010).
[97] The International Centre for Monetary and Banking Studies (ICMB)
is an independent, nonprofit foundation to foster exchanges of views
between the financial sector, central banks, and academics on issues
of common interest. It is financed through grants from banks,
financial institutions, and central banks. In association with The
Centre for Economic Policy Research--a network of over 700 research
fellows and affiliates throughout Europe--the ICMB produces the Geneva
Reports on the World Economy. ICMB, A Safer World Financial System:
Improving the Resolution of Systemic Institutions, Geneva Reports on
the World Economy 12 (Geneva, Switzerland: 2010).
[98] See appendix VIII for some detailed information on insolvency
systems in selected countries.
[99] A common law system gives broad discretion to the judge so that a
body of law is developed through court decisions in addition to law
enacted through legislation. A civil law system is one that places
emphasis on the language of the statute and predictability. See Robert
Adriaansen, "At the Edges of the Law: Civil Law v. Common Law," A
Response to Professor Richard B. Capalli, Temple Int'l & Comp. L.J.
107 (1998). For bankruptcy purposes, one legal writer described the
difference as follows: "Whereas the U.S. bankruptcy court is a court
of equity and a U.S. judge asks under the concept of common law
whether there is anything in the Code that restrains him from granting
the order, the German judge needs under civil law principles a
provision in the Act which allows him to grant the action in
question." See "Lies, Sale of a Business in Cross-Border Insolvency:
The United States and Germany." Am. Bankr. Inst. L.10 Rev. 363 no. 65
(spring 2002).
[100] In re Lehman Brothers Holdings, Inc., Case No. 08-13555, Lehman
Brothers Special Financing Ince. V. BNY Corporate Trustee Services,
LTD, Adversary Proceeding 09-01242, Memorandum Decision Granting
Motion for Summary Judgment and Declaring Applicable Payment
Priorities (Bankr. S.D. N.Y. Jan. 25, 2010).
[101] Depository institutions insured by Canada's federal government
are subject to restructuring and/or reorganization by the Canada
Deposit Insurance Corporation (CDIC) under the Canada Deposit
Insurance Corporation Act (CDIC Act). Provincial loan and trust
corporations whose deposits are CDIC-insured also may be subject to
the act if the relevant province has entered an agreement with the
federal government. The Winding Up and Restructuring Act (WURA)
applies to federal and provincial banks, loan companies, and insurance
corporations. The WURA in effect provides a liquidation regime for
these financial institutions.
[102] The Group of 20 (G20) is a group of finance ministers and
central bank governors from 19 countries--including the United States--
and the EU. The Financial Stability Board brings together from the G20
countries central banks officials, finance and treasury officials, and
financial institution regulators; officials of the International
Monetary Fund and World Bank, and representatives from non-G20
countries to address issues related to global financial stability.
Originally authorized by the Group of Seven countries--Canada, France,
Germany, Italy, Japan, UK, and United States--in 1999 as the Financial
Stability Forum, in April 2009, the G20 changed its name to the
Financial Stability Board and strengthened and broadened its
authority. The mandates of the board currently includes promoting
coordination among authorities responsible for financial stability and
contingency planning for cross-border crisis management, particularly
for systemically important financial institutions. Financial Stability
Forum, FSF Principles for Cross-border Cooperation on Crisis
Management (Apr. 2, 2009).
[103] INSOL is a global group of national associations of insolvency
experts, including attorneys and accountants.
[104] International Insolvency Institute, Judicial Guidelines for
Coordination of Multinational Enterprise Group Insolvencies (2009).
The International Insolvency Institute is a global organization of
insolvency experts.
[105] Prompt corrective action is the requirement that regulators take
increasingly intensive actions as an institution's capital situation
worsens. See 12 U.S.C. § 1831o.
[106] A bridge institution is an institution established to facilitate
the transfer of assets and liabilities from one institution to another.
[107] The IMF, an organization of 184 countries, works to help foster
global monetary cooperation and secure financial stability, among
other aims. The staffs of these institutions have also conducted
research related to these activities.
[108] Pub. L. No. 111-203,§§ 202(e), (f). The mandate requires that we
report on the judicial review for OLA and the effectiveness of the
Code annually for 3 years after the passage of the act and every fifth
year thereafter. The Administrative Office of the U.S. Courts is also
required to address Pub. L. No. 111-203,§ 202(e), and the Board of
Governors of the Federal Reserve System (Federal Reserve) has mandates
to address issues similar to those GAO is addressing in Pub. L. No.
111-203,§§ 216, 217.
[109] A 10-K filing is the Form 10-K filed with the Securities and
Exchange Commission (SEC). The 10-K is an annual report required by
SEC of every issuer of a registered security, every exchange-listed
company, and any company with 500 or more shareholders or $1 million
or more in gross assets. The form provides for disclosure of total
sales, revenue, and pretax operating income, as well as sales by
products for each of a company's separate lines of business. The Form
10-K becomes public information when filed with the SEC.
[110] Prepackaged bankruptcies are those where creditors and others
necessary for approval of a plan accept a reorganization plan before
the company files for bankruptcy. The provisions of any applicable
nonbankruptcy law such as federal securities law governing
communication with shareholders of public companies must be complied
with, and those solicited must have been provided with "adequate
information" in connection with the solicitation of their vote. See 11
U.S.C. 1126.
[111] Dodd-Frank Act, Pub. L. No. 111-203 § 202(b)(2).
[112] See Letter to William J. Sweet, Jr. (April 13, 2009). Section
23A is codified, as amended, at 12 U.S.C. § 371c. Regulation W is set
forth at 12 C.F.R. part 223.
[113] Prepackaged bankruptcies are generally those where the required
number of creditors and other parties of interest accept a
reorganization plan before the company files for bankruptcy, as long
as the solicitation of such acceptance was in compliance with any
applicable nonbankruptcy law, rule, or regulation governing the
adequacy of disclosure in connection with such solicitation. 11 U.S.C.
§1126(b).
[114] See In re CIT Group Inc., and CIT Group Finding Company of
Delaware LLC, Case No. 09-16565, Findings of Fact, Conclusions of Law
and Order (1) Approving (A) The Disclosure Statement Pursuant to
Sections 1125 and 1126(c) of The Bankruptcy Code, (B) Solicitation of
Votes and Voting Procedures, and (C) Forms of Ballots, and (II)
Confirming the Modified Second Amended Prepackaged Reorganization Plan
of CIT Group Inc. and CIT Group Funding Company of Delaware LLC
(Bankr. S.D. N.Y., Dec. 8, 2009).
[115] As of July 21, 2011, the Office of the Comptroller of the
Currency will begin supervising all federal thrifts, and the Office of
Thrift Supervision will cease operations 90 days later.
[116] In the United States, consolidated supervision generally is
equated with holding company supervision at the top tier or ultimate
holding company in a financial enterprise.
[117] According to Lehman's accounting, a "derivative asset" is one
that will yield "probable future economic benefits," and a "derivative
liability" is one that will yield "probable future sacrifices of
economic benefits." That is, a derivative asset is one in which Lehman
was owed money and would have been paid if the counterparty wanted to
close out the position. With a derivative liability, Lehman would have
owed money and would have to pay current market value to close out the
position.
[118] The expert also estimated the notional value of these contracts
at $60 trillion, although authoritative information about the actual
size of the market is generally not available. Notional value means
the amount underlying a financial derivatives contract.
[119] LBI borrowed funds from the Primary Dealer Credit Facility,
which offered short-term collateralized loans, following the LBHI
bankruptcy. LBI borrowed $28 billion on September 15 against $31.7
billion of collateral, $19.7 billion on September 16 against $23
billion of collateral, and $20.4 billion on September 17 against $23.3
billion of collateral.
[120] Two of these debtors (Fundo de Investimento Multimercado Credito
Privado Navigator Investimento No Exterior and Lehman Brothers
Finance) later would have their Chapter 11 cases dismissed.
[121] The SIPA statute requires that a SIPA proceeding be conducted in
accordance with, and as though it were being conducted under the
appropriate sections of Chapter 7.
[122] The procedural history of these proceedings is described in
Lehman Brothers Special Financing Inc. (Adv. Proc No. 09-01242), In re
Lehman Brothers Holdings Inc., Case No. 08-13555 (Bankr., S.D. N.Y.),
Memorandum and Decision Granting Motion for Summary Judgment and
Declaring Applicable Payment Priorities (Jan. 25, 2010).
[123] See 11 U.S.C. § 510.
[124] In re Lehman Brothers Holdings Inc., Case No. 08-13555, In re
Lehman Brothers Inc., Case No. 08-01420 (Bankr. S.D. N.Y.), Opinion on
Motions Seeking Modification of the Sale Order Pursuant to Rule 60(B),
The Trustee's Motion for Relief Under the SIPA Sale Order, Barclay's
Cross-Motion to Enforce the Sale Orders and Adjudication of Related
Adversary Proceedings (Feb. 22, 2011).
[125] 15c3-3 assets are securities held in reserve pursuant to Rule
15c3-3, the Customer Protection Rule promulgated by the SEC. Clearance
box assets are securities held in LBI's "clearance box" accounts at
the Depository Trust & Clearing Corporation. These assets facilitated
securities trading by providing collateral to secure open trading
positions.
[126] In re Lehman Brothers Holdings Inc., Case No. 08-13555 (Bankr.
S.D. N.Y.), Memorandum Decision Granting Debtors' Motion Pursuant to
Sections 105(a) and 362 of the Bankruptcy Code for an Order Enforcing
the Automatic Stay Against and Compelling Payment of Post-Petition
Funds by Swedbank AB (May 5, 2010).
[127] In Re Washington Mutual, Inc. Debtors. Chapter 11. Case No. 08-
122229 (MFW) Jointly Administrated. January 11, 2011.
[128] Washington Mutual Bank was headquartered in Henderson, Nevada
and Washington Mutual Bank FSB was headquartered Park City, Utah.
[129] As of July 21, 2011, OTS will transfer its authority over thrift
holding companies to the Federal Reserve. The Office of the
Comptroller of the Currency then will supervise all federal thrifts.
OTS will cease operations 90 days later.
[130] Department of the Treasury and FDIC Offices of Inspector
General, Evaluation of Federal Regulatory Oversight of Washington
Mutual Bank. Report No. EVAL-10-002. (Washington, D.C.: April 2010).
[131] Joshua R Hochberg. Final Report of the Examiner. In re
Washington Mutual, Inc. et al. Case No. 08-12229 (MFW).
[132] The Federal Home Loan Banks are 12 regional cooperative banks
that member financial institutions use to access credit and liquidity.
Washington Mutual Bank FSB was also a member of the Federal Home Loan
Bank of Seattle.
[133] Purchase and assumption agreements are an FDIC resolution
mechanism that involves transferring some or all of the failed
institution's deposits, certain other liabilities, and some or all of
its assets to an acquirer.
[134] On March 16, 2011, FDIC filed a complaint in the U.S. District
Court in the Western District of Washington at Seattle against three
former executives of Washington Mutual, Inc. and their spouses,
seeking to recover damages for gross negligence, ordinary negligence,
breaches of fiduciary duties, and for assets FDIC said were
fraudulently transferred conveyances.
[135] The examiner also found that: (1) JPMC was the only potential
purchaser of Washington Mutual Bank that did not want government
assistance or guarantees, and the institution had an advantage in
calculating the value of the bank because of its work in the spring of
2008; and (2) FDIC could be more transparent in its actions, better
inform potential purchasers of the value of assets, and should require
better documentation of assets being sold.
[136] In re Washington Mutual, Inc., 442 B.R. 314, 322 (Bankr. D.Del,
2011).
[137] A detailed discussion of the disputed accounts can be found in
the Examiner's report.
[138] A fraudulent transfer could imply the holding company was trying
to hinder, delay, or defraud creditors (such as FDIC) and would have
to be unwound. The fraudulent transfer provision of the Bankruptcy
Code is 11 U.S.C. § 548.
[139] Pub. L. No. 111-92 § 13.
[140] See, e.g., In re Washington Mutual, Inc., 442 B.R. 314, 321
(Bankr. D. Del. 2011).
[141] Trust preferred securities are securities having characteristics
of both debt and equity that often are issued by bank holding
companies through a trust. In this case, the trust preferred security
holders own a preferred equity interest in Washington Mutual, Inc.
[142] In the proceeding brought by trust preferred securities (TPS)
holders, Black Horse Capital LP v. JPMorgan Chase Bank, N.A., 442 B.R.
297 (Bankr. D. Del. 2011), the court granted the defendants' motions
for summary judgment and denied the TPS holders' motion for summary
judgment, finding that the TPS holders no long have any interest in
the TPS because the interests were converted to interest in preferred
stock of Washington Mutual, Inc.
[143] In the litigation tracking warrant proceeding, known in the
context of the WMI bankruptcy as the "Anchor Litigation," the court
ruled that although a genuine dispute remained concerning the status
and valuation of the claims, the holders' interests are adequately
protected by the debtor's Chapter 11 plan. See In re Washington
Mutual, Inc., 442 B.R. 314 at 324-25, 339-341 (Bankr. D. Del, 2011).
[144] Bank of International Settlements, History of the Basel
Committee and its Membership, (Basel, Switzerland, August 2009), and
BIS Chronology - 1970 to 1979, (Basel, Switzerland, August 2009), and
Federal Reserve Bank of New York, "Developments on the Management of
Foreign Exchange Settlement Risk" Remarks by Ernest T. Patrikis, First
Vice President, Federal Reserve Bank of New York before the Bankers
Association for Foreign Trade, the 74TH Annual Convention Tucson,
Arizona, April 30, 1996.
[145] The Group of Ten comprised Belgium, Canada, France, Germany,
Italy, Japan, the Netherlands, Sweden, and Switzerland, the UK, and
the United States. The Basel Committee on Banking Supervision, as it
is known, provides a forum for regular cooperation on banking
supervisory matters. Its objective is to enhance understanding of key
supervisory issues and improve the quality of banking supervision
worldwide. It seeks to do so by exchanging information on national
supervisory issues, approaches and techniques, with a view to
promoting common understanding. At times, the committee uses this
common understanding to develop guidelines and supervisory standards
in areas where they are considered desirable. In this regard, the
committee is best known for its international standards on capital
adequacy; the Core Principles for Effective Banking Supervision; and
the Concordat on cross-border banking supervision. The committee's
current members come from Argentina, Australia, Belgium, Brazil,
Canada, China, France, Germany, Hong Kong SAR, India, Indonesia,
Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia,
Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland,
Turkey, the UK, and the United States.
[146] New Street Capital was acquired in December 1993 by Green
Capital Investors, L.P.
[147] Ring fencing refers to the practice by which local authorities
set aside or shield assets of a local subsidiary from the failed
institution and insist that local creditors get paid first, prior to
any funds being transferred to satisfy claims made against the failed
parent.
[148] Although no statutory definition of hedge funds exists, the term
commonly is used to describe private investment vehicles that often
engage in active trading of various types of securities and
commodities.
[149] See [hyperlink, http://www.gao.gov/products/GAO/GGD-00-03] and
[hyperlink, http://www.gao.gov/products/GAO-09-739].
[150] We have issued several reports on federal assistance to AIG,
including GAO, Federal Financial Assistance: Preliminary Observations
on Assistance Provided to AIG, [hyperlink,
http://www.gao.gov/products/GAO-09-490T] (Washington, D.C.: Mar. 18,
2009); Troubled Asset Relief Program: Status of Government Assistance
Provide to AIG, GAO-09-975 (Washington, D.C.: Sept. 21, 2009);
[hyperlink, http://www.gao.gov/products/GAO-10-325T]; and Troubled
Asset Relief Program: Update of Government Assistance Provided to AIG,
[hyperlink, http://www.gao.gov/products/GAO-10-475] (Washington, D.C.:
Apr. 27, 2010).
[151] A collateralized debt obligation is a security backed by a pool
of bonds, loans, or other assets.
[152] Basel Committee on Banking Supervision, Report and
Recommendations of the Cross-border Resolution Group (Basel,
Switzerland: 2010).
[153] Monoline insurers usually write a single type of insurance
contract, such as for bond issuances.
[154] A feeder fund is an investment fund that conducts virtually all
of its investing through another fund (called the master fund). The
master-feeder fund structure is a common way that hedge funds are set
up to accept assets from both foreign and domestic investors in the
most tax and trading efficient manner possible. The master fund is
often located offshore.
[155] Due to the size of the claim and Colonial not having enough
assets to pay FDIC the full amount, granting FDIC's claim likely would
have forced the debtor into Chapter 7 liquidation (partially) to meet
FDIC's claim.
[156] In re The Colonial BancGroup, Inc., 436 B. R. 713 (Bankr. M.D.
Ala. 2010).
[157] In re The Colonial BancGroup, Inc., 2011 Bankr. LEXIS 275
(Bankr. M.D. Ala. 2011).
[158] The Bank of New York merged with Mellon Financial Corporation on
January 1, 2007, to form The Bank of New York Mellon Corporation (BNY).
[159] The Bank of New York v. FDIC, 453 F. Supp. 2d 82 (D.D.C. 2006),
aff'd, 508 F.3d 1 (D.C. Cir 2007), reh. denied, Bank of New York v.
FDIC, 2008 U.S. App LEXIS 1582, 1586 (D.C. Cir. 2008).
[160] Bank of New York v. First Millenium, Inc., 958 F. Supp. 2d 550
(S.D. N.Y. 2009).
[161] Bank of New York v. First Millennium, Inc., 607 F. 3d 905 at 910-
915 (2d Cir. 2010). The decision contains a description of the
NextBank receivership and subsequent lawsuits.
[162] 11 U.S.C. §§ 365, 547. In bankruptcy, an executory contract is
one in which both parties to the contract have future performance
obligations that, if unperformed by either party, would result in a
material breach. See Regen Capital I, Inc., v. Halperin, 547 F. 3d 484
(2d Cir. 2008); Olah v. Baird, 567 F. 3d 1207 (10TH Cir. 2009).
[163] A general description of these laws is set forth in the
following discussion about special resolution regimes.
[164] Dodd-Frank Act. Pub. L. No. 111-203 § 210(c)(8)(F)(II)
(suspending QFC counterparty's payment or delivery obligations during
the time from when FDIC is appointed receiver until the earlier of the
party's receiving notice that the contract has been transferred to
another entity or 5:00 p.m. (eastern standard time or eastern daylight
time) on the business day following the appointment).
[165] Bank Bankruptcy in Canada: A Comparative Perspective, supra
note, at 66-67.
[166] Jingxia Shi, Twelve Years to Sharpen One Sword: The 2006
Enterprise Bankruptcy Law and China's Transition to a Market Economy,
16 J. Bankr. L. & Prac. 5 (October 2007).
[167] See European Parliament and Council, 2010, Regulation on
Establishing a European Supervisory Authority (European Banking
Authority) Reg. No. 1093/2010.
[168] Jan D. Bayer, German Bank Restructuring Act: Impact on Investors
in Debt, Hybrid and Equity Securities Issued by German Banks,
available at [gyperlink,
http://www.binghamcom/Media.aspx?MediaID=11986] (Feb. 9, 2011).
[169] A bridge institution is an institution established to facilitate
the transfer of assets and liabilities from one institution to another.
[170] The International Comparative Legal Guide to Corporate Recovery
and Insolvency 2010: Netherlands, page 147.
[171] These rankings are based on information from secondary sources
and, in some cases, the laws themselves. The priorities for unsecured
creditors under U.S. law are set forth at 11 U.S.C. § 507.
[End of section]
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