Dynamic Resolution of Large Financial Institutions

University of Pennsylvania Carey Law School Penn Law: Legal Scholarship Repository Faculty Scholarship at Penn Law Fall 10-1-2012 Dynamic Resolution of Large Financial Institutions Thomas H. Jackson University of Rochester David A. Skeel Jr. University of Pennsylvania Carey Law School Follow this and additional works at: https://scholarship.law.upenn.edu/faculty_scholarship Part of the Banking and Finance Law Commons, Bankruptcy Law Commons, and the Law and Economics Commons Repository Citation Jackson, Thomas H. and Skeel, David A. Jr., "Dynamic Resolution of Large Financial Institutions" (2012). Faculty Scholarship at Penn Law. 453. https://scholarship.law.upenn.edu/faculty_scholarship/453 This Article is brought to you for free and open access by Penn Law: Legal Scholarship Repository. It has been accepted for inclusion in Faculty Scholarship at Penn Law by an authorized administrator of Penn Law: Legal Scholarship Repository. For more information, please contact [email protected]. \\jciprod01\productn\H\HLB\2-2\HLB202.txt unknown Seq: 1 1-FEB-13 8:11 DYNAMIC RESOLUTION OF LARGE FINANCIAL INSTITUTIONS THOMAS H. JACKSON & DAVID A. SKEEL, JR.* One of the more important issues emerging out of the 2008 financial crisis concerns the proper resolution of a systemically important financial institution. In response to this, Title II of Dodd-Frank created the Orderly Liquidation Au- thority, or OLA, which is designed to create a resolution framework for systemically important financial institutions that is based on the resolution authority that the FDIC has held over commercial bank failures. In this Article, we consider the various alternatives for resolving systemically important institutions. Among these alternatives, we discuss OLA, a European-style bail-in process, and coerced mergers, while also extensively focusing on the bankruptcy code. We argue that implementing several discrete modifications to Dodd-Frank, as well adopting an ambitious Chapter 14 proposal written by a working group at the Hoover Institution is the best way forward for establishing a strong resolution framework. TABLE OF CONTENTS INTRODUCTION .................................................. 436 R I. DODD-FRANK’S RESOLUTION RULES ........................ 439 R A. The Basic Framework ................................. 439 R B. The Rhetorical Context and its Implications ............ 440 R C. Key Problems with the Dodd-Frank Resolution Rules ... 442 R D. Potential Benefits ..................................... 445 R II. THE BANKRUPTCY ALTERNATIVE ........................... 446 R A. The Bankruptcy Process ............................... 446 R B. Benefits of Bankruptcy ................................ 447 R C. The Limitations of Bankruptcy ......................... 448 R D. The Role and Status of Bankruptcy Judges.............. 450 R III. IS BAIL-IN THE SOLUTION? ................................ 451 R IV. REGULATOR-BROKERED SALES ............................. 455 R V. IMPLICATIONS AND POTENTIAL REFORMS ................... 456 R A. Next Steps for Dodd-Frank and Bankruptcy Reform ..... 457 R B. A More Ambitious Program: Chapter 14 ............... 458 R CONCLUSION .................................................... 460 R * University Professor, University of Rochester, and S. Samuel Arsht Professor of Corpo- rate Law, University of Pennsylvania Law School, respectively. We are grateful to Hideki Kanda, Joseph Sommer, James Thompson and participants at the Chicago Federal Reserve Conference on The Role of Central Banks in Financial Stability for helpful comments, and to the editors of the Harvard Business Law Review for their collaboration throughout the writing and editing process. \\jciprod01\productn\H\HLB\2-2\HLB202.txt unknown Seq: 2 1-FEB-13 8:11 436 Harvard Business Law Review [Vol. 2 INTRODUCTION As of 2008, when the financial crisis hit in earnest, there were two principal options if a large financial institution fell into distress in the United States: bankruptcy or some kind of government bailout. Specialized administrative resolution rules governed particular kinds of subsidiaries—commercial banks were and are subject to resolution by the Federal Deposit Insurance Corporation (FDIC),1 for instance, and state regulators handle insurance company failures2—but bankruptcy or bailout was the choice for bank holding companies and nonbank financial institutions. After the initial wave of the crisis passed, Federal Reserve Chairman Ben Bernanke, Trea- sury Secretary Timothy Geithner, and other key regulators called on Con- gress to put an administrative resolution framework in place for these institutions as well.3 In 2010, with the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), they got their wish.4 Title II of the legislation (the Orderly Liquidation Authority, or OLA) gives regulators the power to take over and resolve financial institutions whose failure could cause systemic problems.5 The Dodd-Frank resolution rules were controversial before they were enacted and that controversy has continued. In response to some of this controversy, the FDIC claimed that it might have secured a recovery of ninety- seven cents on the dollar if it had had its current resolution powers in the months before Lehman Brothers collapsed.6 Critics scoff at these claims and characterize the new administrative resolution framework, despite ominous- sounding statutory language, as having perpetuated bailouts.7 Many of the critics argue for some version of the existing bankruptcy laws as the best strategy for resolving the financial distress of the largest financial institu- 1 See 12 U.S.C. § 1821(c) (2006). 2 See McCarran-Ferguson Act, 15 U.S.C. §§ 1011–1015 (2006). 3 Oversight of the Federal Government’s Intervention at American International Group: Hearing Before the H. Comm. on Fin. Services, 111th Cong. 111-20 (2009) (statement of Ben S. Bernanke, Chairman, Federal Reserve Board), available at http://www.federalreserve.gov/ newsevents/testimony/bernanke20090324a.htm; Systemic Regulation, Prudential Matters, Res- olution Authority and Securitization, 111th Cong. 111-88 (2009) (statement of Timothy F. Geithner, Secretary, U.S. Dept. of Treasury), available at http://financialservices.house.gov/ Calendar/EventSingle.aspx?EventID=231801. 4 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010). 5 Id. §§ 201–217. 6 See Fed. Deposit Ins. Corp., The Orderly Liquidation of Lehman Brothers Holding, Inc. Under the Dodd-Frank Act, 5 FDIC Q. 31 (2011), available at http://www.fdic.gov/bank/ana- lytical/quarterly/2011_vol52.html [hereinafter Lehman Report]. 7 See, e.g., Kenneth Scott, A Guide to the Resolution of Failed Financial Institutions: Dodd-Frank Title II and Proposed Chapter 14, 15 (February 29, 2012) (unpublished manu- script), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2018035 (arguing that Title II precludes bailouts of shareholders but permits creditor bailouts); VERN MCKINLEY, FINANCING FAILURE: A CENTURY OF BAILOUTS 283 (2011) (“Although the goal of ending taxpayer bailouts once and for all is a noble objective, the likelihood that the Dodd-Frank legislation has accomplished this is quite small.”). \\jciprod01\productn\H\HLB\2-2\HLB202.txt unknown Seq: 3 1-FEB-13 8:11 2012] Dynamic Resolution of Large Financial Institutions 437 tions.8 Unlike the new resolution rules (and the FDIC bank resolution powers on which they are based), which vest regulators with the authority to determine how much creditors are paid and how the financial distress is resolved,9 bankruptcy leaves much of the decision making to the parties themselves, subject to statutory rules and judicial oversight. Under the cor- porate reorganization provisions of Chapter 11, a corporation’s managers generally decide when to commence the process,10 and either propose a sale of the firm’s assets or negotiate the terms of a reorganization with its creditors.11 In a traditional reorganization, the negotiations culminate in a vote by each class of creditors and shareholders whether to approve the proposed plan.12 In Europe, lawmakers are considering a third strategy for resolving the financial distress of a large financial institution, an approach generally known as bail-in.13 Like OLA, bail-in is a form of administrative resolution, but it is designed to serve as a mid-course correction to preserve a troubled financial institution rather than as a full-blown, administrative resolution. The most prominent proposals assume that regulators will determine when to intervene, and would dictate which claims could be altered and which could not.14 Under some models of bail-in, adjustments to creditors’ entitlements would occur automatically, based on a market trigger.15 One important objective of this Article is to carefully assess the strengths and weaknesses of each of the principal options. In addition to OLA, bankruptcy, and bail-in, we also consider a more idiosyncratic, but undeniably important, resolution option: coerced, nonresolution sales. Co- erced sales were a major feature of the 2008 crisis—Bear Stearns and Wa- 8 See Scott, supra note 7, at 15–17 (favorably comparing bankruptcy, as amended by a R Chapter 14 proposal advocated by a Hoover Institution working group, to OLA). 9 See Dodd-Frank Act § 204. 10 11 U.S.C. § 301 (2006) (A “voluntary case . is commenced by the filing . of a petition . by an entity that may be a debtor . .”). While, under certain circumstances,

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