December 2009 / Special Alert

A legal update from Dechert’s Business and Reorganization Group

Proposed “Too Big to Fail” Amendments to the Code

H.R. 3310 (the “Bill”), recently introduced in the House of Representatives, proposes among other things the Consumer Protection and Regulatory En- hancement Act of 2009 (the “Act”). H.R. 3310, 111th Cong. (1st Sess. 2009). The Act proposes certain amendments to the Bankruptcy Code de- signed to deal with the adjustment of and liabilities of non-bank fi- nancial institutions that are deemed “too big to fail.” These amendments would create a new chapter 14 to the Bankruptcy Code (“Chapter 14”) which would govern such financial institutions’ bankruptcy. Any financial institution that is not an insured depository institution would be a candi- date for a Chapter 14 filing. Sponsored by a House Republican, the Act primarily aims to allow the largest companies to fail without causing tur- moil in the United States financial system, prevent any bailouts by the United States government and forbid any government lending in bank- ruptcy. The Bill is in the first step of the legislative process and is currently under committee consideration.

Background ance sheets if their collapse would pose another national financial crisis. Additionally, Flores com- The sponsor of the Bill is House Representative mented that the Act is a “simple but effective set Spencer Bachus [R-Alabama]. The Act was pro- of reforms to help us handle the of posed in response to the government’s inconsis- large, interconnected firms.” The paramount bene- tent policies regarding the collapses of financial fit of filing a Chapter 14 bankruptcy is that an holding companies, such as Lehman Brothers, oversight board created by the Act, the Market Bear Stearns and American International Group Stability and Capital Adequacy Board, (discussed Inc. (“AIG”), which fueled a nationwide financial in further detail on page 2) would bring together panic. Allowing Lehman Brothers to file for chapter the failing company, its , its regulators 11 bankruptcy while rescuing Bear Stearns and and other parties-in-interest to address issues and AIG from a similar fate is cited as one example for concerns surrounding the bankruptcy before the these inconsistent policies. filing.

When addressing the reasons for the Act, congres- The Act does not allow for government bailouts, sional staffer Daniel Flores stated, “There are thus removing reliance on a governmental rescue. companies that are too big to fail and those com- Flores commented that the Act will signal to all panies need to be treated specially.” Through a parties-in-interest that “when Humpty Dumpty falls Chapter 14 filing, the Act would help non-bank off the wall, it’s going to be on their dime, not the financial holding companies restructure their bal- taxpayers.” d

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Details of the Proposed Chapter 14 sultation. An immediate filing is only available in certain Bankruptcy situations if it is determined that an immediate filing is necessary, which requires a certification by the , The proposed title of the new Chapter 14 is “Adjustment the functional regulator and the Board. The purpose of a to the Debts of a Non-Bank Financial Institution.” Title I Prepetition Consultation is “to attempt to avoid the need of the Bill outlines the details of the proposed Chapter for the non-bank financial institution’s or 14. In summary, section 101 of the Bill amends the Ju- reorganization in bankruptcy, to make any liquidation or dicial Code to prescribe the venue for Chapter 14 cases, reorganization of the non-bank financial institution un- section 102 describes the changes to the Bankruptcy der [Chapter 14] more orderly, or to aid in the nonbank- Code, and section 103 of the Bill addresses the effective ruptcy resolution of any of the non-bank financial insti- date. tution’s components under its nonbankruptcy regime.” The Prepetition Consultation will include an The Bill seeks to enact major conceptual changes to the attempt to negotiate forbearance of claims between the Bankruptcy Code. Below is a summary of these non-bank financial institution and its creditors if it would changes. help avoid a filing under Chapter 14, would make a liq- uidation or reorganization more orderly or would aid in Creation of the Market Stability and Capital the nonbankruptcy resolution of any or all of the non- Adequacy Board bank financial institution’s components under its non- bankruptcy insolvency regime. A Prepetition Consulta- The Act creates the Market Stability and Capital Ade- tion can continue for 30 days after the filing of a Chap- quacy Board (the “Board”). This entity, established in ter 14 petition. In addition, the Board and the functional section 201 of the Bill, will consist of eleven members. regulator will publish and transmit to Congress a report Six of the members are public members—the Secretary documenting the course of any such Prepetition Consul- of Treasury, the Chairman of the Board of Governors of tation. the Federal Reserve System, the Chairman of the Secu- rities and Exchange Commission (the “SEC”), the Chair- No More Government Bailouts in Bankruptcy person of the Federal Deposit Insurance Corporation (the “FDIC”), the Chairman of the Commodity Futures One change to the Bankruptcy Code that is not limited Trading Commission, and the Chairperson of the Finan- to Chapter 14 filings is contained in section 102(e) of cial Institutions Regulator (“FIR”) (created by the Act) the Bill. This change amends section 364 of the Bank- —while the remaining five members will be appointed ruptcy Code, the provision allowing to obtain by the President. The principal functions of the Board financing while in bankruptcy. The change essentially are to monitor the interactions of various sectors of the adds a restriction on the ability to obtain credit— financial system and identify risks that could endanger debtors will not be allowed to obtain credit if the source the stability and soundness of the system. Additionally, of the credit is the United States government. As a re- the Board is responsible for participating in a prepeti- sult, government bailouts of the type seen in GM and tion consultation (the “Prepetition Consultation”) with Chrysler will be prohibited in any bankruptcy filing. Chapter 14 debtors. Safe Harbors Potentially Not Available for Certain The Prepetition Consultation Derivative Contracts

Another dramatic change to the Bankruptcy Code under As the Bankruptcy Code currently stands, certain deriva- the proposed Chapter 14 is the creation of a mandatory tive contracts are not subject to the automatic stay and Prepetition Consultation. Under the Act, a non-bank fi- may be terminated post petition, i.e., ipso facto clauses nancial institution may not be a debtor in a Chapter 14 are enforceable for such contracts. Chapter 14 cases case, unless the institution has at least 10 days prior to could be exempt from the safe harbors generally appli- the filing taken part in a Prepetition Consultation. Like- cable to these derivative contracts. Section 1401 of wise, a generally cannot commence an involun- Chapter 14 proposes procedures pursuant to which the tary bankruptcy against such a debtor unless the credi- court may hold the safe harbors not to apply, thus sub- tor notifies the non-bank financial institution, the finan- jecting the non-debtor counterparties to the automatic cial regulator with primary regulatory authority over the stay and the invalidation of ipso facto clauses contained debtor (the “functional regulator”), and the Board of its in such derivative contracts. One of the asserted rea- intent to file a petition and requests a Prepetition Con- sons for this conceptual change is the view expressed by

December 2009 / Special Alert 2 d some commentators that the inapplicability of the „ Establishing within the FIR an Office of Consumer automatic stay to certain financial contracts was a cata- Protection (“OCP”). lyst for the government’s rescue of AIG. For a debtor to take advantage of this provision, the debtor is required „ Directing the Comptroller General to complete to file a motion seeking an exemption from the applica- and report to Congress on the audit of the Federal Reserve Board and the federal reserve banks. tion of the safe harbor provisions. The motion can be filed with or without the Board’s consent. If the Board „ Amending the Federal Reserve Act to instruct the supports the filing of the motion, the Board is required Federal Reserve Board and the Federal Open to inform the court of its reasons for consenting. The Market Committee (“FOMC”) to establish and im- court may request that the Board and the debtor’s func- plement an explicit numerical definition of the tional regulator file briefs in support of, or opposition to term “price stability” and maintain a monetary the relief requested. policy that effectively promotes long-term price stability. Right to Directly Communicate „ Revising requirements with respect to the emer- Chapter 14 departs from the other chapters of the gency powers of the Federal Reserve Board. Bankruptcy Code in that it authorizes the court to com- municate directly with certain parties participating in The Bill also proposes the enactment of the Govern- the Chapter 14 case, including the functional regulator, ment-Sponsored Enterprises Free Market Reform Act of the Board, the Board of Governors for the Federal Re- 2009. Some of the major provisions that are relevant to serve System, the Department of the Treasury, or any insolvency are: agency charged with administering a nonbankruptcy „ Requiring the Director of the Federal Housing Fi- regime for any component of the debtor. nance Agency (“FHFA”) to terminate the conserva- torship of the Federal National Mortgage Associa- Although Chapter 14 proposes many radical changes to tion (“Fannie Mae”) or the Federal Home Loan the Bankruptcy Code, it will incorporate most of the Mortgage Corporation (“Freddie Mac,” collectively provisions of chapter 11 of the Bankruptcy Code. Addi- with Fannie Mae, the “GSEs”), if at the end of a tionally, Chapter 14 provides for the appointment of a specified period the GSE is financially viable. trustee or examiner and permits conversion of a Chapter 14 case to a chapter 7 case. „ Requiring the Director of the FHFA to appoint the FHFA as receiver for a GSE if it is not financially viable. Summary of the Bill’s Other Provisions „ Amending the Housing and Community Develop- ment Act of 1992 to restrict the mortgage assets Besides amending the Bankruptcy Code to provide for of a GSE upon its emergence from conservator- Chapter 14 filings, the Act also contains other provi- ship. sions that alter the current consumer protection and the financial regulatory system. Some of the key proposals „ Establishes new conforming loan limits for the in the Act are: year in which the expire.

„ Creating in the executive branch the FIR to exer- cise all powers, duties, and authorities formerly Conclusion vested in the Comptroller of the Currency. The FIR would be transferred all regulatory functions of the Federal Reserve Board, the Director of the Of- In proposing the Bill, Representative Bachus sought to fice of Thrift Supervision (“OTS”) and the FDIC modernize and streamline the regulatory structure of regarding state non-member banks. the United States’ financial services industry. In his in- troductory remarks, he states that the Act will ensure „ Abolishing the OTS and the Office (and position) that “the government stops rewarding failure and pick- of Comptroller of the Currency. ing winners and losers; taxpayers are never again asked to pick up the tab for bad bets on Wall Street while „ Moving the National Credit Union some creditors and counterparties of failed firms are (“NCUA”) within the FIR. made whole; and market discipline is restored so that financial firms will no longer expect the government to

December 2009 / Special Alert 3 d rescue them from the consequences of imprudent busi- handling of non-bank financial institutions’ insolvency, ness decisions.” failure and bankruptcy. And through its prohibition on the provisions of post petition financing by the govern- The Bill is only in the first step in the legislative process ment, could eliminate a repetition of the GM and Chrys- and the majority of bills never make it past this step. If ler bankruptcy framework. enacted, however, the Act will significantly alter the

Practice group contacts

If you have questions regarding the information in this legal update, please contact the Dechert attorney with whom you regularly work, or any of the attorneys listed. Visit us at www.dechert.com/insolvency.

G. Eric Brunstad, Jr. Brian E. Greer Steven B. Smith Hartford New York New York +1 860 524 3960 +1 212 698 3536 +1 212 698 3641 [email protected] [email protected] [email protected]

Katherine A. Burroughs Michael J. Sage Shmuel Vasser Hartford New York New York +1 860 524 3953 +1 212 698 3503 +1 212 698 3691 [email protected] [email protected] [email protected]

Ethan D. Fogel Glenn E. Siegel Charles I. Weissman Philadelphia New York New York +1 215 994 2965 +1 212 698 3569 +1 212 698 3847

[email protected] [email protected] [email protected]

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December 2009 / Special Alert 4