In our paper, Dodd-Frank for Bankruptcy Lawyers, which was recently made publicly available on SSRN, we identify the core congruities between an “Orderly Liquidation Authority” (OLA) created by the Dodd-Frank financial reform legislation and the Bankruptcy Code. Title II of Dodd-Frank removes bankruptcy court jurisdiction from only a narrow range of cases—“financial companies” whose failure is sufficiently threatening to market stability. The vast majority of giant businesses, including systemically important ones (i.e., the General Motors of the next great recession), are not “financial companies” within the meaning of Title II. They remain squarely in the province of bankruptcy law. Moreover, the mechanics of the new receivership process incorporate basic bankruptcy principles. They effectively permit reorganization as well as liquidation, debtor-in-possession financing, asset sales free and clear of existing liens, claw-back of prepetition fraudulent and preferential transfers, and safe harbors for financial contracts.
A common complaint against Title II—that it puts government regulators to solve a problem that existing bankruptcy law or a new chapter of the Bankruptcy Code might solve—may miss the point. To a large extent, Title II is consistent with the basic principles of bankruptcy law. The terminology is different, but this is not a matter of substance. Its basic features and ambitions are the same. The striking differences—the eligibility rules, the minimal judicial involvement, and the consolidation of many different roles in a single government regulator—derive from its underlying premise. A Title II receivership can begin only when private solutions and ordinary judicial processes fail and it does provide a resource that existing law lacks.
While traditional bankruptcy law reflects a balance of power in which the debtor in possession (DIP), the creditors’ committee, the DIP lender, and the bankruptcy judge play discrete roles, this regime concentrates power in a single entity, the FDIC. The FDIC’s powers in this new domain largely track its longstanding powers with respect to commercial banks under the Federal Deposit Insurance Act (FDIA). To be sure, some observers have worried about the limited judicial review of both government decisions to commence a Title II receivership and FDIC decisions as receiver. Although those worries are important, they do not raise meaningful constitutional doubts. Those who are adversely affected do have the right to go to court at a later time to adjudicate their claims. Recoveries are likely to be minimal, but the talisman of a due process violation has long been the inability to have one’s claim adjudicated. That never happens here.
Another change from traditional bankruptcy law is Title II’s approach to financial contracts. Ironically, the need for a new law came not so much from their treatment in bankruptcy, but rather from their exclusion from the bankruptcy process altogether. Title II gives the FDIC a short window (up to two business days) to subject financial contracts to a limited automatic stay and transfer them to a solvent counterparty. At the end of that window, the usual rules apply and parties to these financial contracts are free to exercise their contractual rights. The heart of this new regime, in short, reflects not so much a repudiation of bankruptcy principles, but rather finding a treatment for financial contracts that charts a middle course between the Code’s treatment for ordinary conventional contracts and for financial contracts. Subjecting financial contracts to a (very short) automatic stay is costly, but so too is insulating them from the process altogether.
But to say that Title II is not a radical departure from traditional bankruptcy principles is not to say it will do much good. While it might have handled Lehman’s derivatives portfolio better than existing bankruptcy law, it is hard to see how it would have solved the other problems Lehman or other financial institutions such as AIG faced in September 2008.
Lehman found itself both heavily leveraged and absolutely dependent upon short-term credit markets. It had made large bets on subprime residential real estate, commercial real estate, and loans used to facilitate leveraged buyouts. When all three went sour, it was hopelessly insolvent and, as soon as its sources of credit got wind of this state of affairs, they cut it off. Lehman’s bankruptcy filing not only made plain its own sorry condition, but also that of other large financial institutions that were similarly leveraged and with similar wagers on residential or commercial real estate or leveraged loans.
Laws by themselves can do little to fix this state of affairs. They can do nothing to make an insolvent firm solvent or keep bad news about others from leaking out. Title II, like the Bankruptcy Code, provides a safety net. But it may not be a good one. And, given this, there is room to argue that, Title II may provide a false sense of security. The complete absence of a safety net concentrates the mind wonderfully. Cooler heads may have prevailed in the case of LTCM and held its derivatives book together precisely because there was no one for the investment banks to fall back on. Of course, this line of reasoning assumes that the relevant actors will act rationally when left to fend for themselves. This path contains risk as well.
The full paper is available for download here.