This post summarizes “The Dodd-Frank Act’s Maginot Line:  Clearinghouse Construction,” which will appear in the California Law Review later this year.

Regulatory reaction to the 2008–2009 financial crisis, following the failures of AIG, Bear Stearns, Lehman Brothers, and the Reserve Primary Fund, focused on complex financial instruments that deepened the crisis. A consensus emerged that these risky financial instruments should move through safe, strong clearinghouses, which would be bulwarks against systemic risk.

The consensus turned into law, via the Dodd-Frank Wall Street Reform Act, in which Congress instructed regulators to construct clearinghouses through which these risky financial instruments would trade and settle. Clearinghouses could repel financial risk, reduce contagion, and halt a local financial problem before it became an economy-wide crisis.

But clearinghouses are weaker bulwarks against financial contagion, financial panic, and systemic risk than is commonly thought. They may well be unable to defend the economy against financial stress such as that of the 2008–2009 crisis. Although they can be efficient financial platforms in ordinary times, they do little to reduce systemic risk in crisis times.

…continue reading: The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction

On March 27, 2013, Judge Sean Lane of the United States Bankruptcy Court for the Southern District of New York approved the $11 billion merger of US Airways Group and AMR Corporation effective upon confirmation of the AMR debtors’ chapter 11 plan. Upon completion of the merger, a new entity – “Newco,” for present purposes – will survive. In his March 27 ruling, Judge Lane declined to approve a proposed $20 million severance payment by Newco to Thomas Horton, the current Chief Executive Officer of AMR Corporation. Shortly thereafter, Judge Lane issued a written opinion explaining his reasoning for denying the proposed severance payment and in it, foreclosed an attempt to approve a severance package free from the strict standards of Section 503(c) of the Bankruptcy Code.

Background

In connection with the proposed merger, the AMR debtors sought Bankruptcy Court approval of employee compensation and benefit arrangements (the “Employee Arrangements”) falling into three categories (i) Ordinary Course Changes; (ii) Employee Protection Arrangements; and (iii) the CEO severance payment. Though the US Trustee initially objected to all three Employee Arrangements, she eventually withdrew her objections to all but the CEO severance payment.

…continue reading: Bankruptcy Court Denies $20 Million Severance for American Airlines CEO

On April 15, 2013, the Board of Governors of the Federal Reserve System (Federal Reserve) and the Federal Deposit Insurance Corporation (FDIC) issued additional guidance (Guidance) with respect to the 2013 resolution plan submissions of the U.S. and foreign banking organizations that filed their initial resolution plans on July 1, 2012 (First-Round Filers).

The Guidance shows that the Federal Reserve and FDIC are intensifying their credibility review of resolution plans, requiring analysis of the most challenging issues raised by a Covered Company’s failure. Responding to the Guidance will require First-Round Filers to address head-on difficult questions raised by their original submissions. In recognition of the amount of new information required to be supplied, the Guidance extends the 2013 submission date for First-Round Filers to October 1, 2013.

Although by its terms the Guidance is limited to the plans of the First-Round Filers, it suggests that banking organizations in the second and third filing rounds may be required to undertake more searching analysis in their submissions next year.

In this post, we discuss the most significant aspects of the Guidance:

…continue reading: Guidance on Resolution Plans of U.S. and Foreign Banking Organizations

Frederick Tung and I recently posted “Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain,” to SSRN. It is scheduled to appear in Virginia Law Review later this year. In “Breaking Bankruptcy Priority,” we examine the stability of bankruptcy’s priority structure.

Overall, bankruptcy reallocates value in a faltering firm. The bankruptcy apparatus eliminates some claims and alters others, leaving a reduced set of claims to match the firm’s diminished capacity to pay. This restructuring is done according to statutory and agreed-to contractual priorities, so that lower-ranking claims are eliminated first and higher ranking ones are preserved to the extent possible. Bankruptcy scholarship has long conceptualized this reallocation as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of predetermined rules and contracts.

…continue reading: Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain

Firms offering comprehensive financial services scored a significant victory on April 9, 2013, when Judge Robert Sweet of the United States District Court for the Southern District of New York dismissed Capmark Financial Group Inc.’s (“Capmark”) insider preference action against four lender affiliates of The Goldman Sachs Group, Inc. (“Goldman Sachs”), which arose out of Capmark’s 2009 bankruptcy. [1] Davis Polk represented the Goldman Sachs lender affiliates and advanced the arguments adopted by Judge Sweet. The court’s opinion rejected Capmark’s attempt to cast the lenders as “insiders” of Capmark based on an indirect equity interest in Capmark held by funds managed by affiliates of Goldman Sachs and Goldman Sachs’s service as an advisor to Capmark. In doing so, Judge Sweet reaffirmed that corporate veils separating a lender from an affiliated entity holding equity positions or serving as advisor to the debtor will not lightly be disregarded, and that participation in an arm’s-length transaction as an ordinary commercial lender will not give rise to insider status. Furthermore, Judge Sweet held that reorganized debtors are judicially estopped from making an about-face on key factual issues underlying relief secured in bankruptcy court. In sum, the Capmark decision should pose a substantial obstacle to claims alleging that a lender is an “insider” by virtue of affiliated entities’ contacts with a debtor in the absence of evidence that the lender actually used the affiliates’ contacts to influence the debtor’s decisions.

…continue reading: Court Dismisses Insider Preference Claims Against Affiliates of Goldman Sachs

Do firm boundaries mediate the effect of shocks to the financial intermediation sector? When the functioning of the intermediation sector is impaired – as was the case in the recent financial crisis – shocks can be transmitted to the broader economy since funds may not flow to highest value use without incurring significant cost. This issue has been extensively explored in the credit channel literature (e.g., Kashyap and Stein [2000]; Bernanke and Blinder [1988; 1992], and Bernanke and Gertler [1995]). However, unlike what is assumed in this literature, firms may be able to reallocate resources internally – for instance, between divisions in different industries – to ameliorate the effect of financial shocks. If so, external credit market conditions will impact the nature of resource allocation inside firms and between industries differently than they would in an economy with no internal capital markets. Diversified firms constitute a large part of economies around the world; therefore, resource allocation within firms can be of significant importance. In this paper we propose that firms shift resources between industries in response to shocks to the financial sector. We estimate a structural model to quantify the forces driving this reallocation decision, and show that these forces dampen shocks to the financial sector in economically significant ways.

…continue reading: Resource Allocation within Firms and Financial Market Dislocation

The topic of this outline is mergers and acquisitions where the target company is “distressed.” Distress for these purposes generally means that a company is having difficulty dealing with its liabilities—whether in making required payments on borrowed money, obtaining or paying down trade credit, addressing debt covenant breaches, or raising additional debt to address funding needs.

Distressed companies can represent attractive acquisition targets. Their stock and their debt often trade at prices reflecting the difficulties they face, and they may be under pressure to sell assets or securities quickly to raise capital or pay down debt. Accordingly, prospective acquirors may have an opportunity to acquire attractive assets or securities at a discount. This outline considers how best to acquire a distressed company from every possible point of entry, whether that consists of buying existing or newly-issued stock, merging with the target, buying assets, or buying existing debt in the hope that it converts into ownership.

Some modestly distressed companies require a mere “band-aid” (such as a temporary waiver of a financial maintenance covenant when the macroeconomy has led to a temporary decline in earnings, but the company is able to meet all of its obligations as they come due). Others require “major surgery” (as where the company is fundamentally over-levered and must radically reduce debt).

…continue reading: Dealmaking in a Distressed Environment

The recent financial crisis has rekindled interest in the relationship between the structure of the financial network and systemic risk. Two polar views on this relationship have been suggested in the academic literature and the policy world. The first maintains that the “incompleteness” of the financial network can be a source of instability, as individual banks are overly exposed to the liabilities of a handful of financial institutions. Thus, according to this argument, a more complete financial network, which limits the exposure of the banks to any one counterparty would be less prone to systemic failures. The second view, in stark contrast, hypothesizes that it is the highly interconnected nature of the financial system that contributes to its fragility, as it facilitates the spread of financial distress and solvency problems from one bank to the rest in an epidemic-like fashion.

In our recent NBER working paper, Systemic Risk and Stability in Financial Networks, my co-authors (Asuman Ozdaglar of MIT and Alireza Tahbaz-Salehi of Columbia Business School) and I provide a tractable theoretical framework for the study of the economic forces shaping the relationship between the structure of the financial network and systemic risk. We show that as long as the magnitude (or the number) of negative shocks is below a critical threshold, a more equal distribution of interbank obligations leads to less fragility. In particular, all else equal, the sparsely connected ring financial network (corresponding to a credit chain) is the most fragile of all configurations, whereas the highly interconnected complete financial network is the configuration least prone to contagion. In line with the observations made by Allen and Gale (2000), our results establish that, in the more complete networks, the losses of a distressed bank are passed to a larger number of counterparties, guaranteeing a more efficient use of the excess liquidity in the system in forestalling defaults.

…continue reading: Systemic Risk and Stability in Financial Networks

To what extent are CEOs filing for bankruptcy tainted by the bankruptcy event? On the one hand, the CEO bears a major responsibility for the firm going broke. After all, the filing might have been avoided if the CEO had managed to reduce firm leverage or otherwise reorganize debt claims in time to stay out of court. On the other hand, CEOs going through bankruptcy likely gain valuable experience from the crisis. The net impact of these two opposing effects on executive reputation is an open empirical question.

In the paper, How Costly is Corporate Bankruptcy for Top Executives?, which was recently made publicly available on SSRN, we provide some first systematic estimates of top executives’ personal costs of corporate bankruptcy. The estimates are based on 324 large public companies filing for Chapter 11 bankruptcy over the past two decades.

The study provides evidence on the following three questions. First, do top executives experience large personal losses (both income and wealth) when filing for bankruptcy? Second, do creditor control rights influence the probability of CEO departure and the income losses? Third, do ex ante predicted personal losses affect CEO’s decision to leave the firm and their compensation contract design?

…continue reading: How Costly Is Corporate Bankruptcy for Top Executives?

Amid the current debate over tax policy in Washington, there is a bipartisan consensus on one issue: the corporate tax rate, which is currently 35 percent, should be reduced to roughly 25 percent. At the same time, budgetary pressures preclude any significant increase in the deficit to accomplish corporate tax reform.

In light of these competing demands, most corporate tax reformers advocate broadening the corporate tax base to pay for any rate reduction. Unfortunately, few politicians have put forth base-broadening measures that would generate revenue sufficient to significantly lower the corporate tax rate on a revenue-neutral basis.

In fact, revenue-neutral corporate income tax reform is likely to be very difficult, because corporate tax expenditures represent a relatively small portion of total corporate tax revenues. A preliminary analysis by the Joint Committee on Taxation suggested that the elimination of all corporate tax expenditures—except for the deferral of tax on foreign source profits, a provision whose repeal would be politically and economically infeasible—would allow for the corporate tax rate to be reduced to only 28 percent.

Therefore, if policymakers want to reduce the corporate tax rate on a revenue-neutral basis, they will likely have to adopt other types of reforms to broaden the corporate tax base. Ideally, those reforms should offer the potential for significant revenue gains and reduce economic distortions.

…continue reading: Corporate Tax Reform