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Dodd-Frank's uphill climb off Capitol Hill

by Ira Teinowitz and Bill McConnell | Published November 1, 2011 at 10:07 AM

It's been more than a year since the Dodd-Frank Act hatched what proponents say is an alternative to government bailouts of large, complicated financial companies that defined the financial crisis of 2008. Known as the orderly resolution process, it gives Washington new power to take control of failing financial behemoths and wind them down. The process is the heart of the Dodd-Frank financial reform bill that Treasury Secretary Timothy Geithner told a gathering of bankers in June will "remake the American financial system so that it emerges from this crisis not only transformed but in much stronger shape, with the best mix of protections available in the world for investors and consumers and best opportunities for businesses to raise capital."

The process gives U.S. regulators the power to intervene in failing nonbank financial firms and allows them to sort through claims of creditors and counterparties quickly, without forcing taxpayers to cover the bill. During the 2008 financial crisis, then-Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, under heavy criticism for bailouts of American International Group Inc., Bear Stearns Cos. and others, insisted that they had no other means to prevent the failure of these firms from spreading throughout Wall Street and causing a cascade of failures across the financial system. Bankruptcy, as demonstrated by Lehman Brothers Holdings Inc.'s Chapter 11 filing, was viewed as inadequate and too slow in preventing the crush of claims on the firm from causing broken contracts and failures throughout the financial system. The only alternative to Chapter 11 and a lockup of the credit markets, they insisted, was a massive federal intervention in the financial sector.

Resolution authority is held up as a better way. The Dodd-Frank Act assigns the job of resolving most failed nonbank firms to the Federal Deposit Insurance Corp. Formally known as the orderly liquidation authority, or OLA, it gives the regulators power to quickly prioritize among a failing firm's operations and counterparty relations, preserving those deemed critical to the financial system and placing those in a bridge bank to be run as an ongoing operation. Divisions not critical to the economy will be placed into receivership to be liquidated. To the extent that additional funds are needed to fund the bridge bank and wind down the rest, the FDIC will be allowed to borrow from the Treasury; those loans would be repaid from the proceeds of the liquidation and from an assessment on the financial industry.

Will it work? What will be its unforeseen consequences? While resolution authority is held up as an alternative to the massive intervention into the market, it is itself a new platform for -- what else? -- massive intervention in the market. OLA's many critics warn that it enshrines and even magnifies many of the sins of the Wall Street bailouts, gives regulators vast new powers to bail out creditors of failing firms and may even create a framework for them to intervene in firms' operations for political reasons -- favoring certain companies and their counterparties over others, free of judicial oversight. At the very least, regulators will feel intense political pressure to carry out de facto bailouts under the framework of OLA. And even if regulators are pure of heart, they will be under orders to move quickly, all but assuring that the financial instruments that wreaked the most havoc in the last financial crisis -- derivatives -- will be bailed out at their full value. That alone may well defeat the law's aim of making sure creditors bear the losses created by their risk taking.

The FDIC was chosen because of its 70 years of experience resolving failed banks. Yet many financial services executives were spooked by the choice, in part because the agency has enormous discretion during bank resolutions to decide which creditors are made whole and which contracts are honored. Regulators counter that much of the worry about the process is due simply to uncertainty over how it will work. If ever used, they say, it will prove far more predictable, impartial and stabilizing to the economy than the improvised emergency measures implemented during the 2008 panic.

"One reason why people have difficulty understanding [the resolution process] is they think we are going to go about resolving these larger companies in the same way we resolve a small depository institution. That's not going to be the case," says Jim Wigand, director of the FDIC's Office of Complex Financial Institutions.

The OLA process is designed to be a mixture of the FDIC bank resolution process and the traditional bankruptcy process, which was crafted to give companies a chance to reorganize their finances while protecting creditors' rights. Wigand says OLA procedures will resemble a traditional bankruptcy process more so than the FDIC's approach to resolving failed depositary institutions but will nevertheless be on a far quicker timetable than a traditional bankruptcy, which can take years to work out. He says the government's role will be as short-lived as possible.

"We will leverage all our experience with small bank resolutions and lessons learned, but it doesn't mean we will follow the same model. Trillion-dollar financial companies will have to be resolved differently. You can't take that model and apply it to this type of resolution."

While a Title II resolution will be quicker than bankruptcies, which tend to get bogged down in endless rounds of hearings, Wigand says this process will nevertheless resemble a Chapter 11 restructuring by showing concern for creditors' rights. The FDIC has even conducted talks with companies that provide services in restructurings and bankruptcies, such as Alvarez & Marsal Holdings LLC -- whose CEO, Bryan Marsal, is now running Lehman Brothers Holdings -- and AlixPartners LLP. The FDIC is expected to lean heavily on those two firms and a few competitors to do the heavy lifting in any major OLA resolution.

"The FDIC is very good at what it was created to do -- administer failing banks -- but they don't have any expertise in managing companies that have financial distress," says Michael Rosenthal, co-chair of the business restructuring and reorganization practice at Gibson, Dunn & Crutcher LLP, who applauded the FDIC's move to rely on outside help. "When they handle the failure of a bank, their job is making sure depositors are paid and the assets are transferred on an orderly basis. Companies that are not a bank, if they are systemically important, are likely to have many arms and businesses, and it's going to be very, very difficult for the FDIC to come in, displace senior management and seamlessly take over."

These sorts of worries are echoed around the financial services legal community. "It has never been done before -- no one knows how it would work," says Edwin E. Smith, co-chair of Bingham McCutchen LLP's financial services area practice. "It's a valiant effort but ... I hope we never have to find out."

These gray areas are immense. The new law imposed Federal Reserve Board oversight on systemically important financial institutions, or SIFIs, and required the institutions to come up with "living wills" that would serve as road maps for regulators and the courts in the event of a firm's failure. The exercise of planning their own demise was also meant to prod firms to simplify their structures. In theory, living wills should allow failing firms to avoid OLA altogether and be handled in Chapter 11.

But if bankruptcy won't be speedy enough to prevent "serious adverse effects on financial stability in the United States," Title II of the Dodd-Frank Act calls for the Federal Reserve and regulatory agencies to recommend to the Treasury secretary that the OLA process be initiated. After consultation with the president, the Treasury secretary would appoint a receiver to wind down the affairs of and liquidate the assets of the failing firm.

Usually, but not always, the FDIC will be appointed the receiver. But the Securities Investor Protection Corp. can take on broker-dealer units, and state regulators would handle insurance companies. Sometimes, multiple agencies could be involved in the resolution process.

No matter who is named receiver, management would be replaced. The receiver can dispose of assets by selling them off, turning them over to a bankruptcy court or creating a bridge company and temporarily running portions of the company that it believes are viable while making plans to dispose of the other assets left in receivership.

The FDIC can tap into Treasury funds for temporary funding but also obtain private funding. Repaying the U.S. government funds becomes a higher priority in an orderly resolution than in a normal bankruptcy. While swaps and derivatives automatically close in a bankruptcy, they could be kept open in the resolution process.

Mayer Brown LLP partner Jeffrey Taft predicts OLA will be rare, and that most nonbank companies would continue to be resolved under Chapter 11. "Because it is intended to be used only in circumstances where there is a threat to the financial well-being of the United States, they made it a cumbersome process to put somebody into OLA," he says. "It's going to prove somewhat daunting."

Not only must the Treasury secretary, the FDIC, the Federal Reserve Board and the president sign off, but there must not be any private buyers for the firm either.

Then the matter must be taken to federal district court, which has 24 hours to deny it. "If the request is not denied, only then does the Treasury appoint the FDIC as receiver."

Rosenthal of Gibson Dunn thinks firms will try to design their living wills so as to avoid being put into OLA. "The very existence of OLA and living wills will cause companies to be more cautious," Rosenthal predicts. "Very risky businesses will impose their own limitations. Companies will not want to be divested of the right to reorganize through Chapter 11."

But others say Dodd-Frank's elimination of the Fed's emergency funding capability reduces the options available to regulators. "Before, if you had a nonbank, you had the ability to cobble together a solution," says Paul L. Lee, co-chair of Debevoise & Plimpton LLP's banking group. "It's much more difficult to do that now than it was during the financial crisis. It could force regulators to use the new process."

The FDIC's only direct dealing with a bigger institution was its experience with Washington Mutual Inc. And while private vendors may do much of the workout, not all future decisions can be left to them. WaMu was quickly turned over to J.P. Morgan Chase & Co. in September 2008. IndyMac Federal Bank FSB was put into FDIC receivership in July 2008, and the remnants of it were sold to a newly created OneWest Bank FSB. "There may not be the bandwidth at the FDIC" to tackle issues raised by large resolutions, says Mayer Brown's Taft. "They haven't had a lot of experience running large institutions. IndyMac is the closest example."

One lingering question is what kind of companies are candidates for OLA because the Financial Stability Oversight Council, the interagency body created by Dodd-Frank, has put off any decision about naming which nonbanks are SIFIs. According to the law, all banks with $50 billion in assets are automatically given the designation. It hasn't been so easy to agree on a definition of what constitutes "significant" in a nonbank.

David F. Freeman Jr., a partner in the Washington office of Arnold & Porter LLP who represents Federated Investors Inc., a pioneer in the money market business, says he's worried regulators will have to make interim decisions on such designations. He contends money market funds may be systemically worthy of designation but argues the resolution process is the wrong approach for them. "It's completely and totally inappropriate," he says, noting that money funds don't have long-term obligations and are far more liquid than they were in 2008 when the $62 billion Reserve Primary Fund suffered a run in the wake of Lehman's problems.

Bingham's Smith says it's also unclear whether the FDIC will feel obligated to put an entire holding company into receivership or only the financial parts. "Take a subsidiary that is not a financial company. [It] could be sucked into a parent's receivership," he says.

Despite Wigand's promises about concern for creditors, some of the most important unanswered questions revolve around how they will be treated. Taft argues that they aren't likely to fare as well under OLA. He calls the FDIC a "judge, jury and executioner," and says that's by design.

"Bankruptcy isn't as big a stick against creditors," Taft says. "OLA can be commenced without concern for creditors' interests. It's not like you're going to come out of OLA and be a better, stronger company. The FDIC is thinking about how it's going to liquidate the company, that's a substantial difference from Chapter 11."

The creditor concerns include exactly how the FDIC will determine the value of assets.

Lee says regulators have moved to make the rules for debtors "as consistent as possible," but regulations on how it will all work in some cases still haven't been finished.

Still, it's a claims process, not the process of bankruptcy.

He noted that the law assures creditors will never get less than what they would have received had the company been liquidated under Chapter 7. "As a principle it is very powerful, but in practice, it's going to be hard to implement."

Smith offered similar concerns, noting that the FDIC can claim that without the resolution the creditors would have gotten nothing at all. "How do you value a company that would have collapsed? Would there have been any recovery at all? That is going to be the big question," he says.

Congress drafted the tough line against creditors to prevent the cancellation of credit and the collateral calls that sent Lehman into a death spiral. But Rosenthal insists the process is unfair because FDIC decisions can't be appealed to federal courts.

He lists several areas where creditors are likely to fair worse than under bankruptcy. "Treatment of loan agreements is of particular concern because the FDIC can enforce loan commitments, which a bankruptcy court can't do without permission of the lender," says Rosenthal.

Another concern is treatment of secured creditors, he says. For example, under the law the FDIC has 90 days to rule on a secured creditors' request for expedited relief with regard to collateral. Notes Rosenthal: "Creditors would like to see that period shortened significantly. A lot of things can happen to the value of collateral in 90 days."

Rosenthal also worries about OLA's provisions for clawing back compensation of executives "substantially responsible" for an institution's failure. There is a safe harbor for people who become senior executives or join the board within two years before a filing. That safe harbor is meant to help lure individuals who can assist in preventing further deterioration of the company's financial condition. Without the safe harbor, people may be unwilling to join a troubled firm and help turn it around.

Rosenthal argues that the exclusion may not be long enough. "These companies are like aircraft carriers on steroids," he says. "You cannot turn one around in two months and not always in two years. What if people who come on board are unable to turn things around sufficiently in two years? They will no longer protected by the safe harbor."

What if there were some kind of blowup, say, in the next few days? Wigand says the designation of the SIFIs and their creation of living wills are ongoing refinements that would aid the FDIC in using the new process, as would finishing up a remaining rule on how the FDIC and the SEC will use the process with broker-dealers. Despite those works in progress, the FDIC believes it is ready now to handle any role it has to play in resolving significant financial companies. "The FDIC has always carried out its mission responsibilities and is prepared to do so again," he says.

Wigand also makes clear that the agency's approach to handling individual companies may vary with circumstances. He points to the agency's use of outside contractors in resolving WaMu and of a conservatorship or bridge entity to deal with IndyMac as examples of the agency reacting to events with different approaches. "A tool we now have is the use of bridge authority for nondepository institutions," he says. "Bridge authority, which allows for the company's operations to continue and serves as a mechanism for providing liquidity support, is a step between failure and when the company is turned back to the private sector. To preserve value, it should be as short a period as possible."

Wigand promises whatever the FDIC does, it intends to be public about it. He says that while the Dodd-Frank Act doesn't give creditors any formal representation during the resolution process, the FDIC is considering the possibility of creating a creditors' committee to weigh in on decisions.

He also suggests that the size of the giant companies the FDIC will have to resolve pretty much requires simplified solutions. "Given that a key objective of using Title II is to mitigate systemic risk, the fundamental resolution strategy should be simple, clear and familiar to the market," he says. "Stakeholders have to be able to readily understand where they fit. It has to be executable. We have to strive for simplicity."

Wigand's boosterism notwithstanding, some of the criticisms are unsettling, and are reminiscent of arguments swirling at the time of the Lehman-era bailouts. One fear is that this sort of government-imposed solution creates a moral hazard just as the bailouts did. That can lead to more market chaos, not less. David Skeel, a prominent bankruptcy expert and professor of corporate law at the University of Pennsylvania Law School, argues that the ad hoc power given the FDIC enshrines the biggest sin of the 2008 interventions -- creating an expectation that the creditors of the largest firms will again be rescued.

Skeel praises some aspects of the overall Dodd-Frank law, such as the movement of derivatives trading to exchanges and the creation of living wills. But taken as a whole, he argues that the basic premise of resolution authority is wrong. Geithner and his allies insisted that a resolution process is necessary to prevent a reprise of the chaotic and destructive demise and Chapter 11 filing of Lehman. Skeel, author of "The New Financial Deal," an examination of Dodd-Frank and its "unintended" consequences, says the harm caused by the Lehman collapse is a myth. The market chaos was really a result, he says, of the government's earlier bailout of Bear Stearns Cos., which convinced the market that Lehman and other troubled firms would be bailed out. As a result, Lehman did no planning for bankruptcy until the day before it was forced to file.

"Given the circumstances, Lehman's bankruptcy went smoothly," he says. "The assets that needed to be dealt with right away, namely, the brokerage, were sold to Barclays. Since then, less time-sensitive assets have been unwound at a more leisurely pace."

With OLA, Skeel argues, the time pressure itself creates perverse results. The FDIC has only 24 hours to rule on all of a firm's derivatives contracts and whether it will be put into receivership or into the bridge bank -- too short a time to parse which contracts are important to the financial system. Thus, all are likely to be moved to the bridge bank and kept intact.

"Nobody thinks OLA will be used for a prompt and orderly wind-down of a troubled firm," he says. "Most likely there will be a lot of pressure to bail out the same kinds of creditors who were bailed out in 2008."

Skeel argues that, overall, Dodd-Frank imposes rules that offer merely theoretical fixes and others that do actual harm. The most insidious feature, he says, is the Volcker Rule prohibiting proprietary trading by banks. He predicts that the rule will be used to dissuade institutions from investing in industries that may be politically disfavored at any particular time. "The Volcker Rule offers a lever that can be used to keep banks in line and to channel political policy through the big banks," he says.

Unlike Debevoise's Lee, Skeel isn't impressed by Congress' move to eliminate the Fed's ability to use its emergency-lending authority to bail out individual firms. "I'm sympathetic to the rationale for the change," he says. "Ad hoc bailouts are almost never a good idea." He adds that the likelihood of being bailed out will allow huge institutions to enjoy lower capital costs than smaller rivals. But despite the new rule, the Fed can still use its extraordinary funding authority to address systemic or industrywide problems, he says. "The folks at the Fed are clever and can create an ostensibly industrywide funding mechanism that really is for an individual firm."

Skeel says financial reform could be made much better with one legislative fix. The fix would not be to Dodd-Frank itself, but to bankruptcy law: Derivatives counterparties, Skeel says, should lose their exclusion from an automatic stay that prevents other creditors from enforcing contracts and seizing collateral. "The automatic stay applies to every contact except derivatives. Changing that rule would be very useful. If AIG could have stopped their counterparty claims, they could have used bankruptcy rather than needing a bailout. Changing that rule would put more pressure on creditors to be a little more careful."

After all, the best situation is if no one has to press the OLA trigger at all.

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