Congress is considering a wide-ranging package of financial industry reforms intended to preclude any future taxpayer bailouts of Wall Street. A key component of this legislation, Senate bill 3217, targets the "too big to fail" dilemma; i.e., that some financial companies are so large and integral to the economy that a threat of their imminent demise effectively requires the federal government to commit or spend massive amounts of public funding toward emergency recapitalization (e.g., Bear, Stearns & Co.; American International Group Inc.; Citigroup Inc.) -- or suffer the destabilizing systemic consequences of a free-fall bankruptcy filing (e.g., Lehman Brothers Holdings Inc.).

Congress' solution is to provide federal regulators with the discretion to "liquidate financial companies that pose a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard." Whether this so-called orderly liquidation authority -- notably, the bill does not also include new provisions for "orderly reorganization authority" -- employs the most effective possible tools to achieve its stated goals has been and will continue to be the focus of intense debate. Assuming Congress passes (and President Obama signs) the liquidation powers of S. 3217 in their present form, which appears likely, certain distressed financial firms could find themselves in very foreign territory: forced to wind down in proceedings initiated and administered by the U.S. government, entirely outside the established auspices of a bankruptcy court applying the Bankruptcy Code.

Which financial companies are "covered"? The threshold issue, of course, is defining which firms are subject to this alternate liquidation regime. The touchstone concept of S. 3217 is "covered financial companies," which means U.S.-incorporated bank holding companies, nonbank financial companies supervised by the Federal Reserve Board of Governors, any company predominantly engaged in activities the Fed has determined are financial in nature or the subsidiaries of any of these (but not including insured depository institutions) for which the Treasury secretary (in consultation with the president) has made a number of specific determinations. These include: The financial company is in default or danger of default on its obligations, with no viable private sector remedy, and its failure and resolution under otherwise applicable state or federal law (namely, the U.S. Bankruptcy Code) would have "serious adverse effects on financial stability in the United States" -- whereas liquidation under S. 3217 would avoid or mitigate detrimental impact on "the financial system, the cost to the general fund of the U.S. Treasury and the potential to increase excessive risk-taking on the part of creditors, counterparties, and shareholders in the financial company."

In other words, unlike conventional bankruptcies, which may be commenced (voluntarily or involuntarily) by a relatively limited universe of parties in interest (a debtor and its creditors) for the relatively limited purpose of enforcing their respective rights, liquidations under S. 3217 may be justified by the government's desire to defend the greater good of nonparties in interest or to influence the economic behavior of market actors. It's not difficult to imagine how this discretion could be used unevenly. Will the government be equally inclined to liquidate a covered financial company if the "excessive risk taking" investors exposed to major losses are union pension funds or public university endowments instead of other Wall Street counterparties or foreign sovereign wealth funds? Or what if the covered financial company is Citigroup or AIG, and among the major shareholders to be wiped out is the U.S. government itself?

Treasury: Wall Street, meet the FDIC. A liquidation proceeding under S. 3217 would begin as follows. Upon a determination by the Treasury secretary that a firm qualifies as a covered financial company, the firm and the Federal Deposit Insurance Corp. are notified. If the firm consents, the FDIC is appointed as receiver. If not, the Treasury secretary shall petition the U.S. District Court for the District of Columbia for an order authorizing the FDIC's appointment. Within only 24 hours after receipt of the petition, filed under seal, there will be a hearing at which the company may object (but not creditors, who will not have received notice), the District Court shall rule or the petition is automatically granted, with rights of further expedited appeal to the D.C. Court of Appeals and Supreme Court.

Importantly, once the FDIC's appointment as receiver is final, liquidation of the covered financial company shall proceed exclusively under S. 3217, and no provision of the Bankruptcy Code shall apply. Conversely, for financial companies that are not "covered" financial companies, the Bankruptcy Code, and not the provisions of S. 3217, shall continue to govern.

Once installed as receiver, the FDIC assumes complete financial and operational control of the covered financial company, including the authority to manage, sell, transfer or merge all assets. The FDIC also has the ability to provide funds needed for orderly liquidation, including for direct loans to the covered financial company or its subsidiaries, the purchase or guarantee of debt obligations, and payments to creditors. This assistance shall come from a separate fund to be established in the U.S. Treasury and populated initially by assessments on creditors of the covered financial company, to the extent they received more than the liquidation value of their claims, and then, if needed, by assessments on other financial companies with at least $50 billion in total assets. (The Federal Reserve also may lend to covered financial companies, but only if they are solvent and have collateral sufficient to secure the loans -- an unlikely source of help for firms already found to be distressed enough to require liquidation.) In other words, the FDIC has broad discretion to deploy capital to facilitate liquidation, but all costs ultimately will be paid by counterparties of the liquidating firm, and possibly by other major financial companies as well.

Everything must go (but not necessarily in order). The process of liquidating under S. 3217 to some extent resembles doing so under the Bankruptcy Code, with key distinctions. Within only 60 days after its appointment as receiver, the FDIC must file a report with Congress detailing its plan for winding down the covered financial company. The FDIC shall administer a claims process that includes publication and mail notice to creditors, a bar date and guidelines for the allowance and disallowance of claims. Although S. 3217 is less than precise about whether and how FDIC determinations may be appealed, it does provide that holders of disallowed claims may file suit on their claim in the federal district court where the covered financial company's principal place of business is located.

Properly perfected secured claims, proven to the satisfaction of the FDIC, shall be allowed in full, except for any undersecured portion that exceeds the fair market value of the collateral securing the claim, which will be treated as unsecured. Unsecured claims shall have priority in the following order: (i) administrative claims, (ii) amounts owed to the United States, (iii) unpaid wages or benefits owed to non-executive employees earned in the six months prior to the date the receiver is appointed (up to $11,275), (iv) contributions owed to employee benefits plans, (v) other general unsecured claims, (vi) subordinated claims, (vii) any wages or benefits owed to senior executives and directors and (vii) equity interests.

Here as well, a significant grant of discretion and corresponding potential for selective application is evident. The Bankruptcy Code generally requires that claims with rights of a similar legal nature be placed in the same class, and that no class of junior creditors may receive any recovery unless and until each class of senior creditors receives payment in full (but no more than that) of its claims. In contrast, S. 3217 expressly provides that similarly situated creditors may receive dissimilar treatment, without regard for seniority. Specifically, the FDIC "may take any action" that "does not comply" with the above distribution priorities, including making payments, if it determines doing so is necessary to maximize value and minimize loss -- provided that similarly situated unsecured creditors receive "not less than" they would have in a Chapter 7 or state law liquidation. So long as that minimum threshold is satisfied for all coequal claimants, the FDIC may favor certain creditors over others.

Otherwise, S. 3217 confers on the FDIC at least analogous versions of many of the rights and protections provided to debtors in possession by the Bankruptcy Code. For instance, the FDIC may repudiate (i.e., reject) pre-appointment contracts, debt obligations, and leases; litigation against the covered financial company may be stayed, but only upon request by the FDIC and only for up to 90 days; and the FDIC has robust avoidance powers to claw back fraudulent or preferential transfers.

Management in the crosshairs. Lastly, S. 3217's treatment of management deserves special note. Although unsurprising, given the prevailing public and political animus towards Wall Street, to say S. 3217 is especially tough on executives is an understatement.

The bill specifies "there shall be a strong presumption" that the FDIC will fire management. The FDIC and other agencies "will take all steps necessary and appropriate" to ensure that management (and third parties) "bear losses consistent with their responsibility" for the failure of the covered financial company, including via "actions for damages, restitution, and recoupment of compensation and other gains not compatible with such responsibility."

More specifically, the FDIC may recover from any culpable senior executive or director "any compensation" received within two years of the receiver appointment date, or without time limitation in the case of fraud. Also, compensation is to be construed as broadly as possible "to mean any financial remuneration, including salary, bonuses, incentives, benefits, severance, deferred compensation, or golden parachute benefits, and any profits realized from the sale of the securities of the covered financial company." The FDIC also may seek to ban senior executives or directors from participating in the "affairs of any financial company" for a period of no less than two years for violating laws or regulations, engaging in "unsafe or unsound" practices or breaching their fiduciary duties.

In sum, perhaps just having the "orderly liquidation authority" set forth in S. 3217 will result in the government never actually exercising this discretion, as the largest financial firms may moderate their risk taking to safeguard against default, or regulators may opt to allow a failing covered financial company simply to file for bankruptcy. Then again, no less a free marketeer than Bush administration Treasury Secretary and former Goldman, Sachs & Co. head Henry Paulson once told Congress, while requesting the ability (but disclaiming the need) to shore up Fannie Mae and Freddie Mac, that "if you have got a bazooka [in your pocket] and people know you've got it, you may not have to take it out" -- and then nationalized both companies soon after. So as S. 3217 wends its way towards enactment and implementation, major Wall Street firms and everyone involved with them would be well advised to understand, and be prepared for, the coming implications of being considered "too big to fail" by Washington.

James H.M. Sprayregen is a restructuring partner in the Chicago office of Kirkland & Ellis LLP, and Stephen E. Hessler is a restructuring partner in the firm's New York office.