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Interesting details regarding safe harbor regulations
Financial Companies and the Bankruptcy Code
Large, complex financial companies that are eligible to file for bankruptcy generally file under Chapter 11 of the Code. Such companies operating in the United States engage in a range of financial services activities. Many are organized under both U.S. and foreign laws. The U.S. legal structure is frequently premised on a parent holding company owning regulated subsidiaries (such as depository institutions, insurance companies, broker-dealers, and commodity brokers) and nonregulated subsidiaries that engage in financial activities.
Certain financial institutions may not file as debtors under the Code and other entities face special restrictions in using the Code:
• Insured depository institutions. Under the Federal Deposit Insurance Act, FDIC serves as the conservator or receiver for insured depository institutions placed into conservatorship or receivership under applicable law.13
• Insurance companies. Insurers generally are subject to oversight by state insurance commissioners, who have the authority to place them into conservatorship, rehabilitation, or receivership.
• Broker-dealers. Broker-dealers can be liquidated under the Securities Investor Protection Act (SIPA) or under a special subchapter of Chapter 7 of the Code. However, broker-dealers may not file for reorganization under Chapter 11.14
• Commodity brokers. Commodity brokers, which include futures commission merchants, foreign futures commission merchants, clearing organizations, and certain other entities in the derivatives
1312 U.S.C. § 1821(c).
14Chapter 7 of the Code contains special provisions for the liquidation of stockbrokers. 11 U.S.C. §§ 741-753. Under SIPA, the Securities Investor Protection Corporation (SIPC) initiates a liquidation proceeding, the primary purpose of which is to protect customers against financial losses arising from the insolvency of their brokers. Once a protective decree has been applied for, any other pending bankruptcy proceeding involving the debtor stockbroker is stayed, and the court where the application is filed has exclusive jurisdiction over that stockbroker. SIPC participation can displace a Chapter 7 liquidation pending the SIPA liquidation, but provisions of the Code apply in a SIPA liquidation to the extent they are consistent with SIPA. See 15 U.S.C. §§ 78eee(b)(2)(B), 78fff(b). Because the stockbrokers discussed in this report are also dealers registered with SEC as broker- dealers, we generally use broker-dealer rather than stockbroker in this report.
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Current Role of Financial Regulators in Bankruptcy Proceedings
industry, can only use a special subchapter of Chapter 7 for bankruptcy relief.15
Regulators often play a role in financial company bankruptcies. With the exception of CFTC and SEC, the Code does not explicitly name federal financial regulators as a party of interest with a right to be heard before the court. In practice, regulators frequently appear before the court in financial company bankruptcies. For example, as receiver of failed insured depository institutions, FDIC’s role in bankruptcies of bank holding companies is typically limited to that of creditor. CFTC has the express right to be heard and raise any issues in a case under Chapter 7. SEC has the same rights in a case under Chapter 11. SEC may become involved in a bankruptcy particularly if there are issues related to disclosure or the issuance of new securities. SEC and CFTC are, in particular, involved in Chapter 7 bankruptcies of broker-dealers and commodity brokers. In the event of a broker-dealer liquidation, pursuant to SIPA the bankruptcy court retains jurisdiction over the case and a trustee, selected by the Securities Investor Protection Corporation (SIPC), typically administers the case. SEC may participate in any SIPA proceeding as a party.
The Code does not restrict the federal government from providing DIP financing to a firm in bankruptcy, and in certain cases it has provided such funding—for example, financing under the Troubled Asset Relief Program16 (TARP) in the bankruptcies of General Motors and Chrysler.17 The authority to make new financial commitments under TARP terminated on October 3, 2010. In July 2010, the Dodd-Frank Act amended section 13(3) of the Federal Reserve Act to prohibit the establishment of an emergency lending program or facility for the purpose of assisting a single and specific company to avoid bankruptcy. Nevertheless, the Federal Reserve may design emergency lending
15 Chapter 7 of the Code contains special provisions for commodity broker liquidation (11 U.S.C. §§ 753, 761-767), and CFTC’s rules relating to bankruptcy are set forth at 17 C.F.R. § 190.01 et seq.
16Pub. L. No. 110-343, 122 Stat. 3765 (2008).
17In a bankruptcy proceeding, creditors often provide financing for the debtor to have immediate cash as well as ongoing working capital during a reorganization process. This financing is called DIP financing.
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Current Safe-Harbor Treatment for Financial Contracts under the Code
programs or facilities for the purpose of providing liquidity to the financial system.18
Although the automatic stay generally preserves assets and prevents creditors from taking company assets in payment of debts before a case is resolved and assets are systematically distributed, the stay is subject to exceptions, one of which can be particularly important in a financial institution bankruptcy. These exceptions—commonly referred to as the “safe harbor provisions”—pertain to certain financial and derivative19 contracts, often referred to as qualified financial contracts (QFC).20 The types of contracts eligible for the safe harbors are defined in the Code. They include derivative financial products, such as forward contracts and swap agreements that financial companies (and certain individuals and nonfinancial companies) use to hedge against losses from other transactions or speculate on the likelihood of future economic developments.21 Repurchase agreements, which are collateralized instruments that provide short-term financing for financial companies and others, also generally receive safe-harbor treatment.
Under the safe-harbor provisions, most counterparties that entered into a qualifying transaction with the debtor may exercise certain contractual rights even if doing so otherwise would violate the automatic stay.22 In the event of insolvency or the commencement of bankruptcy proceedings, the nondefaulting party in a QFC may liquidate, terminate, or accelerate the contract, and may offset (net) any termination value, payment amount, or
18Dodd-Frank Act, Pub. L. No. 111-203, § 1101(a). FDIC can create widely available programs to guarantee obligations of solvent insured depository institutions or holding companies during times of severe economic distress.
19Financial derivatives are financial instruments whose value is based on one or more underlying reference items such as a security or assets.
20The term “qualified financial contract” is not used in the Code.
21A futures contract is a contract that is standardized and traded on an organized futures exchange, while a forward contract is privately negotiated between the buyer and seller. A swap is a type of derivative that involves an ongoing exchange of one or more assets, liabilities, or payments for a specified period. Financial and nonfinancial firms use swaps and other over-the-counter derivatives to hedge risk, or speculate, or for other purposes.
22A contractual right includes a right set forth in the rules or bylaws of, among others, a derivatives clearing organization, a multilateral clearing organization, a national securities exchange or association, or a securities clearing agency.
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Orderly Liquidation Authority
other transfer obligation arising under the contract when the debtor files for bankruptcy. That is, generally nondefaulting counterparties subtract what they owe the bankrupt counterparty from what that counterparty owes them (netting), often across multiple contracts. If the result is positive, the nondefaulting counterparties can sell any collateral they are holding to offset what the bankrupt entity owes them. If that does not fully settle what they are owed, the nondefaulting counterparties are treated as unsecured creditors in any final liquidation or reorganization.
OLA gives FDIC the authority, subject to certain constraints, to resolve large financial companies, including a bank holding company or a nonbank financial company designated for supervision by the Federal Reserve, outside of the bankruptcy process.23 This regulatory resolution authority allows for FDIC to be appointed receiver for a financial company if the Secretary of the Treasury, in consultation with the President, determines, upon the recommendation of two-thirds of the Board of Governors of the Federal Reserve and (depending on the nature of the financial firm) FDIC, SEC, or the Director of the Federal Insurance Office, among other things, that the firm’s failure and its resolution under applicable law, including bankruptcy, would have serious adverse effects on U.S. financial stability and no viable private-sector alternative is available to prevent the default.24 In December 2013, FDIC released for public comment a notice detailing a proposed single-point-of-entry
23Pub. L. No. 111-203, § 204, 124 Stat. at 1454-1456.
24The factors to be considered by the Secretary of the Treasury are set forth in Section 203(b) of the Dodd-Frank Act. Pub. L. No. 111-203, § 203(b), 124 Stat. at 1451 (codified at 12 U.S.C. § 5383(b)). Before the Secretary of the Treasury, in consultation with the President, makes a decision to seek the appointment of FDIC as receiver of a financial company, at least two-thirds of those serving on the Board of Governors of the Federal Reserve System and at least two-thirds of those serving on the Board of Directors of FDIC must vote to make a written recommendation to the Secretary of the Treasury to appoint FDIC as receiver. Pub. L. No. 111-203, § 203(a)(1)(A), 124 Stat. at 1450 (codified at 12 U.S.C. § 5383(a)(1)(A)). In the case of a broker-dealer, the recommendation must come from at least two-thirds of those serving as members of the Federal Reserve Board and at least two-thirds of those serving as members of the Securities and Exchange Commission, in consultation with FDIC, and in the case of an insurance company, from at least two-thirds of those serving as members of the Federal Reserve Board and the Director of the Federal Insurance Office, in consultation with FDIC. Pub. L. No. 111-203, § 203(a)(1)(B)-(C), 124 Stat. at 1450 (codified at 12 U.S.C. § 5383(a)(1)(B)-(C)).
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Challenges of Resolving Failing Cross Border Financial Companies
(SPOE) approach to resolving a systemically important financial institution under OLA.25
Under the SPOE approach, as outlined, FDIC would be appointed receiver of the top-tier U.S. parent holding company of a covered financial company determined to be in default or in danger of default pursuant to the appointment process set forth in the Dodd-Frank Act. Immediately after placing the parent holding company into receivership, FDIC would transfer assets (primarily the equity and investments in subsidiaries) from the receivership estate to a bridge financial company. By allowing FDIC to take control of the firm at the parent holding company level, this approach could allow subsidiaries (domestic and foreign) carrying out critical services to remain open and operating. In a SPOE resolution, at the parent holding company level, shareholders would be wiped out, and unsecured debt holders would have their claims written down to reflect any losses that shareholders cannot cover.
The resolution of globally active large financial firms is often associated with complex international, legal, and operational challenges. The resolution of failed financial companies is subject to different national frameworks. During the recent financial crisis, these structural challenges led to government rescues or disorderly liquidations of systemic firms.
• Insolvency laws vary widely across countries. The legal authorities of some countries are not designed to resolve problems in financial groups operating through multiple legal entities that span borders. Some resolution authorities may not encourage cooperative solutions with foreign resolution authorities.
• Regulatory and legal regimes may conflict. Depositor preference, wholesale funding arrangements, derivatives, and repurchase agreements are often treated differently among countries when a firm enters bankruptcy.
• Some resolution authorities may lack the legal tools or authority to share information with relevant foreign authorities about the financial group as a whole or subsidiaries or branches.
25Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy, 78 Fed. Reg. 76614, Dec. 18, 2013.
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Chapter 15 of the Bankruptcy Code Governs Judicial Cross-Border Coordination in Limited Circumstances
• Country resolution authorities may have as their first responsibility the protection of domestic financial stability and minimization of any risk to public funds. For instance, if foreign authorities did not have full confidence that national and local interests would be protected, the assets of affiliates or branches of a U.S.-based financial institution chartered in other countries could be ring fenced or isolated and wound down separately under the insolvency laws of other countries thus complicating home-country resolution efforts.26
In 2005, the United States adopted Chapter 15 of the U.S. Bankruptcy Code.27 Chapter 15 is based on the Model Law on Cross-Border Insolvency of the United Nations Commission on International Trade Law (UNCITRAL). The model law is intended to promote coordination between courts in different countries during insolvencies and has been adopted in 21 jurisdictions.28 More than 450 Chapter 15 cases have been filed since its adoption, with more than half filed in the Southern District of New York and the District of Delaware.
Among the stated objectives of Chapter 15 are promoting cooperation between U.S. and foreign parties involved in a cross-border insolvency case, providing for a fair process that protects all creditors, and facilitating the rescue of a distressed firm.29 In pursuit of these goals, Chapter 15 authorizes several types of coordination, including
• U.S. case trustees or other authorized entities operating in foreign countries on behalf of a U.S. bankruptcy estate;
26Ring fencing refers to the practice by which local authorities set aside or shield assets of a local subsidiary from the failed institution and insist that local creditors get paid first, prior to any funds being transferred to satisfy claims made against the failed parent.
27Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8. § 801, 119 Stat. 23, 134 (2005).
28See, H.R. Rep. No. 109-31, pt. 1 at 105-07 (2005). As of March 2015, legislation based upon the UNCITRAL Model Law had been enacted in Australia (2008); the British Virgin Islands (2003); Canada (2009); Chile (2013); Colombia (2006); Eritrea (1998); Greece (2010); Japan (2000); Mauritius (2009); Mexico (2000); Montenegro (2002); New Zealand (2006); Poland (2003); the Republic of Korea (2006); Romania (2003); Serbia (2004); Slovenia (2008); South Africa (2000); Uganda (2011); UK (2006); and the Unit
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