Orderly Liquidation Authority (§§ 204 & 205)

Congress has acknowledged that some financial firms are going to fail, notwithstanding the intricacies of the framework it has designed to regulate and supervise systemically important companies as ongoing entities. During the financial crisis and in its aftermath, a number of policymakers formed the view—despite evidence to the contrary—that the US Bankruptcy Code and the judicial process it entails are ill-suited to govern the resolution of systemically important institutions that become insolvent.

The FDIC receivership framework that governs the resolution of banks is considered the standard model for preventing runs and financial panics due to the predominantly short-term funding sources (namely, demand deposits) that are used to finance bank lending operations. The hallmark of that model is the substantial discretion afforded to the FDIC in determining which non-depository claims to pay and the order in which to pay them. Although the rights of creditors and debtors alike are largely subordinated to the interests of the US government under the FDIC model, Congress has concluded that those drawbacks are outweighed by the flexibility the framework provides regulators in mitigating systemic risk.

As a direct result of that view, the legislation establishes a new mechanism, based largely on the FDIC’s resolution process, for the liquidation of systemically important financial companies. That class of company will include those entities regulated by the Council and the Federal Reserve under the systemic risk regime outlined above, as well as any financial company whose imminent failure may have considerable adverse ramifications for the US financial system. This new mechanism is called the Orderly Liquidation Authority (Liquidation Authority).

The US Bankruptcy Code will continue to apply to most financial companies, except those posing a systemic risk. In those cases, the new Liquidation Authority will preempt the bankruptcy process and permit the FDIC to seize control of the entity and proceed to liquidate it, rather than allowing the company and its creditors to work out restructuring arrangements as permitted under the US Bankruptcy Code. As a consequence of the legislation, lenders, rating agencies, and other counterparties need to consider the different effects of the US Bankruptcy Code and the Liquidation Authority on those financial firms whose failure might pose a systemic risk.

Covered Financial Companies (§ 204)

The Liquidation Authority potentially applies only to a “financial company,” defined as a company organized under the laws of the United States that is:

  • a BHC
  • a designated nonbank financial company regulated for systemic risk
  • a subsidiary of any of the foregoing kinds of companies, except insurance companies or insured banks and thrifts
  • a broker or dealer registered with the SEC that is also a member of the Securities Investor Protection Corporation (SIPC)

A “financial company” will not fall within the purview of the Liquidation Authority unless the Treasury Secretary specifically designates it as a “covered financial company,” which requires a determination that the company is in default or at risk of default and that it presents a systemic risk. But, as discussed below, this empowers the federal government to subject any financial company to the Liquidation Authority if the government makes such a determination. State regulators will continue to handle insolvent insurance companies, and insured banks and thrifts will continue to be handled under the existing FDIC framework.

Systemic Risk Determination (§ 203)

Although the Treasury Secretary ultimately will determine whether the “failure of the financial company would threaten US financial stability,” the FDIC and the Federal Reserve must initiate the process by recommending that such a determination be made, and the recommendation must be approved by two-thirds of the members of the boards of both the FDIC and the Federal Reserve. If the financial company is a broker-dealer, then the SEC, rather than the FDIC, must make this recommendation. The Treasury Secretary must consult with the President before rendering his or her final determination of systemic risk.

What factors are used to determine systemic risk?
The factors used to determine whether a given company poses a systemic risk include whether:

  • the company is in default or in danger of default
  • the US financial system would experience serious adverse effects resulting from the company’s failure
  • the private sector does not present any viable solutions to the prevention of the company’s insolvency and a bankruptcy case would not be appropriate
  • the FDIC is capable of taking actions that would avoid or mitigate the adverse effects of the company’s collapse

Default or Danger of Default (§ 203)

To determine that the financial company is in “default or danger of default,” the Treasury Secretary must find that one of the following conditions exists:

  • a case under the US Bankruptcy Code has been or is likely to be filed with respect to the company
  • the company has incurred, or is likely to incur, losses that will deplete all or substantially all its capital
  • the company has assets that are, or are likely to be, less than its debts or other liabilities
  • the company is, or likely will be, unable, in the ordinary course of business, to pay back its creditors

Once the Treasury Secretary determines that a company poses a systemic risk and is in default or danger of default, the FDIC may rely on the Liquidation Authority to take steps to place the company in receivership.

Acquiescence and Judicial Review (§§ 202 & 207)

Upon issuing a recommendation that the Liquidation Authority be exercised with respect to a particular company, the Treasury Secretary is required to ask the company’s board of directors whether it “acquiesces” to FDIC receivership. Directors who consent to the appointment of the FDIC as receiver will bear no liability for making this choice. If the board of directors does not acquiesce to FDIC receivership, then the Treasury Secretary must petition the US District Court in Washington, DC, which has 24 hours to respond to the Treasury Secretary’s petition before an order appointing the FDIC as receiver will be deemed automatically granted by that court. Although further review by the US Court of Appeals and even the US Supreme Court is theoretically available, a lengthy appeals process may not be realistic in most circumstances, particularly because no stay or injunction of the receivership order is permitted under the legislation while an appeal is pending.

FDIC’s Powers and Responsibilities as Receiver(§§ 210, 212, & 213)

The Liquidation Authority is just like it sounds—receivership followed by an orderly liquidation. Rehabilitation and reorganization are not permitted. Also, unlike chapter 11 bankruptcies, a debtor under the Liquidation Authority is not permitted to remain in possession of the company; in all cases, the FDIC will assume full control of it.

Upon the FDIC’s appointment as receiver, all existing bankruptcy or other insolvency cases are dismissed, and no further cases may be filed against the company during the liquidation process. The FDIC succeeds to the rights, title, powers, and privileges of the financial company and operates the entity in order to maximize net asset sale value. Under the Liquidation Authority, the FDIC has many of the same receivership powers it has under the current banking laws, but those powers have been modified to address many of the differences between financial companies that pose a systemic risk and insured banks and thrifts in general. In particular, the FDIC’s authorities under the new Liquidation Authority include:

  • repudiating contracts, avoiding preferential or fraudulent transfers, and enforcing any contracts despite provisions (subject to exception for certain types of contracts) that would ordinarily trigger termination, default, acceleration, or other rights to become effective upon insolvency, but subject to valid and perfected security interests
  • transferring the company’s assets and liabilities
  • forming a bridge financial company that can acquire the assets of the company
  • enforcing or disregarding standstill agreements
  • recovering up to two years of compensation paid to directors and senior management substantially responsible for the failure
  • banning senior management from serving at any financial company if they have engaged in serious misconduct
  • appointing itself as a receiver of certain company subsidiaries
  • issuing subpoenas
  • coordinating with foreign financial regulators with respect to any non-US assets or operations of the company

The FDIC is required to exercise its powers so that the company’s creditors and shareholders—and not US taxpayers—bear the company’s losses. Shareholders may not receive any payment until all other claims have been fully paid, and the FDIC is charged with ensuring that the claim priority provisions discussed below are followed with respect to any payments to unsecured creditors. Furthermore, the FDIC is required to dismiss those members of the failing company’s management responsible for the company’s financial condition. Expedited treatment is to be granted to claims against officers, directors, and other parties involved in the company’s operations.

Priorities of payments to unsecured creditors under the Liquidation Authority

  1. FDIC’s expenses as receiver
  2. Amounts owed to the United States
  3. Up to $11,725 in wages, salaries, commissions, or benefits earned by individual employees
  4. General liabilities
  5. Obligations subordinated to general creditors
  6. Wages, salaries, or commissions owed to senior management and directors
  7. Interests of shareholders, members, and general or limited partners

Orderly Liquidation Fund (§ 210)

The legislation also directs the Treasury Department to establish an Orderly Liquidation Fund that will be managed by the FDIC. Although the FDIC may borrow from the US Treasury, the agency is required to replenish any amounts borrowed through ex-post assessments on claimants and, if necessary, risk-based assessments on financial companies with consolidated assets of $50 billion or more. Congress has thus fashioned the Liquidation Authority to ensure that it will not be paid for by taxpayers but by members of the financial industry and those who directly benefited from a prior resolution.