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A Better Idea for Bankrupt Big Banks
Unlike Dodd-Frank, the new act would require that parties with the same legal rights receive the same treatment.

Washington, Apr 25 -

By Stephen E. Hessler

The most significant Wall Street reform in nearly a decade may soon become law. Last Friday President Trump directed Treasury Secretary Steven Mnuchin to review Title II of the 2010 Dodd-Frank Act, which gives the federal government authority to wind down involuntarily failing financial institutions. Treasury is to issue a report that considers whether changing the U.S. Bankruptcy Code “would be a superior method of resolution for financial companies” while preventing bailouts.

Congress is already moving in that direction. The Financial Institution Bankruptcy Act passed the House earlier this month with wide bipartisan support. FIBA would amend the Bankruptcy Code to streamline Chapter 11 cases of “systemically important financial institutions,” or SIFIs, while minimizing disruptions to the rest of the economy. By endorsing FIBA, Treasury could bring the administration a key legislative victory.

Traditional Chapter 11 cases, which facilitate the restructuring of corporations, have many benefits, including fundamental reliance on the rule of law. But for SIFIs, Chapter 11 could be made faster and more nimble to prevent bank runs. FIBA builds upon existing Bankruptcy Code protections but would work more quickly, leave operating subsidiaries outside Chapter 11, and assign Bankruptcy Court judges preselected by the chief justice for their expertise in financial markets.

FIBA would enable a quick separation of “good” and “bad” SIFI assets through the rapid postpetition transfer of the good assets to a newly formed bridge company that is not in bankruptcy. The bridge company would be capitalized by leaving behind unsecured debt, and creditors would pursue their claims in the Chapter 11 case. Any repayment would come in the form of equity in the bridge company or proceeds from the liquidation of bad assets. FIBA would allow a failing SIFI to fix itself in a predictable, rules-based open-court proceeding, and permit counterparties to transact without interruption—while making it possible to create a new, fully capitalized entity that credibly provides most if not all of the same financial services.

Importantly, FIBA would allow for the reorganization of SIFIs with the safeguards of well-settled Chapter 11 precedent and practice, and with the transparency and fairness that come with judicial supervision. Every decision about filing, asset transfer and value distribution would be subject to Bankruptcy Court approval. That is in stark contrast to the opaque process of Title II, which gives unprecedented discretionary power to the Federal Deposit Insurance Corp. to render critical judgments without explanation or even a record or forum for disputes.

Moreover, Title II actually makes risky lender behavior more likely. Dodd-Frank authorizes the FDIC to treat similarly situated creditors dissimilarly—which means the federal government could pick and choose winners and losers according to political priorities. Moral hazard results when investors are assured of outsize profits if an investment succeeds, but the government shields them from outsize harm if it fails. FIBA would require that parties with the same legal rights receive the same economic treatment.

Prior Senate versions of these reforms also included a provision to repeal Title II, which FIBA does not. But debate over Title II should not impede the prospects for FIBA’s prompt enactment. FIBA is worth passing even if Title II endures. And a related benefit is that FIBA would enhance insolvency planning under Title I of Dodd-Frank. Some of the “living wills” submitted by SIFIs have been rejected by the Federal Reserve and FDIC. FIBA could make them feasible.

The best way to resolve failing SIFIs is with clear and established rules administered by an impartial tribunal. The Senate and Mr. Trump would be well-served to follow the House’s lead and shepherd FIBA into law.

Mr. Hessler is a restructuring partner at Kirkland & Ellis LLP and has testified before the House Judiciary Committee in favor of FIBA.

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