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Senate Judiciary Hearing on Bankruptcy Reform

Senate Judiciary Committee

“Big Bank Bankruptcy: 10 Years After Lehman Brothers”

Tuesday, November 13, 2018

Key Topics & Takeaways

  • Taxpayer Bailouts: In response to a question from Chairman Chuck Grassley (R-Iowa) about how Chapter 14 ensures executives will not inappropriately funnel money to themselves prior to bankruptcy or use taxpayer money, Kirkland & Ellis’ Stephen Hessler explained that Dodd-Frank prohibited taxpayer bailouts and that taxpayer money also cannot be used to pay for bonuses of executives, adding that neither Chapter 11 nor 14 have provisions for public funding.
  • Chapter 14 and Title II: Sen. Chris Coons (D-Del.) asked whether Chapter 14 complements Title II, to which Davis Polk & Wardwell’s Donald Bernstein replied that Treasury has recently reported that Chapter 14 and Title II can coexist, adding that the ability of regulators to act if Chapter 14 fails gives the market confidence (and at a global level). Harvard Law School’s Professor Mark Roe agreed, adding that it is not clear whether Chapter 14 could work without having Title II, and vice versa. Hessler also agreed, adding that the threat of Title II proceedings enhances the likelihood of Chapter 14 being used.
  • Involuntary Proceedings: Coons and Sen. John Cornyn (R-Texas) discussed the inclusion of an involuntary petition option under Chapter 14 that would allow regulators to start the bankruptcy proceeding. Roe noted how important it is for regulators to have this option, not because a regulator would file, but so that financial institutions are aware that regulators can forcefully file, adding that pre-coordination with foreign regulators will be necessary so assets are not reinvested abroad. Bernstein added that it will more likely be a voluntary process as institutions will not want the regulators to step in.

Witnesses

Opening Statements

Sen. Chuck Grassley (R-Iowa), Chairman, Senate Judiciary Committee

In his opening remarks, Grassley addressed the financial crisis and falling of Lehman Brothers, noting how taxpayers previously had to bail out institutions as the bankruptcy system could not handle the failings of larger institutions. He continued that the Dodd-Frank Act created an agency-driven process like the Federal Deposit Insurance Corporation’s (FDIC’s) resolution process and called for an examination of how to improve the bankruptcy code to “better handle” the failing of large financial institutions, but that there needs to be a more consistent approach to the bankruptcy process that keeps taxpayers “off the hook.”

Sen. Chris Coons (D-Del.)

Coons stressed how “critical” it is for Congress to work together to build upon bankruptcy reforms and stated his interest in creating a new chapter to the bankruptcy code with the ability for a large financial institution to go through the bankruptcy process and questioned whether it could be successful. He continued that there has been worry that such a chapter could be the first step to repeal Dodd-Frank, but “that isn’t so.” Coons also expressed his interest in discussing how enhanced bankruptcy, regulators and Title II’s Orderly Liquidation Authority (OLA) could work together.

Sen. John Cornyn (R-Texas)

Cornyn noted that the bankruptcy reform proposal is limited in scope and is a “pared down version” of previous legislation he has introduced, explaining that it would enable financial institutions to voluntarily recapitalize and avoid “total collapse.”

Testimony

Donald S. Bernstein, Partner, Davis Polk & Wardwell LLP

In his testimony, Bernstein highlighted the need to find another way to resolve financial institutions without using taxpayer funds, noting that regulators and the financial community have been looking for ways to solve this problem and that if a firm is to recapitalize and remain in business, it must be done “very fast.” He explained that under the proposed new Chapter 14, a mechanism would be created to put a holding company in Chapter 11, suspending debts and subjecting them to an automatic stay in the bankruptcy code. Bernstein continued that the bankruptcy court would then take stock of subsidiaries and transfer to a new debt-free bank holding company, resulting in recapitalizing the financial institution and leaving the old debt behind. Bernstein added that the proposed Chapter 14 would honor the bankruptcy priorities in place, to include creditors of operating companies having priority because they have extended credit at the bank or broker-dealer level, not at the holding company level.

Professor Mark J. Roe, David Berg Professor of Law, Harvard Law School

In his testimony, Roe explained that the proposed Chapter 14 would turn large issuances of debt into equity over a weekend, noting that it is a “useful option to have” and an “incremental improvement” to the bankruptcy process. However, he stated that it could create an atmosphere where prudential regulation is cut elsewhere, adding that there is a risk that regulators could say capital requirements or prudential regulations are not necessary because of the bankruptcy system. Roe discussed the financing of repos and derivatives, explaining that they have obtained “significant” bankruptcy incentives that allow them to run and dump collateral immediately in ways other creditors in a bankruptcy proceeding cannot. Regarding the proposed legislation, he discussed how it would recapitalize an institution over a weekend, assuming that repo creditors do not run when the institution reopens on Monday, noting that the bank would become unstable by the end of the day.

Stephen E. Hessler, Kirkland & Ellis LLP

In his testimony, Hessler noted that the Financial Institution Bankruptcy Act (FIBA) has passed the House and that he has testified on it previously. He focused on the federal government’s ability to file an involuntary Chapter 14 case, noting that it provides this involuntary action for 8-10 global systemically important bank (GSIB) holding companies, noting his skepticism of the grant of authority. Hessler continued that whether or not Title II remains in place, it is highly unlikely there would ever be an involuntary case, as the GSIBs will be “highly motivated” to start a voluntary case rather than be forced into an involuntary proceeding. He stressed that the new Chapter 14 would make it less likely Title II would ever be invoked, which is consistent with Congress’ intent, and that “any uncertainty to Title II makes Chapter 14 adoption more essential.” Hessler also discussed the proposed treatment of director and officer liability in Chapter 14, explaining that there is some concern Chapter 14 improperly shields directors and officers from liability, but that the scope and language are appropriately limited.

Questions & Answers

Taxpayer Bailouts

In response to a question from Grassley about how Chapter 14 ensures executives will not inappropriately funnel money to themselves prior to bankruptcy or use taxpayer money, Hessler explained that Dodd-Frank prohibited taxpayer bailouts and that taxpayer money also cannot be used to pay for bonuses of executives.

Coons asked whether Chapter 14 will increase or decrease the use of public funding, to which Roe replied there should not be any public funding if Chapter 14 works properly, though he noted that if an institution does not reopen in a stable way there would be another problem. Bernstein and Hessler agreed that there would not be a public sector bailout, with Hessler adding that neither Chapter 11 nor 14 have provisions for public funding. 

Chapter 14 and Title II

Coons asked whether Chapter 14 complements Title II, to which Bernstein replied that Treasury has recently reported that Chapter 14 and Title II can coexist, adding that the ability of regulators to act if Chapter 14 fails gives the market confidence (and at a global level). Roe agreed, adding that it is not clear whether Chapter 14 could work without having Title II, and vice versa. Hessler also agreed, adding that the threat of Title II proceedings enhances the likelihood of Chapter 14 being used.

Coons then noted that it has been questioned whether Chapter 14 is needed, to which Hessler replied that the key mechanism incorporated by Chapter 14 is the single point of entry (SPOE), adding that Chapter 14 provides clarity for the courts and stakeholders.

In response to a question from Coons on whether Chapter 14 would encourage banks to engage in riskier activity than they normally would, Hessler stressed that there is significant disincentives for banks to have risky behavior.

Involuntary Proceedings

Coons and Cornyn discussed the inclusion of an involuntary petition option under Chapter 14 that would allow regulators to start the bankruptcy proceeding. Roe noted how important it is for regulators to have this option, not because a regulator would file, but so that financial institutions are aware that regulators can forcefully file, adding that pre-coordination with foreign regulators will be necessary so assets are not reinvested abroad. Bernstein added that it will more likely be a voluntary process as institutions will not want the regulators to step in.

Deferred Compensation

Sen. Sheldon Whitehouse (D-R.I.) focused on deferred compensation tactics used by executives during the financial crisis, to which Hessler replied that severance for executives is almost impossible to get court approval for in bankruptcy. He continued that while bonuses may be included in bankruptcy proceedings, Chapter 11 heightened the standards for insiders to get bonuses, as opposed to non-insiders, adding that Chapter 14 would not impact this. Hessler stressed that nothing could be paid unless the bankruptcy judge approves it.For more information about this hearing, click here.