Dodd-Frank Experts Testify About Liquidation Authority, Discuss Bankruptcy Changes
By Jeff Bater
Witnesses testifying at a congressional hearing held on May 15 to explore the effectiveness of financial regulatory overhaul pointed out flaws in a key part of the landmark law designed to protect taxpayers from bailing out Wall Street behemoths. One witness testified about a proposal for a new Chapter 14– amendments to the Bankruptcy Code to make bankruptcy more effective as a mechanism for handling the default of a large financial institution.
Rep. Patrick McHenry (R-N.C.) chairs the House Financial Services’ Oversight and Investigations Subcommittee, which held a hearing titled Who Is Too Big to Fail: Does Title II of the Dodd-Frank Act Enshrine Taxpayer-Funded Bailouts? Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act created the Orderly Liquidation Authority, or OLA, to wind-down failing systemically important financial institutions. McHenry said the section of law made government guarantees for SIFIs explicit, providing an unfair advantage to the biggest banks.
A witness at the hearing, University of Pennsylvania Law School Professor David Skeel, said Title II does not end too big to fail, but instead perpetuates the problem.
Under Dodd-Frank, regulators would close a failing megabank and its subsidiaries would be transferred to a bridge company. Skeel testified the bridge institution would have advantages over other firms, including access to government funding and tax exemptions.
“I believe it is very important to amend Title II to fix some of these problems,” he said in his remarks. “I do not think that Title II needs to be repealed. But I do think it should be amended to address problems such as the unjustifiable tax advantages given to bridge financial institutions.”
John Taylor, a Stanford University economics professor, testified that the Federal Deposit Insurance Corporation would have to exercise considerable discretion in reorganizing a failing bank.
“There is confusion about how the reorganization process would operate under Title II, especially in the case of complex international firms,” Taylor said. “Indeed, some argue that this uncertainty about the Title II process would lead policymakers to ignore it in the heat of a crisis and resort to massive taxpayer bailouts as in the past.”
Even if Title II were used, bailouts would be likely, Taylor said, adding that as the FDIC exercised its discretion to form a bridge bank, it could give some creditors more funds than they would have expected or been entitled to under bankruptcy law. “For example, they might wish to hold some creditors harmless, or nearly harmless, in order to prevent a perceived contagion of the firm’s failure to other parts of the financial system,” he said. “This action would violate the priority rules that underlie decisions about borrowing and lending in the entire credit market. Under the reasonable definition that bailout means that some creditors get more than they would under bankruptcy laws or under the normal workings of the market, such action would, by definition, be a bailout of the favored creditors. This expectation of bailout of some creditors increases the risk of financial instability.”
Joshua Rosner, managing director of Graham Fisher & Company, said Title II creates further subsidies for a handful of firms that will be costly to taxpayers and grant further advantage to SIFIs over non-SIFI firms. “OLA rewards companies for becoming ‘systemically important’ and overly influential, it hurts smaller companies, and stifles innovation,” Rosner said. “The government created it, and the government can and should take it away.”
Michael Krimminger, a partner with Cleary Gottlieb and former general counsel at the FDIC, said TBTF should be eliminated because it distorts financial markets, but he held that it was not “enshrined” by Dodd-Frank.
“Too big to fail simply reflects the expectation that the government will step in to prevent the insolvency of the largest financial companies,” Krimminger said. “In 2008, this expectation became a proven reality. Title II of the Dodd-Frank Act directly prohibits such a bailout. In fact, the statutory insolvency tools provided by Title II helps support other insolvency tools by serving as a backup to ensure that market discipline will be effective even in the extraordinary cases. However, the elimination of too big to fail is a work in progress. Much work remains to be done.”
TBTF has been a hot issue in banking regulatory circles during the past year. Notably, the Federal Reserve’s Dallas bank president, Richard Fisher, called on Congress to rewrite Dodd-Frank and for rolling back government support for TBTF banks.
In a speech April 18, Mary Miller, undersecretary for domestic finance at the Treasury Department, assured an economics conference that no financial institution, regardless of its size, will be bailed out by taxpayers again. “Shareholders of failed companies will be wiped out; creditors will absorb losses; culpable management will not be retained and may have their compensation clawed back; and any remaining costs associated with liquidating the company must be recovered from disposition of the company’s assets and, if necessary, from assessments on the financial sector, not taxpayers,” she said (25 BBLR 575, 4/25/13).
While Title II is not a solution to TBTF, Skeel said, bankruptcy is an effective alternative for addressing the financial distress of megabanks. “In its living will requirements and in other areas, the Dodd-Frank Act itself suggests that bankruptcy should be the resolution strategy of choice wherever possible. It is interesting to note, in this regard, that the single point of entry strategy can be replicated in bankruptcy, through a prompt sale to a newly created entity. The bankruptcy alternative would not have any of the anti-competitive characteristics that are found in Title II. The new entity would pay taxes like everyone else, for instance, and it would compete in the market on the same terms as other financial institutions.”
Skeel belongs to a working group at the Hoover Institution that has proposed a new Chapter 14–a handful of amendments to the Bankruptcy Code that the think-tank group believes would make it even more effective as a mechanism for handling the default of a large financial institution. “I believe that one of the best things Congress could do is to enact these proposed changes, which would reduce the need to resort to Title II in the next crisis,” he said.
Nearly three years after its passage, Dodd-Frank, particularly Title II, has done “almost nothing” to mitigate the TBTF problem, Rosner said. “In fact, Title II operates under the completely implausible and economically unsound notion that in a crisis, TBTF firms will be taxed to fund losses at other failing TBTF firms,” he testified.
By Jeff Bater
Hearing testimony can be found as follows: Skeel at http://about.bloomberglaw.com/blaw2/files/2013/05/skeel.pdf; Taylor at http://about.bloomberglaw.com/blaw2/files/2013/05/taylor.pdf; Rosner at http://about.bloomberglaw.com/blaw2/files/2013/05/rosner.pdf; and Krimminger at http://about.bloomberglaw.com/blaw2/files/2013/05/krimminger.pdf.