House Judiciary Subcommittee on Regulatory Reform, Commercial and Antitrust Law Holds Hearing Regarding Bankruptcy Code

The House Judiciary Subcommittee on Regulatory Reform, Commercial and Antitrust Law held a hearing titled "The Bankruptcy Code and Financial Institution Insolvencies." The hearing focused on examining the current Bankruptcy code and whether it is equipped to address the insolvency of large and small financial institutions. The following witnesses testified:

• The Honorable Jeffery Lacker, President, Federal Reserve Bank of Richmond (written testimony);
• Mr. Donald S. Bernstein, Co-Chair of the Insolvency and Restructuring Group, Davis Polk Wardwell LLP (written testimony); and
• Professor Mark J. Roe, David Berg Professor of Law, Harvard University (written testimony).

Below is a brief summary of the written testimony of each

Jeffrey Lacker testified regarding the importance of improving the bankruptcy code to make the resolution of failing financial firms in bankruptcy feasible. He began by characterizing the "too big to fail" problem as a set of two mutually reinforcing expectations: (1) that financial institution creditors feel protected by implicit government guarantees, distorting incentives and dampening attention to risk, leading to an over-reliance on borrowing sources, such as short-term wholesale funding, and (2) that policymakers might worry that, if a firm reliant on such short-term borrowings were to file for bankruptcy, it would result in undesirable effects, leading such policymakers to intervene in ways that would allow short-term creditors to escape losses. Lacker then surveyed the two primary options provided by the Dodd-Frank Act for dealing with the failure of large financial institutions: first, the "living will" process provided by Title I of the Act and, second, the FDIC's receivership authority under Title II. Of these two options, Lacker deemed the living will process preferable, as it requires firms to consider a bankruptcy resolution strategy in the absence of government support. On the other hand, a receivership under Title II would implicate the same set of mutually reinforcing expectations that led to the problem of "too big to fail" in the first place and, additionally, would undermine the incentives of financial institutions and their creditors to plan effectively for Title I resolution under the bankruptcy code. Lacker argued that if resolution under bankruptcy without the expectation of implicit government guarantees should become the norm, the incentives of market participants would be better aligned with the goal of a financial system that effectively allocates capital and risks. To the end, Lacker urged an active effort to improve the bankruptcy code and to ensure that firms develop robust and credible resolution plans. Such efforts, Lacker stated, would position regulators to wind down the Orderly Liquidation Authority and other financing mechanisms.

Donald Bernstein's testimony described the negative consequences of financial-entity insolvency and assessed recent efforts to ameliorate those consequences. Bernstein focused on the "single-point-of-entry" approach favored by the FDIC, in which the holding company enters insolvency proceedings but its operating subsidiaries are recapitalized and continue to operate outside of bankruptcy protection. Several tools incorporated into the FDIC's "orderly liquidation authority" ("OLA") can be used in carrying out a single-point-of-entry resolution, including the FDIC's ability to create a bridge holding company and OLA's temporary stay on the liquidation of qualified financial contracts.

Bernstein argued that firms can design their resolution plans (sometimes called "living wills") to replicate some of the advantages of the single-point-of-entry approach within the constraints of the Bankruptcy Code, which is intended to remain the primary body of insolvency law for American corporations. Although it lacks some of the tools available under OLA, the Bankruptcy Code provides significant advantages, including its transparency, court oversight, and familiarity to professionals around the world. Bernstein pointed to recent policy proposals that might strengthen the ability of a firm to preserve the value of its business under the Bankruptcy Code, including the possibility of a temporary stay on the termination and liquidation of financial contracts after the filing of a bankruptcy petition. Nevertheless, Bernstein argued, OLA will remain an important backstop that can be used to address unforeseeable contingencies and prevent another catastrophic insolvency like Lehman's.

Professor Roe's remarks were primarily directed at the bankruptcy law safe harbors for financial contracts, which he asserted should be significantly narrowed.

Click here for a video recording of the hearing.See also: Chairman Goodlatte (R-VA) Statement.