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BANKRUPTCY CODE AND 

FINANCIAL INSTITUTION INSOLVENCIES 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

REGULATORY REFORM, 

COMMERCIAL AND ANTITRUST LAW 

OF THE

COMMITTEE ON THE JUDICIARY 

HOUSE OF REPRESENTATIVES 

ONE HUNDRED THIRTEENTH CONGRESS 

FIRST SESSION 

DECEMBER 3, 2013 

Serial No. 113–59 

Printed for the use of the Committee on the Judiciary 

( 

Available via the World Wide Web: http://judiciary.house.gov 
(II) 

COMMITTEE ON THE JUDICIARY 

BOB GOODLATTE, Virginia, Chairman 

F. JAMES SENSENBRENNER, JR., 

Wisconsin 

HOWARD COBLE, North Carolina 

LAMAR SMITH, Texas 

STEVE CHABOT, Ohio 

SPENCER BACHUS, Alabama 

DARRELL E. ISSA, California 

J. RANDY FORBES, Virginia 

STEVE KING, Iowa 

TRENT FRANKS, Arizona 

LOUIE GOHMERT, Texas 

JIM JORDAN, Ohio 

TED POE, Texas 

JASON CHAFFETZ, Utah 

TOM MARINO, Pennsylvania 

TREY GOWDY, South Carolina 

MARK AMODEI, Nevada 

RAU ́ L LABRADOR, Idaho 

BLAKE FARENTHOLD, Texas 

GEORGE HOLDING, North Carolina 

DOUG COLLINS, Georgia 

RON DeSANTIS, FLORIDA 

JASON T. SMITH, Missouri 

JOHN CONYERS, JR., Michigan 

JERROLD NADLER, New York 

ROBERT C. ‘‘BOBBY’’ SCOTT, Virginia 

MELVIN L. WATT, North Carolina 

ZOE LOFGREN, California 

SHEILA JACKSON LEE, Texas 

STEVE COHEN, Tennessee 

HENRY C. ‘‘HANK’’ JOHNSON, JR., 

Georgia 

PEDRO R. PIERLUISI, Puerto Rico 

JUDY CHU, California 

TED DEUTCH, Florida 

LUIS V. GUTIERREZ, Illinois 

KAREN BASS, California 

CEDRIC RICHMOND, Louisiana 

SUZAN DelBENE, Washington 

JOE GARCIA, Florida 

HAKEEM JEFFRIES, New York 

SHELLEY HUSBAND, Chief of Staff & General Counsel 

PERRY APELBAUM, Minority Staff Director & Chief Counsel 

SUBCOMMITTEE ON REGULATORY REFORM, COMMERCIAL AND ANTITRUST LAW

SPENCER BACHUS, Alabama, Chairman 

BLAKE FARENTHOLD, Texas, Vice-Chairman 

DARRELL E. ISSA, California 

TOM MARINO, Pennsylvania 

GEORGE HOLDING, North Carolina 

DOUG COLLINS, Georgia 

JASON T. SMITH, Missouri 

STEVE COHEN, Tennessee 

HENRY C. ‘‘HANK’’ JOHNSON, JR., 

Georgia 

SUZAN DelBENE, Washington 

JOE GARCIA, Florida 

HAKEEM JEFFRIES, New York 

DANIEL FLORES, Chief Counsel 

JAMES PARK, Minority Counsel 
(III) 

C O N T E N T S 

DECEMBER 3, 2013 

Page 

OPENING STATEMENTS 

The Honorable Spencer Bachus, a Representative in Congress from the State 

of Alabama, and Chairman, Subcommittee on Regulatory Reform, Commercial and Antitrust Law ........................................................................................ 1 

The Honorable Steve Cohen, a Representative in Congress from the State 

of Tennessee, and Ranking Member, Subcommittee on Regulatory Reform, 

Commercial and Antitrust Law .......................................................................... 6 

The Honorable Bob Goodlatte, a Representative in Congress from the State 

of Virginia, and Chairman, Committee on the Judiciary ................................. 8 

WITNESSES 

Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond 

Oral Testimony ..................................................................................................... 10 

Prepared Statement ............................................................................................. 13 

Donald S. Bernstein, Co-Chair, Insolvency and Restructuring Group, Davis 

Polk and Wardell L.L.P. 

Oral Testimony ..................................................................................................... 67 

Prepared Statement ............................................................................................. 72 

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

Oral Testimony ..................................................................................................... 91 

Prepared Statement ............................................................................................. 94 

LETTERS, STATEMENTS, ETC., SUBMITTED FOR THE HEARING 

Material submitted by the Honorable Spencer Bachus, a Representative in 

Congress from the State of Alabama, and Chairman, Subcommittee on 

Regulatory Reform, Commercial and Antitrust Law ........................................ 2 

APPENDIX 

MATERIAL SUBMITTED FOR THE HEARING RECORD

Prepared Statement of the Honorable Spencer Bachus, a Representative in 

Congress from the State of Alabama, and Chairman, Subcommittee on 

Regulatory Reform, Commercial and Antitrust Law ........................................ 116 

Prepared Statement of the Honorable Steve Cohen, a Representative in Congress from the State of Tennessee, and Ranking Member, Subcommittee 

on Regulatory Reform, Commercial and Antitrust Law ................................... 119 

Prepared Statement of the Honorable Bob Goodlatte, a Representative in 

Congress from the State of Virginia, and Chairman, Committee on the 

Judiciary ............................................................................................................... 119 

Prepared Statement of the Honorable John Conyers, Jr., a Representative 

in Congress from the State of Michigan, and Ranking Member, Committee 

on the Judiciary ................................................................................................... 120 

Response to Questions for the Record from Jeffrey M. Lacker, President, 

Federal Reserve Bank of Richmond ................................................................... 121 

Response to Questions for the Record from Mark J. Roe, Professor of Law, 

Harvard Law School ............................................................................................ 123 

(1) 

BANKRUPTCY CODE AND FINANCIAL 

INSTITUTION INSOLVENCIES 

TUESDAY, DECEMBER 3, 2013 

HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON REGULATORY REFORM, 

COMMERCIAL AND ANTITRUST LAW

COMMITTEE ON THE JUDICIARY, 

Washington, DC. 

The Subcommittee met, pursuant to call, at 1:54 p.m., in room 

2141, Rayburn Office Building, the Honorable Spencer Bachus 

(Chairman of the Subcommittee) presiding. 

Present: Representatives Bachus, Goodlatte, Marino, Holding, 

Collins, Smith of Missouri, Cohen, DelBene, and Garcia. 

Staff present: (Majority) Anthony Grossi, Counsel; Ashley Lewis, 

Clerk; and (Minority) James Park, Minority Counsel. 

Mr. BACHUS. Well, good afternoon. 

The Subcommittee on Regulatory Reform, Commercial and Antitrust Law hearing will come to order. 

Without objection, the Chair is authorized to declare recesses of 

the Committee at any time. And, if we have votes, we will recess 

for those votes. 

Now, I will recognize myself for an opening statement. 

I would like to enter into the record the Committee memo that 

was prepared for this hearing. In my view, it is an excellent overview of the issues involved with improving the Bankruptcy Code in 

its role as a primary mechanism for dealing with distressed or insolvent financial institutions. 

[The information referred to follows:] 
2 

To: 

From: 

Date: 

Re: 

MEMORANDUM 

Members of the Subcommittee on Regulatory Reform, Commercial and Antitrust 

Law 

Subcommittee Chainnan Spencer Bachus 

Wednesday, November 27,2013 

Subcommittee Oversight Hearing on "The Bankruptcy Code and Financial Institution 

Insolvencies," Tuesday, December 3,2013, at 1:00 p.m., Room 2141, Rayburn House 

Office Building 

INTRODUCTION 

On December 3, 2013, the Subcommittee on Regulatory Reform, Commercial and 

Antitrust Law will hold an oversight hearing entitled "The Bankruptcy Code and Financial 

Institutions Insolvency" to examine policy issues attendant to the orderly resolution of distressed 

and failing financial institutions. 

Witnesses at the hearing will include: the Honorable Jeffrey M. Lacker, President of the 

Federal Reserve Bank of Richmond; Professor Mark J. Roe, David Berg Professor of Law, 

Harvard Law School; and for the Minority, Donald S. Bernstein, Esq., partner and head of Davis 

Polk & Wardwell LLP's Insolvency and Restructuring Practice and past chair of the National 

Bankruptcy Conference. 

PURPOSE AND BACKGROUND 

I. PURPOSES OF THE HEARING 

The orderly resolution of financial companies presents unique challenges to the U. S. 

Bankruptcy Code for many reasons, including these institutions' interconnectedness and, in the 

case oflarger institutions, a potential to pose "systemic risk." The purpose of the oversight 

hearing is to hear testimony regarding issues related to the orderly resolution of distressed 

tinancial institutions, and to examine whether the Bankruptcy Code could be better equipped to 

facilitate resolution proceedings for financial companies of all sizes. Given its jurisdiction over 

the Bankruptcy Code, the Judiciary Committee has long had an interest in this matter. A 

proposal for an enhanced bankruptcy process was debated during the development of what 

ultimately became the Dodd-Frank Act 

II. BACKGROUND 

A. Title 1 of Dodd-Frank and the Resolution of SlFls and Non-SlFls Pursuant 

to the Bankruptcy Code 

In the fall of 2008, the United States was confronted by a financial crisis widely judged to 

be the most severe to face the financial sector and overall economy in decades. The crisis 
3 

resulted in emergency government support to help stabilize the financial and nonfinancial 

system, and caused significant losses to the American economy that adversely affected 

households across the Nation. Thereafter, Congress began to consider financial reform 

legislation to address perceived deficiencies in the oversight of major participants in the sector, 

the reb'lllation of financial institutions, and the resolution of distressed financial institutions. The 

resulting legislation, the Dodd-Frank Act, was signed into law on July 21,2010. 

The bankruptcy process has been the traditional mechanism for handling the orderly 

resolution of distressed companies in the U.S. because of its established history oflaws, 

precedent and impartial administration. According to a report by the Federal Deposit Insurance 

Corporation (FDIC) and the Bank of England (Resolving Globally Active, Systemically 

Important, Nnancial Institutions, December 20 12), "The U.S. would prefer that large tinancial 

organizations be resolvable through ordinary bankruptcy." However, the report added that "the 

U. S. bankruptcy process may not be able to handle the failure of a systemic financial institution 

without significant disruption to the financial system." One response of the Dodd-Frank Act was 

to require banking organizations with $50 billion or more in total assets and systemically 

important nonbank financial companies ("Systemically Important Financial Institutions" or 

"SIFls") as designated by the Financial Stability Oversight Council to submit resolution plans or 

"living wills" to federal regulators. The living wills provide detailed information on how a 

financial company "would be resolved in a rapid and orderly manner under the Bankruptcy Code 

in the event of the [company's] material tinancial distress or failure." The tirst group of filers 

submitted their plans on July 1, 2012, the second group of filers submitted their plans on July 1, 

2013, and the third wave of filers is scheduled to file on December 31,2013. 

Federal Reserve Bank of Richmond President Jeffrey Lacker, who will testify at the 

hearing, has observed, "resolution planning in some sense reverses the usual bankruptcy 

planning exercise. Instead of asking how to take a given financial institution through 

bankruptcy, (T)itle T asks us to work backward from bankruptcy resolution and detennine what 

the institution needs to look like in order for that bankruptcy to be orderly." 

Smaller financial companies are also eligible to restructure their operations under the 

Bankruptcy Code in the event of material financial distress or failure These smaller companies 

are not required to submit living wills. Smaller financial institutions may also present challenges 

that the Bankruptcy Code as written may not be adequately equipped to address. 

B. Reports by the Federal Reserve and GAO and Other Proposals to Address 

Financial Institution Insolvencies 

The Dodd-Frank Act directed the Federal Reserve and the Governmental Accountability 

Otlice (GAO) to study the Bankruptcy Code and international issues related to the insolvency of 

financial institutions as part of an overall goal of reducing systemic risk within the financial 

sector. 

2 
4 

1. Federal Reserve and GAO Studies 

The Federal Reserve study (Study on the International Coordination Relating to 

Bankruptcy Process/or Nonbank Financial Institlltions, July 2011) and the GAO study 

(Complex Financial instillltions and international Coordinate Pose Chaffenges, July 2011) 

identified a number of issues specific to the resolution of insolvent financial institutions and 

discussed theories regarding how to address such issues. However, the reports did not make 

specific recommendations or independent opinions regarding potential revisions to the 

Bankruptcy Code. 

Both studies noted that the Bankruptcy Code, in its current form, is structured to enhance 

the recoveries of a debtor's creditors while providing an opportunity for the debtor to either 

reorganize or liquidate in an orderly fashion The Bankruptcy Code, however, generally has not 

provided an eiTective means for the consideration of systemic risk associated with the 

reorganization or liquidation of a debtor. 

While not endorsing any specific policy recommendations, the full reports discussed 

several areas of potential reform to the Bankruptcy Code. The proposals generally fell into one 

of the following categories of action: "( I) increasing opportunities for bankruptcy planning, 

(2) providing for regulatory input in the bankruptcy process, (3) modifying safe harbor 

exceptions to the automatic stay for [qualitled t1nancial contracts], (4) treating t1nns on a 

consolidated basis, and (5) improving court expertise on financial issues." The reports also 

discuss existing international impediments to orderly cross-border resolution under the 

Bankruptcy Code for t1nancial institutions with global operations. 

2. Single Point of Entry 

"Single point of entry" is a resolution approach that relies on placing a parent holding 

company into receivership while maintaining the operations and solvency of its operating 

subsidiaries. This is a regulatory concept advocated in a paper by the FDIC and the Bank of 

England and is the FDIC's intended method for implementing its resolution/orderly liquidation 

authority under Title 11 of the Dodd-Frank Act. 

Under this approach, the FDIC would be appointed receiver of the parent holding 

company and could transfer the parent company's assets into a bridge t1nancial holding 

company, impose losses on the shareholders and creditors of the parent company, and eventually 

transition ownership of the bridge t1nancial company into private hands. 

Some commentators have suggested that the single point of entry approach should also be 

made available in the Bankruptcy Code. The hearing will examine ways the Code might be 

tailored to facilitate the use of the bankruptcy process for eligible institutions. 

3. The "Chapter 14 Approach" 

The Chapter 14 approach, advocated by, among others, the Hoover Institution of Stanford 

University, introduces an entirely new chapter to the Bankruptcy Code. This new chapter (a 
5 

proposed "Chapter 14") would solely govern the insolvency oflarge financial institutions. This 

is also among the potential approaches discussed in the Federal Reserve study, and many of the 

issues raised by the Chapter 14 approach are separately discussed in the GAO reports. 

As suggested in concept, the new Chapter 14 would, among other elements: apply to 

large financial institutions; allow the financial institution's primary regulator to initiate, and have 

standing in, the institution's bankruptcy proceeding; allow the t1nancial institution's management 

to initiate the bankruptcy; designate a select group of district and bankruptcy judges to oversee 

Chapter 14 bankruptcies; and provide specialized rules for derivative transactions. Advocates of 

the Chapter 14 approach argue that a transparent judicial process that allows for the 

reorganization, rather than liquidation, of a large financial institution is a preferable resolution 

strategy. The hearing is not intended to be an evaluation of the Chapter 14 approach, but certain 

issues raised by the proposal may be examined. 

C. Certain of the Challenges of Financial Institution Insolvencies and Potential 

Constraints of the Existing Bankruptcy Code 

A challenge presented in resolving distressed or insolvent t1nancial institutions is that 

material distress may need to be addressed quickly to prevent signiticant disruption to the 

marketplace. The existing Bankruptcy Code is structured to afford creditors and parties-ininterest due process by allowing sutlicient notice for such parties to respond to actions taken by 

the debtor during various aspects of the proceedings, including the sale of the debtor's assets. As 

discussed in part by the GAO report, existing due process protections may need to be moditled to 

accommodate for the faster response that may be required when a failing institution is deemed to 

pose a systemic risk to the general economy. Additionally, Professor Roe likely will testify that 

certain incremental changes to how derivative contracts are treated in bankruptcy may be 

necessary to facilitate an orderly resolution. 

CONCLUSION 

The bankruptcy process has long been favored as the primary mechanism for dealing 

with distressed and failing companies because of its impartiality, adherence to established 

precedent, and grounding in the principles of due process and rule oflaw. As t1nancial 

institutions move towards organizing their corporate structures to allow for an orderly 

bankruptcy process, it is proper that the Subcommittee begin the discussion of whether the 

current Bankruptcy Code is properly equipped to address challenges that may arise in connection 

with the resolution of both systemically important financial institutions and smaller financial 

institutions in order to help prevent a repetition of scenarios that were experienced during the last 

financial crisis. 

4 
6 

Mr. BACHUS. One of our witnesses today is the president of the 

Federal Reserve Bank of Richmond, Jeffrey Lacker. And let me say 

that there are statistics in an essay prepared by the Richmond Fed 

that underscore the importance of what we are talking about. And 

let me read from the essay directly. 

And I quote, this was I think 2011 essay and it was on ‘‘too big 

to fail.’’ According to—and I quote, ‘‘according to Richmond Fed estimates, the proportion of total U.S. financial firms liabilities covered by the Federal financial safety net has increased by 27 percent during the past 12 years. The safety net covered $25 trillion 

in liabilities at the end of 2011 or 57.1 percent of the entire financial sector. Nearly two thirds of the support is implicit and ambiguous.’’ 

And I think you see that two-thirds portion when we talk about 

Lehman and Bear Stearns. Where Bear Stearns received financial 

support from the government several months later. People are 

thinking, maybe that it is implied, that they will do the same thing 

with Lehman. And it didn’t happen. And one of the results was 

people didn’t prepare for it. It surprised people. And the uncertainty that ensuring—the government, the taxpayer ensuring that 

large portion of the financial assets of our country, the great majority, and then two thirds of that support being iffy is, I think, is a 

condition that all of us, in a bipartisan way, ought to be concerned 

about. 

Those are very significant financial liabilities to place on the 

Federal Government and ultimately on taxpayers. It is a structure 

that can tilt the field toward government intervention and bailouts. 

In my view, statistics like this strengthen the case for improving 

the bankruptcy process so that risks are borne by private parties 

and cases are handled in a consistent way, based on established 

precedent and rule of law. 

And let me say, this hearing is not about Dodd-Frank. But DoddFrank actually set up the mechanism for utilization of bankruptcy. 

So this hearing is not an attempt to substitute something for DoddFrank. In fact, Dodd-Frank called for a GAO hearing and Fed studies on how to improve bankruptcy. So, nothing we are saying today 

is an indictment of Dodd-Frank. In fact, ‘‘living wills’’ have been 

one of the few things that I think almost everyone, in a bipartisan 

way, has said that was a good thing. Although there is a—we discussed earlier witnesses, you have to be cautious that you don’t set 

up a corporation structure as if it is going to bankrupt. But you 

ought to—there ought to be planning of what you are going to do 

in the case there is a bankruptcy. 

With that, let me recognize the Ranking Member of the Subcommittee, Mr. Cohen of Tennessee, for his opening statement. 

Mr. COHEN. Thank you, Mr. Chair. 

And I couldn’t not start this hearing without congratulating you 

on your Auburn victory. What an unbelievable game. And you were 

there. I would like to yield to you. Would you tell us—we heard 

what the Auburn announcer said, when the kick was returned. Can 

you tell us what you said as the kick was returned? [Laughter.] 

Mr. COLLINS. The Alabama perspective was, ‘‘Oh, God.’’ 

Mr. COHEN. And the Auburn perspective was, ‘‘Thank God?’’ 

[Laughter.] 
7 

Mr. BACHUS. Well, you know, I am—having represented Tuscaloosa County, the home of the University of Alabama for 20 years, 

I am not all that vocal sometimes. But, I was thinking how lucky 

Auburn had been two games in a row. And I thought that after 

that immaculate catch against Georgia that we had had all the 

luck we deserved. But, we got some more of it. It was something 

to see. 

Mr. COHEN. But, what did you say? Did you say anything at all? 

I mean—— 

Mr. BACHUS. No. I sort of had that expression, if you seen number 56, that freshman at Auburn that has been on ESPN 

where—— [Laughter.] 

He is trying to put this all together. That’s what we did. My wife 

is a University of Alabama graduate too. So—— 

Mr. COHEN. That was a smart move on your part. 

Mr. BACHUS. So, I was telling her how sorry I was. But she knew 

I wasn’t very sincere. [Laughter.] 

Mr. COHEN. You are the kind of the opposite of McKaren and his 

girlfriend. 

Mr. BACHUS. Yeah, she is an Auburn brat. 

Mr. COHEN. I know it. 

Mr. BACHUS. That is how it is going to be. [Laughter.] 

All right. 

Mr. COHEN. Did you go to Toomer’s Corner and throw toilet 

paper? 

Mr. BACHUS. No. You know what, an Alabama fan poisoned those 

trees and killed them. That is true, I don’t know if you knew that. 

Mr. COHEN. They pled guilty and should have gone to jail for a 

long time. 

Mr. BACHUS. Yeah. 

Mr. COHEN. Bad guy. 

Mr. BACHUS. But the—— [Laughter.] 

That is actually—that is true he went—but, you know, he was 

responding to Auburn students putting an—after the 2010 victory 

over Alabama, Cam Newton, they put an Auburn jacket on Bear 

Bryant’s statute. So, he felt like that was—— 

Mr. COHEN. That was disrespectful. 

Mr. BACHUS. Yes. 

Mr. COHEN. But, not worthy of killing trees. 

Mr. BACHUS. No, they didn’t kill Bear Bryant’s statue. 

Mr. COHEN. Innocent there. 

Mr. BACHUS. All right. I am sorry. 

Mr. COHEN. Back to Dodd-Frank—— [Laughter.] 

Which I voted for and proudly then, and support to this day and 

continue to. 

Its passage by Congress in 2010 was an acknowledgment that insufficient regulation led to the problem of the so-called ‘‘too big to 

fail’’ financial institutions. Those were institutions that became so 

big and so interconnected that their insolvencies threatened to 

paralyze the entire financial system and the economy of the world. 

This situation in turn resulted in extreme pressure for taxpayer 

bailouts when those institutions fell under financial stress. And the 

bill, I think, was somewhat bipartisan, pretty bipartisan to save 

the country and bail out the banks because we had to. 
8 

The bankruptcy filing of Lehman Brothers in 2008, which was the largest bankruptcy in our history, involved more than $600 billion in assets and illustrates this problem. The bankruptcy filing 

greatly exacerbated the financial panic on Wall Street, leading to 

a severe crisis in the greatest economic downturn since the Great 

Depression, now we call it the Great Recession. The financial markets’ reaction to Lehman Brothers’ bankruptcy highlighted potential limitations of the Bankruptcy Code in handling the resolution 

of these financially distressed institutions and the systemic effect 

they would have on financial institutions in general. Dodd-Frank 

has certain enhancements in it that are strong ways that we have 

dealt with and responded to that problem. 

I support legislation to increase the minimum required amount 

of capital for covered financial institutions under Dodd-Frank. We 

should also consider the potential need for other enhancements like 

adding a representative of the Antitrust Division of the Department of Justice to the Financial Stability Oversight Council, which 

was created by Dodd-Frank to oversee the stability of the financial 

system. 

It is in this spirit that I approach today’s hearing, which will 

focus on whether current Bankruptcy Code is sufficient to allow for 

the early reorganization or liquidation of systemically important financial institutions under title I of Dodd-Frank. 

Whether one supports or doesn’t support Dodd-Frank, we can 

agree that today’s inquiry is an important one to the extent that 

modest revisions to the Bankruptcy Code will help ensure that we 

avoid the need for additional future taxpayer bailouts of financially 

struggling large financial institutions. We should be able to work 

together in crafting such changes. 

Just as the Chairman of the full Committee brought us together 

on patent reform, I feel confident that the Chairman of the Subcommittee, that great Auburn war eagle, can bring us together on 

something to solve this problem too. 

With that, I yield back the balance of my time. 

Mr. BACHUS. I thank Mr. Cohen for that opening statement. 

And, at this time, I recognize Chairman Goodlatte, the full Committee Chairman. 

Mr. GOODLATTE. Well, thank you, Mr. Chairman. I appreciate 

your holding this hearing. 

The Bankruptcy Code has existed in this country for well over 

a hundred years. Over this time, our bankruptcy system has 

evolved to become one of the most sophisticated regimes in the 

world. The bedrock principle embedded in the bankruptcy system 

of providing for the efficient resolution and reorganization of operating firms, has allowed our economy to grow and flourish. Nevertheless, a periodic evaluation of the Bankruptcy Code to ensure its 

adequacy to address the challenges posed by the changing nature 

of operating firms, is one of the fundamental responsibilities of this 

Committee. 

I applaud Chairman Bachus for holding today’s hearing to examine whether the existing Bankruptcy Code is best equipped to address the insolvency of large and small financial institutions. 

The bankruptcy process confers a number of benefits to all operating companies, including financial firms. The bankruptcy court 
9 

provides transparency and due process to all parties involved. Furthermore, bankruptcy case law has been developed over decades 

providing consistency and predictability. Additionally, the bankruptcy process has been sufficiently dynamic to administer the resolution and restructuring of complex operating companies with billions of dollars in assets, as well as smaller companies and individuals. 

But, despite the bankruptcy system’s ability to accommodate 

complex operating companies, financial firms may possess unique 

characteristics that are not yet optimally accounted for in the 

Bankruptcy Code. For example, efficient and orderly resolution of 

financial firms can require an unusual level of speed. Refinements 

to the code might be considered to provide—to better provide that 

speed, while still assuring due process. Additionally, in some circumstances, the failure of financial firms can pose unique threats 

to the broader stability of the economy. To account for that, title 

I of the Dodd-Frank Wall Street Reform and Consumer Protection 

Act requires certain firms to prepare ‘‘living wills’’ to plan for resolution in bankruptcy in the event of failure. 

The Bankruptcy Code is well crafted to maximize the recoveries 

of a debtor’s creditors, while providing an opportunity for the debtor to either reorganize or liquidate in an orderly fashion. It might, 

however, bear improvements designed specifically for the efficient 

execution of title I living wills. There are some of the—these are 

some of the issues that may need to be examined as part of the 

broader evaluation of the existing Bankruptcy Code’s adequacy to 

address financial institution insolvencies. 

I look forward to the testimony from today’s excellent panel of 

witnesses on these important issues. 

And, Mr. Chairman, I thank you and yield back the balance of 

my time. 

Mr. BACHUS. I thank you. 

And without objection, other Members’ opening statements will 

be made a part of the record. 

And I do agree with the Chairman when he says that we have 

an excellent panel of witnesses, because we do have three of—really people that, in a bipartisan nature, we consider experts on bankruptcy and how it can be enhanced to address complex situations. 

I will first begin by introducing our witnesses. 

Governor Lacker is the current president of the Federal Reserve 

Bank of Richmond, where he began his term on August 1st, 2004. 

Prior to serving as the president of the Richmond Federal Reserve, 

he was a research economist with the bank for 25 years, serving 

in various capacities including vice president, senior vice president 

and director of research. He is the author of numerous articles and 

professional journals on monetary financial and payment economics. And he has presented his work at universities and central 

banks worldwide. He received his BA in economics from Franklin 

and Marshall College, and a doctorate in economics from the University of Wisconsin. 

Mr. Bernstein, Donald Bernstein, is a partner of Davis Polk here 

in Washington. Is that right or New York? New York, okay. Where 

he heads the firm’s insolvency and restructuring practice. During 

his distinguished 35-year career, he has represented nearly every 
10 

major financial institution in numerous restructuring, as well as 

leading a number of operating firms through bankruptcy including 

Ford, LTV Steel, and Johns Manville. Mr. Bernstein has earned 

multiple honors for his practice including being elected by his peers 

as the chair of the National Bankruptcy Conference, the most prestigious professional organization in the field of bankruptcy. Mr. 

Bernstein received his AB cum laude from Princeton University 

and his JD from the University of Chicago Law School. And we 

welcome you. 

Professor Mark Roe is a professor of law at Harvard Law School 

where he teaches business bankruptcy and corporations courses. 

Professor Roe has authored countless articles and opinion pieces 

that have been published across the globe including in the law reviews and—the law reviews of Penn, Virginia, Columbia, Michigan, 

Stanford, Yale, and Harvard. He also literally wrote the book on 

corporate restructuring that is used in law schools across the country. Prior to joining Harvard’s faculty, Professor Roe taught law at 

Columbia University, the University of Pennsylvania and Rutgers 

University. Prior to joining academia, he worked at the law firm 

of Cahill Gordon and at the Federal Reserve. Professor Roe received his BA from Columbia University summa cum laude, and 

his JD from Harvard Law School. 

Each of the witnesses’ written statements will be entered into 

the record in its entirety. I ask that each of the witnesses summarize his testimony or her testimony. I am not going to restrict you 

to 5 minutes, I think it is too important. If you go over that, that 

is fine. 

And so I am not going to read this about the light and all that. 

So, we—at this time, Governor Lacker, you are recognized for 

your opening statement. 

TESTIMONY OF JEFFREY M. LACKER, PRESIDENT, 

FEDERAL RESERVE BANK OF RICHMOND 

Mr. LACKER. Thank you, good morning. 

I am honored to speak to the Subcommittee about why I believe 

it is important to improve our Bankruptcy Code to make it easier 

to resolve failing financial firms in bankruptcy. 

At the outset I should say that my comments reflect my own 

views and do not necessarily reflect those of the Board of Governors or my other colleagues at other Federal Reserve banks. 

I think the events of 2008 provide strong evidence of glaring deficiencies in the way financial institution distress and insolvency are 

handled, particularly at large institutions. The problem, widely 

known as ‘‘too big to fail,’’ consists of two mutually reinforcing expectations. 

First, many financial institution creditors feel protected by an 

implicit government commitment of support should the institution 

face financial distress. This belief dampens creditors’ attention to 

risk and it leads to overuse of types of borrowing such as shortterm wholesale funding that are more fragile, more prone to runs, 

more prone to volatility. 

The second of these two mutually reinforcing expectations is that 

if a large financial firm is highly dependent on short-term funding, 

policymakers are often unwilling to let it file for bankruptcy under 
11 

the U.S. Bankruptcy Code fearing that it would result in undesirable effects on counterparties. This fear leads policymakers to intervene in ways that allow short-term creditors to escape losses 

such as through central bank lending or public sector capital injections. 

This behavior just reinforces creditors’ expectations of support. 

That in turn reinforces firms’ incentives to grow large and their incentive to rely on short-term funding which in turn reinforces policymakers’ proclivity for intervening to support creditors. The result is more financial fragility and more rescues. The path toward 

a stable financial system requires that policymakers have confidence in the unassisted failure of financial firms under the U.S. 

Bankruptcy Code and that investors are thereby convinced that unassisted bankruptcy is the norm. This is why I believe it is vitally 

important to ensure that our bankruptcy laws are well crafted to 

apply to large financial institutions. 

In response to the experience of 2008, title I of the Dodd-Frank 

Act laid out a planning process for the resolution of failed financial 

institutions. A resolution plan or ‘‘living will,’’ as they are popularly 

called, is the description of a firm’s strategy for rapid and orderly 

resolution under the U.S. Bankruptcy Code without government assistance. It spells out the firm’s organizational structure, key management information systems, critical operations, and a mapping of 

the relationship between core business lines and legal entities. The 

heart of the plan is the specification of the actions the firm would 

take to facilitate rapid and orderly resolution and prevent adverse 

effects of failure, especially the firm’s strategy to maintain critical 

operations and funding. 

The Federal Reserve and the Federal Deposit Insurance Corporation can jointly determine that a plan is ‘‘not credible’’ or would not 

facilitate the orderly resolution—an orderly resolution under the 

Bankruptcy Code. And, in that case, the firm would be required to 

submit a revised plan to address deficiencies. If the Fed and the 

FDIC jointly determine that the revised plan does not remedy identified deficiencies, they can require more capital, increase liquidity 

requirements, reduce reliance on short-term funding, or restrict the 

growth, activities or operations of the firm. In essence, regulators 

can order changes in the structure and operations of a firm to 

make it resolvable in bankruptcy without government assistance. 

Note the implication here that if a firm would require, the way 

it is running itself now, an unrealistically large amount of ‘‘debtorin-possession’’ financing, regulators can require ex ante, pre-bankruptcy changes in the firm’s funding structure so that plans for 

funding operations in bankruptcy are realistic and credible. 

Title II of the Dodd-Frank Act gives the FDIC the ability to take 

a firm into receivership under its so-called ‘‘Orderly Liquidation 

Authority,’’ if there is a determination that the firm’s failure under 

the U.S. Bankruptcy Code would have serious adverse effects on 

U.S. financial stability. Title II receivership differs from the Bankruptcy Code in that the FDIC would have the ability to borrow 

funds from the U.S. Treasury to support creditors, and would have 

broad discretion to treat similarly situated creditors differently. 

This is likely to replicate the two mutually reinforcing expectations 

that define ‘‘too big to fail.’’ And this is why improving the Bank-
12 

ruptcy Code to facilitate orderly resolution of large financial firms 

is so important. It would position us to wind down the Orderly Liquidation Authority at an appropriate time and to wind down other 

financing mechanisms such as the Federal Reserves’ remaining 

13(3) powers to lend in ‘‘unusual and exigent circumstances.’’ 

Without winding these down, I think that those mutually reinforcing conditions are likely to arise again. Expectations of support, 

in the absence of clear guidance as to when and where support will 

be forthcoming, will encourage excessive risk taking. That risk taking will trap policymakers. It will put them in a box and force them 

to respond with rescues and support, in the event of distress. 

The Dodd-Frank Act itself clearly envisions bankruptcy without 

government support as the first and most preferable option in the 

case of a failing financial institution, and for good reason, in my 

view. The expectation of resolution in bankruptcy without government support would result in a much better alignment between the 

incentives of market participants and our public policy goal of a financial system that effectively allocates capital and risk. 

Thank you very much. 

[The prepared statement of Mr. Lacker follows:] 
13 

Statement 

Subcommittee on Regulatory Reform, Commercial and Antitrust Law 

ofthe Committee on the Judiciary 

December 3, 2013 

Jeffrey M. Lacker 

President 

Federal Reserve Bank of Richmond 

The Committee on the Judiciary 

Rayburn House Otlice Building 

Washington, D.C. 

Good morning. I am honored to speak to the Subcommittee about the bankruptcy code and 

financial institution insolvency. In my remarks, I will discuss why I believe it's so important to 

improve our bankruptcy code to make it feasible to resolve failing financial firms in bankruptcy. 

At the outset, I should say that my comments today are my own views and do not necessarily 

retlect those of the Board of Governors of the Federal Reserve or my colleagues at other Federal 

Reserve Banks. My views have been informed by both my experience leading the Fifth Federal 

Reserve District over the last seven years and as a research economist studying banking policy 

for the prior 25 years. 

The events of 2008 provided evidence, in my view, of glaring deficiencies in the way financial 

institution distress and insolvency are handled, particularly at large institutions. 1 The problem -

widely known as "too big to fail" - consists oftvllo mutually reinforcing expectations. First, 

many t1nancial institution creditors feel protected by an implicit government commitment of 

support should the institution face financial distress. This belief dampens creditors' attention to 

risk and makes debt financing artificially cheap for borrowing firms, leading to excessive 

leverage. Moreover, it leads to overuse of types of borrowing - such as short-term wholesale 

funding - that are more fragile and more likely to prompt the need for such protection. Second, 

policymakers may well worry that if a large financial firm with a high reliance on short-term 

funding were to tile for bankruptcy under the U.S. bankruptcy code, it would result in 

undesirable effects on counterparties, financial markets and economic activity. This expectation 

induces policymakers to intervene in ways that allow short-tenn creditors to escape losses, such 

as through central bank lending or public sector capital injections. This reinforces creditors' 

expectations of support and firms' incentives to grow large and rely on short-term funding, 

resulting in more t1nancial fragility and more rescues. 

Expectations of creditor rescues have increased over the last four decades through the gradual 

accretion of precedents. Research at the Richmond Fed has estimated that one-third of the 

financial sector's liabilities are perceived to benetlt from implicit protection, based on actual 

government actions and policy statements. 2 Adding implicit protection to explicit protection 
14 

programs such as deposit insurance, we found that 57 percent of financial sector liabilities were 

expected to benefit from government guarantees as of the end of 2011. This fit\ure was about 45 

percent at the end of 1999. 

In response to the experience of 2008, Title I of the Dodd-Frank Act laid out a planning process 

for the resolution of failed financial institutions. A resolution plan, or "living will," is a 

description of a firm's strategy for rapid and orderly resolution under the US. bankruptcy code, 

without government assistance, in the event of material financial distress or failure Among other 

things, it spells out the finn's organizational structure, key management infonnation systems, 

critical operations and a mapping of the relationship between core business lines and legal 

entities. The heart of the plan is the specification of the actions the firm would take to facilitate 

rapid and orderly resolution and prevent adverse etTects of failure, including the finn's strategy 

to maintain critical operations and funding. J 

The Federal Reserve and the Federal Deposit Insurance Corporation can jointly detennine that a 

plan is "not credible" or would not facilitate an orderly resolution under the bankruptcy code, in 

which case the firm would be required to submit a revised plan to address identified deficiencies. 

A resubmission could include plans to change the business operations and corporate structure in 

order to eliminate deficiencies. lfthe Fed and the FDIC jointly determine that the revised plan 

does not remedy identified deficiencies, they can require more capital, increase liquidity 

requirements or restrict the growth, activities or operations of the firm. In essence, regulators can 

order changes in the structure and operations of a firm to make it resolvable in bankruptcy 

without government assistance. 

If there is a determination that, among other things, the finn's failure under the US. bankruptcy 

code would have serious adverse effects on "US. financial stability," Title II of the Dodd-Frank 

Act gives the FDIC the ability, with the agreement of other financial regulators, to take a firm 

into receivership. One ditTerence between a Title II receivership and the bankruptcy code is that 

Title II gives the FDIC the ability to borrow funds from the US. Treasury (specifically, the 

Orderly Liquidation Fund at the Treasury) to make payments to creditors of the failed finn or to 

guarantee the liabilities of the failed firm. 4 The funds are to be repaid from recoveries on the 

assets of the failed firm or from assessments against the largest, most complex financial 

companies. 

While the FDIC is to pay creditors no less than they would have received in a liquidation of the 

firm, the Act provides the FDIC with broad discretion to treat similarly situated creditors 

differently.5 This can encourage short-term creditors to believe they would benefit from such 

treatment and therefore continue to pay insutlicient attention to risk and invest in fragile funding 

arrangements. Given widespread expectations of support for tinancially distressed institutions in 

orderly liquidations, regulators will likely feel forced to provide support to these short-term 

creditors to avoid the turbulence of di sappointing expectations. This would replicate the two 

mutually reinforcing expectations that define "too big to fail" 

Clearly, the Dodd-Frank Act envisions bankruptcy without government support as the first and 

most preferable option in the case of a failing financial institution, and for good reason, in my 

view. If resolution in bankruptcy without the expectation of implicit government guarantees 

2 
15 

comes to be expected as the nonn, the incentives of market participants would be better aligned 

with our public policy goal of a financial system that effectively allocates capital and risks. Large 

financial finns themselves would want to be less leveraged and less reliant on unstable shortterm funding. Institutions and markets would, accordingly, be more resilient in response to 

financial stress, and policymakers could credibly commit to forgo the creditor rescues that do so 

much damage to incentives. 

The alternative to robust plans for resolution in bankruptcy is to institutionalize the capacity to 

provide public sector rescues for financial finn creditors outside of bankruptcy, through Title II. 

This would be a far less desirable path, I believe. Trying to correct these incentive distortions 

through the regulation of finn size, structure and capital is likely to fall short. This path thus 

would fundamentally undennine the incentives of financial institutions and their creditors to plan 

effectively for Title I resolution. And it would continue to tilt financial innovation toward 

bypassing regulatory constraints and relying on the fragile short-tenn funding methods that are 

most likely to elicit government protection. The result would be ever-increasing regulatory costs 

and repeated bouts of financial instability. 

Reducing the probability that a large financial firm becomes financially distressed - through 

enhanced standards for capital and liquidity, for example - is useful, but will never be enough. 

The path toward a stable financial system requires that policymakers have confidence in the 

unassisted failure of financial firms under the U.S bankruptcy code and that investors are thereby 

convinced that unassisted bankruptcy is the norm. This is why T believe it is vitally important to 

ensure our bankruptcy laws are well crafted to apply to large financial institutions. 

Tn evaluating alternative approaches to insolvency and bankruptcy provisions, it would be a 

mistake to assume that the behaviors of financial finns and their creditors will remain 

unchanged. For example, 1 have stressed that the heavy reliance oflarge financial institutions on 

wholesale funding markets evolved under the growing expectation of public sector rescues, and 

is likely to depend sensitively on that expectation. In the absence of that expectation, firms and 

their creditors would have strong incentives to reduce reliance on fragile short-tenn funding. 

This is relevant to the frequently heard claim that the large "liquidity needs" offailing financial 

institutions is a stumbling block to resolving such tirms in bankruptcy. The U.S. bankruptcy code 

allows the bankrupt firm to obtain, subject to court approval, "debtor-in-possession," or DIP, 

financing that is generally senior to pre-existing creditors. Such financing can be useful to fund 

ongoing operations - for example, to payoff certain creditors, such as vendors, rather than 

retain them in bankruptcy proceedings. Other creditors often find it advantageous to approve DIP 

funding, despite the dilution of their own claims, because it ensures the continuation of ongoing 

operations. 

The point is that if repayment of short-tenn obligations in bankruptcy depends on large amounts 

of DIP financing that would be difficult for a financial institution to obtain, one would expect to 

see less reliance on short-tenn credit (at least as long as government-provided DIP financing was 

not expected to fill the gap). Moreover, an inability to fund necessary operations in bankruptcy is 

likely to compromise the credibility of a Title I resolution plan. In this case, regulators would be 

warranted to require less reliance on short-term funding in the tirst place. 
16 

The FDIC's authority to lend to distressed institutions under its Orderly Liquidation Authority 

amounts to government-provided DIP financing. The beneficial feature of privately provided 

DIP financing is the presumption that, because it's provided by market participants and approved 

by creditors and the court, it's fairly priced and thus unsubsidized and does not unduly 

disadvantage any particular class of creditors. Indeed, this is why unassisted bankruptcy is so 

critical to ending "too big to fail" and why tlnns were instructed not to assume extraordinary 

government support in their submitted resolution plans. Public sector support can be underpriced 

and distortionary, and can reallocate returns between creditor classes outside the procedural 

safet\uards of bankruptcy. Discretionary government provision of DIP financing would 

undermine the integrity and purpose of the bankruptcy code. 

Some recent proposals to address the "too big to fail" problem would make structural changes to 

tlnancial tlrms - imposing quantitative limits on their size or prohibiting certain risky activities. 

I am open to the notion that such restrictions may ultimately be necessary to achieve a more 

stable financial system, but 1 do not believe we have a strong basis yet for determining exactly 

what activity and size limits should be adopted. The living will process, however, should provide 

an obj ective basis for decisions about how the structure, financing or activities of large tlnancial 

firms need to be altered in order to assure orderly unassisted resolution. In addition, the process 

of writing credible living wills should illuminate etTorts to identify ways in which the bankruptcy 

code could be improved to make the resolution of tlnancial tlrms more orderly. 6 

Robust and credible resolution plans will position us to wind down the Orderly Liquidation 

Authority and other financing mechanisms, such as the Federal Reserve's remaining 13(3) 

powers to lend in "unusual and exigent circumstances." By allowing creditors to escape losses, 

such lending distorts incentives and exacerbates moral hazard. Eliminating the ability to provide 

ad hoc support to firms in financial distress would cement our commitment to orderly unassisted 

resolutions in bankruptcy, thereby contributing to a more stable and competitive playing tleld. 

1 The inherent problems ha,e been widely noted by economists going back decades be [are the crisis. Sec John H. 

Kareken and Neil Wallace, --Deposit InSlrrance and Bank Regulation" A Pm1ial Equilibrium E~1Josition:' JOlll1al of 

Business, July 1978. vol. 51. pp. 413-38: John H Kareken. "Deposit Insurance Refonn or Deregulation Is the Cart. 

Not the Horse." Federal Reserve Bank of Minneapolis Quarterly Review. Spring 1983. vol. 7. no. L Douglas 

Diamond and Philip Dybvig, "Bank Rlms, Deposit Insurance and Liquidity," Journal of Political Economy. Jlme 

19S3, vol. 91, no. 3, pp. 401-19: Marvin Good[riend and Je[Trey M. Lacker, "Limitcd Cormnitmelli and Central 

Bank Lending," Federal Rcserve Bank of Richmond Economic Quarterly, Fall 1999, '01. S5, no. 4, pp. 1-27: Gary 

Stem and Ron Feldman, "Too Big To Fail: The HaC'.ards of Bank Bailouts," Washington, D.C.: Brookings Institution 

Press, 2004. Sec also Hubcrto M. Ennis and Todd Keister. "On the Fundamental Reasons for Bank Fragility," 

Federal Reserve Bmu, of Riehmond Economic Quarterly, First Quarter 2010. vol. 96. no. 1. pp. 33-58: Federal 

Reserve Bank of Richmond Economic Quarterly. First Quarter 20 [0. A Special Issue on the Diamond-Dybvig 

Model and [ts Implications [or Banking and Monetary Policy 

2 The Richmond Fed's estimates of the si7e of the federal financial safety net are available at 

sec Jeffrey Lacker, 'Too Big Is Going to Be Hard Work," 

Speeeh at the University Richmond, Va., 2013. The Federal Reserve's Regulation QQ 

governing resolution planning can be found at httu://\VW\y.gDO.gU\-JfdsvS!DkgJFR-20 11-11-0 1!D~/20 11-27377.m..lf 

4 
17 

4 For a comparison of the Orderly Liquidation Authority provisions with the U.S. baukmptcy process, see Sabrina R 

Pellerin and John R. Waller, "OIgc-C!~_ Ljq~ljq;31tqJ) ~Jllh0XjJ~_Q~JinAJKrJli!.Jb~_~9JJill}j:oIl]J2l~\," Federal Rcscf\c 

Bank or Richmond Economic Quancrl}, First Quartcr 2012, vol. 9H, no. 1, pp. 1-31 

'See Pellerin and Walter. pp. 16-19. 

6 See Kenneth E. Scott and John B Taylor (eds.), "Bmllauptcy Not Bailout: A Special Chapter 14," Stanford, CA 

Hoover Institution Press, 2012 
18 

~EDERAl RESERVE BANK 

Willi ~F RICHMOND· 

Richmond · BaltirTlOR' • Charlotte 

SupplemenlHI Materials 

20 1) Estimates of tile Safety Net. Federal Reserve Bank of Richmond 

2. Orderly L.iquidation Authority as an Alternative 10 Bank ruptcy. Sabrina R. Pellerin and 

John R. Wa ller, Federal Reserve Bank of Richmond l,;collomic Quarterly. First Quarter 

20 12. 

3. "Too Big \0 Fail." Our Perspective, Federal Reserve Bank of Richmond. February 20 U . 
19 

r:r: ... IOIRIL R!I!m DANK 01 RI(HMOND 

2013 Estimates of th e Safety Net (Using Data as of Dec. 31,2011) 

As used by Walter:rnd Weinberg (20021 3/ld Makshc)'a and Waller (2010) the phrasc government 

guaral11cc nx:an~ a federal gO"cmmen! commilmcnllO prolCCllcndcrs from losses duc to a pri'<llC 

borm",," default. Following Ihis defmition. our cS1inl"!C ofth<: safety ncl includes insured bank and 

thrift de posits.. cer1:Un other banking company liabilities. som<: gO\ mrn nt ~ponson:d enterprise (GSE) 

liabilitil'S. scle<:lcd pri"3!c",,"'ployc< pension liabiliTies. the dollar mluc of mOlll'Y market mutual fund 

5ha",s. as ,,-ell as a subset ofll>c tiabililics of other fonJl1cial fimls. 

Our cslim:uc (using dau as ofOcc. 31. 201 1) indudes:I m;" tun:: of clemen IS. Some ofthc liabilities. such 

as insured deposits. arc t"pllclIl)' guaranteed. OIhcrs, such as short-1cnn liabilities Oflhc largest banking 

companies. some deposit b:J.IaJ>CCs not explicitly co\"\,,,,d b)' deposit insurance. and the liabilities of 

ce rtain gO"cmmenl-s ponsorcd enterprises. arc ix:lie-..:d by many markt participants to be'ml'limly 

guaranteed by the federal go\'Cmment. Our approach to implicit guarantees is to ask. ·'Based on past 

go,..:mmcm actions. "hat might market Jl3rticiJl3nts "'3S0nably ~pcct futun; gon:mmcnt actions to be?·· 

Ofooursc. idcnti~ ing e~act market cspcctations is la,¥cly impossible, We thc"'forc pro,·ide 1\'0 

cSlim3\cs-found in Our ··Most Inclusi,·c·· and ··lcastlnciusi,'C·· tables below- thai can be thought of"" 

thc bounds within wh ich market p.:!'CCptioos arc likely to be found. 

Sec the MClhodolog' and Sources se<:tion for gI'C3lCr detail 00 wh:ll " C ha,'C included in oure~plicit and 

implicit categorics forcach liability t)'p.: contained in our twocstim3\cs, 
20 

•••• 

Most Inclusive Estimate 

Expllddy Impllddy 

Guarllnteed Guarllnteed ... ,-, 

UabilltiK UabilltiK UabilitiK 

FInancial FIrms (in billions) ,AI ,., 

Banking & Saving irm~ (include~ BHCs & Sl C~1 $7,146 $5,571 $12,71B $17,369 

41.1% 32.1% 73.2% 

Credit Unions $795 $795 

90.1% 90.1% "" 

GSEs 

Fannie Mae $3,278 $3,278 $3,278 

Freddie Mac $2,204 $2,204 $2,204 

Farm Credit System $196 50" 50" 

Federal Home LOan 8anks $726 $726 $726 

Total $6,405 $6,405 $6,405 

HlO.O% 100.0% 

Prlyate Employer Pensiofl Funds 52,630 S2,630 S2,994 

87.8% g7.8% 

Money Market Mutual Fund~ $2,691 $2,691 $2,691 

Other Financial Firms $170 $170 $14,126 

Total fo r Finandal Firms $10,572 $14,838 $25,409 $44,468 

Percentage of Total Liabilities 23.8% 33.4% 57.1% 100.0% 

NOle. TOlal, ... ranleed ~ab,hll'" ($25,_ B) au ""reo/GOP ($14,991 B)eq ... 1< 169%, u""8 tho< table .est,mate. 

ri<;hmQ/ldled.orghafetyne\ 

Impljcitly 

Explicitly 

, , .. 

Total Liabilities 

$44.S IrlUion 

'" 

... 

, 
21 

• ••• 

l east Inclusive Estimate 

Expllddv ImpllddV 

GWOl'llntHd Gual'llnteed ... .... UabilltiK UabilltiK UabiNtIK 

FInancial FIrms (in billions) IAI 18) 

Banking & Saving firms (includes BHu & SlHCsl $5,577 $5,577 $17,369 

32.1% 32.1% 

Credit Unons S795 $795 $883 

90.1% 9(U % 

GSEs 

Fannie Mae $3,278 $3,278 $3,278 

Freddie Mac $2,204 $2,204 $2,204 

Farm Credit System S196 

Federal Home loan Bank$ $726 $726 $716 "" "" 

Total $6,405 $6,405 $6,405 

100.0% 100.0% 

Private Emplo.",,, Pension Fund, $2,6)0 $2,6)0 $2,994 

87.8% 87.8% 

Money Market Mutual Funds' 

Other Financial Firms $14,126 

TOlal for Financial Flrm$ $9,003 $6,405 $15,407 $41,177 

Percentage of Total liabilities 21.5% 15.3% 36.9% 100.0% 

. Money marloet mutual fund .hare. are not treated as I~bd~~ In thl'l est,ma", . 

Note: TotallUa,anteed I~bllrtl '" 1$15,407 B) .,. share of GOP 1$14,991 Blequals 1()3%, u .. ng this table·,estlmate. 

Implicitly 

'" 

, 

ri<:hmQ/ldled.orWafetyne\ 

Total liabilities 

$41.8 trillion 

'" 

3 
22 

Methodology and Sources 

Banking and Savings Firms 

Explicitly Guarai1leed Liabilities - FDIC-insured deposits of all commercial banks and savings 

institutions (up to the $250,000 insurance limit), which includes transaction accounts covered by the 

FDIC's Transaction Account Guarantee (TAG) program I plus debt guaranteed by the FDIC's Debt 

Guarantee Progranl (DGP) (Both of these FDIC programs expired Dec 31 2012) 

Implicitly Guaranteed Liabilities In our most inclusive estimate of the safety net, we include total 

li"bilities ofthe four largest banking institutions (those larger th"" $1 trillion in assets)3 minus insured 

deposits (included in explicit column); plus short-tenn liabilities (federal fimds, repurchase agreements, 

commercial papeL and other short-tennliabilities as reported in financial reports)" and uninsured 

deposits S ofthe 34 b""k and savings and loan holding companies (beyond the four largest) with assets 

greater tlmn $50 billion. 

Four largest bankin!! institutions - During the financial turmoil of 2008 and 2009, the government 

promised to provide capital if needed by any of the largest 19 bank holding companies (BHCs) 

such that their operations could continue uninterrupted. encouraging the view that all liabilityholders of these finns would be protected. However, the Orderly Liquidation Authority (OLA) 

provisions of the Dodd-Frank Wall Street Refofl11 and Consumer Protection Act (Dodd-Frank) 

may reduce the likelihood that these companies would receive capital injections to allow their 

lmintcITuptcd operation. Nc\,crthclcss. one can imagine that many market participants will fClnain 

skeptical that the government would allow operations of the very largest and most systemically 

important institutions to be disrupted, even if the interruption might be minimized and carefully 

managed by the OLA process.' As a result. our most inclusive estimate includes all of the 

liabilities of the four largest companies. 

Short-tern, liabilities - Market participants might expect that the short-tenn liabilities oflarge 

financial fifl11s would be protected if the firms are resolved under the OLA. All bank and savings 

and loan holding companies (SLHCs) with assets greater than $50 billion have been designated as 

systemically import""t financial institutions (SIFTs). While a SIFT designation does not 

necessarily imply OLA treatment in resolution, market participants are likely to expect that these 

institutions would not be allowed to enter bankruptcy because it seems ill-suited to handle the 

failure of SIFTs (I'elteIiJljlll<i}Yalter 2Ql:L1L14c::1§). The OLA provisions of Dodd-Frank pennit 

the FDIC to pay some creditors more th"" bankruptcy might allow (Pellerin and Walter 20 12. P 

16), and the FDIC's OLA implementing rule suggests that this treatment could apply to shortterm creditors (fDLCJjQI1Ll1Jk.,)uh· ]5, 2illlJLCfR 38Q, p. 41644). Therefore, we include 

short-tenll liabilities ofthe SIFT-designated banking institutions in our most inclusive estimate. 

Uninsured deposits - Historically. lminsured depositors in the largest institutions have been 

protected (Wal!e~L~ntiWcillb~rg, 20()2, p.J8(). Additionally, most uninsured depositors were 

protected during the bank failures tlmt occurred following the financial crisis tI,at began in 2008 

Given these facts. market participants arc likely to expect lminsured depositors at the largest 

4 
23 

banking companies (those with more than $50 billion in assets) to be protected from losses in 

future financial crises. 

[.-east Inclusive F.stimate 

Explicitlv guaranteed liabilities - Drops (compared to Most Inclusive Estimate) liabilities covered 

by TAG and DGP giyen that such deposits and debt lost their FDIC coverage as of Dec. 3 I, 2012. 

In future failures, such programs may not be in place. 

linplicitlv guaranteed liabilities - Drops all liabilities of the four largest banking companies based 

on an assumption tl,at tilese tour BHCs will be handled througli tile OLA process and liability 

holders will suffer losses. Drops short-tenn liabilities of banking companies with assets greater 

than $50 billion, based on an assumption that OLA treatulent may not provide any special 

protection tor such liabilities. Uninsured deposits at banking companies larger than $50 billion 

are dropped under the assumption that the FDIC might not protect such depositors in future bank 

failures. 

Total Uabilities - Includes total liabilities ofBHCs 7 and SLHCs. 8 plus total liabilities of banks and thrifts 

not owned by BHCs or SLHCs,9 plus total liabilities of U.S insured branches offoreign head offices.'n 

Credit Unions 

Explicitly Gllarai1leed Liabilities - Total credit union shares at or below the $250,000 National Credit 

Union Administration coverage 11111i1. II 

Total Uabjfjlie . ." - Total credit union 1iabi1ities.l~ 

ImpliCitly G1Iaranteed Liabilities of: 

Fallllie Mac - Total liabilities, unconsolidated Fallllie Mac mortgage-backed securities hcld by 

third parties and other Fannie Mac guarantees. 13 

Freddie Mac - Total liabilities. non-consolidated Freddie Mac securities and other guarantee 

commitments,l-IFaml Credit System - Total liabilities and Famler Mac guarantees." 

Federal Home Loan Banks - Total liabilities.'" 

Pension Funds 

E'(pficilfy G1Iaranleed Liabifilies - Liabilities of all pension funds insured by tile Pension Benefit 

Guaranty Corporation (PBGC), which insures only defined-benefit plans. were $2,570 billion in 2009, the 

latest d<lte for which d<lm <lre estimated. l7 This figure is infhted by twice the <lvemge annual growth mte 

(because 2009-2011 involyes two years of grow1h) ofPBGC-insured pension liabilities from 1999-2009 

r.iffir)1ongfed.org/safetynet 
24 

to obtain our estimate of all liabilities in pension flmds insured by the PBGC as of Dec. 3 L 2011 ($2.769 

billion). Since the PBGC covers pensions only up to a specified maximum pa)mlent per year, a portion of 

beneficiaries' pensions in guaranteed plans-those with pensions paying above this maximum-are not 

insured. According to the PBGC. this portion is estimated to be 4 percent to 5 percent l' To arrive at the 

guaranteed portion ofPBGC guaranteed pension fund liabilities. we multiplied total 20 II fund liabilities 

($2,769 billion) by 0.95 to yield $2,630 billion 

Total Uabilities - There appears to be no published data estimating tolal liabilities of all private-employer 

defmed-benefit pension funds. Therefore. we develop our own estimate oftotalliabilities based on PBGC 

data. 11,e PBGC insures a portion of private sector single-employer detined-benetit plans. but almost all 

multi-employer plans. l9 The PBGC does not insure certain single-employer plans. importantly those 

offcred by rcligious organizations and professional service employers (for example, those employing 

doctors and lawyers) with fewer than 26 employees [n the following. we reter to this uninsured group 

as Group U. 

In order to calculate the dollar anlOunt of all insured and uninsured pension funds in the United States, we 

inflate the amount of pensions insured by the PBGC (estimated above at $2,769 billion) to account for the 

Group U pensions. As a starting point for our calculation, we use the Bureau of Labor Slatistics' (BLS) 

Quarterly Census of Employment mId Wages to detennine Group U's total wages as a percent oftotal 

private wages in the United States. 11,e BLS provides data on the number of employees who work for 

professional service employers and for religious organizations and their wages. We use these data to 

calculate the proportion of wages eamed bv workers in these sectors relative to all U.s. workers (10 

percent). We then inflate our total liability figure by this proportion. 

To derive our figure for total pension fund liabilities, we divide the single-employer portion of all PBGCguaranteed pensions ($2.029 billion) by 0.9, which is 1 minus the percent of United States wages earned 

by Group U. thereby inflating it to account for the Group U employees. That results in a total of $2,254 

billion in liabilities for single-employer progrmns. We then add d,e multi-employer portion ($740 billion) 

to arrive at $2.994 billion in total liabilities for all insured and uninsured pension fhnds in the 

United States. 2I 

Money Market Mutual Funds 

Implicitly Ciuaranteed Uahilities - Total net assets of money market mutual funds (MMFs)." Included 

because the federal goveflllllent protection that was granted to MMFs in 2008 implies that market 

participants could view MMFs as being likely to receive government protection in future financial crises. 

I£ast Inclusive Fstimate - Walter and Weinberg (2002) and Malvs],""" and Walter (70 I 0) excluded 

MMF balmlces because the principal value of mutual fund investments, including MMF investments. cm1 

decline. without the mutual flmd defaulting, ifthc entity in which d,e funds arc invested defaults. As a 

result. these investments are akin to equity and unlike private liabilities-the focus of our estimateswhich typically must pay back full principal (or else be in default). For example, an investor in an MMF, 

which in tum invested in financial finn connnercial paper. could lose principal ifthe commercial paper 

were not repaid, but the MMF can continue to operate (i.e .. not default). We drop MMF balances in our 

least inclusive table for this reason mld based on the idea that they might not be protected by the 

goyernment in future crises. 

richmondfed.org/safetvnet 
25 

Other Financial Firms 

implicitly Guaral1leed Liabilities - Short-temlliabilities (repurchase agreements, connnercial papee and 

other short-tenn liabilities with original maturities less than or equal to one year) of those non-banking 

financial companies that could be deemed to be S[F[s by the Financial Stability Oversight Council 

(FSOC)-meaning those finns that appear likely to move past FSOC s stage-one designation rule 

analysis announced on April 3, 2012, (See FSOC s final mle, April II, 2012, 12 CFR Part 13 10, p. 

21643.) To move past the stage-one test, the finn must have assets exceeding $50 billion and also exhibit 

at least one ofthe tollO\ving features 

Have more than $30 billion in outstanding credit default swaps: 

Have more than $3.5 billion in derivative liabilities; 

Have more than $20 billion in outstanding loans or bonds: 

Have a leverage ratio (assets to equity) of greater than [5-to-l: 

Have a short-tenn debt-to-total assets ratio of greater than [0 percent. 

Market participants might expect that the short-tennliabilities oflarge financial fin11S that are designated 

as SIFTs would be protected if the finn is resolved under the OLA. 'Wl1ile a SIFI designation does not 

necessarily imply OLA treatment in resolution, market participants are likely to expect that these 

institutions will not be allowed to enter bankruptcy because it seems ill-suited to handle the tailure of 

S[Fls (Pellerin and Walter 2012. p. 14-16). 11,e OLA provisions of Dodd-Frank pennit the FDIC to pay 

some creditors more than bankmptey might allow (Pellerin and Walter 2012, p. 16), and the FDIC's OLA 

implcmenting rule suggests that this treatment could apply to short-term creditors (FDIC final rulc, July 

15,2011,12 CFRPart 380, p. 41644). Theretore, in our most inclusive estimate. we include short-tenn 

liabilities ofthese fimls that may be designated as SIFTs. 

Least Inclusive Estimate - Excludes short-temlliabilities of financial finns that may be designated as 

SIFls, based on the possibility that OLA might not provide any special protection for such liabilities. 

To/al Uahilities - Includes the aggregate amount of liabilities outstanding as of Dec. 3 I, 20 II, from each 

nonbank financial sector as reported in the Board of Governor's Flow of Funds Statistical Release Those 

financial sectors include: 

Property-Casualty Insurance Companies 

Life Insurance Companies 

Issuers of Asset -Backed Securities 

Finance Companies 

Real Estate Investment Trusts 

Security Brokers and Dealers 

Funding Corporations 

r.iffir)1ongfed,org/safetynet 
26 

1 Federal Deposit Insurance Corporation. FDIC Quarterly, 2012, vol. 6, no. 1, pp. 18. "Table III-B: Estimated FDICInsured Deposits by Type of Institution." bbd~w2.fdic.gov/qbp/2911dec/gbp.pdf. 

2 Federal Deposit Insurance Corporation. "Monthly Reports Related to the Temporary Liquidity Guarantee 

Program, Debt Issuance under Guarantee Program." Dec. 31, 20ll. 

http://WIf,,w.fdic.gov/reguliJtion:;/resour~pitotal issuorlce12- Lhtml 

3 Consolidated Statements for Bank Holding Companies (FR Y9C) 

4 Our primary source is corporate annual reports because they report short-term liabilities with original maturities 

of less than one year. FR Y9C uses a broader definition of "other short-term liabilities," one that includes liabilities 

that may have had original maturities greater than one year. When the top tier was a foreign holding company, we 

gathered data on specific short-term liabilities (federal funds, repurchase agreements, and commercial paper, 

almost all of which have original maturities of less than one year) from FR Y9C because FR Y9C contains data only 

on the u.s. subsidiaries, so it excludes liabilities of foreign subsidiaries. To capture as many liabilities as possible 

that would likely fall into the FR Y9C's "other short-term liabilities" category, we then reviewed the call reports to 

find any additional u.S. subsidiary short-term borrowings (e.g. FHLB advances with original maturities of less than 

one year) that the FR Y9C does not separately report. When available, we used average figures. We also added 

"securities loaned" when it was included as a separate line item from repos. 

5 "Deposits held in domestic offices" minus "estimated insured deposits" from the FDIC's report that collects data 

from individual call and thrift financial reports (TFRs) of the insured subsidiaries of a BHC or SLHC. 

6 See, for example: ~!mjl'~·':YY'{:QI.9.Q.m_b.~~g.fO!}l/~~~'!s/3Ql!.-::D~-J.6jQ1J~m~-.~i.d.-t0:.f'}:'~t:-rO_Q-~jE:-tQ:J~j!.::-~}1.Q~~C.~!!-:,0~:, 

J!j3n~~-grR.w.blml; 

ht!Q1L~~LIlY.Q9~9,imiQL!J~w.sIQPjDl~LQQ~ci~Qlli!J1tJ.t;.ill'.1QQJ~lg_Jo f~Lg!.9_\YUVFoc:OFP~AJ..YQ1lgQ3;?iJQ; 

http:// .... vww.reuters.com/artldeI2011/07/12/f!nancial-regu!iltion-rpsearch-id U SN lE76B '1 i 120110712' and 

hURS:/ /www.law.upenn.edufbioP.sireg!.)log/2012/09/11-lipson-orderiy·liquidatiofl-authority.html 

7 From FR Y9C and FR Y9SP 

8 From a memorandum item on the TFRs that provides total liabilities consolidated across the holding company. 

9 Bank data from Consolidated Reports of Condition and Income for a Bank, FFIEC 031 and FFIEC 041, and thrift 

data from TFRs 

10 FFIEC 002 Report of Assets and Liabilities of u.S. Branches and Agencies of Foreign Banks 

11 National Credit Union Administration 2011 Annual Report. Page 76. 

12 Board of Governors of the Federal Reserve System. "Credit Unions, Table L.11S." Federal Reserve Statistical 

Release Z.l, March 8, 2012. "Flow of Funds Accounts of the United States." 

D..n2.lL'!V\Nw.federairese~-:E.9~elea~g~bJfl.Q..l1Q~Q~1P..Qf 

13 Fannie Mae Form 10-K. Dec. 31, 2011. Page 83. 

http://www.sec."ov/Archives!edgar!data/310522/000119312512087297/d282546d10k.htm 

14 Freddie Mac Form lO-K. Dec. 31, 2011. Page 203 and page 209. 

http'! IV\f"'JW sec. pov;' Arch ivest ed 12:3 r I datai102 6214/000102621412000039 If7178 7 e 10vk. htm 

richmondfed.org/sa~net 
27 

15 Federal Farm Credit Banks Funding Corporation. "2011 Annual Information Statement ofthe Farm Credit 

System." Page 3 and page 12, Feb. 29, 2012. 

http://www.f;:lrmcreditfunding.com/furmcrcdit/servt./public/pressre/finin/report.pdf?assetld-199279 

16Federal Home Loan Banks. "2011 Combined Financial Report." Page F-4, March 29, 2012. h!tpjL~_'!-L\~.r"fbj.Q:::. 

ofcol!!1~fYi~h!..ser~~.Qll..rf§ill_lyrend.!2Qf 

17 Pension Benefit Guaranty Corporation. 2010 Pension Insurance Data Tables. "Table S-44: Funding of PBGCInsured Plans (1980-2009) Single-Employer Program" and "Table M-9: Funding of PBGC-Insured Plans (1980-2009) 

M u Itiem ployer Progra m." http://www . pbgc. gmt IDocu ments/pens iOrl- i nsu r<l nC8-data-ta bles-2010. pdf 

18 Pension Benefit Guaranty Corporation. Pension Insurance Data Book 2006. Page 20, footnote 11 

.b.!ill.1L~~Jl.~?,,~Q.gs.l.Lf!l~~I.:.t~Q..o6databqQ.lu?Qi. And, 

Pension Benefit Guaranty Corporation. Pension Insurance Data Book 1996. Footnote to Table 8-5 

.b.!!P~V'J\Nw.pbgc~Q.ld.0..9_cument:&fJ 996databookD.fli 

19 Pension Benefit Guaranty Corporation. Pension Insurance Data Book 2008. Page 5. 

http://www.pbgc.gov/doC5/2008databook pdf 

ZO Note that our estimate could slightly overstate or understate the amount of total liabilities from private pension 

funds because the PBGC does not insure pensions provided by employers in these sectors with fewer than l§ 

emplovees while the BLS's closest comparable category breakdown is fewer than 20 employees. 

21 Bureau of Labor Statistics. "Quarterly Census of Employment and Wages." Annual and quarterly data from 201l. 

http://www.bis.gov!cew/ 

22 Investment Company Institute. 2012 Investment Company Fact Book. Page 170. "Table 37: Total Net Assets and 

Number of Shareholder Accounts of Money Market Funds by Type of Fund." 

htw:l/www.ici.org/pdf/2012 factbook.Ddf 

r.iffir)1ongfed.org/safetynet 
28 

Economic Quarterly-Volume 98, Number i-First Quarter 2012-Pages i-31 

Orderly Liquidation 

Authority as an Alternative 

to Bankruptcy 

Sabrina R Pellerin and John R. Walter 

W hen a large nonbank financial firm becomes troubled and in danger 

of default, government policymakers traditionally have had two 

options: they could 1) allow the firm to enter hankruptcy, or 2) if 

policymakers believed bankruptcy is likely to produce widespread (systemwide or "syslernic") financial dilIicullies, lhe governrnenl could provide aid 

(i.e., a bailout) to forestall failure. In 2010, a third option was made available 

by the Orderly Liquidation Authority (aLA) provisions, contained in the Wall 

Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). This 

legislation authorizes the I'ederal Deposit Insurance Corporation (I'DIC) to 

pursue an agency-administered wind down for certain troubled financial firms. 

The aLA provisions are modeled, in part, after the process long followed by 

the FDIC for handling troubled banks. 

The aLA provisions are a reaction to policymakers' and legislators' dissatisfaction with the two options previously availahle for handling failing 

nonbanks. For example, Ben Bernanke, chairman of the Board of Governors 

of lhe Federal Reserve SysLern, argued, in 2009 lesLimony before lhe House 

Committee on Financial Services, that bankruptcy was not an effective option 

for certain failing financial firms (Bernanke 2009): 

In most cases, the federal hankruptcy laws provide an appropriate 

framework for the resolution of nonbank financial institutions. However. 

the bankruptcy code does not sufficiently protect the public's strong 

interest in ensuring the orderly resolution of a nonbank financial firm 

- The authors would like to thank Kartik Athreya, Keith Goodwin, Michelle Gluck, Trish 

Nunley, Jonathan 'tompkins, Zhu Wang, and John Wemberg for their insightful comments. 

The views expressed in this arLide are lhose of the authurs and do nol necessarily reflect 

those of the Federal Reserve Bank of Richmond or the Federal Reserve System, E-mails: 

sabrina. pellerin @rich.frb.org; john.walter@rich.frb.org. 
29 

2 Federal Reserve Bank of Richmond Economic Quarterly 

whose failure would pose substantial risks to the financial system and 

to the economy. Indeed, after Lehman Brothers and AIG's experiences, 

there is little doubt that we need a third option between the choices of 

bankruptcy and bailout for such firms. 

In a 2010 speech, Chairman llernanke expanded on his testimony and 

noted two goals for this "third option," or "orderly resolution" authority 

(Bernanke 2010): 

The government instead must have the tools to resolve a failing firm in 

a manner that preserves market discipline-by ensuring that shareholders 

and creditors incur losses and that culpable managers are replaced-while 

at the same time cushioning the broader financial system from the possibly 

destabilizing effects of the firm's collapse. 

LegislaLors focused on these two goals in the language of the Dodd-Frank 

Act itself when explaining the purposes of the OLA provisions (or the OLA 

"title"): 

It is the purpose of this title to provide the necessary authority to 

liquidaLe failing financial companies illaL pose a significanL risk Lo Lhe 

financial stability of the United States in a manner that mitigates such 

risk and minimizes moral hazard. 

In this article we review the features of bankruptcy and the OLA. We 

identify some problem areas when large nonbank financial finn failures are 

resolved through bankruptcy. We then describe two important features of 

the OLA that are meant to improve on bankruptcy as a means of handling 

these types of failures, and discuss how they attempt to achieve the goals of 

mitigating risk to financial stability while also minimizing moral hazardgoals that are not easily achieved simultaneously. 

1. FAILURE RESOLUTION 

Goals of any Failure Resolution Regime 

Any resolution regime, whether bankruptcy, bailout, or OLA, must address 

two fundamental problems that arise when a firm faces financial troubles and 

becomes unable to repay creditors. These three regimes each take ditTerent 

approaches to solving these problems, and these differing approaches are at 

the core of each regime. The first problem (detailed below) is preserving "asset complementaritics" and "going-concern value" in the face of detrimental 

creditor incentives to rush in and grab the firm's assets immediately upon a 

firm's default. Resolution methods must take these incentives into account and 

prevent the detrimental actions. The second problem is determining whether 

to "liquidate" or "reorganize" the troubled finn. Beyond addressing these two 
30 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 3 

problems, an additional concern arises when the troubled firm is a large financial finn or one with many inlerconneclions wilh olher financial finns: Whal 

so called systemic eJlecis might the liquidation or reorganization have'? Will 

there be a significant negative effect on other financial firms or on the macro 

economy in response to actions taken to resolve the troubled firm? As noted 

in the introduction, policymakers are likely to have a strong interest in any 

systemic effects when deciding on the appropriate resolution method. 

Preserving Complementarities and Going-Concern Value 

Following a firm's default on a debt, creditors are likely to rush to seize, and 

separately sell, assets that, if sold together with other assets, could produce 

a higher sale price (assets that are "complementary"). For example, one can 

imagine that with numerous creditors vying for a manufacturer's assets, individual components of an assemhly line might he sold off separately, when, if 

sold as a complete assembly line, these components would be of greater value 

and produce a higher price. Therefore, lhis incenlive can reduce lhe lolal 

amount that creditors, as a group, receive and can also undercut productivity 

and economic efficiency. Creditors who manage to be the first to seize assets 

are likely to recover a higher proportion of their debts than creditors who are 

slower to react. As a result, creditors have a strong individual incentive to 

move quickly to undertake such seizures. Preserving complementarities can 

be important whether the firm is liquidated or is preserved via a reorganization 

process. 

If creditors are allowed to rush in and seize assets, they are also likely 

to grab those assets that are fundamental to the firm's continued operations, 

so called "going-concern assets." Such assets might include, for example, 

necessary operating equipment for a manufacturing firm. or buildings for a 

financial firm. For a firm that is going to be closed and liquidated, protecting 

going-concern assets is unimportant, but for finns that might be successful if 

reorganized, creditors will be made better off, as a group, if their removal is 

prevented. Indeed, if creditors are allowed to seize going-concern assets, a 

troubled firm that might otherwise become quite productive in reorganization 

could be doomed to fail by the asset seizures. 

In hankruptcy, the automatic stay (discussed in detail helow) prevents 

immediate asset seizures, and creates a court -overseen process for allocating 
31 

4 Federal Reserve Bank of Richmond Economic Quarterly 

assets in a way that preserves complementarities and going-concern value.!' 2 

The OLA process also involves a sLay, buL granLs Lhe FDIC Lilis preservaLion 

role. Bailouts, by (typically) preventing the troubled finn's default on debts, 

remove the ability of creditors to seize the troubled firm's assets. 3 

Determining Whether to Liquidate or Reorganize 

Whcn a firm bccomcs unable to meets its debt payments, one of two outcomes 

are possible. First, as already mentioned, the firm might be closed and its 

assets liquidated. Alternatively, if the firm can be returned to profitability 

by restructuring (typically reducing) its debts, then, in many cases, it should 

be reorganized, allowing iL Lo conLinue operaLing aIler a debL resLrucLuring 

process. If the finn is unlikely to return to profitability, even with a lowered 

debt burden, because the firm's assets are unlikely to produce a market rate of 

return, then the firm should be liquidated: The firm should be shut down and 

its assets sold to the highest bidders. In this case, liquidation will distribute 

assets to firms that can make more productive use of them, enhancing economic 

1 According to Houl (2006): "TradItionally, the automatic stay has served to 'prevent dismembermenl of Lhe [bankrupLcy] esLaLe ami insure iLs orderly wsLribuLion.' SEC v. Firsl Financial 

Group, 645 F.2d 429, 439 (5th Cir.l98!), citing S. Rep. 1\0. 95-989, 95th Cong., 2d Sess. 50 

(1978); H.R.Rep. 1\0. 95-595, 95th Cong., 2d Sess. 341 (1977), U.S.Code Congo & Admin. 

News 1978, pp. 5787, 5836, 5963, 6297, 6298. In that capacity, the automatic stay serves the 

interests of both the debtor and the creditors of the bankruptcy estate. For the debtor, it provides 

a 'brealhing spell' by 'sLopping all colleclion efforLs, all harassmenL, and all foreclosure aclions.' 

S. Rep. No 95-989, 95th Cong., 2d Sess. 54-55 (1978); H.R. Rep. No 95-595, 95th Cong., 1st 

Sess. 340 (1977), U.S.Code Congo & Admin. News 1978, pp. 5787. 5840, 5841, 5963, 6296, 

6297. However, the stay also serves the interest of creditors, insofar as it 'eliminate[s] the impetus 

for a race of diligence by fast-acting credItors.' SlOe V. flrst flnancial Group, at 43'1. 'lhe stay 

ensures LhaL a.sseLs are wsLribuled according Lo Lhe order of priori Lies esLablished by Congress. Id. 

at 341." 

2 Note that if the troubled firm had only one creditor, there would be no need for bankruptcy 

sInce that one creditor would always take actions that JUaxlm..ize cOInplelnelltallties and goingconcern value. Only in the case where there are many creditors, who, because of their large 

numher, cannot easily coordinate with one another, is hankruptcy necessary. 

3 One Inight inmgine dlat an ideal solution-when a finn has suffered losses such that its 

capital level is low and default seems likely, but it could be profitable with a lower debt loadone that requires no intervention by bankruptcy courts or government agencies, is for the firm to 

gather new funding by issuing new equity shares. The new funding could be used to purchase 

new, profitable assets that will increase revenues available to service debt Oowering the ratio of 

deht to assets) and reduce significantly the chance of default. This course may he impossihle, 

however. because of the so-called "debt overhang problem' and, as a result, bankruptcy and the 

reorganization of debt may be the only course available. Because of the overhang problem. existing 

eljuiLyholders will noL voLe in favor of a new eljuiLy issuance. They will noL do so, aL leasL in 

many cases, because most or all of the benefit flows to the debtholders by improving the market 

value of their deht, and the existing equityholders will suffer dilution because future earnings must 

be shared with the new equityholders (Duffie 2011, 43-4). The likelihood that new issues of equity 

might offer a solution is further reduced by an "adverse selection problem." Weak firms Issuing 

new equity, and especially those finns whose assets are opaque, i.e., financial finns, will have to 

offer to sell shares at a very low price, because equity investors are likely to conclude, based on 

the fact that the firm wishes to issue new shares, that the finn is in exceptionally poor health 

(even worse health than it really is). As a result, existing shareholders will suffer a great deal of 

dilution and vote against new issues. 
32 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 5 

productivity and efficiency. Any resolution regime is faced with a decision 

beLween liquid aLi on and resolution, and, ideally, will choose the one that 

produces the most economically efficient outcome. 

Addressing Systemic Risk4 and Moral Hazard 

When faced with the failure of a large financial firm, or one with many connections with other financial firms, government decisionmakers will not only 

wish to ensure that eomplementarities and any going-concern value are preserved, and that the choice between liquidation or reorganization is optimally 

made, but they will also care greatly about systemic effects. Simply bailing 

out the troubled finn will prevent its failure, preserve compiementariLies and 

going-concern value, as well as avoid systemic effects. But any bailouts will 

create a "moral hazard" problem: the view, among investors, that large financial firms are likely to be protected, such that in the future, creditors of such 

firms will reduce their risk-monitoring efforts and these firms will be willing to 

undertake an inefficiently large amount of risk-taking. Therefore, any method 

employed to resolve a large or interconnected financial firm must balance systemic dangers against the danger of excessive risk-taking. Bailouts prevent 

current systemic problems but are likely to lead to less efficient resource allocation choices in the future. Relying on bankruptcy can avoid future moral 

hazard because, as discussed later, bankruptcy provides no source of funds 

for bailouts, but the bankruptcy of a large financial finn carries the risk of 

heavy current systemic problems. As such, when Congress crafted the OLA, 

addressing systemic risk was a priority, but so was resolving firms in a manner 

that does not simultaneously increase moral hazard. The OLA aims to address 

systemic risks that may otherwise be present when resolving systemically important financial institutions (SIFIs) through bankruptcy, in part, by 1) giving 

the FDIC broad discretion in how it funds the resolution process and pays 

out creditors, as well as by 2) changing the way derivatives and repurchase 

agreements (repos)-known as qualified financial contracts ("QFCs")-are 

treated. 

Overview of Bankruptcy and OLA 

When comparing bankruptcy and OLA, understanding their overarching goals 

is important. The goal of a bankruptcy proceeding is to maximize recoveries 

for creditors, through liquidation or the rehabilitation of the debtor. The goal 

of the OLA, on the other hand, is to resolve "failing financial companies that 

4 There is no clear consenslIs about the definition of "systemic risk" (See Taylor 2010). For 

purposes of this article, we will define systemic risk as "the risk that the failure of one large 

institution would cause other institutions to fail or that a market event could broadly affect the 

financial syslem ralher lhan JUSl one or a few inslilulions" (Governmenl Accounlabilily Office 2011). 
33 

6 Federal Reserve Bank of Richmond Economic Quarterly 

pose a significant risk to the financial stability of the U.S. in a manner that 

miligales such risk and minimizes moral hazard." 

Bankruptcy achieves its goals through a court-overseen process that relies 

largely on the troubled firm's creditors and other investors to decide how best, 

and most profitably, to resolve the firm's troubles. Funding for a bankruptcy 

resolution typically comes only from the assets of the troubled company and 

from any funds that might be provided by private investors. See Table 1 for 

an outline of the bankruptcy process. 

OLA borrows several important ideas from bankruptcy, but moves beyond 

bankruptcy because of policymakers' dissatisfaction with possible outcomes 

under bankruptcy. The OLA attempts to capture the firms whose resolution through bankruptcy could be detrimental to the broader financial system. 

Therefore, lhe OLA can be dilTerenlialed from bankrupLcy based on several 

notable features tllat are designed specifically witll SIFt or covered financial 

company (CFC), resolution in mind. See Table 2 for a review of OLA's main 

features. 

During the 2007 -2008 financial crisis, an unwillingness to trust large finn 

failures to bankruptcy often resulted in government assistance to firms popularly described as "too big to fail," such as Bear Stearns and AIG. Yet the grant 

of government assistance sent strong signals to the market that other, simi1ar firms would receive assistance as well if they were to experience trouble, 

thereby expanding credit subsidies for certain firms and moral hazard. For 

example, bond prices for the largest financial institutions remained relatively 

high during the crisis and prices for Lehman credit default swaps (CDS) may 

not have accurately reflected default risk (Skeel 2010). In contrast, allowing 

Lehman to fail can be seen as an attempt to mitigate moral hazard; however, 

some argue this was done at the cost of creating systemic risk.s These objectives are inextricably linked, and focusing on the reduction of one has the likely 

result of increasing the other. Therefore, the OLA, which charges the FDIC 

with administering these provisions, was an attempt to address this conflict. 

How does the FDIC meet this challenge? 

5 The apparenl worserring of the 2008 financial crisis following Lehman's enlrance inlo 

bankruptcy provides, for many observers, an illustrative example of the deleterious effect of resolution hy hankruptcy for large financial firms. Yet there is some dehate ahout the conclusions 

one should draw from the Lehman experience. Some observers maintain that the cascading losses 

following Lchman's bankruptcy filing wcrc not a result of troublcs or anticipatcd troublcs relatcd 

to dle bankruptcy process itself, but were instead the result of a shock to market expectations and 

therefore to the risk assessments of those who had previously anticipated that Lehman, and firms 

like l.ehman, would certainly he hailed out (see Testimony from Skeel hefore the Suhcommittee on 

Commercial and Administrative Law, Committee on the Judiciary, U.S. House of Reps., October 

22, 2009). Available at http://judiciary.housc.govlhcarings/pdf/Skeel09!022.pdf. 
Table 1 Corporate Bankruptcy 

Types of Bankruptcy 

Chapter 7 Chapler 11 

Chapter 7 bankruptcy (liquidation), the troubled firm is closed down, with the longer-run 

outcome being the sale of all the company's assets (liquidation) because creditors or 

management do not believe it can be successfully reorganized, 

Assets of the troubled firm are assembled by the bankruptcy trustee and then sold in a 

manner that maximizes the sum of the payouts to the creditors. 

The trustee typically must sell all of the bankrupt firm before distributing funds to 

creditors [11 U.S.c. 704(a)I]. 

Under Chapter 11 bankruplcy (reorganizalion), the lroubled firm's debls are reorganized: debl 

maturilles are lengthened, or interest rates or principal amounts are reduced. 

Creditors will only agree to a reorganization if they believe that preserving the firm as a 

going concern will produce larger payments than if the firm is liquidated. 

Corporate Bankruptcies are Overseen by Federal Courts 

The operating arm of the bankruptcy cowts is the Justice Department's Trustee program, so 

that most bankruptcies are largely handled by trustees. 

Circumstances Under which a Firm Enters Bankruptcy 

Voluntary Bankruptcy When a firm's management petitions the court to place the firm in bankruptcy because it is unable 

to pay all its creditors in full. A firm will file for bankruptcy when unpaid creditors will otherwise 

selze complnnentary or going-concern assets. 

Involuntary Bankruptcy When a firm's creditors petition for bankruptcy. Creditors havc inccntivc to seck a firm's 

bankruptcy when they believe that other creditors might seize complementary or going-concern 

assels or lhal the firm mighl dissipale assels. 
Table 1 (Continued) Corporate Bankruptcy 

Automatic Stay 

Immediately, upon the filing of a bankruptcy petition with the clerk of the bankruptcy court, 

creditors' are prohibited ("stayed") from attempting to collect on their claims. 

TIle stay allows a government-appointed trnstee to ensure that assets of the bankrupt finn are 

liquidated in a manner that maximizes the total pool of funds available for creditor repayment. 

As a result. the stay allows the trustee to produce a better result for creditors in aggregate than 

if creditors were simply acting in their own self interest. The trustee can be thought of as 

solving a joint action problem. Similarly. the stay is also the means in bankruptcy by which creditors 

are prevented from seizing going-concern assets. 

Qnalificd financial contract (QFC) holdcrs arc typically exempt from the antomatic stay: They can 

retrieve their collateral in the event of bankruptcy. 

Under bankruplcy law a number of financial inslrumenls are QFCs, induding repurchase agreemenls 

(repos), commodity contracts. forward contracts. swap agreements, and securities contracts. 

Reasons for the QFCs exemption: 

Observers worry that preventing QFC holders from retrieving their collateral could create 

systemic financial problems. 

Some observers believe that QFCs are not complementary with one another or with other assets, 

and can be removed wlthout undercutting the tl'Oubled firm's going-concern value. 
Priority Rules 

In Liquidation 

In Reorganization 

Payouts coming from asset sales are divided among creditors based upon the creditor's location in 

the priority order, which is established in the Bankruptcy Code. 

Secured creditors ate repaid from the assets that secure their debts prior to payments to 

unsecured creditors. 

A secured creditor wrll be fully repaid rf the value of Ius secunty exceeds the aruount he is owed. 

If not. he joins unsecured creditors and must depend on the sale of other assets for repayment. 

Unsecured claimants ate paid based on the following priority list (White 1998, 1): 

FirsL Lo be repaid are Lhose owed any adminisLraLive expenses produced by the bankrupLcy 

process. 

Second. claims are given statutory priority, such as taxes owed, rent, and unpaid wages and henefits. 

Third ate unsecured creditors' claims. including trade creditors' claims. long-term bondholders, and 

holders of daruage claims against the bankrupt firm. 

Last, equityholders receive any remaining funds. 

Payments to creditors and equityholders will often differ from those that would arise based simply on 

priority rules, because reorganization payments typically arise from negotiation between creditors and 

equity holders (White 1998, 8). 

ReorganiLaLion negoLiaLions are driven by Lwo rules: 1) each class of crediLors and equiLyholders musL 

consent to the bankruptcy plan adopted in the negotiation. and 2) rf the negotiation produces no plan 

that is acceptahle to all classes, then the firm is liquidated and payments are determined hy the priority 

rules listed above. 

Because of the mutual consent requirement. some classes can be expected to receive more than would 

be expected if the priorities rules were strictly followed. For example, if assets are insutficient to repay 

all creditors, abiding by the pnority rule would mean equityholders could expect to receive nothing. 

But creditors are likely to allow equityholders to receive payments in exchange for the investors' 

agreement to a plan that allows reorganization rather than liquidation, because the reorganization 

preserves some going-concem value for all classes. In other words, an equityholder agreement is 

achieved by paymg them more than they would get if they held up the plan. 

Debtor-in-Possesion (DIP) Loans 

Loans made to a firm in reorganization, post-bankruptcy filing. 

Such loans are often senior to all pre-bankruptcy debts. 
37 

10 Federal Reserve Bank of Richmond Economic Quarterly 

When the FDIC is appointed as the receiver of a failing financial firm 

designated as a CFC, it assumes complete financial and operational conLrol 

of the institution. The FDIC has the authority to manage, sell, transfer, or 

merge all the assets of the failing firm, as well as provide the funds needed 

for an orderly liquidation, giving it broad discretion.6 The FDIC's guiding 

principles in carrying out these responsibilities include using its best efforts 

to maximize returns, minimize losses, and, unique to this regime, mitigate 

the potential for serious adverse etTects to the financial system and minimizc 

moral hazard.7 Moreover, the language of the OLA forces the FD IC to balance 

two competing interests. On one hand, it is to pay creditors no more than what 

they would receive in hankruptcyS and ensure that creditors hear losses in order 

to promote market discipline. On the other hand, it is to minimize adverse 

e1Tects on financial sLability. In bankruptcy, creditors only inject additional 

funds when the finn seems viable. The FDIC, on the other hand, may find it 

necessary to prop up a firm or perhaps protect certain creditors, at least for 

a time, to prevent any potential systemic consequences even though the firm 

may not be viable. The Dodd-Prank Act granted the PDIC a line of credit from 

the Treasury to fund these efforts. Because the FDIC has broad discretion over 

the way in which it balances these competing objectives, market participants 

may find it difficult to predict which objective might receive more weight in 

any given failure. 

2. KEY FEATURES OF BANKRUPTCY, ITS WEAKNESSES, 

AND OLA AS AN ALTERNATIVE 

In the United States, the failure of a business firm typically results in that 

firm entering bankruptcy, and actions taken by the firm shift from being determined by management to being guided by rules established under federal 

law, specifically under the U.S. Bankruptcy Code. What arc the core features 

of bankruptcy? What features lead observers to conclude that bankruptcy is 

not an appropriate way to handle a STFT whose failure could pose substantial 

risk to the financial system? What are the alternative resolution arrangements 

created by Dodd-Frank's OLA provisions? 

6 The OLA gives the FDIC authonty to operate the company "with all of the powers of 

lhe company's shareholders, directors and officers. and may conducl all aspects of the company's 

business." Dodd-Frank Act § 21O(a)(l)(B). 

7 Dodd-Frank Act § 204(a) and § 210(a)(9)(E). 

8 Dodd-Prank Act § 21O(d)(2). Under § 210(d)(4)(A) additional payments (in excess of what 

would be received in bankruptcy) are authorized only with approval of the Treasury Secretary and 

only if determined to be necessary or appropriate to minimize losses to the receiver. 
Table2 OLA 

Who Qualifies as a "Covel'ed Financial Company" (CFC)? 

A "financial company" whose failure would have serious adverse effects on financial stability. 

Process for Designating a Firm as a CFC 

I. Recommendation by Federal Reserve and either FDIC, Securities and Exchange Commission, or Federal Insurance Office, 

based on their findings that the following is true for the financial company: 

- It is in default or in danger of default 

- A rcsolution undcr the Bankruptcy Code would producc serious advcrsc conscqucnccs 

There is no viable private-sector alternative 

2. Delerminalion made by the TreasUTY Secrelary in consullalion wilh the Presidenl 

3. Appointment of FDIC as receiver of CFC 

The FDIC's Powers and Duties 

- They can 1) sell the CFC, or any portion of the assets or liabilities to a third party; 2) establish a temporary bridge financial 

company to preserve the company's value prior to being sold to a third party; or 3) liquidate the company. 

- Use their best efforts to maximize retmns, minimize losses, and mitigate the potential for serious adverse effects to the 

financial system. - Must cnsme unsecmcd creditors bcar losscs and ensurc the directors and management team responsible for the company's 

condition are removed. 

- Has aUlhorily lo make addilional paymenls lo cerlain credilors (over whal lheir priorily would demand and possibly more 

than similarly situated creditors) if determined to maximize value or limit losses (excess may be "clawed back"), see below. 

FDIC's Access to Funding 

- Treasury: FDIC may immediately borrow funds from the Treasury (up to 10 percent of the CFC's pre-resolution 

book-value assets within first 30 days; 90 percent once fair-value is determined and liquidation and repayment 

plan is in place and approved by Treasury) 

If funds from disposllion of failed firm's assets are insufficient to repay Treasury: 

Creditors (who were paid more than they would in bankruptcy) would have to return excess funds ("claw backs") 

- Large financial institutions can be assessed 

Notes: "Financial Company" includes bank holding companies, nonbank financlal firms, and secmities broker-dealers. Nonbank 

financial firms are characterized as firms that are supervised hy the Fed (because of STFT designation) or that derive at least 

85 percent of their revenues from activities that are financial in nature. 
39 

12 Federal Reserve Bank of Richmond Economic Quarterly 

Key Bankruptcy Feature: The Automatic Stay 

The "automatic stay" is a primary component of bankruptcy and one that 

underlies many of the complaints raised against hankruptcy as a means of 

handling SIFI failures. The stay works as follows. Immediately upon the 

filing of a bankrupLcy peLiLion wilh Lhe clerk of lhe bankrupLcy courL, crediLors 

are enjoined from attempting to collect on their claims.9 '111is feature of 

bankruptcy allows a government-appointed trustee to ensure that assets of 

the bankrupt firm are liquidated in a manner that maximizes the total pool of 

funds available for creditor repayment. Without the stay, as discussed earlier, 

creditors can be expected to rush in, grab, and then sell the bankrupt firm's 

assets. In so doing, creditors could destroy asset complementarities. The stay 

typically lasts for the length of the bankruptcy process, though the courts may 

grant exceptions. 

In a Chapter 7 hankruptcy (liquidation), 10 the type of corporate hankruptcy 

in which the troubled firm is closed down (liquidated), the court-appointed 

LrusLee Lypically musL sell all of Lhe asseLs of Lhe bankrupL Linn before distributing funds to creditors. 11 The goal of the trustee is to sell the assets in 

a manner that maximizes the sum of payouts to creditors. Achieving this 

maximization goal can result in a lengthy process, so that creditors' funds 

may be inaccessible for an extended period. Based on a study of all corporate bankruptcies from two federal bankruptcy court districts between 1995 

and 2001, the average liquidation lasts 709 days (Bris, Welch, and Zhu 2006; 

1,270). It seems likely that for the largest, most complex financial firms the 

process will take at least as long as average or perhaps longer. 

Compared to liquidation, a corporate Chapter 11 bankruptcy (reorganizaLion) process Lends La lasL longer still, 828 days on average according Lo 

Bris, Welch, and LIm (2006), though in reorganization creditors will often be 

repaid well before this process ends. In reorganization, the troubled firm's 

debts are rescheduled or cut-but it continues to operate. 12 A corporation 

that finds itself unable to repay all creditors in full can seek protection from 

creditors' claims by petitioning the bankruptcy court to enter reorganization. 

This protection from creditors, which includes a stay of claims, is important 

when a firm is being reorganized because the stay prevents creditors from seizing "going-concern" assets (assets that might he necessary to keep the firm 

running). The stay can mean that, in aggregate, creditors receive more than 

9 11 U.S.c. § 362 

10 In the remainder of the article, for the sake of simplicity, we will typically replace the 

phrase Chapter 7 hankruptcy with "liquidation" and the phra.se Chapter 11 hankmptcy with "reorganization," We will use the phrase "orderly liquidation" or the acronym OLA when referring to 

a Dodd-Frank Orderly Liquidation Authority process. 

11 11 U.S.C. 704(a)! 

12 TIle airline industry provides 111any well-known exanlples of reorganization, in which plane.s 

continue to fly and contracts are renegotiated with creditors and employees. 
40 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 13 

they would if individual creditors had been allowed to seize assets to protect 

themselves. Because crediLors must agree to the Lroubled finn's proposed reorganization plan-if not, the finn is likely to proceed to a liquidation-firms 

receiving reorganization treatment are those for which creditors, as a group, 

believe going -concern value exceeds the value of firm assets if such assets are 

sold, i.e., if the firm is liquidated (White 1998, 2-3). 

While reorganization can last longer than liquidation, payouts to creditors 

will often be made well before the end of the reorganization process. As part 

of the reorganization, creditors may agree to lower repayments and some may 

receive these repayments quickly. Further, additional funding can flow into 

the trouhled firm fairly quickly to help keep it afloat. 

A source of funding often available to a firm in reorganization is "debtorin-possession" (DIP) funding. In reorganization, Lhe troubled corporation, the 

debtor, continues to operate, or "possess," the troubled entity. Any loans to 

the troubled corporation are therefore loans to the DIP. Such loans are often 

senior to all former-prior to the bankruptcy filing-debts of the bankrupt 

firm. The prospect of being senior to other creditors allows funding to flow 

as long as creditors can be convinced that the firm is likely to survive and 

therefore repay. 

Key Bankruptcy Feature: Limited Sources 

of Funding 

Repayment of a bankrupt firm's creditors and funds to sustain a firm reorganized under bankruptcy can only derive from two sources: the assets of 

the troubled firm, and, in the case of reorganization, added (DIP) loans that 

might flow to the trouhled firm. While hankruptcy law and practice do not 

prohibit government aid to troubled firms, such funding is not typically available. As a resull, creditors have an incenti ve to carefully evaluate Lhe riskiness 

of any firm prior to providing funding and to monitor its activities once funding has been provided. Such monitoring will tend to ensure that the finn 

undertakes only those risks with a positive expected retum. Yet, the government has often provided aid to troubled firms because of the sluggishness 

with which creditors are often repaid following failure and because of thc 

apparent difficulty of lining up DIP funding. In some cases this aid has been 

provided prior to bankruptcy, in others during bankruptcy.13 Therefore, the 

13 Bear Stearns and !\IG provide examples of financial firms that received government aid 

prior to hankruptcy. Tn 2009, hoth General Motors and Chrysler received aid from the federal 

government during their reorganizations. Earlier cases of government aid include Penn Central 

Railroad in 1970, Lockheed Aircraft in 1971, and Chrysler in 1980. 
41 

14 Federal Reserve Bank of Richmond Economic Quarterly 

monitoring advantage offered by bankruptcy can be diminished by the expecLaLion of governrnenL aid for cerLain (especially large) financial firrns.14 

There is no DIP financing in a liquidation. In liquidation, a "bankruptcy 

estate" is created, including all of the assets of the bankrupt firm. One of the 

responsibilities of the trustee is to locate all assets and gather them into the 

estate. The estate assets are sold by the bankruptcy trustee and the proceeds 

of the sale provide the funds from which creditors are repaid. Funds from 

no source beyond the assets of the failed firm are available to the trustee and 

therefore to the creditors. 

Tn a reorganization proceeding, debts are restructured in a manner sueh 

that the firm can continue operating. For example, the creditors of a firm might 

come together and all agree to reduce the amounts the bankrupt firm owes each 

of Lhern by 30 percenL, and ex Lend Lhe rnaLuriLy of all debLs by Lwo years. As 

a result, the bankrupt finn faces lower monthly debt payments, payments that 

it might successfully manage. The creditors will only agree to such a plan if 

they believe that sustaining the operations of the firm is likely to mean larger 

payments than if the firm descends into liquidation. The debt restructuring 

and the mode of future operation is called the "reorganization plan" and is 

subject to court review and creditor appeal to the bankruptcy court. Typically 

the current management of the troubled firm operates the reorganized firm. If 

the firm's liabilities exceed its assets, owners are wiped out and the creditors 

inherit the decisionmaking rights formerly enjoyed by owners. The debtor can 

acquire funding for the reorganized firm because it can otTer very favorable 

terms to the lenders who provide DIP funding because the new lenders have a 

claim that is senior to all other creditors. Thus, lenders will have an incentive 

to provide DIP funding if they believe that the reorganized firm is likely to be 

able to repay their loans from future earnings-that the reorganized firm will 

be profitable. 

Weaknesses of Bankruptcy 

A Weakness of Bankruptcy for Financial Firms: The Stay 

Threatens Short-Term Debtholders 

While the automatic stay, in liquidation or reorganization, may cause no 

spread of losses when the creditors of the troubled firm are typically longterm debtholders (who are not counting on quick receipt of their funds), in the 

14 One might argue that there could be times in which government aid is appropriate, for 

example if credit standards have becOlue inefficiently (or lllationally) strict, as in a financial panic. 

If market participants believe that government aid will only be forthcoming at such times. and will 

only provide the amount of funding that private lenders would provide if they had not hecome 

irrationally strict, then the expectation of government aid will not diminish private investors' riskmonitoring efforts. 
42 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 15 

case of a failing financial firm, creditors are likely to include a large contingent 

of those wilh very shorL-lerrn claims. Funds invested in financial firms (such 

as investment banks) often have maturities of one or a few days. Creditors 

with such short maturity claims are likely to be dependent on the immediate 

access to their funds in order to pay their own creditors. If funds are tied up for 

an extended period, as assets are gathered and sold in a liquidation process or 

as a reorganization agreement is negotiated, the bankrupt firm's creditors may 

find themselves unable to make payments to their own creditors. As a result, 

the bankruptcy of one firm may result in the failure of some of its creditors, 

especially if some of these creditors are also financial firms with their own 

very short-term debts to repay. Therefore, while the automatic stay may have 

significant value in preventing creditors from separating complementary assets in liquidation and preserving going-concern value in reorganization, the 

stay, if it continues more than a very short time, may cause financial distress to 

spread. The importance of short-term funding, which is often present for nonbank financial firms, may make policymakers unwilling to rely on bankruptcy 

when such firms become troubled. 

A Weakness of Bankruptcy for Financial Firms: Opacity 

Reduces Availability of DIP Financing 

New funding, quickly available, will often be necessary in order for a troubled 

firm to be successfully reorganized. After all, funds from former sources may 

have dried up because of the losses these creditors suffered on former loans 

to the troubled firm. But, financial firms may find it to be relatively difficult, 

compared to nonfinancial firms, to quickly obtain DIP funding. Such firms 

often have quite opaque assets: assets that are difficult for outsiders, such as 

lenders, Lo value. For example, asseLs of financial firms oHen include a heavy 

concentration of loans to other firms. The value of such loans may depend 

importantly on information that can be gathered only by performing detailed 

analyses of the financial condition of the borrowing firms. 15 As a result, DIP 

loans may be available only after lenders spend a great deal of time reviewing 

the troubled firm's assets. Further, DIP loans made to financial firms are likely 

to involve unusually high interest rates to compensate for time spent in asset 

review and for the potential risk oflending to a firm with highly opaque assets. 

IS Using statistical analysis to measure firm opacity. by comparing the frequency of bond 

rating disagreements, Morgan (2002, R7fl) finds that hanks and insurance firms are the most opaque 

of major industry groups. Large nonbank SIFIs are likely to have a portfolio of assets that are 

fairly similar to bank assct portfolios so can bc cxpcctcd to bc similarly opaque. Intercstingly, 

1\1organ notes that the industry grouping aOther Finance and Real Estate" seeIllS to be 3IllOUg the 

least opaque. though. according to Morgan. this is likely because the securities being analyzed for 

this group are "asset-hacked honds hacked hy a pool of specific, homogeneous assets 'locked' up 

in special purpose vehicles. This structure. which reduces the risk of asset substitution. seems to 

make the securities relatively safc and ccrtain to outsiders" (2002, 877). 
43 

16 Federal Reserve Bank of Richmond Economic Quarterly 

The opacity of financial firm assets contributes to the desire to employ some 

melhod (i.e., bailouls or OLA) for lheir resoluLion ins Lead of bankrupLcy.16 

Key Features of OLA and OLA's Weaknesses 

As in bankruplcy, when a lroubled financial firm enlers lhe OlA process, 

creditors-with the exception of holders of QFCs, discussed below-are 

stayed (prevented) from collecting their debts. The stay lasts the duration 

of the period in which the financial firm is in the OLA process. During the 

stay, the PDIC will typically establish a receivership estate into which most 

assets and liabilities will be placed. Assets placed in the receivership will be 

sold by thc FDIC in thc manner that results in the largest returns to creditorsso that the receivership may last, and creditors wait, an extended period while 

the FDIC lines up buyers. Tn addition, some of the bankrupt firm's assets and 

liabilities can be moved into a "bridge entity," a separate company formed 

by the FDIC, which might be sold off as a whole entity to a private buyer or 

mighL even be capiLalized by some of Lhe crediLors of the bankrupL linn, and 

continue as a going concern.17 One purpose of a bridge can be to preserve 

going-concern value of portions of the troubled firm.1R 

The Dodd-Frank OLA process also abides by a priority schedule similar to 

the one defined in bankruptcy law (see Table 1 for an overview of bankruptcy 

priorities). But Dodd-Frank authorizes the FDIC to violate the priority list established in OLA under certain circumstances. Specifically, section 21 O( d)( 4) 

of the Dodd-Frank Act permits the FDIC to pay a creditor more than priority 

rules might otherwise allow "if the Corporation determines that such payments 

or credits are necessary or appropriate to minimize losses to the Corporation 

as receiver from the orderly liquidation of the covered financial company." 

According Lo Lhe FDIC's discussion of iLs proposed rules relaLed Lo lhis section of the Dodd-Frank Act, such additional payments may be made if they 

are necessary to "continue key operations, services, and transactions that will 

16 An alternative to bailouts or OLA that would address the problem of a lack of DIP funding 

as a result of SIFI opacity is to allow a troubled SIFI to enter reorganization, and permit the 

government to make DIP loans to the bankrupt firm. The government could quickly provide DIP 

funds to keep the finu operating but d,e bankruptcy process could handle all other aspects of the 

resolution. 

17 See Acting Chairman Martin J. Gruenberg's (2012) presentation before the Federal Reserve 

Bank of Chicago Bank Structure Conference for a discussion of how a bridge bank might be 

capitalized and continue operations as a private entity. 

18 Acting FDIC Chairman Gruenberg (2012) discussed the formation of a bridge. and noted 

its advantages for protfeting going-concern (franchise) value: ".. the most promising resolution 

strategy from our point of view will be to place the parent company into receivership and to pass 

its assets, principally investments in its subsidiaries, to a newly created bridge holding company. 

This will allow subsidiaries lhal are equil y sol venl and conlribule 10 lhe franchise value of the firm 

to remain open and avoid the disruption that would likely accompany their closings... In short. 

we believe that this resolution strategy \~iill pre-serve the franchise valuf' of the finn and mitigatf' 

systemic consequences." 
44 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 17 

maximize the value of the firm's assets and avoid a disorderly collapse in the 

markelplace."19 

Beyond the authority to, in some cases, make greater payments to creditors 

than their priority might allow, the Dodd-Frank Act also provides the FDIC 

with Treasury funding that might be used to make payments to creditors. 

The Act provides that the PDIC can borrow, within certain limits, from the 

Treasury. Immediately upon their appointment as receiver of a firm, the FDIC 

can borrow 10 pcrccnt of the value of the firm's pre-resolution assets. For 

a large financial firm, this initial amount can be significant. In the Lehman 

failure, for example, lOpercentofassers would have amounted to $63.9billion. 

Once the fair value of the failing firm's assets is determined and a liquidation 

and repayment plan is in place, the FDIC may borrow an additional 90 percent 

of lhe value of lhe firm's assels (wilh approval from lhe Treasury). The Acl 

provides that these funds are to be repaid to the Treasury from the sale of the 

liquidated finn's assets. But, importantly, the Act also specifies a means of 

repayment if such assets are not sufficient for repayment, first by attempting to 

"claw back" any "additional payments" (payments beyond what would have 

been received in a liquidation) made to creditors, and, if that is insufficient, by 

taxing all large bank holding companies and other SIFIs (Dodd-Frank Act § 

21O(o)(1)(A»20.21.22 The fact that assets might not be sufficient to repay the 

Treasury in full, and that the legislation authorizes taxes (on large financial 

19 http://edocket.access.gpo.gov/20111pdf/2011-1379.pdf; 4,211 

20 The Dodd-Frank Act § 210(0) specifies that assessments (ta'iCes) to repay the Treasury are- to be inlposed on bank holding companies with assets gre-ater or equal to $50 billion and 

on nonbank financial companies supervised by the Board of Governors of the Federal Reserve 

(meaning nonbank SIHs). Assessments are to be sufficient to repay the Treasury within 60 months, with the upporluniLy for cxLension if repaying in 60 months would have a "serious adverse e[[ed on 

the financial system." Assessments are to be graduated based on company size and riskiness. When 

determining asses'!;tnent 3111011nts, the FDIC, in consultation with the Financial Stability Oversight 

Council, should take account of "economic conditions generally affecting financial companies so as to allow assessments to increase during more favorable economic conditions and to decrease 

during less favorable economic condiLions ... Lhe risks presenLed by Lhe financial company [being 

assessed] to the financial system and the extent to which the financial company has benefitted. or likely would benefit, from the orderly liquidation of a financial company under this title," and any 

government assessments already imposed on the firm under such government programs as deposit lnsurance or secuntles lnvestor protectIOn lnsurance. 

21]be Dodd-Frank Act § 21O(0)(l)(D)(i) prohibits the FDIC from imposing claw backs on creditors who receive "additional payments" if such payments are "necessary to initiate and continue 

operations essential to implementation of the receivership or any bridge financial company." The 

FDIC's implementing regulation, at 12 CFR 380.27, seems to imply that a good portion of any 

additional payments made by the FDIC will be for such essential purposes so will be protected 

from claw back. Note that if all additional funds could be clawed back, there nught be little reason Lo be concerned abouL Lhe poLenLial moral hazard problem croaLed by FDIC paymenLs. BuL, 

given that the FDIC is likely to be prohibited from imposing claw backs on some significant 

portion of paYlnent recipients, the moral hazard concern seems to be in play. 

22 AnalysLs (Acharya eL al. 2009, 31-2; Acharya eL al. 2011, 10-1) have noLed LhaL iL would 

be more appropriate to impose this tax prior to any failure, and base the tax rate on a firm's riskiness. Such a tax would discourage risk-taking. TIle current tax does not discourage risktaking, since the failing firm does not pay it. In fact, because it is paid by survivors, it punishes, 

and therefore discourages, caution. 
45 

18 Federal Reserve Bank of Richmond Economic Quarterly 

firms) to repay the Treasury, implies that creditors may be repaid more than 

the sum of funds generated by asset sales-more than they would have been 

repaid in liquidation. 

It seems likely that Congress intended to provide the FDIC with a good 

bit of discretion to bypass strict priority as well as discretion over whether 

to borrow Treasury funds in order to mitigate systemic risk. Por example, 

given the FDIC's ability to pay some creditors more than they would receive 

in bankruptcy, these creditors may be less likely to pass on losses to other 

firms, lowering the risk of a systemic problem. 

One might argue that legislators' intention for providing the FDIC with the 

authority to borrow from the Treasury was simply to allow the FDIC the ability 

to move quicker than bankruptcy courts. By providing an immediate source of 

funds, the FDIC could gaLher funds, which it could then use Lo make paymenLs 

equivalent to what would be paid in bankruptcy. In this way creditors would 

not be denied access to their funds for months or years (as in liquidation). and 

the FDIC could slowly sell the assets of the failing firm such that fire sales 

are avoided. Under such an arrangement, legislators could have required the 

FDIC to immediately estimate the value of the failing firm's assets (similar to 

the type of analysis currently performed by the FDIC when it determines-and 

announces in a press release-the cost to the FDIC of a bank's failure), and 

then limit itself to paying creditors no more than their pro-rata share (given 

priorities) of this estimated amount. Yet, Congress did not choose this course, 

i.e., it did not require the FDIC to limit the sum of its payments to be no more 

than the estimated value of the failing firm's assets. Instead it left the FDIC to 

determine payments to creditors and authorized taxes on large financial firms 

if payments exceed the liquidation value of assets. Therefore, it seems clear 

that Congress intended for some creditors of a failing firm to receive larger 

payments than bankruptcy allowed, as a means of mitigating systemic risk. 

Investors certainly realize that the OLA provisions provide the FDIC with 

the authority to make larger-than-bankruptcy payments to creditors. As a result. they will tend to under price risk-taking by nonbank firms that might get 

OLA treatment and such firms will engage in more risk-taking than if they did 

not enjoy the potential benefits of receiving government aid. 23 Congress was 

aware that larger payments would have this moral-hazard-exacerbating impact on firm risk-taking and took steps to mitigate the impact in the OLA 

provisions of the Dodd-Frank Act. Broadly. the legislation requires that 

the PDIC attempt to liquidate SIBs "in a manner that ... minimizes moral 

23 Some authors, such as Jackson (2011). argue that a modified hankruptcy procedure can 

address this excessive risk-taking weakness and better resolve SIFIs. According to them, a system 

of established rules. judicial oversight, and full public disclosure has a better chance of both 

reducing bailouts and luaking the costs of them known than does a non-bankruptcy lesolution 

authority. 
46 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 19 

hazard."24 More specifically, the law calls on the FDIC to ensure that any 

member of the management or the board of directors of the failed linn who 

is deemed responsible for the failure is fired. Similarly, the OLA provisions 

require the FDIC to "ensure that the shareholders of a covered financial company do not receive payment until after all other claims and the Fund are fully 

paid and ensure that unsecured creditors bear losses ... "25.26 The provisions 

requiring the removal of management and directors are likely to encourage 

these corporate leaders to limit risk-taking. However, the OLA contains provisions for certain creditors to receive better treatment than they might in 

bankruptcy, even if some creditors suffer losses, so that creditor oversight is 

likely diminished hy the prospect of OLA treatment. 

Dealing With Systemic Risk in Failure Resolution: 

Exceptions to the Automatic Stay 

The class of financial contracts, which are exempt from the automatic stay, are 

commonly referred to as "qualilied linancial contracts" (QFCs).27 Therefore, 

investors who are holding QFCs have the ability to immediately terminate and 

net-out their contracts or liquidate the collateral on their claims once a party 

has defaulted or filed for bankruptcy. Today, under bankruptcy law, a number 

of financial instruments are QPCs, including repos, commodity contracts, 

forward contracts, swap agreements, and securities contracts.28 The treatment 

of QFCs in bankruptcy (and under OLA provisions) has bcen thc focus of a 

great deal of pu blic debate. 

A possible explanation for exempting QFCs is that the collateral that typically hacks QFCs is not directly tied to the defaulting firm's going concern 

value. A primary objective of the automatic stay in bankruptcy is to prevent 

24 Dodd-Frank Act ~ 204(a) 

25 Dodd-Frank Act § 206(1-5) 

26 The Dodd-Frank Act includes other provisions intended to minimize moral hazard including 

I) a requirement that SIFIs create resolution plans ("living wills") to increase the likelihood that 

they would be resolved through bankruptcy rDodd-Frank Act § 165(d)1; and 2) a requirement that 

the FDIC have a plan in plaoe, before borrowing greater than 10 percent of the failing firm's 

assel, for repaying the Treasury [Dodd-Frank Acl § 210(n)(9)(B)]. 

27 In the Bankruptcy Code, contracts exempt from the automatic stay are referred to as "safe 

harbor contracts." Thc Federal Dcposltory InstitutIOn Act and thc Dodd-Frank Act rcfcr to the 

safe harbor contracts as QFCs. Since safe harbor contracts and QFCs genelally refer to the same types of contract, we will use the term "QFC" to refer to both. which is consistent with industry 

practlce. 

28 111e types of contracts exempt from the stay are listed in the following sections of the 

Bankruptcy Code: 11 U.S.c. § 362(b)(6), (b)(7), (b)(17), 546. 556, 559. 560. All terms are defined 

in II U.S.c. § 101 with the exception of a "secunties contract." which is defined as "the purchase, sale, or loan of a security. induding an option for the purchase or sale of a security, certificate 

of deposit. or group or index of securities (including any interest therein or based on the value 

the-reof), or any option entered into on a national securities exchange relating to foreign CIIlTf'ncif's, 

or the guarantee of any settlement of cash or securities by or to a securities clearing agency" (11 U.S.c. § 741). 
47 

20 Federal Reserve Bank of Richmond Economic Quarterly 

the separation of complementary assets (an important goal of the trustee in 

liquidalion) or lo preserve Lhe going-concern value of a firm (lypically a goal 

in reorganization). QI-'Cs can be immediately closed out because the collateral 

backing them will typically not be complementary to other assets of the finn, 

nor will QFC collateral be important to the firm's going-concern value. For 

instance, collateral consisting of highly marketable or cash-like securities (for 

example Treasury bills or mortgage-backed securities) can be removed from 

the firm without necessarily undercutting the firm's ability to produce loans 

or other financial products, since the production of these products depends on 

such resources as the skill of lending staff, staff contacts with possible borrowers, IT assets, office space and equipment, and funding (liahilities) from 

which to make loans. However, some argue that the collateral backing cerlain QFCs can be linn-specilic (e.g., a pool of morlgage cash flows used as 

repo collateral) and therefore not all QI-'Cs should be treated equally (Jackson 

2011). 

Another possible explanation for exempting QFCs is that the markets in 

which Qrcs trade are special, such that delaying creditor recovery attempts 

in these markets (by imposing a stay on QFC counterparties) is especially 

destructive, compared to staying creditors operating in other markets. Morc 

specifically, proponents who hold this view seem to be arguing that staying 

QFCs is more likely to create systemic problems than staying the collection 

of other dehts. This explanation for special treatment-what we will call 

the "systemic risk" rationale-appears to stand out as the argument used by 

policymakers supporting the expansion of the list of QI-'Cs that took place 

over several decades through numerous reforms to the Bankruptcy Code. The 

rationale offered by those supporting the exemption is that in a fast-paced, 

highly interconnected market, a counterparty to a Qrc may need the proceeds 

from the contract to payoff other debts in a timel y manner. If this counterparty 

is unable to mcet othcr obligations as a result of having its contracts held up in 

bankruptcy, other firms relying on that counterparty may become exposed and 

experience financial distress, which could bleed to other counterparties, and 

so on, causing a ripple effect and possihly "destahilizing" markets (Edwards 

and Morrison 2005).29 

Today, lhe lransaclions and agreemenLs covered under lhe deIinilion of a 

QFC include a wide range of instruments. However, when the automatic stay 

29 In a lettel dated September 30, 1998, to Hon. George W. Gekas. Chairman, Subcommittee on Commercial and Administrative Law. Committee on the Judiciary, Robert Rubin, 

former Treasury Secretary, argued that applying traditional insolvency laws, such as the stay, 

to QFCs could cause a "possible domino effect that could turn the failure of one market 

participant into a failure of the market." See www.wilmerhale.comlfileslPublicationleacecfbd0400-4cbl-80aO-cf3a2c3fl637IPresentation/PublicationAttachmentI29blce6d-Icel-4544-a3ec63ecd65dllellBankrnptcy%20%20Derivatives%200utline%20-%20_finaL.pdf. 
48 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 21 

Figure 1 History of QFC Exemptions from the Stay 

1982 

2006 

was first created as part of the new Bankruptcy Code in 1978,30 only commoditics and futures contracts were exempt.31 At the time, these protections were 

intended to "prevent the insolvency of one commodity firm from spreading to 

other brokers or clearing agencies and possibly threatening the collapse of the 

market."32 In the decades to follow, various reforms to the Bankruptcy Code 

expanded the Lypes of conLracLs classiIied as QFCs, as well as expanding Lhe 

types of collateral that could be used to back them (see Figure 1 timeline). 

Legislation enacted in 2005 and 200633 expanded the safe harbor treatment significantly by broadening the definition of a QFC to such an extent 

that it would capture any newly created derivatives product that may otherwise not be explicitly included.34 Moreover, the most recent reforms also expandcd contractual nctting rights to allow for "cross-product nctting" ofQFCs 

(Figure 1). Netting occurs when a non-defaulting counterparty of a defaulting 

bankrupt firm is allowed to offset debts it owes to the defaulting firm against 

dehts owed it hy the defaulting firm.35 Cross-product netting allows contracts 

30 The stay existed as a fundamental feature of bankruptcy before 1978. The Bankruptcy 

Reform Act of 1978, however, created the "automatic stay:' which takes effect Immediately upon 

lhe filing of a bankruplcy pelilion. Prior lo the Bankruplcy Reform Act of 1978, the slay lypically 

took effect only after the grant of an injunction by a court. Such grants were typical. but were 

often not immediate, and certainly not automatic (Jessup 1995). 

31 U.S.C. §3G2(b)(G) 

32 See H.R. Rep. No. 97-420, at 2 (1982). 

33 The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Pub. L. 109-8, 

119 Stat. 23) and the Fmancial Netting Improvements Act of 2006 (Pub. L. 109-390, 120 Stat. 

2692). 

34 The following language was added to the definition of commodities. forward. repo, and 

securilles contracts: "any other agreement or transactions referred to" in the definition and "any 

cOJuhination of the agleements or transactions refelled to" in the definition. 

35 For example, in the simplest case of two contracts, the non-defaulting firm is owed $1,000 

by the bankrupt firm on, say, an interest rate swap (derivative) contract, and owes the defaulting 
49 

22 Federal Reserve Bank of Richmond Economic Quarterly 

of differing types to be netted against one another, for example a debt owed 

on a swap lo be nelled againsl a debl owed on an oplion conlracl. Nelling, 

whether the netting of like product contracts or cross-product contracts, can 

reduce the credit exposure of firms that use financial contracts. In turn, the 

chance that the bankruptcy of one firm might lead to large losses for its financial contract counterparties is reduced, which some observers argue could 

reduce systemic risk (Jones 1999).36 

Observers explain that the expansion of special treatment for QFCs occurred in order to account for the considerable growth in the number and 

diversity of complex financial products over the previous decade (Jones 1999, 

Skadden 2010). These instrument<; grew in popularity as they served as mechanisms for financial firms to insure and hedge against risk, helping to reduce 

uncerlainly and slabilize earnings. This increasingly expansive proleclion for 

derivatives and repos was intended to achieve the goal of "minimizing the 

systemic risks potentially arising from certain interrelated financial activities 

and markets.,,37.38 

Some Possible Weaknesses of Bankruptcy's QFC Exemption 

The onset of the financial crisis led many observers to reexamine whether 

this systemic risk rationale was consistent with the events that occurred when 

financial markets became severely stressed during the recent financial crisis. Therefore, the idea that QPCs should be exempt from the stay was revisited in the lead up to Dodd-Frank and ultimately addressed in the OLA. 

The systemic risk argument is the prominent justification given by those supporting the expansion of the special treatment given to QFCs. However, 

there is another cohort, which argues that any reduction in systemic risk, 

hecause of QFC exemptions, may he offset hy another form of systemic risk 

firm $800 on a different interest rate swap contract. Under bankruptcy law. the creditor firm may 

nel the lWo conlract debLs such lhal the $800 il O\,es the defaulting firm is cancelled (nelled againsl 

the $1.000) and the defaulting firm ends up owing only S200 to the non-defaulting firm. The nondefaulting finn will have to wait for the bankmptcy process to proceed before being repaid any 

portion of the remaining $200 it is owed. This outcome is superior for the non-defaulting party 

compared to the case in which netting were not allowed. Here the non-defaulting party would be 

required to pay the defaulting party the $800 it owed. but wait for the bankruptcy process to be 

completed before getting any of the $1,000 defaulting party owes it. Of course, in reality, the 

defaulting firm and the non-defaulting firm are likely to have many contracts outstanding with one 

another at the time of default, all of which might be netted (Mengle 2010). 

36 This may have magnified the concentration of the derivatives industry according to Bliss 

and Kaufman (2006, 67-8), who argue that "by explicitly protecting these netting agreements, the 

2005 bankruplcy changes reirdorced the compelilive advanlage of the biggesl counkrparlies." 

37 See Jones 1999. 

38 "Immediate termination of outstanding contracts and liquidation of collateral facilitates the 

acquisition of replacement contracts, reduces uncertainty and uncontrollahle risk, improves liquidity 

and reduces the risk of rapid devaluation of collateral in volatile markets" (Yim and Perlstein 2001, 

3). 
50 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 23 

involving runs on repos39 and fire sales40 of the collateral underlying closedouL derivaLives conLracLs (Edwards and Morrison 2005, Taylor 2010, Acharya 

et al. 2011). The simultaneous termination and liquidation of numerous QFCs 

(which is allowed by the exemption of QFCs from the stay) may lead to fire 

sales and possibly further insolvencies. In Lehman's case, of their 930,000 

derivatives counterparties, 733,000 sought to terminate their contracts upon 

their bankruptcy filing on September 15,2008 (Miller 2009). 

Additionally, some observers note that the 2005 bankruptcy laws, which, 

among other things, extended QFC protections to repos backed by all types of 

collateral, including all mortgage-related securities, may have encouraged use 

of mortgage-backed securities as repo collateral (Lubben 2010), and thereby 

contributed to losses during the financial crisis (Skeel 201 0, Government AccounLabiliLy OlIice 2011). As Skeel (2010) poinLs ouL, morLgage values could 

have spiraled down even more had AIG's counterparties been forced to sell 

a significant amount of the mortgage-related securities they had posted as 

collateral on their QFCs (which was avoided when AIG was bailed out). 

The idea that QPC fire sales might result from their exemption is not 

new. In fact, it appears to be what led the Federal Reserve to step in and 

encourage private firms to come to the aid of Long-Term Capital Management 

L.P. (LTCM), preventing it from entering bankruptcy (Edwards and Morrison 

2005).41 

As discussed, the bankruptcy process can be long, but among other things, 

this is intended to give the troubled financial firm and its creditors the time to 

develop plans to salvage the value of the firm. However, with the exemption 

from the stay. a large financial firm facing possible default (because of a 

number of factors, such as a recent credit downgrading or an overall crisis of 

confidence) has a strong incentive not to file for bankruptcy since doing so 

would likely trigger simultaneous termination of all QFCs (Skeel and Jackson 

2012). Thus, a troubled firm may put it off until the last moment and be forced 

into a rapid liquidation that significantly depresses values to the detriment of 

other market participants. These arguments suggest that bankruptcy's current 

treatment of QFCs may not be optimal. 

Observers also find that the special treatment given to QFCs-in order 

Lo prevenL the perceived sysLemic risks LhaL arise when these insLrumenLs are 

39 By "runs on [epos" we mean when counlerparlies, en masse, seize lhe collateral underlying 

these deposit-like instruments. 

40 The phrase "fire sale" typically refers to the possibIlity that the sale of an asset might yield 

a lower-than-typical plice if holders of one type of asset attclnpt to sell en masse. In cOIuparison, 

the "typicar' (non-fire sale) price will result if sales are distributed over time. 

41 Krimminger (1999, 1) notes that. "[iJn the case of LTCM. the absence of any mechanism 

under the Bankruptcy Code to 'slow' the liquidation of assets and collatelal, [a power granted to 

the FDIC under the Federal Deposit Insurance Actl and the resulting 'dump' upon the markets, 

was a key motivation for the pre-msolvency facilitation provided by the Federal Reserve Hank of 

New York." 
51 

24 Federal Reserve Bank of Richmond Economic Quarterly 

subjected to the automatic stay-not only create a different form of systemic 

risk, bUl weaken markeL discipline (Edwards and Morrison 2005, Scoll 2011). 

The special treatment awarded to QFC counterparties in bankruptcy essentially places them ahead of all other creditors in the bankruptcy repayment 

line, allowing QFC counterparties to get out of their contracts when all other 

creditors cannot. As a result, their incentive to monitor the debtor prior to 

bankruptcy and base their pricing and investment decisions on the perceived 

risk of the counterparty may be significantly reduced, increasing moral hazard 

(Edwards and Morrison 2005, Roe 2011). It is argued that this leads to market 

distortions whereby debtors favor short-term repo financing over traditional 

sources of funding, encouraging a more fragile liability structure (Edwards 

and Morrison 2005, Skeel and Jackson 2012). For example, at the time of 

Bear Slearns' failure, a q uarler of ils assels (approximalely $100 billion) were 

funded by repos (Roe 2011). Roe (2011) suggests tllat, without the priority 

given to these instruments in bankruptcy, it is plausible that Bear would have 

financed a much larger proportion of its assets with longer-term debt, which 

would have allowed for a more stable funding structure during the financial 

turmoil. 

Some observers who support thesc arguments maintain that QFCs should 

be subject to the automatic stay provisions in the Bankruptcy Code, although 

there are a range of views concerning the length of the stay and whether all 

QFCs should be treated equally. According to Harvey Miller (2009), lead 

bankruptcy attorney for the Lehman bankruptcy, the automatic stay, as originally contemplated, is intended to provide a firm with the "breathing space" 

to find a third party source of liquidity or to carry out an "orderly, supervised 

wind down of its business assets." Miller argues that, had the special treatment given to QPCs not applied, Lehman's failure may have been avoided 

and certainly would not have been as "systemically challenging." For instance, Lehman suffered a significant loss of value when nearly 80 percent of 

their derivatives counterparties terminated their contracts upon their filing of 

bankruptcy (Miller 2009). 

The OLA's One-Day Automatic Stay for QFCs 

Given the controversy-with somc experts arguing the exemption from the 

stay is necessary to prevent systemic risk and others arguing that the exemption creates systemic risk-it is natural that Congress chose a solution that 

leaves the FDIC with discretion to determine the treatment of QFCs for covered financial companies. Under Congress's solution, QFCs are subject to a 
52 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 25 

one-day automatic stay upon appointment of the FDIC as receiver, whereas 

QFCs are subjecllo no slay in bankruplcy.42 

During the one-day stay under the OLA, the FDIC, as receiver of the 

failing financial company, must quickly identify how to manage the SIFI's 

QFC portfolio. The one-day stay is aimed at addressing fears associated 

with a failing firm's QPC counterparties cancelling their contracts all at once 

and driving asset prices down. Instead, counterparties' rights to cancel their 

contracts are put on hold for one day while the FDIC determines how to treat 

these contracts. The FDIC has this same type of authority when dealing with 

bank failures. Under the OLA, during this short period, the FmC has the 

option to retain the QFCs in receivership, transfer QFCs to another financial 

institution (to an outside acquirer or to a bridge company created by the FDIC), 

or rejecllhe QFCs. 43 However, in all inslances, lhe FDIC musl relain, rejecl,44 

or transfer all of the QFCs with a particular counterparty and its affiliates. 45,46 

Each action taken by the FDIC has different implications for QFC counterparties of the debtor, as well as the failing firm. Retaining the QFCs in 

receivership is most similar to bankruptcy in that after the one-day stay expires, QFC counterparties may terminate or net-out their contracts.47 What 

differs significantly from bankmptcy, but is very similar to the FDIC's resolution process for depository institutions, is the FDIC's ability to transfer or 

reject QFCs. If the FDIC chooses to transfer all of the QFCs with a particular 

counterparty and its affiliates to a third party (including a hridge company), 

the counterparty is not permitted to exercise its rights to terminate or close 

out the contract.48 This awards the FDIC an opportunity to possibly preserve 

the value of the contracts by removing the ability of counterparties to terminate contracts early and sell off the collateral at fire sale prices (Cohen 2011). 

42 111e one-day stay lasts until 5:00 p.m. on the business day following the date the FDIC is 

appointed as receiver. Therefore. the "one-day" stay could last four days if the FDIC is appointed 

as receIVer on a Friday. 

43 For the most pa1t. the FDIC's powers under the OLA to reject or transfer a QFC during 

their limited one-day stay are much like the powers of the FDIC and bankruptcy trustees under 

the Federal Deposit Insurance Act and the Bankruptcy Code, respec!Jvcly, with the exception that 

lhey are nol supervised by a courl nor do lhey receive counlerparly inpul (Skadden 2010). 

44 In bankruptcy, only contracts or leases that are executory-a contract where both parties 

have unperformed obligations-may be rejected. 

45 Dodd-Frank Act § 21O(c)(Y)(A). 'lhis is intended to ehminate "cherry picking" (selec!Jve 

assumplion and rejection) of QFCs by the deb lor. 

46 This differs from the Bankruptcy Code's setoff provision, which allows a creditor to offset 

all obligations under a single master agreement but not all of the contracts with a single counlerparly and ils affiliales (Skeel 2010, Cohen 2011). When Lehman filed for bankruplcy, lhey 

were a counterparty to 930,000 derivatives transactions documented under 6,120 master agreements 

(8umme 2011). 

47 If a nondefaulting COlUlterparty has an unsecured clailll after termlnating a QFC and liquidating any collateral, the claim would then be subject to the same claims process as other 

unsecured creditors. 

48 If the counte1l1aliy were to default at a later tilne on a separate occasion, they Inay exercisetheir close-out rights. 
53 

26 Federal Reserve Bank of Richmond Economic Quarterly 

Moreover, a QFC counterparty may find that their contracts are held with a 

new, and presumably IIlore sLable, counLerparLy or a Lemporary bridge bank 

following the one-day stay and, therefore, may have no incentive to tenninate (in addition to the fact that it has no ability to terminate), leaving the 

market undisrupted by their original counterparty's failure while also maintaining what are possibly valuable hedge transactions. Pinally, the [iDlC may 

reject (or repudiate) the QFCs of a given counterparty to the debtor, effectively 

closing them out at the current market value, if they determine that they arc 

somehow burdensome or doing so would otherwise promote orderly administration. 49 However, counterparties may recover, from the FDIC, any damages 

suffered as a result of the FDIC's rejection of QFCs.50 

Possible Weaknesses of OLA's One-Day Stay 

Some commentators find that the one-business-day stay does not provide the 

[iDIC with sufficient time to identify the potential recipients of the failed firm's 

derivatives portfolio (Skeel 2010, Bliss and Kaufman 2011, Summe 2011). 

Givcn this timc constraint coupled with the "all or nothing" approach to the 

treatment of QFCs (where the FDIC must retain, reject, or transfer all QFCs 

with a particular counterparty) and the potential systemic risks from its failure 

to protect a SIFI' s QFCs, some suggest that the FDIC is highly likely to transfer 

all QFC conLracLs of a given counLerparLy Lo a bridge Iinancial insLiLuLion (i.e., 

protecting or guaranteeing them in full) (Skeel 2010). After all, if the FDIC 

does not protect all contracts, then the non-defaulting counterparties may 

close out and liquidate their contracts upon the expiration of the one-day stay, 

effectively resulting in the systemic problems previously discussed related to 

the QFC exemption-closing out the contracts and selling collateral at fire sale 

prices. Thus, even if various QFC counterparties have differing risk exposures 

to the defaulting firm, they are all likely to be treated the same and "bailed out." 

If counterparties believe that their QFCs are likely to be protected by placement 

in a well-funded hridge company, they are likely to provide more funding (or 

provide lower-cost funding) to a risky firm than they otherwise would. Further, 

counLerparLies may care liLLIe abouL Lhe dilfering risks associaLed wiLh Lhe 

various types of QFCs, because all QFCs of a given counterparty are treated 

the same. Therefore, while bridge company placement of QFCs may limit 

systemic risk, it is likely to do so at the cost of increasing moral hazard. 

In response to the concern that a one-day stay is likely to lead to the 

protection of most QFCs, some observers, such as Thomas Jackson, author 

of a proposal to create a new chapter in the Bankruptcy Code tailored to the 

49 Dodd-Frank Act § 21 O(c) 

50 Damages are calculated as of the date of repudiation. '[he word "damages" is defined as 

the "nurmal and reasonable costs of cover or other reasonable measures of damages uLilized in 

the industries for such contract and agreement claims" Dodd-Frank Act § 210(c)(3)(C). 
54 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 27 

resolution of SIFIs (Chapter 14), proposes an extension of the duration of 

the automatic stay for QFCs to three days. Jackson and others argue that a 

longer stay duration will give the FDIC additional time to make an informed 

decision regarding how to handle the failing firm's QFC portfolio (Jackson 

2011). Jackson's three-day stay appears to be an attempt to balance the desire 

to give the JiDIC more time, against the danger of producing QJiC counterparty 

failures. 51 

Morcovcr, thc protcctions for dcrivativcs contracts havc broadcncd ovcr 

the last several decades and this legislation does not account for the differences 

across QFC products (such as between repos and swaps), or the types of 

collateral backing QFCs, which some observers believe should be considered. 

For instance, several observers find that special treatment (i.e., exemption 

from the stay) should be limiLed to derivatives collateralized by highly liquid 

collateral, such as short-term Treasury securities, since there is little reason 

to assume that such instruments are important for the going-concern value of 

the bankrupt firm (Herring 2011, Jackson 2011). In Jackson's 2011 Chapter 

14 proposal, highly liquid, or otherwise highly marketable, instruments with 

no firm-specific value remain exempt from the stay so that creditors who rely 

on thc immcdiatc availability of their funds can gct thcm back quickly and 

without disruption upon the failure of a firm. On the other hand, the exemption 

is removed (i.e., the stay would apply) for less liquid instruments, such as 

CDS, in an effort to prevent these creditors from running on the troubled firm. 

Clearly, there remains a good bit of controversy about the best way to handle 

the QFC exemption, in both banktuptcy and the OLA, with no obvious best 

solution. 

3. CONCLUSION 

While bankruptcy probably provides the ideal failure resolution mechanism for 

most corporations, it may not be optimal for some financial firms (i.e., SIFIs). 

Financial linus are typically more heavily dependent on short-term funding, 

often including a heavy reliance on QFCs, and their balance sheets are opaque. 

Because of this dependence on short-term funding, a long stay, while the 

banktuptcy process plays out, is likely to result in financial difficulties for some 

of thc troublcd firm's countcrpartics. Morcovcr, DIP funding, which is the 

usual means of keeping a troubled, but viable, firm alive during reorganization, 

is likely to be quite difficult to arrange, given the opacity of most financial firms. 

Because of these weaknesses, handling a SIFI through bankruptcy is likely 

51 While the three-day stay may not provide significantly more time than one day to make 

such valuations, the Dodd-Prank requirement that STTTs create resolution plans or "living wills" 

and provisions forcing swaps to be traded on exchanges could expedite the QFC valuation process, 

improving the abIlity of the FDIC to make appropriate decisions wIthin a three-day stay penod. 
55 

28 Federal Reserve Bank of Richmond Economic Quarterly 

to result in significant risks to financial stability. Policymakers are therefore 

undersLandably re1ucLanL Lo allow SIFIs Lo enLer bankrupLcy, given LhaL Lhese 

risks can be mitigated through bailouts. But bailouts, or the expectation that 

they could be forthcoming, drive down economic efficiency by exacerbating 

moral hazard problems. 

In an etTort to address these difficulties, the OLA was created with the 

explicit goals of mitigating risk to the financial system and minimizing moral 

hazard. Spccifically, thc OLA adjusts thc way that QFCs arc handlcd and how 

creditors are paid out. Despite the attempt to achieve these well-founded goals, 

because they are conflicting, reducing one inevitably leads to an increase in 

the other. The one-day QFC exemption does not clearly resolve potential risks 

to financial stability and it also does not go far to ameliorate the moral hazard 

problem LhaL is apparenL when giving QFCs special LreaLmenL AddiLionally, 

the ability to pay some creditors more than they would be likely to receive 

in bankruptcy may reduce systemic risk. but at the cost of increasing moral 

hazard. In conclusion, the threat of a SIFI' s failure, or the failure itself, presents 

policymakers with a daunting challenge that neither bankruptcy nor the OLA 

seems capable of fully resolving. 

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documems/ken-scott-guide-to-resolution-project.pdf (May). 

Skadden. 2010. "The Dodd-Frank Act: Commentary and Insights." Available 

at www.skadden.com/sites/defaultifiles/publications/SkaddenJnsights_ 

SpeciaLEdi tionj)odd -FrankAct 1_6. pdf. 

Skeel, David A. 2010. "Bailouts, Bankruptcy or Better? Resolution 

Authority II." In The New Financial Deal: Understanding the 

Dodd-Frank Act and its (Unintended) Consequences. Hobokcn, N. 1.: 

John Wiley & Sons, Inc., 129-52. 

Skeel, David A., and Thomas Jackson. 2012. "Transaction Consistency and 

the New Finance in Bankruptcy." Columbia Law Review 112 (February). 
58 

S. R. Pellerin and 1. R. Walter: Orderly Liquidation Authority 31 

Summe, Kimberly. 2011. "An Examination of Lehman Brothers' Derivatives 

Porllolio Posl-Bankruplcy and WheLher Dodd-Frank Would Have Made 

Any Ditlerence." Available at http://media.hoover.org/sites/defaultlfiles/ 

documentslKimberl y-Summe-Dodd -Frank -20110421. pdf. 

Taylor, John B. 2010. "Defining Syslemic Risk Operalionally." In Ending 

Government Bailouts as We Know 1hem, edited by George Shultz, 

Kenneth Scott, and John B. Taylor. Stanford University: Hoover 

Institution Press, 33-57. 

White, Michelle J. 1998. "Corporate Bankruptcy." In The New Palgrave 

Dictionary of Economics and the Law, edited by Peter Newman. 

Macmillan Press. Available at http://weber.ucsd.edurmiwhite/. 

Yim, Soo J., and William J. Perlstein. 2001. "The Effect of Proposed 

Amendments to U.S. Insolvency and Banking Laws on Transactions 

Involving Securities, Commodities and Other Financial Contracts." 

Presentation prepared in connection with the American Dar Association 

2001 Spring Meeting Section of Business Law Business Bankruptcy 

Committee Forum on Derivatives And Proposed Financial Contract 

Netting Legislation, March 24. 
59 

.-III!O!~~L ~!s!R"f! OANK " • • 

" :'1

1

11 ~I RI{HIoiOMO 

Our Pf'rsp« I;"t 

Our I'I:rspcc1;"c is (l series ofcsS<l)'s that al1iculalcs the Ridunond Fed's '-;ew. on issues of particular 

imporl:UOcc 10 (he Fifth Disuic\and!he n:ttional 000n001)" 3nd lhcir policy implications. TlIc following 

essa)' is the Richmond Fed's ,·;owoo "100 big 10 fail." 

Too Big to Fl il 

The federal financial safelY 11<:1 is intended to prOleC! large financ;31 inSliluLions and theircrcdiLors from 

failure and to reduce the possibility Of"syslcmic risk" LO lhc fill3nci.ll system. How'a..:r. fcdcr:>1 

guaranlC\:S (WI cnooumgc imprudent risk ialing. "hich uhimatcly may !cOld (0 inSUlbihty in lhe ,'cry 

system ,hal the s:lfc1y net is designed 10 proL~L . 

Introduction 

Occasional Luroulcne<: in fin.lncial markets is inevitable. l1lcrc will always be shon-lcml "shocks"lh:ll 

span. nO\\ awareness ofprc"iously "nknown risks. just as the housing market declinc thai started in 2006 

m3de clcarth:U some fmancial instilulions had taken 00 greater ris ~ (han m:my investors had realized. 

Shoo.:ks. howe,...,.. do I\O{ easily or frequently lead to large-scale panics like till' global financial crisis of 

2007 and 2008. Many complicated factors led to that outcomc. A,noog thc most import:lnt factors was a 

long hi~of)· ofgo'·cmmenl inlcn·cn(ions th:U led market panicipams loexpeet cert:lin firms 10 be rescued 

in {he e,·ent of dislress. 11L1t "safety net" may make market panicipants 1= inclincd to proIect 

Ihemsckes from risk. making instability and financial panic a mo", common and sc'..,re oc<:ul"n'!I<:e. 

Part of the go,·emmen!"s financial safcly net is ,splicit. such as deposit insurance lhal protecIs relal;wly 

small in,..,SlOrs such as hOUSl.'holds and small businesses. Conmll'rcial banks an: charged fees for thai 

scn·iec and an: supen-iscd. which limits their incenti,.., to take risk. 

A large ponioo of the safelY net is .. mbiguous and implicit. howe vcr. meaning Ihal il is IlOl spelled oul in 

advance. For decades the federal go,·cmmen! has pro,·cn its willingnc-ss to intc,,·ene wilh cmergency 

loans "hen institulions se<:n as "too big to fai l" (fBTF) are 00 the brink ofcollapsc. Market panicipams 

conduct their business making educ,ned guesses about which insututions mal' be supponed in times of 

discress. 

The trouble caused by implicit g'~lr.mtees is tholl they dfccti,"CIy subsidize riSk . In,·esto,s feci little need 

to demand higheryiclds locompensale for the ris~ of loss in their contracts "ith protected finns since 

losses aro expected to be cushioned by the so,·cmmen!. Implicitly protecled funding SOUreeS are thcn:foro 

c1ll'apcr. causing market panieipams to n:ly more hea,·ily on them. At IIII' same time. risk is more likely 10 

accumulate in institutions believed \0 be protected. The expectation ofacccss \0 go,·emmen! sllppon 
60 

reduces the incentive for finns that might be protected to prepare for the possibility of distress by, for 

example, holding adequate capital to cusliion against losses. Meanwliile, investors wlio liave made loans 

to support activities assumed to be guaranteed face less incentive to assess tlie risks and related costs 

associated "vith extending funds to those finns or markets. This is the so-called "moral hazard'! problem 

of tlie financial safety net - expectation of government support weakens tlie private sector's ability and 

willingness to limit risk. 

lil essence. the implicit public safety net provides incentive for finns to make themselves relati vely more 

fragile and makes creditors less likely to pay attention to tliat fragility. Botli effects endorse risk and make 

the firm or activities more likely to require a bailout to remain solvent. This self-reinforcing cycle is tlie 

essence of the TBTF problem 

Although the term "too big to fail" has become tlie popular way to talk about financial safety net issues, it 

is actlkqlly something ofamisnomer. TI,e incentive problems created by the safety net stem from the 

belief on the part of a finn's creditors that they may be protected from losses if the finn experiences 

financial distress. Protection of some creditors can happen even if the finn fails - that is, even ifthe 

shareholders lose everything and management is replaced 

How extensive is the TBTF problem? The nature of the problem does not lend itself easily to study, as 

argued by Gary Stern, former president of the Federal Reserve Bank of Minneapolis, and Ron Feldman, 

the Minneapolis Fed's CUITent head of Supervision, Regulation. and Credit, in their book on the subject 

(Stem and Feldman 2(04). TI,ere is no list of institutions that govemments implicitly view as TETE and 

there is no direct way to observe priYate markets' suspicions about finns or activities that would appear on 

such a list. Moreover. the amount of the subsidy prO\ided by implicit support exists only on the margin 

and is likely to vary across fimls and activities. These characteristics make it difficult to directly identity 

the effects ofTBTF treatment on, for example. the relative perfonnanee of large and small banks(Ennis 

and Malek 2005). 

Economists have accumulated some eyidence, however. Financial institutions ostensibly vie,ved as TBTF 

have enjoyed better credit ratings and favorable financial market treatment after mergers expanding their 

size. Perhaps the most salient evidence ofTBTF lies with Fannie Mac and Freddie Mac, the two fimls 

that were most broadly viewed as implicitly supported by a govemment backstop. For decades markets 

have been willing to lend more cheaply to these institutions than to competitors that do not benefit from 

government support. Economist Wayne Passmore at tlie Federal Reserve Board of Governors has 

estimated the value of that subsidy between $122 billion and $182 billion (Passmore 2005). Suspicions of 

govemment support 'were proven correct "vhen the finns were taken into govemment consen'atorship 

during the financial crisis. 

While the extent of the TBTF problem has not been conclusively detennined, the Richmond Fed believes 

that it is significant. This intuition is based on past experience. The history of govemment interventions 

- from the bailout of Continental Illinois National Bank and Trust Company in 1984 to the public 

concerns raised during the Long Term Capital Management crisis in 1998 - shaped market participants' 

e'<pectations of official support leading up to the events of 2007-0S 

richrnondfed,,,rgjtiJtf 
61 

Why Does This Problem Exist? 

It is easy to see why the TBTF problem developed The potential damage from a large finn's failure is so 

great that governments feel compelled to intenene. That damage comes from at least three forms of 

spillovers. Most directly, when a firm fails, it may be unable to honor its financial obligations to other 

firms, which can snowball until other firms are jeopardized despite being fundamentally sound (Athreya 

2009). To some extent, finns will protect themselves from this possibility by charging a premium to 

counterparties whose risks are unclear. However, the expectation of safety net protection reduces the 

likelihood that a firm will face the full cost of that risk, so it will be less likely to charge those higher 

prClTIILL111S 

A large failure also can provide information about real risks in the economy. However. it is not obvious 

that it would be desirable or even possible to stop that kind of infomlation from spreading 

Finally, a large firm's failure can cause market participants to scramble to reassess which of their 

counterparties are likely to receive government support. This type of panic contributed to the most 

tumultuous days of the financial crisis afler the failure of investment bank Lehman Brothers in September 

200K 

Earlier that year. the investment bank Bear Steams was rescued when the Federal Reserve lent funds to 

JPMorgan Chase to purchase the ailing bank. the first time the Fed had directly extended financing to an 

investment bank. This unprecedented action, along with others taken to treat the financial market strains, 

likely signaled that similar support would be available tor other finllS Yet in September. Lehman 

Brothers, at nearly twice the size of Bear Steams, was allowed to fail. 

TI1C government appearcd to bc offcring support on a casc-by-case basis in a timc of alrcady 

extraordinary market uncertainty (Steelman and Weinberg 2008). But by that time. many investors were 

too entrenched in their contracts to charge premiums for the risks to which they now understood they 

'vere exposed - in particular, the risk that the government ,vQuld not prevent failures. Lehman's failure 

was a turning point after which the financial crisis escalated severely, leading to extraordinary volatility 

and worsening the dO\\11turn in global economic acti,ity. This type of panic - resulting from 

reassessment of the likelihood of protection - would cease to exist if the government's safety net 

boundaries were made explicit and transparent in advance 

Tn other words, the negative, long-tenn effects of a large firnl's failure can be amplified by government 

support. Tri the short term. the spillovers create pain. In the extreme, they could translate to reduced 

economic activity. increased unemployment, and restricted credit to households and businesses. They 

make the case tor intervcntion appear stronger. even as policymakers understand the moral hazard 

problems that intervention creates forthe future. 

For tllis reason. ambiguity around the implicit safety net nearly guarantees that it will grow ever larger 

oyer time (Lacker and \Veinberg 2010). According to Richmond Fed estimates, the proportion of total 

U.S. financial finns' liabilities covered by the federal financial safety net has increased by 27 percent 

during the past 12 years. The safety net covered $25 trillion in liabilities at the end of201l, or 57.1 

richrnondfed,,,rgjtiJtf 
62 

percent ofthe entire financial sector. Nearly two-thirds of that support is implicit and ambiguous 

(Marshall, Pellerin, and Walter 2013). 

What Can Be Done? 

hl the wake of the financial crisis, most policy makcrs agree that TBTF is a problem that must be 

addressed to reduce the frequency and magnitude of future financial crises. There is no consensus on 

solutions, however. 

MmlY advocate broadening the scope of rcgulation to include all institutions and markets that could be a 

source of shocks that lead to finmlcial crises. This is often referred to as systemic risk regulation 

However, more regulation alone cannot be the answer. Regulations impose burdens of their own, creating 

incentivc to innovate arOLUld thcm_ forcing regulators and rule makers to carefully follO\\ and adapt to an 

ever-changing financial landscape (Lacker 2011). Staff at the Federal Reserve mld other regulatory 

agencies put significant resources toward understanding the institutions and markets they supervise. Yet it 

will always be a challenge for them to be as intimately fmniliar with the complex financial arrangements 

into which a given finn has entered as that timl is itself 

Therefore, it is essential for firms to face incentives, separate from the requirements of regulators, to limit 

their own risk. This is called market diseipline_ and it is a critical element of a well-functioning mld stable 

financial system (Hetzel 2009). Market discipline is created when creditors expect to face the hlll costs of 

a finn's losses, and so they have a greater interest in monitoring the risk of finns with which they do 

business. By dctinition, implicit guarantees erode market discipline 

As regulatory reform continues, it is critical to create rules and policies that support market discipline 

rather than merely attempting to supplmlt it with regulation. In the Richmond Fed's view, adopting 

stronger regulations without chmlging what people belie\e about the boundaries ofthc implicit public 

safety net would fail to address a major source ofthe very risks that regulations attempt to minimize. 

A useful first step would be for polieymakers to publicly commit to adhering to a safety net policy that is 

transparent and limited in scope. Reasonable people can debate the exact contours ofthe safety net's 

boundaries. Tn the Richmond Fed's view, the safety net should focus on smaller creditors because, as 

discussed, a larger safety net has proven to grow inexorably over time. Regardless of where the safety net 

boundaries ultimately arc drawn_ making those boundaries explicit should be at the forciront of 

polieYlnakers' efforts to address the TBTF problem. 

The actions of the federal government, including the Federal Reserve, over the past several years have no 

doubt made it harder tor conunitments against intervention to be credible. In tact due to that 

complication, some 'view bailouts as inevitable. believing it 'would make more sense for the government 

to make its guarantees explicit and then charge the associated firms fees tor that service to make those 

activities rightfully costly. 

However, the Fed has some experience dealing with seemingly insumlOuntable credibility problems. 

Many onlookers thought it would be impossible tor the Fed to establish credibility that it would tight 

richrnondfed,,,rgjtiJtf 4 
63 

inflation in the late 1970s. The solution then was to build a reputation for being willing to tighten 

monetary policy to dampen inflation even if it meant higher unemployment in the short run. Similarly. 

only building a reputation to limit lending powers - perhaps by letting large firms fail, which could 

cause disruptions for parts ofthe financial sector - can avoid the moral hazard the central bank's lending 

authority has the potential to create (Goodfriend and Lacker 1999). The stance of the Richmond Fed is 

that, like in the 1970s, the long run benefits of credibility are likely to outweigh the short-term costs of the 

measures taken to establish it. 

One step that could help establish credibility against intervention without enduring an institution's costly 

failure is the creation of "living wills." Living wills are blueprints, written by finns and approved in 

ad\, anced by regulators, for \vinding dOv\l1 large financial institutions in the event of financial distress. 

The purpose of living wills is for firms to plan for how their operations could be lmwound in a manner 

that minimizes spillovers and is unassisted from government protection of creditors, preferably with lower 

costs than a process featuring government assistance. Therefore, living wills present policymakers with a 

viable alternative to emergency "bailouts" in a crisis. The more precisely living wills arc \vrittCl1, the more 

likely regulators would be to invoke them instead of bailouts in a crisis, and the more likely that finns and 

creditors would be to operate without the expectation of government assistance (Lacker and Stern 2012). 

Living wills have the potential to truly end the TBTF problem by making the govenUllent safety net the 

less attractive option in a crisis. 

The Dangers of Discretion 

To help reduce the possibility that a large firnl would have to fail for the Fed's commitment to be 

demonstrated. an additional option is for policymakers to be "tied to the mast" with explicit rules that 

limit their "bility to intervene. A guiding principle for ongoing reb'lliatory refoml should be limiting 

policymakers' discretion to providc loans or othcr means of support to distrcssed firms. 111is would 

prevent market participants from pricing the possibility of that support into contracts (Lacker 2010). 

Some aspects of refonn have the potential to broaden policymakers' discretion if not implemented 

carefully. For exanlple, regulating systemic risk requires some specificity about what makes an institution 

systemically important. 1113t alone is a difficult question. Despite the notion that some finns are '100 big 

to fail", size is not the only detenninant oftiskiness. A timl's connectedness to others in the financial 

systcm is also important. Connectedness. howcvcr, is often hard to dcterminc: thcre arc many possible 

direct and indirect avenues through which one firnl may be exposed to others, and those exposures evolve 

continuously with innovation (Price and Walter 20 11). 111erefore. the basic task of identifying 

systemically important firms necessarily entails discretion (Grochulski and Slivinski 2009). 

One provision of regulatory refoml gives the government authority to step in to unwind the liabilities of 

failing large financial instinltlons and allocate losses among creditors. It is difficult to specify in advance 

the terms of such arrangements since designating any threshold for which creditors will bear losses 

creates considerable incentive for investors to place themselves on the beneficial side ofthe line, 

subsidizing activities located there. For e'(ample, the Orderly Liquidation Authority. established by recent 

regulatory reform efforts, gives the Federal Deposit Insurance Corporation broad discretion over how it 

balances the competing goals of maintaining financial stability (perhaps bailing out short-ternl creditors) 

richrnondfed,,,rgjtiJtf 
64 

and limiting moral hazard (perhaps allowing creditors to bear losses) (Pellerin and Walter 2012). To the 

e,-'tent that such discretion is unavoidable. it should include clear terms of accountability like the leastcost resolution requirements that apply to the Federal Deposit Insurance Corporation when it unwinds 

failing banks (Lacker and Weinberg 2010) 

Conclusion 

Many onlookers believe financial crises and excessive risk·taking are inherent features of a market 

system. The view of the Richmond Fed is that poor incentives, often provided by well-intended but 

UTI\visc market interventions, arc more likely to be behind episodes of financial panic. TIle financial crisis 

of2007-08 was the culmination of many factors, but chief among them was the long history of 

government intervention that e'-'tends back at least to the early 1980s. Such interventions created 

incentives for increased risk-taking. 111CSC incentives arc much harder to correct than they were to create, 

but doing so is imperative to financial stability in the future. 

richrnondfed,,,rgjtiJtf 
65 

Richmond Fed Research 

Athreya. Kartik B. 

2009 Annual Report. 

" Federal Reserve Bank of Richmond 

Ennis. Huberto. and H.S. Malek. 

Goodfriend, Marvin, and Jeffrey M. Lacker " Federal 

Reserve Bank of Riclnnond liconomic Quarterly, Fall 1999, vol 85, no. 4. pp. 1-27. 

Grochulski, Borys, and Stephen Slivinski. 

Federal Reserve Bank of Richmond Fconomic Rriej'09-07, 

Hetzel. Robert L. 

161-200. 

" Speech to the Institute of Intemational Bankers, 

Lacker, Jeffrey M., and John A. Weinberg. Federal Reserve Bank 

of Richmond liconomic Brie110-06, June 2010. 

Lacker. Jeftrey M. lZc:;ub;o,v" Speech to the 2011 

Femnll College Fomm on Critical nlOught, Innovation & Leadership, Roanoke. Va .. April 7. 2011. 

Malvsheva, Nadezhda. and John R. Walter. ",mh: 

Fed~ral Reserve Bank of Richmond Working PaperN~. 10-03R. March 2010. 

Malysheva, Nadezhda. and John R. Walter. 

Federal Reserve Bank of Richmond Fconomic 

290. 

MarshalL Liz, Sabrina R. Pellerin. and John R. Walter. 

l:stinutc·, " Federal Reserve Bank of Richmond Special Report. Febmary 2013 

Pellerin, Sabrina R., and John R. Walter. "On,i,trh Liiltll,t"'[',,;,1. 

BC1nkrurtc;. " Federal Reserve Bank of Richmond Economic Quarterly, 

1, pp 

Price. David A .. and John R. Walter. 

Federal Reserve Bank of Richmond Fconomic 

Steelman. Aaron, and John A. Weinberg 

" Federal Reserve Bank of Richmond 2008 Annual Reporr. 

Additional Resources 

Lacker. Jeftfey M .. and Gary H. Stern. "Lacker and Stem: Large Banks Need Living Wills.'" Wall Street 

Journal, hme 12.2012, p. A13. 

Passmore. S. Wayne. 
66 

Stem. Gary H .. and Ron J. Feldman. 

Brookings Institution Press. 2004. 

website.) 

BJg 

The Hazards a/Bank Bailouts. Washington. D.C.. 

l·,coko are available on the Minneapolis Fed's 

A full list of related researeh and speeches from the Richmond Fed 

richrnondfed,()rgjtiJtf 
67 

Mr. BACHUS. Thank you. 

Mr. Bernstein? 

TESTIMONY OF DONALD S. BERNSTEIN, CO-CHAIR, INSOLVENCY AND RESTRUCTURING GROUP, DAVIS POLK AND 

WARDELL L.L.P. 

Mr. BERNSTEIN. Well, thank you for inviting me to testify. 

I have spent a lot of my practice life dealing with the failures of 

financial institutions, starting with Drexel Burnham many years 

ago. And, in recent years, I have done a lot of work on resolution 

plans, ‘‘living wills.’’ 

I too am here in my individual capacity, however, and the views 

I express are my own. They are not to be attributed to my firm or 

clients or organizations with which I am affiliated. 

I want to begin with a few observations about the Lehman 

Brothers bankruptcy and its implications for the bankruptcy of 

other large financial institutions. Then I am going to provide a bit 

of an overview of how orderly liquidation authority is being contemplated to be used, including the single point of entry resolution 

strategy that has been developed by the FDIC. And then, I am 

going to turn to the Bankruptcy Code and talk a bit about how resolution planning has interfaced with the Bankruptcy Code in its 

current form. And I will end with a few suggestions as to the way 

the code might be amended to make it easier to resolve financial 

firms. 

The unplanned failure of Lehman Brothers as we all know had 

an enormously disruptive effect on the U.S. economy. Financial 

firms are very vulnerable to a loss of confidence. Even if their economic fundamentals haven’t changed once the confidence is lost because they are in the business of so-called maturity transformation. 

They incur short-term liabilities like deposits and some of the other 

short-term liabilities that were just mentioned and they invest 

them in long-term assets like mortgages and corporate loans and 

the like. And when short-term creditors lose confidence they run. 

They take their money and they run. 

And if a run is prolonged and intense, it can force the firm to 

sell assets at fire-sale prices and distress markets and exacerbate 

any losses that might otherwise exist. And that also results in depressing market values generally, which has a follow-on effect to 

other firms. So, if you have this process of unwinding of maturity 

transformation from what it has been called, ‘‘contagious panic,’’ 

you end up with a very destabilizing situation. And, in fact, that 

is how Lehman Brothers’ unplanned failure actually unfolded. 

Now, to avoid this disrupt—this abrupt unraveling of maturity 

transformation, distressed firms need to be able to meet sudden liquidity needs without being forced to abruptly sell their assets. 

And, over the longer term, they need to be able to either be recapitalized or wound down in an orderly way that doesn’t create the 

risk of fire sales of assets. In 2008, neither the regulators nor the 

firms had the tools to accomplish these goals without financial support from taxpayers. And though the large institutions ended up 

repaying those investments, there was wide recognition that more 

tools were needed to avoid having taxpayer funds put at risk again. 
68 

Many regulators and commentators believe that some of the tools 

that are being developed, under title II of Dodd-Frank, actually accomplish this goal. And I am going to describe the single point of 

entry tool, which is the most—the one that is most frequently discussed. In a single point of entry resolution, only the holding company for the financial institution is put into an insolvency or receivership proceeding. All of the losses are borne by the holding 

companies, creditors and shareholders. And the operating subsidiaries, like the bank or the broker-dealer, wouldn’t fail. They would 

be recapitalized using assets that are maintained for that purpose 

at the holding company and they would continue in business as a 

newly created—as subsidiaries of a newly created holding company 

which, under orderly liquidation authority, is called a bridge holding company. 

There are a number of reasons why many people think this approach has some viability. The first is that the holding company 

structure used by large financial institutions creates an additional 

layer of loss-absorbing debt that is effectively subordinated to operating liabilities and especially the short-term liabilities that were 

just mentioned that are down in the operating subsidiaries. The 

firms have also substantially increased the amount of loss-absorbing capital and debt that are in the holding companies and new 

rules are expected to be forthcoming that require them to maintain 

sufficient loss-absorbing debt and assets at their holding companies. So financially the firms should be in a position to execute the 

type of recapitalization that is being contemplated with all of this 

additional loss absorbency that they have. 

In addition, because the firm’s operating subsidiaries keep in 

business, single point of entry eliminates the need for multiple insolvency proceedings for different entities, both domestically and in 

foreign countries, which greatly reduces the complexity of the resolution process. That was one of the big problems in Lehman Brothers. You had a siloing of each entity, one from the other, that resulted in the inability to effectively resolve because you had too 

many people, too many parties to consult with and the inability to 

deal with entities on a regular-way basis. 

To supplement this, there have been initiatives on a multinational level including those at the Financial Stability Board and 

crisis management groups that have been organized by key regulators of individual firms that are creating increased alignment 

among the national regulatory authorities regarding the benefits of 

what are called single point of entry and bail-in approaches to the 

failure of financial firms. And this is evidenced by joint work that 

has been done by the FDIC and the Bank of England on the subject. 

Finally and importantly, orderly liquidation authority does include certain special tools that are not currently available under 

the Bankruptcy Code. And that is going to lead me into my discussion of bankruptcy. But, those tools really are not that—there 

aren’t that many of them. There are three very important ones. 

One is the clear path that orderly liquidation authority provides 

to creating a bridge holding company and transferring the stock of 

recapitalized subsidiaries to the bridge holding company. That sep-
69 

arates them from the debt and the equity of the old holding company and effectively creates a recapitalized entity. 

The second important feature is the orderly liquidation fund 

which is underwritten by the private sector and provides fully secured interim liquidity, if needed, to stabilize the recapitalized 

firm. 

And the third is the preservation of financial contracts by briefly 

staying closeouts and having provisions that override cross-defaults 

and bankruptcy defaults so the contracts can be assumed by the 

ongoing entities. Again, a problem that was faced in Lehman 

Brothers because of the safe harbors in the Bankruptcy Code. 

Recognizing that progress is being made in developing the single 

point of entry strategy, just a couple of weeks ago, Moody’s Investor 

Service announced that it was removing the two notch uplift provided to ratings of debt of the largest bank holding companies to 

account for the possibility of government support. Effectively, they 

have reached the conclusion that that government support is going 

to be unnecessary because of the progress that is being made on 

resolution. 

So, let us turn to the Bankruptcy Code now. I agree completely 

that traditional bankruptcy proceedings do provide a path that, despite the Lehman Brothers’ experience, can be utilized to resolve 

financial firms provided that there is appropriate preplanning. The 

Bankruptcy Code provides transparency. It provides the opportunity for effected parties to receive notice and be heard in court 

and ex ante judicial review prior to major actions. All of which 

serve to inspire market confidence. And, if you talk to people who 

are investors, all of them like—uniformly like the Bankruptcy 

Code. They like the transparency. 

In my view, these are clear benefits of the bankruptcy process. 

However, the absence of the special tools available under orderly 

liquidation authority makes it harder for financial firms in bankruptcy to utilize a single point of entry strategy. As a result, the 

title resolution—title I resolution plans typically adopt a hybrid approach in which some operating businesses are contemplated to be 

sold or recapitalized, while others are allowed to wind down in an 

orderly way. First, the resolution plans identify the material operating entities that, because of their capital structure or the nature 

of their business, are unlikely either to suffer losses or that can be 

recapitalized as they would be under orderly liquidation authority. 

And then, there are tools, such as Section 363 of the Bankruptcy 

Code that can be used to accomplish a speedy sale or transfer of 

the stock of those entities that are not going to fail to a debt-free 

holding company or to a third party. And the debt-free holding 

company might be owned by a trust for the creditors of the bankruptcy estate so that the creditors in fact are not losing value, but 

they are actually preserving the going concern value and it is being 

held for their benefit by a fiduciary. The new holding company can 

then be sold in private transactions or public transactions, pieces 

of it can be sold or its shares can be distributed to the left-behind 

creditors in a conventional Chapter 11 plan of reorganization. 

This is all possible under the current code. Now, entities that 

can’t be sold or recapitalized need to be wound down in an orderly 

way. And the wind downs need to be carefully planned taking into 
70 

account the impact of the different insolvency regimes; the reactions of regulators, customers, counterparties, financial market 

utilities, and others that need to be anticipated in the resolution 

plan. Liquidity needs, through the wind down, need to be conservatively anticipated and the maintenance of shared services and 

technology, and the transition of critical operations to other firms, 

and the distribution of customer assets and property need to be 

provided for. 

Today, liquidity levels at the firms allow them to sustain in addition a pre-failure runoff of some of their balance sheet. You may 

recall that in 2008 one of the problems that faced Lehman Brothers 

was—— 

Mr. BACHUS. Let me—— 

Mr. BERNSTEIN. Sorry. 

Mr. BACHUS. We have a pending vote series—— 

Mr. BERNSTEIN. Okay. 

Mr. BACHUS [continuing]. On the House floor. So, we are going 

to stand in recess. We will come back and I will allow Mr. Bernstein to complete that very good opening statement. 

And the Committee stands in recess, subject to the call of the 

Chair. 

And we ask Members to return immediately so we may resume 

the hearing as soon as possible. And we anticipate doing that fairly 

soon, but the staff will keep you abreast. 

Thank you. 

[Recess.] 

Mr. BACHUS. We will go ahead and commence the hearing so 

that the Committee is called to order. 

And, Mr. Bernstein, you are recognized for your—— 

Mr. BERNSTEIN. Thank you, Mr. Chair. 

So, I was just describing how the resolution plans seem to be 

evolving into hybrid strategies involving continuation of some entities and wind down of others. And I was giving an example of how 

today, with the liquidity levels that the firms have, some of that 

wind down can actually happen prior to failure because they have 

got the ability to address liabilities that are running for a period 

of time because of the liquidity on their balance sheets. And I was 

mentioning the example of prime brokerage accounts, which were 

one of the precipitating liquidity factors in Lehman’s bankruptcy. 

And that is something that can be planned for. And it can actually 

make the resolution process less complex and less systemically disruptive. 

And I also note in my written statement a number of other ways 

that the plans contemplate taking steps, either well in advance or 

immediately prior to the failure of the firm, to reduce the complexity of the wind downs of entities that are not being recapitalized or sold. 

So, to summarize, the title I plans rely on a combination of approaches to orderly resolution under the code. They adjust some 

current operating practices to simplify resolution. They plan for client-driven reductions in the firm’s balance sheet, prior to resolution. They preplan the marketing and sale of some of the firm’s 

businesses. They contemplate recapitalization and continuation of 

others and the wind down of still others. Those hybrid approaches 
71 

can actually be quite robust with appropriately detailed planning. 

And I can’t emphasize that enough. The plans are extremely detailed and they need to be. 

So, part of making these things work is not only the planning 

process, but also appropriate consultation with regulators in advance and education of both regulators, market participants and 

those who administer the bankruptcy process so they understand 

how these plans work and are in a better position to implement 

them. 

Now all of that being said, I think the hybrid approaches do entail complexity and more risk than the single point of entry approach. So, I believe that reforms to the Bankruptcy Code that add 

tools to facilitate the single point of entry approach, perhaps in the 

form of a modified Chapter 14, which I know people have been 

talking about, should be considered. 

These changes would include, among other things, clarifying that 

bank holding companies can indeed recapitalize their operating 

subsidiaries prior to commencement of bankruptcy proceedings; 

clarifying that Section 363 of the Bankruptcy Code can be used to 

create a new bridge holding company, in the manner that I described; briefly staying closeouts and allowing the assumption and 

preservation of financial contracts, including overriding bankruptcy 

defaults or cross defaults to facilitate resolution; and providing a 

fully secured resource, like the OLF, to be available if DIP financing, debtor-in-possession financing, is not available in the market. 

Expanding resolution options in bankruptcy will minimize systemic risk and better avoid putting taxpayer money at risk. But, 

importantly, even if the Bankruptcy Code is amended, I think it is 

important that we retain all of our options. That single point of 

entry in bankruptcy is not the only option, but that the orderly liquidation authority be retained as a backup option; not necessarily 

the first choice, but just to have it there in case it is needed. 

We can’t know what the contours of the next crisis will be. And 

we should want regulators to have the greatest variety of tools in 

their toolkit. In addition, host country regulators, regulators in 

other countries who are less familiar with our bankruptcy system, 

will take comfort from the fact that, if all else fails, U.S. regulators 

have the power to act. 

I want to thank you for allowing me this opportunity to present 

my views. 

[The prepared statement of Mr. Bernstein follows:] 
72 

STATEMENT OF 

DONALD S. BERNSTEIN 

BEFORE 

SUBCOMMITTEE ON REGULATORY REFORM, COMMERCIAL AND 

ANTITRUST LAW 

THE COMMITTEE ON THE JUDICIAR Y 

US HOUSE OF REPRESENTATIVES 

WASHINGTON, D.C. 

DECEMBER 3, 20 \3 

THE BANKRUPTCY CODE AND FINANCIAL INSTITUTION INSOL VENCTES 
73 

Thank you for inviting me to testify today. I am Donald Bernstein, co-chair of the 

Insolvency and Restructuring Group at Davis Polk & Wardwell LLP. I am on the Board 

of Editors of Collier on Bankruptcy., a Commissioner on the American Bankruptcy 

Institute's Commission on the Refonn of Chapter II and a past Chair of the National 

Bankruptcy Conference. I am also a member of the Legal Advisory Panel that advises the 

Financial Stability Board regarding resolution issues, and, during the last few years, I 

have spent a significant portion of my time working on resolution plans for large 

financial firms under Section 165(d) of the Dodd-Frank Act -- commonly known as 

Living Wills. I am here today in my individual capacity, and the views I express are my 

own, and not those of Davis Polk, any client or any organization with which I am 

atliliated. 

I have been asked how financial firms can fail and be resolved in a rapid and 

orderly way in proceedings under the Bankruptcy Code. This requires consideration not 

only of the Bankruptcy Code, but also the insolvency and resolution laws applicable to 

domestic banks (the Federal Deposit Insurance Act), domestic broker-dealers (the 

Securities Investor Protection Act), and, in the case of non-U.S. affiliates of U.S.-based 

financial firms, foreign insolvency and resolution laws (like special administration in the 

United Kingdom). 

As a prelude, I will make a few observations about the Lehman Brothers 

bankruptcy and its implications for the bankruptcy resolution of other large financial 

firms. I will also provide an overview of the single-point-of-entry resolution strategy 

being developed by the FDIC under Title II of the Dodd-Frank Act's Orderly Liquidation 

Authority or OLA. I will then turn to how finns can be resolved in an orderly way under 
74 

current bankruptcy law if - unlike Lehman Brothers - they do appropriate advance 

planning. Finally, I will identify several changes to the Bankruptcy Code that would 

facilitate the resolution offinancial firms in bankruptcy. 

Lehman Brothers and Contagious Panic 

The unplanned failure of Lehman Brothers, the largest failure of a U.S. financial 

firm during the financial crisis, had a very disruptive etIect on the financial stab ility of 

the United States, even though the losses ultimately suffered by creditors in the Lehman 

bankruptcy were not themselves catastrophic. There is no doubt that Lehman's 

bankruptcy exacerbated a crisis of confidence in the financial services sector and was a 

major factor in the subsequent decisions to provide federal government support of a 

variety of kinds to the financial system during the financial crisis. 

Financial firms, both large and small, are vulnerable to a loss of confidence 

because they engage in the economically crucial business of maturity transfonnation. 

They incur short-term liabilities (for example, liabilities to depositors) to permit them to 

invest in long-term assets (such as mortgages and corporate loans). When short-term 

creditors lose confidence in a financial firm, they run for fear that the firm will be unable 

to pay their claims. Such a run strains the financial firm's liquidity resources and, if 

prolonged and intense, ultimately can force the firm to sell its assets to raise cash, 

regardless of the condition of the financial markets at the time. Selling into depressed 

markets can lead to further losses, turning a fear of insolvency into reality. Such fire-sales 

can also depress market prices, which reduces the mark-to-market value of similar assets 

2 
75 

on the books of other firms.' This contagious downward spiral resulting from a loss of 

confidence in financial firms has been called contagious panic in a recent report of the 

Bipartisan Policy Center entitled Too Big to Fail: The Path to a Solution (the BPC 

Rep ort) 2 

Lehman's unplanned failure unfolded injustthis way. A run led to a liquidity 

crisis as Lehman struggled to liquify assets to meet the claims ofshort-tenn creditors, the 

liquidity crisis led to bankruptcy, which in tum led to wholesale close-outs of open 

trades, the selling of collateral into distressed markets and ultimately the sale of 

Lehman's businesses and assets at fire-sale prices. This cycle in tum led to the fear in the 

markets that other finns might suffer the same fate - contagious panic. 

The goal of an effective strategy for resolving distressed financial firms, whether 

large or small, should be to avoid the abrupt unraveling of the finns and the crucial 

maturity transfonnation service they ofTer through fire sales into distressed markets. 

Distressed finns must be able to meet sudden liquidity demands without being forced to 

abruptly sell their assets into the markets at distressed prices. Over the longer tenn, they 

must be able to fail and either be recapitalized or be wound down in an orderly mannerI See, e.g., Andrei Shlcifer & Robert W. Vishny, Fire Sales in l'inance and Jl..licroeconomics, 25 

Journal of Eeommic Perspectives 29 (2011). Fire sales also impose deadweight losses on the wider 

economy. ld. 

, Jolm F. Bovenzi, Randall D. GUYllll & Thomas H. J ackson. Too B~r; to Fai]: The Path to a 

So11llion, A Report of the Failure Resolution Task Force of the Financial Regulatory Refolln Initiative of 

the Bipartisan Policy Cenler, p. 1 (May 2013). See also Daniel K. Tarullo. Member. Board of Govemors of 

the Federal Reserve System, Toward BUildiI1r; a Afore Effecrive Resolution Regime: Progress and 

UldUenges. Remarks at the Federal Reserve Board and Federal Reserv e Bank of Richmond Conference. 

Planning for the Orderly Resolution of a Globally Systemically Important Bank (Washington, D.C.. Oct. 

18,2013): Hal S. Scott. lnrerconnectedness and Conragion (Nov. 20, 2012): Randall D. Guynn Are 

Bailu[][s Incvitablc;>, 29 Yale Journal on Regulation 121 (2012). 

3 
76 

in either case with adverse consequences for shareholders, debt holders and management. 

This allows them to obtain appropriate values for their assets, avoids market panic, and 

does not involve the rapid and disorderly liquidation of their balance sheets. 

Since 2008, the resiliency of the tinancial system has increased substantially, with 

enhanced capital and liquidity requirements as well as enhanced supervision of non-bank 

financial companies. As a result, the ability of the finns to recover from financial shocks 

has increased and the probability of failure has been significantly reduced. In addition, 

the ability to implement resolution strategies that avoid the abrupt unraveling of the 

finns' balance sheets has increased. 

One Approach to Addressing Contagious Panic: The FDIC's Single-point-of-entry 

Recapitalization Strategy 

In 2008, regulators attempting to stem contagious panic and resolve distressed 

financial institutions without fire-sales of assets and the unraveling of maturity 

transformation had a very limited set of tools, and the inadequacy of those tools and the 

lack of pre-failure planning led to the investment of taxpayer funds to support the 

financial system. Though all large financial institutions repaid those investments with 

interest, there was wide recognition that other tools were needed to deal with the failure 

offinancial finns. Title IT of the Dodd-Frank Act (Orderly Liquidation Authority or 

OLA), provides a valuable additional tool. Regulators and commentators, including the 

BPC Report, have increasingly come to favor the single-point-of-entry approach to 

addressing the failure of financial finns proposed by the Federal Deposit Insurance 

4 
77 

Corporation (the FDIC) under OLA. 1 In its purest form, single-point-of-entry involves 

commencing resolution proceedings only with respect to the financial firm's top-level 

holding company, with all losses being borne by shareholders and creditors of that entity 

and not by taxpayers. Operating entities, like the finn's banking or broker-dealer 

subsidiaries, would not be placed in insolvency or resolution proceedings, but instead 

would be recapitalized using assets of the holding company and would continue as 

subsidiaries of a newly created debt -free bridge holding company. Instead of being 

liquidated, the firm would be restructured and recapitalized, leaving behind the holding 

company's creditors and shareholders in the OLA receivership, and creating a viable 

recapitalized firm the value of which would be preserved for the holding company's 

stakeholders without requiring a prolonged resolution process for the operating entities. 

By recapitalizing the firm's operating subsidiaries with holding company assets, 

the single-point-of-entry approach preserves the value of those operating businesses and 

pushes the firm's operating losses up to the old holding company to be absorbed by the 

holding company's shareholders and creditors. The holding company's stakeholders 

nevertheless benefit from the strategy because liquidation of the firm's valuable operating 

, See, e.g .. Federal Deposit Insurance Corporation & Bank of England. Joint Paper. Resolving 

GloballyAcrNe, SystemicaIly Imporrant. Financial Institutions (Dec. 10,2012) (jointly proposing the 

single-point-of-entry approach): Daniel K. Tamll0. Member. Board of Govemors of the Federal Reserve 

System, Toward BUilding a 1110re Effective Resolution Regime: Progress and ChaJlelW,es. Remarks at tile 

Federal Reserve Board and Federal Reserve Bank of Richmond Conference. Plamung for the Orderly 

Resolution of a Globally Systenrieally Important Bank (Washington. DC .. Oct. 18.2013) (",TIle singlepoint-of-entry approach offers the best potential for the orderly resolution of a systenuc financial firm ... "): 

William Dudley. President and CluefExecutive Officer. Federal Reserve Bank of New York. Remarks at 

the Federal Reserve Board and Federal Reserve Bank of Richmond Conference. Planning for tile Orderly 

Resolution of a Globally Systenucally Important Bank, P. I (WaslungtoIl D.C .. Oct. 18.2013) n very 

much endorse tile single-point-of-entry framework for resolution as proposed by the Federal Deposit 

Insurance Corporation (FDIC)."). For stcp-by-stcp diagrams illustrating the FDIC's singlc-point-of-cntry 

resolution strategy, see BPC Report, pp. 23-32. 

5 
78 

businesses and assets at fire-sale prices is avoided and the going concern value of the 

operating subsidiaries is preserved. This value ultimately is available for distribution to 

the stakeholders in the receivership. 

The United States is fortunate that large US. financial firms rely on a holding 

company structure, where significant amounts oflong-term unsecured debt issued by the 

parent holding company are structurally subordinated to deposits and other operating 

liabilities of financial subsidiaries. This structure creates an additional layer of loss 

absorbency at the holding company level, providing the ability, as the FDIC suggests, to 

keep systemically critical operating subsidiaries out of resolution proceedings despite the 

failure of the parent. Other countries are adopting similar recapitalization approaches as 

they pursue local and regional law reform, though in countries that have a unitary bank 

model (where there are no holding companies), the recapitalizations mustbe 

accomplished through bailing in (conversion to equity) of operating entity debt." 

As I have already noted, large financial tirms have undergone substantial changes 

since 2008 that facilitate the implementation of the single-point-of-entry strategy and 

improve their resiliency, including a substantial increase in loss-absorbing capital and 

4 See, e.g.. Martin J. Gruenberg, Chainnan. FDIC. Remarks at the Vo1cker Alliance Program. 

Washington, D.C. (Oct. 13, 2013) (describing endorsement of single-point -of-entry resolution model by the 

U.K.. Gennany and Swit/eriand as the preferred strategy for resolving global financial institutions. and 

progress being made in Europe, China. Japan 311d elsewhere): Europe311 COllnnissi01~ Proposal for a 

Directive of the European Pariiamenl and of the Council establishing a fr31nework for the recovery and 

resolution of credit institutions and investment firms (2012), including the power to bail-in debt (convert it 

to equity) through a single-point-of-entry resolution strategy: Paul Tucker. Deputy Governor for Financial 

Stability at the Bank of England, SolVing 100 big 10 fail- where do (hings sland on resollllion?, Remarks at 

the institute of International Fin311ce 2013 Aimual Membership meeting, Washington, D.C. (Oct. 12. 2013) 

(describing the single-point-of-entry resolution strategy as workable now in the United States and 

predicting it will be workable soon in the U.K. and Europe generally): Federal Deposit ll1SUf311Ce 

Corporation & Bank of England. Joint Papcr, ResolVing GlohallyAcrive, Systemically imponant, Financial 

Instiw[ions(Dec. 10,2012). 

6 
79 

balance sheet liquidity to meet regulatory requirements and risk management needs,s the 

de-risking of the balance sheets of U.S. financial firms and capital restructuring to 

address anticipated requirements for minimum amounts ofloss absorbing debt and assets 

in the holding companies of financial finns 6 

, See Federal Reserve and OCC Regulatory Capital Rules, 78 Fed. Rev, 62, 0 18 (Oct. 11,2013) 

(to be codified at 12 C.F.R. Pts. 3, 5, 6. 165, 167,208,217, and 225); FDIC, Regulatory Capital Rules. 78 

Fed. Reg. 55,340 (Sept 10, 2013) (to be codified at 12.C.F.R. pts. 303, 308,324,327,333,337,347,349, 

360,362. 363,364,365,390, and 391): Federal Reserve, OCC and FDIC Liquidity Coverage Ratio: 

Liquidity Risk Measurement Standards, and Monitoring (Proposed Rule), 78 Fed. Reg. 71, 818 (Nov. 29, 

2013), According to the Federal Reserve, the largest U, S, bank holding companies have increased their 

common equity to morc thau twice the amount they had during the financial crisis of 2008. Specifically, the 

weighted tier 1 conunon equity ratio, which is the ratio of eonnnon eqnity to risk-weighted assets, of the 18 

bank holding companies that participated in the Federal Reserve's CompreheIlSive Capital Analysis and 

Review (CCAR) has more timn doubled from 5.6% at tile end of 2008 to 11,3% in the fourth quarter of 

2012, reflecting an increase in eonnllon equity from $393 billion to $792 billion during thc samc pcriod. 

S"" Federal Reserve, Press Release - Federal Reserve Announces Resnlts of Comprehensive Capital 

Analysis and Revicw (CCAR) (Mar. 14,2013), available at 

http:/;"ww.redcralreserYc.goY/new seventsipress!bcregi20 110:114a.h!l11. The results of the Federal 

Rcserve 's 2013 Dodd-Frank and CCAR stress tcsts show timt the largest U.S. bank holding companics Imvc 

enough common equity to absOlb all of their projected losses under the Federal Reserve's severely adverse 

stress scelk1rio and still have enough common equity left to exceed the minimum risk-based and leverage 

capital rcquirements. See Fcderal Rescrve, Comprchcnsivc Capital Analysis and Review 2013: Assessment 

Framework and Results (Mar. 14,2013), available at 

Inm~LwwwJcdcrl.lln;.£crvc.gQ:ffilcvlSCYCI11S/prcss!'l:>crc.!li>:-'-m:::]O 13 -rc~lJlts-20 13 03J.:LOO!'. Besides a 

significant increase in levels of loss-absorbing capital. U.S. banks have also substantially improved their 

liquidity profiles. For example, U. S. banks' holdings of cash and high-quality liquid securities haYe more 

than doubled since the end 01'2007 and now total more than $2.5 trillion. See Ben S, Bemanke, Chainnan. 

Board of Goyemors of the Federal Reserve Stress Banks: Wlmt Have We Leamed? (Apr. 

8,2013), available 

o See Daniel K. Tamllo, Membcr. Board of Governors ofthe Fcderal Rescrve System, Toward 

Rllilding a More F1f'eclive Resoilltion Regime: [''''grE'' and OJallenges, Remarks at the Federal Reserve 

Board and Federal Reserve B auk of Richmond Conference, Planning for the Orderly Resolution of a 

Globally Systemically Important Bank (Washington, D.C .. Oct. 18.2011) (announcing that the Federal 

Reserve expects to propose minimumlong-tenll debt and eligible assets requirements applicable at the 

bank holding company level for the largest U.S. banking groups within the next few months in order to 

ensure tiley have sufficient loss-absorbing resources to facilitate a single-point-of-entry resolution). See 

also Pmgress and Next Steps l,manls L'nding "j()o-liig-j()-hIiJ" (l1ni'), Report of the Financial 

Stability Board to tile G-20 (Sep. 2, 2013) (atlllouncing that the Financial Stability Board is developing 

minimum gone-concern loss-absorbing capacity requirements to ensure that global and domestic 

systemically important financial iIlStitutions have enough loss-absorbing capacity in the fonu of equity, 

long-term debt atld assets to recapitalize tile institutions without the need for taxpayer capital in the event of 

severe financial distress). See also, Morgan Stanley Research North America, Large and Midcap Banks, 

OL1: Mure Debt Sooner? (Dec, 13,2012); GDldman Sachs Research Loss ,1bsOlbency in Banks (Dec, 

2012); J.P, Morgan North America Credit Research, lamllo Speech iIlcreases Momentum lor l}ebt liullers 

(Dec, 6, 2012) 

7 
80 

Moreover, because of initiatives at the multinational level, including those of the 

Financial Stability Board and the crisis management groups organized among key 

regulators of individual finns, there is increasing alignment among national regulatory 

authorities regarding the benefits of recapitalization and bail-in approaches to dealing 

with failure. 7 A single-point-of-entry recapitalization, for example, protects host-country 

interests by making resolution proceedings for host-country operations unnecessary. 

Since the operations of the largest financial finns are highly concentrated in a few 

jurisdictions, like the US and the UK, 8 coordination and alignment among the relevant 

authorities can readily occur if appropriate advance planning among regulatory 

authorities can be done. Key to these efforts is the fact that recapitalization and bail-in 

strategies allow the finns to continue their business and meet their operating obligations 

in the ordinary course in both home and host countries. As a result, local regulators do 

not feel compelled to take precipitous actions that can hinder the resolution of the overall 

group. 

7 See, e.g.. Financial Stability Board. Key Allribuies for Lffective Resolution Regimes of Findncial 

Instiw[ions (Oct. 2011) (endorsing recapitalization (bail-in) within resolntion strategies and advocating the 

creation of legal tools to effect such strdtegies): Federal Deposit Insurance Corporation & Bank of Engjand. 

Joint Paper. Resolving Globally fictive. Sys[Cmically Important. Financial Instiw[iuns (Dec. 10. 2012) 

(endorsing and advocating singlc-point-of-entry resolution strdtegies for systemically important financial 

institutions): Progress and Next Steps Towards Emling ""Tuo B~f2, To Fail" ([BTF), Report of the Financial 

Stability Board to the G-20 (Sep. 2. 2013) (endorsing single-point-of-entry and multiplc-point-of-entry 

resolution strategies and announcing plans for minimum gone-concern loss-absoJbing capacity 

requirements to ensure the feasibility of such strategies). 

x See FDIC Preseniationto the FDIC Systemic Resolution Advisory COlmnillee Meeting, Panel on 

International Resolution Strategy (Dec. 10.2012) (over 90% oftlle total reported foreign activity for the 

top seven U.S. SIFIs is located in three foreign jurisdictions. with the UK having the largest footprint). 

Video available at llln:i!'DIw.yo"Q!.1un.com/!v~apod.Lillrarviind~x.asp?libraty=pnlil0472 Idle" SRAC. 

Presentation slides from the meeting arc available at 1I1tp://wwvv.fdic.gov/abom/srac/21112/2012-12-

10 in.ternatio nal-reso lurio ll-stratcrrv. pdf. 

8 
81 

Orderly Liquidation Authority includes special tools that facilitate implementation 

of a single-point-of-entry resolution strategy. Among the most important of these tools 

are the following 

• The Bridge Holding Company Tool. OLA provides a very clear path to 

creating and transferring the stock of recapitalized operating subsidiaries 

to a new bridge holding company, leaving holding company debts and 

equity behind in the FDIC receivership. The Bridge Holding Company 

Tool allows the operating businesses to be quickly and clearly separated 

from the failed holding company, and also simplifies the governance of 

the operating subsidiaries, allowing them to maximize their value in the 

most etlicient manner possible. 9 

• The liquidity Support Tool OLA includes the Orderly Liquidation Fund 

(OLF), 10 which is ultimately underwritten by private sector iinancial 

firmsll and provides fully-secured interim liquidity support if necessary to 

help stabilize the recapitalized financial finn and avoid any fire-sale of 

the finn's assets. 

• The Financial Contract Preservation Tool. OLA includes special 

provisions to pennit the preservation oftinancial contracts by briefly 

9 Section 210(0) of the Dodd-frank Wall Street Refonn and Consumer Protection Act (the "DoddFrank Act"), 12 U.S.C § 5390(0). 

In Section210(n) ofthc Dodd-fnlllk Act, 12 U.S.C § 5390(n). 

II Section 2 10(0) ofthc Dodd-fmnk Act, 12 U.S.C § 5390(0), providing for the imposition of 

risk-based assessments on large financial firms to cover any losses of the OLF, 

9 
82 

staying close outs due to bankruptcy defaults, 12 or, in the case of contracts 

of subsidiaries, invalidating cross-defaults arising out of the failure of the 

holding company, so such contracts can be assumed and preserved. 13 

Market participants increasingly recognize the viability of the single-point-ofentry approach to resolution offinancial firms. A few weeks ago, for example, Moody's 

Investor Service announced that, on the strength of the progress being made on singlepoint-of-entry resolution, the two-notch uplift provided to ratings of the debt of the 

largest bank holding companies to account for the possibility of government support 

would be eliminated. 14 

An Alternative Approach: Pre-Planned Resolution of Financial Firms in 

Bankruptcy 

While single-point-of-entry under OLA offers a clear path to the orderly 

resolution of distressed U.S financial firms, more traditional bankruptcy proceedings 

provide another path that, despite the Lehman Brothers experience, can be utilized with 

appropriate pre-planning. The Dodd-Frank Act makes clear that the use of Orderly 

Liquidation Authority is to be limited to situations where bankruptcy is not a viable 

resolution strategy, 15 and the FDIC has announced that it supports the idea that 

12 Section 21 0(c)(8\ (9). (10) of lhe Dodd-Frank Act- 12 U.S.c. § 5190(c)(8), (9), (10). 

13 Section210(c)(l6) of the Dodd-Frank Act. 12 U.S.C. ~ 5390(c)(16). 

14 Moody's Inveslors Service. Raling AClion: Moody's Concludes Review ofEighl Large U.S. 

Banks (Nov 19.2013). 

"Section 201(b) oflhe Dodd-Frank Acl provides in relevanl parllhallhe Orderly Liquidalion 

Authority of Title II oftlle Dodd-Frank Aet may not be legally invoked unless the Secretary of the Trcasury 

delennines lhal "I he failnre of lhe financial company and ils resolulion under olherwise applicable Federal 

or State law L e.g., tlle Bankruptcy Code J would have serious adverse effects on financial stability in tlle 

Uniled Slales" and "any aclion under seclion 204 [oflhe Dodd-Frank ACI] would avoid or miligale such 

adverse effects. .. 

10 
83 

bankruptcy, not OLA, should be the presumptive resolution procedure.'i> The Bankruptcy 

Code provides transparency, the opportunity for affected parties to receive notice and be 

heard in court, and ex-ante judicial review prior to major actions. Bankruptcy is also 

well-established and well-understood by market participants, even though banks, 

insurance companies and securities firms have long been excluded from ordinary 

bankruptcy proceedings. Thus, it is not surprising that Dodd-Frank provided that 

bankruptcy should be used to resolve the failed holding company of a financial firm 

wherever possible. 

The goals of a banlauptcy resolution should be to assure market participants that 

the liquidity needs of the distressed firm can be satisfied and fire sales can be minimized, 

that the firm's critical operations, including intercompany support services, will be 

continued or exited in an orderly way, and that the firm's losses will be imposed on 

shareholders and private creditors, such as long-term debt holders of the finn's holding 

company, while obligations of the operating subsidiaries (such as deposit liabilities and 

other money-equivalent liabilities) are paid in fulL 

Of course, multi-entity financial finns will be resolved not only under the 

Bankruptcy Code, but also their different operating subsidiaries will be subject to 

multiple insolvency regimes, both in the United States and in other countries. There is no 

16 See Remarks by Martin J. Gruenberg. Chairman, Federal Deposit Insurance Corporation, on 

hnplemenlation of the Dodd-Frank Act before the Volcker Alliance Program (October 13. 2013) available 

a/ hllp:! /" WI> .fdic. gOY! ne" s/news/speeches/swelI11' .hlml: See also Slatement of Martin J. Gruenberg. 

Chairman Federal Deposit Insurance Corporation on Implementation of the Dodd-Frank Act before the 

Committee on Ballking, Housing and Urban Affairs. Uniled States Senale (December 6,2011) Clf lhe 

finns are successful in their resolution plaruung. then the OLA would only be used in the rare instance 

where rcsolutionundcr the Code would have serious adverse effccts on U.S. financial 

stability"), available 

11 
84 

question that the multiplicity of insolvency regimes and the related multiplicity of 

controlling parties and contlicting interests greatly complicated the Lehman Brothers 

bankruptcy proceedings. 17 

The simplest way to avoid competing resolution proceedings would be to have a 

clear path to a single-point-of-entry approach to financial firm insolvencies under the 

Bankruptcy Code. However, the absence of an express Bridge Holding Company Tool, a 

Liquidity Stabilization Tool and a Financial Contract Preservation Tool in the 

Bankruptcy Code makes it harder for financial firms to implement a pure single-point-ofentry approach in bankruptcy. As a result, under current law, resolution plans typically 

adopt hybrid approaches, in which some operating businesses and entities continue and 

are sold or recapitalized, while others are allowed to wind-down in an orderly way. 

First, the resolution plans typically identify those material operating entities or 

businesses that, because of their capital structure and the nature of their businesses, are 

unlikely to sutfer material losses and can be continued without resolution proceedings if 

their liquidity needs are met. The plans then specify how the liquidity needs of such 

entities will be met, and provide for their sale, either in advance of or immediately after 

the firm's failure, or their continuation along with other subsidiaries that are recapitalized 

as described below. The sale of such entities or their assets would be analogous to the 

17 More than 100 different insolvency proceedings were ultimately conllnenced for Leiunan 

Brothers legal entities. See Presentation by Harvey R. Miller and Maurice HonvitL. available a/ 

hl.!.p_:Lf}vww.stern.ill'lL<;du!C9EilgnrrlpS!COI!!~!lt.'!!Q@ments/webasset/cQ!I ll4 1231.JK![ This led to complex 

intenrrfiliate disputes between entities that once operated together as a global business, but were now being 

administered under different resolution proceedings as separate legal entities. 

12 
85 

speedy sales that took place in the Lehman case, but would be more orderly and valuepreserving because they would be pre-planned to achieve these objectives. 

Second, the resolution plans typically identity those entities in the financial finn's 

group that may suffer losses but can be recapitalized, provided with liquidity and 

continue in business for the benefit of stakeholders, just as they would be in a singlepoint-of-entry resolution under Orderly liquidation Authority 18 OlA's Bridge Holding 

Company Tool can be replicated under the Bankruptcy Code using section 363 of the 

Bankruptcy Code to authorize a transfer of the recapitalized subsidiaries to a debt-free 

holding company that is set up in advance or at the time offailure, perhaps owned by a 

trust for the benefit of creditors and other stakeholders left behind in the bankruptcy case. 

The new holding company would be separated from the risks of the bankruptcy process 

and once its business was stabilized, it could be sold in one or more private or public 

transactions, or its shares could be distributed to creditors of the old holding company 

under a conventional chapter 11 plan of reorganization. The trust could be structured to 

replicate the governance advantages offered by the Bridge Holding Company Tool, with 

appropriate modifications approved by the Bankruptcy Court. 

Finally, for any entities that cannot be sold or recapitalized, and as a back-up 

strategy even for those that can be, the resolution plans typically provide for such entities 

18 Among other things. any insured depository institution that is fully recapitalized in a singlepoint-of-entry resolution would have access to secured liquidity from the Federal Reserve' s Discount 

Window. In addition. despite the absence of the Financial Contract Preservation Tool in the Bankruptcy 

Code. it may be possible to recapitalize entities that have portfolios offin3ncial contracts. If, for example. 

some or all of the financial contracts housed in a bank or broker-dealer subsidiary are not guaranteed by the 

parent or cross-defaulted by the parent company's bankruptcy. or depending on the number of contracts 

that contain such cross-default provisions, losses. if any. on financial contracts could simply be absorbed by 

the recapitalized entities. 

13 
86 

to be wound down in an orderly way that avoids asset tire sales. These orderly winddowns require advance planning. The impact of different insolvency regimes and the 

reactions of regulators, customers, counterparties, financial market utilities and others 

need to be anticipated and addressed in the resolution plan, and the plan needs to provide 

for the management ofliquidity needs, the orderly transition of systemically critical 

operations to other providers, the maintenance of the continuity of shared services and 

technology during the wind-down, and the orderly distribution of customer assets and 

property. 

One of the characteristics that facilitates an orderly wind down is that the firms' 

enhanced capital and liquidity levels allow them to sustain a pre-failure client-driven run 

so that signiticant parts of their balance sheets can be wound down in an orderly way 

prior to or immediately after failure. Prime brokerage accounts are a good example of 

this. In 2008, one of the factors that precipitated the liquidity crisis at Lehman was a race 

to the exits by prime brokerage customers, requiring rapid liquidation of Lehman's assets 

to meet the demands of exiting customers. 19 Not only was the liquidity strain of meeting 

the run too much for the finn; neither the finn nor its customers were in a position to 

quickly move the accounts even if there had been sufficient liquidity to meet the run. This 

10 See, e.g.. Gary B. Gorlon & Andrew Melrick. Securili/.ed Banking and lhe Run on Repo. 104 

Joumal of Financial Economics 425-51 (2012): Gary B. Gorton, Slapped by the Invisible Hand: The Panic 

of 2007 (2010): Council on Foreign Relations Squam Lake Working Group on Financial RegulaliOl~ 

Working Paper: Prime Brokers and Derivatives Dealers (April 2010) ClPrime brokerage assetl runs, 

together with runs by short-terrn creditors, precipilated Bear Stearns' and Lehman's demise''). available al 

hllp://www.cfr.org/thinktankicgs/squamlakepapers.hlml. See also Darrel Duffie. Bauk for Inlemational 

Settlements Working Papers. No. 30 I: TIle Failure Mechanics of Dealer Banks. Section4.3 (March 2010), 

available al hltp:/.I\, ww .bis.org/publlw ork3C11.pdf.: Remarks of Daniel K. Tarullo. Govemor, Federal 

Reserve Board. Americans for Financial Reform and Economic Policy Institnte Conference, Washingtoll. 

D.C. (Nov. 22. 2013). available at 

http://www.federalrescrve. gov/llewsevenls!speech'tamllo20 131122a.hll11. 

14 
87 

is, however, a contingency that can be planned for as part of resolution planning. Balance 

sheet liquidity can be used to meet the run, and a virtually complete orderly pre-failure 

transition of the finns' prime brokerage customers to other financial intennediaries can 

be accomplished in a matter of days 20 Customers would be protected, systemic risk from 

the possible suspension of access to prime brokerage accounts in bankruptcy would be 

eliminated, and the complexity and systemic impact of any subsequent bankruptcy would 

be substantially reduced. 

Financial finns can take other steps, either well in advance of or immediately 

prior to failure, to reduce the difficulty and complexity ofbankruptcy wind-downs. These 

steps might include, among many others: 

• pre-positioning employees and service assets within the group and 

documenting service relationships to maintain continuity of intercompany 

support services in wind-down; 

• licensing or repositioning technology and related infrastructure within the 

corporate group to assure ongoing availability to all relevant entities after 

failure; 

• replication or repositioning of data resources to assure their availability to 

all relevant entities after failure; 

• using available liquidity to return collateral to the finn's balance sheet 

prior to failure to avoid it being dumped on the market post-failure; 

211 The now prevalent market practice of prime brokemge customers of maintaining accounts with 

multiple prime brokers will also facilitate mpid account tml1sfers. 

15 
88 

• positioning liquidity where needed for purposes of facilitating an orderly 

wind-down of wind-down entities; and 

• advance discussions with relevant host-country authorities regarding how 

host-country interests will be protected and how insolvencies in difJerent 

jurisdictions can be coordinated to minimize systemic risk. 

Resolution plans under current bankruptcy law thus rely on a combination of 

approaches: revising current operating practices to facilitate resolution should it become 

necessary, anticipating a client-driven reduction in the finn's balance sheet prior to 

resolution supported by the finns' enhanced capital and liquidity positions, pre-planning 

of the marketing and sale of some the finn's businesses, pre-planning the recapitalization 

and continuation of other entities and businesses, and detailed pre-planning of the winddown of still others. Hybrid approaches of this type can be very robust with 

appropriately detailed resolution planning. They also can benefit from advance 

consultation with and education of regulators, market participants and those who 

administer the bankruptcy system in each relevant jurisdiction, as well as thoughtful 

changes in market practice to facilitate resolution 21 

Possible Modifications to Existing Bankruptcy Law 

All of the above being said, the benefits of whole-finn recapitalization of the kind 

represented by the FDIC's single-point-of-entry approach cannot be denied. Because of 

their complexity, hybrid approaches entail execution risk and the likelihood of larger 

'1 For example. several regulators recently sent a letter to tile lnternational Swaps and Derivatives 

Association ("ISDA") urging ISDA to revise its standard fOllns to eliminate cross-defaults arising from the 

resolution of a parent holding company in a single-point-of-entry resolution strategy. Joint Letter to [SDA 

dated Nov. 5,2013 from the Bank of England, the Bundcsanstalt fiir Finanzdienstleistungsaufsicht the 

Federal Deposit Insurance Corporation and the Swiss Financial Market Supervisory Authority. 

16 
89 

losses for holding company creditors and shareholders than a pure single-point-of-entry 

approach. Accordingly, reforms to the Bankruptcy Code to add tools that facilitate using 

a single-point-of-entry approach to resolution in bankruptcy, perhaps in the form of a 

modified version of the chapter 14 proposal made by certain commentators,22 would 

facilitate the resolution ofiarge financial firms. Such provisions should, in my view, 

include: 

• Clarifying that bank holding companies can recapitalize their operating 

subsidiaries priorto the commencement of bankruptcy proceedings. 

• Clarifying that section 363 of the Bankruptcy Code can be used to transfer 

recapitalized entities to a new holding company using a bridge structure of 

the kind I have described. 

• Adding provisions that permit a short stay of close-outs and allow the 

assumption and preservation of qualified financial contracts, and 

overriding ipso facto (bankruptcy) defaults or cross-defaults that might 

impede the resolution process. 

• Providing some form offully secured liquidity resource that would offer 

financing to help stabilize the recapitalized firm and prevent fire sales 

until access to market liquidity returns. 

" See 1110111as H. Jackson, Bankrup[cy Code Chapter 14: A Proposal. in BA1<KRUPTCY NOT 

B!\lLOL T: A SPECl.\L CIl.\P'jER 14 (Hoover Institution Keillleth E. Scott & John B. Taylor, eds .. 2012). 

Professor Jackson recenlly disclosed that the Hoover Institution has been working on version 2.0 of its 

Chapter 14 proposal, which will include provisions specifically designed to facilitate a single-point-of-entry 

strategy under the Bankruptcy Code. See Remarks of Thomas H. Jackson. Panel onResolution& Recovery 

- Bankruptcy Not Bailout, AlUlUal Conference of The Clearing House Association (Nov. 21, 2013). See 

also BPC Rcport. pp. 11-14 (recollllllcndations for amending the Bankruptcy Code to facilitate the 

execution of a single-point-of-entry strategy under the Bankruptcy Code). 

17 
90 

Lastly I would note that no single resolution procedure will be perfect for all 

situations. Expanding the options availab Ie by continuing to develop resolution 

approaches under both OLA and the existing Bankruptcy Code, as well as considering 

amendments to facilitate resolution under the Bankruptcy Code, will maximize the 

flexibility to resolve distressed financial firms in a manner that minimizes systemic risk 

and does not put taxpayers at risk 

For these reasons, even if the Bankruptcy Code were amended to add tools to 

facilitate single-point-of-entry recapitalization in bankruptcy, I believe it is crucially 

important to retain Orderly Liquidation Authority as a back-up resolution option for large 

financial firms. Among other things, since we cannot know the causes or contours of the 

next crisis, we should want regulators to have a variety of sensible tools in their toolkit so 

they can use the right one when the time comes. In addition, key host-country regulators, 

who are less fam iliar with our bankruptcy system, will take comfort from the fact that if 

all else fails, United States regulators have the power to implement a recapitalization of 

distressed financial firms. Finally, as evidenced by the recent Moody's action, retaining 

OLA will also reinforce the idea that U.S. taxpayer money will never again be put at risk 

to support distressed financial firms. 

I want to thank the Subcommittee for allowing me this opportunity to present my 

views. I would of course be delighted to answer any questions you may have about my 

testimony. 

18 
91 

Mr. BACHUS. Thank you very much. 

And, Professor Roe? 

Now, let me say this, I think that the testimony so far has been 

very substantial and very helpful. And it—a lot of good discussion 

on policy. So, thank you. 

TESTIMONY OF MARK J. ROE, PROFESSOR OF LAW, 

HARVARD LAW SCHOOL 

Mr. ROE. I will do my best to maintain that. 

So, Chairman Bachus, thank you for the gracious introduction 

earlier. 

I am Mark Roe. I am a law professor who focuses on corporate 

law, business law, business bankruptcy issues. And I do appreciate 

the opportunity to be here to provide you with my views on the 

Bankruptcy Code’s adequacy in dealing with failing, failed financial 

institutions. 

I am going to focus my testimony on the exemptions from bankruptcy for derivatives and short-term financing, the so-called 

‘‘bankruptcy safe harbors.’’ Simply put, the Bankruptcy Code, as it 

is set up now, cannot effectively deal with most large failing financial institutions. And a core reason for that is that the safe harbors 

are far too wide. They exempt too much short-term financing and 

risky investments from the normal operation of American bankruptcy law. They thereby make an effective resolution in bankruptcy without regulatory support harder than it needs to be, quite 

possibly impossible. They undermine market discipline in the 

prebankruptcy market making the financial system riskier and 

more prone to suffer major failures. They subsidize short-term 

lending over stronger, more stable longer-term financing for financial institutions. We get more subsidized short-term debt and less 

stable, but unsubsidized, longer-term debt. They also make it harder for financial upstarts and regional banks to compete with the big 

money center banks. 

Five years ago Lehman Brothers propelled forward the financial 

crisis, when it filed for bankruptcy. The Lehman bankruptcy 

proved to be chaotic and the country suffered a major economic setback from which it is still recovering. Yet, if a Lehman-class bankruptcy occurred today, the Bankruptcy Code and the bankruptcy 

system really couldn’t do any better than it did in 2008. So, if a 

major financial failure gets by the regulators for whatever reason, 

we still really can’t count on bankruptcy to catch the ball. 

Complex systems, and our financial world is one very complex 

system, need redundancy in dealing with failure. If one stabilizer 

fails in a complex system, we want another mechanism to take over 

to avoid a catastrophic failure. Engineers know that and we should 

start to make bankruptcy a more viable option than it is today. 

Second reason for acting on this is that bankruptcy is the first 

line of defense by statute and regulatory preference. Financial regulators say that they will play the Dodd-Frank title II card only if 

bankruptcy fails. But, regulators cannot allow a bankruptcy for 

even a day to see if it works, if we have a major, systemically important financial institution with significant safe harbored securities, because, under today’s bankruptcy rules, as soon as the financial institution with major safe harbored financing files for bank-
92 

ruptcy, the exemption for bankruptcy for much of its short-term 

debt and for its derivatives portfolio will lead its counterparties to 

rip apart the bankrupts portfolio. There will be no chance to put 

Humpty Dumpty back together. 

The third reason to work on bankruptcy as a viable alternative: 

it is possible that title II may not work. It hasn’t been tried. And 

we should be wary of untested systems. 

What are the kinds of things we should be thinking about doing 

for the Bankruptcy Code? 

First, the kind of collateral that is allowed for short-term lending 

safe harbors that are exempt from normal bankruptcy should be 

narrowed. Yes, for United States Treasury securities. No, for mortgage-backed securities. 

Second, the broad exemption from bankruptcy for safe harbored 

counterparties should be curtailed. They should be required to stay 

in bankruptcy for long enough so that the court can sell off bundles 

of the failed firm’s derivatives book intact. The chaotic closeouts in 

Lehman Brothers are said to have cost Lehman about $50 billion 

in value. We could do better with a better Bankruptcy Code. 

Third, the blanket preference safe harbor needs to be better targeted. Preference law has long reduced creditor’s incentives to grab 

collateral and force repayment on the eve of bankruptcy, driving a 

weak but possibly survivable firm into bankruptcy. Preference law 

reduces the incentives to grab and demand repayment on the eve 

of bankruptcy. So, if John owes Jane $1 billion in normal debt and if she holds 

a gun to John’s head and says, ‘‘Repay me,’’ when he is on the 

verge of bankruptcy, she would go to jail for extortion and the $1 

billion will be recovered from Jane as a preference in John’s bankruptcy for the benefit of all of John’s creditors. And the $1 billion 

preference forced out of John prior to his bankruptcy, will be recoverable even if Jane exerts much less pressure than with a gun. 

But, if John owes $1 billion to Jane in derivatives debt and she 

holds a gun to his head to collect, then she will also go to jail for 

extortion, but she won’t have to return the $1 billion as a preference. The derivative safe harbors will fully protect her from the 

operation of preference law. 

I would submit that this exempting of blatant grabs from basic 

preference law is one of the several overly wide aspects of the safe 

harbors that need correction and narrowing to fit markets better. 

And there is reason to believe that the collateral grabs that AIG 

suffered, as it sank in 2008, would have been preferential had the 

safe harbors not existed. AIG might have failed, would probably 

have failed and quite plausibly would have been bailed out anyway, 

but maybe it wouldn’t have been done in such dire circumstances 

and there would have been more regulatory options available, if so 

much of AIG’s obligations were not safe harbored. 

So, overall, bankruptcy should support financial safety better 

than it does now. Bankruptcy should be capable of resolving a nonbank, systemically important financial institution with major positions in safe-harbored financing. But, as of today, it cannot. Because it cannot, bailouts are more likely than otherwise and, perhaps even more importantly, system-wide costs to the economy are 

more likely than they would be otherwise. Bankruptcy should not 
93 

subsidize the riskiest forms of financing and investment, the shortest-term debts in our financial system. And they shouldn’t be facilitating riskier, weaker, systemically important financial institutions. Today, bankruptcy subsidizes this extra risk and short-term 

finance. 

Bankruptcy should promote market discipline. Today it tends to 

undermine that market discipline via the safe harbors, making our 

financial institutions weaker than they otherwise would be. Several 

of these problems can be fixed. They are not that hard to fix. And 

we should fix them. 

Thank you. 

[The prepared statement of Mr. Roe follows:] 
94 

Testimony of Mark J. Roe 

David Berg Professor of Law. Harvard Law School 

Before the 

Subcommittee on Regulatory Reform, Commercial and Antitrust Law 

ofthe 

Committee on the Iudiciary 

United States House of Representatives 

Hearing on 

The Bankruptcy Code and Financial h,stitution hlsolvencics 

December 3, 2013 
95 

Chainnan Bachus, ranking member Cohen, and members ofthe committee: 

I'm Mark Roc. a law professor at Harvard Law SchooL where I teach corporate law and 

bankmptcy law. and do research in the same snbjects. I appreciate the opportnnity to be here to provide 

you with my views on the adequacy ofthe Bankruptcy Code to deal with failing tinancial tirms. 1 will 

focus my testimony on the exemptions from bankmptcy for derivatives and short-tenn financing-the socalled bankruptcy safe harbors 

The safe harbors are too wide. They exempt much short-term financing and risky investing from 

the normal operation of American bankruptcy law. By treating short-term tinancial debt and derivatives 

trading much better than regular lenders and ordinary suppliers to the bankmpt, the safe harbors make an 

effective resolution in a bankruptcy without regulatory support difficult. and for some tinancial tirms. 

impossible. 

Worse yet, they undemline market discipline in the pre-bankmptcy market, making the financial 

system and the American economy riskier than it needs to be and more prone to suffer major failures. The 

safe harbor exemptions from nonnal bankmptcy mles subsidize short-tennloans over stronger, more 

stable longer-terul financing for financial institutions. 

Five years ago, the bankruptcy filing of Lehman Brothers, the major investment bank. propelled 

the financial crisis forward. Its bankmptcy was chaotic, as derivatives counterparties closed out their 

positions, dumped collateral on the markets, and helped to push mortgage-backed securities into an assetprice spiral that threatened the solvency of other major financial institutions. In short order the venerable 

Primary Reserve Fnnd, which owned Lehman debt, failed. leading the Federal Reserve to conclude that it 

had to guarantee the entire money market industry. AIG was on the verge of failure. with catastrophic 

consequences to its counterparties aronnd the world, and the government bailed out AIG. 

111e country suffered from a deep financial crisis and sank into a major economic setback from 

which it is still slowly recovering. 
96 

If a Lehman-class bankruptcy occurred today, the bankruptcy code would do no better in 

2013than it did in 2008. The c1ose-onts would be chaotic, with great potential damage to the financial 

system and the American economy. 

We have exempted a wide range of securities and transactions from the normal operation of 

bankruptcy law. This is not a long-standing exemption, but one that has grown and expanded over recent 

decades, with a major expansion as recently as 2005. Even today, after the financial crisis, if a 

counterparty to a bankrupt finmlcial institution has a favored investment it cml fully opt out of the failed 

fmancial institution's bmlkruptcy process-despite the fact that bankruptcy is ml institution that has 

served this country well. Bankruptcy could help to stabilize the tirm and the surrounding tinancial market 

but for financial finns with these a heavy dose ofthese bankruptcy-exempt obligations, it cannot. Opting 

out ofbmlkruptcy is often good for those opting out but destabilizes the debtor and its other business 

partners. 

The potential for chaotic close-outs and an unstable bankruptcy is only the tirst reason to rethink 

the safe harbors. The safe harbors also subsidize short-term debt at the expense of more stable longertenn debt. When we favor one form of debt over other debt we get more of the subsidized debt and less 

of the rest. 1113!'S what we've done. And, third, the safe harbors sap market discipline. We wmlt to 

hamess market incentives to discipline the financial system. The safe harbors do the opposite. 11,ey tell 

counterparties that they can pay less attention, or none, to the credit quality oftheir counterparties and to 

the extent of their own exposure. We destroy market discipline where we need it. Fourth, the safe harbors 

can be best used by America's largest financial institutions. The safe harbors give the bigger money 

center institutions an artiticial competitive advantage over regional and mid-sized institutions. Narrowing 

the overly-wide safe harbor exemptions will facilitate a more competitive finmlcial market in which 

regional and mid-sized institutions can participate more effectively. 

Each of these four problems would justify a sharp cutback in the safe harbors. Togetherthe 

policy path is clear and compelling. 11,e only questions should be when, how, mld to what extent. 

2 
97 

TI1US far_ our goven1111ental reaction to the financial crisis has been to shore up financial 

regulation, with greater capital requirements, with activity restrictions, and with administrative controls 

like living wills and the single point of cntry structure. These efforts have much that is admirable. But if 

a major financial failure gets by the regulators, we still cannot count on the bankmptcy system to catch 

the ball. Indeed, we should expect a miss as big as bankruptcy' s miss for Lelnllan. 

First, we should want redundancy in complex systems. If one stabilizer fails in a complex system, 

we want another mechanism to take over. to avoid catastrophic failure. Engineers know that. and 

likewise financial regulators and now Congress should tum to improving bankmptcy by stabilizing and 

narrowing its safe harbors. 

Second, bankmptcy is the tirst line of defense by statnte and regulatory preference. Financial 

regulators say they'lI play the Dodd-Frank Title II card only if bankruptcy fails. But regulators cannot 

allow bankmptcy to go for even a day to see if it works. and then decide whether or not banklllptcy is 

getting the systemic risks under control. Undertoday's bankruptcy rules, as soon as a tinancial institution 

with major safe harbored financing files for bankruptcy, the exemption from the automatic stay for the 

safe harbored transactions wil1lead the financial tirm' s counterparties to rip apart the bankrupt's 

portfolio.' TIlere will be no putting Humpty Dumpty back together. 

Third, Title II may not work. It hasn't been tried. 

Be wary of untested systems. 

Fourth, the safe harbors encourage excessive risk-taking and short-tenll financing tllat put more 

of our big institntions at risk. When Bear Steams failed. one-quarter of its liabilities were in short-term, 

often ovelllight debt that did not have to comply Witll basic bankruptcy rules. When Lehman failed, onethird of its liabilities were in short-term. bankruptcy exempt. safe harbored debts. Part of the reason they 

1 The automatic stay stops creditors from acting against the bankrupt until the court and the b.mlmlptcy 

process can ascertain \vhether the fiml is more valuable kept intact If it is_ the finn is continued and creditors are 

compensated later. Ipso facto prm'isions in bankmptcy law limit the impact of loan clauses that make the debtor's 

bankmptcy an irremediable default under the loan documentation 
98 

were in short-telln safe harbored debt is that the safe harbors subsidize short-tenn debt over longer-tenn, 

more stable tinancing.' This short-term debt has become a big part ofthe tinancial system. Evening up 

the legal status of short-tenn and long-telln debt would shift some frnancing away from short-telln, often 

overnight and unstable repo financing to longer-telln financing. Same for derivatives 

What to do? 

First, the kind of collateral allowed for the short-tenn lending safe harbors should be narrowed 

United States Treasury securities, yes: mortgage-backed securities, no. 

Second, the automatic stay should be brought back in for derivatives, but in a limited way' long 

enough to package the failed filln's derivatives book and sell bundles off intact. The chaotic close-outs 

arc said to have cost Lehman $50 billion or more in value.' A modest stay will make an alternative to 

chaotic close-out possible. Sophisticated derivatives industry leaders are now recognizing that the rapid 

close-out rnechmlisrns arc potentially destructive not just of the economy but ofthe derivatives players 

themscl v es 4 

2 In finmleial markets. these short-term, typically safe-harbored loans. are made by one firm selling the 

collateral and agreeing to repurchase (or "repo" it) shortly thereafter, often the ne"i day. The collateral is 

repurchased at a slightly higher amount than its sales price, witll tile difference constituting the loml' s interest 

3 The return of the automatic stay would need to be coordinated with other bankruptcy nues. such as by 

bringing back the long-standing bmlkmptcy bar on effectiveness in bmlkmptcy of ipso facto contract clauses-those 

contract tenns that allow counterpartics to cash out if their debtor goes bankrupt. 

4 Whittall (2013) reports that the derivatives industry was told in the kevnote speech from one of their leaders 

at the Intenmtional Swaps and Derivatives Annual Generdl Meeting: 

Derivatives users should be prepared to make amendments to one of their most-treasured legal rights to help in 

the light to end loo-big-to-l~til_ attendees 

\Vilson 1':rvi11 - vice-chairman in the group executive office at Credit Suisse and a leading architect of the 50-

l:ulled debt bail-in framework - argued in a keynote spee!.:h Lo ISDA delegates thaL modifying legal 

documentation that currently allow~ ~\vap~ countel1mliie~ to leapfrog other creditor~ of bankrupt finm \va~ 

"essential" 

1'0 highlight the ~eyerity of the i~sue, I :rvin cited the lJS$-lObn in cost~ the J ,ehman lhothers administration had 

to swallo\v in order to comply \vith early termination requests from its swaps eounterparties. hugely exacerbating 

the extent of the lo~~es racked up by the bankrupt e~tate 

The s\vaps termination costs dwarf the estimated US$25bn of losses from real estate and private equity holdings 

Lehman was harbouring on iLs balance sheet before iL went under, and contributed 'jubstantially to\vards the 

estimated final bill ofUS$15Ubn to wind up the firm 

4 
99 

Related. the ipso facto clause ban as now constituted makes the regulators' single point of entry 

harder to work. This problem is now well-known in regnlatory and derivatives circles. But there are other 

safe-harbor-induced technical problems.' 

Third, the blanket preference safe harbor needs to be better targeted. Preference law has long 

served American bankmptcy welL by reducing the incentives for creditors to grab collateral and force 

repayment on the eve of bankruptcy, at the expense of other creditors. If John owes Jane $1 billion in 

n0l111a1 debt and she holds a gun to John's head to force him to repay, she goes to jail for extortion and 

assault with a deadly weapon. And the $1 billion will be recovered from Jane in bankmptcy as a 

preference. It will be recoverable even if Jane exerts less pressure than with a gun. Hut if John owes Jane 

$1 billion in derivatives claims and she hold a gun to John' s head to collect. then, while she will also go 

to jail for extortion, she will not have to return that $1 billion as a preference. TI,e derivatives safe harbors 

will protect her from preference law. Exempting even blatant collateral grabs from basic preference law, 

and expecting that other legal institutions will remedy the situation, is one of many overly-wide aspects of 

the safe harbors that need correction. 

The rapid collateral grab that AIG suffered as it sank would likely have been preferential had the 

sate harbors not existed. AIG might have failed and been bailed out anyway. But maybc not in such dire 

circumstances. More options might have been available. 

Fourth, the Code's netting is overly-broad. It is perfectly appropriate for tl,e counterparty to be 

able to net all of its transactions-botll winners and losers-in the same product (say. foreign exchange. 

or interest rate swaps, or weather derivatives) with tl,e same counterparty and tl,en pay (or be paid) a 

single amount to (or from) the bankmptcy debtor. as long as the two parties contracted for this kind of 

offset. This does allow the counterparty to come out better than ifthe debtor could cherry-pick and take 

5 For example, if the holding company redeems some of its long-term debt. under creditor pressure, and in 

advance of its failure. the redemption \vQuld under nonnal bankmptcy hn1' be recoverdble as a preference. But that 

redemption can be made to be safe harbored and beyond recovery in the holding company's bankmptcy. Reh'lilators 

should wish to have a bankmptcy legal team do a bankmptcy forensic review to help make bankmptcy work lmder 

the regulators' plans. 
100 

the contracts if s ahead on while rejecting those that ifs behind on. But the Code now safe harbors much 

more: obligations in otherwise unrelated derivatives businesses can be netted. This not only allows the 

counterparty to do even better than others, but, more importantly, this wide netting (I) makes it harder to 

sell a single business line ofthe debtor in its bankmptcy, because the wide netting expands any sale from 

being a sale of one product line to anotherfiml in tile same product line to being a sale ofthe bankrupt's 

entire derivatives business a single buyer. But the market may better be served by selling tile segmented 

businesses. one-by-one. Furthermore. (2) the wide netting rules encourage tinancial supermarkets that 

become too-big-to-fail financial institutions, because they can take advantage of cross-product netting 

better than single-product line financial finns can. Upstarts in a single product line Calmot compete as 

easily because they carmot gct the subsidy from cross-product netting. Eliminating cross-product netting 

should be on the agenda to give tile little guy and regional banks-the finallcial upstart-a fighting 

chance to compete. 

Fifth. while the safe harbors need narrowing, so that we do not continue to subsidize these 

transactions at the expense of ordinary financing, not all ofthe evening up that needs to be considered is 

in narrowing the safe harbors. The safe harbors allow favored creditors to escape from poorly stmctnred 

parts of the Bankmptcy Code that apply to all creditors. TIlese poorly stmctnred parts should be fixed up. 

Here is one aspect of basic Code mles that could be challged overalL although it is tricky: A 

major advantage of short-term, safe harbored tinancing is that the counterparty does not need to worry 

about bankruptcy's baseline rules, which would not assuredly pay the stayed creditor interest, alld which 

usually would not. But interest is the life blood for a tinancial creditor. The safe harbored creditor, 

however, can cash out and get the time value of its investn1ent, because it can reinvest its funds. The nonsafe harbored counterparty Call find itself providing a no-interest loan to the debtor. Rethinking, and 

reconstructing, the interest payment rules to non-safe harbored creditors could bring the attractiveness of 

stable finallCing more in line with safe harbored finallCing. (Reconstmction will be tricky because of the 

impact on other creditors, but this could be done fairly and efficiently. One possibility: for financial 

6 
101 

fimls, the obligation to pay interest shall continue after any bankruptcy filing, at the prebrnlkruptcy 

contract rate, with a standard rate used for noneontract creditors.) When Bear Stearns failed it owed 

about a quarter of its value in short-ten11 repo, which was about eight times its equity. Yet, as recently as 

1989, it had only 6% of its value. not 25%. exposed to short-ten11 repo'" The safe harbors may have 

played a role in its unstable finrnlcing choices. 

Safer finance is possible. Were the safe harbors better targeted. American finance would be safer 

and the potential call for bailouts less likely to happen. 

Other bankmptcy rules tit badly with the derivatives and short-term repo market, and the Code 

should accommodate the derivatives ffild repo markets, but do so Witllout endrnlgering Americrnl finffilcial 

markets. For example, basic bffilkruptey rules give the debtor a nearly unlimited right to assume or reject 

its prebffilkruptcy contracts. Derivatives counterparties, who arc selling protection from volatility, crnl 

then be slammed by the bankmpt debtor who waits, sees if the pricing has become good for the debtor 

and then assumes the contract, or, if the pricing is bad for the debtor, rejects the contract. Returning to the 

baseline brnlkruptcy rule is inappropriate, unfair, ffild destructive oftlle entire derivatives market. But our 

current safe harbors reverse the situation. allowing the counterpa~' to choose-a result that is no better. 

A middle ground is possible. 

Sixth, we Wffilt bffilkmptey judges pre positioned to deal with major ±inffilcial institutions. 

Brnlkruptcy law should require each Circuit Court to designate a judge who is on-call for such efforts. 

That judge presumably would already have the needed brnlkruptcy ffild financial expertise, would keep 

acquiring more, rnld would follow finrnlcial developments so that he or she would be ready to roll if a 

non-bank systemically important financial institution filed for brnlkruptcy We may wish to confront the 

problem of Article III vs. Article I authority for this class of judges. 

* * * 

6 Bear Steams 1 O-K 's; Roc (2011: 5(3). 
102 

Overall, we should want bm1kruptcy to support financial safety better thffil it docs now. 

Bankruptcy should be capable of resolving a systemically important nonbffilk finffilcial institntion even if 

it has major safe harbored finffilcing. As oftoday, it cmmot. Because it cmmot, bailouts arc more likely 

thm1 otherwise and the costs to the Americm1 economy would be higher thm1 they would otherwise be. 

Bm1kruptcy should not subsidize the riskiest fonns of finffilcing m1d investment, facilitating riskier, larger, 

and less stable finm1cial institutions. Today it docs. Bm1kruptcy should promote market discipline. Today 

it undermines market discipline, making our major tinancial institutions weakerthffil they otherwise 

would be. 

We can tix these problems and we should. 

References 

Edwards. Frffilklin R .. & Edward R. Morrison, 2005. Derivatives and the Bankruptcy Code: Why 

the Special 'i'reatment? Yale Journal on Regulation 22: 91. 

Lubben, Stephen J., 2013. OIA After Single I'oint ofFntr)'" Has Anything Changed:', Nov. II. 

available al http://ssm.com/abstract~2353035. 

Lubben, Stephen l, 2010. Repeallhe Safe Harbors. Americm1 Bm1kruptcy h,stitute Law Review 

18 319. 

Roc, Mark l, 2013. Derivalives Markels in Bankruplcy, Comparative Economic Studies 55: 519. 

availahle at http://ssrn.com/abstract~2040864. 

Roe. Mark J., 20 II. The Derivatives Players' Payments Priorities as Financial Crisis 

Accelerator, Stanford Law Review 63: 539, available athttp://ssrn.com/abstract~1567075. 
103 

Skeel, David A., Jf. & Thomas H. Jackson. 2012 Transaction Consistenc), and the New Finance 

in Hankruptcy, Columbia Law Review 112: 152. 

WhittalL Christopher. 2013. Amending S\vaps Rights "Essenrial".for Resolution Regimes, 

International Financial Review April 26: 1-2. 

9 
104 

Mr. BACHUS. Thank you very much. 

Mr. Smith, do you have any questions or do you want me to? I 

can go first and then you can. All right thank you. 

Hearing your testimony, I think we are all thinking back to 2008 

in our mind. And we are talking about the failures of what is now 

called SIFIs and there was obviously almost a ‘‘domino effect.’’ I 

mean, everyday there was a Merrill Lynch or there was a Lehman. 

For a while there AIG was just—you pick up the paper and what 

is next? 

I do think, as we consider what we are going to do, you mentioned redundancy. I think that was your testimony Professor Roe, 

which I think is tremendously important in a case like that, because I—when you said, you know, title II might work, but it might 

not work. Or enhanced bankruptcy may work, but it may not. But 

you have two tracts. And I have told people that 2008 was almost 

like the economy had a stroke or a heart attack. And it was—you 

know, as with a stroke or heart attack, you need to get to the patient, time is of the essence. 

And knowing that, we also add the political theater of what, you 

know, as these companies either begin to—they become insolvent— 

there is probably only going to be maybe two or three—it would be 

unusual to have one, because I think some of the regulations we 

have now on short-term financing and over leveraging, hopefully 

we won’t have that. But it may be almost a systemic event. And 

you wonder whether you have to also factor in, is Congress going 

to try to intervene which even complicates that. 

I think it is important for us to address this now, not do it in 

the middle of a crisis where we are being pushed around by changing sentiment. And I think you have all given us a roadmap. 

One thing that I am struck by, that I did not know at the time, 

AIG was credit default swaps. I mean this was all pretty risky 

stuff. It was their insurance business, which was their core business, was totally reserved, there was no—but it was one of their 

subsidiaries. And I am just wondering, and I—my first question, 

Mr. Bernstein, in that case you had a subsidiary where the liability 

was overwhelming the whole company. That single point of entry, 

does that work in that situation? 

Mr. BERNSTEIN. I am going to answer this one in the abstract because we had a major involvement in AIG, so I would prefer to 

keep it to the general. 

I think if you have significant liabilities in one subsidiary, first 

of all, if you made some of the changes that permitted you to assume the credit default swaps and other types of instruments rather than having them terminate on bankruptcy, you would have 

many more options. You could put that subsidiary into bankruptcy 

and you could preserve those contracts as a book which had value. 

Or you could recapitalize that entity or do other things. Whereas, 

you know, currently, with the way bankruptcy works, bankruptcy 

wasn’t an option. 

Mr. BACHUS. Right. And, you know, from your testimony, I think 

both of you mentioned that the safe harbor includes derivatives. So, 

it probably included credit default swaps. So, which took, in the 

case of AIG, almost all their liabilities were outside of bankruptcy 

or were in the safe harbor. You know, one—there was a lot of dis-
105 

cussion back then about good bank, bad bank. Though that is not 

what you are proposing, is it? 

Mr. BERNSTEIN. No. It is the single point of entry approach is not 

really so much good bank, bad bank. It is really taking a group of 

stakeholders that are subordinated and imposing the losses on 

them in the private sector, rather than having the public sector 

support the institution. 

Mr. BACHUS. Yeah. 

You know, there is. I think Senator Vitter has a bill to basically 

do away with our largest financial institutions. I know this isn’t 

the subject of this hearing and there is a lot of discussion on that. 

But, I want to say this, I don’t think that is the best alternative 

because we have to compete on a global marketplace. And I think 

one of our strengths is we do have some very large companies and 

financial institutions they are, of course, and I know I am not going 

to ask you all, at this point, you know, unless you want to discuss 

that. Does anyone want to volunteer? 

Mr. Lacker? 

Mr. LACKER. I will just comment that there is a relevance. There 

is a connection between bankruptcy reform and strategies like 

Vitter’s or my colleague—former colleague Tom Hoenig, who have 

advocated dividing up the institutions either by size or activities. 

You know, what you want to achieve. What those strategies are designed to achieve is a situation in which those firms are resolvable 

in bankruptcy without government support. I think that is their 

general objective. And the planning work, that Mr. Bernstein described so eloquently and in detail, that is the way you would deduce, that is the way to figure out exactly what they have to look 

like now in order for us to feel confident in the future, in extremis, 

that you could take them through bankruptcy with a fair amount 

of confidence that it would be orderly enough to be workable. 

At this point in the process of those ‘‘living wills’’ we have just 

been through, we have just had a second round of submissions, I 

don’t think we know enough now to know exactly what changes we 

need to make. Whether it is—I am not sure size is the right criteria and I am not sure activities are. I think it is likely to be 

more—it is more likely to be things like what Mr. Bernstein pointed to, having clear plans, having detailed plans; organizing your 

legal entities in conformance to your operating activities in a way 

that makes them severable, if need be, in bankruptcy, if you ever 

feel the need to spinoff a foreign subsidiary, for example, or handle 

a foreign subsidiary differently than domestic subsidiaries. 

So I think all those things are well motivated. But, I think the 

‘‘living will’’ and the planning process centered around a bankruptcy filing and the fine details of what that looks like, I think 

that is going to be more informative and more reliably get us to 

the right kind of solution. 

Mr. BACHUS. You know, AIG, in all of this, is a great example 

to look at because for—on several different angles. But you did 

have a foreign subsidiary in London that really was making bets 

it couldn’t afford to lose and in staggering percentages. 

You also, if you are dealing with a global financial institution 

headquartered here or even headquartered somewhere else, you— 

and I am sure somewhere in the Bankruptcy Code, I am not sure 
106 

how you would—there would have to be some cooperation globally 

between regulators or between really the court system in different 

countries. And what would you—how would you address a company 

that was operating major subsidiaries and business across the 

globe? 

Mr. BERNSTEIN. This is also an area where resolution planning 

is important because, one, you can’t assume that local jurisdictions 

are going to act outside their own self-interests. So, you have to assume self-interest will be the driving force. And you have to design 

plans that demonstrate that the self-interest of the local jurisdiction is going to be fulfilled by cooperating with the resolution. 

Many of them do not have a bankruptcy process like we do. They 

have got a purely administrative process. Some countries go in the 

other direction and have processes which are purely common law. 

So, you have to really look at each entity and look at how you demonstrate it is in the local interest to cooperate. 

Mr. BACHUS. All right. 

You know, again, derivatives would have, if there was a derivative, if they weren’t in a safe harbor, if there were some provisions 

in dealing with those, as opposed to sort of a fire sale, both Lehman and AIG, I think, you know, would be some benefit if that had 

been in the code. 

Mr. ROE. Well that—the difficulty with the safe harboring that 

causes problems for financial institutions with a major derivatives 

portfolio is that the portfolio is put together as a unit: buy pounds 

on this side and sell pounds on that side. And the best way to be 

able to reposition the portfolio is to sell it intact or to sell obvious 

units of the portfolio intact. The safe harbors make this very difficult because I may have packaged selling pounds with buying 

pounds together, but my counterparty will tend to closeout this 

part of the portfolio and my other counterparty might close out 

that part of the portfolio on terms that aren’t particularly favorable 

to me and make it impossible for me to sell the portfolio somewhere else, if I have a buyer. With some cutback on the safe harbors, we have the potential to be able to put the portfolio together 

and reposition it and sell it presumably quickly in a bankruptcy. 

We can’t really do that in bankruptcy now. It is possible to do that 

under title II, but it is not really viable for a firm that has significant derivatives that actually does the filing for bankruptcy. 

Mr. BACHUS. Would, under the Bankruptcy Code that you envision, would all safe harbors be—would there be no safe harbors or 

would you do it incrementally? 

Mr. ROE. Incrementally. 

And there are several things in the Bankruptcy Code that make 

it difficult or impossible for the good functioning of the derivatives 

market to work. So, one example, when somebody buys or sells a 

derivative, they are basically trying to protect themselves against 

volatility in whatever they are buying or selling. The Bankruptcy 

Code gives the debtor a nearly unlimited right to reject or assume 

that contract without any real time limits on that capacity to reject 

or assume. 

So, if we had a derivatives contract and I went bankrupt, you 

would be very worried, legitimately worried that I just might play 

the market to wait for the moment when the contract has turned 
107 

favorable to me. So there ought to be some fairly sharp limits on 

the debtors’ capacity to reject or assume a contract. Something 

along the lines of a few days, a short period in which the portfolio 

could be assumed and sold intact to somebody else. 

Mr. BACHUS. Okay. 

And, of course you know, to a certain extent, the Fed assumes 

some of those to do that, I think. I mean, their book. I mean they 

assume some of those. I guess they assume some of them were derivatives and that the Fed took on there. 

Mr. LACKER. Are you talking about the AIG case? I am not familiar with the details of what they assumed—— 

Mr. BACHUS. Yeah. I guess well they mortgaged—— 

Mr. LACKER [continuing]. How much, I am not sure. 

Mr. BERNSTEIN. Yes. 

Mr. BACHUS. Mr. Bernstein? 

Mr. BERNSTEIN. One point to make, which I think was being 

made by Professor Roe is that—now I think there are really two 

separate issues here. One, is what it takes to do an effective resolution of a financial institution, in terms of changes to the safe harbors which might be a limited stay and it might be the ability to 

quickly assume and move the contracts. The separate issue and I 

think it is, you don’t necessarily need to deal with it in financial 

institution insolvencies, is the more general question of the scope 

of the safe harbors. And there is a lot of good work being done on 

that by the National Bankruptcy Conference, the American Bankruptcy Institute Commission and I know Professor Roe is involved 

in that. But I think it is worth separating those two issues for purposes of this hearing because it is really the former that we really 

need to focus on for financial firms. 

Mr. BACHUS. All right. I appreciate it. 

Now, mortgage-backed security, is that a derivative? Excuse my 

ignorance, but I am just trying to—— 

Mr. LACKER. No. 

Mr. ROE. The principal place where mortgage-backed securities 

would come into the safe harbors would be as a repo. So, if I lent 

to you with a mortgage-backed security as my collateral, this transaction would be safe harbored under the Bankruptcy Code. One of 

the problems in the financial crisis is that there was a lot of dumping of the mortgage-backed securities when people realized they 

weren’t worth as much as they hoped they were going to be worth 

in 2005 and 2006. They turned out to be worth less in 2008. 

The safe harbors facilitate some of those quick sales in that, if 

you have done a repo on a mortgage-backed security with me and 

I go bankrupt, you can take the mortgage-backed security and immediately sell it. In a traditional bankruptcy you can’t immediately 

get to the mortgage-backed security and sell it. The judge has to 

promise that you will be adequately protected. But, that adequate 

protection can be realized sometime later on. 

Mr. BACHUS. All right. 

Mr. ROE. So, that is where—— 

Mr. BACHUS. And I am not—— 

Mr. ROE [continuing]. The mortgage-backed securities—— 

Mr. BACHUS [continuing]. Thinking that mortgage-backed security wouldn’t be a derivative because it is just a basket of mort-
108 

gages. So, it doesn’t derive its value from anything external, I 

guess, is that correct? 

Governor Lacker? 

Mr. LACKER. It is not traditionally thought of—mortgage-backed 

security is not traditionally thought of as a derivative. 

Mr. BACHUS. Right. 

Mr. LACKER. There are derivatives that are written to replicate—— 

Mr. BACHUS. Right. 

Mr. LACKER [continuing]. The returns on mortgage-backed—— 

Mr. BACHUS. And that’s what—— 

Mr. LACKER [continuing]. Securities or to reference those returns. 

Mr. BACHUS. Well, and I, you know—— 

Mr. LACKER. So, that happens. 

Mr. BACHUS. Some of those were—bets were made to do just 

that. 

Mr. LACKER. Yeah. There is a lot of that. 

Mr. BACHUS. Mr. Jason Smith of Missouri. 

Mr. SMITH OF MISSOURI. Thank you, Mister—— 

Mr. BACHUS. A Missouri Tiger fan. 

Mr. SMITH OF MISSOURI. Absolutely. Is there any other? 

Thank you, Mr. Chairman. 

Mr. BACHUS. When there is not a miracle on the Auburn side? 

Mr. SMITH OF MISSOURI. I hope not. It is a miracle for both of 

us right now. [Laughter.] 

Mr. SMITH OF MISSOURI. My question is to Mr. Lacker. 

In your view, what are the benefits of resolving the financial 

firms through the bankruptcy process? 

Mr. LACKER. So, the alternative are worse, essentially. And the 

alternatives that we have utilized involve the discretionary deployment of public funds to protect creditors. I think that is an unstable and unsustainable approach. And that is what concerns me 

about title II as well. 

The dynamic—the expectation, I talked about that creditors view 

large financial institutions as ‘‘too big to fail’’ and likely to get government support, arose over several decades from the early 70’s 

and it was the accretion of—slow accretion of various precedents 

that led to the expectation that that is how we are going to behave. 

We ended up—those precedents resulted from situations in which, 

faced with a choice between rescuing or not and having the ability 

to do that, policymakers erred on the side of caution and protected 

creditors. 

And this came home, this was most vividly illustrated in the 

Bear Stearns case. The Bear Stearns had a substantial amount of 

RP borrowing that was maturing overnight every day, every morning actually. And there were—there was a substantial amount of 

lending overnight, via purchase agreements, to several other investment banks. And the fear was that, should Bear Stearns not 

get support and should those lenders get collateral back instead of 

their cash and have to sell the collateral for an uncertain value, 

that that would cause lenders to pull away from other financial 

firms as well. 

The ambiguity about that was what drove—is what created this 

awful dilemma for policymakers. And that is an example of the 
109 

kind of dynamic that set up the precedence that led to the widespread expectation coming into the crisis for this. I think that providing that discretion to policymakers is likely to lead to this dynamic replicating itself in the future. 

Mr. SMITH OF MISSOURI. So, if the Bankruptcy Code was adequately equipped to handle these insolvencies for the financial institutions, what is your belief on this ‘‘too big to fail’’ policy? 

Mr. LACKER. I think that the combination of good improvements 

to the Bankruptcy Code and the ‘‘living will,’’ the resolution planning process, can get us to a position where regulators are comfortable and confident that, should a large financial institution experience financial distress, they are willing to take it through 

bankruptcy without extraordinary government assistance. And 

once they are confident about that, we can convince creditors that 

that is going to be the norm. That will shift incentives in financial 

markets. That should lead to less short-term funding, less of the 

fragility that we see, less of the maturity transformation that creates so many problems to begin with. So—and that maturity transformation, that short-term lending like in the Bear case I described, is what gives rise to these terrible dynamics. And that is, 

I think, our best hope for getting out of the ‘‘too big to fail’’ box. 

Mr. SMITH OF MISSOURI. Is the bankruptcy—this question could 

be for anyone. But, is the Bankruptcy Code prepared for a big company, other than just a financial institution but a big company that 

may be the largest employer in the United States let us say, that 

decided to, you know, be insolvent? I mean, is that going to be the 

same type of situation where it comes back to Congress and we 

have to bail out this big corporation? Or is the Bankruptcy Code 

prepared right now to handle a situation that has maybe 200,000 

employees? 

Mr. ROE. I think I could address that. I believe that the bankruptcy system now is capable of handling the bankruptcy of a very 

large industrial firm. And you could put some of this in, not historical perspective, but perspective over the decades, something I was 

mentioning while we were offline. When the Bankruptcy Code was 

passed in 1978, the general thinking was that a large industrial 

firm, such as the kind of firm you are describing, could not survive 

Chapter 11. 

And, in fact, we bailed out Chrysler right after the Bankruptcy 

Code was passed. And Lee Iacocca, the president and chairman of 

Chrysler, persisted and was very convincing with the argument 

that, if Chrysler entered Chapter 11, it would not exit Chapter 11 

intact, that consumers would simply not buy cars from a bankrupt 

Chrysler. 

Over the subsequent decades, the system has learned how to reorganize very large industrial firms effectively. You know, in the 

last few weeks I flew American Airlines in bankruptcy and US Air 

outside of bankruptcy. And I might have been the only one on the 

plane who just noted that when I got on I was flying a bankrupt 

airline. It has just become a normal part of business. It will be very 

good for the economy of the United States if, over the next couple 

of decades, we could routinize the bankruptcy of financial institutions so that it just happens in the background and works effectively. 
110 

So, one additional cost of—one additional advantage of bankruptcy over alternatives is, for example, that to use title II, somebody has to be saying this is a systemically important financial institution whose failure would be very detrimental to the American 

economy. That is the kind of thing that could help propel more 

panic than we really need to have. If this entity could go right into 

bankruptcy and be handled by the bankruptcy institutions, which 

I believe an amended Bankruptcy Code could do, the waters would 

be calmer and bankruptcy would do better for us. 

Mr. BERNSTEIN. I would like to comment on that question also. 

First of all, the Bankruptcy Code was designed for the biggest 

companies. In fact, it really was designed to follow the pattern of 

equity receiverships in the 19th century which took the railroads, 

which were the biggest companies that existed at that time, and reorganized them. 

But there are two issues that it is very hard for the Bankruptcy 

Code to deal with. One is, will the company be able to continue in 

business? And I think what Mark is saying is that, in a lot of instances where people thought companies couldn’t continue in business, they have actually been able to sell their product in bankruptcy. Now, whether that would have been true, had the auto 

manufacturers stayed in bankruptcy for more than 6 weeks, would 

somebody buy a car with a 5-year warranty and the like? The answer may be that they would, as long as somebody stood behind 

the warranty other than the debtor. 

And that gets to the second question, which is somebody has to 

be willing to finance these entities in order for them to reorganize. 

And one of the problems in a downturn that goes beyond just the 

individual company and effects the whole economy is the money 

may not be available to finance you until you can reorganize. You 

know, the Tribune Company went into bankruptcy about 4 or 5 

years ago. And, at the beginning of that bankruptcy case everyone 

thought its value was one-third what it turned out to be when it 

emerged from bankruptcy. 

And, because of the degradation of value in a depressed market, 

it may be difficult to find private financing. And there has to be 

some form of bridge financing, probably other than DIP financing, 

in that kind of market that is available. And that is why it may 

be difficult without that sort of liquidity backup for the largest 

company in America to fail. And that was the experience with the 

auto companies recently. 

Mr. BACHUS. Thank you. 

I have got some prepared questions that I would like to go 

through. There are two for Governor Lacker. These are from staff 

members or the Chairman. 

Can you explain why you believe that shifting away from shortterm financing for financial firms will increase the probability that 

they may be orderly resolved through the bankruptcy process? 

Mr. LACKER. So, Mr. Roe has argued this eloquently in his statement. 

Mr. BACHUS. Right. 

Mr. LACKER. There is a great deal of maturity transformation 

that goes on outside the banking system, outside of deposit taking. 

And it is the type of financial arrangement that is most likely to 
111 

pin down a policymaker, put him in a box and make him feel as 

if he needs to rescue creditors rather than let bankruptcy proceed. 

I think setting the criteria for these large financial institutions 

that they ought to structure themselves so that they can be resolved in bankruptcy without government-provided ‘‘debtor-in-possession’’ financing, with just the debtor-in-possession financing they 

have planned for is a good criteria. If that means they do less maturity transformation, if that means that they do less borrowing 

short and holding longer in liquid assets, then I think so be it. I 

think that the system we have now is—artificially favors the maturity transformation that goes on in qualified financial contracts, 

particularly in RP lending. And I think reforms to the Bankruptcy 

Code and the kind of planning, the kind of resolution planning that 

Mr. Bernstein described, can help us get to a situation where we 

have a more socially appropriate quantity of maturity transformation going on. 

Mr. BACHUS. You know, look Bear Stearns—in Bear Stearns I 

have had knowledgeable people that have said to me, ‘‘You should 

have been able to look at the balance sheet and told they were insolvent.’’ So, I think maybe a more clear accounting or examination 

of their balance sheet. But also they were going through some, 

what I call, some financial shenanigans of shifting things back and 

forth. But I am just—you know there are ways in bankruptcy, 

there are ways to go back and capture some of that, I think. So 

that would probably be another advantage of bankruptcy. 

But anyway, I will get back to it. One of the questions I think 

sort of tracks on the question I have just asked Governor Lacker, 

for you Professor Roe. If the safe harbor exemptions create incentives for short-term financing, in your view, how does that make 

the financial system more difficult to resolve through bankruptcy? 

Mr. ROE. This will parallel Jeffrey Lacker’s comments, in this 

way, if we have safe harbors for short-term debt but don’t have it 

for long-term debt, we will tend to get more short-term debt that 

can run off very quickly in a bankruptcy or during a financial failure. So we have rules that facilitate the runoff when we should either want the rules to be neutral or maybe to slow down that sort 

of runoff. And this actually feeds into the point that Donald Bernstein was making. One of the big problems in a large financial institution bankruptcy would be financing. 

And this—the remark that I am going to make now is not going 

to make the problem go away. But, the safe harbors increase the 

difficulty of financing because some significant portion of the financial structure of a failed financial institution, if they are in safe 

harbored repo, will runoff immediately and then, in the extreme 

case, will have to be replaced. If it couldn’t runoff immediately the 

financial pressure would be less on the firm. 

So, one example, when Bear Stearns filed—when Bear Stearns 

failed and was taken over by JP Morgan Chase, it had about a 

quarter of its liabilities in repo. Only a couple decades before its 

repo level was only about 6 percent of its total liability. When it 

failed in 19-—in 2007, 2008, it is much more difficult for it to go 

through a bankruptcy because so large a portion of its structure is 

going to be immediately withdrawn. 
112 

Mr. BACHUS. And I think, just from reading you all’s testimony 

and sort of coming into this, it is just clear that the safe harbors 

does create some big problems. And the one you have described is 

pretty clear. I don’t know that—Mr. Bernstein, that is to you—— 

Mr. BERNSTEIN. I definitely agree that—— 

Mr. BACHUS. Yeah. 

Mr. BERNSTEIN [continuing]. In order to resolve financial institutions you have got to give them the ability to preserve the book of 

financial contracts and move it on to the continuing entity. 

Mr. BACHUS. And, you know, that seems to be a point if we are 

going to do something. If we don’t do something comprehensive incrementally that would be a good first step that I think would beat 

a little dissension. 

This is for Governor Lacker. Do you think there should be any 

regulatory involvement in the resolution of a financial firm through 

the bankruptcy process? I guess if we ask 12 different Fed governors, we would get 12 different answers to that question. 

Mr. LACKER. I don’t know. 

Mr. BACHUS. I think that the answer you—— 

Mr. LACKER. I think it makes—I have seen proposals that give 

regulators some standing. I think some standing makes sense. But 

I think you have to be careful about this. I think having a regulator initiate insolvency proceedings seems useful. I think you 

would want to carefully prescribe through the principles that they 

ought to be adhering to in making that decision. I think you would 

want to give them that right, but preserve as much clarity as you 

can for market participants as to when it is going to be exercised. 

So, try and do it in a way that provides some bounds around it that 

provides clarity about when it is going to be exercised. 

Mr. BACHUS. I was just thinking the word boundaries. And, you 

know, statutorily there ought to be some, with some marginal, I 

mean, you know, some discretion. But, you would need to define 

the boundaries of that participation. Whether it was to advise, just 

to offer advice or to assist, as opposed to not to dictate to them. 

Mr. LACKER. Yeah. So, the reason I think that is important, is 

it is important to, in a situation in which there is the potential for 

creditors to expect government rescues, you want the regulator to 

be able to force action and force bankruptcy before things unwind, 

before actions are taken that just make the matters dramatically 

worse and force the regulator’s hand later. So, now, there is other 

aspects of standing that I don’t have a—I really don’t have a view 

on. You know, pleadings and I guess things that these guys are an 

experts in. 

Mr. BACHUS. Okay. 

Mr. Bernstein? 

Mr. BERNSTEIN. Yeah. I generally agree with what has just been 

said. The—you know, if in fact you retain orderly liquidation authority as a backup, it will be less likely to be used if the regulator 

has the option of using bankruptcy. So, I think that is probably, on 

balance, a good thing. The—as to other matters, I mean, there may 

be other issues such as, you know, if you did this single point of 

entry approach in bankruptcy that the regulator would want to be 

heard on. So, there may be other standing issues the regulator 

wants to be involved in. 
113 

Mr. BACHUS. Well, and I think you could provide for a regulator 

to actually sit, if not part of the panel, in some position because 

you would have to assemble people that had the expertise. 

Mr. BERNSTEIN. Or at least give the regulator the opportunity to 

be heard on any issue. 

Mr. BACHUS. Okay. 

And I think the last question is for you, Mr. Bernstein. Based on 

your experience working with and developing ‘‘living wills,’’ setting 

aside the question of how a financial firm will be financed through 

a restructuring, what are the major impediments to efficient resolution of a financial firm through the bankruptcy process as the 

Bankruptcy Code is currently drafted? And actually, you have covered an awful lot of this. 

Mr. BERNSTEIN. Yeah, I did. Well, I strongly believe that the 

ability to separate the—first of all, I believe the ability to recapitalize rather than liquidate is extremely important. And I think the 

tools that are there today will permit it for some entities but not 

for all entities in the group. And it would be good if the tools were 

there to have that happen for all entities. I do think liquidity is an 

important issue and I distinguish that very importantly from capital. The capital losses are going to be suffered in the private sector, but if the liquidity is not there to stabilize the firm through 

a lender of last resort that is problematic. Banks have the discount 

window, they can do that; but, broker-dealers don’t. So, I think that 

is an important aspect. 

And so, I think really focusing on the good work that has been 

done by the FDIC on single point of entry. And taking that and 

saying, ‘‘How can we do that in a procedurally appropriate way, 

under the Bankruptcy Code,’’ would be an excellent step. 

Mr. BACHUS. Thank you. 

Let me—and I am going to conclude with a question that—and 

more maybe not a question but to sort of try to encourage some action and that is—you know, National Bankruptcy Conference, the 

American Bankruptcy Institute, the American Bar Association, the 

regulators. It would be extremely helpful to the Judiciary Committee and I know the Senate is also looking at this, so this is not 

something that is—in fact they have had ongoing discussions and 

we have had discussions with them. So there is a willingness and 

a desire to make changes in the Bankruptcy Code. But, we—it 

would be so much easier if, as in the case of some other things, we 

had a model act or we had a something brought to us. And I know 

the Senate actually has some draft language, but that would be extremely helpful. It would give us quite a bit of comfort because it 

would be very hard for us to do that. And so, I would encourage 

the different—the Conference, the Institute, the regulators to continue discussion and give the Congress some guidance. And, if not, 

a draft. 

So, thank you. 

This concludes the hearing. Thanks to all our witnesses for attending. This is a very—we, in this case, both the democrats and 

republican agreed that you were as qualified witnesses as any. 

And without objections all our Members of the Committee will 

have 5 legislative days to submit additional written questions for 

the witnesses or additional materials for the record. 
114 

And this hearing is adjourned. 

[Whereupon, at 3:50 p.m., the Subcommittee was adjourned.] 
(115) 

A P P E N D I X 

MATERIAL SUBMITTED FOR THE HEARING RECORD
116 

Statement of Subcommittee Chainnan Spencer Bachus 

Subcommittee on Regulatory Reform, Commercial and Amitrust l.aw 

Oversight Hearing on "The Bankruptcy Code and Financial Institution Insolvencies" 

Tuesday. December 3. 2013 at 1:00 p.m. 

Our n~tion 's fin~ncial system pro\'ides the capit~l for businesses to dc,"clop. grow, 

hire workers, and prosper. Ensuring thai this system function s emdently in both good 

timrcs and bad is critical to Ihe ongoing \'ilality ofollr economy. On~ lesson that we learned 

during thc fin~lldal crisis of 2008 was thai the finalldal system and existing !Mws -

including our bankruplcy laws - wert nOI adeqllHtely equiplltd 10 dtal wilh the insDlnncy 

of certain financial i.lstitutions. As we all well remember, this thrtatened the stability of 

the fin ancia l system and indeed the global economy. 

When established practices like bankruptcy do not work. yon end np with ad hoc 

a pl)TOaches and a situation where the go,'crnment can be put in a position of I)i cking 

"willners and losers," which is nOI a rol e we should nt for go,·ernmenl. Some of you 

ha"t heard Ine talk nbout the bailout of ,\ IG. AIG's largesl creditors and counttrparties -

nlHn y of them large domestic and foreign institutiolls - were madc whole. but smaller 

parties indudillg some ill m)' home state of Alabama were lold 10 take considerable 

" haircuts." This is but one exalllille of wha t hall pens with ad hoc allproaches where 

dedsions can \'a ry 0 .1 a case-by-case bas1$. There is no consistency or predictability. 

We are now about fi\'cyears out from the low poillt of the fiu31ldal crisis in the fall 

of Z008. Various measures han' been taken to try to return to " regular order" after the 

many fillergency decisions that were lIIade during the crisis. The passage of the DoddFrank Act was one of them. There art likely differing views on tilher side Gfthe a isle on 

this legislation and ils pro .. i, iolls for resol\'ing the status of distressed institutions. 
117 

Today'S hearing, howenr. is not about that dl"bate. In$lud ... 'e will focus on 

whethl"r the Baukruptcy Code can be imWo.'ed to WO" ide beller for the efficieut 

resolutioll ofl~rgt l1d rr fin~nci~1 firms. 

The insol."ency of a financial firm may present a numbu of unique challenges to the 

u istillg Bankruptcy Code. Olle such challenge is that these resolutions generally require 

speed. There 'llust be immediate comfort Ilrovided to II fillancial firm's ( ustomers and the 

'llarket that key obligations will be met. Any uncertainty that is not swiftly and cOlllplflfly 

addressed may result in se"erery ad" ene consequences. So we need to look at whethfr the 

U isting bankruptcy Ilrocess provides for this kind of uptdiency. 

We also should en mine the imllactthat the "living will " IIrovision in Title I of 

Dodd-Frank may ha"t on tht bankruptc)' prOCHS. Tht " living \\'ill"' requirtnttnt has 

resulted in financial firms focnsing their attention on the structnre of their legal corporate 

entities rather than solely on their lines of business. As the fillancial industry concentrates 

their dforts 011 gal1i~ in g themsel."es in a fashioll that iucruses the likelihood of a ll 

orderly resolution through ballkn'IItcy. wt should assns " 'hct her tht uisting Bankruptcy 

Code presents any imllediments to 911 efficient resolution. 

Then have been thoughtful reports by the Fedenl Renn'e and tht GO"ernment 

Accountability Office, among others. which have taken a broad look at these issues and 

possible reforms. So combined with the tHtimon), of Ollr witnesses today. there is a rich 

pool of scholarshill to consider. 

2 
118 

f 

Today's hearing will allow the Subcommittee 10 eumine Ihese and other issues, 

wilh the goal of beginning the og e of ensuring Ihat Ihe nkru Cy Code Ilrovides 9n 

up-to-date mechanis m to resol,'e large d sma ll financial fir ms, 

'" 

3 
119 

Prepared Statement of the Honorable Steve Cohen, a Representative in 

Congress from the State of Tennessee, and Ranking Member, Subcommittee on Regulatory Reform, Commercial and Antitrust Law 

I voted for the Dodd-Frank Wall Street Reform and Consumer Protection Act of 

2010 and remain a supporter of the law. 

The Dodd-Frank Act’s passage by Congress was an acknowledgment of the fact 

that insufficient regulation led to the problem of so-called ‘‘Too Big to Fail’’ financial 

institutions—that is, financial institutions that were allowed to become so big and 

so interconnected that their insolvencies threatened to paralyze the Nation’s financial system and its broader economy. This situation, in turn, resulted in extreme 

pressure for a taxpayer bailout when those institutions fell under financial distress. 

The bankruptcy filing of Lehman Brothers in 2008—the largest bankruptcy in U.S. history, involving more than $600 billion in assets—vividly illustrated aspects 

of the ‘‘Too Big to Fail’’ problem. Lehman’s bankruptcy filing greatly exacerbated a 

financial panic on Wall Street, leading to a severe financial crisis and the greatest 

economic downturn since the Great Depression, the effects of which we continue to 

feel today. 

More importantly, the financial markets’ reaction to the Lehman Brothers bankruptcy highlighted the potential limitations of the Bankruptcy Code in handling the 

resolution of financially distressed systemically important financial institutions. 

I remain a strong supporter of the Dodd-Frank Act, although I also support certain enhancements to it. For example, I support legislation that would increase the 

minimum required amount of capital for covered financial institutions under DoddFrank. 

We should also consider the potential need for other enhancements, like adding 

a representative of the Antitrust Division of the Department of Justice to the Financial Stability Oversight Council, created by Dodd-Frank to oversee the stability of 

the financial system. 

It is in this spirit that I approach today’s hearing, which will focus on whether 

the current Bankruptcy Code is sufficient to allow for the orderly reorganization or 

liquidation of systemically important financial institutions under Title I of the DoddFrank Act. 

Whether one supports or opposes the Dodd-Frank Act, we can agree that today’s 

inquiry is an important one. To the extent that modest revisions to the Bankruptcy 

Code will help ensure that we avoid the need for any future taxpayer bailouts of 

financially struggling large financial institutions, we should be able to work together 

on crafting such changes. 

f 

Prepared Statement of the Honorable Bob Goodlatte, a Representative in 

Congress from the State of Virginia, and Chairman, Committee on the Judiciary 

The Bankruptcy Code has existed in this country for well over a hundred years. 

Over this time, our bankruptcy system has evolved to become one of the most sophisticated regimes in the world. The bedrock principle embedded in the bankruptcy 

system of providing for the efficient resolution and reorganization of operating firms 

has allowed our economy to grow and flourish. 

Nevertheless, a periodic evaluation of the Bankruptcy Code to ensure its adequacy 

to address the challenges posed by the changing nature of operating firms is one 

of the fundamental responsibilities of this Committee. 

I applaud Chairman Bachus for holding today’s hearing to examine whether the 

existing Bankruptcy Code is best equipped to address the insolvency of large and 

small financial institutions. 

The bankruptcy process confers a number of benefits to all operating companies, 

including financial firms. The bankruptcy court provides transparency and due process to all parties involved. Furthermore, bankruptcy case law has been developed 

over decades, providing consistency and predictability. 

Additionally, the bankruptcy process has been sufficiently dynamic to administer 

the resolution and restructuring of complex operating companies with billions of dollars in assets as well as smaller companies and individuals. But despite the bankruptcy system’s ability to accommodate complex operating companies, financial 

firms may possess unique characteristics that are not yet optimally accounted for 

in the Bankruptcy Code. 

For example, efficient and orderly resolution of financial firms can require an unusual level of speed. Refinements to the Code might be considered to better provide 

that speed while still assuring due process. 
120 

Additionally, in some circumstances the failure of financial firms can pose unique 

threats to the broader stability of the economy. To account for that, title I of the 

Dodd-Frank Wall Street Reform and Consumer Protection Act requires certain firms 

to prepare ‘‘living wills’’ to plan for resolution in bankruptcy in the event of failure. 

The Bankruptcy Code is well-crafted to maximize the recoveries of a debtor’s 

creditors while providing an opportunity for the debtor to either reorganize or liquidate in an orderly fashion. It might, however, bear improvements designed specifically for the efficient execution of title I ‘‘living wills.’’ 

These are some of the issues that may need to be examined as part of the broader 

evaluation of the existing Bankruptcy Code’s adequacy to address financial institution insolvencies. I look forward to the testimony from today’s excellent panel of witnesses on these important issues. 

Thank you Mr. Chairman, and I yield back the balance of my time. 

f 

Prepared Statement of the Honorable John Conyers, Jr., a Representative 

in Congress from the State of Michigan, and Ranking Member, Committee on the Judiciary 

This hearing examines whether current law would adequately address the insolvency of a significant financial institution given what we learned from the near collapse of our Nation’s economy just five years ago. 

As we consider this issue, it is critical that we keep in mind what precipitated 

the Great Recession. 

Basically, it was the regulatory equivalent of the Wild West. 

In the absence of any meaningful regulation in the mortgage industry, lenders developed high risk subprime mortgages and used predatory marketing tactics that 

targeted the most vulnerable by promising them that they could finally share in the 

Great American Dream of homeownership. 

This proliferation of irresponsible lending caused home prices to soar even higher, 

ultimately resulting in a housing bubble. 

In the absence of any meaningful regulation in the financial marketplace, these 

risky mortgages were then bundled and sold as investment grade securities to 

unsuspecting investors, including pension funds and school districts. 

Once the housing bubble burst, the ensuing 2008 crash stopped the flow of credit 

and trapped millions of Americans in mortgages they could no longer afford, causing 

vast waves of foreclosures across the United States, massive unemployment, and 

international economic upheaval. 

And, to this day, we are still dealing with the lingering effects of the Great Recession of 2008 in the form of a sluggish national economy, neighborhoods blighted by 

vast swaths of abandoned homes, and municipalities struggling with reduced revenues. 

Fortunately, the Dodd Frank Act reinvigorates a stronger regulatory system that 

makes the financial marketplace more accountable and institutes long-needed consumer protections. 

It also establishes a mandatory resolution mechanism to wind down a systemically significant financial institution that cannot be resolved under bankruptcy. 

The Act also imposes various requirements on financial institutions that will 

allow regulators to better assess the risks such institutions present to Wall Street 

and, most importantly, Main Street. 

A key component of the Dodd Frank Act process requires these companies and 

the regulators to assess resolution under current bankruptcy law. 

In recent years, some of the Nation’s largest companies have used the Bankruptcy 

Code to regain their financial footing, including General Motors, American Airlines, 

and Washington Mutual. 

Questions have been raised, however, as to whether the Bankruptcy Code can be 

improved upon to better accommodate large inter-connected financial institutions 

like those subject to the Dodd Frank Act. 

Some have even suggested that a new form of bankruptcy relief that specifically 

deals with these institutions may be the most expedient. 

There may, in fact, potentially be consensus that some changes to the Bankruptcy 

Code may be warranted. 

In any event, today’s hearing should elicit some helpful guidance and I look forward to the testimony from these experts. 

Thank you Mr. Chairman, and I yield back the balance of my time. 

f 
121 

Questions for the R«ord from 

Rcpres~ nl ti,'C Doug Collins 

for Ihe lIu ring 011 "'Tht Bankruptcy Codt d Fin~ncillii titnti n In olwnci ts~ 

D«tlllber),201l 

Ourstion~ for rrrcv ac ~r 

Mr. Lacker. your lestimony makes the case Ihat. to end "too big to fair and,o prevent public 

resources being used to inappropriately benefIt creditors of financial ins,itu,ions, bankrop'CY is 

bet,er than Title II of Dodd-Frank and other al,ernat;ves. 

I. Fall/lie A-kw alld Freddie A-fac lire Ihe 1(lSIIwo "iMres~;edfi"allcial illSlill/liolls/rOlI! Ihe 1008-

()9 jilKlllcial crisis. file),are 110M' ill CQ/I~nmonhip (II'" II/all)' lIIelllh.:r~ (if Q/I}..,e~ s ""''''110 

M'iI'" 11"'111 doll'/I. 1.\11'1 il bell.:r 10 I/~ e Ihe hallkrup/c)' ~)"!iI':1II1O do so ills/~'(Id o/lI'rilillg a 

lIeM' legal regime/or (1/I1/"'e~'led age/lCY like FHI'"A 10 <1<., ? 

rrn an e«»lornist, not a lawyer or expel"! on insolvency rcgimcs, and my answers to your 

questions StCm from my personal pointS of view as a Reserve Bank president and mcmber of the 

FOMC who's concemed about ,he financial stability of the U.S. My unders'anding is that 

bankroptcy protec,ion, at least as the Bankroptcy Cooe is Currently written. is most likcly 

unavailable to Fannie and Freddie. Federal bankroptcy is unavailable to "governmental units' 

(II U.SC. § 101(41)), the definition of governmental units includes "federal instromentalities" 

(II US.c. § 101(27)), and Fannie and Freddie bear many of the hallmarks of federal 

instromentalities (for example, they serve an imponant governmental purpose, face extensive 

government regulation, and enjoy significant tax exemptions). In fact , federal couns have 

repeatedly classified GSEs. including Fannie, Freddie, the Federal Home Loan Banks. and the 

Farm Credit System. as federal instromentalili es. 

Mcanwhile. the Housing and Economic Recovery Act gave FHFA reccivership powers (12 

U.S.c. § 4617). so while FHF A receivership may be untested and may nOl be the e.xact 

equivalent ofbankroptcy. the FHFA could in theory wind dO\\l1 Fannie and Freddie in a manner 

thaI roughly appro~imates bankroptcy. The advantage of a court-administered bankroptcy 

process lies in the relative predictability it provides to counterparties and fUlUre housing finance 

market participants. compared to an at-times politically-innuenced process. 

2. Is Ihe i>(Ulkruplcy ~}'l lemjlcxihle "I/(JI/gh /Q handle W/WIII CQ/1'IKl/lies like l"annie (/IKI 

Fre<l<.lie. where Ihcre is l'/o<:klwlder e"IIily m"l lln: Cn/crpriIW is meclillg ilsji/l(mcial ob/ig(l{iQlll' 

10 u .'dilor .... bill ii/wed,' 10 he re ... lrl/c/I/ud or 1'111 ;1110 ru"-Off! 

My understanding is that the Cooe doesn't exclude soIven, companies. A debtor f,ling for 

Chapter 7 or Chaptcr II doesn't have 10 be "insolvent" as ,he Cooe defines ,he tenn (II U.S.C. 

§§ 109(b) and (d)). Bankruptcy courts have confirmed thi$. noting that as long as a debtor's 

petition has a valid reorganizational purpose and the debtors board of directors consents to it. 

the debtor doesn 't have to be insolvent to seek bankroptcy protection. Fannie and Freddie, 
122 

f 

however, aren't typical companies and would likely remain ineligible for banklllptcy b('(;ause of 

their legal status and the Code's current language. 

In general, the question of whether the fimls need to be restlllctured or put imo llln-ofT is itselfa 

public policy decision that goes beyond narrow legal issues offinancial restlllcturing. 
123 

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