Financial Company Bankruptcies: Information on Legislative Proposals and International Coordination
Published: 2015-03-19T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The challenges associated with the bankruptcies of large financial companies during the 2007-2009 financial crisis raised questions about the effectiveness of the U.S. Bankruptcy Code and international coordination for resolving complex financial institutions with cross-border activities.
The Dodd-Frank Act mandates that GAO report on an ongoing basis on ways to make the U.S. Bankruptcy Code more effective in resolving certain failed financial companies. GAO has issued three reports on this issue. This fourth report addresses (1) recent changes to the U.S. Bankruptcy Code and (2) efforts to improve cross-border coordination to facilitate the liquidation or reorganization of failed large financial companies under bankruptcy.
GAO reviewed laws, court documents, regulations, prior GAO reports, and academic literature on financial company bankruptcies and regulatory resolution. GAO also reviewed documentation from foreign financial regulators and international bodies such as the Financial Stability Board. GAO interviewed officials from the Administrative Office of the United States Courts, Department of Justice, Department of the Treasury, and financial regulators with a role in bankruptcy proceedings.
GAO makes no recommendations in this report. The Department of the Treasury, Federal Reserve, FDIC, and the Securities and Exchange Commission provided technical comments on a draft of the report that GAO incorporated as appropriate.
section_title: What GAO Found
paragraphs: The U.S. Bankruptcy Code (Code) chapters dealing with the liquidation or reorganization of a financial company have not been changed since GAO last reported on financial company bankruptcies in July 2013. However, bills introduced in the previous Congress would, if re-introduced and passed, make broad changes to the Code relevant to financial company bankruptcies. The Financial Institution Bankruptcy Act of 2014 (H.R. 5421) and Taxpayer Protection and Responsible Resolution Act (S.1861) would have expanded to varying degrees the powers of the Board of Governors of the Federal Reserve System (Federal Reserve) and Federal Deposit Insurance Corporation (FDIC) and would have imposed a temporary stay on financial derivatives (securities whose value is based on one or more underlying assets) that are exempt from the automatic stay under the Code. That stay would prohibit a creditor from seizing or taking other action to collect what the creditor is owed under the financial derivative. The bills also would have added to the Code processes for the resolution of large, complex financial companies similar in some ways to provisions currently in the Orderly Liquidation Authority (OLA) in Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which grants FDIC the authority to resolve failed systemically important financial institutions under its receivership. For example, each bill would have allowed for the creation of a bridge company, in which certain assets and financial contracts of the holding-company would be transferred, allowing certain subsidiaries to continue their operations. The 21st Century Glass-Steagall Act of 2013—a bill introduced in the House of Representatives (H.R. 3711) and the Senate (S. 1282)—would have repealed safe-harbor provisions that allow most counterparties in a qualifying transaction with the debtor to exercise certain contractual rights even if doing so would otherwise violate the automatic stay. As of March 12, 2015, these legislative proposals had not been re-introduced in Congress.
In the United States, the presumptive mechanism to resolve a failed large financial company with cross-border operations is through the judicial bankruptcy process. Since GAO's 2013 report, no changes have been made to the chapter of the Code that relates to coordination between U.S. and foreign jurisdictions in bankruptcy cases in which the debtor has foreign operations. Some structural challenges remain, such as conflicting regulatory regimes related to the treatment of financial contracts between parties in different countries when a firm enters bankruptcy, but efforts are underway to address them. Regulators have implemented a Dodd-Frank Act provision that requires certain large financial firms to submit a resolution plan to assist with an orderly bankruptcy process, which regulators expect to help address potential problems with international cooperation, among others. However, in 2014, FDIC and the Federal Reserve identified shortcomings with the plans for a number of large financial companies that those firms are to address in their 2015 submissions. Further, international bodies, such as the Financial Stability Board—an international body that monitors and makes recommendations about the global financial system—have focused on having countries adopt a regulatory approach to resolutions. Other recent actions include a January 2015 stay protocol for derivatives contracts developed by the International Swaps and Derivatives Association that is intended to give regulators time to facilitate an orderly resolution of a troubled firm.

section_title: Letter
paragraphs: There were a number of bankruptcies of complex financial institutions  such as Lehman Brothers Holdings, Inc. and Washington Mutual, Inc.  during the 2007-2009 financial crisis. Some members of Congress and  some legal and financial experts raised questions about the effectiveness  of the U.S. Bankruptcy Code (Code) in providing for orderly liquidations or  reorganizations of financial institutions that qualify as debtors under the  Code. In addition, the Lehman bankruptcy proceedings, which began in  September 2008 and included the bankruptcy of Lehman Brothers  Holdings, Inc. and a number of its subsidiaries, have highlighted  inconsistencies in laws and regulations across countries and limitations  on the ability of countries to coordinate effectively during the  reorganization or liquidation of a financial institution that operates across  national borders.
In 2011, 2012, and 2013 we issued statutorily mandated reports on the  effectiveness of the Code for resolving or liquidating complex,  internationally active financial institutions. For example, our July 2011  report included a discussion of proposals for revising the Code for large  financial companies and examined international coordination efforts. In  July 2012, we examined actions taken to implement the Orderly  Liquidation Authority (OLA) created by the Dodd-Frank Wall Street  Reform and Consumer Protection Act (Dodd-Frank Act). OLA authorizes  the Secretary of the Treasury to appoint the Federal Deposit Insurance  Corporation (FDIC) as a receiver when, among other things, the failure of  a financial company would have serious adverse effects on U.S. financial  stability. Our July 2013 report discussed proposals from experts,  government officials, and legislators to change the Code to make  bankruptcies of financial companies (especially those that pose systemic  risk to the financial system) more orderly and effective.
This report examines (1) recent changes to the U.S. Bankruptcy Code  and (2) efforts to improve cross-border coordination to facilitate the  liquidation and reorganization of failed large financial companies under  bankruptcy. We also continue to monitor developments in the bankruptcy  cases of three financial companies (on which we previously reported in  reports responding to this mandate) and discuss these cases in appendix  I.
To address these objectives, we reviewed proposed legislation in the  113th Congress to change the Code that was relevant to the liquidation or  reorganization of financial companies, as well as literature by researchers  relevant to such changes. We reviewed documentary evidence from  foreign financial regulators and international bodies to describe the status  of reform efforts to improve cross-border coordination. We reviewed prior  GAO reports, as well as transcripts from expert roundtables on  bankruptcy reform that GAO hosted in 2013, and collected and analyzed  information from regulatory documents and academic studies. In addition,  we interviewed officials from financial regulatory agencies and others with  a role in bankruptcy proceedings including the Commodity Futures  Trading Commission (CFTC), FDIC, the Board of Governors of the  Federal Reserve System (Federal Reserve), and the Securities and  Exchange Commission (SEC); the Administrative Office of the United  States Courts (AOUSC), the U.S. Department of Justice, and the U.S.  Department of the Treasury (Treasury). See appendix II for more  information on our scope and methodology.
We conducted this performance audit from June 2014 to March 2015, in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: There are two approaches for reorganizing or terminating a large financial  company. Large financial companies may be reorganized or liquidated  under a judicial bankruptcy process or resolved under special legal and  regulatory resolution regimes that have been created to address insolvent  financial entities such as insured depository institutions and insurance  companies.
subsections: section_title: Bankruptcy Proceedings
paragraphs: Bankruptcy is a federal court procedure, the goal of which is to help  individuals and businesses eliminate or restructure debts they cannot  repay and help creditors receive some payment in an equitable manner.  Generally the filing of a bankruptcy petition operates as an automatic  stay; that is, it stops most lawsuits, foreclosures, and other collection  activities against the debtor. Equitable treatment of creditors means all  creditors with substantially similar claims are classified similarly and  receive the same treatment. For example, a class of secured creditors— those with liens or other secured claims against the debtor’s property— will receive similar treatment as to their secured claims.
Business debtors may seek liquidation, governed primarily by Chapter 7  of the Code, or reorganization, governed by Chapter 11. Proceedings  under Chapters 7 and 11 can be voluntary (initiated by the debtor) or  involuntary (generally initiated by at least three creditors holding at least a  certain minimum amount of claims against the debtor). In an involuntary  proceeding, the debtor can defend against the proceeding, including  presenting objections. The judge subsequently decides whether to grant  the creditors’ request and permit the bankruptcy to proceed, dismiss the  request, or enter any other appropriate order.
A Chapter 7 proceeding is a court-supervised procedure by which a  trustee takes over the assets of the debtor’s estate subject to limited  exemptions, reduces them to cash, and makes distributions to creditors,  subject to the rights of secured creditors to the collateral securing their  loans to the debtor. A reorganization proceeding under Chapter 11 allows  debtors to continue some or all of their operations subject to court  supervision as a way to satisfy creditor claims. The debtor typically  remains in control of its assets, and is called a debtor-in-possession  (DIP). Under certain circumstances, the court can direct the U.S. Trustee  to appoint a Chapter 11 trustee to take over the affairs of the debtor. As  shown in figure 1, a firm going through a Chapter 11 bankruptcy generally  will pass through several stages. Among these are:
First-day motions. The most common first-day motions relate to the  continued operation of the debtor’s business and involve matters such  as requests to use cash collateral—liquid assets on which secured  creditors have a lien or claim—and obtaining financing, if any.
Disclosure. The disclosure statement must include information on the  debtor’s assets, liabilities, and business affairs sufficient to enable  creditors to make informed judgments about how to vote on the  debtor’s reorganization plan and must be approved by the bankruptcy  court.
Plan of reorganization. A debtor has an exclusive right to file a plan  of reorganization within the first 120 days of bankruptcy. The plan  describes how the debtor intends to reorganize and treat its creditors.  The plan divides claims against the debtor into separate classes and  specifies the treatment each class will receive. The court may confirm  the plan if, among other things, each class of allowed creditors has  accepted the plan or the class is not impaired by the plan. If not all  classes of impaired creditors vote to accept the plan, the court can still  confirm the plan if it is shown that it is fair to all impaired creditors.
Reorganization. Possible outcomes, which can be used in  combination, include (1) distribution under a plan of the proceeds of a  pre-plan sale of the assets of the company (in whole or in part),  sometimes called a section 363 sale. Section 363 of the Code permits  sales that are free and clear of creditor claims of property of the  estate; (2) liquidation of the company’s assets with approval of the  court, through means other than a 363 sale; and (3) reorganization of  the company, in which it emerges from bankruptcy with new  contractual rights and obligations that replace or supersede those it  had before filing for bankruptcy protection.
The debtor, creditors, trustee, or other interested parties may initiate  adversary proceedings—in effect, a lawsuit within the bankruptcy case to  preserve or recover money or property, to subordinate a claim of another  creditor to their own claims, or for similar reasons. Furthermore, the  The U.S. bankruptcy system involves multiple federal entities. Bankruptcy  courts are located in 90 federal judicial districts; however, as we reported  in 2011, the Southern District of New York and the District of Delaware  adjudicate a majority of larger corporate or business bankruptcy cases.  The Judicial Conference of the United States serves as the judiciary’s  principal policymaking body and recommends national policies on all  aspects of federal judicial administration. In addition, AOUSC serves as  the central administrative support entity for the Judicial Conference and  the federal courts, including bankruptcy courts. The Federal Judicial  Center is the education and research agency for the federal courts and  assists bankruptcy courts with reports and assessments relating to the  administration and management of bankruptcy cases. Finally, the  Department of Justice’s U.S. Trustee Program and the judiciary’s  Bankruptcy Administrator Program oversee bankruptcy trustees and  promote integrity and efficiency in the bankruptcy system by overseeing  the administration of bankruptcy estates.
A preference action can be asserted for payments made to an insider within a year prior  to the bankruptcy filing.
section_title: Financial Companies and the Bankruptcy Code
paragraphs: Large, complex financial companies that are eligible to file for bankruptcy  generally file under Chapter 11 of the Code. Such companies operating in  the United States engage in a range of financial services activities. Many  are organized under both U.S. and foreign laws. The U.S. legal structure  is frequently premised on a parent holding company owning regulated  subsidiaries (such as depository institutions, insurance companies,  broker-dealers, and commodity brokers) and nonregulated subsidiaries  that engage in financial activities.
Certain financial institutions may not file as debtors under the Code and  other entities face special restrictions in using the Code:  Insured depository institutions. Under the Federal Deposit  Insurance Act, FDIC serves as the conservator or receiver for insured  depository institutions placed into conservatorship or receivership  under applicable law.
Insurance companies. Insurers generally are subject to oversight by  state insurance commissioners, who have the authority to place them  into conservatorship, rehabilitation, or receivership.
Broker-dealers. Broker-dealers can be liquidated under the  Securities Investor Protection Act (SIPA) or under a special  subchapter of Chapter 7 of the Code. However, broker-dealers may  not file for reorganization under Chapter 11.
Commodity brokers. Commodity brokers, which include futures  commission merchants, foreign futures commission merchants,  clearing organizations, and certain other entities in the derivatives  industry, can only use a special subchapter of Chapter 7 for  bankruptcy relief.
section_title: Current Role of Financial Regulators in Bankruptcy Proceedings
paragraphs: Regulators often play a role in financial company bankruptcies. With the  exception of CFTC and SEC, the Code does not explicitly name federal  financial regulators as a party of interest with a right to be heard before  the court. In practice, regulators frequently appear before the court in  financial company bankruptcies. For example, as receiver of failed  insured depository institutions, FDIC’s role in bankruptcies of bank  holding companies is typically limited to that of creditor. CFTC has the  express right to be heard and raise any issues in a case under Chapter 7.  SEC has the same rights in a case under Chapter 11. SEC may become  involved in a bankruptcy particularly if there are issues related to  disclosure or the issuance of new securities. SEC and CFTC are, in  particular, involved in Chapter 7 bankruptcies of broker-dealers and  commodity brokers. In the event of a broker-dealer liquidation, pursuant  to SIPA the bankruptcy court retains jurisdiction over the case and a  trustee, selected by the Securities Investor Protection Corporation (SIPC),  typically administers the case. SEC may participate in any SIPA  proceeding as a party.
The Code does not restrict the federal government from providing DIP  financing to a firm in bankruptcy, and in certain cases it has provided  such funding—for example, financing under the Troubled Asset Relief  Program (TARP) in the bankruptcies of General Motors and Chrysler.  The authority to make new financial commitments under TARP  terminated on October 3, 2010. In July 2010, the Dodd-Frank Act  amended section 13(3) of the Federal Reserve Act to prohibit the  establishment of an emergency lending program or facility for the purpose  of assisting a single and specific company to avoid bankruptcy.  Nevertheless, the Federal Reserve may design emergency lending  programs or facilities for the purpose of providing liquidity to the financial  system.
section_title: Current Safe-Harbor Treatment for Financial Contracts under the Code
paragraphs: Although the automatic stay generally preserves assets and prevents  creditors from taking company assets in payment of debts before a case  is resolved and assets are systematically distributed, the stay is subject to  exceptions, one of which can be particularly important in a financial  institution bankruptcy. These exceptions—commonly referred to as the  “safe harbor provisions”—pertain to certain financial and derivative  contracts, often referred to as qualified financial contracts (QFC). The  types of contracts eligible for the safe harbors are defined in the Code.  They include derivative financial products, such as forward contracts and  swap agreements that financial companies (and certain individuals and  nonfinancial companies) use to hedge against losses from other  transactions or speculate on the likelihood of future economic  developments. Repurchase agreements, which are collateralized  instruments that provide short-term financing for financial companies and  others, also generally receive safe-harbor treatment.
Under the safe-harbor provisions, most counterparties that entered into a  qualifying transaction with the debtor may exercise certain contractual  rights even if doing so otherwise would violate the automatic stay. In the  event of insolvency or the commencement of bankruptcy proceedings, the  nondefaulting party in a QFC may liquidate, terminate, or accelerate the  contract, and may offset (net) any termination value, payment amount, or  other transfer obligation arising under the contract when the debtor files  for bankruptcy. That is, generally nondefaulting counterparties subtract  what they owe the bankrupt counterparty from what that counterparty  owes them (netting), often across multiple contracts. If the result is  positive, the nondefaulting counterparties can sell any collateral they are  holding to offset what the bankrupt entity owes them. If that does not fully  settle what they are owed, the nondefaulting counterparties are treated as  unsecured creditors in any final liquidation or reorganization.
section_title: Orderly Liquidation Authority
paragraphs: OLA gives FDIC the authority, subject to certain constraints, to resolve  large financial companies, including a bank holding company or a  nonbank financial company designated for supervision by the Federal  Reserve, outside of the bankruptcy process. This regulatory resolution  authority allows for FDIC to be appointed receiver for a financial company  if the Secretary of the Treasury, in consultation with the President,  determines, upon the recommendation of two-thirds of the Board of  Governors of the Federal Reserve and (depending on the nature of the  financial firm) FDIC, SEC, or the Director of the Federal Insurance Office,  among other things, that the firm’s failure and its resolution under  applicable law, including bankruptcy, would have serious adverse effects  on U.S. financial stability and no viable private-sector alternative is  available to prevent the default. In December 2013, FDIC released for  public comment a notice detailing a proposed single-point-of-entry  (SPOE) approach to resolving a systemically important financial institution  under OLA.
Under the SPOE approach, as outlined, FDIC would be appointed  receiver of the top-tier U.S. parent holding company of a covered financial  company determined to be in default or in danger of default pursuant to  the appointment process set forth in the Dodd-Frank Act. Immediately  after placing the parent holding company into receivership, FDIC would  transfer assets (primarily the equity and investments in subsidiaries) from  the receivership estate to a bridge financial company. By allowing FDIC to  take control of the firm at the parent holding company level, this approach  could allow subsidiaries (domestic and foreign) carrying out critical  services to remain open and operating. In a SPOE resolution, at the  parent holding company level, shareholders would be wiped out, and  unsecured debt holders would have their claims written down to reflect  any losses that shareholders cannot cover.
section_title: Challenges of Resolving Failing Cross Border Financial Companies
paragraphs: The resolution of globally active large financial firms is often associated  with complex international, legal, and operational challenges. The  resolution of failed financial companies is subject to different national  frameworks. During the recent financial crisis, these structural challenges  led to government rescues or disorderly liquidations of systemic firms.
Insolvency laws vary widely across countries. The legal authorities of  some countries are not designed to resolve problems in financial  groups operating through multiple legal entities that span borders.  Some resolution authorities may not encourage cooperative solutions  with foreign resolution authorities.
Regulatory and legal regimes may conflict. Depositor preference,  wholesale funding arrangements, derivatives, and repurchase  agreements are often treated differently among countries when a firm  enters bankruptcy.
Some resolution authorities may lack the legal tools or authority to  share information with relevant foreign authorities about the financial  group as a whole or subsidiaries or branches.
Country resolution authorities may have as their first responsibility the  protection of domestic financial stability and minimization of any risk to  public funds. For instance, if foreign authorities did not have full  confidence that national and local interests would be protected, the  assets of affiliates or branches of a U.S.-based financial institution  chartered in other countries could be ring fenced or isolated and  wound down separately under the insolvency laws of other countries  thus complicating home-country resolution efforts.
section_title: Chapter 15 of the Bankruptcy Code Governs Judicial Cross-Border Coordination in Limited Circumstances
paragraphs: In 2005, the United States adopted Chapter 15 of the U.S. Bankruptcy  Code. Chapter 15 is based on the Model Law on Cross-Border  Insolvency of the United Nations Commission on International Trade Law  (UNCITRAL). The model law is intended to promote coordination between  courts in different countries during insolvencies and has been adopted in  21 jurisdictions. More than 450 Chapter 15 cases have been filed since  its adoption, with more than half filed in the Southern District of New York  and the District of Delaware.
Among the stated objectives of Chapter 15 are promoting cooperation  between U.S. and foreign parties involved in a cross-border insolvency  case, providing for a fair process that protects all creditors, and facilitating  the rescue of a distressed firm. In pursuit of these goals, Chapter 15  authorizes several types of coordination, including
U.S. case trustees or other authorized entities operating in foreign  countries on behalf of a U.S. bankruptcy estate;  foreign representatives having direct access to U.S. courts, including  the right to commence a proceeding or seek recognition of a foreign  proceeding; and
U.S. courts communicating information they deem important,  coordinating the oversight of debtors’ activities, and coordinating  proceedings.
Chapter 15 excludes the same financial institutions that are generally not  eligible to file as debtors under the Code (such as insured depository  institutions and U.S. insurance companies), with the exception of foreign  insurance companies. It also excludes broker-dealers that can be  liquidated under SIPA or a special provision of Chapter 7 of the Code and  commodity brokers that can be liquidated under a different special  provision of Chapter 7. Based on the UNCITRAL model law, Chapter 15  contains a public policy exception that allows a U.S. court to refuse  cooperation and coordination if doing so would be “manifestly contrary to  the public policy of the United States.”
section_title: No Changes Have Been Made to the Bankruptcy Code but Proposals Were Introduced in the Previous Congress
subsections: section_title: Two Proposals Would Have Made Broad Changes Relating to Complex Financial Institutions
paragraphs: Since we last reported on financial company bankruptcies in July 2013,  no changes have been made to Chapters 7, 11, or 15 of the Bankruptcy  Code relating to large financial companies, although two bills were  introduced in the 113th Congress that would have attempted to address  challenges associated with the reorganization of large financial firms as  governed by Chapter 11 of the Code. Neither bill was signed into law nor  re-introduced in the current Congress, as of March 12, 2015.
The Taxpayer Protection and Responsible Resolution Act (S. 1861) was  introduced in the Senate on December 19, 2013. The bill would have  added a new chapter to the Code—”Chapter 14: Liquidation,  Reorganization, or Recapitalization of a Covered Financial Corporation”— that would have generally applied to bank holding companies or  corporations predominantly engaged in activities that the Federal Reserve  Board has determined are financial in nature. Its provisions would have  made changes to the role of regulators, changed the treatment of QFCs,  and specifically designated judges to hear Chapter 14 cases, as the  following examples illustrate.
The proposal would have repealed the regulatory resolution regime in  Title II of the Dodd-Frank Act—revoking FDIC’s role as a receiver of a  failed or failing financial company under OLA—and returned all laws  changed by Title II to their pre-Title II state.
The proposal would have allowed the Federal Reserve Board to  commence an involuntary bankruptcy and granted the Federal  Reserve Board the right to be heard before the court. The proposal  would have allowed the court to transfer assets of the estate to a  bridge company (on request of the Federal Reserve Board or the  trustee and after notice and hearing and not less than 24 hours after  the start of the case). The court would have been able to order  transfer of assets to a bridge company only under certain conditions  (including that a preponderance of evidence indicated the transfer  was necessary to prevent imminent substantial harm to U.S. financial  stability). FDIC also would have been granted the right to be heard  before the court on matters related to the transfer of property to the  bridge company. However, this proposal would have explicitly  prohibited the Federal Reserve Board from providing DIP financing to  a company in bankruptcy or to a bridge company and provided no  specific alternative non-market source of funding.
The Taxpayer Protection and Responsible Resolution Act (S. 1861) also  would have changed the treatment of QFCs in bankruptcy. The rights to  liquidate, terminate, offset, or net QFCs would have been stayed for up to  48 hours after bankruptcy filing (or the approval of the petition from the  Federal Reserve Board). During the stay, the trustee would have been  able to perform all payment and delivery obligations under the QFC that  became due after the case commenced. The stay would have been  terminated if the trustee failed to perform any payment or delivery  obligation. Furthermore, QFCs would not have been able to be  transferred to the bridge company unless the bridge assumed all  contracts with a counterparty. If transferred to the bridge company, the  QFCs could not have been terminated or modified for certain reasons,  including the fact that a bankruptcy filing occurred. Aside from the limited  exceptions, QFC counterparties would have been free to exercise all of  their pre-existing contractual rights, including termination.
Finally, the Taxpayer Protection and Responsible Resolution Act (S.  1861) would have required the Chief Justice to designate no fewer than  10 bankruptcy judges with expertise in cases under Title 11 in which a  financial institution is a debtor to be available to hear a Chapter 14 case.  Additionally, the Chief Justice would have been required to designate at  least one district judge from each circuit to hear bankruptcy appeals  under Title 11 concerning a covered financial corporation.
A second bankruptcy reform proposal, the Financial Institution Bankruptcy  Act of 2014 (H.R. 5421), was passed by voice vote by the House of  Representatives on December 1, 2014, and would have added a new  Subchapter V under Chapter 11. Generally, the proposed subchapter  would have applied to bank holding companies or corporations with $50  billion or greater in total assets and whose activities, along with its  subsidiaries, are primarily financial in nature.
The Financial Institution Bankruptcy Act (H.R. 5421) contained provisions  similar or identical to those in the Taxpayer Protection and Responsible  Resolution Act (S. 1861) that would have affected the role of regulators,  treatment of QFCs, and designation of judges. For example, this proposal  would have allowed an involuntary bankruptcy to be commenced by the  Federal Reserve Board and allowed for the creation of a bridge company  to which assets of the debtor holding company could be transferred. This  proposal also would have granted the Federal Reserve Board and FDIC  the right to be heard before the court, as well as the Office of the  Comptroller of the Currency and SEC (which are not granted this right  under the Taxpayer Protection and Responsible Resolution Act). The  changes to the treatment of QFCs under this proposal were substantively  similar to those under the Taxpayer Protection and Responsible  Resolution Act (S. 1861). In addition, the Financial Institution Bankruptcy  Act (H.R. 5421) would have required that the Chief Justice would  designate no fewer than 10 bankruptcy judges to be available to hear a  Subchapter V case. The Chief Justice also would have been required to  designate not fewer than three judges of the court of appeals in not fewer  than four circuits to serve on an appellate panel.
Although the two bills have similarities, there are significant differences.  For example, the Financial Institution Bankruptcy Act (H.R. 5421) would  not have repealed Title II of the Dodd-Frank Act. Instead, Title II would  have remained an alternative to resolving a firm under the Bankruptcy  Code. Also, the Financial Institution Bankruptcy Act (H.R. 5421) would not  have restricted the Federal Reserve Board from providing DIP financing  to a financial firm under the proposed subchapter. Furthermore, the  Financial Institution Bankruptcy Act (H.R. 5421) would have given the  court broad power in the confirmation of the bankruptcy plan to consider  the serious adverse effect that any decision in connection with  Subchapter V might have on financial stability in the United States. By  contrast, the Taxpayer Protection and Responsible Resolution Act (S.  1861) mentioned financial stability as a consideration in specific  circumstances, such as whether the Federal Reserve Board could initiate  an involuntary bankruptcy under Chapter 14, or whether the court could  order a transfer of the debtor’s property to the bridge company.
Certain provisions in these bills resembled those in OLA and may have  facilitated a resolution strategy similar to FDIC’s SPOE strategy under  OLA. For example, each of the bankruptcy reform bills and FDIC’s SPOE  strategy under OLA would have allowed for the creation of a bridge  company, in which assets, financial contracts, and some legal entities of  the holding company would have been transferred, allowing certain  subsidiaries to have maintained operations. In addition, OLA, like the bills,  included a temporary stay for QFCs.
OLA uses a regulatory approach to resolution, while the bankruptcy  reform bills in the 113th Congress would have maintained a judicial  approach to resolution. Some experts have expressed concern that a  regulatory resolution may not adequately ensure the creditors’ rights to  due process. For example, experts attending GAO’s 2013 bankruptcy  reform roundtables noted that if preferences were given to some  counterparties or creditors during a temporary stay, other counterparties  or creditors would have the right to take action to recover value later in  the process, as opposed to having a judge consider the views of all of the  parties prior to making any decisions. However, as we reported in July  2013, other experts have stated that the judicial process of bankruptcy  does not contemplate systemic risk, or have some of the tools available  for minimizing the systemic risk associated with the failure of a  systemically important financial institution. For example, to act quickly in  cases involving large and complex financial companies, courts might  need to shorten notice periods and limit parties’ right to be heard, which  could compromise due process and creditor rights. In the United States,  the judicial process under bankruptcy remains the presumptive method  for resolving financial institutions, even those designated as systemically  important.
section_title: Another Proposal Would Have Removed Safe Harbor Treatment of QFCs in Bankruptcy
paragraphs: A third proposal would have more narrowly amended the Code. The 21st  Century Glass-Steagall Act of 2013 (S. 1282 in the Senate and H.R. 3711  in the House) contained a provision that would have repealed all safe- harbor provisions for QFCs. This legislative proposal was neither signed  into law nor re-introduced in the current Congress, as of March 12, 2015.
Some experts have identified the safe-harbor treatment of QFCs under  the Code as a challenge to an orderly resolution in bankruptcy. For  example, safe-harbor treatment can create significant losses to the  debtor’s estate, particularly for financial institution debtors that often are  principal users of these financial products. As we previously reported in  July 2011, some experts we interviewed suggested that modifying the  safe harbor provisions might help to avoid or mitigate the precipitous  decline of the asset values typical in financial institution bankruptcies.  For example, these experts suggested that the treatment of QFCs in the  Lehman bankruptcy contributed to a significant and rapid loss of asset  values to the estate. Other experts we spoke with in 2011 suggested that  safe-harbor treatment might lessen market discipline. Because  counterparties entered into QFCs may close out their contracts even if  doing so would otherwise violate the automatic stay, the incentive to  monitor the risk of each other could be reduced. Additionally, as we  reported in July 2013, attendees of our roundtable discussions on  bankruptcy reform noted that the safe harbors lead to a larger derivatives  market and greater reliance on short-term funding because QFCs would  not be subject to a stay, which could increase systemic risk in the  financial system.
However, others argue that a repeal of the safe-harbor provisions could  have adverse effects. As we previously reported in July 2011, these  experts assert that subjecting any QFCs to the automatic stay in  bankruptcy would freeze many assets of the counterparties of the failed  financial institution, causing a chain reaction and a subsequent systemic  financial crisis. In January 2011, regulatory officials we spoke with also  told us that the safe harbor provisions uphold market discipline through  margin, capital, and collateral requirements. They said that the  requirement for posting collateral limits the amount of risk counterparties  are willing to undertake. In addition, during the 2013 expert roundtable on  financial company bankruptcies, one expert noted that one of the goals of  safe harbors is to limit market turmoil during a bankruptcy—that is, they  are to prevent the insolvency of one firm from spreading to other firms.
section_title: Recent Efforts to Enhance International Coordination to Resolve Failing Financial Companies under Bankruptcy
paragraphs: In the United States the presumptive mechanism to resolve a failed cross- border large financial company continues to be through the judicial  bankruptcy process, though no statutory changes have been made to  Chapter 15 of the Code or the U.S. judicial bankruptcy process to address  impediments to an orderly resolution of a large, multinational financial  institution. However, while some structural challenges discussed earlier  remain, others, such as conflicting regulatory regimes and the treatment  of cross-border derivatives, are being addressed through various efforts.  For example, the Federal Reserve and FDIC have taken certain  regulatory actions mandated by the Dodd-Frank Act authorities toward  facilitating orderly resolution, including efforts that could contribute to  cross-border coordination. Specifically, certain large financial companies  must provide the Federal Reserve and FDIC with periodic reports of their  plans for rapid and orderly resolution in the event of material financial  distress or failure under the Code. The resolution plans or living wills are  to demonstrate how a company could be resolved in a rapid manner  under the Code. FDIC and the Federal Reserve have said that the plans  were expected to address potential obstacles to global cooperation,  among others. In 2014, FDIC and the Federal Reserve sent letters to a  number of large financial companies identifying specific shortcomings  with the resolution plans that those firms will need to address in their  2015 submissions, due on or before July 1, 2015, for the first group of  filers.
International bodies have also focused on strengthening their regulatory  structures to enable the orderly resolution of a failing large financial firm  and have taken additional actions to facilitate cross-border resolutions. In  October 2011, the Financial Stability Board (FSB)—an international body  that monitors and makes recommendations about the global financial  system—issued a set of principles to guide the development of resolution  regimes for financial firms active in multiple countries. For example, each  jurisdiction should have the authority to exercise resolution powers over  firms, jurisdictions should have policies in place so that authorities are not  reliant on public bailout funds, and statutory mandates should encourage  a cooperative solution with foreign authorities. In addition, in December  2013 the European Parliament and European Council reached agreement  on the European Union’s (EU) Bank Recovery and Resolution Directive,  which establishes requirements for national resolution frameworks for all  EU member states and provides for resolution powers and tools. For  example, member states are to appoint a resolution authority, institutions  must prepare and maintain recovery plans, resolution authorities are to  assess the extent to which firms are resolvable without the assumption of  extraordinary financial support, and authorities are to cooperate  effectively when dealing with the failure of cross-border banks. Unlike the  United States, EU and FSB do not direct resolution authorities to use the  bankruptcy process developed for corporate insolvency situations.
In a letter to the International Swaps and Derivatives Association (ISDA)  in 2013, FDIC, the Bank of England, BaFin in Germany, and the Swiss  Financial Market Supervisory Authority called for changes in the exercise  of termination rights and other remedies in derivatives contracts following  commencement of an insolvency or resolution action. In October 2014,  18 major global financial firms agreed to sign a new ISDA Resolution Stay  Protocol to facilitate the cross-border resolution of a large, complex  institution. This protocol was published and these 18 financial firms  agreed to it on November 12, 2014, and certain provisions of which  became effective in January 2015. Generally, parties adhering to this  protocol have agreed to be bound by certain limitations on their  termination rights and other remedies in the event one of them becomes  subject to certain resolution proceedings, including OLA. These stays are  intended to give resolution authorities and insolvency administrators time  to facilitate an orderly resolution of a troubled financial firm. The Protocol  also incorporates certain restrictions on creditor contractual rights that  would apply when a U.S. financial holding company becomes subject to  U.S. bankruptcy proceedings, including a stay on cross-default rights that  would restrict the counterparty of a non-bankrupt affiliate of an insolvent  U.S. financial holding company from immediately terminating its  derivatives contracts with that affiliate.
Finally, a United Nations working group (tasked with furthering adoption  of the UNCITRAL Model Law) included the insolvency of large and  complex financial institutions as part of its focus on cross-border  insolvency. In 2010, Switzerland proposed that the working group study  the feasibility of developing an international instrument for the cross- border resolution of large and complex financial institutions. The working  group has acknowledged and has been monitoring the work undertaken  by FSB, Basel Committee on Banking Supervision, the International  Monetary Fund, and EU.
section_title: Agency Comments
paragraphs: We provided a draft of this report to AOUSC, CFTC, Departments of  Justice and the Treasury, FDIC, Federal Reserve, and SEC for review  and comment. The agencies did not provide written comments. We  received technical comments from the Department of the Treasury, FDIC,  Federal Reserve, and SEC, which we incorporated as appropriate.
We are sending copies of this report to the appropriate congressional  committees, Director of the Administrative Office of the U.S. Courts, the  Chairman of the Commodity Futures Trading Commission, Attorney  General, the Secretary of the Treasury, the Chairman of the Federal  Deposit Insurance Corporation, the Director of the Federal Judicial  Center, the Chair of the Board of Governors of the Federal Reserve  System, the Chair of the Securities and Exchange Commission, and other  interested parties. The report also is available at no charge on the GAO  web site at http://www.gao.gov.
If you or your staff members have any questions about this report, please  contact Cindy Brown Barnes at (202) 512-8678 or  brownbarnesc@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  Major contributors to this report are listed in appendix III.
section_title: Appendix I: Updates on the Bankruptcy Proceedings for Lehman Brothers Holdings, Inc., MF Global, and Washington Mutual
paragraphs: In our July 2011 and July 2012 reports on the bankruptcy of financial  companies, we reported on the status of the bankruptcy proceedings of,  among other financial companies, Lehman Brothers Holdings Inc., MF  Global, and Washington Mutual. In the 2011 report, we found that  comprehensive data on the number of financial companies in  bankruptcies were not readily available. We collected information to  update the status of the bankruptcy proceedings for Lehman Brothers  Holdings Inc., MF Global, and Washington Mutual. Since we last reported  in July 2012, in each case, additional payments to creditors have been  distributed and litigation with various parties is ongoing.
subsections: section_title: Update on the Lehman Bankruptcy
paragraphs: Lehman Brothers Holdings Inc. (Lehman) was an investment banking  institution that offered equity, fixed-income, trading, asset management,  and other financial services. In 2008, Lehman was the fourth largest U.S.  investment bank and had been in operation since 1850. It had 209  registered subsidiaries in 21 countries. On September 15, 2008, Lehman  filed Chapter 11 cases in the U.S. Bankruptcy Court. Its affiliates filed for  bankruptcy over subsequent months. Some of Lehman’s affiliates also  filed bankruptcy or insolvency proceedings in foreign jurisdictions. There  are three different legal proceedings involving (1) the holding company or  LBHI, (2) the U.S. broker dealer or LBI, and (3) the U.K. broker dealer or  LBIE. On September 19, 2008, Lehman’s broker-dealer was placed into  liquidation under the Securities Investor Protection Act (SIPA). The  bankruptcy court approved the sale of LBI’s assets to Barclays PLC on  September 20, 2008—5 days after the filing of the LBHI Chapter 11 case.
In March 2010, LBHI debtors filed their proposed Chapter 11 plan. In  December 2010, a group of senior creditors filed an alternative plan.  Since then, various plan amendments and counter plans were filed. In  December 2011, the U.S. Bankruptcy Court for the Southern District of  New York confirmed a reorganization plan for LBHI and the plan took  effect in March 2012.
subsections: section_title: Payments to Creditors Continue
paragraphs: LBHI had more than 100,000 creditors. As of October 2, 2014, some $8.6  billion had been distributed to LBHI creditors in the nonpriority unsecured  claims class. The Trustee of LBI has distributed more than $106 billion to  111,000 customers. As of September 2014, £34 billion has been  distributed by the LBIE Administrator to counterparties in the House  Estate (general unsecured estate) and the Trust Estate (Client Assets,  Client Money and Omnibus Trust). In February 2015, the bankruptcy  court approved a second interim distribution of $2.2 billion to general  unsecured creditors with allowed claims. This would bring the total  distributions to allowed general unsecured creditors to approximately 27  percent.
section_title: Litigation Continues
paragraphs: There is ongoing litigation involving a breach of a swap with Giants  Stadium, the payment of creditor committee members’ legal fees, and  transactions with foreign entities, according to an official of the U.S.  Trustees Program. Litigation concerning issues surrounding the sale of  LBI assets to Barclays PLC also continues. On December 15, 2014, the  SIPA Trustee filed a petition for a writ of certiorari with the U.S. Supreme  Court seeking review of the lower court rulings that awarded $4 billion of  margin cash assets to Barclay’s.
section_title: Update on the MF Global Bankruptcy
paragraphs: MF Global Holdings Ltd. (MFGH) was one of the world’s leading brokers  in markets for commodities and listed derivatives. The firm was based in  the United States and had operations in Australia, Canada, Hong Kong,  India, Japan, Singapore, and the U.K. On October 31, 2011, MFGH and  one of its affiliates filed Chapter 11 cases in the U.S. Bankruptcy Court for  the Southern District of New York. In the months following four other  affiliates filed for relief in Bankruptcy Court. Also, on October 31, 2011,  the Securities Investor Protection Corporation (SIPC) commenced a SIPA  case against MF Global’s broker-dealer subsidiary (MFGI). The SIPA  trustee has been liquidating the firm’s assets and distributing payments to  its customers on a rolling basis pursuant to a claims resolution procedure  approved by the bankruptcy court overseeing the case. MFGI was  required to pay $1.2 billion in restitution to its customers as well as a $100  million penalty. In December 2014, CFTC obtained a federal court  consent order against MFGH requiring it to pay $1.2 billion or the amount  necessary in restitution to ensure the claims of MFGI are paid in full.
The bankruptcy court confirmed a liquidation plan for MFGH on April 22,  2013, which became effective in June 2013. As of the end of 2013, the  SIPA trustee reported the probability of a 100 percent recovery of allowed  net equity claims for all commodities and securities customers of MFGI.
subsections: section_title: Payments to Creditors Continue
paragraphs: As of mid-December 2014, 100 percent of the distributions through the  SIPA trustee have been completed to substantially all categories of  commodities and securities customers and 39 percent of the first interim  distribution on allowed unsecured claims. The trustee started to make  $551 million in distributions to general creditors on October 30, 2014. An  interim payment of $518.7 million went to unsecured general claimants  and covered 39 percent of their allowed claims. A reserve fund of $289.8  million was to be held for unresolved unsecured claims and a reserve  fund of $9.9 million will be held for unresolved priority claims. In April  2014, the SIPA trustee began final distributions to all public customers.  With this distribution a total of $6.7 billion was to have been returned to  over 26,000 securities and commodities futures customers. General  creditor claims totaling more than $23 billion in asserted amounts, as  substantial unliquidated claims, were filed in this proceeding as of the end  of June 2014. As of December 2014, the SIPA trustee reports that of  7,687 general creditor claims asserted or reclassified from customer  status, only 23 claims remain unresolved.
section_title: Litigation Continues
paragraphs: Current litigation surrounds a malpractice complaint against  PricewaterhouseCoopers (the company’s former auditor) and an  investigation of the officers, according to an official of the U.S. Trustees  Program.
section_title: Update on Washington Mutual Bankruptcy
paragraphs: Washington Mutual Inc. was a thrift holding company that had 133  subsidiaries. Its subsidiary Washington Mutual Bank was the largest  savings and loan association in the United State prior to its failure. In the  9 days prior to receivership by the Federal Deposit Insurance Corporation  (FDIC), there were more than $16.7 billion in depositor withdrawals. At  the time of its filing, Washington Mutual had about $32.9 billion in total  assets and total debt of about $8.1 billion. Its failure was the largest bank  failure in U.S. history. On September 25, 2008, the Office of Thrift  Supervision found Washington Mutual Bank to be unsafe and unsound,  closed the bank, and appointed FDIC as the receiver. FDIC as receiver  then took possession of the bank’s assets and liabilities and transferred  substantially all the assets and liabilities to JPMorgan Chase for $1.9  billion. On September 26, 2008, Washington Mutual and its subsidiary  WMI Investment Corporation filed Chapter 11 cases in U.S. Bankruptcy  Court for the District of Delaware. On March 12, 2010, Washington  Mutual, FDIC, and JPMorgan Chase announced that they had reached a  settlement on disputed property and claims. This was called the global  settlement. On July 28, 2010, the bankruptcy court approved the  appointment of an examiner, selected by the U.S. Trustee’s office, to  investigate the claims of various parties addressed by the global  settlement. The seventh amended plan was confirmed by the court on  February 24, 2012. The plan established a liquidating trust—the  Washington Mutual Liquidating Trust (WMILT)—to make subsequent  distributions to creditors on account of their allowed claims. Upon the  effective date of the plan, Washington Mutual became a newly  reorganized company, WMI Holdings Corp. consisting primarily of its  subsidiary WMI Mortgage Reinsurance Company, Inc.
subsections: section_title: Payments to Creditors Continue
paragraphs: In 2012, there was an initial distribution of $6.5 billion. Since that initial  distribution, an additional $660 million has been distributed to creditors,  according to officials at the U.S. Trustees Program, including a  distribution of $78.4 million paid on August 1, 2014.
section_title: Litigation Continues
paragraphs: In August 2013, WMILT, pursuant to an order by the U.S. Bankruptcy  Court for the District of Delaware, filed a declaratory judgment in the U.S.  District Court for the Western District of Washington against FDIC, the  Board of Governors of the Federal Reserve System (Federal Reserve),  and 90 former employees who were also claimants in the bankruptcy  proceeding. Certain employee claimants have asserted cross-claims  against FDIC and the Federal Reserve, contending that the banking  agencies are without authority to assert limits on payment from troubled  institutions that are contingent on termination of a person’s employment  over WMILT, because WMILT is a liquidating trust. After the case was  transferred to the U.S. Bankruptcy Court for the District of Delaware in  July 2014 and all pending motions terminated, most of the parties  stipulated to withdraw the reference to the bankruptcy court. FDIC moved  to dismiss the complaint on September 5, 2014. The proposed order to  withdraw the reference and the briefing on the motion to dismiss remains  pending.
section_title: Appendix II: Objectives, Scope, and Methodology
paragraphs: Section 202(e) of the Dodd-Frank Wall Street Reform and Consumer  Protection Act (Dodd Frank Act) mandated that we report on the  orderliness and efficiency of financial company bankruptcies every year  for 3 years after passage of the act, in the fifth year, and every 5 years  thereafter. This report, the fourth in the series, examines (1) recent  changes to the U.S. Bankruptcy Code (Code) and (2) efforts to improve  cross-border coordination to facilitate the liquidation and reorganization of  failed large financial companies under bankruptcy.
For each of our objectives, we reviewed relevant regulations and laws,  including the Code and the Dodd-Frank Act as well as GAO reports that  addressed bankruptcy issues and financial institution failures. We  specifically reviewed the reports we issued during the first 3 years of the  mandate as well as reports written under the same or similar mandates  by the Administrative Office of the United States Courts (AOUSC) and the  Board of Governors of the Federal Reserve System (Federal Reserve).  We interviewed officials from the following federal agencies due to their  role in financial regulation and bankruptcy proceedings: AOUSC; the  Commodity Futures Trading Commission (CFTC); Federal Deposit  Insurance Corporation (FDIC); Department of Justice; Department of the  Treasury (Treasury), including officials who support the Financial Stability  Oversight Council (FSOC); Federal Reserve; and Securities and  Exchange Commission (SEC). We also updated our review of published  economic and legal research on the financial company bankruptcies that  we had originally completed during the first year of the mandate (see  appendix I). For the original search, we relied on Internet search  databases (including EconLit and Proquest) to identify studies published  or issued after 2000 through 2010.
To address our first objective, we reviewed Chapters 7, 11, or 15 of the  Bankruptcy Code for any changes. In addition, we reviewed legislation  proposed in the 113th Congress that would change the Code for financial  company bankruptcies. We also reviewed academic literature on financial  company bankruptcies and regulatory resolution, transcripts of  congressional hearings on bankruptcy reform, and transcripts from expert  roundtables on bankruptcy reform that were hosted by GAO in 2013.
To address our second objective, we reviewed Chapter 15 of the  Bankruptcy Code, which relates to coordination between U.S. and foreign  jurisdictions in bankruptcy cases in which the debtor is a company with  foreign operations, for any changes. In addition, we sought information on  U.S. and international efforts to improve coordination of cross-border  resolutions from the federal agencies we interviewed. We also reviewed  and analyzed documentary information from the Bank of England, Basel  Committee on Banking Supervision, European Union, the Financial  Stability Board, BaFin in Germany, International Monetary Fund, Swiss  Financial Market Supervisory Authority, and the United Nations.
To update the three bankruptcy cases of Lehman Brothers Holdings, Inc.;  MF Global Holdings, Ltd.; and Washington Mutual, Inc. discussed in our  July 2011 and July 2012 reports, we sought available information—for  example, trustee reports and reorganization plans—on these cases from  CFTC, FDIC, Federal Reserve, and SEC; AOUSC, the Department of  Justice, and Treasury. In addition, we collected information from prior  GAO reports, bankruptcy court documents, and the trustees in each case.  To determine whether there were new bankruptcy filings of large financial  companies such as those in our case studies, we inquired of AOUSC,  CFTC, FDIC, Department of Justice, Treasury, Federal Reserve, and  SEC. We also conducted a literature review, which did not show evidence  of any new bankruptcy cases filed by large financial companies.
We conducted this performance audit from June 2014 to March 2015 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Karen Tremba, Assistant  Director; Nancy S. Barry; Patrick Dynes; Risto Laboski; Marc Molino;  Barbara Roesmann; Jessica Sandler; and Jason Wildhagen made key  contributions to this report. Technical assistance was provided by JoAnna  Berry.