Financial Company Bankruptcies: Need to Further Consider Proposals' Impact on Systemic Risk
Published: 2013-07-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) mandates that GAO report on an ongoing basis on ways to make the Code more effective in resolving certain failed financial companies. This report examines advantages and disadvantages of certain proposals, based on those identified in GAO's first report, to revise the Code for financial company bankruptcies--specifically, proposals (1) to change the role of financial regulators in the bankruptcy process; (2) affecting funding of financial company bankruptcies; and (3) to change the safe-harbor treatment of QFCs. For this report, GAO held two expert roundtables in which participants evaluated the proposals using criteria for orderly and effective bankruptcies that GAO developed in earlier reports. The criteria are minimizing systemic risk, avoiding asset fire sales, ensuring due process, maximizing value, and limiting taxpayer liability. GAO identified these criteria by reviewing literature and interviewing government officials, industry representatives, and legal and academic experts.
section_title: What GAO Found
paragraphs: Because the Bankruptcy Code (Code) does not specifically address issues of systemic risk, experts have proposed giving financial regulators a greater role in financial company bankruptcies. However, according to experts at a GAO roundtable, such proposals may have limited impact and raise certain implementation issues. For example, a proposal to require notification before bankruptcy depends on when (number of days) notification would be required and with whom (which regulators). Experts noted financial companies may not know that they will declare bankruptcy even a few days before the event and could have many regulators to notify. Experts also noted ways regulators already can compel financial companies to declare bankruptcy, and that changing the Code to allow regulators to place firms in bankruptcy involuntarily could temporarily place a firm in an uncertain legal status, eroding firms' values and endangering market stability. Other options, such as having regulatory standards forcing the firm into bankruptcy, could improve the likelihood of an orderly resolution, according to these experts. Although the proposals reflect the need to minimize systemic effects of financial company bankruptcies, the Financial Stability Oversight Council (FSOC)--charged with responding to threats to financial stability--has not considered changes to the Code. Consideration could improve FSOC's ability to address such threats in a timely and effective manner.
Experts emphasized that funding is needed to facilitate orderly and effective financial company bankruptcies. They generally agreed that prohibiting all federal funding or guarantees of private funding likely would lead to fire sales of assets. They agreed that fully secured funding should be used only to provide short-run liquidity and not for bailouts of insolvent firms' creditors. Experts suggested a private-sector fund could be created for this purpose. Such funds could be collected voluntarily, through routine assessments (before a bankruptcy), or through a facility similar to the one created for the Orderly Liquidation Authority, which allows federal funding at the time of a bankruptcy and later recovery of funds through an industry assessment. Experts noted some difficulties associated with these proposals, including determining whether a firm was insolvent or needed liquidity, and identifying permissible types of collateral.
Generally, experts did not agree on advantages or disadvantages of proposals to change the safe-harbor treatment of qualified financial contracts (QFC). The Code exempts QFCs, such as derivatives, from the automatic stay that generally prevents creditors from taking company assets in payment of debts before a case is resolved. It also exempts QFCs from provisions that allow bankruptcy judges to "avoid" contracts entered into within specified times before a filing. Proposals to change QFC treatment--subjecting all or some contracts to the automatic stay on a permanent or temporary basis and removing the avoidance exemptions--might address issues raised by extensive contract terminations in the early days of financial company bankruptcies. Experts said it was unclear what lessons should be learned from those experiences. Many noted that narrowing the exemptions would reduce the size of derivative markets, but views varied about whether such narrowing would increase or decrease systemic risk. Some experts said that the current safe harbors decrease systemic risk, while others said they increase it by making firms more dependent on less-reliable short-term financing.
section_title: What GAO Recommends
paragraphs: FSOC should consider the implications for U.S. financial stability of changing the role of regulators and the treatment of QFCs in financial company bankruptcies. FSOC agreed that a disorderly financial company bankruptcy could pose risks to financial stability, but stated that it would be premature for FSOC to consider proposals to change the Code. GAO reiterated that its recommendation was consistent with FSOCs statutory role and responsibilities.

section_title: Letter
paragraphs: The 2007-2009 financial crisis and the failures of large, complex financial  companies led some experts to question the adequacy of the U. S.  Bankruptcy Code (Code) for effectively reorganizing or liquidating these  companies without causing further harm to the financial system.  Questions raised about the effectiveness of the Code have prompted  some financial and legal experts—sometimes working in interdisciplinary  groups—as well as government officials and members of Congress to  propose changes to the Code, or to the supervisory process leading to a  bankruptcy filing.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank Act) mandates that we study, at first annually and then at specified  intervals, issues including the effectiveness of the Code in facilitating the  orderly liquidation or reorganization of financial companies and ways to  make the orderly liquidation process under the Code for financial  companies more effective. In July 2011, we issued our first report, which  addressed the mandate’s requirements and included proposals for  revising the Code to improve the orderliness and effectiveness of financial  company bankruptcies. In July 2012, we issued our second report that  addressed actions taken to implement the Orderly Liquidation Authority  (OLA) created by the 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 financial stability in the  United States and taking action under OLA would avoid or mitigate such  adverse effects.
We focus in this report on the advantages and disadvantages of  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. Specifically, this report examines the advantages and  disadvantages of proposals (1) to change the role of financial regulators  and the Department of the Treasury in financial company bankruptcies;  (2) affecting the funding of financial company bankruptcies, and (3) to  change the safe-harbor treatment of certain financial contracts—including  derivatives and repurchase agreements.
To address these objectives, we reviewed our earlier work under the  mandate and that of the Administrative Office of the U.S. Courts  (AOUSC) and the Board of Governors of the Federal Reserve (Federal  Reserve), which have similar mandates. For this engagement we  reviewed more recent literature to update the proposals we earlier  identified for modifying the Code. We relied on criteria for orderly and  effective bankruptcies that were developed during our earlier work. These  criteria included minimizing systemic risk, avoiding fire sales, maximizing  value, promoting due process, and limiting taxpayer liability. To evaluate  the proposals relative to these criteria, we conducted two expert  roundtables in which participants evaluated the proposed changes to the  role of regulators and the safe-harbor treatment of certain financial  contracts in financial company bankruptcies. These roundtables were  conducted with the assistance of the National Academy of Sciences  (NAS). Roundtable participants included bankruptcy judges, practicing  attorneys, financial regulators, industry representatives, and academics.  We chose the roundtable participants based on their publications  demonstrating an expertise in bankruptcy and financial regulation, input  from regulatory bodies and industry groups, and suggestions from NAS.  Roundtable participants discussed the proposals in relation to the criteria  of orderliness and effectiveness, potential outcomes of implementing the  proposals, and how impediments to implementing them might be  overcome. During our work, we also met with officials from AOUSC, the  Commodity Futures Trading Commission (CFTC), FDIC, the Board of  Governors of the Federal Reserve System (Federal Reserve), Financial  Stability Oversight Council (FSOC), U.S. Department of Justice, National  Association of Insurance Commissioners (NAIC), Securities and  Exchange Commission (SEC), and U.S. Department of the Treasury  (Treasury). See appendix I for more information on our scope and  methodology and appendix II for more information on the expert  roundtables.
We conducted this performance audit from October 2012 to July 2013, 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: Bankruptcy is a federal court procedure conducted under the Code. The  goals of bankruptcy are to give individuals and businesses a “fresh start”  by eliminating or restructuring debts they cannot fully repay and help  creditors receive some payment in an equitable manner. The filing of a  voluntary bankruptcy petition operates as an “automatic stay” that  generally stops lawsuits, foreclosures, and most other collection activities  against the debtor, allowing the debtor time to eliminate or restructure its  debts. In bankruptcy, equitable treatment of creditors means that all  creditors with substantially similar claims shall be 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. Secured creditors are more likely to get  some debt repaid than general unsecured creditors, and creditors  generally receive payment of their debts before shareholders receive any  return of their equity in the failed company.
subsections: section_title: Bankruptcy Proceedings
paragraphs: Business debtors that are eligible for protection under the Code may  qualify for liquidation, governed primarily by Chapter 7 of the Code, or  reorganization, governed by Chapter 11. Proceedings under both  Chapters 7 and 11 can be voluntary (initiated by the debtor) or involuntary  (generally initiated by at least three creditors). However, in an involuntary  proceeding, the debtor can defend against the proceeding, including  presenting objections within 21 days of being served the summons of the  proceeding. 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 reorganization proceeding under Chapter 11 allows debtors, such as  commercial enterprises, to continue some or all of their operations as a  way to satisfy creditor claims. The debtor typically remains in control of its  assets, and is called a debtor-in-possession (DIP). The court also, under  certain circumstances, 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.
Each stage of the Chapter 11 process has key attributes:  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. They may include a motion to pay the  prebankruptcy claims of critical vendors—those deemed vital to  the debtor’s continued business operations.
Disclosure. The disclosure statement filed after the bankruptcy  petition filing 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 plan  of reorganization 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 court may not confirm the plan unless a sufficient proportion  of allowed creditors has accepted the plan or would not be  impaired by the plan. The court’s approval also depends on  whether there are dissenting classes of creditors. If a plan has not  been filed by the debtor within 120 days or accepted by a  sufficient number of creditors after 180 days, any interested  party—including creditors—may file a plan. The plan divides  creditors into classes, prioritizing payments to creditors.
Reorganization. Possible Chapter 11 outcomes, which can be  used in combination, include (1) sale of the company (in whole or  in part), which is sometimes called a section 363 sale because  that section of the Code applies to sales that are free and clear of  creditor claims and interests; (2) liquidation of the company’s  assets with the approval of the court through means other than a  363 sale; and (3) actual 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.
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  Chapter 11 trustee or others may bring a preference action (a type of  avoidance action) challenging certain payments made by a debtor to a  creditor generally within 90 days prior to the bankruptcy filing. In  addition, fraudulent avoidance actions generally can be taken on transfers  made within 2 years prior to a bankruptcy if payments are determined to  be fraudulent. As such, an avoidance action can question the payment as  a preferential or fraudulent transfer of assets and require payments to be  returned to the debtor.
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 broad range of financial services including  commercial banking, investment banking, securities and commodities  trading, derivatives transactions, and insurance. Many of them are  organized under both U.S. and foreign laws. The U.S. legal structure is  frequently premised upon the ownership by a parent holding company of  various regulated subsidiaries (such as depository institutions, insurance  companies, broker-dealers, and commodity brokers) and other  nonregulated subsidiaries that engage in a variety of financial activities.  Many of these businesses have centralized business lines and operations  that may be housed in a holding company or in one or more subsidiaries.  Smaller banking institutions also are organized as holding companies, but  many of these hold few, if any, assets outside a depository institution and  generally engage in a narrower range of 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, also known as futures  commission merchants, are restricted to using only 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 also are  involved in Chapter 7 bankruptcies of broker-dealers and commodity  brokers. In the event of a broker-dealer liquidation, pursuant to the 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 join 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, as it did in the bankruptcies of General Motors and Chrysler  with financing under the Troubled Asset Relief Program (TARP). 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.
The federal government also has provided financial support to companies  who later declared bankruptcy. For example, CIT Group, Inc. received  funding from TARP in 2008. CIT subsequently declared bankruptcy under  Chapter 11 in 2009 and was reorganized.
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 distributed in a systematic way, it is subject to  exceptions, one of which can be particularly important in a financial  institution bankruptcy. Commonly referred to as a safe harbor, this  exception pertains 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, collateralized instruments that  provide short-term financing for financial companies and others, also  generally receive safe-harbor treatment.
Safe-harbor treatment was first added to the Code in 1982 for forward  contracts, commodity contracts, and securities contracts. In a recent  change, the Code’s definition of repurchase agreements was expanded  (in 2005) to include, among other things, agreements for the transfer of  mortgage related securities, mortgage loans, interests in mortgage- related securities or mortgage loans, and government securities issued by  countries that are members of the Organisation of Economic and Co- operation and Development, thereby expanding the scope of contracts  subject to the safe-harbor treatment. According to the legislative history,  the purpose of these safe harbors is to maintain market liquidity and  reduce systemic risk, which we define as the risk that the failure of one  large institution would cause other companies to fail or that a market  event could broadly affect the financial system rather than just one or a  few companies.
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 would otherwise violate the automatic stay. In the  event of insolvency or the commencement of bankruptcy proceedings, the  nondefaulting party in a contract 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, they are treated as unsecured  creditors in any final liquidation or reorganization.
Safe-harbor provisions also generally exempt certain payments made  under financial contracts from a preference action seeking to recover any  payment made by a debtor to a creditor generally within 90 days of filing  for bankruptcy. In addition, they exempt fraudulent transfers made to  financial contract counterparties generally within 2 years prior to a  bankruptcy unless the payments are determined to have been  intentionally fraudulent. Trustees cannot question the payment made in  connection with these contracts as a preferential or fraudulent transfer of  assets and cannot require the payments to be returned to the debtor. See  appendix III for more information on the current safe-harbor treatment for  derivative and repurchase agreement contracts.
section_title: Experts Agreed That Changing Regulatory Involvement May Have Varying Impacts and Needs Further Consideration
paragraphs: Experts at our roundtables evaluated proposals to change the roles of  regulators in financial company bankruptcies. Specifically, they discussed  proposals to require firms to notify and consult with regulators prior to a  bankruptcy; allow regulators to commence an involuntary bankruptcy;  provide regulators with standing or a right to be heard in bankruptcy court;  and have regulators determine how subsidiaries might be consolidated in  a bankruptcy. The experts noted that the proposals could have varying  impacts on the bankruptcy process. For example, they viewed most of the  proposals as having limited impact because regulators already have  similar roles in bankruptcies, whereas efforts to consolidate subsidiaries  in a bankruptcy would undermine key legal and regulatory constructs.  Although experts broadly supported regulatory involvement in financial  company bankruptcies, they said the proposed changes raise several  implementation issues, such as determining the number of days prior to a  bankruptcy that a company would be required to notify regulators and  which regulator(s) to notify. As a result, the proposals require further  consideration. FSOC, which is charged with identifying and responding to  risks to financial stability that could arise from the failure of large financial  companies, has been identified in some proposals as a regulator that  should be notified. However, FSOC has not yet considered implications  of changes to the role of regulators in the bankruptcies of financial  companies.
subsections: section_title: Proposals to Further Involve Financial Regulators in Financial Company Bankruptcies
paragraphs: Several proposals have been made by financial and legal experts, as well  as government officials, to further involve regulators in financial company  bankruptcies. The experts at our first roundtable discussed four such  proposals we identified in our 2011 study.
Require debtors to notify and consult with regulators  (primary, functional, Financial Stability Oversight Council,  foreign, or other) in advance of filing for bankruptcy.  Bankruptcy-related proposals introduced in the 111th Congress  included a notification period. In prior work, we found that the  notice period was intended to provide the regulator with some time  to facilitate actions to minimize the systemic impact of the  bankruptcy. During that time, the regulator might be able to find  ways to maintain critical functions, facilitate an asset sale, identify  potential creditors that would provide financing for the debtor, or  determine if a proceeding under OLA would be more appropriate.  This extra time for preparation could help to maintain the value of  the institution and reduce systemic disruptions to the wider  economy.
Allow regulators to commence an involuntary bankruptcy if  the firm is insolvent or in imminent danger of becoming  insolvent. This proposal was included in the proposal made by  the Hoover Institution resolution project group to have a separate  bankruptcy chapter in the Code—Chapter 14—for large financial  companies. The authors of that proposed chapter noted that  under the existing Code, an involuntary bankruptcy proceeding  can commence when a firm generally is not paying its debts as  they become due unless the debts are subject to a legitimate  dispute. For large financial companies, allowing involuntary  bankruptcies in response to balance sheet insolvency may allow  regulators to initiate a bankruptcy at a time when they could still  limit the spread of damage to other financial companies. The  Chapter 14 proposal specifically provides primary regulators  power to commence an involuntary case against a financial  company in the event that the firm’s assets are less than its  liabilities, at fair valuation, or the firm has unreasonably small  capital.
Allow regulators of the debtor or its subsidiaries to have  standing or a right to be heard in the courts to raise issues  relative to regulation. Proposals introduced in the 111th  Congress contained a provision to allow certain financial  regulators the right to be heard during a bankruptcy case. The  proposals granted the functional regulator, Financial Stability  Oversight Council, Federal Reserve, Treasury, and any agency  charged with administering a nonbankruptcy insolvency regime for  any component of the debtor the right to be heard on any issue in  a bankruptcy case. Experts have contended that regulated  institutions have more complicated legal structures and products  than others; thus, having regulatory expertise would provide more  timely information to the judge and could lead to resolutions that  better preserve asset value.
Consider the role of regulators in determining what  subsidiaries should be included in a bankruptcy proceeding  and the extent to which complex firms might be consolidated  in bankruptcy. This proposal would give regulators a role in  determining whether the court should consider the filing of a  financial company as a whole under processes similar to the  doctrine of substantive consolidation—a rarely used procedure. In  substantive consolidation, the intercompany liabilities of related  companies are eliminated, the assets of these companies are  pooled, and the companies’ liabilities to third parties are paid from  the single pool of assets. The proposal also would give regulators  a role in determining whether existing bankruptcy exclusions for  insurance companies, broker-dealers, or commodity brokers  should be maintained. The Hoover Institution resolution project  group noted that these exclusions can complicate the resolution of  a major financial institution, because the bankruptcy court can  deal only with pieces of the firm.
section_title: Experts Noted Limited Effects on Regulator Roles from Most Proposals and Trade-offs Relating to Orderliness and Effectiveness
paragraphs: The experts at the first roundtable generally supported three of the four  proposed changes to the role of regulators in bankruptcy proceedings, but  noted that these proposals might have limited effects. None of the experts  who responded to written questions indicated that requiring notice and  consultation with regulators or granting regulators a right to be heard in  bankruptcy court would greatly change the existing bankruptcy process.  The experts noted that regulators already play these roles in financial  company bankruptcies.
In response to the proposal to require notice to regulators, the experts  generally agreed that regulators and financial companies usually have  a great deal of communication and involvement, particularly when an  institution is experiencing financial difficulties. One expert worried that  requiring notice to the regulator before filing for bankruptcy might  allow regulators to prevent the debtor from filing and adversely affect  recoveries for creditors.
In relation to regulatory authority to compel involuntary filings, the  experts who specifically addressed this proposal said that regulators  already have ways of forcing a financial company to file for bankruptcy  through their existing regulatory powers. A few experts said that  regulators can use the threat of placing the firm into FDIC receivership  under OLA if the firm does not file voluntarily for bankruptcy. One  expert expressed the view that once living wills are in place,  regulators may compel a financial company to execute its resolution  plan by filing for voluntary bankruptcy. Regulators also can take  other actions. For example, under the statute, the Federal Reserve  and FDIC may jointly take corrective action, including ultimately  requiring the divestiture of certain assets, if they jointly determine that  a firm has not been able to submit a plan that meets the statutory  criteria. Under SEC and CFTC rules, an undercapitalized securities  broker-dealer or commodity broker cannot operate and must therefore  be liquidated. One expert with whom we spoke said that even if  regulators were given an explicit right to place a firm in involuntary  bankruptcy, they would be unlikely to use that authority.
In response to the proposal to give regulators an explicit right to be  heard, experts who addressed the issue said regulators are routinely  heard by the court in bankruptcy proceedings. And as noted  previously, SEC and CFTC already have legal standing in some  cases. Court officials said they were not aware of an instance in which  a regulator was denied the right to be heard by the court. However,  experts also said making this an express right might have benefits,  which we discuss later in this report.
Although experts favored most of the regulatory proposals, they were  opposed to having regulators decide whether a firm should be resolved  on a consolidated basis and noted that these changes would undermine  key legal and regulatory constructs. One expert noted that the idea  undermined the concept of having corporate separateness for  subsidiaries. Corporate separateness is generally the principle that a  parent corporation is not liable for actions taken by its subsidiaries.  Another expert noted that encouraging substantive consolidation as  determined by the regulator could have a negative impact on the  predictability and transparency of the bankruptcy process, detracting from  the orderliness and effectiveness of that process. A third expert noted that  treating the legal entities of a financial company in bankruptcy on a  consolidated basis would conflict with the U.S. regulatory structure, which  is designed around separate legal entities, such as depository institutions,  broker-dealers, and insurance companies. However, companies continue  to manage themselves along business lines that cut across legal entities.  A regulatory expert said that removing the exemption for securities  broker-dealers and commodity brokers from bankruptcy could undermine  the purpose of the regulatory construct applied to those entities and the  ability of regulators to protect customers’ assets. An expert noted that  overriding state insurance regulators could lead to intensive litigation.  Additionally, NAIC and state insurance officials said that the priority  structure for bankruptcy is inappropriate for insurers because the primary  goal in the resolution of an insurance company is to protect the  policyholders. Because of this, policyholders generally receive priority  over creditors in an insurance receivership beyond any claims supported  by collateral.
Experts at our roundtables also broadly discussed the proposals in  relation to criteria for orderly and effective bankruptcies (including  minimizing systemic risk and promoting due process). Most  fundamentally, these experts had differing views on whether bankruptcy,  as currently construed, was an appropriate vehicle for minimizing  systemic risk. Some participants at the roundtable raised issues about  whether the court could act quickly enough to stem systemic spillovers  from the debtor company to other companies and markets. They noted  other potential trade-offs. 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. Similarly, one participant  said that if the goal was to turn the Code into an effective resolution tool,  the fundamental balance of power among debtor, creditor, and regulator  might need to be altered. Another was concerned that if regulators  become more involved in bankruptcy cases, courts might defer to them  over other parties, undermining the ability of creditors to argue their  cases. However, a legal expert at the roundtable doubted that the courts  would be overly solicitous to regulators. Another legal expert noted that  regulators could enhance due process by educating the court and  providing a method for verifying information provided by the financial  institution. One of these participants noted that standards for an  involuntary bankruptcy initiated by the regulator might require a new  definition for insolvency that would consider both regulatory and systemic  interests.
Nevertheless, many of the experts indicated that regulatory involvement  in bankruptcies was consistent with minimizing systemic risk. These  experts said that regulators do and should have influence in times of  crisis and that commencing a bankruptcy without regulatory involvement  could be problematic. Additionally, some of the experts at the roundtable  noted that regulators ought to have the power to compel a financial firm to  file for bankruptcy because, as one regulatory expert said, allowing a  financial firm to continue to do business when it is in vulnerable financial  condition would likely add to concerns for systemic risk.
section_title: Experts Generally Agreed That Proposals Need Further Consideration
paragraphs: Although experts generally supported proposals to change the roles of  regulators, they said implementing the proposals relating to notice and  involuntary proceedings could be difficult. Experts at our roundtable said  that determining the correct number of days for notification to the  regulator would be difficult. For example, requiring a financial institution to  provide notice to and consult with regulators 10 days in advance of filing  for bankruptcy—the number of days specified in proposals introduced in  the 111th Congress—might not work in practice. One expert said that 10  days can be a long time in a financial crisis. Another noted that the firm’s  need to file for bankruptcy might arise very quickly and that a firm might  only be able to notify its regulator a day or two in advance of its filing. As  an example, an expert noted the rapid collapse of the investment firm  Bear Stearns and Co. In 2008, senior management of Bear Stearns gave  the Federal Reserve Bank of New York a 1-day notification, saying that  the company would file for bankruptcy protection the following day unless  it received an emergency loan. In the failure of Lehman Brothers, the  abruptness of the company’s bankruptcy did not allow much time for  attorneys to prepare for filing. Another expert said that a requirement to  “notify and consult” with the regulator before entering bankruptcy should  not interfere with the ability of a company to file for bankruptcy.
Determining which regulators to notify also may be difficult. Complex  financial companies and their subsidiaries may have many regulators  domestically and internationally. As a result, determining which regulator  a bank holding company or nonbank financial company would notify if a  domestic or foreign subsidiary were nearing insolvency is not clear. One  expert noted that because large financial companies have many  regulators, before a firm could file for bankruptcy it would be important to  identify in advance which regulators to notify. Proposals introduced in the  111th Congress would have required that a nonbank financial company  consult with its functional regulator, FSOC, and any agency charged with  administering a nonbankruptcy insolvency regime for any component of  the debtor firm, which could be a large number of regulators. The  proposals define functional regulator as the federal regulatory agency  with the primary regulatory authority, such as an agency listed in section  509 of the Graham-Leach-Bliley Act. Some roundtable experts said that  prebankruptcy consultation should be with the firm’s primary regulator,  although none of them defined this term.
FSOC—which under the Dodd-Frank Act is charged with identifying and  responding to risks to U. S. financial stability—was included as a  regulator in the notification and consultation proposal. Treasury officials,  including those who support FSOC, interpret the Dodd-Frank Act as  having a preference for resolving financial companies through bankruptcy  and said that FSOC has focused its activities on implementing its  responsibilities under the act. Furthermore, in its annual reports FSOC  has described the role that resolution plans are supposed to play in  fostering orderly resolutions under the Code. Specifically, under the  Dodd-Frank Act, bank holding companies with total consolidated assets  of $50 billion or more and nonbank financial companies designated by  FSOC for enhanced supervision by the Federal Reserve are required to  submit resolution plans to the Federal Reserve, FDIC, and FSOC.  FSOC’s 2013 Annual Report included a recommendation that the Federal  Reserve and FDIC implement their resolution plan authorities in a manner  that better prepares firms and authorities for a rapid and orderly resolution  under the Code.
However, in our discussion with Treasury officials, including those who  support FSOC, they noted that FSOC does not routinely evaluate  proposals that could alter the role of regulators in the bankruptcy process  or other changes to the Code that might reduce systemic risk, such as  narrowing the safe harbor treatment of QFCs. While current law does not  specify a role for FSOC related to the potential filing of a bankruptcy by a  systemically important financial company, when MF Global declared  bankruptcy, FSOC met in emergency session to monitor the event and  subsequently reported that the MF Global bankruptcy had not roiled  markets. Treasury officials and staff that support FSOC said that FSOC  is focused on implementing provisions in the Dodd-Frank Act. Since  helping to develop rules to implement OLA is explicit in the Dodd-Frank  Act, FSOC has described activities related to these provisions and made  recommendations—but has not considered the implications of changing  the role of regulators under the Code. Although the Dodd-Frank Act does  not amend the Code or explicitly call for FSOC to consider such changes,  changing the role of regulators could potentially impact FSOC’s ability to  identify and respond to systemic risks in a timely fashion.
The roundtable experts noted that allowing financial regulators to initiate  an involuntary bankruptcy for financial companies raised a number of  implementation questions including appropriate time frames and  standards. These experts generally agreed that lengthy time frames  included in the rules for an involuntary bankruptcy filed by a creditor could  reduce the value of a systemically important financial institution and  endanger market stability. However, one expert expressed concern over  the possibility of regulators acting too quickly to place an institution in  bankruptcy, especially during a financial crisis in which asset valuations  might be in dispute. A legal expert noted that considering what the  appropriate standard for placing a financial institution in bankruptcy would  be was important. The expert noted the difficulty of distinguishing  between an insolvent company and one experiencing temporary liquidity  needs. Another expert proposed that a bankruptcy initiated by the  regulator should require a standard similar to the standard in place for  placing a firm in FDIC receivership under OLA. The regulators at the  roundtable thought that a regulatory framework that required firms to  meet certain standards or be placed in bankruptcy—as currently exists for  commodities brokers and securities broker-dealers—might alleviate some  of the disadvantages posed by the creditor rules and would not  necessarily require a change in the Code.
section_title: Experts Considered Funding Mechanisms Essential for Bankruptcies of Large Financial Companies
paragraphs: One criterion for an effective bankruptcy or resolution process is to limit  taxpayer liability. Legislators have made proposals to limit the ability of  the Treasury or the Federal Reserve to help finance bankruptcies of  financial companies. For example, proposals introduced in the 111th  Congress specifically would have forbidden the U.S. Treasury and  Federal Reserve from participating in bankruptcy financing. However,  some proposals recognize the difficulty of financing bankruptcies of large  financial companies, especially during a crisis. The Chapter 14 proposal  made by the Hoover Institution resolution project group would allow the  government to provide subordinated DIP financing to companies with  assets greater than $100 billion (subsidiaries included) with a hearing and  the court’s approval and oversight. Experts at our roundtable discussed  the appropriate role of the government in providing financing for firms in  bankruptcy.
subsections: section_title: Experts Considered Fully Secured Federal or Industry Funding Mechanisms Essential for Orderly and Efficient Bankruptcies
paragraphs: Experts at our roundtables emphasized that many of the proposals to  make the bankruptcy process more orderly and effective depend on  having an adequate funding mechanism. As a result, experts at the first  roundtable generally agreed that changing the Code to prevent any  federal funding of these bankruptcies would not be consistent with orderly  and effective resolutions. In their written responses to a question asking  what the most important changes would be to achieve most of the  elements of an orderly and effective bankruptcy, experts most  consistently responded that proposals to provide adequate funding, rather  than to restrict it, were the most important changes that could be made.  All but one of the eight experts responding put providing a funding source  as the most important change to avoid fire sales. Experts said that  support for federal funding rested on two propositions. First, voluntary  private funding likely would be unavailable to finance the bankruptcy of a  systemically important financial company. Second, the government  should distinguish between funding for a bailout and funding that provided  short-term liquidity.
Experts did not think that voluntary private funding would be available to  finance a systemically important financial company because these  companies are large and some of them grew substantially over the  course of the financial crisis (see table 1). Solutions that were possible  during the crisis, such as JPMorgan Chase providing funding for Bear  Stearns, or Barclays’ purchase of parts of Lehman, would be unlikely in  the future because some firms have gotten much larger. Experts also  noted that obtaining funding would be especially difficult during a period  of general financial distress when firms large enough to provide funding  might be experiencing difficulties themselves.
Several experts noted that any government funding would need to  distinguish between bailing out an insolvent company, which they  opposed, and providing short-term liquidity for a solvent company  providing collateral, which they generally supported. One of the legal  experts defined a bailout as the government putting in equity capital to  support existing creditors. Legal and academic experts at our roundtables  compared the provision of fully secured, liquidity funding with providing  lender-of-last resort funding. They referred specifically to the Federal  Reserve providing short-term liquidity through its discount window to  solvent depository institutions with eligible collateral to secure the loan.  The Federal Reserve accepts a very broad range of collateral to secure  such loans. Our roundtable experts generally agreed that funding for  liquidity needs was essential and noted that in a period of financial  distress the federal government might be the only entity with enough  resources to provide such funding.
Although experts at the roundtables did not think voluntary private funding  likely would be available for financing or other liquidity support during the  bankruptcy of a large financial company, they did consider whether the  industry as a whole might provide such support. They noted several  options for such funding.
The industry could create a fund or mechanism for providing liquidity  to firms that needed it.
The government could assess companies prior to a bankruptcy as it  does for the deposit insurance fund.
The government could raise funds through postbankruptcy  assessments, while meeting immediate needs through temporary  federal funding as with the Orderly Liquidation Fund under Title II of  the Dodd-Frank Act. Under OLA, the Treasury may make funds  available through an Orderly Liquidation Fund to FDIC as the receiver  of a covered financial company.
A few of the experts noted that some government guarantees might  facilitate private-sector financing.
As with many of the proposals, our roundtable experts noted that  implementing a proposal to allow fully secured federal funding for liquidity  needs raised some difficulties. First, they noted the difficulty of  distinguishing between an insolvent company and one experiencing  temporary liquidity needs. This distinction is particularly difficult in a  period of financial stress when valuation of assets may be difficult. For  example, the value of some of Lehman Brothers Holding, Inc.’s (LBHI)  real estate assets has increased since the time of its bankruptcy in 2008.
Second, experts at the first roundtable noted that the Dodd-Frank Act  amendments to section 13(3) of the Federal Reserve Act might apply to  some Federal Reserve funding related to a bankruptcy. This provision  restricts the Federal Reserve from providing funding to a single distressed  company but would allow it to provide funding to the financial system.  Similar funding provided under the Primary Dealer Credit Facility in  September 2008 (prior to the Dodd-Frank Act amendments), allowed  Lehman Brothers, Inc. (LBI)—the broker-dealer and commodity broker  subsidiary of LBHI—to remain a going concern after LBHI declared  bankruptcy, thus facilitating the transfer of some assets to Barclays later  that week. The remaining parts of LBI were liquidated in a SIPA  proceeding. Under the terms of the loans provided through the Primary  Dealer Credit Facility, the Federal Reserve Bank of New York became a  secured creditor of the firm, giving it higher priority in the event of a  bankruptcy. We found in 2011 that LBI and Barclays had repaid their  overnight loans with interest, according to Federal Reserve officials. One  legal and financial expert suggested that the Federal Reserve would be in  compliance with the amendments to section 13(3) if it set up a fund for  firms being resolved under the Code for large financial companies.
Third, experts noted that determining what types of assets firms could use  to collateralize government or industry funding might be difficult. Although  the Federal Reserve had accepted assets with significant tail risk (the  probability of a rare event occurring that would result in great losses) as  collateral during the crisis, experts noted that such risky assets might not  be acceptable in the future.
section_title: Roundtable Experts Were Concerned about Using Federal Funding for Preferences to Some Creditors
paragraphs: We asked the experts at our first roundtable to discuss the advantages  and disadvantages of the proposal made by the Hoover Institution  resolution project group that calls for using subordinated government debt  to provide payments to certain short-term creditors early in a bankruptcy  proceeding. Such subordinated loans would be repaid with a lower priority  than that of other creditors. The proposal further proposes a “claw-back”  procedure if the preferred creditors have received more than they were  entitled to when the reorganization or liquidation is finalized. The proposal  was made to stem systemic concerns—the failure at one financial  company spreading to others because short-term creditors would not  have access to funds. Reliance on short-term funding exacerbated the  financial crisis of 2007-2009. And as has been noted by some Federal  Reserve officials, regulatory reform has not yet addressed the risks to  financial stability posed by short-term wholesale funding.
Legal experts at the roundtable agreed that such payments could be  made by treating certain short-term creditors as critical vendors during  first-day motions. However, experts who discussed this issue at the first  roundtable said that making decisions about providing funding to certain  short-term creditors during a bankruptcy was not the best way to address  systemic concerns associated with short-term liquidity. They noted that  such a proposal would increase uncertainty for creditors during a  bankruptcy proceeding. Two experts noted that they would not want to  use subordinated federal funding. Another explained that the point of  subordinating the funding is to help ensure that the government uses  such funding to address concerns about liquidity rather than to defray  certain creditors’ losses. However, such funding would expose taxpayers  to potential liability.
Instead, those experts who discussed this proposal at the first roundtable  said that changing the Code to give an explicit priority to short- over long- term creditors would be preferable. They noted that an explicit priority  would be a better option in that it would help to address systemic risk and  lead to a more predictable bankruptcy process. In addition, such a priority  might provide an incentive for firms to continue to provide short-term  funding when a financial company experiences distress. One legal expert  noted that the special bankruptcy laws for railroads had a provision that  any creditor providing funding in the 6 months leading up to a bankruptcy  had priority over other creditors in that bankruptcy proceeding. This type  of provision might have created an incentive to provide funding to a  railroad experiencing short-term financing issues and thus, might have  prevented a bankruptcy. However, a legal expert at our second  roundtable said that this would create unfair treatment for creditors  providing long-term financing, because long- and short-term creditors  were members of the same creditor class.
While a priority for short- over long-term creditors might reduce the  incentive to withdraw funding leading up to a bankruptcy and reduce the  likelihood of systemic issues associated with liquidity shortages during a  bankruptcy, it could have additional consequences. For example, such a  priority would provide more of an incentive for creditors to provide short-  rather than long-term funding. If there were less likelihood that these  short-term creditors would lose their funds in the case of a default  because they had priority over other creditors, they might be less likely to  monitor the credit-worthiness of borrowers. As a result, the market might  be less likely to discipline companies that take on excessive risk.  Although promoting market discipline is not among the criteria we  identified for orderly and effective bankruptcies, it is a goal of the Dodd- Frank Act.
section_title: Experts Had Varying Views on Advantages and Disadvantages of QFC Proposals
paragraphs: Experts at our roundtables evaluated proposals to change the treatment  of certain QFCs relative to criteria for orderly and effective financial  company bankruptcies. Specifically, they discussed the effects of  proposals for removing all safe harbors for QFCs; partially rolling back  safe harbors on specific contracts; implementing a temporary stay for all  or certain contracts; and allowing trustees to “avoid” contracts entered  into within specified periods prior to the bankruptcy filing if they are  determined to be preferential or fraudulent. The experts generally  agreed that limiting safe-harbor treatment would affect derivative and  repurchase agreement markets and could limit short-term funding options  for financial companies especially in periods of distress. However, the  experts had differing views on the advantages and disadvantages of the  proposals, and those views are still evolving as lessons learned from the  treatment of these contracts during the Lehman Brothers bankruptcy  remain unclear.
subsections: section_title: Experts Generally Agreed That Limiting Safe-Harbor Treatment of QFCs Would Affect Markets and Funding Availability
paragraphs: The roundtable experts generally agreed that limiting the safe-harbor  treatment—removing it all together or providing it to a more limited set of  contracts—would reduce the use of derivatives and repurchase  agreements. Some experts have noted that these markets grew  substantially after additional types of contracts were granted safe-harbor  treatment in 2005 (see fig. 2). However, one expert we spoke with noted  that in his opinion the industry has tended to overstate the impact that  limiting the safe harbors would have on the size of the markets, which the  expert thought would likely be minimal.
Several of the roundtable experts thought that if downsizing these  markets was a goal, it should be done directly through regulations rather  than through changes in the Code. For example, the experts noted that  derivatives markets have been undergoing vast change as a result of  requirements in the Dodd-Frank Act (such as requiring certain contracts  to be tracked more effectively and traded on exchanges). However,  another expert noted that it would be good if the Code were consistent  with regulatory goals. Limiting the safe harbors would reduce the  availability of short-term funding for financial companies. Short-term  funding for financial companies creates flexibility, but, at the same time, it  sets the stage for potential runs on firms.
section_title: Experts Held Varying Views on Proposal Impacts Relative to Orderliness and Effectiveness
paragraphs: As figure 3 shows, there was little consensus in written responses  provided by our roundtable experts on how, if at all, changes in QFC  treatment under the Code would affect the orderliness and effectiveness  of financial company bankruptcies (see app. II for more detailed  information on the proposals). However, most of our roundtable experts  responded that removing all of the safe harbors would detract from  orderliness and effectiveness and none of them responded that this would  greatly enhance orderliness and effectiveness. For the other proposals,  the experts were split fairly evenly in their written responses between  those who thought the proposal would enhance the orderliness and  effectiveness and those who thought it would detract from orderliness and  effectiveness. Many of the experts who thought allowing trustees to  “avoid” contracts would detract from orderly and effective bankruptcies  chose “greatly detract.” Generally, those experts representing industry  interests noted that the proposals would detract from orderliness and  effectiveness, and those in favor of adopting certain proposals thought  that industry opposition would be difficult to overcome.
Experts at the roundtable noted that even if there was high-level  agreement on what changes to the Code were needed, legal experts  might disagree on the precise details. For example, with regard to the  safe-harbor exemptions from avoidance actions—trustees’ ability to  “avoid” transfers entered into in the 90 days prior to a bankruptcy if they  are determined to be preferential or up to 2 years prior to a bankruptcy if  they are determined to be fraudulent—some legal experts at the second  roundtable said that the courts were giving preferential treatment to  contracts that in principle should not be receiving it. Specifically, they said  that the courts were interpreting section 546(e) of the Code in a way that  allows contracts that otherwise might be considered preferential or  fraudulent to remain in force. As a result, they noted that changes to the  Code might be made to tighten that section. For example, a roundtable  expert said that section 546(e) of the Code should be changed so that  fictional transactions, such as Ponzi scheme payments, would not receive  such treatment. Another legal expert cited a number of cases in which  contracts entered into within 90 days prior to the bankruptcy filing, which  would be considered preferential without the safe-harbor exemption, were  being given safe-harbor treatment. For example, in the bankruptcy case  of communications company Quebecor, insurance companies that held  private placement notes that qualified for safe-harbor treatment had  received 105 cents on the dollar while other unsecured creditors received  a fraction of a dollar. The expert and others said that it might be useful  to allow a judge to make decisions relative to some contracts. However,  one expert at the roundtable noted that this could be a very long, complex  process. In addition, allowing the judge to decide which contracts would  get safe-harbor treatment when counterparties defaulted would increase  the uncertainty attached to those contracts.
Our roundtable experts also varied in their evaluations of the proposals  relative to some of the specific criteria we had identified for orderliness  and effectiveness such as limiting systemic risk, avoiding fire sales,  maximizing value, and preserving due process.
When explicitly asked, some experts responded that limiting the safe  harbors would increase systemic risk, while others responded that limiting  them would reduce it. Such a dichotomy could result from differences in  the way the experts viewed markets. Having the safe harbors likely  increases dependence on short-term funding and thus increases the  chance for a run if questions arise about a company’s financial  soundness. In addition, needing to sell off assets because of a lack of  funding could lead to a spiral of falling asset prices. However, safe  harbors are also thought to limit systemic effects before and during a  bankruptcy. According to an expert at the second roundtable, if  counterparties are certain about the safe-harbor treatment of their  contracts, such treatment may limit runs prior to bankruptcy because  counterparties know they will be able to terminate or liquidate their  positions in case of default. In addition, the safe harbors primarily exist to  limit market turmoil during a bankruptcy—that is, they are to prevent the  insolvency of one firm from spreading to other firms and possibly  threatening the collapse of an affected market. Although FSOC has  reported on threats to financial stability from derivative and repurchase  agreement markets, as with proposals to change regulators’ roles under  the Code, they have not considered the implications of potential changes  to the safe-harbor treatment of these contracts during bankruptcy.
The roundtable experts made a number of specific points relative to the  impact of QFC treatment on systemic risk and fire sales of assets. One  expert at the second roundtable noted that during the early days of the  Lehman Bankruptcy, he thought that the QFC terminations would lead to  a systemic event in derivatives markets, but that did not happen. The  expert questioned whether the lack of a systemic event reflected  Lehman’s small share of the market—5 percent—or the safe-harbor  protection. In contrast, the commercial paper market did experience a  systemic event—becoming illiquid after the Lehman bankruptcy.  However, another participant noted that it was not the claims process in a  bankruptcy that caused systemic risk; it was the uncertainty, the effect on  counterparties, and market reactions. Roundtable participants also  discussed the likelihood that safe-harbor treatment or bankruptcy in  general could create asset fire sales. One expert noted that fire sales  were more likely to occur in the period leading up to bankruptcy rather  than after the bankruptcy was filed. Another industry expert noted that  some unpublished research suggests that fire sales of Lehman’s assets  that might have resulted from the treatment of QFCs did not take place  following the bankruptcy filing. Instead, counterparties terminated only  those contracts that had maintained their value.
Roundtable experts noted that conflicts might arise depending on whether  the goal of a bankruptcy proceeding was to maximize value for the  economy, for the debtors, or for the creditors. One legal expert noted that  in a time of financial crisis, balancing market expectations and needs  against the needs of an individual company was difficult. Debtors usually  are expected to fare best when companies can be reorganized under  Chapter 11. Under Chapter 11, the purpose of the automatic stay is to  preserve the value of companies while debtors consider their options.  However, one roundtable expert noted that with the rapid dissolution of  value for a financial company as a result of the safe harbors, liquidation is  a more likely outcome than reorganization. Another expert noted that  even if QFCs were stayed, value could dissipate quickly in financial  company bankruptcies because that value rests on the confidence of the  debtors’ counterparties. In addition, one expert raised concern about the  impact of the safe harbors on the remaining value for creditors after QFC  positions were terminated. In a bankruptcy, creditors compete with  counterparties to derivative contracts and repurchase agreements for a  firm’s assets. Allowing the QFCs to be terminated while other debts are  stayed means there are fewer assets available for those creditors.  However, since creditors know that they are less well protected in  bankruptcy, they should command a higher price for the risk they are  taking when they provide credit. So, determining whether creditors are  being disadvantaged overall is difficult.
Roundtable participants also discussed whether a temporary stay for  QFCs would enhance the value of a financial company; however, as  noted earlier, they were split on whether this would contribute or detract  from the overall orderliness and effectiveness of financial company  bankruptcies. For example, while several experts said that a temporary  stay might facilitate a sale of a company’s derivatives to a third party, the  sale would increase concentration in the market and ultimately contribute  to greater overall systemic risk. Other experts agreed that a temporary  stay would be useful only to the extent that an exit strategy, such as  selling to a third-party buyer, was available or a bridge company—which  is a temporary company used to maintain the failed company’s  operations—could be constructed. These experts cited the case of  General Motors as an example of what they were suggesting. However,  the newly formed company in the case of General Motors was not  temporary. In contrast, one expert presented a hypothetical example that  did not involve a sale of the whole entity to a third party or the  construction of a bridge company. In this example the judge would have  from a 10 to 12 day stay, which might allow the judge to dispose of pieces  of the company, leaving a small enough entity that its assets could be  liquidated through normal bankruptcy proceedings. However, other  experts noted that it might be difficult to determine what the appropriate  number of days for a temporary stay might be.
Several of the experts at our roundtables questioned whether bankruptcy  reforms designed to deal with systemically important financial companies  would adequately protect due process given the need to move quickly in  such a bankruptcy. They suggested that due process might be  compromised or would depend on the ability of counterparties and  creditors to take action after regulators or courts make decisions (as is  the case with OLA). For example, 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 or “claw  back” value later in the process, as opposed to having a judge consider  the views of all of the parties prior to making any decisions.
Roundtable experts noted that some changes to the Code relative to the  treatment of QFCs could create uncertainty in the process. Specifically,  counterparties need certainty about bankruptcy treatment when they  enter a contract. To provide that certainty, several experts agreed that  changes should be detailed in the terms of the contract rather than  determined at the time of the bankruptcy. However, one of the experts  noted that even with provisions specified in the Code, counterparties  might still be uncertain for some time about how certain contracts would  be treated. Although the Code had been amended in 2005 to extend safe- harbor treatments to more types of repurchase agreements, that expert  said that uncertainty as to how the courts would treat repurchase  agreements contributed to the Lehman Brothers bankruptcy. Leading up  to the bankruptcy, counterparties were unwilling to extend new short-term  funding because of the uncertainty—essentially precipitating a run on the  firm.
Our roundtable experts noted other issues that would arise relative to  making any changes in the Code, such as whether contracts that already  existed would be processed under the Code at that time or under the new  Code. One expert said that contracts should be grandfathered, while  another pointed out that the grandfathered contracts might be around for  another 30 years, creating other difficulties. While it is difficult to assess  how many contracts would be long term, key contracts are thought to be  used for overnight funding. When the 2005 changes were made to  expand the contracts receiving safe-harbor treatment, the new treatment  applied to all contracts, including those that had been entered into prior to  that time. Some roundtable experts further suggested that not knowing  which judge will have a case and how that judge will make decisions can  introduce additional uncertainty into the treatment of certain contracts.
Not knowing whether a qualified financial contract would be subject to the  Code or OLA creates further uncertainty about how a contract will be  treated. Under the latter, FDIC becomes the receiver of the company and  QFCs are stayed for 1 business day. During that day, FDIC has an  opportunity to transfer a company’s derivatives to a third-party or bridge  company. Under OLA, FDIC can choose to transfer contracts with one  company to the bridge company while choosing not to transfer those with  another company. However, if FDIC chooses to transfer a contract with a  specific company, it would have to transfer all of the contracts with that  company. There was some presumption among roundtable participants  that very large systemically important institutions would be resolved under  OLA rather than through bankruptcy. However, FDIC officials testified  before the Subcommittee on Oversight and Investigations of the House  Committee on Financial Services in April 2013 that under the Dodd-Frank  Act, bankruptcy is the preferred resolution framework in the event of a  failure of a systemically important financial company.
section_title: Experts Noted That Lessons Learned from Lehman Bankruptcy Are Still Unclear
paragraphs: Experts at our roundtable said that the lessons learned from the Lehman  bankruptcy that might be applied in considering changes to the safe  harbors are still unclear. Early reports and statements about the LBHI  bankruptcy said that in the first 5 weeks after LBHI filed for bankruptcy,  approximately 80 percent of its derivatives counterparties terminated  contracts that were not subject to the automatic stay. However, some of  the initial counterparty claims have been found to have been overstated.  Two experts at our second roundtable specifically noted that the large  initial loss in value was, in part, the result of LBHI counterparties’ initially  overstating their claims against LBHI, and subsequently some of these  claims have been overturned in adversary proceedings. For example,  Swedbank AB, a Swedish bank, that was a creditor of LBHI, sought to  offset Lehman’s payment obligations under prepetition swaps with  deposits Lehman had made at Swedbank after filing for bankruptcy. The  Bankruptcy Court of the Southern District of New York ruled against  Swedbank, holding that the post petition deposits could not be used to  offset prepetition swaps. In another proceeding involving the Lehman  bankruptcy, a lender, Bank of America, seized the debtor’s account funds,  which were unrelated to any safe-harbor transaction, to set off certain  contracts that could receive safe-harbor treatment. The court ruled that  the bank’s use of the funds to set off the transactions violated the  automatic stay. Further, some experts no longer supported proposals  they had originally made in response to Lehman’s early perceived losses.
As a result, experts continue to weigh whether changes to the treatment  of derivatives and repurchase agreements under the Code are needed.  The Hoover Institution resolution project group continues to discuss their  proposals and plans to issue additional publications on their Chapter 14  proposals. The American Bankruptcy Institute has a Commission to Study  the Reform of Chapter 11 and has appointed advisory committees to  consider various aspects, including the treatment of QFCs. Its work is  expected to continue for some time. Throughout the roundtable  discussion, the participants noted that changes to the Code should not be  made without considering ongoing changes in the broader legal and  regulatory environment for derivatives. Specifically, they noted that the  Dodd-Frank Act calls for a number of significant changes in the regulation  of derivatives that are still being implemented, and the industry is looking  at potential changes to derivatives contracts. Finally, experts noted the  need to make changes consistently across international borders,  especially in the United States and United Kingdom. During the Lehman  Brothers bankruptcy, differences in the treatment of various contracts  caused courts in the United States and United Kingdom to rule in  opposing ways on the same contracts.
section_title: Conclusions
paragraphs: The financial crisis and the failures of some large financial companies  raised questions about the adequacy of the Code for effectively  reorganizing or liquidating these companies without causing further harm  to the financial system. Although the Dodd-Frank Act created OLA, an  alternative resolution process, filing for bankruptcy under the Code  remains the preferred resolution mechanism even for systemically  important financial companies. Some proposals to modify the Code  recognize that currently the Code may not adequately address threats to  financial stability. Some proposals—changing the role of regulators in the  bankruptcy process, creating funding mechanisms, and limiting the safe- harbor treatment of qualified financial contracts—may address this  potential shortcoming. However, experts are not ready to recommend  specific changes to the Code and the proposals require further  consideration. FSOC—which was established under the Dodd-Frank Act  to identify and respond to threats to financial stability—has not specifically  considered changes to the role of regulators in bankruptcy or the  treatment of QFCs. Although the Dodd-Frank Act does not explicitly  require FSOC to assess changes to the Code, it is well positioned to take  a broad view of potential changes within the context of other regulatory  and market changes prescribed by the act. It is also well positioned to  decide the appropriate level of attention such changes merit. Such  attention to the systemic implications of financial company bankruptcies  could improve FSOC’s ability to take timely and effective action to identify  and respond to threats to U.S. financial stability.
section_title: Recommendations for Executive Action
paragraphs: To fulfill FSOC’s role under the Dodd-Frank Act to identify and respond to  threats to financial stability, we recommend that the Secretary of the  Treasury, as Chairperson of FSOC, in consultation with other FSOC  members, consider the implications for U.S. financial stability of changing  the role of regulators and narrowing the safe harbor treatment of qualified  financial contracts in financial company bankruptcies.
section_title: Agency Comments
paragraphs: We provided a draft of this report to AOUSC, CFTC, FDIC, the Federal  Reserve, NAIC, the Departments of the Treasury and Justice, and SEC,  for review and comment. CFTC, FDIC, NAIC, and SEC provided technical  comments, which we have incorporated as appropriate. AOUSC, the  Federal Reserve, and Department of Justice did not provide comments.  Treasury’s Under Secretary for Domestic Finance, on behalf of the  Chairperson of FSOC, provided written comments, which are reprinted in  appendix IV.
In commenting on our draft report, FSOC said that it shares our concern  that a disorderly financial company bankruptcy could pose risks to  financial stability. However, FSOC stated that it would be premature for  FSOC to prioritize the consideration of proposals to amend the Code until  the Dodd-Frank Act is fully implemented or there is evidence of risks that  cannot be adequately addressed within existing law. FSOC added that  the Federal Reserve Board and FDIC are currently implementing  provisions of the Dodd-Frank Act requiring designated financial  companies to submit resolution plans ("living wills") to facilitate their  orderly resolution under the Code. FSOC also noted that it is facilitating  communication and coordination on the implementation of OLA and living  will requirements. FSOC noted further that the council is engaged in a  variety of other actions to address risks to financial stability posed by the  failure of one or more financial companies such as the designation of  nonbank financial companies.
We acknowledge FSOC’s efforts to implement the Dodd-Frank Act and  the actions they have taken to address risks to financial stability, including  some actions related to implementing OLA. However, rather than  considering changes to the Code after the Dodd-Frank Act is fully  implemented, our recommendation is intended to encourage FSOC to  actively address such changes in conjunction with these efforts— particularly as some suggested changes would affect regulators’ and  ultimately FSOC’s ability to respond to the failure of a large complex  institution. First, changing the role of regulators in a financial company  bankruptcy could be critical for effective resolution. For example, the point  at which regulators become aware of an impending or actual financial  company bankruptcy could be critical to determining whether its living will  could be used to improve the orderliness and effectiveness of the  bankruptcy. Similarly, timing could be critical in determining whether to  use OLA, which is to be used if a bankruptcy under the Code were  determined to have serious adverse effects on U.S. financial stability.  Second, narrowing the treatment of QFCs could also have implications for  limiting systemic risk. As some members of the council have stated  publicly, bankruptcy remains the preferred method for resolving failing  financial companies. Given that preference and FSOC’s charge to identify  and respond to risks to U.S. financial stability, our recommendation—that  FSOC consider the implications for U.S. financial stability of changing the  role of regulators and narrowing safe harbor treatment of QFCs in  financial company bankruptcies—is consistent with its statutory role and  responsibilities.
We are sending copies of this report to the appropriate congressional  committees, the Director of the Administrative Office of the U.S. Courts,  Chairman of the Commodity Futures Trading Commission, Attorney  General, Secretary of the Treasury, Chairman of the Federal Deposit  Insurance Corporation, Director of the Federal Judicial Center, Chairman  of the Board of Governors of the Federal Reserve System, Chief  Executive Officer of the National Association of Insurance  Commissioners, Chairman of the Securities and Exchange Commission,  and other interested parties. The report also is available at no charge on  the GAO website at http://www.gao.gov.
If you or your staff members have any questions about this report, please  contact Alicia Puente Cackley at (202) 512-8678 or cackleya@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 V.
section_title: Appendix I: 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 third in the series, examines the advantages  and disadvantages of certain proposals to modify the Bankruptcy Code  (Code) for financial company bankruptcies. Specifically this report  examines the advantages and disadvantages of proposals (1) to change  the role of financial regulators in the bankruptcy process; (2) affecting the  funding of financial company bankruptcies; and (3) to change the safe- harbor treatment of qualified financial contracts (QFC), including  derivatives and repurchase agreements.
To address all of our objectives, we reviewed relevant 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 2 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 also  updated our review of published economic and legal research on the  effectiveness of bankruptcies that we had originally completed during the  first year of the mandate. For the original search we relied on Internet  search databases (including EconLit and Proquest) to identify studies  published or issued after 2000 up through 2010. We reviewed these  articles to further determine the extent to which they were relevant to our  engagement, that is, whether they discussed criteria for effectiveness of  the bankruptcy process, key features of the bankruptcy process, or  proposals for improving the bankruptcy process. We augmented this  Internet search with articles provided by those we interviewed or obtained  from conferences. In addition, we reviewed a number of prior GAO  reports on financial institutions and the financial crisis. For this report, we  replicated the literature search for 2011 and 2012. Further we met with  officials at the following federal government agencies: AOUSC; the  Commodity Futures Trading Commission; Federal Deposit Insurance  Corporation; Department of Justice; Department of the Treasury,  including officials who support the Financial Stability Oversight Council  (FSOC); Federal Reserve; and Securities and Exchange Commission. In  addition we met with officials of the National Association of Insurance  Commissioners and members of insurance departments in Illinois, Iowa,  and Texas.
We relied on our earlier work and the updated literature review to  establish criteria for orderliness and effectiveness and to develop a list of  proposals related to the role of regulators in the bankruptcy process or  the role of government in financing bankruptcies, as well as proposals to  change the safe-harbor treatment of certain financial contracts. In our  earlier work, we analyzed the results of the literature review and expert  interviews to determine criteria for orderliness and effectiveness of  financial company bankruptcies. These criteria are minimizing systemic  risk, avoiding fire sales, maximizing value; preserving due process, and  minimizing taxpayer liability. In that work, we also used the literature  review to determine the range of proposals that had been made to reform  the bankruptcy process for financial institutions. We categorized some of  the proposals into groups, such as those that included a role for the  regulators or modified the treatment of qualified financial contracts, and  then asked the experts looking at these categories and specific proposals  to tell us which they considered had merit and should be included for  further consideration and why. We also updated the literature review to  determine whether earlier proposals had evolved, proposals had been  subject to critical review, or additional proposals had been made. As we  had for our earlier work, we surveyed relevant government agencies for  information on newer studies they had or were conducting or were aware  of related to our objectives.
To obtain expert views on existing proposals and how these proposals  might be improved, we convened two roundtables to discuss the  advantages and disadvantages of specific proposals. The roundtables  were held at the National Academy of Sciences (NAS) and staff at NAS  assisted with determining who would sit on the roundtables. Generally,  roundtable members were chosen for their expertise on bankruptcy and  financial institutions and markets. We also discussed potential experts for  our roundtables with the relevant government agencies listed previously.  Specifically, we relied on a list of experts compiled for the first report  under this mandate. These experts represented a wide range of interests  including academics, industry representatives, judges, and practicing  attorneys. The experts had made proposals, written extensively on  bankruptcies or financial institutions, or were recommended by relevant  government agencies. In addition, relevant government agencies and  NAS suggested additional potential participants for our roundtables,  whom we considered using our original criteria and the balance of the  experts at the roundtables. Final participants for the roundtables were  chosen for their expertise and to ensure that a number of interested  parties were included. These included academics, industry  representatives, judges, practicing attorneys, and regulators. To ensure  that participants represented a broad range of views and interests and  that we fully understood those interests, we required that participants  complete a conflict of interest form. See appendix II for a list of  participants in each roundtable, as well as background materials and  agendas.
Participants at the first roundtable held on April 1, 2013, discussed the  role of regulators in the bankruptcy process for financial companies and  how those bankruptcies might be financed. The proposals discussed  were:  1.  Require the debtor to notify and consult with regulators (primary,  functional, Financial Stability Oversight Council, foreign, or other) in  advance of filing for bankruptcy.  2.  Allow regulators (primary, functional, Financial Stability Oversight  Council, foreign, or other) to commence an involuntary bankruptcy in  the event that the firm is insolvent or in imminent danger of becoming  insolvent.  3.  Allow regulators (primary, functional, Financial Stability Oversight  Council, foreign, or other) of the debtor or its subsidiaries to have  standing or a right to be heard in the courts to raise issues relative to  regulation.  4.  Consider the role of regulators (primary, functional, Financial Stability  Oversight Council, foreign, or other) in determining what subsidiaries  should be included in a bankruptcy proceeding, the extent to which  complex firms might be consolidated in bankruptcy, including the  possibility of revoking the exclusion from bankruptcy for insurance  companies and the exclusion from Chapter 11 for stock and  commodities brokers.  5.  Restrict U.S. Treasury and Federal Reserve from participating in  bankruptcy financing.  6.  Allow the government to provide subordinated debtor-in-possession  financing to companies with assets greater than $100 million  (subsidiaries included) with a hearing and the court’s approval and  oversight.
Similarly, participants in the second roundtable, held on April 10, 2013,  discussed proposals to change the safe-harbor treatment of certain  financial contracts such as derivatives and repurchase agreements. The  proposals discussed during this roundtable were:  1.  Removing all safe harbors for qualified financial contracts.  2.  Partially rolling back safe harbors on specific contracts; such as  a.  allowing only contracts traded on an exchange to have safe- b.  limiting collateral sales of repos by counterparties to cash-like or  highly marketable securities; or  c.  allowing roll backs with approval of the Financial Stability  Oversight Council or the courts.  3.  Implementing a temporary stay for all or certain contracts.  4.  Exercising certain “reach back” avoiding powers for qualified financial  contracts.
In both cases participants discussed the advantages and disadvantages  of the proposals relative to our criteria for orderly and effective  bankruptcies. In addition they discussed impediments to implementing  proposals and how these impediments could be addressed. The agendas  for the roundtables are included in appendix II. To meet our objectives,  we also interviewed some experts that were not able or did not choose to  participate in the roundtables on their views about the proposals.
We used regulatory data to provide context for some expert statements.  For expert statements on the growth of large financial institutions since  the 2007-2009 financial crisis, we used data from the Federal Reserve  and SEC to provide measures of the growth of global systemically  important banks from 2007 to 2012. For expert statements about the  growth of markets for repurchase agreements and derivatives related to  changes in the Code in 2005, we used data from FSOC’s 2013 Annual  Report, which is signed by the principals of 9 federal agencies and the  independent member with insurance expertise, and the Bank for  International Settlements to provide measures of the growth of  repurchase agreements and derivatives from 2000 to 2012.
We conducted this performance audit from October 2012 to July 2013 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 II: Experts, Background, and Agendas for Expert Roundtables
paragraphs: This appendix includes a list of the experts who participated in our  roundtables, background information that was provided to the experts  prior to the roundtables, and the agendas for the roundtables discussions.
subsections: section_title: Expert Participants
section_title: Appendix III: Safe-Harbor Treatment of Certain Financial Contracts under the Bankruptcy Code
subsections: section_title: Overview of Financial Derivatives
paragraphs: Financial derivatives derive their value from an underlying reference item  or items, such as equities, debt, exchange rates, and interest rates.  Parties involved in financial derivative transactions do not need to own or  invest in the underlying reference items, and often do not. These products  are agreements that shift risks from one party to another—each  commonly referred to as a counterparty. Such shifting of risks may allow  companies to offset other risks—hedging—or to take advantage of  expectations of obtaining an economic gain due to changes in the value  of the underlying reference items—speculation. Although some  transactions are bilateral in that they involve only two counterparties,  derivatives can be used to structure more complicated arrangements  involving multiple transactions and parties.
Financial derivatives are sold and traded on regulated exchanges or in  private, over-the-counter markets that allow highly customized  transactions specific to the needs of the counterparties. A master netting  agreement sets out the terms governing contractual actions between  counterparties with multiple derivative contracts. This agreement provides  for the net settlement of all contracts, as well as cash collateral, through a  single payment, in a single currency, in the event of default on or  termination of any one contract. Generally counterparties net payments to  each other under the contract, and, if a counterparty defaults, the  nondefaulting counterparty can immediately close-out open contracts by  netting one against the other. It can also receive payment under what is  called set off, which is the discharge of reciprocal or mutual obligations to  the extent of the smaller obligation. For example, a nondefaulting bank  can take funds from a defaulting party’s bank deposit held by the bank as  payment for what the bank is owed on a contract it has with the defaulting  party as long as the deposit existed prior to the default.
section_title: Contracts Qualified for Special Treatment under the Code
paragraphs: Financial derivatives receive special treatment under the Code and thus  are sometimes called qualified financial contracts (QFC). The Code  includes five categories commonly considered QFCs, which include  various types of derivatives. Contracts may fall into more than one  category. The Code includes specific definitions of the agreements and  transactions covered. In addition, to have protection under the Code, the  counterparty with the debtor also must meet specified definitions. The  types of derivatives qualifying for special treatment are generally  described as follows:  Securities contract. Securities contact is a broad term defining a  financial agreement between counterparties and may include  contracts for the purchase and sale of various financial products  such as a group or index of securities, mortgage loans, certificates  of deposit, and extensions of credit for settlement purposes.  Margin loans are one type of extension of credit through a  financial intermediary for the purchase, sale, carrying, or trading of  securities. Margin loans do not include other loans secured with  securities collateral. Securities contracts also include options to  purchase and sell securities, or other financial products. Options  give their holders the right, but not the obligation, to buy (call  option) or sell (put option) a specified amount of the underlying  reference item at a predetermined price (strike price) at or before  the end of the contract.
Commodities contract. In a commodities contract the  commodities buyer agrees to purchase from the commodities  seller a fixed quantity of a commodity at a fixed price on a fixed  date in the future. Commodities can consist of agricultural goods,  metals, and goods used for the production of energy such as  crude oil. For example, to hedge against the risk of rising oil  prices, oil refineries can enter a commodities contract to fix a price  today for a future supply shipment.
Forward contract. A “forward contract” is a contract for the  purchase, sale, or transfer of a commodity with a maturity date  more than 2 days after the contract is entered into. Under the  Code, a forward contract can include, but is not limited to, a lease,  swap, hedge transaction, deposit, or loan. As an example, a firm  may want to limit risk to fluctuations in service costs, such as  electricity prices. The firm may enter into a forward contract with  an electricity provider to obtain future service at a fixed rate.
Swap Agreement. A swap involves an ongoing exchange of one  or more assets, liabilities, or payments for a specified period.  Swaps include interest rate swaps, commodity-based swaps, and  broad-based credit default swaps. Security-based swaps include  single-name and narrow-based credit default swaps and equity- based swaps. As an example, interest rate swaps allow one party  to exchange a stream of variable-rate interest payments for a  stream of fixed-rate interest payments. These products help  market participants hedge their risks or stabilize their cash flows.  Alternatively, market participants may use these products to  benefit from an expected change in interest rates. A credit default  swap is generally a contract between two parties where the first  party promises to pay the second party if a third party experiences  a credit event such as failing to pay a debt. Credit default swaps  are contracts that act as a type of insurance, or a way to hedge  risks, against default or another type of credit event associated  with a security such as a corporate bond.
Repurchase agreements are also qualified to receive special treatment  under the Code and are thus considered to be a QFC. In a repurchase  agreement one party sells a security, or a portfolio of securities, to  another party and agrees to repurchase the security or portfolio on a  specified future date—often the next day—at a prearranged price. The  security, or portfolio of securities, serves as collateral for the transaction.  In a reverse repurchase agreement, a security is purchased with the  agreement to resell on a specified future date. Repurchase agreements  have been used to provide financial institutions with funding for  operations.
A bilateral repurchase agreement—a repurchase agreement solely  between two counterparties—can be viewed as two subtransactions  referred to as initiation and completion. A repurchase agreement is  similar to a loan secured by collateral. A firm will lend cash to a  counterparty at an interest rate in exchange for assets provided by the  counterparty as collateral. In a repurchase agreement, a cash provider  willing to invest cash will agree to purchase securities from a collateral  provider, or repurchase agreement dealer. Repurchase agreement  dealers are typically distinguished as the counterparty selling securities,  or providing collateral, at initiation. The market value of the securities  purchased will typically exceed the value of cash loaned to the dealer.  When a repurchase agreement matures, securities are sold back to the  collateral provider and cash plus interest are returned to the cash  provider. Collateral providers or dealers are generally large financial  institutions, such as subsidiaries within bank holding companies. Cash  providers are firms such as, but not limited to, other large financial  institutions, hedge funds, and money market funds. Under the Code, U.S.  Treasury debt securities, agency debt issues, mortgage-backed  securities, and other assets can be used as collateral in repurchase  agreement transactions.
section_title: Treatment of QFCs under the Code
paragraphs: For most of the debtor’s assets, the Code provides an automatic stay, or  freeze, when the bankruptcy petition is filed. That is, the filing generally  stops lawsuits, foreclosures, and most other collection activities against  the debtor allowing the debtor or a trustee time to eliminate or restructure  debts. For example, set-off of any debt owed to the debtor that arose  before the filing against any claim against the debtor is prohibited.  Additionally, in certain situations debtors may not terminate or modify an  executory contract at any time after the bankruptcy is filed solely because  of a provision in the contract that is conditioned on the insolvency or  financial condition of the debtor or the filing of bankruptcy or the  appointing of a trustee. However, the QFC’s described previously  receive safe-harbor treatment that generally exempts them from the  automatic stay. Instead, the contractual rights—to liquidate, accelerate, or  terminate—of nondefaulting counterparties conditioned on the insolvency  or financial condition of one of the counterparties or the filing of  bankruptcy or the appointing of a trustee, such as netting and setoff, are  activated. Counterparties with claims against the debtor’s property are  typically referred to as creditors.
Some contracts that are generally considered QFCs may not be eligible  for safe-harbor treatment or may be otherwise limited. For example:
Repurchase agreements, where the debtor is a stockbroker or  securities clearing agency, and securities contracts that are resolved  under the Securities Investor Protection Act of 1970 (SIPA) or any  statute administered by Securities and Exchange Commission  (SEC).
Certain commodity contracts involved in a commodity broker’s  liquidation under Chapter 7. For example, a commodity broker creditor  may not net or offset an obligation to a commodity broker debtor.
Repurchase agreements are treated differently from some other  contracts in that any excess of the market prices received on  liquidation over the amount of the stated repurchase agreement price  and all expenses in connection with the liquidation of the repurchase  agreement must be deemed property of the debtor’s estate, subject to  the available rights of setoff.
For master netting agreements, the right to terminate, liquidate, or  accelerate is only applicable to the extent it is permissible for each  type of QFC.
After entities exercise their rights of netting for individual QFCs and under  master netting agreements, some debtors still may be indebted to the  creditor. Generally, the creditors’ remaining claims will receive the same  treatment accorded other unsecured creditors.
The figures below illustrate the safe-harbor exemption from the automatic  stay in simplified, yet practical scenarios:  Figure 4 illustrates a bilateral contract, in which two counterparties are  able to net opposing obligations of a contract, or, stated otherwise, net  payments under a single master netting agreement. In this example,  under current market conditions of an existing QFC, Firm A owes $100 to  Firm B while Firm B owes $120 to Firm A. If Firm B files under the Code,  the QFC is not stayed due to the safe harbor and Firm A receives the net  proceeds of $20 ahead of Firm B’s other creditors. However, Firm A has  no guarantee of recouping the total value from the QFC due to other  factors, such as a change in market conditions. Without the safe harbors,  Firm A would not have been able to terminate the transaction and could  have been exposed to further market risk.
Figure 5 depicts the typical completion of a repurchase agreement  transaction along with the possibility that the creditor liquidates collateral  in certain situations. In the case of a repurchase agreement, if a dealer  files under the Code after the initiation but prior to completion, the cash  provider at initiation will be left with the collateral provided by the dealer.  Under the safe harbor, the cash provider has the option to terminate the  transaction with the insolvent dealer. As illustrated in figure 4, the cash  provider may terminate the transaction and sell the collateral in the open  market to a third party. Without the safe harbor, concerns have been  raised that a stay on the overnight repurchase agreement market could  result in adverse market impacts due to simultaneous sales of collateral.
QFCs are generally also exempt from avoidance or claw back provisions  under the Code. These provisions generally require that the trustee may  avoid, or take back, any payments made during the 90 days before the  filing of a bankruptcy petition if those payments are preferential or 2 years  before the filing of the petition if those payments are fraudulent. But, for  QFCs, a trustee may not recover certain transfers made by or to a swap  participant, repurchase agreement participant, commodity broker, forward  contract merchant, stockbroker, financial institution, financial participant,  or securities clearing agency in connection with securities contracts,  commodity contracts, forward contracts, repurchase agreements, or  swaps that were done before the bankruptcy filing. Also, a trustee may  not recover transfers made by or to a master netting agreement  participant or any individual contract covered by a master netting  agreement that was made before the bankruptcy filing. Since many  QFCs are short term, and likely to be agreed to well within the 90 day  window, these exemptions provide protection to many QFCs including  those under master netting agreements.
section_title: Appendix IV: Comments from the Department of the Treasury
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Debra Johnson (Assistant  Director), Nancy S. Barry, Rudy Chatlos, Risto Laboski, Marc Molino,  Barbara Roesmann, Jessica Sandler, and Jason Wildhagen made  significant contributions to this report. Other assistance was provided by  Janet Eackloff and Walter Vance.