Regulatory Reform 10 Years After the Financial Crisis: Systemic Risk Regulation of Non-Bank Financial Institutions
Released: 2018-04-12T00:00:00

T he prospect of a large financial institution's failure often presents policymakers with a stark choice. Regulators can "bailout" a distressed institution, risking taxpayer money and arguably creating incentives for management, shareholders, and creditors of similar institutions to take excessive risks. Alternatively, the government can allow the institution to fail, running the risk of financial destabilization. Before the 2007-2009 financial crisis, regulators relied on a variety of prudential regulations, federal deposit insurance, and the Federal Reserve's emergency lending power to limit the risk of commercial bank failures. Commercial banks are also subject to a special insolvency regime administered by the Federal Deposit Insurance Corporation (FDIC), in which the FDIC has robust authorities to rapidly resolve failed banks outside of the Bankruptcy Code.

However, many non-bank financial institutions fall outside the ambit of these regulations despite facing risks similar to those confronting commercial banks. Many commentators viewed the distress and failure of a number of these institutions during the 2007-2009 crisis as highlighting the inadequacy of existing prudential regulations for such firms, and of the Bankruptcy Code for resolving their failure. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) adopted two general solutions to these perceived problems. First, Title I of the Act created the Financial Stability Oversight Council (FSOC) and granted it the authority to designate systemically important non-bank financial companies for enhanced prudential regulation by the Federal Reserve. Second, Title II of Dodd-Frank established the Orderly Liquidation Authority (OLA), a special resolution regime outside of the Bankruptcy Code that can be invoked for systemically important financial institutions.

As discussed in more detail below, federal regulatory agencies have pursued a number of measures to implement Titles I and II of Dodd-Frank. And 10 years after the crisis, legal commentators continue to debate whether these provisions have improved the resiliency of the financial system. This report provides an overview of how regulatory agencies have implemented Dodd-Frank's systemic risk provisions concerning non-bank financial institutions, and the legal debates surrounding proposals to repeal or change those provisions. In order to provide necessary background, the first two sections of the report discuss the nature of the "too-big-to-fail" problem and the 2007-2009 financial crisis. The report then provides an overview of Titles I and II, their implementation by the relevant federal agencies, criticisms of those provisions and responses, and legislative proposals to change them. An Appendix to this report contains a glossary that defines certain key terms in the report.

The "Too-Big-To-Fail" Problem

When large, interconnected financial institutions become distressed, policymakers often face a choice between (1) a taxpayer-funded bailout, and (2) the destabilization of the financial system—a dilemma that commentators have labeled the "too-big-to-fail" (TBTF) problem. Two features of the financial system help explain the origin of the TBTF problem. First, banks and certain other financial institutions are almost always highly leveraged, meaning that their shareholder equity is a small fraction of their total assets, and that they accordingly fund their assets with large amounts of borrowing. Second, banks and certain other financial institutions often fund themselves with large amounts of short-term debt, while investing in longer-term loans and other illiquid assets—a practice called "maturity transformation." While commentators generally agree that maturity transformation is socially valuable, the process makes financial institutions vulnerable to liquidity "runs." That is, when a financial institution's short-term creditors become concerned about its solvency or liquidity, they have incentives to demand immediate conversion of their claims into cash, or to reduce their exposure in other ways that force the institution to sell its illiquid assets at significantly discounted prices.

A "run" on one financial institution can spread to other institutions that do business with it. Small banks typically hold deposit balances at larger banks, and large banks, securities firms, and insurance companies often face significant exposure to one another through their over-the-counter derivatives portfolios. Accordingly, troubles at one financial institution can spread to others, resulting in additional "runs" and a "contagious panic throughout the financial system that causes otherwise solvent financial institutions to become insolvent." This type of financial "contagion" can cause asset price implosions as institutions liquidate assets in order to meet creditor demands, further impairing their ability to lend and the ability of businesses to raise capital. Faced with a choice between bailouts and economic collapse, policymakers have generally opted for bailouts, arguably creating incentives for financial institutions to take excessive risks and grow larger than is socially optimal.

TBTF Financial Institutions During the 2007-2009 Financial Crisis

The 2007-2009 financial crisis highlighted the significance of the TBTF problem. During that time, the United States experienced what many commentators believe was the worst financial crisis since the Great Depression, triggering a severe recession. According to many observers, a principal cause of the crisis was the collapse of a bubble in the housing market that had developed in the early and mid-2000s. As this bubble popped over the course of 2007 and 2008, many financial institutions experienced large losses related to the real estate market.

In March 2008, Bear Stearns—the fifth largest American investment bank at the time—informed the Federal Reserve that it was unable to refinance its short-term debt as a result of a "run" by its short-term creditors. Believing that the bankruptcy of Bear Stearns raised "the potential for contagion to similarly situated firms," and the possibility of "serious[] disrupt[ions]" to the stability of financial markets, the Federal Reserve exercised its authority to lend to non-banks in "unusual and exigent circumstances" under Section 13(3) of the Federal Reserve Act. According to then-Chairman of the Federal Reserve Ben Bernanke, policymakers "were reasonably sure that [Bear Stearns's] unexpected bankruptcy filing would ignite ... panic." A bankruptcy proceeding, Bernanke explained, could seriously damage the money market funds that lent to Bear Stearns and other corporations, and "lock up the cash of many other creditors, potentially for years." Likewise, according to Bernanke, unwinding Bear Stearns's derivatives portfolio would have "prove[n] chaotic" because of its size and complexity. Moreover, a decision by JP Morgan, the "clearing bank" for Bear Stearns's repurchase agreements (repos), to liquidate collateral on behalf of Bear Stearns's creditors could drive securities prices down even further, "leading to a new wave of losses and write-downs" and possible "runs" on other investment banks.

Accordingly, on March 14, the Federal Reserve Bank of New York (New York Fed) extended a bridge loan of $12.9 billion to Bear Stearns as it worked to orchestrate a deal to save the investment bank. On March 17, the Federal Reserve shepherded an acquisition of Bear Stearns by JP Morgan. In order to facilitate the acquisition, the Federal Reserve again exercised its Section 13(3) authority, creating an entity called Maiden Lane LLC and lending it roughly $29 billion to purchase certain mortgage assets from Bear Stearns.

Although the Bear Stearns rescue temporarily calmed markets, similar troubles surfaced later in 2008 at Lehman Brothers (Lehman), the nation's fourth largest investment bank at the time. Over the weekend of September 12, the New York Fed attempted to coordinate a private-sector solution that would avert a Lehman bankruptcy. During these negotiations, regulators took the position that no government money would be committed to rescuing Lehman, unlike the case of Bear Stearns six months earlier.

The government's attempts to broker an acquisition of Lehman ultimately failed. Bank of America, one of the potential acquirers, purchased the also-troubled investment bank Merrill Lynch instead. British regulators of Barclays, another potential purchaser, refused to approve a proposed deal without a shareholder vote. Unable to secure government support or find a private buyer, Lehman declared bankruptcy on September 15, 2008.

Lehman's bankruptcy reverberated throughout financial markets. On September 15, the Dow Jones Industrial Average dropped more than 500 points, its worst single-day decline in seven years. Shares of Goldman Sachs and Morgan Stanley, two of the largest remaining investment banks, lost an eighth of their value. Lehman's bankruptcy also precipitated a "run" on money market funds. The Reserve Primary Fund, a large fund that had invested in Lehman's commercial paper, "broke the buck," meaning that its asset value per share fell below $1. Because money market investors had come to expect that fund shares would always be worth $1, the troubles at the Reserve Primary Fund precipitated a $300 billion "run" on other funds, threatening a key source of short-term financing for large and medium-sized companies.

Also in September 2008, American International Group (AIG)—the nation's largest insurance company at the time—came under heavy financial pressure. During the real estate boom, one of AIG's affiliates had accumulated significant exposure to the housing market by selling "credit default swaps" (CDSs) on mortgage bonds, which provided their purchasers with credit protection in the event that the bonds defaulted. On September 15, the day Lehman declared bankruptcy, AIG suffered a credit rating downgrade that required it to post margin on its CDS obligations. Later that day, AIG informed the New York Fed that it was unable to access the commercial paper market in order to meet the margin call. As it had done with Bear Stearns, the Federal Reserve invoked its Section 13(3) authority to rescue AIG, reasoning that an AIG bankruptcy would have devastating effects on the financial system. On September 16, the Federal Reserve announced that it would provide AIG with an $85 billion credit line in exchange for a 79.9 percent stake in the firm.

In the fall of 2008, troubles at other large institutions rocked financial markets. Fannie Mae and Freddie Mac—government-sponsored enterprises that purchased and guaranteed mortgage loans and securities—were placed into conservatorships. The FDIC took over Washington Mutual, the nation's third largest mortgage lender, and sold it to JP Morgan. Goldman Sachs and Morgan Stanley, the two largest remaining investment banks, converted to bank holding companies to assure themselves continued access to the Federal Reserve's "discount window," among other reasons. Numerous European financial institutions suffered "runs." In October 2008, President George W. Bush signed the Emergency Economic Stabilization Act. The Act established the Troubled Asset Relief Program (TARP), pursuant to which the federal government would eventually disburse over $400 billion in the form of investments in financial institutions and the automotive industry, among other things.

The troubles in the financial system also spilled over to the real economy. U.S. households lost an estimated 26 percent of their wealth ($17 trillion) between mid-2007 and early 2009. And between 2008 and December 2009, the economy lost an estimated 8.3 million jobs.

In response to the crisis, Congress passed and President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), legislation that some commentators characterized as "the most ambitious overhaul of financial regulation in generations." Among other things, Dodd-Frank reformed certain aspects of securities and derivatives markets, imposed a variety of requirements related to mortgage standards, and created a new federal agency tasked with consumer financial protection (the Consumer Financial Protection Bureau). Other portions of Dodd-Frank are specifically directed at the systemic risk created by TBTF financial institutions. In order to minimize the risks that large financial institutions like Lehman and AIG fail, Title I of Dodd-Frank establishes an enhanced prudential regulatory regime for certain large bank holding companies and non-bank financial companies. And in order to resolve systemically important financial institutions in the event that they nevertheless experience financial distress, Title II establishes a new resolution regime available for such institutions outside of the Bankruptcy Code. The remaining sections of this report discuss the legal issues raised by Titles I and II, their implementation by federal regulatory agencies, and proposals to reform them.

Title I: Enhanced Prudential Standards for Systemically Important Financial Institutions

Regulators have traditionally relied upon a variety of tools to minimize the risks of financial institution failures. In order to reduce the risk of insolvency, regulators have imposed capital requirements on commercial and investment banks. In order to reduce depositors' incentives to "run," regulators require all commercial banks to obtain minimum levels of deposit insurance from the Federal Deposit Insurance Corporation (FDIC). In order to address liquidity problems, the Federal Reserve has the authority to serve as a "lender of last resort" by making "discount window" loans to commercial banks. Moreover, the Federal Reserve can lend to non-banks in "unusual and exigent circumstances" pursuant to its authority under Section 13(3) of the Federal Reserve Act. However, as the 2007-2009 financial crisis arguably demonstrated, sometimes these measures have proven insufficient to prevent financial institution failures.

In response to these concerns, Title I of Dodd-Frank establishes an enhanced prudential regulatory regime for certain large financial institutions. Specifically, the Title I regime applies to (1) all bank holding companies with total consolidated assets of $50 billion or more, and (2) any non-bank financial companies that the Financial Stability Oversight Council (FSOC) designates as systemically important. Section 165 of Dodd-Frank directs the Federal Reserve to impose prudential standards on these institutions that "are more stringent than" those applicable to other bank holding companies and non-bank financial companies, and that "increase in stringency" based on certain statutorily-prescribed considerations. These enhanced standards include

1. risk-based capital requirements and leverage limits; 2. liquidity requirements; 3. overall risk management requirements; 4. a requirement that the relevant companies develop resolution plans (so-called "living wills") describing how they can be rapidly resolved in the event of material distress or failure; and 5. credit exposure reporting requirements.

Congress is currently considering whether to change the first basis for imposition of enhanced prudential regulations on financial institutions—the automatic $50 billion threshold for bank holding companies. That policy question is addressed in another recent Congressional Research Service report. This section of the report accordingly provides a legal overview of (1) FSOC's process for designating non-banks as systemically important and FSOC's designations to date, (2) criticisms of FSOC's designation process and responses, and (3) proposals to reform FSOC's designation process.

Designation of Non-Banks for Enhanced Prudential Regulation

Dodd-Frank Section 113 and FSOC Guidance

As discussed, during the 2007-2009 financial crisis, troubles at certain non-bank financial firms (such as Lehman and AIG) "contributed to a broad seizing up of financial markets and stress at other financial firms." Accordingly, in the aftermath of the crisis, the Obama Administration proposed creating a council to identify non-bank financial companies whose failure could pose a threat to financial stability and subjecting them to consolidated supervision by the Federal Reserve irrespective of their legal structure. Section 113 of Dodd-Frank implemented this recommendation, creating FSOC and granting it the authority to designate certain non-bank financial companies for enhanced supervision by the Federal Reserve.

Section 113 provides that FSOC may, by a vote of at least two-thirds of its voting members (which must include the Treasury Secretary in the majority), designate non-bank financial companies as systemically important under either of two standards :

1. when "material financial distress" at a non-bank financial company "could pose a threat to the financial stability of the United States," or 2. when the "nature, scope, size, scale, concentration, interconnectedness, or mix of the [non-bank financial company's] activities" could pose that same threat.

In making such a designation, FSOC must consider, among any other risk-related factors that FSOC deems appropriate, the following factors:

the company's leverage; the extent and nature of its off-balance-sheet exposures; the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies; the importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities; the extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse; the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company; the degree to which the company is already regulated by 1 or more primary financial regulatory agencies; the amount and nature of the financial assets of the company; the amount and types of the liabilities of the company, including the degree of reliance on short-term funding.

Dodd-Frank requires that FSOC provide a non-bank financial company with written notice of a proposed systemic risk designation, including an explanation for the basis of the proposed determination. A non-bank that receives a notice of a proposed determination has 30 days to request an opportunity for a written or oral hearing before FSOC to contest the proposed determination, and FSOC has 60 days after such hearing to notify the non-bank financial company of its final determination. Once that determination is made, the designated non-bank is subject to the enhanced prudential regulatory regime.

A designated company can then seek judicial review of FSOC's final determination within 30 days in either the U.S. district court for the judicial district in which its home office is located, or in the U.S. District Court for the District of Columbia. The court's review is limited to whether FSOC's determination was "arbitrary and capricious," a standard pursuant to which a court evaluates whether an agency:

has relied on factors which Congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation for its decision that runs counter to the evidence before the agency, or is so implausible that it cannot be ascribed to a difference in view of the product of agency expertise.

FSOC is required to annually re-evaluate systemic risk designations for non-bank financial companies and may rescind such designations upon a vote of two-thirds of its voting members that includes the Treasury Secretary.

In April 2012, FSOC issued guidance concerning the Title I designation process and standards for non-banks. In the guidance, FSOC organized the 10 statutory factors guiding systemic risk designations into six "categories" of considerations:

1. interconnectedness; 2. substitutability (i.e., the extent to which other firms could timely provide similar financial services at a similar price and quantity if a non-bank financial company withdrew from a particular market); 3. size; 4. leverage; 5. liquidity risk and maturity mismatch; and 6. existing regulatory scrutiny.

FSOC explained that the first three categories "seek to assess the potential for spillovers from [a] firm's distress," while the remaining three categories "seek to assess how vulnerable a company is to financial distress."

The guidance further provided that FSOC intends to assess how a non-bank's financial stress could be transmitted to other firms or markets through any of three "transmission channels":

1. exposure (i.e . , the extent to which creditors, counterparties, investors, or other market participants are exposed to the company); 2. asset liquidation (i.e., whether the company holds assets that, if liquidated quickly, would cause a fall in asset prices); and 3. critical function or service (i.e., whether the company provides a critical function or service that is relied upon by market participants and for which there are no ready substitutes).

The FSOC guidance also outlined a three-stage process for systemic risk designations. FSOC explained that during Stage 1, it will apply "a set of uniform quantitative metrics ... to a broad group" of non-bank financial companies in order to identify companies "for further evaluation." According to the guidance, during Stage 2, FSOC will apply "a wide range of quantitative and qualitative information" about the companies identified in Stage 1, and "begin the consultation process" with the company's "primary financial regulatory agencies or home country supervisors." After Stage 2 is completed, companies selected for additional review are notified that they are being considered for designation as systemically important. Finally, during Stage 3, FSOC will evaluate information collected from the company under consideration, in addition to information considered during Stages 1 and 2, and will decide whether to make a proposed determination that the company be subject to enhanced supervision.

Non-Bank Designations to Date

To date, FSOC has designated four non-bank financial companies for enhanced supervision: AIG, General Electric Capital Corporation (GE Capital), Prudential Financial (Prudential), and MetLife. However, FSOC later rescinded the designations of two of these entities—AIG and GE Capital—based on changed circumstances at those companies. Further, MetLife successfully challenged its designation by FSOC in federal district court, leaving Prudential as the only non-bank financial company subject to the enhanced prudential regulatory regime at the time of publication of this report. The following subsections of the report discuss the designations of each of these institutions as illustrations of how FSOC has implemented its designation authority.

AIG

FSOC designated AIG for enhanced supervision in July 2013. In designating AIG, FSOC explained that although a large number of the company's insurance products (such as life insurance and annuities) are intended to be long-term liabilities, many also contain "features that could make them vulnerable to rapid and early withdrawals by policyholders." FSOC further explained that if AIG were to encounter sufficiently severe stress, "funds from products allowing for early withdrawals might be withdrawn regardless of the size of associated surrender charges or tax penalties," forcing AIG to "liquidate a substantial portion of its large portfolio of relatively illiquid corporate and foreign bonds, as well as asset-backed securities." Such an asset liquidation could, in FSOC's view, have disruptive effects on financial markets and "cause financial contagion if the negative sentiment and uncertainty associated with material distress at AIG spread[] to other insurers." FSOC also concluded (1) that "[a] large number of corporate and financial entities have significant exposures to AIG," (2) that because AIG was the leading commercial insurance underwriter in the U.S., its exit from the marketplace "could reduce the availability and affordability of certain insurance products," and (3) that AIG's "highly complex" interstate and cross-border structure complicated its resolvability, further aggravating the effects that its financial distress could have on financial stability. AIG did not contest FSOC's designation.

After an annual re-evaluation required by Dodd-Frank, FSOC voted to rescind its designation of AIG in September 2017. In rescinding its designation, FSOC explained that AIG had reduced the amounts of its total debt, short-term debt, derivatives portfolio, securities lending, repos, and total assets. FSOC further indicated that additional analyses conducted for the purposes of its re-evaluation, "including additional consideration of the effects of incentives and disincentives for [AIG's] policyholders to surrender their life insurance policies and annuities," indicated "that there is not a significant risk that a forced asset liquidation by AIG would disrupt market functioning." FSOC also noted that AIG had sold certain businesses, "reduced its multi-jurisdictional operations, simplified its legal structure, and reduced its size and global footprint," making it "notably different from the company as it existed leading up to the financial crisis."

GE Capital

On the same day it designated AIG for enhanced supervision, FSOC similarly designated GE Capital, a savings-and-loan holding company and wholly owned subsidiary of the General Electric Company. In designating GE Capital, FSOC explained that the company was one of the largest financial holding companies in the United States and "a significant source of credit to the U.S. economy." FSOC further observed that large global banks and non-bank financial companies had significant exposure to GE Capital through their purchase of its commercial paper and long-term debt, and provision of backup lines of credit. Financial distress at GE Capital, FSOC reasoned, could trigger "runs" on money market funds that would in turn "impair the ability of financial and other firms to fund their operations." FSOC also concluded that GE Capital's interstate and cross-border structure, coupled with its intercompany funding and shared service agreements, complicated its resolvability. GE Capital did not contest FSOC's designation.

After an annual re-evaluation required by Dodd-Frank, FSOC rescinded its designation of GE Capital in June 2016, explaining that since its designation, GE Capital had "fundamentally changed its business ... [t]hrough a series of divestitures, a transformation of its funding model, and a corporate reorganization." Moreover, FSOC noted that since its designation, GE Capital had decreased its total assets by more than 50 percent, shifted away from short-term debt, and reduced its interconnectedness with large financial institutions. Finally, FSOC observed that as a result of divestitures and changes to its business, GE Capital no longer owned any U.S. depository institutions, nor did it provide financing to consumers or small business customers.

Prudential

Slightly less than two months after designating AIG and GE Capital, FSOC designated Prudential, a large financial services company and one of the largest U.S. insurers, for enhanced supervision. In designating Prudential, FSOC explained that "[c]orporations, banks, and pension plans have exposures to Prudential through retirement and pension products, corporate- and bank-owned life insurance, and other group insurance products." Moreover, FSOC reasoned that Prudential's capital market activities—specifically, its derivatives activities, use of credit lines from large banks, securities lending, and reverse repo portfolio—further "expand[ed] its connections to other financial firms and markets." As with AIG, FSOC reasoned that if Prudential faced pressure to rapidly liquidate its illiquid assets to meet withdrawals, securities markets could face significant disruptions, and other insurance companies could face "runs" of their own triggered by heightened uncertainty. FSOC also concluded that because of its multi-state and cross-border operations, and because there was "no precedent for the resolution of an insurance company the size and scale of Prudential," the company would likely be difficult to resolve in an orderly fashion. Prudential requested a hearing to contest FSOC's proposed determination, and FSOC made its final determination after reviewing Prudential's written submissions and holding an oral hearing.

As a result of FSOC's rescission of its designations of AIG and GE Capital, and a decision by the U.S. District Court for the District of Columbia overturning MetLife's designation (discussed in " MetLife " infra ), Prudential remains the only non-bank financial company designated for enhanced supervision as of the publication of this report. However, in February 2018, Prudential announced that FSOC was in the process of conducting its annual review of its designation, and that the company intended to make its case that it does not meet the statutory standards for designation.

MetLife

Over a year after its designation of Prudential, FSOC designated MetLife, another large insurance company, for enhanced supervision. MetLife's designation came after a lengthy engagement process that reportedly included 12 meetings between FSOC and the company's representatives, the submission of over 21,000 pages of materials to FSOC, and an oral hearing challenging FSOC's proposed determination. In designating MetLife, FSOC reasoned that MetLife's financial distress "could lead to an impairment of financial intermediation or financial market functioning that could be sufficiently severe to inflict significant damage on the economy." Specifically, FSOC reasoned that large financial intermediaries had significant exposure to MetLife because of its institutional products and capital market activities, such as funding agreements, guaranteed investment contracts, pension closeouts, and securities lending agreements. Moreover, as with AIG and Prudential, FSOC concluded that a large-scale forced liquidation of MetLife's assets could disrupt securities markets. FSOC also reasoned that MetLife's interstate and cross-border operations complicated its resolvability, further exacerbating the effects its distress might have on financial stability.

MetLife proceeded to challenge FSOC's decision before the U.S. District Court for the District of Columbia, which invalidated FSOC's determination in March 2016. In holding that FSOC's determination was "arbitrary and capricious," the court explained that by assessing only the potential impact of MetLife's financial distress, and not MetLife's vulnerability to financial distress, FSOC had violated its April 2012 guidance, which indicated that FSOC would consider both issues and divided its "categories" of analysis accordingly.

The court also concluded that FSOC had failed to abide by its April 2012 guidance—which provided that a non-bank financial company could threaten financial stability only "if there would be an impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy" —by failing to project " what the losses would be, which financial institutions would have to actively manage their balance sheets, or how the market would destabilize as a result" of MetLife's distress. Instead, the court observed, FSOC had only "summed gross potential market exposures" to MetLife in conducting its "transmission channel" analysis, without analyzing the extent to which MetLife's creditors were secured or other mitigating factors.

In arriving at this conclusion, the court acknowledged that counterparties' gross exposure to MetLife is relevant to the second statutory standard for designation—that a company's "nature, scope, size, scale, concentration, interconnectedness, or mix of ... activities" alone "could pose a threat to" financial stability. However, it interpreted FSOC's explanation for its designation as relying on only the first statutory standard, which allows for designation when "material financial distress" at a non-bank financial company "could pose a threat to the financial stability of the United States." Because FSOC's guidance had provided that this standard requires a finding that a firm's financial distress would impair financial market functioning to a degree sufficient to inflict significant damage on the broader economy, and FSOC had not adequately supported that finding, the court held that its determination was arbitrary and capricious.

Finally, the court held that FSOC's designation of MetLife was arbitrary and capricious because FSOC failed to consider the costs of its designation (which MetLife alleged ran in the "billions of dollars")—a consideration that it explained is "essential to reasoned rulemaking."

Although FSOC initially appealed the district court's decision to the U.S. Court of Appeals for the D.C. Circuit, it filed a motion to dismiss the appeal in January 2018, which the court granted, ending the case.

Criticisms of Title I and Responses

Title I and FSOC's process for designating non-banks as systemically important have attracted some criticism. Some commentators have criticized FSOC for failing to provide firms under consideration with meaningful, specific information about the criteria used in determining whether a firm is systemically important. Relatedly, some observers have questioned the rigor of FSOC's analysis of companies under consideration for designation. Others have raised concerns about the transparency of the designation process. Finally, some commentators have criticized FSOC for not considering the costs of designations in conducting its analyses—a criticism echoed in the district court's decision overturning FSOC's designation of MetLife.

In response, defenders of FSOC have argued that the "malleable standard[s]" FSOC applies in determining whether companies qualify as systemically important effectively deter companies from seeking out systemically risky activities. According to this line of argument, the adoption of precise mathematical formulas for distinguishing between safe and risky companies would encourage companies to seek out activities with risks that are not adequately reflected in such rigid standards. These commentators contend that vesting FSOC with "broad discretion" to designate firms as systemically important is appropriate given the inherent difficulty of identifying systemic risks and the perils of failing to identify such risks. Moreover, in responding to arguments that it should consider the costs of designations, FSOC has argued that because Dodd-Frank's statutory text does not require such analysis, it need not engage in that inquiry.

Proposals to Alter Title I

Proposed Legislation

A number of bills that would alter FSOC's authority to designate non-banks for enhanced regulation have been introduced in the 115 th Congress. The Financial CHOICE Act of 2017, as passed by the House of Representatives in June 2017, would repeal FSOC's authority to designate non-banks for enhanced regulation altogether. H.R. 4061 , the Financial Stability Oversight Council Improvement Act of 2017, which was reported out of the House Committee on Financial Services in March 2018, proposes more limited changes to FSOC's authority. Specifically, H.R. 4061 would require FSOC to consider "the appropriateness of the imposition of prudential standards as opposed to other forms of regulation to mitigate the identified risks" in determining whether to designate a non-bank as systemically important. The bill would further require that FSOC provide designated companies with the opportunity to submit written materials contesting their designation during FSOC's annual reevaluation process. If FSOC determines during a re-evaluation that a designation should not be rescinded, the bill would require it to provide notice to the designated company "address[ing] with specificity" how it assessed the relevant statutory factors in light of the company's written submissions.

The Trump Administration's Views

In November 2017, the Trump Administration's Treasury Department released a report outlining four general recommendations for reforming FSOC's process for designating non-banks as systemically important. First, the report recommended that FSOC adopt an "activities-based" or "industry-wide" approach to assessing potential risks posed by non-banks. Under this approach, FSOC would prioritize identifying specific financial activities and products that could pose risks to financial stability, work with the primary financial regulatory agencies to address those specific risks, and consider individual firms for designation as systemically important only as a matter of last resort if more limited actions aimed at mitigating discrete risks are insufficient to safeguard financial stability.

Second, the Treasury Department recommended that FSOC "increas[e] the analytical rigor" of its designation analyses. Specifically, the Report recommended that FSOC: (1) consider any factors that might mitigate the exposure of a firm's creditors and counterparties to its financial distress; (2) focus on "plausible" (and not merely "possible") asset liquidation risks; (3) evaluate the likelihood that a firm will experience financial distress before evaluating how that distress could be transmitted to other firms; (4) consider the benefits and costs of designations; and (5) collapse its three-stage review process into two steps, notifying companies that they are under active review during Stage 1 and voting on proposed designations after the completion of Stage 2.

Third, the Treasury Department recommended enhancing engagement between FSOC and companies under review, and improving the designation process's transparency. Specifically, the report recommended that FSOC: (1) engage earlier with companies under review and "explain ... the key risks" that FSOC has identified, (2) "undertake greater engagement" with companies' primary financial regulators, and (3) publicly release explanations of its designation decisions.

Fourth, the Treasury Department recommended that FSOC provide "a clear off-ramp" for non-banks designated as systemically important. The report recommended that FSOC: (1) highlight the key risks that led to a company's designation, (2) "adopt a more robust and transparent process for its annual reevaluations" that "make[s] clear how companies can engage with FSOC ... and what information companies should submit during a reevaluation," (3) "develop a process to enable a designated company to discuss potential changes it could make to address the risks it could pose to financial stability," and (4) "make clear that the standard it applies in its annual reevaluations is the same as the standard for an initial designation of a nonbank financial company." FSOC has yet to act on these recommendations.

Title II: Orderly Liquidation Authority

While Title I of Dodd-Frank is aimed at minimizing the likelihood that systemically important financial institutions experience financial distress, Title II is directed at resolving such institutions in a rapid and orderly fashion in the event that they nevertheless become distressed. To accomplish this goal, Title II establishes a new resolution regime available for systemically important financial institutions outside of the Bankruptcy Code. The following sections of the report discuss Title II and proposals for its reform. First, the report provides an overview of the resolution mechanisms available for financial institutions before Dodd-Frank. Second, the report discusses Title II's legislative history and the new resolution authority that it establishes. Third, the report canvasses a variety of administrative rules with important implications for Title II. Fourth, the report discusses certain criticisms of Title II, and responses to those criticisms. Finally, the report discusses proposals to repeal or change Title II.

Pre-Dodd-Frank Resolution Mechanisms: Bankruptcy vs. FDIC Resolution

Commercial banks, broker-dealers, and insurance companies are subject to different insolvency regimes. Commercial banks must utilize a special resolution regime administered by the FDIC. Before Dodd-Frank, broker-dealers and bank holding companies were limited to the Bankruptcy Code. Finally, before Dodd-Frank, insurance companies were limited to state law insolvency proceedings.

The purpose and mechanics of bankruptcy and the FDIC's resolution regime differ in important respects. A non-bank corporation may generally file a voluntary bankruptcy petition with the clerk of a federal bankruptcy court, or the company's creditors can file a petition for involuntary bankruptcy if certain conditions are met. By contrast, a bank's chartering agency, primary federal regulator, or the FDIC initiates the bank resolution process based upon one or more statutorily-established grounds, including a bank's undercapitalization. Accordingly, a bank need not have defaulted on any outstanding obligations or be deemed insolvent for an involuntary resolution to begin.

Corporate bankruptcies are usually resolved in special federal bankruptcy courts. In a Chapter 7 bankruptcy, a court appoints an agent such as a trustee to coordinate the insolvency process. In a bankruptcy reorganization, the insolvent corporation's management is generally allowed to continue operating the company and has exclusive rights to develop a reorganization plan for a period of 120 days after the petition is filed, which may be extended under certain circumstances. Many of the trustee or management's decisions—for example, to release collateral to secured creditors, pay employees, and obtain debtor-in-possession financing (i.e., financing used to keep the company operating as a going concern)—are subject to court approval. Moreover, any reorganization plan is subject to the unanimous agreement of a company's creditors unless the court determines that certain conditions are met. These and other decisions by the bankruptcy court are reviewable by higher courts.

By contrast, bank resolutions are handled in administrative proceedings conducted by the FDIC. When the FDIC commences administrative resolution proceedings, it generally removes a bank's senior management without notice or a hearing and assumes control of the bank. The FDIC unilaterally makes decisions related to the liquidation (pursuant to a receivership) or continued operation (pursuant to a conservatorship) of the failed bank. For FDIC resolutions of a commercial bank, there is no separate oversight authority analogous to the relationship between the bankruptcy court and trustee or management, and there is no mechanism for creditors, management, or shareholders to participate in the resolution process beyond filing claims and providing requested information. While some of the FDIC's decisions during this process are subject to judicial review, others—including decisions to disallow creditor claims that are not proved to the FDIC's satisfaction—are not reviewable.

Bankruptcy and FDIC resolution also differ with respect to how creditors can be temporarily prevented from pursuing their claims against an insolvent debtor. In bankruptcy, creditors are temporarily barred from pursuing many of their claims by an "automatic stay" that is effective upon the filing of a bankruptcy petition, and bankruptcy courts have the authority to impose certain additional stays to ensure an orderly reorganization. However, a variety of financial contracts—including certain securities and commodities contracts, swaps, forwards, and repos—are exempt from the Bankruptcy Code's automatic stay. Often, such contracts provide that certain rights—for example, to terminate the contract, net obligations, or liquidate collateral—are triggered by a party's entry into bankruptcy (direct default rights) or by the entry into bankruptcy of a party's parent or affiliate (cross-default rights). Because of the Bankruptcy Code's "safe harbor" provisions, such rights can be exercised immediately upon the filing of a bankruptcy petition, notwithstanding the automatic stay.

By contrast, while the FDIC lacks general power to stay enforcement of a failed bank's contracts, it has broad power to disaffirm or repudiate certain contracts if it determines that performance would be "burdensome," and that disaffirmance or repudiation would "promote the orderly administration of the institution's affairs." Moreover, counterparties to "qualified financial contracts" (QFCs)—a term defined to include certain securities or commodities contracts, swaps, forwards, and repos —with a bank in an FDIC resolution are barred from exercising direct default rights against the bank based on its entry into resolution proceedings for one business day. If the FDIC transfers a QFC to another party (as it often does when it sells a bank's assets to a healthy acquirer), default rights under the QFC are permanently stayed. Accordingly, banks enjoy greater protection against "runs" by their derivatives counterparties in an FDIC resolution than do non-bank corporations in bankruptcy.

Finally, bankruptcy and FDIC resolution differ with respect to the legal priority of creditors. The Bankruptcy Code provides a list of priorities specifying the order in which creditors are to be paid. During a Chapter 11 reorganization, the "absolute priority rule" bars the approval of a reorganization plan that awards property to a junior class of unsecured creditors while failing to compensate a dissenting class of senior creditors in full. A bankrupt firm can also obtain debtor-in-possession financing during a reorganization, which enjoys priority over certain pre-bankruptcy debts.

By contrast, if the FDIC is unable to find a healthy bank to purchase a failing bank in a "purchase and assumption" transaction (the most common method of resolving a failed bank), it generally liquidates the bank, paying off insured depositors and issuing receivership certificates to uninsured depositors and other general creditors. The FDIC pays uninsured depositors and general creditors according to a statutorily prescribed priority scheme. In paying these creditors, the FDIC is required to use the "least costly" resolution method—that is, the resolution method that minimizes expenditures from the deposit insurance fund. However, the FDIC can waive the least-cost resolution requirement if the Treasury Secretary (in consultation with the President and with the recommendation of the Federal Reserve) determines that adhering to that requirement "would have serious adverse effects on economic conditions or financial stability" and that alternative action "would avoid or mitigate such adverse effects." Although there is no external debtor-in-possession financing during an FDIC resolution, the FDIC can offer "open bank assistance" (OBA) to a troubled bank in the form of a loan, an assumption of some or all of its liabilities, a purchase of troubled assets, or a direct infusion of capital. However, OBA is "rarely used" because of the least-cost resolution requirement, among other reasons.

These differences between the Bankruptcy Code and FDIC resolution reflect the different priorities of their respective insolvency schemes. According to many commentators, corporate bankruptcy is principally focused on maximizing creditor recovery by preserving the "going-concern" value of a firm, or equitably distributing its assets in the event of a liquidation. Accordingly, the Bankruptcy Code gives a firm's creditors a prominent role in the insolvency process, allowing them to vote on proposed reorganization plans if their interests are impaired, and subjecting a trustee or management's decisions to judicial scrutiny.

Bank resolution, by contrast, arguably places greater emphasis on financial stability than does the Bankruptcy Code, making the speed of the resolution process especially important. Accordingly, authority over bank resolution is highly concentrated in one actor: the FDIC. With its considerable resolution powers, the FDIC is often able to seize a failed bank at the close of business on a Friday, sell many of its assets, and re-open many of its offices under the auspices of a healthy acquirer by the following Monday, minimizing negative effects on the financial system.

This dual-track insolvency system, with the FDIC in charge of resolving commercial banks and bankruptcy courts tasked with non-bank insolvencies, arguably functioned effectively for much of the 20 th century. However, many commentators have contended that the bankruptcy system is ill-suited for the resolution of large, complex financial institutions. Specifically, observers have noted that the dependence of such institutions on short-term, highly liquid funding leaves them susceptible to "runs"—a problem exacerbated by the Bankruptcy Code's "safe harbor" provisions for certain derivatives contracts. Moreover, commentators have argued that the complicated legal structures of large financial institutions make their resolution in bankruptcy difficult, because such institutions often (1) have regulated subsidiaries such as banks and insurance companies that are not themselves eligible for bankruptcy, and (2) operate their businesses without regard for the legal separateness of these entities. Others have argued that reorganizing a large financial institution in bankruptcy (or continuing its subsidiaries' operations on a temporary basis until a buyer can be found) would be extraordinarily difficult, because such an institution would likely require billions of dollars of debtor-in-possession financing—a sum that "[p]rivate lending markets are not capable of providing" to a bankrupt firm, especially in a period of financial distress. According to these observers, the 2007-2009 financial crisis highlighted these problems with the Bankruptcy Code, and the need to develop alternative resolution mechanisms for financial institutions not subject to the FDIC's supervision.

Dodd-Frank and the Orderly Liquidation Authority

Legislative History

In March 2009, the Treasury Department released a legislative proposal for a new resolution authority "to address systemically significant financial institutions that fall outside of the existing resolution regime under the FDIC." The Treasury Department argued that the financial crisis highlighted the inadequacy of the existing resolution options for large non-bank financial institutions. According to the Obama Administration's Treasury Department, policymakers during the crisis were forced to choose between two untenable options for such institutions: (1) securing outside capital or committing government funds to rescue a TBTF institution (as in the case of AIG), or (2) a destabilizing bankruptcy (as in the case of Lehman).

The Obama Administration accordingly proposed supplementing these options with a resolution regime "modeled on the statutory framework that governs the FDIC's exercise of emergency resolution and other authority with respect to banks." Instead of "subjecting a firm to bankruptcy" or "injecting taxpayers' funds with no real control," the Treasury Department's proposed legislation would enable the federal government to put a firm into a conservatorship or receivership managed by the FDIC, which could sell or transfer the firm's assets and liabilities, renegotiate or repudiate its contracts, and address its derivatives portfolio. The proposed legislation would also allow the FDIC to make loans to a financial institution placed into conservatorship or receivership, purchase the institution's obligations or assets, assume or guarantee the institution's liabilities, or purchase an equity interest in the institution.

The Obama Administration's proposal provided that the Board of Governors of the Federal Reserve and the Board of the FDIC, by two-thirds votes, were to provide the Treasury Secretary with a "recommendation" concerning actions that should be taken with respect to a troubled financial company, and that the Treasury Secretary make certain findings before commencing the conservatorship or receivership. The Administration's proposal allowed a seized firm to file suit requesting that the conservatorship or receivership be set aside within thirty days. The proposal did not restrict the issues that the reviewing court could consider or impose a time limit on the court's review.

In December 2009, the House of Representatives passed a version of the new resolution regime based on the Treasury Department's proposal. Like the Treasury Department's proposal, the House bill provided for the appointment of a receiver after (1) two-thirds votes by the Board of Governors of the Federal Reserve and the Board of the FDIC, and (2) the Treasury Secretary made certain determinations. The House bill also provided for a thirty-day period within which a seized firm could seek judicial review. However, unlike the Treasury Department's proposal, the House bill did not grant the FDIC the authority to provide equity financing to companies during the resolution process. Also in contrast to Treasury's proposal, the House bill required that any debt funding the government provided to a seized company be repaid from ex ante assessments on certain large financial institutions.

A Senate bill introduced in April 2010 built on these proposals, but envisioned a slightly different process for appointing a receiver for non-bank financial institutions. The initial Senate bill required that a panel of three bankruptcy judges from the Bankruptcy Court for the District of Delaware approve the Treasury Secretary's decision to appoint a receiver for a troubled company. However, this panel of bankruptcy judges would consider only one of the Treasury Secretary's various findings: that the relevant firm is in default or in danger of default. The Senate bill also imposed a variety of secrecy requirements related to resolution proceedings. The bill provided that (1) the Treasury Secretary's petition to the bankruptcy panel would be filed under seal, (2) proceedings before the panel would be held "[o]n a strictly confidential basis," and (3) criminal penalties would be imposed on persons who disclosed information about the proceedings. The panel would be required to rule within 24 hours of receiving the petition.

After the initial Senate bill was introduced, Senator Christopher Dodd proposed a series of amendments. Among other things, the amendments provided that the Treasury Secretary would petition the U.S. District Court for the District of Columbia instead of a panel of bankruptcy judges for the appointment of a receiver. The amendments further provided that the district court would review two of the Treasury Secretary's determinations: (1) that the firm to be placed into receivership satisfied the statutory definition of a "financial company," and (2) that the firm is in default or in danger of default. The Senate passed the revised bill on May 20, 2010.

A Conference Committee resolved the differences between the House and Senate bills. Among other things, the Conference Committee report adopted an ex post assessment process on large financial institutions to repay any government funding providing during the resolution process, in place of the ex ante assessment in the House bill. The House and Senate passed the Conference Committee report in late June and mid-July 2010, respectively, and President Obama signed Dodd-Frank on July 21, 2010.

Title II and the Orderly Liquidation Authority

These various legislative proceedings culminated in Title II of Dodd-Frank, which creates an "Orderly Liquidation Authority" (OLA) pursuant to which the FDIC can serve as the receiver for "failing financial companies that pose a significant risk to the financial stability of the United States." Title II can be invoked only for "covered financial companies" and "covered brokers and dealers." Title II defines a "covered financial company" as a "financial company" that is not an insured depository institution, and for which a "systemic risk determination" has been made. Title II defines a "covered broker or dealer" as a broker or dealer that is registered with the Securities and Exchange Commission (SEC) and is a member of the Securities Investor Protection Corporation.

The Decision to Invoke Title II

Under Title II, certain designated federal regulators may recommend to the Treasury Secretary the appointment of the FDIC as receiver of a financial company. The Federal Reserve and the SEC will make the recommendation if the company or its largest subsidiary is a broker or dealer. The Federal Reserve and the Director of the Federal Insurance Office will make the recommendation if the company is an insurance company. The Federal Reserve and the FDIC will make the recommendation in all other cases. Such a recommendation requires a vote of at least two-thirds of the members of the Board of Governors of the Federal Reserve, and (1) at least two-thirds of the SEC members then serving (in the case of a broker or dealer), (2) the Director of the Federal Insurance Office (in the case of an insurance company), or (3) two-thirds of the members of the FDIC's Board of Directors (in all other cases). Any such recommendation shall contain

1. an evaluation of whether the financial company is in default or danger of default; 2. a description of the effect that the default of the financial company would have on financial stability in the United States; 3. a description of the effect that the default of the financial company would have on economic conditions or financial stability for low income, minority, or underserved communities; 4. a recommendation regarding the nature and the extent of actions to be taken regarding the financial company; 5. an evaluation of the likelihood of a private sector alternative to prevent the default of the financial company; 6. an evaluation of why a case under the Bankruptcy Code is not appropriate for the financial company; 7. an evaluation of the effects on creditors, counterparties, and shareholders of the financial company and other market participants; and 8. an evaluation of whether the company satisfies the definition of a "financial company."

Upon a written recommendation, the Treasury Secretary shall seek appointment of the FDIC as receiver of the financial company if (in consultation with the President) he makes a "systemic risk determination"—that is, if he makes the following seven determinations:

1. the financial company is in default or in danger of default; 2. the failure of the financial company and its resolution under otherwise applicable federal or state law would have serious adverse effects on financial stability in the United States; 3. no viable private sector alternative is available to prevent the default of the financial company; 4. any effect on the claims or interests of creditors, counterparties, and shareholders of the financial company and other market participants as a result of actions to be taken under the relevant subchapter is appropriate, given the impact that any such action would have on financial stability in the United States; 5. the relevant action would avoid or mitigate such adverse effects, taking into consideration the effectiveness of the action in mitigating potential adverse effects on the financial system, the cost to the general fund of the Treasury Department, and the potential to increase excessive risk taking on the part of creditors, counterparties, and shareholders in the financial company; 6. a federal regulatory agency has ordered the financial company to convert all of its convertible debt instruments that are subject to the regulatory order; and 7. the company satisfies the definition of a "financial company."

Upon making a "systemic risk determination," the Treasury Secretary must notify the financial company and the FDIC. If the company's board of directors consents to the appointment of the FDIC as receiver, the Treasury Secretary must appoint the FDIC as receiver. If the company's board of directors does not consent to the appointment, the Treasury Secretary can petition the U.S. District Court for the District of Columbia for an order authorizing the appointment. The court must then hold a "strictly confidential" hearing at which it reviews (under the "arbitrary and capricious" standard) two of the Treasury Secretary's determinations: (1) the company is in default or in danger of default, and (2) the company is a "financial company."

If the court determines that these determinations are not arbitrary and capricious, it must issue an order immediately authorizing the Treasury Secretary to appoint the FDIC as receiver of the financial company. If the court does not make a determination within 24 hours after receiving the petition, the petition is deemed granted by operation of law. The court's determination is "final," and "not ... subject to any stay or injunction pending appeal." Moreover, any appeal of the district court's decision must be considered "on an expedited basis." Title II also imposes criminal penalties on persons who "recklessly disclose[]" a systemic risk determination by the Treasury Secretary or the pendency of court proceedings related to such a determination.

The FDIC's Powers as Receiver

Upon its appointment as receiver, the FDIC succeeds to all rights, titles, powers, and privileges of the company and its assets, and of any stockholder, member, officer or director. The FDIC may continue the company's business and "liquidate" and "wind-up" its affairs "in such manner as [it] deems appropriate." Pursuant to this authority, the FDIC may sell the company's assets, merge the company with another company, transfer its assets or liabilities to another company, or transfer the company's assets or liabilities to a newly created "bridge financial company."

The creation of a bridge company allows the FDIC to continue the troubled company's critical businesses on a temporary basis until it can find a buyer or liquidate the company. This new entity would "not be saddled with the shareholders, debt, senior executives or bad assets and operations that led to the failure of the covered financial company." QFCs transferred to a bridge company cannot be terminated simply because they are assumed by the bridge company. According to the FDIC, this provision "is an important tool to avoid market destabilization because, unlike the Bankruptcy Code, it can prevent the immediate and disorderly liquidation of collateral during a period of market distress."

Title II also specifies the priorities governing payment of unsecured claims, mandating that the costs of the receivership be paid first. Claims owed to the United States are paid second, followed by a rank-ordering of other categories of unsecured claims. However, Title II allows the FDIC to depart from this statutory priority list and make "additional payments" to "any claimant or category claimants" if it "determines that such payments ... are necessary or appropriate to minimize losses to the [FDIC]." Title II also requires that the FDIC treat all similarly situated creditors similarly, except when the FDIC determines that not doing so is necessary to (1) maximize the assets of the covered financial company, (2) continue operations that are "essential to implementation of the receivership," (3) maximize the present value return from the sale or other disposition of covered financial company's assets, or (4) minimize the amount of any loss realized upon the sale or other disposition of the covered financial company's assets. Despite granting these powers to the FDIC, Title II provides that "in no event" shall a creditor receive less than it would have received if the FDIC had not been appointed receiver and the company had instead been liquidated under Chapter 7 of the Bankruptcy Code.

As in bank resolutions, the FDIC has the authority to disallow any claims not proved to its satisfaction. A claimant may contest such determinations by filing suit in the federal district where the relevant financial company's principal place of business is located. Title II also provides that the FDIC may disaffirm or repudiate any contract or lease of a company in receivership if it determines that performance would be "burdensome" and that doing so "will promote the orderly administration of the affairs of the covered financial company." The FDIC may transfer its rights under a contract or lease to an acquirer of a financial company's assets, despite any contractual provisions excusing a counterparty from performance in the event of the financial company's insolvency, the appointment of a receiver, or similar circumstances. The FDIC also has the authority to sue to avoid fraudulent transfers, preferences, and improper setoffs, like a trustee in bankruptcy. Finally, Title II gives the FDIC the authority to "recover from any current or former senior executive or director substantially responsible for the failed condition of [a] covered financial company any compensation received during the 2-year period preceding" the FDIC's appointment as receiver.

Although Title II gives the FDIC broad powers to resolve troubled companies, it also imposes a number of mandatory conditions on its conduct as a receiver. Specifically, Title II provides that the FDIC shall

1. determine that any actions it takes as receiver are "necessary for purposes of the financial stability of the United States, and not for the purpose of preserving the covered financial company"; 2. "ensure that the shareholders of a covered financial company do not receive payment until after all other claims and the [Orderly Liquidation] Fund are fully paid"; 3. ensure that unsecured creditors bear losses in accordance with statutorily prescribed priorities; 4. "ensure that management responsible for the failed condition of the covered financial company is removed"; 5. "ensure that the members of the board of directors ... responsible for the failed condition of the covered financial company are removed"; and 6. not take an equity interest in or become a shareholder of any covered financial company.

Title II limits judicial review over the FDIC's actions as receiver. Specifically, Title II provides that except as otherwise provided, no court has jurisdiction over (1) claims for payment from or a determination of rights with respect to the assets of a company in receivership, or (2) any claim relating to acts or omissions of such companies or the FDIC as receiver. Moreover, except as otherwise provided, "no court may take any action to restrain or affect the exercise of powers or functions of the receiver," and "any remedy against the [FDIC] or receiver shall be limited to money damages."

Funding a Resolution Under Title II

Title II allows for the creation of an "Orderly Liquidation Fund" (OLF) funded with money the FDIC may borrow from the Treasury Department. The FDIC's borrowing cannot exceed 10 percent of a financial company's total consolidated assets during the first 30 days of a receivership, or 90 percent of total consolidated assets that are available for repayment thereafter. The FDIC can "in its discretion" and "as necessary and appropriate" make OLF funds "available to the receivership," including by making loans to the company in receivership or purchasing or guaranteeing its assets. However, the FDIC can use the OLF only after developing an orderly liquidation plan for a company in receivership "that is acceptable to" the Treasury Secretary.

Despite granting the FDIC the authority to make loans to a company in receivership from the OLF, Title II provides that taxpayers "shall bear no losses" from an OLA resolution. Any funds expended in the liquidation of a financial company must be "recovered from the disposition of assets of such financial company, or shall be the responsibility of the financial sector, through assessments." Any loans the FDIC makes to a company in receivership from the OLF enjoy priority over all other unsecured creditors. If a company's assets are insufficient to pay the sums borrowed from the Treasury Department within 60 months of their issuance, the FDIC must charge "one or more risk-based assessments" on any creditors that received "additional payments" from the FDIC pursuant to its authority to treat some creditors more favorably than similarly situated creditors. If those funds are also inadequate to satisfy the FDIC's obligations to the Treasury Secretary, the FDIC must impose additional assessments on "eligible financial companies" and financial companies with total consolidated assets equal to or greater than $50 billion.

Title II's Treatment of QFCs

Title II contains a number of provisions addressing QFCs, which are defined to encompass "any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement, and any similar agreement that the [FDIC] determines by regulation, resolution, or order to be a [QFC] for purposes of this paragraph." As in FDIC bank resolutions, Title II stays the exercise of any direct default rights under a QFC—that is, rights against the institution in receivership triggered by the institution's placement into receivership—for one business day. If the FDIC transfers a QFC to a third party, including a bridge financial company, Title II permanently stays the exercise of direct default rights. Moreover, unlike the rules governing FDIC resolutions, Title II addresses cross-default rights under QFCs using a similar procedure. Specifically, Title II empowers the FDIC to "enforce contracts of subsidiaries or affiliates" of a company in receivership that are guaranteed or otherwise support by or linked to the company, notwithstanding any cross-default rights. If a QFC is supported by a guarantee or otherwise supported by a company in receivership, the FDIC must take certain steps to protect the QFC counterparty's interests by the end of the business day following the company's entry into receivership.

Administrative Rules

The OLA has never been used. However, federal agencies have promulgated a number of rules that affect Title II in important ways. Section 209 of Dodd-Frank directs the FDIC, in consultation with FSOC, to "prescribe such rules or regulations as the [FDIC] considers necessary or appropriate to implement [Title II], including rules and regulations with respect to the rights, interests, and priorities of creditors, counterparties, security entitlement holders, or other persons with respect to any covered financial company." A number of other provisions also direct the FDIC to promulgate rules addressing specific issues under Title II. Moreover, other provisions in Dodd-Frank and federal statutes allow federal regulatory agencies to promulgate rules that have important implications for Title II. This subsection provides a general overview of some of the key administrative rules related to Title II.

Early FDIC Rules

In January 2011, the FDIC promulgated a rule addressing a variety of discrete topics. Among other things, the rule addressed the provisions in Title II that allow the FDIC as receiver to pay certain creditors more than similarly situated creditors if it makes certain findings related to maximizing recovery for the receivership. Responding to criticism that the relevant statutory provision permitted it to bailout favored creditors, the FDIC clarified that it will not use this authority to make such "additional payments" to creditors who hold certain unsecured senior debt with a term of more than 360 days or to holders of subordinated debt or shareholders. The FDIC explained that it will evaluate whether to make "additional payments" to holders of shorter-term debt "on a case-by-case basis" and that such payments will be "very rare." Possible examples of creditors who might receive such payments, the FDIC noted, include providers of "essential and necessary service[s]," and creditors with contract claims that are tied to performance bonds or other credit support needed for the company to continue other valuable contracts.

In July 2011, the FDIC promulgated another rule addressing a variety of issues. Among other things, the rule provided that for purposes of Title II's provision allowing the FDIC to recover compensation from executives and directors "substantially responsible" for the failure of a covered financial company, a person will be deemed "substantially responsible" if "he or she failed to conduct his or her responsibilities with the degree of skill and care of an ordinarily prudent person in a like position would exercise under similar circumstances." In establishing a negligence standard for recovery of executive or director compensation, the FDIC rejected proposals to adopt a stricter standard such as gross negligence. The FDIC's rule further provided that a senior executive or director will be presumed to be "substantially responsible" for the failure of a covered financial company in certain circumstances.

Single Point of Entry (SPOE) Resolution (FDIC Notice for Public Comment)

Arguably, the FDIC's most prominent refinement of its Title II authorities has involved its general strategy for resolving a financial company in receivership. In December 2013, the FDIC proposed for public comment a notice describing its "Single Point of Entry" (SPOE) strategy for implementing its Title II authority. As background, in the United States, large financial institutions are generally organized under a holding company structure, with a top-tier parent company and sometimes hundreds or even thousands of subsidiaries spanning different countries. Functions and business lines often are not aligned with the structures of individual subsidiaries, and funding is often allocated among subsidiaries as needed. Moreover, many holding companies own bank and non-bank subsidiaries that are subject to different insolvency regimes, complicating their orderly resolution.

Under its SPOE approach, the FDIC would be appointed as receiver of only the top-tier U.S. holding company of a troubled financial institution, and the institution's subsidiaries would remain open and continue operations. The FDIC would create a bridge financial company into which it would transfer the assets of the holding company. Certain liabilities of the holding company (principally, the company's long-term debt) would remain in the receivership, and losses would be allocated among the holding company's creditors according to the statutory priorities established under Title II. In exchange for their claims, the holding company's creditors would receive debt, equity, or contingent securities (such as warrants or options) in the newly established bridge company. As a result of this process, the bridge company would no longer be burdened by certain debts of the holding company, leaving it with a stronger balance sheet.

Under the SPOE approach, the FDIC would select new management for the bridge company, and the holding company's subsidiaries would continue operating, "allowing them to continue critical operations for the financial system and avoid the disruption that would otherwise accompany their closings." While the FDIC indicated that it "intends to maximize the use of private funding" in a Title II resolution, it noted that it could provide guarantees of new debt issued by the bridge company, or provide the bridge company with funding from the OLF in order to facilitate an orderly resolution.

In its December 2013 notice, the FDIC sought comment on a number of aspects of its SPOE strategy, including the level and types of capital and debt that large institutions should be required to maintain to optimize the SPOE resolution strategy, how the OLF should be used in a resolution, and the treatment of the foreign operations of a failed financial company under Title II. The comment period ended on January 13, 2014, and the FDIC has yet to promulgate a final rule concerning its SPOE strategy.

Total Loss-Absorbing Capacity (TLAC) and "Clean Holding Companies"

In December 2016, pursuant to its authority under Section 165 of Dodd-Frank to impose enhanced prudential standards on large bank holding companies, the Federal Reserve finalized a rule imposing "total loss-absorbing capacity" (TLAC) and "clean holding company" requirements on such companies —a rule that some commentators have described as "essential to the execution of the SPOE resolution strategy." Under the rule, bank holding companies of U.S. global systemically important banks (G-SIBs) and top-tier U.S. intermediate holding companies of foreign G-SIBs are required to maintain minimum levels of long-term debt and certain types of capital (which together represent a bank's TLAC). The "clean holding company" requirements prohibit the relevant holding companies from (1) issuing short-term debt to third parties (i.e., to entities other than their subsidiaries), (2) entering into QFCs with third parties, (3) having liabilities that are guaranteed by their subsidiaries or subject to contractual offset rights for their subsidiaries' creditors, or (4) issuing certain guarantees of their subsidiaries liabilities, if the liabilities provide default rights based on the resolution of the holding company.

The TLAC requirements supplement other regulatory capital requirements, which "are intended to ensure that a banking organization has sufficient capital to remain a going concern." Like other regulatory capital requirements, the TLAC rule is directed at strengthening the resiliency of large bank holding companies in the event that they experience financial distress. However, the TLAC requirements also have the additional goal of improving the resolvability of such companies in the event of distress or failure. The requirements attempt to accomplish this goal by requiring that large bank holding companies hold minimum levels of long-term debt, which can serve as the source of new capital in the event of financial distress. Specifically, unlike regulatory capital (which is likely to be significantly depleted as a result of financial distress) and short-term debt (which must be continually refinanced or "rolled over," and is susceptible to "runs" in the event of financial distress), long-term debt can serve as the source of new capital because it can be reduced in a resolution or bankruptcy proceeding, increasing the ratio of a firm's assets to its liabilities and thereby increasing its equity. Commentators have accordingly argued that because of the loss-absorbing capacity of long-term debt, the availability of TLAC at the holding company level "generate[s] market confidence to help avoid runs on deposits and other liabilities ... that could otherwise lead to financial contagion." Similarly, the "clean holding company" requirements have the potential to help facilitate the orderly resolution of a financial institution by simplifying the holdings of its top-level holding company.

QFCs

In 2017, the Federal Reserve, FDIC, and Office of the Comptroller of the Currency (OCC) finalized rules restricting the types of QFCs into which certain regulated banks and bank holding companies can enter. The rules were directed at plugging gaps in provisions of the Bankruptcy Code, FDIC receivership authority, and Title II involving default rights under QFCs.

As discussed above, the Bankruptcy Code generally subjects creditors to an automatic stay that prevents them from enforcing certain rights (for example, to terminate a contract, set-off obligations, or liquidate collateral) upon the filing of a bankruptcy petition. However, the Bankruptcy Code also provides a "safe harbor" that allows counterparties to a variety of financial contracts—including certain securities and commodities contracts, swaps, forwards, and repos—to exercise their rights against a debtor that are triggered by its entry into bankruptcy. Moreover, the Bankruptcy Code does not stay the exercise of cross-default rights (i.e., rights against a company triggered by the entry of a company's parent, subsidiary, or affiliate into bankruptcy). These "safe harbors" potentially exacerbate the risk of "runs" against a company or its affiliates triggered by bankruptcy proceedings.

By contrast, as noted above, in non-Title II bank resolutions under the Federal Deposit Insurance Act (FDIA), counterparties to QFCs—a term defined as encompassing many of the same financial contracts exempt from the Bankruptcy Code's automatic stay—are stayed from exercising direct default rights for one business day, and are permanently stayed from exercising such rights if the FDIC transfers QFCs to a third party. However, there is no similar stay applicable to cross-default rights. Accordingly, while derivatives counterparties are temporarily stayed from exercising default rights against a bank triggered by the bank's entry into a non-Title II FDIC resolution, they are not stayed from exercising default rights against a parent or affiliate of a bank triggered by the bank's entry into a non-Title II FDIC resolution. The absence of such a stay creates the possibility that a bank's entry into a non-Title II FDIC resolution could trigger "runs" on its parent holding company or its affiliates. Moreover, commentators have raised the possibility that foreign courts may not enforce the FDIA's stay-and-transfer provisions concerning direct default rights, disadvantaging domestic QFC counterparties relative to foreign QFC counterparties, and exacerbating the risk of "runs" against a bank's parent or affiliates.

Finally, in a Title II resolution, QFC counterparties are stayed from exercising direct default rights for one business day, and are permanently stayed from exercising such rights if the FDIC transfers a QFC to a third party (as in non-Title II FDIC resolutions). Moreover, the FDIC can "enforce contracts of subsidiaries or affiliates" of a company in receivership that are guaranteed or otherwise supported by or linked to the company, notwithstanding any cross-default rights. However, as with non-Title II FDIC resolutions, commentators have raised the possibility that foreign courts may not enforce Title II's stay-and-transfer provisions.

In promulgating its QFC rules, the Federal Reserve, FDIC, and OCC were concerned with plugging certain gaps the Bankruptcy Code, the FDIA, and Title II involving default rights under QFCs. Specifically, the agencies were concerned with scenarios in which the entry of one institution into bankruptcy, a non-Title II FDIC resolution, or a Title II resolution would prompt a "run" by its derivatives counterparties or by the derivatives counterparties of its parent, subsidiary, or affiliate. The QFC rules provide that certain institutions regulated by the agencies may enter into a QFC only if (1) the QFC includes terms explicitly providing that, in the event that the institution enters into a Title II proceeding or a non-Title II resolution, any default rights or transfer restrictions under the QFC are subject to the stay-and-transfer limitations imposed under the relevant insolvency scheme, and (2) the QFC does not allow counterparties to exercise cross-default rights against the institution.

The QFC rules accordingly require QFCs entered into by the relevant institutions to affirmatively opt into the stay-and-transfer provisions of the FDIA and Title II, thereby minimizing the risk that a QFC counterparty in a foreign court would successfully challenge stay-and-transfer actions taken by the FDIC. Moreover, the rule prohibits the relevant institutions from entering into QFCs that give counterparties cross-default rights against them, thereby minimizing the risk that the bankruptcy or resolution of the institutions' parents or affiliates will trigger "runs" against them.

Criticisms of Title II and Responses

Title II has attracted criticism and generated a number of alternative proposals concerning the resolution of large financial institutions. Some critics have argued that the broad powers that Title II grants the FDIC—both in determining whether to place a firm into receivership and in conducting a resolution—create uncertainty about creditors' rights, raising the cost of credit for financial institutions. Other commentators have contended that by granting the FDIC the authority to extend credit to companies in receivership, Title II effectively formalizes a practice of bailing out large financial institutions. Still others have criticized the imposition of ex post assessments on the financial industry to recoup OLF expenditures not recovered from a firm in receivership, arguing that "taxing" prudently operated firms for the benefit of mismanaged firms creates moral hazard and free-rider problems. Finally, some observers have raised constitutional concerns with Title II's (1) 24-hour period for judicial review of the FDIC's decision to place a firm into receivership, (2) limitation of judicial review to only two of the seven factors the Treasury Secretary must consider in making a systemic risk determination, (3) imposition of criminal penalties on persons who disclose information about a systemic risk determination or related judicial proceedings, and (4) allowance of compensation claw-backs from executives and directors determined to have been "substantially responsible" for the failure of a firm in receivership.

Defenders of Title II have rejected the argument that the OLA promotes moral hazard, noting that a Title II resolution would result in "the extinction of the firm's equity and the wholesale replacement of its board and management." Others have rejected arguments that Title II puts taxpayers at risk, noting that it requires that the FDIC be reimbursed in full for any OLF expenditures.

In responding to the argument that Title II grants the FDIC excessive discretion, commentators have argued that the level of discretion granted by Title II is "fundamentally the same" as that which the FDIC is granted in resolving failed commercial banks. Moreover, in reflecting on crisis management, former Treasury Secretary and President of the New York Fed Timothy Geithner has argued that a certain level of uncertainty regarding "how fast a government will escalate its support" and "how far that support will extend" is beneficial, "leav[ing] investors in and creditors of financial institutions with a healthy sense of fear" that "should lessen the harmful incentives that a strong backstop creates."

In responding to constitutional concerns regarding Title II's limitations on judicial review, one commentator has argued that "it is within Congress's power to set the standard for judicial review," analogizing the deferential standards imposed under Title II to those imposed by the Administrative Procedure Act. This commentator has argued that the 24-hour period for judicial review of a decision to invoke the OLA "is appropriate for the urgency of the issue," and that Title II accordingly provides for due process, if not "as much process as some might like."

Other commentators have focused on the shortcomings of bankruptcy in defending Title II. Some observers have argued that bankruptcy does not offer the speed or opportunity for coordination with foreign financial regulators required to resolve a large institution during a period of financial turmoil. Other defenders of Title II have argued that during times of financial distress, bankruptcy could function effectively for a large financial institution only with "massive government assistance" such as debtor-in-possession financing, effectively allowing the federal government "to call the shots in the bankruptcy," because "that is what [debtor-in-possession] lenders do." According to this view, an effective form of financial institution bankruptcy (in which the federal government could lend to troubled institutions in periods when private financing is likely to be unavailable) would end up replicating many of the features its proponents dislike about Title II.

Proposals to Alter Title II

Proposed Legislation

Legislation proposed in both the House of Representatives and the Senate has focused on amending the Bankruptcy Code to enhance its ability to resolve large financial institutions, either as a replacement for Title II or as a supplement to it.

During the post-crisis debate over financial reform, a bill introduced in the House ( H.R. 3310 , 111 th Cong.) proposed a new Chapter 14 to the Bankruptcy Code to address the resolution of large non-bank financial institutions. In the proposed Chapter 14, the Bankruptcy Code's "safe harbor" provisions for certain derivatives contracts would not have automatically applied. Instead, the bankruptcy court would make a specific determination upon a motion by the debtor whether the debtor should be subject to any or all of the special provisions of the Bankruptcy Code exempting derivatives and other financial contracts from the automatic stay. The bill would also have prohibited a trustee for an institution in Chapter 14 bankruptcy from obtaining credit "if the source of that credit either directly or indirectly is the United States."

Scholars at the Hoover Institution have also developed proposed amendments to the Bankruptcy Code directed at resolving large financial institutions. In 2010, Professor Thomas Jackson published a proposal to create a new chapter of the Bankruptcy Code in which exclusions for banks, insurance companies, and broker-dealers would not apply. Under the proposal, a financial institution's primary regulator could file an involuntary bankruptcy petition, and a bankruptcy case would be assigned by the Chief Judge of the relevant federal court of appeals to a member of a previously designated panel of special masters. Pursuant to Professor Jackson's proposal, QFCs secured by cash or "cash-like" collateral would enjoy the benefits of the Bankruptcy Code's "safe harbor," but all other QFCs would be subject to the automatic stay and other Bankruptcy Code provisions. The financial institution's regulator would be given special standing to raise motions and the right to file a plan of reorganization. Unlike H.R. 3310 (the bankruptcy bill introduced during debates over financial reform), the institution's regulator would be allowed to provide the bankrupt firm with debtor-in-possession financing subject to the Bankruptcy Code's traditional rules governing the priority of claims. Professor Jackson has released a number of revised versions of his proposal since 2010.

These proposals appear to have served as the basis for a series of legislative proposals to amend the Bankruptcy Code. In April 2017, the House of Representatives passed one of these bills, the Financial Institution Bankruptcy Act of 2017 (FIBA). FIBA creates a new subchapter V of Chapter 11 of the Bankruptcy Code for bank holding companies and financial institutions with over $50 billion in assets. Bankruptcy proceedings under subchapter V would be heard by one of 10 bankruptcy judges designated by the Chief Justice of the Supreme Court. While a case under the new subchapter V could be commenced only by a financial institution itself (and not involuntarily by a regulator), federal regulators could "appear and be heard on any issue in any case or proceeding" under subchapter V. As in the SPOE approach developed by the FDIC for Title II resolutions, a holding company entering subchapter V bankruptcy could transfer certain assets (primarily its equity in subsidiaries and derivatives) to a newly formed bridge company upon the court's determination that the transfer is "necessary to prevent serious adverse effects on financial stability," among other things. The Act also would impose a 48-hour automatic stay on the termination, acceleration, or modification of certain contracts, including QFCs of a financial institution or its affiliates.

The Financial CHOICE Act of 2017, which passed the House in June 2017, also proposes a number of changes to the Bankruptcy Code. The relevant CHOICE Act provisions largely track the reforms in FIBA concerning the creation of a new subchapter V; the appointment of a bankruptcy judge drawn from a panel designated by the Chief Justice of the Supreme Court; the commencement of a bankruptcy case; the transfer of property to a bridge company; and the automatic stay. However, unlike FIBA, the CHOICE Act would repeal Title II.

Other proposals to amend the Bankruptcy Code to deal with large financial institutions have been introduced in the Senate. S. 1840 , the Taxpayer Protection and Responsible Resolution Act (introduced in the 114 th Congress), differs from FIBA and the CHOICE Act as a formal matter by creating a separate Chapter 14 of the Bankruptcy Code as opposed to a new subchapter of Chapter 11. However, like FIBA and the CHOICE Act, S. 1840 would have provided that (1) a bankruptcy judge drawn from a panel of 10 judges designated by the Chief Justice would preside over proceedings under the new regime; (2) only a financial institution could commence bankruptcy proceedings, but federal regulators could appear and be heard in a bankruptcy case; (3) the court could approve the transfer of an institution's assets to a bridge company after making certain determinations; and (4) certain contractual rights against a debtor institution would be stayed for 48 hours. Like the CHOICE Act (but unlike FIBA), S. 1840 would have repealed Title II. Moreover, unlike FIBA and the CHOICE Act, S. 1840 would have explicitly prohibited the Federal Reserve from making advances to a financial corporation in bankruptcy or to a bridge company.

The Trump Administration's Views

The Trump Administration's Treasury Department has endorsed efforts to amend the Bankruptcy Code to deal with large financial institutions, and expressed support for reforming (but not repealing) Title II. In February 2018, the Treasury Department issued a report in which it recommended retaining Title II "as an emergency tool for use under only extraordinary circumstances," but proposed a number of reforms to address what it characterized as "serious defects" in its original design. The report "unequivocally" concluded that "bankruptcy should be the resolution method of first resort" for large financial institutions, while recommending "significant reforms to make bankruptcy a more effective option for financial firms."

In recommending changes to Title II, the Treasury Department proposed reforms aimed at (1) limiting the FDIC's discretion in managing a receivership, (2) protecting taxpayers against losses, and (3) strengthening judicial review of the decision to invoke Title II. Specifically, in order to limit the FDIC's discretion, the Treasury Department proposed (1) restricting the FDIC's ability to treat similarly situated creditors differently in a Title II resolution, (2) providing that a bankruptcy court (instead of the FDIC) adjudicate claims against a Title II receivership, (3) clarifying the circumstances in which a financial company is "in default or in danger of default" for purposes of invoking Title II, (3) repealing the tax-exempt status of a bridge company in a Title II receivership, and (4) confirming that the FDIC is committed to the SPOE strategy.

In order to protect taxpayers against losses, the Treasury Department proposed (1) limiting the duration of any advances from the OLF, (2) that loan guarantees be preferred over direct lending to companies in receivership, (3) that the FDIC lend to companies in receivership only on a secured basis, and (4) imposing any industry-wide assessments necessary to recoup OLF funds "as soon as reasonably possible."

In order to strengthen judicial review of the decision to invoke Title II, the Treasury Department recommended allowing a court to review all seven of the Treasury Secretary's required findings (as opposed to only two), and allowing for ex post judicial review after a receiver is appointed, without a statutory time limit for the court to issue a decision.

Appendix. Glossary