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

Letter

Background

There are two approaches for reorganizing or terminating a large financial company. Large financial companies may be reorganized or liquidated under a judicial bankruptcy process or resolved under special legal and regulatory resolution regimes that have been created to address insolvent financial entities such as insured depository institutions and insurance companies.

Bankruptcy Proceedings

Bankruptcy is a federal court procedure, the goal of which is to help individuals and businesses eliminate or restructure debts they cannot repay and help creditors receive some payment in an equitable manner. Generally the filing of a bankruptcy petition operates as an automatic stay; that is, it stops most lawsuits, foreclosures, and other collection activities against the debtor. Equitable treatment of creditors means all creditors with substantially similar claims are classified similarly and receive the same treatment. For example, a class of secured creditors— those with liens or other secured claims against the debtor’s property— will receive similar treatment as to their secured claims.

Business debtors may seek liquidation, governed primarily by Chapter 7 of the Code, or reorganization, governed by Chapter 11. Proceedings under Chapters 7 and 11 can be voluntary (initiated by the debtor) or involuntary (generally initiated by at least three creditors holding at least a certain minimum amount of claims against the debtor). In an involuntary proceeding, the debtor can defend against the proceeding, including presenting objections. The judge subsequently decides whether to grant the creditors’ request and permit the bankruptcy to proceed, dismiss the request, or enter any other appropriate order.

A Chapter 7 proceeding is a court-supervised procedure by which a trustee takes over the assets of the debtor’s estate subject to limited exemptions, reduces them to cash, and makes distributions to creditors, subject to the rights of secured creditors to the collateral securing their loans to the debtor. A reorganization proceeding under Chapter 11 allows debtors to continue some or all of their operations subject to court supervision as a way to satisfy creditor claims. The debtor typically remains in control of its assets, and is called a debtor-in-possession (DIP). Under certain circumstances, the court can direct the U.S. Trustee to appoint a Chapter 11 trustee to take over the affairs of the debtor. As shown in figure 1, a firm going through a Chapter 11 bankruptcy generally will pass through several stages. Among these are:

First-day motions. The most common first-day motions relate to the continued operation of the debtor’s business and involve matters such as requests to use cash collateral—liquid assets on which secured creditors have a lien or claim—and obtaining financing, if any.

Disclosure. The disclosure statement must include information on the debtor’s assets, liabilities, and business affairs sufficient to enable creditors to make informed judgments about how to vote on the debtor’s reorganization plan and must be approved by the bankruptcy court.

Plan of reorganization. A debtor has an exclusive right to file a plan of reorganization within the first 120 days of bankruptcy. The plan describes how the debtor intends to reorganize and treat its creditors. The plan divides claims against the debtor into separate classes and specifies the treatment each class will receive. The court may confirm the plan if, among other things, each class of allowed creditors has accepted the plan or the class is not impaired by the plan. If not all classes of impaired creditors vote to accept the plan, the court can still confirm the plan if it is shown that it is fair to all impaired creditors.

Reorganization. Possible outcomes, which can be used in combination, include (1) distribution under a plan of the proceeds of a pre-plan sale of the assets of the company (in whole or in part), sometimes called a section 363 sale. Section 363 of the Code permits sales that are free and clear of creditor claims of property of the estate; (2) liquidation of the company’s assets with approval of the court, through means other than a 363 sale; and (3) reorganization of the company, in which it emerges from bankruptcy with new contractual rights and obligations that replace or supersede those it had before filing for bankruptcy protection.

The debtor, creditors, trustee, or other interested parties may initiate adversary proceedings—in effect, a lawsuit within the bankruptcy case to preserve or recover money or property, to subordinate a claim of another creditor to their own claims, or for similar reasons. Furthermore, the The U.S. bankruptcy system involves multiple federal entities. Bankruptcy courts are located in 90 federal judicial districts; however, as we reported in 2011, the Southern District of New York and the District of Delaware adjudicate a majority of larger corporate or business bankruptcy cases. The Judicial Conference of the United States serves as the judiciary’s principal policymaking body and recommends national policies on all aspects of federal judicial administration. In addition, AOUSC serves as the central administrative support entity for the Judicial Conference and the federal courts, including bankruptcy courts. The Federal Judicial Center is the education and research agency for the federal courts and assists bankruptcy courts with reports and assessments relating to the administration and management of bankruptcy cases. Finally, the Department of Justice’s U.S. Trustee Program and the judiciary’s Bankruptcy Administrator Program oversee bankruptcy trustees and promote integrity and efficiency in the bankruptcy system by overseeing the administration of bankruptcy estates.

A preference action can be asserted for payments made to an insider within a year prior to the bankruptcy filing.

Financial Companies and the Bankruptcy Code

Large, complex financial companies that are eligible to file for bankruptcy generally file under Chapter 11 of the Code. Such companies operating in the United States engage in a range of financial services activities. Many are organized under both U.S. and foreign laws. The U.S. legal structure is frequently premised on a parent holding company owning regulated subsidiaries (such as depository institutions, insurance companies, broker-dealers, and commodity brokers) and nonregulated subsidiaries that engage in financial activities.

Certain financial institutions may not file as debtors under the Code and other entities face special restrictions in using the Code: Insured depository institutions. Under the Federal Deposit Insurance Act, FDIC serves as the conservator or receiver for insured depository institutions placed into conservatorship or receivership under applicable law.

Insurance companies. Insurers generally are subject to oversight by state insurance commissioners, who have the authority to place them into conservatorship, rehabilitation, or receivership.

Broker-dealers. Broker-dealers can be liquidated under the Securities Investor Protection Act (SIPA) or under a special subchapter of Chapter 7 of the Code. However, broker-dealers may not file for reorganization under Chapter 11.

Commodity brokers. Commodity brokers, which include futures commission merchants, foreign futures commission merchants, clearing organizations, and certain other entities in the derivatives industry, can only use a special subchapter of Chapter 7 for bankruptcy relief.

Current Role of Financial Regulators in Bankruptcy Proceedings

Regulators often play a role in financial company bankruptcies. With the exception of CFTC and SEC, the Code does not explicitly name federal financial regulators as a party of interest with a right to be heard before the court. In practice, regulators frequently appear before the court in financial company bankruptcies. For example, as receiver of failed insured depository institutions, FDIC’s role in bankruptcies of bank holding companies is typically limited to that of creditor. CFTC has the express right to be heard and raise any issues in a case under Chapter 7. SEC has the same rights in a case under Chapter 11. SEC may become involved in a bankruptcy particularly if there are issues related to disclosure or the issuance of new securities. SEC and CFTC are, in particular, involved in Chapter 7 bankruptcies of broker-dealers and commodity brokers. In the event of a broker-dealer liquidation, pursuant to SIPA the bankruptcy court retains jurisdiction over the case and a trustee, selected by the Securities Investor Protection Corporation (SIPC), typically administers the case. SEC may participate in any SIPA proceeding as a party.

The Code does not restrict the federal government from providing DIP financing to a firm in bankruptcy, and in certain cases it has provided such funding—for example, financing under the Troubled Asset Relief Program (TARP) in the bankruptcies of General Motors and Chrysler. The authority to make new financial commitments under TARP terminated on October 3, 2010. In July 2010, the Dodd-Frank Act amended section 13(3) of the Federal Reserve Act to prohibit the establishment of an emergency lending program or facility for the purpose of assisting a single and specific company to avoid bankruptcy. Nevertheless, the Federal Reserve may design emergency lending programs or facilities for the purpose of providing liquidity to the financial system.

Current Safe-Harbor Treatment for Financial Contracts under the Code

Although the automatic stay generally preserves assets and prevents creditors from taking company assets in payment of debts before a case is resolved and assets are systematically distributed, the stay is subject to exceptions, one of which can be particularly important in a financial institution bankruptcy. These exceptions—commonly referred to as the “safe harbor provisions”—pertain to certain financial and derivative contracts, often referred to as qualified financial contracts (QFC). The types of contracts eligible for the safe harbors are defined in the Code. They include derivative financial products, such as forward contracts and swap agreements that financial companies (and certain individuals and nonfinancial companies) use to hedge against losses from other transactions or speculate on the likelihood of future economic developments. Repurchase agreements, which are collateralized instruments that provide short-term financing for financial companies and others, also generally receive safe-harbor treatment.

Under the safe-harbor provisions, most counterparties that entered into a qualifying transaction with the debtor may exercise certain contractual rights even if doing so otherwise would violate the automatic stay. In the event of insolvency or the commencement of bankruptcy proceedings, the nondefaulting party in a QFC may liquidate, terminate, or accelerate the contract, and may offset (net) any termination value, payment amount, or other transfer obligation arising under the contract when the debtor files for bankruptcy. That is, generally nondefaulting counterparties subtract what they owe the bankrupt counterparty from what that counterparty owes them (netting), often across multiple contracts. If the result is positive, the nondefaulting counterparties can sell any collateral they are holding to offset what the bankrupt entity owes them. If that does not fully settle what they are owed, the nondefaulting counterparties are treated as unsecured creditors in any final liquidation or reorganization.

Orderly Liquidation Authority

OLA gives FDIC the authority, subject to certain constraints, to resolve large financial companies, including a bank holding company or a nonbank financial company designated for supervision by the Federal Reserve, outside of the bankruptcy process. This regulatory resolution authority allows for FDIC to be appointed receiver for a financial company if the Secretary of the Treasury, in consultation with the President, determines, upon the recommendation of two-thirds of the Board of Governors of the Federal Reserve and (depending on the nature of the financial firm) FDIC, SEC, or the Director of the Federal Insurance Office, among other things, that the firm’s failure and its resolution under applicable law, including bankruptcy, would have serious adverse effects on U.S. financial stability and no viable private-sector alternative is available to prevent the default. In December 2013, FDIC released for public comment a notice detailing a proposed single-point-of-entry (SPOE) approach to resolving a systemically important financial institution under OLA.

Under the SPOE approach, as outlined, FDIC would be appointed receiver of the top-tier U.S. parent holding company of a covered financial company determined to be in default or in danger of default pursuant to the appointment process set forth in the Dodd-Frank Act. Immediately after placing the parent holding company into receivership, FDIC would transfer assets (primarily the equity and investments in subsidiaries) from the receivership estate to a bridge financial company. By allowing FDIC to take control of the firm at the parent holding company level, this approach could allow subsidiaries (domestic and foreign) carrying out critical services to remain open and operating. In a SPOE resolution, at the parent holding company level, shareholders would be wiped out, and unsecured debt holders would have their claims written down to reflect any losses that shareholders cannot cover.

Challenges of Resolving Failing Cross Border Financial Companies

The resolution of globally active large financial firms is often associated with complex international, legal, and operational challenges. The resolution of failed financial companies is subject to different national frameworks. During the recent financial crisis, these structural challenges led to government rescues or disorderly liquidations of systemic firms.

Insolvency laws vary widely across countries. The legal authorities of some countries are not designed to resolve problems in financial groups operating through multiple legal entities that span borders. Some resolution authorities may not encourage cooperative solutions with foreign resolution authorities.

Regulatory and legal regimes may conflict. Depositor preference, wholesale funding arrangements, derivatives, and repurchase agreements are often treated differently among countries when a firm enters bankruptcy.

Some resolution authorities may lack the legal tools or authority to share information with relevant foreign authorities about the financial group as a whole or subsidiaries or branches.

Country resolution authorities may have as their first responsibility the protection of domestic financial stability and minimization of any risk to public funds. For instance, if foreign authorities did not have full confidence that national and local interests would be protected, the assets of affiliates or branches of a U.S.-based financial institution chartered in other countries could be ring fenced or isolated and wound down separately under the insolvency laws of other countries thus complicating home-country resolution efforts.

Chapter 15 of the Bankruptcy Code Governs Judicial Cross-Border Coordination in Limited Circumstances

In 2005, the United States adopted Chapter 15 of the U.S. Bankruptcy Code. Chapter 15 is based on the Model Law on Cross-Border Insolvency of the United Nations Commission on International Trade Law (UNCITRAL). The model law is intended to promote coordination between courts in different countries during insolvencies and has been adopted in 21 jurisdictions. More than 450 Chapter 15 cases have been filed since its adoption, with more than half filed in the Southern District of New York and the District of Delaware.

Among the stated objectives of Chapter 15 are promoting cooperation between U.S. and foreign parties involved in a cross-border insolvency case, providing for a fair process that protects all creditors, and facilitating the rescue of a distressed firm. In pursuit of these goals, Chapter 15 authorizes several types of coordination, including

U.S. case trustees or other authorized entities operating in foreign countries on behalf of a U.S. bankruptcy estate; foreign representatives having direct access to U.S. courts, including the right to commence a proceeding or seek recognition of a foreign proceeding; and

U.S. courts communicating information they deem important, coordinating the oversight of debtors’ activities, and coordinating proceedings.

Chapter 15 excludes the same financial institutions that are generally not eligible to file as debtors under the Code (such as insured depository institutions and U.S. insurance companies), with the exception of foreign insurance companies. It also excludes broker-dealers that can be liquidated under SIPA or a special provision of Chapter 7 of the Code and commodity brokers that can be liquidated under a different special provision of Chapter 7. Based on the UNCITRAL model law, Chapter 15 contains a public policy exception that allows a U.S. court to refuse cooperation and coordination if doing so would be “manifestly contrary to the public policy of the United States.”

No Changes Have Been Made to the Bankruptcy Code but Proposals Were Introduced in the Previous Congress

Two Proposals Would Have Made Broad Changes Relating to Complex Financial Institutions

Since we last reported on financial company bankruptcies in July 2013, no changes have been made to Chapters 7, 11, or 15 of the Bankruptcy Code relating to large financial companies, although two bills were introduced in the 113th Congress that would have attempted to address challenges associated with the reorganization of large financial firms as governed by Chapter 11 of the Code. Neither bill was signed into law nor re-introduced in the current Congress, as of March 12, 2015.

The Taxpayer Protection and Responsible Resolution Act (S. 1861) was introduced in the Senate on December 19, 2013. The bill would have added a new chapter to the Code—”Chapter 14: Liquidation, Reorganization, or Recapitalization of a Covered Financial Corporation”— that would have generally applied to bank holding companies or corporations predominantly engaged in activities that the Federal Reserve Board has determined are financial in nature. Its provisions would have made changes to the role of regulators, changed the treatment of QFCs, and specifically designated judges to hear Chapter 14 cases, as the following examples illustrate.

The proposal would have repealed the regulatory resolution regime in Title II of the Dodd-Frank Act—revoking FDIC’s role as a receiver of a failed or failing financial company under OLA—and returned all laws changed by Title II to their pre-Title II state.

The proposal would have allowed the Federal Reserve Board to commence an involuntary bankruptcy and granted the Federal Reserve Board the right to be heard before the court. The proposal would have allowed the court to transfer assets of the estate to a bridge company (on request of the Federal Reserve Board or the trustee and after notice and hearing and not less than 24 hours after the start of the case). The court would have been able to order transfer of assets to a bridge company only under certain conditions (including that a preponderance of evidence indicated the transfer was necessary to prevent imminent substantial harm to U.S. financial stability). FDIC also would have been granted the right to be heard before the court on matters related to the transfer of property to the bridge company. However, this proposal would have explicitly prohibited the Federal Reserve Board from providing DIP financing to a company in bankruptcy or to a bridge company and provided no specific alternative non-market source of funding.

The Taxpayer Protection and Responsible Resolution Act (S. 1861) also would have changed the treatment of QFCs in bankruptcy. The rights to liquidate, terminate, offset, or net QFCs would have been stayed for up to 48 hours after bankruptcy filing (or the approval of the petition from the Federal Reserve Board). During the stay, the trustee would have been able to perform all payment and delivery obligations under the QFC that became due after the case commenced. The stay would have been terminated if the trustee failed to perform any payment or delivery obligation. Furthermore, QFCs would not have been able to be transferred to the bridge company unless the bridge assumed all contracts with a counterparty. If transferred to the bridge company, the QFCs could not have been terminated or modified for certain reasons, including the fact that a bankruptcy filing occurred. Aside from the limited exceptions, QFC counterparties would have been free to exercise all of their pre-existing contractual rights, including termination.

Finally, the Taxpayer Protection and Responsible Resolution Act (S. 1861) would have required the Chief Justice to designate no fewer than 10 bankruptcy judges with expertise in cases under Title 11 in which a financial institution is a debtor to be available to hear a Chapter 14 case. Additionally, the Chief Justice would have been required to designate at least one district judge from each circuit to hear bankruptcy appeals under Title 11 concerning a covered financial corporation.

A second bankruptcy reform proposal, the Financial Institution Bankruptcy Act of 2014 (H.R. 5421), was passed by voice vote by the House of Representatives on December 1, 2014, and would have added a new Subchapter V under Chapter 11. Generally, the proposed subchapter would have applied to bank holding companies or corporations with $50 billion or greater in total assets and whose activities, along with its subsidiaries, are primarily financial in nature.

The Financial Institution Bankruptcy Act (H.R. 5421) contained provisions similar or identical to those in the Taxpayer Protection and Responsible Resolution Act (S. 1861) that would have affected the role of regulators, treatment of QFCs, and designation of judges. For example, this proposal would have allowed an involuntary bankruptcy to be commenced by the Federal Reserve Board and allowed for the creation of a bridge company to which assets of the debtor holding company could be transferred. This proposal also would have granted the Federal Reserve Board and FDIC the right to be heard before the court, as well as the Office of the Comptroller of the Currency and SEC (which are not granted this right under the Taxpayer Protection and Responsible Resolution Act). The changes to the treatment of QFCs under this proposal were substantively similar to those under the Taxpayer Protection and Responsible Resolution Act (S. 1861). In addition, the Financial Institution Bankruptcy Act (H.R. 5421) would have required that the Chief Justice would designate no fewer than 10 bankruptcy judges to be available to hear a Subchapter V case. The Chief Justice also would have been required to designate not fewer than three judges of the court of appeals in not fewer than four circuits to serve on an appellate panel.

Although the two bills have similarities, there are significant differences. For example, the Financial Institution Bankruptcy Act (H.R. 5421) would not have repealed Title II of the Dodd-Frank Act. Instead, Title II would have remained an alternative to resolving a firm under the Bankruptcy Code. Also, the Financial Institution Bankruptcy Act (H.R. 5421) would not have restricted the Federal Reserve Board from providing DIP financing to a financial firm under the proposed subchapter. Furthermore, the Financial Institution Bankruptcy Act (H.R. 5421) would have given the court broad power in the confirmation of the bankruptcy plan to consider the serious adverse effect that any decision in connection with Subchapter V might have on financial stability in the United States. By contrast, the Taxpayer Protection and Responsible Resolution Act (S. 1861) mentioned financial stability as a consideration in specific circumstances, such as whether the Federal Reserve Board could initiate an involuntary bankruptcy under Chapter 14, or whether the court could order a transfer of the debtor’s property to the bridge company.

Certain provisions in these bills resembled those in OLA and may have facilitated a resolution strategy similar to FDIC’s SPOE strategy under OLA. For example, each of the bankruptcy reform bills and FDIC’s SPOE strategy under OLA would have allowed for the creation of a bridge company, in which assets, financial contracts, and some legal entities of the holding company would have been transferred, allowing certain subsidiaries to have maintained operations. In addition, OLA, like the bills, included a temporary stay for QFCs.

OLA uses a regulatory approach to resolution, while the bankruptcy reform bills in the 113th Congress would have maintained a judicial approach to resolution. Some experts have expressed concern that a regulatory resolution may not adequately ensure the creditors’ rights to due process. For example, experts attending GAO’s 2013 bankruptcy reform roundtables noted that if preferences were given to some counterparties or creditors during a temporary stay, other counterparties or creditors would have the right to take action to recover value later in the process, as opposed to having a judge consider the views of all of the parties prior to making any decisions. However, as we reported in July 2013, other experts have stated that the judicial process of bankruptcy does not contemplate systemic risk, or have some of the tools available for minimizing the systemic risk associated with the failure of a systemically important financial institution. For example, to act quickly in cases involving large and complex financial companies, courts might need to shorten notice periods and limit parties’ right to be heard, which could compromise due process and creditor rights. In the United States, the judicial process under bankruptcy remains the presumptive method for resolving financial institutions, even those designated as systemically important.

Another Proposal Would Have Removed Safe Harbor Treatment of QFCs in Bankruptcy

A third proposal would have more narrowly amended the Code. The 21st Century Glass-Steagall Act of 2013 (S. 1282 in the Senate and H.R. 3711 in the House) contained a provision that would have repealed all safe- harbor provisions for QFCs. This legislative proposal was neither signed into law nor re-introduced in the current Congress, as of March 12, 2015.

Some experts have identified the safe-harbor treatment of QFCs under the Code as a challenge to an orderly resolution in bankruptcy. For example, safe-harbor treatment can create significant losses to the debtor’s estate, particularly for financial institution debtors that often are principal users of these financial products. As we previously reported in July 2011, some experts we interviewed suggested that modifying the safe harbor provisions might help to avoid or mitigate the precipitous decline of the asset values typical in financial institution bankruptcies. For example, these experts suggested that the treatment of QFCs in the Lehman bankruptcy contributed to a significant and rapid loss of asset values to the estate. Other experts we spoke with in 2011 suggested that safe-harbor treatment might lessen market discipline. Because counterparties entered into QFCs may close out their contracts even if doing so would otherwise violate the automatic stay, the incentive to monitor the risk of each other could be reduced. Additionally, as we reported in July 2013, attendees of our roundtable discussions on bankruptcy reform noted that the safe harbors lead to a larger derivatives market and greater reliance on short-term funding because QFCs would not be subject to a stay, which could increase systemic risk in the financial system.

However, others argue that a repeal of the safe-harbor provisions could have adverse effects. As we previously reported in July 2011, these experts assert that subjecting any QFCs to the automatic stay in bankruptcy would freeze many assets of the counterparties of the failed financial institution, causing a chain reaction and a subsequent systemic financial crisis. In January 2011, regulatory officials we spoke with also told us that the safe harbor provisions uphold market discipline through margin, capital, and collateral requirements. They said that the requirement for posting collateral limits the amount of risk counterparties are willing to undertake. In addition, during the 2013 expert roundtable on financial company bankruptcies, one expert noted that one of the goals of safe harbors is to limit market turmoil during a bankruptcy—that is, they are to prevent the insolvency of one firm from spreading to other firms.

Recent Efforts to Enhance International Coordination to Resolve Failing Financial Companies under Bankruptcy

In the United States the presumptive mechanism to resolve a failed cross- border large financial company continues to be through the judicial bankruptcy process, though no statutory changes have been made to Chapter 15 of the Code or the U.S. judicial bankruptcy process to address impediments to an orderly resolution of a large, multinational financial institution. However, while some structural challenges discussed earlier remain, others, such as conflicting regulatory regimes and the treatment of cross-border derivatives, are being addressed through various efforts. For example, the Federal Reserve and FDIC have taken certain regulatory actions mandated by the Dodd-Frank Act authorities toward facilitating orderly resolution, including efforts that could contribute to cross-border coordination. Specifically, certain large financial companies must provide the Federal Reserve and FDIC with periodic reports of their plans for rapid and orderly resolution in the event of material financial distress or failure under the Code. The resolution plans or living wills are to demonstrate how a company could be resolved in a rapid manner under the Code. FDIC and the Federal Reserve have said that the plans were expected to address potential obstacles to global cooperation, among others. In 2014, FDIC and the Federal Reserve sent letters to a number of large financial companies identifying specific shortcomings with the resolution plans that those firms will need to address in their 2015 submissions, due on or before July 1, 2015, for the first group of filers.

International bodies have also focused on strengthening their regulatory structures to enable the orderly resolution of a failing large financial firm and have taken additional actions to facilitate cross-border resolutions. In October 2011, the Financial Stability Board (FSB)—an international body that monitors and makes recommendations about the global financial system—issued a set of principles to guide the development of resolution regimes for financial firms active in multiple countries. For example, each jurisdiction should have the authority to exercise resolution powers over firms, jurisdictions should have policies in place so that authorities are not reliant on public bailout funds, and statutory mandates should encourage a cooperative solution with foreign authorities. In addition, in December 2013 the European Parliament and European Council reached agreement on the European Union’s (EU) Bank Recovery and Resolution Directive, which establishes requirements for national resolution frameworks for all EU member states and provides for resolution powers and tools. For example, member states are to appoint a resolution authority, institutions must prepare and maintain recovery plans, resolution authorities are to assess the extent to which firms are resolvable without the assumption of extraordinary financial support, and authorities are to cooperate effectively when dealing with the failure of cross-border banks. Unlike the United States, EU and FSB do not direct resolution authorities to use the bankruptcy process developed for corporate insolvency situations.

In a letter to the International Swaps and Derivatives Association (ISDA) in 2013, FDIC, the Bank of England, BaFin in Germany, and the Swiss Financial Market Supervisory Authority called for changes in the exercise of termination rights and other remedies in derivatives contracts following commencement of an insolvency or resolution action. In October 2014, 18 major global financial firms agreed to sign a new ISDA Resolution Stay Protocol to facilitate the cross-border resolution of a large, complex institution. This protocol was published and these 18 financial firms agreed to it on November 12, 2014, and certain provisions of which became effective in January 2015. Generally, parties adhering to this protocol have agreed to be bound by certain limitations on their termination rights and other remedies in the event one of them becomes subject to certain resolution proceedings, including OLA. These stays are intended to give resolution authorities and insolvency administrators time to facilitate an orderly resolution of a troubled financial firm. The Protocol also incorporates certain restrictions on creditor contractual rights that would apply when a U.S. financial holding company becomes subject to U.S. bankruptcy proceedings, including a stay on cross-default rights that would restrict the counterparty of a non-bankrupt affiliate of an insolvent U.S. financial holding company from immediately terminating its derivatives contracts with that affiliate.

Finally, a United Nations working group (tasked with furthering adoption of the UNCITRAL Model Law) included the insolvency of large and complex financial institutions as part of its focus on cross-border insolvency. In 2010, Switzerland proposed that the working group study the feasibility of developing an international instrument for the cross- border resolution of large and complex financial institutions. The working group has acknowledged and has been monitoring the work undertaken by FSB, Basel Committee on Banking Supervision, the International Monetary Fund, and EU.

Agency Comments

We provided a draft of this report to AOUSC, CFTC, Departments of Justice and the Treasury, FDIC, Federal Reserve, and SEC for review and comment. The agencies did not provide written comments. We received technical comments from the Department of the Treasury, FDIC, Federal Reserve, and SEC, which we incorporated as appropriate.

We are sending copies of this report to the appropriate congressional committees, Director of the Administrative Office of the U.S. Courts, the Chairman of the Commodity Futures Trading Commission, Attorney General, the Secretary of the Treasury, the Chairman of the Federal Deposit Insurance Corporation, the Director of the Federal Judicial Center, the Chair of the Board of Governors of the Federal Reserve System, the Chair of the Securities and Exchange Commission, and other interested parties. The report also is available at no charge on the GAO web site at http://www.gao.gov.

If you or your staff members have any questions about this report, please contact Cindy Brown Barnes at (202) 512-8678 or brownbarnesc@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Major contributors to this report are listed in appendix III.

Appendix I: Updates on the Bankruptcy Proceedings for Lehman Brothers Holdings, Inc., MF Global, and Washington Mutual

In our July 2011 and July 2012 reports on the bankruptcy of financial companies, we reported on the status of the bankruptcy proceedings of, among other financial companies, Lehman Brothers Holdings Inc., MF Global, and Washington Mutual. In the 2011 report, we found that comprehensive data on the number of financial companies in bankruptcies were not readily available. We collected information to update the status of the bankruptcy proceedings for Lehman Brothers Holdings Inc., MF Global, and Washington Mutual. Since we last reported in July 2012, in each case, additional payments to creditors have been distributed and litigation with various parties is ongoing.

Update on the Lehman Bankruptcy

Lehman Brothers Holdings Inc. (Lehman) was an investment banking institution that offered equity, fixed-income, trading, asset management, and other financial services. In 2008, Lehman was the fourth largest U.S. investment bank and had been in operation since 1850. It had 209 registered subsidiaries in 21 countries. On September 15, 2008, Lehman filed Chapter 11 cases in the U.S. Bankruptcy Court. Its affiliates filed for bankruptcy over subsequent months. Some of Lehman’s affiliates also filed bankruptcy or insolvency proceedings in foreign jurisdictions. There are three different legal proceedings involving (1) the holding company or LBHI, (2) the U.S. broker dealer or LBI, and (3) the U.K. broker dealer or LBIE. On September 19, 2008, Lehman’s broker-dealer was placed into liquidation under the Securities Investor Protection Act (SIPA). The bankruptcy court approved the sale of LBI’s assets to Barclays PLC on September 20, 2008—5 days after the filing of the LBHI Chapter 11 case.

In March 2010, LBHI debtors filed their proposed Chapter 11 plan. In December 2010, a group of senior creditors filed an alternative plan. Since then, various plan amendments and counter plans were filed. In December 2011, the U.S. Bankruptcy Court for the Southern District of New York confirmed a reorganization plan for LBHI and the plan took effect in March 2012.

Payments to Creditors Continue

LBHI had more than 100,000 creditors. As of October 2, 2014, some $8.6 billion had been distributed to LBHI creditors in the nonpriority unsecured claims class. The Trustee of LBI has distributed more than $106 billion to 111,000 customers. As of September 2014, £34 billion has been distributed by the LBIE Administrator to counterparties in the House Estate (general unsecured estate) and the Trust Estate (Client Assets, Client Money and Omnibus Trust). In February 2015, the bankruptcy court approved a second interim distribution of $2.2 billion to general unsecured creditors with allowed claims. This would bring the total distributions to allowed general unsecured creditors to approximately 27 percent.

Litigation Continues

There is ongoing litigation involving a breach of a swap with Giants Stadium, the payment of creditor committee members’ legal fees, and transactions with foreign entities, according to an official of the U.S. Trustees Program. Litigation concerning issues surrounding the sale of LBI assets to Barclays PLC also continues. On December 15, 2014, the SIPA Trustee filed a petition for a writ of certiorari with the U.S. Supreme Court seeking review of the lower court rulings that awarded $4 billion of margin cash assets to Barclay’s.

Update on the MF Global Bankruptcy

MF Global Holdings Ltd. (MFGH) was one of the world’s leading brokers in markets for commodities and listed derivatives. The firm was based in the United States and had operations in Australia, Canada, Hong Kong, India, Japan, Singapore, and the U.K. On October 31, 2011, MFGH and one of its affiliates filed Chapter 11 cases in the U.S. Bankruptcy Court for the Southern District of New York. In the months following four other affiliates filed for relief in Bankruptcy Court. Also, on October 31, 2011, the Securities Investor Protection Corporation (SIPC) commenced a SIPA case against MF Global’s broker-dealer subsidiary (MFGI). The SIPA trustee has been liquidating the firm’s assets and distributing payments to its customers on a rolling basis pursuant to a claims resolution procedure approved by the bankruptcy court overseeing the case. MFGI was required to pay $1.2 billion in restitution to its customers as well as a $100 million penalty. In December 2014, CFTC obtained a federal court consent order against MFGH requiring it to pay $1.2 billion or the amount necessary in restitution to ensure the claims of MFGI are paid in full.

The bankruptcy court confirmed a liquidation plan for MFGH on April 22, 2013, which became effective in June 2013. As of the end of 2013, the SIPA trustee reported the probability of a 100 percent recovery of allowed net equity claims for all commodities and securities customers of MFGI.

Payments to Creditors Continue

As of mid-December 2014, 100 percent of the distributions through the SIPA trustee have been completed to substantially all categories of commodities and securities customers and 39 percent of the first interim distribution on allowed unsecured claims. The trustee started to make $551 million in distributions to general creditors on October 30, 2014. An interim payment of $518.7 million went to unsecured general claimants and covered 39 percent of their allowed claims. A reserve fund of $289.8 million was to be held for unresolved unsecured claims and a reserve fund of $9.9 million will be held for unresolved priority claims. In April 2014, the SIPA trustee began final distributions to all public customers. With this distribution a total of $6.7 billion was to have been returned to over 26,000 securities and commodities futures customers. General creditor claims totaling more than $23 billion in asserted amounts, as substantial unliquidated claims, were filed in this proceeding as of the end of June 2014. As of December 2014, the SIPA trustee reports that of 7,687 general creditor claims asserted or reclassified from customer status, only 23 claims remain unresolved.

Litigation Continues

Current litigation surrounds a malpractice complaint against PricewaterhouseCoopers (the company’s former auditor) and an investigation of the officers, according to an official of the U.S. Trustees Program.

Update on Washington Mutual Bankruptcy

Washington Mutual Inc. was a thrift holding company that had 133 subsidiaries. Its subsidiary Washington Mutual Bank was the largest savings and loan association in the United State prior to its failure. In the 9 days prior to receivership by the Federal Deposit Insurance Corporation (FDIC), there were more than $16.7 billion in depositor withdrawals. At the time of its filing, Washington Mutual had about $32.9 billion in total assets and total debt of about $8.1 billion. Its failure was the largest bank failure in U.S. history. On September 25, 2008, the Office of Thrift Supervision found Washington Mutual Bank to be unsafe and unsound, closed the bank, and appointed FDIC as the receiver. FDIC as receiver then took possession of the bank’s assets and liabilities and transferred substantially all the assets and liabilities to JPMorgan Chase for $1.9 billion. On September 26, 2008, Washington Mutual and its subsidiary WMI Investment Corporation filed Chapter 11 cases in U.S. Bankruptcy Court for the District of Delaware. On March 12, 2010, Washington Mutual, FDIC, and JPMorgan Chase announced that they had reached a settlement on disputed property and claims. This was called the global settlement. On July 28, 2010, the bankruptcy court approved the appointment of an examiner, selected by the U.S. Trustee’s office, to investigate the claims of various parties addressed by the global settlement. The seventh amended plan was confirmed by the court on February 24, 2012. The plan established a liquidating trust—the Washington Mutual Liquidating Trust (WMILT)—to make subsequent distributions to creditors on account of their allowed claims. Upon the effective date of the plan, Washington Mutual became a newly reorganized company, WMI Holdings Corp. consisting primarily of its subsidiary WMI Mortgage Reinsurance Company, Inc.

Payments to Creditors Continue

In 2012, there was an initial distribution of $6.5 billion. Since that initial distribution, an additional $660 million has been distributed to creditors, according to officials at the U.S. Trustees Program, including a distribution of $78.4 million paid on August 1, 2014.

Litigation Continues

In August 2013, WMILT, pursuant to an order by the U.S. Bankruptcy Court for the District of Delaware, filed a declaratory judgment in the U.S. District Court for the Western District of Washington against FDIC, the Board of Governors of the Federal Reserve System (Federal Reserve), and 90 former employees who were also claimants in the bankruptcy proceeding. Certain employee claimants have asserted cross-claims against FDIC and the Federal Reserve, contending that the banking agencies are without authority to assert limits on payment from troubled institutions that are contingent on termination of a person’s employment over WMILT, because WMILT is a liquidating trust. After the case was transferred to the U.S. Bankruptcy Court for the District of Delaware in July 2014 and all pending motions terminated, most of the parties stipulated to withdraw the reference to the bankruptcy court. FDIC moved to dismiss the complaint on September 5, 2014. The proposed order to withdraw the reference and the briefing on the motion to dismiss remains pending.

Appendix II: Objectives, Scope, and Methodology

Section 202(e) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd Frank Act) mandated that we report on the orderliness and efficiency of financial company bankruptcies every year for 3 years after passage of the act, in the fifth year, and every 5 years thereafter. This report, the fourth in the series, examines (1) recent changes to the U.S. Bankruptcy Code (Code) and (2) efforts to improve cross-border coordination to facilitate the liquidation and reorganization of failed large financial companies under bankruptcy.

For each of our objectives, we reviewed relevant regulations and laws, including the Code and the Dodd-Frank Act as well as GAO reports that addressed bankruptcy issues and financial institution failures. We specifically reviewed the reports we issued during the first 3 years of the mandate as well as reports written under the same or similar mandates by the Administrative Office of the United States Courts (AOUSC) and the Board of Governors of the Federal Reserve System (Federal Reserve). We interviewed officials from the following federal agencies due to their role in financial regulation and bankruptcy proceedings: AOUSC; the Commodity Futures Trading Commission (CFTC); Federal Deposit Insurance Corporation (FDIC); Department of Justice; Department of the Treasury (Treasury), including officials who support the Financial Stability Oversight Council (FSOC); Federal Reserve; and Securities and Exchange Commission (SEC). We also updated our review of published economic and legal research on the financial company bankruptcies that we had originally completed during the first year of the mandate (see appendix I). For the original search, we relied on Internet search databases (including EconLit and Proquest) to identify studies published or issued after 2000 through 2010.

To address our first objective, we reviewed Chapters 7, 11, or 15 of the Bankruptcy Code for any changes. In addition, we reviewed legislation proposed in the 113th Congress that would change the Code for financial company bankruptcies. We also reviewed academic literature on financial company bankruptcies and regulatory resolution, transcripts of congressional hearings on bankruptcy reform, and transcripts from expert roundtables on bankruptcy reform that were hosted by GAO in 2013.

To address our second objective, we reviewed Chapter 15 of the Bankruptcy Code, which relates to coordination between U.S. and foreign jurisdictions in bankruptcy cases in which the debtor is a company with foreign operations, for any changes. In addition, we sought information on U.S. and international efforts to improve coordination of cross-border resolutions from the federal agencies we interviewed. We also reviewed and analyzed documentary information from the Bank of England, Basel Committee on Banking Supervision, European Union, the Financial Stability Board, BaFin in Germany, International Monetary Fund, Swiss Financial Market Supervisory Authority, and the United Nations.

To update the three bankruptcy cases of Lehman Brothers Holdings, Inc.; MF Global Holdings, Ltd.; and Washington Mutual, Inc. discussed in our July 2011 and July 2012 reports, we sought available information—for example, trustee reports and reorganization plans—on these cases from CFTC, FDIC, Federal Reserve, and SEC; AOUSC, the Department of Justice, and Treasury. In addition, we collected information from prior GAO reports, bankruptcy court documents, and the trustees in each case. To determine whether there were new bankruptcy filings of large financial companies such as those in our case studies, we inquired of AOUSC, CFTC, FDIC, Department of Justice, Treasury, Federal Reserve, and SEC. We also conducted a literature review, which did not show evidence of any new bankruptcy cases filed by large financial companies.

We conducted this performance audit from June 2014 to March 2015 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the individual named above, Karen Tremba, Assistant Director; Nancy S. Barry; Patrick Dynes; Risto Laboski; Marc Molino; Barbara Roesmann; Jessica Sandler; and Jason Wildhagen made key contributions to this report. Technical assistance was provided by JoAnna Berry.