“SPOE” Resolution Strategy for SIFIs under Dodd-Frank

On December 10, 2013, the Federal Deposit Insurance Corporation (the “FDIC”) proposed for public comment a notice (the “Notice”) describing its “Single Point of Entry” (“SPOE”) strategy for resolving systemically important financial institutions (“SIFIs”) in default or in danger of default under the orderly liquidation authority granted by Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). [1] The Notice follows the FDIC’s endorsement of the SPOE model in its joint paper issued with the Bank of England last year.

The SPOE strategy entails the appointment of the FDIC as receiver for only the SIFI’s top-level U.S. holding company, while permitting the operating subsidiaries of the failed holding company to continue their operations uninterrupted. As receiver, the FDIC would establish a bridge financial company for the failed U.S. holding company to which the FDIC would transfer the assets and certain very limited liabilities of the receivership estate. The claims of unsecured creditors and other claimants in the receivership would be satisfied by issuance of securities by one or more new holding companies that would emerge from the bridge financial company through a securities-for-claims exchange.

The SPOE strategy seeks to achieve two basic goals. One is to carry out the Dodd-Frank mandate of ending “too-big-to-fail.” To this end, management of the failed SIFI responsible for its failure would be replaced; shareholders would be wiped out (or virtually so); creditors of the failed SIFI would bear the losses resulting from the failure; and taxpayers would bear no losses. The second goal is to fulfill the Dodd-Frank mandate of limiting disruption to the U.S. financial system.

The FDIC has requested comment on critical aspects of its SPOE strategy, including what level and types of capital and debt SIFIs should maintain to optimize a SPOE resolution, how and when the Orderly Liquidation Fund provided for by Title II should be utilized and how the foreign operations of a failed SIFI should be treated in a SPOE resolution. Resolution of these issues should significantly advance the development of a defined and effective resolution structure for SIFIs.

The FDIC’s Notice provides for a 60-day comment period following publication in the Federal Register.

Overview

Title II of the Dodd-Frank Act grants the FDIC the authority, referred to as the “orderly liquidation authority” (the “OLA”), to resolve a SIFI following a determination by various government authorities that no viable private-sector alternative is available to prevent the failure of the SIFI, when resolution under the Bankruptcy Code would have a serious adverse effect on U.S. financial stability and when the other conditions set forth in Title II are satisfied. The FDIC’s exercise of its authority under Title II is subject to a number of restrictions and requirements, including adherence to the general principle that the FDIC must resolve the failed SIFI in a manner such that creditors and shareholders bear the losses in accordance with the statutory priorities established by Title II and that no costs are imposed on U.S. taxpayers. The SPOE strategy is an approach developed by the FDIC to implement the OLA based on this principle, with the objective of minimizing the risk of disruption to the U.S. financial system and satisfying the other requirements of Title II.

Organization of a Bridge Financial Company. A fundamental element of the SPOE strategy is that the FDIC would be appointed receiver for only the top-tier U.S. holding company of the SIFI. Subsidiaries of the failed SIFI would, in general, remain open and operating, thereby preserving the continuity of critical operations for the financial system and avoiding or minimizing the systemic disruption that could otherwise accompany their bankruptcy (or similar reorganization or liquidation).

Under the SPOE strategy, the assets of the receivership estate, primarily consisting of the top-level holding company’s investments in, and loans to, subsidiaries, would be transferred to a bridge financial company chartered by the FDIC. The equity value of the bridge financial company would be the principal asset of the receivership estate. Equity, subordinated debt and senior unsecured debt of the failed SIFI would remain as claims in the receivership estate. The claims of creditors in the receivership would be satisfied by the issuance of securities representing debt and equity in one or more new holding companies (or “NewCos”), which would be successors to the bridge financial company, through a securities-for-claims exchange as described further below.

Governance and Operation of the Bridge Financial Company. The FDIC proposes that it would appoint the members of the initial board of directors of the bridge financial company and nominate a new chief executive officer and other key managers from a pre-screened pool of eligible candidates from the private sector. The FDIC anticipates that most personnel of the failed SIFI would be retained; however, as required by the Dodd-Frank Act, management responsible for the failure of the SIFI would be removed.

The FDIC and the bridge financial company would enter into an initial operating agreement that would mandate:

• a review of risk management policies and practices of the failed SIFI to ascertain causes of failure and to develop and implement a plan to mitigate identified risks;
• delivery to the FDIC of a business plan, including asset disposition strategies, that would maximize recoveries and avoid fire sales of assets;
• a review of pre-failure management practices of all businesses and operations;
• preparation of a capital, liquidity and funding plan consistent with the terms of any mandatory repayment plan and any capital and liquidity requirements established by the appropriate regulatory agencies;
• retention of accounting and valuation consultants acceptable to the FDIC and completion of audited financial statements and valuations necessary for securities-for-claims exchanges; and
• preparation of a plan for restructuring the bridge financial company that would lead to the emerging NewCo(s) being resolvable under the Bankruptcy Code without causing risk of severe adverse effects to financial stability in the United States.

The FDIC would retain control over certain key financial, strategic and governance matters of the bridge financial company, including any issuance of stock, amendments of the articles of incorporation or bylaws, capital transactions or asset transfers in excess of established thresholds, any plan of reorganization or merger, any change in the composition of the board of directors, any distribution of dividends, the adoption of any equity-based compensation plans, the designation of valuation experts and the termination and replacement of the bridge financial company’s independent accounting firm.

Funding of the Bridge Financial Company. The Notice states that, given the strength of the bridge financial company’s balance sheet, the FDIC expects that the bridge financial company and its subsidiaries would be in a position to borrow from customary sources of liquidity in the private markets. The SPOE strategy, however, contemplates use of the Orderly Liquidation Fund (the “OLF”), provided for by Title II, if private sector funding is not immediately available. The Notice provides for two basic methodologies for funding under the OLF. The FDIC could provide funding directly from the OLF by issuing obligations backed by the assets of the bridge financial company. Alternatively, the FDIC could facilitate the provision of private-sector funding for the bridge financial company by providing guarantees backed by its authority to obtain funding through the OLF. This latter alternative would provide greater flexibility as to the amount of the initial funding and would involve the private sector in the SPOE process. In either case, as contemplated by the FDIC, the use of OLF funds would be significantly limited: they could be used only for purposes of providing liquidity to the bridge financial company, as opposed to providing capital; they could be used only during a brief transitional period at the outset of the resolution process; and the use of these funds would be discontinued as soon as private funding becomes available. [2]

Because of the limitations on the amount of any OLF funding, it is anticipated that any borrowings from the OLF would be repaid from the operations and assets of the bridge financial company, its subsidiaries and the receivership. If this proves insufficient to repay the OLF borrowings fully, the FDIC must impose risk-based assessments on SIFIs sufficient to repay the borrowings in full. As a result, all OLF obligations would be repaid without any loss to the taxpayer.

Claims Determination. Under the Dodd-Frank Act, the FDIC must determine the amount and priority of claims against the SIFI left in receivership through an administrative claims process. After valuation of the bridge financial company’s assets and completion of the administrative claims process, creditors’ claims would be satisfied through a securities-for-claims exchange. As required by the Dodd-Frank Act, administrative expenses of the receiver would be paid first, followed by amounts owed to the United States, certain allowed employee salary and benefit claims, general or senior unsecured claims, subordinated debt claims, wage and benefit claims of senior officers and directors and, finally, shareholder claims. Allowable claims against the receivership would be made pro rata to claimants in each class to the extent that assets in the receivership estate are available after payment of all senior classes.

The Dodd-Frank Act requires the FDIC to treat creditors of the same class and priority similarly, but allows for disparate treatment in limited cases. [3] The FDIC emphasizes in the Notice that it expects that disparate treatment of creditors would occur only in very limited circumstances, such as to permit ongoing payments to critical vendors at the outset of the resolution, and that it has, by regulation, expressly limited its discretion to treat creditors differently even where permitted under the Dodd-Frank Act. [4]

Capitalization. The SPOE strategy contemplates capitalization of the NewCo(s) emerging from the resolution through a securities-for-claims exchange. The exchange would involve the issuance and distribution to the FDIC of new debt, equity and, possibly, contingent value securities, such as warrants or options, in the NewCo(s). The FDIC would, in turn, exchange the new debt and equity for the claims of the creditors left in the receivership. As contemplated by the FDIC, the contingent value securities would be issued to creditors in lower priority classes who would not otherwise have received value for their claims, and thus would afford them some protection from the possibility of an undervaluation of the NewCo(s).

Valuation and Preparation of Financial Statements. A valuation of the bridge financial company would need to be conducted to serve as a basis for the securities-for-claims exchange as well as to satisfy various regulatory, reporting and disclosure requirements, including with respect to requirements of the Securities and Exchange Commission (the “SEC”) governing the registration (or exemption from registration) of securities issued by the NewCo(s). Independent experts, including investment bankers and accountants, would conduct the valuation, with the FDIC engaging its own experts to review this valuation and to render a fairness opinion.

An independent public accounting firm would be engaged to prepare audited financial statements for the bridge financial company in accordance with generally accepted accounting principles as promptly as possible. The FDIC, after consultation with the SEC, has determined that the “fresh start model” (commonly used by companies exiting Chapter 11 bankruptcy) is the most appropriate accounting treatment to establish the new basis for financial reporting for the emerging company. [5] The fresh start model requires the determination of a fair value measurement of the assets and liabilities of the company, which represents the value at which each asset or liability would be transferred between market participants at an established date.

Restructuring and Emergence of NewCo(s). The FDIC intends to return the operations of the bridge financial company to the private sector as promptly as possible. The FDIC anticipates that it may take about six to nine months to prepare the bridge financial company for the execution of the securities-for-claims exchange, at which time the bridge financial company’s charter would be terminated and NewCo(s) would be established.

The Notice provides that NewCo(s) replacing the bridge financial company would be required to meet or exceed all regulatory capital requirements. As noted above, the initial operating agreement would require the bridge financial company to prepare a restructuring plan under which the NewCo(s) could be resolved under the Bankruptcy Code without the risk of serious adverse effects on the U.S. financial system, should resolution later become necessary. To this end, the Notice explicitly contemplates the possibility of divestitures or a break-up of the bridge financial company into multiple NewCos. Each NewCo would be expected to enter into an agreement with its primary financial regulator to comply with the restructuring plan.

Reporting. As contemplated in the Notice, the bridge financial company would comply with all disclosure and reporting requirements under applicable securities laws. To the extent that audited financial statements were not available, the FDIC would develop appropriate standards in cooperation with the SEC. The bridge financial company and its operating subsidiaries would also file other required regulatory reports, including call reports.

Request For Comments

The FDIC requests comments on the following issues relating to its proposed SPOE strategy:

• Disparate Treatment. Unlike a bankruptcy proceeding, a Title II receivership process does not involve a creditors’ committee and no creditors’ consent is required for disparate treatment of similarly situated creditors. Although the FDIC’s regulations and the Dodd-Frank Act place strict limitations on the application of disparate treatment (as described above) and provide protection to all creditors, the FDIC requests suggestions on other potential limits or ways of providing creditors assurance of the FDIC’s intended use of disparate treatment.
• Use of the OLF. The Notice raises the issue of whether the OLF could be considered the equivalent of a public “bail-out.” It notes, in this regard, that the use of the OLF would be strictly limited; that, in particular, the OLF could be used only for liquidity and not capital purposes; and that the taxpayer is not at risk because eligible financial companies would be required to pay assessments to repay any amounts that cannot be repaid by the bridge financial company itself. More generally, the FDIC seeks comment on the proposal to address the liquidity needs of the bridge financial company through the OLF.
• Funding Advantage of SIFIs. The FDIC seeks comment on whether the potential use of the OLF in a Title II resolution results in a funding advantage for a SIFI and its operating subsidiaries, whether such a funding advantage could lead to consolidation in the financial industry that otherwise would not occur and whether there are other measures that could address any perceived funding advantage for SIFIs. More broadly, the Notice refers to a “widely perceived” funding advantage over smaller competitors, but provides that “[o]ne goal of the SPOE strategy is to undercut this advantage.”
• Capital and Debt Levels at the Holding Company. The FDIC seeks comment on the amount of equity and unsecured debt that would be needed at the holding company level for a successful implementation of the SPOE strategy. In addition, the FDIC seeks comment on what types of debt and what maturity structure would be optimal to effectuate a SPOE resolution and whether a leverage ratio, as compared to a risk-based capital ratio, would provide a more meaningful measure of capital during a financial crisis. The Federal Reserve has indicated that it expects to propose a long-term debt requirement for the largest SIFIs.
• Foreign Operations of the Bridge Financial Company. In one of the most far-reaching aspects of the Notice, the FDIC seeks comment on whether a “subsidiarization” requirement (by which the FDIC presumably means a requirement that SIFIs transfer their operations in their various jurisdictions to separate subsidiaries) would facilitate Title II resolutions under the SPOE strategy, the alternative “Multiple Point of Entry” strategy or under the Bankruptcy Code and whether such a requirement would reduce the likelihood of ring-fencing by foreign authorities. The FDIC also seeks comment on whether a subsidiarization requirement would limit the spread of contagion across jurisdictions in a financial crisis and what the potential financial and operational costs of requiring subsidiarization are. Finally, the FDIC requests comment on the impact that a branch structure may have on a banking organization’s ability to withstand adverse economic conditions that do not threaten the viability of the group, the extent to which a branch model may provide flexibility to manage liquidity and credit risks globally and whether funding costs may be lower under the branch structure.
• Cross-Border Cooperation. Citing its recent work with the Bank of England, the Financial Stability Board and other foreign and international authorities, the FDIC seeks comment on additional steps that can be taken with foreign regulators to increase the prospects of a successful resolution using the SPOE strategy. Importantly, in this context, the FDIC raises the concern that a lack of cooperation could lead to ring-fencing, which, in turn, could “exacerbate financial instability.”
• Securities-for-Claims Exchange. The FDIC seeks comment on whether there are creditors (or groups of creditors) for whom a securities-for-claims exchange would be particularly difficult or unreasonably burdensome.
• Valuation. The FDIC seeks comment on the effectiveness of contingent value securities as a tool to mitigate valuation uncertainty and on what characteristics would be useful in structuring such contingent value securities.
• Information. The FDIC seeks comment on what information reports or disclosures by the bridge financial company would be most important to claimants, the general public and other stakeholders and on what additional information about the administrative claims process would be useful in addition to the information already provided by the FDIC.
• Effectiveness of the SPOE Strategy. The FDIC seeks comment as to whether there are any additional factors that the FDIC should consider with respect to the SPOE strategy and any better alternatives to the SPOE strategy.

Conclusion

The Notice represents a critical step in establishing the predictability and acceptability that will lead to SPOE being an effective strategy for resolving a SIFI in the event that the OLA must be invoked. Once the FDIC has addressed the issues raised by this Notice, further analysis may be useful with respect to additional aspects of the SPOE strategy, such as the manner in which the bridge financial company would recapitalize or provide liquidity to the operating subsidiaries whose operations are to be continued or how to address those operating subsidiaries that may not be capable of continuing operations, notwithstanding the strong capitalization of the bridge financial company. Similarly, some of the procedural aspects of the proposed strategy, such as the application of the U.S. securities laws to the securities-for-claims exchange, may be usefully developed. Furthermore, the relationship of the SPOE strategy to other pending regulatory efforts, such as those relating to the development of capital, debt and liquidity requirements, may benefit from further development.

Endnotes:

[1] FDIC, The Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy (Dec. 10, 2013), available at http://www.fdic.gov/news/board/2013/2013-12-10_notice_dis-b_fr.pdf.
(go back)

[2] As summarized in the Notice, the Dodd-Frank Act caps the amount of OLF funds available in a Title II resolution at the maximum obligation limit, which is initially set at 10% of the total consolidated assets of the SIFI based on the most recent financial statements available. If any OLF funds are used beyond the initial 30-day period or in excess of the initial maximum obligation limit, the FDIC must prepare a mandatory repayment plan that provides for a repayment schedule. After a preliminary valuation of the assets and preparation of the mandatory repayment plan, the maximum obligation limit would change to 90% of the fair value of the total consolidated assets available for repayment. The Notice does not offer additional guidance on how these limitations would be interpreted in practice.
(go back)

[3] In general, the Dodd-Frank Act permits the FDIC to make a transfer of liabilities from the receivership estate to the bridge financial company that has a disparate impact on similarly situated creditors is permissible only if (1) the FDIC determines that making the transfer is necessary to maximize the value of the assets of the failed SIFI or the present value return from the sale of its assets or to minimize the loss from the disposition of the assets of the failed SIFI and (2) all similarly situated creditors receive not less than the amount that they would have received in a liquidation of the SIFI under Chapter 7 of the Bankruptcy Code. The FDIC acknowledges in the Notice that any disparate treatment of creditors requires a determination by the board of directors of the FDIC that the treatment is necessary and lawful, and the Dodd-Frank Act requires that the identity of any creditors benefiting from disparate treatment must be reported to Congress.
(go back)

[4] See 12 C.F.R. § 380.27. The FDIC has stated that it would not exercise its discretion to treat similarly situated creditors differently in a manner that would result in preferential treatment to holders of long-term senior debt (defined as unsecured debt with a term of longer than one year), subordinated debt or equity holders.
(go back)

[5] “Fresh start” accounting would typically require, among other things, that all assets and liabilities of the emerging company be restated at their “fair value.” In a proceeding under Chapter 11, this revaluation generally would be made on or about the date on which the debtor emerges from bankruptcy.
(go back)