Harvey R. Miller is a partner of the law firm Weil, Gotshal & Manges, where he created and developed the firm's business finance and restructuring department that specializes in reorganizing distressed business entities. Maurice Horwitz is an associate in that department.
More than four years after the collapse of Lehman Brothers, Congress has failed to adequately resolve how to deal with the collapse of financial institutions.
Legislators and regulators seemingly cannot overcome the powerful lobbyists employed by the financial industry. And, to some extent, it appears that federal regulators seem to suffer from parochial bureaucratic views that limit their objectives.
The Dodd-Frank Act, while a good faith effort, does not solve the problem of a distressed global financial institution facing failure. The attempt to put into effect the most important provision of Dodd-Frank, known as Title II - which gives the government “orderly liquidation aut hority†over systemically important institutions - is inadequate and, to some extent, ill-conceived.
How do we know? As the bankruptcy attorneys in the Chapter 11 cases of Lehman Brothers Holdings, we have first-hand knowledge of the tremendous difficulties in dealing with the failure of global integrated financial institutions. The collapse of Lehman, which resulted in more than 100 separate insolvency proceedings around the world, highlighted the inadequacy of the existing regulatory, bankruptcy and insolvency regimes.
Dodd-Frank has failed to fill the gap because of the complex and unique organizational and operational structures of big financial institutions. While global financial institutions generally operate as a single enterprise, typically with consolidated management, an integrated technology base, and â€" most significantly â€" a common capital and liquidity pool, they typically consist of thousands of legal entities incorporated in multiple ju risdictions (Lehman comprised some 8,000 legal entities in 40 countries).
Most clients transact business with the prime brokerage operations of the global firm without generally knowing - or caring - which subsidiary with which they transacted business. Behind these subsidiaries, however, firms manage risk and capital on a global scale through a web of interconnected subsidiaries. As a result, no single subsidiary has the ability to stand (or be resolved) alone.
The Federal Deposit Insurance Corporation initially urged global financial institutions to hive off their systemically important businesses into stand-alone subsidiaries, each with its own capital base. Financial institutions uniformly resisted, arguing that such “subsidiarization†would be inefficient and uneconomical.
While the banks' arguments may hold true in good times, in bad times, these interconnected subsidiaries make it impossible to prevent systemic consequences.
Fiduciaries a nd receivers in each jurisdiction will typically be appointed by local courts or regulators to liquidate the entities within their jurisdiction and maximize recoveries for the creditors of those particular entities. These liquidators may need to take actions that are not in the best interests of the enterprise resolution and are not conducive to preserving or winding-down the systemically important functions of the enterprise.
To circumvent that potential result, the F.D.I.C., under Dodd-Frank, is proposing the concept of a “single receivership†strategy. The agency states in a recently proposed rule that the orderly liquidation of a failed financial institution “may best be accomplished by establishing a single receivership of a parent holding company and transferring valuable operations and assets to a solvent bridge financial company, including the stock or other equity interests of the company's various subsidiaries.â€
The bridge financial company wo uld then borrow from an “orderly liquidation fund†established by the Treasury Department and recapitalize systemically important operating subsidiaries through intercompany loans. The group would thus stay intact and under the control of a single receiver: the F.D.I.C.
The proposed solution is fraught with problems. How much would the Treasury be willing (or able) to lend to keep struggling subsidiaries afloat? What would be the consequences of protecting the creditors of subsidiaries with funds (probably best described as a bailout) provided by the Treasury, while creditors of the holding company are left with unsecured claims in the F.D.I.C. receivership with a high probability of no return?
The proposal does not take into account that creditors of the holding company may hold guarantees of subsidiaries as well as be cross-guarantees among entities, with the result that the proposed resolution would require the Treasury to satisfy the claims of essenti ally all the creditors of the failed financial institution. Surely, if the proposal is adopted, any creditor with leverage would require guarantees of subsidiaries, and cross-guarantees could become standard operating procedure.
But the most glaring defect of a “single receivership†proposal is that it works only for purely domestic institutions. If the institution has systemically important subsidiaries in foreign jurisdictions, the onset of an F.D.I.C. receivership would precipitate the commencement of foreign insolvency proceedings for all foreign operating subsidiaries, as occurred with Lehman.
Foreign regulators might well balk at the F.D.I.C. unilaterally taking charge and trying to impose its receivership rules in such foreign jurisdictions. As such, the F.D.I.C. proposal and Dodd-Frank do not deal with the critical consequences of cross-border failure.
In contrast, a recently published European Union directive on bank resolution and recovery recognizes that in the interest of minimizing systemic impact, regulators should be charged with devising “an efficient resolution for the group as a whole with the protection of financial stability in both the member states where the group operates and the Union.†The proposed framework would establish a “group level resolution authority†and “resolution colleges,†consisting of resolution authorities from other E.U. member states, to deal with the resolution of the group.
Although limited to the E.U., this “hub and spoke†model would represent a considerable step forward in providing a framework for dealing with cross-border resolution of systematically important financial institutions. A similar model has been proposed recently by the International Institute of Finance. It is a proposal that deserves the attention of legislators and regulators.
Crucially, as these proposed frameworks demonstrate, the key to solving the cross-border conundrum is not legal harmonization â€" a universal law to deal with the universal bank â€" but rather, mandated coordination among regulators, and a shift in fiduciary obligations from individual entities or jurisdictions to the group and the global financial system.
If the objective of resolution authority is to prevent or mitigate systemic impact, it cannot be achieved through a solely domestic regime. To preserve systemically important functions of a failed financial enterprise, regulators must be able (and mandated) to deal with the enterprise as a whole across national borders, while balancing a respect for sovereign interests. This would be a dramatic change in the well-settled norms of applicable laws in most jurisdictions, but necessary and appropriate if systemic impact is to be avoided.
The danger of another Lehman exists. Failure to be prepared would result in another and, maybe, greater and more enduring catastrophe than Lehman.
