Title II, the Orderly Liquidation provision of the Dodd-Frank Act, provides a process to quickly and efficiently liquidate a large, complex financial company that is close to failing. Title II provides an alternative to bankruptcy, in which the Federal Deposit Insurance Corporation (FDIC) is appointed as a receiver to carry out the liquidation and wind-up of the company. The FDIC is given certain powers as receiver, and a three to five year time frame in which to finish the liquidation process. Title II is aimed at protecting the financial stability of the American economy, forcing shareholders and creditors to bear the losses of the failed financial company, removing management that was responsible for the financial condition of the company, and ensuring that payout to claimants is at least as much as the claimants would have received under a bankruptcy liquidation.
In 2008, large financial institutions that had always been considered “too big to fail” were in dire financial straits. The government attempted to preserve some of these institutions with over $1.7 trillion in bailouts to companies such as Bear Stearns, Fannie Mae/Freddie Mac, AIG, the Troubled Asset Relief Program, Citigroup, and Bank of America. Despite the bailouts, over 250 banks failed in the period from 2008 to 2010, and Lehman Brothers, the fourth-largest investment bank in the United States, filed for bankruptcy, the largest Chapter 11 bankruptcy in U.S. history. In light of the failure of these “too big to fail” institutions, Congress saw the need for a government authority to provide for efficient liquidation of large, complex financial institutions, and to eliminate the potential of future government bailouts.
Placing a Financial Company in Receivership
In determining when a financial company should be placed in receivership under Title II, the Secretary of the Treasury applies a two part test. See 12 U.S.C. § 5383 (Dodd-Frank Act § 203). First, the Secretary looks at whether the company is in default, or in danger of default. See id. A company is in default when it is likely to file for bankruptcy, has incurred debts that will deplete all or most of its capital, has greater debts than assets, or will likely be unable to pay its debts in the normal course of business. See id. (Dodd Frank Act § 203(c)(4)). Second, the Secretary must evaluate the systemic risk involved in the potential default of the financial company. See id. (Dodd Frank Act § 203). Therefore, the Secretary must consider the effect of default on financial stability, low income, minority, or underserved communities, and on creditors, shareholders, and counterparties. See id. (Dodd-Frank Act § 203(b)). The Secretary also considers the likelihood of bankruptcy or private sector alternatives, and what future actions can be taken. See id. If these issues are considered, and the FDIC believes it should be appointed as receiver, the FDIC will take control of the assets, obligations, and operations of the company.
Receiver Duties of the FDIC
As a receiver, the FDIC takes on the duties of transferring or selling assets, creating bridge financial organizations that can help assume assets or liabilities during the liquidation process, and approving valid claims against the company that will need to be paid. To help fund the liquidation process, Title II creates the Orderly Liquidation Fund, a separate fund created by the U.S. Treasury to cover the administrative costs of liquidation for companies under this title. See 12 U.S.C. § 5390 (Dodd-Frank Act § 210(n)). The FDIC may avoid or invalidate certain prior transfers, agreements, leases, or compensation to executives that hinder the ability of the FDIC to carry out its duties. See id. (Dodd-Frank Act § 210). If the financial company is a broker or dealer, in addition to the FDIC appointment as receiver, the Securities Investor Protection Corporation (SIPC) is appointed as trustee that will take over managing any assets that are not transferred to a bridge company by the FDIC. See 12 U.S.C. § 5385 (Dodd-Frank Act § 205).
Title II provides a claims process to assert claims against a defaulting financial company, and a series of rules to allow for liquidation of assets and the payment of claim holders according to a list of priority payments. See 12 U.S.C. § 5389, 12 U.S.C. § 5390 (Dodd-Frank Act §§ 210(a)(2), 209(b)). Claims are paid in the following order: (1) administrative costs; (2) the government; (3) wages, salaries, or commissions of employees; (4) contributions to employee benefit plans; (5) any other general or senior liability of the company; (6) any junior obligation; (7) salaries of executives and directors of the company; and (8) obligations to shareholders, members, general partners, and other equity holders. See 12 U.S.C. § 5389 (Dodd-Frank Act § 209(b)).
The priority list helps advance the goal of ensuring that the executives, directors, and shareholders bear the losses of the failed company by being last in line to receive payment. Title II includes other provisions to hold executives liable, including the executive clawback provision, which allows the FDIC to recover incentive payment and other compensation made to executives from up to two years prior to the company’s failure. See 12 U.S.C. § 5390 (Dodd-Frank Act § 210(s)). Directors and management can also be held personally liable for losses in cases of gross negligence and other bad conduct. See id. (Dodd-Frank Act § 210(f)).
Regardless of how the FDIC conducts the liquidation, certain base requirements must be met. See 12 U.S.C. § 5386 (Dodd-Frank Act § 206). All action under Title II must be taken to preserve the financial stability of the economy as a whole, not merely to preserve the specific company in question. See id. Shareholders cannot receive payment until all other claims against the company and the Orderly Liquidation Fund are paid. See id. Unsecured creditors receive payment in accordance with the priority list, so executives and shareholders receive payment last. See id. Management and board members who were responsible for the financial condition of the company must be removed. See id. And finally, the FDIC cannot take an equity interest in the financial company for which it acts as receiver. See id.
Elimination of Government Bailouts for Struggling Financial Institutions
One final provision of importance is the ban of use of taxpayer funds to preserve a company that has been put into receivership under Title II. See 12 U.S.C. § 5394 (Dodd-Frank Act § 214). In essence, this provision prevents any future government bailouts for struggling financial institutions, no matter how big, or how impactful their failure might be. This provision makes it even more critical that a liquidation under Title II work quickly and effectively; without the safety net of federal bailout money, a failing financial institution will have no choice but to liquidate.
Under Title II, large companies will need to consider this alternate resolution process, and produce plans for a quick and orderly wind-up in the case of financial distress or failure. The FDIC will promulgate additional rules to establish standards for the resolution plans and credit exposure reports that companies must provide. Additionally, the claims process under an orderly liquidation by the FDIC is modeled like the bankruptcy code claims process, but does have some differences that impact how Title II liquidation will operate. Large financial companies will need to keep in mind both the claims process codified in Title II and any FDIC rule promulgations that clarify that process.