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18 February 2011
On January 18 2011 the Federal Deposit Insurance Corporation (FDIC) approved an interim final rule, with request for comments, to implement certain provisions of Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act.(1) Title II of the Dodd-Frank Act provides for the orderly liquidation under a special resolution regime of a financial company whose failure would have serious adverse effects on the financial stability of the United States (a 'covered financial company').(2)
The interim rule adopts, with certain changes, the FDIC's proposed rule on the subject contained in the notice of proposed rulemaking that it issued in October 2010.(3) As further discussed below, changes from the notice in the interim rule relate to provisions regarding the valuation of collateral and the treatment of contingent claims. Otherwise, the interim rule is generally identical to the notice. Comments on the interim rule must be received by the FDIC not later than 60 days after publication of the interim rule in the Federal Register.
Like the notice of proposed rulemaking, the interim rule addresses only a sub-set of issues raised by the orderly liquidation authority provisions of Title II. In recent letters the FDIC's acting general counsel has separately expressed his opinion regarding how the FDIC, as the receiver of a covered financial company, will exercise its Title II power to set aside preferential transfers, given certain differences between the statutory language of Title II and the Federal Bankruptcy Code(4) and whether, in the exercise of its repudiation powers, the FDIC would seek to reclaim assets transferred by a covered financial company in certain transactions in circumstances in which the assets would not be part of the covered financial company's bankruptcy estate under the Federal Bankruptcy Code.(5) In the letters the FDIC's acting general counsel, while expressing his opinion, noted that those issues will be subject to future regulations.
Numerous other issues remain to be addressed. In issuing the interim rule, the FDIC noted that the majority of the comments it received on the notice related to matters beyond the scope of the notice, and acknowledged the need for additional rulemaking in the future.
Under Title II, the secretary of the Treasury (in consultation with the president) has the authority to appoint the FDIC as receiver of a financial company that poses a significant risk to the financial stability of the United States if the secretary makes certain determinations following the recommendation of the Board of Governors of the Federal Reserve System and, depending on the type of financial company, the FDIC, the Securities and Exchange Commission or the director of the new Federal Insurance Office.
Like the notice of proposed rulemaking, the interim rule addresses four different topics that may arise in liquidation proceedings following such appointment:
Priority of payments to creditors
Under Title II, the FDIC is generally required to treat "similarly situated" claimants in a covered financial company receivership in a similar manner.
However, Title II provides that in certain limited circumstances, the FDIC may pay certain creditors of a receivership more than similarly situated creditors if this is necessary to:
This authority is similar to the FDIC's power under the Federal Deposit Insurance Act to take action to minimise losses and maximise recoveries in connection with a bank failure.
Despite requests from commenters on the notice of proposed rulemaking that the FDIC adopt a more flexible stance, the interim rule, like the notice, continues to provide that three categories of creditor will "never" be permitted to receive additional payments beyond those to which they would otherwise be entitled under the statute:
In addition, as under the notice of proposed rulemaking, most other general creditors of a covered financial company will not be permitted to receive additional payments under the FDIC's exception authority, unless the FDIC Board of Directors grants the exception, in its sole discretion, pursuant to a majority vote. To emphasise the intent that any such exception would need to meet a high hurdle, the interim rule, like the notice, provides that this authority cannot be delegated to FDIC staff or others. Under Section 210(o)(1)(D) of the Dodd-Frank Act, additional payments are also generally subject to clawback if the proceeds of the sale of the covered financial company are insufficient to repay any moneys drawn by the FDIC from the Treasury in the liquidation.(7)
Among the creditors which may qualify to receive additional payments under the FDIC's exception authority are holders of short-term debt which provide necessary liquidity for the continuation of operations of a failing covered financial company. In order to differentiate holders of long-term senior debt which may never receive such payments, the interim rule, like the notice, generally defines 'long-term senior debt' as senior debt issued by the covered financial company to bondholders or other creditors with a term of more than 360 days.(8)
In the preface to the interim rule, the FDIC emphasises that the prohibition on additional payments to holders of long-term senior debt should not be read as making it more likely that short-term debt holders will receive additional payments. In particular, the FDIC states that:
"[s]hort-term debt holders (including, without limitation holders of commercial paper and derivatives counterparties) are highly unlikely to meet the criteria set forth in the statute for permitting payment of additional amounts. In virtually all cases, creditors with shorter-term claims on the covered financial company will receive the same pro rata share of their claim that is being provided to the long-term debt holders."
Finally, the interim rule, like the notice, specifies that "proven claims" secured by a legally valid and enforceable or perfected security interest or security entitlement will be paid to the full extent of the fair market value of the collateral, and that any excess claim over such amount will be treated as a general unsecured claim. For the purposes of valuing collateral, the notice provided that collateral consisting of direct or fully guaranteed obligations of the United States or any agency of the United States would be valued at par, and left open how other collateral would be valued. In a change from the notice, the interim rule provides that all collateral, including government securities, will be valued at fair market value, and that the FDIC will determine such valuation as of the date the FDIC is appointed receiver of the covered financial company. However, the FDIC requests comment on whether it may be appropriate for valuations to be made on the day before the appointment of the FDIC as receiver.
As was evident in the recent financial crisis, fair market valuation can be particularly challenging and contentious when markets are illiquid. The interim rule does not indicate what methodology the FDIC will use to establish the fair market value of collateral or what procedures will be available to creditors to challenge the FDIC's determination of such value. In addition, the interim rule does not address the important question of whether and to what extent secured creditors may exercise self-help remedies to realise on collateral outside the proven claims process in which the FDIC determines collateral values.
Personal services agreements
In order to facilitate employee retention during the receivership process, the interim rule, like the notice of proposed rulemaking, provides that if the FDIC (as receiver of a covered financial company itself or of a bridge financial company established for purposes of liquidating the failed institution) accepts services from employees of the covered financial company during the receivership, those employees will be paid according to the terms and conditions of their personal services agreements, including collective bargaining agreements. Such amounts will be considered administrative expenses of the receivership entitled to priority in payment. However, the acceptance of these services does not impair the FDIC's ability to repudiate such an agreement subsequently if it would promote the orderly liquidation of the covered financial company. The protection for personal services agreements does not apply to agreements with any senior executive or director of a covered financial company or subsidiary, and does not limit the ability of the FDIC to recover compensation from a senior executive or director of a failed financial company.
In addition, the interim rule, like the notice, provides that no party acquiring a covered financial company, or its operational units, subsidiaries or assets, from the FDIC or any bridge financial company will be bound by a personal services agreement unless it expressly assumes that agreement. It appears that this provision will apply not only to covered subsidiaries that are themselves placed in receivership, but also to other subsidiaries whose shares are simply transferred as assets of the receivership in the liquidation of the parent company. This could raise significant issues for the employees of such entities.
In the preface to the interim rule, the FDIC states that the provision in the notice regarding contingent claims has been revised in the interim rule to make clear that the treatment of contingent claims under Title II parallels their treatment under the Federal Bankruptcy Code, and more precisely to follow the contingent claim provision in Title II.
In this regard, the interim rule affirms that the FDIC as receiver for a covered financial company will not disallow a claim solely because it is based on an obligation that was contingent as of the date of the appointment of the FDIC as receiver. The notice provided only that a contingent claim "may" be provable against the FDIC as receiver and covered only contingent claims based on guarantees, letters of credit, loan commitments and similar credit obligations. Further, the interim rule provides that, to the extent that an obligation is contingent, the FDIC will estimate the value of the claim, "as such value is measured based upon the likelihood that such contingent obligation would become fixed and the probable magnitude thereof". The interim rule does not specify the date on which the contingent claim would be estimated. Instead, the FDIC solicits comment regarding whether the FDIC, as receiver, should designate a specific time during the term of the receivership to estimate contingent claims. Further, the interim rule does not clarify what happens if a contingent claim becomes a fixed claim after estimation, but before final distributions are made to creditors.
The interim rule further provides that if the FDIC repudiates a contingent obligation of a covered financial company consisting of a guarantee, letter of credit, loan commitment or similar credit obligation, the actual direct compensatory damages for repudiation shall be no less than the estimated value of the claim as of the date when the FDIC was appointed receiver, as such value is measured based on the likelihood that such contingent claim would become fixed and the probable magnitude thereof.
The FDIC requests comments on the interim rule that would help to refine the rule further. In addition, the FDIC specifically requests comments on the following questions:
(1) The interim rule is available at www.fdic.gov/news/board/2011Janno6.pdf.
(2) For a summary of Title II please see "Conference Committee Report on Dodd-Frank Act is approved".
(3) For a summary of the notice of proposed rulemaking, please see "Proposed FDIC rulemaking on orderly liquidation of covered financial companies".
(4) Letter of December 29 2010 from FDIC Acting General Counsel Michael H Krimminger regarding certain transfers under Section 210(a)(11) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 USC § 5301 et seq.
(5) Letter of January 14 2011 from FDIC Acting General Counsel Michael H Krimminger regarding application of Section 210(c) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to the repudiation of certain contracts.
(6) At the FDIC Board of Directors meeting approving the interim rule, board member and Acting Comptroller of the Currency John Walsh, echoing such commenters, expressed concern that the blanket prohibition on making additional payments to holders of long-term debt could limit the flexibility of the FDIC in resolutions and opens up broader systemic concerns by potentially discouraging the use of long-term debt by systemically important financial companies. He indicated his hope that during the comment period on the interim rule, interested parties will focus on this issue and make their views known so that the FDIC can determine the impact of the provision and make revisions as necessary. Although in favour of the prohibition, FDIC Chairman Sheila Bair noted at the meeting that the interim rule requests further comment on the prohibition and proposed that the FDIC conduct a roundtable to solicit further market views on the issue.
(7) There is an exception to the clawback for "payments or amounts necessary to institute and continue operations essential to implementation of the receivership or any bridge financial company". In the interim rule, the FDIC provides as possible examples of payments not subject to clawback payments to trade creditors, such as payments necessary to ensure that a vendor can continue to provide the failed financial company with essential software or hardware that could not be replicated, and payments to a utility with a local monopoly.
(8) The definition of 'long-term senior debt' excludes "partially funded, revolving or other open lines of credit that are necessary to continuing operations essential to the receivership or any bridge financial company" and contracts to extend credit enforced by the FDIC as receiver pursuant to the FDIC's Title II power to enforce such contracts.
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