Alert October 19, 2010

FDIC Proposes Rule to Clarify Creditor Priority Rules in Nonbank Liquidations Under Dodd-Frank Act

On October 8, 2010, the FDIC Board of Directors issued a proposed rule (the “Proposed Rule”) to clarify how it would treat certain creditors in liquidations of non-banks.  The FDIC was granted the power to liquidate nonbank financial institutions designated as “Covered Financial Companies” under Title II of The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”).  The FDIC’s new Title II powers to act as receiver apply to financial companies whose failure and subsequent liquidation under the Bankruptcy Code or alternative insolvency procedures would pose a significant risk to the stability of the United States financial system (a “Covered Financial Institution”).  The receivership and liquidation authority granted to the FDIC has been widely analogized to the FDIC’s receivership authority to resolve the affairs of failed banks.  Pursuant to the Act, the FDIC was granted the authority to make additional payments to creditors of a Covered Financial Institution, regardless of the priority of such creditor, if such payments would: (i) maximize the value of the assets or the present value return of such assets, (ii) initiate and/or continue operations essential to the receivership or any bridge financial company established by the FDIC in connection with the receivership, or (iii) reduce losses from any sales or disposition of the assets.

The FDIC was granted broad authority to treat creditors with similar priority disparately.  The Proposed Rule addresses only the treatment of creditors in a failed financial firm and was proposed to provide clarity and certainty as to how key elements of the FDIC’s resolution authority will be implemented.  The Proposed Rule establishes several bright line rules regarding the distribution of any additional payments from a failed institution to its creditors.  These include:

  • Holders of long-term senior debt (defined in the Proposed Rule as senior debt with a term of more than 360 days), subordinated debt and equity interests in Covered Financial Institutions are barred from receiving additional payments that would result in such holders recovering more than other creditors entitled to the same priority of payments under the law;
  • No creditor may receive additional payment from a Covered Financial Institution unless the FDIC Board determines by recorded vote that the payments meet the statutory requirements;
  • Any payment to any creditor would be subject to recoupment if recoveries were insufficient to repay temporary government liquidity support provided as part of the FDIC’s orderly wind-down of the Covered Financial Institutions, unless such additional payments were made to initiate and/or continue operations essential to the receivership or any bridge financial company;
  • Recoupment must occur prior to the imposition of a general assessment on industry to cover the shortfall.  The intent of the recoupment rules is to prevent taxpayer money from covering losses associated with the failure of a Covered Financial Institution;
  • Secured creditors are only protected to the extent of the fair value of their collateral.  If a secured creditor is undersecured, the unsecured portion of its claim will receive the same treatment as other unsecured creditors.  Secured obligations collateralized with United States government securities are exempt from this rule and such securities will be valued at par.

In addition to these key priority rules, the FDIC’s Proposed Rule also addresses several other discrete areas, including provisions:

  • Giving the FDIC receiver authority to continue operations by making additional payments to pay for basic services provided by employees and third parties, such as information technology, building maintenance and other services necessary to maintain the Covered Financial Institution as it is wound down;
  • Clarifying how damages will be measured with respect to contingent claims by defining that a claim will be contingent if the future event creating the contingency: (i) cannot occur by the mere passage of time, (ii) is not under the control of either the Covered Financial Institution or the party to whom the obligation is owed, and (iii) has not occurred as of the date of the appointment of the receiver;
  • Clarifying that the remaining value of any liquidated subsidiary of a Covered Financial Institution that is an insurance company will be paid in accordance with the priorities provided in Title II of the Act, as is currently the case in other types of FDIC receiverships.  The net effect of this provisions is that the shareholders of a Covered Financial Institution that is an insurance company will be at the last to receive any value from any subsidiary;
  • Establishing rules for determining the compensation of employees of Covered Financial Institutions who would continue in a bridge institution, including that any employee who would continue shall be paid in accordance with existing personal services agreements, including collective bargaining agreements, and such amounts would be entitled to administrative priority in the receivership of the Covered Financial Institution.  This provision will not apply to agreements with senior executives or directors of the failed institution; 
  • No party acquiring a Covered Financial Institution will be bound by any personal services agreement unless it expressly assumes such agreement.

The Chairperson of the FDIC, Sheila Bair, stressed that the policy goal of the Proposed Rule is to establish that shareholders and unsecured creditors, rather than taxpayers, are at risk upon the failure of a Covered Financial Institution.  The FDIC stated that it is seeking to ensure that even those creditors eligible for additional payments are likely to suffer a diminished recovery for their claim by setting a difficult standard for the receipt of additional payments.  Commentators have noted that the most significant departure from established insolvency rules is that the collateral of a secured lender is valued at fair value, reducing the claim value of a secured creditor.  Under the Bankruptcy Code, secured creditors may file claims for the amount lent to the debtor. 

The FDIC has proposed two separate requests for comment.  The first request seeks comment on specific issues related to creditor claims under the Proposed Rule and the FDIC will accept comments on this first request that are submitted by November 18, 2010.  The second request for comment asks for comment on broader questions that will inform the FDIC’s future rulemaking on the issue of orderly liquidations under the Act and the FDIC will accept comments on its second request until January 18, 2011. 

For a more detailed description of Title II of the Act, its scope and its anticipated impact on financial institutions, please see the July 28, 2010 Special Edition of the Alert