House Passes Financial Institution Bankruptcy Act of 2014

The House of Representatives passed the Financial Institution Bankruptcy Act of 2014 (H.R. 5421) on December 1, 2014. The bill, if enacted, would add provisions to the U.S. Bankruptcy Code, including a new "subchapter V" of Chapter 11, under which "covered financial institutions" would be eligible to be debtors in a Chapter 11 bankruptcy case.

The House Report says that the bill seeks to implement a "transparent judicial process that allows for the reorganization, rather than the liquidation, of a large financial institution" as a "preferable resolution strategy because of, among other things, the benefits of due process."¹

H.R. 5421 would "amend[] chapter 11 of the Bankruptcy Code to address better the unique challenges presented by the insolvency of a financial institution and better allow such an institution to be resolved through the bankruptcy process."² It would allow "the … holding company that sits atop the financial firm's corporate structure to transfer its assets, including the equity in all of its operating subsidiaries, to a newly-formed bridge company over a single weekend. The debt, any remaining assets, and equity of the holding company will remain in the bankruptcy process and absorb the losses of the financial institution."³

H.R. 5421 would function as an alternative to the FDIC receivership proceedings under title II of the Dodd-Frank Act, although the House bill does not expressly repeal title II of Dodd-Frank.⁴ H.R. 5421 would use a "single point of entry" approach that is similar to an FDIC receivership. "Single point of entry" refers to placing only the parent or holding company, and not its various subsidiaries, into bankruptcy.⁵

"Covered financial institutions" eligible to be Chapter 11 debtors under H.R. 5421

Under H.R. 5421, a "covered financial institution" would be eligible to be a Chapter 11 debtor. The bill defines a "covered financial institution" as either (1) a bank holding company, as defined in section 2(a) of the Bank Holding Company Act of 1956 or (2) a corporation that exists primarily for the purpose of owning, controlling and financing subsidiaries that have consolidated assets of $50 billion or more and that derives 85 percent or more of its revenue or total assets from activities that are "financial in nature," as defined in section 4(k) of the Bank Holding Company Act of 1956.⁶

Filing a Chapter 11 covered financial institution bankruptcy case

H.R. 5421 would authorize a covered financial institution to file a voluntary Chapter 11 petition with the bankruptcy court, and the bill also provides for the Board of Governors of the Federal Reserve (the Board) to file an involuntary petition against a covered financial institution.⁷  The covered financial institution could then consent to an involuntary Chapter 11 petition filed by the Board, or dispute it.

Proposed section 1183 provides that in support of an involuntary petition against a covered financial institution, the Board must state under penalty of perjury that one of the following conditions exist:

(i) the covered financial corporation has incurred losses that will deplete all or substantially all of the institution's capital and there is no reasonable prospect for the institution to avoid such depletion;
(ii) the institution is insolvent;
(iii) the institution is not paying, or is unable to pay, its undisputed debts as they come due; or
(iv) the institution is likely to be in one of the conditions specified in (i)-(iii) soon such that the immediate commencement of a bankruptcy case is necessary to prevent serious adverse effects on financial stability in the United States.

In addition to one of the foregoing conditions, the Board also must establish that the commencement of a bankruptcy case is necessary to prevent serious adverse effects on financial stability in the United States.

Transfer of assets in a covered financial institution Chapter 11

H.R. 5421 would facilitate the transfer of assets, contracts and licenses to a "bridge company" pursuant to an order of the bankruptcy court. The term "bridge company" is defined in the proposed legislation to mean "a newly formed corporation to which property of the estate may be transferred under section 1185(a) and the equity securities of which may be transferred to a special trustee under section 1186(a)." The special trustee would then distribute assets held in trust pursuant to a court-approved bankruptcy plan or, if the case converts to a Chapter 7 liquidation, in accordance with Chapter 7 of the Bankruptcy Code.

Proposed section 1185 sets forth the process and legal standards for the approval of such a transfer. These procedures require that not less than 24 hours notice of the request for a transfer be given to creditors and other affected parties, including governmental entities.

For a bankruptcy court to authorize a transfer, it would be required to make several legal and factual determinations, including that (i) the transfer is necessary to prevent serious adverse effects on financial stability in the United States; (ii) the transfer does not provide for the transfer of any unsecured debts, other than unsecured debts under a qualified financial contract; (iii) transferred property that is subject to a lien will remain subject to the lien following the transfer; (iv) the transfer does not include any equity of the debtor institution; (v) the bridge company is not likely to fail to meet any obligations it assumes pursuant to the transfer; and (vi) a special trustee will be appointed for the bridge company and will hold all equity interests in the bridge company.

Upon entry of a bankruptcy court order authorizing the transfer, the transferred property, executory contracts and licenses no longer would be property of the covered financial institution's bankruptcy estate. Bankruptcy Code sections 363 and 365, which govern the sale of assets and assignment of executory contracts and leases of a debtor in all bankruptcy cases, would apply in a subchapter V Chapter 11 case to the extent consistent with the other provisions of H.R. 5421.⁸

Covered financial institution's ability to challenge the Board's involuntary petition

If a covered financial institution does not consent to the Board's Chapter 11 petition, under the proposed legislation, the bankruptcy court would be required to conduct a hearing on the petition within 16 hours of the petition's filing, with notice of the hearing given only to the covered financial institution, the FDIC, the Office of the Comptroller of the Currency and the Secretary of the Treasury. Only the covered financial institution, the Board, the FDIC, the OCC and the Secretary of the Treasury would be authorized to participate at the hearing on the petition, and there are provisions in the bill for the Board or trustee to ask the court to seal all pleadings, transcripts, hearings and orders in connection with the hearing if their disclosure could create financial instability in the United States. Moreover, H.R. 5421 would require the court either to grant the Board's Chapter 11 petition or to dismiss the chapter 11 bankruptcy case within 18 hours after the Board files a petition.

H.R. 5421 also contains procedures for expedited appeals of the decision to grant a Chapter 11 petition filed by the Board.

Role of the special trustee for the bridge company

The appointment of a special trustee for the bridge company is a condition to the transfer of assets to a bridge company, and proposed section 1186 describes the selection and duties of a special trustee.⁹ The covered financial institution is required to give the Board consultation rights with respect to the selection of the special trustee and must report to the bankruptcy court on the result of its consultation with the Board. Once appointed, the special trustee has various obligations to prepare and file with the bankruptcy court periodic reports on the trust, and to provide notice of material changes in, or actions of, the bridge company.

The special trustee would hold all equity securities of the bridge company in trust for the benefit of the debtor institution's bankruptcy estate, and would be permitted to dispose of the equity securities of the bridge company in accordance with the trust agreement. Upon a sale of the equity securities in the bridge company, the special trustee would be required to hold the sale proceeds in trust for the bankruptcy estate, to be distributed either under a bankruptcy plan or pursuant to Chapter 7 of the Bankruptcy Code. H.R. 5421 provides that the office of the special trustee terminates as soon as practicable after the final distribution of assets is complete.

Stay of actions by creditors and counterparties to contracts with the financial institution debtor

H.R. 5421 would create, under new section 1187, an automatic stay prohibiting actions by creditors, as well as lease and contract counterparties.¹⁰ While the section 1187 stay is similar to the automatic stay that arises pursuant to section 362 of the Bankruptcy Code in other bankruptcy cases, there are some significant differences.

First, the section 1187 stay would extend to the covered financial institution that filed bankruptcy and to the institution's "affiliates." Under the relevant Bankruptcy Code definition, an "affiliate" would be (A) an entity that owns, controls or holds with voting power 20 percent or more of the debtor's outstanding voting securities and (B) a corporation 20 percent or more of whose outstanding voting securities are owned, controlled or held with power to vote by (i) the debtor or (ii) by an entity that owns, controls or holds with voting power 20 percent or more of the debtor's outstanding voting securities.¹¹ Essentially, "affiliates" are parents, subsidiaries and sister companies.

In addition to limiting the ability of creditors to exercise remedies against the debtor and its affiliates, proposed section 1187 contains specific provisions for the assignment of contracts, leases and other agreements to the bridge company, and the bridge company's corresponding obligations to cure defaults and provide counterparties with adequate assurance of future performance under the assigned agreements.

Finally, in keeping with the purpose of a speedy transfer of assets to a bridge company, the section 1187 stay would expire upon the earlier of the time that the bankruptcy court authorizes an asset transfer, denies an asset transfer, or 48 hours after the commencement of the bankruptcy case.

Stay of rights of a party to a securities, commodities, forward, repo or swap agreement to terminate, liquidate or accelerate those contracts upon bankruptcy

New section 1188 would impose a 48-hour stay during which counterparties to securities, commodities, forward, repo or swap agreements (qualified financial contracts) are prohibited from exercising contractual rights to modify, terminate, liquidate or accelerate a qualified financial contract with the debtor or an affiliate.¹² This stay extends to rights to offset or net out termination values and rights under security agreements or credit enhancements related to the qualified financial contract. The section 1188 stay would have the same limited life-span as the section 1187 stay: it expires upon the earlier of the time that the bankruptcy court authorizes an asset transfer, denies an asset transfer, or 48 hours after the commencement of the bankruptcy case.

Proposed section 1188 also contains protections for the non-debtor party. It requires the debtor or affiliate that is benefitting from the stay to continue to perform all of its payment and delivery obligations under the qualified financial contract during the pendency of the stay, or else the stay terminates as to that contract. In addition, proposed section 1188 prohibits the debtor from "cherry picking" contracts with a counterparty-if the debtor is going to assign a given counterparty's qualified financial contract to the bridge company, it must transfer all qualified financial contracts with that counterparty to the bridge company.

Bridge company's legal rights and obligations after the transfer

Under proposed section 1189, the terms of the transfer may provide for the bridge company to assume all of the Federal, State or local licenses, permits and registrations that the debtor institution had prior to the transfer, and these rights would remain valid and vest in the bridge company. In addition, these licenses, permits and registrations could not be terminated on account of the debtor institution's bankruptcy, insolvency or financial condition, or as a result of the transfer.

After a transfer to the special trustee, the special trustee is subject only to applicable non-bankruptcy law and the actions and conduct of the special trustee would no longer be subject to approval by the bankruptcy court.

Venue of financial institution bankruptcy cases

In the first instance, a case under proposed subchapter V would be heard under section 157 by a bankruptcy judge. H.R. 5421 would require the Chief Justice of the United States to designate at least ten experienced bankruptcy judges to hear subchapter V bankruptcy cases, and to designate at least three appellate court judges in at least four circuits to hear the expedited appeals of petitions to commence a subchapter V bankruptcy case.

Next steps for H.R. 5421

H.R. 5421 has been referred to the Senate Judiciary Committee. With the change in control of the Senate following the 2014 elections, Senator Chuck Grassley will assume the role of Chair of the Judiciary Committee, and this committee will play an instrumental role in the future prospects of H.R. 5421.