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Whatever Happened to Bankruptcy?

posted by Adam Levitin

It's hard to remember in the midst of the bailout craze, but the United States does have legal mechanisms for dealing with insolvency.  We have the FDIC system for banks and bankruptcy for everyone else just about.  These are well-established institutions.  There's a wealth of experience and caselaw about both.  We know how they work, and both are reasonably transparent and fair.  While they have some limitations, they have served the country well for years.

And yet there has been a marked resistance in both the Bush and Obama administrations to putting banks into FDIC receivership and non-banks into the Chapter.  To be sure we had WaMu, Wachovia, and IndyMac cycled through the FDIC, and Lehman is wending its way through bankruptcy.  But the list of companies we haven't required to go through the ringer is equally impressive:  AIG, Citi, Bank of America, Bear Stearns, GM, Chrysler (and probably many of the financial institutions that took TARP funds).  

All of this raises a couple important questions:  why have some institutions been allowed to go through the established legal regimes, while others have received ad hoc treatment?  Is there something about the FDIC process or bankruptcy that the Bush and Obama administrations think doesn't work?  If so, what is it? (And let's fix it if it's a problem.)   Or is it a matter of whose ox would get gored in these processes, but not in an ad hoc treatment?  Consider--the bonuses that were specially protected per Geithner's request in the EESA would just be general unsecured claims in bankruptcy or FDIC proceedings.  And implicit recourse to banks by investors in off-balance sheet entities (like SIVs) wouldn't stand a chance in FDIC proceedings because of the O'Doench doctrine (FDIC not bound by secret deals).  

I'm bothered by the apparent lack of rhyme or reason for when we will use FDIC/Bankruptcy and when we won't.  It'd be nice to see the administration articulate why FDIC/bankruptcy aren't good options.  It can't just be a matter of funding--I'd much rather see the government as DIP lender than as the vulnerable preferred (or common) shareholder, bailing out bondholders.  

[Hat tip to Stephen Lubben for inspiring these thoughts.]

Comments

I'm not a lawyer, but surely it's obvious that the explanation lies in the special privileges in bankruptcy granted to over the counter derivatives in laws ranging from 1982 to 2005. If it weren't for the fact that derivative counterparties are super-senior creditors with the right at bankruptcy to strip financial firms of their hedges (and therefore the value of their assets), bankruptcy would indeed be an option.

It seems to me that you lawyers have turned our financial system into a network of unexploded grenades.

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