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The Code and the new Financial Reform Act

posted by Stephen Lubben

Unless you have been living under that rock, you probably know that the President signed the new Financial Reform Act yesterday. Good summaries of the various stages of implementation, and the overall Act are already available online.

But what is the effect of the new Act on the Bankruptcy Code?

The direct provisions in the Act that implicate the Bankruptcy Code are rather limited:

  • §202(e) requires both the Administration Office of the Courts and the Comptroller General to study the use of the Code to resolve distressed financial institutions.  See also §215(a)(2).
  • §216 seems to require the Board of Governors to conduct the same study, although §216 provides greater detail on what the study should consider. Arguably this section directs the Fed to consider the derivative safe harbors in the Bankruptcy Code. But perhaps that's just wishful thinking on my part.
  • §202(f) requires the Comptroller General to study the issue of international coordination of proceedings under the Bankruptcy Code regarding financial institutions.
  • And §217 gives a similar obligation to the Board of Governors.
  • §203(c)(4) requires the Secretary provide a written explanation of why a case under the Code is not appropriate before invoking the new resolution process under Title II of the Act.
  • §§205(c), 208 suspend the Bankruptcy Code with regard to a debtor in the resolution process.  Pending bankruptcy cases are to be dismissed, although under §208(c) prior orders of the bankruptcy court remain effective.
  • §724(b) of the Act amends §761 of the Code to provide favorable treatment to centrally cleared swaps.
  • §763 amends the 1934 Securities Exchange Act in a way that seems to be designed to give centrally cleared swaps and margin payments priority "customer property" treatment under Chapter 7 of the Code.
  • §952 excludes companies in bankruptcy from the requirement of having an independent compensation committee, which is a bit of a head-scratcher.
  • §1106(c) gives the FDIC the right to file an involuntary bankruptcy petition against a company that has defaulted on a loan guarantee received from the FDIC during a "liquidity event," as defined in §1105(g).

Several provisions, especially those dealing with avoidance actions and claims, make reference to a hypothetical chapter 7 case involving the same debtor. And several defined terms in the new Act incorporate by reference the definitions in section 101 or chapter 7 of the Bankruptcy Code.

There are some arguably more important indirect effects on the Bankruptcy Code, namely

  • The uncertainty created by the ability to upend an ongoing bankruptcy case with a resolution proceeding, especially with regard to non-bank financial institutions whose systemic importance might vary from day to day, combined with
  • The difference in treatment of certain creditors under resolution vs. the Bankruptcy Code.  This is particularly true of senior management, whose claims are deeply subordinated under the resolution authority. §210.  Managers are also subject to immediate termination. §206.  This may give management some incentives to try to resolve matters under chapter 11 -- cf. CIT's recent prepackaged case -- but then my first point intrudes.

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