Following the 2008 financial crisis, Congress enacted Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act), titled “Orderly Liquidation Authority,” to address concerns that certain large interconnected financial companies are simply “too big to fail.” Title II provides the authority to the Federal Deposit Insurance Corporation (FDIC) as receiver to liquidate and unwind failing financial companies or “covered financial companies” that pose a “significant risk to the financial stability of the U.S. in a manner that mitigates such risk and minimizes moral hazard.” The following is an overview of many of the rights and remedies available to creditors and contract counterparties in the event of a Title II Orderly Liquidation of such a covered financial company.
Priority of Claims
In contrast to bankruptcy which contemplates the possibility of the debtor’s reorganization, once the FDIC is appointed as receiver under Title II, its automatic mandate is to liquidate the covered financial company. Title II sets forth a comprehensive scheme for addressing the priority of payment of claims against the covered financial company upon liquidation. This scheme is substantially similar to the scheme set forth in the Bankruptcy Code.
Allowed unsecured claims are paid in the order of priority outlined below.
- First: Claims with respect to post-receivership debt extended to the covered financial company where such credit is not otherwise available from commercial sources.
- Second: Other administrative costs and expenses of the receiver. Examples of these administrative expenses include contractual rent under an existing lease until the date that such lease is disaffirmed or repudiated and amounts owed for services performed and accepted by the receiver.
- Third: Amounts owed to the United States.
- Fourth: Wages, salaries, and commissions, including vacation, severance, and sick pay earned by an individual within 180 days prior to the appointment of the receiver up to the amount of $11,725 (as adjusted for inflation).
- Fifth: Contributions to employee benefit plans arising from services rendered within 180 days before the date of appointment of the receiver due with respect to such employees up to the amount of $11,725 (as adjusted for inflation) times the number of employees covered by each plan, subject to adjustments.
- Sixth: Claims by creditors who have allowed claims for lost setoff rights by action of the receiver.
- Seventh: Other general unsecured creditor claims.
- Eighth: Subordinated debt obligations.
- Ninth: Wages, salaries, and commissions, including vacation, severance, and sick leave earned owed to senior executives and directors.
- Tenth: Post-insolvency interest, which shall be distributed in accordance with the priority of the underlying claims.
- Eleventh: Distributions on account of equity to shareholders and others.
Like bankruptcy, each class of claims is required to be paid in full before payment of any claims in the next priority class, and if funds are insufficient to pay any class of creditors, the funds will be allocated among creditors of that class pro rata. Also, when considering priority of payment similar to bankruptcy, enforceable contract subordination agreements are respected in a Title II receivership. Creditors transacting business with a covered financial company in receivership will want to closely monitor to ensure that their claims are treated as administrative costs and expenses of the receiver, which are paid well ahead (second priority) of other general unsecured creditors (seventh priority).
When funds are available, creditors will receive post-insolvency interest on their claims (10th priority) at a rate based upon the coupon equivalent yield of the average discount rate set on the three-month Treasury bill. In contrast, bankruptcy law does not expressly provide a rate of interest in this circumstance. Bankruptcy courts apply a range of rates including the federal rate, the contract rate where one is specified, or any other specified contract rate.
With limited exceptions, all claimants of a covered financial company that are similarly situated in terms of priority are required to be treated similarly. When dissimilar treatment occurs, all similarly situated claimants must receive at least as much as if the company had been liquidated under Chapter 7 of the Bankruptcy Code or any similar provision of state insolvency law.
In contrast to the Bankruptcy Code, where many of the debtor’s or trustee’s actions are subject to prior approval by the bankruptcy court, a Title II proceeding is an administrative process and initial valuation decisions regarding a secured creditors’ collateral are made by the FDIC as receiver. Title II provides that secured claims are not affected by an Orderly Liquidation except to the extent that the security is insufficient to satisfy the claim. In this circumstance the receiver may classify a secured creditor’s claims as unsecured to the extent that the claim exceeds the value of the collateral. The fair market value of the secured creditor’s collateral is determined by the receiver in light of the purpose of the valuation and the proposed disposition or use of the property and at the time of the proposed disposition or use. Similar to bankruptcy law, to the extent of the value of the collateral, secured creditors can include interest, fees, costs, and charges in their claim. Also similar to bankruptcy law, the secured creditor may be surcharged by the receiver for the reasonable and necessary costs and expenses of preserving or disposing of the property.
The Claims Allowance Process
Upon the FDIC’s appointment as receiver, it initiates an administrative procedure for the determination of claims against the covered financial company. The claims process does not apply to a bridge financial company or to any extension of credit from a federal reserve bank or the FDIC to a covered financial company. The receiver notifies known creditors of the claims bar date by which creditors of the covered financial company are required to file their claims with the receiver. Later discovered creditors are required to receive notice within 30 days of their discovery, and if the bar date has not yet passed, then the creditor is required to file a claim by the original bar date. If the original bar date is too close to the date the notice is sent to the newly discovered claimant, then the claimant may invoke certain statutory exceptions permitted for late-filed claims, which include that (1) the claimant did not have notice of the appointment of the receiver in time to file by the claims bar date and (2) the claim is filed in time to permit payment by the receiver. Title II’s treatment of late claims for allowance purposes is somewhat similar to the Bankruptcy Code’s “excusable neglect” standard in practice. Also, while under the Bankruptcy Code, late-filed claims are paid ahead of claims for post-petition interest and distributions to the to the holders of equity interests, a Title II Orderly Liquidation does not permit such payment. Late filed claims are generally disallowed on a final basis.
The receiver is required to notify the claimant within 180 days after its claim is filed (or such later date agreed to) whether its claim is allowed or disallowed. Failure to timely notify the claimant has the effect of the claim being absolutely disallowed. Notwithstanding, a creditor will still receive payment if it did not receive timely notice of the receiver’s appointment and the claim is filed in time to permit payment.
Once the administrative process is exhausted and a claim is disallowed, the claimant can seek de novo judicial review of the claim by filing a lawsuit in the district or territorial court of the United States for the district within which the principal place of business of the covered financial company is located or continue a pending lawsuit in the court where the case was pending within 60 days of the claim’s disallowance. Failure to seek judicial review of the claim during this time period results in the claimant having no further rights or remedies with respect to the claim.
Expedited Relief for Secured Creditors
Claims allowance. A secured creditor is entitled to expedited relief, outside of the standard claims process, if (1) it holds a legally valid and enforceable or perfected security interest in property of a covered financial company or control of any legally valid and enforceable security entitlement in respect of any asset held by a covered financial company and (2) irreparable harm will occur if the administrative claims process is followed. The receiver has 90 days to determine whether to allow or disallow the claim or any portion thereof, or whether the claim should be determined pursuant to the standard administrative claims procedure. After the expiration of 90-day period or upon the denial of the secured claim by the receiver, the secured creditor is entitled to file suit (or continue a suit filed before the date of appointment of the receiver). After obtaining such relief, the creditor must move to renew the previously filed suit within the prescribed time or the creditor’s claim will be disallowed other than any portion of such claim which was allowed by the receiver.
Seeking possession or control of the property. A secured creditor can also seek to obtain possession of or control or to permit a foreclosure or sale of any property that serves as collateral for its secured claim. The receiver is required to grant its consent if the creditor has a legally valid and enforceable or perfected security interest or other lien against the property and the receiver will not use, sell, or lease the property. If the receiver intends to use, sell, or lease the property and adequate protection is necessary and appropriate, the receiver can provide the creditor adequate protection instead of granting consent. The failure by the receiver to grant or withhold consent within 30 days results in the receiver’s consent being deemed granted. Even absent consent, after 90 days, the creditor is permitted to terminate, accelerate, or declare a default of its contract.
In the event that the receiver is required to provide adequate protection to a secured creditor, it must do so in a fashion that is nearly identical to adequate protection under the Bankruptcy Code. Adequate protection may be provided by (1) making a cash payment or periodic cash payments to the claimant, (2) providing to the claimant an additional or replacement lien, or (3) providing any other relief that will result in the realization by the claimant of the indubitable equivalent of the claimant’s security interest in such property. If the value of the property is not depreciating or is sufficiently greater than the amount of the claim so that the creditor’s security interest is not impaired, then the creditor is not entitled to adequate protection. When a secured creditor’s contract is repudiated by the receiver, the effect is that the security interest will secure any claim for repudiation damages. In contrast to bankruptcy law, it is the receiver itself, rather than a bankruptcy court, which determines the extent that a secured creditor is entitled to adequate protection.
Estimation of Contingent Claims
Title II does not permit the disallowance of a claim merely because of its contingent nature. The receiver is required to estimate contingent claims based upon a measurement of the likelihood that such contingent obligation will become fixed and the probable magnitude thereof. Unless the claim becomes fixed and absolute prior to the estimation by the receiver, this is the value that will be used for purposes of distribution. While contingent claims estimation is common in bankruptcy cases, it generally is used for purposes of understanding the value of the claims rather than for distribution purposes.
Setoffs rights are intended to be unaffected under Title II except to the extent that (1) the creditor’s claim is disallowed, (2) an entity other than the covered financial company transferred the claim to the creditor (x) after the FDIC was appointed as receiver or (y) during the 90 days preceding the date of the appointment of the FDIC as receiver and the covered financial company was insolvent (except for a setoff in connection with a QFC (defined below)), or (3) the debt being offset was incurred by the covered financial company. As noted above, claims for the loss of setoff rights are given a priority above other general unsecured creditors but below administrative claims, amounts owed to the United States, and certain employee-related claims. In bankruptcy, setoff rights are considered the functional equivalent to a secured claim that has a significantly higher priority than the priority status afforded setoff rights in a Title II liquidation.
Similar to bankruptcy, the Title II receiver may avoid both (1) actual and constructively fraudulent transfers made by the covered financial company within the two years prior to the receivership and (2) payments made by the receiver within 90 days prior to the appointment of the receiver or with respect to insiders, one year prior to the appointment of the receiver. The receiver also has the authority to avoid unauthorized post-receivership transfers. These powers are similar in many respects to the powers of the trustee under the Bankruptcy Code and are designed to recover property to distribute to creditors of the covered financial company. The defendant shares many of the defenses that are available to a defendant under the Bankruptcy Code and is entitled to assert the defenses set forth in Sections 547, 548, and 549 of the Bankruptcy Code. The receiver’s authority to recover is also limited by Sections 546(b) and (c), Section 547(c), and Section 548(c) of the Bankruptcy Code (e.g., reclamation rights, preference defenses, good faith purchaser for value).
Rights in the Event of Contract Repudiation or Disaffirmance
Similar to bankruptcy, the receiver may disaffirm or repudiate contracts that are burdensome and for which repudiation will promote the orderly administration of the affairs of the covered financial company. In contrast to bankruptcy which permits a counterparty damages available under applicable law, counterparties’ resulting damages in a Title II receivership are generally limited to actual direct compensatory damages determined as of the date of the appointment of the receiver, or the date of the disaffirmance or repudiation in the context of qualified financial contracts (QFCs). Actual damages do not include (1) damages for lost profits or opportunity, (2) damages for pain and suffering, nor punitive or exemplary damages. Title II also provides for special damages in the following circumstances:
- Damages of a counterparty lessor are limited to the contractual rent accruing before the latter of the date on which the notice of disaffirmance or repudiation is mailed or the disaffirmance or repudiation becomes effective, unless the lessor is in default or breach of the terms of the lease. The lessor has no claim for damages under any acceleration clause or other penalty provision in the lease. The lessor may also claim any unpaid rent due as of the date of the appointment of the receiver.
- Where the covered financial company is a lessor under a lease and the lessee is not in default, the lessee may treat the lease as terminated or remain in possession for the balance of the term, unless the lessee defaults after the date of repudiation. When the lessee remains in possession, it is obligated to continue to pay contractual rent and may offset, against any rent payment which accrues after repudiation, any damages which accrue after such date due to the nonperformance of any obligation of the covered financial company.
Contracts for the Sale of Real Property
- If the receiver repudiates any contract for the sale of real property, and the purchaser is in possession and not in default as of the repudiation date, the purchaser may treat the contract as terminated, or remain in possession subject to making all payments due under the contract after the date of repudiation of the contract.
- Claims for services performed before the date of appointment of the receiver are deemed to have arisen as of the date the receiver was appointed. The receiver is obligated to pay the other party according to the terms of the contract for the services performed as an administrative expense prior to any decision to repudiate the contract.
Qualified Financial Contracts
QFCs, including securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements, and any other similar agreement that the FDIC determines by regulation, resolution, or order to be a QFC, receive special treatment under Title II.
- In the case of a QFC, no person is stayed or prohibited from exercising (1) any right to termination, liquidation, or acceleration of a QFC that arises upon the date of appointment of the receiver or any time thereafter; (2) any right under any security agreement or arrangement or other credit enhancement related to one or more QFCs; or (3) any right to offset or net out any termination value, payment amount, or other transfer obligation arising under or in connection with one or more QFCs, including any master agreement for such QFCs. Further, the FDIC may not avoid any transfer of money or other property in connection with any QFC with a covered financial company, unless the transferee had actual intent to hinder, delay, or defraud. These protections are generally available to the holder of a QFC under the Bankruptcy Code.
- Similar to bankruptcy law, walkaway clauses are not enforceable in QFCs of a covered financial company in default.
- When transferring assets or liabilities that include QFCs, the receiver must either (1) transfer all QFCs between a person or any affiliate thereof and the company, and related claims, security property, and credit enhancements, or (2) transfer none of the QFCs, claims, property, or credit enhancements.
- In exercising its repudiation rights, the receiver must either (1) disaffirm or repudiate all QFCs between (A) any person or its affiliate and (B) the covered financial company in default or (2) disaffirm or repudiate none of such QFCs.
Rights of a Contract Counterparty
The receiver has the authority to enforce contracts of subsidiaries or affiliates of the covered financial company, the obligations under which are guaranteed or otherwise supported by or linked to the covered financial company, notwithstanding any contractual right to cause the termination, liquidation, or acceleration of such contracts based solely on the insolvency, financial condition, or receivership of the covered financial company. The right to enforce non-debtor affiliate contracts is not available to a bankrupt debtor. In order to enforce these contracts, the receiver must first either (1) transfer supporting obligations of the covered financial company that back the obligations of the affiliate or subsidiary under the contract (along with all assets and liabilities that relate to those supporting obligations) to a bridge financial company or qualified third-party transferee by the statutory on-business day deadline or (2) provide adequate protection to such contract counterparties.
Adequate protection in these circumstances includes the receiver (1) making payments to counterparties of enforced contracts to the extent of any losses caused by the failure to transfer related support, (2) providing a guarantee of the obligations of subsidiaries or affiliates, or (3) providing relief that would result in realization by the counterparty to the enforced contract of the “indubitable equivalent” of the covered financial company’s support. While the term “indubitable equivalent” is required to be interpreted consistent with bankruptcy law, this term is generally only used in the context of dealing with secured claims in bankruptcy and not necessarily in the context of dealing with contract guaranties.
Adequate Protection for Priming Liens
Title II permits the establishment of bridge companies for use in exercising the receiver’s liquidation responsibilities. Essentially, the bridge financial company is a vehicle to house the valuable assets of the covered financial company, while leaving the “bad” assets and liabilities of the covered financial company behind. The receiver is generally authorized to obtain on behalf of the bridge company debt or issue credit secured by a senior or equal lien on property of the bridge financial company that is already subject to a lien if the bridge financial company is unable to otherwise obtain such credit or issue such debt, and there is adequate protection of the interest of the holder of the lien on the property with respect to which the senior or equal lien is proposed to be granted. Prior to priming the secured creditors liens, the receiver is required to provide the creditor being primed with notice and the creditor is entitled to a hearing before the court.
On a separate note, many of the same principles discussed herein with respect to the treatment of creditors of a covered financial company, including the potential to treat similarly situated creditors differently, subject to satisfaction of a minimum payment requirement to disfavored creditors, apply in connection with the establishment and operation of a bridge financial company.
While the liquidation rules under Title II are designed to achieve parity with the Bankruptcy Code, and facially in many respects do, a creditor must still be proactive in protecting its interests including timely filing its claim and meeting many of the other deadlines required under the Act. Further, the Orderly Liquidation Authority process is not particularly creditor friendly in that in most circumstances there is very little review by a neutral third-party arbitrator, particularly in the context of valuing the collateral of secured creditors. Finally, the process is still in its infancy, particularly given that no financial company has been subject to the Orderly Liquidation Authority, and so there will be likely continue to be development of regulations to help guide the wary creditor through the process.