Restructuring

Contributed by Edward Wu
On August 15, 2011, a Final Rule issued by the FDIC addressing several important aspects of the Orderly Liquidation Authority under the Dodd-Frank Act became effective.  As discussed in a prior blog entry, the Final Rule addresses various issues, such as which systemically important financial companies are subject to the Orderly Liquidation Authority and, if an orderly liquidation is commenced, the treatment of similarly situated creditors, the avoidance of fraudulent and preferential transfers, the recoupment of compensation from executives and directors, and the claims resolution process.
Among those issues, the treatment of claims in an orderly liquidation and the procedures by which those claims will be resolved are of particular interest to insolvency practitioners and financial institutions and their stakeholders.  This treatment could affect the cost of capital for financial companies and the strategies employed by creditors both prior to and after a company enters receivership under the Dodd-Frank Act.  This article focuses on the claims resolution process for unsecured claims, as clarified by the Final Rule.  The treatment of secured claims will be addressed in a subsequent article.
The Claims Resolution Process
In any insolvency proceeding, recoveries to creditors are determined not only by the value of assets available for distribution, but also by the aggregate amount of allowed claims.  As it relates to this latter factor, the Orderly Liquidation Authority claims resolution process may have a significant impact on creditor recoveries.  As set forth in the Final Rule, the main sequence of events relating to the resolution of claims would unfold as follows:

1. After the FDIC (or other applicable agency) is appointed as receiver of a financial company, it will “promptly” provide notice by publication of the deadline to submit claims against the company to the FDIC.  Such bar date shall be at least 90 days after the publication date.  Concurrently, the FDIC will also provide actual notice of the bar date to known creditors.
2. Within 180 days after a claim is submitted, subject to any consensually agreed upon extensions of time, the FDIC can disallow all or a portion of the claim that is not proved to its satisfaction.  If the FDIC does not make a decision within 180 days, the entire claim is automatically disallowed.
3. After all or a portion of a claim is disallowed, the claimant shall have 60 days to seek de novo judicial review in the federal district court of the financial company’s principal place of business or, if applicable, to continue an action commenced prior to the receivership in the court in which such action was pending.

The Dodd-Frank Act’s approach to resolving claims is aggressive and potentially unrealistic in the case of a systematically important financial institution, which will likely have tens of thousands of creditors.  The Final Rule puts significant pressure on creditors and the FDIC to act quickly by requiring a bar date to be set promptly after commencement of the receivership and, more importantly, providing the FDIC with only 180 days to review each proof of claim.  Realistically, the FDIC is unlikely to be able to resolve the tens of thousands of claims in that time period, especially if the FDIC must exert concurrent efforts to find purchasers and/or otherwise preserve the value of the financial company’s assets, all while mitigating risk to the financial system from the company’s failure.  While such a timeframe also applies under the FDIA with regard to the resolution of traditional depositary institutions, virtually no failures under the FDIA could rival the size and complexity of a failure of an entity subject to the Orderly Liquidation Authority.  The likely result under the Dodd-Frank Act is that there will be large numbers of claims that the FDIC does not have time to consider or strategically chooses not to resolve, which consequently will be automatically disallowed without any explanation by the FDIC.  Many unsophisticated creditors and holders of smaller claims are unlikely to pursue judicial review after disallowance by the FDIC due to, among other things, the cost of litigation.
Neither the Dodd-Frank Act nor the Final Rule specifies the choice of law and legal standard used by the FDIC in determining whether all or a portion of a claim should be disallowed or what it means for a claim to be proved to the FDIC’s satisfaction.  Drawing upon similarities from the resolution of institutions under the FDIA, it can be expected that the FDIC will determine the allowance of contract claims pursuant to the law of the jurisdiction set forth in a choice of law clause.  In other situations, where no such clause exists or when dealing with a tort claim, it is reasonable to expect that the FDIC will determine the appropriate legal standard from the choice of law rules of the jurisdiction in which a claimant will have recourse upon disallowance (i.e., the district court of the financial company’s principal place of business or, if applicable, the forum in which an action was commenced prior to the receivership).  Depending upon the precise definition of a “principal place of business,” which is not defined in the Dodd-Frank Act or the Final Rule, for many large financial firms, it can be expected that the applicable forum will be the District Court for the Southern District of New York.  As with the FDIA, however, the legal standard applied by the FDIC in any given situation may be arbitrary given that a rigorous analysis by the FDIC of a jurisdiction’s choice of law rules cannot be assumed, particularly in the tight timeframe for the FDIC’s claims review.
Litigation relating to disallowed claims, which is necessary to determine the final recoveries of creditors, may be extraordinarily time consuming and expensive under the Dodd-Frank Act.  Several months after the commencement of the receivership, notwithstanding that many unsophisticated creditors and holders of smaller claims may lack the means to seek judicial review of a disallowance by the FDIC, the district court of the principal place of the financial company’s business could be inundated with claims litigation.  While bankruptcy trustees may file omnibus objections to many types of claims, which tremendously decreases both the time and cost of litigation, the Dodd-Frank Act does not set forth a similar mechanism.  This will put pressure on the applicable district court, which is unlikely to have experience handling floods of insolvency claim litigation, to implement creative solutions to effectively manage its docket.
It is also unclear how and to what extent the FDIC will establish reserves for disputed claims prior to making distributions.  Nevertheless, the FDIC has the authority to make “advance dividends” on claims that are proven to its satisfaction.  Thus, while the FDIC has resolved that holders of “long-term senior debt” (including certain bondholders) may never be treated more favorably than other similarly situated creditors to mitigate contagion of systemic effects, the FDIC touts that it still has the option to provide some liquidity to these and other creditors through advance dividends.  It remains to be seen how the FDIC will determine the amount of dividends to distribute given that, to be effective, such distributions will likely be made at an early stage when the value of the financial company’s assets and/or amounts of liabilities are unclear.  While the Dodd-Frank Act allows the FDIC to recoup certain over-payments to favored creditors through assessments, it does not appear to address the ability to recoup over-payments that result from advance dividends.
Conclusion
As it is currently structured, the claims resolution process under the Dodd-Frank Act is aggressive because of the short time frame in which the FDIC is expected to resolve claims and the wide discretion afforded to the FDIC in disallowing claims.  Perhaps the most puzzling aspects of the claims resolution process are the ability of the FDIC to automatically disallow claims after 180 days and the ability to determine the allowance of claims without announcing or adhering to established choice of law rules.  While these procedures were presumably adopted to allow for an expedient resolution of claims, it remains to be seen how district courts will be affected by, and respond to, the ensuing claims litigation.  These and other aspects of the Dodd-Frank Act may become clearer in time as the FDIC continues to introduce further rules to shape its contours.