A Functional Analysis of Sifi Insolvency

Abstract

In a 1989 article that remains one of the clearest, most sensible explications of an especially tricky point of bankruptcy law, Jay Westbrook announced a forthright methodology: "I call my approach "functional," because it proceeds by working through the problem from first principles." The same basic technique can tell us a lot about how banks - and other bank-like creatures or SIFIs, to use the industry lingo - should fail.

On the one hand, governmental rescue of shareholders and other investors is beyond annoying, and there is some intuitive sense that if management does a poor job, they and their investor backers should face the consequences, just like any other firm. That bank managers would have the temerity to pay themselves large bonuses shortly after a taxpayer rescue only emphasizes the point.

On the other hand, there is a widespread understanding that a large bank, or a sufficiently interconnected one, is not quite like Kmart, Enron, or even American Airlines, in that when the bank fails, it tends to take a large chunk of the economy along with it.

Should we use bankruptcy or not? The 2010 legislative response to Lehman, and AIG, and Bank of America, and Citibank, and every other large financial institution that almost failed (or did, in the case of Lehman) is notably wobbly on the question of "how will a big bank fail?" Dodd-Frank created a new, FDIC-focused "orderly liquidation authority" or OLA to handle these cases, but then made it incredibly difficult to actually use OLA. Instead, banks are told to plan for failure under the Bankruptcy Code, and this time they should not expect any of the help that Lehman got.

Bank insolvency, I submit, is all about special priorities: both ordinal and temporal. The Bankruptcy Code, on the other hand, takes an "equality is equity" approach to priorities as a baseline, mostly using state law to draw the claim-asset border. Bargaining for results within the general "equality" framework is another key feature of traditional insolvency law.

Financial insolvency law expressly rejects this model; it instead is all about protecting some favored group from the effects of insolvency. There is no equality here, and it was never intended that there would be equality. And thus it is time to stop pretending SIFI insolvency is "normal" corporate insolvency but bigger.

After nearly a decade of waffling between "special" and "normal" bankruptcy for banks, I believe we are now ready to build upon what we have learned and to take the necessary further step: stop feigning that bank insolvency can or should happen in bankruptcy court.

Keywords: Dodd-Frank; chapter 11; SIFI; too big to fail; FDIC; OLA; Lehman; bankruptcy; SPOE; chapter 14; CHOICE Act