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FDIC Establishes Draft Rule for Dismantling Large Financial Firms

Source: WSJ - Victoria McGrane & Jeffery Sparshott

Posted on 16 Mar 2011

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To avoid future bailouts or the collapse of large financial firms, U.S. regulators have laid out a partial plan for dismantling them.

The Dodd-Frank financial-overhaul law enacted last year aimed to provide the government with tools that officials said they lacked in 2008 when confronted with the imminent collapse of big financial firms—Bear Stearns, Lehman Brothers and American International Group Inc.—that weren't organized as banks.

The draft rule, approved unanimously by the five-member board of the Federal Deposit Insurance Corp., sets priorities for repaying creditors if the federal government seizes and breaks up a large, faltering financial firm. In this way, the government would no longer face the unpalatable choices of either letting the firm fail as Lehman Brothers did in 2008, by securing a rescue as in the case of Bear Stearns or bailing it out as the government did for AIG.

The proposed rule also establishes criteria the FDIC would use to determine if a firm's senior executives or directors are "substantially responsible" for the failure of the firm, and thus could be forced to repay past compensation.

Under the new rules, as has been the case with banks for decades, the FDIC can take over flailing firms, pay off some creditors, fire the management and temporarily operate the entities until it closes or sells them.

Under the Dodd-Frank law, the Federal Reserve, Treasury Department and FDIC would all have to agree to put a firm into this process, called "orderly liquidation."

The draft rule proposed Tuesday by the FDIC picks up after that decision has been made. The law directs the FDIC, as receiver of the failed firm, to decide if any senior officials are "substantially responsible" for its failure. Generally, the FDIC can recoup a full two years of pay from any executives found to be at fault. In cases of fraud, this clawback provision can apply to earnings over an unlimited time period.

Under the proposed rule, the FDIC would weigh in if a senior executive did his job with the "requisite degree of skill and care required by that position," and whether his performance caused a loss that "materially contributed" to the company's failure.

The rule, however, puts the burden of proof on the senior executives in most cases; the FDIC will go into its decision presuming the executives are substantially responsible. This presumption would not apply to recently arrived executives hired to "save" or turn around firms.

After Lehman failed, Chief Executive Richard Fuld Jr. and other firm executives faced severe criticism over their past pay packages, which were unaffected by the bankruptcy, while many creditors took huge losses. Had the new law been in place then, regulators could have sought to force Mr. Fuld and his colleagues to pay back some part of their compensation.

Rep. Barney Frank (D., Mass.), a lead architect of the financial-overhaul law, said the purpose of the clawback provision "is not to punish people as much as to make them take risks more into account." Current incentive practices encourage executives to take excessive risks because there is no downside if the bets turn sour, he said.

The draft rule also lays out the order in which unsecured creditors would get paid and how creditors would file claims. The rule would give top priority to debts incurred after the government seizes a company. Next in line for payment are administrative costs to keep the failed company operating, followed by any taxpayer funds borrowed from the Treasury Department or other federal agencies to cover the costs of winding down the failed firm.

"We want shareholders and creditors to understand that if their institution fails, they are on the hook for losses, not taxpayers," FDIC Chairman Sheila Bair said at the board's meeting.

Taxpayers are followed by rank-and-file employees, benefit plans, different classes of creditor claims, subordinated debt obligations, wages for senior executives, and lastly, shareholders. Secured creditors would be paid before all unsecured creditors based on the fair-market value of the collateral they hold.

After the proposal is published in the Federal Register, it is opened to public comment for 60 days. It would then be subject to another vote before it would take effect.