Looking at One Exchange From Today's Oversight Hearings
Source of Strength and the Bankruptcy Code
Today between the House and the Senate there was a total of around six and a half hours of testimony and questioning relating to recent U.S. regional bank failures. This post focuses on a two minute exchange that was not really the main highlight and that, to be honest, involves a legal issue I am not sure I fully understand. But if my interpretation of this line of questioning is correct, I think it was trying to get at something important and something that is still largely unsettled in the law.
Let’s start with the exchange in full:1
Rep. French Hill: Chairman Gruenberg, let me talk to you about source of strength. Holding companies deliver a major source of strength to their depository institutions, right?
FDIC Chair Gruenberg: Yes, sir.
Rep. Hill: And we take that for granted to some degree, is that true? We just accept that that holding company is there?
Chair Gruenberg: Well not all institutions as you know have holding companies, but the system is set up for those that do, the holding company is expected —
Rep. Hill: Silicon Valley had a holding company?
Chair Gruenberg: It did.
Rep Hill: Do you have a written agreement that that holding company provide a source of strength to the depository bank?
Chair Gruenberg: We were not the supervisor of Silicon Valley and the Fed as you know is the holding company regulator, so I think that they’d be —
Rep. Hill: No, but don’t you have to have as the FDIC a written agreement with that bank holding company to provide a source of strength to the bank?
Chair Gruenberg: I believe that’s a regulatory standard, not something that we would have, some sort of —
Rep. Hill: Well can you provide me a yes or no in writing whether you and the Federal Reserve had a written supervisory agreement that the holding companies of all the banks that have over 50% of their deposits in uninsured accounts, that they have a written agreement with the holding company — if they have a holding company — with the supervisor?
Chair Gruenberg: I’d be glad to.
Rep. Hill’s time then expired.
This post is written from the perspective of someone without a ton of background in the area whose only real qualification is reading a lot of stuff by people smarter than me, and so is not legal, financial, or any other sort of advice. But with that disclaimer provided, I am pretty sure the above exchange is a lightly garbled line of questioning about the bankruptcy code.
The bankruptcy code is relevant here because although Silicon Valley Bank failed and went into receivership, its parent company Silicon Valley Bank Financial Group (SVBFG) is currently in Chapter 11 proceedings. And, as this Skadden Arps memo from a few months ago explains, such proceedings involving bank holding companies have “significant distinguishing features” as compared to other Chapter 11 cases.
Treatment of Certain Capital Commitments to a Bank Under the Bankruptcy Code
The general rule in bankruptcy is that a debtor has the option to either assume or reject “executory contracts,” which you can think of as contracts under which both parties still have material performance obligations remaining.2 That is, in an ordinary Chapter 11 case, the debtor generally can choose whether to keep performing under the contract (assume) or to not do that (reject) if it would be in the interest of the debtor to do so.
Section 365(o) of the Bankruptcy Code, however, provides a different rule in the case of a “commitment by the debtor to a Federal depository institutions regulatory agency . . . to maintain the capital of an insured depository institution subsidiary.” In that case, the debtor does not have the choice. Instead, the debtor is “deemed to have assumed,” and thus must perform under, the commitment.
Back to the Skadden memo:
As a result of this automatic assumption, the debtor holding company must also immediately cure any deficit under any such a commitment, or its bankruptcy case will be converted from chapter 11 to a chapter 7 liquidation proceeding in which a trustee is appointed to liquidate the debtor’s assets. In such a case, FDIC claims relating to valid capital maintenance obligations will come ahead of general unsecured claims (e.g., unsecured funded debt at the bank holding company as well as the bank holding company’s shareholders).
The problem though is that the Bankruptcy Code does not define what a commitment means in this context. Skadden again:
[W]hether a valid, enforceable commitment exists becomes an issue for bankruptcy court interpretation, based on the evidence. Several bankruptcy courts have examined whether particular communications or undertakings constitute valid, enforceable contracts and thus whether they constituted the sort of capital maintenance obligation envisioned by section 365. In two cases, courts found no enforceable commitment:
In re The Colonial BancGroup, 436 B.R. 713 (Bankr. M.D. Ala. 2010) (holding that bank holding company did not make a commitment to maintain the capital of its bank subsidiary).
In re AmFin Financial Corp., Case No. 10-CV-1298, 2011 WL 2200387 (N.D. OH., June 6, 2011) (holding that the FDIC failed to present sufficient evidence that either the regulator or the holding company understood or intended for the documents at issue to create a “commitment” by bank holding company to maintain the capital of its former bank subsidiary).
In two other cases, courts held there was an enforceable obligation:
In re Imperial Credit Indus., Inc., 527 F.3d 959 (9th Cir. 2008) (finding a holding company’s performance guaranty constituted a capital maintenance obligation under section 365(o)).
In re Overland Park Fin. Corp., 236 F.3d. 1246 (10th Cir. 2001) (finding holding company’s stipulation in writing to regulator that it would maintain net worth of savings and loan subsidiary constituted a commitment for purposes of section 365(o)).
The Skadden memo is only meant to be an introduction to potential issues and so the 365(o) discussion stops there, but I think from this you can already see why Rep. Hill might have been asking the questions he did.
If a “commitment” (whatever that means) existed for SVBFG to maintain the capital of SVB, then the FDIC as SVB’s receiver would all else equal be in a better position to recover from SVBFG in the bankruptcy proceeding.
The Case Law
Just because I was interested and had not read them before, I took a look at the cases cited in the Skadden memo above to see what the courts in question did, or did not, find compelling as evidence of a commitment to maintain capital. I make no claims that the case law cited in the memo is or is not representative - refer to the above disclaimer about this not being legal or financial advice. Also, see the next section below for a discussion of why this case law may not be dispositive in a post Dodd-Frank world.
In any case:
Here, a bank holding company in bankruptcy had previously been subject to a series of enforcement actions brought by the Federal Reserve, including a 4(m) agreement, an MOU and a Cease and Desist order. The FDIC argued that the holding company’s entry into these agreements represented a commitment to maintain capital at the bank subsidiary. For example, under the MOU the holding company committed to, among other things, “assist its subsidiary bank in addressing weaknesses identified by its primary banking supervisors and achieving/maintaining compliance with [a bank-level MOU].” In addition, the C&D order with the holding company included a paragraph titled “Source of Strength” that required the holding company’s board to “take appropriate steps” to ensure compliance by the bank with its own C&D order.
The court ruled against the FDIC, saying it had “found no case law supporting the FDIC's position that these documents create a commitment within the meaning of 11 U.S.C. § 365(o).”
The language is broad and general and requires only that the Debtor "assist" the Bank. The language does not specify any particular method of assistance or prescribe specific steps that the Debtor must take. The language does not dictate what financial and managerial resources the Debtor must utilize. Nor does it require the Debtor to serve as a guarantor of the capital ratios or to pledge any assets to secure any capital deficiency. Most importantly, the language does not require the Debtor to make a capital infusion, in any amount, in the Bank.
The parent holding company, which was regulated by the OTS, had entered into a C&D order in which the holding company committed to “ensure that [the Bank] complies” with the bank’s obligation to maintain certain capital ratios under its own C&D order. The holding company was also required to adopt a “detailed capital plan” for how it would ensure the bank would maintain those ratios.
The lower court found that this provision was better read as describing an oversight role for the board, not a capital-maintenance obligation, and the Sixth Circuit did not disturb that conclusion on appeal.
Despite the complicated fact pattern and the variety of legal arguments raised in the parties' briefs, the ultimate issues here are relatively straightforward. The district court correctly held that the C & D is ambiguous on its face because paragraph 8's requirement that AFC's board “ensure that [the Bank] complies” with its own cease-and-desist order can reasonably be read as establishing either an oversight role or a capital-maintenance commitment. OTS's alleged interpretation of the C & D is not entitled to deference because it is too vague to be considered an interpretation or else because it is a clearly erroneous reading of the C & D. And the district court's decision construing the C & D as not including a capital-maintenance commitment was not clearly erroneous because the bulk of the extrinsic evidence favors the “oversight” reading of the C & D.
In re Imperial Credit Indus., Inc.
The parent holding company of a bank subject to a prompt corrective action notice had been required to provide a guaranty of the bank’s performance under a capital restoration plan. The Ninth Circuit held that this was sufficient to constitute a commitment to maintain capital under Section 365(o).4
In re Overland Park Fin. Corp.
This case concerned a holding company that in 1978 had acquired a savings and loan association. As part of that acquisition, the holding company committed to FSLIC that it would cause the net worth of its savings and loan subsidiary to be maintained at a required level, and that the holding company would, where necessary, “infuse sufficient additional equity capital to effect compliance with such requirement.” More than a decade later in 1990 the savings association subsidiary failed to meet its minimum capital requirements, so the OTS asked the holding company to infuse capital. The holding company said no thanks, the situation continued to deteriorate, and in November 1992 OTS placed the savings association into receivership.
The Tenth Circuit ultimately held that the 1978 stipulation was a commitment under Section 365(o):
We disagree with Overland Financial's strained reading of the statute and its attempt to re-characterize the stipulation as a "mere acknowledgment. […]
The common definition of "commitment" is an "`[a]greement or pledge to do something.'" Firstcorp, 973 F.3d at 249 n. 5 (quoting Black's Law Dictionary 248 (5th ed. 1979)). The facts of this case show Overland Financial's stipulation is well within the boundaries of this definition, and unequivocally constitutes a "commitment." First, the language employed in the stipulation is mandatory and evinces Overland Financial's understanding it is obligated to maintain, and if necessary infuse, capital in order to ensure Overland Financial's compliance with federal regulatory code. Overland Financial even admits it understood, at the time of the signing, the stipulation was an integral condition precedent to the Federal Home Loan Bank Board's approval of the acquisition. In other words, Overland Financial could not have acquired Overland Savings Loan without the stipulation, and the President of Overland Financial personally signed the stipulation. Thereafter, Overland Financial had the privilege of operating Overland Savings Loan from 1979 to 1992. In reviewing this aggregated evidence, we hold Overland Financial provided, in its stipulation, a unilateral pledge to maintain Overland Savings Loan's capital. Therefore, Overland Financial's stipulation is a binding commitment.
Under the case law as summarized above (again assuming it is representative), and given my understanding of the Federal Reserve Board’s general practice, it seems like it could be tough for the FDIC to find a written agreement between SVBFG and the Federal Reserve that could be construed as a commitment to maintain capital at SVB.
For example, although the Vice Chair for Supervision Barr report says that SVBFG/SVB were poised to enter into an MOU that would have included a source of strength provision requiring the board of SVBFG to “take appropriate steps to fully utilize SVBFG’s financial and managerial resources … to serve as a source of strength to the Bank, including, but not limited to, taking steps to ensure that the Bank complies with any supervisory action taken by its federal or state regulators,” it is not clear that under the case law this would be viewed as a commitment to maintain capital.5 And regardless, the MOU remained in draft form and had not been entered into at the time SVB failed and SVBFG entered Chapter 11 proceedings.6
The Statutory Source of Strength Requirement
What this post has left out until now, however, is a provision of the Dodd-Frank Act that, by statute, mandates that the Federal Reserve Board “require the bank holding company or savings and loan holding company to serve as a source of financial strength for any subsidiary of the bank holding company or savings and loan holding company that is a depository institution.”
Does this change the analysis? I have no idea, although I am given some comfort by the fact that other people also seem uncertain:
Indeed, even before the enactment of Dodd-Frank, conflicts often arose when a BHC and its IDI subsidiary experienced financial failure at the same time. Under those circumstances, the FDIC (acting as receiver for the IDI) was frequently at odds with the bankrupt BHC over whether the BHC was obligated to provide capital support for the benefit of the IDI and its depositors. If the FDIC could convince a bankruptcy court that the BHC had made an affirmative commitment (such as through a capital maintenance agreement or other similar arrangement) to prop up the IDI, then Section 365(o) of the Bankruptcy Code provided that the arrangement was deemed assumed and the debt would receive priority in bankruptcy.
Section 616(d) of Dodd-Frank further complicates the pre-existing issue by amending the FDI Act to require BHCs to “serve as a source of financial strength for any subsidiary…that is a depository institution.” It is unclear whether Congress was mindful of Section 365(o) when it enacted this provision of Dodd-Frank, or how the provisions might be reconciled.
Your guess is as good as mine as to whether the bankruptcy court currently overseeing the SVBFG Chapter 11 proceedings will be called upon to decide whether SVBFG actually made any sort of commitment to SVB within the meaning of 365(o), but Rep. Hill’s questions at the hearing today indicate at least one person or group is thinking about the issue.
One final thing: In the exchange above, Chair Gruenberg refers to source of strength as a regulatory standard. It is clear what he means, obviously, but it’s worth pointing out that though the Dodd-Frank Act required the banking agencies to adopt source of strength regulations by a date “not later than one year” after the law’s enactment, more than a decade later there still has not been a proposal, much less a final rule. This is listed as a long-term action on the Federal Reserve Board’s most recently published regulatory agenda, as it has been on several prior regulatory agendas.
Thanks for reading! Are you a restructuring lawyer upset that I missed something glaringly obvious in this post (which I have the sinking feeling I have done)? If so, or if you otherwise have thoughts, challenges, or criticisms to share they are always welcome at bankregblog@gmail.com.
See the DOJ summary in the link above for a more nuanced look at how courts have approached deciding whether something is an executory contract (a term which is not defined in the Bankruptcy Code).
The link here is to an appellate court decision rather than to the bankruptcy court decision in the Skadden memo, as it was the appellate decision was the most readily accessible public opinion I could find in the case.
There was also some dispute in the case about whether the guaranty in question applied under the finalized version of the capital restoration plan, which went through several rounds of back and forth with the FDIC. According to the holding company the guaranty only applied to earlier versions of the restoration plan, but the court rejected this argument.
Other than the expanded language relating to taking “appropriate steps to fully utilize” the holding company’s financial and managerial resources to serve as a source of strength to the bank, this language is not much advanced over the language in the Colonial BancGroup case, which the bankruptcy court found not to constitute a commitment to maintain the capital of a subsidiary. There is reason to believe that a bankruptcy court would find that the standard language does not meet the requirements of Section 365(o).
See pages 7-8 of the executive summary:
For example, it took more than seven months to develop an informal enforcement action, known as a memorandum of understanding (MOU), for SVBFG and SVB to address the underlying risks related to “oversight by their respective boards of directors and senior management and the Firm’s risk-management program, information technology program, liquidity risk management program, third-party risk-management program, and internal audit program.” SVBFG failed before the MOU was delivered.