Margaret L. Merrill** Abstract Title II of the Dodd-Frank Act of 2010 establishes a new specialized insolvency regime, known as orderly liquidation, for nonbank financial companies deemed to be too big to fail. Title II raises a number of serious constitutional questions, most of them related to the provisions requiring a federal district judge to appoint the receiver for a failing firm. In order to vest the appointment authority in an Article III judge, and yet also avoid a financial panic, the Act requires that the judicial proceedings be conducted in secret, that no notice can be given to the public or other interested parties on pain of criminal penalties, and that the judge must rule on the petition to appoint the receiver within twenty four hours. These unprecedented procedures raise serious questions under the Due Process Clause, Article III of the Constitution, and the First Amendment. The very broad discretion given the executive branch to decide whether a distressed financial firm should be subject to mandatory liquidation under Title II, as opposed to conventional bankruptcy, also raises questions under the uniformity requirement of the Bankruptcy Clause. Finally, Title II raises a number of potential takings issues. Given the extremely abbreviated time for judicial appointment of a receiver, the prohibition on any stay pending appeal, and the absence of any post-appointment judicial review of the decision to put a firm into receivership, there are also a number of vexing questions about how and when the constitutional issues raised by Title II might be presented to the courts. This article examines these constitutional and procedural questions, and argues that Congress should amend the Dodd-Frank Act to provide for plenary judicial review after rather than before a receiver is appointed. This simple change, along with some tightening of the language that determines when orderly liquidation rather than bankruptcy is appropriate, would help assure that the new Title II authority is not undermined by a confusing welter of constitutional claims, if and when it becomes necessary to use this authority to avert a future financial crisis.
Introduction The Dodd-Frank Act1 is in significant part a response to public outcry over public bailouts of financial firms that are deemed too big to fail. In the financial crisis of 2008-09, the federal government supplied emergency financial support to many financial firms in order to keep them afloat.2 The fear was that the insolvency of one or more of these firms would trigger a chain reaction by creditors, analogous to a run on the bank, which would in turn have ripple effects throughout the economy. As it happened, the financial system did freeze up for a short time after the Lehman Brothers bankruptcy,3 which tipped the economy into a deep recession followed by a painfully weak recovery.4
Once the immediate crisis subsided, many perceived that large financial firms and their well-paid officers and directors had survived quite nicely, whereas large numbers of ordinary Americans were suffering from the lingering effects of the downturn. The idea that the federal government would rescue large financial firms with taxpayer dollars, while ordinary citizens lost their jobs and watched their savings evaporate, resulted in widespread voter anger. One proposition all politicians seem to agree upon, at least publicly, is that never again should ordinary folks be taxed to prop up giant financial firms deemed too big to fail by the government.5
In terms of reform, there were a number of possible structural alternatives to public bailouts of financial firms deemed too big to fail. One would be to break up large financial firms, so that no single firm could be said to be too big to fail. This might be accomplished by imposing line of business restrictions, as under the Glass Steagall Act, with companies limited to one line of business, such as commercial banking, investment banking, brokerage, or insurance. Dodd-Frank’s so-called Volker rule6, which limits the ability of banks to engage in proprietary trading, is a diluted version of this strategy. Or Congress could impose limits on the maximum assets of financial firms, with mandatory divestiture once the limit is reached. Downsizing presumably would reduce the risk of single rogue institution bringing the entire financial system down when risky bets turn bad.
Another structural solution would be to impose limits on the debt financial firms can take on, as by increasing capital reserve requirements or (in the case of nonbank firms) imposing them for the first time.7 The higher the capital reserve requirements, the lower the risk of insolvency, and hence the lower the need for future bailouts. Higher reserve requirements would of course reduce the profitability of the financial sector, which would presumably re-direct assets (and talent) to other sectors. From a social welfare perspective, the tradeoff might be worthwhile – lower profitability for financial firms in return for lower risk of future financial crises that afflict pain on millions of ordinary Americans.
A third structural solution, which has been advanced by bankruptcy scholars,8 would be to amend the Bankruptcy Code to subject novel financial instruments like repurchase agreements (repos) and derivatives or swaps (collectively referred to in the Dodd-Frank Act as “qualified financial contracts” or QFCs) to the automatic stay and avoidance provisions of the Bankruptcy Code. Interestingly, the law had moved in exactly opposite direction before the financial crisis, with special legislation (pushed by the financial industry) exempting QFCs from resolution in bankruptcy.9 Without the shield of the bankruptcy process, the logical response of counterparties to these instruments when they sense a financial firm is in distress is to race to cash out – exactly the kind of free-for-all that bankruptcy is designed to prevent. It is thus plausible that the special exemption from bankruptcy adopted for QFCs contributed if it did not cause Lehman’s collapse and the panic that followed.10 Subjecting these instruments to ordinary bankruptcy powers might significantly mitigate the too big to fail problem, at least insofar as nonbank financial firms are concerned.11
These structural solutions – any one of which could be implemented with a relatively simple piece of legislation – were rejected, we believe, not because they are bad ideas but because they were adamantly opposed by the financial industry. Clearly, financial firms did not want to be downsized or de-leveraged. It is also clear that the financial industry opposed any move to subject QFCs to the automatic stay and avoidance provisions of the Bankruptcy Code, presumably on the ground that this would diminish the substantial profits associated with developing such products.12 In any event, because each of these solutions faced concerted opposition from big finance, they were never seriously considered by the Treasury Department – which provided the initial draft legislation that became the Dodd Frank Act – or the Congress that adopted it. Firms that are too big to fail are apparently also too big to be challenged politically.
Given that these relatively straightforward structural solutions were off the table, how could the politicians square the circle between preventing future taxpayer bailouts of large financial firms while leaving the prerogatives of these firms essentially untouched? The answer is complicated, as revealed at once by looking at the immense length of the Dodd-Frank Act. Some of the measures in the Act are designed to improve the regulation of derivatives and other complex financial instruments thought to have been inadequately regulated before the financial crisis.13 Others are designed to ensure better advance warning of systemic financial risks.14 Still others are designed to beef up consumer information and protection against overly-aggressive lending and other banking practices.15 But the fundamental decision not to tinker with the size or profitability of large financial firms, or to subject novel financial instruments to ordinary bankruptcy processes, created challenging design issues in achieving the fundamental objective of eliminating future taxpayer-funded bailouts of financially distressed firms.
The core of the legislative strategy, which is set forth in Title II of Dodd- Frank, is to replace taxpayer bailouts of systemically significant distressed firms with a kind of specialized bankruptcy process, which the Act labels “orderly liquidation.” Ordinary depository banks and savings and loans that take government-insured deposits have long been subject to special resolution procedures that utilize a receivership or conservatorship; this authority was augmented before the enactment of Dodd-Frank to include provisions allowing the receiver or conservator to take systemic financial risk into account in certain circumstances.16 The new orderly liquidation authority adopted in Title II of Dodd-Frank applies to large financial firms other than depository banks and savings and loans, namely, to bank holding companies and other systemically significant nonbank financial firms such as brokerage houses, investment banks, and insurance companies.17 Under this new resolution authority, government agencies are given broad discretion to decide on a case-by-case basis that a large nonbank financial firm is in trouble and that its failure would pose a threat to the economy. This decision leads to a takeover of the firm by a government receiver, typically the Federal Deposit Insurance Corporation (FDIC),18 which proceeds to run the company as it resolves claims of creditors until the firm is eventually liquidated. Positive-value assets can be transferred to a “bridge financial company” and eventually folded into another firm.19 If financing is required to meet obligations while the firm is wound down, the necessary funds will be supplied by the Treasury.20 The Act nevertheless insists that this funding is not a bailout, because any deficiencies will be financed by wiping out shareholder equity, rejecting claims of unsecured creditors,21 and, if need be, imposing special ex post “assessments” on other large financial firms.22
The idea of bailing out firms deemed too-big-to-fail is not only condemned on fairness grounds, such a policy is also objectionable on the ground that it promotes excessive risk taking. When a too-big-to-fail firm makes risky bets that pay off, the gains are captured by top level management and shareholders; but when the firm makes risky bets that turn disastrous, the losses are borne by taxpayers.23 This asymmetry creates a moral hazard of the heads-I-win-tails-you-lose variety. If permanently institutionalized, this implicit guarantee would almost certainly exacerbate excessive risk taking by large financial firms, which in turn would magnify the risks of triggering another financial crisis.
Title II is supposed to put an end to this moral hazard.24 The statute includes a number of punitive features designed to deter systemically significant financial firms from engaging in excessively risky behavior.25 A distressed firm that goes through the Title II process must be “liquidated,” its shareholders must be wiped out before creditors take a hit, its directors must be fired, and its officers who were “responsible” for the financial distress must be dismissed.26 These provisions are designed to assure that the public will not immediately see a firm with the same name, and the same personnel, raking in millions shortly after the resolution process is over.
Nevertheless, Title II’s orderly resolution process preserves a version of taxpayer-funded socialization of losses. This is because the Treasury is authorized to advance funding to a firm undergoing resolution under Title II, and if, after wiping out shareholders and unsecured creditors, the proceeds obtained from selling the firm’s assets are inadequate to reimburse the Treasury, the statute authorizes the Treasury to impose so-called “risk-based assessments” on other large financial firms in order to recoup these monies.27 These assessments are a tax by any other name. Whether the incidence of this tax will be borne by the shareholders of the assessed financial firms or the public in the form of higher fees for financial services is impossible to determine; almost certainly some of both.28 In any event, under Dodd-Frank Title II losses created by excessive risk-taking will be borne at least in part by ordinary taxpayers and citizens, as under the regime of bailouts now so widely condemned.
No one seems happy with the complicated compromise embodied in Title II. Small financial firms are aggrieved by the provisions that continue to provide an implicit subsidy for large financial firms, in the form of the socialization of losses in the event they fail. They argue that this implicit subsidy lowers the costs of borrowing to large firms relative to small firms, giving them an unwarranted competitive advantage.29 Managers and investors of big financial firms are uneasy with the prospect that they will be wiped out if and when they get into trouble sometime in the future. Certainly those who wanted fundamental reform of the financial industry are dissatisfied with the statute’s preservation of the essential attributes of the status quo.
In keeping with Tocqueville’s famous adage that “[s]carcely any political question arises in the United States that is not resolved, sooner or later, into a judicial question,”30 Dodd-Frank’s orderly liquidation authority is now the subject of a lawsuit. Eleven state attorneys general have filed a lawsuit in the U.S. District Court for the District of Columbia charging that Title II violates due process, Article III of the Constitution, and the uniformity requirement of the Bankruptcy Clause.31 The suit was recently dismissed by the district court on standing and ripeness grounds,32 and this jurisdictional ruling is now pending on appeal to the D.C. Circuit.33 As we detail, however, many of the plaintiffs’ arguments are surprisingly strong on the merits. This makes it highly unlikely that constitutional claims advanced by the state AGs will disappear, even if the dismissal of their lawsuit on jurisdictional grounds is upheld on appeal. Indeed, these constitutional arguments are likely to re-emerge at the worst possible time – if and when another financial crisis hits and one or more systemically significant financial firms are slated for orderly liquidation under Title II. The need to sort out these constitutional questions in the midst of a financial crisis could significantly disrupt or at least delay the resolution process envisioned by Congress. It would be far better to fix these problems now, by appropriate legislative amendment, while the legal machinery associated with Title II is being put into place.
Most of the constitutional infirmities in Title II stem from the decision to have the receiver for a systemically significant nonbank financial firm appointed by a federal district judge. In order to confer appointment authority on a federal judge, and yet also prevent the modern-day equivalent of a run on the bank, the statute prescribes a clandestine process in which the district judge is given 24 hours to rule on a petition to appoint a receiver; it prohibits the court from giving notice of the proceedings to creditors or other interested third parties; and it imposes criminal penalties on anyone who publicly discloses the pendency of the proceedings. Moreover, the district judge is entitled to consider only two factual issues under a highly deferential standard of review in deciding whether to order the liquidation of a major financial firm and is given only 24 hours to make the decision. If the judge fails to make a decision within 24 hours the petition is automatically granted. For good measure, the statute proscribes any stay pending appeal. In effect, the statute seeks to draw on the prestige of the federal courts in making the appointment of a receiver, while depriving parties with a vital stake in the matter of any notice or meaningful opportunity to be heard – and handcuffing the court from acting in a way that is consistent with judicial authority.
The statute also creates a specialized form of bankruptcy that gives the executive branch of the federal government broad discretion to subject some nonbank financial firms to this special insolvency regime leading to liquidation, while others go through ordinary bankruptcy, which includes the possibility of reorganization. Allowing the executive to pick and choose different resolution regimes for firms in the same industry based on necessarily subjective determinations of the impact of insolvency on “financial stability in the United States”34 at least arguably violates the uniformity requirement of the Bankruptcy Clause.35 And within the new regime of orderly liquidation, the statute gives a federal agency – typically the FDIC – broad discretion to depart from the principle that all creditors of the same class should be treated equally.36 This too arguably violates the perceived understandings of uniformity in the bankruptcy context.
These constitutional infirmities could easily have been avoided and hence would be relatively easy to fix. Ordinary bank receiverships are commenced by an executive appointment of a receiver, followed by a right of plenary judicial review – a process that allows affected interest holders to challenge the appointment of a receiver after-the-fact, and permits the reviewing court to function in an appropriate judicial manner. This kind of ex post judicial review is undoubtedly constitutional in the context of a statutory regime designed to prevent a financial crisis. In fact, the Administration’s proposed legislation, and the House bill, called for a process for appointing a receiver closely modeled on the bank receivership model. For unexplained reasons, however, the Senate rejected this model, and substituted the provisions that ended up in the legislation, calling for ex ante judicial appointment of a receiver coupled with draconian limitations on the court that render the judicial process virtually meaningless. Thus, the constitutional infirmities associated Title II’s provisions for appointment of a receiver could be fixed simply by amending the statute to incorporate the House provisions on appointment, rather than the substitute insisted upon by the Senate.
Whether the violations of the uniformity requirement of the Bankruptcy Clause could be fixed is harder to say. The central objective of Title II is to give the government a new tool to avoid bailouts or government takeovers of troubled financial firms. Whether such authority can be cabined by predictable rules laid down in advance is debatable. However, the loosely-written provision allowing the FDIC to depart from equal treatment of similarly-situated creditors37 could almost certainly have been drafted more narrowly. Of course, in today’s legislative environment, obtaining these kinds of legislative fixes may be impossible, which makes it much more likely that they will have to be confronted by the courts.
We begin by examining the two statutory models for establishing the resolution authorities that served as a backdrop to the Dodd-Frank Act – bank receivership law and bankruptcy – and summarize the ways in which Dodd-Franks’ Title II deviates from both models. We then consider various legal avenues for raising a constitutional challenge to Title II, each of which is problematic. Part III analyzes the due process and Article III objections to Title II in greater detail, including possible strategies for avoiding these difficulties. Part IV turns to the potential constitutional issues under the Bankruptcy Clause and the First Amendment. Part V lists some possible takings issues, including an analysis of how the authority to impair or disregard security interests created prior to the enactment of Title II might be analyzed under the Takings Clause. A brief conclusion follows.
I. Title II’s Orderly Liquidation Authority
Title II of the Dodd-Frank Act sets forth a new “Orderly Liquidation Authority” (OLA) designed to serve as a substitute for future government bailouts of financial firms deemed too big to fail. Implicit in this newly created authority is that the resolution of these large financial firms’ affairs under ordinary bankruptcy law or other insolvency laws would threaten the stability of the financial markets. Lehman Brothers bankruptcy is the obvious object lesson here.38 To avoid financial panic or various contagions analogous to a run-on-the-bank, the statute assumes that the resolution of these systemically-significant firms must occur rapidly and without any advance public notice. Thus, the process of appointing a receiver must occur “on a strictly confidential basis” without any public disclosure and the judge who makes the appointment must rule within 24 hours.39 This clandestine process deprives stakeholders of any notice of a process that must lead to liquidation of a major financial firm. And the extremely short deadline renders judicial oversight essentially meaningless, given the complexity of the matters involved. These draconian procedures represent a classic example of an unforced legislative error, for they render the statute vulnerable to constitutional challenge on due process, Article III and First Amendment grounds.
The OLA process may never be used. It may remain the proverbial musket in the closet that the government holds in reserve while arranging workouts with creditors or sales or mergers of the troubled firm in lieu of “orderly liquidation.”40 If implemented with the consent of the distressed financial firm, the OLA process may not be contested. The statute specifically invites the directors of a troubled financial firm to consent to OLA and dangles a carrot in front of directors in the form of promised immunity from any action by shareholders or creditors for “acquiescing in or consenting in good faith to the appointment of the Corporation as receiver.”41 It would take an intrepid director to do battle with the Executive Branch over the fate of a financially troubled firm, knowing that any diminution in financial value attributable to resistance could be challenged in future litigation by disgruntled creditors and shareholders, whereas capitulation to the government will result in immunity.
In any event, whether the OLA authority is used or merely threatened, the credibility of the government to use the new procedure will depend importantly on whether the relevant actors perceive this authority to be constitutional. As we shall see, there are several features of Title II that give rise to serious questions on this score.
The basic model for the OLA process is existing law providing for administrative receiverships of FDIC-insured banks. Dodd-Frank takes this bank receivership law and adds to it a number of provisions borrowed from the Bankruptcy Code, which is essentially a judicially-supervised resolution process. As a result, the OLA is an administrative rather than a judicial resolution process, but one that hews more closely to the substantive law of bankruptcy than it does to the substantive law that governs bank receiverships. Many of the constitutional issues raised by Title II stem from the unique provisions that govern the appointment of a receiver under the OLA. These provisions do not follow the template of either bank receivership law or bankruptcy law. Rather, they were adopted by the Senate during the final days of intense negotiation over what was to become the final version of the law. Accordingly, we begin with a brief review of the benchmarks established by bank receivership and bankruptcy law, and trace these within the evolution of the Title II provisions via an examination of its legislative history.