FDIC Has Unexpected Partner on Firm Failures

WASHINGTON — Not exactly sister organizations, the Federal Deposit Insurance Corp. and Securities Investor Protection Corp. are part of a select group of entities tasked with cleaning up the messes of financial ruin.

And for the first time as a result of the Dodd-Frank Act, they will soon join forces.

The FDIC is working on a proposal jointly with the Securities and Exchange Commission outlining the SIPC's role in Dodd-Frank's wind-down facility. Although the FDIC calls the shots in the new regime, the agency must appoint the SIPC — which is not a government agency — as a trustee for liquidating broker-dealer subsidiaries of firms in receivership.

The SIPC is "normally working for a bankruptcy court, but instead they're going to be working for the FDIC," said Christopher Whalen, senior managing director of Tangent Capital Partners in New York.

Many see the unprecedented pairing as positive since the SIPC has expertise the FDIC lacks in transferring the mountains of customer brokerage accounts from failing giants — such as Lehman Brothers — to new acquirers.

But their collaboration also poses uncertainty, including how the SIPC's relatively narrow focus on protecting brokerage accounts will square with the regime's overall mandate to prevent one failure from wrecking the economy.

The FDIC's broad authority, meanwhile, to transfer assets from the failed company — including from its broker-dealer — into a bridge firm could end up limiting the SIPC's role.

"The FDIC will be appointing SIPC to do what it is currently very familiar with, and that is handling liquidation of a broker-dealer. … The part that we really don't know is how the two organizations will handle their respective mandates but work in conjunction with each other," said Anita Ryan, general counsel for eSecLending, a securities financing companies.

The law allows the government to subject certain systemically important firms to orchestrated wind-downs instead of bankruptcy, which during the crisis was deemed inadequate to limiting a systemic breakdown.

Michael Krimminger, who was the FDIC's general counsel when Dodd-Frank was debated and is now in private practice, said including the SIPC in the new resolution facility — which was enacted under "Title II" of the law — helped ensure the regime resembled how failed companies are normally wound down.

"I've always believed that the Title II resolution process needs to be as much like the other preexisting insolvency proceedings as possible, with changes needed only to deal with the systemic issues," said Krimminger, a partner at Cleary Gottlieb Steen & Hamilton LLP. "As a result, it always seemed to me to make sense to have SIPC involved in this process."

But he added that the main objective of the Dodd-Frank regime — allowing a firm to be closed without a broader economic impact — is not necessarily part of the SIPC's traditional mission.

"SIPC tends to view the bankruptcy process as being adequate for doing what it needs to do in a broker-dealer insolvency. Most of the time, that may be true," Krimminger said. "But what SIPC is responsible for is making sure that investors are protected against essentially loss of funds in customer investment accounts. … That's one of the goals of Title II, but the bigger goal is to make sure you can close a broker-dealer without cratering the rest of the market. That's not really SIPC's focus."

The SIPC is not the FDIC's only partner in running the new facility. When a failed company has an insurance subsidiary, its resolution will generally be handled by the insurer's appropriate state regulator.

While the liquidation of broker-dealer subsidiaries has not been addressed fully in past FDIC rules implementing the new resolution regime, the FDIC and the SIPC have discussed planning and coordination as the new facility is built. (Dodd-Frank requires the SIPC to be consulted in drafting the regulation for broker-dealer liquidations in the new regime.)

"This would be a case of first impression, which makes the planning all the more important," said Stephen Harbeck, the president and chief executive of the SIPC, under whose tenure the nonprofit corporation has been called into action for not only the Lehman collapse, but also that of MF Global and the broker-dealer tied to convicted fraudster Bernard Madoff.

Sylvia Mayer, a partner at Weil, Gotshal & Manges LLP, said the two entities will have to "figure out how to marry different objectives into a seamless process."

"In reality, those objectives are not mutually exclusive," she said. "They just aren't always consistent."

Mayer said subjecting a subsidiary to a different resolution process than its holding company through the SIPC could pose complications if the parent shared systems with the broker-dealer.

"If the FDIC takes control of entity A, SIPC takes control of entity B, and the two entities had historically shared a database, who has control of the database?" she said. "A solution to that is laying out protocols beforehand for working with each other."

A key difference between resolutions under Dodd-Frank and bankruptcies that have involved the SIPC is the FDIC's authority in the new framework to create bridge companies to preserve the healthy operations of the failed firm.

Under that scenario, which acting FDIC Chairman Martin Gruenberg called a "promising strategy" in a May speech, the new bridge firm would assume holdings from subsidiaries of the failed holding company that are solvent and add value to the receivership. That could include customer brokerage accounts. Whatever was not transferred out of an original broker or dealer into the bridge company would still be subject to the SIPC-run liquidation.

Observers said that could limit the SIPC's involvement.

"The FDIC could, in consultation with the SEC and SIPC, reconstitute the broker-dealer as a new broker-dealer over a weekend by virtue of the ability to create a bridge financial company," said Donald Bernstein, a partner at Davis Polk & Wardwell LLP. "A 'single point of entry' approach, where only the holding company is placed in receivership and the operating entities continue in business, simplifies the resolution process quite a bit."