The FDIC and the Board of Governors of the Federal Reserve System will soon finalize one of the more significant requirements of the Dodd-Frank Act — the mandate for large banking organizations and systemically important nonbank financial institutions to prepare resolution plans, more commonly known as "living wills."
As proposed, a living will would, among other things, include a description of the infrastructure and financial relationships of the company, how its affiliated insured depository institutions would be protected from risks arising from nonbank activities, and how the company could be resolved under the U.S. Bankruptcy Code in a manner that substantially mitigates the risk that the failure would have serious adverse effects on financial stability in the United States.
The board of directors would be required to authorize the initial filing and each annual update of a living will. If an acceptable living will were not timely submitted, the FDIC and the Board could jointly subject the covered company or any subsidiary thereof to capital, leverage, liquidity, growth, activities or operational restrictions. If one were not filed within two years, the FDIC and the board, in consultation with the Financial Stability Oversight Council, could direct the company to divest assets or operations in order to facilitate its orderly resolution under the Bankruptcy Code.
Separately, in May 2010, the FDIC proposed a similar regulation requiring insured depository institutions with more than $10 billion of assets, which are owned or controlled by parent companies with more than $100 billion of total consolidated assets, to submit resolution plans.
As future regulatory and industry standards and best practices emerge, a wide range of financial companies may be required or simply find it prudent to prepare some form of living will.
On the positive side, the development of a resolution roadmap is likely to yield certain governance benefits to covered companies as they catalog their various operations, subsidiaries and affiliates around the globe, and examine their liquidity options and plans with regard to areas of potential vulnerability. This exercise will require a blend of resources to address complex business, regulatory, corporate restructuring, bankruptcy, information technology, intellectual property and tax issues, among others.
Furthermore, regulators may likely come to rely on detailed resolution roadmaps as a key component of their regulatory arsenal. To the extent that such roadmaps make them more confident about their ability to resolve specific problem companies, it may lessen the need for general regulation of the financial industry.
But the proposal has it issues also. As it is currently drafted, it is difficult to envision how a covered company can anticipate all of the business and economic situations that may, in theory, cause it severe financial distress. These planning demands are multiplied further by the fact that while the proposed rules require living wills to prepare covered companies for resolution under federal bankruptcy law, the FDIC will rely on the same living wills to help it resolve covered companies under its special resolution powers and procedures in Title II of the Dodd-Frank Act.
One potential legal issue in the proposed regulation is the requirement that a living will should promote the interests of U.S. financial stability — an objective not expressly stated in the statute. That could raise a very significant issue for the directors of a covered company who, consistent with their fiduciary duties, may not elevate U.S. financial stability over the interests of their shareholders and creditors. There may not be inconsistencies in every case between the creation of a sound living will and the responsibilities of the board of directors, but pitting the goal of U.S. financial stability against the interests of a covered company's stakeholders is not a dilemma that the final regulation should create. Directors and their lawyers would have to cope with such conflicts and the extent to which federal law could preempt state law regarding directors' fiduciary duties.
Unfortunately, Congress did not address in Dodd-Frank whether living wills were to be confidential documents protected against disclosure. One can hardly imagine a more sensitive company document that outside parties would be anxious to review, yet the protection provided to living wills by the proposed regulation is woefully inadequate.
Even if such plans are protected from disclosure under the Freedom of Information Act's trade secrets exception or the examination privilege, the breadth of those privileges would be determined by the FDIC and the board, not the company.
Moreover, third-party subpoenas for information about living wills would be handled by the ultimate arbiters of disclosure — the courts — without the guidance of an express statutory protection. Potential filers should develop the broadest grounds for confidentiality and affirmatively assert them when a living will is filed.
Finally, as the ultimate penalty for not filing an acceptable living will within two years, a covered company could be compelled to restructure its balance sheet and/or jettison risky activities, investments or subsidiaries. This raises a host of significant policy and legal issues regarding the government's authority, as well as the constitutionality of such actions. Though living wills could be useful tools to limit the adverse collateral impact of a covered company's financial distress, it would be another thing entirely if they were used to systematically restructure large companies.
When companies sell or spin-off operations in voluntary market transactions, whether integrated divisions or separate affiliates, experienced advisors, including IT, intellectual property and restructuring specialists, among others, must disentangle a company's operations while ensuring that both sides have the technological support, intellectual property and management systems to make the spun-off entity commercially viable. Drafting a living will with the understanding that some break-up of the company could result by regulatory fiat requires a careful eye with regard to the commercial and legal consequences that could flow from that.
Finally, living wills are likely to play an important role in mergers and acquisitions. At the front end, the parties will want to evaluate each other's living will, and in application process, the regulators will want to know how the combination will impact the potential resolution of the surviving company.
Thomas P. Vartanian is a partner in the Washington office of Dechert LLP, where he heads the firm's financial institutions transactions group. He represents clients in the living will rulemaking proceeding.
