Current Legal Issues Affecting Central Banks, Volume V
Chapter

COMMENT

Author(s):
Robert Effros
Published Date:
May 1998
Share
  • ShareShare
Show Summary Details
Author(s)
HENRY N. SCHIFFMAN

Legal Aspects of Bank Insolvency

Banks are highly regulated because of the nature of their liabilities—the savings of the public—and banks also provide the medium of the payment system; consequently, bank insolvency must be managed somewhat differently than the actual or impending insolvency of an industrial or commercial enterprise. Thus, the law should have distinctive provisions providing for the reorganization of a bank facing actual or impending insolvency.

The best methods for restructuring the finances of a bank are usually the purchase by another bank of the troubled bank, or some of its assets and the assumption of its liabilities, and the infusion of new capital. For a bank, these matters are so closely connected with regulatory considerations that it would be inappropriate for depositors (the predominant creditors) or the courts (which have little expertise in financial analysis of bank assets and in bank supervision) to have the same legal authority to determine the outcome of the insolvency as creditors and the court have in an enterprise insolvency. Expertise may, in a given country, be limited to a few qualified conservators and the bank supervisory authorities.1 Nevertheless, if there are suitable liquidation provisions in a country’s insolvency law, then the receivership functions could be performed, consistent with bank supervisory authority guidelines, under supervision by the bankruptcy court.

The distinctive provisions for bank insolvency in the banking or insolvency law would be intended for a country that has a reasonably sound banking system and only occasional bank failures, rather than for a country in which the fragility of banks’ conditions is systemic and where government funding, among other things, will be required to resolve the banks’ problems. For the latter situation, there could be a special law on bank rehabilitation that apportions the burden of losses among depositors, other creditors, shareholders, and the government. However, the general provisions of a bank insolvency law should not preclude bank recapitalization. In the absence of any special law on bank insolvency, losses should be apportioned in a liquidation as provided in the section of the general insolvency law that contains priorities in the distribution of proceeds from the sale of the insolvent’s assets.

The objective to be realized in managing a bank insolvency should be clearly defined and serve as a guidepost for actions of the bank supervisory authorities, conservators, and receivers. While the government, the bank supervisory authorities, the bank’s management, the shareholders, the depositors, and the other creditors may have different objectives, as a legal matter the primary objective should be protection of the interests of creditors. In some countries, the law is clear that when a company becomes insolvent the duty of the directors of the company is to protect the creditors rather than the shareholders.2 The law can explicitly provide for this objective. The powers of conservators and receivers should be designed to maximize the value of assets or have the liabilities assumed by a sound bank in the interest of creditors.

An appropriate insolvency law could provide that, if a bank is critically undercapitalized or faces actual or imminent insolvency, it should be liquidated in most cases in the interest of depositors and other creditors. This is based on the premise that its owners and managers had the responsibility to maintain the solvency of their bank and that supervisory remedial actions, by which they have been invited to maintain the bank’s capital adequacy, will have preceded a decision to place a bank in conservatorship as a prelude to receivership.3 In many cases, remedial measures may have failed or the time for their use may have passed. The challenge for bank supervision policy is to overcome the moral hazard arising from formal government-administered bank supervision, deposit insurance (where it is in effect), and a widely held belief that the government will make whole the losses of depositors in distressed banks often by rescuing the bank itself. Thus, there is a need to strengthen market discipline to overcome moral hazard. Depositors do not usually exert such discipline because they lack information or they are complacent. Shareholders have the best prospect to exert a salutary external influence on their banks, and, while this is still rare in most countries, it is to be encouraged. To this effect, the law should not provide special favorable treatment of bank shareholders. To the contrary, the provisions of the law should be a warning to shareholders that if their bank becomes insolvent, they risk losing control over the bank and their financial interest. This strengthens the credibility of the less intrusive supervisory remedial measures that will ordinarily be taken when a bank’s capital declines.

A remaining issue is whether those who were the shareholders at the initiation of a bank conservatorship should be able to benefit to some extent from the actions of a conservator in rehabilitating or selling a bank. One consideration is that shareholder governance, except in a few countries and only in the past several years, is largely theory rather than practice. Thus, the question is whether the shareholders should be made to suffer unduly for the sins of management. It may be unlikely that shareholders of a distressed bank will get a “free ride,” because if rehabilitation is the result of recapitalization and if the shareholders do not inject new equity capital, their interest will probably be significantly diluted. If a bank is sold to another bank when not insolvent, the shareholders of the insolvent bank would be entitled to some consideration. However, again, if the market economy is working, the price paid for existing shares is likely to be less than the shareholders’ investment and, if paid in stock of the acquiring bank, their interest in the new organization may be diluted to less than the proportion that the assets of the distressed bank represent in the new organization.

Consideration should be given to whether the bank insolvency law should provide only for the sale or liquidation of banks that are critically undercapitalized or insolvent, because this may be too harsh (especially for banks in existence at the time such new legal provisions take effect) and politically inexpedient. Banks facing actual or imminent insolvency should perhaps have the prospect of reorganizing under the management of a conservator if the bank supervisory authorities determine that this should be attempted for a limited period of time. No time, however, should be lost in liquidating a bank when the bank supervisory authorities determine that revocation of the bank’s license and liquidation are clearly the proper actions.4 The reorganization of a bank may include the injection of new capital by existing or new shareholders and either the retention or replacement of existing management, depending upon the determination of the conservator as to what is feasible in the interest of protecting the depositors and other creditors.

There are four basic actions that may be taken in dealing with a financially distressed bank: (i) rehabilitation; (ii) sale or merger of the bank as a going concern; (iii) asset sales and assumption of liabilities on a whole-sale basis in the context of downsizing or liquidating the bank; and (iv) liquidation, in which case the assets will be sold in pieces, and depositors’ and other creditors’ claims will be resolved in winding up the bank. The distinction between conservatorship and receivership is as follows: conservators would manage options (i), (ii), and (iii), and receivers would be concerned with options (iii) and (iv).5 Unlike the situation in the Group of Ten and other industrialized countries where actual or imminent bank insolvencies are resolved by the purchase of the distressed bank by a strong bank, in some countries it may be extremely difficult to rehabilitate an insolvent bank without substantial government funding. Banks in transition economies generally have been deeply insolvent (beyond remedy through a change in management and policy) because of the financial condition of the enterprise borrowers. Thus, rehabilitation by virtue of conservatorship would probably occur in such countries in only a small fraction of the cases of bank insolvency.

Essential provisions of a law on bank conservatorship and receivership are those regarding the

  • determination, on an objective basis, of the events that will give rise to the initiation of a bank conservatorship by the bank supervisor;

  • definition of the objectives of a conservator and a receiver;

  • criteria for determining whether a conservator or receiver is to be appointed;

  • strict time limits for actions of the conservator, the receiver, and the bank supervisor;

  • conservation of a bank’s assets;

  • powers of the conservator and receiver;

  • limitation on opportunities for appeals by shareholders and creditors;

  • rules for the distribution of assets in liquidation appropriate for bank insolvencies;

  • standards of integrity for conservators and receivers;

  • standards for determination of appeals;

  • legal protection provided for actions of a conservator and receiver; and

  • exclusive jurisdiction over claims arising from a bank insolvency.

The provisions of law that may govern a bank insolvency can be complex. For some countries, an important objective is to keep both the legal text and the requirements for the actions of a conservator or receiver as simple as possible. It is useful to limit discretionary determinations by the bank supervisor and by a conservator or receiver, under the policy that action is preferable to inaction in dealing with a distressed bank because delay generally leads to increased losses. Time limits for actions are desirable for the same reasons. The rehabilitation or liquidation process might be left predominantly to the conservator or receiver so as not to encumber the process, rather than referring many steps to a court for approval or permitting frequent court intervention, as is common in countries with courts equipped to handle complex commercial transactions. The purpose in having recourse to courts is for expert and impartial determinations. However, if there is a strong likelihood that court decisions will not satisfy both of these objectives, then it would seem better to have expert determinations by the bank supervisory authorities, even though there is some risk of loss of impartiality. The law could provide for registering before a court objections to placing a bank in conservatorship or receivership as the sole role for the courts in relation to a bank insolvency.

Consideration should be given as to whether traditional provisions in commercial bankruptcy law, such as those regarding an automatic stay of claims against the debtor, executory contracts, and the avoidance of certain prior transactions should apply to a bank conservatorship (as distinguished from a receivership). Arguably, these traditional provisions for enterprises should apply only partially to a bank conservatorship. With respect to a stay of claims, if a bank’s prospective failure to pay its short-term obligations is permitted by the law, its chances of obtaining funding at anywhere near the level of the past would be diminished greatly when it is experiencing difficulties. Consequently, its chances of reorganization would also be diminished. Thus, it may be presumed that if it appears that a stay on creditors’ actions or a freeze on deposits would be necessary to keep the bank in operation, such bank may not be worth keeping in conservatorship but rather should be placed in receivership because it is not likely to be viable.6

Executory contracts are those that have not been substantially performed by both parties. To decrease the workload of the conservator and not complicate the relations of banks with suppliers, not all such burden-some contracts should be subject to rescission, only those leases in which the bank is lessee. These should be among the most important contracts for banks in monetary terms. The law should also contain a provision to prevent the cancellation of utility services so that banks in conservator-ship can continue to operate. A range of avoidance powers should be given to the conservator, including the power to avoid insider and gratuitous (including fraudulent) transactions, since these are traditional voidable transactions in bankruptcy and also are often important reasons for bank distress. Unwinding these types of transactions deemed to be unfair to creditors should not discourage funding from the public and may be important to recover assets of the bank and to improve its prospects for rehabilitation or sale.

The following hypotheticals raise further legal issues regarding bank insolvency laws.

Hypothetical Cases Regarding Legal Considerations in Bank Insolvency

Bank A is suffering severe liquidity constraints. Its asset quality problems over the past two years have caused its management to decide to pay well above prevailing market rates to attract extraordinarily large amounts of medium-term deposits to fund additional assets in an effort to grow out of its problem, but this has not been successful. Its liabilities primarily consist of 60 percent household deposits (more than half of which are in amounts above the deposit insurance limit) and 30 percent liabilities to enterprises and institutional investors (banks and investment funds).

Hypothetical Number 1

Bank A defaults on the payment of principal on a one-year note issue whose principal amount represents approximately 8 percent of its total liabilities. Investment Fund B, which holds a large portion of the notes, files a petition under the applicable law to initiate an insolvency proceeding with respect to Bank A.

Should an insolvency proceeding be commenced based on these facts? What is the applicable law? If a proceeding should not be commenced, what further facts would justify the initiation of such proceedings?

Hypothetical Number 2

In an insolvency proceeding concerning Bank A that is properly initiated, the law provides that a reorganization or rehabilitation may be effected if creditors holding a majority of the claims approve a plan of reorganization. Bank A presents a plan to all its depositors and other creditors that provides for all household depositors to be paid in full, including interest due, and for other creditors to receive 40 percent of the amount of their claims. The plan is approved by depositors and other creditors holding 55 percent of the claims. Should a reorganization be effected?

    Other Resources Citing This Publication