Chapter

XIII Taking Control of a Bank Under General or Special Insolvency Law

Author(s):
T. Asser
Published Date:
April 2001
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1. General Issues

When viewed from a legal vantage point, the law of insolvency of banks is extraordinarily complex. General insolvency law—including both bankruptcy law and the law of reorganization by composition—is one of the most demanding fields of the law and this extends to the treatment of insolvent banks. In addition, whereas in many countries the general insolvency law is content to balance only three sets of competing interests, namely, the interests of creditors, owners, and employees, the law of bank insolvency addresses these and one more, namely, the interests of the public in a sound banking system, represented by the bank regulator. Subject to some important exceptions discussed below, the law governing the bankruptcy of banks is generally the same in a material sense as the general insolvency law that governs other enterprises. Therefore, a general reference is made to the extensive analysis of general insolvency law in the Insolvency Report of the Legal Department of the IMF; no attempt will be made to go over the same ground or to repeat its conclusions here.

In many countries (Australia, Austria, Belgium, Denmark, England, France, Germany, Netherlands, Switzerland), banks are subject to court-administered bankruptcy proceedings governed by general insolvency law.380

In some countries a special insolvency statute for banks replaces the general insolvency law.381 Thus, in Canada, the Winding-up and Restructuring Act governs banks and also federally regulated trust and insurance companies, while general federal insolvency law governing corporations does not apply to banks:

An interesting difference between the two regimes which illuminates the degree to which banks are regulated relative to other corporations is the principal process by which banks become subject to insolvency proceedings: (1) the threshold test for application of the insolvency regime to banks is not only insolvency but also other criteria related to the fitness of the bank to stay in business; (2) the instigator in the case of a bank is the regulator, while in the case of other corporations it is a creditor or someone with a financial interest in the corporation; and (3) to the extent that a control order in favour of the Superintendent of Financial Institutions is tantamount to the making of an insolvency order, the determination of insolvency is made by a regulator in the exercise of his or her discretion rather than the courts, as is the case for other corporations.382

In some of the countries where the general insolvency law applies to banks, it is the only law governing bank receivership, and bank receiverships are formal judicial insolvency proceedings (Australia, Austria, Belgium, England, Germany). Rehabilitation procedures included in the general insolvency law may fulfill functions similar to the bank restructuring procedures of provisional administration or receivership under the banking law. For example, in England, under general insolvency law, the court may make an administration order in relation to a company, placing the company under the management of an administrator, if the court is satisfied that the company is or is likely to become unable to pay its debts, and considers that the making of an order would be likely to achieve one or more of the following purposes:

the survival of the company, and the whole or any part of its undertaking, as a going concern;

the approval or sanctioning of a compromise or other voluntary arrangement between the company and its creditors; and

a more advantageous realization of the company’s assets than would be effected on a winding up.383

In France, general insolvency law authorizes the courts to take control of a bank in distress with the advice of the bank regulator.384 One purpose served thereby is to rescue the bank as a going concern. An important feature of the French legislation is that the initiative for corrective action rests largely with the court. Thus, for instance, the law authorizes the President of the Commercial Court to call meetings with the management of a bank in distress and interested third parties, to gather information about the bank’s condition from the bank and from monetary authorities, and to promote the formulation and adoption of a financing plan designed to correct the bank’s problems; ultimately, if such financing plan cannot be adopted, the President of the Commercial Court may appoint a provisional administrator or may attempt to reach an arrangement with the bank’s creditors suitable to ensure the continued operation of the bank.385

In the countries, such as France, where banks may be submitted to both regulatory administration under the banking law and a formal bankruptcy proceeding under insolvency law, it is possible that, while a bank is already under administration, a petition is filed with the court for bankruptcy of the bank and that general insolvency proceedings are opened against the bank. The effect of this may be that the existing administration is superseded by a bankruptcy proceeding. Alternatively, the existing administration continues as a regulatory receivership under a stricter application of the provisions of general insolvency law, to the extent that the general insolvency law did not already apply to the liquidation,386 or the administration turns into a bankruptcy proceeding under the general insolvency law with the administrator continuing as bankruptcy receiver.387 In Australia, the banking law takes precedence: while the bank regulator has control of a bank’s business, no external administrator must be appointed, whether under general insolvency law or corporation law.388

In Switzerland, general insolvency proceedings against a bank that is not overindebted are suspended by a judicial moratorium intended to achieve an extrajudicial rehabilitation of the bank, while the bank continues its banking activities under the supervision of a court appointed provisional administrator.389

2. Special Bank-Related Features of the General Insolvency Law

In countries where banks can be subject to a bankruptcy proceeding, the general insolvency law often gives recognition to the special status of banks and the role of the bank regulator.

Petitions

The parties entitled to bring a petition for bankruptcy of a bank would normally include the bank regulator, the bank, and the bank’s creditors.390

In some countries, the law grants the regulator the exclusive right to petition for bankruptcy, to the exclusion of all other petitioners.391 For banks under provisional administration, this right may be given to the provisional administrator.392 It has been argued that this exclusive power serves to exclude frivolous bankruptcy petitions by creditors that could threaten the bank. However, frivolous petitions can be precluded by including a bankruptcy petition threshold in the law, for instance, by requiring that petitions are supported by overdue claims on the bank that total a specified minimum percentage of the bank’s liabilities.

Sometimes, the law makes the filing of a petition for bankruptcy of a bank mandatory. Examples would be the case where the bank becomes insolvent,393 or where bank administration fails and the bank has become insolvent,394 or where the bank cannot be rescued by bank administration within the time limit set by the law.395

The law often provides for participation of the bank regulator in general insolvency proceedings for a bank. Thus, for instance, the law may require the court to consult the bank regulator, before ruling on a petition for bankruptcy of a bank that is presented by another party.396 In addition, the law may provide for participation of the bank regulator in the appointment of trustees, in meetings with creditors, or in the assessment of the bank’s financial statements.397

It was argued before that there are significant policy-related costs attached to submitting bank receivership to judicial general insolvency proceedings. The most important of these costs concerns the risk that a judiciary that is not qualified to assess the interests of the banking system would nevertheless have the power to commence insolvency procedures against a bank that the monetary authorities have decided to rescue for systemic reasons.398 To reduce this risk in countries where, notwithstanding this argument, it is decided to submit insolvent banks to receivership under the general insolvency law, it is suggested that the law of these countries be amended to provide that no general insolvency proceedings may be opened against a bank without the explicit consent of the central bank—representing the monetary authorities—and that such consent may be withheld only for systemic reasons. As such a provision would disregard the interests of bank creditors, the law may include the qualification that, before a bank may be so released from general insolvency proceedings, the central bank must show in court that the monetary authorities have determined that the business of the bank must be rescued as a going concern for systemic reasons, and that exceptional financial support is available to cover the bank’s liabilities.

Effects of the Opening of Insolvency Proceedings on Payment Systems

Many of the payments and securities transfers made by banks for their own account or for the account of their customers are processed by clearing and settlement systems. Often, such systems use net settlement procedures whereby payments or transfers between a bank and its counterparties in the system are periodically processed and netted against each other, producing a single net balance due to or from each participant.

Insolvency law typically provides that, from the time that insolvency proceedings are effectively opened by a court decision against a company, that company may no longer dispose of its assets. As payments and transfers are acts of disposal of assets, they are covered by such provisions. Orders for such payments and transfers are covered as well, and not only when they are issued after insolvency proceedings are opened, but also when they are issued to, but not yet fully executed by, a payment system before insolvency proceedings are opened. Consequently, payments or transfers whose execution is completed after insolvency proceedings are opened may be void or voidable by law.

To determine the legal effects of the opening of insolvency proceedings on particular payment or transfer orders that straddle the time that insolvency proceedings are opened, it is important to know precisely at what time the court decision opening the insolvency proceedings and the resulting statutory payment or transfer prohibition take effect.

Traditionally, a court decision opening insolvency proceedings and the resulting statutory prohibition on the disposal of assets take effect at the beginning of the day on which the decision is taken. This means that payments made during that day are void or voidable under the law.

Often, when a court decides to open an insolvency proceeding against a bank and a payment prohibition takes effect, payment and transfer orders issued by the bank are being processed at home and abroad by payment and transfer system operators who are blissfully ignorant of the court decision. Following the traditional rule giving effect to the court decision at the beginning of the day that it is rendered may force the operators to reverse on a subsequent day transactions that were processed for the bank during the previous day. Such reversals can be an administrative and operational nightmare, requiring the recalculation and resettlement of net balances due to or from the bank (and many other financial institutions that are counterparties of the bank), if these balances result from netting payments or transfers due to and from the bank concerned. Such reversals can cause gridlock and significantly slow down or suspend the operations of a payment or transfer system, with the potential of causing serious damage to the national economies concerned. It is not difficult to imagine that such reversals could ultimately constitute a major risk for the international monetary system, especially if they would concern a large clearing and net settlement system in a major international financial center, such as CHIPS in New York. Therefore, the effective time of a prohibition on executing a bank’s payments and transfers, and the timely notification of that prohibition to payment and transfer systems operators, is of crucial importance to clearing and settlement systems.

There are several solutions to this problem, including the following.

In order to mitigate the risks inherent in the traditional effectiveness rule, at least one country has amended its legislation to provide that a court order opening insolvency proceedings against a bank, and its attendant prohibition on discharging the bank’s obligations, will take effect at the beginning of the day following the day of the court order.399

According to the general insolvency law of Switzerland, bankruptcy proceedings against a bank are opened by court decision at the time specified in the decision, and any acts whereby the bank disposes of assets of its estate after that time are null and void with regard to the bank’s creditors.400 The following procedure has been adopted that permits the Swiss bank regulator to avoid problems for payment system operators that might otherwise result from these provisions of the insolvency law. When a bank’s license is revoked, the bank is ordered by the regulator to cease business operations from a particular date and hour onwards determined by the regulator. The bank regulator can preempt problems for payment and transfer systems operators at home and abroad by (1) revoking a bank’s license well before bankruptcy proceedings are opened against the bank; (2) specifying a time for the cessation of the bank’s business operations that precedes the time that bankruptcy proceedings are opened against the bank; and (3) giving the payment and transfer systems operators advance notice of the time at which the bank must cease its business operations.401

The most straightforward solution to the problem is for the law specifically to exempt payment and transfer system orders straddling the commencement of insolvency proceedings from the before-mentioned legal effects. This is the approach followed by the European Union Directive on settlement finality in payment and securities settlement systems.402 The Directive establishes the following principles, which are to be incorporated into the national legislation of the member countries. Transfer orders entered into a payment or securities settlement system before the moment that the decision opening insolvency procedures is handed down shall be legally enforceable and be binding on third parties; transfer orders entered into such a system after the moment that the decision opening insolvency procedures is handed down and carried out on the day of opening of such proceedings shall be legally enforceable and binding on third parties only if, after the time of settlement, the settlement agent, the central counterparty, or the clearinghouse can prove that they were not aware, nor should have been aware, of the opening of such proceedings. Decisions opening insolvency proceedings shall immediately be notified to the authorities of the other member states. No law, regulation, rule, or practice on the setting aside of contracts and transactions concluded before the moment of opening of insolvency proceedings shall lead to the unwinding of a netting. The moment of entry of a transfer order into a system shall be defined by the rules of that system. Transfer orders entered into a system may not be revoked by a participant in the system or a third party from the moment defined by the rules of that system. Insolvency proceedings shall not have retroactive effects on the rights and obligations of a participant arising from, or in connection with, its participation in a system earlier than the moment of opening of such proceedings; these rights and obligations shall be determined by the law governing that system.403

Compositions

Some laws exclude composition proceedings and compositions with creditors with respect to banks.404 The reasons may include that compositions are generally predicated on an assumption that the bank will be rehabilitated, an assumption that cannot be realized without consent of the bank regulator. Other countries do permit compositions, provided that they are approved by the bank regulator and the court.405 In Switzerland, where compositions are permitted, the banking law provides that the receiver in bankruptcy of a bank exercises the powers of the meeting of the bank’s creditors; this means that, even though creditor committees can be formed, the receiver must approve the schedule of claims and agree on the terms and conditions of a settlement.406

Setoff and Netting

Another technique to reduce the risks of bank failure for payment systems is to reduce the use banks make of payment systems.

A growing portion of a bank’s business is with other banks (including nonbank financial institutions). Frequently, this business is conducted within the framework of long-term business relationships. Much of this business takes the form of spot transactions, swaps, options, and forward foreign exchange and interest rate transactions that banks conclude for their own account and risk or for the risk of their customers with other banks, requiring both parties to those transactions to exchange payments.

These exchanges of payments can be harnessed in a series of bilateral arrangements, one arrangement for each bank and each of its bank counterparties, in order to offset or otherwise net out the mutual rights and obligations of each pair of banks, so that the mutual debt exposure at any time for each pair of banks is reduced to a single net balance payable by one bank to the other. Such arrangements often take the form of a so-called master agreement covering specified categories of financial transactions; they specify the terms and conditions for the netting and settlement of the payments between the two banks resulting from individual transactions and they provide rules for contract termination and close-out netting in the event of a default or bankruptcy of one of the banks.

A major advantage of these arrangements is that they reduce the risk of default to payment systems, by converting what otherwise would have been two streams of payments between the two banks to one single net payment of one bank to the other. It is easy to see that this reduces the risk to a payment system of failure of one of the banks from a large number of payments for a large aggregate amount to a single net payment of a much smaller amount.

Reduction of risks of payment systems is not the only advantage of these arrangements. They also reduce the mutual exposure of banks to each other. Consequently, setoff and netting arrangements play an important role in curtailing the risk of international financial contagion, whereby domestic financial problems spread around the world through the failure of banks to meet their commitments to foreign banks, causing difficulties in turn for the foreign institutions and the foreign payment and transfer systems through which these commitments are to be settled.

The law of setoff usually provides that mutual obligations that are simultaneously due and payable are discharged ipso facto. Consequently, mutual debts between two banks that become due and payable and are therefore discharged by setoff before insolvency proceedings are opened against one of the banks would normally not be covered by the insolvency proceedings. However, the before-mentioned master agreements between financial institutions often go beyond the general rule of setoff and also net out, under close-out netting covenants, payment obligations that would have become due and payable after the opening of insolvency proceedings against one of the institutions.

This raises the issue whether such extended close-out netting arrangements can be upheld in the event of bankruptcy or whether, pursuant to general principles of insolvency law, each leg of such mutual obligations would be disconnected from the other in order to run separately to and from the estate. The issue is of practical significance, as without close-out netting the creditors of insolvent banks would have to pay the full amount of their debt to the estate while they would usually receive only a fraction of their claim from the estate. Conversely, if close-out netting arrangements would be immune from the legal effects of insolvency, the creditor would be permitted to net out the full amount of his claim against the amount of his obligation to the estate, leaving only a net balance due to or from the estate.

Obviously, such immunity must be granted by an amendment of the insolvency law. Several countries have adopted such an amendment. Their legislation now provides that such close-out netting is exempt from the effects of insolvency proceedings.407 These provisions have been included in banking law,408 in general insolvency law,409 in other general legislation,410 or in a special statute.411

Although these provisions afford protection to payment and banking systems, they do so at the price of creating a special class of preference for claims of creditor banks and other financial institutions over the claims of other types of creditors. While financial creditors benefiting from netting agreements may use the full aggregate amount of their claims on an insolvent bank to reduce their obligations to the insolvency estate, other creditors with obligations to an insolvent bank that are matched by claims on the insolvency estate must pay their obligations in full when due, whereas they may expect only partial payment on their claims from the bank’s estate on some distant future date. The ensuing inequality of treatment between financial and non-financial creditors of failing banks can be justified only by systemic risks that otherwise would be uncovered, and then only to the extent of what is required to cover those risks.

Principal Objectives To Be Pursued by Law

If banks are submitted to general insolvency procedures, the special interests of the banking system must be served in the form of special provisions, such as provisions requiring consent of or consultation with the bank regulator before the court decides on a petition for bankruptcy of a bank. General insolvency proceedings must not be opened against a bank if the central bank determines that the bank should be rescued for systemic reasons and shows that the funds required to cover the bank’s liabilities are available.

In countries where the law submits banks to both a special receivership or liquidation procedure under the banking law and a general insolvency procedure under other legislation, the law should delineate the scope of operation of these laws with respect to each other and provide for a more or less seamless transition from one procedure to the other.

Laws permitting setoff and netting of financial claims should be carefully weighed in light of the inequality of treatment they cause for nonfinancial institutions that are creditors of failing banks; they should be strictly limited to what is necessary to afford the required degree of protection against systemic risks.

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