As 2015 came to an end, so perhaps did a central tenet of resolving failed companies, the notion that “similarly situated” creditors ought to be treated equally, or, as the lawyers like to say “pari passu” (Latin for “on the same footing”).* The turning point was Portugal’s treatment of creditors of Novo Banco SA.
Until its failure in August of 2014, Banco Espirito Santo SA had been Portugal’s second largest bank. When it failed, the Banco de Portugal, acting as receiver, divided the failed bank into “good” and “bad” components, as the FDIC commonly does in the event of a large U.S. bank failure. Banco Espirito Santo SA continued as the “bad bank,” which was to be liquidated in an orderly process. The “good bank” became Novo Banco SA, which would stay in business.
In such “good bank-bad bank” resolutions, all equity holders usually remain with the bad bank, while more senior creditors are transferred to the good bank. In any event all creditors of the same class are treated alike. Creditors assigned to the good bank are much more likely to recover some part of their investment.
In the case of Novo Banco, the usual practice was at first followed. All creditors within certain classes were transferred to it in August 2014. Those who weren’t transferred took losses instead of taxpayers, which was also the generally correct approach (would that it had been our approach during the financial crisis!). But last month, something odd happened: a small number of bonds were re-assigned to Banco Espirito Santo SA. The holders of those bonds were likely to recover less than if they had remained with the good bank. This was done to reduce leverage at Novo Banco SA. One can read the listing of bonds and the justification here. The problem is that other bonds of similar seniority remained with Novo Banco. That meant that the pari passu principle was violated. Some bondholders would recover considerably more than others, despite holding bonds having the same priority.
So far as I can tell, what Portugal did was perfectly legal (but I’m not a lawyer, keep that in mind). And one could even justify it, if the alternative would have been to have the taxpayers take a hit. Still there are good reasons for regretting Portugal’s action. The whole point of bankruptcy law and its administrative cousin, receivership, is to establish a chain of priority in the event of insolvency. Basically where you stand in line is predetermined. You generally have the ability to contract as to where you stand in line, and generally your expected return reflects that risk (farther back in line you are, less likely are to get paid). Pari passu dictates that everyone who contracted for a particularly spot in line is treated the same. While pari passu seems to have arose originally as contractual boilerplate, it has somewhat taken the status of an implied contractual term. If the recovery is insufficient, the proceeds are share pro rata. If I hold bond A and you hold bond A, we both get the same pay-off. If I get 50 cents on the dollar, you get 50 cents on the dollar. A decent respect for equality under the law demands such, as well as the rule of law.
If pari passu no longer holds, the ability to estimate default recoveries is greater reduced, increasing uncertainty in the debt market. Particular groups of creditors are also more likely to become playthings of politics. Witness the treatment of certain pension funds in the auto bankruptcies, which were harmed in order to benefit the auto unions. Deviations from pari passu risk turning the resolution process into a political game, rather than a legal proceeding.
Unless you’re investor in either Banco Espirito Santo SA or Novo Banco SA, why should you care about this? You should care because thanks to Dodd-Frank’s Title II resolution process, the same thing is now a lot more likely to happen in the good-ol’ U. S. of A. That’s because Dodd-Frank’s Title II resolution process explicitly allows for exceptions to pari passu. Given how the recent financial crisis response played out, one could easily envision, under a Title II resolution, creditors in a Florida pension fund being treated differently than those in a California pension fund, especially in an election year. One could also envision differing treatment depending upon whether the creditors were domestic or foreign, as was the case with Novo Banco SA.
Section 210 of Dodd-Frank is loosely modeled on Section 11 of the Federal Deposit Insurance Act (FDIA), which calls for strict adherence to the pari passu principle. But while Dodd-Frank suggests that pari passu generally be followed, Section 210(b)(4) allows for various exceptions. Pari passu may be set aside when the receiver determines that doing so serves, according to the language of the statute:
(i) to maximize the value of the assets of the covered financial company;
(ii) to initiate and continue operations essential to implementation of the receivership or any bridge financial company;
(iii) to maximize the present value return from the sale or other disposition of the assets of the covered financial company; or
(iv) to minimize the amount of any loss realized upon the sale or other disposition of the assets of the covered financial company.
Although a further clause states that these exceptions can be made only provided that “all claimants that are similarly situated under paragraph (1) receive not less than the amount provided in paragraphs (2) and (3) of subsection (d),” this clause merely requires that a creditor get at least what he would have gotten in a liquidation, allowing the receiver to disregard any going-concern value, including goodwill. In practice, this is unlikely to be a constraint at all.
In short, I think it is fair to say that Dodd-Frank, far from enforcing pari passu, allows almost anything to happen, especially in a Chevron deference world. In fact the protections for a receiver are tighter than in the Chevron case (see Section 210(e) of Dodd-Frank and its limit on judicial review).
As depositors have historically been the dominant, and sometimes the only creditors in bank resolutions, the discretion that Dodd-Frank allows may not matter much in such cases. But Dodd-Frank’s application to non-banks raises a whole new set of disturbing possibilities for the extra-judicial treatment of creditors.
Congress, at the suggestion of the FDIC, included similar flexibility in the resolution procedures for Fannie Mae and Freddie Mac. That whole process has, of course, gone swimmingly.
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*Some additional legal background on pari passu, particularly in the case of sovereign defaults, is here. For a more skeptical legal read this.
