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Federal plan May Change Corporate Bankruptcy Process

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The rise of mega-bankruptcies in the last two years has literally changed the face of how our financial system works, incorporating new precedents for pre-arranged Chapter 11 filings and instituting new standards of government intervention. Now the results of these sweeping insolvencies are being translated into legislative activity.

For a number of weeks, lawmakers have been considering a new method by which to systematically dismantle struggling companies that if allowed to crumble under current laws, would pose a significant risk to the economy. In other words, the debate is really about how the government deals with companies that are "too big to fail."

Naturally, there is debate among the parties but in general, the plan calls for creating a government standard for strategically dismantling large companies. At the heart of the floor disagreements is how creditors are treated under the new plan.

The current bankruptcy code follows an order for who should be paid when a company becomes insolvent. It starts with securitized debt (such as bonds issued to investors), then unsecured senior debt, subordinated debt, preferred stock and then common stock.

However, that order would change under the proposed rules, which grant seniority to the FDIC (Federal Deposit Insurance Corporation.) Basically, the new plan uses the resources of the government, not bankruptcy court, to decide who gets what. The new approach, called the "systemic resolution bill," would first pay funds to the FDIC to cover its expenses, next the government itself if any bailout funds were used, and then the traditional repayment priority would begin.

Creditors often involved in these types of bankruptcies are voicing support for the current bankruptcy system, citing primarily that government interaction at this level would lead to legislative bottlenecks and surely delay a company's ability to repay them and effectively handle the sale of its assets. Additionally, their stance is that the bankruptcy process entails an independent judicial review and enables the negotiation of payments.

The bill would allow the FDIC to decide the payout to creditors and delays judicial review until after the resolution is completed. There are also a number of ancillary issues involving bankruptcies of this type, such as contingent claims and indemnities, that the FDIC has not yet considered.

Systemic-resolution proponents argue that the bankruptcy system is already ill-equipped to handle massive, economy-damaging bankruptcies, citing that the Lehman bankruptcy remains tied up in court as a result of countless loose-ends. Michael Krimminger, an adviser working with the FDIC on the formulation of the plan insists that "... there is a reason large financial firms have not been allowed to fail — because no one has had enough confidence in the bankruptcy code to handle it. We must have a process that can close the largest financial firms without creating a systemic crisis."

Krimminger and others in his court believe that the government plan would handle things much more efficiently. However, none of the bill's detractors are willing to listen to that argument.

They also believe that the bill will severely impact the market as a whole by spreading doubt about how such companies will be end up in the market once inside the government blanket. Other companies monitor bankruptcies for a number of financial reasons that can play out on Wall Street in daily trading, especially if another financial crisis hits. In other words, the plan could make the impact of large bankruptcies even worse because of the lack of "sunshine" (public information) the FDIC allows.

Is this plan a legitimate effort to alleviate a burden from the bankruptcy code or another attempt by the government to control corporate America? Stay tuned ...

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