Sixty-four banks failed in the United States in the first seven months of 2009, compared to only 24 in all of 2008 and a mere three in 2007. Many more are expected to fail by the end of the year, as commercial real estate loan defaults increase and high unemployment hampers economic growth. This dramatic spike in bank failures also has significantly increased the probability that a business might be a counterparty to a failed bank in a variety of contractual relationships.1
Anticipating a bank failure can be a difficult prospect for counterparties. Telltale signs are rarely evident. Banks are obliged to maintain both capital adequacy and balance sheet solvency. However, those calculations are rarely simple, and sometimes they are not wholly transparent to outsiders. Complex banking regulations relating to capital adequacy further complicate the evaluation of a bank's assets and liabilities. Additionally, the "supervisory" correspondence, examination reports, and warnings from a bank's regulators often are confidential.
Bank regulators usually work very hard to keep a troubled bank's predicament quiet to prevent a run on the bank, preserve systemic economic confidence, and obtain the best price for the bank's assets in any arranged deal. In some cases, regulators issue an order requiring the institution to take certain actions--usually to increase its capitalization over a specified time2--but determining the status of the institution's compliance is still difficult. Often, the only advance signal is a securities filing from the institution itself that it cannot continue as a going concern, but this filing usually comes only days before serious regulatory action.
An official resolution is underway when the agency that chartered the bank issues a Failed Bank Letter to the FDIC, stating that the bank is failing or is in imminent danger of failing, and will be closed. This typically happens when a bank has become critically undercapitalized, insolvent, or unable to meet requests for deposit withdrawals. Failed Bank Letters are eventually posted on the Web site of the Federal Deposit Insurance Corporation (FDIC)3 but only after a failed bank has been closed, so they do not provide timely warning for the bank's creditors.
Unfortunately for the counterparty in a bank transaction, some banks may be subject to special rules on their transactions long before any official resolution process commences. For example, capital inadequacy--which might occur passively through downward revaluations of investment assets in the bank's portfolio--may limit a bank's ability to lend. Alternatively, a regulator can impose interest rate limits or similar restrictions on a troubled bank's permitted loan terms if the regulator decides that the bank's interest rate practices or exposures are questionable.4
Whether a bank is in an official or unofficial resolution stage, counterparties will have numerous questions about their rights and liabilities regarding the failing or failed bank. This is true for a variety of customary transactions in which these counterparties may be involved, including deposit accounts, secured loans, unsecured loans, syndicated loans, swaps and similar derivatives, and letters of credit. For counsel advising these parties, an understanding of how the FDIC5--as overseer of U.S. insurance funds for depositary financial institutions--approaches bank failures is a necessary prerequisite to assessing how these failures may affect any particular transaction.
The Role of the FDIC
The FDIC's process for resolving bank failures (and how it deals with bank counterparties) is driven by its primary goals of maintaining stability and public confidence in the U.S. banking system, and minimizing the government payout of monies from the FDIC insurance fund. In carrying out these goals, the FDIC serves several functions. First, it is one of several regulators responsible for banks and thrifts. Others include the Office of the Comptroller of the Currency, which is responsible for national banks; the Federal Reserve, which is responsible for both state member banks and holding companies; the Office of Thrift Supervision, which is responsible for thrift institutions; and various state agencies.6
Second, as the insurer of deposit accounts, the FDIC controls risks to the Deposit Insurance Fund, which protects the depositors in FDIC-insured institutions. When a federally insured depository institution fails, and if no other resolution proves less costly, the FDIC pays out insured bank deposit accounts.
Third, the FDIC acts as receiver, conservator, or liquidating agent for failed insured depository institutions--whether chartered as a national bank, state bank, or federal thrift--to promote their efficient and expeditious liquidation. In this capacity, the FDIC has broad power and authority to "resolve" the problems of the failing institution through asset sales or other techniques, or to put the institution into receivership and close it, or to combine a partial resolution with a receivership. In fact, regulators enjoy far more discretion in working out a troubled bank's obligations than do parties to a corporate bankruptcy, as there are significant differences between corporate bankruptcy law and the insolvency laws for financial institutions--and the latter are actually excluded from Title 11 of the U.S. Code (governing business reorganizations).7
Bank regulators have five basic options to fix, sell off, or liquidate all or part of a failed bank's business: open bank assistance, management change, purchase and assumption transactions, receivership, and depositor payoff. These options are described, along with some commentary about the FDIC's choices of methods, in the FDIC's Resolutions Handbook.8 The handbook states that the FDIC's official resolution process usually takes 90 to 120 days, but much of this process occurs in secret before the official closure--and typically without notice to most of the bank's employees.
Once the FDIC gets the needed data about the failing bank, a team of FDIC resolution specialists will analyze the bank's condition. Because it does not have enough time to assess every asset, the team generally estimates the value of the bank's assets by using a statistical sampling procedure to populate valuation models. For each category of loans, the FDIC identifies a sample, reviewing selected loans to establish an estimated liquidation value based on discounted future cash flows and collection expenses. The team derives a loss factor for that category of loans and applies it to all the loans issued by the failed bank in that category.
The FDIC is required to use the type of resolution that is the least costly option calculated over time on a net present value basis. The cost to the FDIC can vary depending on a wide range of factors,9 including the premium paid by an acquirer, the likely losses on contingent claims, the estimated value of the assets and liabilities of the bank, the levels of insured and uninsured liabilities, any cross-guarantees available against the failed bank's affiliates, and the cost of collecting on assets not transferred in purchase and assumption deals.
Any losses are borne first by equity investors (shareholders) and unsecured creditors. The FDIC and customers with uninsured deposits absorb the remaining losses, with the FDIC proportionately sharing all the amounts it collects with uninsured customers.
The FDIC can choose to leave a troubled bank open and pump assistance into it--the "open bank assistance" (OBA) option--which has not been used with any frequency since the savings and loan crisis in 1989. That was when the FDIC started comparing the cost of the OBA option with the sale of bank assets via competitive bidding, and found that selling assets usually costs less.
Evolving policies also caused the FDIC to move away from leaving a troubled bank's assets in the hands of its original management. For example, in 1987, the FDIC was first authorized to establish free-standing "bridge banks"10--temporary banks created to service a failed bank's assets prior to their sale. A bridge bank provides the FDIC with more time to find a permanent solution for resolving a significant collection of assets. As a result of this less expensive policy option, OBAs are no longer commonly used. But the OBA option is available when the financial system is perceived to be threatened by systemic risks, such as in late 2008 and early 2009 when the Troubled Asset Relief Program provided billions of dollars to banks deemed by the government to be "too big to fail."
From time to time the FDIC has used similar programs to prop up or deliberately overlook some of a troubled bank's failings. These options include "net worth certificates," which essentially constitute a temporary fiat that the troubled bank will be deemed to have more reserves than its examination verifies. Other programs include "income maintenance" and "regulatory forbearance," in which a bank is acknowledged (at least privately by the regulators) to have defects in its balance sheet or practices but is permitted to continue to operate subject to certain conditions.11 Few of these methods, though, preserve the possible value of a troubled bank's assets--or minimize the running losses--as quickly as a "purchase and assumption" asset sale transaction, so these older options are no longer favored.
Changing the management is an option not found in the FDIC's official resolutions playbook, but the FDIC appears to use it with some frequency. As a regulated industry, banks always are subject to supervision for "safety and soundness" and to continuing vigilance over the qualifications, competency, and absence of conflicts of interest of a bank's senior management and board of directors. The wide-ranging powers of a bank's principal regulators to unilaterally remove a bank's management are difficult to challenge.
Most of the large-scale bank merger-and-sale transactions accomplished at the beginning of the current wave of resolutions in 2008 apparently were instigated by regulators. News reports noted that even the management of some buying institutions may have determined that their jobs were threatened if they did not accept the rescue transactions that federal bank regulators were urgently suggesting.12 In their business dealings with banks, counterparties should be sensitive to the bank's loss of flexibility and other changes in tone.
Purchase and Assumption Transactions
Purchase and assumption transactions currently are the FDIC's most favored procedure for resolution. Under this procedure, the failed bank, or some of it, is sold to a healthy acquirer. The buyer assumes certain liabilities, particularly deposits, in return for assets and, usually, some federal assistance or risk protection. If the FDIC decides that a purchase and assumption transaction is the most cost-effective resolution, it will choose whether to sell the failed bank as a whole or in parts, what assets should be offered for sale, how to package them, whether loss sharing will be offered, and at what price the assets should be sold.
Operating under strict confidentiality prior to the bank closure, the FDIC markets the failing bank as broadly as possible to its list of approved potential acquirers. Either financial institutions or private investors seeking a new bank charter may be potential acquirers, but all acquirers must have adequate funds first and foremost. Typically, all bidders are invited to an informational meeting, sign confidentiality agreements, and are provided with an information package prepared by the FDIC's resolution team. The deal terms usually focus on the treatment of the deposits and assets held by the failing bank.
Once a bidder completes its due diligence, it submits its proposal to the FDIC. Bids often must be submitted only a few days before the scheduled bank closing. The FDIC evaluates the bids to determine which one of them costs least and compares them to the FDIC's estimated cost of liquidation. Many of the FDIC deals that are being transacted today are structured essentially as "as-is" deals, with negotiations allowed for price and perhaps also for downside loss protections but not for much else. This makes some sense in light of the large current and anticipated volume of resolution transactions facing the FDIC and its desire to assure lowest-cost outcomes by letting the market set the prices. This reduces the risk that the FDIC's resolutions will be subject later to second guessing.
The FDIC submits a written request for approval of the negotiated purchase and assumption transaction to the FDIC Board of Directors. Following board approval, the FDIC notifies the acquirer (or acquirers, if assets of the failed bank are split up), all unsuccessful bidders, and the failing bank's chartering agency; arranges for the acquirer to sign all needed legal documents; and coordinates the mechanics of the closing with the acquirer. After the FDIC closes the bank, typically on a Friday, the acquirer reopens the bank, often on the next business day.13 If the purchase and assumption agreement includes continuing FDIC assistance, such as loss sharing, then the FDIC monitors the assistance payments until the agreement expires, which may not be for several years.
If a failing bank resolution is not completed before there is a run on the bank or other liquidity crisis, the FDIC might not have time to complete a purchase and assumption transaction. In that case, the FDIC must use its other options such as electing to pay off the insured deposits, transferring the insured deposits to another bank, or forming a bridge bank. To avoid those typically more expensive and therefore less desirable results, the FDIC prefers speed and relative secrecy in its purchase and assumption deals.14
If a purchase and assumption transaction is the FDIC's carrot, its power to undo a failed bank's deals in a receivership is its stick. Most bank receiverships are administered by the FDIC, which, as the insurer and protector of the bank's depositor claimants, represents what often is a troubled bank's largest creditor group.
The formal rules of a bank receivership proceed much like those for a corporate bankruptcy. Based on a finding that the institution is insolvent, the receiver takes over for the bank's management. Many claimants must assert their claims with rapidity in a formal process or lose their rights. The receivership can move to stay litigation against the bank and undo fraudulent conveyances. Further, the regulator can clean up or reject many of the bank's liabilities using other special legal powers that change or ignore the bank's legal obligations. Also, the regulator can sell off, liquidate, or close pieces or the entirety of the bank's business.15
However, practitioners must be aware of some serious differences between receivership and conventional bankruptcy. For one, the finding of insolvency--which generally comes from the institution's lead regulator--is discretionary to the regulator,16 which has less responsibility to listen to creditors than in a corporate bankruptcy.17
Moreover, in bank insolvencies, deposit accounts have a special priority.18 Whatever funds are available in the bank's resolution will, after receivership costs, generally be applied first to pay off insured depositors. This class of creditors is paid ahead of general unsecured, contract, and trade creditors of the bank, who may wind up with nothing.
Additionally, the avoidance powers of an FDIC receiver19 are far more broad and powerful than those in an ordinary bankruptcy. Ongoing contracts with a failed bank may be repudiated if the regulator simply decides within a "reasonable" time that they are disadvantageous to the bank or if the regulator is dissatisfied with the bank's original level of paperwork and approval of the contracts. The FDIC may overturn ongoing leases; the unperformed parts of partially completed contracts, including loan funding commitments; and some of the bank's issued letters of credit. A party can sue the receivership for its damages for a repudiated contract but only for actual--not consequential or punitive--damages,20 and the claims will be paid off as general unsecured claims with the same low priority of payment as trade creditors' claims.21 Finally, the FDIC as receiver can prevent a counterparty from enforcing most contract clauses that are specifically triggered by a bank insolvency or receivership.22
The backstop option for the FDIC--which it tries to avoid--is a straight payoff of federally insured depositors from the FDIC's insurance funds.23 This option comes at relatively high cost to the FDIC's insurance funds and occurs when the bank's total assets fall short and there is no lower-cost method of resolution. As a result, the bank's other counterparties frequently lose their rights.
Options for Counterparties
When representing a counterparty contracting with a bank, a lawyer should consider how to protect the client in light of the power of bank regulators to reform or reject contracts and deals. If the bank fails, the client's post-resolution fortunes may be influenced by factors such as whether the bank's failure presents systemic risk to the financial markets, the quality of documentation, and the applicability of some protected classes of transaction.
Some types of transactions have a reasonable chance of riding through a resolution. In packaging assets for sale, regulators can use discretion to favor and preserve assets they think are essential to the marketplace. The types of institutions with which a counterparty deals may matter as well because regulators can, and do, play favorites to ensure that their resolutions and bank closings do not overly disrupt either geographic markets or market segments. The FDIC tries to keep some credit available to all creditworthy marketplaces.
In documenting deals with a bank to minimize the risks resulting from a bank's failure, even the most careful attorney faces several handicaps. A bank is not likely to be able to provide timely, reliable notification of its adverse or declining financial condition. So many of the covenants, certificates, or defaults typically used by lawyers for early warnings and remedies in cases involving a counterparty's imminent failure do not work well in circumstances involving the failure of regulated financial institutions.
Thus, bank counterparties usually will be best protected against receivership risk by economic choices rather than the contractual structuring of their deals. Counterparties may find that the most effective method of avoiding bank receivership issues is by carefully selecting the banks with which they deal--giving consideration to as much market data as is available. In the same vein, counterparties can distribute their risk across banks by using such mundane approaches as syndicated loan commitments and letters of credit with "confirming banks"--that is, additional banks with undertakings to pay. They should consider other options as well involving the diversification of risk.
Deal design also may play a role. Once a bank is near or in receivership, a counterparty's fortunes may be best served by mutually positive transactions of value. A bank receiver who is rejecting "the bad parts" of deals is not as likely to repudiate or sever a good deal. Lawyers should watch for, and consider correcting, deal structures that put all the bank's obligations, or those most expensive or risky to the bank, at the end of an extended timeline. These structures include interest rate resets, automatic extensions, and certain unsecured credit funding commitments.
In addition, the appearance of a deal may matter. Because the FDIC's purchase and assumption transactions take place at lightning speed, the receiver's assessment and resolution of the bank's commitments, or at least its initial sorting of the obligations (into those worth selling to an acquirer and those slated for liquidation), may be done very quickly as well. Transactions that on their face appear economically feasible--and perhaps are secured by valuable collateral--but in any case are not extraordinarily burdensome, may fare better compared to others.
Any person or entity with rights against a failed bank--such as a debt, an existing lawsuit, or anticipated damages from a contract repudiation by the receiver--must take timely steps to keep the bank's regulators officially aware of their rights. Bank receiverships include a bankruptcy-like "proof of claim" process that generally gives creditors a 90-day period for response.24 Failure to comply can result in a claim being rejected despite its merits.25 So creditors must be vigilant concerning notices of deadlines for their claims and should work with counsel familiar with troubled bank workouts.
Another risk arises in the event of incomplete documentation or approvals. Current receivership law codifies the special authority requirements set by the courts in D'Oench, Duhme & Company v. FDIC.26 The D'Oench, Duhme case held that a contract with a bank would not be honored in its later receivership if it was not in writing, signed by the right parties, formally approved by the bank at an appropriate board level, and correctly and continuously reflected in the bank's official financial records. A lawyer documenting a transaction with a bank should insist that all important aspects of the deal are fully documented and approved by the bank. Side letters and similar informal devices risk being repudiated by the FDIC.
Survivability of Claims and Deals
The fortunes of a creditor's specific claim often depend on the nature and priority of the class of its claim: depositors, borrowers, trade creditors, those buying or leasing real estate, or letter-of-credit holders. Deposit accounts are a favored class of liability, provided that the accounts in question are federally insured.27 FDIC coverage may be affected simply by the balance on deposit in the account. Many business accounts (such as cash management, impound, or lockbox accounts, through which the essential daily cash flow of a business moves) are likely to exceed this limit. Therefore, businesses should carefully consider the effects of a freeze of, or partial loss from, these essential accounts, and should also give serious consideration to the stability of the bank. One indication that a bank may be troubled is if it offers unusually high interest rates, because institutions trying to increase liquidity sometimes offer high rates to attract deposits. Deposit accounts that are not fully federally insured likely will experience losses or delays if they are not quickly transferred in a resolution to a new, solvent bank.
Another type of contract to which the FDIC as receiver may show relative deference is a loan secured by legitimate collateral. A nondefaulted secured real estate loan, for example, with an adequate loan-to-value ratio and proper documentation, is a valuable asset to a bank. Even if moderately diminished in value, it may have a strong chance of being packaged into an asset sale and surviving with a new, stable lender. Also, regulators are somewhat limited in their ability to abrogate or change vested property rights. The FDIC has stated that it usually will not seek to reject properly perfected and documented security agreements (including real estate mortgages).28 However, the outer limits of that protection are not well defined.
Regulatory laws also provide limited protection for some kinds of specific derivative, option, swap, and forward contracts defined as "qualified financial contracts,"29 and for some kinds of "true sale" asset-structuring transactions for securitization.30 QFCs generally are contracts with sophisticated parties and are often executed at high speed and in large denominations. Their aim is to serve specific goals for financial risk management, such as foreign currency exchange exposure, and are thought to be necessary to keep capital markets working well.
Counterparties that have ongoing unsecured deals with a bank--such as unfunded loan commitments, agent bank responsibilities, real estate leases, or servicing contracts--are less protected. These counterparties should evaluate the likely attractiveness that their deal has to the bank and its successors in a potential resolution. The FDIC may seek to take on only favorable contracts or may reform contracts by accepting only the "good parts." For example, the FDIC might continue to collect on amounts due under a partially funded construction loan but repudiate the duty to fund any future advances.
Other common types of unsecured open contracts with a bank include a real estate lease in which the bank is either a tenant or a landlord or an unfinished sale of real property by a bank turned insolvent. As in corporate bankruptcy, in a bank receivership the unfinished contracts may be reevaluated by the receiver and accepted, rejected ("repudiated"), transferred in a sale, or partially assumed and partially rejected.31 Generally, if the receiver repudiates, a thwarted buyer in possession, or a thwarted tenant in possession with an unexpired term, may choose either to remain in possession or treat the arrangements as terminated.32 Like other contract obligations, careful and timely response to the receiver's notices and filing of a proof of claim may be important to preserve a creditor's rights and any possible reimbursement.
Multiple lender arrangements also may provide some safety. The receivership of one member of a syndicated loan's lender group may not be highly consequential to the borrower or the other lenders. While that lender's receiver probably will not fund future advances under the loan--especially on a construction loan--the typical syndicated deal has provisions for lender replacement, so long as the replacement lender satisfies certain eligibility requirements (or other lenders in the group can make up the share). The failed lender that does not advance will become a defaulting lender and likely will lose its voting rights and its right to distributions.
A deal that was first transacted with a lender and then sold, such as a securitization transaction,33 is even less likely to be affected by a receivership of the originating lender. If the originating lender has retained loan servicing rights, those rights may be transferred with the loan or to a new servicer either by FDIC action or, if the FDIC repudiates the servicing contract, by the new owner or trustee of the relevant special purpose entity.
Letters of credit, often considered a rock-solid commitment in business transactions, do not necessarily fare well in bank receiverships. Letters of credit constitute a bank's forward commitment to pay an amount on demand to a beneficiary, based on the credit of another (the "account party"). However, unlike the FDIC's assurance regarding perfected collateral, the FDIC does not do the same for letters of credit. The FDIC states that "payment will be made to the extent of available collateral, up to...the outstanding principal amount...of the secured obligations, together with interest at the contract rate" and certain contractual expenses.34
But an unsecured or undersecured letter of credit, with a credit-impaired account party, is at risk of repudiation, because the FDIC is likely to view it as akin to an unfunded loan commitment to a shaky borrower. That is little comfort to the letter-of-credit beneficiary. However, the apparent rationale for this result is that the beneficiary accepted the letter of credit based on the creditworthiness of the issuing bank and thus took the risk of having erred in that assessment. Counterparties relying on letters of credit may want to reexamine the stability and credit risk presented by the banks that issued them.
No magic bullet will keep a deal with a bank facing regulatory resolution or receivership from being terminated or changed. The legal processes for resolution are complex and discretionary. However, counterparties still can exercise vigilance and take some steps to recognize and protect against risks in their deal structuring with banks.