What corporate counsel needs to know about the FDIC in 2009
An interview with Megan Kraai by Teresa Zink
Wachovia, IndyMac, Washington Mutual…these and other bank failures have rocked the financial world and should be a wakeup call for corporate counsel and others who represent banks or companies that do business with banks. So far in 2008, there have been 24 bank failures, with ten of those in the last quarter alone, notes DLA Piper partner Megan Kraai. Compare that to three bank failures in 2007 and none in 2005 or 2006 and it is easy to understand why the number and speed of recent bank failures have caught many by surprise.
“I would encourage lawyers to talk with their clients and make sure their clients understand the nature of their relationship with the bank, even when the bank is healthy,” Kraai advises. “2008 has shown us is that these bank failures can happen quickly.” It is important to understand what your position is in the event of a bank failure, and it is equally important to understand the role the Federal Deposit Insurance Corporation (FDIC) plays in addressing the problems of failed banks.
Because there were few bank failures in recent years, there are not as many practitioners as there were in the 1980s who understand what the FDIC does when a bank becomes troubled. But they should. “When the FDIC takes over a bank, it has what are sometimes called superpowers in the event of a receivership,” Kraai warns, and the situation is not all that similar to a business bankruptcy. Lessons learned from the recent wave of consolidations in the banking industry won’t help much either, she says. “A bank acquisition is much different than a receivership by the FDIC.”
Acknowledging that “we are all reluctant to admit what we don’t know,” Kraai offers a primer on the FDIC for 2009.
The FDIC is Busy, And Getting Busier
As a response to the sheer numbers of bank failures, Kraai notes, the FDIC has taken steps to bolster its ability to respond. For example, she says, in an effort to find people with relevant experience, the FDIC in August began hiring back some of its retirees who had experience in the savings and loan crisis of the 1980s. In October, the FDIC increased the amount of the deposit insurance on accounts to $250,000, in part to preempt runs on banks and in part reacting to the reactions of WaMu depositors as the bank was failing, according to Kraai.
The FDIC maintains what is called a Troubled Bank List and while the names of the banks are confidential in order to prevent runs on the banks, the size of the list is important, Kraai says. “Currently there are 171 troubled banks on the list, which is up 46 percent since just the second quarter and it is the highest number since 1995,” according to Kraai. Historically approximately 13 percent of the banks on the list have failed.
However, Kraai warns, “although it is an important list, no list is perfect.” For example, she points out, “IndyMac, which was an historic failure, was not on the troubled bank list six months before it failed. WaMu never went on it. So, I think it is interesting to note that the list is large and growing larger, but I think it also indicates that the speed of some of these recent failures has taken many by surprise.”
New Territory For Many
Kraai thinks that, “because it has been a fairly long time, thankfully, since we have seen bank failures on this scale,” it is worth thinking about what happened and how to advise clients who “haven’t experienced this type of economic environment or bank failure environment.” Whether the clients are banks, companies that have service contracts with the banks or large depositors, it is worth taking the time to understand what their rights and responsibilities are if a bank should fail.
“I think an important thing to recognize is, to the extent that you look at a traditional business bankruptcy as an analogy, it is not all that useful.” Kraai warns. “In a regular business bankruptcy, the goal is to keep the business operating as a going concern and try to find a private sector resolution.” However when a bank fails and the FDIC comes in, it has “significant powers and wide latitude in what it can do and the goal is to resolve the failed bank’s problems and its commitments at the least cost possible to the FDIC and therefore the consumer.” That is a very different goal.
The other often surprising thing is how quickly the banks operations can be wound up. “The FDIC is efficient, which might surprise some people in a government agency,” says Kraai. She notes that companies can operate in Chapter 11 for years, but a bank failure is generally resolved within 90 to 100 days, and sometimes more quickly than that. So even if a bank your client does business with is on sound financial footing, it is still a good idea to take the time to understand what their rights and responsibilities are should something happen to the bank.
What Happens When A Bank Fails?
When a bank fails, the FDIC is appointed either receiver or conservator in order to wind up the bank’s business in the way that will minimize the cost to the FDIC deposit insurance fund or to operate the bank as a going concern. Generally, that means drawing up a menu of the assets and the liabilities of the troubled bank and offering it for sale to other financial institutions, according to Kraai.
According to Kraai, “There are different ways that the FDIC can dispose of the assets and liabilities of a failed bank when the FDIC is acting as a receiver, but the most commonly used approach is a purchase and assumption (P&A) transaction.” In a P&A transaction, the FDIC acts as broker and finds a healthy bank to take over part or all of the failed bank.
“There are certain things that you should know if you are advising someone who has a relationship to a failed bank, if you are advising the bank that is having problems or if you are advising a bank that is thinking of acquiring a failed bank,” Kraai says. For example, there are types of claims that never go to the acquiring bank, but stay with the FDIC. These include: claims or lawsuits against the directors and officers of the failed bank, any claims under directors and officers insurance policies and employee benefit plans. Real estate and subsidiaries of the failed bank usually don’t go to the acquiring bank, according to Kraai, however in the case of WaMu, JPMorgan Chase acquired WaMu’s real estate.
Most of the time when a bank fails, the FDIC is appointed as receiver. However, occasionally, the FDIC operates the bank in a conservatorship proceeding. IndyMac, is one conservatorship in the news right now, according to Kraai. When that bank failed it had assets of $32 billion and deposits of $19 billion. According to Kraai, “a conservatorship is more akin to a regular bankruptcy because the FDIC is trying to conserve the resources of the bank and operate the bank, whereas the goal of receivership is to liquidate the bank, wind it up, sell its assets and move on.”
“Though each bank failure is different, there are broad parameters: if a bank fails, the FDIC will either act as conservator or receiver, almost always a receiver. If it is a receivership, most of the time the FDIC disposes of the failed bank’s assets and liabilities through the mechanism of a purchase and assumption agreement. If it is a purchase and assumption agreement, most of the time these claims don’t pass, they stay with the FDIC.” However, she warns “other than those broad parameters, every single failure is different.”
In addition, Kraai emphasizes that, “When assessing the bids for the bank’s assets the FDIC is required to accept the bid that will be least costly to the FDIC deposit insurance fund,” known as the “least cost rule.” If the FDIC believes that a particular failure poses systemic risk, it can waive the least cost rule, but doing so is rare.
Kraai points to the Wachovia transaction as a special situation. At the end of September the FDIC seized Wachovia and brokered a transaction with Citigroup for Citigroup to buy Wachovia on an “open bank basis,” which means that the FDIC was going to advance funds to help make the purchase. Then on October 5, Wells Fargo, “which had been at the table with Citigroup and had walked away from the transaction,” according to Kraai, came back in and bought Wachovia in a private transaction. “It seems as though the FDIC was willing to entertain that because it fit with the least cost resolution since federal government did not have to put forth any funds to make that transaction happen,” Kraai speculates.
The FDIC has extensive powers as the receiver of a failed bank which are designed to help the agency achieve its mission very quickly. These powers include the authority to: merge the bank with another bank, transfer any asset of the failed bank, issue subpoenas,
hire private sector services (like law firms) if it is cost effective, repudiate leases or contracts, and sue directors and officers personally for gross negligence. Further, when the FDIC acquires bank assets in the receivership it can defeat claims against those assets, according to Kraai.
Something that surprises many companies that do business with a bank that goes into receivership is that during first 90 days of the receivership, you cannot terminate a contract with the failed bank, says Kraai. “No matter what the contract says, you cannot exercise your right to terminate the contract or declare a default or accelerate any of the remedies. You have to keep performing under the contract.”
In addition, the FDIC has the power to repudiate any contract with the failed bank that it finds “burdensome” and, unlike in other areas of the law where there are certain standards for termination of a contract “the FDIC has sole discretion for determining what it finds burdensome,” Kraai says. “The FDIC does not need to explain, or write down, why it found the contract to be burdensome.” In addition, the FDIC has the power to assign any contract with a failed bank, even if the terms of the contract specifically prohibit assignment.
However, Kraai says, “although the FDIC can chose what contracts to accept or repudiate, it can’t cherry pick within those contracts. So if you have a contract with a failed bank, the FDIC either has to accept that contract in whole or repudiate it in whole.”
Something else to keep in mind, says Kraai, is that if your client is a depositor with money in a foreign branch of a bank that fails, that deposit is not insured, even if it is a domestic bank.
Where are the Failing Banks?
Briefly examining the demographics of recent bank failures, Kraai notes that this year they have been spread around the country, including California, Georgia, Texas, Michigan, Minnesota, Illinois, North Carolina, West Virginia, Ohio, Nevada, and it is fairly obvious that the failures can be tied to banks that were heavily involved in mortgages.
In addition to making sure clients understand the nature of their relationships with banks, it is also important to for people to understand that “if you have a relationship with a bank that has gone into receivership there are priorities of how people are going to get paid out, just like in a business bankruptcy.” Administrative expenses of the receivership are paid first (which can sometimes work to the advantage of entities that have a contract with a failed bank), then the deposits, other senior liabilities, subordinated debt and finally shareholders.
Talk To The FDIC
Also, she says, don’t be shy about going to the FDIC and asking questions. “I think it can be a natural tendency to not want to go in and ask ‘What’s my status, where am I?’” Kraai notes. Although anyone with an agreement with a failed bank is required to keep performing under any contracts for the first 90 days, “there may be things you can do and it is wise to talk with the FDIC.” She notes that the FDIC maintains a website with information on all of the failed banks and telephone numbers to call “and they are very responsive, even with the volume of work they are doing.” Because every P&A agreement is different, “it can be confusing for someone who has an agreement with the bank to know where it is residing and what is going to happen to it,” according to Kraai.
“So I think that it makes sense to spend some time talking with your clients and understanding ‘this is what my agreement means and this is what happens if the bank goes under or is taken over.’ Then if the bank fails, avail yourself and your client of the resources the FDIC provides.”
Teresa Zink is a freelance writer living in the suburbs of Philadelphia. She is former legal news editor at Mealey Publications . She is a frequent contributor to HB Litigation Conferences, formerly Mealey’s Litigation Conferences. You can email Teresa at firstname.lastname@example.org.