What You Need To Know When Litigating For or Against the FDIC
By Teresa Zink
Invariably when he is working for a client in litigation with the FDIC, Stinson Morrison Hecker partner Michael Tucci says “four words come out at some point in time. Those four words are, ‘They can’t do that.’ My response is virtually always, ‘Unfortunately, they can.’”
Tucci, who is a former Senior Counsel to the Resolution Trust Corporation (RTC) and Senior Attorney with the Federal Deposit Insurance Corporation (FDIC) joined Kilpatrick Stockton partner Rex Veal in a panel discussion on the FDIC’s special powers at HB Litigation Conference’s program on The FDIC and The New Banking Crisis in mid-January. Veal is a former FDIC Associate General Counsel and served as Special Counsel to the RTC prior to going into private practice in 1990. Both men were members of the five person S&L Management Group at the FDIC which was responsible for drafting many of the provisions of the FIRREA, which established many of the powers still employed by the FDIC in handling failing banks.
“Laying aside the specifics of the statutes and the case law, there are a couple of things that you should take away from all of this,” Veal told the assembled attorneys. “As lawyers one of the most important things we are going to have to deal with in these situations, probably in most situations, but clearly when we are dealing with failed banks, is our client’s expectations, regardless of whether we are litigating for or against the FDIC.”
“If you are representing clients who are litigating against the FDIC, you should understand that your client’s expectations are probably going to be unreasonable,” he said. “These statutes, first FIRREA and then the Improvements Act, were written in a time of crisis. They were written to give the agency an extremely large stick.”
Often the biggest hurdle, said Veal, is clients who “come in and just cannot believe that this is where things are.” Business is not going to operate as normal and expectations have to be adjusted. One of the key requirements, “regardless of which side of the fence you are on, particularly in today’s environment, is patience.” Stays, the claims process, potentially an approval process all take time, “You just need to be prepared to exercise some patience,” he says.
Borrowers also have to realize “this is not your old lender.” Handshake deals and verbal agreements no longer apply. “If you are representing a borrower, you are going to have to come forward with a plan and be proactive.”
On the other side, if you are representing an agency, Veal says, there is a new phenomenon emerging which can be described as the “It’s not my fault, it’s the economy” defense. He predicts that judges will be “bending over backwards to try to help folks because there is not an alternative out there. They ostensibly did everything they were supposed to do. They were paying their loan and the floor fell out from under them. They just can’t make their payments now and it is not fair.”
According to Veal, “In the last 18 months essentially we are seeing where everybody stands after they got caught when the music stopped. Whether that is the banks who didn’t get their loans sold into a securitization before the music stopped and they got stuck with them, or whether it is the borrowers who were a little too aggressive in accepting loans that were going to have resets that they couldn’t possibly manage to afford. Just as a general practice tip, patience and understanding the timing that your clients are going to be going into with respect to these matters is very important.”
What are the FDIC’s special powers? In his opening comments at the conference, co-chair Scott H. Christensen of Hughes Hubbard & Reed explained that the FDIC functions in three distinct legal capacities, in a corporate capacity providing assistance to open banks, as a receiver and as a conservator of failed banks. The FDIC’s powers differ based on the capacity in which it is operating.
Automatic Stays and the Claims Process
The FDIC has a right to an automatic stay of 45-days when acting as a conservator and a 90-day stay when acting as receiver for a failed bank, Tucci explained. “There is no discretion on the part of the district court to grant the stay or not grant the stay, although many of them would like to read some discretion into the provisions.” In a receivership, he explained, in addition to the 90-day stay, there is a 180-day determination period through the claims process. What that means is “there is basically 270 days that can be requested by the agency and it will be granted. Once the case is in the process of going through the administrative process, district courts will allow that as a general rule to run its course prior to reengaging.” The statute also has provision for further agency review after the determination has been made, but that does not usually occur. “Most litigants are sort of adamant that they had a claim and they want it determined by a federal judge as opposed to the agency that would actually be on the hook for the determination.”
Federal Court Jurisdiction
Tucci also explained that the FDIC “has the basically unfettered right to remove to federal court,” whether the case is at the trial court or appellate court level. “The hook here and the issue you need to focus on,” said Tucci, is that “the right to remove begins when the agency is substituted as a party. What did creative litigants do? They fought the substitution of the FDIC as a party. And some state court judges are inclined to deny the substitutions. Tucci anticipates additional litigation over that issue.
So what law applies? “I am often fond of saying, because I’ve written it in probably a thousand briefs that the rights and obligations of the FDIC are determined pursuant to federal law. That is what the statute says. That is what the cases say,” Tucci explained. However, he noted “The source of federal law and the determination of federal law has evolved substantially over the last 25 years or so. Clearly, federal statutes apply with respect to the rights and obligations of the FDIC. We were fond of arguing, maybe 20 years ago, that if there was no federal law, then federal common law applied. That is the prong of this issue that has been hotly contested and litigated over the last maybe 15 years.” As the case law has developed, Tucci says, application of federal common law will really only be found when there is an “important” federal interest at stake. “What that means is if there is no federal statute on point, and state law would not frustrate important federal objectives, state law is basically going to be incorporated as a rule of decision with respect to that particular issue.”
A corollary to federal jurisdiction is the specific application of 1823(e) and the D’Oench Doctrine. “Obviously, federal law is embodied in 1823(e),” Tucci said, which requires agreements recognized by the FDIC to be in writing, “executed by the depository institution and person claiming an adverse interest there under, including the obligator, contemporaneously with the acquisition of the asset by the depository institution,” approved by the board of directors of the depository institution or its loan committee, and continuously on the official record of the depository institution from the time of its execution. The D’Oench Doctrine is the federal common law doctrine from which many courts have said 1823(e) was generated, Tucci explained. It says essentially that “secret agreements…aren’t enforceable against a financial institution because they aren’t part of the books and records and not available for inspection by examiners when the examiners examine the bank.” The FDIC issued a policy statement in 1997 on when it would apply 1823(e) and when it would apply the D’Oench Doctrine, Tucci said.
The FDIC may also enforce any contract, or require performance under a contract, even if the contract contains a default provision, or ipso facto clause, that would normally be triggered by the insolvency of one of the parties. According to Veal “It doesn’t excuse performance on either side for any other reason. It just says that they can enforce the contract if they choose.”
“You still get paid whatever the contract says you are supposed to get paid. You can still expect performance from the receiver at least until it decides to repudiate the contract, but you can’t walk away from the contract because it is bad for you and you just got lucky that the party on the other side became insolvent,” Veal explained.
The converse to the enforcement power is the right of the receiver or the conservator to repudiate a contract, Veal explained. “Essentially there is authority to repudiate any contract to which the institution was a party which the conservator or receiver determines to be burdensome to the administration of the estate.”
He added, “There is not really going to be any judicial second guessing with respect to whether or not the contract is in fact burdensome or whether or not it in fact will promote the orderly administration of the institutions affairs. The agency is going to have a lot of discretion in making those determinations.”
“If you are representing someone who has a contract with the failed bank, the first thing you want to do is get your hands on a copy of the purchase agreement to try and see if your client’s contract is in fact been assumed by the new institution,” Veal urges. “Oftentimes that will not be abundantly clear and oftentimes you will not be able to get a straight answer on that issue until you get a repudiation notice.”
Further he notes, because the purchase agreements on assisted sales are often made under accelerated timetables and pressure, “they often are not particularly long.” Therefore. “There are going to be open points and issues with respect to what the contracts say or what they intended. At the end of the day, unfortunately, as a creditor or a claimant or somebody on the outside looking in, you don’t have a lot of ability to argue about what they say or don’t say if the assuming bank and the FDIC agree on what they say.” It a contract is repudiated, damages are very limited Veal adds, “limited to actual direct compensatory damages” determined as of the date of the appointment.
Essentially that means punitive damages are off the table as are compensation for such claims as lost profits. Tucci added that he expects some litigation over the question of how repudiation impacts a securitization, since securitizations “are sort of master contracts that have different pieces.” According to Tucci, “the question then becomes, ‘to what degree can the FDIC repudiate part of a contract and leave the rest of the contract in place?’ That quite frankly is what it is going to try to do.”
Further, Veal added, “essentially now that depositor preference is the law, if you have a general unsecured claim in the vast majority of these receiverships, you are really going to have nothing. Maybe the balance sheets aren’t as bad as they look, but if you assume that all of the administrative expenses get paid, all of the depositor claims a hundred percent and not just the insured amount but all of the depositor claims get paid, the chances that there is going to be much left over for other creditors that aren’t secured is fairly remote and certainly at best it is going to be cents on the dollar.”
“One of the difficult things is that it is going to be extremely hard to figure out whether or not it is worth anything when you are initially dealing with these claims,” he explained. While it is a fairly simple thing to get a claim filed, “The critical point will come 180 days later, maybe a little earlier when the agency says, ‘Yes, we agree you have a claim,’ or, ‘No, you don’t have a claim.’
At that point your client is going to have to decide whether to spend any more money or not.”
Setoffs & Loan Participation
While not technically an FDIC special power, Tucci said something clients have been asking him about is the issue of setoffs and loan participations. “The scenario is this: bank fails. The failed bank has a $2 million loan with a particular customer. That customer also has $2 million on deposit at the institution. Well, the loan has been participated to another institution. Let’s say that $1 million has been participated to the other institution. What the prudent borrower does at that point, because let’s say it is a situation where not all of the deposits are being transferred to the acquiring institution, only the insured deposits are being transferred. The prudent borrower comes in and says, ‘I want to do a setoff,’ because in that way it can actually obtain 100 percent of the benefit of its deposit whereas if it doesn’t do the setoff then it gets its insured deposit and a receiver certificate for the remainder.”
According to Tucci, “The setoff right is fairly clear in the law. The setoff right belongs to the customer in this case especially if the loan is not in default. If it is in default, the bank may have the right as well. So it does the setoff and it reduces its liability on the loan to zero. You have the participating bank out there with $1 million participation. Logic would suggest that the FDIC would owe that participating bank the million dollars on the loan participation. Unfortunately, every case that has determined this issue has said, ‘No, you get a receiver certificate for the million dollars for the loan participation.’ And as we just went through, that receiver certificate is worth zero. So the FDIC has basically been paid off in full. The participant bank has taken a 100 percent hit on that loan.”
Tucci said he still has a question as to what impact depositor preference has on that kind of claim. “Does the participant bank have some sort of subrogation argument that it could make that it should be treated as a priority claim? I think that there is going to be litigation there because there are lots and lots and lots of loan participations out there.”