FDIC Law, Regulations, Related Acts
4000 - Advisory Opinions
Treatment of Payments Made to Bondholders Pursuant to Letters of Credit When Issuing Bank Becomes Insolvent
January 11, 1991
Carroll R. Shifflett, Associate General Counsel
We have been requested to provide our response concerning the treatment of certain payments made to bondholders pursuant to letters of credit (LOCs) commitments should the bank issuing the letters of credit become insolvent.
As you are aware, neither the FDIC nor the RTC issues binding advisory opinions concerning hypothetical situations that may arise in future receiverships or conservatorships of insured institutions. The FDIC's and the RTC's actions as receiver or conservator are determined on a case by case basis, in accordance with applicable laws and in light of specific factual situations. I am willing, however, to provide my views as to what a court would hold in response to your inquiry, although I have not attempted to analyze these transactions under any provisions of law other than those specified or to ascertain the rights or obligations of any other parties.
Under the circumstances at issue, an FDIC-insured bank (Bank) has issued its LOCs to support tax-exempt, variable rate industrial development bond or other municipal offerings, and tax-exempt and taxable commercial paper offerings. A transaction involves a municipal issuer which issues the bonds and lends the proceeds to a borrower. The borrower, as account party, obtains an LOC from the Bank. The Bank issues its LOC on behalf of the borrower to a trustee (Trustee) on behalf of the registered owners of the bonds (Bondholders). The Trustee may draw upon the LOC (a) for periodic payments of interest or scheduled annual principal installment payments, (b) when an "event of default" occurs to accelerate maturity, (c) when tendered bonds cannot be successfully remarketed, or (d) upon the happening of certain events triggering a mandatory tender of all bonds.
Due to the Bank's recent financial difficulties and the resultant downgrading of the ratings on these bonds by Moody's and Standard & Poor's, a large volume of bonds have been tendered for redemption. Since the Trustees have not been able to successfully remarket the bonds, they have been forced to draw under the LOCs to redeem these bonds. When the Bank is forced to pay the Trustees under its LOCs, its liquidity is reduced and the borrower is forced to pay a higher rate of interest, which may cause substantial hardships on the borrower or result in defaults against the interest then owing to the Bank.
In an attempt to remedy these problems, the Bank has entered into agreements with higher-rated foreign banks, which have issued confirmations of the Bank's LOCs (Confirming Bank). Pursuant to the confirmation agreements, these higher-rated banks agree to pay the LOCs in the event that the Bank fails to honor any proper draw request. In order to obtain these confirmation agreements, the Bank has paid a confirmation fee, pledged its own marketable securities as collateral, and assigned or agreed that the Confirming Bank will be subrogated to the Bank's rights in the underlying documents between the Bank and the borrower.
Should the Confirming Bank be required to pay under one of these confirmations, the agreements contemplate that the Confirming Bank will look first to the Bank for repayment, then if repayment is not forthcoming in a timely manner, it will seek to liquidate the collateral. Then, if a shortfall still exists, the Confirming Bank will look to the underlying borrower through either subrogation or assignment. Each confirmation agreement also gives the Confirming Bank the right to terminate the confirmations on 75 or 85 days notice, if the Bank breaches certain covenants or warranties. The Confirming Bank will be directly liable for payment under the confirmation issued to the Trustee on behalf of the Bondholders if the Bank fails to honor a proper draw by the Trustee.
We have been asked to address the following two questions:
"1. Could the FDIC receiver, under 12 U.S.C. 91, recover payments made to Bondholders by the Trustee which are derived from a draw under the applicable Bank LOC, under the theory that such payments either (a) were not made in the "ordinary" course of the business of the Bank, (b) were made with a view to the preference of one creditor over another or (c) were made with a view to prevent the application of the Bank's assets in the manner prescribed by the National Banking Act?
2. Could the FDIC receiver, under 12 U.S.C. 91, recover payments made to Bondholders with the proceeds of a draw by the Trustee under the applicable Confirmation, under the theory that the reasoning of In re Air Conditioning, Inc., 845 F.2d 293 (11th Cir. 1988) would be applicable to the transaction because the Bank had pledged collateral to the Confirming Bank to secure the Bank's repayment obligations under the Confirmation Agreement?"
In response to the first question, it is my view that a court would hold that the FDIC as receiver or as conservator could not recover payments, under 12 U.S.C. 91, made to the Bondholders by the Trustee which were derived from a draw under the applicable Bank LOC, as described above.
In response to your second question, it is my view that a court would hold that the FDIC as receiver or as conservator could not recover payments, under 12 U.S.C. 91 or the reasoning of In re Air Conditioning, Inc., 845 F.2d 293 (11th Cir. 1988), made to the Bondholders by the Trustee, which were derived from a draw under the applicable confirmation of a Bank LOC.
The foregoing opinion only addresses the ability of the FDIC, if appointed as receiver or as conservator of the Bank to recover payments made to the Bondholders by the Trustee pursuant to 12 U.S.C. 91. Further, our comments should not be considered as an endorsement or review of the appropriateness of the proposed transactions.