FDIC May Repudiate Letters of Credit from Banks in Receivership

                            FDIC May Repudiate Letters of Credit from Banks in Receivership

US banks and thrifts are failing at an alarming pace, and the Rating Agencies have dramatically downgraded the credit ratings for numerous institutions whose financial strength would have been unquestioned just a year or two ago. For banks, 2008 was a very painful year. In 2007, only three banks were placed into receivership; in 2008, 25 failed, an increase of more than 800 percent.

2015 is looking ominous for the banking industry, and many experts predict that large numbers of banks and thrifts will be placed under government control throughout the year. Meanwhile, the Rating Agencies will downgrade ratings as institutions’ prospects dim. While the government agencies often transfer assets and liabilities of a failed institution to a successor, the government has the statutory right to repudiate all “burdensome” contracts – including letters of credit – when it places a bank or thrift under government control.

FDIC has recently reminded letter of credit Beneficiaries – most notably commercial landlords – that FDIC may not honor undrawn standby letters of credit issued by banks that have been placed under government receivership or conservatorship. In other words, the FDIC has announced that it can repudiate undrawn letters of credit, and that no damages against the Issuer will be available to the Beneficiary, unless the conditions for drawing were fully satisfied before the receivership or conservatorship occurred. Because the United States Supreme Court has held that letters of credit are typically not deposits, the Beneficiary is not protected up to the FDIC insurance limit for deposit accounts – currently $250,000 – if a letter of credit is repudiated. Letters of credit can, of course, be assumed by any bank that accepts the obligations of a failed institution, but the critical message here is that this may occur at the sole discretion of the FDIC and the acquiring bank. FDIC has wide latitude in the way it structures the transfer of assets of a failed institution, so even if a failed bank “merges” into a healthy institution, letters of credit may still be at risk.

Meanwhile, in the event the Issuer is placed under FDIC control, any cash deposited with the Issuer by the Account Party as collateral for a letter of credit will likely be considered a deposit account that is insured only up to $250,000.


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