#11141 - Bank Failure - Federal Banking Regulation

Bank Failure

1. In General

   1. When a bank fails, the FDIC pays insured claims from the insurance fund and then recoups what it can by selling the bank's assets

   2. The FDIC has two roles: (1) Receiver and (2) Deposit Insurer

      1. The FDIC as insurer can purchase assets and assume liabilities of the FDIC as receiver. See 12 U.S.C. § 1812(d)(1).

         • When the FDIC does this, it acquires the same rights and powers - and undertakes the same fiduciary duties to creditors - as a receiver had. See 12 U.S.C. § 1812(d)(3)(A), (C).

2. Process

   1. Step 1: Appointing a Receiver

      1. Who appoints the receiver?

         • If a bank is to be placed into receivership, the government agency that issued the charter appoints the receiver.

           • Thus, OCC for National Banks, The Federal Reserve for Federal Thrifts, and state regulators for state banks and thrifts

         • If the primary regulator unjustifiably fails to appoint a receiver for an FDIC insured institution, the FDIC can appoint itself receiver if necessary to avoid or mitigate loss to the insurance fund

         • By law, the FDIC serves as receiver for all failed national banks and federal thrifts. See 12 U.S.C. § 1821(c)(2)-(A)(ii).

           • In practice, the FDIC also serves as receiver for all failed FDIC-insured state banks and thrifts.

      2. Grounds for Receivership (12 U.S.C. § 1821(c)(5))

         • (1) The bank has obligations exceeding its assets.

         • (2) The bank cannot or probably cannot meet its obligations in the normal course of business.

         • (3) The bank is in an unsafe or unsound condition to transact business.

         • (4) The bank incurs or is likely to incur losses depleting substantially all of the bank's capital, and has no reasonable prospect of becoming adequately capitalized.

         • (5) The bank is critically undercapitalized or otherwise has substantially insufficient capital.

         • (6) The bank is undercapitalized and (a) has no reasonable prospect of becoming adequately capitalized; (b) fails to recapitalize when ordered to do so under the prompt corrective action statute, 12 U.S.C. § 1831o(f)(2)(A); (c) fails to submit a timely and acceptable capital restoration plan; or (d) materially fails to implement such a plan.

         • (7) The bank substantially dissipates assets or earnings through a violation of a statute or regulation or through an unsafe or unsound practice.

         • (8) The bank conceals records or assets, or refuses to let authorized examiners inspect records.

         • (9) The bank willingly violates a cease-and-desist order.

         • (10) The bank commits any violation of a law or regulation, or any unsafe or unsound practice or condition that is likely to cause insolvency or substantial dissipation of assets or earnings, weaken the bank's condition, or otherwise seriously prejudice the interests of the deposit insurance fund.

         • (11) The bank is convicted of money laundering crimes.

         • (12) The bank loses its FDIC insurance.

         • (13) The bank consents to the receivership or conservatorship.

      3. Due Process

         • Regulators generally appoint a receiver or conservator without prior notice or hearing. The bank may then challenge the appointment in court. See, e.g., 12 U.S.C. §§ 191, 203(b), 1464(d)(2).

         • This practice has been upheld by the Supreme Court. See Fahey v. Mallonee

         • With respect to judicial review of a decision to appoint a receiver or conservator, "(1) the scope of review is ordinarily limited to the agency record before the director at the time he made the decision to appoint a [receiver or] conservator; and (2) the standard of review to be utilized is that . . . in 5 U.S.C. § 706(2)(A) that an appointment decision may be set aside only if the decision was 'arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.'" Franklin Savings Assoc. v. Director, Office of Thrift Supervision; see also Camp v. Pitts

      4. Receiver vs. Conservator

         • A receiver resolves a failed bank, whereas a conservator can correct the problems at the bank regulators intend to keep open.

   2. Step 2: Marshaling Assets: Identifying which of the failed bank's assets might be of value and turning said assets into cash (e.g. loans, leases, securities, insurance claims, other financial and nonfinancial contract rights, buldings, equipment, and current or potential legal claims)

      1. The receiver has four key powers (among other): (1) "avoid" (i.e., invalidate) fraudulent transfers, (2) pursue claims against a failed bank's directors and officers, (3) terminate contracts and leases, and (4) enforce cross-guarantee liability to the FDIC

         • (1) Avoiding Fraudulent Transfers

           • Debter-creditor law has long prohibited a debtor from transferring property to "hinder, delay, or defraud" a creditor

           • The FDIC as receiver can attack such transactions using its authority to avoid transfers made and obligations incurred by debtors or insiders of a bank "with the intent to hinder, delay, or defraud" the bank. 12 U.S.C. § 1812(d)(17)(A).

           • By proving transactions are fraudulent, the receiver can obtain a judgment invalidating the transactions. See 12 U.S.C. § 1821(d)(17)(A)-(B).

         • (2) Pursuing Claims Against Failed Banks' Directors and Officers

           • A failed bank's assets includes potential claims against directors and/or officers of the failed institution, including claims for breach of fiduciary duty, intentional wrongdoing, or other actionable misconduct.

           • The receiver reviews potential claims and gauges the strength of those claims and prospects for obtaining and collecting judgments on them

           • When the receiver gauges claims, it will consider whether the bank or insider has insurance.

             • Two relevant types:

               • (1) The Bankers' Bond

                 • Covers fraudulent or illegal conduct by bank directors, officers, or employees BUT typically excludes all forms of negligence

               • (2) D & O Liability Policy

                 • Covers negligence or gross negligence BUT typically excludes intentional or criminal misconduct

                 • BUT EXCLUSIONS

                 • (1) Regulatory Agency Exclusion: this excludes actions by the FDIC even the suit was taken over by the agency versus commenced by the agency. See FDIC v. American Casualty Co.

                 • (2) Insured versus Insured Exclusion

         • (3) Terminating Contracts and Leases

           • Issue is what happens to executory contracts upon receivership

           • A failed bank's receiver may, within a reasonable time after the bank enters receivership, terminate any agreement to which the bank is a party if the receiver determines that the agreement is burdensome and that terminating it will "promote the orderly administration of the institution's affairs." 12 U.S.C. § 1821(e)(1)-(2).

           • The receiver is generally liable only for "actual direct compensatory damages" determined as of the date the bank entered receivership - not for punitive damages or damages for lost profits, lost opportunity, or pain and suffering. 12 U.S.C. § 1821(e)(3)(A)-(B).

           • Special rules apply to leases, contracts for the sale of real property, service contracts, and "qualified financial contracts."

             • Special Rules

               • Agreement not within any other category:

                 • Receiver is liable only for "actual direct compensatory damages" determined as of date bank entered receivership. Receiver is not liable for punitive damages or damages for lost profits, lost opportunity, or pain or suffering.

               • Lease under which bank is lessee

                 • Lessor can recover only rent accrued before termination. Lessor has no claim for damages under any acceleration clause or penalty provision.

               • Lease under which bank is lessor

                 • Lessee, if not in default when receiver terminates lease, may either treat lease as terminated or remain in possession of property for remainder of lease term. If lessee remains in possession, lessee must continue paying rent; and if receiver fails to perform bank's duties under lease, lessee may deduct any resulting damages from rent due to receiver.

               • Contract for sale of real property

                 • If purchaser has possession of property and is not in default when receiver terminates contract, purchaser may either treat contract as terminated or remain in possession of property. The following rules apply if purchaser elects to remain in possession: purchaser must continue making payments; if receiver fails to perform the bank's duties under contract, purchaser may offset damages against payments due to receiver; receiver shall deliver title as provided in contract; and receiver has no other duty or liability.

               • Service contract

                 • If receiver accepts service under contract before terminating contract, receiver shall pay under contract for those services and treat payment as administrative expense. Receiver can terminate contract even if receiver has accepted services under contract.

               • Qualified financial contract

                 • Receiver must terminate either all or none of a party's qualified financial contracts with the bank. If receiver terminates QFC, other party may recover reasonable costs of cover.

         • (4) Enforcing Cross-Guarantee Liability

           • If an FDIC-insured bank fails and causes a loss to the FDIC, the FDIC can hold liable for the loss any other FDIC-insured depository institution that controls, is controlled by, or is under common control with the failed bank. 12 U.S.C. § 1815(e).

           • Imposing cross-guarantee liability typically causes the affiliated bank to fail and makes that bank's assets (and net worth) available to help reduce the FDIC's loss at the first failed bank.

           • Cross-guarantee liability applies only among FDIC-banks; it does not extend to their holding companies or holding-company affiliates (unless those entities are themselves insured depository institutions.

   3. Step 3: Paying Valid Claims in Order of Priority

      1. Determining Validity of Claims

         • The FDIC as receiver notifies a...