COLLATERAL CONCERNS IN TIMES OF FINANCIAL CRISES PHILADELPHIA SURETY CLAIMS ASSOCIATION T. Scott Leo LEO & WEBER, P.C.
Letters of Credit • Two Types • Conventional/Commercial • operates as a transaction's primary payment mechanism for goods or services • Contemplates payment upon performance • Standby Letter of Credit • Requires the issuer to pay a specified sum upon certain conditions stated in the letter of credit. This type is most commonly used by sureties • Contemplates payment upon failure of performance
Standby Letters of Credit • In 1985, standby letters of credit issued in the US totaled to $147 billion • As of 1998, standby letters of credit jumped to over $750 billion • 11% of the standby letters of credit are drawn down as a result of the account debtor’s failure to perform its obligations
Benefits of Letters of Credit • Standby letters of credit protects a surety’s collateral • In the event of a principal’s bankruptcy, the surety may draw on the letter of credit without lifting the automatic stay because the letter of credit is not property of the bankruptcy estate • Allows the surety unfettered access to the funds without the risk and delay of seeking a court’s approval to use the collateral
Risks in Times of Financial Crises • The surety’s collateral is protected with a letter of credit in the event of a principal’s insolvency….this is not necessarily the case in the event of the issuing bank’s insolvency….
Letters of Credit are not FDIC insured • Although letters of credit are specifically listed in the definition of insured deposits in the Federal Deposit Insurance Act (12 U.S.C. 1813(1)(l)) the FDIC has long held that a stand-by letter of credit “should not be treated as a deposit for insurance purposes unless the customer of the depository institution, at whose behest the standby letter of credit is issued, provides some form of asset or ‘hard earning’ to cover the liability.” -FDIC Advisory Opinion FDIC-90-13 June 4, 1990.
D’Oench Duhme Doctrine • Named after the 1942 Supreme Court case and codified in 12 U.S.C. 1823(e) which provides obligations that are not found in the records of the institution, i.e., not susceptible to discovery during an audit, are not binding on the FDIC and RTC as a receiver of the institution. • Because standby letters of credit were not always accounted for in the books and records of financial institutions, in some instances during the 1980’s the FDIC refused to honor outstanding letters of credit as a consequence of the D’oench Duhme Doctrine
Philadelphia Gear Corp. v. FDIC427 U.S 426 (1986) • The Supreme Court held that a standby letter of credit backed only by a contingent promissory note and was not an insured “deposit”.
Impact of Philadelphia Gear • An unsecured letter of credit beneficiary might only receive a pro-rata share of an institution’s distribution to its uninsured and unsecured creditors. • The FDIC can completely repudiate letters of credit that did not appear in the records of he failed institution.
Changes in Accounting Practices • In December 1991, the FASB issued Statement of Financial Accounting Standards No. 107, entitled "Disclosure about Fair Value of Financial Instruments“.
Collateralized Standby Letters of Credit • In a Statement of Policy issued by the FDIC in 1995, the FDIC stated that after its appointment as conservator or receiver the FDIC may either • Continue any collateralized letters of credit as enforceable • Call, redeem, or prepay any collateralized letters of credit by repudiation or disaffirmance and pay the beneficiary the amount held as collateral • The Policy Statement did not change the FDIC’s position that standby letters of credit are contingent obligations.
Temporary Liquidity Guarantee Program • Fully guarantees certain noninterest-bearing transaction accounts • All other deposit accounts are guaranteed up to $250,000
Letters of Credit Still a Useful Tool • Abandonment of letters of credit during times of financial crisis may not be prudent • Monitor the financial strength of the bank holding collateral or issuing letters of credit • www.standardandpoors.com • www.bankrate.com • www.moodys.com • www.fitchratings.com • Monitor the FDIC Watchlist • Draw before the issuer is placed under receivership or conservatorship
T. Scott Leo LEO & WEBER, P.C. One North LaSalle Street Suite 3600 Chicago, Illinois 60602 Telephone: (312) 857-0910 Facsimile: (312) 857-1240 E-Mail: email@example.com Michigan Office 20 West Michigan New Buffalo, Michigan 49117 Telephone: (269) 469-2293 Facsimile: (269) 469-2316