Documentary Credit World

Creditworthiness and reliability are foundational to letters of credit. By substituting the creditworthiness of the issuing bank for that of its customer, the risk of non-payment in the underlying transaction is reduced, but not eliminated. What happens to an LC if the issuing bank fails? Unfortunately, this is not a hypothetical question. Since 2001, there have been 565 bank failures in the United States, including several among the largest ever in 2023.₁ This article examines the unique intersection of LCs and failed banks.

Letters of credit are liabilities of a failed bank. Deposits are also liabilities of a failed bank, insured by the Federal Deposit Insurance Corporation (FDIC) up to USD 250,000. Are LCs insured deposits? Most LC professionals would immediately answer, “of course not”, but this matter has actually been litigated all the way to the U.S. Supreme Court. In the U.S. Code, Title 12 (Banks and Banking), “Deposit” is defined as “the unpaid balance of money or its equivalent received or held by a bank … for which it has given or is obligated to give credit” (12 U.S.C. §1813(l)(1)). In FDIC v. Philadelphia Gear Corp., 476 U.S. 426 (1986), the Supreme Court held that a standby letter of credit backed by a continent promissory note (covering the reimbursement obligation) is not “money or its equivalent”, and therefore not a deposit liability.

Thus, an LC issued by a bank that has failed is a contingent uninsured liability. In practice, what does that mean? If FDIC is appointed receiver of the failed bank, how will its portfolio of outstanding LCs be treated? There are two alternative outcomes, one negative and the other positive. These alternatives do not constitute choices that any party to an LC can make. Rather, as explained below, FDIC controls which outcome will be applicable.

The Negative Possible Outcome

Under 12 U.S.C. §1821(e)(1), FDIC as receiver has the power to “disaffirm or repudiate any contract … to which [the failed bank] is a party … the performance of which … the receiver … determines to be burdensome; and … the disaffirmance or repudiation of which … in the receiver ’s discretion, will promote the orderly administration of the [failed bank’s] affairs.” The business of FDIC as receiver of a failed bank is to wind up its affairs. Maintaining an open contingent liability under an LC is inconsistent with that orientation. Therefore, subject to the alternative possible outcome discussed below, FDIC as receiver can and does repudiate LCs. This is the worst-case scenario for LC beneficiaries.

FDIC repudiation of LCs has been challenged legally. The argument is that the statutory power of repudiation is not applicable because an LC is not a “contract”. This has been an issue as long as there have been LCs. It has been observed that “letters of credit are sui generis”,₂ “an idiosyncratic form of undertaking”,₃and “a distinctly odd beast”;₄ a descendant of the ancient lex mercatoria (law merchant), not the common law of contracts. In 1948, one legal scholar optimistically wrote “[i]t may be that some day one of our courts will have the perspicacity and courage to state frankly and clearly that the rights under a letter of credit are not, and never were, dependent upon the principles of consideration of the common law [of contracts]”.₅ LC professionals are still awaiting that day and should not be holding their breath. The concept that LCs are not contracts has not gained purchase in the accretion of U.S. case law, likely because it is obscure and “counter-intuitive to lawyers and judges versed in general commercial law”.₆

This is manifest in the decisions of U.S. courts rejecting the argument that FDIC’s power of repudiation is not applicable to LCs because they are not contracts.₇The key statutory phrase is “any contract” [emphasis added]. As a matter of construction, “any” means the term should be interpreted broadly. For the reasons explained above, there are ample cases referring to an LC as a contract, which supports the judicial reasoning that, for purposes of the repudiation power, it is. In a sense this can be viewed as a self-perpetuating legal conclusion, born of generations of case law that blur the ancestral distinction. So rolls the ever-evolving common law juggernaut.

The Positive Possible Outcome

The purpose of FDIC is “to maintain stability and public confidence in the nation’s financial system”.₈ A lack of public confidence can trigger a bank run, as demonstrated very dramatically with the collapse of Silicon Valley Bank in March 2023. Deposit insurance promotes public confidence, but FDIC also serves its mission in the manner it selects to resolve a bank that has failed. To mitigate the risk that erosion of public confidence may spread and jeopardize other banks, FDIC’s abiding goal is to assure that the customers of a failed bank continue to be served by a successor without interruption. To accomplish this, although there are alternative methods of resolution that may be employed to address unique circumstances, “FDIC strongly favors use of the Purchase and Assumption method in dealing with the failed bank problem”.₉ Under a Purchase and Assumption (P&A) Agreement, subject to certain exceptions, a successor bank (called an “Assuming Institution”) purchases assets of the failed bank (including loans) and assumes liabilities of the failed bank (including insured deposits and sometimes uninsured deposits as well).

As previously stated, an LC issued by a failed bank is a contingent liability, so the key question is how that is treated under FDIC’s standard template P&A Agreement. It depends on the letter of credit. The list of liabilities assumed under section 2.1 of FDIC’s standard form of P&A Agreement (publicly available per bank failure) includes:

(g) liabilities for any acceptance or commercial letter of credit, provided, that the assumption of any liability pursuant to this Section 2.1(g) will be limited to the market value of the Acquired Assets securing that liability as determined by the Receiver;
(h) liabilities for any “standby letters of credit” as defined in 12 C.F.R. §337.2(a) issued by the Failed Bank in connection with an Acquired Asset, but excluding any other standby letters of credit[.]

“Acquired Assets” is defined to mean “all assets of the Failed Bank purchased by the Assuming
Institution pursuant to this Agreement,” (section 1.3).

Under FDIC’s standard form of P&A Agreement, therefore, the fate of an LC is tethered to the asset side of the failed bank. Commercial LCs and outstanding acceptances are assumed by the Assuming Institution, but only to the extent of acquired collateral securing the reimbursement obligation. A standby LC issued “in connection with an Acquired Asset” presumably means a standby issued under a line of credit (loan) acquired by the Assuming Institution under the asset purchase terms of the P&A. Excluded from assumption are what might be called “standalone” standbys, which FDIC as receiver would then likely repudiate in due course (which must occur “within a reasonable period of time,” 12 U.S.C. §1821(e)(2)).

Compared to the negative outcome described above (i.e., repudiation), this outcome is positive in that it likely means that many, if not most, LCs outstanding at a failed bank will be assumed by the Assuming Institution and will therefore remain available for draw by beneficiaries.

This outcome makes sense. Commercial banking relationships are “sticky” because, once established, they can be difficult to move. The failure of a bank forces disruption and movement of commercial relationships. Recognition of bank failures as a unique growth opportunity is a powerful incentive for a bank to enter into a P&A transaction, aligning with FDIC’s goal of avoiding erosion of public confidence by promptly arranging a P&A with a successor to the failed bank. Viewed against that backdrop, when an LC is but one part of a larger commercial banking relationship (very common), it would be damaging to splinter that relationship, with some parts picked up by the Assuming Institution, leaving letter of credit parts relegated to the repudiation dustbin. So understood, the iteration struck in FDIC’s standard P&A Agreement respects the holistic value of
integrated commercial banking relationships.

Silicon Valley Bank, Signature Bank and First Republic Bank were all resolved in P&A transactions, using the P&A Agreement language quoted above.₁₀

Practice Pointers for LC Professionals

When an issuing bank fails, do not assume its LCs are no longer available and will be repudiated by FDIC. FDIC communicates in real time about the manner of resolution of a failed bank. Check FDIC’s website (fdic.gov). If there is P&A Agreement (very common), it will be posted as soon as possible (see examples at footnote 10). Read it. If an LC has been assumed, the Assuming Institution is the replacement issuing bank. Perhaps allowing some time for dust to settle, reach out to the Assuming Institution (the relevant employees of which could very well be the same employees responsible for LCs at the failed bank). Will there be a new place for presentation? A new LC number? Amendments to that effect?

If you are a beneficiary, review the terms of your LC and the underlying transaction. What are your rights? Does issuing bank failure trigger a default in the underlying transaction? Can you demand a replacement LC? If your LC has been assumed under a P&A, are you comfortable with the Assuming Institution? Do you have a right to draw? If so, do you want to exercise that right? What impact would that have in the underlying transaction?

If you are a beneficiary and your LC has not been assumed, you can expect repudiation within a reasonable period of time. What are your rights in the underlying transaction? Declare a default? Demand a replacement LC? If you are unable to obtain a replacement LC, look into the process for filing a claim against the FDIC receivership estate, taking note of any deadlines. FDIC issues public notices with information about the process. Bear in mind that bank insolvencies are governed by Title 12 of the U.S. Code, not the Bankruptcy Code (Title 11).

In sum, the failure of an issuing bank scrambles the letter of credit landscape. Careful examination of FDIC’s manner of resolution and evaluation of impact within the underlying transaction are in order, requiring a close reading of all relevant legal documents. As such, consideration should be given to engagement of experienced legal counsel to assist with navigation of that complicated landscape.

* Mark W. Warren is a Senior Vice President and Associate General Counsel of M&T Bank in Buffalo, New York. He previously worked for FDIC in New York City. He is a graduate of the University of Buffalo Law School and a member of the New York bar.

** Any opinions expressed herein are solely those of the author and do not represent the views of his employer, present or previous.

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