Bank Failure - Classes Home

10 BANK FAILURE

Richard Scott Carnell

Draft—August 22, 2006

A. INTRODUCTION

Note on FDIC’s Dual Roles



B. THE LOGIC OF RECEIVERSHIP



C. APPOINTING RECEIVER

1. Who Appoints Whom

2. Grounds for Receivership

3. Due Process

Note on Receivership Versus Conservatorship

Problems



D. MARSHALING ASSETS

1. Overview of Receiver’s Powers

2. Avoiding Fraudulent Transfers

3. Pursuing Claims Against Failed Bank’s Directors and Officers

4. Terminating Contracts

5. Enforcing Cross-Guarantee Liability

Problems



E. PAYING VALID CLAIMS IN ORDER OF PRIORITY

1. Determining Validity of Claims

2. Priorities

a. Secured Claims

b. Unsecured Claims

3. Setoff

4. Angling for Priority

a. Constructive Trusts

b. Shareholders’ Direct Litigation

Problems



F. STRUCTURING RESOLUTION

1. How Receivership and Deposit Insurance Intertwine

2. Resolution Options

3. Subrogation

4. Least-Cost Resolution Requirement

a. General Rule

b. Systemic-Risk Exception



G. SYSTEMIC RISK

Overview

What Is Systemic Risk?

Problems

12 BANK FAILURE

A. INTRODUCTION



Bank failure made a dramatic entrance in chapter 1 of this book. It brooded in the wings



during the intervening chapters as regulators sought to ward it off with safeguards like capital



standards, prudential restrictions, examination, supervision, and enforcement. Now bank failure



takes center stage. What if banks fail despite all precautions? In this chapter we will examine the



process and legal framework for dealing with failed banks. We will focus on receivership, a legal



mechanism for taking control of a failed bank and using the bank’s assets to pay the bank’s



depositors and other creditors. We will also closely examine the two distinct roles played by the



Federal Deposit Insurance Corporation: as deposit insurer and as receiver.



The process for dealing with (―resolving‖) a failed bank has three basic steps. First,



regulators appoint a receiver to take control of the bank. Second, the receiver marshals the bank’s



assets, identifying and collecting on all items of potential value owned by the bank. Third, the



receiver determines the validity of claims against the bank and uses the proceeds of the bank’s



assets to pay valid claims. If those claims exceed the value of bank’s assets, as they typically do,



the receiver pays creditors in the order of priority prescribed by law, notably by paying deposits



before—and subordinated debt after—ordinary nondeposit claims (e.g., claims by employees,



suppliers, and holders of bonds and commercial paper). These three steps may occur sequentially



or simultaneously.

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This process could—and for more than a century did—operate without deposit insurance.



After all, even with no insurance (and, for good measure, no bank regulation), we would still need



to safeguard a failed bank’s assets, determine the validity of claims against the bank, pay valid



claims, and have some standard for deciding which claims to pay when valid claims exceeded the



value of the bank’s assets. To carry out these tasks we could use the federal Bankruptcy Code or



develop a specialized mechanism like bank receivership.



Deposit insurance gives us an additional reason to have an efficient resolution process:



bolstering the insurance fund by minimizing the loss incurred when an insured bank fails. The



FDIC pays insured claims from the insurance fund and recoups what it can by selling the failed



bank’s assets. The more efficient the resolution process, the smaller the FDIC’s loss. By acting as



the failed bank’s receiver, the FDIC controls the process and has an opportunity to minimize its



loss.



Policymakers, bankers, and economists have long debated whether the FDIC should use



its insurance fund to prevent a large bank’s uninsured depositors from incurring any loss if the



bank fails. We have encountered this ―too big to fail debate‖ in earlier chapters. Proponents of a



―too big to fail‖ policy argue that letting uninsured depositors suffer a loss would destabilize the



financial system and undercut macroeconomic prosperity. Opponents stress that such a policy



promotes inefficiency and long-term instability by subverting market discipline and encouraging



large banks to take excessive risks. FDICIA curtailed ―to big to fail‖ treatment by generally



requiring the FDIC to use the least costly method of satisfying its own insurance obligation. Thus



the FDIC generally cannot incur additional expense to protect uninsured depositors. But if a large



bank fails, the FDIC may nonetheless face political pressure and policy arguments at odds with

4





the statutory imperative to conserve the insurance fund. Those who regard the bank as ―too big to



fail‖ may press the FDIC to protect all depositors so as to avert alleged ―systemic risk.‖



In this chapter we will consider the rationale for receivership by noting what could go



wrong if we had no adequate legal mechanism to handle bank failure and how receivership helps



avoid those problems. We will examine each key step in the receivership process: appointing the



receiver, marshaling assets, and using the proceeds to satisfy valid claims against the bank. We



will also look at the resolution methods available to the FDIC, the requirement that the FDIC use



the least costly resolution method, and the meaning of systemic risk.



Although we will focus on receivership, we will give some attention to conservatorship, a



little-used alternative to receivership. Conservators and receivers both take control of troubled



banks, have fiduciary duties to depositors and other creditors, and have many of the same powers.



But a conservator operates a bank as a going concern and, unlike a receiver, lacks authority to



liquidate the bank.







NOTE ON FDIC’S DUAL ROLES



In dealing with the failure of FDIC-insured banks, the FDIC has two distinct sets of



powers and responsibilities: as receiver and as deposit insurer. These functions, though



complementary, are logically separable: Congress could have assigned receivership to a different



government agency or to the private sector. Private individuals acted as bank receivers during the



nineteenth and early twentieth centuries. Private individuals continue to act as trustees in



bankruptcy. In 1989 Congress created the Resolution Trust Corporation, a temporary government



agency, to act as failed thrift institutions’ receiver even as the FDIC assumed responsibility for



insuring thrifts’ deposits.

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To underscore the distinction between the FDIC’s two roles, this chapter—in discussing



receivership—will usually refer to the ―receiver‖ or the ―FDIC as receiver‖ rather than simply to



the ―FDIC.‖ In discussing the FDIC’s insurance role, this chapter will usually refer to the ―FDIC



as insurer.‖



Now comes a complication: The FDIC as insurer (officially, ―the FDIC in its corporate



capacity‖) can purchase assets and assume liabilities of the FDIC as receiver. See 12 U.S.C.



§1821(d)(1). When it does so, it acquires the same rights and powers—and undertakes the same



fiduciary duties to creditors—as the receiver had. See id. §1821(d)(3)(A), (C). Thus the FDIC as



insurer will marshal assets, notify creditors to file their claims, determine the validity of those



claims, and pay valid claims in order of priority.



Take the case of Hodgepodge Bank, a failed FDIC-insured bank with loyal customers,



good assets worth $250 million (e.g., investment-grade securities and sound commercial and



consumer loans), dubious assets probably worth $100 million (e.g., corporate bonds whose rating



has fallen from BBB to BB–, and loans to solvent but unskillful real estate developers), and bad



assets probably worth $50 million (e.g., loans in default). Hodgepodge has $600 million in



insured deposits and no other liabilities:





HODGEPODGE BANK

Before Asset-Purchase by FDIC as Insurer

Millions of Dollars



Assets Liabilities

Good assets $250

Dubious assets $100 Deposits $600

Bad assets $50

Total Assets $400 Total Liabilities $600





Tidy Bank wants to buy Hodgepodge’s good assets but balks at buying Hodgepodge’s dubious



and bad assets. It is willing to assume liability for Hodgepodge’s deposits if the FDIC pays it the

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amount by which the assets it acquires are worth less than the deposit liability it assumes. The



FDIC and Tidy Bank ultimately agree that the FDIC will replace Hodgepodge’s dubious and bad



assets with $200 million in cash and pay Tidy Bank an additional $200 million to assume all $600



million of Hodgepodge’s deposits. The FDIC and Tidy Bank might effectuate this deal as



follows: First, the FDIC as insurer buys Hodgepodge’s dubious and bad assets from the FDIC as



receiver for $150 million in cash. The FDIC as insurer thereby takes on the risk that those assets



fetch less than $150 million; it also stands to benefit if those assets fetch more than $150 million.



The sale leaves Hodgepodge with $400 million in good assets:





HODGEPODGE BANK

After Asset-Purchase by FDIC as Insurer

Millions of Dollars



Assets Liabilities

Good assets $400 Deposits $600

Total Assets $400 Total Liabilities $600





Second, Tidy Bank purchases Hodgepodge’s good assets from the FDIC as receiver and assumes



Hodgepodge’s insured deposits. Third, the FDIC as insurer pays Tidy Bank $200 million to make



up the difference between the assets Tidy Bank is acquiring ($400 million) and the insured



deposits Tidy Bank is assuming ($600 million). The FDIC as insurer then marshals the dubious



and bad assets it has acquired, using the same powers as the receiver has.



In discussing a receiver’s powers and duties, this chapter could repeatedly note the



potential role of the FDIC as insurer in marshaling assets and paying claims. But that would



clutter an already complicated subject. Suffice it to note here that the FDIC as insurer can take on



those functions when it purchases assets and assumes liabilities from the receiver. We will return



to the FDIC’s dual roles later in this chapter when we consider how the FDIC structures the



resolution of a bank (Part F-1).

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B. THE LOGIC OF RECEIVERSHIP



Let’s think about what could go wrong if we had no legal mechanism to handle bank



failure. We would have no deposit insurance, for such insurance necessitates some means of



paying insured depositors and disposing of failed banks’ assets. The lack of an adequate



resolution mechanism would exacerbate the costs of bank failure. It could tie up depositors’



money for years and increase the probability that they would ultimately recover only a fraction of



it. This increased risk of delay and loss would heighten depositors’ incentive to run if they



believed their bank in danger of failing. A run could pressure the bank to sell assets at fire-sale



prices and precipitate the bank’s failure (MM&C 3d ed. p. 58). Depositors at the front of the



withdrawal line would receive full payment while depositors at the end might receive nothing.



Pain from the bank’s failure could extend beyond the bank’s depositors, other creditors, and



shareholders:



If a merchant can not meet his bills promptly the general public is not disturbed. He is not

ruined at once, and if he should fail the effects are limited to comparatively a few persons.

If a bank is unable to meet a check drawn upon it the refusal to pay is an act of insolvency.

Its doors are closed, its business is arrested, its affairs go into liquidation and the mischief

takes a wide range. Those who have been accommodated with loans must pay, whatever

their readiness or ability to do so. Further advances cannot be obtained. Other banks must

call in their loans and refuse to extend credit in order to fortify themselves against the

uneasiness and even terror of their own depositors. Confidence is destroyed. Enterprises

are stopped. Business is brought to a standstill. Securities are enforced. Property is

sacrificed and disaster spreads from locality to locality. All these incidents of the banking

business are matters of common knowledge and experience. They clearly distinguish

banking from the ordinary private business, illustrate its public nature and show that it is

properly subject to the police power of the state, vested in its legislature.

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Schaake v. Dolley, 118 P. 80, 83 (Kan. 1911). Moreover, if regulators could not promptly close or



sell a terminally ill bank, the bank’s managers could gamble for recovery, dissipate or



misappropriate assets, incur inappropriate liabilities, and engage in favoritism and self-dealing.



These practices would further prejudice the interests of depositors and other creditors.



Receivership helps avoid or mitigate such problems. Closing a bank stops a run,



constrains aggressive collection practices by nondeposit creditors, and allows time for orderly



sale of the bank’s assets. The availability of receivership may reduce depositors’ incentive to run



on a troubled bank (and panic about the safety of other banks) by diminishing legal uncertainty,



increasing the likelihood of prompt payment, and assuring equal treatment of all depositors. The



prospect of a receiver scrutinizing a bank’s affairs may help deter the bank’s managers from



improper self-dealing, sweetheart deals (e.g., selling property to a crony for a fraction of what



others would have paid for it), and other irregularities. In sum, an effective receivership



mechanism can, with or without deposit insurance, significantly benefit depositors, other creditors



of banks, and the public.



Like bank receivership, bankruptcy law provides an orderly mechanism for selling a



faltering firm’s assets and satisfying the firm’s liabilities so as to protect the collective interests of



the firm’s creditors. Without such a mechanism, individual creditors’ attempts to collect from the



firm (e.g., by seizing assets the firm needs to conduct its business) could leave creditors



collectively worse off by impairing the firm’s viability and squandering the going-concern value



of the firm’s assets. In the following excerpt, Professor Thomas H. Jackson elucidates this



creditor-protection rationale. He argues that in the context of a failed or troubled firm (as



distinguished from an individual needing a fresh start), creditor-protection represents bankruptcy



law’s only proper purpose. In Jackson’s view, bankruptcy law should concern itself only with

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maximizing recovery by the firm’s creditors—and not with the external costs of the firm’s failure



(e.g., harm to customers, employees, business confidence, and the local or national economy).



This argument helps highlight for us the broader purpose of bank receivership: to pay depositors



swiftly enough to preserve public confidence and limit the external costs of bank failure.





Thomas H. Jackson, The Logic and Limits of Bankruptcy Law

8-13 (1986)





Bankruptcy law can be thought of as growing out of a distinct aspect of debtor-creditor

relations: the effect of the debtor’s obligation to repay Creditor A on its remaining creditors. This

question takes on particular bite only when the debtor does not have enough to repay everyone in

full. . . .



Creditor remedies outside of bankruptcy . . . can be accurately described as a species of

―grab law,‖ represented by the key characteristic of first-come, first-served. The creditor first

staking a claim to particular assets of the debtor generally is entitled to be paid first out of those

assets. It is like buying tickets for a popular rock event or opera: the people first in line get the

best seats; those at the end of the line may get nothing at all.



When the issue is credit, the ways that one can stake a place in line are varied. Some

involve ―voluntary‖ actions of the debtor: the debtor can simply pay a creditor off or give the

creditor a security interest in certain assets that the creditor ―perfects‖ in the prescribed manner

(usually by giving the requisite public notice of its claim).4 In other cases a creditor’s place in line

is established notwithstanding the lack of the debtor’s consent: the creditor can, following

involvement of a court, get an ―execution lien‖ or ―garnishment‖ on the assets of the debtor.5. . .





4

In real estate this generally requires the recording of a deed of trust or mortgage with the applicable county

recorder. With personal property, governed by Article 9 of the Uniform Commercial Code, it generally requires

either the filing of a financing statement in the applicable office or offices or possession of the property by the

secured party.

5

Execution lien generally refers to the lien that arises at or around the time the sheriff, following a judgment and the

issuance of a writ of execution, seizes property. With respect to real property, the applicable lien is sometimes called

a judgment lien, and it arises upon docketing of the judgment in the applicable files. With respect to many kinds of

intangible personal property, such as an employer’s obligation to pay wages to a debtor or a bank’s obligation to pay

money the debtor has on deposit with the bank, the applicable lien is called a garnishment lien, and it arises upon the

serving of a writ of garnishment on the employer or bank, as the case may be. . . .

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Although the methods for establishing a place in line are varied, the fundamental ordering

principle is the same. Creditors are paid according to their place in line for particular assets. With

a few exceptions, moreover, one’s place in line is fixed by the time when one acquires an interest

in the assets and takes the appropriate steps to publicize it. A solvent debtor is like a show for

which sufficient tickets are available to accommodate all prospective patrons and all seats are

considered equally good. In that event one’s place in line is largely a matter of indifference. But

when there is not enough to go around to satisfy all claimants in full, this method of ordering will

define winners and losers based principally on the time when one gets in line.



The question at the core of bankruptcy law is whether a better ordering system can be

devised that would be worth the inevitable costs associated with implementing a new system. In

the case of tickets to a popular rock event or opera, where there must be winners and losers, and

[apart from increasing the ticket price], there may be no better way to allocate available seats than

on a first-come, first-served basis. In the world of credit, however, there are powerful reasons to

think that there is a superior way to allocate the assets of an insolvent debtor than first-come,

first-served.



The basic problem that bankruptcy law is designed to handle . . . is that the system of

individual creditor remedies may be bad for the creditors as a group when there are not enough

assets to go around. Because creditors have conflicting rights [i.e., each dollar of assets paid to

one creditor becomes unavailable to all other creditors], there is a tendency in their debt-

collection efforts to make a bad situation worse [e.g., one creditor seizes and sells equipment

essential to the debtor’s business]. Bankruptcy law responds to this problem. Debt-collection by

means of individual creditor remedies produces a variant of a widespread problem. One way to

characterize the problem is as a multiparty game—a type of ―prisoner’s dilemma.‖9 As such, it

has elements of what game theorists would describe as an end period game, where basic problems

of cooperation are generally expected to lead to undesirable outcomes for the group of players as

a whole. [Thus individual creditors, fearful that the firm will fail, have an incentive to grab what

they can even if, by so doing, they risk making creditors collectively worse off.]





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A ―prisoner’s dilemma‖ rests (as does a common pool problem) on three essential premises. One, that the

participants are unable . . . to get together and make a collective decision. Two, that the participants are selfish (or

cold and calculating) and not altruistic. Three, that the result reached by individual action is worse than a cooperative

solution.

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Another way of considering it is as a species of what is called a common pool problem,

which is well known to lawyers in other fields, such as oil and gas.



This role of bankruptcy law is largely unquestioned. But because this role carries limits on

what else bankruptcy law can do, it is worth considering the basics of the problem so that we

understand its essential features before examining whether and why credit may present that

problem. The vehicle will be a typical, albeit simple, common pool example. Imagine that you

own a lake. There are fish in the lake. You are the only one who has the right to fish in that lake,

and no one constrains your decision as to how much fishing to do. You have it in your power to

catch all the fish this year and sell them for, say, $100,000. If you did that, however, there would

be no fish in the lake next year. It might be better for you—you might maximize your total return

from fishing—if you caught and sold some fish this year but left other fish in the lake so that they

could multiply and you would have fish in subsequent years. Assume that, by taking this

approach, you could earn . . . . $50,000 each year. Having this outcome is like having a perpetual

annuity paying $50,000 a year. It has a present value of perhaps $500,000. Since . . . when all

other things are equal, $500,000 is better than $100,000, you, as sole owner, would limit your

fishing this year. . . . But what if you are not the only one who can fish in this lake? What if a

hundred people can do so? The optimal solution has not changed: it would be preferable to leave

some fish in the lake to multiply because doing so has a present value of $500,000. [But now you

can no longer limit how many fish are taken from the lake: you have to worry about how many

fish others will catch.] If there are a hundred fishermen, you cannot be sure, by limiting your

fishing, that there will be any more fish next year, unless you can also control the others. You

may, then, have an incentive to catch as many fish as you can today because maximizing your

take this year (catching, on average, $1,000 worth of fish) is better for you than holding off

(catching, say, only $500 worth of fish this year) while others scramble and deplete the stock

entirely.14 If you hold off, your aggregate return is only $500, since nothing will be left for next

year or the year after. But that sort of reasoning by each of the hundred fishermen will mean that

the stock of fish will be gone by the end of the first season. The fishermen will split $100,000 this

year, but there will be no fish—and no money—in future years. Self-interest results in their

splitting $100,000, not $500,000.

14

Note that this, like the prisoner’s dilemma, assumes that you are selfish, not altruistic. Where there are a hundred

fishermen, it only takes one selfish one to upset the altruism of the others. [Emphasis added.] Thus, the assumption

seems quite reasonable.

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What is required is some rule that will make all hundred fishermen act as a sole owner

would. That is where bankruptcy law enters the picture in a world not of fish but of credit. The

grab rules of nonbankruptcy law and their allocation of assets on the basis of first-come, first-

served create an incentive on the part of the individual creditors, when they sense that a debtor

may have more liabilities than assets, to get in line today (by, for example, getting a sheriff to

execute on [i.e., seize] the debtor’s equipment), because if they do not, they run the risk of getting

nothing. This decision by numerous individual creditors, however, may be the wrong decision for

the creditors as a group. Even though the debtor is insolvent, they might be better off if they held

the assets together. Bankruptcy provides a way to make these diverse individuals act as one, by

imposing a collective and compulsory proceeding on them. Unlike a typical common pool

solution, however, the compulsory solution of bankruptcy law does not apply in all places at all

times. Instead, it runs parallel with a system of individual debt-collection rules and is available to

supplant them when and if needed.





QUESTIONS AND COMMENTS



How does ―grab law‖ work against creditors’ interests? Can you give an example, not



discussed in this chapter, of how individual creditors’ lawful collection efforts could disserve the



interests of creditors as a group?







C. APPOINTING RECEIVER



Having considered the rationale for receivership, we will look more closely at the process



for appointing a receiver: who appoints the receiver; who serves as receiver; the grounds for



receivership; and the process for judicial review of the appointment. We will also compare and



contrast receivership with conservatorship, an infrequently used alternative aimed at rehabilitating



(rather than liquidating) a troubled bank.

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1. Who Appoints Whom



If a bank is to be placed in receivership, the government agency that issued the bank’s



charter appoints the receiver. Thus the OCC appoints the receiver for a national bank; the OTS,



for a federal thrift; and the state supervisor, for a state bank or thrift. See, e.g., 12 U.S.C.



§1464(d)(2)(A). If the chartering agency unjustifiably balks at appointing a receiver for an FDIC-



insured institution, the FDIC can appoint itself receiver if necessary to avoid or mitigate loss to



the insurance fund. Id. §1821(c)(10).



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



Many grounds for receivership exist. Regulators can appoint a receiver (or conservator)



for an FDIC-insured bank if the bank:



(1) has obligations exceeding its assets;



(2) cannot or probably cannot meet its obligations in the normal course of business;



(3) is in an unsafe or unsound condition to transact business;



(4) 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) is critically undercapitalized or otherwise has substantially insufficient capital;



(6) is undercapitalized and (a) has no reasonable prospect of becoming adequately



capitalized; (b) fails to recapitalize when ordered to do so under the prompt

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corrective action statute, id. §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) substantially dissipates assets or earnings through a violation of a statute or



regulation or through an unsafe or unsound practice;



(8) conceals records or assets, or refuses to let authorized examiners inspect records;



(9) willfully violates a cease-and-desist order;



(10) 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) is convicted of money laundering crimes;



(12) loses its FDIC insurance; or



(13) consents to the receivership (or conservatorship).



Id. §1821(c)(5).





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). Such an ex parte regulatory seizure raises obvious due process concerns. But the



government has reasons to act swiftly. By the time a bank enters receivership, it typically has



scant capital and dubious prospects for survival, giving its managers incentives to take excessive



risks at the FDIC’s expense (MM&C 3d ed. pp. 310-11). Similarly, doubts about the honesty or

15





competence of current management would figure prominently in any decision to place a healthy



bank in conservatorship. Thus the circumstances of receivership and conservatorship normally



demand urgent action.



If receivership or conservatorship needed prior judicial approval, word of the proposed



action could spread to depositors and other creditors, exacerbating the bank’s problems and



possibly triggering a run that would deepen the FDIC’s loss. In upholding the appointment of a



conservator without a prior hearing, the Supreme Court declared:



This is a drastic procedure. But the delicate nature of the institution and the

impossibility of preserving credit during an investigation has made it an almost

invariable custom to apply supervisory authority in this summary manner. It is a heavy

responsibility to be exercised with disinterestedness and restraint, but in the light of

the history and customs of banking we cannot say it is unconstitutional.



Fahey v. Mallonee, 332 U.S. 245, 253-54 (1947). Delay would also give current managers a



chance to conceal or destroy records.



Due process, although not requiring a hearing before the appointment of a receiver or



conservator, does require a prompt post-seizure hearing. Federal law affords such a hearing when



the OCC or OTS appoints a receiver or conservator for a federally chartered depository



institution. 12 U.S.C. §§203(b)(1), 1464(d)(2)(B); see James Madison Ltd. by Hecht v. Ludwig,



82 F.3d 1085, 1092, 1094 (D.C. Cir. 1996). The court must rule ―upon the merits‖ and can



overturn the agency’s action only if it is ―arbitrary, capricious, an abuse of discretion, or



otherwise not in accordance with law‖—the basic standard for review of informal agency action



under the Administrative Procedure Act. 12 U.S.C. §203(b)(1); see James Madison Ltd., supra, at



1096-98; Guaranty Savings & Loan Association v. FHLBB, 794 F.2d 1339, 1341-42 (8th Cir.



1986).

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How stringent, in practice, is judicial review ―upon the merits‖ under this standard?



Despite judicial reluctance to second-guess a receivership or conservatorship order, plaintiffs



have occasionally persuaded federal district judges to overturn such an order. They have had less



success on appeal, as the following case illustrates.





Franklin Savings Association v. Director, Office of Thrift Supervision

934 F.2d 1127 (10th Cir. 1991)

BRORBY, J.:



[After operating conservatively for almost a century, Franklin Savings Association

(Franklin) adopted a more venturesome strategy in 1981. Over the next eight years it increased its

deposits fifty-fold, largely by attracting short-term, high-rate brokered deposits (MM&C 3d ed. p.

245). It invested heavily in mortgage-backed derivative securities and junk bonds. By the end of

1989, such investments accounted for more than 35% of Franklin’s total assets, and junk bonds

accounted for 70% of its total deposits. Franklin had begun to ―resemble a securities trading firm

rather than a traditional savings and loan association.‖ Yet it had declining earnings and bleak

prospects for profitability.]



[In February 1990, the Director of the Office of Thrift Supervision (Director) appointed a

conservator for Franklin after finding that Franklin was in an unsafe and unsound condition; had

depleted and could not replenish its capital; and had violated laws or committed unsafe and

unsound practices likely to cause serious prejudice to its depositors’ interests. The Director based

these findings upon ―three volumes of documents that included reports of examinations, monthly,

quarterly and annual financial reports filed by Franklin, supervisory directives, other required

annual reports, and the results of an independent audit.‖]



PROCEEDINGS IN DISTRICT COURT



[Franklin filed an action to require the Director to remove the conservator. The Director

argued that the district court should base its review of the conservatorship order solely on the

administrative record compiled by the Director. Franklin sought to introduce additional evidence.

The district court accommodated Franklin by conducting an eighteen-day bench trial at which it

―heard live testimony from twenty-five witnesses; accepted deposition testimony from eighteen

witnesses; received over 650 trial exhibits; engaged in credibility determinations regarding

17





competing experts; and basically made its own findings, compared those to the findings of

Director, and decided the conservator was wrongly appointed.‖ The Director appealed the court’s

order to remove the conservator.]



I. SCOPE OF REVIEW



. . . We must first define the proper scope of review. . . . The pertinent portions of [12

U.S.C. §1464(d)(2)(B)] provide:



The Director shall have exclusive power and jurisdiction to appoint a conservator.

. . . If, in the opinion of the Director, a ground for the appointment of a conservator

. . . exists, the Director is authorized to appoint ex parte and without notice a

conservator. . . . In the event of such appointment, the association may . . . bring an

action . . . for an order requiring the Director to remove such conservator . . . , and

the court shall upon the merits dismiss such action or direct the Director to remove

such conservator. . . .





The plain language of this statute reveals: (1) the director has the exclusive power to

appoint a conservator; (2) the director may appoint a conservator if, in his opinion, a statutory

ground for the appointment exists; (3) [the director’s] decision whether to appoint a conservator is

discretionary; and (4) the statute, while clearly authorizing judicial review of the director’s

decision, fails to specifically define the scope of that review.



We first emphasize [that under the statute] the determination of whether the statutory

grounds to appoint a conservator exist lies in the province of the director’s opinion. . . . An

opinion is formed after an evaluation of the facts based upon special knowledge and expertise.

Congress did not mandate a hearing or specific findings of fact be made; rather, it required only

the director be of the opinion statutory grounds for appointment of a conservator exist. There

exist compelling reasons for this statutory provision: A savings association’s assets . . . can be

quickly dissipated; liabilities may be just as quickly created; and liquidity may suddenly

disappear. If there is inadequate capital to absorb losses, the losses fall upon the FDIC, and if

these funds are depleted, then upon taxpayers. For these reasons, . . . it is essential the director act

promptly in appointing a conservator once he is of the opinion that a statutory ground exists. The

close supervision, broad discretion, and quick response directed by FIRREA dictates a narrow

and limited scope of review that gives deference to the director’s judgment, knowledge, and

expertise. . . .

18





We therefore find the district court erred in . . . deciding the phrase ―upon the merits‖ . . .

directed something more than a review of the administrative record in accordance with

the[Administrative Procedure Act]. Review ―upon the merits‖ simply means the district court’s

decision to either dismiss the action or remove the conservator should be based upon the merits of

the action (i.e., whether statutory grounds for the appointment of a conservator exist), rather than

on procedural or policy oriented grounds.

In the case before us, Director did make formal findings and produced and certified a

voluminous and detailed [administrative record that should have enabled] the reviewing court to

conduct a substantial and meaningful review. . . . The trial court, however, determined the three-

volume administrative record . . . was not the ―whole administrative record‖ since it believed

there were missing documents upon which Director relied. The appropriate remedy for this

alleged defect would have been for the trial court to call for any missing documents or require

Director to testify or provide further explanation. Instead, the district court crafted and conducted

a hybrid scope of de novo review. . . .



[The administrative record adequately supported the Director’s determination that

Franklin relied excessively on brokered deposits. The record need not] contain extensive

treatment on the use of brokered funds, their pros and cons, and what levels are excessive. Such

information is common knowledge to those in the banking industry. [Moreover, to] require the

director to have reviewed and relied on all working papers, synopses of all conversations, and

other minutiae, would defeat FIRREA’s objective requirement of prompt supervisory action. The

director need review only such information as he deems necessary or desirable to enable him to

arrive at an informed and fair opinion. Absent extraordinary circumstances, the decision of the

director as to what information he must review . . . should be left to his discretion. [If challenged

in court, the Director must] produce and certify the record upon which he relied at the time of the

decision. This record must contain sufficient data to allow the reviewing court to determine

whether the director had a rational basis for the appointment decision. [The record here] was

adequate to permit meaningful judicial review. . . .



In sum, we conclude and hold: (1) the scope of review is ordinarily limited to the agency

record before the director at the time he made his decision to appoint a 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

19





otherwise not in accordance with law.‖ [The district court erred in applying a form of de novo

review.]



[The court of appeals went on to uphold the Director’s findings and conservatorship

order.]





QUESTIONS AND COMMENTS



1. Seizures of depository institutions sometimes have the drama and excitement of a



police raid, as in the following case:



The only remaining step in the well-orchestrated federal takeover of the state

savings and loan association was the physical seizure of the association. Over the

weekend, the federal regulators dispatched hundreds of federal bank examiners from

all over the country to California to serve in their appointed outposts in individual

branches. On Tuesday, April 13, 1982, a handful of federal and state officials entered

the Fidelity offices in Oakland, California, at precisely 4:40 p.m., twenty minutes

before closing. With watches synchronized, the officials entered Fidelity’s executive

offices and served the papers ―closing‖ the association at 4:47 p.m. [D]ifferent

members of the takeover team fanned out to tell other employees in the building of the

association’s seizure. [Regulators had debated whether to] bar all doors but such was

not done because some Fidelity employees needed to go home. [T]he entire operation

took less than thirty minutes.





Fidelity Savings & Loan Association v. FHLBB, 540 F. Supp. 1374, 1380 (N.D. Cal.), reversed,



689 F.2d 803 (9th Cir. 1982).



2. Does the ―arbitrary or capricious‖ standard of review used in Franklin Savings provide



sufficient due process protections? How could we provide greater protections? What problems



might result from tougher standards and procedures?

20





3. What did Congress intend by judicial review ―upon the merits‖? The term has at least



three possible meanings: first, that the court should conduct a standard review on the



administrative record, scrutinizing the substance of the agency’s decision but admitting no



additional evidence; second, that the court should review the law and facts de novo, creating its



own evidentiary record; and third, that the court should follow an intermediate course by



considering both the administrative record and a supplemental evidentiary record created by the



court. The district court opted for the third approach; the court of appeals, for the first.



Which approach makes the most sense? Under the first approach, what does the



administrative record consist of if the agency has held no hearing? Is the second approach



consistent with the statutory directive to uphold agency action unless it is ―arbitrary, capricious,



an abuse of discretion, or otherwise not in accordance with law‖?



4. Although in conservatorship, Franklin Savings still existed—so that its former



managers could have resumed control had Franklin’s legal challenge prevailed. But if Franklin



had been placed in receivership, the receiver could have sold Franklin’s assets before a court



resolved the challenge. Should a court provide injunctive relief against such an asset sale?



Applicable statutes evidently make an action to terminate the receivership or conservatorship the



exclusive avenue for judicial review and forbid a court to otherwise ―restrain, or affect the



exercise of powers or functions of a conservator.‖ 12 U.S.C. §§203(b)(3), 1464(d)(2)(D), 1821(j).



Do these statutes preclude a temporary restraining order or preliminary injunction against the sale



of assets? See Haralson v. FHLBB, 837 F.2d 1123 (D.C. Cir. 1988) (concluding that an action to



remove the receiver is the exclusive remedy). Are shareholders sufficiently protected by their



right to receive any proceeds remaining after the receiver has satisfied creditors’ claims?

21





5. What if an agency engages in improper conduct before closing a bank? Does such



misconduct provide grounds for challenging the receivership? In Biscayne Federal Savings &



Loan v. FHLBB, 720 F.2d 1499 (11th Cir. 1983), the district court removed the receiver because



the thrift’s regulator had engaged in ―outrageous,‖ ―outlandish,‖ and ―egregious‖ behavior,



―wrapped in a shroud of deception.‖ The appeals court reversed, holding those factual findings



(whose accuracy it did not question) irrelevant. The thrift had stipulated that it was insolvent



when the receiver was appointed. As this statutory ground for receivership existed, ―judicial



inquiry ends!‖ Did the thrift’s shareholders therefore have no remedy?





NOTE ON RECEIVERSHIP VERSUS CONSERVATORSHIP



This chapter focuses on receivership as the key legal mechanism for dealing with bank



failure. But regulators also have the option of placing a troubled bank in conservatorship, as they



did in Franklin Savings. Receivers and conservators both take control of troubled banks and both



have fiduciary duties to the banks’ depositors and other creditors. But a receiver liquidates a bank,



whereas a conservator operates the bank as a going concern. The bank as a corporate entity still



exists at the end of a conservatorship but not at the end of a receivership. In saying that a receiver



―liquidates‖ a failed bank, we must distinguish between legal and practical realities. The receiver



liquidates the old corporate entity by selling its assets, and the old corporate entity ceases to exist.



But the receiver can structure the sale so as to maintain substantial practical continuity with the



failed bank: a different corporate entity may continue the failed bank’s business at the same



locations, with the same employees, and with many of the same assets and liabilities. Most people



would, understandably enough, regard the new bank as a continuation of the old, yet a



fundamental legal change would have occurred.

22





Receivership and conservatorship serve largely different purposes. A receiver resolves a



failed bank, whereas a conservator can correct problems at a bank regulators intend to keep open.



Regulators can use conservatorship to wrest control of a bank from management of dubious



competence or honesty or to seek to rehabilitate a troubled bank. In exceptional cases, regulators



might appoint a conservator to prepare a failing bank for receivership: e.g., if the bank’s records



were in such disarray that no one would buy the bank even though it potentially had value as a



going concern.



Conservatorship is relatively rare. From 1934 through 2005, regulators placed some 2094



FDIC-insured institutions in receivership but only two in conservatorship (both of which ended



up in receivership). Regulators made more extensive use of conservatorship during the thrift



debacle to deal with insolvent FSLIC-insured institutions, as FSLIC could not afford to pay off or



otherwise protect closed institutions’ insured depositors (MM&C 3d edition p. 36). During the



1980s, regulators placed dozens of FSLIC-insured institutions in conservatorship before



receivership.





QUESTIONS AND COMMENTS



1. Although used to resolve a failed bank, receivership also has deterrent and rehabilitative



functions. Regulators can place a solvent but capital-deficient bank in receivership for failing to



comply with the prompt corrective action statute. They can place a robustly healthy bank in



receivership for concealing records or assets, willfully violating a cease-and-desist order, or



laundering money. The prospect of receivership helps encourage compliance and deter



misconduct. In prompting capital-deficient banks to resolve their problems by raising capital or



finding an acquirer, that prospect also serves a rehabilitative purpose.

23





2. Why do regulators, in dealing with open but failing banks, prefer receivership to



conservatorship? If the banks remained open in conservatorship, uninsured depositors would



withdraw their money and leave the FDIC with the loss those depositors would otherwise have



borne. Take the case of Bleak Bank, which verges on failure and has no realistic prospects for



recovery. At market value, the bank has $1.2 billion in total liabilities, consisting of $1 billion in



insured deposits and $200 million in uninsured deposits; and $1 billion in total assets. Thus the



bank has a net worth of negative $200 million, the amount by which its liabilities exceed its



assets. Someone will have to bear this loss when the bank fails. If Bleak Bank went directly into



receivership, the receiver would pay each depositor $83.33 for each $100 of deposits,



representing the depositor’s pro rata share of the bank’s assets ($1 billion in total assets is 83.3%



of $1.2 billion in total deposits). Each depositor, insured or uninsured, would bear a 16.7% loss.



This loss would total $167 million for insured deposits collectively and $33 million for uninsured



deposits collectively. The FDIC’s insurance fund would cover the loss on insured deposits, while



holders of uninsured deposits would bear their own loss.



Now consider what would happen if Bleak Bank instead went into conservatorship before



receivership. Alert, rational depositors would infer that the bank has serious problems and would



withdraw deposits that exceeded the $100,000 insurance limit. The conservator would have to pay



those deposits in full from the bank’s assets. With all uninsured deposits withdrawn, the bank



would have $800 million in total assets and $1 billion in insured deposits—still a net worth of



negative $200 million. But now the FDIC’s insurance fund would bear the entire $200 million



loss when the bank failed and entered receivership. Conservatorship would thus have cost the



FDIC $33 million more than immediate receivership.

24





BLEAK BANK

Millions of Dollars

Conservatorship Followed

Immediate Receivership

Item by Receivership

Assets Liabilities Assets Liabilities

Total Assets 1,000 800

Insured Deposits 1,000 1,000

Uninsured Deposits 200 0

Net Worth -200 -200

Total Loss to Depositors -200 -200

Loss to FDIC -167 -200

Loss to Uninsured Depositors -33 None

For simplicity, data omit omit administrative expenses of receivership and conservatorship









PROBLEMS



Assume that each bank mentioned here is FDIC-insured, and that state law has exactly the



same grounds for receivership and conservatorship as those in 12 U.S.C. §1821(c)(5).



1. Ivan Rimsky controls Nightshade Bank, a state nonmember bank, which has $100



million in total assets and $90 million in total liabilities.



(a) Ivan learns that a bank examiner plans to ask him about the bank’s purchase of a



$200,000 high-seas speedboat. Ivan takes the file on the speedboat home and places it behind a



bookcase. Can and should a receiver or conservator be appointed?



(b) The FDIC issues a cease and desist order requiring the bank to sell the speedboat and



requiring Ivan to reimburse the bank for any loss incurred on the sale. The cease and desist order



becomes final in February. Although the order requires the bank to sell the speedboat by



September 1, the bank receives only one offer for the speedboat—for $30,000—by that date. The



bank’s board of directors decides to spend three additional months trying to sell the speedboat. It



is now late October. Can and should a receiver or conservator be appointed?

25





(c) Ivan wires $2 million of Nightshade Bank’s cash to a numbered account at



PromoBank, Ruritania. When asked about the transaction, he changes the subject. No information



is available about PromoBank’s ownership, management, or condition. Can and should a receiver



or conservator be appointed?



(d) When the FDIC asks Nightshade Bank’s primary supervisor whether she plans to take



action against the bank, she replies, ―Not yet. Ivan’s been good for Nightshade, and he may have



some good explanation. Besides, banks are scarce up here. I’ve got to err on the side of keeping



them open.‖ The FDIC then learns that Ivan plans to wire another $1 million to PromoBank. Can



and should the FDIC appoint a receiver or conservator?



2. Baroque Bank’s total assets exceed its total liabilities, but the bank ran out of cash



yesterday afternoon. When depositors seek to withdraw money, Baroque Bank’s tellers tell them



to come back later. The four other banks in town allow their customers to make unlimited cash



withdrawals. Can and should a receiver or conservator be appointed for Baroque Bank?



3. Under the local building code, any stairway handrail must be capable of bearing a load



of at least 240 pounds per linear foot. A remote corner of Achilles Bank’s records archive has a



short flight of stairs with a handrail ten feet long that can bear a load of 1000 pounds (i.e., 100



pounds per linear foot). Can and should a receiver or conservator be appointed?





D. MARSHALING ASSETS





A receiver marshals a failed bank’s assets by identifying all items of any potential value



owned by the bank and turning them into cash. These items include any loans, leases, securities,



insurance claims, other financial or nonfinancial contract rights, buildings, equipment, and current



or potential legal claims. To marshal assets, the receiver has a potent array of legal powers,

26





including the powers formerly possessed by the bank plus additional powers granted by



receivership law.





We will get an overview of the receiver’s powers, then focus on four of those powers: the



power to (1) ―avoid‖ [i.e., invalidate] fraudulent transfers, (2) pursue claims against the failed



bank’s directors and officers, (3) terminate contracts, and (4) enforce cross-guarantee liability to



the FDIC. Other types of insolvency proceedings, including liquidations under the Bankruptcy



Code, employ the first three of these powers; the fourth, cross-guarantee liability, applies only



among FDIC-insured institutions.





1. Overview of Receiver’s Powers



A receiver succeeds to all the bank’s ―rights, titles, powers, and privileges,‖ and can



exercise all the powers of the bank’s directors, officers, and shareholders. 12 U.S.C.



§1821(d)(2)(A)(i), (B)(i). Moreover, the receiver has additional powers conferred by receivership



law—in the case of the FDIC serving as receiver for FDIC-insured banks, by the Federal Deposit



Insurance Act. The receiver can collect on the bank’s loans and other assets: e.g., receive



borrowers’ principal and interest payments as they become due, foreclose on defaulted loans, and



sell securities in the bank’s portfolio. It can sell the bank’s loans without the borrowers’ consent.



Thus if the bank had made you a loan to finance your small business, the receiver can sell the



bank’s rights under the loan agreement (including the right to receive your principal and interest



payments) to another lender regardless of whether you want to deal with that lender. The receiver



can, without depositors’ consent, transfer deposits to another bank. Thus if you had $50,000 on



deposit at Bank X when it failed on Friday afternoon, you may find that by Monday morning you



have $50,000 on deposit at Bank Y, a healthy FDIC-insured bank. The receiver can terminate



some kinds of contracts without becoming liable for liquidated damages or lost profits. Thus if a

27





bank had leased office space that it no longer needs, the receiver can terminate the lease. The



receiver can invalidate pre-receivership transfers made to defraud the bank or its creditors. Thus if



the bank’s president had sold her brother a $25,000 car for $25 during the bank’s waning days,



the receiver can require the brother to return the car. The receiver can also merge the bank with



another FDIC-insured bank. Id. §1821(d)-(e) Courts generally cannot ―take any action . . . to



restrain or affect the exercise of [the FDIC’s] powers or functions . . . as a conservator or a



receiver.‖ Id. §1821(j).





2. Avoiding Fraudulent Transfers



The doings of Jay, an imaginary bad banker, will help us understand fraudulent transfers.



Jay serves as chief real estate lending officer of Gull Bank, the largest real estate and construction



lender in its region. Commercial and residential real estate developers publicly praise Jay while



secretly paying him the bribes he demands to approve their loans. Over the years, Jay oversees



$600 million in lending and collects $3 million in kickbacks. Gull Bank eventually fails, brought



down largely by bad real estate loans. The FDIC, as the bank’s receiver, finds evidence of Jay’s



corruption, which the FBI begins to investigate.



Learning of the investigation, Jay redeploys his assets. First, he has his wife, Ibis, open



her own bank account in the Cayman Islands, a bank secrecy haven, and transfer to that account



most of the money in their joint bank and brokerage accounts. Second, Jay sells his $200,000



Bentley Continental automobile to his daughter, Raven, for $10,000, and Raven leases the car to



Jay for $100 a month. Third, Jay pays the law firm of Grackle & Grouse $400,000 for future legal



fees. Fourth, Jay and Ibis, who jointly own a Martha’s Vineyard vacation home, give Jay’s Uncle



Albatross and Aunt Anhinga a $500,000 first mortgage on that home. ―But we haven’t lent you



any money!‖ Anhinga protests. ―You’ve both been extremely kind to us,‖ Jay replies, ―We want

28





to express our gratitude.‖ Cf. Resolution Trust Corp. v. Spagnoli, 811 F. Supp. 1005 (D.N.J.



1993) (invalidating a similar set of fraudulent transfers to a banker’s relatives).



The FDIC as receiver can attack each of these transactions as fraudulent, using the



receiver’s 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. §1821(d)(17)(A). In



transferring money to an Ibis-only account in the Cayman Islands, Jay and Ibis sought to conceal



Jay’s ownership interest and put the money out of creditors’ reach. The sale and lease-back of the



Bentley at below-market prices involved sweetheart deals if not an outright sham. The sham



mortgage on the vacation home encumbered an asset that would otherwise have been available to



Jay’s creditors. By proving these transactions fraudulent, the receiver can obtain a judgment



invalidating the sham mortgage and awarding the receiver the Bentley (or its value at the time of



the transfer) and Jay’s share of the Cayman Islands bank account. See id. §1821(d)(17)(A)-(B).



The receiver can also attack fraudulent transfers under state laws such as the Uniform Fraudulent



Transfer Act.





3. Pursuing Claims Against Failed Banks’ Directors and Officers



A failed bank’s assets include any legal claims the bank may have against its directors and



officers, including claims for breach of fiduciary duty, intentional wrongdoing, or other



actionable misconduct. Accordingly, the receiver reviews bank insiders’ conduct (including



conduct that may have contributed to the bank’s failure), identifies potential claims, and gauges



the strength of those claims and the prospects for obtaining and collecting judgments on them.



When the receiver identifies a credible claim, it will consider whether the bank or insider



has insurance to pay the claim. Banks have two relevant types of insurance: the bankers’ bond



and the directors’ and officers’ (D&O) liability policy. These types of insurance apply to different

29





forms of misconduct. Bankers’ bonds cover fraudulent or illegal conduct by bank directors,



officers, or employees but typically exclude all forms of negligence. D&O liability insurance



covers negligence or gross negligence but typically excludes intentional or criminal misconduct.



Thus a bankers’ bond will cover embezzlement from the bank, whereas a D&O insurance policy



will cover a failure to exercise due care in managing the bank’s affairs.



To limit their exposure under D&O liability policies, insurance companies have adopted



various ―exclusions‖ specifying loss or risk not covered by the policies. The following case deals



with the two most important exclusions, the regulatory agency exclusion and the insured versus



insured exclusion.



FDIC v. American Casualty Co.

998 F.2d 404 (7th Cir. 1993)

KANNE, J.: . . .

[Gibson, who owned shares in a small Illinois bank incongruously known as the State



Bank of Cuba (―Bank‖), brought a derivative suit against the Bank’s directors, including Wayne



and Linda Grove, alleging that the directors had negligently mismanaged the Bank. While the suit



was pending, the Bank failed and the FDIC became the Bank’s receiver and took over the



derivative suit. The FDIC ultimately obtained a $1.2 million default judgment against the Groves,



and the Groves responded by obtaining a discharge in bankruptcy. Thus the FDIC could pursue



the judgment only against the Groves’ insurer, American Casualty Company (―ACC‖). An ACC



directors’ and officers’ liability policy (―Policy‖) insured the Bank’s directors and officers against



liability for ―any actual or alleged error, misleading statement, act or omission, or neglect or



breach of duty.‖ The Policy contained regulatory agency and insured versus insured exclusions.



ACC argued that those exclusions precluded the FDIC from collecting on the Policy.]



The regulatory agency exclusion . . . provides as follows:

30





―It is understood and agreed that the Insurer shall not be liable to make any payment for

Loss in connection with any claim made against the Directors [or] Officers based upon or

attributable to: any action or proceeding brought by or on behalf of the Federal Deposit

Insurance Corporation . . . , any other depository insurance organization, the Comptroller

of the Currency, . . . or any other national or state regulatory agency (. . . hereinafter

referred to as ―Agencies‖), including any type of legal action which such Agencies have

the legal right to bring as receiver, conservator, liquidator, or otherwise; whether such

action is brought in the name of such Agencies or by or on behalf of such Agencies in the

name of any other entity or solely in the name of any Third Party.‖



[The FDIC argued that the exclusion did not apply because the FDIC had not brought the



suit but had merely taken over a suit brought by Gibson. The court rejected this argument as



―overly technical and unreasonable.‖]



[The insured versus insured exclusion in the Policy applied to:] ―Loss . . . based upon or



attributable to any claim made against any Director or Officer by any other Director or Officer or



by the [Bank] . . . except for a shareholder derivative action brought by a shareholder of the



Institution other than an Insured.‖



As a former director and officer, Gibson was considered an ―insured‖ under the Policy.



Consequently, even though his action was a shareholder derivative suit . . . , the insured



versus insured provision would have excluded from coverage any damages owed to Gibson by



the Groves [even if the FDIC had not taken over the suit]. In addition, the plain language . . .



would have excluded from coverage an action by the Bank itself against the directors or



officers. . . .



We refuse to conclude that, by excluding all losses resulting from claims filed by the



FDIC and excluding all losses resulting from shareholder derivative claims made by insured



shareholders, the parties intended to [make ACC liable] for shareholder derivative actions filed by

31





an insured shareholder and later maintained by the FDIC. Rather, when read in conjunction with



the regulatory [exclusion for] losses resulting from all legal actions the FDIC has a right to bring



as receiver, the Policy’s broad language excluding ―any action or proceeding brought by or on



behalf of the [FDIC]‖ can only be interpreted as excluding the . . . judgment at issue. . . .



The FDIC contends that [enforcing] the regulatory agency exclusion . . . would violate



federal public policy. . . . [as reflected in] the following section of FIRREA:



―The [FDIC] shall, as conservator or receiver, and by operation of law, succeed to (i) all

rights, titles, powers, and privileges of the insured depository institution, and of any

stockholder, . . . depositor, officer, or director of such institution with respect to the

institution and assets of the institution.‖



12 U.S.C. §1821(d)(2)(A)(i). As the receiver, the FDIC possesses all the rights of the Bank’s



shareholders, including the right to sue directors and officers. Under the Policy, ACC would



cover any loss relating to shareholder derivative claims. Thus, the FDIC reasons that when the



FDIC obtained a judgment against the Groves in its capacity as shareholder, it should have been



able to [collect on] the Policy to the same extent as could any other uninsured shareholder.



According to FDIC, enforcing the regulatory agency exclusion would deprive it of the same rights



afforded to shareholders under the Policy, in violation of a clear public policy embodied in



§1821(d)(2)(A)(i).





[But in] enacting FIRREA, Congress considered and rejected the inclusion of ―a provision



that the FDIC could require contracts, including [directors’ and officers’] liability policies, to



remain in effect even if the contract contained a provision terminating the contract upon the



appointment of the FDIC as a conservator or receiver.‖ . . . Instead, Congress enacted 12 U.S.C.



§1821(e)(12):

32





―(A) In general. The conservator or receiver may enforce any contract, other than a

director’s or officer’s liability insurance contract . . . , entered into by the depository

institution notwithstanding any provision of the contract providing for termination,

default, acceleration, or exercise of rights upon, or solely by reason of, insolvency or the

appointment of a conservator or receiver.



―(B) Certain rights not affected. No provision of this paragraph may be construed

as impairing or affecting any right of the conservator or receiver to enforce or recover

under a director’s or officer’s liability insurance contract or depository institution bond

under other applicable law.‖



The enactment of §1821(e)(12) evidences Congress’ intent to remain neutral on regulatory



exclusions and completely rebuts the FDIC’s argument that the enforcement of such clauses



violates a public policy embodied in a different subsection of the same provision. [Accordingly,



enforcing the regulatory exclusion violates no public policy.]





QUESTIONS AND COMMENTS



1. Bank D&O liability policies routinely include both the regulatory exclusion and the



insured versus insured exclusion. Most reported decisions construing these exclusions in cases



brought by the FDIC are consistent with American Casualty.



2. Coverage under bankers’ bonds does not neatly align with coverage under D&O



liability policies. As we have seen, bankers’ bonds cover fraudulent or illegal conduct but not



negligence, whereas D&O liability policies cover negligence but not fraudulent or illegal conduct.



But difficult coverage issues may arise when a director or officer is accused but not convicted of



(or otherwise adjudicated to have engaged in) fraudulent or illegal conduct. Thus unsuccessfully



prosecuting a bank officer for misapplying bank assets may trigger the fraud or illegality

33





exception in the bank’s D&O liability policy without enabling the FDIC to recover under the



bankers’ bond.



3. Key coverage issues under bankers’ bonds include the following:



Timing of claims. Bankers’ bonds typically cover only claims actually made during the



bond period. Thus a bond effective from 2001 through 2005 would not cover embezzlement



committed in 2003 but discovered only in 2007. (In insurance industry parlance, the typical



bankers’ bond is a ―claims made‖ policy, not an ―occurrence‖ policy: the bond keys coverage to



when the bank files its claim, not when the underlying loss occurs.) Moreover, the bond usually



terminates immediately upon the appointment of a receiver or conservator. Thus if the loss comes



to light only after the bank has entered receivership, the receiver may have no recourse under the



bond. The receiver might challenge the termination clause under 12 U.S.C. §1821(e)(12)(A)



(discussed in American Casualty).



Losses resulting from an employee’s “manifest intent.” Bankers’ bonds typically cover



only losses from actions taken with ―manifest intent‖ to cause loss to the bank and obtain



financial benefit for someone other than the bank. Coverage problems arise when an employee



acts dishonestly but the evidence does not clearly indicate that the employee sought to benefit



someone other than the bank. Thus the claim may qualify neither under the bankers’ bond nor



under the D&O policy.



Losses resulting directly from dishonesty or fraud. Bankers’ bonds may exclude coverage



for loan losses not directly resulting from employee fraud or dishonesty. As loan losses are



usually the principal reason a bank fails, the FDIC may seek to recover under the bond for loan



losses allegedly caused by employee dishonesty. The insurer may disclaim coverage on the



ground that the loss resulted not from employee dishonesty but from the borrower’s default.

34





4. Terminating Contracts



See MM&C 3d edition pp. 774-76.





5. 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). The FDIC can, in effect, disregard the



corporate separateness of affiliated FDIC-insured institutions and treat them as a single economic



entity. 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.



But cross-guarantee liability applies only among FDIC-insured institutions; it does not extend to



their holding companies or holding-company affiliates (unless those entities are themselves



insured depositories).





PROBLEMS



1. Persephone Construction Corporation enters into a written contract to renovate one of



Dis Bank’s branches. Under the contract, the bank will pay Persephone $1 million once



Persephone completes the work. If the bank terminates the contract before Persephone begins



work at the site, the bank will pay Persephone $200,000 in liquidated damages. Persephone



expects performance of the contract to cost it $900,000. Relying on the contract, Persephone buys



$50,000 in specially cut marble not usable for any other purpose; it also turns down other



construction jobs, on which it would have earned a $300,000 profit. Before Persephone begins

35





work at the site, Dis Bank fails and the receiver repudiates the contract. What is Persephone’s



claim against the receivership?





E. PAYING VALID CLAIMS IN ORDER OF PRIORITY





We turn now from the failed bank’s assets to its liabilities. Once the receiver has



marshaled the bank’s assets, how does the receiver go about distributing the proceeds to



creditors? All creditors must file proof of their claims with the receiver. The receiver decides



whether those claims are valid, and dissatisfied creditors may pursue their claims in court. The



receiver pays secured claims—e.g., claims backed by a properly filed mortgage or lien on bank



property—from the value of the collateral. The receiver pays unsecured claims in the following



order: (1) administrative expenses, the costs the receiver incurs in carrying out its responsibilities;



(2) deposits, whether insured or uninsured; (3) general liabilities (e.g., bonds and most unpaid



bills and unpaid wages incurred before receivership), a residual category for liabilities that do not



fit the other categories; (4) subordinated liabilities (e.g., subordinated debt); (5) cross-guarantee



liability to the FDIC; and (6) the ownership interest of the bank’s shareholders. The right of



setoff—in which a creditor may use a debt the bank owes the creditor to offset a debt the creditor



owes the bank—presents a special case. So do potential circumventions of the priority system,



such as might arise when uninsured depositors assert a constructive trust on the bank’s assets or



shareholders sue the bank’s directors. We will explore each of these topics in turn.





1. Determining Validity of Claims



The FDIC as receiver notifies a failed bank’s creditors to file proof of their claims and



decides whether those claims are valid. Dissatisfied claimants can sue the receiver in federal



district court and have their claims adjudicated de novo. 12 U.S.C. §1821(d)(3)-(7). Similarly,

36





plaintiffs with lawsuits pending against the bank before receivership must give the receiver proof



of their claims and an opportunity to decide the validity of those claims. Plaintiffs dissatisfied



with the receiver’s decision can continue their suits. See id. §1821(d)(5)-(6), (13)(D). In any



event, claimants generally forfeit claims not timely filed with the receiver. See id.



§1821(d)(5)(C).



In evaluating the validity of claims, receivers and courts generally employ the same legal



rules as would apply if there were no receivership: they allow adequately proved, legally



enforceable claims and reject all other claims. Thus they reject claims that lack a sound legal



foundation or proper evidentiary support, are barred by the statute of limitations, or are otherwise



invalid for any reason. But four special rules apply to claims against a receiver.



First, the claim must arise from a legal obligation that existed before receivership and its



value must be certain or promptly ascertainable. See First Empire Bank v. FDIC, 572 F.2d 1361,



1367-69 (9th Cir. 1978).



Second, if no assets remain to pay a claim, neither the receiver nor a court need determine



the validity of the claim. Thus if a failed bank had $100 million in assets, $110 million in



deposits, and $10 million in other liabilities, the deposit claims would exhaust the bank’s assets,



leaving nothing to pay the lower-priority nondeposit claims. Determining the validity of the



nondeposit claims would serve no useful purpose: even if the claims were perfectly valid, the



receiver could not satisfy them.



Third, the receiver can make payments (known as ―dividends‖) on properly proved claims



at any time—even before the announced deadline for filing claims. Thus a claimant could go



unpaid because it had not proved its claim before the dividend. The receiver has no liability for



―failure to pay dividends to a claimant whose claim is not proved at the time of any such

37





payment.‖ 12 U.S.C. §1121(d)(10)(B). This rule facilitates making partial payments on claims



(and thus reducing inconvenience to creditors) even as the receiver continues to marshal the failed



bank’s assets.



Fourth, the so-called ―side agreement rule‖ can invalidate a claim that depends on an



agreement with the failed bank if the agreement is adverse to the FDIC’s interests as receiver or



insurer and the bank’s records do not adequately evidence the agreement. See 12 U.S.C.



§1123(e); D’Oench, Duhme & Co. v. FDIC, 315 U.S. 447 (1942). Consider the case of Titan



Bank, which sold Kronos half of a large tract of land the bank had acquired by foreclosure.



Kronos later discovered that the legal description of his property covered only 90% of what it



should have. The bank readily agreed to correct the error but failed before doing so. As long as



the bank remained open, a court could and would have entered judgment for Kronos. Yet the



receiver can reject Kronos’ claim if the bank’s records do not provide sufficiently formal



substantiation of the agreement. Thus an agreement enforceable against the bank while the bank



remained open could be unenforceable against the receiver. The FDIC has eased its enforcement



of the side agreement rule. See Statement of Policy Regarding Federal Common Law and



Statutory Provisions Protecting FDIC, as Receiver or Corporate Liquidator, Against Unrecorded



Agreements or Arrangements of a Depository Institution Prior to Receivership, 62 Fed. Reg. 5984



(1997). But the rule remains a trap for the unwary.





QUESTIONS AND COMMENTS



1. In Coit Independence Joint Venture v. FSLIC, 489 U.S. 561 (1989), a failed thrift



institution’s creditors challenged the claim procedures of FSLIC, the thrift’s receiver. The



Supreme Court, voicing concern about the adequacy of those procedures, held that creditors could

38





sue the receiver without waiting for the receiver to determine the validity of their claims, and that



courts should adjudicate creditors’ claims de novo. Congress responded to Coit in FIRREA. It



required all claimants to file their claims with the receiver but assured prompt action by requiring



the receiver decide claims within 180 days. FIRREA retained de novo judicial adjudication of



creditors’ claims.



2. Lethe Corporation provides a cautionary example of how someone who files a valid



claim before the announced filing deadline may go unpaid because the receiver has already



distributed the failed bank’s assets. When Tantalus Bank fails, it has $90 million in deposits and



$10 million in other liabilities, including $1 million owed to Lethe. The receiver immediately



gives creditors written notice to file their claims within 90 days. One month later, the receiver



estimates that it can sell the bank’s assets for at least $94 million and perhaps as much as $99



million and decides to pay a $92 million dividend. All creditors except Lethe have filed and



proved their claims. The receiver satisfies deposit claims, then pays 25 cents on each dollar of



proved nondeposit claims ($2 million dividend divided by $8 million in claims). Lethe files its



claim after the dividend but before the 90-day deadline. Unfortunately, the bank’s assets



ultimately fetch only $92 million, leaving nothing from which to make any further payment to



nondeposit creditors. Lethe has missed the boat. Had Lethe filed and proved its claim before the



dividend, it would (together with all other nondeposit creditors) have received 22 cents for each



dollar claimed ($2 million dividend divided by $9 million in claims).





2. Priorities



We have already seen, in broad outline, the priorities a receiver applies when paying



claims against a failed FDIC-insured bank. Secured claims come first, up to the value of the



collateral securing those claims. Unsecured claims follow in a statutorily prescribed order of

39





priority, with the receiver’s administrative expenses first and bank shareholders’ ownership



interest last. This system of priorities seeks to uphold creditors’ reasonable expectations while



conserving the deposit insurance fund and facilitating swift resolution of failed banks. We will



now look more closely at this system, beginning with the treatment of secured claims.





a. Secured Claims



A creditor with a security interest (e.g., mortgage or lien) in particular property of a debtor



can have the property sold—and receive payment from the proceeds—if the debtor defaults. To



protect its rights, the creditor must perfect the security interest, generally by filing notice of it in



the appropriate set of public records. A perfected security interest takes precedence over



subsequently filed claims to the property and binds any purchaser of the property.



A failed bank’s receiver pays secured claims against the bank from the value of the



collateral. If the collateral is worth less than the claim, the claim is secured only up to the value of



the collateral; the remainder constitutes an unsecured claim. See 12 U.S.C. §1821(d)(5)(D)(ii). If



the collateral is worth more than the claim, the excess value is available to pay other claims. If a



creditor has not perfected its security interest, the receiver treats the claim as unsecured.



The case of Precipice Bank illustrates these principles. Desperate for cash, the bank uses



loans in its portfolio to secure a $10 million loan from Brimstone Corporation. Brimstone perfects



its security interest, and Precipice Bank later fails. If the bank’s receiver sells the loans for $8



million, Brimstone will receive that sum and have an unsecured general claim for the remaining



$2 million of the loan. If the loans sell for $14 million, the receiver will pay Brimstone $10



million and use the remaining $4 million to satisfy other creditors. Had Brimstone failed to



perfect its security interest, it would have had only an unsecured general claim against the bank



and received nothing until all deposits had been paid in full.

40





Brimstone Corp's $10 Million Secured Loan to Precipice Bank

Facts Brimstone Receives

Brimstone has not perfected its

Unsecured claim for $10 million

security.interest

Brimstone has perfected its security

interest and the collateral is worth:

$14 million $10 million*

$10 million $10 million

$8 million + Unsecured claim for

$8 million

remaining $2 million

*Receiver uses remaining $4 million to pay bank's unsecured creditors







b. Unsecured Claims



Let’s take a more detailed look at the six-class hierarchy of unsecured claims. 12 U.S.C.



§1821(d)(11)(A). First, the costs of the receivership itself, known as administrative expenses.



These expenses include employee compensation, legal and accounting fees, and utilities.



Second, deposits, both insured and uninsured. This priority, enacted to conserve the



deposit insurance fund, can also help a failed bank’s uninsured depositors avoid significant losses.



In any event, it presents the most striking difference between bank receivership and Bankruptcy



Code priorities: deposits constitute the majority of bank liabilities, whereas the claims covered by



Bankruptcy Code priorities typically account for only a small proportion of a firm’s liabilities.)



Third, general liabilities, consisting of any liabilities that do not fit the other categories.



Examples include bonds, commercial paper, employee compensation, accounts payable (such as



unpaid bills for office supplies, overnight delivery services, and outside lawyers, consultants, and



party-planners).



Fourth, subordinated liabilities, most notably subordinated debt. Holders of subordinated



debt agreed to wait in line behind deposits and general liabilities, presumably in return for a



higher interest rate.

41





Fifth, any cross-guarantee liability to the FDIC.



Sixth, the ownership interest of the bank’s shareholders. Placing shareholders dead last



reflects shareholders’ implicit bargain with creditors. Shareholders controlled the bank and had an



opportunity for potentially unlimited returns: all income and assets remaining after the bank had



met its obligations to creditors would inure to the shareholders’ benefit. Creditors opted for fixed



returns with precedence over the shareholders’ claims. The shareholders had their chance; now



creditors get priority.



A bank’s receiver generally pays all allowed claims within a given priority class before



making any payment on claims in the next lower priority class. Thus the receiver pays nothing on



general liabilities unless all receivership expenses and all deposits have been paid in full; nothing



on subordinated liabilities unless all receivership expenses, deposits, and general liabilities have



been paid in full; and nothing to shareholders unless all liabilities have been paid in full. If a



given class of claims exceeds the remaining assets, then the claims share in those assets pro rata.



(The FDIC as receiver has leeway to deviate from these priorities as long as each claimant



receives no less than it would have received in a straight liquidation—a point we will revisit in



Part F of this chapter.)



The case of Valhalla Bank, a failed FDIC-insured bank, illustrates the application of the



statutory priorities. The receiver sells the bank’s assets for $950 million. Creditors file and prove



$1 billion in claims, consisting of $900 million in deposits, $70 million in general liabilities, and



$30 million in subordinated liabilities. The receiver incurs $1 million in administrative expenses.



The receiver first pays those expenses, leaving $949 million in assets. The receiver next pays the



$900 million in deposit claims, leaving $49 million in assets. The receiver then distributes that



$49 million pro rata to holders of the $70 million in general claims. Each such claimant

42





accordingly receives 70 cents on the dollar ($49 million in assets ÷ $70 million in claims = 70%).



No assets remain to pay subordinated creditors anything.



VALHALLA BANK

Millions of Dollars

Percentage $ Remaining

Priority Proved Claims Total Paid on

Class of Claims Payment on After Paying

Rank in This Class Those Claims

Each Claim This Class

First Administrative $1 $1 100% $949

Second Deposits $900 $900 100% $49

Third General $70 $49 70% $0

Fourth Subordinated $30 $0 0% -

Fifth Cross-Guarantee - $0 - -

Sixth Shareholders * $0 - -

* Shareholders receive whatever remains after full payment of creditors' claims







3. Setoff



Now let’s turn to another mechanism affecting unsecured creditors’ prospects of payment



when a bank fails: the right of setoff. Francesca Bank clears checks for and provides services to



Paolo Bank. By agreement, Francesca lends Paolo $25 million and Paolo keeps the $25 million



on deposit at Francesca to facilitate check-clearing. If Paolo Bank fails, what happens to each



bank’s claim against the other? Were there no setoff right, the receiver could withdraw Paolo’s



$25 million deposit on demand but pay Francesca only Francesca’s pro rata share of Paolo’s



assets. If the receiver, after satisfying secured claims and deposit claims, had $600 million in



assets to satisfy $1 billion in general claims, Francesca would receive only $15 million on its $25



million loan. Thus Francesca, having owed Paolo the same amount as Paolo owed it when Paolo



failed, would end up making a $10 million net payment to the receiver.



Fortunately for Francesca Bank, courts have long allowed a failed bank’s creditors to set



off (i.e., deduct) what the bank owes them against what they owe the bank. The Supreme Court



upheld this setoff right in Scott v. Armstrong, 146 U.S. 499 (1892), on facts similar to the tale of

43





Francesca and Paolo. Farmers’ and Merchants’ State Bank (F&M) had borrowed $10,000 from



Fidelity National Bank and, by prior agreement, deposited the proceeds at Fidelity. Fidelity failed



two weeks later. F&M offered to pay Fidelity’s receiver the difference ($1,009) between the



amount owed on the loan ($9,818) and F&M’s deposit at Fidelity ($8,810). The receiver rejected



F&M’s tender and sued for the full amount owed on the loan ($9,818). The Court sided with



F&M, declaring:



[T]he ordinary rule is that where the mutual obligations have grown out of the same

transaction, insolvency on the one hand justifies the set-off of the debt due upon the

other.



Indeed natural justice would seem to require that where the transaction is such as to raise

the presumption of an agreement for a set-off it should be held that the equity that this

should be done is superior to any subsequent equity not arising out of a purchase for

value without notice.



In the case at bar the credits between the banks were reciprocal and were parts of the

same transaction, in which each gave credit to the other on the faith of the simultaneous

credit, and the principle applicable to mutual credits applied. It was, therefore, the

balance upon an adjustment of the accounts [i.e., the difference between the two

obligations] which was the debt, and [F&M] had the right, as against the receiver of the

Fidelity Bank, . . . to set off the balance due upon its deposit account. . . .



Id. at 507-08, 510.



The right of setoff eases the pain of any party that, like Francesca Bank, is both creditor



and debtor of the failed bank. Such a party can subtract what the bank owes it from what it owes



the bank. Thus Francesca can subtract its $25 million loan to Paolo from Paolo’s $25 million



deposit at Francesca—and owe the receiver nothing. A creditor with a setoff right enjoys—to the



extent of the setoff—de facto priority over other creditors with the same class of claims.

44





Francesca receives full payment on its $25 million loan to Paolo even though other creditors



receive only 59 cents per dollar of general claims ($575 million in assets remaining after



Francesca Bank’s setoff, divided by $975 million in general claims).







QUESTIONS AND COMMENTS



1. Scott v. Armstrong illustrates a correspondent banking relationship in which a smaller



bank kept money on deposit at a larger bank to facilitate check-clearing, letters of credit, and



other services. This relationship benefited both banks: the larger bank earned income for helping



the smaller bank offer additional services. The larger bank often loaned the smaller bank the



money needed to maintain the agreed-on balance at the larger bank.



2. Why does—and why should—the law accord a right of setoff? Do the parties implicitly



agree to allow setoff if either becomes insolvent? Are debts like those in Scott v. Armstrong mere



bookkeeping artifacts, so that setoff simply cancels out the fictitious debts and leaves behind the



real debt? What do you think of the Supreme Court’s ―natural justice‖ theory? In any event, how



should the rationale for allowing setoff affect the breadth of the setoff right?





4. Angling for Priority



Claimants dissatisfied with their place in the hierarchy of claims against a failed bank



have an incentive to find ways around the statutory priorities. We will examine two such



stratagems: (1) uninsured depositors’ attempt to assert a constructive trust against their bank’s



assets; and (2) shareholders’ attempt, in competition with the receiver, to sue their bank’s



allegedly faithless directors.

45





a. Constructive Trusts



During the two decades before Penn Square Bank failed, the FDIC had protected all



depositors at every failed FDIC-insured bank, without enforcing the statutory limit on deposit



insurance coverage. But when the FDIC resolved Penn Square, it surprised uninsured depositors



by enforcing the limit. In the following case two uninsured Penn Square depositors sought to



recover the full amount of their deposits. They argued that the bank had defrauded them by



misrepresenting itself as solvent and that their money had never, from an equitable standpoint,



become an asset of the bank. In their view, the bank had merely held the money for them in a



―constructive trust.‖



This case preceded the 1993 statute applying a uniform set of priorities to all failed FDIC-



insured banks and giving deposits priority over general claims. Before that statute federal law had



classified national bank deposits as general claims, and the language of the court’s opinion



reflects that rule. Yet the court’s reasoning and result hold true even with depositor preference:



uninsured depositors generally cannot use a ―constructive trust‖ theory to obtain more favorable



treatment than other uninsured depositors.





Downriver Community Federal Credit Union v. Penn Square Bank

879 F.2d 754 (10th Cir. 1989)

TACHA, Circuit Judge.



This appeal arises from a dispute between certain uninsured depositors in the insolvent

Penn Square Bank, N.A. (PSB), and the Federal Deposit Insurance Corporation (FDIC), in its

capacity as receiver, over the priority of the depositors’ claims against the insolvent bank’s assets.

The district court found that PSB fraudulently induced the plaintiffs to deposit funds through

issuing financial statements that were materially misleading as to PSB’s financial condition. [T]he

district court imposed a constructive trust upon PSB’s assets in favor of the plaintiff-depositors,

thereby entitling them to recover the full amount of their deposits, rather than their pro rata share

46





under the relevant provision of the National Bank Act, 12 U.S.C. §194. We hold that federal law

limits these depositors’ recovery to their pro rata share of the assets held by the receiver, and

reverse. . . .



The plaintiffs, Downriver Community Federal Credit Union (Downriver) and Wood

Products Credit Union (Wood Products), were among the 140 credit unions, 48 savings and loans,

and 47 commercial banks holding substantial uninsured deposits in PSB when the Comptroller of

the Currency ordered PSB closed on July 5, 1982. Like many other credit unions, Wood Products

and Downriver had purchased certificates of deposit in PSB relying in part upon

recommendations and financial information provided by money brokers, ―the middlemen in the

CD market whose fees were paid not by the credit unions, but by Penn Square.‖



[Both plaintiffs purchased their PSB certificates of deposits during the bank’s final four

months. Downriver had $4,038,240 on deposit when PSB failed, received a $100,000 FDIC

insurance payment, had a claim against the receiver for the remaining $3,938,240, and by the end

of 1986 had received 55% of that claim—the same rate paid on all general claims. Similarly,

Wood Products, with $504,583 on deposit, had received a $100,000 insurance payment, had a

claim against the receiver for the remaining $404,583, and had received 55% of that claim. By

asserting a constructive trust on PSB’s assets, the plaintiffs sought to recover 100% of their

claims.]



Upon the insolvency of a national bank and appointment of the FDIC as receiver . . . , it is

well settled that all claims against the receiver’s estate [i.e., the failed bank’s assets] are governed

by federal law.



The plaintiffs attempt to avoid the application of federal law to their claim, however, on

the ground that their equitable right to the funds arose prior to insolvency. They contend that

Oklahoma law governs the nature of their preinsolvency relationship with PSB, and that, because

of PSB’s fraud, their deposits never became part of PSB’s assets, but were instead impressed with

a trust relating back to the date of their initial deposits. The equitable fiction of the trusts relating

back to the date that the plaintiffs deposited funds in PSB, however, does not change the fact that

by purchasing a certificate of deposit in PSB, the plaintiffs intended a debtor and creditor

relationship. Although the state law of contracts governs whether the parties intended to form a

47





trust or a debtor/creditor relationship prior to insolvency, any attempt to recharacterize that

relationship equitably after insolvency is governed by federal law.



The FDIC, as receiver, takes control of an insolvent national bank subject to the ―rights

and equities‖ existing prior to insolvency. . . .



Congress chose to achieve, through the National Bank Act, ―a just and equal distribution

of the assets of national banks among all unsecured creditors.‖. . .



The Act’s unfriendliness to special interests requires a claimant seeking a [better than] pro

rata distribution of assets to bear a heavy burden of proof. A national bank’s fraudulent conduct

may give rise to a constructive trust only when the plaintiff can show that the bank’s fraud caused

a particular harm that is not shared by substantially all other depositors, and that granting relief to

the plaintiff does not disrupt the orderly administration of the receiver’s estate. This general rule

is exemplified in the cases involving constructive trusts imposed upon the assets of a hopelessly

insolvent bank.



A bank receiving deposits after its officers know that the bank is hopelessly insolvent is

deemed to commit fraud upon those depositors, entitling them to reclaim their deposits. . . .



Those who deposit funds after a bank is hopelessly insolvent can show a specific act of

fraud that affects only them, and therefore they have a superior equitable position over others who

deposited funds prior to hopeless insolvency with a hope or belief in the bank’s future ability to

repay the deposit. Furthermore, a hopelessly insolvent bank should have been closed by the

Comptroller of the Currency as of the date of such insolvency, thereby preventing the receipt of

further deposits. Equity therefore . . . permits the rescission of deposit contracts made after the

bank should have been closed.



Even in the case of hopeless insolvency, however, full restitution may be denied when it

would sufficiently disrupt the orderly administration of the receiver’s estate or otherwise result in

inequitable treatment to other similarly situated depositors. . . .



Here, the application of these policies—preserving the orderly administration of the

receiver’s estate and achieving an equitable distribution among creditors—is not a question to be

decided fortuitously because ―a particular state happened to have the greatest connection in the

conflict of laws sense.‖ We refuse here to adopt Oklahoma law as the federal rule of decision

48





because to do so would permit a constructive trust in favor of plaintiffs in contravention of the

principles implicit in the National Bank Act.



In awarding a constructive trust in favor of the plaintiffs, the district court relied upon an

Oklahoma statute providing that:



one who practices a deceit with intent to defraud the public, or a particular class of

persons, is deemed to have intended to defraud every individual in that class, who is

actually misled by the deceit.



The plaintiffs, having proved reliance upon PSB’s published financial statements, were deemed to

have been ―actually misled‖ by PSB at the time they purchased PSB certificates of deposit, and

accordingly the trial court ordered that they be allowed to recover all of their deposits. Such

recovery violates both of the federal policies implicit in the National Bank Act.



Permitting recovery to the plaintiffs because they could prove reliance upon the financial

statements, to the detriment of other uninsured depositors who could not or did not come forward

to prove reliance upon PSB financial statements, fails to accord equal treatment to PSB creditors.

PSB’s deceptive acts could not have reached only the plaintiffs. . . .



Whether independently analyzing PSB financial statements, or relying upon money

brokers who analyzed PSB’s financial condition based upon the information contained in those

statements, financial institutions other than the plaintiffs undoubtedly placed similar trust in

PSB’s misrepresented financial condition in assessing their risk of future loss. The National Bank

Act precludes these depositors from being treated differently. . . .



Although the plaintiffs contend that we might avoid this unequal treatment by permitting

all depositors situated similarly to the plaintiffs to sue as a class to establish constructive trusts, to

allow such suits would potentially jeopardize the orderly administration of the receiver’s estate

that is required by the Act. We do not think that Congress would have intended to deluge the

FDIC with the potentially crushing weight of claims for preferences on behalf of all the uninsured

depositors who could allege that they relied upon misleading information that was available to all

depositors. Allowing such a preference to be based upon a [race] among creditors would make

―the equality promised to them by the [National Bank Act] . . . a mere mockery.‖ Any remedy for

fraudulent representations that affects, or potentially affects, all creditors belongs to the receiver,

who asserts such claims for the benefit of all creditors. . . .

49





Accordingly, the order of the district court imposing a constructive trust upon the assets of

PSB in favor of the plaintiffs is reversed.





QUESTIONS AND COMMENTS



1. When the court refers to ―both of the [relevant] federal policies implicit in the National



Bank Act,‖ which policies does it have in mind?



2. Citing old cases, the court declares that if a bank accepts deposits after the bank’s



officers ―know that the bank is hopelessly insolvent,‖ the bank defrauds the depositors in question



and those depositors have ―a superior equitable position over others who deposited funds prior to



hopeless insolvency.‖ Were the two plaintiffs here that innocent? What had drawn them to Penn



Square during its final months? How could you argue that—quite apart from the court’s concern



about ―orderly administration‖ of the receivership—the court reached a just result here?





b. Shareholders’ Direct Litigation



A failed bank’s shareholders, faced with losing their entire investment in the bank, may



seek to reclothe themselves as creditors. They may, for example, sue the bank’s former directors



for harm resulting from the directors’ alleged misconduct. But such a suit would conflict with any



effort by the receiver to recover from those directors, as the directors’ wealth may not suffice to



satisfy both sets of claims. Here the distinction between direct and derivate shareholder litigation



becomes important. In direct litigation, shareholders sue in their own names to enforce their own



rights. In derivative litigation, shareholders sue in the corporation’s name to enforce the



corporation’s rights. The shareholders would frame their suit as asserting their personal rights, but



the receiver might well respond that the suit in substance asserts corporate rights. This issue is

50





crucial because claims based on corporate rights belong to the receiver, who is entitled both to



control the litigation and to receive any money recovered.





Leach v. FDIC

860 F.2d 1266 (5th Cir. 1988), cert. denied, 491 U.S. 905 (1989)

GOLDBERG, Circuit Judge: . . .



[Two years after a national bank (―Bank‖) failed, minority shareholders of the Bank

(―Plaintiffs‖) sued the Bank’s former directors, alleging that the Plaintiffs’ Bank stock had

become worthless because the directors had mismanaged the Bank and failed to make timely,

accurate disclosure of the Bank’s financial condition. The Bank’s receiver sued the directors for

the same alleged misconduct. The district court dismissed the Plaintiffs’ suit after concluding that

the Plaintiffs lacked standing to assert their claims. The court of appeals noted that the Plaintiffs,

by alleging that they had suffered real injury (the lost value of their stock), had met one requisite

of standing. The key question was whether Congress—in enacting 12 U.S.C. §93(a), the statute

on which the Plaintiffs based their claim—intended to let bank shareholders sue for their own

injuries.]



On its face, 12 U.S.C. §93(a) is worded broadly and appears to allow a wide range of suits

for injuries allegedly resulting from the misconduct of a bank’s directors, agents or officers.

However, the historical context in which the provision was passed, the judicial decisions which

followed its passage, and judicial decisions from the modern era, all militate in favor of a

narrower reading of [the statute]. Thus, we conclude that Congress intended the statute . . . to

differentiate between persons who have suffered injury which the law treats as ―corporate‖ injury

and persons who have suffered injury which the law treats as ―personal‖ to the person.



For example, when a director embezzles the assets of a corporation, and the value of the

corporation’s stock falls as a result, the law treats the corporate body as the injured party, not the

individual stockholder who has lost the value of his stock. On the other hand, the law treats a

person who buys stock in reliance on false information from a director as personally injured by

the director’s conduct. On a certain level, the difference is a matter of diffusion of injury. That is,

when all shareholders are wounded it is the corporate body itself which the law treats as

51





experiencing the pain. When only one person suffers and the other shareholders have not been

hurt by the misconduct, the law recognizes that person’s pain as personal.



Plaintiffs in this case seek to show that they are different from all the other stockholders

because they are the only ones who have lost money from the directors’ mismanagement.

However, corporate law, as it existed when the National Bank Act was passed in 1864, treated a

director’s mismanagement, resulting in a diminution in the corporation’s stock value, as a

corporate injury. The right to complain of the injury belonged then and belongs now to the

corporation. There are exceptions to this rule that allow shareholders to sue derivatively for

corporate injury. They arise . . . when the corporation refuses to sue after being asked by the

shareholder, or when the corporation has been ―captured‖ by the misbehaving directors so that

any demand made would be in vain. But these exceptions only provide mechanisms to protect the

corporation when it will not or cannot protect itself. In this case, any possible legal relief for

Plaintiffs’ grievances belongs to the corporate body now in the hands of the FDIC-Receiver, not

the Plaintiffs. . . .



Section 93(a) of the National Bank Act reads:



If the directors of any national banking association shall knowingly violate, or

knowingly permit any of the officers, agents, or servants of the association to

violate any of the provisions of this [Act], all the rights, privileges, and the

franchises of the association shall be thereby forfeited. Such violation shall,

however, be determined and adjudged by a [federal district court] in a suit

brought for that purpose by the Comptroller of the Currency, in his own name,

before the association shall be declared dissolved. And in cases of such violation,

every director who participated in or assented to the same shall be held liable in

his personal and individual capacity for all damages which the association, its

shareholders, or any other person, shall have sustained in consequence of such

violation. . . .



This statute on its face would appear to permit Plaintiffs to sue the Defendants for alleged

mismanagement which allegedly caused Plaintiffs’ stock to lose its value. The last sentence of

section 93(a) states that ―every director who participated [in a violation . . .] shall be held liable in

his personal and individual capacity for all damages which the association, its shareholders, or

52





any other person, shall have sustained in consequence of such violation‖ (emphasis added).

However, even apparently plain words, divorced from the context in which they arise and in

which their creators intended them to function, may not accurately convey the meaning the

creators intended to impart. It is only, therefore, within a context that a word, any word, can

communicate an idea.



Section 93(a) of the National Bank Act as enacted in 1864 was not created in a vacuum. In

this pre-Erie v. Tompkins era, it was commonly understood that there existed a general

commercial common law. . . . [Under that common law,] only the corporate body could sue

misbehaving directors for wounds that the corporation suffered resulting from directors’

misconduct. . . .



What we today term a shareholder derivative suit was a part of the general commercial

common law when Congress enacted Section 93(a) in 1864. When writing Section 93(a),

Congress relied upon the fact that injured shareholders did not possess a right of action against

delinquent directors until the corporation itself had refused to bring suit. [I]t is this context which

gives meaning to the phrase ―every director . . . shall be liable . . . for all damages which the

association, its shareholders, or any other person, shall have sustained. . . .‖. . .



Plaintiffs in this case do not fall within either of the two exceptions . . . that would allow

them to sue derivatively: (1) where they make a demand upon [the] corporation and the

corporation refuses to sue; or (2) misbehaving directors or officers have ―captured‖ the

corporation so that any demand to sue would be a useless action. . . . [As neither exception

applies, the Plaintiffs lack standing to sue under §93(a).]





QUESTIONS AND COMMENTS



1. Can a failed bank’s shareholders maintain a direct ―civil RICO‖ suit against the bank’s



former managers for the lost value of their shares? Courts classify rights under civil RICO as



derivative under those circumstances. See, e.g., Crocker v. FDIC, 826 F.2d 347, 349 (5th Cir.



1987). What about a failed mutual thrift institution’s uninsured depositors? See In re Sunrise



Securities Litigation, 916 F.2d 874 (3d Cir. 1990) (same result).

53





2. A shareholder sues a solvent national bank’s directors under 12 U.S.C. §93(a) for



mismanagement. The plaintiff’s lawyer frames the action as a derivative suit and alleges that



there would be no point in demanding that the incumbent directors authorize a corporate suit



against themselves. The bank fails several months later, and the receiver seeks to remove the



plaintiff’s lawyer on the ground that the receiver alone should control the litigation. What result?



See Gaff v. FDIC, 814 F.2d 311, 315 (6th Cir. 1987) (shareholder asserting a derivative claim



against a national bank had no standing to pursue the suit as an individual once the bank entered



receivership; by vesting in the receiver every asset of the bank, receivership ―effectively



precluded individual shareholders from bringing derivative actions based on the same conduct‖).



Do you agree?



3. Shareholders have a strong incentive to find some cause of action that will withstand a



motion to dismiss for lack of standing. Plaintiffs’ lawyers have identified a variety of direct



causes of action, notably actions arising under the federal securities laws. See, e.g., Howard v.



Haddad, 916 F.2d 167 (4th Cir. 1990) (action under SEC Rule 10b-5 is direct, not derivative).



Plaintiffs typically argue that the failed bank’s directors had the bank misrepresent its financial



condition and that the plaintiffs lost money by relying on those misrepresentations. But federal



securities fraud suits benefit only persons who purchased or sold securities during the relevant



time period and give no priority boost to shareholders generally. State law causes of action, such



as for negligence, securities fraud, common law fraud, or unfair business practices might



conceivably benefit a broader range of shareholders.





PROBLEMS



1. Karnak Bank failed and left the following types of liabilities (millions of dollars):

54





Accounts payable $ 50

Bonds 200

Deposits, FDIC-insured 1,600

Deposits, uninsured 200

Receiver's administrative expenses 20

Subordinated debt 120

Other liabilities 110

Total Liabilities $ 2,300



The FDIC as receiver marshaled the bank’s assets and now has $2 billion to distribute. How much



money, if any, should go to the holders of each type of liability?



2. As chief real estate lending officer of Gull Bank, Jay supervised $600 million in real



estate lending and collected $3 million in kickbacks (see Part D-2). Bad loans overseen by Jay



played a major role in causing the bank to fail. Jay is now serving a lengthy prison term for his



misdeeds. The FDIC, as Gull Bank’s receiver, has sued Jay for breaching his fiduciary duties of



care and loyalty. Jay currently has $7 million in assets and $3 million in liabilities (notably for



unpaid taxes and an unpaid criminal fine). Gull Bank has its headquarters in the State of Falconia,



where Jay lived, worked, and collected his kickbacks. Under a Falconia statute, ―any person



whose business or property has suffered injury as a result of any unlawful or unfair business



practice may, in a civil action, recover three times the damages that person has sustained.‖ Gull



Bank’s former shareholders have sued Jay under that statute. If successful in their respective



lawsuits, the FDIC and the shareholders will each obtain judgments far exceeding Jay’s assets,



much less his net worth. The FDIC has intervened in the shareholders’ suit and moved that the



court dismiss their claims for lack of standing. How should the court rule on that motion?

55





F. STRUCTURING RESOLUTION





In examining the process for handling bank failure, we have thus far focused on the role of



the receiver. The basic tasks we have considered—marshaling assets and paying claims—need



doing with or without deposit insurance. Even with insurance, someone other than the insurer



could perform those tasks. But when FDIC-insured banks fail, the FDIC acts as both insurer and



receiver. To underscore the legal distinction between those roles, this chapter has referred to the



―receiver‖ (or ―the FDIC as receiver‖) and ―the FDIC as insurer.‖ As we turn to the structure of



bank resolutions, we will see the FDIC’s dual roles further intertwine. We will now examine the



options for resolving failed banks, the mechanics of protecting insured deposits, and the legal



constraints on treating large banks as ―too big to fail.‖





1. How Receivership and Deposit Insurance Intertwine



When structuring the resolution of a failed bank, any receiver (whether government or



private, and whether having or not having insurance responsibilities) must make fundamental



decisions about how to dispose of the bank’s assets and liabilities. At one extreme, the receiver



can sell the assets piecemeal and use the proceeds to pay liabilities. At the other extreme, the



receiver can look for a healthy bank willing both to purchase the failed bank’s assets and to



assume the failed bank’s liabilities. (In so doing the receiver would still be marshaling assets and



paying claims but would be doing so in bulk.) Intermediate options include selling some or all of



the assets as a package and using the proceeds to pay liabilities.



But a stand-alone receiver—with no access to an insurance fund, government line of



credit, or the like—would have limited options: it would have to rely on the value of the failed



bank itself. Consider the challenges a privately owned corporation would face as receiver for a

56





failed bank with no deposit insurance. To view these challenges most starkly, we will assume that



the receiver has no assets or income of its own. Such a receiver could pay claims only insofar as it



sold or could borrow against the failed bank’s assets. This reliance on the bank’s assets would



necessarily defer payment and increase hardship to the bank’s depositors. If an economic



recession had depressed asset prices, the receiver would have to choose between selling assets



now for a fraction of their former value and holding the assets for later sale and thereby further



delaying payment to depositors. Lacking assets and income of its own, the receiver could not



make credible guarantees to facilitate the sale of dubious assets. (Such a guarantee would limit an



asset-purchaser’s potential loss: e.g., by the purchase the option of selling bad loans back to the



receiver for 50% of the purchase price.) At every turn the relative illiquidity of the failed bank’s



assets would constrain the stand-alone receiver’s freedom of action and hinder prompt payment of



claims.



The FDIC’s role as deposit insurer helps solve each of these problems. The FDIC can use



its insurance fund to pay a failed bank’s insured deposits immediately, without waiting to sell the



bank’s assets. It can retain or credibly guarantee doubtful assets. It need not dump assets in



severely distressed markets but can hold them for orderly sale. If a healthy bank seeks to acquire



only the failed bank’s deposits, the FDIC can pay the acquirer to assume liability for those



deposits (and can make the price reflect the value banks place on gaining new customers—e.g.,



by paying the acquirer only 99 cents per dollar of deposits assumed). The FDIC’s insurance fund



and government lines of credit give it ample liquidity.



Although the legal distinction between the FDIC’s receivership and insurance roles



continues at this stage of the process, the tasks performed overlap to a greater degree. The FDIC



as insurer pays insured deposits immediately after a bank fails, succeeds to the depositors’ claims

57





against the receivership, and replenishes the insurance fund once the receiver pays those claims (a



topic to which we will return shortly). The FDIC as insurer can buy some or all of a failed bank’s



assets from the FDIC as receiver—and thus become responsible for marshaling those assets. The



FDIC as insurer can pay for those assets by assuming some or all of the bank’s liabilities—and



thus become responsible for evaluating and paying claims. To the extent that receivership and



insurance functions may converge or overlap, this part of the chapter may refer simply to the



―FDIC.‖





2. Resolution Options



In resolving a failed bank, the FDIC uses four basic types of transactions. In a deposit



payoff, also known as a straight liquidation, the FDIC liquidates the bank’s assets (piecemeal or



as a package) and pays the bank’s liabilities. In an insured deposit transfer, the FDIC pays a



healthy bank to assume the failed bank’s insured deposits. In a purchase and assumption, the



FDIC arranges for an acquirer to purchase some or all of the failed bank’s assets and assume



some or all of the bank’s liabilities. See generally 12 U.S.C. §§1821(c), (d), (f), (i), (m)-(n),



1823(c). If the FDIC plans to sell the failed bank as a going concern but has not yet found an



acquirer, it can form a bridge bank, transfer to the bridge bank part or all of the failed bank’s



assets and liabilities, and have the bridge bank carry on the failed bank’s business until the FDIC



lines up an acquirer. See id. §1821(n); see also id. §1821(d)(2)(F), (m).



The FDIC can also combine one or more of these resolution options. It can, for example,



establish a bridge bank to carry on the failed bank’s business and later arrange for an acquirer to



purchase the assets and assume the liabilities of the bridge bank. Likewise, after having an



acquirer purchase part of the assets and assume part of the liabilities of the failed bank, the FDIC



can use a payoff to dispose of the remainder. In any event, the receiver can make an immediate

58





partial payment (―modified payoff‖) to uninsured depositors and other creditors based on an



estimate of what their claims will ultimately receive from the liquidation. See id. §1821(d)(10).







QUESTIONS AND COMMENTS



In theory, the FDIC can give a troubled bank ―open-bank assistance‖ to prevent the bank



from failing in the first place. The FDIC would provide such assistance by purchasing nonvoting



securities from the bank or assuming some of the bank’s liabilities. Id. §1823(a)(3), (c)(5), (8).



But except in cases of systemic risk, open-bank assistance must meet two nearly prohibitive



conditions: it must satisfy the least-cost resolution requirement (discussed below) and must not



―in any manner . . . benefit‖ the bank’s shareholders. Id. §§1821(a)(4)(B), 1823(c)(4).





3. Subrogation



When the FDIC as insurer pays a failed bank’s insured depositors, it becomes



―subrogated‖ to their claims against the bank. Id. §1821(g)(1). The FDIC in effect steps into those



depositors’ shoes, becoming entitled to receive whatever share of the bank’s assets would



otherwise have gone to those depositors. For an illustration of subrogation and priorities at work,



let’s take a closer look at Valhalla Bank (Part E-2-b), which has $950 million in assets, $900



million in deposits, and $100 million in other liabilities. Let’s specify that FDIC insurance covers



$800 million of the bank’s deposits. Almost immediately after the bank fails, the FDIC uses $800



million from its insurance fund to make full payment on all insured deposits (e.g., by paying a



healthy bank to assume liability for those deposits). By so doing, the FDIC as insurer becomes



subrogated to $800 million in deposit claims. After paying its own administrative expenses ($1



million), the FDIC as receiver turns to deposit claims, paying itself as insurer $800 million and



paying holders of uninsured deposits $100 million. Neither the FDIC as insurer nor the uninsured

59





depositors incur any loss, and enough assets remain to make a partial payment on the bank’s



general claims.



But what if Valhalla Bank’s assets were worth only $850 million? After paying its



administrative expenses, the FDIC as receiver would pay 94.3 cents on each dollar of deposits



($849 million in assets ÷ $900 million in deposits = 94.3%). Thus a claimant with $500,000 in



uninsured deposits would receive $471,667 (94.3% of $500,000). The FDIC as insurer would



receive $754.7 million on its deposit claims (94.3% of $800 million) and thus incur a $45.3



million loss ($800 million paid to insured depositors minus $754.7 million received on those



depositors’ claims). The bank’s general and subordinated creditors would receive nothing.





4. Least-Cost Resolution Requirement



a. General Rule



In dealing with a particular failed bank, the FDIC must adopt the resolution method ―least



costly to the deposit insurance fund of all possible methods‖ for meeting the FDIC’s obligation to



the bank’s insured depositors. 12 U.S.C. §1823(c)(4). To identify the least-cost approach, the



FDIC must ―evaluate alternatives on a present-value basis, using a realistic discount rate,‖ and



―document that evaluation and the assumptions on which the evaluation is based.‖ The FDIC



must retain the documentation for at least five years, so that Congress and its watchdog arm, the



General Accounting Office, can review the FDIC’s compliance with least-cost resolution.





b. Systemic-Risk Exception



A narrow systemic-risk exception exists for cases in which least-cost resolution of a



particular bank ―would have serious adverse effects on economic conditions or financial

60





stability.‖ Id. §1823(c)(4)(G). The secretary of the Treasury, ―in consultation with the President,‖



can make such an exception only if recommended by two-thirds majorities of both the Federal



Reserve Board and the FDIC’s Board of Directors. The Treasury must document the secretary’s



determination. The General Accounting Office must review and report on the exception,



including the potential for it to increase moral hazard. The FDIC must levy a special assessment



to recoup the additional cost of deviating from least-cost resolution. Such an assessment applies



not only to insured institutions’ domestic deposits (as in the case of regular FDIC premiums) but



to their foreign deposits and most of their nondeposit liabilities. Congress designed these rules to



promote accountability and make the process unpleasant enough so that systemic-risk exceptions



would be granted rarely (if at all) and never lightly.





G. SYSTEMIC RISK



Concern about ―systemic risk‖ has played a key role in shaping banking policy, especially



as it relates to bank failure. In a free market individual banks are susceptible to runs and the



banking system is susceptible to panics, as we have previously seen (MM&C 3d ed. pp. 57-59).



Congress instituted federal deposit insurance to help maintain confidence in the banking system



and prevent any repetition of the ―contagion of fear‖ evident in bank panics during the early



1930s (MM&C 3d ed. p. 21). Concern about systemic stability has influenced the FDIC’s



decisions about how to deal with bank failures, most conspicuously in the case of Continental



Illinois National Bank (MM&C 3d ed. pp. 336-37). And FDICIA, although generally curtailing



the practice of treating banks as ―too big to fail,‖ included a narrow exception for cases of



systemic risk.

61





1. Definition



What, then, is systemic risk? How does it arise? Robert E. Litan and Jonathan Rauch



discuss systemic risk and its sources in a report prepared for the U.S. Department of the Treasury.





Litan & Rauch, American Finance for the 21st Century

98-112 (1997)





Systemic crisis is something quite different from ordinary financial loss or marketplace

turbulence. It must strike suddenly enough, and affect enough people and companies

simultaneously, to compromise the performance of the market as a whole, rather than just costing

some people some money. How fast and extensive must a crisis be to qualify as systemic? [For

present purposes] the following working definition should suffice: Systemic risk refers to the

possibility of a sudden, usually unexpected, event that disrupts the financial markets, and thus the

efficient channeling of resources, quickly enough and on a large enough scale to cause a

significant loss to the real economy.





Bringing the whole financial system to the verge of dysfunction requires a special sort of

shock. If a systemic breakdown happens, its cause is likely to be a cascade, a contagion, an asset

implosion, or, most likely, some combination of the three. . . .





Cascades



Financial institutions, and banks in particular, conduct business not only with their

customers but with each other. Small banks typically hold deposit balances at larger banks.

Systemic risk theoretically can crop up if one or more of the largest links in the chain—a large

bank or securities firm—fails, triggering in domino-like fashion the failure of other firms that are

owed money by the failed institution.



For instance, the risk of a cascade of losses was a major reason why in 1984 the

government extended the federal safety net to cover all depositors, including uninsured ones, of

the failed Continental Illinois Bank. Many smaller banks had uninsured accounts at Continental in

excess of their shareholders’ equity and thus would have been forced into insolvency had they

been forced to write off all their deposits at Continental. In reality, this fear was misplaced:

62





although uninsured depositors’ exposure to Continental was large, their actual losses were not. In

fact, none of them lost more than a small fraction of their deposits. And so the cascade of failures

that regulators feared was never a real problem, at least not on that occasion. . . . Nevertheless, the

Continental Illinois episode illustrates at least how, in principle, interlinkages can be the

mechanism by which the failure of one especially large institution can trigger insolvencies, or at

the very least cause significant losses, among the others.



A relatively new source of interlinkages among the very largest banks and securities firms

has been the explosive growth in the volume of off-exchange or over-the-counter derivatives

contracts. [D]ealing in financial derivatives is heavily concentrated among the largest banks,

insurance companies, and securities firms. . . .



[But] derivatives contracts represent just one form, albeit a new and sometimes unusually

complex form, of the interlinkages that weave the fabric of modern financial markets. And

interlinkages need not be disastrous. The failure of any very large party, for whatever reason,

inevitably causes headaches for its creditors. But creditors (and counterparties) generally try to

stay conscious of those risks and diversify to manage them. Moreover, the arithmetic of

dispersion across a large financial universe makes it difficult for even large failures to cripple the

whole system. Say Bank A fails. Bank B, which has invested 15 percent (say) of its assets in A,

certainly has a problem. But at one further remove, Bank C has (say) 15 percent of its assets in

Bank B and none in Bank A, which means that, at most, only 2.25 percent of its own assets are at

risk from A’s failure (the true figure almost certainly being less, since even uninsured depositors

typically get some of their money back if their bank fails). At still one more remove, Bank D is

only trivially affected. Of course, the example is much oversimplified. A number of institutions

may be in Bank B’s position; and if those banks fail, they may become new sources of disruption.

So the arithmetic of dispersion does not mean that cascades cannot happen. It does mean,

however, that in a very large marketplace, where few institutions are large enough to absorb more

than a small fraction of the economy’s assets, shock waves tend to diffuse quickly as they radiate

outward from their source. Particular institutions may indeed be subject to shocks, but, like jelly

beans in a jar, they are not very good at transmitting shocks more than short distances. To

endanger the functioning of the financial system, a triggering event would need to be huge, much

larger in impact, for instance, than the Continental Illinois failure turned out to be.

63





There is, however, one portion of the financial sector that can potentially serve as quite an

efficient shock transmitter, one capable, in principle, of spreading a local crisis throughout the

system in a matter of hours. This is the set of mechanisms for clearing and settling transfers

among banks and securities firms each day.



Just as a computer cannot run without an operating system—a program that tells the

hardware what to do with the software and vice versa, and that lets the user tell the computer what

to do—the financial markets have their own operating systems without which they, too, would be

useless. No such operating system is required when buyers pay with cash; the clearing and

settlement is then done instantaneously and in person. But payments made by check or

electronically require a system of bookkeeping to ensure that money and securities are credited

and deducted from the proper accounts every day, so that the parties in every transaction leave the

market with the payment or financial instruments for which they bargained. The fortunes of

thousands of banks and securities firms are linked to each other through the settlement system,

and the volume of funds flowing through this system is staggering—several trillion dollars every

day. If the system fails, commerce can literally come to a halt. That is why the smooth

functioning of clearing and settlement is the most essential financial task in the economy and why

ensuring that it is carried out each and every day must always be a central objective of financial

policy. . . .





Contagion



The financial equivalent of shouting ―fire‖ in a crowded theater is contagion. A deposit

run on one troubled bank, for example, becomes contagious when depositors at other banks run as

well, deciding it is better to be safe than sorry. If monetary authorities fail to provide sufficient

liquidity (as happened in the 1930s), then runs on many banks at the same time can lead in turn to

the downfall of many more banks, in turn damaging the economy as lending grinds to a halt.

Unlike cascades, which are characterized by interlinkages among banks and other financial

institutions, contagious deposit runs can bring down banks whether or not they have claims on

each other.



Contagion arises because of a lack of accurate and timely information. Depositors run

because, having seen one prominent institution fail, they cannot easily know whether their own is

completely safe. The contagious bank runs of the 1930s prompted the introduction of deposit

64





insurance, which has handily achieved its objective: no deposit run has ever been mounted by

insured depositors, nor is any likely.



Uninsured Depositors. Potential runs by uninsured depositors are another matter. It was to

prevent such runs that policymakers extended the federal safety net to cover all depositors of a

number of large banks (beginning with the failure of Franklin National in the 1970s and repeated

with Continental Illinois and other large institutions in the 1980s). But such blanket guarantees

may tempt big banks to take excessive risks. So, in FDICIA, Congress made it more difficult (but

not impossible) for the government to extend protection beyond the $100,000 per account

insurance ceiling [see Part F-4 of this chapter]. That firmer limit on the federal safety net, along

with FDICIA’s stricter capital standards and its requirements for prompt action when banks get in

trouble, should help make large bank failures less likely in the future. . . .



Commercial Paper. Contagion need not be limited to bank depositors. As corporations

have discovered that they can borrow directly from the market rather than through banks, the

commercial paper market—or the market in unsecured, short-term debt instruments—has grown

by leaps and bounds. . . . What would happen if a very large issuer of commercial paper,

especially one active in financial markets, were to default? Would such an event trigger the

equivalent of a run by holders of commercial paper throughout the market, so that other

corporations that depend on rolling over their paper when it comes due [i.e., issuing new paper to

raise the money needed to pay off old paper] would be unable to do so? Perhaps even more

important, would investors in money market mutual funds (MMFs), which are large investors in

commercial paper, mount a run on MMFs on the fear that the commercial paper losses would

force some MMFs to ―break the buck‖ and not honor redemptions at the $1 per share par value at

which MMF shares are issued?



Those who worry about such outcomes point to the only real commercial paper scare this

country has had: the 1970 Penn Central railroad bankruptcy and subsequent default on its

commercial paper. . . .



Fortunately, today and in the future the market, unassisted by the Federal Reserve, should

ordinarily be able to withstand the default of a commercial paper issuer, even one much larger

than Penn Central. . . . With greater size has come much more liquidity and sophistication on the

part of both buyers and sellers, who have become accustomed to assessing the financial health of

65





issuers and distinguishing the strong from the weak. Accordingly, market participants are much

less likely to practice the financial equivalent of guilt by association, which was so feared when

Penn Central failed. . . .



Even if the failure of a large issuer of commercial paper caused other issuers to have

trouble rolling over their obligations, banks probably would be able to fill the void, albeit perhaps

at higher cost to the borrowers involved. . . .



As a last resort, the Federal Reserve should be able to prevent the failure of even a large

issuer of commercial paper from having systemic effects [by lowering interest rates enough so

that investors prefer commercial paper to low-yielding Treasury securities]. . . .





Asset Implosions



Beyond cascades and contagions, of course, a further important source of systemic risk is

a sudden and sustained drop in asset values. The most worrisome financial events of the 1980s

were of this type: the October 1987 stock price plunge, the savings and loan crisis and the

developing country debt crisis, when loans to commercial developers and to Third World

countries went sour. What are the prospects for future asset collapses?



Another Stock Market Crash. One way a deep plunge in equity values can cause broad

problems is simply by unnerving people, sapping consumer and business confidence and thus

triggering a decline in aggregate spending and in turn a downturn in the economy as a whole. But,

beyond that, a stock market crash can be characterized by both contagion and cascade. An

element of contagion is almost always present when stock prices drop suddenly: many investors

may simultaneously panic, driving prices down regardless of objectively determined fundamental

values. And cascades can worsen any initial price decline. For example, the selling induced by the

very low margins before the Great Depression can be viewed as an example of a cascade. . . .



A Decline in Asset Values. Apart from a stock market crash, what about another episode of

constricted lending, like the one in the 1980s in the United States when loans for developing

countries and commercial real estate went sour, or the one in Japan, when the bubble economy of

the 1980s burst, leaving banks severely stressed? Or, to take another example from the past, what

if interest rates were again to spike into double-digit territory, causing the market value of all

loans with longer maturities to drop sharply in value? In cases like these, the economy can suffer

66





harm not so much from the lending losses themselves as from the corrective action—enforcing

capital requirements that inevitably curtail lending—that regulators eventually must take to

prevent farther financial damage and losses to taxpayers. Many economists believe that the

recovery from the 1990-1991 recession was, once begun, slowed by the reluctance of many banks

to lend as they struggled to rebuild their balance sheets and meet stricter capital standards.



Scholars debate whether large-scale lending losses suffered by depository institutions

really qualify as ―systemic events.‖ Skeptics point out that such troubles, far from appearing

suddenly, typically are drawn-out affairs more like business cycle downturns than financial

shocks. Others retort that, in any case, widespread lending losses can hurt the whole economy, not

only by inhibiting investment and spending, but also by draining the pockets of taxpayers, who

stand behind the deposit insurance funds. . . .





QUESTIONS AND COMMENTS



1. Using the concepts outlined by Litan and Rauch, how would you analyze the Panic of



1907?



2. Congress has taken two steps specifically aimed at reducing the risk of cascades among



financial institutions. FDIC-insured banks must limit the amount of credit exposure they have to



any one depository institution. See MM&C 3d ed. pp. 337-38. This constraint resembles the limit



on loans to one borrower.



Congress also validated bilateral and multilateral ―netting agreements,‖ under which



banks and other financial institutions settle each business day’s transactions with a single net



payment. See 12 U.S.C. §§4401-4422. For a simplified example of net settlement, let’s consider



one business day in the life of Green Bank and Red Bank, both of which deal in government



bonds, foreign currencies, and precious metals. Each bank’s bond traders daily buy and sell



billions of dollars of bonds, currencies, and metals, seeking to profit from price fluctuations. Over



the course of this day, Red Bank bought from Green Bank $350 million in government bonds,

67





$150 million in foreign currencies, and $50 million in precious metals. Green Bank bought from



Red Bank $300 million in government bonds and $200 million in foreign currencies, and $40



million in precious metals. At the close of business, Red Bank owes Green Bank a total of $550



million, and Green Bank owes Red Bank a total of $540 million. Under a gross settlement system,



each bank would pay the other the full amount owed, with Red Bank paying $550 million and



Green Bank paying $540 million. Net settlement simplifies the process. The two banks agree to



settle their accounts through a single net payment of the amount by which one bank’s payment



obligations exceed the other bank’s payment obligations. Today Red Bank would pay Green



Bank $10 million—the amount by which Red Bank’s payment obligations ($550 million) exceed



Green Bank’s payment obligations ($540 million). Net settlement is a form of setoff. If Red Bank



failed, Green Bank would have a $10 million claim against Red Bank’s receiver. (The receiver



cannot argue that Green Bank must pay the receiver the full $540 million yet receive payment on



its $550 million claim only insofar as Red Bank has assets available to pay the claim.) Valid



netting agreements thus reduce the potential for a large bank’s failure to send a damaging ripple



through the financial system.





PROBLEMS



1. Titania is a poor country with a pleasant climate, spectacular scenery, and large reserves



of titanium—a strong, lightweight metal used to build aircraft. Titania’s economy boomed for two



decades as it mined and exported titanium and developed a large tourist industry. The price of real



estate septupled. Titania’s banks prospered as they financed the development of tourist-oriented



hotels, restaurants, shops, and other facilities. The banks had ample capital and a well-deserved



reputation for prudence. Then fears about international terrorism caused sharp declines in tourism



and demand for titanium. Unemployment in Titania tripled. Real estate prices fell by 50 percent.

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Borrowers defaulted on loans. Loan-losses depleted banks’ capital, and banks largely stopped



making new loans. Even the most creditworthy customers had difficulty borrowing money. This



lack of credit further increased unemployment and deepened the decline in real estate prices.



Titania’s economy has remained in a severe recession ever since. How would you analyze the



problem in Titania?



2. Cadmia also had a recent economic boom, after decades of totalitarian rule and



economic stagnation. A new democratic government privatized state enterprises, including all



four existing banks, and abolished bank regulation. Forty new banks opened. Some, like Primi



Bank, had good management and ample capital. Some, like Drugi Bank, had poor management



and little capital. Yet these weak banks delighted their customers by making loans aggressively



and paying high interest rates on deposits. All seemed well. Then Drugi Bank—the most famous



and aggressive of the new banks—abruptly failed, and its managers fled the country. Depositors



nationwide lined up to demand their money bank. In vain did Primi Bank point to its good



management, high capital, and strong loan quality; its depositors would not listen. Soon Primi



Bank and every other bank in Cadmia failed. How would you analyze the problem in Cadmia?



3. Jade Bank, Opal Bank, and Rhinestone Bank operate in Libertaria, a prosperous country



with minimal banking regulation. All three banks have excellent reputations for financial



soundness. Each bank has a 10% ratio of capital to total assets. Jade Bank and Opal Bank have



ample deposits and too few lending opportunities: after making loans to all creditworthy loan



applicants, each bank still has excess cash on hand. Each bank accordingly deposits its excess



cash at Rhinestone Bank. These deposits total 20% of Jade Bank’s assets and 22% of Opal Bank’s



assets. Early one morning, the presidents of Jade Bank and Opal Bank learn that the president of



Rhinestone Bank has looted his bank of half its assets and disappeared in a high-seas speedboat.

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―Our bank is ruined!‖ each innocent president declares, ―We can’t even open for business.‖ How



would you analyze the problem in Libertaria?