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