Tag: FDIC

Information for Borrowers with Loans from Silicon Valley Bank or Signature Bank

This alert provides information for borrowers with loans from Silicon Valley Bank (“SVB”) or Signature Bank (“Signature”) based on information available from the FDIC and our clients’ experiences over the last few days. We have also included information regarding the FDIC’s general policies and procedures when selling and administering loans of failed banks. We will update this alert as additional information becomes available.

Borrowers with loans from SVB or Signature continue to wait for information from the FDIC, and the new bridge banks it formed, with respect to their loans, including any information regarding the sale of their loans, new bank contact information and updates to borrowing procedures and payoff logistics. At present, we understand that the bridge banks are attempting to operate in the same manner with respect to their borrowers (and depositors) that SVB and Signature operated prior to their failures, including through use of the existing relationship managers/bank contacts and online platforms and consistent borrowing and payment mechanics.

Systemic Risk Exception

As widely reported, on Sunday, March 12, the Federal Reserve, the FDIC and the Treasury Secretary announced a systemic risk exception and created Silicon Valley Bridge Bank, N.A. and Signature Bridge Bank, N.A. (together, the “Bridge Banks”). The systemic risk exception is an attempt to avoid a widespread bank run and to ensure that all of SVB and Signature Bank’s depositors would be made whole after the failures of the two banks. The systemic risk exception is an exception to federal law that otherwise would require the FDIC to resolve a bank failure at the lowest cost to the Government’s deposit insurance fund.  See Crisis and Response: An FDIC History, 2008-2013, p. 36. Otherwise, the FDIC would not have been in a position to backstop uninsured deposits beyond the $250,000 insured limit per depositor per ownership category. For more information about FDIC deposit insurance limits please see our prior alert: SVB Receivership – What You Need to Know.

Prior to Sunday, the only uses of the systemic risk exception occurred in 2008 and 2009.  Id., pp. 35-36. The systemic risk exception has never before been used to create bridge banks at which loans at failed institutions would then be sold or administered by the FDIC.

Sale of SVB and Signature Loans

The general expectation after a bank failure is that the failed bank’s loans will be sold to a new lender as expeditiously as possible. The FDIC conducted an auction for the assets of SVB (including its loan portfolio) on Sunday, March 12. The Wall Street Journal reported on Monday, March 13 that, while none of the largest U.S. Banks bid on SVB at the initial auction, there was at least one offer which was declined by the FDIC. The WSJ is also reporting that regulators are planning to hold another auction of SVB’s assets. We also anticipate an auction of Signature’s assets. The timing of these auctions remains unclear.

In the event that either or both of these auctions produce buyers of the Bridge Banks’ respective assets in bulk, those buyers will become the lenders under the failed banks’ loans. In that case, the applicable successor lender will advise its new borrowers of their new bank contacts and provide relevant loan administration information including loan payment procedures.

If either or both of the auctions fail to produce a buyer for all of the bank’s assets, a bank’s loan portfolio may be split up and sold piecemeal. In this event it may take longer before borrowers know the identity of their new lender. If some or all of the loans are not purchased, they will continue to be administered by the respective Bridge Banks or the FDIC. As noted above, the intent of the FDIC is to continue to operate the Bridge Banks pending substantial completion of the sale process.

Borrowing Under an SVB or Signature Line of Credit

In general, when the FDIC is appointed receiver, it immediately begins analyzing loans that require special attention, such as unfunded and partially funded lines of credit, and construction and development loans. Typically speaking, the role of receiver generally precludes the FDIC from continuing the lending operations of a failed bank; however, the FDIC will consider advancing funds if it determines an advance is in the best interest of the receivership, such as to protect or enhance collateral, or to ensure maximum recovery to the receivership. See A Borrowers Guide to an FDIC Insured Bank Failure.

When the FDIC is operating as receiver, its general procedures provide that if a borrower submits a request for additional funding, the FDIC will conduct a thorough analysis to determine the best course of action for the receivership. The FDIC uses information contained in the failed bank’s loan files to the extent available and considered reliable. Because the files of failed banks are often incomplete or poorly documented, the FDIC may require additional financial information to perform its analysis and make decisions.

In the current circumstances, with the Bridge Banks operating under the systemic risk exception, these general FDIC rules appear to have been relaxed, at least for the time being and our clients are reporting that borrowing (and deposit) operations are generally functioning in the ordinary course. We have not yet heard from any clients that additional information has been required in connection with advances from the Bridge Banks.

SVB Contact Information

The FDIC is currently directing SVB borrowers with questions about drawing on lines of credit to contact their existing relationship manager/bank representative at SVB. SVB also has a call center at 800-774-7390 open from 5:00 AM to 5:30 PM (Pacific) with representatives that can assist borrowers.

Signature Contact Information

The FDIC is currently directing Signature borrowers with questions about drawing on lines of credit to contact their existing relationship manager/bank representative at Signature Bank. Signature Bank also has a 24-hour call center at 866-744-5463 with representatives that can assist borrowers.

On Monday, March 13, our clients had mixed results contacting their existing bank relationship managers and drawing on lines of credit. Some clients requested online draws but have not been successful as a result of system malfunctions (and we heard the same reports with respect to some attempts to access and move deposits). On the other hand, we heard reports from our clients that automatic draws and account sweeps have continued to function (and many borrowers successfully accessed their accounts). Today (March 14), clients appear to be having more success in accessing their lines of credit. We will continue to gather information about borrowers’ ability to access their lines as it becomes available.

Loan Payoff/Lien Release Information

Many clients have inquired about the mechanics for arranging a loan payoff/refinancing of their SVB loan or Signature loan. In the event that the loan is sold, the borrower can coordinate payoff with the new lender that purchased the loan. In the meantime, borrowers should reach out to their relationship managers or otherwise contact the bank using the means provided above to arrange any payoff and/or lien release. Further information regarding lien releases may also be found on the FDIC lien release website. In the event that borrowers’ loans are not sold quickly by the FDIC to a new lender, we expect that those borrowers will be strongly encouraged by the FDIC to arrange for a refinancing. See A Borrowers Guide to an FDIC Insured Bank Failure.

Continue Performing Obligations under Loan Documents

Notwithstanding the failures of SVB and Signature, their borrowers should continue to abide by their loan documents, including submitting payments as required by their loan documents at the same addresses and complying with all other covenants and agreements. Borrowers will be advised by the FDIC, the Bridge Banks or a subsequent purchaser of their loan if there are any updates to payment mechanics or bank contact information.

Article By Timothy John Carter, Jonathan C. Hayden, Trevor Hoffmann, Muryum Khalid, Kevin Renna, Douglas B. Rosner, Andrew Rothstein, Jesse Rubinstein, and Jesse Scott of Goulston & Storrs.

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2023 Goulston & Storrs PC.

Congress Eases Criminal Offense Restrictions for Employment With Financial Institutions

Included in the defense spending bill signed by President Biden in December 2022 is a section with key provisions for financial institutions that will ease restrictions on hiring candidates with criminal records. Section 5705 in the National Defense Authorization Act (NDAA) for Fiscal Year 2023, titled “Fair Hiring in Banking,” further narrows convictions that would constitute a bar to employment under Section 19 of the Federal Deposit Insurance Act (FDIA) absent a written waiver by the Federal Deposit Insurance Corporation (FDIC). A representative for the FDIC confirmed that the changes are effective now and will be implemented by the FDIC in 2023.

Background

Section 19 generally prohibits any person who has been convicted of a crime of “dishonesty or a breach of trust or money laundering or has agreed to enter into a pretrial diversion or similar program in connection with a prosecution for such offense” from working in banking without first obtaining written consent from the FDIC.

Section 19 requires financial institutions to conduct criminal background checks on job candidates, regardless of whether state or local laws limit consideration of criminal histories in hiring. In July 2020, the FDIC issued a final rule that loosened the prohibitions in Section 19 by, among other things, expanding what are considered “de minimis” offenses and expanding the definition of “expungement” to include an order to seal a criminal record or a record relating to a pretrial diversion program.

Older Offenses

The Fair Hiring in Banking provisions go even further, providing that a waiver is not needed if it has been seven years or more since the offense occurred or if the individual was incarcerated with respect to the offense and it has been five years or more since the individual was released from incarceration. The need for a waiver also does not apply to conduct that an individual committed before the age of 21 and if it has been at least thirty months since the sentencing.

De Minimis Offenses

The provisions further permit the FDIC to exempt other “de minimis offenses” that they may determine by rule. Those rules must include a requirement that the offense “was punishable by a term of three years or less.” Applicable de minimis offenses may include offenses for writing bad checks so long as the aggregate value of all the bad checks is $2,000 or less. The FDIC may further designate other “lesser offenses” to be exempt if one year or more has passed since conviction, “including the use of a fake ID, shoplifting, trespass, fare evasion, driving with an expired license or tag, and such other low-risk offenses.”

Consent Applications

According to the provision, when reviewing an application to allow an individual with an applicable criminal conviction to work for a bank, the FDIC must make an “an individualized assessment.” This assessment must take “into account evidence of rehabilitation, the applicant’s age at the time of the conviction or program entry, the time that has elapsed since conviction or program entry, and the relationship of individual’s offense to the responsibilities of the applicable position.” They must further consider the individual’s employment history, letters of recommendation, and the completion of any substance abuse or job preparation programs.

Key Takeaways

The Fair Hiring in Banking provisions clear some barriers for financial institutions to hire individuals who may have committed criminal offenses in the past but have since been rehabilitated, providing needed flexibility in hiring and recruitment. Further, the provisions go beyond the 2020 FDIC rule changes by amending Section 19 of the FDIA to create exceptions to hire individuals convicted of certain criminal offenses without burdensome consent review by the FDIC.

While the federal laws preempt conflicting state and local laws, the Fair Hiring in Banking provisions are in line with the growing number of jurisdictions across the country that have prohibited or limited consideration of job candidates’ criminal histories in the hiring process. Those measures, such as so-called ban-the-box laws, have been imposed in part to promote rehabilitation and concerns that considering criminal histories in hiring disproportionately affects individuals in protected classes.

© 2023, Ogletree, Deakins, Nash, Smoak & Stewart, P.C., All Rights Reserved.
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FRB and FDIC Issue Joint ANPR on Possible Resolution Requirements for Large Banking Organizations While FRB and OCC Approve U.S. Bank MUFG Union Bank Merger

The Federal Reserve Board (“FRB”) and Federal Deposit Insurance Corporation (“FDIC”) Board issued an Advanced Notice of Proposed Rulemaking (“ANPR”) titled “Resolution-Related Resource Requirements for Large Banking Organizations.” Separately, but relatedly (if for no other reason than the FRB put it in the same press release as the ANPR), the Office of the Comptroller of the Currency (“OCC”) and the FRB approved their respective applications for the merger of MUFG Union Bank into U.S. Bank.

The ANPR is seeking comment on possible changes to the resolution-related standards applicable to large banking organizations (“LBOs”) that are not global systemically important banks (“GSIBs”). Those possible changes that the FRB and FDIC are contemplating would bring some of what is required for GSIB resolution planning down to LBOs, particularly focusing on “Category III” firms with $250 billion to $700 billion in total assets. The main focus of the ANPR is on whether LBOs ought to be required to issue long-term debt similar to the total loss-absorbing capacity (“TLAC”) requirements for GSIBs. The ANPR notes that the Fed and FDIC are considering “whether an extra layer of loss-absorbing capacity could increase the FDIC’s optionality in resolving the insured depository institution,” but also costs associated with such a requirement.

The ANPR flows logically from remarks made by Acting Comptroller Hsu at the Wharton Conference on Financial Regulation in April (and which we discussed in a previous issue), and that Acting Comptroller Hsu noted in his statement when he voted in favor of the ANPR at the FDIC Board meeting.

As noted above, in the same press release announcing the ANPR, the FRB announced the approval of the application by U.S. Bancorp to acquire MUFG Union Bank. The FRB’s order noted that upon consummation, U.S. Bancorp’s consolidated assets would total approximately $698.7 billion, and noting the close proximity to becoming a “Category II” firm over $700 billion in assets imposed a unique commitment to give quarterly implementation plans for complying with Category II requirements. The commitment by U.S. Bancorp also could trigger a need for U.S. Bancorp to comply with Category II requirements by December 31, 2024, even if its asset size has not gone above the $700 billion threshold. FRB Governor Michelle Bowman issued a statement supporting both the issuance of the ANPR and the approval of U.S. Bancorp’s application, but questioned the appropriateness of imposing Category II requirements on a one-off basis. The OCC’s approval was conditioned, among other things, on U.S. Bank making plans for its possible operability in the event of a resolution in order to facilitate its sale to more than one acquiring institution.

Article By Daniel Meade of Cadwalader, Wickersham & Taft LLP

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© Copyright 2022 Cadwalader, Wickersham & Taft LLP

US Banking Agencies Issue Statement on Alternative Date in Credit Underwriting

On December 3, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Consumer Financial Protection Bureau (CFPB) and the National Credit Union Administration (the Banking Agencies) released interagency guidance related to the use of alternative data for purposes of underwriting credit (the Guidance).

The Guidance acknowledges that alternative data may “improve the speed and accuracy of credit decisions,” especially in cases where consumer credit applicants have “thin files” because they are generally outside the mainstream credit system. In order to comply with applicable federal laws and regulations when using such alterative data, including those related to unfair, deceptive, or abusive acts or practices, the Banking Agencies advise that lenders should responsibly use such information. Furthermore, the Guidance reminds lenders of the importance of an appropriate compliance management program that comports with the requirements of applicable consumer protection laws and regulations.

As a final recommendation, the Banking Agencies suggest that lenders consult with appropriate regulators when planning to use alternative data to underwrite credit.

The Guidance is available here.

©2019 Katten Muchin Rosenman LLP

Republican Senators seek action from FDIC to ensure end of Operation Choke Point

Thirteen Republican Senators have sent a letter to FDIC Chairman Jelena McWilliams urging the FDIC to take action to ensure that lawful businesses are no longer at risk of adverse financial consequences as a result of “Operation Choke Point, and its associated culture and Choke Point-like regulatory actions.”

“Operation Choke Point” was a federal enforcement initiative involving various agencies, including the DOJ, OCC, FDIC, and Fed.  Initiated in 2012, Operation Choke Point targeted banks serving online payday lenders and other companies that have raised regulatory or “reputational” concerns.  In June 2014, the national trade association for the payday lending industry and several payday lenders initiated a lawsuit in D.C. federal district court against the FDIC, Fed, and OCC in which they alleged that certain actions taken by the regulators as part of Operation Choke Point violated the Administrative Procedure Act and their due process rights.  In September 2018, pursuant to a joint stipulation of dismissal, the Fed was dismissed from the lawsuit.  Cross-motions for summary judgment are currently pending before the court.

In their letter, the Senators ask the FDIC if it is the agency’s official position “that lawful businesses should not be targeted by the FDIC simply for operating in an industry that a particular administration might disfavor” and “[i]f so, what [the FDIC is] doing to make sure that bank examiners and other FDIC officials are aware of this policy and have communicated it to regulated institutions?”  They also ask whether there were any communications explaining supervisory expectations of “elevated risk” or “high risk” merchants with regulated institutions that would likely qualify as a rule under the Congressional Review Act that were not properly submitted to Congress and what the FDIC is doing to ensure that its staff does not communicate policy in a matter that is inconsistent with the position of the FDIC’s Board of Directors.

The letter does not reference the FDIC’s January 2015 Financial Institution Letter(FIL) entitled “Statement on Providing Banking Services” that attempted to rectify the damage created by Operation Choke Point.  In the Statement, the FDIC “encourages institutions to take a risk-based approach in assessing individual customer relationships rather than declining to provide banking services to entire categories of customers, without regard to the risks presented by an individual customer or the financial institution’s ability to manage the risk.”  The Statement followed the FDIC’s July 2014 FIL in which the FDIC withdrew the list of “risky” merchant categories (such as payday lenders and money transfer networks) that was included in prior guidance on account relationships with third-party payment processors (TPPPs).  Consistent with the July 2014 FIL and an October 2013 FIL on TPPP relationships, the 2015 FIL advised banks that they were neither prohibited nor discouraged from providing services to customers operating lawfully, provided they could properly manage customer relationships and effectively mitigate risks.  However, unlike the prior FILs, the new FIL expressly acknowledged that “customers within broader customer categories present varying degrees of risk” and should be assessed for risk on a customer-by-customer basis.

 

Copyright © by Ballard Spahr LLP
This post was written by Barbara S. Mishkin of Ballard Spahr LLP.

Bank Regulators Require Changes to Tax Allocation Agreements

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Acting in response to divergent results in recent court decisions, the Federal bankregulatory agencies have adopted an Addendum to their longstanding rules regardingincome tax allocation agreements between insured depository institutions (“IDI”) and their parent holding companies.[i] The Addendum requires holding companies and their IDI subsidiaries to review their existing income tax allocation agreements and to add a specified provision. The review and modifications must be effected as soon as reasonably possible, which the regulators expect to be prior to October 31, 2014.

Background

Most banks and thrift institutions holding deposits insured by the Federal Deposit Insurance Corporation (“FDIC”) are subsidiaries in a holding company structure. The Federal and State income tax returns of these IDI, as members of a consolidated group, are usually filed by the holding company parent. Refunds and other tax benefits of the consolidated group attributable to the IDI subsidiaries received by a parent holding company must be allocated to the IDI subsidiaries.

Since 1998, the Board of Governors of the Federal Reserve System (“Board”), the Office of the Comptroller of the Currency, and the FDIC (collectively, the “Agencies”) have applied uniform rules regarding such allocations. They are set forth in their Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure (the “Policy”).[ii]

The Policy generally mandates that inter-corporate settlements between an IDI and its parent holding company be conducted in a manner that is no less favorable to the IDI than if it were a separate taxpayer. It also establishes a supervisory expectation that a comprehensive written tax allocation agreement will be entered into between a parent holding company and its IDI subsidiaries.

Among other things, the Policy specifies that a parent holding company that receives a tax refund from a taxing authority holds such funds as agent for the members of the consolidated group. It also requires that neither the tax allocation agreement nor the corporate policies of the parent holding company should purport to characterize refunds attributable to an IDI subsidiary received from a taxing authority as being property of the parent.

Addendum to the Policy

In several holding company bankruptcies since 2008, the FDIC has been unsuccessful in recovering for IDI subsidiaries tax refunds received and held by the parent holding company. In those cases, the courts have interpreted the applicable tax allocation agreement as creating a debtor-creditor relationship between the parent holding company and its IDI subsidiaries. Those courts have reached that result notwithstanding the Policy and its mandate that a parent holding company act as an agent for its IDI subsidiaries.[iii]Although other decisions have interpreted tax allocation agreements consistently with the Policy, the Agencies determined to modify the Policy and require additional action by holding companies and IDI with a view to avoiding such situations in future.

Under the Addendum to the Policy, each tax allocation agreement must be reviewed and revised to ensure that it explicitly acknowledges an agency relationship between the holding company and its subsidiary IDI with respect to tax refunds and does not contain any other language to suggest a contrary intent. A sample paragraph which the Agencies regard as sufficient is included in the Addendum.

The Addendum to the Policy also makes clear that tax allocation agreements are subject to the requirements of Sections 23A and 23B of the Federal Reserve Act. Among other things, this means that the parent holding company must promptly transmit tax refunds received from a taxing authority to its subsidiary IDI. An agreement that permits a parent holding company to hold and not promptly transmit tax refunds owed to an IDI may be regarded by the Agencies as inconsistent with Section 23B, and may subject the holding company and IDI to supervisory action. Similarly, an agreement that fails to clearly establish the agency relationship between the parent holding company and its IDI subsidiaries may be treated as subject to the loan collateralization and other requirements of Section 23A.

Conclusion

The Addendum the Agencies have made to the Policy does not represent a change in supervisory approach to these issues. It is a clarification in light of adverse bankruptcy experience and constitutes a reaffirmation of the Policy. Parent holding companies and IDI subsidiaries should arrange for a review of their existing tax allocation agreements and the inclusion in those agreements of the provision specified in the Addendum to the Policy. Action is required as soon as reasonably possible, but in any event before October 31, 2014.

Article By:

John K. Lawrence
Of:
Dickinson Wright PLLC

[i] Board Press Release (June 13, 2014). The Addendum will be published in the Federal Register.

[ii] 63 Fed. Reg. 64757 (Nov. 23, 1998).

[iii] See, e.g., FDIC v. Siegel (In re IndyMac Bancorp, Inc.), 2014 WL 1568759 (9th Cir., 2014).

© Copyright 2014 Dickinson Wright PLLC

Letters of Credit Overview and Fundamentals

vonBriesen

 

Letters of Credit (“L/Cs”) have evolved over nearly three centuries of commerce into an essential tool for banks and their customers in international business transactions, financings and government contracting. This Update provides an overview of some of the key legal and practical concepts that are necessary to use this tool effectively.

The FDIC’s examiner’s handbook defines a letter of credit as “a document issued by a bank on behalf of its customer authorizing a third party to draw drafts on the bank up to a stipulated amount and with specified terms and conditions,” and states that an L/C is a bank’s “conditional commitment…to provide payment on drafts drawn in accordance with the document terms.”

Governing Law

The sources of “law” governing L/Cs are:

  • Statute: UCC Article 5 applies to “letters of credit and to certain rights and obligations arising out of transactions involving letters of credit.” UCC Section 5-108(e) provides that an issuing bank “shall observe standard practice of financial institutions that regularly issue letters of credit.”
  • Practice codes: Derived from two sources: the UCP600 (Uniform Customs and Practice for Documentary Credits 2007 Revision, International Chamber of Commerce Publication No. 600) and the ISP98 (Institute for International Banking Law and Practice Publication 590; International Standby Practices (1998)).
  • Contract law: With some limited exceptions, any provision of Article 5 may be modified by contract. Thus, if the UCP600 or ISP98 is incorporated into an L/C, it supersedes any contrary provision of Article 5. The exceptions include the “Independence Principle” (discussed below) and certain other rights and obligations of the issuing bank.

Terminology

Certain terms are important to an understanding of the parties’ respective rights and obligations, with some of the most basic being:

  • Issuer – the bank that issues the L/C and is required to Honor a Draw by the Beneficiary;
  • Applicant – the customer for whose account the L/C is issued;
  • Beneficiary – the person in whose favor the L/C is issued and who is entitled to Present/Draw and receive payment from the Issuer;
  • Honor – performance of the Issuer’s undertaking (in the L/C) to make payment; and
  • Presentation (also called a Draw) – delivery of document(s) to an Issuer for (or to induce) Honor of the L/C.

The Independence Principle

Central to an understanding of L/C law and practice is that an L/C is a self-contained whole. This is known as the “Independence Principle” based upon language in UCC §5-103, which states that the rights and obligations of an Issuer to a Beneficiary under an L/C are “independent of the existence, performance, or nonperformance of a contract or arrangement out of which the letter of credit arises or which underlies it, including contracts or arrangements between the issuer and the applicant and between the applicant and the beneficiary.”

The Independence Principle protects all parties. The Issuer is protected because, as long as the Presentation requirements in the L/C are strictly complied with, the Issuer must Honor it without looking into the relationship between the Applicant-customer and the Beneficiary making the Draw. The Applicant and Beneficiary are also both protected because the Issuer’s obligations under the L/C are not affected by the relationship between the Applicant-customer and the Issuer itself. Thus, the Applicant may be in default of its obligations to the Issuer, but the Issuer must nevertheless Honor a proper Presentation.

Types of L/Cs

L/Cs fall into two general categories: “commercial/documentary L/Cs” (which are the primary focus of the UCP600) and “everything else,” consisting mainly of what are known as “Standby L/Cs” which, themselves, come in several varieties and are covered by the ISP98.

“Commercial/Documentary L/Cs” are typically issued to facilitate specific transactions and to assure payment in trade or commerce (usually international). Generally, Presentation is made when the underlying transaction is consummated. These are referred to as “documentary L/Cs” because a Draw requires documentary proof that the underlying transaction has occurred.

For example, an exporter and importer might agree that goods will be paid for at the time of shipment. The exporter won’t ship without assurance of getting paid, and the importer won’t pay without assurance that the goods have been shipped. Thus, the importer (Applicant) arranges with its Bank (Issuer) for an L/C that gives the exporter (Beneficiary) the right to Draw when the exporter provides the Issuer with an original Bill of Lading proving shipment. Anecdotally, this is partly why documentary L/Cs were conceived – to avoid having the Issuer bank independently verify shipment, which might have involved the banker making a trip to the dock and watching the goods being loaded and the ship sailing off beyond the horizon.

“Consummation” of the underlying transaction – i.e., the goods being placed on the ship – is defined by the terms of the L/C, as are the documentation requirements, which are either spelled out in the L/C or incorporated from the UCP600.

“Standby L/Cs“. The ISP98 defines eight types of Standby L/Cs, of which the most common are “Financial Standbys.”

A Financial Standby is an irrevocable guarantee by an Issuer of Applicant’s payment or performance in an underlying transaction. The Beneficiary may Draw, and the Issuer must Honor, if its customer (Applicant) does not pay, deliver or perform. Some event, usually a default by Applicant under its contract with Beneficiary, “triggers” the Beneficiary’s right to Draw. Although independent proof of the Beneficiary’s right to Draw is not required, a Financial Standby is still “documentary” in the sense that the Beneficiary must make the Draw in writing and (typically) represent to the Issuer that Applicant has defaulted. Due to the Independence Principle, the Issuer (without verifying the default) must Honor if the Draw complies with the Presentation requirements spelled out or incorporated into the L/C.

Financial Standbys present an Issuer with both a credit benefit and a credit risk. Because Applicant’s default under its contract with the Beneficiary is a condition to the Issuer having to Honor the Beneficiary’s Draw, the Issuer may never have to “fund” (Honor) as long as Applicant doesn’t default; BUT, if the Issuer does have to fund, it will be on account of a customer who has already defaulted on a (probably material) business obligation.

A “Direct Pay L/C” is a type of Financial Standby. While it is also an Issuer’s guarantee of Applicant’s payment of a debt or other obligation, the difference is that Applicant’s default is not a condition to Draw – all payments are made by Draws on the L/C. Direct Pay L/Cs are useful in cases where the “Beneficiary” is a group of unaffiliated debt holders (i.e., holders of publicly-traded bonds) because this payment method provides liquidity and avoids bankruptcy preference claims against debt service payments. Because of the Independence Principle, the Issuer is the primary obligor for payment of debt service; thus, Applicant’s default is of no concern to bondholders and bonds backed by an irrevocable Direct Pay L/C are marketed on the strength of the Issuer’s credit, not the Applicant’s.

Of special note are Standby L/Cs required by governmental entities. Various Wisconsin Statutes and Administrative Rules require or permit a person transacting business with a state agency (obtaining a license or permit, for example) to provide a Standby L/C primarily to demonstrate proof of financial responsibility in cases where the license or permit, for example, creates a potential monetary obligation to the State. Many Wisconsin state agencies’ regulations make reference to such L/Cs, but only the Department of Natural Resources and the Department of Transportation have prescribed forms.

Issuer’s Risks

An Issuer’s most obvious risk is its customer’s default: failure to reimburse the Issuer after a Draw has been Honored. The reimbursement obligation can be a requirement to deposit funds with the Issuer immediately upon a Draw, but can also be part of an ongoing credit relationship where Draws are simply treated as “advances” on a term or revolving credit agreement.

Issuer banks also face other risks, such as fraud (a legitimate Beneficiary makes a fraudulent Draw), forgery (impostor Beneficiary makes a Draw) and sovereign, regulatory and legal risks. Regulatory issues created by L/Cs involving lending limits, contingent liabilities, off-balance sheet treatment and regulatory capital requirements also come into play but are beyond the scope of this overview.

Common Problems

Among the more common L/C problems we have seen with our Issuer bank clients are:

  • Standby L/Cs that incorrectly incorporate provisions of the UCP600 or, less frequently, Commercial/Documentary L/Cs that incorrectly incorporate from the ISP98;
  • not being aware of automatic renewal and reinstatement provisions, and potential post-expiry obligations;
  • failing to insist on strict adherence to the Presentation requirements, especially if they are incorporated from the UCP600 or the ISP98;
  • failing to Honor a proper Draw as an “accommodation” to its customer/Applicant who has informed the bank of a dispute with the Beneficiary; and
  • poorly-drafted L/Cs that make inappropriate reference to non-documentary issues.

Banks issuing L/Cs to assist customers in export-import transactions, or providing proof of financial responsibility or liquidity/credit support, should be aware that their obligations and rights are often not obvious from simply reading the L/C without being familiar with the underlying laws and practice codes that are summarized in this Update. As noted above, a carefully-considered and well-drafted L/C protects all parties, including the Issuer.

Article by:

von Briesen & Roper, S.C.

Dodd-Frank Update — Several Regulatory and Legislative Proposals of Note

Recently posted in the National Law Review an article by attorneys  Sylvie A. Durham, Genna Garver and Dmitry G. Ivanov of Greenberg Traurig, LLP regarding  the OCC, FDIC and SEC’s proposed a joint rule implementing theVolcker Rule:

GT Law

REGULATORS PROPOSE VOLCKER RULE:

On October 11, 2011, the Office of the Comptroller of the Currency, Treasury (OCC), Board of Governors of the Federal Reserve System (Board), Federal Deposit Insurance Corporation (FDIC), and Securities and Exchange Commission (SEC) issued a joint proposed rule implementing the long awaited Volcker Rule. This proposal establishes exemptions from the prohibition on proprietary trading and restrictions on covered fund activities and investments as well as limitations on those exemptions. In addition, the proposal requires certain banking entities to report quantitative measurements with respect to their trading activities and to establish enhanced compliance programs regarding the Volcker Rule, including adopting written policies and procedures. Appendices to the proposal provide the quantitative measurements to be used to report trading activities, commentary regarding the factors the agencies propose to use to distinguish permitted market making-related activities from prohibited proprietary trading and the minimum requirements and standards for compliance programs. Comments should be received on or before January 13, 2012. A copy of the proposed rule is available here.

FSOC PROPOSES RULE TO SUPERVISE AND REGULATE CERTAIN NON-BANK FINANCIAL COMPANIES:

On October 11, 2011, the Financial Stability Oversight Council (FSOC) issued its second proposed rule and interpretive guidance to provide additional details regarding the framework that FSOC intends to use in the process of assessing whether a nonbank financial company could pose a threat to U.S. financial stability, and further opportunity for public comment on FSOC’s approach to making determinations to require supervision and regulation of certain nonbank financial companies in accordance with Title I of Dodd-Frank, previously proposed on January 26, 2011. The proposed rule, previously proposed on January 26, 2011, has been modified to provide additional details about the processes and procedures through which FSOC may make this determination under Dodd-Frank, and the manner in which a nonbank financial company may respond to and contest a proposed determination. Importantly, the interpretive guidance sets out a three-stage process of increasingly in-depth evaluation and analysis leading up to a proposed determination that a nonbank financial company could pose a threat to the financial stability of the United States. The first stage would involve a quantitative analysis by applying thresholds that related to the framework categories of size, interconnectedness, leverage and liquidity risk and maturity mismatch. A company will be evaluated further in stage 2 only if it both meets the total consolidated assets threshold ($50 billion in global consolidated assets for U.S. global financial companies or $50 billion in U.S. total consolidated assets for foreign nonbank financial companies) and any one of the other enumerated metrics. Stage 2 would involve a wide range of quantitative and qualitative industry-specific and company-specific factors. Stage 3 would focus on the company’s potential to pose a threat to the U.S. financial system. Comments are due by December 19, 2011. A copy of the proposed rule is available here.

PROPOSED LEGISLATION ON TO EXTEND DEADLINE FOR DERIVATIVES RULEMAKING:

A bill was introduced in the Senate to extend the deadline for rulemaking on derivatives to July 16, 2012. The Dodd-Frank Improvement Act of 2011 (S. 1650) would require the SEC, the CFTC and other relevant regulators to jointly adopt an implementation schedule for derivatives regulations by December 31, 2011, which would, among other things, specify schedules for publication of final rules and for the effective dates for provisions in Dodd-Frank on derivatives. The proposed bill would also allow the regulators to issue exemptions with respect to swap transactions, activities or persons from the Dodd-Frank Act derivatives provisions, would exempt end-users of swaps from margin requirements, would revise the definition of major swap participants to “prevent Main Street businesses that are using derivatives to hedge business risks from being regulated like swap dealers,” and would exempt inter-affiliate transactions from the definition of “swaps.” The bill would also create the Office of Derivatives within the SEC to “administer rules, coordinate oversight and monitor the developments in the market.” The text of the bill is available by clicking here.

PROPOSED LEGISLATION TO FREEZE REGULATORY RULEMAKING:

Two bills were introduced in the House of Representatives to freeze regulatory rulemaking actions during a “moratorium period” and to repeal certain existing regulations. The Job Creation and Regulatory Freeze Act of 2011 (H.R. 3194)would establish a moratorium period until January 20, 2013, prohibiting regulators from adopting any “covered regulations,” which would include final regulations that, among other things, would have an adverse effect on employment, economy or public health or are likely to “have an annual effect on the economy of $100,000,000 or more.” At the same time, the bill would allow rulemaking, to the extent necessary “due to an imminent threat to human health or safety, or any other emergency” or if it promotes “private sector job creation,” encourages economic growth or reduces “regulatory burdens.” The Stop the Regulation Invasion Please Act of 2011, or STRIP Act of 2011 (H.R. 3181) would also establish a two-year moratorium period for all new rulemaking, except in certain limited circumstances. In addition, that bill would repeal, with certain exceptions, all rules that became effective after October 1, 1991. The existing rules that would continue in effect would need to be justified before the Congress based on cost-benefit analysis. The H.R. 3194 is available by clicking here; and the H.R. 3181 is available by clicking here.

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