Bank Failure: Background and Issues to Consider

As with any business, a bank can become insolvent. But unlike most businesses, your bank holds your money or your customers’ money, making insolvency particularly fraught. On Friday, March 10, 2023, the California Department of Financial Protection and Innovation closed Silicon Valley Bank (“SVB”) and appointed the Federal Deposit Insurance Corporation (“FDIC”) as receiver. To protect insured depositors, the FDIC created the Deposit Insurance National Bank of Santa Clara (“DINB”). At the time of closing, the FDIC as receiver immediately transferred to the DINB all insured deposits of SVB which will be available for withdrawal at the open of business on Monday, March 13.

In light of SVB’s failure, we summarize in this client memorandum the general bank resolution process and discuss some practical considerations for customers of failed banks. We urge our clients to carefully consider all relevant facts when making important decisions based on the reasoned consideration of applicable law and verifiable information.

1. Bank Failure

A bank “fails” and is subject to resolution in any one of the following situations:

• The bank has insufficient assets or liquid funds to meet its obligations or depositor demands in the normal course of business;
• The bank is in an “unsafe or unsound condition” as determined by the Federal Deposit Insurance Corporation (“FDIC”) or the bank’s chartering authority;
• The FDIC has revoked the bank’s deposit insurance;
• The bank’s conduct poses a risk to the FDIC’s Deposit Insurance Fund; or
• The bank is “critically undercapitalized” as defined in the FDIC’s regulations.¹

If any of these conditions is satisfied, the bank’s chartering authority will revoke the bank’s charter and close the institution.² The chartering authority may then appoint the FDIC as receiver or the FDIC may appoint itself.

2. Pre-Failure FDIC Actions

The FDIC usually acts even before a bank “fails,” and may require the bank to adopt a capitalization improvement plan. If failure appears imminent to the FDIC, it will begin its preparations and begin a search for a healthy bank willing to acquire some or all of the failing bank’s assets and liabilities– a process known as “franchise marketing.” 

3. FDIC Resolution Process

a. Establish a Receivership

There are essentially two ways that the FDIC can resolve a failed bank: (1) sell the bank in whole or in part, or (2) “pay out” the bank. In either case, the FDIC establishes a receivership – a legal entity to resolve the bank – the moment a failed bank is closed.

Banks are usually closed after the close of business on a Friday to avoid unnecessary customer disruptions. Upon closing, customers may no longer deposit or withdraw funds, though the FDIC aims to enable customer withdrawals from transaction accounts (i.e., checking accounts) on the Monday following closing. If the FDIC has already found an acquirer, the assets and liabilities are transferred from the receivership to the healthy bank over the weekend.

Once a receivership is established, the FDIC will, among other things, sell any assets an acquirer does not purchase; perform bookkeeping, accounting, and reporting tasks; identify, verify, and pay claims as funds become available; determine whether to file suit or refer for criminal prosecution anyone whose actions contributed to the failure; and monitor any ongoing agreements with acquirers or the purchasers of assets; and so forth. A receivership is terminated only when all the bank’s assets and liabilities have been sold, liquidated, or transferred.

b. Sell the Failed Bank to a Healthy Bank

The FDIC’s preferred resolution mechanism is to sell the failed bank through one of the following purchase and assumption (“P&A”) structures:

• Basic P&A. A healthy bank purchases the totality of the failed bank's assets, insured deposits, cash and cash equivalents. Sometimes, the healthy bank will contractually retain the option to sell certain specified assets back to the FDIC. The FDIC may also agree to share in future losses the healthy bank incurs in connection with certain assets.
• Loan purchase P&A. A healthy bank purchases a portion of the failed bank's loan portfolio, insured deposits, cash and cash equivalents.
• Bridge bank. The FDIC temporarily acquires the failed bank's assets until a purchaser can be found and the assets sold.

c. Payout

If the FDIC cannot sell the bank through one or more P&A arrangements, it will “pay out” the failed bank. To do so, it will first determine, based on the insurable capacities and limits set forth in the FDIC’s regulations, the appropriate payout amount owing to each depositor based upon either the records of the bank or the records submitted by agents on behalf of depositors claiming through the agent. The FDIC will then pay out the insured deposits as soon as possible after the bank closes (with the goal of paying off all depositors within two business days). In its almost century of existence, the FDIC has never failed to make a full payoff of insured deposits.

The funds of an individual that are deposited in one or more deposit accounts in the individual’s name are added together and insured up to $250,000 in the aggregate. For legal entity depositors, the deposits of each legal entity engaged in “independent activity”³ are added together and insured up to $250,000 in the aggregate. The deposits of divisions or units of a legal entity that are not separately incorporated (such as Delaware Series LLCs) are not separately insured. If a legal entity maintains deposit accounts as a fiduciary for beneficiaries, such deposits may be insured on a “pass-through” basis if other eligibility criteria are otherwise satisfied.

It is important to note the distinction between “deposits,” which evidence a debt obligation that a bank owes to depositors, and assets that are held by the bank in custody for a customer, which are not a product of a creditor-debtor relationship between the bank and customer. Because a depositor is a creditor of the bank, there is a need for a special resolution procedure to make sure they are put first in line in front of other creditors.

If a depositor holds funds at the failed bank exceeding the insurable limit, the depositor will have a claim against the failed bank’s estate for the uninsured amount. Under the principle of “depositor preference,” the claim of an uninsured depositor is prioritized and will be paid prior to the claims of any general creditors. Based on a preliminary assessment of the estimated value of a failed bank’s assets, the FDIC may pay uninsured depositors a portion (an “advance dividend”) of their claim. Advance dividends often range from one-third to one-half of a depositor’s claim and are typically paid within 30 days of the failed bank's closing.

In contrast to deposits, if the failed bank is acting as custodian for a customer’s assets, those assets will not become part of the failed bank’s estate and will be returned to the customer or transferred to another custodian at the customer’s direction. Such assets do not become part of the failed bank’s “estate” and thus no special resolution procedure is necessary to move those assets in front of any other creditor’s claim.

After returning custodied assets and paying out insured deposits, the FDIC will then liquidate the bank’s assets, pay out the remaining claims of uninsured depositors first, and then creditors and shareholders generally according to common bankruptcy procedures.

4. Contractual Relationships with a Failed Bank

The following describes how contracts are treated during an FDIC receivership under the FDIC’s statutory authority:

• The FDIC may enforce any contract entered into by the failed bank 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 or the exercise of rights or powers by a receiver.
• No person may exercise any right or power to terminate, accelerate, or declare a default under any contract to which the failed bank is a party, or obtain possession of or exercise control over any property of the bank or affect any contractual rights of the bank, without the consent of the receiver during the 90-day period beginning on the date of the appointment of the receiver.
• The FDIC may disaffirm or repudiate any contract to which the failed bank is a party; the performance of which the FDIC in its sole discretion determines to be burdensome; and the disaffirmance or repudiation of which the FDIC determines in its sole discretion will promote the orderly administration of the failed bank’s affairs.
• Damages for a repudiated contract are limited to actual direct compensatory damages as of the date of repudiation.

5. Other Practical Considerations

In general, if your banking partner is in danger of failing you should consider taking one or more of the following steps:

• Anticipate the closure of a failed bank on a Friday and the possible transfer of deposits to another bank over the weekend or early the next week.
• Evaluate whether your banking relationships are sufficiently diversified.
• Determine whether any deposits you hold at the bank, either in your own capacity or in an agency capacity, are fully insured by the FDIC.
• If you have uninsured deposits at the bank, determine potential loss amounts.
• Establish contingency plans for the inaccessibility of any funds on deposit at the bank (up to one week for insured deposits and up to six weeks for uninsured deposits).
• If you hold deposits for your customers as their agent, consult the FDIC’s Deposit Broker’s Processing Guide to ensure that you can timely provide customer information to the FDIC for deposit insurance payouts.
• Continue making all required payments under any loan agreements. The FDIC will inform counterparties how to do so, though there may be a delay.
• Abide by the terms of any agreement with a failed bank. Do not attempt to assign the agreements to another party until further guidance is provided by the FDIC.
• Review counterparty relationships and contractual obligations to determine whether they involve affected accounts or banking relationships and assess the need for action to avoid or mitigate potential disputes.
• Because deposits are not permitted to be made into accounts at a failed bank, clients should assess whether they have any obligors that are currently making deposits into accounts at the failed bank and contact them as soon as possible to provide new account details for an account not held at the failed bank so as to minimize business and transaction disruption.

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As events here are moving very fast, we anticipate sending out further communications to reflect the latest developments in the situation. In the meantime, if you have any questions or concerns based on the foregoing, please reach out to your Seward & Kissel relationship attorney at any time, or directly to Casey Jennings (jennings@sewkis.com).

¹ Generally, a bank must be closed within 90 days of becoming critically undercapitalized. See 12 U.S.C. § 1831o.

² If the chartering authority is unable or unwilling to close a failing bank, the FDIC or a regional Federal Reserve Bank can close the bank and appoint the FDIC as receiver. See 12 USC § 1821(c).

³  “A corporation, partnership or unincorporated association shall be deemed to be engaged in an ‘independent activity’ if the entity is operated primarily for some purpose other than to increase deposit insurance.” 12 CFR 330.1(g).