Colonial Bancgroup Appellate Court Finds FDIC Entitled to Setoff Rights for Deposits at Failed Bank Subsidiary

Contributed by Dana Hall
The United States District Court for the Middle District of Alabama has vacated and remanded a bankruptcy court ruling that had denied the FDIC-receiver’s attempt to lift the stay to set off its prepetition claim against deposit accounts maintained at Colonial Bank by its bankrupt holding company, The Colonial Bancgroup, Inc. (“HoldCo”).  We previously provided an analysis of the bankruptcy court’s original decision here.
As explained more fully in our prior post, the facts of Colonial Bancgroup closely resemble those of many other post-2008 failed bank sales.  On August 14, 2009, the Alabama State Banking Department closed Colonial Bank and appointed the FDIC as receiver.  That same day, the FDIC entered into a purchase and assumption agreement with BB&T Corp (the “P&A Agreement”).  Under that agreement, BB&T assumed liability for the majority of Colonial Bank’s deposit accounts.  The agreement also contained a clawback provision that enabled the FDIC to designate certain deposits for retention by the receivership.  The clawback provision permitted the FDIC, in its capacity as receiver, to direct BB&T to withhold all or any portion of any account balance or to return the deposit to the FDIC (thereby discharging BB&T of all liability to the depositor).  In the rush to quickly execute the P&A Agreement, the FDIC specifically carved out certain deposit accounts from the assumed liabilities of BB&T, but did not carve-out HoldCo’s deposit accounts.  Shortly after the closure of Colonial Bank, HoldCo filed for chapter 11 protection.  The FDIC subsequently filed a proof of claim against HoldCo asserting prepetition liabilities and moved to obtain relief from the automatic stay to claw back HoldCo’s deposit accounts from BB&T and exercise its alleged setoff rights against the deposit liabilities.  The issue faced by the bankruptcy court, and the district court on appeal, was whether, as required by section 553 of the Bankruptcy Code, the FDIC’s liability to HoldCo on account of HoldCo’s deposits was a mutual, prepetition debt that could be offset against the receivership’s prepetition claims against HoldCo.
The FDIC and HoldCo Obligations Are “Mutual”
Section 553 of the Bankruptcy Code preserves the right of setoff under applicable nonbankruptcy law if a creditor is able to show that the obligations it seeks to setoff are both prepetition and mutual.  Further, 12 U.S.C. § 1822(d) grants the FDIC a federal statutory right to setoff but does not add substantive criteria to those required under section 553.
Debts are generally considered to be mutual when they are between the same parties, acting in the same capacity.  The bankruptcy court in Colonial Bancgroup had determined that, although mutuality had initially existed between the FDIC and HoldCo, it ceased to exist when the FDIC assigned the deposit accounts to BB&T pursuant to the P&A Agreement.  The district court rejected this reasoning and found that the P&A Agreement had not extinguished the FDIC’s liability on the deposit accounts and, therefore, had not terminated mutuality between the FDIC and HoldCo.  The district court noted that the underlying obligation came into existence when HoldCo deposited its funds in the Colonial Bank deposit accounts and that the only pertinent question for purposes of determining mutuality was “whether anything in the P&A Agreement destroyed mutuality by extinguishing the FDIC-receiver’s liability on [HoldCo’s] deposit accounts.”  According to the district court, under principles of contract law, absent an obligee’s consent, an obligor cannot extinguish its own liability by assigning its contractual obligations to a third party.  Accordingly, the district court determined that, because HoldCo had not consented to a novation of the FDIC’s liability on the deposit accounts, BB&T’s assumption of the deposit accounts merely resulted in joint and several liability with the FDIC, but did not ultimately extinguish the FDIC’s liability.
The district court also determined that, even in the unlikely event that the P&A Agreement could have somehow extinguished the FDIC’s liability without HoldCo’s consent, the language of the P&A Agreement reflected that it was not intended to have that effect.  The P&A Agreement, for instance, expressly provided that, to the extent a depositor asserted a claim against the FDIC for deposit liabilities, the FDIC was authorized to pay such claim and seek reimbursement from BB&T.  Furthermore, under the P&A Agreement, the FDIC could order BB&T to withhold payment on contested account balances, penalize BB&T for wrongly distributing funds, and order the return of deposit accounts to the FDIC.  As a result, the district court concluded that the assignment of the deposit accounts to BB&T had not extinguished the FDIC’s liability on the accounts and that, so long as the FDIC remained liable on the accounts, mutuality existed for purposes of setoff.
The FDIC’s Liability on the HoldCo Accounts Arose Prepetition
Pursuant to section 553 of the Bankruptcy Code, in order to assert a right of setoff, the underlying obligations must not only be mutual, but must also arise before the filing of the debtor’s bankruptcy case.  Contingent liabilities may be considered prepetition in nature so long as “all acts giving rise to liability arose before the petition date.”  The bankruptcy court found that, although the FDIC retained the right to claw back deposit accounts from BB&T, to be considered a prepetition obligation of the FDIC, the accounts would have had to be either clawed back prior to the commencement of HoldCo’s chapter 11 case or specifically carved out in the P&A Agreement.  The district court, in contrast, found that, notwithstanding that the particular accounts subject to setoff were not identified until after the petition date, the execution of the P&A Agreement had created a contingent, prepetition claim.  The district court pointed to the express language of the P&A Agreement, which specifically excluded from the definition of “deposits” transferred to BB&T “all or any portion of those deposit balances which, in the discretion of [the FDIC], . . . may be needed to provide payment of any liability of any depositor to [Colonial Bank] or the [FDIC], . . . whether or not the amount of the liability is or can be determined as of [execution of the P&A Agreement].”  In addition to granting the FDIC the authority to determine that any portion of any deposit balance is not a “deposit” at all for purposes of the agreement, the P&A Agreement also granted the FDIC the authority to direct BB&T to withhold payment on such accounts.  Although the actual amounts subject to FDIC offset had not been determined as of the petition date, because both HoldCo’s deposit of funds and the parties’ execution of the P&A Agreement had occurred prior to the petition date, the FDIC, nonetheless, retained a contingent prepetition claim.
The district court also focused on the Congressional intent behind the enactment of 12 U.S.C. § 1822(d) and set forth a public policy rationale in support of its determination that the FDIC’s claims constituted a prepetition, contingent liability.  That provision states that:

the [FDIC] may withhold payment of such portion of the insured deposit of any depositor in a depositary institution in default as may be required to provide for the payment of any liability of such depositor to the depository institution in default or its receiver, which is not offset against a claim due from such depository institution, pending the determination and payment of such liability by such depositor . . . .

According to the district court, the logical implication of that section of the banking laws is that the FDIC “should be entitled to offset debt from the debtor’s estate without proceeding as an unsecured creditor in the general bankruptcy distribution scheme.”  Accordingly, clawback provisions, such as that contained in the P&A Agreement, along with the statutory authority provided by 12 U.S.C. § 1822(d), enable the FDIC to consummate a purchase and assumption on an expedited basis while still retaining the ability to setoff prepetition claims against certain deposit accounts to the extent that, postpetition, the FDIC determines such action to be warranted.  Furthermore, the court opined that requiring the FDIC to identify and carve out any deposit accounts subject to setoff prior to the depositor’s commencement of a bankruptcy case would not only slow the process of transferring the deposit accounts to a subsequent purchaser, but would also create a perverse incentive for holding companies to race into bankruptcy to cut off any possible setoff rights of the FDIC.
Although the district court vacated the bankruptcy court’s order and determined that the FDIC retained a right to setoff of its prepetition claim against the HoldCo deposit accounts, the district court did not decide whether the bankruptcy court had erred by denying the FDIC’s request for relief from the automatic stay.  Instead, it remanded the case to the bankruptcy court for consideration of this issue.  The district court has, however, stayed its order pending its own ruling on a motion for reconsideration filed by HoldCo.  Regardless of how the district court rules on the reconsideration motion, it looks like this case is headed to the Eleventh Circuit Court of Appeals for further appellate review.  Watch our blog for future developments.  In the meantime, the effect of this decision is that the FDIC-receiver and acquirers of failed banks will be able to adopt a “wait and see” approach and allocate a holding company’s deposit accounts between them to maximize their potential setoff rights.