Step Off! Colonial BancGroup Bankruptcy Court Rejects FDIC Setoff Attempt

Contributed by Andrea Saavedra and Kyle J. Ortiz
A recent decision in In re The Colonial BancGroup, Inc., Case No. 09-32303-(DHW) (Bankr.M.D. Ala. Jan. 24, 2011), addresses the complex tripartite relationship between a bank holding company in bankruptcy, the Federal Deposit Insurance Corporation as receiver for the failed bank subsidiary, and the successor bank which assumed liability for the failed bank’s deposit accounts. The decision limits the FDIC’s ability to exercise setoff rights with respect to deposit accounts of the holding company/debtor.
The financial crisis of 2008 and the collapse of the housing market precipitated a slew of  consumer depository bank failures, the likes of which has not been seen since the savings and loan crisis of the 1980s. In most bank failures, the FDIC is appointed as receiver for the failed bank, and in many instances the FDIC immediately enters into a Purchase and Assumption (P&A) agreement with a healthy bank to acquire assets of the failed bank and assume its liabilities to depositors. These transactions, often negotiated quickly in the days before a bank failure, allow retail depositors immediate and seamless access to their money and protect the federal deposit insurance fund from depletion. One issue often not clearly addressed by the P&A agreement, however, is the treatment of intracompany deposit accounts. Many bank and thrift holding companies keep their cash in deposit accounts with their subsidiaries. When the holding company files for bankruptcy, as many have done, its deposit accounts often are a critical source of recovery for its creditors.
The FDIC often appears as a putative creditor in a HoldCo bankruptcy case, trying to recover any assets that it may claim title to on behalf of the failed bank and maximize the assets of the receivership. As a result, a HoldCo is often found in a face off with the FDIC as to whether certain assets, such as deposits of the HoldCo, are really assets of the HoldCo, assumed assets/liabilities of the bank purchaser, or somehow subject to claims of title by the FDIC. To that end, the FDIC has become a major player in our nation’s bankruptcy courts over the past few years.
The facts of Colonial are common in the current landscape of failed banks. On August 14, 2009, the Alabama State Banking Department closed Colonial Bank and appointed the FDIC as receiver. On the same day, the FDIC entered into a P&A agreement with BB&T Corp. As part of the P&A agreement, BB&T Corp. assumed liability for the vast majority of Colonial’s deposits. However, the P&A agreement had a clawback provision, Section 9.5, that entitled the FDIC to designate certain deposits for retention by the receivership. The clawback provision found in Section 9.5 of the P&A agreement (which contains language similar to that found in other failed bank sale agreements), permits the FDIC, in its capacity as receiver, to:

in its discretion, determine that all or any portion of any deposit balance assumed by the Assuming Bank pursuant to [the P&A agreement] does not constitute a “Deposit” (or otherwise, in its discretion, determine that it is the best interest of the Receiver or Corporation to withhold all or any portion of any deposit), and may direct the Assuming Bank to withhold payment of all or any portion of any such deposit balance.

In the hurried negotiations, the FDIC specifically carved out certain deposit accounts from the assumed liabilities of BB&T, but there was no carve-out for the deposit accounts of Colonial’s HoldCo.  Shortly after the closure of the bank,  the HoldCo filed for chapter 11 protection and a dispute arose between the FDIC, the HoldCo, and BB&T as to whether the HoldCo’s deposits were assumed by BB&T or remained subject to the FDIC’s clawback rights under Section 9.5. The FDIC filed a motion seeking relief from the automatic stay so that it could exercise alleged setoff rights against the deposits.
In simple terms, setoff is a creditor’s right to cancel mutual debts against the debtor, in full or in part. Bankruptcy preserves the right of setoff under applicable nonbankruptcy law if a creditor is able to show that the debt it seeks to setoff is both prepetition and mutual (same parties, same capacity). 11 U.S.C. § 553. The FDIC argued that it had a right of setoff because either (1) BB&T did not assume HoldCo’s accounts under the P&A agreement (because the FDIC did not intend for those accounts to be part and parcel of the sale), or (2) even if BB&T had assumed the accounts, the FDIC has the right to claw back the deposits under section 9.5 of the P&A agreement, thereby creating mutuality and a right of setoff.
The Bankruptcy Court rejected both of the FDIC’s arguments. First, the Bankruptcy Court found that, although the FDIC had the discretion to exclude the HoldCo’s deposits under the P&A agreements, there was no evidence that it did so – or intended to do so – before HoldCo filed its chapter 11 petition. In contrast, there was “overwhelming evidentiary support” that BB&T assumed liability for HoldCo’s accounts, including that: after the petition date, the accounts were designated as “debtor-in-possession” accounts by BB&T; since the closing of the sale, BB&T included the balances for the accounts in statistics included within its quarterly reports to the Securities & Exchange Commission; and, since the closing of the subsidiary bank, BB&T included the balances of the HoldCo’s accounts in calculating its deposit insurance premiums paid to the FDIC. While the court recognized that the FDIC did have the statutory right under 12 U.S.C. § 1822(d) to offset mutual debt, the debt in question was assumed by BB&T when the P&A agreement was signed, and at that time mutuality ceased to exist. Thus, the Bankruptcy Court held that the FDIC did not have a right to setoff because there was a lack of mutuality as between the FDIC and the HoldCo as BB&T, and not the FDIC, was liable on the accounts to the HoldCo.
Second, the Bankruptcy Court also rejected the FDIC’s attempt to utilize section 9.5 of the P&A agreement to allow for postpetition assumption of the deposits so as to create a prepetition setoff right. While not unsympathetic to the speed under which the FDIC must operate to ensure “seamless operation of the banking system and the confidence of the general public,” the court held that the optionality provided by the clawback provision ended when the bankruptcy of the HoldCo intervened. Once the HoldCo filed for chapter 11, “the FDIC could not, within this universe of time and space, transform its postpetition assumption of the accounts into a prepetition debt.” In other words, once HoldCo filed for chapter 11, the FDIC’s  clawback rights under the P&A could not be used to create a right of setoff.
The FDIC wasted no time in filing an appeal the day after the Bankruptcy Court released its decision. The FDIC clearly recognizes that the effect of a HoldCo bankruptcy on clawback rights under a P&A agreement is an important precedent with implications for many other cases. The FDIC already is appealing an earlier decision in the case in which the bankruptcy court rejected its contention that section 365(o) of the Bankruptcy Code required the HoldCo to satisfy a capital maintenance requirement. Keep an eye on the Weil Bankruptcy Blog for updates as these appeals move forward.