FEDERAL DEPOSIT INSURANCE CORPORATION, PETITIONER V. PHILADELPHIA GEAR CORPORATION No. 84-1972 In the Supreme Court of the United States October Term, 1984 The Solicitor General, on Behalf of the Federal Deposit Insurance Corporation, Petitions for a Writ of Certiorari to Review the Judgment of the United States Court of Appeals for the Tenth Circuit in this Case. Petition for a Writ of Certiorari to the United States Court of Appeals for the Tenth Circuit TABLE OF CONTENTS Opinions below Jurisdiction Statement Reasons for granting the petition Conclusion Appendix A Appendix B Appendix C Appendix D OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-19a) is reported at 751 F.2d 1131. The February 9, 1984 order of the district court (App., infra, 20a-45a) is unreported. JURISDICTION The judgment of the court of appeals (App., infra, 19a) was entered on December 27, 1983. A petition for rehearing was denied on February 19, 1985 (App., infra, 46a). On May 10, 1985, Justice White extended the time within which to file a petition for a writ of certiorari to and including June 19, 1985. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). QUESTION PRESENTED Whether a standby letter of credit is a deposit within the meaning of 12 U.S.C. 1813(l)(1) for purposes of the federal deposit insurance program. STATEMENT 1. The Orion Manufacturing Corporation (Orion) produced drilling equipment. One of its suppliers was respondent, the Philadelphia Gear Corporation. App., infra, 2a. On April 23, 1981, on Orion's application, Penn Square Bank, N.A. (Penn Square), a national banking association doing business in Oklahoma City, Oklahoma, issued a so-called standby letter of credit for the benefit of respondent in the amount of $145,200. /1/ The letter was intended to guarantee that respondent would receive payment for its equipment in the event of a payment default by Orion (App., infra, 5a). To this end, the letter obligated Penn Square to pay Philadelphia Gear upon receipt of the latter's "signed statement that (it) ha(d) invoiced Orion * * * and that said invoices ha(d) remained unpaid" (id. at 3a). As security for this undertaking, Orion executed an unsecured "backup" note in the amount of $145,200 in favor of Penn Square, which the bank would draw upon for reimbursement if it was forced to pay respondent under the letter of credit (id. at 3a, 6a, 23a). Although this condition was not expressed in the note, both Orion and Penn Square "understood that nothing would be considered due on this note nor would interest be charged unless and until (respondent) presented to Penn Square the requisite documents detailed in the letter of credit" (id. at 5a). On July 2, 1982, the Comptroller of the Currency declared Penn Square insolvent, and appointed the Federal Deposit Insurance Corporation (FDIC or Corporation) as its receiver pursuant to 12 U.S.C. 1821(c). Over the next several weeks respondent sought payment from the FDIC in its capacity as receiver (which is distinct from the FDIC's corporate role as insurer of bank deposits) under the letter of credit, citing defaults by Orion that had occurred prior to the bank's failure but that had not been presented to the bank at that time. The FDIC as receiver, however, refused to honor drafts on the letter of credit. App., infra, 4a. Respondent then brought this suit, claiming that the letter was a "deposit" insured by the FDIC under 12 U.S.C. 1813(l)(1), which in relevant part defines a deposit as -- (T)he unpaid balance of money or its equivalent received or held by a bank in the usual course of business and * * * which is evidenced by * * * a letter of credit * * * on which the bank is primarily liable: Provided, That, without limiting the generality of the term 'money or its equivalent', any such account or instrument must be regarded as evidencing the receipt of the equivalent of money when credited or issued in exchange for * * * a promissory note upon which the person obtaining any such credit or instrument is primarily or secondarily liable. As the beneficiary of the letter, respondent maintained that it was a depositor entitled to the statutory maximum of $1000,000 in insurance proceeds (App., infra, 2a, 4a). See 12 U.S.C. 1821. 2. The United States District Court for the Western District of Oklahoma ruled for respondent. The court explained that, "although the letter of credit was not issued in exchange for legal tender, it must be considered as having been issued in exchange for 'money or its equivalent' because it was issued in exchange for Orion's promissory note" (App., infra, 40a; emphasis in original). The district court then found that Penn Square had been "primarily liable" on the letter (id. at 40a-41a). In relevant part, the court of appeals affirmed. /2/ The court premised its opinion on the understanding that Congress had not "explicitly delegated to the FDIC authority to refine the definition of a deposit contained in Section 1813," and that the Corporation had not in any event promulgated regulations "pinpointing Section 1313's precise meaning" (App., infra, 8a). In these circumstances, the court concluded that the FDIC's views on the meaning of the statute were due no special deference (ibid.). /3/ With this understanding of the weight that should be given the FDIC's views, the court began its opinion by holding that Penn Square had received "money or its equivalent" in connection with the letter -- that is, Orion's unsecured back-up note. While the court acknowledged that both Orion and Penn Square understood that "nothing would be considered due on the note" until Orion defaulted and respondent made a proper demand, it nonetheless found that the note was negotiable on its face (App., infra, 6a) and thus, evidently, was by its nature the equivalent of money. And even apart from the negotiability of the note, the court found the "money or its equivalent" aspect of Section 1813(l)(1)'s definition satisfied simply because "(t)he bank's customer had signed a promissory note obligating it to repay advances made by the bank" (App., infra, 6a). Rejecting the FDIC's proposed distinction between commercial and standby letters of credit, the court next concluded that the letter in this case was one on which "the bank (was) primarily liable." Again declining to accord the FDIC deference, the court found that "(t)he liability of a bank issuing a standby letter of credit is nearly absolute," because the bank must pay claims against the letter even if the customer has "ordinary" defenses to payment, such as failure of consideration or fraud in the inducement. App., infra, 10a-11a. "(T)his facet of standby letter liability," the court concluded, "places it closer to the paradigm of primary liability" (id. at 10a). Finally, the court added several further considerations in support of its conclusion. Because it found that a bank's liability under a standby letter of credit is nearly absolute, it reasoned that the FDIC will not have difficulty in determining the amount of the bank's obligations to the Corporation's insurance fund (which are based on total deposits, see 12 U.S.C; 1817). App., infra, 12a. And it noted that Section 1813(l)(1) on its face refers to letters of credit generally, without distinguishing between the different types; because Congress nowhere stated that standby letters should be excluded from the definition, "the plain language dictates the conclusion that these instruments are within the statutory definition of a 'deposit.'" App., infra, 13a. /4/ REASONS FOR GRANTING THE PETITION The court of appeals' decision is based on several fundamental misconceptions. Its holding that unfunded standby letters of credit are deposits within the meaning of Section 1813(l)(1) disregards both economic reality and the purposes of the Federal Deposit Insurance Act: the decision affords the benefits of federal deposit insurance to the beneficiary of a financial instrument that sinply does not represent deposited funds. In so doing, the court entirely disregarded the settled views of the agency that for some 50 years has applied the current statutory definition of the term "deposit." Despite its illogic, the decision below will have immediate, substantial and continuing effects on banking and related financial transactions in the United States. It will bring under the FDIC's insurance umbrella the almost $120 billion worth of outstanding standby bank letters of credit, while making banks liable for more than $100 million in additional annual insurance assessments. At the same time, the ruling will play havoc with the multi-billion dollar market in industrial revenue bonds, which may lose their tax exempt status if backed by an FDIC-insured letter of credit. In these circumstances, immediate review by this Court of the question presented here is appropriate. 1. At the outset, the court of appeals erred in concluding that it was entirely free to disregard the FDIC's views on the meaning of the statutory term "deposit." The court flatly asserted that the Corporation's views were entitled to no special deference here. In fact, however, the FDIC is the agency that for 50 years has administered the statutory provisions at issue, and Congress plainly has indicated that the FDIC's interpretation of Section 1813 must be accorded the greatest deference. See 12 U.S.C. 1813(l)(5) and 1819 Tenth. As a general matter, this background suggests that the agency's views must be given "controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute." Chevron U.S.A. Inc. V. Natural Resources Defense Council, Inc., No. 82-1005 (June 25, 1984), slip op. 5. But beyond that, on the particular question in this case, the legislative history indicates that the FDIC's construction of the statute should be dispositive. The definition of "deposit" that now appears in Section 1813(l)(1) was first used in a 1935 FDIC regulation issued pursuant to the Banking Act of 1935, ch. 614, 49 Stat. 484 et seq. /5/ The Corporation's Regulation I was in all relevant respects identical to the current Section 1813(l)(1), providing that "(t)he term deposit shall include * * * letters of credit on which the bank is primarily liable" when those letters are issued "(f)or money or its equivalent" or for "a charge against a deposit account." Regulation I further provided that such instruments would be deemed to have been issued for money or its equivalent when present "in exchange for * * * promissory notes upon which the person procuring the instrument is primarily liable." 12 C.F.R. 301 and 301.1(d) (1939). Although the language of Regulation I, like that of the current statute, did not in terms exclude unfunded standby letters of credit from the definition of deposit, from the moment of the regulation's promulgation the FDIC informally but consistently declined to treat such instruments as deposits. Immediately after the regulation went into effect, for example, an FDIC official explained its meaning to banking officials and auditors as follows: If your letter of credit is issued by a charge against a depositor's account or for cash and the letter of credit is reflected on your books as a liability, you do have a deposit liability. If, on the other hand, you merely extend a line of credit to your customer, you will only show a contingent liability on your books. In that event no deposit liability has been created. Transcript of Notes Taken at a Special Meeting of N.Y. Bank Comptrollers and Auditors Conference 25-26 (Sept. 27-28, 1935), quoted in FDIC v. Irving Trust Co., 137 F. Supp. 145, 161 (S.D.N.Y 1955). From 1935 until the time of the decision below, the FDIC accordingly never has assessed insurance premiums on letters of credit of the sort at issue here -- and never has paid out on insurance claims relating to such letters -- because it has not treated them as deposits. Although the Corporation's interpretation was by then a long-standing one, Congress did not disturb Regulation I when, in 1950, it substantially overhauled the federal deposit insurance program. See Federal Deposit Insurance Act of 1950, ch. 967, 64 Stat. 873 et seq. Indeed, Congress in 1960 incorporated Regulation I's language concerning letters of credit and promissory notes directly into what is now Section 1813(l)(1). Although the FDIC's general regulatory approach was called to the attention of Congress at that time (see Federal Deposit Insurance Assessment: Hearings on H.R. 12465 Before the Senate Comm. on Banking and Currency, 86th Cong., 2d Sess. 50 (1960) (statement of William G. Loeffler); Federal Deposit Insurance Act: Hearings on H.R. 8916 and H.R. 8928 Before the House Comm. on Banking and Currency, 86th Cong., 2d Sess. 112-113 (1960) (statement of Royal L. Coburn)), absolutely nothing in the legislative history of the 1960 amendment expresses congressional dissatisfaction with, or an intent to depart from, the FDIC's application of Regulation I. To the contrary, the 1960 legislation was designed principally to simplify the determination of assessments owed by FDIC-insured banks. See S. Rep. 1821, 86th Cong., 2d Sess. 1 (1960). This legislative background strongly suggests that Congress affirmatively intended to endorse the FDIC's treatment of unfunded standby letters of credit: "once an agency's statutory construction has been 'fully brought to the attention of the public and the Congress,' and the latter has not sought to alter that interpretation although it has amended the statute in other respects, then presumably the legislative intent has been correctly discerned." United States v. Rutherford, 442 U.S. 544, 554 n.10 (1979). See Lorillard v. Pons, 434 U.S. 575, 580-581 (1978). And Congress did more here than decline to disturb the agency's views; it actually incorporated those views into the statute. /6/ At the very least, the factors at work here present the clearest imaginable case for deference to the FDIC. The Corporation developed the statutory language (see Miller v. Youakim, 440 U.S. 125, 144 (1979)); the interpretation at issue involved a contemporaneous construction of that language (see Zenith Radio Corp. v. United States, 437 U.S. 443, 450 (1978)) that has been followed for 50 years; Congress has expressed no dissatisfaction with the Corporation's approach, despite congressional amendment of the controlling statute (see Lorillard, 434 U.S. at 580-581); and, of course, Section 1813(l)(1) is a central portion of a complex regulatory scheme that the FDIC is charged with administering (see Board of Governors v. Investment Company Institute, 450 U.S. 46, 56 & n.21 (1981)). In these circumstances, the court of appeals could appropriately have rejected the FDIC's approach only if it found "compelling indications that (the approach) is wrong." Red Lion Broadcasting Co. v. FCC, 395 U.S. 367, 381 (1969). 2. There are no such indications in this case. To the contrary, the FDIC's interpretation of the term "deposit" is the only one that is faithful both to the statutory language and to the congressional purpose. The federal deposit insurance program, of course, is intended "to prevent the destruction of deposits because of bank failure and to protect depositors against loss." S. Rep. 1821, supra, at 2. And because it is only a "customer who delivers his own funds to the bank (who) risks their total or partial loss if the bank should suspend operations" (Irving Trust, 137 F. Supp. 15 162), Congress has provided that insured deposits basically are defined as "money or its equivalent received or held by a bank." 12 U.S.C. 1813(l)(1); see 12 U.S.C. 1813(l)(2)-(5). If the bank's customer has not entrusted the bank with anything of value, then, there is no deposit in existence that warrants the protection of federal deposit insurance. a. Section 1813(l)(1) provides that an instrument must be regarded "as evidencing the receipt of the equivalent of money" when a bank issues it in exchange for, among other things, a "promissory note"; the court of appeals in this case held that the unfunded letter here in dispute fell within this proviso because Penn Square issued it in exchange for Orion's unsecured back-up note. But the Orion note plainly was not a "promissory note" of the type that Congress intended to describe when it enacted Section 1813(l)(1). In reality, the standby letter functioned as a line of credit that Penn Square offered to its customer, Orion, for the benefit of respondent; as such, the letter had to be included in Penn Square's calculation of its statutory lending limits. See, e.g., 12 C.F.R. 208.8(d)(2) and 337.2(b). Orion's backup note served simply to secure this undertaking. Under the controlling understanding between Orion and Penn Square (see App., infra, 5a-6a), the liability evidenced by the note was wholly contingent -- through the note, Orion simply undertook to repay a debt that might arise in the future if certain contingencies occurred -- so that the note created no present indebtedness and bore no interest. Such a contingent instrument is in no economic sense the equivalent of money. Neither Orion nor respondent deposited any funds with or obligated themselves to entrust anything of value to the bank when Orion obtained the note. And because the note did not represent an existing debt, Penn Square could not realistically expect to obtain value for it. Thus, Penn Square at no point during the transaction functioned as a depository and Orion at no point had its "own funds (at) * * * risk ( ) * * * (had) the bank * * * suspend(e)d operations;" Irving Trust, 137 F. Supp. at 162. In these circumstances, treating the letter of credit secured by Orion's back-up note as an insured deposit would frustrate the purposes of the federal deposit program and provide respondent with a windfall, because nothing of value ever was deposited with Penn Square. That the Orion note was not a "promissory note" within the meaning of Section 1813(l)(1) is strongly corroborated by the other terms of the statute. The proviso to the Section states that an instrument (such as a letter of credit) "must be regarded as evidencing the receipt of the equivalent of money" when issued in exchange for a promissory note or for "checks or drafts * * * or for a charge against a deposit account, or in settlement of checks, drafts, or other instruments forwarded * * * for collection." All of these instruments have a substantial present value, and all represent unconditional obligations. Obviously, the inclusion on this list of an unsecured back-up note would have been highly anomalous. Cf. Fedorenko v. United States, 449 U.S. 490, 512 (1981). That Orion and Penn Sauare chose to use the statutory term by labelling their instrument a "promissory note" should not change this conclusion, for the purpose and structure of the statute make it plain that the nature of the note at issue, rather than its title, should control its treatment for insurance purposes. /7/ Indeed, it appears that the drafters of Regulation I would not have understood a contingent note to be a "promissory note" within the ordinary meaning of that term. See, e.g., Gilman v. Commissioner of Internal Revenue, 53 F.2d 47 (8th Cir. 1931) (instrument is not a promissory note if there is no unconditional commitment to pay on it). This conclusion also should not be affected by the court of appeals' finding (see App., infra, 6a) that the Orion note was negotiable on its face because the conditions attached to Orion's liability were not addressed in the note itself. That the note may in a technical sense have been a negotiable instrument hardly answers the question whether it was the equivalent of money for purposes of the federal deposit program. Given the agreement between the parties, Penn Square obviously could not have negotiated the note against Orion until the bank actually advanced funds to respondent. And while Penn Square conceivably could have sold the note fraudulently to an innocent third party, it is difficult to believe that Congress intended to define as "money or it equivalent" an instrument that becomes valuable only when used unlawfully. In any event, whether a particular note is negotiable has nothing to do with the purpose of the deposit insurance program: protecting funds that depositors have entrusted to banks. Here, it is undisputed that no such funds were deposited. b. While the court of appeals relied primarily on the promissory note proviso to Section 1813(l)(1) in finding that the letter of credit here was issued for money or its equivalent, the court also noted that, under the plain language of the statute, a deposit includes the equivalent of money "received or held by a bank * * * which is evidenced by * * * a letter of credit * * * on which the bank is primarily liable." Because a letter of credit is involved in this case, the court concluded that the instruments here "are within the statutory definition of a 'deposit'" (App., infra, 13a). But in reaching this conclusion the court of appeals entirely disregarded the first portion of the statutory definition, for here the bank did not receive money or its equivalent in exchange for the standby letter; it received only the contingent back-up note. This distinction has been accepted by the Sixth Circuit, which has held that a purchase and assumption transaction effected by the FDIC in certain failed bank siutations (see 12 U.S.C. 1823(c)(2)(A)) does not transfer liability for standby letters of credit because such instruments are "contingent liabilities" that are supported by "contingent assets" (In re F & T Contractors, Inc., 718 F.2d 171, 181 (1983)) -- an analysis that cannot be reconciled in principle with the decision below. Indeed, as we have noted, for regulatory purposes standby letters of credit issued for the account of bank customers are aggregated with loans from a bank (see, e.g., 12 C.F.R. 208.8(d)(2) and 337.2(b)), rather than with deposits received by the bank. /8/ In any event, there is a basic difference between a standby letter of credit and the other instruments listed in the first portion of Section 1813(l)(1). That portion of the statute provides that the term "deposit" means "money or its equivalent received or held by a bank * * * which is evidenced by its certificate of deposit, * * * or a check or draft drawn against a deposit account and certified by the bank, or a letter of credit or a traveler's check on which the bank is primarily liable." With the exception of letters of credit, the various listed instruments create unconditional liability of a certain value. A bank becomes liable to pay on a letter of credit only when certain conditions are met, however -- and the general expectation is that, in the usual situation, the bank never will become liable on a standby letter of credit. See note 1, supra. In these circumstances, "the essential test (of whether a letter of credit is a deposit) is whether the funds involved are those of the customer himself or funds of the bank which have been made available to the customer under a loan"; it is only in the first situation that the customer risks the loss of "his own funds * * * if the bank should suspend operations before they are paid out to the beneficiary or returned to the customer." Irving Trust, 137 F. Supp. at 162. A standby letter of credit thus cannot evidence the receipt of money or its equivalent, /9/ and the fundamental error of the court below was its conclusion to the contrary. c. The court of appeals erred for a second reason as well in rejecting the FDIC's conclusions here. A letter of credit may represent a deposit only if it was issued for the equivalent of money and if the issuing bank was "primarily liable" on it. As we have shown, the letter in this case was not issued for the equivalent of money. And Penn Square -- like any bank issuer of a standby letter of credit -- was not in any event primarily liable on the letter within the meaning of Section 1813(l)(1). While there are some ways in which a standby letter of credit differs from a simple guaranty or performance bond (see Comment, The Independence Rule in Standby Letters of Credit, 52 U. Chi. L. Rev. 218, 223-224 (1985)), there is little doubt that such a letter is "closely akin to a suretyship or guaranty contract." Colorado National Bank v. Board of County Commissioners, 634 P.2d 32, 37 (Colo. 1981). Indeed standby letters often are discribed as "guaranty" letters of credit (see, e.g., Kimball & Sanders, Preventing Wrongful Payment of Guaranty Letters of Credit -- Lessons From Iran, 39 Bus. Law. 417 (1984); Verkuil, Bank Solvency and Guaranty Letters of Credit, 25 Stan. L. Rev; 716 (1973)) because "(t)he bank is, in essence, secondarily liable (on a standby letter), a conceptual distinction that separates the guaranty letter of credit from traditional letters of credit." Id. at 725. That distinction is readily apparent here: the letter issued by Penn Square indicated on its face that respondent was required both to provide invoices and to attest to Orion's default before the bank became liable. Viewed in this light, the court of appeals' analysis of the primary liability issue, which looked to the type of defenses that could have been asserted by Penn Square in the event of a claim by respondent, is largely beside the point. /10/ The purpose of a standby letter of credit is to guarantee payment of an underlying debt, on which the customer -- in this case Orion -- is primarily liable. And absent fraud or other unusual circumstances, the bank's liability is in fact contingent on the customer's default. The court of appeals' finding that Penn Square was "primarily liable" on the letter in this case therefore entirely disregards the purpose of a standby letter of credit. Indeed, the court's analysis would appear to make issuing banks "primarily" liable on all letters of credit, a reading that would make the statute's use of that limiting term meaningless. In these circumstances, the FDIC's conclusion that banks are primarily liable on commercial but not on standby letters of credit plainly is reasonable. Cf. 12 C.F.R. 208.8(d)(2) and 337.2(b) (standby and commercial letters of credit accorded different treatment for purposes of bank lending limits). 3. The decision below will have an immediate and significant effect on the regulation of the banking industry and, potentially, on each of the nation's FDIC-insured banking institutions. Most obviously, the court of appeals' ruling would for the first time accord insurance coverage to the approximately $120 billion in outstanding standby letters of credit -- a development that would increase the aggregate domestic deposits held by FDIC-insured banks by some 9%, while proportionately reducing the ratio of the FDIC's insurance fund to deposits outstanding. /11/ Moreover, because bank failures are not an altogether uncommon occurrence, /12/ a decision that permits additional creditors to make insurance claims can be expected to impose significant new demands on the FDIC. This development is particularly troubling given the standby letter of credit's essential character as a loan to the bank's customer; as this case demonstrates, the court of appeals' decision potentially makes the federal government the guarantor of business transactions that are financed by standby letters of credit. While aspects of this problem may be ameliorated over time through the payment by insured banks of increased insurance premiums to the FDIC, those premium adjustments in turn would impose significant new burdens on banking institutions. The FDIC generally assesses contributions to its insurance fund at 1/12 of 1% of a bank's deposits (see 12 U.S.C. 1817(b)); given the current volume of unfunded letters of credit outstanding, the FDIC would be forced to collect additional annual assessments of approximately $100 million. Indeed, the FDIC's discretionary authority to charge back assessments for a four-year period (see 12 U.S.C. 1817(g)) could make banks liable for a one-time payment (including interest) of close to $400 million. By thus increasing the cost of standby letters of credit, this development could put American banks at a serious disadvantage vis-a-vis foreign or other non-insured institutions in arranging standby letter of credit transactions. See, e.g., Quint, Bank Credit Rulings Cause Concern, N.Y. Times, Fed. 18, 1984, at D1. /13/ Moreover, the effects of the decision below are not confined to the banking industry; the Tenth Circuit's ruling also has significant implications for the bond market. Under the Deficit Reduction Act of 1984, Pub. L. No. 98-369, 98 Stat. 494 et seq., so-called industrial revenue bonds -- which include many municipal bonds -- are exempt from federal tax unless they are guaranteed by the federal government. Such bonds are viewed as federally guaranteed if, among other things, they are "invested (directly or indirectly) in federally insured deposits." Pub. L. No. 98-369, Section 622, 98 Stat. 919. The decision below suggests that the many billions of dollars worth of such bonds that are backed by standby letters of credit (see Quint, supra, at D4) may be viewed as federally guaranteed, and therefore as not tax exempt. While the Internal Revenue Service recently announced that it will give "grandfather" tax exempt status to all standby letter of credit industrial revenue bond transactions issued by December 31, 1985, the uncertainty created by the court of appeals' ruling is threatening to disrupt the extraordinarily sensitive market in tax free bonds. And again, this development may give foreign or other non-insured institutions an advantage in the financing of such bond offerings. Ibid. /14/ CONCLUSION The petition for a writ of certiorari should be granted. Respectfully submitted. CHARLES FRIED Acting Solicitor General RICHARD K. WILLARD Acting Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General CHARLES A. ROTHFELD Assistant to the Solicitor General ANTHONY J. STEINMEYER ROGER CLEGG Attorneys JOHN C. MURPHY, JR. General Counsel LAWRENCE F. BATES Counsel RALPH E. FRABLE Senior Attorney JANE ROSSOWSKI Attorney Federal Deposit Insurance Corporation JUNE 1985 /1/ A standby letter of credit functions as a guarantee mechanism in which the issuing bank (the "issuer") undertakes to pay a third party (the "beneficiary") in the event that the bank's customer does not itself make payment to the beneficiary when due. The issuer generally must make payment on the letter when the beneficiary presents documents establishing the customer's default. See generally Comment, The Independence Rule in Standby Letters of Credit, 52 U. Chi. L. Rev. 218, 219-220, 222-226 (1985). Such letters typically are unfunded (that is, they are not supported by funds on deposit with the bank), because banks do not anticipate having to pay out on them; the customer simply guarantees that the bank will be reimbursed if it is forced to pay out on the letter. In contrast, traditional "commercial" letters of credit are not contingent on a default. They function as a payment mechanism; in the typical case, the letter will obligate the issuing bank to pay the seller of goods upon the presentation of a bill of lading indicating that the seller has made delivery to the buyer, the bank's customer. See id. at 218-219. Such letters generally are backed (or funded) by the customer's placement of funds into an account in the issuing bank in an amount sufficient to pay the seller. See U.C.C. Section 5-117, official comment (1985); Resnick, The Risky New Wrinkles in Letters of Credit, N.U. Times, Nov. 11, 1984, Section 3, at 8-9. See generally Verkuil, Bank Solvency and Guaranty Letters of Credit, 25 Stan. L. Rev. 716 (1973). /2/ The court of appeals overturned the district court's award of prejudgment interest to respondent (App., infra, 15a-16a). /3/ Although these statements were made during the course of the Tenth Circuit's analysis of "primary liability" (see pages 5-6, infra), the court's view on the FDIC's regulatory role presumably affected its holding on the other issues in the case as well. Indeed, in the discussion of the other issues the court failed even to suggest that the FDIC has special expertise in interpreting Section 1813(l)(1). /4/ The court also rejected the FDIC's argument that respondent's claims were unrecorded contingent liabilities (see 12 U.S.C. 1822(c)), holding that the claims were provable because they were in existence prior to insolvency and were certain at the time that the beneficiary sued the bank's receiver (App., infra, 14a-15a). That conclusion is not challenged here. /5/ That statute defined a deposit as "the upaid balance of money or its equivalent received by a bank in the usual course of business and for which it has given or is obligated to give credit to a commercial, checking, savings, time or thrift account, or which is evidenced by its certificate of deposit, and trust funds held by such bank whether retained or deposited in any department of such bank or deposited in another bank, together with such other obligations of a bank as the board of directors (of the FDIC) shall prescribe by its regulations to be deposit liabilities by general usage." 49 Stat. 685-686. /6/ Indeed, Congress very recently reaffirmed its long-settled view that standby letters of credit are not insured deposits within the meaning of Section 1813(l)(1). The Deficit Reduction Act of 1984, Pub. L. No. 98-369, 98 Stat. 494 et seq., provides that industrial revenue bonds lose their tax exempt status if they are "invested (directly or indirectly) in federally insured deposits." Pub. L. No. 98-369, Section 622, 98 Stat. 919. A bond is not viewed as federally guaranteed, however, "solely because a financial institution guarantees repayment of the loans (to financial institutions) other than by means of federal deposit insurance (e.g., by a letter of credit)." Joint Comm. on Taxation, 98th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 at 941 (Comm. Pring 1984). Thus, it is still the congressional view that standby letters of credit (that is, those used to guarantee payment) are not federally insured. /7/ Similarly, it is not significant that the controlling conditions that made the note contingent were spelled out in a separate agreement between Orion and Penn Square, rather than on the face of the back-up note itself. Any other conclusion would allow the parties to such agreements to obtain federal insurance for their transactions simply by engaging in clever drafting. /8/ While a bank's deposits must be set forth on the liability side of its balance sheet, standby letters of credit must be disclosed only in the "general notes" to the sheet. See 12 C.F.R. 117.7(c)(9)(viii), 11.44, 206.7(e)(12)(vii), 335.621, 335.627. /9/ This distinction has been recognized by the Federal Reserve Board, which has excluded from its definition of "deposit" those obligations "that represent( ) a conditional, contingent or endorser's liability." 12 C.F.R. 204.2(a)(2)(i). /10/ Indeed, that analysis might not even have been accurate on its own terms. Looking generally to law concerning traditional commercial letters of credit, the court concluded that Penn Square's liability on the letter here was "nearly absolute" (App., infra, 10a), whatever the state of the underlying transaction between respondent and Orion. But application of this rule may well be improper in cases involving standby letters of credit, because "the rule distorts the 'bargain-in-fact' between the parties to the underlying contract by requiring the bank to pay even when the customer has not in fact breached (his) contract (with the beneficiary)." Comment, 52 U. Chi. L. Rev. at 228-229. See Note, "Fraud in the Transaction": Enjoining Letters of Credit During the Iranian Revolution, 93 Harv. L. Rev. 992, 1011-1013 (1980). /11/ The figures estimating the amounts involved have been provided to us by the FDIC, and are derived from its annual reports and published statistics on banking, and from call reports submitted to the FDIC by banking institutions. /12/ The FDIC reports that in the years 1982-1984 there were 179 bank failures in the United States. Through mid-June. there were 47 bank failures in 1985. /13/ In addition, depending upon the required accounting method, treating standby letters of credit as deposits could increase bank capital requirements. FDIC-insured banks are required to maintain a minimum level of capital as a ratio to assets. If banks must carry standby letters of credit on their books as deposits, total bank assets will be increased; as a result, banks will be required to carry additional capital. See generally 50 Fed. Reg. 11128 (1985) to be codified at 12 C.F.R. 325. The FDIC estimates that, in the aggregate, this development could increase bank capital requirements by as much as $6.5 billion. /14/ Because the decision below imposes new demands on the federal deposit insurance program and is disrupting the national market in industrial revenue bonds, we believe that review by this Court is warranted despite the absence of an existing conflict in the circuits on the question presented. Briefing on a case involving similar issues recently was completed in the Sixth Circuit (Allen V. FDIC, No. 85-5003) in a suit growing out of the failure of Knoxville's United American Bank. Because the default in Allen occurred six months after the bank's failure, however, the Sixth Circuit could rule for the FDIC simply by holding that a deposit obligation cannot be created by events occurring after the failure of a bank -- a holding that would not conflict directly with the decision below. We are now aware of any other cases pending in the courts of appeals presenting similar issues. APPENDIX