Alert June 10, 2008

Ninth Circuit Rules Against FDIC on Capital Guarantees by Parent Company of Federally Insured Bank

The US Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) ruled against the FDIC on certain issues in a bankruptcy case in which the FDIC sought to collect on a guarantee by Imperial Credit Industries (“Imperial”), the bankrupt holding company for Southern Pacific Bank (“SPB”), of SPB’s performance of a capital restoration plan.  The FDIC demanded that Imperial pay its $18,375,800 obligation under the guarantee after SPB failed to implement its capital plan.  The case is Wolkowitz v. Federal Deposit Insurance Corporation (In re: Imperial Credit Industries Inc.),No. 05‑56072 ( 9th Cir. June 4, 2008).  A central fact impacting the Ninth Circuit’s decision was that Imperial converted from Chapter 11 bankruptcy to Chapter 7 bankruptcy during the course of litigation.

The issues on which the Ninth Circuit ruled against the FDIC were that (1) the district court erred in dismissing Imperial’s claim that the performance guaranty was a fraudulent conveyance, and (2) the FDIC’s claim for the $18,375,800 was entitled only to ninth priority in a Chapter 7 proceeding rather than administrative priority.  These two issues are discussed in turn below.

The Ninth Circuit declined to find Imperial’s fraudulent conveyance claim barred for either of two reasons.  First, the Ninth Circuit found that the claim could not be dismissed as a “trustee defense” that may only be brought by debtors who have cured their deficits to federal depository institutions as required under 11 U.S.C. §365(o), because the obligation to immediately cure deficits applies only to Chapter 11 proceedings and not Chapter 7 proceedings.  In addition, the Ninth Circuit found that the district court had erroneously interpreted 12 U.S.C. §1828(u)(1) in holding that the section did not make a distinction between assets and obligations.  Rather, the Ninth Circuit found that there was such a distinction, and that §1828(u)(1) only prohibits bringing fraudulent conveyance claims against federal banking agencies based on transfers of assets.  The Ninth Circuit rejected the FDIC’s policy argument that limiting §1828(u)(1) to transfers of assets would render performance guarantees effectively unenforceable against insolvent parent companies of federally insured banks.  It noted that it was only deciding on the issue of whether the fraudulent conveyance claim survived dismissal, not whether it would prevail on the merits and that the next step would be to determine whether the performance guaranty was a fraudulent conveyance.  

As a result of converting from Chapter 11 to Chapter 7 bankruptcy, Imperial was able to avoid its obligation to immediately pay the $18,375,800 to the FDIC under 11 U.S.C. §365(o).  The Ninth Circuit noted that §365(o) mandates immediate payment of deficits to federal depository institutions as a condition to Chapter 11 bankruptcy.  If the debtor cannot meet this condition, then it cannot benefit from Chapter 11 reorganization, but must proceed to Chapter 7 where the status of unsatisfied obligations to federal depository institutions under §365(o) would have whatever status was accorded to them under Chapter 7.  The Ninth Circuit held that the FDIC’s claim came within the section granting ninth priority (§507(a)(9)) for several reasons:  (1) because the section has specific language about capital commitments; (2) because it was not an actual, necessary cost of preserving Imperial’s estate and so not within the more general section according administrative priority; (3) because to hold otherwise would result in different outcomes for debtors who filed for Chapter 11 and converted to Chapter 7 from those who filed for Chapter 7 initially; and (4) because the only consequence of failing to immediately cure under §365(o) is that the debtor is prohibited from proceeding under Chapter 11, and not that the claim gets superpriority.

The FDIC is in the process of studying the ruling and has not yet commented on the decision.