Collateralization of public deposits.

Growing concern over a federal court decision handed down more than a year ago has prompted the Government Finance Officers Association (GFOA) to take the lead in advising state and local government depositors to follow the procedures necessary to ensure compliance with the federal statute governing collateralized security interests and to call for federal statutory changes. At its recent annual conference, the association passed a policy statement reminding those responsible for public unit deposits about the importance of complying with the requirements of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). FIRREA mandates that certain steps be taken to maintain an enforceable security interest in collateral pledged to secure deposits against the receiver of a failed financial institution. Also recommended by GFOA are changes in the FIRREA statute itself as it relates to these requirements.

North Arkansas v. Barrett

In April 1992, the U.S. Court of Appeals for the Eighth Circuit handed down its decision in North Arkansas Medical Center v. Barrett, 962 F.2d 780 (8th Cir. 1992). While the facts in the case are somewhat unclear, the essential elements are as follows: the North Arkansas Medical Center (NAMC) had, over a period of time, placed almost $1 million in deposits with Guaranty Savings and Loan Association (Guaranty). Because this amount exceeded the $100,000 coverage provided under federal deposit insurance, collateral was pledged by Guaranty to secure the uninsured funds. Guaranty subsequently sold the collateral without the knowledge of NAMC. NAMC's release of the collateral was obtained later, and substitute collateral was designated by Guaranty. The collateral was held by a third-party custodian.

Soon thereafter, Guaranty was placed in receivership and the Federal Deposit Insurance Corporation (FDIC) ultimately became the receiver. NAMC brought an action to recover its funds based on its collateralized security interest. The district court dismissed NAMC's complaint, and the Eighth Circuit affirmed that decision.

The court's decision focused on the provisions in FIRREA, particularly Section 1823(e) of Title 12 of the U.S. Code, specifying the requirements that must be satisfied if an asset acquired by the receiver of a failed institution is to be subject to the claims of a depositor based on a security interest. By the terms of the statute, a valid security agreement 1) is in writing, 2) was executed by the depository institution and the entity making the claim contemporaneously with the acquisition of the asset, 3) was approved by the board of directors or loan committee of the institution and reflected in the minutes of that group, and 4) has been an official record of the institution continuously from the time of its execution. Section 1823(e) is a codification of law previously set out in D'Oench Duhme & Co. v. FDIC, 315 U.S. 447 (1942). The decision in that case applied the federal common law to protect the FDIC from the effect of a secret agreement regarding a debtor's note.

The court in North Arkansas held that the statutory requirements were not met because the pertinent documents were not executed contemporaneously with Guaranty's acquisition of the asset and there is no evidence that any security agreement regarding these assets had been approved by Guaranty's directors or loan committee. The court declined to decide whether or not the perfection of a security interest is relevant to the determination of the claim.

The Court of Appeals also declined to consider whether a creditor in this situation may have rights other than those of other creditors sharing in the pro rata distribution of assets of a failed institution. This leaves intact the District Court decision that the creditor is in the same position as other pro rata distributees.

FDIC Position and Policy

Representatives of the FDIC met with members of GFOA's Committee on Cash Management in January to address concerns expressed by GFOA in light of the North Arkansas decision regarding the safety of collateralized public funds. The FDIC indicated that it believes the factual circumstances in this case to be unusual and pointed out that no similar decisions have been handed down. The FDIC has consistently held that it must be able to determine from its examination of the records of a failed institution what the obligations and assets of that institution are. Any agreements that may exist outside the records maintained by the institution will not be considered. Given the existence of an agreement, however, the fact that it may not have been executed at precisely the same time that an asset was acquired is not of primary concern to the FDIC as long as the other requirements of Section 1823(e) have been met.

In response to questions from public entities, the FDIC provided as guidance two advisory opinions issued by its current and former general counsels. These opinions, issued in 1989 and 1991, expressed the position of the FDIC that, subject to certain assumptions about the transaction, it would not seek to avoid a security interest in collateral based only on the fact that its execution did not occur contemporaneously with the acquisition of the collateral or because the collateral may change from time to time.

Following the meeting with GFOA and conservations with other state and local organizations, the FDIC Board of Directors adopted a policy statement setting forth procedures and guidelines as to how the FDIC, acting in its capacity as conservator or receiver of a failed depository institution, will treat security interests in the assets of that institution. The policy statement, published in the March 31, 1993, Federal Register, emphasizes that both statutory and case law require that, to be "legally enforceable," a perfected security interest must be in compliance with all aspects of the law concerning FDIC's conservator rights, including the requirement that acquisition of collateral be contemporaneous with execution of a security agreement. The FDIC board states, however, that it has previously maintained and now formally adopts a policy that it will not attempt to avoid otherwise legally enforceable and perfected security interests solely because either the agreement does not meet the contemporaneous requirement and/or the collateral may change or be substituted. The FDIC reserves the right to redeem or prepay a secured obligation of an institution by repudiation or otherwise.

Other FDIC considerations in this policy statement include the legal rights and powers of the FDIC, previous assurances provided by staff and the reliance on those assurances by market participants, the desirability for market certainty and stability, and the potential cost of adopting alternative positions or policies. Although a policy statement is not the equivalent of statutory or case law, it is the best indication of the course of action that will be pursued (or not pursued) by the agency and is so recognized by the courts.

Limitations on the FDIC Policy

Despite the formal reassurances from the FDIC, the policy statement only partially addresses the problems arising from the North Arkansas decision and from the FIRREA statute itself. The most obvious concern is the existence of the decision itself. While it is true that no other cases have been similarly decided since this decision was handed down, the ruling now provides ample precedent for federal courts in other circuits to render a like decision. In addition, the legal authority of a federal court decision relative to an agency policy statement clearly gives the edge to the case law, although a court could reasonably be expected to consider the policy statement in its decision.

The FDIC's policy statement itself also has limitations. No discussion of the "contemporaneous" term is included, either as definition or description. Nor is there any discussion or guidance regarding the order of distributees in the event that a security interest is not enforceable.

The FIRREA statute is problematic as well. Even the good faith of the FDIC will be of little help to public depositors if a third-party creditor challenges the enforceability of a security interest that may not strictly meet the requirements of the statute. In order to increase the assets available for distribution to all other creditors, others may try to defeat a collateral agreement that would otherwise confer preferential status on the public unit depositor. A less-than-perfect agreement may enable such an effort to succeed. State and local government customers of financial institutions may be kept in the dark regarding other elements of the statute, such as whether or not the board of directors or the loan committee of an institution has approved the collateral agreement and whether or not the agreement has been maintained continuously as a record of the financial institution.

Protecting Public Deposits

GFOA, as it has in the past, continues to urge state and local government depositors to take action necessary to protect collateralized deposits. GFOA has long endorsed statutes that require financial institutions to collateralize public deposits exceeding the $100,000 federal insurance limits. State statutes governing collateral agreements should be followed closely. The FDIC has indicated that, while compliance with state statutes will not necessarily be sufficient for compliance with the federal law, the failure to comply with state law could allow the security interest to be avoided by the FDIC on that ground alone.

Public depositors can further protect themselves by evaluating a financial institution prior to using it as a depository and attempting to make sure that the officers of that institution follow procedures required to ensure a perfected security interest. Care also should be taken when collateral is substituted to ensure that both the release and the new pledge are properly executed, a step that would have protected the depositors in the North Arkansas case. Finally, finance officers may consult the publications available from GFOA for more details on the prescribed content of collateral agreements and other means to ensure the safety of public funds.

Legislative Proposals

In addition to cautioning public entity depositors to protect public funds, GFOA also is examining legislative changes. As part of a larger effort to reduce regulatory red tape and remove impediments to economic recovery, the American Bankers Association (ABA) and state bankers associations have developed a comprehensive legislative proposal which includes a provision that would ensure that public funds are adequately secured and protected in financial institutions. This legislation has been introduced in the U.S. Senate (S.265) by Senator Richard Shelby (D-AL) and in the House of Representatives (H.R. 962) by Representatives Doug Bereuter (R-NE) and Jim Bacchus (D-FL). The pertinent provision contains language that would make Section 1823(e) inapplicable to the deposit custody or collateralization of funds of public entities. This is one method of addressing the concerns of public depositors responsible for collateralized security interests. Other alternatives may include the clarification or definition of particular terms used in the statute, specification of the relative responsibilities of the institution and the depositor, or elimination of specific requirements.

Outlook

The cooperation of the FDIC in response to the North Arkansas decision and prodding by state and local governments has eliminated some of the concerns of public depositors regarding the enforceability of collateralization agreements with failed financial institutions. This has produced only temporary relief, however. As long as depositors continue to receive federal insurance protection at federally insured financial institutions, they will be required to comply with federal statutes and regulations regarding those deposits. As soon as a federally insured depository institution is declared insolvent and is taken over by a receiver, federal law governs the distribution of the institution's assets. Therefore, while compliance with state statutes and recommended procedures is necessary, public depositors must be cognizant of federal requirements as well in order to protect their entity's funds.

This same federal responsibility also means that limitations on the protection of collateralized funds must be removed by changes in federal law. The ABA proposal, offered as a means of reducing the "credit crunch" in order to encourage the release of deposited funds for local investment, has been supported in concept by the Clinton administration. There is no administration position, however, on the specific legislation or on the specific collateralization provision in the bill. GFOA intends to continue its two-tracked effort of educating public depositors while working for legislative changes to fully protect public funds.

Author BETSY DOTSON is assistant director of CFOA's Federal Liaison Center.