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How secure are letters of credit?

Among the various kinds of security that local governments require of developers to guarantee the completion of public improvements, letters of credit have enjoyed a number of advantages--until recently, when financial institutions have failed and the Resolution Trust Corporation has become the receiver.

Besides the recession's often discussed local government problems of revenue declines and budget shortfalls, the economic downturn has aggravated a less noticed problem. What should be done about the increasing volume of public improvements left uncompleted by developers who either have been forced out of business or are close to bankruptcy?

When their subdivisions were platted, citizens were promised roads, water, sewers, stormwater systems and more. Local governments have had to search for ways to ensure that, should it become necessary, nontax funds will be readily available for the governments themselves to complete these promised public improvements.

Typically, local jurisdictions require that developers provide security to guarantee that these public improvements will not become a further burden on local resources. A variety of security methods have been used, including: 1) cash escrows deposited with the local government; 2) surety bonds, provided by insurance companies or other corporations; 3) collateralized escrow accounts in financial institutions; and 4) letters of credit (LOCs) issued to local governments by financial institutions on behalf of developers. When economic conditions deteriorate, and developers come under increasing financial pressure, it becomes even more important that the funds to complete public improvements be fully secured.

But hard economic times lead to the increasing likelihood of legal contests with developers, their sureties or their creditors over a local government's right to these funds. Under these conditions, what types of security are best? If a local jurisdiction already has the security in cash form, of course, it is one step closer to being able to utilize these funds.

Pros and Cons of LOCs

Apart from cash deposited directly with a local government, are some forms of security less likely to lead to disputes than others? Surety bonds leave localities open to arguments with insurance companies over interpretation, and may prompt valid concerns about the soundness of particular insurers. Collateral in a financial institution may be subject to setoff by the institution or lawsuits by creditors.

Until recently, an LOC has appeared to many local governments to be perhaps the least vulnerable to obstructive tactics and outright legal assault.

An LOC has advantages because:

1) a presumably neutral and disinterested party provides the security;

2) the issuing institution is much more financially sound than a developer;

3) the security is granted in irrevocable and unconditional terms;

4) when a developer defaults (however the local government may define default in its agreement with the developer), the LOC may be drawn on immediately, up to its face value;

5) under Article 5 of the Uniform Commercial Code, a local government's sight draft must be honored by the issuing institution within three business days; and

6) failure to honor a draft against an LOC could result in a losing lawsuit and damage to the institution's reputation.

A number of difficulties, however, can offset any or all of these advantages.

Neutrality and Bankruptcy. The financial institution that issues an LOC may, in fact, be neither neutral nor disinterested. On the contrary, it may be very involved in the financial affairs of a developer and be its principal lender. The institution, therefore, will be reluctant to have the LOC drawn upon, particularly if the developer's financial difficulties go beyond failure to complete promised public improvements. This may lead to attempts by the institution to defeat the unconditional terms of the LOC.

If the developer has already filed for protection under the bankruptcy laws, the situation worsens because the institution may not be able to offset the value of the LOC against the developer's corresponding balance that it has on deposit. Instead, it may have to join a long line of creditors in bankruptcy court.

As a result, the institution may raise the objection that it cannot honor a local government's sight draft without an order of the bankruptcy court. When bankruptcy papers are filed, an automatic stay of actions against the bankruptcy estate's assets springs into effect. If the LOC were subject to the stay, a court order would be necessary.

Fortunately, the courts so far seem to agree that LOCs are not part of the bankruptcy estate;(1) therefore, they are not affected by the bankruptcy code's automatic stay provisions.(2)

Even when the developer has not yet filed for protection, when the financial institution charges the LOC to the developer's account, it might precipitate a bankruptcy filing. Depending on what other money was owed the financial institution, any draft against an LOC would not be desirable from its viewpoint and might be worth fighting or at least delaying.

Deteriorating Financial Condition. The second advantage of LOCs--the financial strength of the issuing institution--may change dramatically over a relatively brief time, converting this advantage into a major source of concern for local governments.

Looked at from the outside, financial institutions have, at least in the past, often presented an imposing picture of health--until they suddenly collapsed. Nationally, more than 300 federally insured institutions have gone under since January 1990, and former FDIC Chairman William Seidman has forecast several hundred more failures by 1993. Understandably, local governments, as well as the general public, have become more skeptical about the apparent health of these institutions.

Like a potential heart attack victim, a financial institution's internal condition may have been deteriorating undetected for some time, so how can an observer determine when its illness may become terminal?

In Virginia, state law has provided the foundation for a solution.(3) Local governments are permitted by statute to determine whether a bank or savings and loan association is a satisfactory issuer of an LOC. But who is "satisfactory"?

Rating Financial Institutions

One way to get an early warning of deteriorating financial health is through an analysis of the financial statements of the banks and savings and loans with which a local government does business. Unfortunately, very few jurisdictions have the in-house expertise needed to effectively evaluate the financial condition of these institutions.

There are commercial rating systems that can help a local government to critically assess the health of banks and savings and loans. In some instances, ratings are based on Reports of Income and Condition that must be filed quarterly with federal regulators by all FDIC-insured institutions. Federal regulatory agencies, as well as some commercial rating systems, utilize these quarterly reports to analyze insured institutions. A series of ratios relating to capital adequacy, asset quality, earnings strength and liquidity level is typically employed. Sometimes a weighted, summary rating also is provided.

A clear statistical relationship appears to exist between financial institution failures and low rating levels. All but a few financial institution collapses over the past several years have occurred only when banks and savings and loans have dropped below relatively lenient benchmark standards.

The Resolution Trust Corporation

But the major concern about an institution's financial condition is not that it may not be able to fund an LOC. In most cases, the biggest worry is what the Resolution Trust Corporation (RTC) will do once it has become the receiver for a failed institution.

Typically, the RTC disaffirms outstanding LOCs under the unusual authority granted it by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). Under this Act, the RTC, as receiver, "may disaffirm or repudiate any contract. . .the. . .receiver. . .determines to be burdensome; . . .the disaffirmance. . .of which. . .the receiver. . .determines. . .will promote the orderly administration of the institution's affairs."(4)

Although a local government may be the beneficiary of an LOC, this fact does not exempt this instrument from the RTC's sweeping power of disaffirmance. In a RTC takeover, such an LOC is not treated as the equivalent of public funds deposited in the institution, but is simply another contingent, and disavowable, contractual liability of the issuing bank or savings and loan.

If a local government is compelled, as a result of the RTC's disaffirming an LOC, to provide funds for completion of a subdivision's public improvements, what recourse does it then have against the RTC?

Claims for damages resulting from repudiations are permitted under the law.(5) Such claims, however, get entangled in technical requirements, which complicate things further.(6) A statute that establishes particularly difficult requirements is Section 1823(e) of Title 12, United States Code.(7)

The statute largely codifies the holding by the Supreme Court in D'Oench, Duhme & Co. v. FDIC (1942).(8) This decision requires an agreement that is the basis of a claim against the FDIC (or in this discussion, the RTC) to be: 1) in writing, 2) executed by the institution and the obligor, 3) approved by the board of directors of the institution, or its loan committee, and reflected in their minutes; and 4) an official record of the institution.

This multipart test is one that almost all LOCs would fail in some respect. It is worth noting, however, that in one recent case, Agri Export Co-operative v. Universal Savings Association (1991), the court permitted recovery against the RTC.(9) It did so on the grounds that an LOC was not an agreement concerning an asset, and therefore was not covered by either D'Oench or Section 1823(e).

Whether other courts will follow this approach is difficult to say. What is clear is that this technical issue will no doubt be the basis for future legal disputes.

Recovering damages against the RTC for disaffirming an LOC seems certain to continue to be extremely difficult, if not impossible. For most jurisdictions, the cost of pursuing a legal action against the RTC is prohibitive and, in view of the long odds against success, probably not worth the effort. A primary objective, therefore, becomes how to avoid getting into a probably losing argument with the RTC.

Becoming More Secure

This discussion has raised significant questions about the level of security offered by LOCs. Nevertheless, other than cash, an LOC, with all its problems, is still probably better security than any of the alternatives available. But this is not a terribly strong statement in light of the potential difficulties that have been reviewed here.

Recently, several local governments in Virginia have addressed the basic issue of possible financial institution insolvency. In July 1991, for example, the government of Stafford County, Virginia, took a major step toward assuring the security of funds for public improvements. The county amended its security policy to establish a benchmark standard of minimum financial acceptability for banks and savings and loans that issue LOCs for the county's benefit. This standard was based on analyses provided by one of the commercial rating systems previously described.(10)

Using a system employing a scale of 0 to 100, with 100 being highest, Stafford County adopted a benchmark of 25. Almost all bank and savings and loan failures have occurred only when ratings fell below this level.

Developers active in Stafford County were, of course, informed of the rationale for the change when it was instituted. The policy was then applied prospectively to new or amended LOCs for public improvements in subdivisions.

Over the past year, this policy change has proven its value. Periodic ratings have provided just the early warning system that was needed to help the county gauge the health of the financial institutions with which it deals.

In a number of instances, the county was alerted to the need to draw on existing LOCs because of the threatened failure of the issuer. Subsequently, several of these institutions were in fact taken over by the RTC and outstanding LOCs were disaffirmed. If the county had not acted, it would have faced responsibility for public improvements well into seven figures, without the funds to finance construction.

A few developers, who have been cut off from their usual sources of LOCs because the institutions they do business with were rated below the county's benchmark, have opposed this policy. They have complained that because of the sometimes significant level of risk associated with their proposed subdivision ventures, financial institutions acceptable to the county have been unwilling (particularly in an economic downturn) to provide them with LOCs. Only more marginal banks and savings and loans, they stated, were willing to do so.

A reasonable response to this argument is that these developers have, in essence, made a very strong case for the policy.

Frequently, financial institutions that are approaching insolvency agree to finance higher risk projects in an attempt to recoup earlier losses; thus, the institutions that have been most willing to provide LOCs for more financially marginal developments have often been precisely those most exposed to the risk of failure themselves.

Ultimately, the burden of that risk falls on the taxpaying citizens of the county, who would have to cover the cost of unsecured public improvements. Any potential offsetting slowdown in the rate of development and the growth of the tax base seems more speculative than the certainty that promised roads, water and sewers will have to be provided.

The sounder public policy, therefore, would be to strike the balance between these relatively few developers and their financial institution sureties, on the one hand, and the taxpaying public, on the other, in favor of protecting the taxpayers. This can best be done by taking prudent steps to assure the availability of funds for public improvements.

Without its recent policy of accepting LOCs only from sound financial institutions, Stafford County would have faced considerable financial risk recently. The county's experience suggests that local governments would be wise to adopt a policy that sets out standards for financial institution acceptability. The absence of such a policy may end up creating more financial insecurity than security for citizens and their hardpressed local governments.


1 11 USC 541. In one recent Chapter 11 case, however, Wysko Investment Co. v. Great American Bank, 131 Bankr. 146 (D. Ariz. 1991), the court held that where there are "unusual facts," it had general authority under 11 USC 105 to enjoin payment of an LOC. This case runs counter to almost all court decisions, which uphold payment of LOCs despite bankruptcy filings.

2 11 USC 362.

3 Section 15.1-466.5(iii), Code of Virginia (1950), as amended.

4 12 USC 1821(e)1.

5 12 USC 1821(e)(3)(A).

6 12 USC 1821(d)(9)(A).

7 For a detailed discussion of Section 1823(e), see Stillman, Robert J., "Enforcing Agreements with Failed Depository Institutions: A Battle with the FDIC/RTC Superpowers," in The Business Lawyer, November 1991.

8 315 U.S. 447

9 767 F. Supp. 824 (S.D. Tex.).

10 Several other Virginia governments, including Fairfax and Prince William Counties, have established similar rating-based indicators of general financial condition.

PAUL M. METZGER, of the Stafford County, Virginia, government's financial services department, heads the county's securities management program, among other responsibilities. He is an attorney and also serves as adjunct professor of law and finance at Mary Washington College in Fredericksburg, Virginia. Readers who would like further information about the topics discussed in this article are invited to call Metzger at 703/659-8697. The views expressed in the article are the author's, and do not necessarily represent those of the Stafford County government.
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Author:Metzger, Paul
Publication:Government Finance Review
Date:Oct 1, 1992
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