Expert Views: Breaking The Bank Holding Company: The Extraordinary Power of Bankruptcy Code Section 365(o)
Tue Mar 21, 2023 10:43 am Bankruptcy Filings

Editor’s Note: Below is the latest in Reorg’s Expert Views series: an article written by Martin J. Bienenstock and Vincent Indelicato of Proskauer Rose LLP.

Date originally published: Mon 03/13/2023 02:41 PM GMT

Over the last several days, alternative capital providers have raced to identify new money opportunities exacerbated by distress across the regional banking sector, from bidding on deposit claims to structuring rescue loans for portfolio companies with imminent payroll obligations.

This underwriting exercise inevitably brings into focus one very important question: What happens when a holding company of an FDIC-insured bank subsidiary files for chapter 11?

One answer lies in an obscure and underutilized provision of the Bankruptcy Code, albeit one with outsized powers, and highlights the potential obstacles bank holding company creditors must overcome in a chapter 11 case where the FDIC asserts its priority to holding company assets for the benefit of the bank subsidiary.[1]

Bankruptcy Code Section 365(o): An Exception to the Rule

As a general matter, Bankruptcy Code section 365 empowers a chapter 11 debtor with the sacred right to assume or reject executory contracts and unexpired leases. Bankruptcy Code section 365(o), however, creates an exception to the wide berth of discretion that otherwise facilitates the rejection of burdensome agreements, and instead requires the chapter 11 debtor to assume a capital maintenance commitment to a bank subsidiary.

Congress enacted section 365(o) to “prevent institution-affiliated parties from using bankruptcy to evade commitments to maintain capital reserve requirements of a federally insured depository institution.” Resolution Trust Corp. v. Firstcorp, Inc. (In re Firstcorp), 973 F.2d 243, 246 (4th Cir. 1992) (quoting H.R. Rep No. 681(I), 101st Cong., 2d Sess. 179 (1990), reprinted in 1990 U.S.C.C.A.N. 6472, 6585). Firstcorp remarks further that Congress promulgated Bankruptcy Code section 365(o) to ensure that a bank holding company which has committed to maintain the capital of its federally insured depository subsidiary could not use chapter 11 “to jettison the subsidiary in an effort to enhance its own financial position and that of its creditors, while leaving the federal deposit insurance system (and ultimately the taxpayers) to bail out the capital-deficient subsidiary.” Firstcorp, 973 F.2d at 248.

The text of Bankruptcy Code section 365(o) provides:

“In a case under chapter 11 of this title, the trustee shall be deemed to have assumed (consistent with the debtor’s other obligations under section 507), and shall immediately cure any deficit under, any commitment by the debtor to a Federal depository institutions regulatory agency (or predecessor to such agency) to maintain the capital of an insured depository institution, and any claim for a subsequent breach of the obligations thereunder shall be entitled to priority under section 507. This subsection shall not extend any commitment that would otherwise be terminated by any act of such an agency.”

11 U.S.C. § 365(o). The Bankruptcy Code also recognizes the FDIC as a “Federal depository institutions regulatory agency” for purposes of this statute when the FDIC has been appointed receiver of “an insured depository institution” 11 U.S.C. § 101 (21B)(D).

Importantly, section 365(o) applies only to enforceable commitments, and because the statute does not specify the form or nature of such commitments (i.e., written vs. oral, formal vs. informal), the issue often becomes ripe for litigation. See, e.g., In re Colonial Bancgroup, Inc., 436 B.R. 713 (Bankr. M.D. Ala. 2010) (holding that the debtor did not make a commitment to a “Federal depository institutions regulatory agency” to maintain the capital of Colonial Bank within the meaning of 11 U.S.C. § 365(o), particularly when the bank was no longer operating); Wolkowtiz v. FDIC (In re Imperial Credit Industries, Inc.), 527 F.3d 959 (9th Cir. 2008) (finding a holding company’s performance guaranty of a capital restoration plan gave rise to a maintenance obligation under 365(o)).

Nevertheless, when section 365(o) does apply, the bank holding company debtor must cure the deficit at the federally insured depository institution at 100 cents on the dollar, or convert its chapter 11 case to chapter 7:

“If the holding company is not financially able to satisfy its capital maintenance obligations, then § 365(o) denies it the opportunity to reorganize under Chapter 11, leaving liquidation under Chapter 7 as its only option. Through this mechanism, § 365(o) places the financial interest of the federal deposit insurance system ahead of that of the holding company and its creditors.”

Firstcorp, 973 F.2d at 248. Indeed, the application of section 365(o) would have the effect of subordinating other bank holding company creditors to the FDIC on account of the bank subsidiary. Should the case convert to chapter 7, section 507(a)(9) does not entitle the FDIC to an administrative priority claim, but, rather, to a ninth priority unsecured claim that still comes before general unsecured claims.

Key Takeaways for Distressed Investors

Distressed investors evaluating the potential acquisition of bank holding company securities must proceed with caution when the subsidiary bank remains in extremis. The appearance of a solvent entity today seemingly insulated from the contagion of a cash-deficient bank subsidiary may quickly dim tomorrow if the FDIC files a motion in the early days of a bank holding company chapter 11 case alleging a commitment to maintain the capital of the subsidiary bank as required by Bankruptcy Code section 365(o), or convert the case to a chapter 7 liquidation if the debtor cannot cure the deficiency. At a minimum, such a dispute would necessitate protracted litigation that will consume value and diminish certainty of outcome.

Similar to the question of capital commitment enforceability as required by section 365(o), the interpretation of sharing agreements that allocate tax payments and refunds between the bank holding company and the bank subsidiary also has the potential to impact value allocation and recovery scenarios, while inviting fact-intensive discovery and litigation, an adverse ruling of which, when combined with an allowed 365(o) claim, could take away bank holding company assets for the benefit of the FDIC.

[1] The FDIC also has powers under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, known as FIRREA. These powers include, in certain circumstances, the overriding of bank contracts insufficiently approved and documented, avoiding powers, and entitlements to a portion of the bank holding company’s pension plan surplus.

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