Professionally dressed male and female business owners look at a paper and discuss bank failure.

Bank Failure: What Happens and How to Navigate It

The bank failures last month have been a sobering reminder of the risks involved with banking and lending. Yet bank failure is more common than you think and can affect account holders and business parties who become unintentional participants in the process. For example, if you or your company is a borrower from a bank or has a contract with a bank (such as being a landlord to a bank), the failure of that bank may well affect you. 

It is certainly difficult to predict which banks are more likely to collapse. Failures can occur for various reasons, such as mismanagement, risky lending practices, or economic changes. In the United States, the Federal Deposit Insurance Corporation (FDIC) typically steps in to minimize disruptions to depositors and to parties who have contracts with the bank, such as borrowers or landlords. Understanding exactly what is likely to happen if this occurs and what your role should look like will help guide you through the experience.

What Often Happens in the Event of a Bank Failure

Bank Receivership. When an insured bank fails, the FDIC will likely put it into receivership to help recover funds and resume operations. In these cases, the FDIC acts as a third party that can sell the failed bank’s assets to another bank or close out the failed bank altogether. 

In the case of last month’s Silicon Valley Bank (SVB) failure, the FDIC did not dispose of the assets quickly and had to create a “bridge bank” to continue operations temporarily. The powers of the FDIC over the failed bank and its assets remain the same in most, but not all, of these situations.

FDIC Deposit Insurance. To help safeguard against bank failures, the FDIC insures deposits up to $250,000. In the SVB situation, the FDIC protected all deposit amounts even if they exceeded $250,000, but there is no guarantee that such an accommodation will be made in the event of future bank failures. In cases where the FDIC stays within the $250,000 cap on insurance, depositors with accounts above $250,000 will have a claim for that excess against the bank’s assets. That claim will have seniority ahead of all other creditors.

Escrowed Fund Protection. The purpose of an escrow account is to hold funds for a specific purpose, such as to pay property taxes, insurance premiums, or other expenses related to a real estate transaction. If a failed bank is holding any of your funds in escrow, like tax payments, they will be returned to you.

New Faces and Uncertain Relationships. There is a more subtle side to the impacts of bank failure. Most likely, you have developed a relationship with the officers and staff of your current bank and a comfort level to go along with that. They understand your business and your needs. In the case of a failed bank, it is unlikely that any of the old bank’s officers will be installed at the new bank, and there will be many new faces who may want to operate “by the book,” even on simple requests that you had become accustomed to making.

The new bank bought an entire bank, so your piece of the old bank’s portfolio—although vital to you—may not be so important to the new bank. You could be in an industry the old bank was enthusiastic about, but your new bank may be less so. The new bank may decide to exit acting as a lender in your business area or to your financial profile leaving you without an assured lender. This circumstance can happen without a bank collapse. However, in the case of bank failure, this could descend on the industry swiftly, leaving you little time to react. One recent example of this phenomenon is the ongoing uncertainty reflected in press reports as to whether the collapse of SVB will eliminate a major source of funding for affordable housing projects, which was a specialty of SVB and one of its subsidiaries.

Less Default Tolerance. Occasionally you may need favors from your bank: you have a difficult quarter, you might have received overdraft protection or temporary relief from some of your financial formulas. You may have received help for these situations. Unfortunately, the new bank may be less inclined to accommodate you, and you may only learn of its reluctance at the last minute. 

Potential Legal Implications

Repudiation of Contracts and Leases. If you have a contract, such as a lease, with a failed bank, the FDIC, as Receiver, has the right to repudiate any contract within a “reasonable time,” which most experts interpret is within 180 days of the creation of the receivership. The FDIC’s repudiation power is much stronger than in a Bankruptcy proceeding, which means the FDIC can do as it pleases with contracts—and without court involvement.  

Unlike in a Bankruptcy proceeding, in the case of an FDIC lease repudiation, you won’t have a claim for future damages, only for the unpaid rent generated before the repudiation. In addition, a commitment to issue letters of credit on your company’s behalf could also be retracted. In all such events, you would have a claim for damages, but your ability to collect on that would depend on how much money the FDIC has available after insuring deposits. The good news is that a new bank may well wish to maintain the same position as the old one, but you could need to negotiate and inquire in real time as to what those intentions are.

Elimination of Most Defenses. Before a bank failure, you could hold the lender to usual commercial standards if a dispute arose between you and your lender.  For example, if a bank suddenly and without warning stops making discretionary advances on a loan, you might claim damages. Whether you prevail or not, you at least have arguments or “defenses” with which to challenge the lender – for example, lack of consideration or the standard defenses of waiver, estoppel, laches, fraud in the inducement, usury, and accord, and satisfaction.

In the case of receivership, a Supreme Court case from 1942 and Congress has eliminated most such defenses[1]. The result is that whether or not the FDIC transfers the lending agreement to the new bank, the only defenses a borrower has must be in a written agreement, executed by the bank and the obligor (you), agreed to by the board of directors or loan committee of the bank, and from the time of execution maintained as an official record of the bank.  

Let’s assume your business had a rough patch before the bank failed, and your friendly bank officer agreed not to call the loan. Now that bank has failed, and a new bank is on the scene. If you invoke the previous bank’s promises with some, but not all, documentation to back up your claim, you would have the right to assert the agreement you had with the bank officer. Worse, if the new bank or the FDIC calls the loan, you must pay up even if you can assert a claim for continued funding.

Inability to Walk Away. Many non-bank parties have provisions in their contracts with the bank to modify or terminate their obligations to the bank in the event of the bank’s insolvency or failure. However, those provisions are widely believed to be unenforceable when a bank fails. 

What Can You Do?

Much can happen quickly in the situation of a bank failure. The more prepared you are, the less your pain will be.

Be Aware of and Keep Up with Your Obligations

If there is a bank failure, keep honoring your commitments. If you have borrowed money from the failed bank, you are still obligated to pay even if your contract with the failed bank has been repudiated.

If you expect your customers to continue to make payments into your account at the failed bank, make arrangements to ensure that any new bank, or bridge bank, will accept those payments on your behalf. Otherwise, the FDIC will not accept payments into the account of a failed bank, which means the money may not make it to you for a while.

You may have arranged for your old bank to make payments, often scheduled automatically, to your own creditors. The FDIC may contract with another bank to handle these payments from your funds, but you should make sure that it is indeed the understanding in your situation. 

Have a “Rainy-Day” Fund and a “Plan B”

Keep money aside for circumstances where your bank may not continue to advance funds. Some experts have suggested keeping at least a week of cash elsewhere in case you need it quickly and maintaining at least six weeks of money available in case the FDIC repudiates the agreement of the failed bank to continue to fund or even to honor letters of credit.  

You may also need an operational “Plan B” that consists of cutting back on upcoming expenses, even long-term expenses, or finding a backup funding source. You can’t be sure of convincing a new lending source to advance funds.

Know Your Rights and Be Aware of Deadlines if the Bank Is Your Customer

If you have a claim—for instance, you may be a bank’s landlord—make sure you act quickly and in accordance with the publicly available information concerning deadlines. For example, any claims against the SVB are due to the FDIC by July 23, 2023, and can be filed online. In most cases, there are insufficient funds to pay bank creditors, but each case may differ. In addition, you may well have the right to pursue the new bank in its capacity as a tenant in connection with any repudiated leases for which the FDIC is not responsible.

You should also regularly check with any acquiring bank or the FDIC to see if your particular contract has been assigned to a new bank. If so, the FDIC has probably lost the right to repudiate. If not, the limitations on damages are as described above, although you will still have a claim for damages against the acquiring bank that accepted the assignment of the contract.

Moving Forward

Bank failures have significant economic and social impacts, particularly in cases where the failure is widespread or systematic. Accordingly, governments and regulators work to prevent such shortcomings through various means, including regulation, supervision, and monitoring of financial institutions. 

It is important to work with experienced attorneys to fully understand your rights in the event of a bank failure and the steps you can take to minimize consequences to you. The business team at Sassoon Cymrot Law represents businesses and individuals in dealing with banks and representation of other banks in loan transactions and has experience working with the FDIC. Contact us today to gain insight into how we can help you. 

[1] D’Oench Duhme v. FDIC, 315 US. 447. Its central holding was most recently codified in 1989 as 12 U.S.C., section 1823(e), as part of FIRREA (Financial Institutions Reform, Recovery, and Enforcement Act).

Rick has represented just about every kind of client in bankruptcy and insolvency proceedings, including debtors, creditors, creditors’ committees, receivers, trustees, and buyers of assets.
Devon A. Kinnard is a Partner at the firm focusing on finance and commercial transactions, including bilateral and syndicated asset-based and commercial real estate loan facilities; state and federal tax credit financing; bond and public finance transactions; private securities offerings and debt and equity capitalizations; joint ventures; mergers and acquisitions and other corporate transactions arising out of the day-to-day operations of closely- and publicly-held companies.

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