4000 - Advisory Opinions
Standby Letters of Credit Issued in Lieu of Contractors' Performance Bonds
June 23, 1986
Robert W. McPherson, Regional Attorney
You asked for a response to the opinion of bank counsel that the letters of credit cited as violations of law *** are permissible "standby letters of credit" rather than unauthorized exercises of inconsistent powers pursuant to Part 332 of the FDIC's rules and regulations.
Although the letters of credit could be viewed as falling within the prohibitions of Part 332, they should be deemed to be authorized standby letters of credit rather than impermissible transactions. However, this in no way precludes objection to the indeterminable duration of the letters of credit, the failure to document the bank's collateral position, the amounts involved in relation to such failure, and the possibility of exposure of indeterminable amount.
The bank issued letters of credit totalling $2,078,129 to various partnerships of which *** is general partner, acting through the FmHA. The letters of credit are irrevocable and are issued:
"[T]o assure that ***, contractor, faithfully performs and fulfills all the obligations, terms and conditions of that certain construction contract dated . . . , any extension thereof and during the guaranty period . . . , and to assure that contractor pays all persons, firms and corporations supplying labor and materials to contractor in the prosecution of the work provided for in said contract."
The letters of credit were issued in lieu of contractors' performance bonds (which could not be obtained), have varying maturities, and after completion and final inspection are reduced to 15% of the original amount to cover the contractor's continuing warranty on construction. One letter of credit totalling $135,109 represented such a warranty, the other two letters of credit represented contracts.
The letters of credit are guaranteed by *** and ***, individually. Notes and collateral pledge agreements are held pledging and assigning proceeds from the syndication of various apartment projects. The proceeds are not handled on a notification and acknowledgement basis and the amounts are not precisely identified. The bank usually obtains copies of various documentation, including the contract, approval of FmHA financing, mortgages on realty pledged to FmHA, and letters of intent from various agents for investors. Collateral pledged to direct debts of *** and ***, and ***, is cross-pledged to the letters of credit.
Section 332.1 of the FDIC's rules and regulations provides in applicable part that:
"A state nonmember insured bank (except a District Bank) which does not have any of the powers hereinafter enumerated, or which, although it has any such power, does not exercise the same, shall not hereafter exercise, take, or assume the power: . . . (d) to guarantee or become surety upon the obligations of others except as provided in § 347.3(c)(1).'' (emphasis added)
Section 347.3(c)(1) referred to above has to do with foreign branches and is not applicable.
Footnote No. 1 to section 332.1 provides that:
"the limitations prescribed in § 332.1(d) do not include acceptances, endorsements, or letters of credit made or issued in the usual course of the banking business. " (emphasis added)
Section 337.2(a) of the FDIC's rules and regulations defines "standby letter of credit" as:
"Any letter of credit, or other similar arrangement however named or described, which represents an obligation to the beneficiary on the part of the issuer . . . (3) to make payment on account of any default (including any statement of default) by the account party in the performance of an obligation. " (emphasis added)
Footnote No. 1 to section 337.2 provides that:
"As defined in this paragraph (a), the term standby letter of credit' would not include commercial letters of credit and similar instruments where the issuing bank expects the beneficiary to draw upon the issuer, which do not guaranty' payment of a money obligation of the account party and which do not provide that payment is occasioned by default on the part of the account party." (emphasis added)
The fact that the subject letters of credit are issued in lieu of contractors' performance bonds (which could not be obtained), and that after completion of the jobs are reduced to 15% of the original amount for an indeterminable time to cover the contractors' continuing warranty on construction, creates the appearance that the bank has "guaranteed or become surety upon the obligations of others" in violation of section 332.1(d). Such terms may not seem to be "in the usual course of the banking business" as would make the letter of credit permissible under footnote No. 1 to section 332.1. Although the letters of credit represent an obligation to the beneficiary on the part of the issuer "to make payment on account of . . . default . . . by the account party in the performance of an obligation" within the definition of "standby letter of credit" at section 337.2(a), the obligation arising under the contractors' warranty might not seem to be the sort of "money obligation" required by footnote No. 1 to section 337.2.
Nevertheless, it is the FDIC's practice not to object to transactions structured so much like more traditional letters of credit. ***. The subject letters of credit should be viewed as letters of credit made or issued in the usual course of the banking business pursuant to footnote No. 1 to section 332.1, and as obligations to the beneficiary on the part of the issuer to make payment on account of a default (including any statement of default) by the account party in the performance of an obligation, pursuant to section 337.2(a). However, this in no way precludes the Corporation's objection to other unfavorable features, such as the indeterminable duration of the letters of credit, the failure to document the Bank's collateral position, the excessive amounts involved in relation to such failure, and the possibility of the existence of exposure of an undeterminable amount.