Letters of Credit in U.S. Bank Failures: Possible Outcomes

Creditworthiness and reliability are foundational to letters of credit. By substituting the creditworthiness of the issuing bank for that of its customer, the risk of non-payment in the underlying transaction is reduced, but not eliminated. What happens to an LC if the issuing bank fails? Unfortunately, this is not a hypothetical question. Since 2001, there have been 565 bank failures in the United States, including several among the largest ever in 2023.¹ This article examines the unique intersection of LCs and failed banks.

Letters of credit are liabilities of a failed bank. Deposits are also liabilities of a failed bank, insured by the Federal Deposit Insurance Corporation (FDIC) up to USD 250,000. Are LCs insured deposits? Most LC professionals would immediately answer, “of course not”, but this matter has actually been litigated all the way to the U.S. Supreme Court. In the U.S. Code, Title 12 (Banks and Banking), “Deposit” is defined as “the unpaid balance of money or its equivalent received or held by a bank … for which it has given or is obligated to give credit” (12 U.S.C. §1813(l)(1)). In FDIC v. Philadelphia Gear Corp., 476 U.S. 426 (1986), the Supreme Court held that a standby letter of credit backed by a continent promissory note (covering the reimbursement obligation) is not “money or its equivalent”, and therefore not a deposit liability.

Thus, an LC issued by a bank that has failed is a contingent uninsured liability. In practice, what does that mean? If FDIC is appointed receiver of the failed bank, how will its portfolio of outstanding LCs be treated? There are two alternative outcomes, one negative and the other positive. These alternatives do not constitute choices that any party to an LC can make. Rather, as explained below, FDIC controls which outcome will be applicable.