The Supreme Court ruled yesterday that federal banking laws do not require the Federal Deposit Insurance Corp. to insure a standby letter of credit in the same way it insures any deposit.
Standby, or "guaranty," letters, backed only by contingent promissory notes, are not "deposits" that must be insured by the FDIC, Justice Sandra Day O'Connor wrote for a six-member majority of the court.
Normal commercial letters of credit from a bank, which guarantee payments to third parties selling goods to bank customers, were not affected by the ruling. Those letters, backed by deposits or other assets pledged to the bank, still would be insured, O'Connor said.
O'Connor said Congress, in setting up the deposit insurance system, "wanted to ensure that someone who put tangible assets into a bank could always get those assets back." She said that the purpose of the Depression-era legislation was to protect "assets and hard earnings entrusted to a bank."
The ruling overturned a 1984 decision by the 10th U.S. Circuit Court of Appeals in a case involving the failed Penn Square Bank of Oklahoma City. The appeals court had ordered the FDIC to pay claims involving a letter issued by Penn Square, saying that such letters were the equivalent of deposits.
The FDIC appealed, saying the ruling would require it for the first time to insure about $120 billion worth of outstanding standby letters of credit and would make banks liable for more than $100 million in additional annual insurance assessments.
The FDIC, joined by the Council on International Banking and local government groups, said the appeals court ruling also would play havoc with the multibillion-dollar market in industrial bonds, which could lose their tax-exempt status if backed by an FDIC-insured letter of credit.
The case, FDIC v. Philadelphia Gear Corp., involved a standby letter of credit issued by Penn Square on behalf of Orion Manufacturing Corp. to Philadephia Gear Corp. The latter company supplied Orion with parts for its drilling-equipment production. Philadelphia Gear, citing defaults by Orion, attempted to collect from Penn Square.
After Penn Square was declared insolvent in 1982, Philadelphia Gear tried to collect from the FDIC, saying that it was, in effect, a depositor and entitled to the maximum $100,000 insurance.
O'Connor and the court majority disagreed. The FDIC system was set up to protect depositors from losses when a bank went under, she said; but when Penn Square failed, neither Orion nor Philadelphia Gear actually lost anything. Neither had deposits at the bank.
She said that, under a "standard 'commercial' letter of credit, Orion would typically have unconditionally entrusted Penn Square with funds before Penn Square would have written the letter of credit, and thus Orion would have lost something if Penn Square became unable to honor its obligations." O'Connor said that, in this case, "Nothing was ventured and, therefore, no insurable deposit was lost."
Justice Thurgood Marshall, joined by Justices Harry A. Blackmun and William H. Rehnquist, dissented, said Congress made no distinction between various types of letters of credit, and that neither the FDIC nor the courts should do so.
"The court's attempt to draw distinctions between different types of letter-of-credit transactions, forces it to ignore both the statute and some settled principles of commercial law," Marshall said.