Tax Issues Related to FDIC-Assisted Acquisitions of Troubled Banks

Tax Issues Related to FDIC-Assisted Acquisitions of Troubled Banks

[Editor's Note:  This narrative is derived from Taxation of Financial Institutions, Chapter 9 (Matthew Bender) by KPMG LLP.  The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.]

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The financial crisis, which began at the end of 2007, brought significant turmoil to the financial services industry and in particular, to depository institutions.  As a result of a substantial increase in loan loss experience, diminished liquidity and decreased confidence in the system on the part of depositors and investors, many institutions that had been financially sound were pushed to the precipice of insolvency.  Moreover, these banks experienced a decrease in their capital base due to substantial increases in required reserves for loan losses at a time when raising additional capital was difficult or, in some cases, impossible.  Because of the sharp increase in the number of institutions reaching this precarious position in such a short timeframe, the Federal Deposit Insurance Corporation ("FDIC") found itself in the daunting position of needing to facilitate the orderly workout of literally hundreds of institutions.  Due to the enormous cost involved in effecting these workouts, the FDIC pursued a course of identifying the types of transactions that would enable the assets and liabilities of these troubled institutions to be taken over by healthy institutions, while ensuring a seamless transition from the perspective of bank customers and the least possible cost to the FDIC insurance fund.

Due in part to the rapidity with which these transactions needed to occur, healthy institutions that were potential acquirors of the assets and liabilities of the failed institutions often had little opportunity to perform in-depth due diligence.  To help ameliorate the obvious concerns on the part of potential acquirors, the FDIC employed a transaction structure pursuant to which the FDIC would share in losses occurring during a period ending several years after the acquisition.  These "loss share" transactions became the prevalent vehicle for effectuating the resolution of failed institutions and, as of the date of this writing, several hundred have been concluded.  These transactions have typically been governed by a purchase and assumption agreement ("P&A Agreement") entered into between the FDIC and the acquiring Institution which, among other things, sets forth the terms of the loss share. [A common P&A agreement provides for the FDIC to share in losses associated with different categories of loans over varying periods of time following the consummation of the transaction.  For example, in the case of loans secured by residential mortgages, the loss-share period may be 10 years, while for commercial loans, the loss share period may be limited to 5 years.]

Typically, these FDIC-assisted acquisitions involve a transaction between a failed bank that has been taken into FDIC receivership and a healthy bank that agrees to acquire all or most of the assets and liabilities (e.g., deposit liabilities) of the failed bank. [The FDIC has employed a number of different structures to facilitate the orderly restructuring of failed or failing financial institutions.  Because the preponderance of these transactions stemming from the financial crisis commencing in 2007 were conducted through the FDIC taking the distressed institutions over and acting as receiver, this discussion will focus on this transaction structure.]  In exchange for assuming the deposit liabilities of the failed bank, in addition to the aforementioned loss-share, the FDIC may provide cash to the acquiring bank. . . .  

As part of the P&A Agreement, the FDIC and the acquiring bank enter into a loss sharing agreement ("LSA") under which the FDIC agrees to reimburse the acquiring bank for losses incurred on specified assets upon the occurrence of certain events.  Originally, the standard terms of the LSA provided that the acquiring bank would absorb a specified portion of the loss generated by the acquired loan portfolio.  Many of these LSAs provide that the FDIC and the acquiring bank would share any potential losses incurred on the acquired loans in various ways as discussed further below. 

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As previously discussed, the resolution of many of the institutions that failed as a result of the financial crises was accomplished by the affected banks being placed into receivership with the FDIC. [For a complete listing of failed banks visit http://www.fdic.gov/bank/individual/failed/]. In many of these transactions, in addition to conveying assets and liabilities, the P&A Agreements executed with the FDIC provide the acquiring institution with an option (though not an obligation) to acquire certain fixed assets of the failed institution including branch properties, etc.  As discussed in greater detail below, the exercise of options of this nature will result in a host of tax considerations.

While seemingly straightforward, the transactions that have been conducted under P&A Agreements with LSAs present a large number of complex tax issues for which, in many cases, the proper tax treatment is unclear given the relative lack of contemporary guidance. In general, the regulations under section 597 provide rules governing the federal income tax treatment of transactions where FFA is provided with respect to a bank. As a starting point in this analysis, it is important to recognize that, because the tax treatment of FDIC-assisted acquisitions is governed by section 597 and the regulations promulgated thereunder, the transactions are taxed as asset acquisitions.

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