FDIC 'Falling Flat' on Busted Bank Tax Claims: Street Whispers

NEW YORK ( TheStreet) --The Federal Deposit Insurance Corp. has been striking out in its efforts to lay claim to tax refunds from failed banks, and at least one analyst who has been following the cases believes the regulator is doomed to failure in these efforts.

When the FDIC takes over a failed bank, the entity it takes over is the operating company. The legal corporate entity--known as the holding company--files for bankruptcy. In many instances the only asset it retains is a claim to a tax refund from the Internal Revenue Service.

CRT Capital Group analyst Kevin Starke writes for an audience of investors in distressed debt securities who want to know the likelihood the refund will be paid out to the banks' creditors. According to Starke, the FDIC's efforts to step in front of creditors and lay claim to the refund, while dogged, are "falling flat in case after case."

The FDIC doesn't discuss active litigation, according to a spokesman.

The key to the FDIC's arguments are the tax sharing agreements between the legal entities that make up the company.

The FDIC has tried to claim that the holding company is merely a conduit through which assets automatically get passed on to the operating company. While such a "principal-agent" relationship isn't specifically laid out in the vast majority of the tax sharing agreements, neither do they state that such a relationship doesn't exist. As a result, the FDIC has been arguing, a principal-agent relationship should be accepted as the default.

But bankruptcy courts don't work that way, according to Starke.

"Bankruptcy courts look at your rights as a creditor typically more in line with the minimum protection that you're entitled to rather than the maximum protection that you're entitled to. You have to prove that you're entitled to something more, not assume that you're entitled to something more and then simply prove that you're not entitled to less. The FDIC's trying to go that latter route--they're trying to say its obvious that we're entitled to something more and you had to prove that we're entitled to less. That's not working at all," Starke says.

As a result, the FDIC has been ending up standing in line alongside all the other creditors with a general unsecured claim.

That is what has happened in the bankruptcies of IndyMac, NetBank, Team Financial, and BankUnited Financial, and Starke expects the same outcome from pending cases such as Downey Financial Corp., Colonial BancGroup, Irwin Financial.

In the case of Downey, for example, Starke expects the FDIC's claim to $373.8 million in tax refunds will be diluted by $200 million worth of bond claims.

Some bankruptcy experts don't see the FDIC as categorically doomed to failure in these cases, however.

Michael DeBaecke, partner with law firm Blank Rome who has represented creditors facing off against the FDIC, says it is "hard to generalize, but certainly the FDIC has met with some losses of late."

The FDIC uses the tax refunds to offset the losses in its insurance fund--a critical activity since it can't simply tap the Treasury for more money once its funds are depleted. Even in the best of circumstances, the refund only offsets a small portion of the loss to the FDIC insurance fund. The FDIC estimated Downey Financial's failure would cost the insurance fund $1.4 billion.

The good news for the FDIC is that the 2010 Dodd-Frank legislation changes how banks are resolved. Rather than putting the holding company into bankruptcy, Dodd Frank will give regulators the discretion to take it over as well.

So for the next round of bank failures, Starke predicts, "there won't be any more arguments about tax refunds because if the FDIC has seized a bank and the bank holding company and has lost money, any tax refunds will go to it first."

-- Written by Dan Freed in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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