The Office of General Counsel issued the following opinion on January 23, 2003, representing the position of the New York State Insurance Department.
Re: Letters of Credit
Will certain letters of credit issued in connection with the proposed transaction constitute financial guaranty insurance or any other kind of insurance under the New York Insurance Law?
No, under the facts presented, the letters of credit will not constitute financial guaranty insurance or any other kind of insurance under the New York Insurance Law.
The letters of credit in question herein are being issued in connection with a transaction between an investment bank and its affiliates ("Investment Bank") and a non-United States commercial bank (the "Bank") and certain of its subsidiaries. Under the transaction, the Investment Bank will extend loan commitments to its customers and the Cayman Islands branch of the Bank ("Cayman Branch") will issue letters of credit to reimburse the Investment Bank for certain losses on loans made to customers of the Investment Bank that have been previously approved by the Bank. In addition, duplicate letters of credit will be issued by a limited purpose entity ("Cayman Co.") established in the Cayman Islands. All of the shares of Cayman Co. will be owned by the Cayman Branch. This duplicate structure is intended to address concerns associated with the possible bankruptcy or receivership of the Bank or the Cayman Branch.
The Cayman Branch is a direct office of the Bank. It is regulated and supervised by the Cayman Islands Monetary Authority, and its books and records are subject to the examination by the New York Superintendent of Banks.
The Cayman Branch will initially invest US$ 1 billion in Cayman Co., which amount will be provided by the head office of the Bank. Cayman Co. will use these funds to purchase either demand notes1 of the Investment Bank ("Demand Notes") or principally U.S. government and government agency securities ("Eligible Securities").
The Cayman Branch will issue, for the account of Cayman Co. and the benefit of the Investment Bank, letters of credit (the "Branch Letters of Credit") that will entitle the Investment Bank to draw thereunder in the event that the Investment Bank realizes a loss on a covered commitment or loan. As the account party, Cayman Co. will be obligated to reimburse the Cayman Branch for amounts paid to Investment Bank under the Branch Letters of Credit. The Cayman Branchs interest in, and payment under, this reimbursement obligation will be pledged to the Investment Bank.
Cayman Co. will also issue, for its own account and for the benefit of the Investment Bank, letters of credit (the "Cayman Co. Letters of Credit", and together with the Branch Letters of Credit, the "Letters of Credit") that will entitle the Investment Bank to draw thereunder in the event that the criteria for drawing on the Branch Letters of Credit are met but either the Cayman Branch fail to perform on that letter of credit or any of the Bank, its holding company or the Cayman Branch is in bankruptcy or receivership. The coverage of the Cayman Co. Letters of Credit will be the same as that of the Branch Letters of Credit, reduced by any amounts paid thereunder. Demand Notes or Eligible Securities will be pledged to the Investment Bank by Cayman Co. to secure its obligations under the corresponding Cayman Co. Letters of Credit.
In the event of a loss realized by the Investment Bank on loans or commitments covered by one of the Branch Letters of Credit, if Cayman Co.s obligations are secured by the Demand Notes, (i) the Investment Bank will prepay principal on the corresponding Demand Note in the amount of the loss, (ii) Cayman Co. will pay such proceeds to the Cayman Branch pursuant to Cayman Co.s reimbursement obligations with respect to such Branch Letter of Credit, and (iii) the Cayman Branch will pay the Investment Bank the same amount under the corresponding Branch Letter of Credit. Thus, reimbursement of a realized loss under a Letter of Credit will also result in a reduction of the principal amount of the corresponding Demand Note held by Cayman Co. by an amount equal to the amount of the loss. The remaining coverage under the respective Letters of Credit will also be reduced by the same amount.
In the event that the criteria for the payment of a Branch Letter of Credit are met but either the Cayman Branch fails to perform, or if any of the Bank, its holding company or the Cayman Branch is in bankruptcy or receivership, if Cayman Co.s obligations are secured by the Demand Notes, (i) the Investment Bank will prepay principal on the Demand Note to Cayman Co. in the amount of the loss and (ii) Cayman Co. will pay the same amount directly to the Investment Bank under the Cayman Co. Letter of Credit.
If Cayman Co.s obligations are secured by Eligible Securities, then payment of a realized loss pursuant to the Branch Letter of Credit would be made by Cayman Branch either through its own funds or those provided by Cayman Co. pursuant to its reimbursement obligation under the Branch Letter of Credit following liquidation by Cayman Co. of a sufficient amount of Eligible Securities. If payment is made by the Cayman Branch from its own funds, Cayman Co. will be released from its collateral obligations with regard to the Cayman Co. Letters of Credit to the extent of the amount of such payment and Cayman Co. will reimburse the Cayman Branch for the amount of such payment pursuant to its reimbursement obligation. In the event that payment of a realized loss is made pursuant to the Cayman Co. Letter of Credit, Cayman Co. would fund the draw through liquidation of an amount of Eligible Securities sufficient to cover the loss.
In certain circumstances relating to the creditworthiness of the Bank or relating to a breach or misrepresentation by the Cayman Branch or Cayman Co., under its agreements with the Investment Bank, the Investment Bank may draw the remaining undrawn amounts on the Cayman Co. Letters of Credit. In this event, the outstanding Demand Notes will be repaid (or Eligible Securities sold) and, upon payment of such draws, the Letters of Credit will terminate.
The Letters of Credit issued by the Cayman Branch and the Cayman Co. are substantially equivalent in terms and have been characterized in your representations as constituting "clean" standby letters of credit. As an initial matter, with respect to the Cayman Branch Letters of Credit, there does not appear to exist an issue as to whether such Letters of Credit constitute any kind of insurance under the New York Insurance Law. This is because Cayman Branch is a division of a bank, and the issuance of letters of credit is recognized as clearly falling within the business of banking. As such, the Cayman Branch Letters of Credit is not insurance and its issuance does not constitute the unauthorized doing of an insurance business.
Although the Cayman Co. Letters of Credit are essentially equivalent in terms to those of the Cayman Branch, Cayman Co. is not a bank. As such, its issuance of letters of credit cannot be disposed of with the conclusion that it is engaging in the business of banking.2 As indicated in the facts presented, the role of the Cayman Co. is the provision of bankruptcy/insolvency protection (via the insulation of assets) to the Bank. In this connection, it is clear that the Cayman Co., through the Cayman Co. Letters of Credit, is providing a guaranty of the Branch Letter of Credit issued by its parent, the Cayman Branch. As recited above in the facts, this guaranty operates should the Cayman Branch fail to perform on the Branch Letter of Credit or in the event that the Bank, its holding company or the Cayman Branch is in bankruptcy or receivership.
The facts as presented indicate that the role of the Cayman Co. in this transaction is essentially one that constitutes the making of a contract of surety or guaranty because the obligation is based upon the failure of the Cayman Branch to perform. In addition, N.Y. Ins. Law § 6901(a) (McKinney Supp. 2003), provides, in pertinent part, as follows:
As used in this article: (a) (1) "Financial guaranty insurance" means a surety bond, insurance policy or, when issued by an insurer or any person doing an insurance business as defined in paragraph one of subsection (b) of section one thousand one hundred one of this chapter, an indemnity contract, and any guaranty similar to the foregoing types, under which loss is payable, upon proof of occurrence of financial loss, to an insured claimant, obligee or indemnitee as a result of any of the following events:
(A) failure of any obligor on or issuer of any debt instrument or other monetary obligation (including equity securities guarantied under a surety bond, insurance policy or indemnity contract) to pay when due to be paid by the obligor or scheduled at the time insured to be received by the holder of the obligation, principal, interest, premium, dividend or purchase price of or on, or other amounts due or payable with respect to, such instrument or obligation, when such failure is the result of a financial default or insolvency or, provided that such payment source is investment grade, any other failure to make payment, regardless of whether such obligation is incurred directly or as guarantor by or on behalf of another obligor that has also defaulted
When viewed in light of the above-cited statutory definition, the activities of Cayman Co. appear to fall within that definition.
However, under the New York Insurance Law, in certain circumstances the making of a contract of surety or guaranty does not constitute the doing of an insurance business. This exemption is contained in the following statutory provision, which states, in pertinent part, as follows:
(b) (1) [A]ny of the following acts in this state, effected by mail from outside this state or otherwise, by any person, firm, association, corporation or joint-stock company shall constitute doing an insurance business in this state and shall constitute doing business in the state within the meaning of section three hundred two of the civil practice law and rules:
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(B) making, or proposing to make, as warrantor, guarantor or surety, any contract of warranty, guaranty or suretyship as a vocation and not as merely incidental to any other legitimate business or activity of the warrantor, guarantor or surety;
N.Y. Ins. Law § 1101(b)(1)(McKinney 2000).
Under § 1101(b)(1), the making of a contract of guaranty or surety is regarded as the conduct of an insurance business only where it is done as a vocation. The Department has interpreted the above section on numerous occasions, concluding in many opinions that contracts of guaranty or surety provided from one member of a consolidated corporate group to another member of that group do not constitute the conduct of the business of insurance. See, e.g., OGC Opinion No. 86-74 (August 21, 1986) (parents guaranty of subsidiarys debt arising out of subsidiarys liability to third party does not constitute doing an insurance business); OGC Opinion No. 87-26 (June, 1987) (parents guaranty of subsidiarys liability to third party for injury caused by accident does not constitute doing an insurance business); OGC Opinion No. 88-19.1 (April 5, 1988) (parent corporations guaranty of the obligations of its subsidiaries does not constitute doing an insurance business); OGC Opinion No. 92-120 (December 3, 1992) (loan guaranties from cooperative corporation to the owner-members thereof would not be subject to regulation by the Department); and OGC Opinion (unnumbered) (April 8, 1997) (personal guaranty by president/shareholder of corporation to the corporation would not constitute the doing of an insurance business).
The Cayman Co. Letters of Credit, under the facts specified, does not constitute the doing of an insurance business. First, similar to the above-cited authorities, the issuance of the Cayman Co. Letter of Credit will serve only to provide a guaranty to its parent, Cayman Branch and is an isolated circumstance. Further, Cayman Co. will not be providing guaranties to any entities other than its corporate parent. Therefore, it does not constitute the making of a contract of guaranty or surety as a "vocation" under N.Y. Ins. Law § 1101(b)(McKinney 2000). This opinion is limited to the facts specified herein.
For further information you may contact Supervising Attorney Michael Campanelli at the New York City Office.
1 "Demand Notes" have a stated maturity, but must be prepaid on demand.
2 The inquirers suggestion that "a letter of credit issued by a bank or branch or affiliate thereof is a banking product" is overbroad in that it disregards the separate corporate identity of the affiliate. Post Gramm-Leach-Bliley, it is quite likely that many insurers or other non-banking entities will constitute affiliates of banks. A conclusion that any "letter of credit" type instrument written by such an entity is per se a banking product elevates form over substance with the result that actual insurance products may escape regulation as such.