Debt buyers beware: a partnership with the FDIC could close the doors to the federal courthouse.

In a growing trend, some federal courts have concluded that whenever the FDIC owns an interest in a limited liability company (LLC), the LLC cannot qualify for federal diversity jurisdiction because the FDIC, as a federally chartered bank, is not a citizen of any state.

For banks and investors purchasing loans from the FDIC under certain types of risk sharing arrangements, these rulings may directly affect litigation strategy, and awareness of this issue can mean the difference between recovering on your investment, or losing it altogether.

In recent years banks and private equity investors have partnered with the FDIC by purchasing interests in FDIC-owned LLCs holding loan portfolios seized from failed banks.  These arrangements allow the FDIC to retain a financial interest in the assets while transferring management responsibilities to its co-venturers, including managing the loan enforcement process and overseeing the ultimate disposition of any collateral.  This process frequently involves litigation.

Federal court is often the preferred venue for this type of contract-based judicial action for a variety of reasons, including predictability of outcome; clear precedent; avoiding the risk of judicial bias; and a tendency on the part of federal judges to construe contracts and statutes plainly and as written.

But co-venturers must recognize that the mere fact of partnering with the FDIC may prevent the venture from using the federal courts. In a decision issued on October 27, 2011, the U.S. District Court for the District of Nevada dismissed a case brought by an FDIC co-venture for lack of jurisdiction. In RES-NV TVL, LLC v. Towne Vistas, LLC, (U.S.D.C. Nev. 2011), the court found that it lacked diversity jurisdiction over a lawsuit brought by that co-venture to recover on an eight-figure deficiency balance.

For diversity jurisdiction to attach, the court said, the plaintiff’s “entire ownership structure” must be diverse, meaning that each member of the LLC must be a citizen of states different from the citizenship of the defendants. But the court said the FDIC’s status as a federally-chartered bank “destroys” diversity jurisdiction.

The ramifications of the RES-NV decision are striking. For example, in western states with anti-deficiency statutes, there can be statutory time limits that bar a note holder from recovering upon a deficiency balance unless it initiates a lawsuit to recover a deficiency balance within a certain time after a foreclosure has occurred. If the note holder has sued in federal court when jurisdiction is lacking, the statutory time to recover a deficiency balance can lapse before the federal court makes a determination on whether it has jurisdiction. If the federal court dismisses the case, the note holder may be unable to recover a deficiency balance in state court because the statutory time to file suit will have lapsed. The resulting losses can mean the difference between recovering millions of dollars, or getting nothing.

Federal court jurisdiction over lawsuits brought by FDIC co-ventures have been a hot topic for those involved in distressed real estate. To the litigators of Ballard Spahr’s Commercial Real Estate Recovery Group, the Nevada court’s ruling comes as no surprise. Based on similar, but non-binding, rulings from other federal courts, see RES-NC Settlers Edge, LLC v. Settlers Edge Holding Company, LLC, (Sept. 3, 2011), we recommended, even before the Nevada court’s ruling, that FDIC co-ventures carefully evaluate the risks and benefits of filing a lawsuit in federal court, versus state court, when jurisdiction may be an issue. 

For further discussion, please feel free to contact the author, Abran Vigil, or any member of Ballard Spahr’s Commercial Real Estate Recovery Group.

Copyright © 2011 by Ballard Spahr LLP.
(No claim to original U.S. government material.)

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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.