The Federal Deposit Insurance Corp. has been engaged in a running battle over the past three years with unsecured creditors over rights to assets owned by the holding companies of dozens of failed banks.

The disputes would be unremarkable except for one surprising fact: the unsecured creditors are beating the pants off the feds.

The assets at issue are essentially table scraps left behind by bankrupt banking companies. They include tax refunds, miscellaneous cash balances and claims against management. In some cases these scraps amount to hundreds of millions of dollars.

When the FDIC takes over a failed bank, it typically lays claim to such assets with the holding company. Its demands are backed by the "source-of-strength doctrine" which the Federal Reserve Board issued nearly three decades ago and requires bank holding companies to support their banks financially.

In a recent twist, however, hedge funds have led a group of debt holders in buying up billions of dollars' worth of failed-bank debt at pennies on the dollar. Then they have challenged the source-of-strength doctrine's validity in bankruptcy court with remarkable success.

Their victories have exposed a costly flaw in the FDIC's failed-bank resolution process that threatens its ability to recoup billions of dollars in assets. In the meantime, the FDIC has been relegated to settling some claims for far less than full value and appealing bankruptcy cases it has lost to higher courts. As with the original cases, it appears to face an uphill battle.

"The FDIC has had a hard time convincing the bankruptcy courts that the source-of-strength doctrine meets the requirements of the bankruptcy code," says Paul Lee, an attorney at Debevoise and Plimpton in New York City who represents large domestic and international banks and has written extensively on the doctrine.

The FDIC said it does not comment on ongoing legal matters.

Source of Weakness

The FDIC's right to seize failed-bank assets from their former holding companies has been disputed since the source-of-strength doctrine was first issued. For twenty years, however, it had rarely been challenged. Then the 2008 financial crisis brought the issue back into bankruptcy courts.

In what appears to be the most recent hedge fund victory, a federal judge in May awarded to the company's creditors a $30 million tax refund left behind by the bankrupt Imperial Capital Bancorp. The FDIC has said it may appeal the case to the U.S. Court of Appeals for the Ninth Circuit.

To prevail, it will need to convince appeals court judges to make a ruling that contrasts with the victories achieved by hedge fund-led creditors in the bankruptcies of IndyMac, BankUnited, AmFin and others.

The FDIC's argument is straightforward: If a bank was responsible for most or all of its holding company's revenue, its tax refunds should rightfully be the property of the bank and in bankruptcy be granted to the FDIC.

For the bank overseer, the catch is that such cases are decided on the basis of the precise wording of tax-sharing agreements between the holding companies and their banks, which differ slightly in each instance. In cases where the agreements fail to specify that a holding company must return refunds to a bank, bankruptcy judges have been ruling that the assets are rightfully the property of the holding company's creditors and not the FDIC.

These agreements "could easily have said that any refund received by the parent company belongs to the bank. Any lawyer worth his salt could have written it that way," says hedge fund partner Vik Ghei. "They did not say that, and in fact they said the opposite."

Ghei, a 31-year-old New York City native, has invested in the holding companies of over 70 failed or distressed banks. HoldCo Advisors, the fund he co-founded two years ago, has been involved in "virtually every community bank restructuring since the 2008 financial crisis," it said in a bankruptcy court filing last month. It has also outflanked the FDIC in several high-profile bankruptcy court cases in which it has sponsored creditor-friendly liquidations.

Currently, HoldCo owns $1.5 billion of debt in the parents of bankrupt or distressed financial firms. That makes it the largest creditor in IndyMac and owner of debt issued by Imperial Capital, BankUnited and Corus Bancshares.

Ghei's reputation as one of the most aggressive and successful investors in the business has garnered the ire of regulators and state agencies. An FDIC attorney characterized the fund as "a speculator whose views are entitled to no deference" and called its principals "gamblers" in a U.S. bankruptcy court filing. In another case, an attorney for the state of Michigan described the hedge fund's business as "buying up severely distressed debt for deep discounts and picking over the bones for scraps of flesh."

Beginning at WaMu

Ghei's career in dead-bank investing began with the Washington Mutual bankruptcy. Ghei was an analyst at the hedge fund Owl Creek Asset Management looking for investment opportunities in WaMu in September 2008 as financial markets were collapsing.

With a limited background in the field, he was tasked with investing in distressed banks based on his previous work with distressed companies at a private equity firm and as a Goldman Sachs analyst covering financial institutions.

The debt of Washington Mutual Inc., the holding company for the operating bank, was organized in a complex, multi-tranche structure and was trading at deep discounts. Ghei studied the company's corporate structure and realized that behind the debt was more than $4 billion of cash, as well as projected tax refunds.

"The holding company, in theory, was supposed to have nothing," Ghei says. "That's what I think people assumed. People did not realize there were so many assets, or who owned what."

The FDIC seized WaMu on September 25, 2008 after a nine-day bank run and sold it to JPMorgan Chase. On the morning of its failure, its holding company's approximately $4 billion of senior bonds were trading at less than a penny on the dollar of face value. Ghei had spent the previous night in the office analyzing the company and decided to pounce.

By that evening, the value of the debt he'd acquired had risen to around forty cents on the dollar. Over the next several months, Owl Creek increased its holdings in other types of WaMu debt, eventually becoming one of the holding company's largest creditors.

After one of the most complex bankruptcies in history, WaMu's creditors were repaid at par, plus accrued interest. That made Ghei's trades hugely lucrative for Owl Creek, which earned hundreds of millions of dollars and turned him from an analyst into a partner, Ghei says.

The WaMu bankruptcy also gave Ghei a crash course in how the bankruptcy process works for a bank holding company. He realized that he could potentially replicate the trade that had worked so spectacularly for Owl Creek with the hundreds of banks that had failed during the financial crisis.

Ghei decided to leave Owl Creek to invest in distressed financial firms at Tricadia Capital Management, the hedge fund famous for pioneering the CDO-squared. A year and a half later, he set up HoldCo, with Misha Zaitzeff, a former Tricadia analyst. Despite the large number of bank failures at the time, and bank holding companies with large amounts of debt, Ghei had a tough time convincing potential investors that his investment thesis was viable.

"People said 'Look, the FDIC is never going to let you get this money,'" Ghei recalls. "We were buying things that we thought had a lot of value but the market was basically laughing at us."

Brett Jefferson, who runs the hedge fund Hildene Capital, had serious doubts before investing with HoldCo. "At first I didn't trust him," Jeferson says of Ghei. "Everybody was trying to figure out ways to get something out of these deals, but he's already gotten us some recoveries."

More are likely on the way, if court decisions to date are any guide.

Creditors have prevailed over the FDIC in case after case. In March, a federal judge in Ohio rejected the FDIC's claim of rights to a $195 million tax refund due to AmFin Financial Corp., the holding company for AmTrust bank in Cleveland, which failed in December 2009. That decision followed a September ruling in the U.S. Court of Appeals for the Sixth Circuit denying the FDIC's claim to $765 million from AmFin's estate.

Separately, a U.S. District Court judge for the Central District of California ruled last year that IndyMac Bancorp's creditors, and not the FDIC, were entitled to its $55 million tax refund.

In 2011, a U.S. bankruptcy judge in Florida awarded the creditors of BankUnited Financial Corp., the holding company for the Florida bank that failed in 2009, the company's $45 million tax refund. In the case of NetBank, the U.S. bankruptcy court for Florida affirmed that the company's $6.2 million tax refund belongs to the creditors. The ruling was later upheld by a U.S. district court in Florida.

A $1 Billion Appeal

The legal scrum over large tax refunds harks back to a 2009 law permitting companies to use losses incurred in 2008 and 2009 to offset taxes paid during the previous five years. All told, more than $1 billion worth of tax refunds are at stake in cases in which the FDIC is either awaiting a ruling or appealing a bankruptcy court verdict.

The agency's victories have been few. In 2011, a U.S. district court in Georgia awarded the FDIC more than $10 million in tax refunds from the estate of Integrity Bancshares. Unlike with many other banks, the tax-sharing agreement between Integrity and its holding company clearly granted ownership to the bank.

In cases where tax agreements fail to stipulate that holding company assets belong to the creditors of failed bank subsidiaries, the FDIC has marshaled a range of legal arguments. They include the claim that the agreements are ambiguous or flawed, and the invocation of decades-old case law involving nonbanks and in which tax agreements are absent.

Bankruptcy judges have rarely been persuaded and delivered some stinging rebukes. In the IndyMac opinion, Judge Sheri Bluebond of the U.S. Bankruptcy Court for Los Angeles said the agency was, in essence, throwing up a legal smokescreen through the "sheer number of arguments and theories" it advanced, in order to complicate a straightforward case.

With AmFin, Judge John Adams of the U.S. District Court for the Northern District of Ohio wrote that the company's tax-sharing agreement "unambiguously" grants the refund to the holding company, and that "the remaining arguments raised by the FDIC," have already been rejected by "numerous other courts."

As the case law against the FDIC mounts, hedge funds holding claims against failed bank holding companies have become bolder in pressing courts to reject the agency's arguments.

That boldness has even involved financing litigation against the FDIC. Owl Creek and two other hedge funds last year agreed to lend the estate of Colonial Bancgroup $15 million to fund legal expenses in the dispute with the FDIC. At stake: over $610 million in tax assets and other claims. One of the loans was structured to pay the hedge funds 15% annually in interest; the other involved the hedge funds receiving between 27.5% and 100% of the estate's litigation recoveries, depending on how much they recoup.

The FDIC objected on the grounds that the estate's case against the FDIC had been dormant for nearly eight months before the hedge funds stepped in. Judge Dwight Williams of the U.S. bankruptcy court for the Northern District of Alabama permitted the loan to go through, and litigation is ongoing.

Among cases where the FDIC could still prevail: the Corus litigation over a $250 million tax refund and the Downey Financial case involving a $374 million refund.

Some observers expect more losses for the FDIC. Creditors "are likely (though not certain) to prevail in all of the publicly tradable cases," wrote CRT Capital Group analyst Kevin Starke, who specializes in failed banks' debt.

The FDIC officials have "a bad argument," and have been losing these cases "because they should be losing them," says an attorney who asked to remain anonymous because he is involved in litigation against HoldCo.

There are signs that the FDIC is softening its stance, having concluded that expensive litigation offers less hope of recovery than do settlements.

In April, it agreed to a 50-50 split of a $3.3 million tax refund owed to Team Financial, which went bankrupt in 2009. Ghei, who helped negotiate that settlement, calls it a "fair" split and says he's hopeful that the FDIC will be willing to strike deals in other cases.

Beyond the current lawsuits, reforming the resolution process before the next round of bank failures is a major issue for the FDIC.

Strengthening the source-of-strength doctrine would require a legislative change and could take years. The banking industry would likely object, arguing that changing the law would make it harder to raise capital. Meanwhile, the FDIC has yet to propose any legal reforms, say lawyers involved in related litigation.

Another possible route for the FDIC would be to pressure banks to sign capital-maintenance agreements. That would involve requiring the directors of the holding companies for viable banks to pledge that they will use the parent's capital to support the bank, even in bankruptcy.

Even Ghei admits that such a move could solve the agency's problems.

"Guarantee agreements are written all the time and are enforceable," he says. "You can do that in a one-page agreement. You can probably do that in two sentences. But it didn't happen."