A federal judge has vacated a bankruptcy-court ruling that allowed Colonial BancGroup Inc. to access millions of dollars held in a disputed account, a win for the Federal Deposit Insurance Corp., the receiver for the holding company's former subsidiary, Colonial Bank.

Judge Myron Thompson of the U.S. District Court in Montgomery, Ala., ruled that a bankruptcy judge erred when he said the FDIC had no right to millions in disputed cash held in a Colonial bank account to set off a debt resulting from the bank's failure that could cost the bank regulator and U.S. taxpayers $5 billion.

The FDIC, the federal agency that manages the receiverships of failed banking institutions, was named receiver of Colonial in the summer of 2009 after state regulators seized the Alabama bank. It then sold most of Colonial's holdings to North Carolina's BB&T Corp.

U.S. Bankruptcy Court Judge Dwight H. Williams had ruled there was no setoff right against the deposit because after the Colonial accounts were transferred to BB&T, they were no longer a debt of the FDIC. U.S. bankruptcy law permits setoffs only when they are mutual, prepetition debts.

Williams's decision last January allowed Colonial BancGroup to use the funds in its bank account — which totaled more than $38 million — at BB&T to pay for its bankruptcy expenses, overruling an objection from the FDIC.

The FDIC appeal cited various missteps that the holding company made with respect to the bank prior to its 2009 seizure and the subsequent transfer of its accounts to BB&T. The FDIC argued that under federal and state law, it had the right to the cash in the account to offset mutual debt.

Thompson agreed, noting the FDIC must at times act swiftly during the closing of a bank, not least of which to ensure the confidence of the bank's customers. Because of this "need for speed," the judge wrote, the agency's public policy mission in effect trumps bankruptcy law.

"Congress has determined that a certain creditor — the FDIC — should be entitled to offset debt from the debtor's estate without proceeding as an unsecured creditor in the general bankruptcy distribution scheme," Thompson said in his ruling Wednesday.

The judge noted his decision only addressed the FDIC's right to set off the debt, not whether it was entitled to the funds.

"The court cannot say its conclusion...means that the bankruptcy court erred by denying the automatic stay and by granting use of the operating account to pay BancGroup's operating expenses and fees," Thompson said. He sent the case back to Williams to reconsider the matter.

The decision is the latest development in a long-running legal fight between the FDIC and the remnants of the bank-holding company.

Colonial, which has no revenue or business prospects, isn't seeking to reorganize. Instead, the Chapter 11 plan, which was approved last year, created a litigation trust to pursue lawsuits on behalf of creditors.

The FDIC says the bankruptcy-related litigation has become a vehicle for hedge funds and other institutions that bought debt at a deep discount to pursue greater recoveries by targeting the FDIC. Indeed, that strategy could serve as a blueprint for creditors of other bank-holding companies mired in Chapter 11 as the result of hundreds of bank closures by regulators in recent years.

Colonial was founded more than 20 years ago by Bobby Lowder, perhaps best known as the Auburn University "kingmaker" whom ESPN once called the most powerful booster in college sports. Lowder built it into a regional banking power largely through mortgage-lending activities in the Southeast.

The bank suffered big losses as the housing market cratered, but its fate was sealed with the collapse of mortgage lender Taylor Bean & Whitaker Mortgage Corp., which filed for bankruptcy in August 2009.

Colonial, which had $25 billion in assets and $20 billion in deposits, was the biggest bank failure of 2009. The FDIC estimates Colonial's collapse will cost its insurance fund $5 billion, making it one of the most expensive bank failures in U.S. history.

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