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Committees : Governance

Sharing Directors Brings Added Experience to Your Board, But Could Cause Problems

March 7th, 2012 |

DropFiles.jpgMany financial institutions, particularly community banks, have enhanced the experience level of their boards by adding a director who is a banker or serves on the board of another financial institution.  In general, utilizing a director who has current experience with another financial institution is a great way to add valuable perspective to a variety of issues that the board may encounter.  In addition, as private equity funds made substantial investments in financial institutions, they often bargained for guaranteed board seats.  The individuals selected by private equity firms as board representatives often serve on a number of different bank boards.  As market conditions have led to increased bank failures, however, a problem has resurfaced that may cause some financial institutions to take a closer look at nominating directors who also serve other financial institutions: FDIC cross-guarantee liability.

The concept of cross-guarantee liability was added to the Federal Deposit Insurance Act by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA).  The pertinent provision states that any insured depository institution shall be liable for any loss incurred by the FDIC in connection with:

  • the default (failure) of a “commonly controlled” insured depository institution; or
  • open bank assistance provided to a “commonly controlled” institution that is in danger of failure.

This means that if two banks are “commonly controlled” and one of them fails, the other bank can be held liable to the FDIC for the amount of its losses or estimated losses in connection with the failure.  As many of us see each Friday, the amounts of these estimated losses are often quite high.  In fact, the FDIC’s estimated losses for 2011 bank failures were approximately 20 percent of total failed bank assets for the year.  Accordingly, the prospect of cross-guarantee liability can be a tremendous financial issue for the surviving bank.

The concept of cross-guarantee liability was developed in response to some perceived abuses by multi-bank holding companies during the 1980s.  In those instances, one or more institutions owned by a multi-bank holding company failed, causing significant losses to the FDIC, while the other subsidiaries of the multi-bank holding remained open and viable, allowing the holding company to continue to profit from their operations while the FDIC was stuck with the losses from the failed institutions.  With authority to assess cross-guarantee liability now in hand, however, the FDIC has shown a willingness to assert cross-guarantee liability under facts that would not be considered by most to be abusive.  In this cycle, the FDIC appears to be willing to take full advantage of the assessment authority granted to it by FIRREA, using cross-guarantee liability as a “sword” to provide a recovery to the Deposit Insurance Fund.

The imposition of cross-guarantee liability starts with an assessment of control.  Whether institutions are “commonly controlled” for purposes of determining cross-guarantee liability depends upon whether each institution is under the control of a common entity under the Bank Holding Company Act of 1956, as amended (BHC Act).  Because the determination of control is made under the BHC Act, the Federal Reserve’s BHC Act control guidance is a useful guide. However, this guidance is very dense and can be quite complicated, requiring a review of the ownership structure, management practices, and other business affiliations of the two institutions.  However, one thing is clear:  In questions of control, institutions that share “management officials”—common directors and/or executive officers—are generally more likely to be found to be under common control than those that do not, all other factors being similar.

As a result, institutions with directors who serve on other bank boards or as officers of other banks should assess potential cross-guarantee risk through the director nomination process.  Nominating committees (or other committees of the board reviewing director qualifications) should ask the following questions:

  • Does the individual serve on as a director or officer of another financial institution?
  • Is there a basis for determining that the two institutions are under common control?  Answering this question will likely require consultation with legal counsel.
  • Is the other financial institution in a financial condition that is less than sound?

If the answer to all of these questions is “yes,” the nominating committee should think carefully about whether nominating that individual is a good idea.  In addition, institutions guaranteeing board seats to investors (such as in connection with a private equity investment) should consider an exception to the nomination requirement when the election of the representative could create a risk of assessment of cross-guarantee liability.

A risk assessment requires an in-depth factual, legal and financial analysis. There are few organizations that will find out this issue places them at risk, but it’s worth attention because the consequences can be severe. As a result, an assessment of this risk should be an integral part of the annual nomination process.

jhightower

Jonathan Hightower is an attorney in the Financial Institutions Group of Bryan Cave LLP.  His experience includes representation of both banks and bank directors on a wide range of issues. 

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