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Issues : Liability

What Keeps Directors Up at Night

January 4th, 2011 |

worried.jpgDuring the S&L crisis of the late 80’s and early 90’s, the Federal Deposit Insurance Corporation sued or settled claims against bank officers and/or directors on nearly a quarter of the institutions that failed during that time. If the past is any indication of the future, then there is a significant risk that directors of failed banks from the recent financial crisis may see some type of action taken against them by the FDIC.

In addition to lawsuits against senior executives of IndyMac Bank, and also senior officers and directors of Heritage Community Bank in Illinois, the FDIC has authorized actions against more than 109* insiders at failed banks to recover over $2.5* billion in losses to the deposit insurance fund resulting from this wave of bank failures.

Based on their work with a number of banks as well as individuals who are the targets of recent FDIC cases in various stages of development, John Geiringer and Scott Porterfield from the Chicago-based law firm of Barack Ferrazzano answer some questions about what could be keeping bank directors up at night.

What are the steps taken by the FDIC after the closure of a bank?

The FDIC begins a preliminary investigation when it believes that a bank may fail and will interview bank employees, officers and directors promptly after the bank’s closure.It is common for the FDIC to send a demand letter to the bank’s officers and directors demanding payment, usually in the tens or hundreds of millions of dollars, shortly before the expiration date of the bank’s D&O insurance policy.The FDIC sends that letter in an apparent attempt to preserve the D&O insurance for any litigation claims that it may later assert.

The FDIC may then subpoena officers and directors for documents and depositions. After conducting depositions, the FDIC will decide whether to initiate litigation against any officer or director. If the agency decides to litigate, it will initiate settlement discussions before actually filing its lawsuit. Because of the many evolving issues in these situations, such as whether insiders may copy documents for defense purposes before their banks fail, potential targets of these actions should ensure that they are being advised by counsel through every step of this process, even before their banks have failed.

What are the legal standards by which the FDIC may sue directors?

The FDIC bases its lawsuits on general legal principles that govern director and officer conduct and also considers the cost effectiveness of any potential lawsuit when making its decision. Federal law allows the FDIC to sue directors and officers for gross negligence and even simple negligence in certain states. What those standards mean as they relate to the conduct of bank insiders during this unprecedented economic cycle is difficult to predict at this time, although we are getting a clearer picture.

In the Heritage case, for example, the FDIC alleges that the defendants did not sufficiently mitigate the risks in the Bank’s commercial real estate portfolio and made inappropriate decisions regarding dividend and incentive compensation payments.

Will the FDIC differentiate between inside and outside directors?

Whether someone is an inside or outside director is one of the factors that the FDIC considers in determining whether to sue a director of a failed bank. According to the FDIC’s Statement Concerning the Responsibilities of Bank Directors and Officers, the most common lawsuits likely to be brought against outside directors will probably involve insider abuse or situations in which directors failed to respond to warnings from regulators and bank advisors relating to significant problems that required corrective actions.

Will D&O insurance cover any liability to the FDIC?

That depends on the amount and terms of the D&O policy. Directors should work with their insurance broker and bank counsel to review their D&O policies and to help them to make this determination. They should determine whether their policy amount is sufficient, whether their policy has certain exclusions (such as regulatory and insured vs. insured exclusions), whether proper notices are being made and under what conditions their policy can be cancelled.

What can directors do to mitigate their risk in the event that their bank fails?

In its Policy Statement, the FDIC states that it will not bring civil suits against directors and officers who fulfill their responsibilities, including the duties of loyalty and care, and who make reasonable and fully informed business judgments after proper deliberation. The FDIC generally requires bank directors to: (i) maintain independence; (ii) keep informed; (iii) hire and supervise qualified management; and (iv) avoid preferential transactions.

Directors should ensure that their bank’s counsel and other advisors are discussing these crucial issues with them. If their bank is in troubled condition, directors should seriously consider the need to hire personal legal counsel and to understand their ability to obtain indemnification.

Figures updated as of 1/4/11 based on latest reportings.

jgeiringer

John M. Geiringer is a partner with Barack Ferrazzano’s Financial Institutions Group and leads its regulatory practice area.

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