FDIC Lawsuit Targets Directors at Failed Banks and Thrifts
Directors of Heritage Community Bank sure haven’t caught many breaks. When the Glenwood, Illinois bank was seized in February 2009, the Federal Deposit Insurance Corp. invited the “60 Minutes” news show to tag along, making it America’s poster child for failed banks.
Now, outside board members can claim another dubious distinction: they are the first to face a civil suit by the FDIC in the wake of the financial crisis.
In a complaint filed in November of last year, the agency is seeking at least $20 million from 11 executives and directors, including five outsiders. The suit alleges the directors were guilty of “negligence, gross negligence and breach of fiduciary duty” in their oversight of a commercial real estate lending program that led to $230–million-asset Heritage’s collapse. The failure was estimated to cost the deposit insurance fund $42 million.
The directors aren’t talking, and John George, Jr., an attorney representing some of the defendants, declined to comment. In a statement, the group calls the suit “both regrettable and wrong.
“With the advantage of 20-20 hindsight, the FDIC blames the former officers and directors of a small community bank for not anticipating the same market forces that also caught central bankers, national banks, economists, major Wall Street firms and the regulators themselves by surprise,” the statement goes on. “The allegations in the complaint are utterly without merit, and defendants expect to be fully vindicated by the court.”
The Heritage suit is viewed as a harbinger of things to come for many of the 300-some banks that have already failed–and an esti-mated 200 to 300 more that might follow.
While it is actually the second filed by the FDIC–last July, the agency sued four former executives of IndyMac Bank F.S.B., a $32-billion-asset thrift in Pasadena, California that failed in July 2008– it’s the first to name outside directors as defendants.
The suburban Chicago bank got into trouble pursuing an aggressive CRE lending strategy that “looks consistent with what many other [failed] banks did” before the crisis, says Benjamin Shapiro, a partner at Belongia Shapiro & Franklin in Chicago, and a former regional FDIC counsel, who is familiar with Heritage. “That doesn’t bode well for those other banks.”
By early December 2010, the FDIC’s board had authorized civil suits to recover some $2 billion from more than 80 former bank di-rectors and executives, according to Richard Osterman, Jr., the agency’s acting general counsel. But, he adds, the numbers will cer-tainly get larger as more investigations are completed.
The agency filed suits in 24 percent of all failures during the thrift crisis of the late-80s and early-90s.
For boards at even relatively healthy banks, the coming surge in FDIC suits could mean “lower limits, elevated premiums and higher deductibles” for D&O insurance, says Christine Wartella, worldwide banking practice leader for Chubb Specialty Insurance.
Premiums “reflect the overall risk environment,” Wartella explains. While well-run institutions with strong balance sheets can still land competitive pricing, those facing “financial challenges” could see their options limited.
The flip side, Osterman says, is that most of the recoveries go to the deposit insurance fund. “It’s that much less that we have to collect in assessments, which is good for the industry.”
Not everyone is convinced that we’ll see a big wave of civil suits. David Baris, executive director of the American Association of Bank Directors, notes that during the thrift crisis, the FDIC brought many cases on the theory that a simple “negligence” standard applied.
The courts shot that idea down, in part because many states have “insulating statutes” that shield directors from liability. Today, a federal standard of “gross negligence” is in place, which supersedes state law for FDIC D&O claims.
Gross negligence typically involves a conscious and reckless disregard of well-understood required practices, such as not re-sponding appropriately after a regulatory warning to reduce loan concentrations. That makes it a tougher standard to meet than simple negligence, which is a mere failure to exercise reasonable care. One example might be failing to ask tough questions during board meetings.
“If they were operating under the theory that simple negligence was the standard for all these banks, and the FDIC sued in 25 per-cent of the cases, wouldn’t that suggest that there’d be fewer suits this time around?” Baris asks.
If state law permits, however, the FDIC can and will pursue cases based on simple negligence, but it can get confusing. Heritage’s directors are being sued for both gross and simple negligence, though a presentation by Vedder Price, the Chicago law firm, asserts that Illinois law bars suits for the latter. It will be up to a court to decide the validity of the charges.
According to the 33-page complaint, Heritage jumped into CRE lending in the early-2000s without having put in place the proper in-frastructure and controls. The bank made loans with high loan-to-value ratios and “routinely financed CRE projects–including specula-tive ones– … without any meaningful analysis of their economic viability,” employing entry-level employees as credit analysts.
In 2002, Heritage had $40 million in CRE loans on its books. By 2006, the number had ballooned to $178 million, or 634 percent of the bank’s Tier 1 capital, while net losses on its construction and land development portfolio ranked in “the bottom 3 percent to 4 per-cent of its peer group,” the suit alleges.
That year, the Illinois Department of Financial and Professional Regulation warned the board to halt CRE lending, launch a workout program and boost capital levels.
Instead, the bank added another $86.3 million in CRE-related loans between December 2006 and February 2009, when the bank was shuttered. The board “took little or no action to work out troubled loans” when the portfolio began to falter, and waited “until 2008, when the bank was on the brink of failure,” to commission an independent review of those loans, the complaint states.
Significantly, directors attempted to mask the bank’s problems by lending additional money to borrowers to help them pay existing balances, the suit says. The board also approved $10.2 million in dividend payments to the bank’s holding company, and more than $1 million in incentive awards related to CRE lending, when the bank needed to boost capital levels and loan-loss reserves, the suit adds.
Osterman won’t comment directly on Heritage, but according to a 1992 FDIC policy statement, outside directors are likely to face suits when they fail to heed warnings from regulators and outside advisors to correct significant problems.
One thing seems certain: the Heritage directors are in for a very rough time. Facing an FDIC suit “is like an atom bomb has gone off in your life,” says Baris, a partner at the Washington, D.C., law firm BuckleySandler LLP, who represented directors during the thrift crisis.
“You’re vilified by your government, embarrassed in the community, paying thousands of dollars every month to lawyers … and [enduring] depositions [that ask you] to remember what you did on a loan 12 years ago,” Baris says. “It’s a horrible experience.”
TARP’S Uncertain Legacy
How will history judge the Troubled Asset Relief Program? Launched in October 2008 during the depths of the global economic cri-sis, TARP was and remains deeply unpopular with many Americans. In April 2010, a Pew Research Center poll found that only 42 percent of respondents thought that TARP prevented a more severe financial crisis.
That certainly doesn’t square with U.S. Treasury Secretary Timothy Geithner, who told a congressional panel last December that TARP was “one of the most effective crisis response programs ever implemented.” The program eventually invested $389 billion in a large number of bank and non-bank financial institutions, as well as General Motors Corp. Much of that money has been repaid, and Geithner said the final cost to taxpayers could be less than $25 billion—a small price to pay, one might argue, to avoid a global eco-nomic meltdown.
But did TARP really prevent a financial Armageddon? Dennis Hild, associate director of regulatory relations at the consulting firm Crowe Horwath, in Oak Brook, Illinios, says the fact that most of the large systemically important banks repaid their TARP funds so quickly suggests they didn’t really need them in the first place. “It’s hard to say whether we would have been better off or worse off if we hadn’t had TARP,” Hild argues. “Did the crisis subside because of TARP, or would it have subsided anyway?”
Of course, that question is unanswerable. And yet it seems inconceivable that any presidential administration would have refrained from acting in the waning days of 2008—when the global financial system had seized up in a massive liquidity crunch—on the assump-tion that the crisis would somehow solve itself.
“If we had done nothing, the consequences in my judgment would have been severe,” says Hal Reichwald, co-chair of the banking and specialty finance practice group at Manatt, Phelps & Phillips in Los Angeles. “History will judge this as having been the right thing to do.”
No doubt economists, politicians and historians will debate the effectiveness of TARP for many years to come without a clear reso-lution since no one will ever be able say with any authority what would have happened if Washington hadn’t acted.