In July 2011, the former directors and officers of the failed $572 million-asset Haven Trust Bank in Duluth, Georgia, about 30 miles outside of Atlanta, were sued by the Federal Deposit Insurance Corp. in Washington, DC. A federal judge had previously dismissed a lawsuit from shareholders who were wiped out when Haven Trust went belly up. But now the FDIC was after them as well, suing for recovery of $40 million it says was lost due to ill-advised acquisition and development loans, improper loans to insiders and dividend payments to the parent company, Haven Trust Bancorp Inc. Twelve of the defendants in the FDIC case were outside directors who served on the bank’s board.
The FDIC has authorized lawsuits against more than 290 former directors and officers at more than 29 failed institutions, although the agency announced lawsuits against only 14 banks as of mid-September. Even more banks could be targeted as the agency seeks to recover losses that have been paid out by the deposit insurance fund in recent years. Legal action by the FDIC is just one liability threat facing the banking industry today. Suits from angry shareholders who saw the value of their equity holdings plummet because of poor lending decisions also have been widespread since the 2008 financial crisis sent bank stocks into a death spiral. And various legislative and regulatory initiatives—including the landmark Dodd-Frank Act—have heightened the industry’s liability risk even further.
Policy terms and pricing for directors & officers (D&O) liability coverage for healthy banks actually improved this year compared to 2010 as insurance underwriters became more comfortable with their liability profile. Unfortunately, banks in distressed financial condition must pay higher premiums and will have a difficult time finding insurance coverage without a host of exclusions that limit indemnification. Essentially they pay more for less because the liability landscape is so much worse for a troubled bank.
Kevin LaCroix, an attorney who works for insurance brokerage OakBridge Insurance Services in Beachwood, Ohio, and writes the blog “The D&O Diary,” says that if you use the savings and loan crisis of the late 1980s as a guide, less than one-quarter of bank failures will result in FDIC lawsuits. So far, there have been more than 390 bank failures since the start of 2008. More are expected, but the tide may be turning, as there were 865 banks on the FDIC’s “problem list” as of the second quarter of 2011, a 2.5 percent decline from the first quarter and the first pullback since 2006.
There were only 21 bank failures between 2002 and 2007, according to the FDIC. In contrast, there have been at least 71 since the start of 2011.
Haven Trust failed in December 2008, putting it fairly early on in the wave of bank failures that was to come. The FDIC has three years to file a lawsuit, and that’s almost how long it took for the agency to file against the Georgia bank. The FDIC says most investigations are completed in 18 months and there are opportunities to negotiate a settlement.
If none is made, the lawsuits usually are filed in federal court.
The regulators say Haven Trust Bank made loans to insiders, including family members of some of its directors, that didn’t meet the bank’s underwriting standards or were in violation of banking regulations regarding insider loans. In one instance, the bank gave a $3.4 million line of credit to an adult child of one of the directors to buy a hotel.
The lawsuit contends that the directors and officers violated the negligence standard under Georgia state law, saying the law sees “directors as agents of the bank ‘clothed with fiduciary character’— that is, owing a fiduciary duty of good faith and due care to the corporation. Any failure to meet this legal responsibility subjects the bank director to personal liability for any resulting losses to the bank, its depositors or other creditors.”
Tod Sawicki, the Atlanta attorney for the defendants, says the FDIC’s lawsuit is meritless.
“These officers and directors were experienced and highly respected bankers and businessmen who at all times acted in good faith, and with diligence and sound business judgment,’’ he writes in a statement. “They successfully grew the bank for eight years before the economic turmoil in 2008. All loans made by the bank were in accord with the bank’s standard policies and procedures, which policies and procedures had been approved by the regulators. Notably, as the unprecedented financial crisis put pressure on the bank’s condition during 2008, the regulators did not assist, and indeed appeared to resist, the directors’ and officers’ efforts to add capital to the bank and save it from failure. Their motive for doing so remains unclear and baffling to us.”
LaCroix says there will be a lot of such lawsuits during the next two or three years.
“It looks like it takes 18 to 24 months before they file an FDIC lawsuit,’’ he says. “They have every reason to take their time and make sure they have a good case. If it takes a year, they could never file a lawsuit or they could be taking time on other cases, and you don’t necessarily know what is happening. They don’t have to tell you anything.”
Dan Bailey, an attorney in Columbus, Ohio, who represents directors and officers on insurance and liability issues, says regulatory agencies have gotten more aggressive in recent years, in part because they were criticized for being at fault in the financial crisis.
“It’s a more difficult environment for public companies in general, but especially for banks,’’ he says. “You add to that the number of provisions in (the Dodd-Frank Act) relating to officers and directors, and the spotlight is very much on banks.”
The FDIC’s Deputy General Counsel Richard Osterman counters the claim that regulators have gotten more aggressive in response to the financial crisis.
“Bank directors and officers have certain duties for their banks and constituencies and Dodd-Frank doesn’t really change that,’’ he says.
During every financial crisis, and Osterman remembers the savings and loan crisis well, people criticize regulators, he says.
“At first, they say, ‘you’re not suing enough’ and at the end (of the crisis), they say ‘you’re suing too many people,’’’ he says.
In response to criticism during the last fiscal crisis, the FDIC issued a policy statement in 1992 clarifying when it would sue. Osterman says that still applies today. The agency recognizes a difference in what it calls “duty of care” between management and outside directors who aren’t involved in the day-to-day operations of the bank.
“The most common suits brought against outside directors either involve insider abuse or situations where the directors failed to heed warnings from regulators, accountants, attorneys or others that there was a significant problem in the bank which required correction,’’ the agency says. “In the latter instance, if the directors fail to take steps to implement corrective measures, and the problem continued, the directors may be held liable for losses incurred after the warnings were given.”
The agency says 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 business judgments on a fully informed basis and after proper deliberation. This is also known as the “business judgment” rule and protects business executives and directors who take reasonable care during the performance of their duties.
“We want to have good people serving (on bank boards) and we don’t want to have a chilling effect on good people serving,’’ Osterman says.
However, it’s not just the facts of the case that are considered in an FDIC lawsuit. Osterman says the agency considers how cost effective it would be to sue, meaning the potential recovery minus legal expenses, including what sort of insurance coverage the bank had and personal assets of the potential defendants.
Publicly traded companies have more to worry about in part because they have public shareholders who also might sue if the bank gets into trouble. LaCroix says he is most concerned about the potential impact of a provision of Dodd-Frank that applies to all publicly traded companies—the whistleblower rule—particularly since the Securities and Exchange Commission (SEC) for the first time is offering a specific award to encourage people to come to the agency with reports of wrongdoing at publicly traded companies. Information leading to a fine totaling $1 million or more will nab a 10 to 30 percent award for the whistleblower. Previously, awards were at the discretion of the SEC.
“That would definitely be a concern for me if I were managing a publicly traded company,’’ LaCroix says, adding it is doubly important to make sure your bank has a well-constructed monitoring and reporting system, to reduce the likelihood that management is unaware of problems.
For publicly traded companies, there’s also a new provision under Dodd-Frank that could impact banks. Following an accounting restatement of earnings, the SEC can clawback up to three years of incentive-based compensation, including stock options, from a chief executive officer, whether current or former, if that compensation was based on false earnings as a result of “material noncompliance” with any financial reporting requirement under securities laws. That is an expansion of the 12-month clawback allowed under the Sarbanes-Oxley Act of 2002.
Dodd-Frank also gave the FDIC powers to clawback up to two years of compensation from directors and officers of failed “systemically important” financial institutions—a provision that applies only to those institutions so designated by the U.S. government, according to a spokesman for the FDIC. The rule was intended to expand the FDIC’s powers beyond depository institutions to other large, complex financial companies.
Insurance underwriters and brokers have responded to the heightened liability environment by creating new products that meet specific needs.
The New York-based underwriter Chartis, which is the global property/casualty business of American International Group, introduced a new policy in March called Investigation Edge for publicly traded companies that covers up to $25 million of costs associated with SEC and U.S. Department of Justice investigations, including legal fees. (It doesn’t cover fines and penalties.)
The New York-based brokerage firm Marsh Inc. has a new FDIC endorsement this year to cover the costs of responding and defending bank officers and directors against FDIC attempts to recoup compensation and benefits of bank officers and directors of failed “covered financial companies” under the Dodd-Frank Act. It also indemnifies for amounts recouped by the FDIC, including salaries and benefits.
An FDIC spokesman, David Barr, says “covered financial institutions” under Dodd-Frank are only systemically important institutions as defined by federal regulators.
A spokesman for Marsh says the brokerage believes community bank holding companies and hedge funds as a group could be considered systemically important at some point in the future.
Despite all the insurance marketing pitches, it can be a real challenge to find coverage that will pay for the legal expenses and penalties associated with FDIC and SEC investigations.
Many insurers have been excluding regulatory coverage from their policies even as prices and availability have become more attractive for financially healthy banks, says Christine Wartella, vice president and worldwide manager for the banking practice at Chubb Group of Insurance Companies in Warren, New Jersey.
The FDIC actually fought regulatory exclusions in court after the savings and loan crisis in the early 1990s, because the exclusions limited the agency’s ability to recover money for the bank insurance fund, but the legality of regulatory exclusions were upheld in court.
Banks that are under distress will have a more difficult time getting insurance without a regulatory exclusion and their insurance will cost more, Wartella says.
However, the pace of bank failures has slowed this year, which is leading some underwriters to feel more comfortable about the industry’s liability profile, contributing to better pricing and coverage, especially for healthy banks, she says.
“D&O prices have been notching down,’’ she says. “We have seen the market willing to broaden some coverage. Unfortunately the D&O market has not been as soft on the banking industry as it has on general corporate America.”
According to insurance brokerage Aon Corp. in Chicago, the financial sector saw D&O pricing fall 11.5 percent in the first quarter compared to a year ago, while other sectors fell 18 percent on average. It was the sixth consecutive quarterly price drop for financials.
David Payne, a national practice leader and managing director at Aon Risk Solutions, says an average price for a healthy mid-sized bank is $15,000 to $20,000 per $1 million of coverage, amounting to at least $300,000 per year in premiums for $20 million worth of coverage.
However, the actual amount varies widely.
“Pricing is very much correlated to whether banks are public or private or the size of the assets,’’ he says.
Marsh says the average limit purchased by banks with $1 billion in assets is between $15 million and $20 million in coverage, corresponding to premiums of $225,000 to $290,000 for $20 million worth of coverage.
It depends on the condition of the bank, but the price can be three or four times as much for a distressed bank with financial problems, says Greg Flood, the president of Hamilton, Bermuda-based IronPro, the management and professional liability division of Ironshore Inc., an underwriter that will cover distressed banks.
“In my mind, a distressed bank is a bank whose lending portfolio is deteriorating and its lending capital is deteriorating,’’ he says. “If you can capture a sense of a management plan and an execution of a plan that could result in some sort of successful recovery, we are willing to get involved. It’s when you walk in, management doesn’t have a plan, and there is no interest from new investors and things are deteriorating,” that the insurer won’t provide coverage.
IronPro will rarely insure for what happened in the past, he says.
Dominic Senese, assistant vice president at CNA in Chicago, says the insurance company does insure distressed banks, but “that kind of coverage is going to be very restricted. Typically, it’s going to have a regulatory exclusion on it. We may put a past acts exclusion prior to the day of the policy. Typically, the premium is going to be higher.”
“A lot of the problems are (with) capital,’’ he says. “If they don’t have enough capital they can go to existing shareholders and ask for additional capital. Another situation is getting acquired. If we can meet with the bank, we really get to a good understanding as to how they’re going to be able to raise additional capital. We can meet on a conference call or in person.”
Thomas Iorio, vice president of financial institutions for Freedom Specialty Insurance Co. in New York, says his firm entered the market for D&O insurance for banks in 2008—at the height of the banking crisis—when it saw an opportunity in a market that would soon shrink in size.
Iorio says his insurance company looks at a regulatory agreement or order, even an informal one such as a memorandum of understanding, as a sign of distress for a bank.
“A significant amount of those banks don’t recover,’’ he says.
Smaller banks often pose a greater risk because they have trouble getting capital and have a higher concentration of land and construction loans, he says. The smallest bank his company insures has only $300 million in assets.
For banks trying to make themselves more attractive to insurance companies, and also reduce claims, Senese advises them to make sure they have a strong board with good corporate governance practices, and are attracting the right people to work at their institution.
“We spend a lot of time underwriting to the financial quality of the bank,’’ he says. “If it’s a good bank, it’s hiring good people to manage operations. It has qualified executives who know how to lend and abide by the standards.”
But the board’s make-up matters, too, he says.
“We look at the oversight from the various (board) committees,’’ Senese says. “We look at the mix of directors and the qualifications and what their experience level is. We like to see a good mix of independent and inside directors.”
The next couple of years will no doubt be a challenging time for the industry, given all the new regulations that have come out, as well as the possibility that the U.S. economy could be heading for another recession—which would place added pressure on bank loan portfolios. But while banks can’t control the economy or roll back regulations, having a strong board and well constructed internal controls and monitoring systems are still be best defenses against liability risks. |BD|