Legal and Regulatory Challenges for 2005: What Bank Boards Should Prepare for in the Year Ahead

James M. Rockett and Neal J. Curtin, attorneys with the law firm of Bingham McCutchen LLP, spoke to Bank Director about the regulatory landscape, director liability, and boardroom challenges for the year ahead.

What major pieces of legislation have had the most impact on the banking landscape in the last five years?

James Rockett: One of the most sweeping changes came from Title III of the USA Patriot Act, which gave new life to the discredited “Know Your Customer” rules. Title III shifted the national focus from customers’ need for privacy to bigger concerns over security after 9/11. However, this new intrusion by the government has now created what one might refer to as a “network of spying” by banks on their customers—without providing any specific guidance for how banks are expected to do so.

Why is Title III such a challenge?

Rockett: At the time of its conception, the implementation of Title III was seen as relatively benign—it was viewed as a bank’s patriotic duty to keep track of suspicious or high risk customers and to help track terrorist financing. However, in light of the Riggs Bank and Amsouth cases, which have been used as examples of a failure to adhere to anti-money-laundering (AML) procedures and to file suspicious activity reports (SARs), the regulators have become completely obsessed with the implementation of both Title III and the AML provisions of the Bank Secrecy Act. These require banks to track any transactions that appear “suspicious.”

This emphasis has resulted in a flood of enforcement actions against banks—many of them accompanied by substantial fines. Along with these developments, law enforcement has taken the position that a bank’s failure to file an SAR can lead to criminal prosecution of the institution. So in essence, what we’ve done is criminalized what would normally have been a compliance and regulatory matter.

Neal Curtin: All of this is really part of a larger, more general trend of an increased focus on compliance, and it has been coupled with the heretofore never seen activist positions being taken by federal and state regulators, U.S. attorneys, and state attorneys general. All regulated industries, including insurance and securities, as well as banking, have had major developments along these lines. The regulators are scrutinizing business activities in a manner that is more dramatic than ever before.

The result is that smaller institutions are suffering tremendously—AML is a profound burden on them. However, I do think we are starting to see some signs of regulators’ recognition of that, so perhaps some of the beaurocratic requirements will start to peel away, and we will see some results that move banks in a better direction.

Rockett: The challenge for bankers is that they grew comfortable in the “war on drugs” which involved spotting large transactions of “dirty cash” entering the system and reporting them under the Currency Transaction Report guidelines—but the process changed dramatically with the relatively small amounts of money used to finance terrorist activity—it’s like locating a needle in a haystack. In fact, I would submit that it’s almost impossible. And this is further complicated by the fact that the government has expanded its focus from terrorist financing and is using the Patriot Act and Bank Secrecy Act to attempt to detect other types of money laundering and financial crimes such as Ponzi schemes or check-kiting operations.

The bottom line is the nation’s banks are now subject to scrutiny and possible adverse regulatory action for providing banking services to anyone who transfers funds that could potentially be used for terrorist activity or any other financial crime. It is a real second-guessing process.

How should bank boards approach this new mandate?

Rockett: Directors have to weave in compliance as part of the fabric of their institution. And they have to understand that if they don’t have it ingrained in the character of the organization, they are likely to spend a good deal of time in the penalty box—and thus be unable to pursue their strategic growth objectives through M&A transactions, other strategic growth initiatives, or even by de novo branching. So today it’s critically important for board members to focus on compliance—which is not something, historically, that has been a priority at the board level.

In reality, many board members—especially those who have confronted these issues because of enforcement actions—are truly frightened about what is going on. Some of them feel victimized by the apparent arbitrary manner in which these laws and regulations are enforced. Moreover, these laws require the devotion of enormous resources to accomplish objectives that are clearly outside the scope of banking and properly belong to law enforcement.

And what about the expense?

Rockett: It’s enormous, and it’s required without giving banks any equalizing sense of accomplishment. By comparison, if you look back to the implementation of the Community Reinvestment Act (CRA) in the 1980s, banks put up a lot of resistance to it. But eventually, CRA became routine, and, more important, banks learned how to make money from it. Investing in and building relationships is a natural outgrowth of community banking. But there is no business benefit from anti-money-laundering compliance programs where thousands upon thousands of largely ignored SARs are filed with the government. I would even go so far as to say there is no law enforcement crime prevention benefit, though I may be challenged for doing so.

Do you see any benefit that helps balance these negatives?

Curtin: While there are aspects of the scrutiny that are onerous, and many people agree with Jim that there’s no social benefit for it, in many ways, the thrust of the reform is in the right direction from the standpoint of good governance. Today, boards are much more sensitive to what their responsibilities should be and that they can’t just sit there like a bump on a log and enjoy the collateral benefits of the position. So in theory, it’s good, but in reality, it’s often two steps forward and one step back.

In terms of other legal developments, what impact will the Enron/WorldCom cases have in the boardroom?

Rockett: Backing up a bit, we should first look at the Sarbanes-Oxley Act, which superimposed a new structure on the boardroom that has begun to tarnish the relationship between directors and management. Some people would say that is healthy, because you need directors who are independent and are able to express themselves without fearing they will be viewed as disruptive. But that’s only partially true, because you need to have cooperation and a sense of common goals to advance the overall objectives of the corporation.

Having said that, a couple of bad apples can always spoil the barrel— and Enron and its progeny have certainly done that. But overall, it isn’t healthy for directors and management to view each other with mutual skepticism and suspicion. It’s healthier for the board and management to have a sense of commonality and a good working relationship.

But aren’t these reforms setting the stage for a corporate America with an improved sense of best practices?

Rockett: I think the pendulum has swung too far with Sarbanes-Oxley. In the past, there was an expectation that the board was protected in its decisions as long as it consistently acted with informed business judgment. In the new environment, trial lawyers have acted punitively and have undertaken to extract personal financial settlements from directors. These developments have created grave concern on the part of directors. One might ask: Did these cases involve aberrant circumstances? We don’t know at this time. Will such cases cause directors to act more efficient and effective in their oversight? In my view, it is unlikely. Directors have to be free to do what they think is in the best interest of shareholders and to advance what they believe to be a proper agenda. If that turns out in hindsight to be wrong, they shouldn’t be held accountable—and certainly not on a personal level. The recent settlements where the directors were held accountable—beyond the D&O insurance available to them—are not in the best interest of corporate America. Moreover, I think they will stifle innovation and dampen the corporate entrepreneurial spirit.

Having said that, clearly, when directors don’t provide the oversight, guidance, and judgment that is required of them, they should be held accountable—though right now the pendulum has probably swung too far.

Do you believe the protection afforded by the business judgment rule has been eroded?

Rockett: There has been a tightening of the application of the business judgment rule, and it no longer provides the barriers to liability it once did. Is this temporary? One would hope so, because it really will stifle the corporate entrepreneurial spirit. In some ways, Sarbanes-Oxley represents an overreaction—the laws under which the Enron directors were held accountable actually pre-dated Sarbanes-Oxley. I hope, eventually, directors will feel more comfortable and be more enthusiastic with their business plans and their management teams so that once again they are free to create value for their shareholders and the American economy.

Curtin: There have been some recent cases to come out of Delaware that have been troubling. What's happened is, despite the general proposition that the business judgment rule is supposed to protect directors, courts have begun to examine whether directors have truly been loyal or not, looking at conduct or the lack of it, and concluding that the actions or inactions were not in good faith and therefore not loyal. They are second-guessing whether a director has fulfilled his duties in a manner that I think many people have found surprising.

Even so, while some cases out of Delaware seem to set standards that are troubling, they never really achieve a broad acceptance in other states. Massachusetts, for example, never adopted a Revlon doctrine (referring to the duty of directors to get the highest price during a sale). In effect, Revlon meant that the sale must be at the highest price—but it failed to take into consideration all of the complexities and constituencies that are involved in whether you sell your company and how you orchestrate it. It took years for Revlon to evolve into a more balanced position. So sometimes ideas come out of Delaware that are a little radical.

What constitutes the duty of loyalty and why is it being questioned more today?

Curtin: When a court attempts to determine whether directors are appropriately loyal, it raises a question about whether or not it is really applying the business judgment rule. Determining loyalty traditionally meant determining whether board members have a side agenda. For instance, if a bank were to sell, the CEO director might lose his job, so he may not be as objective as he needs to be. The board must be loyal to the shareholders. The standard is for board members to act honestly in good faith as a reasonably prudent director would do. As a general principle, this is unremarkable. What has happened, in one sense, is a litigation development. Once corporations were authorized by law to exculpate directors for breaches of the duty of care, plaintiffs then argued that the conduct was so bad, it was not honest and in good faith. If courts accept this argument, directors are exposed to personal financial liability and, even worse, the protection of indemnification and insurance may not be available.

Has this heightened awareness about duty of loyalty accelerated the trend toward more independent boards?

Curtin: Yes—it is almost a base requirement today even for smaller companies to have a majority of board members who are “disinterested.” Building a board with independent members is one way to do so. It’s a great comfort to have directors who have no other interest besides that of a shareholder.

In your view, are boards prepared to handle all that has been put on their plate?

Curtin: Today there is more intelligent discussion in the boardroom about how general issues and director responsibilities should be addressed. I am seeing this, even to the extent that many smaller banks are applying best practices and Sarbanes-Oxley requirements where they aren’t required by law. So in general, it’s a time of heightened awareness about governance practices and compliance that is beyond anything anyone has seen in the past.

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