FDIC Blues
Michael Perry, the former chairman and chief executive of failed IndyMac Bank, finds himself a defendant in a civil lawsuit filed by the Federal Deposit Insurance Corp., and he’s not happy about it.
The suit alleges that Perry knew the secondary mortgage market was “volatile and uncertain” in 2006 and 2007, even as $32-billion asset IndyMac continued to generate some $10 billion in “risky” home loans. The Pasadena, California-based company’s inability to sell those loans led to its 2008 failure, which cost the Deposit Insurance Fund (DIF) $10.7 billion. The suit seeks damages of $600 million.
Most bankers and directors settle such suits quietly before they ever hit court; those who don’t typically maintain a low profile-if not to minimize the embarrassment, then on the advice of lawyers. Perry, however, has gone public with his frustrations.
On his blog, nottoobigtofail.org, he charges that the FDIC is “inappropriately seeking to blame banking executives like me for [its] own failures,” while also lamenting how the suit is damaging his reputation, finances and career. If IndyMac had only been bigger, he adds, the government wouldn’t have let it go under.
“Even if you accept all of the FDIC’s factual allegations against me as true … I am protected by the business judgment rule, which prohibits imposing personal liability on directors and officers for ordinary negligence,” he argued in a September motion to dismiss the suit.
Perry’s outspokenness over his lawsuit might be rare, but he’s far from alone in being sued by the FDIC. Through February, the agency had authorized suits against 427 directors and officers in connection with 49 bank and thrift failures sprouting from the crisis. Total damages involved: $7.8 billion.
Twenty-two suits were actually filed, naming 182 former directors or officers, with total damages sought of $1.98 billion. Fifteen of the suits included outside directors as defendants; three named spouses of directors and officers. Two, including one involving the biggest banking failure in U.S. history, Seattle-based Washington Mutual Inc. (WaMu), have settled.
If the past is prologue, then plenty more lawsuits are on the way. During the S&L crisis of the late 80s and early 90s, the FDIC and its cousin, the Resolution Trust Corp., brought claims against directors and officers in about one-quarter of all failures.
Since the beginning of 2008, the agency has shuttered more than 420 institutions, nearly 300 of them in 2009 and 2010. It investigates all failures, looking for ways to recoup losses incurred by the Deposit Insurance Fund and has three years to file a directors and officers liability suit. The statute of limitations on a growing number of those cases is fast approaching.
Another 813 institutions remained on the “problem bank” list at the end of 2011, many of them with grim prospects. “There will be more banks that fail, and the directors of those banks will be vulnerable to FDIC lawsuits,” warns David Baris, executive director of the American Assn. of Bank Directors and in Washington, D.C.
Shareholder lawsuits following a company’s collapse are common fare in corporate America. Bank directors get an added bonus: a federal agency empowered to bring personal claims against them to help recover losses incurred in a failure.
“If you have personal assets, those are at risk,” warns Richard Osterman, the FDIC’s deputy general counsel. “We will come after directors if they’ve breached their duties.”
Walt Moeling, an Atlanta-based partner with law firm Bryan Cave LLP, says the business judgment rule should protect most independent directors from liability, provided they didn’t violate their duty of loyalty or engage in self-dealing. Most boards have directors and officers insurance that covers regulatory action; that, practically speaking, is usually the pot of gold the agency targets.
“For an outside director who honestly thinks he’s performed his job adequately well, the odds are overwhelmingly against paying out-of-pocket,” Moeling says.
Insiders get sued more-Perry notes with mixed emotions on his blog how outside board members have escaped most of the legal turmoil-but even they don’t appear to face much risk. The agency’s suit against three former WaMu executives, for instance, settled in 2011 for $64.7 million, almost all of it covered by insurance.
Former Chairman and CEO Kerry Killinger paid $275,000 and agreed to forfeit $7.5 million in claims against the company’s retirement accounts-a relative slap on the wrist compared to his $88 million in compensation during the previous six years. The $309-billion asset thrift was seized in September 2008, its banking operations sold to JPMorgan Chase & Co. for $1.9 billion.
Even so, when it comes to facing the FDIC in legal proceedings, nothing is certain. Baris says that during the S&L crisis, the agency regularly pursued claims against individual directors that exceeded insurance coverage. He recalls one wealthy director who “wound up settling for 20 percent of his net worth.
“If there are deep pockets around the table, the FDIC will go after them,” Baris adds.
Not surprisingly, defense attorneys say most directors facing suits feel unjustly persecuted. The lending decisions that led to many bank failures were made before a big collapse in real estate prices that no one, including regulators, foresaw. How can the agency hold directors, or even management, personally liable for forces beyond their control?
Yet that appears to be happening. According to figures compiled by Cornerstone Research in San Francisco, 57 percent of the suits filed through January cited losses on commercial real estate loans as a basis for damages, while 43 percent counted construction loans as a basis. Only 4.76 percent of the suits included a basis-imprudent dividend payments-that sounds governance-related. (Many suits claim damages on multiple bases.)
Members of loan committees are the most-likely targets of suits, according to an analysis by Baris. “The theory is that being on the loan committee changes the relationship between the [loan committee members] and the institution-that they are exercising executive management responsibilities, and hence are not entitled to the protections of the business judgment rule,” explains Harold Reichwald, a partner and co-chair of the financial services group at Manatt, Phelps & Phillips LLP, a Los Angeles-based law firm.
That’s not fair, he adds, because the regulators have encouraged directors of community banks to serve on loan committees.
Bank directors who are pursued by the FDIC “find themselves at a loss, trying to figure out what they did wrong, short of having made decisions that were based on the best information available at the time,” Reichwald says.
The FDIC’s Osterman counters that loan committees at most failed banks had sound lending policies down on paper, but directors ignored or overrode them. “Anyone who looks at it in a reasonable way would say, ‘Just follow your own rules,’” he says.
Despite the real estate collapse, he adds, most banks did not fail. “The fact is, the economy will go bad at some point. That’s not a surprise. We have cycles all the time.” The job of directors, he adds, is to ensure the bank is prepared to ride out the bad times, not just bask in the good ones.
Even if a director doesn’t pay out-of-pocket for a failure, the process of being targeted by an FDIC suit-or even being investigated for one, which most failed-bank directors experience-can be painful.
In most cases, board members have worked overtime fighting a losing battle with problems for which they feel only somewhat responsible. Their investment in the bank’s stock is worthless, and they feel guilt over what the failure has done to shareholders and employees. Now, they face months, sometimes years, of stress, scrutiny and uncertainty as a federal agency looks for ways to recoup the losses.
The process isn’t supposed to be punitive-the agency is charged with bringing suits only when they are deemed both “meritorious” and “cost-effective”-but it sure can feel that way.
Directors must hand over personal financial records to investigators, and are subject to subpoenas for other documents. Sometimes, they are deposed. Local newspapers like to write stories detailing the failings of community leaders. “It tears people up,” Baris explains. “For a lot of these people, it’s about more than the money. It’s their reputation. If the FDIC sues you, there’s a taint that you did something wrong.”
During the last big round of failures, the pressure caused nervous breakdowns or other health problems in some of Baris’ clients. “I’d get calls in the middle of the night from people who were worried sick” about the prospects of going to a public trial against the government, he says. “And now I’m getting those kinds of calls again.”
Osterman says the agency is aware the experience isn’t pleasant, but it has prescribed duties to perform in the public interest. “We understand. It does affect people’s lives. That’s why we look at these cases so carefully before we bring them,” he says. “Our job as receiver is to maximize recoveries to the receivership estate, not to punish people.”
Civil suits against directors and officers typically charge either negligence or gross negligence, depending on the laws of the state in which the bank is headquartered. Sometimes, the charges can look scandalous. In a suit against nine directors and officers of failed Mutual Bank in Harvey, Illinois, the FDIC alleged, among other things, that the board approved spending $250,000 for a director’s wedding, and another $300,000 for a board meeting in Monte Carlo.
Mutual’s directors have vigorously denied the claims. The $1.6-billion asset family-run bank failed in 2008, due to bad loans, and the FDIC expects costs to the DIF to hit $775 million. The agency is seeking $127 million in its suit, which is pending in U.S. District Court in Chicago.
Most cases lack such drama. Typical was the agency’s case against Corn Belt Bank & Trust Co. in Pittsfield, Illinois. The $260-million asset company failed in 2009, due to a handful of bad loans to out-of-market startup businesses that were “improperly underwritten,” costing the DIF $79.7 million. The FDIC sought $10.4 million and the case was settled for an undisclosed sum in May 2011.
The countdown toward a failure typically starts several months before the actual seizure, when the bank receives a Prompt Corrective Action notice from its primary regulator. Issued when Tier 1 capital levels fall below 2 percent of assets, a PCA gives the institution 90 days to raise additional capital.
Board members who suspect they will not be able to raise that money should hire counsel, if they haven’t already, some attorneys say. The bank’s attorneys might be able to lend some help, Moeling says, but their primary allegiance is to the institution, not the board. Sometimes, individual directors-or subgroups of the board-might hire their own counsel, if they perceive a unique risk.
An experienced attorney can walk directors through their options, review the insurance coverage and prepare them for what comes next. Some directors and officers (D&O) policies, for instance, require the board to formally notify the insurer as soon as it knows that the bank is in trouble.
On Failure Friday, investigators from the FDIC’s Division of Resolutions and Receiverships conduct short, on-site interviews with bank officers, who are required to be there, to begin piecing together what happened.
The initial questions are typically broad: Why do you think the bank failed? How did it get to the point where it is today? Attorneys are not allowed to be there-if you insist on one, then the FDIC will likely raise the legal stakes by conducting formal depositions. The best advice: Tell the truth, don’t point fingers at someone else, and don’t concede that decisions made five years ago look wrong today.
Above all, keep up your guard. The investigators might not know much about the bank that first weekend, and are fishing for evidence. “Often they’ll be very friendly and conversational,” says John Bielema, a D&O litigation attorney for Bryan Cave. “But they’re not your friend. The investigators have an agenda-to put together a claim against you. So you need to be very careful about what you say.”
Outside directors should steer clear of the bank. Technically, they no longer have any role to play, and if they show up, they will likely be interviewed. Nothing good can come from that. “We tell them, if there’s a reason to take a mountain weekend or go to the Caribbean, do it,” Bielema says.
In the weeks that follow, investigators will gather bank data, including loan and appraisal information. The agency has full subpoena power, although it doesn’t always use it, and will demand to see any documents related to bank business, including emails, in a director’s possession. They also will collect personal financial backgrounds on directors and officers, to see what resources are available in a potential suit.
Fairly early in the process, sometimes within weeks, the FDIC sends a formal claim letter by mail to directors’ homes. “It says, ‘Please send us a cashier’s check for $64 million to cover the losses,’” Bielema says. The letter is an expected formality, meant to activate the D&O coverage before a policy expires, and “no one in the history of the world has ever paid it.”
Nonetheless, most directors “freak out” when they receive it, Reichwald says. “It’s a little bit of a fan dance. The FDIC goes through this process without any real understanding of what it does to that body of serious-minded people who serve on boards.”
After the claim letter arrives, there is often a lull in activity. The agency typically takes about 18 months to investigate a failure. During that time, it might communicate with board representatives, or it might not. If the investigators find enough evidence of malfeasance-and enough money to be recouped, via either insurance or deep-pocketed directors-they recommend to the FDIC board that a suit be authorized.
The recommendation “lays out what we’ve found, the theory of the case we might bring, and discusses the cost-effectiveness of bringing that action,” Osterman explains.
Since the agency will only sue if there is recovery money available, it’s possible that directors could have committed “bad acts,” but won’t become defendants. “If there’s a clear regulatory exclusion in the D&O policy and the board is populated by 12 folks with an average net worth of $400,000, it’s highly unlikely they’ll go forward,” Bielema says.
Before authorizing a suit, FDIC board members ask investigators a lot of questions, Osterman says. He says the board seeks to strike a balance between holding people accountable, and not discouraging good people from wanting to serve on bank boards.
If a suit is authorized, the FDIC’s attorneys-often including an outside firm that helps bring cases to court-are ready to negotiate. The agency has no big desire to go to trial, Osterman says. That costs money on both sides, and funds-including the pool of D&O insurance money being spent on the board members’ defense-are dwindling.
This is where mediation comes into play. For directors, it’s often the most crucial stage of the process. Until now, the board hasn’t had access to such vital documents as loan committee minutes, loan files or regulatory reports that the FDIC is basing its case on. Those belong to the bank, which was taken over by the agency.
The agency will typically provide the relevant documents, if for no other reason than it will have to hand things over in a lawsuit anyway, and most defense attorneys won’t enter into mediation without them. But it takes time. Customer privacy is important, so confidentiality agreements must be hammered out. “The information flow sometimes becomes an impediment,” says Christine Wartella, banking practice worldwide manager for Chubb Specialty Insurance.
Sometimes mediation takes the form of informal talks over weeks between attorneys on both sides. More often, a daylong formal session is set up. Usually held at a suite of offices in a law firm or specialized mediation firm, directors arrive early in the morning nervous and full of anticipation, knowing a resolution is possible that day.
“It’s the window to put this whole ordeal behind them, to get full releases and move on with their lives,” Bielema explains. “But the mood is almost always tense.”
The specifics can vary. Often, the two sides will exchange briefs outlining their positions. Sometimes, the mediator-usually a retired judge or lawyer-will hold an opening “plenary session” that brings both sides together to make their cases. Occasionally, confidential briefs are submitted to the mediator, but not shared with the other side.
Most of the day is spent sequestered in a suite with the directors’ legal team and insurer. The FDIC team, in a suite down the hall, makes its first offer. “Invariably, it’s outlandish,” for more than the D&O insurance can cover, Bielema says. “We try to prepare the directors for that. The opening offer is not their final position.”
The directors’ side responds in kind, with a lowball offer. And the session has begun. The mediator works “to pressure the sides to understand the weaknesses in their own positions and move their number closer to the other side’s number,” Bielema explains. As long as progress is being made, the process continues.
The negotiations can take on the feel of a high-stakes poker game. But it also can be boring. The FDIC submits an offer, it’s discussed around the room, and a counter-offer is made. The folks in the room might briefly discuss what they expect the agency’s response to be. Mostly, they sit around, drink coffee, play with their smartphones and engage in idle conversation. It’s not unusual for the session to last a full day, or longer. Reichwald has been involved in talks that have stretched over several days.
Along the way, issues can emerge. If an offer comes in below the D&O coverage limit, for instance, directors might want to settle, while the carrier wants more reductions. The pressure they can exert on the insurance firm is a major reason the FDIC wants directors to participate in the mediation, attorneys say.
Sometimes, unusual alliances are formed. In a suit following the failure of the First National Bank of Nevada, the D&O carrier, Lloyd’s of London Catlin Syndicate 2003, balked at a proposed settlement. So the agency and officers settled, with the latter settling for $40 million and assigning the right to collect against Lloyd’s to the FDIC. The fight is now between the agency and the carrier.
If a settlement isn’t struck by the end of the day, but the mediator feels that progress is being made, a second session may be scheduled. If the two sides are close, the attorneys can sometimes whittle away the differences over the phone. If the mediator believes the talks have stalled, he will call off the proceedings, leaving litigation as the last resort-though negotiations can continue until the day of the trial.
Pre-suit mediation doesn’t occur in all cases. Sometimes the insurance carrier won’t come to the table; other times, it’s the directors who refuse. Reichwald is representing a group of failed-bank board members right now. “They’re saying, ‘Hell, no. We’re not going to admit that we did anything wrong in a settlement,’” he explains. “Why should they have an admission of wrongdoing on their records? No director wants to bargain away his reputation.”
That’s within the directors’ rights, but sometimes D&O policies include clauses that reduce the amount of insurance money available if the carrier wants to settle, and the directors choose not to. “If the insured wants to continue the fight, then the policy might only cover 50 percent of the defense costs thereafter,” Wartella explains.
THAT COULD LEAVE BOARD MEMBERS IN PERRY’S SITUATION, EMBITTERED AND WAITING AS AN UGLY CHAPTER IN THEIR PERSONAL AND PROFESSIONAL LIVES PLAYS OUT IN THE PUBLIC EYE.
Join OUr Community
Bank Director’s annual Bank Services Membership Program combines Bank Director’s extensive online library of director training materials, conferences, our quarterly publication, and access to FinXTech Connect.
Become a MemberOur commitment to those leaders who believe a strong board makes a strong bank never wavers.