Boardroom on Fire: A Bank Chairman’s Painful Lessons from the Financial Crisis

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chairman-4-9-19.png“A sheriff’s car pulls up—the bank is on lockdown.” David Butler wistfully recalls that day in 2009; the day he lost everything.

“It was pretty traumatic,” he admits. “You have to ask tough questions. Can we survive it? What do we do? What’s our exit strategy?”

The events that transpired that fateful Friday afternoon send shivers down the spines of every bank director—the worst case scenario. No, not a robbery. The other worst case scenario.

“The FDIC comes in. They lock the doors and secure all our records before anyone’s allowed to go home.”

Butler was a founding board member of Western Community Bank. Western was big, state-chartered and publicly-traded. In 2007, they acquired a chain of banks with a sizable chunk of money tied up in Florida real estate. It was a ticking time bomb—and, spoiler alert: it was about to go off.

The early fallout of the housing market crash saw Western hemorrhaging $6 million a quarter, making Butler’s board an easy target for regulators.

“The FDIC wanted litigation wherever they could get it; half the time, even where they couldn’t,” he groans. “The public wanted heads to roll and we made perfect targets.”

Western had a clean public shell; no run-ins with the SEC—they were squeaky clean. But as the recession raged on, it became clear that “clean” didn’t cut it. “People were investigated, detained even, based on what? The suspicion of malfeasance? Yet we saw banks engaging in improper, verging on illegal activity walk away scot-free.”

This federal fishing expedition left Butler with a lingering paranoia; the fear that an army of pencil pushers sporting black suits and earpieces might knock on his door to have their Mission Impossible moment at his expense.

One month into 2009, Western’s shares plunged 95 percent. The finger of blame inevitably found a target. “Our CEO was a great guy, but the recession hit him like headlights on a deer,” Butler laments. “We asked him to resign. It was one of the most painful things I’d ever done.” The resulting shuffle in leadership landed David in the role of acting chairman.

“My job primarily became keeping morale up as we scrambled to find a partner,” he recounts. “We didn’t want depositors losing money, but we didn’t want to lose depositors. If they’ve got half a million in the bank, telling them to move it is hard, but it’s the right thing to do.”

Depositors weren’t the only people Western risked losing. The FDIC shot down attempts to offer retention bonuses, leaving Butler at the mercy of employees’ goodwill. “How do you ask someone not to jump ship when they’re waist-deep in water?”

As Butler fought to keep all hands on deck, Western’s board was rocking from the turbulence of days spent sparring over the bank’s balance sheet and late-night conference calls consumed by quarrels over how and where they would stretch its tier one capital.

“You can’t measure the character of your board until it’s been strained.”

“We had our share of those who didn’t stay the course,” he concedes. “Some resigned; some pointed blame—but then there were the ones who stuck it out. Even when it looked hopeless; even when tensions ran high, their commitment never wavered. I hold those people in the highest regard to this day.”

It was an act of bittersweet mercy when, in May 2009, the other shoe finally dropped.

A cease-and-desist order earlier in the year saddled Western’s board with a bureaucratic obstacle course of audits, reorgs, policy rewrites and loan appraisals; with no less than 15 deadlined reports to the state banking commission. One of the many hoops the board was forced to throw itself through required a reevaluation of Western’s loan loss reserves; an amount they determined to be $33 million. Butler was called to meet with the FDIC shortly thereafter.

“They sat me down and told me we needed $47 million,” he says. “I told them they were about to close my bank. We all sat there silently for a minute.”

Three months later, the state banking commission seized control of Western Community Bank, just $2 million shy of meeting its reserve requirement. The bank was turned over to the FDIC and sold to a local competitor for pennies on the dollar.

Where was Butler—the man who risked it all—that Friday afternoon when they came to take it all away?

“Our legal counsel advised us to stay away from the transition to avoid any situation where we might be questioned without an attorney present,” he explains. “So my wife packed a picnic basket and we drove to the beach.”

What about the anger, the resentment, the righteous indignation at the hopelessness of it all? “There was plenty of that to go around,” he admits. “The fact that we could fail was all they needed to treat us like we would. But you reach a certain age where you don’t have time to be angry. There’s no use holding onto all that bitterness.”

A decade has passed since that Friday afternoon when Butler lost it all. Murmurs of a looming recession seep from the rich vein of alarmist gossip to circulate amongst those with a finger on the pulse. “If those kind of whispers reach your ears, it means you’ve kept one to the ground,” Butler posits. “If you’re a bank director, you’ve got a choice. You can pick that ear up off the ground and look towards the future. Or,” he adds with a grin, “you can bury the rest of your head.”

Assessing a Bank’s Culture Is Hard. Here’s One Way To Do It.

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culture-6-28-18.pngIf the members of Wells Fargo’s board of directors had spent time a few years ago reading through comments on job review websites, where current and former employees post reviews of their employers, the bank might have been able to avoid its current predicament.

The phrase “sales goals” shows up in 1,253 reviews on Glassdoor.com, a popular website used by job seekers. And hundreds of those reviews were posted before Wells Fargo’s management identified sales practices as a “noteworthy risk” to the board in February 2014.

Here’s a teller in 2008:

At least on the retail side of the company, the pressure of getting sales is too high…leading to unethical selling practices which are not corrected.

Here’s a branch manager in 2009:

I saw other stores exceeding [sales goals] by 150 percent or more and initially wanted to learn from those stores . . . What I found was that they had thrown all ethics out the door. I was shocked and appalled . . . So, naturally, I alerted my manager. I reported blatant cheating to the ethics line. I alerted human resources. Nothing happened to the officers except promotions!

Here’s a personal banker in 2013:

Unethical behavior, very high sales goals, things are not done with customers’ best interests [in mind].
It isn’t easy for a bank’s directors to gauge its culture, but the fallout from Wells Fargo’s sales scandal shows how important it is to do so.

“Good news tends to travel up much more quickly” than bad news, said Elizabeth “Betsy” Duke, the chairwoman of Wells Fargo, at a recent conference on governance and culture reform hosted by the Federal Reserve Bank of New York.

One way directors can assess culture is to visit business units and attend corporate functions. “Such dip-sticking appraisal does not require detailed understanding of technology or process, but an outside board member’s opinion on the behavioral atmosphere and tone at the front line or in the engine room could be critical input,” said Sir David Walker, former chairman of Barclays plc, in his concluding remarks at the conference.

Another way is to use websites like Glassdoor. Had the directors of Wells Fargo done so, they would have known long before February 2014 that the bank’s sales practices were a noteworthy risk.

A board should also monitor job review websites because the reviews on them reflect the bank’s reputation and impact its ability to attract talent. Job seekers use these websites in the same way that diners use Yelp.com to choose a restaurant and apartment seekers use websites like ApartmentRatings.com to find a place to live.

This is especially important right now. With an unemployment rate below 4 percent, good workers are hard to come by, and the ones that are willing to switch jobs are demanding higher salaries.

We captured the challenge of a competitive labor market in our 2018 Compensation Survey, done in collaboration with Compensation Advisors, a member of Meyer-Chatfield Group, which will be published in the third-quarter issue of Bank Director magazine.

“It’s a tight labor market, and the expense to hire and retain talent is going up,” said Flynt Gallagher, president of Compensation Advisors.

A good score on job review websites helps combat this. A study published by Glassdoor in 2017 found that people who read positive reviews about a company were more eager to apply to it and recommend it to friends than they would have been if they read negative reviews.

The study also found that people are willing to accept smaller salary increases to switch jobs if they are recruited by a company with a high employee approval score relative to a company with a low score. “This is consistent with economic theory, which predicts that people will accept lower salaries in exchange for a good workplace environment or other positive features of a job,” noted the study’s authors.

It’s worth pointing out, too, that participants in the study found online reviews to be more credible than human resource awards—“The Best Place to Work in Chicago in 2018,” for example—which are often publicized by companies to attract talent.

These findings underscore the value of monitoring websites that include reviews of the company’s internal work environment. A bank’s human resources department does it, and so should its board. If Wells Fargo’s directors had done so prior to 2014, its reputation might not have since suffered so much.

Who Wants to Be a Bank Director?

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governance-9-22-17.pngThe Wall Street Journal recently ran a column under the headline, “Why Would Anyone Sane Be a Bank Director?” It was written by Thomas P. Vartanian, a partner at the law firm Dechert LLP and a former general counsel of the old Federal Home Loan Bank Board, a former thrift regulatory agency that was superseded by the Office of Thrift Supervision. Vartanian pointed out that after every financial crisis over the last four decades, Congress and the bank regulatory agencies have piled a new layer of regulation on the banking industry, which has given bank directors an increasingly difficult governance task, while also raising their legal liability. I found little to argue with in that statement, and in fact, the increasing regulatory burden was the subject of a Bank Director magazine cover story in the second quarter 2016 issue.

So, to his question, why would anyone want to be a bank director? Certainly, it’s a challenging job which rarely offers a level of compensation commensurate with the time demands and liability risk. And operating in a thicket of regulations isn’t the only problem facing bank directors today. Emerging threats like cybersecurity, a challenging interest rate environment and the impact that digital commerce and fintech disruptors from outside the industry is having on the traditional bank business model are also bedeviling bank boards today. I think many bank directors serve because they are interested in banking and still see prestige in such an appointment, and because it provides an opportunity to give something back to their community.

On September 25-26, Bank Director will host the 2017 Bank Board Training Forum at the Ritz-Carlton Buckhead, in the northern edge of Atlanta. This will be the fourth year for this event (the first two years were in our hometown of Nashville, and last year we were in Chicago), and it is designed to provide bank directors with a broad perspective on many of the issues that bank boards must deal with today, including risk, compensation, governance and technology.

In his article, Vartanian pointed to a recent proposal made by the Federal Reserve Board that, among other things, would provide updated guidance on the supervisory expectations for the boards of banks and thrifts. The Fed would more clearly define the roles of the board and ensure that most supervisory findings make their way to the right hands—management teams, rather than the board. For supervisory purposes, boards of bank and thrift holding companies with more than $50 billion in assets would have several responsibilities. Here they are:

  • Set clear, aligned and consistent direction regarding the firm’s strategy and risk tolerance.
  • Actively manage information flow and board discussions.
  • Hold senior management accountable.
  • Support the independence and stature of independent risk management and internal audit.
  • Maintain a capable board composition and governance structure.

To me, those are principles of good corporate governance in a banking context that every board should internalize as their modus operandi. And it’s the kind of governance that the Bank Board Training Forum was designed to support.

The Bank Director of the Future: Diversity of Experiences and Skill Sets Matter

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bank-director-2-22-17.pngWhile the requirements needed in a bank leader today continue to evolve, the same can also be said for bank directors. Boards of directors today are under more scrutiny than ever before, whether from governance advisors, shareholders, Wall Street analysts, activist investors, community leaders and customers. Even mutuals and privately held institutions face more visible scrutiny around corporate governance from their regulators and key constituents. Serving as a bank director today may still have a certain amount of prestige (depending on whom you ask), but the expectations for director performance and engagement have never been higher.

Community banks in particular tend to have long tenured board members—in many cases with decades of service. Continuity can be a good thing, provided the director skill sets continue to be relevant and the board does not become too close to the CEO, compromising objectivity. However, many bank boards have begun to focus more on the “collective skills” represented around the board table, and have started to emphasize a skill-based approach in making director retention and recruiting decisions.

There are certain skills sets which nearly every bank board likely needs more of; first and foremost in technology. So-called cyber or digital skills are paramount in today’s industry, from both risk and growth perspectives. Likewise, we often see high demand for new board members to serve as qualified financial experts—particularly in public companies—and for directors who bring risk management, strategic planning, marketing/branding, human capital or prior CEO experience to the board table. Depending on the ownership structure, many publicly traded banks are also interested in directors with prior exposure to best practices in public company governance.

However, the real place for improvement in the boardroom is often around how the board behaves. Research from numerous sources validates that how a board operates is the most critical factor of whether a board is a truly valuable strategic asset for the company. Director willingness to discuss the truly vital issues—such as strategy, CEO and board succession, transactions and risk—in an open and candid manner is an important ingredient for institutional success. CEO succession in particular can be an Achilles heel for banks if they are unwilling to deal with the elephant in the room.

One of the other weaknesses in the boardroom involves the underperforming director. According to audit and consulting firm PwC, 35 percent of directors think someone on their board should be replaced. Yet the percentage of community banks conducting peer reviews (compiled by an objective third-party to maintain confidentiality) remains low. In addition, PwC research also suggests that 25 percent of directors come to board meetings unprepared. If we truly believe in building a strategic-asset board as governance best practices would suggest, then boards have an obligation to raise their game and make some tough decisions. A board seat is a rare and precious thing, and not having every director contribute in a currently meaningful way reduces board effectiveness considerably.

The single biggest determinant in board effectiveness is the board’s willingness to address these tough topics head-on, and to do so in a non-personal, collaborative and open manner. Boards that cannot handle straight-talk, or dodge the big issues around director or CEO succession, often prove less effective, in part because they are presenting a status-quo message rather than a forward-thinking viewpoint. Fostering a boardroom culture which enables robust discussions from divergent viewpoints, in order to arrive at the best decisions, remains critical. And, while boards have had to increase their focus on checks and balances in this regulatory climate, it is important to maintain some focus on looking through the windshield and not just the rear-view mirror as well.

Lastly, diversity around the board table has become a front burner issue. Many governance experts tout a diversity of thought, perspectives and experiences as critical in order for the board to make the wisest decisions. Yet in order to garner those wider viewpoints, it is usually necessary to move beyond the classic board which still often remains stale, pale and male. Boards will need to become proactive in seeking a more diverse group around the board table, and will likely need to broaden how and from where as they think about sourcing new potential directors.

In summary, the new bank director today needs to be a subject matter expert in an important area, but also a collaborative, communicative, engaged partner in the boardroom. The more willing a board is to tackle the toughest business issues, and encourage and respect divergent views around the table, the more likely the bank will continue to be successful.

Federal Agencies Heighten Expectations and Penalties for Bank Directors

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regulation-9-21-16.pngThere have been two changes in bank regulatory enforcement that should be interesting to all directors. Recently, the Office of the Comptroller of the Currency released a new examination handbook applicable to institutions of all asset sizes and changed a corresponding handbook for directors, guiding examiners in assessing an institution’s risk strategy and control environment and heightening the responsibilities of bank board directors. The guidance requires directors to be in a position to pose “credible challenges to management” and states a director’s prime duty is to “ensure the bank operates in a safe and sound manner,” altering a director’s previous duty of “protecting the bank.”

Also, recent rulemaking has intensified the sting of civil money penalties (CMPs). Effective August 1, 2016, the list of violations has been augmented and fines have materially increased. CMPs will increase for directors, institutional affiliated parties (IAPs), banks, thrifts, and other financial institutions. CMP statutes that carry three-tiered penalties geared to levels of severity and intent generally have risen 80 percent to 90 percent to $9,468, $47,340 and $1,893,610. Note that regulators forbid banks from making indemnification payments to a director or IAP assessed a CMP.

The changes in the handbooks, coupled with the enhanced CMPs, signal “regulatory creep,” suggesting strongly that less complex institutions will be held to standards expected of complex institutions. This supervisory approach should be noted by a bank and its board. If a federal banking agency decides to proceed with an enforcement action, the target (either the institution or the IAP) will be notified in writing and provided 15 days to explain why a CMP is unwarranted. Additionally, an IAP target will be required to update personal financial statements.

The bank’s response to the agency requires a deep dive into the record of the supervisory communication between the bank and the agency. A thorough legal analysis of the evidence, counsel’s opinion regarding the likelihood of a violation being upheld on appeal, and advice regarding the potential penalty range is critical. The penalty could range from an informal (supervisory) penalty to a public monetary penalty and industry ban. This is the time the target, along with experienced counsel, should meet with the relevant agency officials to seek to resolve the principal supervisory concerns, so the exposure is contained. It’s a good idea to address the possibility of agency referrals for criminal charges. The process of personal interaction with agency officials, and submission of the legal analysis with focused strategic dialog, is paramount.

While it is typically useful that bank management and directors present a unified front, because the federal banking agencies apply different standards and penalties to directors than bank management, a bank must appreciate the potential for conflicts of interest between directors and bank management. It may be necessary to engage independent legal counsel for the board. To the extent there is a uniformity of interests between management and directors, a joint defense agreement can be fashioned. Most bank board protection plans will cover legal fees and costs associated with independent counsel, although, again, the payment of an assessed CMP cannot be indemnified by the bank.

If alleged violations cannot be resolved by settlement, the CMP assessment or other sanctions will be made public. The sanctioned person may request a hearing before an administrative law judge. After the hearing occurs and submissions from counsel are received, the administrative law judge issues an opinion and recommendation to the agency. The administrative law judge’s opinion can be appealed to the agency head. A similar process then occurs before the agency head, and final agency action is rendered. Final agency action may be appealed to the relevant federal court of appeals. The Federal Reserve Board, the Federal Deposit Insurance Corp. and to a certain extent, the Consumer Financial Protection Bureau, use similar procedures.

Now more than ever, it is imperative that a bank director appreciate heightened supervisory expectations, actively provide oversight to management and, importantly, document for the record curiosity and skepticism. A director’s best defense is to be alert to warning signs that a finding of a legal violation is being considered. With management, the board should be proactive in addressing supervisory concerns, and document curative actions taken before the violation is outlined in a written supervisory communication.

Considering a Sale of the Bank? Don’t Forget the Board’s Due Diligence

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due-diligence-5-16-16.pngIn today’s competitive environment, some bank directors may view an acquisition offer from another financial institution as a relief. With directors facing questions of how to gain scale in the face of heightened regulatory scrutiny, increased investor expectations, and general concerns about the future prospects of community banks, a bona fide offer to purchase the bank can change even the most entrenched positions around the board table.

So, how should directors evaluate an offer to sell the bank? A good starting place is to consider the institution’s strategic plan to identify the most meaningful aspects of the offer to the bank’s shareholders. The board can also use the strategic plan to provide a baseline for the institution’s future prospects on an independent basis. With the help of a financial advisor, the board can evaluate the institution’s projected performance should it remain independent and determine what premium to shareholders the purchase offer presents. Not all offers present either the premium or liquidity sought by shareholders, and the board may conclude that continued independent operation will present better opportunities to shareholders.

Once the board has a framework for evaluating the offer, it should consider the financial aspects of the offer. The form of the merger consideration—be it all stock, all cash, or a mix of stock and cash—can dictate the level of due diligence into the business of the buyer that should be conducted by the selling institution.

If the proposed offer consists of primarily cash consideration, the selling institution’s board should focus on the buyer’s ability to fund the transaction at closing. Review of the buyer’s liquidity and capital levels can signal whether regulators may require the buyer to raise additional capital to complete the transaction. Sellers bear considerable risk once a merger agreement is signed and the proposed transaction becomes public. The seller’s customers often think of the announcement as a done deal and the merger also naturally shifts the seller’s attention to integration rather than its business plan, which can benefit the combined company, but affect the seller’s independent results. It is difficult for the seller to mitigate these risks in negotiations, so factoring them into the board’s valuation of a sale offer is the best approach.

When considering a transaction in which a significant portion of the merger consideration is the buyer’s stock, the board has additional diligence responsibilities. First, the board should consider whether the buyer’s stock is publicly traded on a significant exchange or lightly traded on a lesser exchange. As the liquidity of the buyer’s stock decreases, the burden on the seller to understand the buyer’s business and future plans increase, as its shareholders will be “investing” in the combined company, perhaps for a lengthy period of time. The board should also consider if and when there will be opportunities for future shareholder liquidity.

On the other hand, when the seller’s shareholders are receiving an easily-traded stock, both parties will have an interest in mitigating the effects of market fluctuations on the pricing of the transaction. In most cases, a pricing collar, fixing the minimum and maximum amounts of shares to be issued, can allocate market risk between the parties. Such a structure can ensure that a market fluctuation does not cause the seller to lose its premium on sale or make the transaction so costly that it could affect the prospects of the buyer.

In addition to the financial terms of the proposed transaction, the seller’s organizational documents may include language allowing the board to consider a broad range of non-financial matters as part of the evaluation of a proposal. Certain matters, particularly with respect to how the seller’s executives and employees are integrated into the resulting institution and how the buyer’s business plan fits into the seller’s market, can have a significant impact on the success of the transaction. Just as community banking is largely a relationship-based model, the most successful mergers are those that make not only economic sense, but also address the “human element” to maintain key employee and customer relationships. The board can add value by raising these issues with management as part of its discussion of the merger proposal and definitive agreement.

In evaluating an offer to sell, the board is responsible for determining whether the bank’s financial advisors and management have considered a range of relevant items in evaluating an offer, including the offer’s financial terms, execution risks associated with the buyer, and social issues relating to the integration of the transaction. Using the bank’s strategic plan to determine which issues require closer scrutiny can focus the board’s attention on truly meaningful issues that will provide additional value to the institution’s shareholders.

Five Steps for Dealing With Subjective Regulation

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bank-regulation-2-24-16.pngThere has always been a level of subjectivity in the regulatory process. In the past, it manifested itself as interpretations of written regulations. The post-crisis regulatory environment continues to evolve—as does the subjective aspect of regulation—creating new challenges for bank boards. Bank directors are now faced with subjective terms like “risk culture” and “deceptive acts and practices” included in their exam reports as standards, as well as a regulatory focus on “adequacy” when evaluating strategic planning and capital and liquidity management. Bank directors are now challenged to understand what needs to be done to meet these evolving subjective expectations of the regulators and, in turn, hold senior management accountable.

Trying to define these terms is probably futile, but there are things the board can and should do to ensure these standards are being met.

Educate Yourself
Directors should start by learning as much as they can about these subjective requirements. Understanding how they evolved and what they are intended to correct or prevent will help you understand what has to be done to meet them. The regulators have made it clear they have higher expectations for director oversight of risk taking activities, and the board is expected to challenge, question and, where necessary, oppose management proposals. Education is key to meeting these expectations.

Identify Behaviors
Actions speak louder than words. Too many organizations rely solely on policies or pronouncements to demonstrate compliance with subjective requirements. Take risk culture, for example. The board should ask and understand how everyone in the firm is held accountable for risk. How do compensation plans incorporate risk concepts? How do you deal with policy violations? Are employees rewarded for identifying and addressing risk matters? Directors must then ask whether the answers to these questions demonstrate the type of risk culture the firm is trying to achieve.

Learn From Others
Directors should be acutely aware of industry trends when it comes to subjective regulation. Regulators are relying more and more on horizontal reviews of financial firms to identify best practices. Understanding what has been considered inadequate when it comes to a financial firm’s capital or liquidity planning can provide guidance on evaluating a firm’s own plans. For example, the Federal Reserve publishes the results of its Comprehensive Capital Analysis and Review for the largest banks, which is a good place to start. The public release of capital planning results showed there is both a quantitative and qualitative aspect to planning. While the quantitative aspect of planning is made public through establishing acceptable minimums, the qualitative aspect (how you got there) can best be met by understanding how others succeeded or failed to properly plan.

Create a Program
Understanding what needs to be done is the first part of the challenge. The second step is making sure your firm is doing it properly. Subjective standards have to be incorporated into risk and audit programs. It may seem impossible to audit for something like risk culture, and an audit of risk culture is certainly more art than science, but some questions the audit should include are:

  • Is there an understanding, communication and alignment of values in the firm? 
  • Are risk commitments being met and does the firm and management do what they say they will do?
  • Are there any exploitations of gray areas to benefit individuals?
  • Is there evidence of a balance in the firm between achieving results and managing risk?

Bottom line is the board should insist audits and risk assessments take into consideration how these areas of subjective regulation are reflected in the operation of each area, procedure or process they review.

Tell Your Story
Directors should be ready and able to express their understanding of how they meet today’s subjective standards. For example, understanding the strategic planning process and the manner risk factors are taken into account in both planning and execution of strategy allows directors to ask the right questions throughout the process. The same is true for capital and liquidity planning, where reflecting the right level of question and debate in the minutes will likely be crucial to meeting the regulatory “adequacy” standard.

The examples shared are just some of the subjective terms permeating the regulatory process in today’s environment. Like written regulations, they will continue to evolve and will be heavily influenced by the regulatory climate. Dealing with this regulatory uncertainty will continue to be an important practice for directors.

What’s Changing in Bank D&O Insurance

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To quote Shakespeare, “What’s past is prologue.” By looking back at Federal Deposit Insurance Corp. (FDIC) actions in 2015 and beyond, I believe it provides a good template for what we can expect for insurance in 2016. For purposes of this article, there are two areas we will look at: FDIC settlements and regulators’ civil money penalties (CMPs).

The Impact of the Wave of Failed Banks
Here are the trends with regards to the impact that failed banks have had on FDIC suits and then on FDIC settlements:

Year Failed Banks # of FDIC Suits # of FDIC Settlements Settlement $ (total)
2008 25      
2009 140      
2010 157 2    
2011 92 16 1 $700,000
2012 51 26 7 $186,345,000
2013 24 40 9 $49,466,093
2014 18 21 23 $90,800,500
2015 8 3 45 $347,947,183
Totals 515 108 85 $675,258,776

We see an interesting chain reaction that begins with failed banks. Since 2008, there have been 515 total failed banks, with a peak of 157 in 2010. We see a similar trend with the number of FDIC suits against banks, albeit with a three-year lag, which is consistent with the statute of limitations. This trend continues with FDIC settlements, which generally have a two-year delay following the lawsuit. For example, a bank that failed in 2010 will typically be sued in 2013 and settle in 2015. And a vast majority of those settlements are represented as directors and officers’ (D&O) claims payments associated with the D&O insurance policy that existed at the time the bank failed.

A majority of the claims are being paid by the same insurance carriers that currently represent today’s community and regional banks. This implies that healthy banks will continue to pay for the sins of their ancestors. The good news is that it is fair to say that settlements against bank directors and officers peaked in 2015. So while we can expect slightly higher D&O rates at least until the time when these claims amortize off the carrier’s books, fewer settlements in 2016 should begin to put downward pressure on prices for D&O insurance.

The best way to mitigate against these increases is to make sure your bank is seen for its strengths. We recommend hosting an underwriting meeting/call approximately six weeks prior to the renewal, which should include both the incumbent D&O underwriter and one or two of the  alternative underwriters who typically will offer terms for similar banks.

FDIC Civil Money Penalties (CMP)
Since 1996, the FDIC has forbidden banks from insuring against CMP payments for their officers and directors. However, we regularly saw civil money penalty endorsements on D&O policies up until 2013. On October 10th of 2013, the FDIC sent out the letter FIL-47-2013 which explicitly reinforced that civil money penalties (CMPs) can neither be indemnified by the banking institution or covered under the bank’s D&O policy. Once that letter came out, most insurance carriers refused to offer the CMP endorsement(s) previously provided, thus creating a significant gap in coverage for all bank directors and officers.

Since then, we have seen several new insurance products created to address this gap and we continue to get inquiries about them. Remember, since the bank cannot cover the CMP, the individual must complete the application and pay for the coverage themselves. And it will be the individual’s name as the only named insured listed on the policy.

Here is the 2014 vs. 2015 data with regards to the CMP trends against individual D&Os:

  • The average CMP amount increased from $67,646 to $74,980
  • The median CMP amount increased from $15,000 to $50,000
  • The maximum individual CMP in 2014 was $500,000 and in 2015, $545,000
  • In the past two years, approximately 29 percent of CMPs were for failed institutions
CMP Fine Size 2014 2015
<= $50K 71% 64%
$51K – $100K 10% 12%
$101K – $150K 10% 12%
$151K – $250K 2% 8%

Since a vast majority of banks cited are solvent, it behooves D&Os of even the healthiest institutions to consider this coverage. Factors that go into eligibility are the regulatory status of the bank and any past regulatory history of the individuals. So if you are interested, it is better to inquire prior to any type of regulatory restriction, although that would not disqualify you for the coverage.

What Keeps Directors Up at Night

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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.