During 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.
Recently, Bank Director and the American Banker presented the 2nd annual America’s Bank Board Symposium tailored to provide bank boards with the knowledge to develop, implement, and monitor strategies for their institutions. Several key industry speakers joined CEOs, board members and experienced financial leaders in Dallas to help navigate the sea of challenges facing bank directors today.
On the heels this event, I had the chance to catch up with one of the presenters, Susan O’Donnell, Managing Director with Pearl Meyer & Partners, an independent compensation consulting firm, to further explore her insights on what she believes are the top three issues concerning directors. Below is what she shared with me via email:
1. Responding to a Rapidly Changing Regulatory Environment
New regulations and requirements are coming at bank directors at an unprecedented pace, particularly in the last decade. Whether Sarbanes Oxley, recent banking regulatory agency guidance on risk assessment of incentive compensation practices, or new proxy disclosure requirements under the Dodd-Frank Act – there is a much greater need for board members to keep up with the rapid and constantly changing regulatory environment. This is particularly true of public banks that now have to meet even more disclosure requirements.
2. Understanding Changing Executive Compensation Trends, Including the Role of Risk Management
Keeping informed of the emerging best practices has also become a major challenge, as boards today must ensure their executive compensation practices reflect sound risk management, pay-for-performance alignment and align with shareholder interests. Board members (particularly compensation committee members) need to adapt their institution’s compensation practices, where appropriate, to reflect the new regulations and emerging best practices, while continuing to support their unique compensation philosophy.
What was ‘acceptable’ practice several years ago might be considered inappropriate today. For example, incentive compensation programs that place significant (or sole) focus on profits and top line growth may be perceived as potentially diverting banks’ focus on safety and soundness. Regulators are reviewing incentive plans with a new “set of glasses” and board must also review their executive compensation programs through these new lenses.
Severance/change in control benefits are also changing in response to increased scrutiny and transparency. Provisions such as the gross-up payments to cover the taxes to the executive under certain situations used to be common several years ago, but are no longer considered appropriate. And companies that continue to put such provisions in place with new contracts will come under increased pressure from shareholders and shareholder advisory groups, potentially impacting future Say on Pay votes. Boards need to be aware of these changing perspectives and the potential reaction from regulators and shareholders.
As executive compensation is under increased pressure, boards need to be ready to respond to the new level of scrutiny. More importantly, they will need to articulate their own compensation philosophy and develop programs that address their own unique needs, rather than chase historical market practice, which in many cases is no longer applicable or appropriate.
3. Responding to Increased Transparency, Disclosure and Shareholder Influence
The new disclosure requirements, starting in 2006 and culminating with many new requirements enacted through the Dodd-Frank Act, are placing a greater spotlight on executive compensation (and governance) practices. With a brighter light comes increased scrutiny.
With Say on Pay, shareholders will have an opportunity to vote their approval (or disapproval) of bank compensation programs. While non-binding, the votes will be public information, subject to media scrutiny. As such, boards will need to listen and be prepared to adapt or change in response to the feedback they receive. It is critical that boards today focus on ensuring their proxy disclosure effectively communicates their compensation philosophy, programs, decisions, rationale for decisions and pay –performance alignment.
Boards will also need to know and understand their shareholders better. Say on Pay, Proxy Access and the loss of the Broker vote will increase shareholders’ influence on compensation programs and banks should be prepared for this new level of transparency and disclosure.
The Characteristics of Success
With all the new regulations and increased scrutiny within the financial industry, I was curious to know what characteristics would separate the winning banks from the losing ones over the next five years. O’Donnell highlighted these top three traits that she recommends bankers will need to make it through this period of reform:
1. Adaptability: Bank boards will need to be responsive to all the changes going on in the industry, including the new economic, business and regulatory requirements.
2. Leadership: Boards that exercise strong leadership as they navigate the bank through challenging times will more than likely come out on the winning side.
3. Focused: Boards must have clearly defined goals and strategies, knowing what needs to be done to execute them effectively.
One thing I’ve learned very quickly since joining Bank Director is that these are without a doubt some of the most challenging times the U.S. banking industry has experienced in quite some time. But with knowledge, flexibility and effective execution, I am confident that smart bankers will continue to excel at growing their financial institutions.
In 1991 when I helped start Bank Director, the experts predicted technology and regulation would winnow the number of banks down to 2,000 over the next twenty years. The thought was that technology would ultimately make it impossible for the smaller banks to compete without economies of scale to justify the expense of implementing new technology.
The experts who predict our futures are often wrong. The new technologies turned out to be an asset to all banks and in fact, leveled the playing field for the institutions that could adapt technology solutions to their unique customer needs. In addition, they forgot that smart bankers go out and start new banks when theirs are bought, and that customers tend to support the financial institutions within their communities.
This fall, our parent company, Board Member Inc. sold our sister publication Corporate Board Member magazine to the New York Stock Exchange. However, Bank Director wasn’t sold because our owner saw a great future for the brand given our unique position in the marketplace and the many opportunities we foresee as the banking business rebuilds itself once again.
Twenty years later I am more excited than ever to be part of a growing enterprise that supports the bankers who lead every kind of institution from the largest international banks to the main street community banks. I fear to predict anything that might happen to the banking industry in the next twenty years, but in the next few I think we can speculate that:
- approximately 200-300 more banks will fail;
- many more will merge as the cost of compliance rises;
- and international banks may give our largest institutions new competition.
No one knows for sure about the future, but I can say with certainty that Bank Director will be there in the middle of it all.