Bank Failures Reveal Stress Testing Gaps

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Within days of Silicon Valley Bank’s failure on March 10, Democratic lawmakers quickly pointed out that the bank’s holding company, $212 billion SVB Financial Group, and $110 billion Signature Bank, which failed days later, weren’t subject to regular stress tests mandated for the largest banks under the Dodd-Frank Act. The requirement for mid-sized banks, between $50 billion and $250 billion in assets, had been rolled back in 2018.  

But the stress test scenarios developed by the Federal Reserve largely focused on adverse impacts on credit and declining interest rates. In contrast, SVB’s failure had its roots in a rising rate environment that led to an unprecedented deposit run; the Fed’s Vice Chair for Supervision, Michael Barr, testified on March 28 that customers were set to withdraw $142 billion in deposits over two days — roughly 82% of the bank’s total deposits.  

“When we think of stress testing, the key word is stress,” says Brandon Koeser, senior manager and financial services industry senior analyst at RSM US. “When you think of true stress and how that impacts the organization as a whole, it can be credit — but it should also hit liquidity, it should hit capital, and then look at earnings and profitability.” 

Internal stress testing is a regular practice for community banks, according to Bank Director’s 2023 Risk Survey. More than three-quarters of executives and directors say their institution conducts an annual stress test. This can be a valuable exercise that helps boards and leadership teams understand the impact of adverse events on their organization. 

Members of the Bank Services Program can access the complete results to all Bank Director surveys, by asset size and other attributes.

“Banks have enough resources, even small banks, to do some simple stress testing and put pen to paper,” says Patrick Hanchey, a Dallas-based partner at Alston & Bird. The results should be shared with the board, with the discussion reflected in the meeting minutes. “You can take small steps to show that you’ve been thoughtful,” he says. “That’s all the stress test is — thinking about, ‘What if x happens? What do we do, and how does it affect us?’”

Banks should build scenarios that consider account types and depositor behavior, says Sean Statz, a senior manager at Baker Tilly. “We’ve been doing data analytics on the loan portfolio forever,” he says. “Data analytics around the deposit portfolio is going to be a big focus to better understand what [the] portfolio is made up of [and] what could happen [so banks can] start applying some assumptions.” It’s easier to forecast behavior around assets, due to set terms around investments, borrowings and loans. Industry-level assumptions around deposit activity can help fill in some gaps.

The recent bank failures spotlight a key area of risk: deposit concentrations within particular sectors or industries. While much has been made of uninsured deposits, Hanchey cautions that these aren’t necessarily bad if they’re managed safely and soundly. Deposits from municipalities, for example, can be quite stable. Decision-makers should understand how those deposits are concentrated.

Hanchey adds that regulators within the Texas Department of Banking acted quickly to compare levels of uninsured deposits to the availability of other funding sources in a crunch, such as lines of credit from the Federal Home Loan Banks or correspondent banks. “Stress testing your FHLB advance capabilities, lines of credit from your correspondent banking relationships, access to the Fed [discount] window, all those traditional sources of liquidity that have always been important,” says Hanchey. “It’s a new focus on the interplay between those sources of liquidity and [a bank’s] ability to cover uninsured deposits.”

Scenarios should take multiple factors — credit, interest rates, liquidity — into account, helping decision-makers build a narrative that they can use to discuss and assess the impact on the organization, says Joe Sergienko, a client relationship executive at Treliant. They can then come up with a playbook for each scenario — essentially a decision tree that examines how leadership could react in different situations. “No scenario is going to play out exactly the way you forecast,” he says, “but it gives you [a] road map to say, ‘Here’s how we should manage our bank or our process through this.’”

And executives and boards should prepare for the absolute worst: the seemingly low-probability event that could break the bank, like massive outflows in deposits such as those that caused SVB and Signature Bank to fail. This reverse stress testing process provides clues to help leaders avert a disaster. At what point does the bank lose so much liquidity that it can no longer operate? How quickly could that occur?

Stress testing should help foster a larger conversation around risk, and strengthen risk management governance and policies, says Koeser. Scenarios and models should consider the bank’s size, geography and other factors relevant to the business, like concentrations on either side of the balance sheet.

Examiner scrutiny on risk management promises to get more onerous in the year ahead. “We should all expect the pendulum to swing toward heavy, heavy oversight and strict regulation of very discrete issues,” says Hanchey. “Banks should be prepared and have their answers ready when the regulators come in and ask them about things like deposit concentration, interest rate risk, stress tests, rising rate environments. The more proactive banks can be on the front end, the more pleasant their examination experiences will be.”

FDIC Lawsuits: Avoiding the Worst Outcome

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hard-hat.jpghard-hat.jpghard-hat.jpgIn the wake of over 400 bank failures since the beginning of 2008, the Federal Deposit Insurance Corp. is well underway with its process of seeking recoveries from directors and officers of failed banks who the FDIC believes breached their duties in the course of managing those institutions. As of mid-May 2012, the FDIC had filed lawsuits against almost 30 groups of directors and officers alleging negligence, gross negligence and/or breaches of fiduciary duties. While the litigation filed by the FDIC tends to sensationalize certain actions of the directors and officers in order to better the FDIC’s case, there are lessons to be learned.

Some of the take-aways from the FDIC lawsuits are fairly mechanical:  carefully underwrite loans, avoid excessive concentrations and manage your bank’s transactions with insiders. However, there are two major themes that are more nuanced and which are present in almost all of the lawsuits. Those themes relate to the loan approval process and director education.

Develop a thoughtful loan approval process. As evidenced by the recent piece published on BankDirector.com, a spirited debate among industry advisors is currently taking place with respect to whether directors should approve loans or not. On the one hand, many attorneys believe directors have a duty to consider and approve (or decline to approve) certain credits that are or would be material to their banks. Regulation O requires approval of certain credits, the laws of some states require approval of some loans, and there is a general feeling among many bank directors that they should be directly involved in the credit approval process. In addition, many bank management teams believe that directors should “buy in” with them to material credit transactions.

On the other hand, the FDIC litigation clearly focuses on loan committee members who approved individual loans that did not perform. This should give pause to directors in general and loan committee members in particular. It is now the belief of many legal practitioners that the practice of approving individual loans when the loans are not otherwise required to be approved by the directors paints a target on the backs of the loan committee members. The FDIC may be able to target directors who participated in the underwriting of a credit (or were deemed to have done so given their involvement in the approval process) when they did not have the expertise necessary to do so. Some practitioners argue that the directors should instead focus on the development and approval of loan policies that place appropriate limits on the types of loans—and the amounts—that the bank is willing to make. This policy would be consistent not only with safe and sound banking principles but also with the board’s risk tolerance, and it would be appropriate to seek guidance from management and outside advisors on the development of the policy. The idea is that it is much more difficult to criticize a policy than an individual credit decision with the benefit of hindsight.

No matter the approach that your board chooses, the common theme is that the board and the loan committee should expect and receive all relevant information from management about material credits. If directors are actually approving loans, they should get detailed information in a timely fashion that allows them to review and approve the underwriting of the credit. If the directors aren’t approving loans, they should still get information that confirms that the loans conform to the bank’s loan policy and the board’s risk appetite.

Directors should be educated and informed. Above all else, the FDIC lawsuits make clear that the bank board is certainly no longer a social club. Bank directors are charged with very real responsibilities and face the very real prospect of personal liability if their banks are not successful. Indeed, being a bank director is a job.

Because the bank’s shareholders and regulators demand that the directors do a job for the bank, the bank should offer appropriate training to do that job well. Bank directors should be offered the opportunity to engage outside consultants to provide training for the directors to develop the skills they need, particularly at the committee level. In addition, directors should attend conferences that allow them to familiarize themselves with industry trends and best practices. We suggest that there is no better expense for the bank than ensuring that its directors are equipped with the education and tools they need to fulfill their duties.

In addition to more general training, the FDIC lawsuits bring focus to the fact that some directors simply did not understand the material risks to their banks. We have encountered directors who do not fully understand the material risks their institutions face, even at high performing banks. As a result, we recommend that at least annually the directors have a special session to focus on enterprise risk management and discuss the key risks that face the institution. These sessions can be conducted by the chief risk officer or, at smaller banks, by an outside consultant who has helped to manage the enterprise risk management process. This understanding of material risks should better inform the decision making of the board.

While the FDIC lawsuits paint a picture of inattentive, runaway directors and officers, a number of the practices that the FDIC found objectionable could be found at many healthy institutions. By learning from the situations that led to many of these lawsuits, even the best performing banks can enhance the performance of their boards, which will ultimately result in greater value to the shareholders of the bank.

Lessons Learned from FDIC Lawsuits

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As bank failures went on the rise after the crisis of 2008, so did lawsuits from the Federal Deposit Insurance Corp. The target of many of these lawsuits has been both the management of banks, but also independent directors, which can be a scary thought for anyone serving on a bank board today. So what can we learn from this moving forward? Based on the responses Bank Director received from lawyers across the country, the “best practices” today can still be summarized by the same timeless instructions: make sure your board is engaged, get a good directors and officers (D&O) insurance policy, and document, document, document!  

What is the most important lesson that bank boards should learn from the surge in FDIC lawsuits, and how should this be institutionalized in the form of a best practice?

William-Stern.jpgSome things never change, and it’s never too late to re-learn old lessons. Directors must remain independent, informed and involved in their institution’s affairs. It’s not enough to simply attend board meetings. Directors need to read materials provided by management, ask questions and actively participate in board discussions. And they should make sure their participation is accurately reflected in the minutes. Special care should be taken when considering transactions with insiders and affiliates, and directors should always require detailed presentations from management regarding steps to address regulatory criticisms raised in examinations or otherwise. In addition, professional advice and expertise should be sought when addressing complex issues or other out of the ordinary course matters, and fully documented when appropriate. 

—William Stern, Goodwin Procter

Gregory-Lyons.jpgGiven that the FDIC  has authorized lawsuits in a significant number of failed bank cases, directors are appropriately concerned about liability.  I continue to believe that ensuring fulfillment of the two underpinnings of the business judgment rule—the duty of loyalty and the duty of care—remain a director’s best defense against such actions.  The bank can help institutionalize that as a best practice by providing full board packages in a timely manner, strongly encouraging attendance at meetings, and making internal and external experts and counsel available to board members.

—Gregory Lyons, Debevoise & Plimpton

John-Gorman.jpgThere has been a surge in FDIC lawsuits because there has been a surge in bank failures and FDIC losses due to the financial market meltdown and the great recession. Perhaps the most important lessons for bank boards are that 1) capital is KING and 2) process is KING. Moreover, a board has to be diligent and honest in terms of assessing management performance and replacing management as needed. Finally, and as discussed above, a board’s fiduciary obligations require that adequate systems be in place to monitor compliance with laws, regulations and policies and that boards be informed and engaged and take action as necessary when red flags indicate issues or problems in certain areas. A cardinal sin in banking, which mirrors this fiduciary obligation, is to have regulatory violations repeated, i.e., uncorrected. Uncorrected violations are probably the single most cause of civil money penalties against banks and their boards.

—John Gorman, Luse Gorman

Douglas-McClintock.jpgFrom a legal standpoint, a best practice is threefold. First, maintain capital levels substantially higher than the minimum levels necessary to qualify as well-capitalized, even if it causes the bank’s return on equity (ROE) to suffer. Second, make sure that the bank’s charter and by-laws provide the maximum legal indemnification protection permitted under the applicable law, including providing for advancement of funds during litigation to defend the directors. And third, be sure to maintain an adequate directors and officers liability policy with no regulatory exclusion, so the insurance company has an obligation to defend FDIC claims. The only good protection from a storm surge such as this is a good wall of defenses and a plan of retreat!

—Doug McClintock, Alston + Bird

Victor-Cangelosi.jpgExcessive concentration of credit risk is a recurring theme in FDIC lawsuits.  Boards need to monitor on an ongoing basis significant credit risk concentrations, whether it be in type of loan, type of borrower, geographical concentration, etc.  Management reports to the board should address these and other concentration risks inherent in the institution’s loan portfolio.

—Victor Cangelosi, Kilpatrick Townsend

Mark-Nuccio.jpgDirectors should pay attention to their D&O insurance. All policies are not equal and the insurance markets are constantly evolving. Banks and their boards should consider involving experts in the negotiation of the policy terms and cost. Independent directors may want special counsel to be involved. Beyond paying attention to D&O insurance, directors need to pay more attention—pure and simple. The recent case brought by the FDIC against directors of Chicago-based defunct Broadway Bank criticizes the directors for not digging into lending policies or the details of lending relationships and deferring entirely to management. Documenting involvement is almost as important as the involvement itself.

—Mark Nuccio, Ropes & Gray

Trends in FDIC Lawsuits Against Directors and Officers

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cornerstone-wp.pngThis is the second in a series of articles that examines statistics and offers commentary on the characteristics of professional liability lawsuits filed to date by the Federal Deposit Insurance Corporation (FDIC) against directors and officers of failed financial institutions. Here is a summary of some of our findings. For a full report with charts, click here.

Overview

Seizures of banks and thrifts by regulatory authorities have subsided in 2012 relative to the levels in 2011 and 2010. From January through late April 2012, 22 financial institutions have been seized. If the current pace of seizures continues throughout the year, 69 financial institutions will be seized in 2012, compared to 92 seizures in 2011 and 157 seizures in 2010. In contrast, the FDIC has been intensifying its litigation activity associated with failed financial institutions, filing 11 lawsuits through late April 2012, compared with 16 lawsuits in all of 2011. If filings continue at the current pace, an additional 24 lawsuits will be filed this year.

Overall, from July 2, 2010, through April 20, 2012, the FDIC filed 29 lawsuits against directors and officers of 28 failed institutions. As we observed previously, these lawsuits continued to target the officers and directors of financial institutions that had a large asset base and a high estimated cost of failure. Aggregate damages claimed in the complaints totaled $2.4 billion and were typically based on losses related to commercial real estate (CRE) lending, and acquisition, development and construction (ADC) lending.

Summary of Findings

  • To date, 6 percent of financial institutions that have failed since 2007 have been the subject of FDIC lawsuits. The 28 financial institutions targeted in lawsuits had median total assets of $973 million, compared with median total assets of approximately $241 million for all failed institutions. Six of these institutions had total assets of more than $3 billion. An additional seven had total assets between $1 billion and $3 billion. None had assets less than $100 million.
  • Geographically, the largest concentration of financial institution failures between 2007 and April 2012 occurred in Georgia, Florida, Illinois and California. The percentage of FDIC lawsuits targeting failed institutions in Georgia, Illinois and California is similarly high and in fact, slightly higher than the percentage of failed institutions in these states. Florida is currently the exception, with only one FDIC lawsuit related to the failure of a Florida institution.
  • Defendants named in the 29 filed lawsuits included 239 former directors and officers. In nine of these cases, only inside directors and officers were named as defendants. Outside directors were named as defendants in addition to inside directors and officers in the remaining 20 lawsuits. CEOs were named as defendants in 26 cases. Other officers commonly named as defendants included CFOs (five cases), chief loan officers (nine cases), chief credit officers (nine cases), chief operating officers (six cases), and chief banking officers (two cases). In addition, three lawsuits named insurance companies as defendants, and one case identified a law firm as a defendant. Three cases also included spouses of the directors and officers as named defendants. Although we do not address separate suits that may be brought only against other associated parties, such as accountants, appraisers or brokers, these parties are also potentially subject to litigation by the FDIC.Allegations of negligence, gross negligence, and breach of fiduciary duty were made in 26, 26 and 23 of the lawsuits, respectively.

Losses on CRE and ADC loans were the most common bases for alleged damages. Seventeen of the complaints identified CRE loans as a basis for the damages claim and fifteen identified ADC loans as a basis. Despite the widespread problems in residential lending and residential real estate markets, fewer lawsuits focused on those types of lending.

As of April 27, 2012, three of the 29 lawsuits have settled:

FDIC as Receiver of Corn Belt Bank and Trust Company v. Stark et al. settled on May 24, 2011, with settlement details remaining undisclosed.

FDIC as Receiver for First National Bank of Nevada v. Dorris and Lamb, which claimed damages of $193 million, settled on October 13, 2011, with the two officers and director defendants each agreeing to pay $20 million. The defendants assigned their rights to collect from the insurer to the FDIC. The FDIC’s success in collecting from the insurer is unknown.

FDIC as Receiver for Washington Mutual Bank v. Killinger et al. agreed to settle in late-2011 with three former executives agreeing to pay $64 million in total. The case was dismissed by the court on April 26, 2012.

 

About the Authors

Abe Chernin is a senior manager in the San Francisco office of Cornerstone Research; Catherine J. Galley is a senior vice president of Cornerstone Research in the firm’s Los Angeles office; Yesim C. Richardson is a vice president in the firm’s Boston office; and Joseph T. Schertler is a senior consultant in the firm’s Menlo Park office.

Characteristics of FDIC Lawsuits against Directors & Officers of Failed Financial Institutions

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As widely reported in the press, seizures of banks and thrifts by regulatory authorities began to subside in 2011. Throughout the year, 92 institutions were seized compared with 157 in 2010 and 140 in 2009. In contrast, Federal Deposit Insurance Corporation professional liability lawsuits targeting failed financial institutions began to increase in 2011. These are lawsuits in which the FDIC, as receiver for failed financial institutions, brings professional liability claims against directors and officers of those institutions and against other related parties, such as accounting firms, law firms, appraisal firms or mortgage brokers.

Overview

From July 2, 2010, through January 27, 2012, the FDIC filed 21 lawsuits related to 20 failed institutions (two of the 21 lawsuits were associated with IndyMac Bank, F.S.B). Of the 21 lawsuits, two were filed in 2010, 16 in 2011, and three in January 2012. Aggregate damages claimed in the complaints totaled $1.98 billion. 

cs-exh1-1.12.pngOn average, the FDIC waited 2.2 years to file a lawsuit related to a failed financial institution, although the majority of recent FDIC lawsuits were filed more quickly.

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To date, only 4.7 percent of financial institutions that failed since 2007 have been the subject of FDIC lawsuits (20 out of a total of 424 bank failures). These lawsuits have tended to target larger failed institutions. The 20 banks named in lawsuits had median total assets of $882 million compared with median total assets of $241 million for all failed institutions. Furthermore, the 20 bank failures had a median estimated cost to the FDIC of $179 million at the time of seizure. This compares with the median estimated cost of failure of $60 million for all failed banks.

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The FDIC lawsuits to date have included those related to the two largest failed institutions (Washington Mutual and IndyMac). However, there are many other large or costly failures that have not yet been the target of FDIC lawsuits. In particular, many of the most costly failures that occurred in 2008 and 2009 have not yet resulted in FDIC lawsuits. Given statute of limitations restrictions, these would seem to be the most likely candidates for FDIC lawsuits in the near future. 

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Each federal banking regulator was the primary supervisor for at least one of the institutions targeted by an FDIC lawsuit. Among the 20 sued institutions, two were savings associations regulated by the former Office of Thrift Supervision (OTS), two were nationally chartered commercial banks regulated by the Office of the Comptroller of the Currency (OCC), 14 were state-chartered nonmember banks supervised by the FDIC, and two were state-chartered member banks supervised by the Federal Reserve Board.

The geographic mix of lawsuits has paralleled the location of failed institutions, with the largest concentrations in Georgia, Illinois and California. One exception is Florida, where a large percentage of failed financial institutions were located (60 banks or 14 percent of all failures since 2007), but where no FDIC lawsuits have been filed to date.

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Defendants and Claims

Defendants named in the 21 filed lawsuits included 178 former directors and officers. In six of these cases, only inside directors and officers were named as defendants. Outside directors were named as defendants in addition to inside directors and officers in the remaining 15 lawsuits. CEOs were named as defendants in 18 cases. Other officers commonly named as defendants included CFOs (four cases), chief loan officers (eight cases), chief credit officers (six cases), chief operating officers (four cases), and a chief banking officer (one case). In addition, three lawsuits named insurance companies as defendants, and one case identified a law firm as a defendant. Three cases also included spouses of the directors and officers as named defendants.

Allegations of negligence, gross negligence, and breach of fiduciary duty were made in 19, 18, and 18 of the lawsuits, respectively.

Damages Claimed

In 19 of the 21 complaints, the FDIC explicitly claimed damages amounts ranging from $20,000 to over $600 million. The average and median damages claims were $104 million and $40 million, respectively.

Losses on commercial real estate (CRE) loans and acquisition, development and construction (ADC) loans were the most common bases for alleged damages. Twelve of the complaints identified CRE loans as a basis for the damages claim and nine identified ADC loans as a basis. Despite the widespread problems in residential lending and residential real estate markets, fewer lawsuits focused on those types of lending.

cs-exh7-1.12.pngSettlements

As of January 27, 2012, three of the 21 lawsuits have settled. FDIC as Receiver of Corn Belt Bank and Trust Company v. Stark et al. settled on May 24, 2011, with settlement details remaining undisclosed. FDIC as Receiver for First National Bank of Nevada v. Dorris and Lamb, which claimed damages of $193 million, settled on October 13, 2011, with the two officer and director defendants each agreeing to pay $20 million. Most recently, FDIC as Receiver for Washington Mutual Bank v. Killinger et al. agreed to settle with three former executives agreeing to pay $64 million in total.

Final Note

These findings do not include the many negotiations and mediation discussions the FDIC has undertaken with officers and directors of failed institutions. Statistics for these activities are unavailable. The number of lawsuits filed has yet to approach the numbers authorized by the FDIC. As of January 18, 2012, the FDIC has authorized lawsuits in connection with 44 failed institutions against 391 individuals, claiming damages of at least $7.7 billion. The difference suggests that more lawsuits may be filed before long.

Download all exhibits in PDF format.

Survivor Guilt: An Assessment of Financial Crisis Lawsuits

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shipwreck.jpgWhat banks have paid the piper from securities fraud lawsuits following the financial crisis?

So far, the biggest losers have been Bank of America Corp. and Wells Fargo & Co. They represent more than half of the $4.4 billion paid in subprime and credit crisis-related settlements, according to Kevin LaCroix, an attorney who writes an extremely well sourced and exhaustive blog on directors and officers (D&O) liability insurance.

But what may be interesting about that fact is not so much that two banking giants have paid the biggest settlements, but that the settlements suggest surviving banks are paying more than the entities that collapsed, notes LaCroix.

Bank of America and Wells Fargo both had bigger settlements than say, Lehman Brothers, whose former executives and underwriters have settled for $507 million. Washington Mutual Inc. became the biggest bank failure in U.S. history when it collapsed into never-never land. The WaMu settlement with investors was $208.5 million, half owed by the directors and officers of the bank but paid by D&O insurance. The other half was owed by the company’s underwriter and auditor, amounting to three separate settlements, according to LaCroix.

Bank of America survived, but paid far more for it. It gobbled up a couple of losers in acquisitions: subprime mortgage aficionado Countrywide Financial and investment bank Merrill Lynch & Co., which was heading toward absolute demise. Settlements stemming from the actions of those two failed entities have amounted to $1.56 billion. Countrywide Financial amounted to the biggest chunk, $624 million in 2010, making it one of the biggest securities fraud settlements ever, according to Stanford University’s Securities Class Action Clearinghouse. The case pitted New York state pension funds and others against the bank for making misleading statements about the quality of its loan portfolio. Bank of America paid $600 million of the Countrywide settlement and Countrywide’s audit firm, KPMG, paid $24 million.

Wells Fargo, another survivor, gets the credit for an even bigger settlement: $627 million in August of last year for the Wachovia Preferred Securities action—$37 million of it paid by, again, KPMG. Wells Fargo bought Wachovia in December 2008 after Wachovia had previously acquired Golden West Financial Corp. and its notorious “pick-a-payment” loans, where the borrowers got to pick how much to pay each month. The loans still drag on Wells Fargo’s portfolio to this day. Wells Fargo’s settlements related to the crisis have totaled $827 million so far.

Of course, there are a lot of complicated factors that go into settlement amounts that have nothing to do with simple guilt. A failed bank like WaMu has insurance proceeds and the personal assets of executives and directors on the table, but that’s about it. A surviving megabank such as Wells Fargo has a lot more assets for plaintiffs to fight over.

Only about 40 cases have settled and 76 dismissed out of about 230 that have been filed relating to the credit and subprime fallout, according to LaCroix.

The years ahead will provide an opportunity to see how much survivors will have to pay for the financial crisis. 

 

Troubled financial institutions face their own compensation restrictions

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stormy-board.jpgWhile financial institutions will shy away from the hint of a “troubled condition” designation, such designations are unfortunately a common fact of life in today’s economy. Many more banks and thrifts are finding themselves subject to new compensation restrictions when they fall into the “troubled” category. After an institution is determined to be in troubled condition, it becomes subject to the restrictions on golden parachute payments set forth in 12 C.F.R. Part 359 (“Part 359”).  If its condition continues to deteriorate, the institution might also become subject to the prompt corrective action (“PCA”) rules, which limits the ability to pay bonuses and increase salaries.

Overview of Part 359.  Part 359 limits the ability of financial institutions and their holding companies to pay, or enter into contracts to pay, golden parachute payments to institution-affiliated parties (“IAPs”).  The Part 359 troubled condition “taint” will flow from a troubled institution to its healthy holding company and also from a troubled holding company to a healthy institution (but not from a troubled institution, through a healthy holding company, to a healthy subsidiary).

An IAP is broadly defined and can include any director, officer, employee, shareholder, or consultant.  In certain situations, it can also capture independent contractors including attorneys, appraisers, and accountants.

A “golden parachute payment” (“parachute payment”) is any payment of compensation (or agreement to make such a payment) to a current or former IAP of a troubled institution that meets three criteria.  First, the payment or agreement must be contingent upon the termination of the IAP’s employment or association with the financial institution.  Second, the payment or agreement is received on or after, or made in contemplation of, a determination that, among other things, the institution is in troubled condition.  Third, the payment or agreement must be payable to an IAP who is terminated at a time when the institution meets certain conditions, including being subject to a determination that it is in troubled condition.  Even where a contract pre-dates the troubled condition designation, any parachute payment payable thereunder will be prohibited by Part 359 while the institution is in troubled condition.

Certain types of payments and arrangements are excluded from the definition of a parachute payment.  Generally, payments made under tax-qualified retirement plans, welfare benefit plan, “bona fide deferred compensation plans or arrangements,” and certain “nondiscriminatory” severance plans, as well as those required by statute or payable by reason of the death or disability of an IAP are excluded.

In addition to the general categories of excepted payments, the rules under Part 359 permit a financial institution to make certain parachute payments, or enter into agreements providing for parachute payments, where the institution obtains the prior approval of one or more regulatory agencies.  Such approval is required to pay obligations that pre-date the troubled condition, for the institution to pay, or enter into an agreement to pay, severance to someone who is retained as a “white knight,” or to enter into agreements that provide for change in control termination payments (that are contingent on both the occurrence of a change in control and termination of employment).  In nearly every case, if approval is granted, the approved severance payments will be limited to no more than 12 months of base salary (tax gross-ups will not be permitted in any form) to be paid over time and subject to claw back.

In October 2010, the FDIC issued Financial Institution Letter 66-2010 (“FIL-66-2010”) which expanded the information required to be submitted with an application for approval under Part 359 by requiring an institution to demonstrate that the IAP is not a “bad actor” and is not materially responsible for the institution’s troubled condition.  The guidance also provides for a de minimis severance of up to $5,000 per individual that can be paid without regulatory approval, so long as the institution maintains records detailing the recipient’s name, date of payment and payment amount, and also maintains a certification covering each individual who receives a payment.

Overview of Prompt Corrective Action Rules.  The PCA rules designate four capital categories: “adequately capitalized” (which is an institution in “troubled condition”); “undercapitalized;” “significantly undercapitalized;” and “critically undercapitalized.”  If an institution is significantly undercapitalized or critically undercapitalized, the institution becomes subject to additional compensation restrictions.  Undercapitalized institutions may also become subject to these additional restrictions.  When subject to the PCA compensation restrictions, the institution generally cannot pay any bonus to or increase the salary level of senior executive officers.

Is Bank of America Too Big to Manage?

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too-big.jpgLast week’s news that Warren Buffett was putting $5 billion into troubled Bank of America Corp. (BAC) might have brought a sigh of relief from those folks who were concerned that the country’s largest bank was in danger of failing, although I doubt the actual risk of failure was very high. I think we can safely assume that the regulators in Washington have been overseeing BAC with the same level of care that the Nuclear Regulatory Commission might give to an ailing nuclear reactor–and I don’t think the dooms-day metaphor is inappropriate here.

If you read the financial headlines or watch the business news shows, you know that BAC is struggling to extricate itself from a host of mortgage-related problems, including continuing credit losses from its 2008 acquisition of Countrywide Financial Corp., which has turned out to be a hellish disaster for the bank. Institutional investors had become increasingly concerned that BAC was undercapitalized and drove the stock price down to around $6 a share. The low share price might not have been an accurate reflection of BAC’s true financial condition, but this is one of those situations where perception can quickly become reality. If enough consumer and business customers had become spooked by the falling share price and began to pull their deposits out of the institution, or if other banks had stopped funding it in the interbank lending market, the result could have been a dangerous liquidity crunch.

And that would force President Obama, Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Tim Geithner to make a really tough call: With the weak U.S. economy in danger of falling into the second trough of a double-dip recession, would they prop up the nation’s biggest bank—or allow it to go under? Supposedly the Dodd-Frank Act brought an end to the unofficial regulatory policy of “Too Big to Fail” by providing the Federal Deposit Insurance Corp. with new liquidation authority that will allow it resolve the failure of a large and complex institution in an orderly manner. But would the White House and the Fed be willing to take the risk that such an event wouldn’t push the economy into another ditch? Would they flinch?

Hopefully, we’ll never find out.

The real significance of Buffett’s $5 billion capital infusion is that it offers BAC a much needed vote of confidence from one of the world’s most successful investors, and that seems to have stabilized the bank’s share price for now. Interestingly, Buffett’s money does little to strengthen BAC’s capital position from a regulatory perspective. What Buffett actually purchased was preferred stock, which won’t count towards its Tier 1 capital ratio. Buffett also received warrants to purchase 700 million shares of BAC common stock at $7.14 a share, so he will most likely be handsomely rewarded for his public service.

The interesting question to me is whether BAC, with $2.26 trillion in assets as of year-end 2010, is simply too big to manage. The bank scored 127th out of the 150 largest publicly owned U.S. banks and thrifts on Bank Director’s 2011 Bank Performance Scorecard, which is a measurement of profitability, capitalization and asset quality. The company scored poorly in all three categories. (To see the 2011 ranking, view our digital issue). CEO Brian Moynihan, who was not responsible for the Countywide acquisition, is trying to revive the bank’s profitability through a program of asset sales and layoffs, although the continued decline in housing prices nationally makes BAC’s home mortgage exposure look like a cosmic black hole.

I think it’s fair to say that risk diversification is viewed by most experts as a good thing. The great majority of banks that have failed in recent years were small institutions that had a high concentration of commercial real estate loans on their books. A little more diversification would have been a good thing for them. But diversification is a double edge sword than can cut both ways. BAC is so big and so diversified that it’s hard to find a meaningful banking business in the consumer, corporate or capital markets sectors that it isn’t in, or a financial product that it doesn’t offer. So when the U.S. economy goes into a deep recession as it did a few years ago, a large and highly diversified financial institution often ends up with an impressive assortment of afflictions that are Job-like in nature.

Perhaps BAC is simply too large for any management team and any board of directors to run effectively. I don’t believe that Congress or the regulators should break up the company into smaller pieces. In a free market economy, BAC should be allowed to seek its own destiny. 

But the company’s performance might be twice as good if it were half as large.

What Directors and Officers at Failed Banks Should Know

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The law firm Covington & Burling’s involvement in defending financial institutions and their directors and officers dates back to the representation of clients in the savings and loan crisis of the 1980s and is as current as the ongoing representation of the CEO of the former IndyMac Bank.  Some of the lawyers have served in high-ranking government positions, such as former Comptroller of the Currency John Dugan.  Bank Director magazine talked to Covington & Burling partner Jean Veta recently about what steps officers and directors should take if they are sued and what trends she sees in liability cases.

What are some of the first steps officers and directors should take if their bank fails?

As soon as the bank fails, they should get legal counsel—in fact, they should get counsel when they see the bank is headed toward receivership.  The bank’s counsel cannot represent the individuals because the bank counsel’s client is the bank, not the individuals.  Counsel for the individual officers and directors can assess the probability of getting sued and assist these individuals in preparing for potential lawsuits.  In addition, counsel can help the individuals determine whether they have directors and officers (D&O) liability insurance and, if so, how to seek coverage under those policies.

What kinds of claims does the FDIC make in its lawsuits against officers and directors?

The FDIC brings suits against officers and directors for damages caused by the loss to the deposit insurance fund when the FDIC put the bank into receivership.  Although each case is different, the FDIC typically will allege that the officers and directors were negligent or breached their fiduciary duty with respect to some activity that purportedly resulted in the bank’s failure.  These claims often focus on such areas as the underwriting for residential mortgage loans, commercial real estate lending practices or insider transactions.

What other kinds of legal exposure do officers and directors face?

In addition to suits by the FDIC, the officers and directors can face other types of lawsuits, including those filed by private plaintiffs, a holding company’s bankruptcy trustee or the bank’s primary regulator.  If the bank was publicly held, the individuals may also risk lawsuits by shareholders and the Securities and Exchange Commission. In the worst cases, the Department of Justice or local U.S. attorney’s office may open a criminal investigation.

Because the officers and directors can face a number of different lawsuits, it is important to develop a legal strategy that deals with all the potential areas of exposure.  You need to make sure, for example, that the individuals’ defense theory in an FDIC case doesn’t adversely affect the individuals’ defense against claims being asserted by the holding company’s bankruptcy trustee or the bank’s primary regulator.

You made reference to the bank’s primary regulator.  What role do they play?

It is now becoming apparent that in addition to the traditional suits by the FDIC, the bank’s primary regulator may also seek to go after individual officers and directors if the regulator believes the individual’s conduct was especially problematic.  In those circumstances, the bank’s primary regulator typically will seek civil money penalties and/or prohibition orders that would bar the individual from participating in the banking industry.

What should an officer or director know about D&O insurance?

The availability and amount of D&O insurance is often important in determining whether the individuals have adequate resources available to mount a defense against the various threatened claims. Although most financial institutions have D&O insurance, the insurance carriers may seek to limit the amount of coverage available, so the individuals need to know how to respond to the carrier’s position. D&O insurance also is an important factor in the FDIC’s decision to sue the officers and directors.  Unless the individuals were really bad actors, the FDIC typically is not interested in suing an individual with modest personal assets and little or no D&O coverage.  In contrast, the primary bank regulator may well go after an officer and director—regardless of the level of personal assets or D&O insurance—if the regulator believes the individual’s conduct was especially bad.  In these circumstances, the primary regulator is not looking for substantial monetary damages (as is the case in an FDIC lawsuit), but rather a prohibition order or civil money penalty that comes out of the individual’s own pocket.