Federal Agencies Heighten Expectations and Penalties for Bank Directors

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.

What’s Changing in Bank D&O Insurance

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.

Getting Insurance for Civil Money Penalties

9-17-14-AHT.pngFor 20 years, banks have been buying insurance that covers civil money penalties (CMP) levied against directors and officers, the fines regulators sometimes impose on individuals and institutions for alleged wrongdoing. Commonly, this coverage is offered under the bank’s directors and officers (D&O) liability policy with a sub-limit of $100,000 per individual with a $1 million total limit and no deductible. Interestingly enough, the entire time this coverage was being offered, Part 359 of the FDIC Act has been in effect, stating that these penalties can’t be insured or indemnified by the bank. Then, in October of 2013, the Federal Deposit Insurance Corp.’s FDIC letter FIL-47-2013, made it explicitly clear that the bank can’t insure or indemnify civil money penalties on the bank’s D&O policy, leaving every bank director and officer exposed. This letter was sent by the FDIC to all institutions with total assets of less than $1 billion.

Insurance Reaction
The D&O insurance carriers came up with a solution at the time. They reiterated that the CMP endorsement was applicable to state and regulatory laws and that they would be happy to remove the endorsement at the request of the insured. Simply removing the CMP endorsement does accomplish two goals:

  • The bank’s D&O policy thereby becomes compliant with the FDIC letter.
  • Since a CMP would be considered a formal proceeding, the policy would offer legal costs coverage associated with the defense of the CMP. This extension of defense costs coverage would be available for the entire D&O policy’s limit of liability but only after the applicable deductible amount has been reached (which typically ranges from $25,000 to $100,000 for banks with less than $1 billion in assets).

Considering that the median CMP assessed against an individual D&O within the past 18 months was $25,000, there still was a demand for another option. Many carriers were willing to create a new CMP endorsement. The endorsement was similar to the original in that it continued to offer $100,000 of protection for each insured person with a $1 million aggregate for the entire board. The endorsement would specifically state that coverage was afforded for defense costs, but not for the penalty itself and it was available with either a $0 deductible or a very low deducible amount. The benefits of this type of endorsement is that it is in compliance with the FDIC letter since it specifically states that the penalty is not covered and it offers coverage after a very low deductible amount. The downside of this endorsement versus having no endorsement on your D&O policy is that there are lower limits for the CMP coverage ($100,000 per individual versus the full policy limits). Most banks I work with recognize that CMPs are much more likely to get resolved at a low dollar amount and thus they prefer the lower deductible/lower limit option. However, regardless the option, there was still a void of coverage for the actual penalty itself; that is until recently.

New Coverage Available
AHT and Lloyds of London recently began offering a third option: a separate policy that does cover CMP. What distinguishes this policy is that it is bought and paid for by the director or officer wishing to get insurance to cover his or her personal liability, not the bank. This new policy is structured as follows:

  • The policy will be in the name of the individual and would cover all of the bank boards he/she sits on
  • The policy is written with a $0 deductible and offers limits ranging from $50,000 to $250,000
  • The policy covers only the penalty and does not include defense costs coverage

The application must be completed by the individual. Coverage would not be in place until the premium is paid (by the individual) after which a policy will be issued to either the individual’s home address or personal e-mail address. Here is a sample of the policy wording. So bank officers and directors do have options now if they want some kind of coverage for civil money penalties. The liability of serving on a bank board these days is significant, and it pays to research your options.

Coverage Options for Civil Money Penalties

The Federal Deposit Insurance Corp. (FDIC) issued guidance saying banks should not offer coverage for civil money penalties under directors and officers (D&O) liability insurance policies. In this video, Dennis Gustafson of AHT Insurance advises how boards can modify their policies in order to stay in compliance and still cover defense costs.