Should Bank Directors Approve Loans?


Following several lawsuits where the Federal Deposit Insurance Corp. sued directors of failed banks who serve on the loan committee, Bank Director decided to ask bank attorneys for their insight on whether directors should be involved in approving loans. It turns out there are a variety of opinions on this. Some think the FDIC’s lawsuits clearly point to the hazards of bank directors getting involved in loan decisions. Others say with a prudent approach, directors need to be involved in a way that shows their due diligence and expertise.

Q. Should directors be directly involved in approving loans, and what are the important liability issues to keep in mind?

Harold-Reichwald.jpgNo. Given recent experience with the FDIC, directors who served on a directors’ loan committee and actually approved loans (as opposed to a mere recommendation) are being singled out for allegations of liability while other non-loan committee directors get a pass. A theory of liability being espoused by the FDIC is that directors’ loan committee members acted in a quasi-executive role when approving loans and hence should be treated differently with perhaps a standard of care of mere negligence, not gross negligence.

—Hal Reichwald, Manatt, Phelps & Phillips, LLP

Heath-Tarbert.jpgTo involve directors in directly approving individual loans that are not to insiders or are otherwise routine can needlessly conflate the role of directors with that of management. As the institution grows in size, such a practice is a recipe for diminished—rather than enhanced—corporate governance. What is critically important, however, is that every director become confident that the bank’s overall lending and credit policies are sound in substance and in practice.

—Heath Tarbert, Weil, Gotshal & Manges LLP

Chip-MacDonald.jpgMany loans require director approval to comply with Regulation O and securities exchange corporate governance rules, among other things. It is customary bank practice to require director approval of larger credits. Board or director loan committee consideration of loan requests are the first line of risk control and corporate governance, and properly conducted, provide better assurance of compliance with laws and bank policies, including credit quality and asset concentrations. Loan decisions are subject to the business judgment rule and generally should not be second-guessed by the courts. The recent Integrity Bank decision that held directors cannot be liable for negligence should be very helpful in limiting liability in this area.

—Chip MacDonald, Jones Day

Jonathan-Wegner.jpgState law often drives whether or not directors are required to be involved in large loan approvals, but the reality is that—whether required by law or not—bank directors often do become involved in approving loans. If you’re engaged in approving loans, the most important thing to understand is that you are going to have a Monday-morning quarterback looking over what you’ve done, so it is crucial that you strictly adhere to your bank’s lending and risk management policies, as well as any laws or regulations applicable to your bank’s loans (such as loan limits or transactions with affiliates). If a loan goes bad that complies with law and fits within your bank’s policy parameters, chances are regulators will find something to blame besides your decision to authorize the loan.

—Jonathan Wegner, Baird Holm, LLP

Mark-Nuccio.jpgIn light of the FDIC’s publicized lawsuits against former directors of failed banks, it has become fashionable to suggest that directors curtail their involvement in lending decisions that are not specifically required by law. In my mind, that’s like throwing the baby out with the bath water. Directors would be unwise to eschew responsibility for a business unit that is the key revenue driver for most banks. Directors first need to focus on establishing sound credit and risk policies appropriate for the size and complexity of their organization. Those policies should delineate when a board level loan committee is required and what it should do. A recent spate of lawsuits by the FDIC against directors involved in lending approvals is probably more about shaking a recovery out of a directors & officers insurer than it is about trying to take personal assets away from bank directors.

—Mark Nuccio, Ropes & Gray LLP

Kathryn-Knudson.jpgWhile directors should have a significant role in establishing loan policies and procedures, especially from a risk management perspective, they should not have additional potential liability from “approving” loans. This is particularly true when the director has no specific loan underwriting training and his or her involvement with a given loan may be a 5- to 15-minute presentation by the bank’s senior loan officer. It is still appropriate for directors to have factual input. For example, at the directors’ loan committee meeting, if a director has information concerning a borrower that may not have been available to the lending team, the director should tell the team. The lending team still makes the ultimate decision. Moreover, the directors should verify with the lending team (and have documented) that the loan meets all of the legal and risk appetite parameters set forth in the bank’s loan policy.

—Kathryn Knudson, Bryan Cave LLP

Part 4: Best Practices for Bank Boards


relay-baton.jpgI frequently speak to groups of bank CEOs and directors at state and national conferences.  One of my favorite topics is “best practices for bank boards.”  The audience reaction always confirms my belief that bank boards of directors all face the same fundamental challenges, regardless of the size or geographic location of the bank and the shareholder base which they serve.  Boards of directors are groups of people, and every group of people develops its own set of shared expectations and priorities.  It can be helpful for a bank board to occasionally take the time to reflect on its approach to self governance and decision making, especially when this is done by examining the experience and success of other boards of directors in the industry.

This is the fourth and final article in a series on best practices for bank boards. This series of articles describes ten of those best practices.  In this article, I will discuss the last two best practices—developing real board leadership and making use of special purpose board meetings.

Best Practice No. 9 – Develop Real Board Leadership

 Every board should periodically evaluate whether it has effective leadership.  Just as no director has a “right” to sit on a board, which gives rise to the need for director assessments and evaluations, leadership positions also are not tenured.  To be effective, a leader must be engaged, prepared for meetings, willing to take on difficult issues, and, in my view, willing to lead by example.  Burnout and growing complacency can be expected in all leadership roles.  It is in the best interest of the board, the bank and its shareholders for the board to have the ability and willingness to recognize and address these issues when they arise, and not delay action.

If the CEO is also chairman of the board, is that arrangement working for the board?  A test for whether such an arrangement is working is for the non-management independent directors to consider whether the board is truly making its own decisions.  If not, then reconsider the existing leadership structure and, at a minimum, appoint a lead director to bring more balance to the board’s decision making process and better ensure a flow of important information to the board.

Also, consider rotating committee leadership on a regular basis, particularly among the most important committees such as the audit, asset-liability and loan committees.  Fresh leadership perspective can be an effective risk management tool.

Best Practice No. 10 – Make Use of Special Purpose Board Meetings

Have at least two meetings a year dedicated to focusing on the bank’s strategy and why it works (or should work) and its strengths and challenges.  Include in one such meeting a discussion of “Buy, Sell or Hold,” since management needs to know the direction of the board on this fundamental issue in order to effectively run the bank and position it for the future.

Consider scheduling a special meeting to address any questions or concerns that directors may have but won’t express in a regular board meeting.  For example, in this time of increased regulatory burden and more aggressive regulatory enforcement, many directors are interested in knowing what their personal liability exposure is and what protections exist, whether they ask or not.  Directors also are very interested these days in hearing a more complete description of the impact of the Dodd-Frank Act and the scope of authority and impact of the Consumer Financial Protection Bureau.

Finally, consider setting aside most or all of a board meeting to have the directors hear directly from the key senior staff of the bank.  This can be helpful for the board to gain confidence in the bank’s overall management team, and it can also be a source of insight into the strength of the institution.  Good banking is fundamentally about good people, and in-person communication is the best way for the board to take the measure of the bank’s people.

I wish you and your board great success. The other articles in this series are below:

Part 3: Best Practices for Bank Boards


team-row.jpgOver the past several years we have seen the regulatory agencies become much more focused on board oversight and performance.  This is a natural point of focus for regulators in a time of crisis in the banking industry.  The fiduciary and oversight obligations of members of boards of directors are well established, and there is a road map in the corporate records for following the actions and deliberations of a board.  I would suggest, however, that a board could receive a gold star for the quality of its minutes and its adherence to the established principles of corporate governance, and yet fall well short of being an effective working group.

This is the third in a series of articles of best practices for bank boards.  Over the past several decades my partners and I have worked with hundreds of bank boards.  Regardless of the size of the entity we have noticed a number of common characteristics and practices of the most effective boards of directors.  In this article, I will discuss three additional best practices—meeting in executive session, making use of a nominating committee and director assessments and participating in the examination process.

Best Practice No. 6 – Meet in Executive Session

It is not uncommon for the most passionate and meaningful discussions among board members to occur in the parking lot of the bank following a board meeting.  Much more time is spent in these parking lot sessions discussing a possible sale of the bank and the compensation and performance of the bank CEO than ever takes place in the board room.  The most effective boards of directors move these conversations to the board room by means of executive sessions.  Whether monthly or quarterly, the independent (i.e., non-management) directors meet in executive session and set their own agenda for those meetings.

I have found that CEOs who welcome and facilitate such executive sessions never regret doing so.  Executive sessions provide a structured forum for the independent directors to meet as a group and speak freely regarding matters of interest and concern to them.  Many positive ideas and discussions can result from these sessions.  If the CEO is also chairman of the board, a “lead director” can chair the executive sessions.  A best practice is for the chairman or lead director to meet with the CEO following an executive session and report on the substance of the matters discussed.

Best Practice No. 7 – Make Use of a Nominating Committee and Director Assessments

No director has a “right” to sit on a board.  Members of the most effective boards of directors have an active desire to serve the bank, which is evidenced by a high level of engagement, preparation and participation.  There should be a transition from the typical practice of automatically re-nominating existing board members to a process of conducting annual director assessments coupled with a nominating committee for director elections.

The CEO should not be involved with either director assessments or the nominating committee—these are board functions and should be managed by the board under the direction of the chairman or the lead director.  Annual director assessments could initially be done by means of self-assessments, coupled with a one-on-one meeting between each director and the chairman.  These one-on-one meetings can serve as the basis for discussion of the director’s enthusiasm for and participation in the activities of the board.

The process of implementing an active nominating committee and annual director evaluation process is also about risk management going forward.  In these times of continued economic uncertainty and increased regulatory scrutiny, it is important that banks have active and engaged directors.

Best Practice No. 8 – Actively Participate in the Examination Process

Members of the board should be involved in the regulatory examination process.  The regulators really do want and expect the board to be involved in and understand the issues which the regulators believe may be facing the bank.  Involvement of the entire board or key members of the board from the first management meeting with the examiners to the exit meeting is tangible evidence that the board is actively engaged in oversight of the bank.  It can also be beneficial for members of the board to hear the concerns of the regulators directly, and to observe management’s interaction with the examiners.

I recently attended an exit meeting with bank management following conclusion of an exam.  Several of the bank’s directors were present because they wanted to get a preview of the exam findings on asset quality.  During the exit meeting the lead examiner raised concern about a risk management issue of potentially significant magnitude.  The issue clearly took the bank’s CEO by surprise, but the presence at the meeting of the board’s chairman had a calming effect.  The chairman looked across the table at the lead examiner and said in a convincing tone, “We will fix this immediately.”  The issue was then quickly resolved, and the final examination report commented favorably on that action.  The end result may well have been the same without the presence of board members at the exit meeting, but I believe their presence was very helpful and reflected well on the bank.

Managing the Board and CEO Relationship During Times of Stress


boxing.jpgImagine this scene between a disgruntled bank director and the CEO.

Director: How did these bad loans happen?
CEO: They were good when we made them. The economy has gone south and you guys agreed and approved these deals.
Director: But we’re not bankers. You were supposed to know. Now the regulators are all over us.

This exchange has occurred in countless bank boardrooms lately. For most directors and CEOs, this is their first experience living through a severe credit crisis and they are now learning how to manage a bank – and boardroom tensions – in this environment. We offer the following guidelines to help navigate this difficult experience so that the board and bank can emerge stronger. 

Recognition

Repeated, emotional “debate” should be viewed as a “dispute,” which boards need to address immediately. It is time to address the dispute if it:

  • has divided the board into “camps” or has divided management from the board
  • becomes known to the employees, stockholders, customers or community
  • consumes too much board meeting time and interferes with making other decisions
  • causes the board to doubt the CEO’s recommendations or increasingly turn to attorneys and consultants on key decisions
  • prompts previous undercurrents to resurface and boil over
  • spurs conversations between directors outside of board meetings on a particular issue, and complaints arise that it is not being addressed in an open session

There are many natural reasons directors attempt to ignore a festering dispute, however, the costs of denial can substantially impact the board. Denial can result in a drain on time and emotions, poor decision making, decreased morale, loss of key directors or officers and regulatory perceptions of inaction.

Facilitation

Dispute resolution cannot begin until it is determined who will facilitate the process. Some boards have effectively used an insider who is not a combatant. Outside facilitators, however, are advantageous in dealing with trust issues and other emotions. A neutral party, such as an attorney or consultant, can be invaluable.

When choosing a facilitator, it is important to consider:

  • Is this person experienced as a director or an advisor who has regularly attended board meetings?
  • Does this person understand the special issues facing bank boards, including regulatory issues?
  • Will this person be patient, a good listener, and maintain neutrality and independence?
  • Take special care if a local facilitator is used, and have any facilitator sign a confidentiality agreement
  • This person must understand the unique dynamics between board/governance and CEO/management.
  • A good facilitator should help the board develop their solution, and one that is owned by the entire board.

Resolution

Based on our experience with bank boards, we offer some suggestions on dispute resolution:

  • Trust issues exist in bank boardroom disputes that worsen as disputes go unresolved. Again, we urge boards to deal with disputes immediately. 
  • Power imbalances exist in the boardroom. The CEO is the only person who can be fired and therefore may feel isolated and threatened. It is beneficial to have a consultant, such as a former bank CEO or chairman, to serve as a confidant. Additionally, it is important to remember that all directors equally share liability regardless of their personal company stock holding. Their fiduciary responsibility is the same as the larger stockholder. 
  • Scheduling routine executive sessions provides a forum for independent director discussion, which is healthy and beneficial. Following executive sessions, one or two directors should communicate the results to the CEO. 
  • Create a written understanding of the resolution once it is reached. This allows everyone to understand the resolution and helps create a sense of closure to the process.

Diagnosis

Boards often determine the true source of a dispute is related to the bank’s governance process.

  • Many boards realize they were not properly involved in setting risk parameters or overseeing compliance, understanding loan risk concentrations, and understanding how lending strategies had drifted toward risky waters.
  • An unhealthy understanding of the board’s role versus the CEO’s role might exist. The recent banking stress has caused many bank boards to properly redefine their role from a “social/advisory” to a “fiduciary/governance” role.
  • Communication process improvements might help reduce the probability and severity of future disputes.
  • Is the dispute simply a “rough patch” or has it revealed a root cause that points to performance/qualification issues with the CEO, or, conversely, the board?

Future Planning

During inevitable future disputes, who does a CEO turn to if he feels there is a dispute with a director or the board? How does the board make it easier to identify and resolve small disputes before they become large ones? Most governance experts agree that as a best practice, boards include a dispute resolution process in the board policy, conduct dispute resolution training, and even consider conflict resolution skills when recruiting new directors.

Do the Europeans have it right?


global.jpgEuropean bank boards, it turns out, are a lot different than in the U.S.  A study earlier this year by the English bank consultancy Nestor Advisors compared nine of the largest European banks with their nine counterparts in the U.S. (e.g. Banco Santander versus U.S. Bancorp and Wells Fargo & Company). Here is what the firm found:

  • U.S bank boards tend to have older members. The median age is 63 compared to 59 on the European boards.
  • U.S. bank boards have fewer designated financial experts than European boards. The difference is 30 percent of board members on European banks versus 15 percent in the U.S.
  • Six out the largest nine U.S. banks have chairmen who also serve as the bank’s CEO, compared to only two of their European counterparts (BBVA and Société Générale).
  • U.S. non-executive directors are more often senior executives at other institutions than in Europe. The median number of non-executive directors with outside senior-level jobs is five in the U.S. versus three in Europe.
  • U.S. bank boards pay their directors with more stock options and less cash than European boards.

By reading the report, you could almost conclude that European banks do a better job following best practices in corporate governance than U.S. bank boards.

Paying stock options could encourage more risk taking, the firm notes. Financial experts might be better qualified to challenge management on matters than impact the bank. Directors who are busy with outside jobs have less time for the bank’s business, presumably.

However, the report notes that large U.S. bank boards tend to be smaller than European bank boards. (The median is 13 directors in the U.S. versus 16 in Europe.) That can encourage more cohesiveness and ability to get work done. U.S. banks tend to have fewer executives and more non-executive directors on the board than European banks. (The median U.S. big bank has 85 percent non-executive directors versus 69 percent for big European banks).

Whether or not these significant differences in board structure translated into any meaningful value for shareholders, or meant European banks avoided the financial crisis better than American banks is another question. (Interestingly, one of the U.S. banks in the study, Goldman Sachs, previously was an investment bank and wasn’t even regulated as a bank before the financial crisis).

Europe is still embroiled in its own problems with an overheated housing market, just like the United States. The Spanish bank bailout fund alone has committed the equivalent of $14 billion in today’s U.S. dollars to recapitalize banks there.

Europe hasn’t recovered yet from its financial hangover, and neither has the United States.

What audit committees need to know


 

Robert Fleetwood, a partner in Chicago-based law firm Barack Ferrazzano who specializes in financial institutions, will be speaking at Bank Director’s Bank Audit Committee conference June 14-15 in Chicago.  Here, he discusses the increasing importance of audit committees understanding capital issues, the advent of risk committees, and the one thing all audit committee members should do.

What is the most important thing that audit committees should be focusing on in today’s environment?

I am always hesitant to say that there is one “most important” issue or factor on which audit committees should be focused. Proper governance and adhering to practical, sound procedures are always critical, and should never be dismissed or overlooked.

audit-mtg.jpgFrom an issue standpoint, it is critical that audit committees, as well as the entire board, understand the ever-increasing importance of capital in the industry’s current environment. The audit committee must understand the organization’s capital structure, the risks inherent within that structure, and the possible effects of Dodd-Frank, Basel III and the overall regulatory environment. As the past few years have illustrated, capital is key. An organization must have a clear plan regarding how to maximize its capital resources now, and how to keep its options open for the future. The audit committee can play a key and important role in that overall process.

How have the responsibilities for audit committees changed during the last few years?

One change that I have witnessed over the past few years is the audit committee’s evolving role in overall risk management. A few years ago, it was common to have the audit committee oversee the organization’s board-level risk management. As audit committees became more and more overwhelmed, enterprise risk management systems have developed and risk committees have become more common.

Recently, it has become more common that overall risk management is not centered with the audit committee, particularly at larger organizations, but instead with a risk committee or the board generally. This is filtering down to smaller organizations, but in my experience smaller companies still are more likely to have the audit committee involved in overall risk management practices. I expect that this trend will continue to evolve over the next few years.

Name a best practice that you would like to see more audit committees adopt.

There are actually a number of best practices that many audit committees do not adopt or implement, often for very good reasons. We stress that there is not a “one size fits all” when it comes to governance. Just because one of your peers implements something, does not mean that you have to adopt it, particularly if it doesn’t make sense within your organization.

One practice that is applicable to all companies, all boards and all committees, however, is the importance of having directors actively participate, ask questions and engage in meaningful dialogue with management, the company’s advisors and other directors. We often hear of situations in which directors have not asked any questions, or did not engage in any meaningful discussions, regarding important decisions affecting the company. Not only does this potentially hinder the decision-making process, but it may not allow the directors to adequately establish that they satisfied their fiduciary duties in the decision-making process. The lack of participation, or the lack of proper documentation of participation through meeting notes and other mechanisms, opens the organization, as well as the directors, to potential liability if the action ultimately has a negative impact on stakeholders.  

 

We’ve been through this before: Corporate governance ratings don’t work


Following the S&L crisis twenty years ago, a number of banking trade organizations, usually in association with a directors and officers liability (D&O) insurance company, trotted out the idea that directors should be accredited. Banks were told that if they sent their boards to special programs on corporate governance, the directors would be accredited and this would save the bank money on D&O policies. The organizations then offered the accreditation programs and made money on them. And if the D&O was placed with the preferred insurance company, the association made a finder’s fee.

However, D&O insurance is a hand written policy, so a discount on your policy is not transparent. It is like getting a discount on a house or a used car. In a negotiated process, how would you be able to tell what kind of discount you actually got?

D&O prices are determined by an underwriter who tries to anticipate how likely it is that you or your bank will be sued. If your bank recently merged, had its CAMELS rating take a beating or saw an ugly drop in the value of its shares, the underwriter either will not write it or charge a great deal of money to cover you. The board’s accreditation won’t affect the price.

The accreditation and corporate governance rating concept was recycled right after Sarbanes Oxley passed in 2002 when Institutional Shareholder Services (ISS, which is now part of MSCI) created a corporate governance rating for publicly traded companies.  ISS then asked the same companies to pay them a consulting fee through its RiskMetrics brand to figure out how to improve their corporate governance. Since ISS voted a great number of shares for institutional investors, companies paid more often than they would publicly admit.

MSCI is changing this business model because it failed to have predictive value in the latest crisis. In fact, as reported by the Huffington Post: “Exactly fourteen days before Lehman Brothers Holding[s], Inc. filed for bankruptcy in September 2008, ISS gave Lehman a corporate governance rating of 87.6 percent, meaning that Lehman’s corporate governance in ISS’ view was better than 87.6% of other diversified financial companies. ISS also doled out generous ratings to other ailing financial companies such as Washington Mutual, which was rated by ISS as being ‘better than 44.3% of S&P 500 companies and 95.6% of [b]ank companies’  just weeks before it’s [sic] undoing. And if that was not enough, a few days before AIG scurried to put together an emergency loan, ISS rated AIG as being ‘better than 97.9% of S&P 500 companies and 99.2% of [i]nsurance companies.’”

Our partner Bill Seidman used to say: “When the tide goes out you get to see who was swimming without their shorts on.” The tide went out and corporate governance ratings took a beating.

director-education.jpg

There is a big difference between accreditation and education. Educated boards are stronger boards.

Right now, if I were serving on a bank board I would be drilling into the issues that really affect the health of the bank. I would be asking about our strategic plan around the coming wave of M&A and if we had a firm idea of what the bank was worth. I’d want to hear what the regulators are saying about our bank and how the Dodd-Frank Act might affect our institution. I would focus on how we pay our people, especially the CEO and the top five key leaders, and how we are developing our bench. I would want to hear about pockets of opportunity for lending and how much we know about our customers. I would attend highly focused programs, talk to my director peers and talk to auditors, lawyers and consultants that work with banks regularly to identify the coming challenges and opportunities. And of course I would read Bank Director. (Yes, that is a plug for our magazine).

I think that a toolbox of information for a board is far better that a one-time, one-size-fits-all accreditation process that focuses on corporate governance in a traditional sense.