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

How is Your Bank Perceived by the D&O Underwriter?

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hockey-goalie.jpgWhether you are an executive preparing for the upcoming directors & officers (D&O) liability insurance renewal or a board member preparing for the D&O discussion at the next meeting, there is one person you should be trying to impress. That’s the underwriter who is analyzing your bank and determining the D&O renewal terms and conditions.

The perceptions of this individual are going to determine whether the insurance policy that protects the personal assets of the directors and officers and the corporate balance sheet is comprehensive enough to include the most up-to-date coverage enhancements, or is so restrictive as to include a regulatory exclusion. Now before getting into what steps you can take to improve that perception, it is important to understand the claims and litigation trends that these underwriters are talking about before they start to take a look at your bank.

The top two claims leaders in the banking D&O marketplace continue to be regulatory exposures and M&A. With regards to regulatory concerns, the data provides an interesting dichotomy. While we see a decrease in 2011 for both class action claims relating to the credit crisis and to the number of failed banks (figure 1), we continue to see a very large spike in the number of FDIC D&O defendants (figure 2).

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This is consistent with the fact that the FDIC reports that “most investigations are completed within 18 months from the time the institution is closed” (www.fdic.gov). And it is not just failed banks that concerns underwriters. Most underwriters would categorize a bank as a regulatory risk if any of the following exist:

  • Any open regulatory agreement
  • Consent order
  • Cease and desist order
  • MOU (memorandum of understanding relating to asset quality, earnings, or capital, but not so much for safety and soundness or the Bank Secrecy Act)
  • Severe degradation of asset quality following a regulatory exam or audit where the expectation would be a regulatory restriction on the following exam (Texas ratio close to 100 percent or Tier 1 capital/total loan ratio of <2 percent)

And once a bank is perceived as a regulatory risk, there is a good chance that the D&O liability terms would include the very restrictive regulatory exclusion.

As mentioned, the second significant risk exposure is M&A (mergers and acquisitions), which also demonstrates compelling data points. In 2010, M&A filings represented the largest broken out category with 40 such filings representing out of 167 filings or 24 percent. That percentage jumps to 30 percent in the first half of 2011. So if your institution has any regulatory exposures or is anticipating some type of M&A, you can expect a lot of questions during the upcoming renewal process.

And while there are many ways to address those questions, we believe that coordinating some type of underwriter meeting or call is the best way to improve underwriter perceptions and generate the most comprehensive D&O renewal with regards to terms, conditions and pricing. The process usually entails coordinating a meeting with the management team, the incumbent underwriter and all competing underwriters either at the bank’s office or a centrally located site. In order to make the meeting as productive as possible, your broker should obtain any questions the underwriters would have and present that to the management team prior to the meeting. The benefits of such a meeting are four-fold:

1. Unlike insurance lines such as property/casualty or workers’ compensation, where actuaries are able to somewhat predict the likelihood of a claim based on past trends, there has been no reliable model to mathematically predict when the next securities class action or next suit against a director/officer will be. So when an underwriter has an opportunity to meet or listen to the management team, this provides a gut feeling as to the quality of the management.

2. Having all of the underwriters in a room or on a call at the same time goes a very long way in fostering the competitive influences in the marketplace. One comment I hear is that it is unfair to include the incumbent underwriter in the same meeting as all of his/her competitors What we recommend instead is to then have a one-on-one lunch or dinner meeting with the incumbent underwriter(s) to further develop that existing relationship.

3. By meeting with the underwriter, you have now developed more of a personal relationship with the underwriter, which can be helpful in the future is in the event of there is a claim or a service request.

4. One of the frustrations I hear a lot from bankers is that the process to finally bind up the renewal often incorporates a lot of last minute questions or requests. At this meeting with the underwriters, you are basically saying, “speak now or forever hold your peace.” We find that once the meeting is completed, the remainder of the renewal process becomes very streamlined.

So as you prepare for that D&O renewal or discussion, don’t forget to think about that underwriter and what you can do to improve the perception of the bank.

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.

 

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

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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.

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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.

 

What Keeps Directors Up at Night

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worried.jpgDuring the S&L crisis of the late 80’s and early 90’s, the Federal Deposit Insurance Corporation sued or settled claims against bank officers and/or directors on nearly a quarter of the institutions that failed during that time. If the past is any indication of the future, then there is a significant risk that directors of failed banks from the recent financial crisis may see some type of action taken against them by the FDIC.

In addition to lawsuits against senior executives of IndyMac Bank, and also senior officers and directors of Heritage Community Bank in Illinois, the FDIC has authorized actions against more than 109* insiders at failed banks to recover over $2.5* billion in losses to the deposit insurance fund resulting from this wave of bank failures.

Based on their work with a number of banks as well as individuals who are the targets of recent FDIC cases in various stages of development, John Geiringer and Scott Porterfield from the Chicago-based law firm of Barack Ferrazzano answer some questions about what could be keeping bank directors up at night.

What are the steps taken by the FDIC after the closure of a bank?

The FDIC begins a preliminary investigation when it believes that a bank may fail and will interview bank employees, officers and directors promptly after the bank’s closure.It is common for the FDIC to send a demand letter to the bank’s officers and directors demanding payment, usually in the tens or hundreds of millions of dollars, shortly before the expiration date of the bank’s D&O insurance policy.The FDIC sends that letter in an apparent attempt to preserve the D&O insurance for any litigation claims that it may later assert.

The FDIC may then subpoena officers and directors for documents and depositions. After conducting depositions, the FDIC will decide whether to initiate litigation against any officer or director. If the agency decides to litigate, it will initiate settlement discussions before actually filing its lawsuit. Because of the many evolving issues in these situations, such as whether insiders may copy documents for defense purposes before their banks fail, potential targets of these actions should ensure that they are being advised by counsel through every step of this process, even before their banks have failed.

What are the legal standards by which the FDIC may sue directors?

The FDIC bases its lawsuits on general legal principles that govern director and officer conduct and also considers the cost effectiveness of any potential lawsuit when making its decision. Federal law allows the FDIC to sue directors and officers for gross negligence and even simple negligence in certain states. What those standards mean as they relate to the conduct of bank insiders during this unprecedented economic cycle is difficult to predict at this time, although we are getting a clearer picture.

In the Heritage case, for example, the FDIC alleges that the defendants did not sufficiently mitigate the risks in the Bank’s commercial real estate portfolio and made inappropriate decisions regarding dividend and incentive compensation payments.

Will the FDIC differentiate between inside and outside directors?

Whether someone is an inside or outside director is one of the factors that the FDIC considers in determining whether to sue a director of a failed bank. According to the FDIC’s Statement Concerning the Responsibilities of Bank Directors and Officers, the most common lawsuits likely to be brought against outside directors will probably involve insider abuse or situations in which directors failed to respond to warnings from regulators and bank advisors relating to significant problems that required corrective actions.

Will D&O insurance cover any liability to the FDIC?

That depends on the amount and terms of the D&O policy. Directors should work with their insurance broker and bank counsel to review their D&O policies and to help them to make this determination. They should determine whether their policy amount is sufficient, whether their policy has certain exclusions (such as regulatory and insured vs. insured exclusions), whether proper notices are being made and under what conditions their policy can be cancelled.

What can directors do to mitigate their risk in the event that their bank fails?

In its Policy Statement, the FDIC states that it will not bring civil suits against directors and officers who fulfill their responsibilities, including the duties of loyalty and care, and who make reasonable and fully informed business judgments after proper deliberation. The FDIC generally requires bank directors to: (i) maintain independence; (ii) keep informed; (iii) hire and supervise qualified management; and (iv) avoid preferential transactions.

Directors should ensure that their bank’s counsel and other advisors are discussing these crucial issues with them. If their bank is in troubled condition, directors should seriously consider the need to hire personal legal counsel and to understand their ability to obtain indemnification.

* Figures updated as of 1/4/11 based on latest reportings.