By Jonathan Joseph*
Since the initial crush of the financial crisis in the summer of 2008, 406 banks have failed. As of October 24, 2011, the FDIC has authorized suits in connection with 34 failed institutions and 308 officers and directors for D&O liability of at least $7.3 billion.
The current cycle of litigation initiated by the FDIC has begun slowly, however, now that that more than three years has elapsed since the first major bank failure occurred in July 2008, the pace of lawsuits against former bank officers and directors will increase markedly. Since more than 335 of the current round of bank failures didn’t occur until July 2009 or later, most of the FDIC’s suits have focused on the earliest failures. As receiver, the FDIC has three years to file civil damage actions for tort claims from the time a bank is closed. If state law permits a longer time, the state statute of limitations is followed.
To date, only 15 of the FDIC’s civil lawsuits have actually been filed against former officers and directors of failed banks including suits against five former officers of IndyMac Bank in California (but none of its directors). Two-thirds of the fifteen suits were filed in Georgia, California and Illinois and claims included negligence, gross negligence and breach of fiduciary duty. Some of the suits have also included claims for recklessness, corporate waste and willful misconduct. In the prior era, the FDIC brought suit against directors and officers in 24% of the bank failures from 1985 and 1992. With 38 failures in California, 17 in Washington and failures in Arizona (11), Nevada (11) and 6 in Oregon since 2008, if the past is prologue, the FDIC will bring additional civil damage claims against a significant number of bank officers and directors in the Western states during the next 24 months.
San Francisco based United Commercial Bank (UCB), with $11.2 billion in assets, was closed on November 6, 2009. On October 11, 2011, just prior to the second anniversary of UCB’s failure, the U.S. Attorney for Northern California unsealed a criminal indictment that resulted in the arrest of two former UCB executives. The investigation is “ongoing,” meaning more indictments are possible. The dame day, the Securities and Exchange Commission brought civil charges against UCB’s former CEO, Tommy Wu, as well as the two indicted executives for securities fraud, falsifying corporate books and records and false statements to the outside auditor. The FDIC also commenced enforcement actions seeking permanent banking industry bans against 10 former UCB officers (including Tommy Wu and the two indicted officers) and civil money penalties. Three additional officers, who cooperated in the FDIC’s investigation, consented to prohibition orders and civil money penalties. As of October 24, 2011, there had been no announcement of any civil damage suit by the FDIC against any directors or officers of UCB.
This is the environment in which commercial bank D&O’s are operating today. Important lessons can be distilled from the current round of FDIC lawsuits, criminal indictments and regulatory enforcement actions – applicable to sound and troubled banks. The current lawsuits and enforcement actions challenge past conduct and recount recurring themes that help further define corporate best practices and delineate strategy and duties for bank leaders in the future.
The following guidelines are derived from the author’s experience in the “trenches” advising banks and defending officers and directors of failed and distressed banks:
1) Adopt Corporate Best Practices. Well-drafted board minutes should demonstrate directors have exercised reasonable business judgment. Use outside experts as needed to help show that decisions were prudent and made in good faith. Take regulatory criticisms seriously. Address them promptly and responsibly. Hold management accountable. Develop practices and procedures to identify conflicts of interest and don’t approve transactions premised on conflicts without thorough vetting. In connection with complex transactions, management succession, board compensation, bank agency enforcement issues and guiding a “distressed” bank, outside directors should consider retaining independent board counsel to assist in understanding and satisfying fiduciary duties, documenting reasonable business judgments, addressing conflicts of interest and responding to regulatory matters.
2) Director & Officer Liability Insurance. Annually, directors should assess whether coverage is tailored specifically to the current profile of the bank and its D&O’s. The D&O insurance market is fluid. Consequently, a specialty broker and independent counsel with banking and coverage expertise should guide the board. Regulatory exclusions should be avoided. Don’t wait until trouble brews to obtain policies without such exclusions. Consider purchasing policies at both the bank and the bank holding company level since such policies often play out differently in the event of a bank failure. D&O’s should consider purchasing (solely with individual funds) endorsements or separate policies that cover civil money penalties since the FDIC will not allow a bank to fund this type of coverage.
3) Be Aware that Outside Directors Are Not Treated Equally. In several recent suits, the FDIC has focused on outside directors that had elevated banking industry expertise compared to ordinary businessmen. For example, in August 2011 the FDIC sued 14 outside directors of Georgia’s Silverton Bank. The complaint alleged that these directors were either CEO’s or presidents of other banks and asserted they were more “skillful and possessed superior attributes in relation to fulfilling their duties” compared to other directors that were not professional bankers. The FDIC’s position is that these individuals should be held to a higher standard of care. Arguably, the FDIC could assert this position as to any outside director with superior skill or experience. Such individuals should document vigilance in the boardroom and understand how their duties may differ from other directors and officers.
4) Establish and Follow Sound Loan Underwriting Policies and Avoid Rapid Growth. Many recent FDIC suits assert that board’s approved deficient loan underwriting policies and further exacerbated this conduct by repeatedly permitting exceptions to weak standards. Many failed banks were alleged to have implemented “unsustainable business models pursuing rapid asset growth concentrated in high-risk” loans that violated the bank’s underwriting policies. Some banks permitted extremely high CRE/ADC concentration levels even after repeated regulatory warnings. One failed California bank had ADC loans to total capital ten times the regulatory guideline prior to failure.
5) Evaluate Bank and Holding Company Interests. In one-bank holding companies, the interests of the bank and the holding company are often similar. However, when a holding company is controlled by a single person or small group, the interests of the bank may not align with the parent. Where a holding company or bank becomes troubled or holds insufficient capital, the interests of the two companies could significantly diverge. In such cases, directors and officers will need to well understand conflicting duties and interests and address them suitably.
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*About the author: Jonathan Joseph has focused for over 30 years on regulatory, corporate and transactional matters for community and regional banks and officers and directors of distressed and failed institutions. He is a member of the Financial Institutions Committee of the Business Law Section of the California State Bar and the managing partner of Joseph, Cohen & Del Vecchio, Professional Corporation in San Francisco, CA.
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