FDIC Seeking to Recoup Failed Bank Losses from Bank Directors

The FDIC appears to be gearing up to sue directors and officers at many banks that are failing under the current financial crisis.

After an almost 20 year hiatus since the savings and loan crisis (when over 1,800 financial institutions failed), and in the wake of the recent rash of bank failures (325 between 2008 and January 2011), the FDIC appears to be back with a vengeance. Between November 2010 and January 2011, the FDIC authorized lawsuits against over 100 officers and directors at failed banks seeking to recoup over $2.4 billion in losses.

In the first salvo against directors of a failed bank--FDIC v. Saphir, et al., No. 10 CV 07009 (N.D. Ill.)--the FDIC filed an action against all of the directors of Heritage Community Bank, a small community bank in suburban Chicago (the "Heritage Bank Case"). The FDIC alleged that the directors breached their fiduciary duties to the bank and were negligent and grossly negligent in violation of 12 U.S.C. § 1821(k) by: (1) approving loans with inadequate documentation; (2) failing to implement a process to ensure loans were properly assessed for risk and to properly monitor loans once approved; (3) authorizing loans for "speculative" developments in neighborhoods "saturated with [similar] projects"; (4) neglecting to anticipate the real estate bubble bursting; (5) sanctioning loans too large given the bank's size and capital; (6) disregarding criticism by regulators of the bank's policies and procedures; (7) ignoring internal bank procedures and policies; and (8) and awarding excessive pay packages and bonuses to officers and employees and dividends to the shareholders, which included the outside directors.

Under internal FDIC policy, established during the savings and loan crisis, the FDIC will pursue claims against directors based on: (1) dishonest conduct; (2) insider transactions; (3) violations of internal policies, law, and regulations; (4) failure to establish, monitor, or follow proper underwriting procedures; and (5) refusal to heed regulatory warnings. In the current crisis, however, based on the Heritage Bank Case, the FDIC appears initially to have taken a more aggressive position, seeking to hold directors liable not just for failing to follow proper underwriting procedures, but for making real estate loans when the directors allegedly should have known of the real estate meltdown just around the corner.

The FDIC, however, did not assert any regulatory violations in the Heritage Bank Case. In addition to the general fiduciary duty claims, directors and officers are in theory liable for specific statutory violations. The FDIC can bring claims for breaches of lending limit violations, 12 U.S.C. § 84; 12 C.F.R. § 32.1 et. seq.; of safety and soundness standards; 12 U.S.C. §§ 1818, 1831; 12 C.F.R. § 364; or of general provisions of cease and desist orders, and unjust enrichment (12 U.S.C. § 1818(b)). The reason for the lack of any statutory claims in the Heritage Bank Case is that directors and officers (D&O) insurance policies often contain exclusions from coverage for bank regulatory violations and penalties and fines thereunder. If the FDIC alleged that the officers and directors of the bank committed regulatory violations or sought statutory penalties, the carrier would likely deny coverage. The FDIC seems to realize this and so far appears to be aiming to collect from the applicable D&O policies plus whatever it can collect from the officers and directors personally. While the FDIC might take some of the more egregious cases (e.g., fraud) to trial, it will most likely settle the vast majority of the current cases, as it did in the savings and loan crisis.

Standard for Liability of Bank Directors

Under the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), 12 U.S.C. § 1821(k), to prevail on a claim against an outside director, the FDIC must prove at least gross negligence. Where, however, the applicable state law provides for a stricter standard, i.e., ordinary negligence, the director can be held liable for less than gross negligence. FIRREA directs courts to look at the applicable statute to determine the definition of "gross negligence." The chart below sets forth the states that have had a significant number of bank failures and whether the state provides for a cause of action for negligence against bank directors for simple negligence and how state law defines "gross negligence."

Defenses to the Current FDIC Claims

The FDIC's current wave of claims against bank directors so far can be grouped into three categories: (1) the failure to implement a system to assess risk and monitor loans (oversight failure); (2) the decision to approve loans that defaulted; and (3) the approval of excessive executive compensation and/or dividends.

With respect to director oversight failure, many courts use the standard set forth by the Delaware Supreme Court in In re Caremark Int'l, 698 A.2d 959 (Del. 1996). King v. Baldino, 648 F. Supp. 2d 609, 621 (D. Del. 2009), held that to prevail on a director oversight case under Caremark, the FDIC must prove that: (1) "the directors utterly failed to implement any reporting or information systems or controls"; or (2) implemented a system or controls but "consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention." A lack of oversight claim "is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." To prevail under this theory "requires a showing that the directors knew that they were not discharging their fiduciary duties, which requires the FDIC to prove a sustained or systematic failure of oversight." To prove a systematic failure, the FDIC will need to prove that the directors either completely ignored the business of the bank and/or red flags that would have alerted a reasonable bank director to the underlying problems.

Similarly, with respect to director decisions to approve loans that went bad, or decisions on executive compensation and dividends, the business judgment rule creates a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action was taken in the best interest of the company. Absent a showing that the directors failed to make an informed decision or the decision was not made in good faith (i.e., the director personally benefited from the decision), the business judgment rule protects the directors from decisions that turn out to be poor ones in hindsight, particularly where other banks made similar decisions.

In assessing director liability, courts often separate outside directors (those directors that are not officers or employees of the bank) from inside directors (those directors that are also officers or employees of the bank). Outside directors are entitled to rely on the advice and reports from the bank's officers and generally have a different degree of duty to the bank with respect to the day-to-day responsibilities and decisions of the bank. To impose a higher duty on outside directors or to subject them to liability for good faith decisions made based on information provided by the bank would result in banks not being able to obtain responsible local businesspeople to sit on their boards. Bank directors should not be sued every time a loan proves to be uncollectible. Such a result would be catastrophic to banks, particularly small community banks that need to have directors drawn from the local business community.

A good example of a successful defense by directors in a failed bank in the savings and loan crisis is found in Washington Bancorportion v. Said , 812 F. Supp. 1256 (D.D.C. 1993). The FDIC brought an action against 10 directors and one officer of the failed bank alleging negligence, gross negligence, and breach of fiduciary duty, based, in part, on the board's approval of: (1) a $10 million line of credit to a law firm; and (2) a golden parachute to the bank president. With respect to the negligence claims, the court held that bank directors could only be liable for negligence for extraordinary transactions, such as when a bank loans "a great amount of its capital to a new customer and the subject of the loan is an area in which the bank is unfamiliar (for instance, a local savings and loan investing for the first time in speculative oil fields)." In such instances, the "bank directors would be under an obligation to thoroughly investigate the prudence of making such a loan." For more routine transactions, however, the gross negligence standard applied. As a result, the court dismissed all the negligence counts under Rule 12(b)(6) based on the fact that from the complaint it was apparent that the transactions at issue--extending a line of credit to an existing customer and payment to the bank president--were routine transactions and not subject to the negligence standard.

The court also entered summary judgment in favor of the directors on the gross negligence counts. In so ruling, the court held that the bank directors were not grossly negligent in approving the loans that went bad because: (1) the directors made an informed decision based on the information provided to them by the bank's officers; and (2) several major New York City banks made similar loans. The court rejected the FDIC's contention that the directors were grossly negligent for failing to look at the borrower's most recent financial statement because the FDIC failed to show that this would have "been so negative as to put the board on notice that the loan was unreasonably or inordinately risky." The court likewise found that the directors' decision to approve the payment of a golden parachute to the bank's president was not grossly negligent because in making this decision the directors relied on lawyers and bank committees.

Accordingly, under Washington Bancorportion and the above cases, directors, and particularly outside directors, should have very strong defenses to allegations of gross negligence and negligence where the directors: (1) relied on reports and information provided by the failed bank's officers; (2) followed the bank's contractual requirements; and (3) made decisions similar to directors at similarly situated banks.

What Directors at Troubled Banks Should Do

There are several steps that directors at troubled and failed banks can take to help protect themselves from potential FDIC lawsuits.

FDIC's Pre-Suit Investigation

When regulators close a bank, the FDIC steps in as receiver and obtains all the rights and privileges of the bank. Upon taking over, the FDIC begins a formal inquiry into the actions of the bank's officers and directors. The FDIC immediately takes control of the bank's books and records and interviews officers, directors, and key employees (e.g., loan originators). Unlike a typical plaintiff, before filing suit, the FDIC can issue document subpoenas to officers, directors, and employees and can also depose those persons. After conducting its pre-suit investigation, which can take between 18 and 24 months, the FDIC publishes its findings in a report entitled "Material Loss Review" and sends a demand letter for the failed bank's losses to officers, directors, and employees that the FDIC deems culpable seeking compensation. Absent a settlement, the FDIC will then file a lawsuit.

Director Checklist--Troubled Banks

Directors of "troubled" banks must not wait until the FDIC closes the bank to take proactive action. The troubled bank is one that is effectively on probation by the FDIC--usually the subject of a cease and desist order or memorandum of understanding. These regulatory orders often direct the bank to rapidly improve its management and finances. Also, the bank may show significant losses due to loan write-offs, and will often not have sufficient capital to absorb another non-accrual loan.

Directors should take the following steps to protect themselves before the FDIC takes over the bank.

• Work overtime to address as many of the criticisms as possible in the memorandum of understanding or cease and desist order. These days, safety and soundness is king--which means addressing problems in making and managing loans. Have the files reviewed, organized, and completed. Distressed banks frequently have a troubled history of documenting loans. Thus, it is important for the bank's staff to make sure that the loan files are organized and complete. If the regulators demand new management, look for ways to supplement or shift management responsibilities. If regulators demand higher capital ratios, adjust the balance sheet and solicit more investors. Failure to substantially address criticisms will provide great ammunition to the FDIC as it tells a judge that the directors repeatedly demonstrated a fatal nonchalance toward regulatory orders.
• Update and complete policies and procedures. All policies should be vetted to ensure that they are at least as good as those of similar banks, if not better. Because a court will subject management practices to scrutiny, the policies and procedures should likely be more complete than those of the bank's peers. These policies include those mandated by regulations and industry practices--such as loan approval and underwriting procedures, liquidity policies, and policies for approving and managing investments.
• Create committees of independent directors. Banks should demonstrate a willingness to separate oversight of the board from the daily management of the institution. Frequently, banks encounter problems when the owner is the president and the dominant director. If the board is more of a rubber stamp than an independent overseer, the directors face a greater threat of liability. The bank should empower outside directors, even if this requires establishing independent committees to review loans and prior procedures.
• Document personal effort. FDIC lawsuits are personal attacks, and therefore the director needs a personal defense. This requires that the director document the effort to persuade the board to take actions requested by the regulators; if the other board members balk at addressing the problems, the minority squeaky-wheel director should send e-mails and memoranda that demonstrate an effort to convince the board to address problems.
• Review the D&O insurance policies. Notify the carrier if a claim is imminent. Be aware of actions that would trigger policy exclusions.

Director Checklist--Failed Banks

Once the FDIC closes a bank, the directors are out and can no longer affect bank policy. Directors (or rather, former directors), however, can take the following steps to protect themselves.

• Hire a personal lawyer. The moment the bank is seized, the bank's counsel is beholden to the receiver. The director no longer has any right to advice, documents, or confidentiality. Anything said to the bank's lawyer can, and probably will, be used against the director. Thus, it is imperative that directors obtain independent counsel that have experience dealing with the FDIC, lawsuits against officers, directors, and insurance carriers on D&O policies.
• Limit discussion with other directors. Each individual director and officer may be sued for different reasons. Outside directors with ownership stakes of less than 10 percent of the bank will be at odds with senior management or a controlling owner. The FDIC lawsuit will be a zero-sum game--the defense of one individual will come at the expense of others.
• Review the D&O insurance polices--again. The director's counsel should review the policies to determine limits, deductibles, and coverage exclusions. If the carrier has not already been notified, the director should immediately see that proper, timely notice is given.
• Gather documents. The FDIC will almost certainly demand copies of all records and correspondence of the director regarding the bank. The director should work with counsel to gather and organize documents. Counsel should also review the documents to determine the basis for possible claims by the FDIC and defenses by the director.