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July 14, 2011 Articles

A Test for Determining Whether a Claim Is Derivative or Direct

Just as bankruptcy follows bank failure, often litigation follows in the form of derivative or direct claims against officers and directors of the failed bank and its holding company.

By Deborah D. Williamson

“A failed bank, a bankrupt holding company, and a single D&O policy––it is a recipe for litigation between those starving fiduciaries scrounging through the remnants of assets for scraps of creditor recovery.” Official Comm. of Unsecured Creditors of BankUnited Fin. Corp. v. FDIC (In re BankUnited Fin. Corp.), 442 B.R. 49 (Bankr. S.D. Fla. 2011).

Over the past few years, a wave of bank failures has triggered subsequent bankruptcy filings by bank holding companies. Just as bankruptcy follows bank failure, often litigation follows as well in the form of derivative or direct claims against officers and directors of the failed bank and its holding company. Typically, the ownership of and delineation between such claims is easily determined; however, a complication arises when the failed bank and its holding company share common directors and officers. Such were the facts in BankUnited, in which Bankruptcy Judge Laurel M. Isicoff from the Southern District of Florida addressed this issue and formulated a test to determine whether claims are direct or derivative when asserted against shared officers and directors of a failed bank and its holding company.

In 2009, BankUnited, FSB failed. As with many other failed financial institutions, the failed bank’s “good” assets were sold, and the remaining assets were transferred to a special-purpose entity created by the Federal Deposit Insurance Corporation (FDIC). In BankUnited, that entity was the FDIC as receiver (FDICR) for BankUnited, FSB. Included in the assets transferred to the FDICR were “any interest, right, claim or judgment against . . . any officer, director, employee, accountant, attorney or any other Person employed or retained by the Failed Bank or any Subsidiary of the Failed Bank.” The day after these transfers occurred, the Failed Bank’s holding company, Bank United Financial Corporation, filed for Chapter 11 bankruptcy protection. The debtor holding company was the sole shareholder of the failed bank; the membership of the board of directors of the failed bank and the holding company were identical; and each member of each of the boards was a named beneficiary under a single directors’ and officers’ liability policy.

Shortly after the holding company filed for bankruptcy, the Official Committee of Unsecured Creditors sought standing to investigate, assert, and prosecute claims against officers, directors, and pre-petition professionals of the holding company. The FDICR opposed the motion, arguing that the only permissible claims against officers and directors were derivative claims, which were within the sole purview of the FDICR, and, consequently, “any investigation would be a waste of estate resources.” Despite the FDICR’s objections, Judge Isicoff initially granted the committee’s request to investigate potential claims. However, based on demand letters sent to former officers and directors by the committee, the FDICR subsequently asserted that it was “clear the Committee was pursuing only derivative claims and the Committee should not be allowed to proceed.”

After extensive briefing and a lengthy hearing, the court determined that it was unable and unwilling to determine whether the claims asserted by the committee were derivative or direct absent the filing of an actual complaint.

[The court] invited the Committee either to file the actual complaint and let the presiding judge rule on the direct/derivative issue once the complaint was filed, or to file a declaratory action attaching a proposed complaint which proposed complaint would then be considered for purposes of determining whether the Committee could bring the claims asserted therein.

The committee accepted the latter option, and the parties agreed that the matter should be determined on summary judgment.

The Proposed Complaint
The committee’s proposed complaint consisted of three counts. Count I sought recovery against officers and directors of the holding company for breach of their fiduciary duty for failing to, “among a myriad of failures, exercise vigilant control and attention to the financial accounting and reporting of the Holding Company and its subsidiaries, including the Bank, and failing to make sure the Bank was managed properly.” The alleged damages included the “diminution in value of the Holding Company’s interest in its primary subsidiary and most valuable asset,” which was the failed bank.

Count II sought recovery for breach of fiduciary duty arising out of a failure to “provide complete and accurate disclosures to the Holding Company Board regarding the financial condition of the Holding Company and its subsidiaries, and the various reporting inaccuracies and inadequacies that ultimately led to the Bank’s downfall.” Count II included specific damages relating to a repurchase of common stock by the holding company, payment of dividends, and “the improvident incurrence” of debt that “prolonged the Holding Company’s existence and caused it to incur additional losses.”

Count III sought recovery against the former chief executive officer and chairman of the board of the holding company for breaching his duty of loyalty to the holding company by “failing to provide its board of directors with all relevant and necessary information it needed to determine whether it was appropriate for the Holding Company to make a capital contribution of $80 million to the Bank.”

Derivative or Direct, or Derivative and Direct?
Neither the committee nor the FDICR contested that only the FDICR could bring derivative claims arising from the failure of the bank; the determination of whether a claim is derivative or direct is a question of state law; and under Florida law, the same facts can give rise to both direct and derivative claims. As such, the task undertaken by the court was to determine which claims in the case were derivative and which were direct.

The FDICR argued that “a derivative claim is any claim brought by the shareholder of a failed bank which claim arises from the failure of the bank.” The committee argued that “the failure of the bank is not what causes a shareholder’s claim to be derivative, but rather the nature of the cause of action and the alleged harm to the shareholder.”

In her analysis, Judge Isicoff first noted that the determination of whether a claim is direct or derivative is simpler when the shareholder is an individual: “In such an instance, the court need focus only on the activity of the directors and officers and the claims of the shareholder and determine whether the nature of the claims are unique to the shareholder or are actually claims that belong to the corporation itself.” The “waters get muddied” when the shareholder is a corporation. Indeed, each officer and director owes fiduciary duties to each respective corporation, which obligation does not change even where the shareholder and subsidiary have common boards. As the court observed, the analysis is further complicated when the directors and officers of the parent and subsidiary corporations are shared.

The Test
To resolve this concern, the FDICR urged that “courts need a simple test to resolve the direct versus derivative issue” and argued that “in every case where a bank holding company has suffered injuries due to a bank failure, any claims by the holding company caused by that failure can only be derivative claims, at least where the boards have the same, or almost the same, constituency.”

Judge Isicoff agreed that a test is needed but rejected the FDICR’s suggested resolution based on case law that previously “addressed these tensions.” The court, instead, held that:

The test to determine whether a claim brought by a bank holding company against officers and directors of the holding company, who also happen to be officers of a failed corporate subsidiary, is a direct claim or a derivative claim is a two-part inquiry. First, does the complaint state a cause of action for breach of fiduciary duty by the holding company officer or director to the holding company? Second, if the act or failure to act could also be viewed as a breach of duty to the subsidiary by the same person in his or her capacity as a director or officer of the subsidiary, is the injury alleged to have been caused by the breach one that could only occur at the parent level or is it a harm shared with, or occurring solely at, the subsidiary level. If the answer to either of these questions is ‘no,’ then the claim being pursued is a derivative claim. However, if the answer to both of these questions is ‘yes,’ then the claim is direct.

Applying this test to the proposed complaint and relying on Florida precedent, Judge Isicoff held that counts I and III were derivative, while count II was direct. Count I was derivative because it “alleged injury based solely on loss due to the Bank.” The court explained that “[w]hile, in the absence of a common board, such injury might be direct, where there is a common board, or where the shareholder is an individual, [courts] have held that such a claim is derivative.” Count II was direct because the damages alleged were unique to the holding company, and it did not contain claims that the bank could bring or injuries “the Bank would or could suffer.” Count III was derivative because the losses from the “futile and ill advised $80 million capital contribution” were “tied completely to the failure of the Bank, an injury suffered by the Bank.”

The court concluded, “A great deal of time and effort has been spent arguing who gets to chase after the alleged bad guys. Hopefully now the turf war will end and each of the Committee and the FDICR can move forward towards a tangible benefit for their respective constituencies.” Judge Isicoff’s ruling should help avoid such “turf wars.” Further, although BankUnited dealt with skirmishes involving the FDIC and failed banks, the analysis is relevant to other cases where there were two or more entities with interlocking boards and officers but control of the entities is not unified. Application of her test could allow for increased efficiency and effective enforcement of claims for breach of fiduciary duty in such cases.

Keywords: direct claim, derivative claim, failed bank, bank holding company, FDIC

Deborah D. Williamson – July 14, 2011

Copyright © 2011, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).