Bank directors and officers may be held to a different standard of care from the directors and officers of other business corporations, leaving their actions without the protection of the business judgment rule, according to a recent and highly unusual decision from a Georgia federal court.

On December 4, 2009, the Buckhead Community Bank failed. The Federal Deposit Insurance Corporation took over as a receiver and subsequently filed suit against nine former directors and officers of the bank. In its complaint, the FDIC charged that the defendants were negligent and grossly negligent in their management of the bank’s loan portfolio, leading to the failure.

According to the FDIC complaint, the bank’s Loan Committee “took unreasonable risks” and violated bank policy by approving speculative commercial real estate loans without adequate information and participating in loan purchases from other banks without independently reviewing the loans, despite repeated warnings from regulators, according to the FDIC.

In Georgia, the business judgment rule explicitly holds bank directors and officers to an ordinary negligence standard of care: “[d]irectors and officers of a bank or trust company shall discharge the duties of their respective positions in good faith and with that diligence, care, and skill which ordinarily prudent men would exercise under similar circumstances in like positions.” O.C.G.A. § 7-1-490(a). Other states with the business judgment rule, such as California, only protect directors, not officers, in this way.

The defendants filed a motion to dismiss the suit. Despite O.C.G.A. § 7-1-490(a), they argued they could not be liable for ordinary negligence under the business judgment rule and their actions did not rise to the level of gross negligence.

U.S. District Court Judge Thomas W. Thrash, Jr., acknowledged that Georgia federal courts have “uniformly applied the business judgment rule to protect bank officers and directors,” but reached a different conclusion.

“There is every reason to treat bank officers and directors differently from general corporate officers and directors,” he wrote. “In general, when a business corporation succeeds or fails, its stockholders bear the gains and losses. The business judgment rule is primarily applied in Georgia because ‘the right to control the affairs of a corporation is vested by law in its stockholders – those whose pecuniary gain is dependent upon its successful management.’ But when a bank, instead of a business corporation fails, the FDIC and ultimately the taxpayer bear the pecuniary loss. The lack of care of the officers and directors of banks can lead to bank closures, which echo throughout the local and national economy. To some extent, the failure of bank officers and directors to exercise ordinary diligence led to the very financial crisis that continues to affect the national economy.”

State courts in Georgia have generally applied the business judgment rule to preclude claims for ordinary negligence against the officers and directors of a corporation, the court said, but “no Georgia state court has explicitly extended the business judgment rule to protect the officers and directors of a bank being sued by the FDIC as a receiver.” With “no clear controlling precedents on this issue by the Supreme Court of Georgia,” and having reached a contrary conclusion from his fellow federal judges, Judge Thrash certified the question “of whether the business judgment rule should supplant the standard of care required of bank officers and directors by O.C.G.A. § 7-1-490 in a suit brought by the FDIC as receiver” to the state’s highest court.

Even lacking guidance from the state court, Judge Thrash declined to apply the business judgment rule to the FDIC’s ordinary negligence claim. The agency “has set forth numerous allegations indicating the Defendants failed to exercise even slight diligence when acting as directors and officers of the Bank,” he wrote, continuing to approve the questionable loans despite being aware of a decline in housing sales and in contravention of bank policy. “These risky assets led to the Bank’s ultimate crash, and led to the losses incurred by the FDIC.”

The Financial Institutions Reform, Recovery, and Enforcement Act allows bank directors and officers to be liable for monetary damages based on gross negligence, the court noted, again denying the defendants’ motion to dismiss.

“The alleged facts show an ongoing tendency to ignore risks while taking on loans that were flagged by regulators. Similarly, the allegations suggest that the Defendants invested the Bank’s loan portfolio in a manner far more aggressive than banks in their peer group. Additionally, the Defendants failed to adhere to procedures that would have identified the deficiencies in the loans, including internal policies concerning diversification and inspection,” Judge Thrash said. “The allegations of such disregard of care and procedures are sufficient for a reasonable jury to conclude that the Defendants were grossly negligent in their management of the Bank.”

To read the opinion in FDIC v. Loudermilk, click here.

Why it matters: The decision in Loudermilk may strike fear in the hearts of bank executives, particularly those located in the state of Georgia. Under the reasoning of the opinion, the protections of the business judgment rule for liability based on ordinary negligence would not apply to the directors and officers of banks because the Deposit Insurance Fund of the FDIC bears the impact of their actions, which the court said can “echo” nationwide. However, the court failed to recognize that the Deposit Insurance Fund (funded by bank assessments) bears the alleged losses, not the taxpayers. One possible light at the end of the tunnel, however, could be that Judge Thrash certified the question to the Georgia Supreme Court, which could reach a different conclusion.