As a result of the financial crisis that began in 2007, in the last few years more than 350 banks have failed across the country – with many more expected to fail in the foreseeable future. With bank failures mounting, the Federal Deposit Insurance Corporation (FDIC) has initiated an onslaught of investigations and litigation against former officers, directors and other institution-affiliated parties for the failure of their respective institutions. Utilizing tactics similar to those that yielded more than $2 billion in settlements from officers and directors involved in the savings and loan crisis in the late 1980s, bank regulators are vigorously pursuing a new wave of potential claims against bank management and directors.
The FDIC’s Aggressive Pursuit of Bank Management
As of May, 2011, the FDIC had filed six lawsuits against former officers and directors of failed banks. The claims brought thus far generally stem from banks’ aggressive residential and commercial real estate loan policies during the real estate bubble. The lawsuits, which typically include claims for breach of fiduciary duty and gross negligence, fault bank management for overly aggressive lending practices, failing to enforce prudent lending and underwriting policies, and failing to maintain diversity in the bank’s asset portfolios. Allegedly improper insider transactions also are frequently identified in the suits as providing grounds for damages.
Although the FDIC usually sues in federal court, state law generally governs in these suits, unless a specific federal law establishes a higher standard of conduct. For example, although under the Financial Institution Reform, Recovery and Enforcement Act of 1989 (FIRREA) a bank officer or director will be liable for monetary damages for gross negligence, he or she may be personally liable upon a lesser showing of culpability, such as simple negligence, if applicable state law provides such a lesser standard.
Even though the most recent suit by the FDIC seeks nearly $1 billion in damages from three former bank executive of Washington Mutual (WaMu), the regulator is not limiting its focus only to bank officers and inside directors. As a sign of just how aggressive the FDIC is willing to be, two wives of the former WaMu executives were also named in the lawsuit for allegedly illegally transferring personal assets into trusts to try to protect the assets from future legal claims. In another recent case, several outside directors who served on a failed bank’s loan committee were also named as individual defendants.
These lawsuits are harbingers of things to come for former management at the 350-plus failed banks that are already in the FDIC’s crosshairs and the scores of troubled banks that are looming in the regulator’s sights. To date, the FDIC has authorized suits against more than 185 individual officers and directors for damages in excess of $3.7 billion. Although fewer than 50 of these individuals have been sued so far, the list is likely to grow. The FDIC has also devoted significant resources to substantially increasing its staff and it has engaged outside law firms to help conduct investigations and litigate those lawsuits it chooses to file. There can be no doubt that bank officers, directors and other institution-affiliated parties face a new, high-risk environment in which regulatory oversight and enforcement will likely intensify as bank failures continue to rise. By heeding regulatory warnings and taking some of the precautionary measures discussed here, however, they can substantially mitigate the risks and damages from any FDIC investigation or lawsuit.
Regulatory Oversight of Troubled and Failed Banks
Obviously, the best way to avoid a lawsuit by the FDIC is to ensure that the bank remains solvent and does not fail. This can be a daunting task for the management and board of a troubled bank that is effectively on probation by the FDIC as a result of a memorandum of understanding (MOU) or a cease and desist order. These regulatory orders typically include detailed mandates requiring the bank to improve its finances, management, and business practices by a designated date. As a result of the economic downturn in recent years, many troubled banks have been unable to comply with these regulatory requirements and have been forced to close their doors.
For those banks that degrade from troubled to failed status, the dynamics change dramatically. After a bank collapses, the former officers and directors are no longer managers of the bank, but instead become targets of investigation by the FDIC. As receiver of the failed bank, the bank’s “new manager” is required to investigate why the failure occurred.
Even though the FDIC will have developed an opinion regarding the causes of a pending failure while the bank was on regulatory probation, upon the closing of the institution, investigators from the FDIC’s Professional Liability Group launch a formal, multi-step investigation that typically lasts between 18 months to three years. The investigation generally targets officers and directors to determine whether
- they violated any applicable laws
- they engaged in fraudulent transfers
- they possess any bank properties that should be attached
- it would be cost effective to commence suit and seek to recover damages
In so doing, the FDIC will aggressively scrutinize former management’s decisions to determine whether, among other things: sound corporate governance policies were in place and adhered to; there was meaningful response to supervisory criticism or signs of problems; lending functions were not abdicated to those compensated based on volume rather than the quality of loans; and the general decision-making practices of the bank were sound and free from conflicts of interest.
During the first phase of the investigation, the FDIC will take control of all bank property and documents, thereby leaving the former officers and directors without access to critical materials that may contain exculpatory facts. At this stage of the investigation, interviews are conducted with bank personnel to gather additional information about the root causes of the bank’s failure.
The second stage of the FDIC’s investigation consists of a forensic review of the bank’s losses. Often, the FDIC is assisted in the local component of the investigation by outside counsel, who conduct depositions and other discovery, and make recommendations to the FDIC. Simultaneously, the FDIC inspector general generally conducts a more global investigation of the causes of the institution’s failure and issues a public material loss report. After considering all the information it has compiled, the FDIC then generally sets its aim on some or all of the officers and directors of the failed bank.
Simultaneously, the FDIC inspector general typically conducts a global investigation of the causes of the institution’s failure and issues a public material loss report. After considering all the information it has compiled, the FDIC then generally sets its aim on some or all of the officers and directors of the failed bank.
The final step of the investigative process is triggered by a civil demand letter issued by the FDIC to the targeted individual officers and directors (and their insurance carriers), which sets forth the theories of liability against them and demands money damages for the alleged wrongdoing. These civil demand letters typically contain numerous, extremely broad allegations of misconduct, and have been known to consist of up to 10 single-spaced pages of purported errors and omissions. The civil demand letters are frequently accompanied by administrative subpoenas for documents that often seek personal financial information from officers and directors that may be used by the FDIC to identify possible sources of recovery. Upon completion of its investigation and document review, the FDIC will decide whether to initiate a lawsuit against the targeted individuals or to try to negotiate a settlement, which may include a portion or all of the proceeds of their liability insurance policy.
Practical Considerations for Officers and Directors Who Are, or May Be, Subject to Regulatory Action
Prophylactic Steps for Management of Troubled Banks
- Actively respond to criticism in regulatory orders. According to the FDIC, claims will not be brought against bank management “who fulfill their responsibilities, including the duties of loyalty and care, and who make reasonable business judgments on a fully informed basis and after proper deliberation.” This means that officers and directors of troubled banks must remain vigilant, heed regulators’ warnings during bank examinations, and respond to criticism by taking appropriate steps to remedy identified problems. In today’s environment, necessary corrective actions might require adjusting a bank’s composition of loan portfolios, managing capital ratios, or more critically overseeing its loan approval process. If the regulators mandate higher capital ratios, management must respond by finding new sources of capital to infuse into the bank and adjusting the balance sheet. Where regulators criticize loan documentation, bank management should diligently review, organize and audit files to ensure they contain the necessary documentation and are in compliance with applicable policies. Such prudent steps that timely address identified shortcomings may pay dividends by staving off a bank failure and the ensuing investigation and litigation that would likely follow.
- Ensure oversight by outside, non-employee directors. It is critical that a bank is subject to independent board oversight that is separate and distinct from its day-to-day management. Banks often encounter problems when they are dominated by one or more insiders who control the daily management of the institution, as well as its board of directors. Under such circumstances, where the board tends to be more of a rubber stamp than an independent overseer of the management of the institution, the FDIC will be more inclined to sue the directors individually. Thus, a bank should strive to stack its board with a majority of outside directors and to empower those non-employee board members by establishing independent committees to critically review the institution’s loans, finances and governance.
- Maintain adequate records of critical decision making. Although most officers and directors of troubled banks are intently focused upon returning the institution to good financial health, they should, nevertheless, simultaneously plan for its failure. Such planning includes the documentation of the circumstances and reasons underlying critical business decisions that are likely to come under regulatory scrutiny if the institution fails. Even when judged in hindsight, a decision need not have been correct to avoid liability, but it must have been based on sound business judgment that was free from bias and conflicts of interest. To reduce the risk of personal liability, a bank official should create a paper trail documenting the circumstances underlying, and the reasonableness of, any of his decisions that will likely be reviewed in 20/20 hindsight. Moreover, if a board member who is actively attempting to address issues raised by regulators is meeting resistance from management or other board members who refuse to take the necessary remedial actions, the minority board member should document his dissent from the others’ ranks and his personal efforts to rectify the noted shortcomings. Thus, bank management should ensure that the board minutes and other key documents explain how and why critical decisions and actions were undertaken so there is an indisputable record of each individual’s participation in significant events involving the bank.
In addition to documenting their actions, officers and directors should keep their own set of records detailing key decisions – because if the bank fails, the FDIC will take possession of all of its corporate records. It is also important to collect and safeguard employment records which explain the specific duties and responsibilities of officers and directors so that there is documentation of each individual’s expected role in critical decision making. These measures will ensure that not only the FDIC, but also each officer or director who may come under the regulatory scrutiny, will have a fully documented account of his individual role and impact in critical bank decisions and policies.
- Review D&O insurance policy. The FDIC generally looks to the banks’ liability insurer as a potential deep pocket when it pursues an investigation or initiates litigation against former officers or directors to recoup bank losses. As a result, officers and directors of troubled banks should review their policies to ensure that the appropriate amount of coverage is included and that the scope of the coverage is sufficient to adequately protect them from individual exposure in the event of a bank failure. If necessary, legal counsel who specializes in this type of liability coverage should be retained to identify potential exclusions and other coverage issues and to advise regarding actions that might trigger exclusions or void coverage.
Risk-Mitigating Steps In the Event of a Bank Failure
- Put insurers on notice of potential claims. After the FDIC takes over as receiver, bank officers and directors, whose status changes immediately from insiders to outsiders, must take steps to protect themselves. First, if notice to the insurers has not been provided before the bank’s failure, it is important that all liability insurance carriers be put on notice of potential claims immediately upon the bank’s closure. In the notice letter, the particular officer or director seeking coverage should also make a formal demand for coverage and request a timely response to his demand.
- Hire independent counsel to conduct parallel investigation. The moment the bank is seized its internal legal team and outside counsel, who may have been actively advising the officers and directors prior to the failure, immediately become aligned with the FDIC and may be required to disclose previous communications with the officers and directors. As a result of this relationship change, it is important for former officers and directors to hire independent counsel, with no prior relationship with the bank or its management, to represent them individually. The hiring of independent counsel is also critical in situations where conflicts of interest exist between outside directors and management such that each of them require separate counsel. Moreover, although a bank failure may trigger the need for multiple counsel, it is imperative that each insured consult with the insurance carrier prior to retaining counsel to ensure that the insurer approves the requested attorney.
After engaging independent personal counsel, the officer or director who is under investigation should direct his lawyer to launch an investigation similar to that of the FDIC’s. Although such a task will be difficult because the FDIC will have all of the bank’s documents, it is important to gather as much information as possible to rebut any allegations of improper conduct. To that end, counsel should try to obtain public records regarding any regulatory examinations at the bank, the Material Loss report, and any other documents that may include exculpatory evidence or explain the underlying reasons for criticized decisions.
- Limit transfers of assets and communications with prior counsel or other targets. Officers or directors who are under regulatory investigation should avoid giving the FDIC evidence to build its case by, among other things, communicating with prior counsel or other targets of investigation or transferring their personal assets without a proper purpose. These individuals must remember that everyone they previously worked with at their former bank either now works for the FDIC or is the subject of regulatory investigation. Former officers and directors must refrain from communicating with the bank’s counsel because anything they say to the lawyer can, and likely will, be used against them. In addition, because, for example, the defense of an outside director may come at the expense of an insider, targets of regulatory investigation should also limit communications with each other to ensure that no harmful facts are inadvertently disclosed.
The FDIC contends it has the statutory authority to negate improper transfers of personal assets by former officers or directors of a failed bank. Because the FDIC is focused on recovering losses for the bank, it will closely scrutinize any transfers of personal assets during its investigation and, as in the WaMu case, initiate claims against those who attempt to improperly move their assets to try to shield them from legal actions. As a result of this emphasis by the FDIC, once targeted by the regulator, former officers and directors of any failed institution should exercise caution when engaging in personal financial planning.
After many years of relative inactivity, regulators are once again sighting their scopes on former officers and directors of failed institutions and looking for ammunition to hold them accountable for bank failures. Given this renewed focus and the plethora of bank failures to date, it is advisable for bank officers and directors to take precautionary measures to try to avoid being caught in the FDIC’s crosshairs.
This article was first published in the July/August 2011 issue of ABA Bank Compliance magazine. The authors would like to acknowledge the assistance of Charles Stutts, a partner in the firm’s Tampa office.