This is Part III of our three-part series regarding the fi nancial and regulatory crisis and its consequences for the banking industry, banking institutions and their directors and offi cers. As we write Part III, which focuses on potential director culpability following a bank’s demise, we look back to 2009, which ended with 140 bank failures. There have been 111 failures to date in 2010. This year easily could end with double that number considering more than 700 institutions remain on the FDIC’s “troubled bank” list.

With the high number of institutional failures— many occurring very quickly—the FDIC is only in the initial stages of its efforts to sue directors and offi cers of failed banks in its role as receiver of the estate of the closed institution.1 When a bank is closed, at the direction of its chartering authority, the FDIC becomes the party-in-interest to recover damages caused by the institution’s management for actions and inactions amounting to fraud, breach of fi duciary duty, violation of law, gross negligence and, in some cases, simple negligence. Since 1985, the FDIC has sued management in approximately three bank closures out of ten. What the agency will do in 2010 and beyond remains to be seen. Already visible signs appear ominous.2 It should be noted that the statute of limitations applicable to the FDIC for bringing tort claims is the longer of three years or the applicable state law statute of limitations.3  

During the last banking crisis, the FDIC was quick to sue many beleaguered executives and boards of directors alleging the charges noted above. Recoveries were substantial, and in some cases the agency was able to recover from the bank’s directors and offi cers liability (D&O) policy up to the limits of the coverage. In certain cases, amounts beyond such coverage were obtained from individual defendants themselves.  

As failure for an institution becomes more certain, the FDIC typically begins to intensify its focus on the institution’s management and takes preliminary steps to ensure that the bank’s failure does not mean the directors are off the hook. Just the opposite is their intent.

During 2009, as bank failures cascaded across the country, the following stood out as having the most failures: Georgia (29), Illinois (21), California (17) and Florida (14). This was not surprising because these states all had recent, explosive growth of de novo banks and high levels of commercial real estate (CRE) development. After the bank fails, the FDIC typically sends out a notice letter of impending regulatory scrutiny and a possible full investigation of the institution before the bank’s D&O policy expires. This notice is sent to the bank’s D&O carrier, but it is also sent to the directors and management who may have culpability. Some observers believe that a notice letter from the FDIC was sent to the D&O carrier in every 2009 Georgia bank failure.4  

In order to get its recent director liability program up to speed, the FDIC has been hiring so-called “fee counsel,” private law fi rms that will do the brunt of the pre-fi ling investigation work and fi le and prosecute the claims for the FDIC. On the other side, attorneys for the failed institution will be precluded from representing the institution’s directors and offi cers post-failure because the FDIC will assert that it, as receiver, is the bank’s successor-in-interest (and thereby the attorney’s client), and the FDIC will not allow such attorneys to take actions inconsistent with the FDIC’s position. Directors and offi cers, therefore, will be left without the lawyers who advised them during the institution’s crisis and failure. By statute, the primary federal regulator of the institution must investigate and determine the causes of each bank’s failure. The reports that follow such failures (available on the FDIC’s website) are road maps for the fee counsel to follow in ascertaining who was at fault and why.  

Directors and offi cers in the FDIC crosshairs are not without defenses and means to defend themselves. As explained more fully below, the FDIC never must prove more than gross negligence, which normally requires a pattern of acts or especially egregious failures to adhere to well-understood, required practices. It is not necessarily the same test as the FDIC must meet to remove a director or offi cer from banking—the so-called “heedless indifference to known risks” standard—but it is close (see the discussion in Part II of this series, which discusses removal from banking).  

The FDIC recently went public with its intent to sue management of BankUnited in Florida, which failed on May 21, 2009. The allegations on fi le and discussed below provide insight into potential FDIC allegations during this crisis and refl ect some typical banking practices thought to be problematic.  

In its November 5, 2009 letter (the “Letter”)5 to various members of management, the FDIC stated that its demand was based on damages “arising out of losses suffered due to wrongful acts committed in connection with the origination and administration of unsafe and unsound residential real estate loans.” The Letter cited in particular the individuals’ alleged wrongful acts in connection with “pursing an overly aggressive growth strategy focused primarily on the controversial Payment Option ARM product.” The Letter asserted that, by the end of 2007, Option ARM mortgages represented 70 percent of the bank’s residential loan portfolio and 60 percent of its total loan portfolio, and by 2008 represented 575 percent of the bank’s capital.  

The Letter further asserted that individuals failed “to implement adequate credit administration and risk management controls and failed to heed warnings and/or recommendations of bank supervisory authorities and bank consultants.” In addition, the Letter stated that the “inherent risk” of Option ARM loans was “coupled with defi ciencies in the Bank’s underwriting, appraisal process and credit administration.”  

With respect to the directors and offi cers of the institution, the Letter asserts that they:  

(i) adopted an overly aggressive and reckless growth strategy by investing most of the bank’s assets in Option ARM lending products;

(ii) failed to provide the bank with adequate reserves for potential loan losses resulting from its investments in Option ARM lending products;

(iii) engaged in reckless, high-risk and limited scrutiny lending; (iv) failed to oversee the bank’s affairs, including the failure to monitor the rising volume of loan delinquencies and to establish lending policies that would adequately protect the bank; and  

(v) failed to provide adequate personnel and administrative capacity to appropriately monitor loan appraisals and to carry out diligent underwriting reviews.  

Most damaging, the Letter accuses the former bank directors and offi cers of authorizing an overly aggressive lending mentality “to make the loan as long as the borrower had a pulse.” This is the sort of allegation that, if proven, could tie the current fi nancial crisis to the historic standards of director culpability for bank failure. A key component of the culpability analysis in this crisis is the huge and largely unexpected downturn in the residential and commercial real estate markets. Defendant directors and offi cers will have a hard time arguing that “no reasonable person could have foreseen how residential values would plummet” if the FDIC can show that the bank gave loans to anyone with a heartbeat.  

The Letter also stated that the bank’s compensation policies were designed to encourage loan production with a blind eye toward delinquencies. Specifi cally, it said the compensation policies “created personal fi nancial incentives for bank offi cers and directors to engage in risky, aggressive and short-sighted lending practices.” This allegation may prove to be key, as the FDIC will attempt to prove the executives were fi nancially incented to disregard safety and soundness concerns.  

The Law

Both federal and state statutory law impose duties on directors and offi cers of banks. The statutes and their implementing regulations cover key topics such as lending limits, false reports, loans to insiders and other such matters. One key but sometimes overlooked statutory requirement regards making false statements to regulatory offi cials. Bank offi cers sometimes forget this obligation during examination discussion with regulators.6 It is also possibly a criminal violation if intentional.  

In addition, bank directors and offi cers must comply with applicable fi duciary duties. Courts have held directors and offi cers of banks to a higher common-law standard of care and loyalty than their counterparts in other industries. When the FDIC as plaintiff in bank director liability lawsuits sues for breach of the duties of care and loyalty, it relies on 12 U.S.C. § 1821(k). This statute permits the FDIC as conservator or receiver of a failed institution to sue the directors and offi cers for gross negligence, or for simple negligence if applicable state law allows. In addition, the FDIC has aggressively pursued directors and offi cers suspected of selfdealing for breach of the duty of loyalty.  

Under the common law, individual bank directors are considered fi duciaries and are subject as such to the common-law duties of care and loyalty. Bank directors are often held to a higher standard than directors of non-bank corporations, on grounds that bank directors are in a trust relationship with depositors, as well as stockholders, and are insured by the government.7  

Despite this strict standard for breaches of fi duciary duties, other common-law doctrines limit the liability of individual bank directors. Bank directors may be shielded by the “business judgment rule,” although not necessarily to the degree enjoyed by non-bank directors. Courts have also held that individual “[b]ank directors are not insurers for losses which were not caused by their fault or neglect of duty.” As one court noted, no persons “of sense would take the offi ce, if the law imposed upon them a guaranty of the general success of their companies as a penalty for any negligence.”8

In Briggs vs. Spaulding,9 the Supreme Court defi ned the duty of care as the care that “ordinarily prudent and diligent men would exercise under similar circumstances,” taking into account “the restrictions of the statute and the usages of business.” The Briggs standard of care is the “wellspring from which more specifi c duties flow.”  

Courts have been divided over whether bank directors who are sued for disinterested business decisions are liable for gross negligence or also for simple negligence. Certain jurisdictions, including Illinois, have declined to assess bank directors with common-law liability for anything short of gross negligence and have held that the business judgment rule bars suits for simple negligence. In negligence suits by the FDIC under 12 U.S.C. § 1821(k), a gross negligence standard will apply unless applicable state law imposes liability for a lesser standard. It remains unclear to what extent a gross negligence standard would actually exonerate a bank director who was otherwise guilty of simple negligence.

In Atherton v. FDIC,10 the Supreme Court unanimously held that the gross negligence standard in Section 1821(k) sets a fl oor in liability suits brought by the FDIC against fi nancial institution offi cers and directors, unless the law of the state has a more stringent standard. In other words, at a minimum, bank directors must be found grossly negligent before they are found culpable, unless the state standard is less stringent, e.g., simple negligence. As a result, Section 1821(k) has two effects. First, in FDIC damages suits against offi cers and directors of failed fi nancial institutions, Section 1821(k) preempts more lenient state standards of conduct (in terms of exonerating directors), such as recklessness or intentional conduct. Second, where the applicable state law standard is stricter than gross negligence, the state law standard controls pursuant to the savings clause of Section 1821(k). As a result, offi cers and directors defending FDIC suits for damages can be sued for simple negligence, notwithstanding the gross negligence test in Section 1821(k), if the relevant state law so permits.