Why it matters

Bank officers may be liable in a lawsuit brought by the Federal Deposit Insurance Corp. (FDIC) while the directors escaped liability, in a new ruling from the Fourth Circuit Court of Appeals interpreting the North Carolina business judgment rule. The FDIC filed suit against former directors and officers of the Cooperative Bank of Wilmington, N.C., after it failed in 2009, asserting negligence, gross negligence and breach of fiduciary duty. Relying on the business judgment rule, a federal court judge granted summary judgment in favor of all of the defendants. On appeal, a three-judge panel of the Fourth Circuit reversed with respect to the negligence and breach of fiduciary duty claims against the officers. The district court improperly applied the business judgment rule to the officer defendants, the court said, because the FDIC presented adequate evidence to rebut the presumption that their decisions were made in good faith and in the bank's best interests. The panel relied heavily on an expert witness affidavit provided by the FDIC that stated the officers did not act in accordance with generally accepted banking practices and that the bank's CAMELS ratings indicated the lending process needed substantial improvement.

Detailed discussion

Cooperative Bank first opened in Wilmington, N.C., in 1898 as a community bank and operated as a thrift until 1992 when it converted to a state-chartered savings bank regulated by the FDIC. In 2002, the bank became a state commercial banking institution with a growth strategy focused on commercial real estate lending.

In the summer of 2006, the FDIC conducted an annual exam of Cooperative. The bank received a 2 for each of its CAMELS ratings, but the report identified deficiencies in credit administration and underwriting that the FDIC attributed to oversight weakness. The North Carolina Commission of Banks (NCCB) performed a review in 2007 and again awarded the bank CAMELS ratings of 2 for each category. The regulator noted, however, that the bank had been slow to correct the weaknesses identified in earlier exams.

An external loan review in 2008 gave failing grades to many loans, and a joint exam conducted by the FDIC and NCCB the same year awarded the bank a rating of 5 in all CAMELS categories except one, which received a 4. The report was extremely critical, noting that the bank's management had ignored or inadequately addressed previously raised concerns about credit administration, underwriting practices and liquidity, problems traced to the decision to pursue commercial real estate to increase assets.

The NCCB closed the bank in June 2009, and the FDIC was appointed as receiver. The agency then filed suit against the officers and directors of Cooperative, alleging that they were negligent, were grossly negligent and breached their fiduciary duties in approving 78 residential lot loans and eight commercial loans over a 15-month period.

In their motion for summary judgment, the officers and directors relied on the business judgment rule to argue that they were shielded from claims of negligence and breach of fiduciary duty. The directors also alleged that exculpatory clauses in the bank's articles of incorporation shielded the directors (not the officers) from liability. As for the gross negligence allegations, the defendants said the FDIC failed to state sufficient facts to support the claims.

A federal district court agreed, granting summary judgment in favor of the officers and directors on all claims.

The FDIC appealed. The Fourth Circuit Court of Appeals affirmed the ruling as it applied to the directors but reversed in part when considering the application of the business judgment rule to the officers on the claims of negligence and breach of fiduciary duty.

North Carolina law permits an officer or director to be held liable for ordinary negligence but also allows corporations to protect directors from liability by including exculpatory clauses in their articles of incorporation. Cooperative included such a clause, which shielded the directors from the FDIC's negligence and breach of duty claims, the court said.

The FDIC made "no allegation or evidence in the record that the directors engaged in self-dealing or fraud or otherwise acted in bad faith," the court wrote. "Rather, the FDIC-R argues only that the evidence suggests that the Director Appellees took actions harmful to the Bank, in part by making decisions without adequate information. This is insufficient. The exculpatory clause protects directors from monetary liability unless the directors 'knew or believed [that their acts or omissions] were clearly in conflict' with the Bank's best interests."

However, Cooperative's exculpatory clause did not cover the bank's officers, leaving the federal appellate panel to analyze their liability through the lens of North Carolina's business judgment rule.

The rule begins with an initial evidentiary presumption that the officers acted with due care and in good faith, in the honest belief that their action was in the best interest of the corporation. That presumption can be rebutted with evidence showing that the officers "did not avail themselves of all material and reasonably available information (i.e., they did not act on an informed basis); acted in bad faith, with a conflict of interest, or disloyalty; or did not honestly believe that they were acting in the best interest of Cooperative," the court explained.

"The FDIC-R has presented adequate rebuttal evidence," the panel concluded. "Specifically, its evidence is sufficient to rebut the presumption that the Officer Appellees acted on an informed basis." An expert affidavit and reports from an independent banking consultant stated that, in his opinion, the officers did not act in accordance with generally accepted banking practices.

For example, the officers often approved loans over the telephone, without first examining relevant documents; sometimes they did not receive the loan documents until after the loans had been funded, and the review process was inconsistent with practices at other banking institutions, the expert testified. The defendants also failed to address warnings and deficiencies in the bank's examination reports, he said.

"To be sure, the Bank's regulators awarded it '2' ratings on its CAMELS," the court acknowledged. "But, as [the FDIC's expert] observed, the Bank's reports of examination also contained several indications that Cooperative's credit administration and audit processes, among others, needed substantial improvement. He also thought it clear from his review that certain loans should never have been approved."

The three-judge panel affirmed summary judgment in favor of the defendants on the gross negligence claims, rejecting the FDIC's argument that North Carolina law does not require a showing of intentional wanton or reckless conduct to sustain such a claim.

"Here, the FDIC-R has failed to present evidence that the Appellees' actions were grossly negligent," the court said. "To be sure, the Appellees failed to address deficiencies outlined in examination reports issued by the FDIC and the NCCB. But those same reports repeatedly awarded Cooperative ratings of '2' in the CAMELS categories. In the face of this contradiction, we find that there is insufficient evidence that the Appellees acted wantonly or with reckless indifference."

The court also addressed the defendants' contention that alternative grounds existed to enter summary judgment in their favor, and particularly that the Great Recession, and not the actions of the officers and directors, caused the loan defaults pled by the FDIC.

"Certainly, it is convenient to blame the Great Recession for the failure of Cooperative, and in turn for the losses sustained by the FDIC-R when it took over the Bank," the panel wrote. "However, there is evidence in the record … that suggests that 'in the exercise of reasonable care,' the Bank officers could have 'foreseen that some injury would result from [their] act[s] or omission[s], or that consequences of a generally injurious nature might have been expected.' Even before the Recession, exam reports from both of Cooperative's regulators indicated that the Bank was utilizing unsafe practices. And while the Recession undoubtedly contributed to the failure of the Bank, it may have been only one of many contributing factors. This is a genuine issue of material fact, and thus this is a question for a jury."

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