Recently, in response to a post I did about the FDIC allegedly preparing to sue directors and senior executives of failed banks in Georgia, a regular reader e-mailed me to ask whether the threat was a credible threat in light of the "regulatory exclusion" found in director and officer errors and omissions policies. There's some question as to the prevalence of such exclusions in policies today. According to a blurb on the current web site of the American Bankers Association, between 50% and 75% of policies contain such an exclusion. On the other hand, a recent issue of Bank Director magazine asserted that the regulatory exclusion "faded away" after the end of the S&L bailouts and that as of the first quarter of 2009, it had not been "brought back" by insurers. In a recent telephone conversation with a bank director defense attorney in another state, he stated that he'd seen the regulatory exclusion in a policy written in the last few years for more than one of his clients, all from the same Kansas-based insurance company. I'll assume for that it might very well be included in some D&O policies today.
As well-known blogger Kevin LaCroix explained in a post from last July following the meltdown of IndyMac, the regulatory exclusion came into prominence during the last mass failure of thrifts and commercial banks in certain areas of the country during the late 1980s and early 1990s.
The regulatory exclusion typically precludes coverage for claims brought by any governmental, quasi-governmental, or self-regulatory agency. In the competitive underwriting environment that has prevailed in recent years, the regulatory exclusions has become an infrequent part of financial institutions’ D&O insurance policies, a development that has seemed unremarkable as the prior failed bank era has receded into the past. However, with the dramatic news of IndyMac’s regulatory seizure, and the consequent concern that further financial institutions failures may lie ahead...the issues surrounding the regulatory exclusion could once again become relevant.
Kevin linked to an excellent memorandum prepared by Latham & Watkins that discusses the regulatory exclusion. For those who are interested, I recommend it for a little history on the exclusion.
To show how far things have fallen in less than a year, Kevin made some qualifications last summer that he would have not made had he written his blog post today.
It remains to be seen whether or not there will in fact be further financial institution failures, and if there are, whether the regulators will pursue claims against the failed institutions’ former management. Even if the government does pursue these kinds of claims, it is relatively unlikely that many of the institutions current policies contain a regulatory exclusion that would preclude coverage for these claims.
We all know that banks have been dropping like flies since Kevin wrote that post. Moreover, as discussed above, I'm not certain that it is "realtively unlikely" that many current policies contain such an exclusion. If I were a board member, I'd want to make certain.
My correspondent is right to bring up the issue. If the D&O policy will not cover the directors of the failed bank in connection with a law suit brought by the FDIC as receiver for a failed bank, then the FDIC will factor that into its judgment of whether or not a successful lawsuit might result in a pyrrhic victory. In cases where there is a D&O policy but it contains a regulatory exclusion, I think that much will depend on the strength of the evidence that supports the FDIC's claims under applicable law and that might support any defenses to those claims. In other words, what are the chances the FDIC can win if the directors, their backs to the wall, decide they have nothing to lose by slugging it out? In such cases, I think that also important will be whether the defendants have unencumbered assets that the FDIC can seize and liquidate to satisfy any judgment it might obtain or extract through settlement. In addition, there may be cases where the conduct of officers and/or directors was so objectionable that the FDIC decides to pursue claims in order to send a message, however rare such cases might be. Therefore, the existence of a regulatory exclusion in a D&O policy will certainly be a critical factor, but not the only factor, that influences a decision by the FDIC to sue or not to sue the directors and management of a failed bank.