Bank Lawyer's Blog

M&A Litigation's Logical Consequences

Last week, we discussed a recent study that had shown that nearly every merger or acquisition transaction involving a publicly traded company last year had resulted in a lawsuit by class action attorneys aggrieved shareholders. Yesterday, the American Banker (paid subscription required) ran a story about one of the consequences of this litigation-by-the-numbers: increased underwriting scrutiny from D&O insurance carriers.

"With a pickup in M&A activity, it is the one thing that we are asking about in every meeting," Heather Hill, a regional underwriting officer in Zurich North America's Chicago office, said during a panel discussion in Greensboro, N.C., hosted by the North Carolina Bankers Association last week.

"We'd want to know about the types of banks they want to buy, the condition of those banks and the loan portfolios" that would be acquired, Hill said in an interview following the discussion. "A one-off situation is different from [acquisitions becoming] a strategic way for a client. Transparency is the overarching theme."

For instance, banks owned by private-equity firms can expect "significantly higher requirements" for liability coverage, Eric Marshall, the managing director for financial institutions at Travelers, said during the panel discussion.

Other consequences include higher deductibles and higher premiums.

This increased scrutiny and expense comes on top of increases caused by FDIC claims against former shareholders and directors of failed banks.

Bankers have endured several years of increased premiums to insure directors and officers because of the financial crisis and a high rate of bank failures in 2009 and 2010. A heightened risk of litigation from the Federal Deposit Insurance Corp., which has a three-year window to pursue claims against managers of failed institutions, has continued to drive rates higher, panelists said.

I suppose this is looked at as simply another cost of doing business by those banks that are aggressive acquirers. For more conservative potential acquirers, it’s another potential downside to doing a deal.

The Not-So-Secret Facts of Life

The LA Times obtained a bunch of documents from the FDIC pursuant to a FOIA request and uncovered some startling news: the FDIC is settling lawsuits against those it alleges caused banks to fail. Worse than that, the FDIC is agreeing not to issue press releases regarding many of the settlements. This earth-shattering news is labeled a "major policy shift" from the way the FDIC handled failed bank litigation that arose out of the last big bank meltdown, "when the FDIC trumpeted punitive actions against banks as a deterrent to others."

Before I address that last point, let's listen to some more suspicious minds support the Times theme that all of this "secret settlement" skulduggery smacks of some kind of plot to let evil-doers escape the lynch mobs that surely would have strung them up if only the FDIC had set public outrage en fuego by  trumpeting these settlements from the top of the Rocky Mountains.

Critics fault the government for going easy on banks in the aftermath of the financial crisis. At a Feb. 14 hearing, Sen. Elizabeth Warren (D-Mass.), founder of the Consumer Financial Protection Bureau, criticized FDIC Chairman Martin J. Gruenberg along with other bank regulators for their reluctance to make examples of Wall Street firms by taking them to trial.

Quoting "The Founder" is a go-to proposition for the Times, and one that lacks the punch that soundbites from other less usual suspects bring to the table. In addition, the Times' accusations range far beyond Wall Street banks. It's mostly (if not entirely) the little guys that are being pursued. God forbid they should get a break today from anyone other than MacDonalds.

Attorneys who have represented bank officials and the FDIC said regulators are now far likelier to settle cases before filing lawsuits than after the last spate of failures, when more than 2,300 institutions collapsed in the 1980s and early 1990s, bankrupting a fund that insured savings and loan deposits. That crisis grew out of Reagan-era deregulation, which allowed thrifts already hurting from 1970s inflation to make riskier investments, including commercial real estate deals that soured en masse during the second half of the 1980s.

Critics describe the FDIC's current practice of low-profile deal-making as a major departure from the S&L crisis.

"In the old days, the regulators made it a point to embarrass everyone, to call attention to their role in bank failures," said former bank examiner Richard Newsom, who specialized in insider-abuse cases for the FDIC in the aftermath of the S&L debacle. The goal was simple: "to make other bankers scared."

Newsom said he couldn't understand the shift, unless the agency doesn't "want people to know how little they are settling for."

The FDIC should disclose as much as it can, said Lauren Saunders, managing attorney at the National Consumer Law Center in Washington. "Transparency is always better, and serves as a deterrent to future misconduct."

Yes, let's deter the future conduct of owning, managing, and directing a community bank that concentrates on loan products that the regulators find are being originated and managed within the parameters of safety and soundness guidelines until, within a few months, the world falls apart in the greatest economic collapse since the Great Depression. Thereafter, although we feel compelled to go after many failed bank officials, directors, and third parties because we've got an obligation to recover whatever losses to the fund we are able whenever we can do so without being laughed out of court, we understand, in our heart-of-hearts, notwithstanding the posturing we might do for political or litigation purposes, that these times are different than late 1980s.

This is what neither the Times nor its talking heads understand (or, if they do understand, will admit): the facts are different this time. In the 1980s, there were a number of outright crooks involved in the banking and, especially, the thrift business in certain parts of the country, some wearing stetsons and cowboy boots, others clad in three-piece Armani suits. There were fraudulent appraisals, my-dead-cow-for-your-dead-horse swaps, 100 percent loan-to-value ADC loans on raw dirt, rapid multiple flips that would have taxed Shawn Johnson, and similar shenanigans. The damages were also limited to certain regions of the country where real estate bubbles were exploited (or partially created) by financial institutions who engaged in outright speculation until those bubbles burst. Also, many of the worst players were (relatively) smaller players.

In the latest debacle, the causes of losses are more complicated and the resulting economic consequences much more devastating and widespread. Many of the hundreds of banks that failed collapsed because they were steamrolled by the swiftness of the onset, and the depth, of the economic collapse triggered, in large part, by subprime residential mortgage loans, the complex web of securities they spawned, and the resulting residential real estate inflation. Commercial real estate wasn't the primary cause of the collapse this time, it was a casualty of the collapse. You can argue until you're blue in the face about the nuances of fiduciary duties and CRE concentrations, but in all but the low hanging fruit cases, the FDIC doesn't have smoking guns laying in plain sight to use to extract huge settlements or litigation awards out of either defendants or, more importantly, their insurance companies, who are fighting back.

As to the lack of a "deterrent" to future potential wrongdoers that allegedly results from not making settlements public, I wouldn't be concerned that "silent settlements" are encouraging prospective bank officers and directors to do anything. Those who haven't said "screw it" and opted to sip mai-tais in Cabo until they need their livers "Rolfed," or are seriously considering an alternative exit strategy, aren't chomping at the bit to jump feet-first back into subprime anything or to make CRE or any other product or service their concentration-of-choice, and their primary regulatory supervisors wouldn't let them go there even if they yearned to do so. "Other bankers" are plenty scared Mr. Newsome, without the need to read about FDIC settlements. At least, that's the story with the vast number of smaller banks in this country.

I suppose there might be some deterrent effect if the FDIC announced settlements against the officers and directors of the large Wall Street banks that helped create the mess we're in and which then failed, so that future Wall Street bankers would...oops...none of them failed. That's right: they were bailed out. My bad!

Buried in the story is the rationale for keeping mum (until FOIA forces disclosure) about settlements.

Defendants benefit by settling because they can avoid admitting guilt and limit the damages they might face in court. The FDIC benefits by collecting money without the hassle and expense of litigation. The no-press-release arrangements help close those deals.

Those are valid reasons, and they make sense for both parties.

Let's hope the Times drills a little deeper next time and strikes oil instead of gas.

Georgia On My Mind

From the "that was quick" department comes the news (via Kevin LaCroix's D&O Diary) that a mere week after a jury rendered a verdict against a group of former IndyMac officers and in favor of the FDIC on a D&O lawsuit, the former CEO of IndyMac, Michael Perry, settled his FDIC lawsuit for $1 million and an assignment of his claims against IndyMac's D&O insurance carrier. As Kevin astutely observes, "the FDIC’s settlement with Perry also appears in large measure to be about the D&O insurance."

In other words, it appears that the $11 million insurance portion of Perry’s settlement with the FDIC basically represents a claim check for the agency to try to redeem in the interpleader action. Because there are numerous other claimants each attempting to assert their own claims to the insurance proceeds, it will remain to be seen how much of the $11 million insurance portion of its settlement with Perry the FDIC will ultimately collect.

Kevin also noticed another interesting aspect of the settlement agreement.

[T]he FDIC expressly acknowledges that the FDIC’s complaint “does not allege that Mr. Perry caused the Bank to fail or that he caused a loss to the FDIC insurance fund.” Nevertheless, on December 14, 2012, the FDIC entered – apparently with Perry’s consent – an Order of Prohibition from Further Participation (here) reciting that Perry “engaged or participated in unsafe or unsound banking practices” at IndyMac; that these practices "demonstrate [his] unfitness" to serve as a director or officer at any FDIC-insured institution; and prohibiting him from involvement in any financial institution. The Am Law Litigation Daily article quotes Perry’s counsel as saying with respect to this order, to which Perry consented, that “the FDIC extracted this condition at the eleventh hour because they could,” and that “the FDIC knew Perry was out of insurance funds, and they took advantage of the situation."

"Were not alleging that he caused a loss to the insurance fund, but we're alleging that he engaged in unsafe and unsound practices and must be banned from the business until hell freezes over."

Only lawyers could think of getting away with serving up such contradictory baloney with a straight face. Then again, when a large segment of your profession is basically shameless, its not such a stretch.

Kevin's blog post also discusses a recent FDIC lawsuit against former officers and directors of a failed Georgia bank as evidence that the FDIC has it in for the land of peaches. One third of all FDIC lawsuits arising out of the current crop of bank failures have been filed against officers and directors of Georgia banks (even though Georgia bank failures represent 18% of all failures), and the last four lawsuits filed by the FDIC all involve failed Georgia banks. That's good news for Georgia defense lawyers (and FDIC lawyers, for that matter), but a lousy omen for Georgia bankers. When I made the statement in one of my recent speeches that being a bank officer or director was the equivalent to being a featured actor in "The Hurt Locker," I didn't have Georgia on my mind, but I should have.

An in-house counsel for one of my good clients recently said candidly over lunch, "Why would anyone want to be a community bank director, given the FDIC's perfect 20/20 hindsight, exercised years after decisions are made?" I couldn't think of an answer for that one. Certainly, in Georgia, I wouldn't sign on to a directorship without combat pay.

Where There's A Policy, There's A Way

A recent settlement by the FDIC of a lawsuit against five former bank officers whose bank failed (and, therefore, the FDIC contended, with the benefit of its customary 20/20 hindsight, MUST have been negligent, grossly negligent, and fatally debauched), led to some speculation by a few of my readers that the FDIC is not really interested in punishing the malign, but merely in squeezing blood out of turnips. While I agree that the FDIC as receiver of failed banks is always primarily interested in recouping its losses, I'm not so sanguine about the absence among the bank regulatory Tourquemadas of the desire to flay sinners. On the other hand, my readers have a point.

As discussed by Kevin LaCroix in his blog post on the case, the former officers sued the bank's D&O insurance carrier for denying coverage of the FDIC's claims, and the carrier defended on the "insured versus insured" exclusion contained in the insurance policy.

The individuals contend that the policy’s base form had a regulatory exclusion, which had it remained in the policy would have precluded coverage for the FDIC’s action against them. The individuals allege further that the bank had purchased an endorsement to the policy that removed the regulatory exclusion from the policy. The individuals essentially contend that the point of the endorsement to remove the regulatory exclusion was to ensure that the policy provided coverage for claims brought by the FDIC, and the carrier therefore should not be able to rely on a different exclusion to try to deny coverage for an FDIC claim.

According to defense counsel’s press release, in their settlement with the FDIC, the five individuals assigned their claim for bad faith and breach of contract to the FDIC, while retaining their right to try recover from the D&O insurer their defense fees incurred prior to the settlement. The parties also exchanged covenants not to bring any further actions against each other, and the settlement also included a covenant by the FDIC not to assert any claims against the five individuals’ property or assets. The FDIC will control and prosecute the assigned claims against the insurer at the agency’s own cost and expense. The officers maintained their right to continue their own retained claims.

Critically, the officers agreed to the entry of a judgment against them in favor of the FDIC, then assigned their claims against the insurance company to the FDIC. Since The FDIC will look solely to the insurance carrier to collect the agreed upon judgment, a cynic might posit that the defendants agreed to a judgment that might have been a wee bit higher than an objective view might have justified. As a slap-happy optimist, I'd never encourage that view, but Kevin LaCroix is not an optimist.

However, the problem with these type of consent judgment/covenant not to execute type deals is that this approach can run the risk of slipping into a collusive arrangement, with the insured individual willingly agreeing to a settlement amount that has no relation to the his or her true liability exposure. Without meaning to suggest anything one way or another about this particular deal, I will say that in my prior life as an insurer-side coverage attorney, I did see deals that were questionable.

You can't blame either side for doing what it believes is in its own best interest. In this case, the insurance company might have avoided any possibility of collusion between the defendants and the FDIC by deviating from the normal business model of an insurance company: collect premiums, deny liability.

Targeting TAG

ICBA CEO Cam Fine pulled off another Howard Beale impersonation today, this time over a Wall Street Journal editorial that opposed the extension of the TAG program, which is set to expire at year end. Cam's fires have been especially stoked by the fact that the WSJ refuses to publish the position of the ICBA and its allies that the transaction account guaranty program helps community banks at a time when they need all the help they can get, while the Too Big To Fail banks and Wall Street firms that the WSJ (allegedly) speaks for have gotten the lion's share of government bailout largess. Cam rightly points out that TAG is a risk primarily to the FDIC, not to the American taxpayers, since the FDIC is funded by assessments paid by FDIC-insured financial institutions. He ignores the fact that, ultimately, the American taxpayer backs the FDIC insurance of accounts, but his essential point is correct.

Here is the meat of his argument:

And while detractors point out the largest banks hold the bulk of TAG deposits, this should come as no surprise—they hold most of all the nation’s deposits. The four largest banks alone hold 40% of the nation’s deposits, a dangerous concentration that continues to grow. This is all the more reason why extending TAG is so important: if the program is allowed to expire, the largest banks will still hold over $1 trillion in TAG deposits, yet only the first $250,000 of each account will be explicitly insured. The rest will enjoy an implicit guarantee, based on the banks’ too-big-to-fail status. If the author is so concerned with government backstops for the private sector, he should be doubly troubled by the thought of the American taxpayer underwriting all those concentrated deposits in the absence of a bank-funded TAG program.

Although they might hold fewer TAG deposits because of their scale, community banks do more with less. In addition to helping small businesses, farmers and municipalities meet payroll and other recurring expenses, community banks use their limited TAG deposits to support relationship-based lending in local communities. This type of banking is fundamentally different from the transaction-based banking practiced by large banks, which use deposits for all kinds of investments that do nothing for local communities. This further illustrates why any flight of deposits from smaller banks due to a TAG expiration would be so devastating to local communities.

He makes valid points. Anyone who reads this blog knows how concerned I am about the increasing concentration of banking assets and deposits in the largest banks, as well as the continued decline in the number of community banks in this country. I also think too little has been done to save community banks from being steamrolled. Moreover, we're still wallowing in a severe slump, so extending TAG for another few years shouldn't pose a threat to the American taxpayer. If the Fed can continue to punish savers by keeping interest rates on savings deposits at ridiculously low levels through 2015 to help out the big banks, surely there's justification for extending TAG until the economy improves.

On the other hand, at some point, TAG will end. Bankers need to think about life after TAG, and advance planning can never start too soon. Community banks may win this round (although, they need to start pressing their elected officials to move quickly if this is to be accomplished by the end of 2012), but I sincerely doubt that they'll get another extension.

Loaning To The Little Guys: A Dastardly Turn Of Events

Five years ago, when The Care Bair womanned the helm at the FDIC and was prodding banks to make payday-like loans to poor consumers, but to cap those loans at a 36 percent APR, most banks who experimented with the products were scratching their heads, trying to figure out how to make money on small loans made at those rates when the borrowers posed such a high default risk. These days, when banks of all sizes are strapped for income-yielding products and are dipping appendages bigger than than their pinky fingers into the icy waters of small loans, left-leaning propaganda rags main stream newspapers like The New York Times are aghast at how "big banks" are "preying" on "the little people."

An increasing number of the nation’s large banks — U.S. Bank, Regions Financial and Wells Fargo among them — are aggressively courting low-income customers like Mr. Wegner with alternative products that can carry high fees. They are rapidly expanding these offerings partly because the products were largely untouched by recent financial regulations, and also to recoup the billions in lost income from recent limits on debit and credit card fees.

Predictably, consumer advocates, including the chart-topping consumer band "Recess Richie and The Jackboots," are threatening to inspect these products with a bias-detecting electron microscope of political correctness to ensure that banks don't actually provide a needed service to lower-income consumers at a price that permits the bank to make a profit.

The Consumer Financial Protection Bureau, a new federal agency, said it was examining whether banks ran afoul of consumer protection laws in the marketing of these products.

[...]

“We look at alternative financial products offered by both banks and nonbanks through the same lens — what is the risk posed to consumers?” said Richard Cordray, director of the bureau. “Practices that make it hard for consumers to anticipate and avoid costly fees would be cause for concern.”

Buried in the middle of the piece is this disconcerting news for Cordray and his fellow-travelers.

Still, in an April survey of prepaid cards, Consumers Union found that some banks’ prepaid cards come with lower fees than nonbank competitors.

Wait a minute! If banks are jumping into these products and offering them at rates that are lower than those offered by non-bank predatory payday lenders, wouldn't it be logical to expect that this might eventually force the non-bank small-loan lenders to lower their prices in order to compete? Given most banks' funding advantage over most of their non-bank competitors, isn't it likely that if the banks are able to find a pricing model that allows them to expand this business while lowering existing rates and fees, this would ultimately benefit low-income consumers? Therefore, shouldn't consumer advocates, including the "We're Just Here To Help You" crowd from the KGB CFPB, think that banks entering this business is a potentially good thing for consumers? Shouldn't they encourage, rather than discourage, this trend?

Personally, I think bankers are thinking about getting into this line of business need to have thick hides, because it's a business in which the more successful you are in offering the right type of products and services to your targeted customer base, the greater your chance of being determined to be a discriminatory thug, fit only for being stretched on the rack, then drawn anhd quartered.

Mr. Wegner, the U.S. Bank customer, said that once he mentioned that he needed a bank account, an employee started selling him prepaid cards, check cashing and short-term loan options. Mr. Wegner, who makes about $1,200 a month, said that he felt like a second-tier customer.

“It was clear that I was not getting the same pitches that wealthy clients would,” he said. Since that initial visit, Mr. Wegner said he avoided the branch so he was not approached with offers. “I go through the drive-through now,” he said.

Next year, Mr. Wegner will be complaining that the bank never offers him any credit options at any price. He'll moan about having become invisible.

Mr. Wegner, wealthy clients have high incomes and substantial assets to pledge as collateral and, therefore, pose much less repayment risk to the bank. Of course they're not going to be offered products and services they won't purchase, just as you won't be offered products and services for which you do not qualify under prudent underwriting standards, the kind mandated by safety and soundness standards that are imposed upon banks by law. This is called "living in the real world."

It's obvious that there's an element of the chattering classes that desires that banks be run as public utilities that parcel out credit as mandated by politicians and bureaucrats at rates and fees deemed "fair" by government committee. Until that system's in place, banks will be damned if they do and damned if they don't.

Directors: It's Long Past Time To Check The Liability Policy

An article in The Las Vegas Review-Journal that discusses the recent settlement by the former CEO and the former EVP (both also directors) of First National Bank of Arizona, which failed in 2008 as a result of a business plan that focused on Alt-A residential mortgage loans, also known as "liar loans," is noteworthy not so much for its content, but for the fact that most of the online commenters to the story don't bash the defendants but, rather, the US government and big banks that were bailed out while little banks like this one were allowed to sink. One commenter who calls herself "BarbVe" must have inside knowledge.

FNB had received the highest asset quality ratio possible from its regulators as late as 2006. The mortgage market crashed in 2007. Virtually every mortgage company went out of business during that time frame (the exceptions are those that received govt support--e.g., BofA, Wells Fargo, etc...). While bankers should take some responsibility for the crash, it should be shared with regulators, policy makers (e.g., the Fed's low interest rates, numerous incentives to promote home ownership), and yes, homeowners themselves. These mortgages went bad because the borrowers stopped paying.

Those of us who represent officers and directors of distressed community banks, as well as the banks themselves, have been struck by how common it was for many of the banks to have been highly rated, with a composite CAMELS rating of 1 or 2, right up until the year the market crashed. Then, suddenly, these geniuses were converted into idiots, and "grossly negligent" idiots at that. The FDIC argues that the bank's examiners expressed concerns and "warned" the bank of the dangers of the bank's lending strategy in reports of examination years in advance of the market crash, but it seems that those "warnings" never resulted in directives to "stop what you're doing" or even affected the high ratings given the bank. I don't know what the facts involved in the ANB case might have been, since all I've read is the FDIC's complaint;however, the bottom line, however, is that whether or not the defendants actually thought they bore responsibility for the bank's failure, the FDIC sued them for $193 million and settled for $20 million from each of them. To make matters more painful, the D&O liability insurance carrier denied coverage, although, since the defendants assigned their claims against the insurer to the FDIC, it's likely the denial will not go unchallenged.

On a related note, McDermott Will & Emery published a newsletter yesterday that contains some timely advice concerning the wave of D&O litigation that's rolling (and will continue to roll) as a result of the hundreds of failures of banks so far and the additional failures that are coming down the pike. As the article points out, "[a]s of August 2011, the FDIC had initiated suits in connection with 11 failed institutions against 77 individuals.  Other suits have been authorized but not yet filed, involving a total of 30 failed institutions against 266 individuals." That's just the tip of the iceberg.

With respect to D&O liability insurance coverage, the firm notes that directors and officers of community banks are well advised to understand what's covered and what's not. Specifically, the "insured vs. insured exclusion" and the "regulatory exclusion" found in many of these policies can cause substantial heartburn. It's better to focus on ways to address these potential landmines while the bank is doing well rather than getting a sinking feeling in the pit of you stomach when realize at the most inopportune moment that you're "uncovered" and the FDIC is breathing down your neck.

The Bailed Out Now Bailing Out

A couple of years ago, Hartford Insurance Company wanted to partake of TARP and in order to do so, needed to become a bank or savings and loan holding company. So, it acquired a relatively small ($2.2 billion) federal savings bank, became a savings and loan holding company regulated by the OTS, and got a healthy helping of preferred stock courtesy of the US Treasury Department. It bailed out of TARP last year, and this year it's bailing out of the savings bank business.

Many experts believe that other insurers are likely to sell off any thrifts they own prior to July when The Office of the Comptroller of Currency (OCC) assumes the duties of the Office of Thrift Supervision and the Federal Reserve will oversee the compliance of insurers with thrifts. Those insurers that continue to operate thrifts past the July transition need to make sure they are in compliance with the Collins Amendment, the Volcker Rule and they may be put on the list of those institutions that are systemically important (SIFIs).

"We expect there will be a lot of interest in restructuring and shedding these thrifts to avoid oversight," said Howard Mills, former superintendent of the New York State Insurance Department and chief advisor with Deloitte LLP's insurance industry group told its TheStreet earlier. "We think the reporting requirements would be costly for these insurers."

I suppose the timing of these sales is yet more proof for OTS critics that the OTS was, indeed, the softest touch among all the federal bank regulators. The demise of the OTS this coming July, and the transfer of supervision of the banks to the OCC and of the holding companies to FRB, is apparently a prospect that those used to the relatively gentle ministrations of the OTS do not relish. In addition, as other experts quoted in the linked article observe, many insurers only got into the banking business because the economy was crumbling and they wanted to receive a bailout capital injection that only a bank could buy. Now that the Treasury's largess is no longer needed, being a bank holding company is simply one more burden to shed.

It's hard to complain that TARP didn't do what it was intended to do, however. The OTS knew why the insurance companies were acquiring thrifts, decided that it was in the interest of the broader economy to allow them to become a S&L holding company and get TARP capital injections to stabilize them, and let them in the house. Now that the crisis has passed (until the next time, at least), there's no good reason not to hold open the door for those that want out and to wish them well, especially since they'll likely be selling to institutions already in the business and unfazed by the prospect of more oversight and reporting.

TheStreet article linked above includes a table with all the insurers that own banks. You'll notice some very large and recognizable names, including companies like State Farm and USAA that have owned banks for years and didn't enter the game simply to take advantage of TARP. Therefore, while a number of those insurers like Hartford may exit the banking business in the next few months, I expect many of the others to continue as bank holding companies regardless of the perceived additional regulatory burdens come this July.

CYA: We're Not Referring To The "Christian Youth Association"

Long-time bank lawyer Jeff Gerrish has a nice column in the most recent edition of the ABA Banking Law Journal whose subtitle is "Three key items for your "CYA" do-list." The "to-do" list is that of bank directors, and the three items should be on every director's list. They are: (1) Make sure that you do your job; (2) review the bank and holding company's Articles of Incorporation and Bylaws; and (3) Make sure you understand your directors and officers insurance coverage. Obviously, Jeff puts some meat on those bare bones, and I encourage community bank directors to give it a serious reading.

Jeff adapted the article from remarks he gave as a panelist for a recent ABA Baking Law Journal webinar. He includes some advice to directors given by other three panelists, a state bank trade association head, the former board chairman (and current board member) of a community bank, and an insurance company executive who focuses on D&O liability insurance. It's not a long article and well worth a read.

More useful advice for directors was given in a recent op-ed piece in the American Banker (paid subscription required) by former FDIC Chairman (and current chairman of Fifth Third Bancorp., Bill Issac. I'll condense some of Bill's discussion to brief bullet points:

• Beware the dominant CEO who essentially "runs the board." Select your own leadership and membership (with input, but not control, of the CEO). Separate the titles of chairman and CEO. As a director, be independent and act as an independent check on management's assumptions and risk analysis. As questions. Demand answers. I would add, based upon my own experience, that independent directors do themselves and their banks a favor by not being doormats and by insisting that questions they ask and the answers the board is given by management be reflected in the board minutes (or appropriate board committee minutes). While litigators may tell boards of directors that the more generic and less specific board minutes are, the better they are, I think that's dangerous for independent directors. When the FDIC starts second-guessing the board's oversight of management-gone-wild, the directors need to be able to demonstrate that they were sitting at board meetings doing something more beneficial than reading the latest issue Playboy.
• Give careful thought to "the structure, composition, and mandate of board committees." From what we've been seeing in the midst of the meltdown's aftermath, I'd say that a number of community banks wish they'd given more attention to the loan committee (or loan review committee) and the audit committee.
• When is comes to board material, try to make them as "high-level and big-picture oriented" as possible. Bill doesn't say this, so I will: don't let management bury the board with scores of pages of data that would baffle Albert Einstein. Make management give you reports in plain English that reflect accurately the bank's "condition and risks, the results of its operations, and its challenges." If critical information is buried in a footnote on page 88, then like Cool Hand Luke, you've likely got a failure to communicate.
• The most critical means to manage risk is to diversify. Now he tells us!
• Compensate directors well, or else you may find "that you get what you pay for." At the same time, the board must focus on management compensation because, there again, you often "get what you pay for." As Bill observes, if you pay based on loan production, don't be surprised when you grow rapidly through loan production "for good or ill."

For many community banks, a number of these suggestions (made with the benefit of much hindsight), while useful, are going to be problematic. For example, a $200 million community bank is going to have a tough time paying the best directors what they are worth (although the bank's business should be less complex and more easily understood and monitored at that size). In addition, as the FDIC lawsuits against former directors of failed community banks continue to be filed, the pool of the most competent eligible directors will likely shrink. As I said recently, in many cases, the risks of serving on a board of a community bank that today looks like it's as well run as the trains in Italy under Mussolini can appear to be much different ten years later, after the sky unexpectedly fell on the bank's head, the composite CAMELS rating went from 1 to 5 in a one-to-two-year span, and you suddenly discover that nasty regulatory exclusion in your D&O policy. Smart people learn from the experiences of others.

Jeff's and Bill's advice is excellent for those directors who are sufficiently confident (a cynic might say sufficiently hubristic) to be willing to serve on the board of directors of a community bank. The trick for a number of banks is whether they can continue to find enough suckers qualified candidates to fill the bill.

Unlucky Number Seven

Kevin LaCroix discussed the most recent lawsuit filed (last week) by the FDIC against former officers and directors of a failed bank, in this case Wheatland Bank of Napierville, Illinois. This was the seventh lawsuit filed thus far by the FDIC against former officers and directors of a failed financial institution. Although Wheatland Bank failed last August and the FDIC customarily takes at least eighteen months to investigate claims against former officers and directors prior to commencing litigation, in this case it appears that a great deal of the FDIC's leg work may have been done for it by the former shareholders of the bank, who filed a lawsuit against the defendants prior to the bank's failure. The FDIC removed the case to federal court and was granted leave to intervene as a party plaintiff and file an amended complaint.

The allegations made by the FDIC in its amended complaint are in many respects typical (as we discussed last month in connection with a similar lawsuit): rapid growth; over-concentration on high-risk commercial real estate loans without adequate underwriting and credit administration practices to manage the risk; loans made in violation of the bank's loan policies; loans made to borrowers who had little prospect of repaying the loans (without, I assume, rapid appreciation in the value of the collateral, which would have to be sold in order to repay the loan). In this case, there are also  allegations of favorable loans having been made to insiders and a lack of enforcement of repayment of those loans. As in other lawsuits filed to date, the FDIC claims that the defendant officers and directors ignored repeated warnings from banking regulators to clean up their act. In addition, the bank fits the FDIC's all-too-typical model of a bank gone wrong: a de novo bank that blew out of the starting gate, rushed headlong into CRE lending, and died rounding the first turn a mere three years after being born.

Unlike many similar lawsuits, however, the FDIC claims that all four outside directors who did not sit on the bank's loan committee (as well as the four directors who did sit on that committee) were negligent and grossly negligent for failing properly to supervise the bank's lending program. That is an ill omen for any outside board member who thinks he or she might have a closet within which to hide from the vengeful glare of the FDIC. When it comes to pursuing directors of failed banks, no director should feel safe.

For those interested in keeping track of this area (and, being involved in the representation of directors and officers of community banks who are facing an uncertain future, I'm one of those), Kevin's keeping a running list of FDIC lawsuits (accessed through this post). His list is a kind of Implode-O-Meter of FDIC litigation.

As Kevin observes, there are more lawsuits to come.

On May 11, 2011, the FDIC updated its professional liability lawsuit page on its website to reflect that the FDIC has authorized suits against 208 individuals for D&O liability with damage claims of at least $3.86 billion. (The latest update increased the number to 208 from last month’s figure of 187.) Since the seven lawsuits the agency has filed includes only 52 individual lawsuits, there clear implication is that there are many more lawsuits yet to come against the remaining 156 defendants.

The FDIC’s website also discloses that the FDIC also has authorized 13 fidelity bond, attorney malpractice, and appraiser malpractice lawsuits. In addition, 135 residential malpractice and mortgage fraud lawsuits are pending, consisting of lawsuits filed and inherited.

The number of directors and officers against whom the FDIC has authorized litigation has increased every month since the FDIC first began publishing the data in September 2010. The aggregate figure has increased much more quickly than the total number of individuals against whom lawsuits have actually been filed. The clear implication is that the FDIC is being very deliberate in preparing its claims. The suggestion is that the lawsuits will continue to come in slowly – and that the process of filing the lawsuits may go on for quite a while yet.

I've recently heard of some boards of directors whose members have stood on the tracks like a herd of cud-chewing bovines, staring dully into the distance while the onrushing train of failure speeds relentlessly towards them. As a general proposition, the officers and directors of a distressed community bank, and especially the outside directors, need to seek advice of competent counsel (and someone other than the bank's existing counsel) sooner rather than later, for a whole host of reasons, not the least of which is that following the failure of the bank, getting access to the necessary records of the bank will be much more difficult, inasmuch as the party in possession of those records will be the FDIC. In addition, assuming that applicable state law, and, under certain circumstances, FDIC regulations, permit it, the directors (particularly the outside directors) may be able to make an indemnification claim against the bank to cover the costs of independent counsel and related expenses. Moreover, someone with expertise ought to check the D&O policy and fidelity bond to see if the directors (or the bank, in the case of the fidelity bond) have coverage and, if so, if claims or other notices to carriers should be made prior to failure. The foregoing is only scratching the surface of the many reasons why directors should not be overcome with inertia when it comes to understanding where they are exposed with respect to their fiduciary duties and how best to don a little asbestos clothing to protect themselves from the coming flamethrower of the FDIC.

As a wise mentor once advised this lawyer many, many moons ago, during a similar period of upheaval in the banking business, "It's never too early to panic."