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Finding the Unicorn in Lender Liability Litigation

Investors frequently talk in terms of trying to find the next unicorn, that small start-up company that is going to turn into a billion dollar valuation.  Lawyers are like that as well, always looking for that new decision where a court opens a crack in the door of some long held legal theory. Something like this occurred in the 1980’s when the courts in California held that a party could bring a tort action for the breach of the obligation of good faith. The courts were expanding a doctrine that then existed only in the area of insurance contracts. The expansion of this theory to noninsurance contracts generated universal criticism by other courts and scholars across the US and after a ten year experiment the California Supreme Court reversed its earlier decision for the following reasons: (1) the different objectives underlying the remedies for tort or contract breach, (2) the importance of predictability in assuring commercial stability in contractual dealings, (3) the potential for converting every contract breach into a tort, with accompanying punitive damage recovery, and (4) the preference for legislative action in affording appropriate remedies. [See: Blanchard, Lender Liability: Law, Practice and Prevention, Chapter 4, Bad Faith Tort Claims]

When a party enters into a loan agreement or a promissory note, one understands what the consequences of a breach might be. If a lender is found to have improperly failed to fund under a line of credit it knows that it may have to pay compensatory damages to the borrower. Likewise, guarantors understand that if the borrower fails to pay the underlying obligation the guarantor must step in and pay the obligation.  Our commercial banking industry is built on this understanding that parties will need to put the nonbreaching party into as good of condition as they would have been if there had been no breach. Damages for breach are therefore predictable.

The unicorn for borrowers counsel today is to tag a lender with punitive damages. This has traditionally been a difficult endeavor. Courts almost uniformly dismiss breach of fiduciary duty claims because absent some unusual set of facts, the normal lender/borrower relationship is not a fiduciary one. Lenders owe no special duty to borrowers or guarantors to advise them on whether a particular business transaction for which the borrower is obtaining funds is a “good” one or not. Fraud claims are a bit easier for a borrower to keep from being dismissed but such claims are subject to heightened pleading standards and require specificity in making the claim, a general claim of “fraud” without more will be dismissed.

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The Transition Away from LIBOR

LIBOR, or the London Interbank Offered Rate, is a benchmark utilized in a variety of financial transactions (including the setting of interest rates in credit agreements). It was intended to be an average of the rates at which banks can obtain unsecured funding in the London interbank market for a specified time period in a specified currency. The rate is based on submissions by banks to the LIBOR administrator (currently ICE Benchmark Administration Limited) of their good faith estimate of borrowing costs and not necessarily actual transactions. Since estimates can at times be imprecise, together with the fact that (particularly after the financial crisis) unsecured credit was not generally available to banks in the London interbank market for periods of time, LIBOR as a benchmark was ripe for reconsideration.

On July 27th, Mr. Andrew Bailey, Chief Executive of the U.K. Financial Conduct Authority (FCA) announced that the FCA will no longer require banks to submit quotes for LIBOR rates in sterling by the end of 2021, indicating that the benchmark that underpins trillions of dollars in financial contracts will be phased out by 2021 and replaced with a benchmark that is more closely tied to interest rates for actual transactions in the lending markets. This announcement has prompted plenty of concerns and more than a few troubling headlines, especially given the extremely common use of LIBOR as an interest rate benchmark in commercial credit agreements, adjustable rate mortgages and other financing arrangements.

Notwithstanding some of the more recent reactions, the financial markets have seemingly taken this development in stride without much turmoil. There are a few reasons for this. First off, there are almost 4 ½ years before this reporting requirement ends, and work has already begun to determine LIBOR’s replacement.1 Second, LIBOR may still be available even if banks are no longer required to report their quotes, although caution has been expressed not to rely on this. Last, in the commercial loan context, customary fallbacks have been built into the “LIBOR” definitions in most well-drafted credit agreements that could provide short term solutions in the event of the unavailability of the LIBOR screen rate.

While the market does seem to be generally in agreement that it is premature to attempt to craft a definitive solution to this issue now, since there is insufficient information as to what will “replace” LIBOR (and how that replacement might affect the all-in rate in any particular credit facility), market participants can take proactive steps now to prepare for the eventual transition away from LIBOR to a new benchmark rate.

First, we would recommend a review of any applicable fallback provisions mentioned above to analyze whether these provisions should be amended now (or in the next couple of years) to attempt to facilitate a smoother transition to an eventual discontinuation of LIBOR (as opposed to temporary unavailability). As highlighted by the August 3rd LSTA article, “LIBOR (Transition) in the Loan Market”, these fallbacks were designed for temporary disruptions rather than a full transition away from the use of LIBOR as a benchmark. Moreover, some fallback language is better than others. For example, some language focuses on the unavailability of the publication of LIBOR, rather than the actual underlying rate itself. If the underlying benchmark rate goes away, as opposed to just the referenced information source, the ability of an agent or designated bank to specify an alternative information source as a screen rate will be of no use. Other fallback language is much more broad, in the sense that it permits a lender or agent to determine LIBOR “in good faith” based on a variety of factors that can include, among others, an offered quotation rate to first class banks for deposits in the London interbank market by the agent or a designated bank as well as a rate determined on the basis of quotes from designated “reference banks”. This creates more flexibility in this context, but it could be argued that it gives the lender or agent too much control in an environment where the traditional LIBOR has simply disappeared.

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Counter-Cyclical Thoughts About D&O Insurance

It can be a challenge, when economic times are relatively good, to take time away from thinking about new opportunities to discuss topics like D&O insurance.  Even though I am biased, I’ll admit that, in those times, discussing the risks of potential liability and how to insure those risks can feel both a pretty unpleasant and a pretty remote thing to be discussing.  However, like all risk-related issues, it is precisely in those times when business is going well that a little bit of counter-cyclical thinking and attention can do the most good over the long haul.

As you approach your next D&O policy renewal – and particularly in the 30-60 days prior to the expiration of your current policy, there are a few things that you may want to consider.

Multi-year endorsements – what’s the catch? 

In good times, many insurers will offer packages styled as multi-year policies, usually touted as an option that allows for some premium savings and perhaps a reduced administrative burden.  However, as with all things, these advantages may come with a catch.

Many multi-year endorsements will reserve to the insurer the discretion to assess additional premium on an annual basis within the multi-year period if the risk profile of the bank changes in a material way.  So premium savings may not ultimately be realized, depending on the facts.

Beyond this, some multi-year endorsements will actually impose additional requirements on the insured to provide notice of events that could trigger the carrier’s repricing rights or other conditions.  Those obligations may be triggered when those events occur on an intra-period basis, which can set up a potential foot-fault for an organization that does not keep those requirements front of mind (which can be a practical challenge, as if those events are happening, it is likely that there are a number of issues competing for management and the board’s attention).

Companies looking at multi-year endorsements should make sure they understand fully the terms on which the multi-year option is being provided and should have counsel or an independent broker review the specific language of the proposed multi-year endorsement itself on their behalf.  In addition, while it may be tempting to use a multi-year endorsement to try to extend the renewal horizon and to try to reduce the administrative burden that comes with the renewal process, doing so may also reduce your ability to negotiate appropriate enhancements to your policy terms over the multi-year period.

Multi-year policies may be the right fit for your institution, but they should not be viewed as a one size fits all solution.  Before heading down that road, ask yourself how much is being saved and how real those savings actually are and, perhaps just as importantly, whether avoiding a broader discussion of your coverage strategy on at least an annual basis is a good thing or not.

What about the bank has changed? 

Times of economic expansion often bring with them opportunities to explore new lines of business.  In addition, substantial recent technological innovations in the financial services industries and increasing consumer demands for technological solutions have meant that not only are new market opportunities being explored but that they are being explored in new ways.  And if that isn’t enough, there is always the ever-changing regulatory and compliance landscape to contend with.

All of these trends – as well as your decisions of where and how your institution will choose to participate (or not to participate) in them – bring with them new and different risks.  To the extent that your bank has expanded its offerings, changed its footprint or portfolio mix, or otherwise changed its policies or ways of doing business, you should think about how those changes may impact your insurance needs.  It can be easy, particularly when you have a long relationship with an incumbent carrier, for the renewal process to become somewhat rote.

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HVCRE Lending: An Area of Regulatory Examination Focus

HVCRE Lending: An Area of Regulatory Examination Focus

August 24, 2017

Authored by: Bank Bryan Cave

the-bank-account

Jonathan and I are joined by our colleague, Jerry Blanchard, to discuss High Volatility Commercial Real Estate (HVCRE) Loans on the latest episode of The Bank Account.

HVCRE Loans are one of the areas of focus on regulatory exams, and we’re seeing increased attention to not only ensuring that a bank’s reported HVCRE loans are correct, but also that the bank has sufficient internal controls in place to monitor and track HVCRE lending.

Formal regulatory guidance on HVCRE lending is still rare, as the various regulatory agencies struggle to find consensus in an area that is fraught with technicalities and details.  Our colleague, Jerry Blanchard, has assisted numerous banks in evaluating overall HVCRE programs as well the application of the HVCRE requirements to countless loans.  In addition, he’s written extensively on the topic, including:

You can always follow us on Twitter.  Jonathan is @HightowerBanks, I’m @RobertKlingler, and Jerry is @Blanchard_Jerry.  Our producer, Sam Katz, is @SamathaJill1, and is not responsible for my inability to read simple copy at the end of this episode.

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Two Recent Card Payment Developments

Our Bryan Cave-affiliated sister site, the BC Retail Law Blog, recently published two posts that may be of interest to our banking, fintech and payments clients.

In “Bans on Credit Card Surcharges Face First Amendment Challenges,” the Retail Law Blog looks at how state laws that prohibit retailers from charging customers a surcharge for using a credit card are being challenged on First Amendment grounds.

For more than four decades, California’s Song-Beverly Credit Card Act of 1971 prohibited retailers from charging credit card customers such a surcharge. In Italian Colors Restaurant, et al. v. Harris, 99 F.Supp.3d 1199 (E.D. Cal. 2015), a federal judge ruled that the law unconstitutionally limits retailers’ freedom of speech. The California attorney general appealed, and the case is set for oral argument before the Ninth Circuit Court of Appeals on August 17.

One consequence of these actions may be to make credit cards more expensive to the consumer, which, in turn, could encourage further development of alternative forms of payment.

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The Same Old Wrongdoer Blues: Creative Fraud Leaves Employer Holding the Bag for Fraud on its Account

Articles 3 and 4 of the UCC provide a roadmap for addressing how to allocate liability for the various mistakes, embezzlements and forgeries that have followed the payments system since its invention several centuries ago.  While as a general rule a customer is not liable for forgeries and other fraud on its account there are several exceptions where the risk of loss can be shifted back to the customer. One of those situations is what practitioners refer to as the “same wrongdoer rule” found in section 4-406(d)(2). The rule says that when the bank sends a customer their statement, the customer has a certain time period, usually 30 days, to review the statement and notify the bank of any unauthorized signatures or alterations. Should the customer fail to flag such transactions then the UCC shifts the risk of loss for all subsequent forgeries by the same wrongdoer to the customer. This result is modified somewhat by the following subsection, 4-406(e) which provides that if there are subsequent forgeries by the same wrongdoer and the customer establishes that the bank failed to exercise ordinary care then the loss is allocated between the customer and the bank unless the customer can show that the bank did not pay the item in good faith in which case all risk is shifted to the bank.

Section 4-406 also provides that without regard to lack of care by either party, a customer who fails to discover and report unauthorized items or any alteration within 60 days after the statement is made available to the customer is precluded from asserting a claim against the bank.

These issues were recently applied in the recent case of Ducote v. Whitney National Bank.   On July 25, 2014, David Ducote, Avery Interests, LLC, Jebaco, Inc., and Iberville Designs filed suit against Whitney and Ducote’s former employee, Michelle Freytag (“Freytag”), alleging that Freytag, in her position as Ducote’s executive assistant, had obtained fraudulent credit cards from Whitney on plaintiffs’ accounts, made personal charges on the cards, and transferred funds from plaintiffs’ accounts to pay the balance on these credit cards. The petition alleged that plaintiffs were not responsible for the charges because the contract on the credit card agreements was null, or alternatively that the credit card agreements should be rescinded because of the fraud committed by Freytag. The petition further alleged that Freytag could not have accomplished this theft without the assistance of Whitney, which failed to follow established procedures and facilitated Freytag’s theft. Whitney responded by denying all liability and argued that the claims were barred by various provisions of the UCC, one of which was Section 4-406.

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New CFPB Rule Prohibits Class Action Waivers

On July 10, 2017, the Consumer Financial Protection Bureau (CFPB) released a rule prohibiting class action waivers in certain pre-dispute arbitration agreements. The rule drastically impacts arbitration clauses currently used by many financial products and services providers in their consumer agreements.

The rule has three main components. First, the rule prohibits providers from using a pre-dispute arbitration agreement to prevent consumers from bringing or participating in class actions in federal and state court. Second, the rule requires that arbitration agreements inform consumers that their right to bring a class action is unrestricted. Third, the rule requires providers to supply certain records and data relating to arbitral proceedings to the CFPB.

The rule is effective 60 days after publication in the Federal Register and generally applies to agreements entered into more than 180 days after the effective date. Congress, however, can use the Congressional Review Act to prevent the rule from taking effect.

What is the effect of the rule?

The new rule prohibits pre-dispute arbitration agreements for certain consumer financial products or services that block consumer class actions in federal and state courts. The rule accomplishes this in two ways:

  1. providers cannot rely on any pre-dispute arbitration agreement entered after the compliance date that restricts or eliminates a consumer’s right to a class action in state or federal court (§ 1040.4(a)(1)); and
  2. providers must include certain specified plain language in arbitration agreements that explicitly disclaims the arbitration agreements applicability to class actions (§ 1040.4(a)(2)).

The rule also requires providers to submit certain records relating to arbitral proceedings to the bureau, including copies of pleadings, the pre-dispute arbitration agreement, and the judgment. (§ 1040(b).)

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The HVCRE Easter Egg for Community Banks

We have written several times about the rules concerning the appropriate risk weighting for High Volatility Commercial Real Estate (“HVCRE”) loans. The interagency FAQ published on April 6, 2015 provided some guidance but many banks continue to have questions about fact situations that are not addressed under the regulation.  Despite indications that an interagency task force was looking at a further set of FAQ nothing has yet come out. Despite that, there are actually grounds for optimism that the rules will yet be simplified.

Section 2222 of the Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA)  requires that, not less than once every 10 years, the Federal Financial Institutions Examination Council (FFIEC) and the Board of Governors of the Federal Reserve System (Board), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) must conduct a review of their regulations to identify outdated or otherwise unnecessary regulatory requirements imposed on insured depository institutions. In conducting this review, the statute requires the FFIEC or the agencies to categorize their regulations by type and, at regular intervals, provide notice and solicit public comment on categories of regulations, requesting commenters to identify areas of regulations that are outdated, unnecessary, or unduly burdensome.

In late spring of this year the FFIEC reported to Congress that one of its goals was to simplify the capital rules for community banks. The very first area of attention listed under that heading was to replace the complex treatment of HVCRE exposures with a more straightforward treatment for most acquisition, development, or construction (“ADC”) loans. While the agencies are not ready to lift the curtain on what the revised rule might look like they did cite certain comments they had received from community banks including (i) that the definition of HVCRE is neither clear nor consistent with established safe and sound lending practices; (ii) the 150 percent risk weight applied to HVCRE lending is simply too high; (iii) the criteria for determining whether an ADC loan may qualify for an exemption from the HVCRE risk weight are confusing and do not track relevant or appropriate risk drivers; and (iv) in particular, commenters expressed concern over the requirements that exempted ADC projects include a 15 percent borrower equity contribution, and that any equity in an exempted project, whether contributed initially or internally generated, remain within the project (i.e., internally generated income may not be paid out in the form of dividends or otherwise) for the life of the project.

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Changes in Georgia’s Law on Director Duties

On July 1, 2017, significant amendments to the director and officer liability provisions of Georgia’s Financial Institution Code and Business Corporation Code will take effect.  These amendments, adopted as House Bill 192 during the 2017 General Assembly session and signed into law by Governor Deal in May, enhance the protections available to directors and officers of Georgia banks when they are sued for violating their duty of care to the bank.  The amendments also apply to directors and officers of Georgia corporations, including bank holding companies.

First and foremost, House Bill 192 creates a statutory presumption, codified at O.C.G.A. § 7-1-490(c) for banks and at O.C.G.A. §§ 14-2-830(c) and 14-2-842(c) for corporations, that a director or officer’s decision-making process was done in good faith and that the director or officer exercised due care.  This presumption may be rebutted, however, by evidence that the process employed was grossly negligent, thus effectively creating a gross negligence standard of liability in civil lawsuits against directors and officers.  This is a response to the Supreme Court’s 2014 decision in FDIC v. Loudermilk, in which the Court recognized the existence of a strong business judgment rule in Georgia but also held that it did not supplant Georgia’s statutory standards of care requiring ordinary diligence.  The Court interpreted the statutes as permitting ordinary negligence claims against directors and officers when they are premised on negligence in the decision-making process.  (As you may recall, Loudermilk also held emphatically that claims challenging only the wisdom of a corporate decision, as opposed to the decision-making process, cannot be brought absent a showing of fraud, bad faith or an abuse of discretion.  This part of the Loudermilk decision is unaffected by the new amendments.)  Many Georgia banks and businesses expressed concern that allowing ordinary negligence suits would open the door to dubious and harassing litigation.  The Court’s opinion noted these concerns but held that they were for the General Assembly to address.

As amended, O.C.G.A. § 7-1-490(c) and its corporate code counterparts will foreclose the possibility of ordinary negligence claims by requiring a plaintiff (which can be a shareholder, the bank or corporation itself, or a receiver or conservator) to show evidence of gross negligence, which the statutes define as a “gross deviation of the standard of care of a director or officer in a like position under similar circumstances.”   It is important to note that the actual standard of care that directors and officers must exercise is essentially unchanged.  As we have written in the past, it is important for a bank board in today’s legal and business environment to develop careful processes for all decisions that are entrusted to the board, and to follow those processes.  A director should attend board meetings with reasonable regularity and should always act on an informed basis, which necessarily entails understanding the bank’s business, financial condition and overall affairs as well as facts relevant to the specific decision at issue.  The new amendments should not be read as relaxing these requirements.  The only thing that has changed is the standard of review that courts will follow when evaluating a process-related duty of care claim.  By requiring plaintiffs to show gross negligence in order to defeat the statutory presumption, the amended statute should discourage the filing of dubious lawsuits, and also provide defendants with a strong basis for moving to dismiss such suits when they are filed.  Many states, including Delaware, recognize a gross negligence floor for personal liability either by statute or under the common law.  The amendments bring Georgia law more closely in line with these states.

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If the Shoe Fits, Wear It – Bank Third Party Vendors as Institution-Affiliated Parties

When negotiating bank third party vendor contracts it is not unusual to ask the vendor to acknowledge in the contract that bank regulators might exercise some sort of supervision over the vendor. Vendors will oftentimes push back on that point, claiming that since they are not a bank the FDIC has no jurisdiction over their affairs. We typically respond that “if the shoe fits, wear it.”

The fit arises because of the definition of “institution-affiliated party” (“IAP”). The definition was added under FIRREA when the regulatory agencies were seeking additional authority to impose sanctions against lawyers, accountants and appraisers whose negligence may have contributed to the failure of a bank. The language added to the statute is broader than just those professionals and covers any shareholder, consultant joint venture party, any other person determined by the appropriate federal banking agency (by regulation or case-by case) who participates in the conduct of the affairs of the bank and any independent contractor who knowingly or recklessly participates in any violation of law or regulation, any breach of fiduciary duty or any unsafe or unsound practice which caused or is likely to cause more than a minimal financial loss to the bank. (12 USC 1813(u))

The practical application of being designated an IAP was recently driven home in an enforcement action the FDIC took against Bank of Lake Mills, Freedom Stores, Inc. and Military Credit Services, Inc. All three parties entered into Consent Orders with the FDIC. The Bank agreed to fund restitution of $3,000,000 and to pay a civil money penalty of $151,000 while Freedom Stores, Inc. agreed to pay a penalty of $54,000 and Military Credit Services agreed to pay a penalty of $37,000.

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