One of the most dramatic tools a lender can use in the collection of a loan is the involuntary bankruptcy case. It is dramatic because of the implications for both the debtor and the lender who files the case. If a bankruptcy court determine that the petitioning creditor has not met the statutory requirements it may require the creditor to pay the debtor’s costs and attorneys fees in defending the petition and if the court finds that the petition was filed in bad faith it can award compensatory and punitive damages. The consequences for the debtor are that if the creditor is successful, the debtor’s business and assets are now subject to disposition under a frameworks found in the Bankruptcy Code which may involve the appointment, at least initially, of a bankruptcy trustee to administer the debtor’s estate. Even if the debtor is successful in fighting off the petition it may suffer dramatic reputational risks that might affect its continued viability. Think of it then as the “nuclear” option.
This tool has now been used at least twice in connection with the enforcement by holders of Trust Preferred Securities (“TruPS”) against bank holding companies (“BHCs”). TruPS are hybrid securities that are included in regulatory tier 1 capital for BHCs and whose dividend payments are tax deductible for the issuer. In 1996 the Federal Reserve Board’s decided that TruPS could be used to meet a portion of BHCs’ tier 1 capital requirements. Following that decision many BHCs found these instruments attractive because of their tax-deductible status and because the increased leverage provided from their issuance can boost return on equity.
Smaller BHC’s typically did not bring TruPS to the market themselves, rather they were issued into a collateralized debt obligation (“CDO”) which in turn purchased TruPS from many different BHCs. According to Fitch since 2000 over 1,800 entities issued roughly $38 billion of TruPS that were purchased by CDO’s. In addition, many federally insured institutions held TruPS themselves once the banking regulators determined that TruPS were an acceptable investment.
Many financial institutions, particularly community banks, have enhanced the experience level of their boards by adding a director who is a banker or serves on the board of another financial institution. In general, utilizing a director who has current experience with another financial institution is a great way to add valuable perspective to a variety of issues that the board may encounter. In addition, as private equity funds made substantial investments in financial institutions, they often bargained for guaranteed board seats. The individuals selected by private equity firms as board representatives often serve on a number of different bank boards. As market conditions have led to increased bank failures, however, a problem has resurfaced that may cause some financial institutions to take a closer look at nominating directors who also serve other financial institutions: cross-guarantee liability to the FDIC.
The concept of cross-guarantee liability was added to the Federal Deposit Insurance Act by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). The pertinent provision states that any insured depository institution shall be liable for any loss incurred by the FDIC in connection with:
- the default (failure) of a “commonly controlled” insured depository institution; or
- open bank assistance provided to a “commonly controlled” institution that is in danger of failure.
This means that if two banks are “commonly controlled” and one of them fails, the other bank can be held liable to the FDIC for the amount of its losses or estimated losses in connection with the failure. As many of us see each Friday, the amounts of these estimated losses are often quite high. In fact, the FDIC’s estimated losses for 2011 bank failures were approximately 20 percent of total failed bank assets for the year. Accordingly, the prospect of cross-guarantee liability can be a tremendous financial issue for the surviving bank.
Following the failure of over 400 financial institutions since the beginning of 2008, the FDIC has clarified its expectations with respect to collection and retention of bank documents by directors and officers of troubled or failing financial institutions for the purpose of explaining or defending their conduct. The FDIC’s Financial Institution Letter (FIL) released today sets forth the FDIC’s position that “[d]irectors and officers of troubled or failing financial institutions who remove originals or copies of financial institution records under such circumstances breach their fiduciary duty to the institution.” Presumably the FDIC would also object to a director or officer of a healthy bank copying and removing bank documents if the FDIC concludes that it is being done for improper purposes, although the FIL does not specifically address that issue.
Even though the guidance comes late in the game, we believe it is helpful for the FDIC to articulate its position on this matter to provide clarity to industry participants. We are disappointed, however, that the FDIC chose to issue this broad guidance through a financial institution letter (which cites no statutory authority or judicial decisions in support of its position) rather than through a formal rulemaking process whereby affected parties could offer comments.
Just as many bankers believed that the worst of the enforcement environment was behind them, a threat of “new” Consent Orders for some state non-member banks has arisen. These “new” orders are not reflective of banks for which the regulators have identified new problems but are instead based upon the FDIC’s apparent decision that orders that were “led” by state regulators are not adequate for the FDIC’s enforcement purposes. To illustrate this point, the new orders we have seen thus far have been substantively consistent with the existing state orders.
This movement by the FDIC comes at an unfortunate time given overall downward trend in the number of FDIC consent orders being issued as banks continue to identify and manage their problems. From a practical standpoint, the publication of a new FDIC order may result in perception that a bank’s condition is worsening when in fact the bank is well on its way to compliance with the existing state order.
Doctors recommend various self exams to catch disease early, so it can be treated before it’s too late. As it turns out, a self examination can be good for the health of a bank as well. My colleagues and I recommend that our banking clients and friends undertake a regular self examination in order to identify potential internal and external challenges that the bank may face. As discussed more thoroughly below, these self examinations can also be very helpful when the bank’s doctor (your friendly regulator) comes in for a check-up.
Enlist internal audit
To initiate the self examination, the audit committee of the bank’s board of directors should charge management with preparing a report that outlines the current and projected status of the bank’s key areas of risk. Ideally, the bank’s internal audit function will take the lead in performing the examination and preparing the related report. In order to maximize the value of this report, the audit committee should direct management to deliver the report at least 60 days prior to the bank’s next scheduled regulatory exam. The self examination report, in its most basic form, should cover the areas that are the focus of the bank’s regulators: CAMELS (capital, asset quality, management, earnings, liquidity and sensitivity to market risk). The report should also address any key areas of risk identified by the directors.
Analyze your market
In addition to analyzing the typical CAMELS components and other areas of risk, a very important part of the self examination process is a market study. The report should present facts, trends and projections related to the market area in order to define the opportunities and challenges being faced by the bank’s customers. While many bank directors have a good feel for market trends, we have found that this data, when presented with specific facts and trends, can inform the board’s discussions of a variety of topics a great deal. It can also provide the bank with support for dealing with its examiners, who conduct their own market analysis prior to each examination.
In recent exam cycles, bankers have generally been no strangers to heightened scrutiny by FDIC examiners on a variety of topics. In the past several months, the insurance policies carried by banks have been added to the list of potential hot-button items.
Specifically, FDIC examiners have begun to scrutinize bank insurance policies to determine whether the policies provide coverage for civil money penalties (“CMPs”) that may be assessed against bank officers or directors. If any bank insurance policies are found on examination to contain an endorsement extending coverage for CMPs to officers or directors, the FDIC is citing such policies as being in violation of Part 359 of the FDIC’s Rules and Regulations.
Part 359, among other things, prohibits banks and affiliated holding companies from making certain “prohibited indemnification payments.” These prohibited payments include any payment or agreement to pay or reimburse bank officers or directors for any CMP or judgment resulting from any administrative or civil action which results in a final order or settlement in which that officer or director is assessed a CMP, removed from office or ordered to cease and desist from certain activities. As a matter of public policy, this provision is designed to prevent banks from bearing the costs of penalties assessed against individuals for actions that could result in harm or potential harm to a bank or to the safety and soundness or integrity of the banking system more generally.
Part 359 explicitly permits reasonable payments by banks to purchase commercial insurance policies, provided that the policy not be used to pay or reimburse an officer or director the cost of any judgment or CMP assessed against him or her. However, Part 359 does permit the insurance paid for by the bank to cover (1) legal or professional expenses incurred in connection with such a proceeding and (2) the amount of any restitution to the bank, its holding company, or its receiver.
Each year it seems that someone or other will comment on the “green shoots” that seemingly presage the end of the banking crisis. More often than not, the green shoots were simply the product of an overactive imagination.
There was recent news from the FDIC though that I think qualifies pretty strongly as green shoots material. On September 14 the FDIC announced that it will be closing down its Midwest Temporary Satellite Office located in Schaumburg, IL toward the end of September 2012. The FDIC had previously indicated that the office would remain open until the end of the second quarter of 2013. The FDIC had announced earlier this year that its West Coast Satellite Office will close January 30, 2012.
The Southeast Temporary Satellite Office located in Jacksonville is theoretically scheduled to stay open until the end of 2013 due to the larger number of bank receiverships located across Georgia and Florida. I believe, however, there is a fair chance that the late 2013 date will, in fact, be moved up closer to early 2013 or even late 2012 based upon a review of the latest CALL Reports. While there are still a fair number of troubled banks moving through the FDIC pipeline toward receivership the numbers of troubled banks are definitely in the decline.
There is a corresponding decline in the number of new problem credits banks are seeing. Whereas a year ago bank special assets departments were bringing in two new credits for each one they resolved, now the ratio is one to one or even less. There is also much more internal pressure at institutions to rehabilitate credits if possible so that they can be moved out of special assets and back to the line.
On August 16, 2011, the Financial Institutions and Consumer Credit subcommittee of the House Committee on Financial Services held a field hearing in Newnan, Georgia, with a stated topic of “Potential Mixed Messages: Is Guidance from Washington Being Implemented by Federal Bank Examiners?”
Representatives Shelley Moore Capito, Spencer Bachus, Lynn A. Westmoreland and David Scott each heard testimony from panels of federal banking regulators and Georgian bankers about the condition of banking in Georgia, including the effect that federal banking regulations, guidance, policies and actions have had on community banks. Copies of the written testimony submitted, including that of the FDIC, OCC and Federal Reserve are now available on the Subcommittees website.
Although it is hard to draw any overall themes from the hearings (other than possibly that the issues involved aren’t easily addressed in this format), there were several good points made.
From the FDIC’s written testimony, addressing the challenges faced by Georgia banks:
As the Subcommittee has discussed in previous oversight hearings, the collapse of the U.S. housing market in 2007 led to a financial crisis and economic recession that has adversely affected banks and their borrowers in Georgia and nationwide. Georgia’s economy was hit especially hard following years of strong economic growth characterized by rising real estate prices, abundant credit availability, and robust job creation. Financial institutions, whose performance is closely linked to economic and real estate market conditions, have been significantly affected by a rise in the number of borrowers who are unable to make payments.
Gil Barker, the Deputy Comptroller for the Southern District, specifically addressed many concerns expressed by bankers in his written testimony, including statements of regulators criticizing loans to a particular industry, performing non-performing loans, criticizing loans merely because of a decline in collateral value, and the second guessing of independent appraisers. While one can certainly question whether the interpretations provided by Mr. Barker line up with some of the actions of the on-site examiners, it is definitely a good read for anyone dealing with the OCC in the Southern District.
The loss share method of resolving closed institutions seems to have significant benefits over the FDIC retaining the assets for bulk sale, but there is significant disagreement as to whether the loss share agreements properly incent the acquiring bank with regard to working with borrowers to minimize losses. The representatives seemed particularly attuned to the additional issues related to loan participations where the lead bank has gone through receivership.
The FHLB system has been a major source of liquidity to its over 8,000 members during the financial crisis and faces many challenges as the system deals with:
- shrinking demand for loan advances;
- losses incurred in mortgage backed securities that have led to a number of the FHLB’s having to enter into Consent Orders with their primary regulator; and
- greater Congressional scrutiny of all government sponsored entities.
Banking regulators deal with the consequences of FHLB policies and actions when financial institutions are taken into receivership. In some instances, the availability of FHLB advances may have led to some banks to incurring more risk than they would have otherwise incurred.
Jerry’s presentation addressed how the banking regulators view the role of the FHLB ‘s and how those views might affect bank examinations in the future. If you would like more information, a copy of Jerry’s FHLB presentation is available online, or reach out to Jerry Blanchard to discuss further.
There is a common presumption among community banks, and their directors, that D&O insurance coverage is a commodity. That presumption is inaccurate; there can be significant differences in the scope and quality of D&O coverage between policies and among carriers. D&O insurance policies can, and should, be negotiated to improve the coverage for directors and officers.
In the article, Jim highlights ten possible enhancements that you may be able to obtain in your D&O coverage, including:
- limiting the definition of “Application” in the policy to public filings for the past 12 months;
- expanding the definition of “Claim” in the policy;
- obtaining non-rescindable Side A coverage;
- limiting insured vs. insured carve-backs for derivative suits and bankruptcy;
- carving back defense costs from regulatory exclusions; and
- including coverage for punitive damages.
If you’d like to discuss further, please consider reaching out to Jim McAlpin or any other member of Bryan Cave’s Financial Institutions practice.