The FDIC recently sued a former director of Carson River Community Bank (Carson City, NV), which failed and went into receivership on February 26, 2010. The defendant, James M. Jacobs, was one of five directors who served on the Bank’s Senior Loan Committee and who approved three ADC loans that ultimately went into default, resulting in more than $3.6 million of losses to the Bank.
So why is the FDIC suing only Mr. Jacobs, and not the other members of the Senior Loan Committee for the allegedly imprudent loans? There are two probable reasons – one rooted in fact, and the other rooted in law. First, according to the FDIC’s complaint, the three subject loans were participated out to two Oklahoma banks owned by Mr. Jacobs’ family and for which Mr. Jacobs served as a director. The other directors on the Senior Loan Committee knew about Mr. Jacobs’ interest in the participating banks. What they did not know, however, was that Mr. Jacobs had secretly arranged for the Oklahoma participating banks to have preferential rights to repayment upon default. As a consequence of those preferential repayment rights, the Oklahoma banks were ultimately paid in full and Carson River Community Bank shouldered the bulk of the loss on the loans. This conduct, the FDIC alleges, constituted a breach of Mr. Jacobs’ fiduciary duty to Carson River Community Bank. Since the other directors on the Senior Loan Committee did not know about the preferential repayment rights, the FDIC was not in a position to assert similar fiduciary breach claims against them.
Second, the FDIC has not sued the other directors because Nevada has a very forgiving standard of liability for corporate directors. Under the Nevada corporate code, a director is not liable unless it is proven that: (a) the director’s act or failure to act constituted a breach of his fiduciary duties; and (b) the breach of those duties involved intentional misconduct, fraud or a knowing violation of law. Nev. Rev. Stat. § 78.137(7). Although it characterized the approval of the subject loans as imprudent, the FDIC must not have had sufficient facts to support an allegation that the other directors had committed “intentional misconduct, fraud, or a knowing violation of the law.”
This case is a true factual outlier, and it does not signal a trend that the FDIC will target single director defendants. We expect the FDIC will continue its now long-established practice of targeting all of the former directors and officers who played a substantial and active role in approving allegedly imprudent loans.
For the first time since the advent of the Great Recession, the FDIC has filed an action against former bank directors based only on theories of gross negligence. The lawsuit was filed against the former directors of Orion Bank (“Orion” or the “Bank”) of Naples, FL, which failed and went into receivership in November 2009. A copy of the FDIC’s complaint is available here.
The FDIC’s central case theory focuses on the defendant directors’ completely lack of oversight over Orion’s President and CEO, Jerry Williams. According to the complaint, Mr. Williams became such a dominant decision-maker that the defendant directors generally approved any and all of his proposals with little, if any, scrutiny. Their alleged abdication of responsibility bled over into role as members of the Board Loan Committee, and they “blithely rubberstamped” any loan that Mr. Williams proposed without any meaningful review or deliberation. The FDIC contends that the director defendants continued to “rubberstamp” Mr. Williams’ proposed loans even after banking regulators had specifically criticized their lack of oversight and had warned them to be personally and directly involved in reviewing, analyzing and independently evaluating loans presented for approval.
Apart from its allegations that the defendant directors failed to properly oversee management, the FDIC also alleges that the defendants routinely disregarded proper loan underwriting standards, the Bank’s own loan policy, repeated warnings from regulators, and the rapidly declining real estate market. Worse yet, the defendant directors continued to approve ADC lending at an accelerated rate between 2005 and 2007 despite obvious signs that the real estate market was in steep decline. In total, the FDIC seeks to recover more than $53 million in connection with several bad loans approved by the defendants.
In today’s environment, many bank directors are faced with difficult strategic decisions regarding the future of their organizations. We have been involved in many great board discussions of whether it is best for the bank to continue to grind away at its business plan in this slow growth environment or to look for a business combination opportunity that will accelerate growth. There is rarely a clear answer in these discussions, but some guidelines are helpful: All directors must respect the conclusion of the full board of directors and follow the appropriate process established by the board with respect to merger opportunities.
Over the years, we have seen a number of instances in which one or more bank directors conduct merger discussions with potential partners without bringing the opportunity to the full board of directors immediately. In many cases, these directors are acting in good faith and simply leveraging relationships they have with other bankers or bank directors. In other cases, these directors may feel the need to engage in these discussions because they disagree with the full board’s strategy of remaining independent. However, all directors should understand that it is in the bank’s best interest, and the director’s own personal best interest, not to take matters into their own hands without authorization by the board of directors.
On October 2nd, the FDIC filed its 33rd lawsuit against former directors or officers of failed banking institutions since the beginning of the current economic recession. This suit is against the former directors of Benchmark Bank (“Benchmark” or the “Bank”) of Aurora, Illinois, which was placed into FDIC receivership on December 4, 2009. For a copy of the FDIC’s complaint, click here.
A central theme of the FDIC’s complaint is that the director defendants, all of whom served on the Director’s Loan Committee, embarked on a strategy of aggressive growth through the approval of high-risk acquisition, development and construction (“ADC”) and commercial real estate (“CRE”) loans. The director defendants approved the high-risk loans, the FDIC alleges, “without analysis of their economic viability or a complete evaluation of the creditworthiness of borrowers and guarantors”. Even after the real estate market declined, the FDIC contends, the director defendants exacerbated the Bank’s problems by making new loans and renewing existing troubled loans, rather than curtailing ADC/CRE lending and preserving capital to absorb losses from existing loans went bad.
The most unique of the FDIC’s case theory centers on the role of Benchmark’s former chairman, Richard Samuelson, who was not only a director, CEO, and long-time acting president of the Bank, but also the principal originator of the Bank’s ADC and CRE loans. As CEO and acting president of the Bank, Mr. Samuelson was ultimately responsible for the underwriting and credit administration of loans. Yet those functions were never segregated from the loan origination function, leaving the Bank with a significant internal control deficiency. Moreover, since Mr. Samuelson originated most of the ADC and CRE loans, it created a dynamic in which credit analysts were very reluctant to report underwriting deficiencies on his loans. To make matters worse, the FDIC contends, Mr. Samuelson earned generous incentive awards from his loan originations, providing him with additional motivation to ensure that loans were approved. In view of these facts, the FDIC alleges, the director defendants knew or should have known that the ADC and CRE loans required a higher degree of scrutiny and monitoring. The FDIC contends that the director defendants breached their duties with respect to 11 specific ADC and CRE loans, resulting in losses of over $13.3 million.
We have previously summarized an important district court ruling dismissing the FDIC’s ordinary negligence claims against former directors and officers of Integrity Bank of Alpharetta, Georgia. The FDIC asked the U.S. District Court for the Northern District of Georgia to reconsider its decision in that case, but the court recently denied that request and reaffirmed its rationale that Georgia’s version of the Business Judgment Rule bars claims for ordinary negligence against corporate directors and officers. A copy of the court’s recent order in the Integrity Bank case is available here. Although the district court declined to reconsider its prior dismissal of the ordinary negligence claims, it acknowledged that there was “substantial ground for difference of opinion” on that issue, and it granted the FDIC’s request to certify an order of interlocutory appeal to the Eleventh Circuit Court of Appeals. Everyone in the D&O defense community, and especially those here in Georgia, is anxiously awaiting to learn if the Eleventh Circuit will accept interlocutory appeal of the case.
In the meanwhile, district courts in two other cases have weighed in on whether the Business Judgment Rule bars claims for ordinary negligence. The first of these also comes from the Northern District of Georgia, and specifically from the FDIC’s lawsuit against certain former directors and officers of Haven Trust Bank. (We have previously summarized the Haven Trust complaint.) Utilizing the same rationale set forth in the Integrity Bank rulings, the court here ruled that the FDIC’s claims for ordinary negligence are not viable by virtue of the Business Judgment Rule. Furthermore, the court ruled, to the extent that the FDIC’s claims for breach of fiduciary duty are based on the same alleged acts of ordinary negligence, those claims are foreclosed by the Business Judgment Rule as well. The ruling was not a complete victory for the D&O defendants, however, as the court declined to dismiss the FDIC’s claims for gross negligence under FIRREA. Specifically, the court held that the FDIC had alleged, in a collective fashion, sufficient facts on which a jury might reasonably conclude that the defendants had been grossly negligent. Despite that holding, the court took the unusual step, “in the interest of caution,” of ordering the FDIC to replead the gross negligence claim with specific allegations as to each defendant’s involvement or responsibility for the alleged wrongful acts. A copy of the court’s ruling can be viewed here.
While the FDIC lawsuits paint a picture of inattentive, runaway directors and officers, a number of the practices that the FDIC found objectionable could be found at many healthy institutions.
In the wake of over 400 bank failures since the beginning of 2008, the FDIC is well underway with its process of seeking recoveries from directors and officers of failed banks who the FDIC believes breached their duties in the course of managing those institutions. As of mid-May 2012, the FDIC had filed lawsuits against almost 30 groups of directors and officers alleging negligence, gross negligence and/or breaches of fiduciary duties. While the litigation filed by the FDIC tends to sensationalize certain actions of the directors and officers in order to better the FDIC’s case, there are lessons to be learned.
Some of the take-aways from the FDIC lawsuits are fairly mechanical: carefully underwrite loans, avoid excessive concentrations, and manage your bank’s transactions with insiders. However, there are two major themes that are more nuanced and which are present in almost all of the lawsuits. Those themes relate to the loan approval process and director education.
Develop a thoughtful loan approval process. As evidenced by the recent piece published on bankdirector.com, a spirited debate among industry advisors is currently taking place with respect to whether directors should approve loans or not. On the one hand, many attorneys believe directors have a duty to consider and approve (or decline to approve) certain credits that are or would be material to their banks. Regulation O requires approval of certain credits, the laws of some states require approval of some loans, and there is a general feeling among many bank directors that they should be directly involved in the credit approval process. In addition, many bank management teams believe that directors should “buy in” with them to material credit transactions.
On the other hand, the FDIC litigation clearly focuses on loan committee members who approved individual loans that did not perform. This should give pause to directors in general and loan committee members in particular. It is now the belief of many legal practitioners that the practice of approving individual loans when the loans are not otherwise required to be approved by the directors paints a target on the backs of the loan committee members. The FDIC may be able to target directors who participated in the underwriting of a credit (or were deemed to have done so given their involvement in the approval process) when they did not have the expertise necessary to do so. Some practitioners argue that the directors should instead focus on the development and approval of loan policies that place appropriate limits on the types of loans and the amounts that the bank is willing to make. This policy would be consistent not only with safe and sound banking principles but also with the board’s risk tolerance, and it would be appropriate to seek guidance from management and outside advisors on the development of the policy. The idea is that it is much more difficult to criticize a policy than an individual credit decision with the benefit of hindsight.
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.
As many readers are aware, Georgia has led the nation in the number of failed financial institutions in the recent financial crisis. Integrity Bank, of Alpharetta, was one of the first of those banks to fail in Georgia, on August 28, 2008, and drew the first lawsuit filed by the FDIC as receiver against former directors and officers in Georgia. The lawsuit was filed against former members of the Director Loan Committee of the Bank, and asserted claims against the Defendants based on their alleged pursuit of an unsustainable rapid growth strategy, involving high risk lending concentrated in speculative real estate and acquisition, construction and development loans. The suit alleged over $70 million in losses from 21 such loans, between February 4, 2005 and May 2, 2007.
On February 27, 2012, in response to motions to dismiss filed by the defendants, and motions to strike certain affirmative defenses filed by the FDIC as Receiver, Judge Steven C. Jones of the United States District Court for the Northern District of Georgia issued an Order which made some critical rulings regarding the standard of care and the availability of certain defenses in actions brought by the FDIC as receiver in Georgia. A copy of the Order is available here. Given that this is the first such substantive ruling in this context by a court in Georgia, the decision is notable and will likely have a significant impact on future FDIC litigation in Georgia going forward.
Of potentially greatest significance, the Court granted the Defendants motion to dismiss all of the FDIC’s claims based on ordinary, as opposed to gross, negligence. The Court was persuaded that in Georgia, the deviation from the standard of care necessary to state a claim against former bank officers and directors must rise at least to the level of the “gross negligence” floor set by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) . The Court reached this conclusion after determining that Georgia ‘ s Business Judgment Rule protects directors and officers from claims based on simple, or ordinary, negligence. This sets the bar fairly high for the FDIC to prevail on claims against former directors and officers of failed banks,and should provide some comfort in that regard.
Detracting somewhat from the defendants victory on that aspect of the motion to dismiss, however, Judge Jones also ruled that the relatively unexceptional allegations by the FDIC of uncontrolled rapid growth and over concentration in speculative and risky acquisition, development and construction loans were sufficient to withstand a motion to dismiss, even at the heightened “gross negligence” standard. Thus, while the decision sets the bar high for the FDIC to ultimately prevail on these sorts of claims, it does not necessarily provide much ammunition to argue for dismissal at the motion to dismiss stage.
Are any of your bank branches and offices owned by directors? That could spell trouble but it can be handled well. Here’s how.
During the mid-2000′s, it was commonplace for a bank, particularly a de novo bank, to lease some or all of their bank facilities from an entity controlled by the bank’s directors. At the time, these arrangements truly represented a “win-win” situation. The bank was able to occupy built-to-suit facilities while conserving liquidity so that cash could be deployed through making loans with attractive yields. At the same time, the directors, many of whom were real estate professionals, were able to make a sound real estate investment with the knowledge that a very stable tenant would occupy the property.
As we know, much has changed since the mid-2000′s. Vacancies in commercial properties have caused market lease rates to plummet. Similarly, market values of commercial properties have decreased substantially. Many banks have excess liquidity caused by soft loan demand, making a potential investment in fixed assets more attractive.
Because many of these leases were written with five-year initial terms, a number of banks are now weighing their options with respect to renewal, extension or renegotiation of the leases. To make matters more complex, many director-controlled entities borrowed money to construct the bank facilities. If those notes had five-year terms, they are coming up for renewal, and the lending bank may be eager to move the commercial real estate loans off of its books.
This fact presents a particularly difficult challenge for the affected directors. Banking regulations require that transactions with affiliates be made on terms at least as favorable to the bank as those terms prevailing at the time for transactions with unaffiliated parties. Most bank directors understand their duty to act in the best interests of the bank, but they are also facing personal financial exposure if the lease is not renewed on terms that allow the entity to continue to service its debt obligations. In addition, given public scrutiny of directors and officers who are perceived to have profited at the expense of the bank they serve, creating a proper process to manage these situations has never been more important.
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.