Though the year-to-date tally of failed banks is, as of Friday night, now up to 133, the much-anticipated wave of FDIC litigation against the directors and officers of the failed institutions has been slower to emerge. As I recently noted, however, the signs are that the FDIC is now starting to assert itself. Along those lines, a demand letter from the FDIC to the former directors and officers of BankUnited FSB, filed in the bankruptcy proceedings of BankUnited’s corporate parent company, shows that the FDIC is prepared to assert claims and demonstrates what those claims will look like.


On May 21, 2009, in a rare Thursday night action, the FDIC took over BankUnited, about which refer here. At the time of its closure, BankUnited has assets of over $12 billion, but as a result of the loss share arrangement the FDIC reached with the investors that purchased BankUnited’s assets, the FDIC estimated that the bank’s failure would cost the FDIC $4.9 billion.


On May 22, 2009, BankUnited’s parent company, BankUnited Financial Corporation, and related entities filed a petition for bankruptcy in the bankruptcy court for the Southern District of Florida.


According to court filings in the bankruptcy proceedings, BankUnited carried $50 million in directors’ and officers’ liability insurance, arranged in four layers. The program’s extended reporting period had a November 10, 2009 expiration date.


On November 24, 2009, the FDIC filed a motion with the bankruptcy court regarding the FDIC’s rights to assert claims against the BankUnited’s former directors and officers. A copy of the motion can be found here. In essence, the FDIC’s motion sought to establish the FDIC’s right to assert its claims in priority over the claims against the bank’s former directors and offices that committee on unsecured creditors and others sought to assert.


As part of its motion, the FDIC attached a copy of a November 5, 2009 letter that the FDIC, as BankUnited’s receiver, had sent to fifteen former directors and officers of the bank, in which the FDIC presented its "demand for civil damages arising out of losses suffered as a result of wrongful acts and omissions committed by the named Directors and Officers." The letter explains that the demand for civil damages is "based on the breach of duty, failure to supervise, negligence, and/or gross negligence of the named Directors and Officers."


Though the letter is nominally addressed to the fifteen individuals, copies of the letters also were sent directly to the bank’s primary and first level excess D&O insurers. The FDIC’s motion papers explain, in footnote 4, that the FDIC sent the letter to the bank’s primary and first level excess D&O insurers, but not to the second and third level excess D&O insurers, because the second and third level excess insurer’s policies "contain a regulatory exclusion."


In its November 5 letter, the FDIC states that its demand is based on damages "arising out of losses suffered due to wrongful acts committed in connection with the origination and administration of unsafe and unsound residential real estate loans." The letter cites in particular the individuals’ alleged wrongful acts in connection with "pursuing an overly aggressive grown strategy focused primarily on the controversial Payment Option ARM product (the ‘Option ARM’)." The letter asserts that by the end of 2007, Option ARM mortgages represented 70% of the bank’s residential loan portfolio and 60% of its total loan portfolio, and by 2008 represented 575% of the bank’s capital.


The letter asserts that individuals failed "to implement adequate credit administration and risk management controls failed to heed warnings and/or recommendations of bank supervisory authorities and bank consultants." The letter also states that the "inherent risk" of Option ARM loans was "coupled with deficiencies in the Bank’s underwriting, appraisal process and credit administration."


As the FDIC summarized in its November 24, 2009 motion, the letter asserts that the bank’s directors and officers:


(i) adopted an overly aggressive and reckless growth strategy by investing most of the Bank’s assets in "Option ARM" lending products;

(ii) failed to provide the Bank with adequate reserves for potential loan losses resulting from its investments in Option ARM lending products;

(iii) engaged in reckless, high-risk, and limited scrutiny lending;

(iv) failed to oversee the Bank’s affairs, including the failure to monitor the rising volume of loan delinquencies and to establish lending policies that would adequately protect the Bank; and

(v) failed to provide adequate personnel and administrative capacity to appropriately monitor loan appraisals and to carry out diligent underwriting reviews.


Among the FDIC’s more colorful allegations, the letter accuses the directors and offices of "encouraging an extremely liberal and aggressive lending mentality to ‘make the loan as long as the borrower has a pulse.’" The letter also accuses the individuals of "engaging in reckless, high-risk, and limited-scrutiny lending to fuel the bank’s aggressive and rapid growth — in direct contradiction to public representations of the bank’s conservative lending and strict underwriting policies."


In addition, the letter accuses the individuals of "approving and putting in place a compensation structure that drove the bank’s directors and officers to pursue recklessly risky lending and business practices."


The letter asserts that these "breaches of their fiduciary duties" caused the bank to suffer loan losses between January 1, 2006 and May 21, 2009 of over $227 million. In addition to these losses, the FDIC recognized a $4 billion loss to pay off liabilities the Bank used to fund its lending activities. The FDIC’s letter concludes with the note that its investigation is continuing and that it will supplement its demand as appropriate as its investigation progresses.


The FDIC’s demand letter demonstrates not only its willingness and intent to assert claims against the former officials of failed lending institutions, but also show that it is highly aware of the D&O insurance requirements relating to those claims. The timing of the FDIC’s November 5 demand letter (sent just prior to the insurance program’s expiration), coupled with the fact that no demand was sent to the excess carriers whose policies contain regulatory exclusions, shows that the FDIC claims approach is keyed to the failed financial institutions’ D&O insurance program.


So the signs are that the claims against the directors and officers of failed banks are coming, and that one of the principal purposes of the exercise is to try extract recoveries from the banks’ D&O insurance policies. Seems just like old times…


A December 11, 2009 Palm Beach Post article about the FDIC’s demand letter can be found here. Special thanks to a loyal reader for providing a copy of the Palm Beach Post article.


More Troubled Bank Litigation: In yet another sign that litigation involving troubled banks could be an increasingly important part of D&O claims activity in the weeks and months ahead, on December 11, 2009, plaintiffs filed a purported securities class action lawsuit in the Eastern District of Washington against Sterling Financial Corporation and two of its officers.


As reflected in the plaintiffs’ lawyers’ December 11 press release, the complaint, which can be found here, alleges that the defendants failed "to disclose the extent of seriously delinquent commercial real estate loans and construction and land loans" and that the defendants "failed to adequately and timely record losses for its impaired loans, causing its financial results and its Tier 1 capital ratio to be materially false."


According to the press release, the complaint further alleges that:


(a) defendants’ assets contained hundreds of millions of dollars worth of impaired and risky securities, many of which were backed by real estate that was rapidly dropping in value and for which Sterling had failed to record adequate loan loss reserves; (b) defendants failed to properly account for Sterling’s commercial real estate loans and construction and land development loans, failing to reflect impairment in the loans; (c) Sterling had not adequately reserved for loan losses such that its financial statements were presented in violation of Generally Accepted Accounting Principles ("GAAP"); (d) Sterling had not adequately accounted for its goodwill or its deferred tax assets such that its financial statements were presented in violation of GAAP; (e) Sterling had not adequately reserved for loan losses such that its Tier 1 capital was presented in violation of banking regulations; and (f) the Company’s capital base was not adequate enough to withstand the significant deterioration in the real estate markets and, as a result, Sterling would be forced to consent to a cease and desist order from the Federal Deposit Insurance Corporation directing it to raise $300 million in capital.


What makes the FDIC’s demand letter to the BankUnited officials and the shareholders’ complaint against Sterling Financial noteworthy is not that the banking activities to which the allegations relate are unique; to the contrary, it seems particularly important to note that during the period of the these banks’ alleged misconduct, many other banks were involved in the same or similar banking activities. This fact together with the growing number of failed banks and the significant additional numbers of troubled banks suggests that in the weeks and months ahead there could be many more demands and lawsuits along the lines of the ones described above.


I don’t think I am going out on a limb to say that litigation involving failed and troubled banks could be one of the most important litigation trends in 2010.