scrutiny2Federal banking regulators have stepped up their interactions with and scrutiny of bank directors, according a recent Wall Street Journal article. The March 31, 2015 article, entitled “Regulators Intensify Scrutiny of Bank Boards” (here) details the ways in which regulators are “zeroing in on Wall Street boardrooms as part of the government’s intensified scrutiny of the banking system.” However, as the article also makes clear, the increased pressure is not limited just to the largest banks; smaller banks are also facing scrutiny. The level and intensity of the regulatory scrutiny, and of the regulators’ efforts to impose what amounts to performance standards, has raised concerns that the regulatory activity could encourage new director liability claims.

 

According to the article, the stepped up regulatory scrutiny is the result of concerns that that banking problems that contributed to the global financial crisis were due in part to the fact that banks’ boards did not understand the risks their firms were taking or did not exercise appropriate oversight. In the immediate aftermath of the financial crisis, regulators first focused on ensuring the banks had robust financial cushions. According to the article, in the last two years regulators have turned their attention to corporate governance and the role of directors to “ensure banks have the right culture and controls to prevent excessive risk taking.”

 

The practical result is that bank directors “have begun facing a new level of scrutiny.” The regulators are now focused on “whether directors are adequately challenging management and monitoring risks in the banking system.”

 

The article makes clear that the steps regulators are taking as part of this increased scrutiny are nothing short of extraordinary. It is clear from the article that that the specific steps regulators are taking varies from institution. But the range of actions regulators are taking is quite broad and arguably even intrusive in some cases.

 

Among other thing, according to the article, regulators are holding regular meetings with banks’ independent directors; “singling out boards in internal regulatory critiques of bank operations and oversight”; attending and sitting in on board meetings; meeting with board committee members; and even, in one case detailed in the article, dictating the makeup of the board by requiring the expansion of the board by the inclusion of additional independent board members.

 

In addition, regulators are reviewing information directors receive from bank management; asking about succession planning; and inquiring about how directors gauge the potential downsides of certain transactions.

 

Although the banking institutions mentioned by name — such as Goldman Sachs, Bank of America, J.P Morgan, and GE Capital – are among the world’s largest financial institutions, the article also emphasizes that “directors at smaller banks are also being pressed, including on how much they understand and the kinds of loans banks are making and the associated risks.”

 

It is little wonder then that, as stated by the Comptroller of the Currency Thomas Curry in the article, that “We have the independent directors’ attention.”

 

The heightened regulatory scrutiny has triggered alarm bells. According to one independent board member quoted in the article, the threat of being held accountable for failing to properly supervise management is “creating a ton of tension” for directors. Some regulatory moves have raised concerns that the banking supervisors are pushing directors to “take on managerial duties beyond their traditional roles as overseers.”

 

These concerns about the pressure on directors and the expansion of the directors’ roles have in turn raised concerns that the “new, material obligations” being placed on boards “could give rise to new director liability claims.” These fears about potential future director liability claims are reinforced by the wave of lawsuits the FDIC brought against the former directors and officers of failed banks in the wake of the financial crisis.

 

These concerns about potential personal liability have in turn raised concerns about whether banks might have trouble recruiting and retaining qualified directors. The Journal article quotes one commentator as saying that there are many qualified individuals who “simply … won’t serves as directors … because of fear” of personal liability. The article also quotes a federal regulator as conceding that regulators are sometimes guilty of placing too may requirements on boards.

 

Discussion

The suggestion that increased regulatory scrutiny and heightened regulatory expectations could lead to new liability claims against directors is not far-fetched. To the contrary, some regulators have made overt, express calls for the scope of fiduciary duties expected of bank directors to be expanded (at least for directors of systemically important financial institutions), as discussed, for example, here. These public statements, along with the level of regulatory expectations of directors, suggest that regulators may consider expanded director accountability to be appropriate. As the Journal article correctly points out, the FDIC failed bank lawsuit show not only that banking regulators intend to hold directors accountable and even to seek to impose liability on them.

 

Nor is it far-fetched to contend, as the Journal article suggests, the (apparently well-founded) fears of personal liability may deter qualified persons from serving on banking boards. As I discussed in a prior post (here), a recent survey of the American Association of Bank Directors found that existing and potential bank directors increasingly are unwilling to serve due to fear of personal liability. Among other things, the survey results showed that nearly a quarter of the survey respondents have had a director or potential director shun or shy away from board service based on personal liability concerns.

 

It is important to emphasize that, although the Journal article highlighted developments involving the largest Wall Street firms, the article also showed the increased scrutiny is not restricted just to the global financial firms. The increased scrutiny also extends to smaller institutions.

 

Among the more troubling items in the article is the suggestion that the banking regulators are creating written “regulatory critiques of bank operations and oversight” and that boards are being “written up” in supervisory reports. Although these type of reports are highly confidential and would be very difficult for non-regulatory claimants to obtain, the fact that they exist and the possibility that they might come to light in claims brought by third-party claimants adds an additional layer to the concern that the increased regulatory scrutiny could lead to increased personal liability for bank directors.

 

Given the magnitude of the problems at financial institutions that came to light in the global financial crisis, it may be no surprise the bank directors are facing heightened scrutiny. Just the same, the level of scrutiny, and the forms that the scrutiny is taking (as detailed in the Journal article), pose a significant challenge for banks, for bank directors, and for the banks’ D&O liability insurance carriers. The possibility that the current level of heightened scrutiny might foster new director liability claims is of particular concern.

 

Corporate Boards and CFO Hiring: The same Wall Street Journal issue that contained the article discussed above about regulatory pressure on bank directors and the directors’ changing roles included another article about the changing roles of corporate directors. An article entitled “Boards Join in CFO Picks” (here) discusses how “corporate boards are playing an increasingly pivotal role in choosing CFOs.” Companies identified in the article where directors played an active role in recruiting and hiring the firms’ Chief Financial Officer include Google, McDermott International, Avon Products, and Newell Rubbermaid. The article also notes that boards “also can help unseat underperforming finance chiefs.”

 

The increased board role in CFO hiring – and sometimes firing – is in part due to the heightened expectations of the Sarbanes-Oxley Act and in part due to the financial crisis, which underscored the importance of “having a veteran at the helm.” In addition, “directors are also assuming a stronger role because more finance chiefs now rise to the top job.” According to sources cited in the article, 12 of the Fortune 50 CFOs are former finance chiefs.

 

There is no doubt that the boards’ increased involvement in CFO hiring is a direct consequence of the changed environment in which boards conduct their business these days. Investors (and as discussed above, regulators) increasingly expect active board involvement, and in turn boards are increasingly engaged in company operations in ways they might not have been in the past. Overall, increased board involvement in CFO hiring should be a positive thing, particularly as it is portrayed in the Journal article.

 

But perhaps because I read the Journal article about increased board involvement in CFO hiring immediately after reading the article discussed above about bank director scrutiny, I immediately thought about whether increased board involvement in CFO hiring and firing might also lead to liability claims.

 

I can imagine these kinds of potential claims taking at least two forms. On the one hand, because, as the article details, some corporate boards are becoming actively involved in CFO firing, it is possible claimants might assert that the board of a company that sustained problems because of CFO misconduct breached its duties by failing to act quickly enough to discharge the deficient finance chief. By the same token, if a company were to sustain problems because of misconduct by a CFO that the board had proactively recruited and hired, claimants might try to assert that the board breached its duties through its negligent recruiting and hiring activities (for example, by failing to scrutinize the candidate or identify past problems).

 

All of which is another way of saying that in an era where boards are increasingly under scrutiny, even the actions of an active and engaged board can come in for criticism and challenge. Or to put it another way, in our hyper-litigious society, even a seemingly positive development could lead to litigation.

 

More About Shareholder Activism: In a recent post (here), I jumped into the ongoing debate about shareholder activism, a topic that has grown importance as level of shareholder activism has grown. Readers who are interested in the topic will want to read the cover article in the latest issue of the American Lawyer. The March 30, 2015 article, which is written by Michael Goldhaber and is entitled “Marty Lipton’s War on Hedge Fund Activists” (here, subscription required), frames the debate on shareholder activism in terms of the continuing battle between corporate champion Marty Lipton of the Wachtell Lipton law firm and the Harvard Law School Professor and corporate scourge, Lucian Bebchuk.

 

As the article states, the only thing the two can agree on is that, lately at least, “the activist hedge funds are winning the war.” As for whether or not this is a good thing, that “depends on which narrative you accept.” In Lipton’s view, the activists are short-term focused and very bad for the economy. In Bebchuk’s view, the activists’ efforts regularly create shareholder value that is sustained over the longer term.

 

The article quotes a chorus of voices suggesting that perhaps the real answer is somewhere in between. Among other things, critics arguing for the middle view suggest that while activists are not as evil as Lipton suggests, Bebchuk does not look at the effect of their activities on the economy as a whole, as they cut corporate spending by laying off workers and cutting R&D budgets. Others suggest that Lipton is too willing to overlook executive compensation excesses.

 

After laying out the parameters of the debate, the article concludes with reference to Delaware Supreme Court Chief Justice Leo Strine’s call for institutional investors to become more involved, particularly in making sure that short term thinking does not overwhelm strategic corporate decision-making. As the article quotes the venerable New York lawyer Ira Millstein as saying, “Companies and pension funds are getting smarter. If the real investors think the activists are wrong, then they don’t have to go along.”