The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

As of year-end 2009, the FDIC identified 702 banks as "problem institutions," representing about 9% of all institutions reporting to the FDIC and the highest number of problem banks since 1993, according to the FDIC’s latest banking report.

On February 23, 2010, the FDIC released its Quarterly Banking Profile for the fourth quarter 2009, which can be found here. The FDIC’s February 23, 2010 press release describing the report can be found here.

The FDIC defines "problem institutions" as those with "financial, operational or managerial weaknesses that threaten their continued financial viability." Problem institutions are ranked as either 4 or 5 on the FDIC’s 1 to 5 scale of "risk and supervisory concerns." The FDIC does not publicly identify the problem institutions by name.

The 702 problem institutions at year end (out of 8,012 reporting institutions) represent the largest number of problem institutions since 1993. The 702 institutions also represented combined assets of $402.8 billion. The year end number of problem institutions is 27 percent greater than the 552 problem institutions as of the end of 3Q09. The 2009 year end figures compare to the 252 problem institutions, representing $159 billion in assets as of the end of 2008.

Given that the "problem institution" category tracks banks with "financial viability" concerns, it is hardly surprising that the increase in the number of problem institutions has been accompanied by a growing number of failed financial institutions. There were 140 bank failures in 2009, and there have already been 20 bank failures already in just the first seven weeks of 2010. The number of bank failures so far this year suggests that we may have at least as many if not slightly more bank failures this year compared to last year.

The FDIC’s report comes on the heels of the recent report of the Congressional Oversight Panel (about which refer here), in which the watchdog committee warned that coming commercial mortgage woes could further damage many lending institutions.

But not all of the banking news is bad. FDIC Chairman Sheila Bair is quoted in the FDIC’s press release as saying that the FDIC sees "signs of improving performance in the industry, " although basically that means that the pace of deterioration has slowed, not necessarily that the negative trends have been reversed.

Whatever else that might be said, the continued increase in the number of problem institutions as 2009 progressed suggests that we can expect to continue to see growing numbers of failed financial institutions as 2010 unfolds.

A Business Week article about the FDIC’s report can be found here, and a New York Times report can be found here.

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The FDIC has picked up where it left off at the end of 2009, with its first bank closure of the New Year. On Friday, January 8, 2010, the FDIC took control of Horizon Bank of Bellingham, Washington, for the first bank closure of 2010. While the FDIC’s continuation of its regulatory actions regarding troubled banks seems likely in the near term, what remains to be seen is whether the FDIC’s actions will include litigation against the former directors and officers of the failed banks.

Though the FDIC has yet to launch D&O litigation, the lawsuits may be just ahead. The FDIC is taking a series of steps clearly designed to prepare for litigation.

First, as reported in a January 10, 2010 article in FinCri Advisor (here), the FDIC is "subpoenaing bank officials and workers, hoping to gather evidence to use in potential litigation." By way of illustration, a recent motion filed by bank officials in connection with the bankruptcy proceedings involving Haven Trust Bancorp, the holding company for a Duluth, Georgia bank that failed in December 2008, states that certain of the officials "received subpoenas…issued by counsel to the [FDIC] regarding the FDIC’s investigation of certain matters relating to the failure of Haven Trust Bank." (The former officials’ motion sought access to the D&O insurance policy proceeds in order for the officials to be able to defend themselves.)

Second, as I noted in a prior post, the FDIC is sending civil demand letters to former directors and officers of failed banks. According to the FinCri Advisor article, former directors in Florida, California, Illinois, Texas and Georgia have received FDIC claims letters. According to a commentator in the article, one obvious trigger for a demand letter is the approaching expiration date of the D&O insurance policy.

An example of one of these demand letters is described in a January 8, 2010 Atlanta Business Chronicle article, here (registration required). The article describes a September 28, 2009 letter sent to the D&O liability insurer for Georgian Bank, an Atlanta bank that the FDIC closed on September 25, 2009. According to the article, the letter details the potential claims the FDIC might make against the bank’s former directors and officers, including allegations of "unsafe and unsound banking practices."

Industry experts quoted in the Atlanta Business Chronicle article say that "such letters likely have been filed with insurers by all 30 banks that have failed in Georgia since August 2008."

But while the FDIC is clearly pursing investigations and taking steps to try to preserve the right to try to recover D&O insurance proceeds, it "has not filed any D&O lawsuits in connection with the bank failures since the crisis began in 2008," according to an FDIC spokesman quoted in the article.

According to the FinCri Advisor article, "the FDIC spends about a year conducting an investigation into a failed bank before deciding whether it can pursue a claim against former directors and officers."

Because of the FDIC’s many continuing investigations, 2010, according to an attorney quoted in the FinCri Advisor article, "will be the year of investigation and tolling agreements." One reason for the FDIC to proceed carefully is that it doesn’t want to push cases early that may set bad precedents, which could "doom subsequent cases."

But though the FDIC is now proceeding cautiously, when the litigation ultimately comes, there is likely to be a lot of it. The FinCri Advisor article quotes the FDIC’s former head of litigation as saying that "about half" of the bank failures will "see some director litigation." Before all is said and done, the coming litigation "could rival the litigation that occurred in the 80s and 90s as a result of the many thrift failures."

Special thanks to loyal reader Henry Turner for providing me with a copy of the Haven Trust pleading and the Atlanta Business Chronicle article.

Another Perspective: As a continuation of my early post in which I linked to a variety of Top Ten lists, I note here the recent post on the Corporate Disclosure Alert blog (written by my law school classmate and investor advocate, Sanford Lewis) about "10 Questions of Risk Management for the New Decade" (here). Lewis contends that "far more must be done to turn the patchwork of risk management approaches into viable public policy and corporate governance solutions." The list of issues that Lewis contends should be addressed is interesting and provocative.

We Aren’t What We Watch – Are We?: On New Year’s Day, my hyperkinetic eldest daughter -- collegiate swimmer, rugby player – who rarely sits still long enough to watch TV, announced "I think I’ll watch some college football" and she plopped herself down beside me on the couch. Unfortunately for the nascent possibility of a little father-daughter bonding, the game broadcast at that moment was in the middle of the Flomax halftime report, and the commercial had just reached the point where it advised that Flomax’s adverse side effect may include a "reduction in semen."

As she was leaving the room, my daughter offered the observation that at least on TV college football is clearly meant for a "different demographic."

Indeed. But what exactly is the intended demographic?

The commercials themselves suggest that the target audience consists of people who are basically worried. They are not only worried just because they have to go pee all the time. They are worried about their credit scores. They are worried that their nest eggs have shrunk. They are worried about figuring out their taxes. They are worried because their computers are too slow and because their 3G network’s coverage areas are too small.

So many things to worry about. Too bad for you if all you want to do is watch a little football.

But in the midst of all of this apprehension and fear, there is cause for hope. For the overweight, for example, Taco Bell would like to communicate the optimistic message that you can lose weight by eating fast food. (I am not making this up.)

If playing time alone is any measure, the most important message for our society seems to be that Taco Bell now has a five-layer burrito for 89 cents. For those of you thinking, "No Way!" -- you have to understand that they are not offering to pay you 89 cents to eat that thing. They are expecting you to pay them. Seriously. As my son said, "Is that supposed to be food?"

Perhaps (I can hope optimistically) we are all in the wrong demographic. How much more fortunate are the viewers of the UK premier league soccer games. Since the game clock never stops, there are no commercial interruptions – which obviously is the reason that soccer has never been allowed to catch on commercially in the U.S. Of course, the soccer games do have halftimes, which does hold open the theoretical possibility for Flomax halftime reports.

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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.

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The FDIC’s latest Quarterly Banking Profile (here) shows that as of September 30, 2009, the country’s commercial banks are continuing to struggle, and that as a result of the banks’ woes the FDIC’s Deposit Insurance Fund (DIF) is $8.2 billion in the red. The rising numbers of "problem" institutions suggests both that the number of failed banks could continue to grow and that the DIF could remain under pressure – although as discussed below, the DIF situation may not be quite as dire as the headline details might otherwise suggest.

The FDIC report states that the number of banks on the FDIC’s "problem" institution list rose during the third quarter to 552 from 416 at the end of 2Q09, and that the total assets of "problem" institutions increased from $299.8 billion to $345.9 billion. If assets at "problem" institutions of a third of a trillion dollars sound bad, that’s because it is. The FDIC reports that both the numbers and assets of "problem" institutions are "now at the highest level since the end of 1993."

The FDIC defines "problem" institutions as "those with financial, operational or managerial weaknesses that threaten their continued financial viability." To be classified as a "problem," an institution would have to be ranked as either a "4" or a "5" on the FDIC’s "scale of 1 to 5 in ascending order of supervisory concern." The FDIC does not provide the names of the "problem" institutions, nor does it specify how many of them are rated "4" and how many are rated "5."

To put the number (552) and assets ($345.9 billion) of the third quarter-end "problem" institutions into some perspective, there were "only" 171 "problem" institutions as of the end of 3Q08. In twelve months, the number of "problem" institutions more than tripled, and the assets at "problem" institutions more than doubled.

Along with the growing numbers of "problem" institutions have come an escalating number of bank failures. During the third quarter of 2009, "fifty insured institutions with combined assets of $68.8 billion failed," which represents "the largest number [of bank failures] since the second quarter of 1990 when 65 insured institutions failed." As of the September 30, 2009, 95 banks had failed, and as of November 20, 2009, the 2009 YTD total number of bank failures stood at 124.

This wave of bank failures has taken its toll on the Deposit Insurance Fund (DIF). During the third quarter, the DIF decreased by $18.6 billion, to negative $8.2 billion, "primarily because of $21.7 billion in additional provision for bank failures."

Although these DIF figures sound disastrous, there is more to the story than just the reported negative figure. The FDIC’s November 24, 2009 press release accompanying the report (here) explains that the negative balance reflects a $38.9 billion "contingent loss reserve that has been set aside to cover estimated losses over the next year." In addition, the DIF balance is not the same as the FDIC’s cash resources, which stood at $23.2 billion as of the end of the third quarter.

To further bolster the FDIC’s cash position, on November 12, 2009, the FDIC’s board voted to required insured institutions to prepay three years’ of deposit insurance premiums – worth about $45 billion – at the end of 2009. The press release on the prepayment assessment can be found here.

With the increase in the number of "problem" institutions and the obvious relationship between rising numbers of "problems and the likely number of future bank failures, signs are that we could continue to see significant numbers of bank failures as we head into 2010. While I still don’t think we are going to see 1,000 failed banks by the end of 2010, we are clearly going to be seeing a lot more failed banks.

As bad as all of this is, the Quarterly Banking Profile hints at the possibility that all of the bad news might not even be out in the open yet. Among any other details, the Quarterly Banking Profile also reports that "growth in [loan loss] reserved continued to lag the rise in noncurrent loans, and the industry’s ratio of reserves to noncurrent loans declined for a 14^th quarter, from 63.6 percent to 60 percent."

In terms of what all of this means for the economy, perhaps the most significant detail in the document is its report that "loan balances declined by the largest percentage since quarterly reporting began in 1984." The FDIC’s press release quotes FDIC Chairman Sheila Bair as saying that "there is no question that credit availability is an important issue for economic recovery. We need to see banks making more loans to their business customers."

Europeans Worried About Proposed U.S. Investor Protection Law: According to a November 23, 2009 Financial Times article (here), the European Commission is worried about legislation currently before Congress that would specify the circumstances under which investors could sue foreign domiciled companies in U.S. courts.

As I discussed in a prior post (here), Section 215 the Investor Protection Act of 2009 is addressed to "Extraterritorial Jurisdiction" which would amend the ’33 Act, the ’34 Act and the Investment Advisors Act of 1940 to specify that U.S. courts could properly exercise jurisdiction in any action involving "conduct with the United States that constitutes significant steps in furtherance of violation, even if the securities transaction occurs outside the United States and involves only foreign investors," as well "conduct outside the United States that has a foreseeable substantial effect in the United States."

Under the first of these two prongs, U.S. based conduct alone would be sufficient jurisdictional basis, even with respect to foreign purchasers of who purchased their shares of foreign-domiciled companies on foreign exchanges (so-called "f-cubed claimants").

The article quotes the former director of litigation for Bank of America as saying that "if this legislation passes, there will be greater opportunity for foreign companies to be hauled into U.S. courts." The article also reports that Charlie McCreevy, the European Union Commission for Internal Markets as having "expressed concern over the measure."

All-Time Worst E-Mail Faux Pas?: The title of the Clusterstock’s post (here) pretty much says it all: "Cornell Business School Employees Accidentally Email Everyone with Their Dirty Email Love Notes." Clusterstock observes that the "this might set some kind of record for the worst email mistake anyone has ever made."

Due to the family-oriented nature of this blog, The D&O Diary will not reproduce any examples of the couple’s inadvertently forwarded emails.

The good news is that the two employees involved are married. The bad news is that they are not married to each other.

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