In an interesting variant on the kinds of claims that the former directors and officers of a failed financial institution can face, on April 6, 2012, the SEC charged two former officers of the publicly traded holding company for the failed Franklin Bank of Houston with securities fraud. In its April 6, 2012 complaint (here), the SEC alleges that the two former officers engaged in a fraudulent scheme designed to conceal the bank’s deteriorating loan portfolio and inflate its earnings at the outset of the financial crisis. The SEC’s litigation release about the case can be found here.


According to the SEC’s complaint, in the second and third quarters of 2007, the bank began to experience increased delinquencies in its mortgage loan portfolio. During this same period, the bank was considering “strategic alternatives” include the possible sale of the bank. Investment advisers told the bank’s CEO Anthony Nocella and its CEO Russell McCann that the bank needed to “polish the apple” by showing positive earnings “momentum” and “stable asset quality.”


The SEC alleges that in order to conceal the bank’s rising loan delinquencies and improve its earnings for the third quarter of 2007, Nocella and McCann instituted three loan modification schemes by which the bank was able classify non-performing loans as performing. These alleged modification schemes, with names like “Fresh Start” and “Great News,” allegedly enabled the bank to conceal from shareholders over $11 million in delinquent and nonperforming residential loans and $13.5 in nonperforming construction loans. The SEC alleges that the bank overstated its 2007 net income and earnings by 31% and 77% respectively.


On May 2, 2008, in a filing on Form 8-K, the bank acknowledged that the accounting for the loan modifications should be revised and that investors should no longer rely on the bank’s filing on Form 10-Q from the third quarter of 2007. On November 7, 2008, the bank was closed by Texas state banking regulators and the FDIC was appointed as receiver. The bank’s holding company also filed for bankruptcy in 2008.


In its April 6 complaint against Nocella and McCann, the SEC seeks financial penalties, officer-and-director bars, and permanent injunctive relief against the two individuals to enjoin them from future violations of the federal securities laws. In reliance on Section 304 of the Sarbanes Oxley Act, the complaint also seeks to “clawback” bonus compensation that Nocella and McCann received. (See the note below about another recent action in which the SEC has sought to use Section 304 to clawback bonus compensation from executives of a company that had restated its financial statements.)


In its litigation release, the SEC expressly acknowledges “the assistance of the Federal Deposit Insurance Corporation in this matter,” which suggests that at a minimum that two agencies were cooperating in this matter and also suggests the possibility that the FDIC may even have referred the matter to the SEC. The FDIC’s involvement is also a reminder that  as part of its post-failure post-mortem processes, the FDIC is not only attempting to determine whether or not it has a valuable civil suit on its own as receiver, but is also looking to see whether or not wrongdoing has occurred that warrants referral to other authorities. The FDIC has not on its own pursued any claims in connection with Franklin Bank’s closure. It is also interesting to note that the SEC is only now pursuing this enforcement action, though the events complained of took place well over four years ago, and the though the bank itself failed over four years ago.


The SEC’s filing of its action against the two former Franklin Bank officials is not the first time the SEC has pursued an enforcement action against former directors and officers of a failed bank. As noted previously (here, scroll down), in an October 11, 2011 complaint (here), the SEC filed a civil enforcement action against four former officers of UCBH Holdings, Inc., the holding company for United Commercial Bank, which failed in November 2009. According to the SEC’s October 11, 2011 litigation release, the complaint alleges that the defendants “concealed losses on loans and other assets from the bank’s auditors, causing the bank’s holding company UCBH Holdings, Inc. (UCBH) to understate its 2008 operating losses by at least $65 million.” The complaint alleges that the further loan losses ultimately caused the bank to fail. The SEC action seeks permanent injunctive relief, an officer bar, and civil money penalties.


Though the FDIC has not itself filed a civil action against the former directors and officers of Franklin Bank, in June 2008, as reflected here, the bank’s holding company’s investors did file their own securities class action lawsuit against the failed bank’s former directors and officers, its auditor and its investment banks. In a March 21, 2011 order (here), Southern District of Texas Judge Keith Ellison granted the defendants’ motions to dismiss. The investors have appealed to dismissal. The appeal remains pending.


The SEC action against the two former Franklin Bank officials, along with the investor lawsuit, serve as a reminder that the former directors and officers of a failed bank face significant additional litigation threats beyond just the possibility of a civil action by the FDIC in its role as receiver of the failed bank. Where, as here, the failed institution or its holding company were publicly traded, the potential liability exposures include the possibility of an SEC enforcement action or a securities class action lawsuit. Even though the penalties and clawback amounts the SEC is seeking in the enforcement action would not be covered under a D&O policy, the costs associated with defending this type of enforcement action would likely be covered (assuming that D&O insurance coverage is in fact available). These costs, along with the costs of defending the type of shareholder suit filed here, erode the limits of liability of any applicable insurance, while at the same time competing claimants may be in a race to try and claim a portion of the dwindling policy limits. All of which is a reminder of the strains that post-failure litigation can put on the D&O insurance resources of a failed bank.


The FDIC’s Latest Failed Bank Lawsuit: The FDIC may not yet have filed a civil action against the former directors and officers of Franklin Bank, but it has been active in pursuing claims against the former officials of other failed institutions. In the FDIC’s latest failed bank lawsuit, on April 4, 2012, the FDIC filed a lawsuit in the Eastern District of North Carolina against seven former directors and officers of the failed Cape Fear Bank of Wilmington, North Carolina. In the its complaint (here), the FDIC as receiver for the failed bank seek to recover $11.2 million in losses the bank allegedly suffered on 23 loans the defendants approved between September 27, 2006 and February 27, 2009. The FDIC asserts claims against the seven defendants for negligence, gross negligence and breach of fiduciary duty.


It is interesting to note that the FDIC’s April 4 action against the former Cape Fear Bank officials was brought just short of the third anniversary of the bank’s April 10, 2009 closure. The highest number of bank closures during the current wave of bank failures took place during 2009 and the pace of closures increased as the year progressed. The implication is that 2012 moves forward, the third anniversary of many of the class of 2009 bank closures will be approaching. The likelihood is that pace of FDIC failed bank lawsuit filings will increase for the rest of this year, as the FDIC tries to get out ahead of the rolling statute of limitations dates for the 2009 bank failures.


The latest suit is the 28th that the agency has filed as part of the current wave of bank failures and the tenth so far in 2012. This suit is also the third that the FDIC has filed so far in North Carolina.


While the number of FDIC failed bank lawsuits seems likely to be cranking higher this year, the pace of the bank failures themselves clearly is slowing. Through the end of the first quarter, the FDIC has taken control of only 16 financial institutions so far this year, putting the agency on pace for a total of 64 this year, which would be the lowest number of annual failures since 2008. Given that even the pace so far this year seems to be slowing, the 2012 annual total may well come in below the projected total of 64 closures.


Scott Trubey has an interesting April 8, 2012 article in the Atlanta Journal-Constitution (here) about the failed bank litigation so far and yet to come, with a particular emphasis on the litigation involving failed Georgia banks. Among the many former bank officials that the FDIC has targeted is the former NFL quarterback, Jim McMahon, who was among seven former directors and officers named as defendants in the FDIC’s lawsuit relating to the failed Broadway bank, as discussed in an April 9, 2012 Chicago Sun-Times article (here)


FDIC Settles Malpractice Claim Against Failed Bank’s Lawyers: According to an April 4, 2012 filing in the Western District of Oklahoma (here), the parties to the FDIC’s lawsuit against the former lawyers for the failed First State of Altus Bank of Altus, Oklahoma, have settled the case. An April 7, 2012 article from The Oklahoman newspaper describing the settlement can be found here.


The First State Bank of Altus failed on July 31, 2009. On October 26, 2011, the FDIC, as receiver for the failed bank, filed an action in the Western District of Oklahoma against the bank’s outside law firm, Andrews Davis, and two of its attorneys, Joe Rockett and Matthew Griffith. In its complaint (here), the FDIC as receiver for the failed bank asserted claims for professional negligence and malpractice.


The complaint alleges that the bank failed because of losses it suffered in connection with projects of what the complaint described as the Anderson-Daugherty Enterprise, which the complaint describes as the business efforts of the bank’s former CEO, Paul Daugherty, and Fred Don Anderson, who was CEO of a company called Altus Ventures, a substantial borrower of the bank. The FDIC alleges that the law firm assisted Anderson in planning and implementing the so-called Anderson-Daugherty Enterprise, while at the same time representing both Daugherty personally and the bank itself. The complaint alleges that as a result of these relationships, the law firm and the two individuals had substantial conflicts of interest. The law firm also was allegedly involved in counseling the bank in connection with certain loans to certain enterprises in which Daugherty and Anderson or their related entities had financial interests. The complaint alleges that the bank ultimately suffered losses of over $10 million on related loans.


Neither the April 4 court filing nor the newspaper article about the filing reflects any of the details of the settlement of the case. It is worth noting that though the FDIC filed the lawsuit against the failed bank’s former lawyers, it has not to date filed an action against any of the failed bank’s former directors and officers.


The suit against the lawyers for First State Bank is not the first instance where the FDIC has pursued claims against a failed bank’s former law firm. As discussed here, in October 2011, when the FDIC filed suit against the former directors and officers of the failed Mutual Bank of Harvey, Ill., the defendants included the bank’s former outside general counsel, as well as the former outside general counsel’s law firm. Indeed, on its website, the FDIC reports that as of March 20, 2012, the agency states, without providing any further breakdown, that it “has authorized 29 other lawsuits for fidelity bond, insurance, attorney malpractice, appraiser malpractice, and RMBS claims.”


SEC Files Another Strict Liability Clawback Action: The clawback action the SEC filed against the two former officers of Franklin Bank was not the only action under Section 304 of the Sarbanes Oxley Act that the SEC filed last week. In addition, on April 2, 2012, the SEC also filed a Section 304 clawback action in the Western District of Texas against the former CEO and CFO of ArthroCare. But unlike the case involving the action involving the former Franklin Bank executives, the action against the former ArthroCare executives does not allege that the two individual defendants were involved in or even aware of the alleged wrongdoing. The SEC is pursuing its action against the two ArthroCare executives on a strict liability basis.


In its complaint (here), the SEC alleges that during the tenure of the two ArthroCare executives, two sales ArthroCare executives engaged in a channel stuffing scheme in order to inflate the company’s revenue and earnings. The SEC has pursued a separate enforcement action against the two sales executives. ArthroCare was later required to restate its financial statements for 2006 and 2007. The former CEO and CFO both resigned from the company following the company’s own internal investigation of its revenue reporting practices.


In its compensation clawback complaint against the former CFO and former CEO, the SEC expressly states that it “does not contend” that the former CFO and CFO “participated in the wrongful conduct.” However, the SEC contends, Section 304 requires the former CEO and CFO to reimburse the company for their bonus compensation and stock sale profits garnered during the periods corresponding to the financial statements that were later restated.


The action involving the former CEO and CFO of ArthroCare is not the first occasion on which the SEC has used Section 304 to pursue a compensation clawback even though the targeted executives were not alleged to have been involved in the wrongdoing that caused their companies to have to restate the companies’ financial executives. The SEC previous pursued a clawback action against the CSK Auto; as discussed here, in that case the federal district affirmed the SEC’s authority to seek a clawback without a showing of complicity in the wrongdoing. The district court judge stated that “"the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer’s CEO or CFO."


As discussed here, in a similar case, the SEC pursued a Section 304 clawback action against the former CFO of Beazer Homes, though the individual was not alleged to have been involved in any wrongdoing.


My thoughts on the deeply troubling implications of the increasing trend toward imposing liability even without culpability can be found here. As I have previously noted (here), these provisions allowing for the return of compensation without fault or culpability also raise a host of potentially troublesome insurance coverage issues. The D&O insurance marketplace has responded to these concerns, as many carriers are now willing in at least some cases to add a provision to their policy stating that the policy will cover defense expenses incurred in connection with a SOX 304 action.


An April 2, 2012 post on the SEC Actions blog about the SEC’s clawback action against the former ArthroCare executives can be found here.