In the wake of the current round of bank failures, the
FDIC has filed
a number of lawsuits against former directors and officers of failed banks,
indicated that it intends to file more. Among the issues this litigation
raises is the question of when the former directors of a failed bank can be
held liable. As discussed in an August 10, 2011 memo from the Manatt, Phelps
& Phillips law firm (here), a
recent decision a case in the Central District of California involving a failed
credit union may provide some insight into this question.
First, some background. Section
11(k) of the Federal Deposit Insurance Act provides that directors and
officers of failed institutions can be held liable "for gross negligence." in
an action brought by the FDIC in its role as receiver. As explained in the FDIC's
online materials about professional liability claims, case law interpreting
this statute has established that "state law, not federal common law provides
the liability standard for directors and officers, and that section 11(k)
provided a gross negligence floor for the FDIC claims in states with insulating
statutes." (State insulating statutes allow corporations to amend their
bylaws to limit the civil liability of the corporations' directors.) As a
result, even in states with insulating statutes, directors cannot protect
themselves from FDIC claims based on gross negligence.
The recent decision in the Central District of California
involved a case brought by the National Credit Union Administration (NCUA) against
16 former directors and officers of Western Corporate Federal Credit Union
(WesCorp). As discussed at greater length here,
the NCUA alleged that the defendants had allowed WesCorp to purchase vast
amounts of securities backed by Option ARM mortgages without appropriate
analysis of the creditworthiness of the underlying securities or appropriate
regard for the limits on concentrations in the company' s portfolio.
In an August 1, 2011 order (here),
Central District of California Judge George Wu granted the
director defendants' motion to dismiss the NCUA's most recently amended
complaint, for reasons discussed in the court's July 7, 2011 minute order (here).
In the July 7 minute order, Judge Wu noted that "the business judgment rule
protects the director defendants," adding that the director defendants "may
have made choices-or not made choices - with which the NCUA disagrees, but that
does not mean they failed in their responsibilities so severely that they lose
the protection of the business judgment rule."
Judge Wu drew a distinction between the officer
defendants (whose dismissal motion he denied) and the director defendants,
observing that "the question in assessing the director defendants' liability vis
a vis the Option ARMs and concentration levels is what the director
defendants knew at the time that should have dictated to them that they do
something more or different from all that they did do." He concluded that the
NCUA has "failed to present sufficient allegations in this regard, so as to fit
within the exceptions to the business judgment rule."
The law firm memo linked above observes that the holding
in the WesCorp case is "equally applicable to actions brought by the FDIC
against former directors of a failed bank." In that regard, it is worth noting
that the FDIC itself has said, in its online materials describing its approach
to professional liability claims, that it is the FDIC's "long-standing internal
policy" of pursuing claims against outside directors only where "the facts show
that the culpable conduct rises to the level of gross negligence or worse." In
other words, the FDIC itself has said that it is not its policy to pursue claims
against directors based on mere negligence. The law firm memo suggests,
by reference to the WesCorp case, that conduct within the protection of the
business judgment rule by definition is not grossly negligent, and therefore
cannot serve as a basis for director liability.
In the law firm memo, the author notes that the
misconduct that the FDIC has alleged in many of the cases it has filed as
part of the current wave of bank failures arise in the context of the collapse
of the residential real estate market and against the background of the global
economic crisis. In light of those circumstances, the FDIC's allegations may be
susceptible to the argument that it is "attempting to substitute its after-the
-fact judgment for that of the board made in real time." The business
judgment rule exists to "prevent a court from second guessing honest, if inept,
Directors' protections under the business judgment rule
may, however, be overcome where, for example, there is evidence that the directors'
"improper motives or undue influence, conflict of interest" or where the
directors failed to be "fully informed before making decisions."
The possibility of being drawn into an FDIC lawsuit is a
recurring source of anxiety for outside directors of failed or troubled banks.
Indeed, the FDIC has filed a number of these suits and clearly intends to file
more. But directors concerned about the possibility of this type of litigation
can be reassured, first, that it is the FDIC's own policy only to pursue claims
against outside directors where it believes there is evidence of gross
negligence, and, second, that as a result of the protections of the business
judgment rule, the directors cannot be held liable for actions that merely
prove to have been mistaken or even inept. Judge Wu's ruling in the Wescorp
provides directors reassurance that defendant directors may even be able to get
the claims against them dismissed -- even if claims against the officer
defendants are not -- where the allegations presented are insufficient to meet
The law firm memo concludes with a number of lessons for
current bank directors from the current environment and from the FDIC's
allegations in the cases that it has filed so far. Among other things, the memo's
author notes the following: that board membership is a serious responsibility
for which the individual directors must be willing to devote "substantial
amounts of time" in order to perform their duties in accordance with the FDIC's
expectations; that board members are "charged with holding management's
feet to the fire in addressing strategic challenges and operational problems";
that directors must act independently and must not "turn a blind eye to unsafe
or unsound practices; and that directors "must be very sensitive to the
appearance of a conflict of interest."
other items of interest from the world of directors & officers liability,
with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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