Why Did the Bank Fail?: Defending Failed Bank Directors and Officers

 Since the early stages of the financial crisis, nearly 500 banks have failed across the U.S., and even though we are now well past the peak of the financial crisis, banks continue to fail. Yet during the same time as scores of banks were failing, many more banks did not fail – which raises the question of why some banks failed while others did not.

Among the many questions asked after a bank fails is whether the failed bank’s directors and officers violated legal duties they owed to their institution and brought about the institution’s failure. Even the FDIC recognizes that merely because a particular bank failed does not mean that a failed bank’s directors and officers can be held liable. The agency has asserted claims against the former directors and officers of only some of the banks that have failed.

According to the recent Cornerstone Research report about the FDIC failed bank litigation (here), the FDIC has so far filed lawsuits in connection with about 17% of bank failures. However, because of the approximately three year lag that typically follow between the time a bank fails and any lawsuit, the agency has not (yet) filed litigation in connection with the more recent bank failures. Most of the failed bank litigation to date has involved institutions that failed in 2010 or prior. Thus, for example, the FDIC has filed lawsuits or asserted claims in connection with 46% of the banks that failed in 2009, and 34% of the banks that failed in 2010.

But merely because the agency chooses to sue the former directors and officers of only some failed banks but not others does not establish that the individuals the FDIC has chosen to sue violated their legal duties. Holding these individuals liable requires affirmative evidence that they breached their duties.

As Christopher Laursen of NERA Economic Consulting discusses in his February 18, 2014 paper entitled “Failed Bank D&O Litigation, Trends and Economics” (here), “it is not sufficient to merely demonstrate – with the benefit of hindsight – that D&O made decisions that ultimately led to losses.” That is, directors and officers were not negligent – much less grossly negligent – merely because their decision-making failed to anticipate unanticipated outcomes.

The fact is that “even the most well-informed individuals and institutions failed to anticipate the massive deterioration that occurred across financial markets.” Indeed, it is clear from Congressional testimony and other sources that the banking regulators themselves “did not expect the severity and direction of the financial crisis.” Given this backdrop, “it is not surprising that bank D&O often made decisions based on information available at the time, which did not lead to expected results.”

In order to address the question of whether or not failed banks’ directors and officers breached their duties, it is worth looking at why some banks failed while others did not. According to Laurson, the bank failures over the last several years fell roughly into two distinct waves. The first wave of failures, in 2008 and 2009, generally involved larger banks and resulted from losses in assets related to residential real estate. The second wave, roughly from 2010 to the present, has been centered on smaller community banks that specialized in construction and development and commercial real estate lending.

Laursen’s detailed analysis shows that larger banks that failed were more concentrated in residential real-estate loans and mortgage-backed securities than surviving banks of similar size. By the same token, compared to banks that survived, medium and smaller banks that failed had at least a two-fold concentration in construction and development loans.

These data, while suggesting a pattern, are not sufficient to tell a story. In order to understand what happened at any specific bank (and in particular to determine whether or not the bank’s directors and officers breached any duties), it is critical to compare the failed bank to an appropriate peer group of banks. If the surviving banks in the peer group used similar underwriting standards and strategies as did the banks that failed, then “the performance gap may not be attributable to D&O conduct.” The difference in performance “may merely be a product of unforeseen worse conditions and outcomes.”

What the FDIC has sought in the many lawsuits it has filed to characterize as negligent misconduct may be “largely based on poor guidance from regulators and unexpected deterioration in economic and financial conditions.” 

In order for the individual defendants in the failed bank lawsuits to defend themselves against the allegations of wrongdoing, it is necessary in light of “the unanticipated and unprecedented nature of the financial crisis” to “distinguish the effects of underwriting practices from the effects of deteriorating markets.” If the bank’s failure is attributable only to the unforeseen conditions and outcomes rather than individual misconduct, then the individuals should not be held liable.

The need for expert testimony to support these arguments is the point and purpose of Laursen’s paper. In addition, however, the report contains extensive useful and interesting information about the factors surrounding the banks’ failures and the environment that contributed to the banks’ failures. He certainly has a valid point that merely because a bank failed does not establish that the bank’s directors and officers violated their duties, and that if a bank’s closure was merely the result of unanticipated outcomes rather than director and officer misconduct, then the directors and officers should not be held liable.

So, You’re Saying You Wouldn’t Have Paid $19 Billion for WhatsApp?: In case you missed it, on February 24, 2014, Fortune published onlilne an excerpt from Warren Buffett’s forthcoming annual letter to Berkshire shareholders (here). In the excerpt, Buffett uses two real estate investments he made as examples of his investment philosophy. Essentially, he will only make an investment if the prospective investment can be expected to produce an income stream over the next five years sufficient to make the purchase price make sense. Buffett’s advice for investors who aren’t sure they can make this calculation should invest in a low cost index fund, like the Vanguard S&P fund. Buffett’s reasons for suggesting an S&P fund are quite reassuring; he has a great deal of confidence in the future of the American economy.

 Read 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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