SECURITIES LAW CLAIMS AGAINST BANK D&Os
Claims against bank directors and officers have increased dramatically in the last 9 to 12 months. Most of these recent claims allege the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder by failing to disclose adequate and timely material information concerning the bank's loan loss reserves. In virtually every instance where a bank reports a substantial increase in its loan loss reserves, one or more shareholder suits are now filed charging that the bank and its D&Os should have disclosed sooner its declining asset quality and related losses. A recent article in the Boston Globe reported that over 50 shareholder suits have been filed against 18 banks in the region, almost all charging "a continuous course of conduct and conspiracy to conceal adverse material information about the business, finances, financial condition and future business prospects…" of the bank.
These lawsuits are problematic for the bank D&Os for several reasons. Little guidance is available as to the appropriate timing and detail of financial disclosures by banks. Regulators, in the wake of the S&L crisis, are now applying heightened regulatory standards to loan portfolios. Loan loss reserves that would have been acceptable to regulators a few years ago under identical facts may now be viewed as inadequate by the regulator, thus causing sudden and unexpected increases in reserves. In addition, economic conditions have been deteriorating quickly in recent months, causing even further concerns about reserve adequacies. Perhaps the most distressful aspect of these claims is the continuing publicity given by the litigation to the bank's financial difficulties. Public confidence in the financial health of many banks is relatively low in any event. Continuing reminders of large loan loss reserves and operating losses erode that confidence level even more.
To avoid this continuing publicity and the distraction of management at this crucial time, many banks are anxious to settle these claims as soon as possible and before any discovery is conducted. Plaintiffs have parlayed this anxiousness into large settlements at a preliminary stage of the litigation. These quick, inexpensive yet large recoveries entice professional plaintiff lawyers to focus on this type of claim, thereby increasing the frequency of these claims in the future.
Bank directors and officers should be particularly cautions when evaluating the adequacy of loan loss reserves and disclosing changes in those reserves. Consultation with and good faith reliance upon the information and recommendations from legal counsel, accountants, appraisers, appropriate bank employees and perhaps board committees may reduce the likelihood of such a suit being filed and should enhance the defense of the suit when filed. This type of lawsuit is frequently quite defensible if the possibility of litigation is anticipated, a prudent record is established by the D&Os and the claims are aggressively contested by qualified and experienced legal counsel.
NEW LIMITATIONS ON IDEMNIFYING AND INSURING BANK D&Os
In an attempt to further deter and punish financial institution misconduct, Congress in October, 1990, enacted the Crime Control Act of 1990, which includes the Comprehensive Thrift and Bank Fraud Prosecution and Tax Recovery Act of 1990. Although many bankers are still vague about the implications of this new legislation, the banking industry is quite critical of the many sweeping provisions and fearful that the legislation will frighten away from the industry qualified directors and officers.
One of the most troubling provisions in this new law authorizes the FDIC to prohibit or limit an insured depository institution or holding company from indemnifying D&Os against certain loss and from purchasing D&O insurance coverage for that loss. Loss potentially subject to this prohibition or limitation includes any liability or legal expense incurred by a director, officer or employee with regard to any administrative proceeding or civil action by a federal banking agency that results in a final order under which that person is (i) assessed a civil money penalty; (ii) removed or prohibited from participating in conduct of the affairs of the depositary institution; or (iii) required to take certain affirmative action pursuant to a cease-and-desist order.
The FDIC is required by the new law to prescribe by regulation factors, which it will consider when deciding whether to prohibit or limit indemnification and insurance coverage for this loss. Pursuant to the new law, these factors may include whether the director, officer or employee: committed any fraudulent act, breach of fiduciary duty or insider abuse that had a material effect on the financial condition of the institution; is substantially responsible for the insolvency of the institution or its troubled condition; has violated any law or regulation that had a material effect on the financial condition of the institution; or committed certain financial institution related crimes.
The new law is subject to potentially broad interpretation and application by the regulators and therefore is of concern to bankers. The law as enacted represents a partial victory to bankers because unlike earlier versions, the FDIC is authorized to prohibit or limit indemnification and insurance protection only with respect to certain suits and proceedings initiated by regulators in which compensatory damages are not sought. However, D&Os can be subjected to substantial defense costs and other loss in such regulatory proceedings. Pursuant to this new law, the D&Os may have no indemnification or insurance protection for such loss.
The new legislation appears to prohibit only the depository institution or holding company from purchasing the referenced insurance coverage. Individuals concerned about this potential loss in coverage may be able to circumvent the statutory insurance prohibition by personally paying a portion of the D&O insurance premium, thus arguably purchasing themselves the coverage which the bank itself is prohibited from purchasing. Banks and their D&Os are encouraged to consult their legal counsel concerning the ramifications of this important new legislation and possible methods to minimize the potentially adverse ramifications of the new law.
RESOLVING ALLOCATION DISPUTES IN THE 1990s
Perhaps the most troublesome coverage issue that arises in a D&O claim is the allocation issue. However, few insured D&Os understand that issue or appreciate its complexity prior to a claim. By focusing on the issue before a claim is made, the insureds, their broker and the D&O insurer can better resolve the issue when it arises. The need for allocation arises in several contexts. First, a lawsuit may assert claims against both insured D&Os and other non-insured persons including the corporation. Second, claims asserted against an insured D&O may include both insured and uninsured claims. The D&O insurer is obligated to pay only that portion of defense costs or settlement amounts which can reasonably be allocated to the insured D&Os and to the insured claims.
This issue is difficult because there is no well-defined, universally accepted standard to determine the proper allocation. As recognized by a federal appeals court in October, 1990, allocation under a D&O insurance policy requires a "fact-intensive inquiry" and will therefore vary from case to case. In addition, some conceptual issues are involved. For example, what method should be used to allocate liability between a corporate defendant and D&O defendants since a corporation acts by or through its agents? Courts consistently make such allocations by apportioning to the corporation the losses resulting from its corporate wrongdoings and to the D&O defendants the losses resulting from the wrongful acts which they commit.
Unfortunately, the need to allocate defense costs sometimes creates tension between D&O insureds and their insurer at exactly the moment in their long-term relationship when such tension is least desirable; i.e. when a D&O claim is first made. Under current D&O coverage concepts, there is no practical way to avoid this issue. Instead, the goal should be to handle it in a fair and equitable manner. Suggestions to accomplish that goal include:
AVOID SURPRISE
D&Os should understand the need for allocation before a claim is filed and be prepared to address the issue objectively and in a constructive manner. D&Os who learn for the first time after a claim is made that the insurer will not pay 100% of the defense costs are frequently surprised and sometimes upset with the insurer, thus aggravating the situation.
COMMITMENT TO RESOLUTION
The allocation issue can best be resolved through good faith negotiation, which may at times be tedious and difficult. A commitment to resolve the issue through negotiation, rather than hastily seeking a third-party adjudication, will usually enhance the chances of a cost-effective and timely resolution.
ARBITRATION/MEDIATION
Too frequently, insureds rush to court to seek resolution of D&O insurance disputes. Although insureds may believe they will receive favored treatment in court, in reality no one (other than perhaps the attorneys) typically "wins" a lawsuit. Alternative dispute resolution methods, such as binding arbitration as provided in the ACE and CODA D&O policies, assure a fair resolution of the dispute sooner and cheaper than traditional litigation.
The severity of this difficult claim issue can be reduced through an appreciation by all concerned of the competing interests and by committing to a good faith, cooperative dialog when the issue arises.
D&O LIABILITY LOSS PREVENTION
An article in the May-June 1990 Harvard Business Review entitled "Why Sane People Shouldn't Serve on Public Boards" persuasively concludes "the economics of being a director are fundamentally off balance. For a fixed amount of money in the near term, directors expose their time, reputations and finances to great risk." Unless this "great risk" is managed properly and reduced where possible, strong and competent outside directors may be unwilling to serve, thereby jeopardizing the integrity of corporate governance. Even the most effective D&O loss prevention program cannot prevent D&O claims in their entirety. However, recent statistical studies tend to confirm that the frequency and severity of D&O claims can be reduced and the ability to defend the claims when made can be improved by an appropriate D&O loss prevention program. In addition, such a program can improve management's performance and the quality of decisions made on behalf of the organization.
Some resource materials are now available to assist risk managers, officers, directors and consultants in structuring a loss prevention program for an organization. Perhaps the most noteworthy of these resources is a series of loss prevention booklets recently published by Chubb Group of Insurance Companies addressing loss prevention for directors and officers of for-profit corporations, non-profit organizations and financial institutions and for ERISA fiduciaries. It is important to recognize what these resource materials are and are not. They are a compilation of various ideas to improve the structure, processes and effectiveness of corporate governance. They are not a listing of legally required procedures which if not followed will constitute a breach of duty or other illegal act by D&Os. These materials are not a blueprint of the ideal loss prevention program for every organization. Each organization should tailor its own unique program in light of its particular position, background, structure and management personalities.
The single most important goal of any D&O loss prevention program is to sensitize directors and officers to the fact that everything they do can be scrutinized with the benefit of 20/20 hindsight for possible wrongdoing and can result in a claim against them. Once D&Os fully appreciate the fact that every decision and indecision can potentially create a D&O claim, they will likely identify and implement common sense loss prevention ideas on their own.
The topic of D&O loss prevention should be approached with forethought. If presented improperly, directors and senior management may perceive the program as dictating how they should perform their jobs, thus destining the program for failure. Frequently, one of the most important decisions in structuring and implementing a D&O loss prevention program is identifying how and through whom the topic should be presented to the board and senior management. Depending upon the circumstances, the best procedure may include one or more of the following: a formal presentation by in-house or outside legal counsel, by the in-house risk manager or by an outside consultant; a less formal discussion by the board about the need for and desirability of a D&O loss prevention program; a distribution of D&O loss prevention material to directors to review at their leisure; or a general brainstorming session of the board, a board committee and/or senior management to identify areas or methods by which the organization can enhance the effectiveness and efficiency of its governance processes.