By Katie Kuehner-Hebert
Although the economic crisis seems to be ratcheting down, directors and officers of failed banks should still beware.
The Federal Deposit Insurance Corp. is ramping up its filing of lawsuits against directors and officers of failed banks to recoup losses in the agency's Deposit Insurance Fund. That could have serious effects on the directors' and officers' (D&O) insurance market not only for troubled banks, but also for much of the industry, experts said.
The pace of such FDIC litigation "increased markedly" in the fourth quarter of 2012, according to a December report by Cornerstone Research. Twenty-three lawsuits were filed for the year, with nine lawsuits filed in the fourth quarter as of the report's Dec. 7 closing date, after a lull during the second and third quarters (The FDIC has not updated its fourth quarter figures as of this magazine's press time, but it appears that since the report, one lawsuit was filed on Jan. 17.)
The uptick in recent lawsuit filings compares to 16 filings in 2011 and two in 2010. The FDIC has filed lawsuits against about 9 percent of the 467 financial institutions that have failed since Jan. 1, 2007.
The total lawsuit filings on failed banks within this last crisis could ultimately be comparable to the amount of filings by regulators against failed institutions during the savings and loan crisis of the late 1980s, said Katie Galley, a Cornerstone Research senior vice president based in Los Angeles and one of the authors of the report. About a quarter of the failed institutions in that crisis were sued.
"The number of problem institutions remains high, so I don't know if we're out of the woods yet in terms of failures, though the number of failures has substantially slowed since the crisis," Galley said.
Nearly 700 banks were classified as "problem institutions" by the FDIC as of September, according to the report.
Yesim Richardson, a Cornerstone vice president based in Boston and another author of the report, said there will likely be quite a few more cases this year, as the three-year statute of limitations for tort claims is coming up this year for the 157 banks that failed in 2010 -- the highest number of failures in a year since the start of the crisis.
The FDIC's choice on which failed banks to target depends in part, on how much the agency speculates it can recover from their D&O carriers, Galley said.
"It's pretty clear that D&O insurance is playing a big role in the intent of the FDIC to recover losses associated with bank failures," she said. "Absent directors and officers having significant personal assets, the D&O insurance represents the majority of the funds the FDIC can recover from these individuals."
Each case is independent -- the FDIC has to conduct an investigation to determine if a case is meritorious and cost-effective, Galley said. While the FDIC may believe a bank's directors and officers acted with "gross negligence," their behavior may have been limited to just a small amount of loans, and consequently, the FDIC might not decide it is cost-effective to file a lawsuit, she said.
Gross negligence is the minimum standard of care for which bank directors are held liable except where state law allows for simple negligence -- though in some cases, that standard might be challenged, she said.
While the FDIC might believe a bank should have stopped earlier or was reckless in pursuing certain loans after 2007, the crisis evolved fast and "almost no one saw it coming," Galley said.
"Defense attorneys could argue that there were just very dramatic, unforeseeable changes," she said. "Indeed, many of these banks could show that they were still receiving CAMELS ratings of 1 or 2 by their examiners, up until just two years before the failures occurred."
CAMELS ratings, given on a scale of 1 to 5 (with one being the best) are based on the adequacy of an institution's capital, assets, management, earnings, liquidity and sensitivity to systemic risk.
Kevin LaCroix, an attorney and executive vice president at RT ProExec in Beachwood, Ohio, and a blogger with The D&O Diary, said the FDIC is currently trying to negotiate "a fair amount" of settlements with a number of D&O carriers of failed banks, to prevent lawsuit filings.
"In most cases, the insurers are defending the claims, and the FDIC is trying to compel insurers to negotiate a settlement," LaCroix said. "That isn't happening in every case -- the IndyMac case went all the way to a jury verdict."
On Dec. 7, a jury in federal court in Los Angeles found three former officers of IndyMac Bank liable for $169 million in damages in connection with 23 loans. This was the first D&O lawsuit filed by the FDIC after the 2008 financial crisis and the first case to go to trial. The case was brought against four former officers of IndyMac. At the time of trial, only three remained in the case. The fourth settled with the FDIC earlier in the year for $4.75 million -- to be paid by D&O insurance.
Jeffrey Tisdale, managing partner at Tisdale & Nicholson LLP in Los Angeles, and one of the attorneys representing 11 failed bank groups, said the FDIC has another 45 or so cases that have already been approved for litigation byits board of directorsand is attempting to get authority to suefrom the FDIC board of directors foreven more cases.
"The FDIC is trying to get the D&O carriers toparticipatein mediationand pay out the limits ofany applicable policy, but if the insurance companiesmake clear that theywon't cooperate and the FDIC thinks its case is strong enough, the agencyis increasinglyseeking authority to sue from its board of directors," Tisdale said."Howoften it will act on such authoritywith thefiling of litigation only time will tell,butwe already are seeing the battle lines being drawn."
After nine quarters of D&O insurance rate increases from the start of the crisis in 2007 until the fourth quarter of 2009 -- and then seven quarters of rate reductions as the industry stabilized, the D&O market is again changing due to increasing settlements of crisis-related claims, said Tom Orrico, managing director of Marsh's FINPRO and financial institutions practice leader in New York.
"We're seeing some high-profile settlements, including shareholder security class action settlements, derivative settlements, regulatory enforcement action settlements, overdraft fee settlements and mortgage-backed securities settlements," Orrico said. "The banks in these settlements are starting to recoup some of these losses, and as a result we're starting to see the market change."
Orrico would not classify the market for D&O as a hard market, "but it's becoming much more challenging."
He and his team are advising their bank clients to start their D&O renewal process very early -- 120 to 180 days prior to renewal, he said. Secondly, banks should meet with their underwriters, to discuss how their risk profile is different than the prior year or from the credit crisis.
Banks should also make sure policy contracts specifically address their particular exposures, as well as regulatory issues and proceedings, and that the policy's definition of a claim includes claims brought by regulators, including subpoenas, target letters and "Wells notices."
"Try to get some form of regulatory coverage, versus not having it at all," he said.
Moreover, banks should do business with an insurance company that is financially stable and has experience with D&O litigation and adjusting D&O claims.
"We found that smaller banks may have been with smaller insurance companies and brokers and when faced with a D&O claims, they may not have had the proper advice to maximize claim recovery and mitigate loss," Orrico said. "Whereas a larger, more experienced company can give advice to mitigate damages in a way that everyone benefits."
KATIE KUEHNER-HEBERT lives in California. She can be reached at firstname.lastname@example.org.
March 1, 2013
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