Seven Lessons Learned from D&O Litigation During the Financial Crisis

Dennis Klein

The recent financial crisis, and the resulting litigation, has led to a wealth of knowledge as to how current directors and officers can limit their exposure to potential liability.  Seven takeaways that directors and officers should have from this experience are as follows:

LESSON #1 – A DIRECTOR CANNOT BE A POTTED PLANT

 A director must be proactive in ensuring that the bank has adequate policies and practices in place, and that they are followed.  In particular, monitoring loan portfolios and concentrations, aggregate policy exceptions,[1] and conducting regular stress tests[2] are essential to knowing the health of a bank.  Proactive director participation is especially important to protect sensitive customer information for banks that experience periods of rapid growth and move to digitize files and increase online banking services. 

Finally, directors should be wary of blindly following strong leaders who seek to try to pack the board with friends, family, and directors whom they can otherwise influence or control. [3]  Directors have an obligation to stand up to “strong man” executives when his or her actions would not be in the bank’s best interests.

LESSON #2 –DOCUMENTING CORPORATE DECISIONS CAN BE KEY TO AVOIDING FUTURE LIABILITY

Since courts emphasize the process by which the decision at issue was made, [4] directors and officers should properly inform themselves, and make a record of the steps they took to do so, prior to taking an action.   In particular, the minutes and other records of meetings should be accurate and reflect the consideration that went into a decision. [5]  Documents distributed during board meetings can be crucial for avoiding future liability, and should accordingly be attached to the minutes for the meeting.  Finally, if the proposed loan requires an exception to the bank’s policies, that exception should be explicitly noted in the minutes, along with the justification for approving the exception.

LESSON #3 – ENSURE THAT THE CORPORATION HAS AND FOLLOWS ADEQUATE DOCUMENT RETENTION POLICIES

Directors and officers must demand that the corporation has policies for maintaining the minutes and records, and that those policies are followed, since such minutes can do directors and officers no good if they are lost or destroyed prior to litigation.  In particular, minutes – and all attachments – should be kept together and retained indefinitely.    The policy should vest an individual, perhaps a dedicated records manager, with responsibility for executing the document retention policy.  The document retention policy should also extend to documents individuals take home.  Sensitive information (such as the personal information of borrowers) could be contained in such documents, and regulatory agencies prohibit the disclosure of non-public personal information of borrowers.[6]

LESSON #4 –STATE LAWS PROVIDE A SHIELD AGAINST DIRECTOR AND OFFICER LIABILITY BUT HAVE LIMITATIONS

Numerous state laws provide protection for directors and officers in litigation, but each have limitations.  Perhaps the most powerful law for defending directors and officers is the business judgment rule.  In general, the rule protects good-faith business decisions.  

Although the rule insulates the decision makers from ordinary negligence,[7] it can typically be overcome by a showing of gross negligence.[8] States may differ in whether the rule applies to both directors and officers (e.g., Delaware[9]), only to directors (e.g., Florida[10]), or only to “outside” directors (e.g., California[11]).

Insulating statutes can exculpate directors from liability for certain actions.  Some of these insulating statutes are “mandatory,” such as Florida’s statute, which automatically limits directors’ liability to breaches of duty that were, inter alia, reckless or in bad faith.[12]  Other states, such as California, have “permissive” insulating statutes, which only apply if the corporation includes an exculpatory clause in its Articles of Incorporation.[13]  Insulating statutes, whether mandatory or permissive, typically do not provide protection for certain conduct, such as intentional wrongdoing.

Further, state law could allow a corporation to indemnify a director or officer.  The indemnification is typically provided for in the corporation’s charter documents.  As with insulating statutes, indemnification statutes can be mandatory or permissive.

LESSON #5 – BY LAW, BANKING REGULATORS ARE “SUPER-PLAINTIFFS”

Banking regulators enjoy immense advantages in claims against directors and officers.  The Financial Institution Reform, Recovery, and Enforcement Act (“FIRREA”) sets a minimum limitations period for claims that have not yet expired at the time of the bank’s closing of 3 years for tort claims and 6 years for contract claims.[14]  As receiver, the FDIC enjoys a number of other powers typically not afforded to plaintiffs, such as broad power to issue subpoenas.[15]

In addition, defenses that might prevail against other plaintiffs are unlikely to succeed against banking regulators.  A defense that the economy was a superseding cause of the failed loans, for example, must show that the economic downturn was a highly improbable and extraordinary event that was not reasonably foreseeable.  Since downturns have occurred many times, they are, therefore, probably not unforeseeable events.  The comparative negligence of banking regulators in failing to identify poor policies or loans during examinations has also been generally unavailing, as many federal courts have found that the FDIC as regulator owes no legal duty to the directors and officers to conduct bank regulatory examinations in any particular manner.[16]

LESSON #6 – D&O INSURANCE IS A LAST LINE OF DEFENSE, NOT A COMPREHENSIVE SHIELD AGAINST LIABILITY

D&O insurance is an important safety measure in protecting directors and officers in potential litigation, but should not be viewed as the primary shield against liability.  As an initial matter, directors and officers should insist that their corporation maintains D&O insurance with sufficient limits of liability.  While there is no formula for determining what amount of liability is “sufficient,” most D&O insurance policies are “wasting”, meaning that defense costs are drawn down from the policy limits.  Failure to ensure that there is sufficient coverage to cover the legal costs of a protracted litigation could expose director and officer defendants to personal liability for remaining defense costs, settlements, and/or judgments.  If the corporation’s current policy limits are insufficient, excess policies can be purchased to increase the aggregate coverage (typically with the same terms as the underlying primary policy).

The policy may also contain a number of exclusions that could block coverage.  For example, many policies contain a “prior acts” exclusion, which precludes claims for events or transactions that occurred prior to a specific date.  Another common exclusion is the insured versus insured exclusion, which typically precludes coverage for claims brought by an insured person (or the corporation) against any other person (or the corporation).  A third exclusion that arises in bank failure cases is the regulatory exclusion.  This precludes coverage for suits brought by governmental, quasi-governmental, or self-regulating agencies.  If possible, directors should avoid such exclusions that could limit the scope of their coverage.

LESSON #7 – INDEPENDENT COUNSEL CAN BETTER REPRESENT THE INTERESTS OF DIRECTORS AND OFFICERS WHEN LITIGATION IS ANTICIPATED

Independent counsel, paid out of pocket rather than from the insurance proceeds, can be especially useful during litigation.  Independent counsel could monitor counsel hired by the insurer in order to keep litigation costs low and preserve the policy limits.  Additionally, independent counsel can be instrumental in advocating a settlement within policy limits in order to protect the defendants from personal liability.  Finally, if the insurer refuses to settle the case within policy limits after a policy limits demand by the plaintiff, independent counsel can help the directors and officers settle the claim without the consent of the insurer.  In such agreements – known alternatively asCoblentz, Damron, or Miller-Shugart agreements – the defendant directors and officers assign the plaintiffs any claims they may have against the insurer for refusing the defend them under the policy.[17]  This can allow the directors and officers to exit the litigation early, and let the insurer and plaintiff, rather than the directors and officers, expend resources litigating coverage under the policy.

CONCLUSION

 Litigation from the recent banking crisis has taught hard-earned lessons – some common sense and some counter-intuitive – into how current directors and officers can limit their future liability.  While these seven lessons scratch the surface of what can be learned, they demonstrate that directors must be constantly vigilant in performing their duties, documenting their decisions, and[18] ensuring they are adequately insured and represented by competent counsel.

This article is for informational purposes only and is not intended to be relied upon as legal advice.  A lengthier version of this article is scheduled for publication in “The Review of Banking and Financial Services.”

Dennis Klein (Dennis.klein@hugheshubbard.com) is a partner in the Miami, Florida office of Hughes Hubbard & Reed LLP.  Tyler Grove, an associate in the Washington, DC office, and Jeffrey Goldberg, an associate in the Miami office, assisted with this article. 

[1] See FDIC, DSC Risk Management Manual of Examination Policies (“FDIC Examination Manual”) at 3.2-9 (Dec. 2004), available athttps://www.fdic.gov/regulations/safety/manual/  (“Institutions should also establish limits for the aggregate number of policy exceptions.”)

[2] To implement the Dodd-Frank Wall Street Reform and Consumer Protection Act, the FDIC recently required annual stress tests for banks with assets over $10 billion. See 12 C.F.R. § 325.204.

[3] See, e.g., FDIC v. Aultman, No. 2:13-cv-00058-FtM-99SPC, Complaint at ¶ 3, 17 (M.D. Fla. Jan. 29, 2013) (alleging bank CEO dominated bank and defendant directors “never made more than token attempts to monitor, supervise, and restrain him”); FDIC v. Coburn, No. 7:12-cv-00082-BO, Complaint at ¶¶ 14 (E.D.N.C. Apr. 4, 2012) (alleging that the bank’s CEO “dominated the Board and the Bank’s lending”).

[4] See, e.g., Panter v. Marshall Field & Co., 646 F.2d 271 (7th Cir. 1981).

[5] See FDIC Examination Manual at 4.2-9 (“Decisions regarding these considerations [regarding whether to undertake financial statement audits, internal control reviews, or additional auditing procedures] and the reasoning supporting the decisions should be recorded in committee or board minutes.”)

[6] See, e.g., 12 C.F.R. § 332.10.

[7] See e.g., FDIC v. Rippy, 799 F.3d 301 (4th Cir. 2015).

[8] See Smith v. Van Gorkom, 488 A.2d at 872-75.

[9] See, e.g., Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1162 (Del. Supr., 1995).

[10] See FLA. STAT. § 607.0830.

[11] See Van Dellen I, 2012 WL 4815159, at *6-8; FDIC as Receiver for County Bank v. Hawker, No. 1:12-cv-00127, slip op. at 7-10 (E.D. Cal. June 7, 2012); and FDIC as Receiver for IndyMac Bank, F.S.B. v. Perry, No. 11-cv-05561, 2012 WL 589569 (C.D. Cal. Feb. 21, 2012).

[12] See Fla. Stat. § 607.0831.  Recklessness is defined as acting “in conscious disregard of a risk” that was “[k]nown to the director, or so obvious that it should have been known, to be so great as to make it highly probable that harm would follow” from such breach.  Id.  At least one court has said that this statute prevents liability except for breaches of duty that amount to “more than gross negligence.”  See FDIC v. Gonzalez-Gorrondona, 833 F. Supp. 1545, 556 (S.D. Fla. 1993).

[13] See California Corporate Code § 204(10).

[14] Id.

[15] Id. at § 1821(d)(2)(I)(i).

[16] See First State Bank v. United States, 599 F.2d 558, 566 (3d Cir. 1979), cert. denied, 444 U.S. 1013 (1980); FDIC v. Butcher, 660 F. Supp. 1274, 1281-82 (E.D. Tenn. 1987).

[17] See Coblentz v. Am. Sur. Co. of N.Y., 416 F.2d 1059 (5th Cir. 1969); Damron v Sledge, 460 P.2d 997 (Ariz. 1969); Miller v Shugart, 316 N.W.2d 729 (Minn. 1982).

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