Now more than at any time since the savings and loan (S&L)crisis in the 1980s, directors and officers of financialinstitutions must be aware of liability risks related toperformance of their duties.

All indications point toward the Federal Deposit Insurance Corporation(FDIC) digging in for a litigation campaign against bank directorsand officers of the same size and scope as the S&L crisis. OnNov. 1, 2010, the FDIC filed its second lawsuit against officers ofa failed bank, Heritage Community Bank in Illinois, following theFDIC's first such suit in July 2010 against former officers ofIndyMac Bank. On Jan. 14, 2011, the FDIC filed two more suitsagainst former officers of Integrity Bank of Alpharetta, Ga., andof 1^st Centennial Bank in California. 

These suits are at the leading edge of a building wave oflitigation against bank directors and officers. In addition to thefour suits identified above, the FDIC has authorized suits againstnumerous other officers and directors of failed banks. In total, asof the end of February 2011, the FDIC has authorized suits against130 officers and directors, seeking total damages of over $2.5billion.

The FDIC has hired a substantial number of lawyers for thespecific purpose of litigating FDIC claims against directors andofficers of failed financial institutions. The agency recentlyreported to Congress that its "professional liability activitiesare expected to increase substantially" moving forward. A formersenior FDIC official was quoted as saying that about half of thefailedbanks will see some form of litigation against its directorsand officers.

What the FDIC Is DoingNow

Over the last twelve to eighteen months, counsel for the FDIChas been contacting a substantial number of former directors andofficers of failed financial institutions, often with some form ofdemand letter, tolling agreement, or both. (In a tolling agreement,the potential director/officer target of the lawsuit agrees thatthe statute of limitations can be extended against that personwhile the FDIC considers how to proceed. In most instances, thetargeted director/officer agrees to tolling in hopes that the FDICultimately will opt not to file the lawsuit.)

Recent litigation has involved the first failed banks of 2007and early 2008. For the most part, the FDIC appears to be targetingthe institutions chronologically, addressing the earliest failuresfirst and continuing down the list while staying within the statuteof limitations (tolling agreements among other factors can changethat order). For example, the failureof IndyMac Bank in California occurred July 11, 2008, and theFDIC's lawsuit against former officers at IndyMac was filed on July10, 2010, almost two years to the date. The IndyMac complaintasserted 68 causes of action against former officers.

Unlike a securities class action, which has stringent statutoryand case law pleading requirements for securities fraud claims,FDIC complaints typically assert negligence and breaches of duty ofcare, which are not as easily subject to dismissal beforediscovery. Because the FDIC has authorized a large number ofadditional suits, it is a near certainty that similar litigationinvolving more recent bank failures will begin to build in the next12 to 24 months.

The FDIC follows a consistent process for assessing potentialclaims when an FDIC-insured financial institution fails.

First, the FDIC attorneys in its professional liability groupopen an investigation to identify potential claims againstdirectors, officers, and carriers, as well as independentaccountants, attorneys, appraisers, or anyone else who providedprofessional advice to the failed bank. These investigations areseparate from the material loss reviews conducted by the FDICOffice of InspectorGeneral.

Because the FDIC is typically a receiver of the failed bank, ithas access to all of the bank's internal documents. FDICinvestigators also have the power to subpoena bank officials andothers as a means of gathering additional evidence.

Findings from the investigation are sent to the senior FDICsupervisory and legal staff for review, and litigationrecommendations are made to the FDIC board of directors or designeefor final approval.

What Is on the FDIC'sRadar

The FDIC reports that contributing factors leading to bankfailures include material loss reviews during each perioddescribed, inadequate policies and controls, overly aggressivebusiness strategies, and lack of oversight (particularly withregard to underwriting) – all similar underlying factors in thesavings and loan crisis 20-25 years ago. From the few demandletters that are publicly available, such as the one sent toBankUnitedin Florida, the FDIC's claims also appear to track those assertedduring the savings and loan crisis. The FDIC is more likely topursue cases where the underlying factors for bank failure arealleged to go beyond just the economy and other market-wideeffects, such as:

1)     Uninformed orinattentive boards, with the primary factors being lack ofknowledge or inattention to lending policies, failing to adequatelyreserve for loan losses, and general risk management controls overlending practices

2)     Operationalweaknesses, such as understaffing appraisal departments

3)     Overly aggressiveactivity such as rapid and unprepared growth, inappropriatelending, or over-concentration of assets in certain products (forinstance, in BankUnited, Option ARM products)

4)     Dishonest conduct byofficers or directors

5)     Approval orcondonation of abusive transactions with insiders 

While the FDIC has a pecuniary interest in maximizing totalrecovery and therefore will focus many of its resources on largerbank failure cases, smaller-scale cases are unlikely to be ignored.During the savings and loan crisis, the average recovery by theFDIC was around $2 million, with most of the D&O lawsuitsinvolving banks with less than $1 billion in assets. The FDIC hassaid it will pursue any case it deems cost-effective to do so.Therefore, one can expect the FDIC to bring a large number of caseseven where potential recoveries are not significantly greater thanexpected costs of litigation.

Other Potential Litigation Threats

In addition, for those companies, institutions, and individualssubject to Securities and ExchangeCommission (SEC) jurisdiction, the SEC represents a separateand independent litigation threat from the FDIC and othergovernment agencies. SEC jurisdiction exists for public companiesor those having something to do with the sale or transfer ofsecurities (which is often broadly defined, expanding SECjurisdiction). About one-quarter of banks that have failed inrecent years are publicly held. Even in non-public banks, or salesunder exemption, there may be significant exposure to litigationdue to disclosure requirements of the securities laws andbroad-based shareholder groups. 

Assuming recent budget issues are resolved, other developmentswould indicate that the SEC and other government agencies, as wellas private plaintiffs, are likely to become increasingly moreinvolved in these issues in the coming months. The Dodd Frank Act,while only applicable to reporting companies, is a broadwhistle-blower provision currently in force. Because of the DoddFrank Act, the SEC and many plaintiff's lawyers are reporting asizable spike in the number of whistle-blowers going to the SEC andplaintiff's firms. The provision requires the SEC to award betweenten and thirty percent of all recoveries over $1 million towhistle-blowers who satisfy certain requirements (such as being theoriginal source of the information and other provisions similar tothe federal False Claims Act). 

The Fraud Enforcement Recovery Act and federal health carelegislation also amended the False Claims Act (FCA), bolstering theFCA following a period where its reach was scaled back by thecourts. These amendments generally make it easier forwhistle-blowers to assert misuse of government funds under the FCA,increasing the potential litigation threat to members of thefinancial services industry. Some bank directors and officers alsomay face criminal investigations.

Preparing to Defend Potential Claims

In sum, the wave of coming FDIC litigation focused at directorsand officers is preparing to hit shore. In preparation for thisapproaching wave, bank directors and officers should be careful tokeep well-documented records of their oversight and preparation andconsideration of alternatives in decision-making. An additionalprudent measure is conducting a review of director and officerinsurance policies to ensure appropriate coverage for claims fromregulators, shareholders, and vendors. In the event a claim isinitiated, directors and officers should immediately provideappropriate notification to carriers. If the FDIC or otherauthorities come knocking, these policies may be one of the onlythings standing between individual bank directors and officers andpotentially significant personal liability.