FDIC D&O Suits Likely Despite Lag In Activity In Recent Years

History can have an unpleasant way of repeating itself.

If recent activity by federal banking regulators is any indication, many bank executives will face a costly rendezvous with history within the next few years. For those bank officials, ensuring the strength of their directors and officers liability insurance programs now could be critical in protecting their personal wealth later.

Regulators, once again responding to a crisis in the financial institution industry, are beginning to turn to a measure they invoked in the aftermath of the Savings and Loan meltdown a generation ago. During that period, more than 1,000 thrifts failed, at a cost of $124 billion to the federal government, according to the Federal Deposit Insurance Corp.

In an effort to recover a portion of the government's losses, federal agencies sued former directors and officers of approximately one-quarter of the failed thrifts–a tactic that allowed the government to tap the executives' D&O liability insurance.

The government eventually recovered $1.3 billion of D&O insurance proceeds.

Now, the FDIC may again be looking at D&O insurance as a resource for replenishing at least a portion of the government's losses resulting from the recent spate of bank failures.

Since the beginning of the recession in December 2007, hundreds of banks have failed, including 140 in 2009 and 120 through the first nine months of this year.

The FDIC already has sent civil demand letters to some former directors and officers, perhaps so they can place their insurers on notice of an impending claim. In the letters, the FDIC often does not list any charges but warns that it might file suit against them at a later date.

The FDIC may be sending the letters now to ensure that the potential defendants have insurance to draw on if the agency pursues a claim.

Significantly, the former head of litigation at the FDIC has predicted that up to half of all directors and officers of failed banks will be sued. That's an observation that should grab the attention of all bank executives because bank failure statistics likely will deteriorate.

Through the second quarter of this year, the FDIC had placed 829 banks on the agency's list of problem facilities. That figure represents more than 10 percent of the nation's 7,800 banks and is nearly a 100 percent increase over the total at the end of the second quarter of 2009.

The financial hole that the FDIC, which insures more than $7 trillion of bank and thrift deposits, is trying to claw out of was deep even before considering the expansion of its problem bank list. At year-end 2009, the agency reported a $20.9 billion deficit in its Deposit Insurance Fund. A year earlier, the fund had a nearly $17.3 billion surplus.

Since 2007, however, the FDIC has sued the executives of only one failed bank. In July, the agency filed a $300 million claim against four former IndyMac Bank executives.

But current bank directors and officers should not take comfort in the dearth of FDIC litigation in recent years. This is not an indication that the agency has little inclination to pursue bank executives.

Like the S&L crisis, the current mayhem in the banking industry is evolutionary in nature, advancing from an early stage of great uncertainty to a later period of improved stability.

Bank executives should expect regulators to act now as they did before. That means the regulators will focus initially on seizing troubled institutions and stabilizing the industry, only then turning to recover government losses through litigation. The FDIC can delay litigation for years under the statute of limitations.

IndyMac failed two years before the agency filed suit.

Clearly, regulators have more work ahead of them before the industry stabilizes, despite the recent determination by the nonprofit National Bureau of Economic Research that the recession ended in June 2009.

Significantly, 60 percent of banks continue to boost their loss reserves. During the second quarter of this year, banks added $40.3 billion to reserves, according to the FDIC.

While that addition to reserves is the lowest amount the industry has reported over the past two years, it is still high by historic standards and could be a function of the improving financial condition of large banks.

Small community banks, which have less than $1 billion in assets, account for 90 percent of the nation's banks. They reported that loans that are 90 days past due increased 0.3 percent on average during the second quarter. Large banks, by contrast, reported a 5.3 percent drop in past-due loans on average during the quarter.

At the end of the third quarter, banks foreclosed on more than 95,000 home loans–a record number during the financial crisis and a 25 percent increase from August 2009, according to RealtyTrac Inc.

Another problem looming larger on the horizon for banks is the $1.4 trillion of commercial real estate loans that will mature between the end of this year and 2014. Half of those loans are on properties with values that have fallen below the loan amounts. More than one-third–37 percent–of all U.S. banks are exposed to those problematical loans, according to a congressional banking oversight panel.

Given these conditions, bank directors, officers and risk managers should closely examine the strength of their D&O coverage and consider purchasing Side A coverage as additional protection.

If a policy contains a regulatory exclusion, the FDIC might decide a lawsuit would not be worth the agency's effort. However, as the former top litigator for the agency has noted, the FDIC still might pursue claims against executives in an effort to recover from them personally.

In addition, those directors and officers whom the FDIC decides to leave alone still could face shareholder securities class action claims.

Purchasing Side A-only insurance would protect executives if they were to be sued by the FDIC or shareholders following a bank failure. Unlike a traditional D&O policy, bankruptcy courts do not freeze Side A policies covering the executives of an insolvent entity, since those limits are not deemed assets of the insolvent entity and a Side A policy may provide broader coverage in those circumstances.

Bank risk managers, however, would have to be careful that those policies do not contain regulatory exclusions.

(For another perspective on D&O policy questions raised by a Bloomberg report that the FDIC is ready to sue 50 directors and officers of failed banks, see related article, "FDIC Plan to File Lawsuits Creates D&O Policy Coverage Questions, posted Oct. 18 on NU's Online News Service.")

Of course, the FDIC still must prove that bank executives breached their fiduciary duties or engaged in unlawful banking practices and that the institution did not fail solely because of generally poor economic conditions.

Also, unlike the situation that existed during the S&L crisis, the FDIC now must show that executives were grossly negligent, rather than simply negligent, in order to recover damages. That's a tougher standard of proof, which the Financial Institutions Reform, Recovery and Enforcement Act of 1989 established.

Directors and officers also may take some solace in the fact that in the more than 220 shareholder securities class action claims filed over subprime mortgage losses, the dismissal rate is higher than in other D&O securities class action cases.

However, bank executives should not count on those factors too heavily. Among the subprime mortgage- or credit-related cases that have survived, 15 have settled for a total of more than $1.8 billion. And the government succeeded for several years under the gross negligence standard in pursuing claims against S&L executives.

Bank executives should count on the FDIC to press for "déjà vu all over again."

Trevor Howard is a senior vice president of U.S. management liability with Liberty International Underwriters in New York