6-11-08

The last 15 years have been smooth sailing for banks and their directors. Borrowers paid loans, earnings remained strong, and bank failures were almost non-existent. Recently, however, matters became choppy as borrowers defaulted, earnings plummeted, and a few banks began to fail.

In good times, bank directors could enjoy a directors meeting as a combination of social hour and civic duty. Director preparation satisfied the lower standard politeness, not the more rigorous goal of thorough professionalism.  Now, these directors are discovering that serving on a bank board is more work and possibly more risk than serving on the board of an unregulated private firm.

Plain Old Director Duties

Bank directors must first satisfy the same standards of competence and conduct imposed on all firms in any industry. State courts require that directors satisfy two elements of corporate law: first, exercising “due care,” and second, fulfilling duties with loyalty. Hundreds of court cases apply the rules to specific circumstances where shareholders have claimed that directors did not use “due care” – that is being duly  diligent, inquisitive and experienced in corporate management. Though the basic standard is generally very low and undemanding for directors in an unregulated business, a bank board member with little banking experience might silently suffer in the board room from the confusing torrent of arcane terms and accounting methods of financial institutions.  In addition, courts evaluate directors’ loyalty, regardless of industry, most commonly arising in cases of conflicts of interest and self dealing.

The Director Watchdog

For the non-banking firm, the corporate watchdog is often the disgruntled shareholder who files suit. The only venue where shareholders might lodge a complaint is in the courtroom – a notoriously slow and expensive institution. As a result, the discipline of private corporate directors looks less like a boxing match and more like a slow-motion pillow fight. The scrutiny of these directors arises mainly when a company is sold, directors engage in massive self-dealing, or after a truly catastrophic decision.

Enhanced Oversight of the Bank Director

In the world of banking, directors must endure another level of review. Not only are the laws far more specific regarding director standards, but state and federal regulators remain poised with their hand on the legal trigger for violators. When banks slip financially, regulators can act swiftly and unilaterally. In good times, this added layer of oversight is little more than an inconvenient imposition of a few hours of training and an occasional finger-wagging lecture by a bank examiner. When loans go bad, deposits dry up and bank capital shrinks, these regulators can quickly unpack their legal weapons against lax and self-dealing directors.

Self-Dealing

Federal regulations specifically target insider transactions. In the case of loans, these include Federal Reserve Regulation O; in the case of other non-loan insider deals, these include Federal Reserve Regulation W. These regulations impose the following standards, among others, on insider deals:

Banks operate in a world of debits and credits, along with a very tempting inventory of cash. Therefore, senior management must remain vigilant that banks maintain strong controls - with regulators assisting by prescribing a litany of internal written policies. Directors are accountable for overseeing staff preparation of proper policies; in addition, directors must actually read these things. If regulators find that the policies are poorly written or poorly administered, they may directly take directors to task. Among the most common policies which usually range from five to 30 pages, are the following:

Anti-money Laundering; Lending; Investment management; Community Reinvestment Act; Regulatory Compliance; Privacy and Security; General Risk Management

Money Laundering

Banks have operated for decades under the presence of money-laundering regulations. However, with the passage of the Patriot Act following the terrorist acts of 9/11, Congress radically expanded these laws and the penalties for non-compliance. This expanded and detailed set of rules prescribe the following, among other things:

Maintain detailed records of certain cash transactions in Suspicious Activity Reports; Review and understand a “Know Your Customer” policy, including awareness of high risk cash-oriented clientele; Closely monitor the bank’s compliance resources and efforts.

More than any other set of rules, anti-money laundering regulations require that directors become familiar with the details and avoid relying on staff summaries of these policies.

Fast-Track Enforcement

Regulators can ask courts to hold directors personally accountable for mistakes. Laws provide that “institution affiliated parties” - such as executive officers and directors - may be personally liable for non-compliance and negligent management. Congress adopted these rules in the late 1980s to address the savings and loan abuses. If banks now suffer from mismanagement or noncompliance, regulators may sue to hold a director personally liable. Individual fines range from a few thousand dollars to $25,000 per day, up to a $1 million. Even if the regulators do not seek full penalties, the specter of personal liability often frightens directors into infusing their personal savings into a troubled institution. In addition, if a bank fails to comply with the letter of a cease and desist order, the regulators may hold the directors personally liable for violations of an earlier regulatory letter or order.

The Regulatory Nasty-Gram

Banking regulators may issue one of several types of letters critical of bank management. Directors might expect the following from their new regulatory pen pal depending on the extent of the mess:

        —       Informal comment in a report of periodic examination.

        —       Commitment letter by the bank promising specific correction of violations of bank directors. 

        —       Formal recommendation as part of a separate memorandum of  understanding. This letter is often issued following a bank examination that exposed one or more specific deficiencies in management, such as violation of anti-money laundering regulations, poor controls and policies, or prescribed actions to address specific problems such as specific large problem loans.

        —       A very formal and often very public cease and desist order. This letter is an order from a bank regulator demanding that the bank either cease engaging in a particular action, or more commonly, impose deadlines for correcting specific and significant problems. These cease and desist orders are occasionally publicized by the regulators to make an example out of a non-compliant bank.

Capital Directives

Regulators might issue an order that the bank management, including its directors, raise equity for an undercapitalized bank. These orders may specify the amounts and timing of capital to be raised. In the case of a community bank where the directors are often also significant shareholders, these directives are thinly veiled demands for the directors to personally invest more money in the bank. Failing a director infusion of cash, the regulators might threaten to hold the directors personally liable for money lost by the bank.

All Is Not Lost

Despite the parade of theoretical horribles, the vast majority of banks remain stable, and therefore the vast majority of directors remain safe. The problem is not the frequency of failure, but the magnitude. In the very unlikely event that the bank suffers financial disaster, or the directors and management fail to communicate, then directors will face the prospect of personal liability. However, a director may conscientiously study policies and procedures, and diligently prepare for and attend almost all the director and committee meetings. If so, the director need only glance at legal liability in the rear view mirror, while focusing on the challenges and opportunities of the bank that lie ahead.

For more information, please contact Craig McCrohon at (312) 840-7006 or cmcrohon@burkelaw.com.