FDIC Has Major Stake in Battle Over D&O Coverage

WASHINGTON — The Federal Deposit Insurance Corp. is speaking up about a risk facing banks — from the agency itself.

The FDIC warned institutions last week to be on notice for potential holes in their director and officer liability coverage. But the agency is not just focused on such gaps as a supervisor. As the plaintiff in over 80 lawsuits against failed-bank managers, the FDIC is interested in the frequency of policy exclusions — particularly in suits involving regulators — that can limit how much the agency can recoup.

"The FDIC has issued its advisory statement because it wants to try to enlist banking officials' assistance in trying to ward off the inclusion of these kinds of exclusions on D&O insurance policies," Kevin LaCroix, executive vice president at RT ProExec, wrote earlier this week on his D&O Diary blog.

Insurers often added such exclusions, which state that they will not cover damages if a regulator is a plaintiff, following the savings and loan crisis two decades ago. As many as half of D&O policies sold to banks in the mid-nineties had such clauses. They became rarer as failures decreased again, but the financial crisis has spurred an uptick in regulatory and other types of exclusions. That has complicated FDIC efforts to recoup losses from more recent failures.

Observers praised the FDIC's warning to the banks it supervises to be more wary of insurers adding exclusions when a policy is renewed or amended.

"They want banks to have the best directors they can get. If you don't have good D&O insurance, you're not going to get capable directors," said Jeffrey Gerrish, the chairman of Gerrish McCreary Smith Consultants. "That would be the argument from a safety and soundness standpoint. Directors also get sued by people other than the FDIC."

But the FDIC's authority to resolve failed banks and sue former directors and officers for claims of negligence in running the institution also affects the agency's interest in D&O coverage, he added.

"They would like the directors to have as much D&O insurance as they can without exclusions. There is some self-interest in that regard," he said.

In its letter, the agency warned that defendants could be personally liable for claims not covered by a D&O insurer, and encouraged board members and officers to ask key questions about coverage, including what exclusions exist and "what is my potential financial exposure arising from each policy exclusion?" Separately, the letter clarified that the FDIC bars banks and holding companies from using their D&O coverage to pay civil money penalties levied against specific individuals such as board members.

Interestingly, the agenc's letter avoided mention of the FDIC's litigation authority as well as discussion of specific types of insurance exclusions. The advisory statement noted an increase in exclusions, adding that in certain instances "directors and officers may not be fully aware... of such exclusionary language."

But the letter came as disputes over how much a D&O carrier will or will not provide to cover FDIC claims in litigation or settlements have arisen in numerous failed-bank cases, even at times pulling the insurer into a separate legal dispute. Regulatory exclusions tend to be added to policies when banks become troubled, yet exclusions can also be removed if banks agree to pay higher premiums.

"If it's a bank on [the FDIC's] troubled bank list, most insurers would not renew the policy without a regulatory exclusion," said Joseph Monteleone, a partner at Tressler LLP who represents insurers in coverage litigation.

For example, a U.S. District Court judge in California sided with Federal Insurance Co. in July over a claim by former managers of the failed Alliance Bank based in Culver City — who were targeted by the FDIC — that the insurer had wrongly denied coverage. The judge wrote that "it is clear from the language of the Regulatory Exclusion Endorsement that Defendant had a right to refuse to defend Plaintiffs from the FDIC claim."

In another case, a judge in Georgia ruled that the insurer for directors and officers of the failed Community Bank & Trust could withhold coverage under a so-called "Insured v. Insured" exclusion, which relates to disputes between two parties considered to be covered by the same insurer. As receiver, the FDIC is viewed to stand in the shoes of the former bank which has failed. But in other cases, such exclusions have been ruled invalid.

"The D&O carriers recognize that they face much more substantial risk than they did five years ago, before the economic crisis. For many years, we had very few failed banks," said Aaron Kaslow, an attorney at Kilpatrick Townsend.

Some observers argued that the steady stream of FDIC lawsuits against officers and directors has influenced the amount of insurance provided by carriers.

"There is a certain irony to this. Part of the reason, and it may be a large part, that some of the insurance carriers are balking at providing the regulatory coverage has to do with the fact that the FDIC has been aggressive in suing directors of failed banks," said David Baris, a partner at BuckleySandler LLP and executive director of the American Association of Bank Directors.

Mary Gill, a partner at Alston & Bird who advises directors and officers of financial institutions, said recent changes to insurance policies — implemented "as banks' conditions worsened" — have indeed caught some former bankers off guard.

"In some instances, changes in coverage were a surprise to directors, who did not appreciate what the changes in the policies meant or the coverage they were intended to limit," Gill said. "It is essential for directors and officers to understand the coverage their bank's D&O insurance program provides, and be attentive to any proposed changes in coverage that might leave them exposed in the event the bank becomes unable to indemnify them against claims for personal liability."

Yet Monteleone said banks often try to make a cost-versus-benefit calculation of the appropriate level of insurance to purchase.

"There's a tendency to ask, ‘Why should we pay all of this money to buy a larger amount of insurance with certain exclusions removed when we may never need this insurance?'" he said. "You're talking about significant premiums, as much as six figures, to get a large a tower of insurance and exclusions such as the regulatory exclusion removed."

Monteleone added that the risk of the FDIC going after a director or officer's personal assets is somewhat minor.

"It does make sense for banks to buy more insurance than some of the smaller banks are buying now," he said. "The contrary view is that you're setting up a bigger target for the FDIC to aim at. The agency may make a lot of noise about going after the personal assets, but to date they haven't been that successful in doing that following the most recent crisis. In many instances, they eventually back off from that demand."