Liability Concerns Impede Director Recruitment at Banks

Want to spook out a local business leader? Ask him or her to serve on a bank board.

A rise in the number of lawsuits filed against bank directors has stoked fears that board members could be forced to pay out-of-pocket costs if a bank messes up, particularly when a bank fails.

The Federal Deposit Insurance Corp. has filed at least 90 lawsuits against directors or executives of banks that have failed since the financial crisis in hopes of recouping losses to the agency's insurance fund.

Banks usually hold directors and officers insurance policies to cover liability for such litigation. But there is growing concern about the limits of such coverage. Complicating matters is a lack of information about who has paid what in previous FDIC settlements.

The lawsuits have had a "chilling effect" on directors' willingness to serve, says David Baris, a partner at BuckleySandler and executive director of the American Association of Bank Directors.

The American Association of Bank Directors recently released the findings of a survey on how fears of personal liability are hampering banks' efforts to fill board seats. A fourth of the survey's 80 respondents said they had a potential candidate reject their offer in the last five years, with some citing concerns over legal exposure.

A significant number of participants also said that they have had a director resign, or refuse to serve on a loan committee, over similar concerns.

The association commissioned the survey after hearing reports of resignations. "The fear has always been there but we've never quantified it," Baris says.

The survey's sample size is small, but other industry observers say they tend to agree with its overall findings.

"I'm surprised the number of directors to resign over liability isn't higher" than what the survey found, says Joseph Monteleone, a partner at Tressler who specializes in director and officer liability. "The perception that there could be personal liability is out there."

Concerns are as elevated as they were during the savings-and-loan crisis, says Charles Thayer, a director of MainSource Financial (MSFG) in Indiana. "FDIC lawsuits create heightened awareness of liability risks," says Thayer, who also chairs asset management and advisory firm Chartwell Capital.

Settlements in some post-2008 lawsuits, like those following the IndyMac and Washington Mutual failures, called for personal payments from executives in addition to payments from insurers. It's far from clear, however, that such settlements are common.

"The fear is somewhat out of proportion to the evidence of actual risk," says Donna Ferrara, managing director of the management-liability group at insurance broker Arthur J. Gallagher. "It appears that there have been relatively few cases in which directors have had to pay anything out of pocket."

Nobody really knows how much money the FDIC has received from insurers and how much from directors and officers themselves in its failed-bank settlements.

The FDIC began posting online a large amount of documentation of its post-crisis settlements with failed banks last year following a report in the Los Angeles Times that scores of settlements had not been made public.

The agency often doesn't know the source of payment because the defendants and insurers decline to provide the data, says FDIC spokesman Andrew Gray.

It is impossible, given such limitations, to do more than estimate how much directors and officers have had to pay out-of-pocket in those settlements.

Cornerstone Research pegged the amount at $34 million in a February report, but the figure is not definitive since it is based on settlement agreements with unclear language, says Cornerstone Senior Vice President Catherine Galley, who prepared the report.

It is clear that, before the financial crisis, out-of-pocket legal costs for directors were very rare. From 1981 to 2006, there were just 13 instances among all U.S. corporations when a director paid directly to settle costs or legal damages, according to a paper by Stanford University law professor Michael Klausner. The risk of personal liability "is very low, far lower than many commentators and board members believe," the paper concluded.

The FDIC can go after directors' personal assets, but the statutory requirement to limit losses to its insurance fund means the agency often has an incentive to settle rather than engage in costly litigation. In such negotiations, many banks have successfully resisted demands for personal contributions, Monteleone says.

"Often there will be a settlement demand that is higher than the D&O insurance limit," he says. "Those demands usually go by the wayside. Often, the first demand to drop off is a matter of personal contribution."

A bigger danger is the possibility of holes in a bank's D&O coverage, Monteleone says. This danger prompted the FDIC to recommend last year that banks buy comprehensive D&O policies.

After the financial crisis, some insurers reinstated the "regulatory exclusion" — a clause stipulating that the carrier does not need to pay damages to a regulator — became more common in D&O policies. Such clauses were common after the savings-and-loan crisis, but gradually disappeared as bank failures declined. Troubled banks can find it difficult to buy plans without this exclusion.

Directors were also jarred by a court ruling in an FDIC lawsuit against two former officers of Community Bank & Trust, a failed Georgia lender. A district court judge ruled in August that the "insured vs. insured" exclusion — a common stipulation that says insurers don't have to pay damages when two people covered by the same policy sue each other — bars carriers from covering officers sued by the FDIC.

The ruling was a significant victory for insurers, though it is unclear if other courts will follow it. In several cases, judges have had a contrasting opinion.

Overall, bank directors and prospects are more concerned than ever about the extent of D&O coverage — and rightly so, Ferrara says. The risk of paying out-of-pocket damages may be low, but directors should be concerned and must do their homework to determine if they are covered.

"Fears about personal liability can have an impact on the quality of the board," Baris says. "Unfortunately, the ones who are asking the most questions about liability are sometimes the best directors."