Since 2007, more than 475 banks in the United States have failed, according to the FDIC. The regulator has obtained authorization to bring lawsuits, arising out of such bank failures, against 1,007 defendants as of September. Seventy-nine such lawsuits have been filed, 35 of them in 2013 alone. All of these actions target directors and officers of failed banks.
The FDIC’s increasingly aggressive pursuit of these cases coincides with efforts by President Obama’s Financial Fraud Enforcement Task Force, which was founded in November 2009, to hold accountable those who created the financial crisis and those taking advantage of recovery efforts. The task force includes 20 federal agencies (including the FDIC), 94 separate U.S. Attorneys’ offices, and state and local government entities. Through the work of the task force, the Justice Department has filed more than 10,000 financial fraud cases in the past three years, according to its website. To date, criminal charges have not been brought against a single Wall Street executive — the bank-related cases are focused on the officers and directors of community banks.
Although generalities are not always helpful, it appears that the vast majority of cases against bank insiders follow a similar pattern. To begin with, the cases largely relate to loans made by the failed banks. In addition, the claims in such cases include allegations that the directors and officers of the bank engaged in unsafe and unsound banking practices, including: (1) pursuing an overly aggressive growth strategy; (2) failing to implement proper risk-management techniques during the period of high growth; (3) failing to recognize the level risk to which they were subjecting the bank (even when the economy began to turn down); and (4) acting to mask the bank’s true condition, thus artificially prolonging the bank’s life. Such cases often also involve allegedly excessive concentrations in real estate loans, particularly loans for commercial real estate development, such as acquisition, development and construction loans.
Whether in a civil or criminal suit, the government has a high hurdle to clear — regardless of the widespread nature of the so-called unsafe and unsound practices. In civil suits brought under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, 12 U.S.C. §1821(k), the government must prove that an officer or director acted in a grossly negligent manner in supervising or overseeing the bank. Under a criminal conspiracy to commit bank fraud pursuant to 18 U.S.C. § 1349, on the other hand, the government must demonstrate that the officer or director intended to trick or deceive the bank (or the shareholders of a bank holding company) to obtain a successful conviction.
In order to negate claims of gross negligence or any effort to trick or deceive, an officer or director would be well served to use the bank’s own regulatory history as part of his or her defense. Indeed, it seems to be universally the case that the unsafe and unsound practices of these failed banks were well known to regulators well in advance of the banks’ ultimate failures. In other words, while community banks did grow aggressively, created large commercial real estate portfolios and often failed to implement proper risk-management practices, the officers and directors of such banks were neither grossly negligent nor engaged in some sort of scam to trick or deceive. Instead, they acted in a transparent manner that was readily observable by the regulators.
Additionally, the officers and directors shared the same belief that many people — including regulators — had: that real estate was a sound investment and that commercial real estate would continue to appreciate in value and act as adequate security for loans. In numerous instances, regulators observed high concentrations of commercial real estate loans, deficient loan documentation and even loans that violated the law (by, for example, not having appraisals prior to funds being issued to borrowers) and failed to downgrade bank ratings in any manner. This fact alone demonstrates the officers and directors of such banks were not reckless or criminal in their actions, but that any number of rational actors in the system made assumptions that, ultimately, were simply wrong.
To test the universality of this defense, the author accessed the Material Loss Report for a single bank, picked at random, among the 79 banks on whose behalf the FDIC is suing officers and directors. That report, a September 2010 “In-Depth Review of the Failure of Columbia River Bank, the Dalles, Oregon,” report, NL. IDR–10–002, details the reasons for the failure of the Columbia River Bank.
According to the Material Loss Report, the bank was placed into receivership on Jan. 22, 2010. Also according to the report, “between 2004 and 2008, CRB management shifted its focus to commercial real estate in particular acquisition, development and construction residential projects in the Bend and Portland, Ore., regions and Vancouver, Wash., area. The bank historically relied on ‘core deposits but to fund asset growth became more dependent on brokered deposits.’” This is, of course, a familiar scenario, as it is true of many of the failed banks.
The report also concludes — buried on page 25 — that CRB’s regulators knew or should have known of the allegedly unsafe and unsound practices that plagued the bank, but failed to downgrade the bank early enough:
“In retrospect, considering: (1) CRB’s ADC concentration levels; (2) identification of weak credit administration practices; (3) signs of financial deterioration; and (4) the start of deterioration in the local real estate markets, the FDIC and the DFCS should have placed greater emphasis on management practices in assigning the Asset Quality rating. According to the Risk Management Manual of Examination Policies (Examination Manual), a “2” Asset Quality component rating indicates that the level and severity of issues warrant a limited level of supervisory attention. A “3” rating generally indicates that an elevated level of supervisory attention is required. Although the level of classified loans (26.03 percent) at the time appeared manageable, heightened supervisory attention appears to have been warranted.”
In other words, according to the Office of Inspector General itself, the regulators fell prey to the same irrational exuberance to which the bank’s management had succumbed. Ultimately, we suggest, the regulators’ views ought to be a critical component of any officer or director defense in such cases.
Although the federal government is currently actively pursuing directors and officers civilly and criminally, these officers and directors acted in a way that was consistent with the actions of, and conclusions reached by, federal regulators. Officers and directors facing such suit may consider making prior regulatory reviews a central part of their defenses, depending on their situations.
Certainly, if regulators observed the very components later deemed to be part of the banks’ failures, such as high concentrations of ADC loans, poor risk management, poor documentation and loans that violated the law, but continued to rate the banks’ highly in view of the strength of the real estate market, it would be strong evidence that the officers and directors of such banks were neither grossly negligent nor criminal in their actions.
Vincent Paul ”Trace” Schmeltz III is the co-chair of the financial, corporate governance and M&A litigation group at Barnes & Thornburg LLP in Chicago. Contact him at 312-214-4830 or tschmeltz(at)btlaw.com. Special thanks to Solomon Wisenberg, co-chair of Barnes & Thornburg LLP’s white collar practice group for his input into this article.
Copyright (c) November 2013 by BankNews Media