In a recent ruling, a federal court in Los Angeles found that directors of a failed credit union were not liable for acts alleged to be negligent because the actions of the directors were protected by the so-called business judgment rule.
The case was brought by the National Credit Union Administration, the federal regulator of federal credit unions. The defendants were former directors of WesCorp FCU, a now-defunct credit union that acted as a “banker’s bank” for other credit unions. The NCUA alleged that WesCorp had purchased very large amounts of Option-ARM based mortgage-backed securities without regard to conducting sufficient analysis of the creditworthiness of the underlying securities or concentration limits in the institution’s portfolio. The NCUA alleged that this failure was negligence and the proximate cause of the credit union’s subsequent collapse.
The former directors countered that they had acted in good faith and in the exercise of their business judgment in overseeing the credit union, and that as a consequence, the director’s actions were protected by the business judgment rule. The court agreed and dismissed the allegations of the complaint founded on negligence without leave to amend because multiple previous efforts to amend the complaint had been insufficient to allege director conduct that would support an exception to the protections of the business judgment rule.
The holding of this case is equally applicable to actions brought by the FDIC against former directors of a failed bank. In fact, the provisions the Federal Deposit Insurance Act force the FDIC in these suits to allege facts that constitute “gross negligence,” a higher requirement, or such acts as demonstrate an even greater disregard of the director’s duty of loyalty. In effect, gross negligence in the context of director conduct would amount to an exception to the business judgment rule. The question is, “When does director conduct cross the line from protected acts to unprotected, and hence vulnerable, conduct?”
A director owes a three-fold duty to a corporation the director serves: a duty of obedience, a duty of loyalty and a duty of care. This concept is encompassed in the doctrine of the fiduciary duty owed by a director. The duty of obedience requires the director to act in a manner that does not extend the entity’s activities beyond those authorized by the entity’s organization document and by law. The duty of care requires the director to be informed with all the material information concerning any issue before the board before making a business decision. The duty of loyalty raises the expectation of director independence and the lack of any conflict of interest. A failure by a director to adhere to these duties raises the specter of personal liability unless, as permitted in Delaware, the corporation has adopted an exculpatory provision in its certificate of incorporation. For bank directors, no such exculpatory protection is permitted because of the Federal Deposit Insurance Act.
Recurring themes have emerged in complaints the FDIC has filed to date against former directors of failed banks. Here are some of them:
—Overconcentrations in acquisition, development and construction loans, which in at least one case was more than 80 percent of the bank’s entire loan portfolio
—Lack of supervision of senior management and undue reliance on them in loan originations without assurances of core competencies in areas of credit administration and risk underwriting and without adequate policies and procedures to enforce prudent lending, informed decisions and adequate monitoring.
Even though conduct rising to the level of gross negligence does not necessarily mean the directors acted in bad faith, it still means the directors were aware of the issues before them and chose to ignore them. In many cases, no matter what an attentive, well-meaning and competent board of directors tried to do, the solutions to the problems facing the bank simply eluded them because of various market factors. In many ways, the FDIC is attempting to substitute its after-the-fact judgment for that of the board made in real time.
The cases make it clear that courts should not substitute the plaintiff’s assessment for that of the board of directors. Or, as is sometimes said, the application of the business judgment rule is to prevent a court from second guessing honest, if inept, business decisions.
The lesson for directors or prospective directors of existing banks is that these FDIC-led challenges of past behavior help to delineate the boundaries of proper director fiduciary conduct expectations for banks. Current directors should take note and act accordingly as they face challenges within their institutions or in their markets. Here are some takeaways to be considered:
Most bank directors understand their job. Still, failures of a few are now being trotted out by the FDIC as a warning to the many directors serving today.
Harold P. Reichwald is co-chair of the financial services and banking practice group at law firm Manatt, Phelps & Phillips LLP.
Copyright (c) November 2011 by BankNews Media.