Vedder Thinking | Articles FDIC-R Professional Liability Lawsuits: A Call for Uniformity
Vedder Price is proud to announce that a current thought leadership article entitled "FDIC-R Professional Liability Lawsuits: A Call for Uniformity," which had previously been selected for advance online publication by Palgrave Macmillan Publishers, will appear in the August 2016 issue of the International Journal of Disclosure and Governance.
An excerpt of the article follows.
From June 2004 to February 2007, there was not a single bank failure in the United States (FDIC, 2015a). As of 7 December 2015, 518 banks have failed nationwide (FDIC, 2015a) since February 2007 – an epidemic not seen since the savings and loan crisis (the 'S&L Crisis').1 Beginning in January 2009, in response to this wave of failures and for the purpose of recovering losses to the Deposit Insurance Fund,2 the Federal Deposit Insurance Corporation operating as receiver for the failed banks (the 'FDIC-R') has authorized professional liability lawsuits (the 'Lawsuits') (FDIC, 2015c)3 against those it deems responsible for the bank failures. As of 26 October 2015, the FDIC-R has authorized professional liability lawsuits against 1,207 professionals4 in connection with the failure of 150 of the failed banks and has launched hundreds of additional investigations (the 'Investigations') (FDIC, 2015c). The vast majority of the professionals targeted by the FDIC-R are former directors and officers of the failed banks (the 'Directors and Officers'). To date, the FDIC-R has filed 108 Lawsuits against 826 Directors and Officers (FDIC, 2015c).
Unfortunately, the Investigations and Lawsuits have not had a constructive impact. While recovering only a small fraction of the Deposit Insurance Fund’s losses, the FDIC-R has disproportionately targeted community banks,5 driven away qualified current and potential bank directors for fear of personal liability, choked the free flow of credit and created significant animosity between bankers and regulators.
Given the disparity in power and resources endemic to Investigations and Lawsuits involving community banks – which pit the vast financial resources of the federal government and the unfettered and unilateral access to bank documents of a receiver against the limited individual resources of Directors and Officers with no access to bank documents until formal discovery commences – it is important for Directors and Officers to be able to fall back on the well-reasoned body of law protecting corporate decision making. However, as a result of inconsistent and unclear application of the business judgment rule and the standard of liability by which Directors and Officers are judged in the Lawsuits, confusion reigns in place of clear legal standards that would otherwise protect innocent Directors and Officers and provide for punishment of only those most culpable (if any).6
Much of the FDIC-R's ability to force Directors and Officers into settlements – both before and during litigation – is the risk of personal financial ruin engendered by the lack of a clear application of the business judgment rule and lack of a clear standard of liability.
The business judgment rule is a legal doctrine pursuant to which 'courts will not interfere with good faith decisions made in the exercise of business judgment' (19 C.J.S. Corporations § 568, 2007). Stated alternatively, it provides that corporate directors and officers are presumed to 'have acted in good faith and in the best interest of the corporation' (19 C.J.S. Corporations § 568, 2007) and 'will not be held liable for honest errors or mistakes of judgment' (Treco, Inc. v. Land of Lincoln Sav. & Loan, 1984). The business judgment rule embodies two fundamentally important concepts: (i) that courts are not in a position to second-guess corporate decisions (Binks v. DSL.net, Inc., 2010)7 and (ii) that corporate directors and officers are not strict-liability guarantors of the success of their good faith decisions (RTC v. Norris, 1993).8 While the precise permutations vary from state to state based on common law and statute, the business judgment rule is, and has been for generations, an indelible part of American jurisprudence.
During the S&L Crisis, a federal court presciently identified the reason for the importance of applying the business judgment rule in the context of banking:
[W]ith the benefit of hindsight, the FDIC or a disgruntled shareholder could almost always allege one or more acts of negligence by bank directors in approving a bad loan. Had the directors obtained better or more current appraisals, more or better security for the loan, and had the bank better monitored the payment history of the loan and subsequent changes in the creditworthiness of the borrower, almost any loan could have been made more secure, or at least the bank could have suffered a smaller loss on it. The business judgment rule protects bank directors from being guarantors on loans made by banks…. The rule also encourages directors to exercise their judgment in making loans and not to foreclose credit markets to all but blue-chip borrowers. (FDIC v. Brown, 1992)
Further, the former Chief Counsel of the Office of Thrift Supervision (OTS), who served the OTS during the S&L Crisis, has since argued that the business judgment rule shields bank directors from claims of ordinary negligence (Weinstein, 1993). He contends that, while some directors of failed banks are objectively bad actors, '[t]he large number of honest men and women who brought their best business judgment to their work as directors of failed savings and loans should not be subjected to standards that disregard the uncertainties and risks of business life' (Weinstein, 1993 at 1501). He cautions that '[a] simple negligence standard draws attention away from the process of corporate decision making, which has been the focus of the well-established business judgment rule,' and instead 'seeks to reassess the substance of the business decisions, and to do so at a time when 20–20 hindsight may be applied' (Weinstein, 1993 at 1501).
As a result of a series of interstate inconsistencies, and even inconsistencies within federal district courts, the benefit of the business judgment rule to Directors and Officers facing FDIC-R Lawsuits has arguably been decimated.
In some states, the business judgment rule is built into legislation establishing a standard of liability for either or both of Directors and Officers, while in others it is a common law doctrine. In Florida, for example, the state statutory standard for director liability was interpreted by a federal court to be 'something beyond ordinary negligence,' which warranted dismissal of the FDIC-R's ordinary negligence claim against former directors of a failed bank (FDIC v. Price, 2012).9 In Illinois, on the other hand, the business judgment rule is a creature of common law, created and applied by courts, and it has been held by at least one district court to not bar FDIC-R claims for ordinary negligence (FDIC v. Spangler, 2011).10 Maryland takes yet another approach, combining statutory and common law business judgment rule provisions to conclude that '[t]he business judgment rule's requirement that plaintiffs allege gross negligence therefore appl[ies]' to FDIC-R Lawsuits and therefore proscribes FDIC claims against bank directors for ordinary negligence (FDIC v. Arthur, 2015).
In Georgia, the issue of the standard of liability under the business judgment rule was sent from the U.S. District Court for the Northern District of Georgia to the Supreme Court of Georgia on the following certified question: 'Does the business judgment rule in Georgia preclude as a matter of law a claim for ordinary negligence against the officers and directors of a bank in a lawsuit brought by the FDIC as receiver for the bank?' (FDIC v. Loudermilk, 2014). In response, the Supreme Court of Georgia issued a 34-page treatise in which it quixotically concluded:
[T]he business judgment rule at common law forecloses claims against officers and directors that sound in ordinary negligence when the alleged negligence concerns only the wisdom of their judgment, but it does not absolutely foreclose such claims to the extent that a business decision did not involve ‘judgment’ because it was made in a way that did not comport with the duty to exercise good faith and ordinary care. (FDIC v. Loudermilk, 2014 at 585–586)
In a case decided based on North Carolina common law, a federal court granted summary judgment in favor of the defendants in an FDIC lawsuit on the basis that the FDIC had failed to reveal evidence rebutting the business judgment rule's presumptive protections (FDIC v. Willetts, 2014). On appeal, the U.S. Court of Appeals for the Fourth Circuit reversed, concluding that a single affidavit from the FDIC’s expert witness, which questioned the processes by which loans were approved, was sufficient to rebut the business judgment rule (FDIC v. Rippy, 2015). The differences in the application of the business judgment rule under Florida, Illinois, Maryland, Georgia and North Carolina law are microcosmic of a nationwide lack of consistency and clarity regarding this important legal doctrine.
While the disagreement among states – and the federal courts sitting within their respective borders – is apparent and harmful, there is also disagreement within district courts themselves as to how the business judgment rule is applied. In cases brought in federal courts applying Illinois law, for example, some courts have treated the business judgment rule as a presumptive protection for directors and officers, while others have treated it as an affirmative defense. In FDIC v. Saphir, the U.S. District Court for the Northern District of Illinois concluded that the business judgment rule was an affirmative defense not appropriate for consideration on a motion to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6), and thus 'overrule[d] [d]efendants' objection based on the business judgment rule' (FDIC v. Saphir, 2011). Three months later, however, the U.S. District Court for the Northern District of Illinois concluded in FDIC v. Spangler that 'Illinois courts have repeatedly clarified that the business judgment rule is a presumption that arises by operation of law' (FDIC v. Spangler, 2011 at 791). The Spangler court further stated:
[W]hile in essence [the business judgment rule] is a defense under Illinois law, it does not appear to be an affirmative defense that cannot be raised in response to a motion to dismiss … Thus, at the motion to dismiss phase, it stands to reason that the burden of proof is on the party challenging a corporate decision made by a director to present allegations that rebut the presumption created by the business judgment rule. (FDIC v. Spangler, 2011 at 791 (emphasis in original).)
As noted by another judge in the US District Court for the Northern District of Illinois, '[t]his distinction [between affirmative defense and presumption] is significant' (FDIC v. Elmore, 2013). The significance of this distinction has several layers. For one, where courts view the business judgment rule as an affirmative defense, 'the FDIC need not plead facts in the Complaint to anticipate and defeat affirmative defenses' (FDIC v. Elmore, 2013). Thus, if the business judgment rule is deemed to be an affirmative defense, the FDIC need not plead around it. Further, courts have consistently ruled that 'it [is] inappropriate to decide the merits of [an] affirmative defense on a motion to dismiss' (FDIC v. Giancola, 2014). This may well preclude defendants from availing themselves of the benefits of the business judgment rule until – at earliest – a motion for summary judgment after costly discovery is completed. But even more consequential is the fact that a defendant has the burden of proving its affirmative defenses (see, for example, Premier Capital Mgmt., LLC v. Cohen, 2008).11 Thus, Directors and Officers seeking to assert the business judgment rule, in a court where it is considered an affirmative defense, may well have the burden of proving their entitlement to the business judgment rule. To do this, they would inexplicably be required to prove that they exercised due care (FDIC v. Spangler, 2011 at 791)12 in order to overcome an FDIC claim that they failed to exercise ordinary care.
By failing to consistently apply the business judgment rule in a manner consistent with its time-tested and well-settled purposes, courts have effectively defused one of the most important defenses available to Directors and Officers against the FDIC-R's Investigations and Lawsuits.
While it is well settled that the business judgment rule, in any state where it exists, does not shield Directors and Officers from gross negligence claims, the standard for gross negligence is far murkier. FIRREA establishes gross negligence as the most lenient possible standard for bank professionals being sued by the FDIC-R, but leaves the definition of gross negligence to state law (12 U.S.C. § 1821(k)). Thus, the uniform minimum standard of 'gross negligence' is, in practice, anything but uniform.
The confusion over the application of the business judgment rule and standard of care applicable to Directors and Officers has created numerous problems, including short-sighted FDIC-R practices and inconsistent case law, and is driving away qualified directors.
Whether the issues highlighted above are viewed legally, empirically or anecdotally, it is clear that changes are necessary to bring clarity to standards governing the FDIC-R's Investigations and Lawsuits.
By amending FIRREA to authorize professional liability lawsuits only in cases of gross negligence (with gross negligence defined as recklessness), Congress can incorporate the well-established business judgment rule into the very statute that authorizes the FDIC-R's professional liability lawsuit, while simultaneously bringing clarity to the standard of care by which Directors and Officers are judged.
Full text of the article can be accessed (via subscription) here.
1 The S&L Crisis occurred during the 1980s, with repercussions lasting well into the 1990s, and involved the closure by the Resolution Trust Corporation of 747 savings and loan institutions.
2 It is a popular misconception that the cost of a failed bank is borne by taxpayers. In actuality, it is borne by the Deposit Insurance Fund, which itself is funded by banks (see FDIC, 2015b). Note, however, that the Deposit Insurance Fund has a line of credit with the Treasury but has not drawn on it during this wave of bank failures.
3 According to the FDIC, '[a]s receiver for a failed financial institution, the FDIC may sue professionals who caused losses to the institution in order to maximize recoveries. These individuals can include officers and directors, attorneys, accountants, appraisers, brokers, or others. Professional liability claims also include direct claims against insurance carriers such as fidelity bond carriers and title insurance companies' (FDIC, 2015c).
4 While this article will focus on Lawsuits against directors and officers, the FDIC-R has also sued professionals such as law firms and accountants.
5 Because of the federal government's 'too big to fail' approach to bailing out financial institutions, it was primarily community banks that were left to collapse under the weight of the worldwide economic meltdown. Directors and Officers of banks that survived the Great Recession because of bailout relief have not had to face investigation, while their community bank counterparts that did not receive government assistance have frequently been the targets of the FDIC-R.
6 The fallacy of the FDIC-R's all-too-common position that a bank failure necessarily indicates tortious conduct by Directors and Officers is made apparent when taken to its logical conclusion. If it is true that bank failures necessarily indicate tortious conduct by Directors and Officers, then bank failure statistics tell us that from 2004 to 2007 no Directors and Officers acted in a sufficiently tortious manner to cause a bank failure; yet beginning in February 2007, over 500 sets of Directors and Officers across the country suddenly decided to violate their legal standards of care and cause their respective banks – many of which had recently received composite ratings of 1 or 2 from regulators – to fail in rapid succession.
7 'The business judgment rule operates to protect corporate officers and directors and the decisions they make, and our courts will not second-guess these business judgments' (Binks v. DSL.net, Inc., 2010).
8 'The business judgment rule protects bank directors from being guarantors on loans made by banks' (RTC v. Norris, 1993).
9 The Florida statute provides, in pertinent part, that a director's alleged misconduct must rise to the level of 'conscious disregard for the best interest of the corporation, or willful misconduct' (see FDIC v. Price, 2012 (quoting Fla. Stat. § 607.0831(I)(b)(4))).
10 Finding that the business judgment rule was a rebuttable presumption that directors acted 'on an informed basis, in good faith, and with the honest belief that the course taken was in the best interest of the corporation', but that the FDIC successfully pled around this presumption by alleging that the directors failed to exercise due care in carrying out their duties.
11 '[Defendants] have the burden of proof of the affirmative defense' (Premier Capital Mgmt., LLC v. Cohen, 2008)
12 The court in FDIC v. Spangler quoted Stamp v. Touche Ross & Co., 263 Ill. App. 3d 1010 (1st Dist. 1993), for the proposition that '[t]he [business judgment] rule does not shield directors who fail to exercise due care in their management of the corporation.