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From Banking and Finance Law Daily, August 15, 2014

Bankruptcy estate owns holding company’s direct claims against company officers

By Richard A. Roth, J.D.

Whether a bank holding company’s bankruptcy trustee can sue the BHC’s former officers and directors depends on whether the trustee is asserting claims that arise from the managers’ duties to the BHC or to its subsidiary banks, the U.S. Court of Appeals for the Seventh Circuit has decided. Claims that the managers breached duties owed directly to the BHC belong to the bankruptcy estate, the court said, but claims that their actions in operating the banks resulted in loss to the BHC were derivative claims that could be raised only by the Federal Deposit Insurance Corporation as the banks’ receiver (Levin v. Miller, Aug. 14, 2014, Easterbrook, Circuit Judge).

The suit began with the 2009 failure of Irwin Union Bank & Trust and Irwin Union Bank, FSB. The banks’ failures led to the bankruptcy of their holding company, Irwin Financial Corporation. According to the court, the failures were caused by the banks’ concentration in higher-risk mortgage loans in the period leading up to the financial crisis.

Seeking funds for Irwin Financial’s creditors, the trustee sued three of the company’s officers and directors, two of whom also were bank managers, for allegedly mismanaging both the company and the banks. The appellate court separated the claims into three categories:

  • The officers and directors, as the banks’ managers, failed to diversify the banks’ assets and failed to hedge the risks and, as Irwin Financial’s managers, failed to require the banks to manage the risks.

  • The managers gave Irwin Financial inadequate information about the banks, inducing it to reduce its capital by paying dividends or buying back stock, which left the company undercapitalized when the crisis began.

  • The managers gave in to the FDIC’s demand that Irwin Financial contribute millions of dollars of capital to the banks when they were in distress, benefitting the FDIC—and perhaps the managers as bank management—but offering no benefit to Irwin Financial.

Trial court decision. Once the trustee filed his suit against the managers, the FDIC intervened in order to protect its interests. As the appellate court noted, any money the trustee could get from the managers would be unavailable to the FDIC if the receivership decided to sue them.

The managers convinced the trial court judge to dismiss the complaint, arguing that all of the claims asserted by the trustee actually belonged to the FDIC under the Financial Institutions Reform, Recovery, and Enforcement Act. The trustee appealed the dismissal.

FIRREA. The appellate court began its analysis by noting the relevant FIRREA provision. According to the law, when the FDIC is acting as a bank’s receiver, it acquires “all rights, titles, powers, and privileges of the insured depository institution, and of any stockholder, member, accountholder, depositor, officer, or director of such institution with respect to the institution and the assets of the institution” (12 U.S.C. §1821(d)). This is generally understood to include not only claims that a closed bank could assert but also claims that investors could assert derivatively on the bank’s behalf, the court added.

The issue was the application of that provision to the trustee’s claims against the managers.

Derivative claims. Irwin Financial was an Indiana corporation, so Indiana law provided the standard for determining whether a claim was derivative, the court said. Under that law, a shareholder’s claim is derivative “if the corporation itself is the loser and the investor is worse off because the value of the firm’s stock declined.”

That was the theory behind the first category of the trustee’s claims, the court said—the banks were harmed when their loan portfolios collapsed, and Irwin Financial was harmed when the value of its investments in the banks fell. The trustee’s claim that the managers owed Irwin Financial a duty to protect it from their misbehavior as bank managers was “a veneer over a derivative claim” arising from the harm they caused the bank by their actions as bank managers.

The right to sue the managers because of their actions as bank managers belonged to the FDIC as the banks’ receiver, the court decided. Dismissing these claims was proper.

Direct claims. On the other hand, claims based on what the managers did at Irwin Financial could be asserted by the trustee, the court said.

If the claim relating to Irwin Financial’s dividend and stock buy-backs were dismissed, the FDIC would not benefit, the court pointed out, because the receiver could not sue the managers based on anything they might have done wrong as holding company managers. While the court expressed considerable doubt about the trustee’s prospects for success on the claim, it also said the claim should not have been dismissed.

The trustee’s claim that the managers gave in to the FDIC and “threw good money after bad” by adding capital to the banks also laid out an injury to Irwin Financial directly, the court said. There was no injury to the banks or to the receivership; if anything, they were benefitted. This claim, which the court observed was the trustee’s strongest claim, should not have been dismissed.

Concurring opinion. In a concurring opinion, Circuit Judge Hamilton opined that the case raises policy considerations that Congress ought to consider. Hamilton pointed out that any money collected by the trustee likely would come from Irwin Financial’s director and officer liability policy. He then observed out that permitting the trustee to raise, and recover on, Irwin Financial’s direct claims could well mean that the company’s creditors—or in a slightly different situation, its shareholders—would be in a better position than the FDIC. Why should that be the case, he asked?

Construing 12 U.S.C. §1821(d) more broadly as transferring all claims to the FDIC, or at the least the claims of persons who were involved in the financial institution, would be a better result from a public policy point of view, Hamilton argued. Perhaps the direct claim/derivative claim distinction should be abandoned, he said.

The case is No. 12-3474.

Attorneys: Alfred S. Lurey (Kilpatrick Townsend & Stockton) for Elliott D. Levin, Trustee in bankruptcy for Irwin Financial Corporation. James A. Knauer (Kroger, Gardis & Regas) for William I. Miller.

Companies: Irwin Financial Corporation; Irwin Union Bank, FSB; Irwin Union Bank & Trust

MainStory: TopStory BankHolding IllinoisNews IndianaNews Receiverships WisconsinNews

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