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From Banking and Finance Law Daily, August 19, 2015

Directors, but not officers, shielded by business judgment rule

By Richard A. Roth, J.D.

A failed bank’s directors were protected from the Federal Deposit Insurance Corporation’s negligence claims by the North Carolina business judgment rule and a related provision of the bank’s articles of incorporation, according to the U.S. Court of Appeals for the Fourth Circuit. A pretrial judgment rejecting the FDIC’s gross negligence claims against the directors also was affirmed, which will leave the agency with no chance of recovering any of the deposit insurance fund’s $216 million in losses from them. The bank’s officers were not so fortunate, as the appellate court said they might be liable for bad loan approval decisions in the several years leading up to the Great Recession (FDIC v. Rippy, Aug. 18, 2015, Gregory, R.).

Genesis of the failure. The suit arose from the failure of a 100-year-old North Carolina financial institution. According to the appellate court, Cooperative Bank initially was a community bank that, from the time it opened in 1898 until 1992, operated as a thrift, concentrating on single-family home loans. It converted to a state-chartered savings bank in 1992. The bank became a state commercial bank after its board of directors decided 10 years later that the time was right to concentrate instead on commercial real estate lending and to increase the bank’s assets by 125 percent in only three years, between 2002 and 2005.

Things seemed to go well through 2007, as the bank received favorable examination reports and CAMELS ratings of “2” across the board on two occasions; however, a 2006 report did note deficiencies in credit administration, underwriting, audit practices, risk management, and underwriting. A 2007 examination report also raised a concern over the bank management’s efforts to correct the deficiencies. A private loan review in 2007 was favorable to the bank.

As happened to many banks, the situation soured in 2008. A follow-up loan review criticized the bank’s loan documentation and monitoring processes and complained that loans had been made based on obsolete financial information. A subsequent joint state-federal examination downgraded Cooperative to a CAMELS rating of “5,” the lowest possible rating. The appellate court characterized that report as “extremely critical.” Among the joint report’s criticisms was that the bank’s management had failed to address the previous voiced concerns over credit administration, underwriting, and liquidity. The bank’s high concentration in commercial real estate lending as a means to grow its assets—in essence, management’s basic strategy—was said to be the core of the problem.

The FDIC became Cooperative’s receiver in 2009.

Receiver’s suit. The FDIC, as receiver, later sued the bank’s directors and officers, claiming that they were negligent and grossly negligent and had breached their fiduciary duties when they approved 78 residential lot loans and eight commercial loans in 2007 and 2008. The district court judge granted the individuals summary judgment after finding that they were protected by the state’s business judgment rule because there was no evidence that they engaged in any fraud, self-dealing, or other conduct that showed bad faith.

More specifically, the judge said there was no evidence the individuals had approved the loans or made any policy decisions with the knowledge that the actions would harm the bank or breach any duties they owed the bank.

Business judgment rule. The appellate court began by noting that federal law sets a minimum standard of conduct for bank officers and directors but leaves states the option of setting a higher standard. The minimum federal standard makes officers and directors liable only for gross negligence.

North Carolina law sets such a higher standard, allowing officers and directors to be sued for ordinary negligence. That higher standard that would apply, the court said.

On the other hand, the business judgment rule sets a standard for what is considered to be negligent, the court continued. Under the rule, there is a presumption that officers and directors made their decisions on an informed basis and in good faith. Moreover, Cooperative’s articles of incorporation included a permissible provision that shielded the bank’s directors—but not its officers—from liability for breach of their fiduciary duties unless the individual knew or believed the challenged action was clearly in conflict with the bank’s interests.

Directors’ liability. The exculpatory clause protected the directors from liability for breach of any fiduciary duty, the court said, and the FDIC did not claim they had breached their duty of loyalty to the bank. That left one claim available to the agency—that the directors had breached their duty of good faith.

Under North Carolina law, the duty of good faith essentially requires directors to refrain from self-dealing, the court said. There was no evidence of self-dealing, or of fraud or other bad-faith actions. Making lending decisions based on inadequate information did not alone constitute acting in bad faith.

Officers’ liability. Things did not go so well for Cooperative’s officers. The court began by noting that they were not protected by the articles of incorporation’s exculpatory clause that had benefitted the directors. Thus, the business judgment rule applied in full strength.

While the business judgment rule establishes a presumption that the officers had acted on an informed basis and in good faith, the FDIC had offered enough evidence to rebut the presumption, the court decided. The focus was on the “informed basis” aspect.

An expert report provided by the agency said the bank’s officers did not act in accordance with generally accepted banking practices. Specifically, they approved loans over the telephone without first examining relevant documents, the report said. In fact, on some occasions the documentation was not received until after the loans had been funded. The report also described substantial deficiencies in the bank’s credit administration and audit processes. The report concluded “that certain loans should never have been approved,” the court said.

Gross negligence. The FDIC could not establish gross negligence by the directors or officers without proving intentional wrongdoing, the court decided. While North Carolina law perhaps is not clear on what constitutes gross negligence, the definition does seem to turn on whether punitive damages are being sought. As the agency was not demanding punitive damages, it was required to satisfy a common law gross negligence definition: wanton conduct with a conscious or reckless disregard for the rights of other persons.

The agency’s evidence of the failure to make needed improvements at the bank did not meet that standard, the court said. While the officers and directors had not made improvements called for by the examination reports in 2006 and 2007, both reports had given the bank strong CAMELS ratings. In that situation, the failure to take action was not gross negligence.

Other defenses. The appellate court also considered and rejected three defenses raised by the officers that the district court judge had not needed to address. According to the court, a jury should be allowed to decide whether:

  • the officers reasonably relied on information supplied by the bank’s loan officers and credit administrators;

  • the loan defaults resulted from the officers’ actions rather than from the effects of the Great Recession; or

  • the FDIC had adequately established its damages with reasonable certainty.

The case is No. 14-2078.

Attorneys: James Scott Watson for the Federal Deposit Insurance Corporation. Thomas E. Gilbertsen (Venable LLP) for Richard Allen Rippy, James D. Hundley, Frances Peter Fensel Jr., Horace Thompson King III, Frederick Willetts III, Dickson B. Bridger, Paul G, Burton, Ottis Richard Wright Jr., and Otto C. Buddy Burrell Jr.

Companies: Cooperative Bank

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