Failed Bank Wins Coverage Despite Prior Acts Exclusion

Financial Services Law

Despite the existence of a prior acts exclusion in an insurance policy, the officers and directors of a failed bank were entitled to coverage for a lawsuit brought by the Federal Deposit Insurance Corporation (FDIC), the U.S. Court of Appeals for the Eleventh Circuit recently ruled.

What happened

Between 2005 and 2007, the Community Development Lending Division (CDLD) of Georgia-based Omni National Bank engaged in unsound lending practices, which triggered internal and external regulatory investigations. The bank closed the CDLD in December 2007.

During 2007 and 2008, the bank foreclosed on many of the properties that served as collateral for the risky loans it had made and held the properties in its portfolio, known as Other Real Estate Owned, or OREO, properties. Certain members of the board of directors launched a plan to renovate and hold the OREO properties rather than sell them “as is” at the time of foreclosure. The bank’s regulators approved this plan in 2008. At that time, the bank’s CAMELS rating was 2, or “fundamentally sound.”

However, on September 5, 2008, the regulators issued a report changing the rating to 5, indicating the bank was failing or would fail immediately. The board members continued to invest in the OREO properties even with the ratings change, putting in approximately $12.6 million before the bank closed in March 2009.

The FDIC then filed suit against the board members, seeking to recover for the CDLD and OREO properties’ wrongful acts. The defendants tendered the suit to Certain Underwriters at Lloyd’s of London, relying on a $10 million directors and officers insurance policy purchased for the period of June 2008 through June 2009.

But the insurer refused to provide coverage, relying on a prior acts exclusion to argue that the investments into OREO properties related back to the earlier CDLD activities and therefore were not covered by the policy.

A district court judge disagreed, and the Eleventh Circuit affirmed.

“[T]he claim for coverage for the OREO Wrongful Acts is not inextricably linked to the Bank’s unsound lending practices in the CDLD,” the court said. “Rather, the wrongful acts claimed are for the particular expenditures to rehabilitate OREO properties that occurred after—and only after—the Bank received the downgrade to the CAMELS 5 rating in September 2008.”

The board defendants authorized the OREO property rehabilitations between September 15, 2008, and March 2009, clearly within the policy period and after the CDLD was closed by the bank in December 2007, the panel noted.

“The decision to continue with these expenditures, even when not necessary, occurred after the board knew of the Bank’s impending failure and thereby constituted an independent business decision from the initial lending practices in the CDLD division,” the court wrote. “Before the CAMELS 5 rating the [defendants’] investment in the OREO properties was not a wrongful act. And Underwriters never claims nor proves that the CAMELS 5 rating ‘arose out of’ the wrongful acts of the CDLD division.”

“Thus, the continuing investments into the OREO properties were not ‘interrelated wrongful acts’ under the policy but rather were independent wrongful acts that occurred during the policy period. As such, Underwriters must afford the coverage due under the Bank’s policy,” the court said, affirming summary judgment for the FDIC.

To read the opinion in Certain Underwriters at Lloyd’s of London v. FDIC, click here.

Why it matters

In the wake of the Great Recession, courts across the country have struggled with the application of insurance policies to failed banks. While some have found coverage may be required, others have let insurers off the hook, leaving directors and officers facing litigation without a safety net.