Financial Services Law

Bank Directors, Officers Win Dismissal of FDIC Suit

Almost all cases brought by the FDIC in the last few years against former directors and officers of failed banks have been resolved by negotiated settlements. However, in a recent decision, a federal court judge in North Carolina granted summary judgment to the former directors and officers of a failed bank in an action brought by the FDIC.

The Cooperative Bank of Wilmington was declared insolvent in June 2009. The FDIC stepped in as receiver and initiated a lawsuit against former officers and directors of the bank alleging negligence, gross negligence, and breaches of fiduciary duty. The claims focused on the approval of 86 loans made over a 15-month period in 2007 and 2008, which the FDIC said deviated from prudent lending practices established by Cooperative’s loan policy, published regulatory guidelines, and generally established banking practices. The FDIC sought to recover approximately $40 million.

Relying on the North Carolina version of the business judgment rule, the directors and officers filed a motion for summary judgment, contending that they acted reasonably, in good faith and in the best interests of the bank. They also claimed that the losses allegedly incurred could not have been reasonably foreseen.

U.S. District Court Judge Terence W. Boyle – characterizing the FDIC’s position as “absurd” and “wholly implausible” – granted the motion.

“The substantial discovery produced in this case, which includes voluminous records, 15 depositions of party, third party, and expert witnesses including Cooperative’s regulators at the FDIC, fails to reveal any evidence that suggests any defendant engaged in self-dealing or fraud, or that any defendant was engaged in any other unconscionable conduct that might constitute bad faith,” the court said, refusing to engage in Monday morning quarterbacking.

“Although the decisions of defendants to engage in various forms of lending and to make the particular loans challenged in the complaint, and the wisdom of such decisions raise interesting discussion points in hindsight, the business judgment rule precludes this court from delving into whether or not the decisions were ‘good’ and limits the court’s involvement to a determination of whether the decisions were made in ‘good faith’ or were founded on a ‘rational business purpose,’ ” Judge Boyle wrote.

While the complaint alleged that the defendants ignored multiple Reports of Examination (ROE) issued by the FDIC warning Cooperative about underwriting and credit practices, the court said the very same ROEs also graded the defendants’ management, asset quality, and sensitivity to risks as “satisfactory” and not requiring “material changes,” with a CAMELS 2 rating.

“Therefore the facts show that the process that defendants used to make the challenged loans were expressly reviewed, addressed, and graded by FDIC regulators,” the court said, “and to now argue that the process behind the loans is irrational is absurd. Further, each of the loans at issue was subject to substantial due diligence and an approval process that defies a finding of irrationality.”

The defendants’ actions could also be attributed to a rational business purpose, the court found. “Cooperative’s pursuit of the challenged loans was in furtherance of Cooperative’s goal to grow to a $1 billion institution and stay competitive with other regional and national banks making substantial inroads into its territory,” Judge Boyle wrote.

“Although there were clearly risks involved in Cooperative’s approach, the mere existence of risks cannot be said, in hindsight, to constitute irrationality. Further, corporations are expected to take risks and their directors and officers are entitled to protection from the business judgment rule when those risks turn out poorly. Where, as here, defendants do not display a conscious indifference to risks and where there is no evidence to suggest that they did not have an honest belief that their decisions were made in the company’s best interests, then the business judgment rule applies even if those judgments ultimately turn out to be poor.”

Judge Boyle also took the opportunity to opine on the FDIC’s claim that the officers and directors should have foreseen the economic recession.

The FDIC’s “absurd” position “claims that defendants were not only more prescient than the nation’s most trusted bank regulators and economists, but that they disregarded their own foresight of the coming crisis in favor of making risky loans. Such an assertion is wholly implausible,” he wrote. “It appears the only factor between defendants being sued for millions of dollars and receiving millions of dollars in assistance from the government is that Cooperative was not considered to be ‘too big to fail.’ Taking the position that a big bank’s directors and officers should be forgiven for failure due to its size and an unpredictable catastrophe while aggressively pursuing monetary compensation from a small bank’s directors and officers is unfortunate if not outright unjust.”

To read the order in FDIC v. Willetts, click here.

Why it matters: This is the first time in the aftermath of the Great Recession that a court has soundly rejected FDIC’s claims that bank officers and directors could have foreseen the recession where federal regulators like Federal Reserve Chairmen Alan Greenspan and Ben Bernanke could not. It upheld the validity of the North Carolina business judgment rule, taking a hands-off approach to the analysis of the defendants’ actions once the court determined their actions were rational and employed in a good faith effort to advance the corporate interests. Significantly, Judge Boyle also used the FDIC’s own regulatory examinations of the bank and satisfactory ratings to rebut its contention that the defendants acted negligently. In view of the court’s complete dismissal of the claims, the FDIC is likely to appeal.

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FDIC to Banks: Prep for “Urgent” Threat of Cyberattacks

Financial institutions are facing an “urgent” threat of hacks and cyberattacks causing regulators to take a closer look at banks’ efforts to combat such concerns, the Federal Deposit Insurance Corporation (FDIC) Chairman recently cautioned.

At the American Banker Regulatory Symposium, FDIC Chairman Martin Gruenberg told attendees that the rise of cyberattacks targeting banks has triggered a need for regulators to assess the efforts of institutions to fight back or prevent such attacks.

Working in partnership with the Federal Financial Institutions Examination Council (FFIEC), the FDIC has developed a framework for conducting IT examinations to cover “a broad spectrum of technology, operational, and information security risks,” Gruenberg explained, featuring published standards, examination procedures, routine on-site inspections, and enforcement capability.

Because “Internet cyber threats have rapidly become the most urgent category of technological challenges facing our banks,” cybersecurity is no longer just an issue for the IT department, Chairman Gruenberg said. “Instead, it needs to be engaged at the very highest levels of corporate management.”

He noted that a new group formed by the FFIEC, the Cybersecurity and Critical Infrastructure Working Group – which liaises with the Department of Homeland Security – will soon release a report assessing the banking sector’s overall readiness to address a significant cyberthreat.

The FDIC’s own efforts to combat cyberthreats include a “Cyber Challenge” online resource with videos and a simulation exercise as well as the institution of a requirement that third-party technology service providers (TSP) update client financial institutions on any operational concerns the FDIC identifies at a TSP during an examination.

Given that cybersecurity “has become an issue of the highest importance not only at the FDIC, but for the FFIEC and its member agencies as well as the federal government as a whole,” Chairman Gruenberg said the FDIC “encourage[s] banks to practice responding to cyber threats as part of their regular disaster planning and business continuity exercises.”

Why it matters: Chairman Gruenberg characterized the current economic period as one of transition, as banks continue to recover from the financial crisis by repairing balance sheets, building capital, and enhancing liquidity. “However, with these opportunities the industry will face new risk management challenges that will require the attention of their senior management and boards,” he added. Financial institutions should take note of the three areas of ongoing supervisory focus highlighted by the Chairman: in particular, the rising threat of cyberattacks and the need to engage the highest levels of corporate management on the issue. Case in point: JPMorgan Chase & Co. just revealed in a filing with the Securities and Exchange Commission that a cyberattack on the institution compromised information from 76 million households and 7 million small businesses, including names, addresses, phone numbers and e-mail addresses, as well as internal JPMorgan Chase information about the users – one of the largest corporate breaches reported to date.

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CFPB Proposes Expanded Auto Lenders Regulation

The Consumer Financial Protection Bureau’s (CFPB) recent proposal to exercise its authority under the Dodd-Frank Act to supervise large nonbank automobile lenders may have finance companies working to enforce nondiscrimination and fair lending standards at dealerships.

The proposal, issued in September, would implement a Dodd-Frank authority for the CFPB to define and then regulate “larger participants” in consumer financial markets other than those directly covered by the CFPB’s mandate (such as mortgage lending).

The proposed rule would define larger participants to be those providers of auto finance credit that originate 10,000 or more auto loans and leases in a year. Loans and leases on motor homes, recreational vehicles, golf carts, and motor scooters are excluded, as are loans and leases for business purposes.

The auto finance business is dominated by lenders that engage in indirect financing, by purchasing loans and leases that have been originated at the dealership. These include finance subsidiaries of all the major auto manufacturers. In this form of indirect financing, the consumer interacts directly with the dealership, and the dealer typically is afforded the ability to adjust the overall cost of the financing by adjusting the dealer’s own share of that cost. The CFPB was precluded by the Dodd-Frank Act from regulating the dealers in these transactions. Yet the CFPB has a concern that the pricing to consumers (inclusive of the dealer’s share) not be discriminatory or otherwise in violation of fair lending principles. By initiating a program to regulate the indirect lenders and lessors, the CFPB seeks to put itself in a position to gather information, evaluate and ultimately affect the behavior of the credit originators in the dealerships.

According to the CFPB’s estimate, the proposed rule will generate oversight of roughly 90 percent of nonbank auto loans and leases, through regulation of about 38 finance companies. The proposed rule has a 60-day comment period.

To read the CFPB’s proposed rule, click here.

To read the Bureau’s white paper, click here.

To read the latest edition of Supervisory Highlights, click here.

Why it matters: The proposed rule would bring the indirect auto finance companies into the general jurisdiction of the CFPB, subjecting them to more extensive examination and scrutiny. It could have the effect of making indirect auto finance companies do the bidding of the CFPB to narrow the range of choices a dealer can make when negotiating the financing for an auto purchase. The comment period is short, so if affected finance companies wish to have a say in the final form of this rule, they must act quickly.

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New DoD Regs to Protect Military Families May Have Broader Impact

In an effort to provide additional financial protections to military families, the Department of Defense (DoD) proposed amendments to its regulations that the agency said will “reduce predatory lending practices, significantly expand the protections provided to service members, close loopholes in current rules, and help to ensure military families receive the important consumer protections they deserve.”

Building upon a voluntary partnership between the DoD and mortgage lenders announced in August, the regs would expand the protections of the Military Lending Act (MLA) to additional financial services, including payday loans, vehicle title loans, refund anticipation loans, deposit advance loans, installment loans, unsecured open-end lines of credit, and credit cards.

In 2006, the passage of the MLA capped the interest rate on covered loans to active duty service members at 36 percent (referred to as the Military Annual Percentage Rate (MAPR)), required disclosures to inform service members of their rights, and prohibited the use of arbitration clauses in contracts with service members.

The law also provided the DoD with the power to define the scope of credit covered by the statute. Initially, the agency used a narrow definition of credit that covered only three products: closed-end payday loans for no more than $2,000 and a term of 91 days or fewer; closed-end auto title loans with a term of 181 days or fewer; and closed-end tax refund anticipation loans.

Frustrated when some lenders responded by changing their terms to fall outside of the MLA’s protections, the DoD determined a broader scope of coverage was necessary. “Today, some lenders continue to market loans at triple-digit interest rates targeting service members, including storefronts clustered outside military installations and on websites geared toward service members,” the agency said in a press release.

The new regulations will end such activity, which the DoD said negatively impacts military readiness and can make the transition from military service to civilian life “significantly” more challenging. Pursuant to the proposal, the MLA would be extended to active duty service members and their families when seeking credit subject to the requirements of the Truth in Lending Act (TILA), with purchase-money loans and loans secured by real estate excluded.

For service members, that means the extension of the MAPR to additional credit products – although an exception exists for bona fide credit card account fees that are reasonable and customary – as well as additional disclosures for military borrowers, including a statement to consider options other than high-cost credit. In addition, creditors under the proposal would be prohibited from including an arbitration provision in contracts with service members or requiring military borrowers to waive their rights under the Service members Civil Relief Act for products covered by TILA.

Lenders would also benefit from the tweaks to the MLA, the DoD said, by simplifying the disclosure obligations to borrowers covered under the statute. “The proposal would rely on existing protections under TILA and would provide for a non-numerical descriptive statement of Military APR that would be consistent across loans offered to service members,” the agency said.

In addition, the regs propose to allow lenders access to an existing DoD database to check the status of borrowers to determine if the MLA covers them. Use of the database would provide a safe harbor from liability under the statute, the agency noted.

To read the proposed regulations, click here.

Why it matters: The DoD’s proposed regulations – currently open for public comment – move application of the MLA away from a product-by-product approach, the agency explained, towards a more comprehensive alignment with credit products that are already regulated under TILA. In addition to expanding the scope of existing rules to cover more types of loans, the proposal would prohibit binding arbitration, a common feature in credit card agreements. While the changes would obviously impact service members, the DoD regulations could also have an impact on other loans. For example, the 36 percent MAPR has become an informal limit for the pricing of some subprime products. So the prohibition on mandatory arbitration could have an impact on credit cards generally and influence the upcoming Consumer Financial Protection Bureau rulemaking with respect to arbitration clauses.

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