Board Report: 2014-SR-B-011 July 25, 2014
The purpose of the FDIC's professional liability program is to maximize recoveries to receiverships and hold accountable directors, officers, and other professionals who caused losses to failed depository institutions. The FDIC as Receiver, pursues PLCs pertaining to all failed depository institutions, regardless of whether the PFR was the FDIC, FRB, OCC, or OTS. The main objectives of the FDIC's PLC process are to investigate all potential claims and recover losses on those PLCs that are determined to be meritorious and expected to be cost-effective.
PLCs are civil tort and breach of contract claims that seek recovery for damages caused to failed institutions by their directors, officers, and other professionals who worked for or provided services to the failed institutions such as lawyers, accountants, appraisers, and other professionals. Recoveries are used to pay claims against the receivership estate in accordance with statutory priorities set out by Congress, which provide first for payment of the receiver's administrative expenses, second for any deposit liability, and third for general creditor claims.
When an institution fails, the FDIC acquires a group of legal rights, titles, powers, and privileges, which include PLCs. PLCs are claims under civil law for losses caused by the wrongful conduct of directors, officers, lawyers, accountants, brokers, appraisers, and others who have provided professional services to a failed institution. To collect on these claims, the FDIC often must sue the professionals for losses resulting from their breaches of duty to the failed institution. PLCs also include contract rights inherited from the institution under fidelity bonds that institutions purchase to cover losses resulting from dishonest or fraudulent acts by their employees.
For each institution failure, the FDIC investigates 11 PLC types, as described in Table 3. Most PLCs are closed after the investigations are completed, including those that are not applicable to an institution's operations. However, when warranted, the FDIC pursues PLCs that are meritorious and expected to be cost-effective. The FDIC has 3 years to file tort PLCs and 6 years to file contract PLCs, from the date of an institution failure, unless state law permits a longer timeframe.19 The FDIC documents the resolution of each PLC in written memoranda.
Table 3: Description of PLC Types
|
PLC Type |
Description |
|
Director and Officer (D&O) Liability |
Claims against former directors and officers of a failed institution for conduct that caused loss to the failed institution, such as negligence, gross negligence, or breach of fiduciary duty. |
|
Fidelity Bond |
Claims against insurers for failure to pay under a financial institution bond issued to the failed institution for covered acts. |
|
Accountants' Liability |
Claims against external or internal accountants and auditors for conduct that caused loss to the failed institution, such as breach of contract, negligence, and professional malpractice. |
|
Attorney Malpractice |
Claims against attorneys and law firms for conduct that caused loss to the failed institution, such as breach of contract, negligence, and professional malpractice. |
|
Appraiser Malpractice |
Claims against individual appraisers and appraisal firms for conduct that caused loss to the failed institution, such as breach of contract, negligence, and professional malpractice. |
|
Insurance |
In states permitting such claims, direct actions against liability insurance carriers, or actions brought as assignee of a professional liability insurance policy. |
|
Commodity Broker |
Claims against brokers or brokerage firms whose conduct in connection with the purchase or sale of commodities caused loss to the failed institution, such as breach of contract, negligence, professional malpractice, and violation of law. |
|
Issuer |
Claims against insurance brokers for conduct in connection with the issuance of insurance policies that caused loss to the failed institution, such as breach of contract and negligence. |
|
Residential Mortgage Malpractice and Fraud |
Claims against mortgage brokers, title insurance companies, closing agents, and appraisers for conduct in connection with residential mortgages that caused losses to the failed institution, such as breach of contract, breach of fiduciary duty, negligence, and professional negligence. |
|
Securities and Residential Mortgage Backed Securities |
Claims against securities brokers, brokerage firms, control persons, issuers, depositors, underwriters, and sellers in connection with the purchase or sale of securities to the failed institution, such as breach of contract, negligence, gross negligence, breach of fiduciary duty, and violations of law. |
|
Other Miscellaneous Claims |
Other claims against professionals that do not fit into the other professional liability claim types. |
Source: Generated by the FDIC OIG based on information from the FDIC.
PLC investigations require a coordinated effort between the FDIC's DRR Investigations Department and PLU. Prior to an institution's failure, DRR develops a Strategic Resolution Plan, which identifies critical issues and strategies from all of DRR's functional areas pertaining to the orderly closing of an institution.
At the closing, DRR Investigations and PLU staff interview former institution officials, review insurance policies, and gather documents needed to investigate and make decisions on whether to pursue any of the 11 PLC types. Key documents include:
After the closing, DRR and/or PLU begin the process of determining whether or not a PLC is meritorious and expected to be cost-effective to pursue. For example, to show that a tort PLC has merit, the FDIC generally must establish:
The legal criteria to support certain claims such as those pertaining to negligence or gross negligence may not be as rigorous as the criteria necessary to support a removal/prohibition order, depending on the applicable federal or state law that applies to the PLC.
To establish that a claim is expected to be cost-effective, the FDIC's estimated recoveries should exceed its estimated costs to pursue the claim. Potential sources of recovery for the FDIC include obtainable proceeds from insurance policies and assets of the targeted individuals or entities. The FDIC's costs include internal DRR and PLU costs and outside counsel fees and expenses.
PLCs that are deemed to either lack merit or cost-effectiveness are closed out by DRR and PLU through a dual approval process. Claims that are deemed to be both meritorious and cost-effective are pursued. For claims that are pursued, the FDIC and potential defendants are sometimes able to reach a negotiated settlement prior to litigation. In these cases, settlements are approved by delegated authority or the FDIC Board.20 If the FDIC and potential defendants are unable to negotiate a settlement and the FDIC litigates, the FDIC's Board or appropriate delegated authority must first approve the filing of a lawsuit.21 Even after the FDIC files a lawsuit, the defendants and the FDIC may still reach a negotiated settlement or the case may proceed to trial.
SOLs. The SOL to file a lawsuit in support of a tort and contract PLC is 3 and 6 years, respectively, from the date of an institution failure, unless state law permits a longer timeframe.22 The SOL can be extended for any of the 11 PLC areas if the FDIC and potential defendants execute a tolling agreement. Tolling agreements are typically used when both parties need more time to attempt to reach a pre-suit settlement. The FDIC executed tolling agreements for 15 PLCs from our sample of 63 failed institutions (24 percent).
Performance Reporting. Since 2008, the FDIC has had an annual performance goal to make a decision to close or pursue 80 percent of PLCs within 18 months of an institution's failure. The FDIC achieved this target each year from 2008 through 2013 with decision rates on PLCs ranging from 80 to 87 percent.
PLU prepares annual and quarterly reports for the FDIC Board, which summarize PLC recoveries and expenses, significant litigation and settlements, and PLU staffing and workloads.
The FDIC provides an annual report to Congress, which contains information on PLC recoveries during the year, the number of authorized and filed lawsuits, the number of open investigations, and the results of its efforts to achieve the annual performance goal.
The FDIC also places general information about PLCs on its public Web site including the number of PLC lawsuits authorized, the number of authorized D&O liability defendants, and a listing of D&O liability lawsuits filed in court. The FDIC began posting settlement agreements to its external Web site in March 2013.
Internal Coordination Enhancements. During 2013, the FDIC enhanced information sharing among its personnel working on PLCs and EAs.
Pursuant to the MOU, PLU and DRR now share information regarding the status of the 11 claim areas, the assigned PLU attorney, and fidelity bond proofs of loss with RMS and Legal Enforcement. PLU also provides draft and final Authority-to-Sue memoranda to Legal Enforcement prior to the related FDIC Board meeting.
PLU management requires its close-out memoranda to state whether PLCs have been referred to Legal Enforcement. This requirement has been in effect since January 2013, or possibly earlier.
Legal Division guidance also instructs PLU attorneys to share information about meritorious claims that are not cost-effective from a PLC perspective with the Legal Enforcement attorneys. This enables Legal Enforcement to determine if EAs should be pursued in relation to FDIC-supervised institutions and information should be provided to the PFRs for claims pertaining to non-FDIC-supervised institutions.23 In this regard, we reviewed a sample of PLCs that were deemed not cost-effective, but appeared to have some level of merit, to confirm that PLU shared case information with Legal Enforcement and/or the PFR for EA consideration. Based on a sample of 611 closed PLCs from 63 failed institutions, we identified 15 PLCs that indicated some level of merit, but were closed out for lack of cost-effectiveness. In these 15 instances:
PLU stated that although these 15 PLCs were potentially meritorious, they were not referred to Legal Enforcement because the facts were not sufficiently egregious to support an EA, which requires a higher standard of proof than a negligence claim.
We are not making a recommendation in this area because the FDIC made significant improvements in its internal coordination efforts during 2013. Further, the FDIC OIG verbally discussed with PLU and Legal Enforcement issues related to referring meritorious claims to Legal Enforcement, which then coordinates with FDIC regional offices and the PFRs, when warranted.
For the 465 institutions that failed during 2008 through 2012, the FDIC investigated 5,641 potential PLCs, as shown in Table 4.24 As of September 30, 2013, the FDIC:
In total, the 735 completed and pending PLCs noted above were associated with 193 of the 465 failed institutions (42 percent). Table 4 shows the number of PLCs pursued by claim type and the status of those PLCs as of September 30, 2013. Of the 5,641 potential claims, 430 were completed (7.6 percent), 875 were pending a final decision (15.5 percent), and 4,336 were not pursued (76.9 percent).
Table 4: PLCs Pertaining to 465 Failed Institutions
|
Claim Type |
Closed Out by FDIC and Not Pursued |
Pending a Decision by FDIC to Close or Pursue |
Pending Results from Litigation or |
Completed (Judgment, Settlement, or Dismissed)* |
|
D&O Liability |
186 |
135 |
102 |
60 |
|
Fidelity Bond |
376 |
79 |
19 |
17 |
|
Accountants' Liability |
381 |
82 |
5 |
3 |
|
Attorney Malpractice |
411 |
40 |
10 |
8 |
|
Appraiser Malpractice |
404 |
50 |
4 |
8 |
|
Insurance |
437 |
29 |
1 |
0 |
|
Commodity Broker |
438 |
29 |
0 |
0 |
|
Issuer |
438 |
27 |
0 |
0 |
|
Residential Mortgage Malpractice and Fraud |
422 |
42 |
117 |
329 |
|
Securities and Residential Mortgage Backed Securities |
392 |
24 |
47 |
2 |
|
Other Miscellaneous Claims |
451 |
33 |
0 |
3 |
|
Total |
4,336 |
570 |
305 |
430* (7.6%) |
|
5,641 PLCs |
||||
Source: Generated by the FDIC OIG based on an analysis of FDIC data as of September 30, 2013.
* Completed PLCs comprised settlements and court judgments to pay the FDIC and cases dismissed by the courts. Of the 430 completed PLCs, 379 resulted from settlements, 32 resulted from court judgments, and 19 were dismissed. Return to text
Comparison of Current and Historical PLC Data. With regards to the 2008 financial crisis, the FDIC completed PLCs against directors and officers affiliated with 56 out of the 465 failed institutions (12 percent). PLCs against directors and officers were pending a final decision based on litigation or negotiation at 99 institutions. In all, a PLC had either been completed or was pending a final decision against directors and officers at a total of 154 institutions (33 percent), as of September 30, 2013.
From 1980 through 1995, the FDIC investigated PLCs for more than 1,600 failures for which it was the Receiver. The FDIC brought claims against directors and officers in 24 percent of the institution failures occurring between 1985 and 1992.25
Types of Actions Warranting PLCs. PLCs were pursued in response to the following types of misconduct:
Review of PLCs from 63 Failed Institutions. We reviewed 693 potential PLCs from a sample of 63 failed institutions. As discussed earlier, these institutions had the highest loss rates as a percentage of assets. In 611 instances (88 percent), the FDIC did not pursue PLCs because cases lacked merit or were not expected to be cost‑effective. For the remaining 82 PLCs:
The FDIC pursued at least one PLC on 42 of the 63 sampled institutions (67 percent) with the most commonly pursued PLC type being D&O liability. We verified that the FDIC obtained proper authority before initiating litigation or agreeing to a settlement and that close-out decisions were properly approved by DRR and PLU.
Based on our research and interviews, we identified the following factors that have impacted the pursuit of PLC's by the FDIC.
Regulatory and Other Insurance Policy Exclusions. D&O insurance contracts purchased by institutions before failure are a primary source of recovery for losses resulting from misconduct of culpable directors and officers before their institutions failed. These potential recovery sources have been impacted by insurance policy exclusions, which prohibit or attempt to prohibit government agencies, such as the FDIC from recovering losses under the policy, even if the losses from wrongful acts by management would have been paid to non-government claimants. These exclusions became prevalent during the 2008 financial crisis as the condition of the banking industry deteriorated. As the crisis unfolded, an increasing number of insurance policies reduced their coverage periods from 3 years to one-year, resulting in annual renewals. Upon renewal, private insurance companies added exclusions, especially for troubled institutions. D&O liability insurance companies also increased the number of policies with regulatory exclusions during the banking crisis of the 1980s and early 1990s.
Table 5 shows that regulatory exclusions became more common in insurance policies as the 2008 financial crisis progressed. The rate of regulatory exclusions steadily increased from 2007 through 2013.
Table 5: D&O Insurance Policies with Regulatory Exclusions
|
Year |
Failed Institutions with Regulatory Exclusions |
Total Number of Failed Institutions |
Percentage |
|
2007 |
0 |
3 |
0% |
|
2008 |
3 |
25 |
12% |
|
2009 |
50 |
140 |
36% |
|
2010 |
98 |
157 |
62% |
|
2011 |
65 |
92 |
71% |
|
2012 |
46 |
51 |
90% |
|
2013 |
23 |
24 |
100% * |
|
Total |
285 |
492 |
58% |
Source: FDIC's PLU.
* One institution never had a D&O insurance policy. Return to text
In addition to regulatory exclusions, three other types of exclusions also became prevalent during the 2008 financial crisis.
For the most part, the FDIC has not been successful in pursuing claims when regulatory and prior act exclusions are present in insurance policies because these exclusions are specific and straightforward. The FDIC has had some success in pursuing claims when the related insurance policies had "insured versus insured" clauses and carve out provisions. When pursuing PLCs, the FDIC has also targeted an individual's personal assets.
The FDIC has performed some research to quantify the potential impact of regulatory exclusions. Specifically, PLU conducted an informal study on 492 institution failures that occurred from 2007 through 2013 and estimated the potential impact of lost PLC recoveries due to regulatory exclusions in insurance policies.26 PLU found that 285 of the 492 failed institutions (58 percent) had D&O insurance policies with regulatory exclusions and estimated that these exclusions reduced the FDIC's potential PLC recoveries by $271.1 million.
The FDIC has considered potential alternative recovery sources such as increasing the deposit insurance assessments for institutions with regulatory exclusions. However, FDIC officials concluded that it would be difficult to implement an assessment-based alternative to D&O policies, particularly when D&O policies renew annually. We believe that the FDIC should continue to research alternative recovery sources. One option we discussed with FDIC officials was requiring institutions with regulatory exclusions in their insurance policies to establish reserves on their balance sheets to compensate for the additional risk of loss when D&O policy proceeds may not be available to the FDIC. Doing so, could preserve a reserve amount in lieu of the D&O proceeds and limit DIF losses should the institution fail. However, requiring such a reserve would reduce an institution's regulatory capital and could be detrimental to a problem institution.
We recommend that the FDIC:
In response to the increase in insurance policy exclusions, in October 2013, the FDIC issued a financial institution letter27 to institutions for which the FDIC was the PFR. The letter discussed the importance of reviewing and understanding the risks associated with coverage exclusions pertaining to D&O liability insurance policies. When such exclusions apply, directors and officers may be personally liable for damages arising out of civil suits relating to their decisions and actions. The letter recommended that each director and officer fully understand the protections and limitations provided by the institution's D&O liability policy when considering renewals of and amendments to existing policies.
This letter appropriately raises awareness of this issue among banking directors and officers. The OCC and the FRB did not issue similar letters. Given its significance and applicability to all insured institutions, the information in the October 2013 advisory letter would be beneficial to institutions regulated by the FRB and OCC.
Accordingly, we recommend that the FRB and OCC:
Legal Requirements. Legal requirements are a factor in pursuing PLCs because the FDIC must prove certain elements to establish that a claim has merit. To show that a tort PLC has merit, the FDIC generally must prove: duty, breach, causation, and damages. Federal and state statutes and judicial decisions establish the legal obligations of individuals and entities subject to PLCs. In some instances, proving each required element can be difficult. Additionally, some state laws include a business judgment rule that have been interpreted to require the FDIC to prove gross negligence to succeed on a PLC.
Based on a review of 611 claim areas from our sample of 63 failed institutions, 596 (97.5 percent) were closed due to a lack of merit.
Limited Recovery Resources. The FDIC evaluates potential recovery sources such as available insurance coverage and personal or company assets of the targeted defendants along with the estimated cost to litigate the claim and the probability of success in litigation.
The majority of PLCs are paid out of insurance proceeds. In other instances, individuals or entities pay PLCs. Recoveries can be impacted when insurance policy funds are reduced as a result of legal fees to defend individuals and entities against PLCs. If insurance is unavailable as a recovery source, the FDIC can still pursue personal assets of potential defendants or company assets. However, potential defendants may have limited assets, the assets may be subject to bankruptcy proceedings, or the cost to pursue the assets may be prohibitive.
Based on a review of 611 claim areas from a sample of 63 failed institutions, we found that 15 (2.5 percent) contained some level of merit but were not pursued because the FDIC determined that it was not cost-effective to do so because of limited recovery resources.
SOLs and Restrictions of Tolling Agreements. SOLs place time constraints on the FDIC to file suit on PLCs. Tolling agreements extend a SOL and allow more time for the FDIC and potential defendants to reach pre-litigation settlements. FDIC officials noted that SOLs have not impacted the agency's ability to pursue PLCs. However, if the FDIC does not identify misconduct until after the expiration of an SOL, the FDIC is generally prohibited from pursuing a PLC.
In 15 out of 63 sampled institutions (24 percent), the FDIC and potential defendants entered into tolling agreements on one or more PLCs. The FDIC and defendants entered into 20 tolling agreements associated with those 63 institutions.
The FDIC has limited its use of tolling agreements due to an April 2013 Kansas court decision prohibiting their use by the NCUA. The court ruled that an extender statute, which allows the NCUA to file claims on behalf of failed credit unions for a certain period of time after the institutions fail, prohibits the use of tolling agreements. Because the FDIC has a similar extender statute (12 U.S.C. § 1821(d)(14)(A)) to allow for the filing of PLCs for a certain period of time after institutions fail, the court's order impacted the FDIC and it now files cases earlier that might have otherwise been settled without litigation. The FDIC disagrees with and has filed an amicus brief in support of the NCUA's position and pending appeal of the Kansas court's decision. FDIC officials noted that the FDIC has prevailed in PLC lawsuits in which this decision has been raised as a defense.
Staffing Resources. We did not identify staffing resources as an impediment to pursuing PLCs. To address greater PLC workloads as the financial crisis progressed, the FDIC increased staff dedicated to investigating and litigating PLCs. As of December 31, 2012, DRR Investigations had 102 total staff located in two offices (the Dallas Regional Office and East Coast Temporary Satellite Office).28 DRR also receives assistance from contractors during times of peak workload. PLU had 55 staff located in three offices (the Virginia Square facility, Dallas Regional Office, and East Coast Temporary Satellite Office). PLU also receives assistance from outside counsel to investigate claims and litigate cases.
Tracking Recoveries and Expenses. The FDIC tracks PLC recovery and expense information on an aggregate, program-wide basis and reports this information to the FDIC Board on a quarterly and annual basis. Table 6 presents annual PLC recoveries and expenses. Recoveries often lag expenses because a significant amount of time can pass before the FDIC is able to collect on PLCs. Annual recoveries can also be heavily impacted by large settlements. For example:
Table 6: FDIC PLC Recoveries and Expenses: 2008-2013 (Dollars in Millions)
|
Year |
Recoveries |
Expenses* |
Recoveries to Expenses |
|
2008 |
$31.3 |
$9.7 |
3.23 to 1 |
|
2009 |
$47.1 |
$52.9 |
0.89 to 1 |
|
2010 |
$79.4 |
$160.8 |
0.49 to 1 |
|
2011 |
$231.9 |
$139.5 |
1.66 to 1 |
|
2012 |
$337.3 |
$110.1 |
3.06 to 1 |
|
2013 |
$674.2 |
$144.6 |
4.66 to 1 |
|
Total |
$1,401.2 |
$617.6 |
2.27 to 1 |
Source: FDIC's PLU.
* Expenses include all costs associated with investigating, closing, and
pursuing PLCs. Return to text
Currently, the FDIC's Legal Division does not report PLC cost and recovery information by individual institution. PLC costs include DRR investigation costs, PLU attorney costs, and outside counsel expenses. As discussed previously, the FDIC investigates each of the 11 claim areas for each failed institution and most of these claims are closed out. The FDIC makes the decision on the merit and cost-effectiveness of pursuing a PLC after completing the investigation phase and by comparing expected settlements with anticipated litigation costs. Accordingly, because these investigative expenses are sunk costs, PLC expenses will exceed recoveries for failed institutions when no claims are pursued.
For those PLCs that are deemed to be meritorious and cost-effective, the Legal Division provides estimated recovery and expense information by institution to the FDIC Board when requesting its approval to issue a lawsuit in support of a PLC. However, actual recovery and expense information by institution is not reported to the FDIC Board. Formally tracking and providing recovery and expense information by institution to the FDIC Board and other FDIC executives could provide greater transparency, better ensure that the FDIC's recoveries associated with pursuing PLCs align with expenses on a case-specific basis, and allow for another means of assessing PLC costs and program success. For example, the Legal Division could periodically report to the FDIC Board total cost and recovery information pertaining to institutions for which all 11 PLC types were closed or completed during a reporting period.
We recommend that the FDIC:
