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Finding the Unicorn in Lender Liability Litigation

September 14, 2017

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Investors frequently talk in terms of trying to find the next unicorn, that small start-up company that is going to turn into a billion dollar valuation.  Lawyers are like that as well, always looking for that new decision where a court opens a crack in the door of some long held legal theory. Something like this occurred in the 1980’s when the courts in California held that a party could bring a tort action for the breach of the obligation of good faith. The courts were expanding a doctrine that then existed only in the area of insurance contracts. The expansion of this theory to noninsurance contracts generated universal criticism by other courts and scholars across the US and after a ten year experiment the California Supreme Court reversed its earlier decision for the following reasons: (1) the different objectives underlying the remedies for tort or contract breach, (2) the importance of predictability in assuring commercial stability in contractual dealings, (3) the potential for converting every contract breach into a tort, with accompanying punitive damage recovery, and (4) the preference for legislative action in affording appropriate remedies. [See: Blanchard, Lender Liability: Law, Practice and Prevention, Chapter 4, Bad Faith Tort Claims]

When a party enters into a loan agreement or a promissory note, one understands what the consequences of a breach might be. If a lender is found to have improperly failed to fund under a line of credit it knows that it may have to pay compensatory damages to the borrower. Likewise, guarantors understand that if the borrower fails to pay the underlying obligation the guarantor must step in and pay the obligation.  Our commercial banking industry is built on this understanding that parties will need to put the nonbreaching party into as good of condition as they would have been if there had been no breach. Damages for breach are therefore predictable.

The unicorn for borrowers counsel today is to tag a lender with punitive damages. This has traditionally been a difficult endeavor. Courts almost uniformly dismiss breach of fiduciary duty claims because absent some unusual set of facts, the normal lender/borrower relationship is not a fiduciary one. Lenders owe no special duty to borrowers or guarantors to advise them on whether a particular business transaction for which the borrower is obtaining funds is a “good” one or not. Fraud claims are a bit easier for a borrower to keep from being dismissed but such claims are subject to heightened pleading standards and require specificity in making the claim, a general claim of “fraud” without more will be dismissed.

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Why Your Board Should Stop Approving Individual Loans

In this the new era of banking, our clients are continually looking for ways to enhance efficiency and effectiveness at all levels of their organizations. This line of thinking has led to the revolution of the bank branch and the adoption of many new technologies aimed at serving customers and automating or otherwise increasing process efficiency. Perhaps most importantly, however, banks have begun to focus on optimizing their governance structures and practices, particularly at the board level.

(A print version of this post if you’d like to print or share with others is available here.)

As we discuss this topic with our clients, the conversation quickly turns to the role and function of the bank’s director loan or credit committee, which we refer to herein as the “Loan Committee.” We continue to believe that Loan Committees should move away from the practice of making underwriting decisions on individual credits absent a specific legal requirement, and here we set forth the position that this change should be made in order to enhance Board effectiveness, not just to avoid potential liability.

Ensuring Board Effectiveness

Whenever we advise clients with regard to governance, our fundamental approach is to determine whether a given course of action helps or hinders the Board’s ability to carry out its core functions. Defining the core functions of a Board can be a difficult task. Fortunately, the staff of the Board of Governors of the Federal Reserve System recently outlined its view of the core functions of a bank Board. We agree with the Federal Reserve’s outline of these functions as set forth in its proposed guidance regarding Board Effectiveness applicable to large banks, which was based on a study of the practices of high-performing boards. Based on our experiences, many of the concepts expressed in that proposed guidance constitute board best practices for banks of any asset size. The proposed guidance indicates that a board should:

  • set clear, aligned, and consistent direction;
  • actively manage information flow and board discussions;
  • hold senior management accountable;
  • support the independence and stature of independent risk management and internal audit; and
  • maintain a capable board composition and governance structure.

We believe that an evaluation of the board’s oversight role relative to the credit function is a necessary part of the proper, ongoing evaluation of a bank’s governance structure. As it conducts this self-analysis, a board should evaluate whether the practice of underwriting and making credit decisions on a credit-by-credit basis supports its pursuit of the first four functions. We believe that it likely does not.

Considering Individual Credit Decisions May Hinder the Committee’s Ability to Set Overall Direction for the Credit Function.

We have observed time and time again Loan Committee discussions diving “into the weeds” and, in our experience, once they are there they tend to stay there. In most Loan Committee meetings, the presenting officer directs the committee’s attention to an individual credit package and discusses the merits and challenges related to the proposal. Committee members then typically ask detailed questions about the particular financial metrics, borrower, or the intended project, assuming that any discussion occurs at all prior to taking a vote.

While it may sometimes be healthy to quiz officers on their understanding of a credit package, focusing on this level of detail may deprive the Loan Committee of the ability to focus on setting direction for the bank’s overall loan portfolio. In fact, in many of the discussions of individual credits, detailed questions about the individual loan package may in fact distract from the strategic and policy questions that really should be asked at the board level, such as “What is the market able to absorb with regard to projects of this type?” and “What is our overall exposure to this segment of our market?”

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Frenemies: Gaining Efficiency Through Shared Services

the-bank-accountBryan Cave colleagues Ken Achenbach and Sean Christy join Jonathan and me on this episode of The Bank Account to examine the ability of banks to gain efficiency through shared services.  Throughout the business environment, business are looking to out source all non-core competencies.  Ken and Sean explore the opportunity for banks to similarly explore the opportunity for banks to join forces to purchase outsourced services and invest in technology platforms together. By working together, banks can leverage buying power and share the burden associated with evaluating their vendor options.

You can follow most of us on Twitter.  Jonathan is @HightowerBanks, I’m @RobertKlingler, and Sean is @SeanChristy.  Following Ken on Twitter is difficult, as he has, so far, refused to access that part of the internet.  Our producer, Sam Katz, is @SamathaJill1.

Note:  This episode was recorded before the University of Florida announced it was cancelling this weekend’s football game against Northern Colorado due to Hurricane Irma.  The Gators drought in offensive touchdowns will therefore continue at least another week.  We hope everyone stays safe.

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The Transition Away from LIBOR

LIBOR, or the London Interbank Offered Rate, is a benchmark utilized in a variety of financial transactions (including the setting of interest rates in credit agreements). It was intended to be an average of the rates at which banks can obtain unsecured funding in the London interbank market for a specified time period in a specified currency. The rate is based on submissions by banks to the LIBOR administrator (currently ICE Benchmark Administration Limited) of their good faith estimate of borrowing costs and not necessarily actual transactions. Since estimates can at times be imprecise, together with the fact that (particularly after the financial crisis) unsecured credit was not generally available to banks in the London interbank market for periods of time, LIBOR as a benchmark was ripe for reconsideration.

On July 27th, Mr. Andrew Bailey, Chief Executive of the U.K. Financial Conduct Authority (FCA) announced that the FCA will no longer require banks to submit quotes for LIBOR rates in sterling by the end of 2021, indicating that the benchmark that underpins trillions of dollars in financial contracts will be phased out by 2021 and replaced with a benchmark that is more closely tied to interest rates for actual transactions in the lending markets. This announcement has prompted plenty of concerns and more than a few troubling headlines, especially given the extremely common use of LIBOR as an interest rate benchmark in commercial credit agreements, adjustable rate mortgages and other financing arrangements.

Notwithstanding some of the more recent reactions, the financial markets have seemingly taken this development in stride without much turmoil. There are a few reasons for this. First off, there are almost 4 ½ years before this reporting requirement ends, and work has already begun to determine LIBOR’s replacement.1 Second, LIBOR may still be available even if banks are no longer required to report their quotes, although caution has been expressed not to rely on this. Last, in the commercial loan context, customary fallbacks have been built into the “LIBOR” definitions in most well-drafted credit agreements that could provide short term solutions in the event of the unavailability of the LIBOR screen rate.

While the market does seem to be generally in agreement that it is premature to attempt to craft a definitive solution to this issue now, since there is insufficient information as to what will “replace” LIBOR (and how that replacement might affect the all-in rate in any particular credit facility), market participants can take proactive steps now to prepare for the eventual transition away from LIBOR to a new benchmark rate.

First, we would recommend a review of any applicable fallback provisions mentioned above to analyze whether these provisions should be amended now (or in the next couple of years) to attempt to facilitate a smoother transition to an eventual discontinuation of LIBOR (as opposed to temporary unavailability). As highlighted by the August 3rd LSTA article, “LIBOR (Transition) in the Loan Market”, these fallbacks were designed for temporary disruptions rather than a full transition away from the use of LIBOR as a benchmark. Moreover, some fallback language is better than others. For example, some language focuses on the unavailability of the publication of LIBOR, rather than the actual underlying rate itself. If the underlying benchmark rate goes away, as opposed to just the referenced information source, the ability of an agent or designated bank to specify an alternative information source as a screen rate will be of no use. Other fallback language is much more broad, in the sense that it permits a lender or agent to determine LIBOR “in good faith” based on a variety of factors that can include, among others, an offered quotation rate to first class banks for deposits in the London interbank market by the agent or a designated bank as well as a rate determined on the basis of quotes from designated “reference banks”. This creates more flexibility in this context, but it could be argued that it gives the lender or agent too much control in an environment where the traditional LIBOR has simply disappeared.

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The Sanity of Bank Directors

The Sanity of Bank Directors

September 1, 2017

Authored by: Robert Klingler

the-bank-accountOn the latest episode of The Bank Account, Jonathan and I address two items of significant interest in our office: (a) a recent Wall Street Journal opinion piece on the sanity of bank directors, and (b) the start the of college football season (not necessarily in that order).

When starting the podcast, we expected the podcast would offer listeners an opportunity to hear the conversations we have around the office on a wide variety of topics.

Today, that includes a topic that represents a significant part of our fall conversations, college football, with a particular focus on the SEC.  As a Georgia Bulldog, Jonathan brings his bizarre view of the world, while as a Florida Gator, I correct him (or at least that’s how I see it, and I write the blog posts).  If you want to participate in the conversation, please do not hesitate to reach out to either of us (Jonathan.Hightower@bryancave.com and @HightowerBanks or Robert.Klingler@bryancave.com and @RobertKlingler).

Following the football discussion, we get down to the real business of the day, the insanity of a recent Wall Street Journal Opinion piece.  On August 28th, the Wall Street Journal published an opinion piece by Thomas Vartanian titled Why Would Anyone Sane be a Bank Director?  Jonathan’s response, Why Sane People Serve as Bank Directors, is available here.  Jonathan and I walk through aspects of Vartanian’s analysis that we agree with… as well as the many portions that we strongly disagree with.  We also address a few other items related to the analysis of what should be involved in director’s roles on bank boards and the FDIC’s approach in litigation.

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Counterpoint: Why Sane People Serve as Bank Directors

Bank directors have played a crucial role in the turnaround of the banking industry, an accomplishment that deserves recognition in light of the fact that it has been done under tremendous regulatory burden and tepid economic growth.  Given that, why do we continue to question why the country’s most respected business people would be willing to serve as bank directors?  Respected attorney and industry commentator Thomas Vartanian recently asked in an opinion piece in The Wall Street Journal, “Why would anyone sane be a bank director?”  Well, sane people are serving as bank directors every day, and in doing so they are benefiting the economy without exposing themselves to undue risk.

(A print version of this post if you’d like to print or share with others is available here.)

The regulatory environment for bank directors is clearly improving. The Federal Reserve’s recent proposal to reassess the way in which it interacts with boards is appropriate if overdue, and the other banking agencies should follow the path that the Federal Reserve has set forth.  We also witnessed the FDIC acting very aggressively in pursuing lawsuits against directors of failed banks in the wake of the financial crisis.  However, suggesting that the FDIC relax its standards for pursuing cases against bank directors is not only unrealistic, it misses the greater point for the industry in that it needs to continue to refine its governance practices in order to provide for better decision-making by bank directors and to enhance protections from liability for individual directors.

In order to fully understand the point of this position, it is important to clear up a couple of commonly-held misconceptions.  First, when the FDIC sues a bank director after a bank failure, it does so for the benefit of the Deposit Insurance Fund, which is essentially an insurance cooperative for the banking industry.  As a result, the FDIC should be viewed as a purely economic actor, no different from any other plaintiff’s firm in the business of suing corporate directors.  Lawsuits by FDIC should not be given any higher profile or greater credibility than any number of other suits against corporate directors that inevitability occur during market downturns.  There should be no additional stigma, and certainly no additional fear, with regard to a claim by the FDIC on the basis that it is “the government.”

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Counter-Cyclical Thoughts About D&O Insurance

It can be a challenge, when economic times are relatively good, to take time away from thinking about new opportunities to discuss topics like D&O insurance.  Even though I am biased, I’ll admit that, in those times, discussing the risks of potential liability and how to insure those risks can feel both a pretty unpleasant and a pretty remote thing to be discussing.  However, like all risk-related issues, it is precisely in those times when business is going well that a little bit of counter-cyclical thinking and attention can do the most good over the long haul.

As you approach your next D&O policy renewal – and particularly in the 30-60 days prior to the expiration of your current policy, there are a few things that you may want to consider.

Multi-year endorsements – what’s the catch? 

In good times, many insurers will offer packages styled as multi-year policies, usually touted as an option that allows for some premium savings and perhaps a reduced administrative burden.  However, as with all things, these advantages may come with a catch.

Many multi-year endorsements will reserve to the insurer the discretion to assess additional premium on an annual basis within the multi-year period if the risk profile of the bank changes in a material way.  So premium savings may not ultimately be realized, depending on the facts.

Beyond this, some multi-year endorsements will actually impose additional requirements on the insured to provide notice of events that could trigger the carrier’s repricing rights or other conditions.  Those obligations may be triggered when those events occur on an intra-period basis, which can set up a potential foot-fault for an organization that does not keep those requirements front of mind (which can be a practical challenge, as if those events are happening, it is likely that there are a number of issues competing for management and the board’s attention).

Companies looking at multi-year endorsements should make sure they understand fully the terms on which the multi-year option is being provided and should have counsel or an independent broker review the specific language of the proposed multi-year endorsement itself on their behalf.  In addition, while it may be tempting to use a multi-year endorsement to try to extend the renewal horizon and to try to reduce the administrative burden that comes with the renewal process, doing so may also reduce your ability to negotiate appropriate enhancements to your policy terms over the multi-year period.

Multi-year policies may be the right fit for your institution, but they should not be viewed as a one size fits all solution.  Before heading down that road, ask yourself how much is being saved and how real those savings actually are and, perhaps just as importantly, whether avoiding a broader discussion of your coverage strategy on at least an annual basis is a good thing or not.

What about the bank has changed? 

Times of economic expansion often bring with them opportunities to explore new lines of business.  In addition, substantial recent technological innovations in the financial services industries and increasing consumer demands for technological solutions have meant that not only are new market opportunities being explored but that they are being explored in new ways.  And if that isn’t enough, there is always the ever-changing regulatory and compliance landscape to contend with.

All of these trends – as well as your decisions of where and how your institution will choose to participate (or not to participate) in them – bring with them new and different risks.  To the extent that your bank has expanded its offerings, changed its footprint or portfolio mix, or otherwise changed its policies or ways of doing business, you should think about how those changes may impact your insurance needs.  It can be easy, particularly when you have a long relationship with an incumbent carrier, for the renewal process to become somewhat rote.

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HVCRE Lending: An Area of Regulatory Examination Focus

HVCRE Lending: An Area of Regulatory Examination Focus

August 24, 2017

Authored by: Bank Bryan Cave

the-bank-account

Jonathan and I are joined by our colleague, Jerry Blanchard, to discuss High Volatility Commercial Real Estate (HVCRE) Loans on the latest episode of The Bank Account.

HVCRE Loans are one of the areas of focus on regulatory exams, and we’re seeing increased attention to not only ensuring that a bank’s reported HVCRE loans are correct, but also that the bank has sufficient internal controls in place to monitor and track HVCRE lending.

Formal regulatory guidance on HVCRE lending is still rare, as the various regulatory agencies struggle to find consensus in an area that is fraught with technicalities and details.  Our colleague, Jerry Blanchard, has assisted numerous banks in evaluating overall HVCRE programs as well the application of the HVCRE requirements to countless loans.  In addition, he’s written extensively on the topic, including:

You can always follow us on Twitter.  Jonathan is @HightowerBanks, I’m @RobertKlingler, and Jerry is @Blanchard_Jerry.  Our producer, Sam Katz, is @SamathaJill1, and is not responsible for my inability to read simple copy at the end of this episode.

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Two Recent Card Payment Developments

Our Bryan Cave-affiliated sister site, the BC Retail Law Blog, recently published two posts that may be of interest to our banking, fintech and payments clients.

In “Bans on Credit Card Surcharges Face First Amendment Challenges,” the Retail Law Blog looks at how state laws that prohibit retailers from charging customers a surcharge for using a credit card are being challenged on First Amendment grounds.

For more than four decades, California’s Song-Beverly Credit Card Act of 1971 prohibited retailers from charging credit card customers such a surcharge. In Italian Colors Restaurant, et al. v. Harris, 99 F.Supp.3d 1199 (E.D. Cal. 2015), a federal judge ruled that the law unconstitutionally limits retailers’ freedom of speech. The California attorney general appealed, and the case is set for oral argument before the Ninth Circuit Court of Appeals on August 17.

One consequence of these actions may be to make credit cards more expensive to the consumer, which, in turn, could encourage further development of alternative forms of payment.

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Regulators Tackle Board Effectiveness and Overdrafts

the-bank-account

On the latest episode of The Bank Account, Jonathan and Ken Achenbach discussed the Federal Reserve’s proposed supervisory expectations for boards of directors.

Before digging into the Federal Reserve’s proposed guidance, Jonathan and Ken first discussed the CFPB’s statistical analysis of frequent overdrafters.  As noted in the CFPB’s analysis, “very frequent overdrafters account for about five percent of all accounts at the study banks but paid over 63 percent of all overdraft and NSF fees.”  They also touched on the CFPB’s prototype model forms for overdrafts.   As might be expected from the CFPB, the sample forms do a good job of highlighting the economic consequences of utilizing overdrafts, but not mention the potentially significant benefits (tangible and psychological) that can be provided by allowing such payments to proceed.

As noted by Jonathan and Ken, the Federal Reserve’s proposed supervisory guidance identifying expectations for boards of directors of banking holding companies would only apply to institutions with consolidated assets of $50 billion or more.  However, we believe the guidance is appropriate for all bank directors to look at, particularly as it draws on the Federal Reserve’s experience with approaches that improve bank governance.

Per the Federal Reserve guidance, effective boards are those which:

  1. set clear, aligned, and consistent direction regarding the firm’s strategy and risk tolerance;
  2. actively manage information flow and board discussions;
  3. hold senior management accountable;
  4. support he independence and stature of independent risk management (including compliance) and internal audit; and
  5. maintain a capable board composition and governance structure.

We believe this Federal Reserve guidance is consistent with our advice that boards need to get out of the weeds and focus on the big picture, a topic we have addressed on earlier podcasts as well.

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