September 7, 2011
Authored by: Jake Bielema
In the wake of the financial crisis, and with the increasingly growing number of failed banks, the FDIC has repeatedly signaled its intent to seek to hold former directors of failed banks liable for losses to the insurance fund under appropriate circumstances, and through litigation, if necessary. A recent decision from the Central District of California involving the directors of a failed credit union, which dismisses the claims against those directors based on the protections of the so-called “business judgment rule”, shows that claims against directors of failed banks by the FDIC will likely need to show more than that decisions on the part of the board may have been imprudent with the benefit of hindsight.
The suit was brought by federal regulators on August 31, 2010 in the Central District of California against sixteen officers and directors of a failed credit union, Western Corporate Federal Credit Union of San Dimas, California (“WesCorp”). The complaint basically alleged that, at the direction of the credit union’s officers and directors, WesCorp embarked on an aggressive campaign of growth, which included heavy reliance on borrowed funds to make investments in mortgage backed securities. The complaint alleged that, in 2009, WesCorp was forced to record $6.9 billion in losses, which rendered the institution insolvent. The complaint alleged that roughly two-thirds of the losses to the credit union were from mortgage backed securities purchased in 2006 and 2007 (specifically option ARMS).
Among others, the directors defendants filed a motion to dismiss the claims against them. On August 1, 2011, Judge George Wu granted the directors defendants’ motion to dismiss on the basis that any decisions by the directors that ratified the strategy of investing in mortgage backed securities, as alleged in the complaint, were entitled to the protections of the business judgment rule. The business judgment rule is essentially a doctrine that precludes any liability on the part of directors for the decisions that they may make in good faith and in the best interests of the company. The doctrine essentially exists to prevent courts from second guessing honest decisions by directors of corporations, even if those decisions turn out with the benefit of hindsight to have been unwise or even inept.
In dismissing the claims against the directors, the court stated that “the question in assessing the directors defendants liability vis a vis the option ARMs and concentration levels is what the director defendants knew at the time that should have dictated to them that they do something more or different from all that they did do”. The court concluded that the plaintiff had “failed to present sufficient allegations in this regard, so as to fit within any exception to the business judgment rule.”
Although the WesCorp ruling involved former directors of a failed credit union, the decision should apply with equal force to former directors of failed banks. The decision reinforces the notion that, in order to prevail or even to proceed with claims against former directors of a failed bank, the FDIC must allege something more than conduct that, with the benefit of hindsight, was ultimately damaging to the financial health of the bank. Under the application of the business judgment rule in the WesCorp case, it is unlikely that mere allegations that the Board of a failed bank wrongfully pursued an aggressive growth strategy that focused on concentrations in commercial real estate or acquisition and development loans would be sufficient to state a claim, in light of the protections afforded by the business judgment rule.