Lawsuit Fears Push Up Costs for Risky Banks

The FDIC aims to recover losses from leaders of failed institutions

On Nov. 1, the Federal Deposit Insurance Corp. sued 11 former officers and board members of Heritage Community Bank, a Glenwood (Ill.) lender closed by state regulators last year. The complaint alleges that the bank's leaders ignored losses on risky commercial real estate loans while paying out millions of dollars in dividends and bonuses. The lawsuit, seeking at least $20 million, foreshadows a likely wave of litigation against the people who ran the 314 banks that have failed since the start of 2008. The FDIC has authorized lawsuits to recover more than $2 billion from scores of former bank officials.

Whatever the FDIC wins will probably come from directors and officers insurance, which companies buy to cover damages when managers are found liable in lawsuits filed by shareholders or regulators. The FDIC "has a fiduciary duty to collect money," says Jeff Gerrish, a Memphis attorney for community banks who in the early 1980s oversaw the agency's division in charge of suing directors of failed institutions. "It will bring a claim where there's insurance or where the directors have a personal ability to pay."

Although the rates banks must pay for D&O insurance have eased somewhat over the past year after spiking during the financial crisis, they're now rising fast for many community banks at risk of failure. A healthy bank might pay $70,000 annually for $5 million in coverage, while troubled banks pay four or five times that amount, estimates Kevin LaCroix, a partner at broker OakBridge Insurance Services in Beachwood, Ohio. He says one of his clients, a small bank that is operating under a warning from regulators, saw its D&O premiums more than quadruple this year. Lawsuits from the FDIC could affect premiums even for healthy banks if insurers haven't set aside enough money to cover claims. "If the number of failed institutions continues to swell, there could be further tightening," LaCroix says.

After the savings and loan crisis in the 1980s, the FDIC sued officials from about one quarter of the failed institutions. This time around, the agency has so far settled just one case, with a bank it declines to name, for $897,000— the entire value of a $1 million D&O policy after defense costs were deducted. The agency has launched two lawsuits: against managers from Heritage and failed California lender IndyMac Bank. (Former executives at both banks have denied any wrongdoing.) And it has notified officials from 164 failed banks that it may pursue claims, FDIC spokesman Andrew Gray says. After a bank goes belly-up, the agency has three years to sue. That means executives at most banks that closed during the recent financial crisis could face lawsuits through the end of 2011.

D&O premiums for financial institutions declined almost 10 percent last year, to an average of $133,000 for $5 million in coverage, according to a report by insurance brokerage Aon. Still, the report notes that "financial institutions, and particularly community banks, continue to face a difficult D&O market." That will only get tougher as the FDIC begins to take more former bank officials to court to recover some of the billions the crisis has cost the agency, says David Payne of Aon's Risk Solutions group. "We are early in the litigation process," he says. "The FDIC is very busy with just managing the process of failed banks."

The bottom line: Rates for directors and officers insurance for community banks have risen sharply as the FDIC prepares a wave of lawsuits.

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