Sorting out director liability, and preventing it

“Chapter 5, The risks of directing a financial Institution,” by Ben S. Branch and Robin Russell—what I consider the key section of this handbook—starts with the paragraph above.

Initially I took it for a wisecrack. Then I analyzed all 17 pages of this chapter, plus the 5 additional condensed pages of related notes. Now, I feel the lead passage is but an understatement of the new banking age.

Overall, this is an interesting, action oriented, and practical book packed with insightful analysis, stats, case studies, advice and templates. The liability section is especially important.

Editor Benton Gup notes in the preface to the Handbook that he came to organize the book after interviewing directors of a bank that had gotten into serious trouble. “The directors were intelligent and very successful in their own professions,” he writes. “However, they had little or no background in financial institutions, which can be extraordinarily complex.” Gup is Professor of Finance and holder of the Robert Hunt Cochrane/Alabama Bankers Chair at the University of Alabama.

 

For directors of regulated financial institutions, a proactive and vigilant analysis of their own risk factors, comprehensively but succinctly described in Chapter 5, would more than justify the price of the entire book. In my view, every board chairman should make this handbook required reading for all board members. In turn, each and every board candidate should probably spend at least a day in seclusion, along with their personal lawyer, accountant, and insurance broker, brainstorming the remuneration and liability insurance packages that have been offered to them.

By chance, I had recently discussed liability insurance coverage with several bank directors from the U.S. and other countries. Each proudly stated that their bank provides $30 million (or $50 million or even $100 million) policy for director’s coverage, which they considered more than adequate. Hogwash! 

There is a good chance that many directors are simply in denial. They may be blindly trusting the assertions of their bank’s officers. Or possibly, they haven’t carefully analyzed the numerous insurance policy exclusions that would make a “one-number-covers-all” quote all but meaningless. The Handbook mentions that $25 million coverage of the directors of Bank of New England Corporation—a “classic” of the federal seizure bailout in the 1990s—proved to be inadequate, with the litigation pending years later.

As noted in the book, not all of a bank holding company director’s liabilities are even derived from regulations. For instance, as a bank is also a corporate entity, bank holding company directors might have fiduciary responsibility for various non-banking issues (i.e., labor, health, environment, etc.) that might not be covered by a standard banking director insurance policy.

According to the Handbook, when your liability insurance is a last-resort lifesaver, various policy exclusions might explicitly or subtly favor the governments, creditors, certain other parties, and even bank executives versus the interests of bank directors. In a crisis they might suddenly find themselves entirely on their own. An extensive subsection of Chapter 5 analyses nebulous points in director’s personal liability insurance coverage and describes how to review the details of this document, thus mitigating exposure of their personal assets.

How likely is exposure to such a crisis for an individual director of a financial institution?  As some examples in the Handbook illustrate, litigation challenges by the shareholders and other stakeholders increase the likelihood of bank directors being exposed to major lawsuits that they might have to cover from their own assets.

Although the Handbook’s own extensive lists of bank directors’ personal risks, due diligence issues, sources of liability, and potential plaintiffs are hefty, even they might not be exhaustive. Chapter 5 excludes at least one very new risk—increased International Financial Reporting Standards (IFRS) accountability and transparency that for many a bank board accustomed to obscurity of financial reporting might be a radical game changer, in terms of potential litigation.

The Handbook covers the critical subject of the financial institution director’s duties. A well-organized and proactive board is critical for the operation of any modern enterprise, especially those that deal with financial services. With recent sweeping changes in socioeconomic, regulatory, and technological environments, FI boards must proactively fulfill their role of setting strategic directions, establishing bank policies and overseeing management.

Outside directors in particular must ensure that they are provided with an accurate picture of the bank’s business, regulatory and financial situation. According to the Handbook, seemingly commonplace issues—such as directors training, organization of independent audit, and ongoing monitoring of capital and management—are in fact critically important to the bank’s survival.

 

The Handbook’s editor, Benton Gup, was able to assemble an impressive group of authors with complementary expertise. (He also authored or co authored several chapters.) Early chapters briefly describe the state of the industry, new financial products, business models, and competition. A deficiency, which I’ll come back to later, concerns ebanking and payment technologies. “Chapter 4: Improving director oversight of compliance” mainly describes regulators’ expectations.

“Chapter 6: Corporate social responsibility,” tackles a vital subject that is often expressed as ideological fluff. That’s not the case here. The subject is presented in the Handbook as a continuum of pragmatic actions and principles, integrating self interest with the expectations of legitimate stakeholders. The author stresses that codes of ethics promoted by leading industrial associations have a high practical value, provided the bank’s top managers are truly committed to them.

“Chapter 8: Advice for new directors” provides guidance from two seasoned financial institution board members. Overall, it is a highly practical section.

Some chapters are very specialized, and their authors come from countries and reflect their environments or discuss issues not on the radar of the typical community bank board.  One such chapter, nonetheless interesting, was written by Hungarian banking officials and deals with some wrinkles on retail banking. Another chapter looks at governance issues from an Australian viewpoint and another presents a simple guide to Islamic banking principles, a  relatively new [for U.S. banks] and important subject.

 

A deficiency of this excellent book was that it was limited to analyzing the old “brick-and-mortar” banking paradigm. The role of board members in oversight of global online and mobile financial institutions and payment gateways requires equally effective and highly pragmatic chapters.

In addition, some issues that I missed, though American board members might not, were detailed coverage of banking issues in the European Union, Southeast Asia, and the emerging BRIC [Brazil, Russia, India And China] economies. It also did not cover effective headhunting of new industry leaders from the perspective of their boards of directors.

Hopefully new editions of the Handbook for Directors of Financial Institutions will be able to address these issues based on the type of sound research and practical experience accumulated to date by its distinguished group of authors.

 

 

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