A Voice from the Past

It has been almost fifteen years since the S&L debacle passed into history. But one of the more frightening pieces of that history may be resurrected in the form of a provision in the Financial Services Regulatory Relief Act (HR 3505), which the House of Representatives passed on March 8, 2006. The Senate Committee on Banking, Housing, and Urban Affairs reported out of committee a streamed-down version on May 4, 2006, and the Senate passed that version on May 25, 2006.

Section 405 of HR 3505 (Section 702 of the Senate Banking Committee version, S 2856) grants the federal banking agencies the authority to enforce conditions to corporate application approvals that would require bank directors and other insiders to recapitalize their banks out of their own pockets without limitation. See Appendix I.

This section overrides federal legislation enacted in 1989 that prevents the agencies from enforcing financial guarantees from institution-affiliated parties without proving that the party was unjustly enriched or engaged in a practice or violation involving a reckless disregard for the law or regulations. See 12 USC 1818(b)(6), reproduced as Appendix II.

As an example, a federal banking agency could impose a condition to the approval of a bank charter or deposit insurance requiring that all of the organizers or directors agree to maintain adequate capital for the bank for three years or beyond. Other corporate applications, such as mergers, other acquisitions, and branch expansion, would also provide the agencies with an opportunity to impose a condition or written agreement that would effectively require the board or others to guarantee the financial success of the bank. The legislation does not even require that the conditions be attached to an application. The agencies can attach a condition to any "notice" or "request." Any matter requiring a notice or a request to the agency would allow the agency to condition such notice or request with a requirement that the bank director or other institution-affiliated party guarantee the success of the bank.

The organizers, directors or other institution-affiliated parties could refuse to accept the condition. But the agency could then refuse to grant the charter or deposit insurance or other corporate application or insist on a written condition to any notice or request, thereby preventing the bank from opening or acquiring another institution or expanding its offices or activities. The organizers or directors would then feel pressured into agreeing to the condition and if they did and if, following the effectiveness of the corporate action, the institution's capital fell below the required minimums (not necessarily because of the actions of the organizers or directors), the agency could enforce the condition by requiring each party to make capital contributions to the institution in amounts necessary to bring the capital levels back to minimum levels and to make additional capital contributions as required.

This is not an implausible scenario. In fact, it happened, on a number of occasions, in the late 1980's and early 1990's. The Office of Thrift Supervision tried to enforce conditions to approvals of corporate applications that would hold investors and directors liable for any future capital shortfalls. Fortunately, the courts struck down the use of this power, based on a statute ((12 USC 1818(b)(6)) that Section 405 would override.

This proposed new regulatory power is contrary to precepts of American corporate law, which has long recognized that the risks of financial success of a corporation lie with shareholders to the extent of their investment in the corporation, but that those risks do not extend to requiring shareholders and directors to guarantee the success of the corporation by making additional capital infusions.

A bank director has a fiduciary duty to act as a prudent person and to put the interests of the bank ahead of his or her personal interests. But if the bank director acts in accordance with his or her fiduciary duties and the bank does not do well financially or even fails, the director should not be held financially responsible for what happened.

Current law, as interpreted by the Federal Circuit Court of Appeals of the District of Columbia, prohibits the federal banking agencies from requiring, through enforcement of a condition to a regulatory approval or a written agreement between the agency and the bank or bank-affiliated party, a party to pay restitution or guarantee against loss unless the agency can prove that the party was unjustly enriched or the practice involved a reckless disregard for the law.

Current law was designed by Congress to protect institution-affiliated parties from becoming financially responsible for the success of their institution unless the agency could prove some egregious behavior. This makes sense given the concern that huge potential liability would cause many qualified persons to refuse to serve as directors and other bank-affiliated parties.

In the Circuit Court of Appeals case (Wachtel v Office of Thrift Supervision, 982 F.2d 581 (D.C. Circuit, 1993)), the OTS conditioned approval of a change in control application by investors in a savings institution on the investors guaranteeing the capital adequacy of the institution without any time or dollar limitations. Several years later, in 1989, the thrift failed, and the OTS sought to have the investors pay up—a total of $5.3 million. The investors balked, and the case was referred to an administrative law judge. The judge recommended to the head of the OTS to reject the OTS claim on the basis that the investors had not been unjustly enriched and had not acted recklessly. The head of the OTS rejected the judge's recommendation and issued an order requiring the investors to pay up, even though he did not determine that they had been unjustly enriched or acted recklessly.

The court reversed the OTS director's order, rejecting "…OTS's rather bizarre construction of the statute." The court concluded as follows:

In sum, the government simply cannot make a monetary claim against the petitioners under section 1818 without meeting the prerequisites of sec. 1818(b)(6)(A) — a showing of either reckless disregard of legal obligations or unjust enrichment. We recognize that S&L investors are now about as popular in Washington, D.C. as were Hollywood screen writers in the early 50's or oil company executives in the early 70's. Perhaps that is why OTS' efforts in this case to circumvent the statutory language strike us as attributable not so much to creative lawyering as to excessive zeal.

Section 405 is part of a "regulatory relief" bill, but there is nothing in this section that fits into that category. The prefatory material to Section 405 refers to it as a "clarification." But this is in reality a partial repeal of one of the central protections for bank directors against unlimited liability and unbridled agency administrative powers.

The testimony of the OCC and FDIC representatives, both of whom testified in favor of Section 405, did not explain specifically why the agencies believe that they need this legislation. The OCC and FDIC representatives both cited safety and soundness reasons, but without specifying how they intend to use the new powers. But there has been no effort to explain exactly how Section 405 will enhance the safety and soundness of the banking system. Our view is that it could have the opposite effect. It could discourage qualified persons from serving as bank directors, and could diminish the number of de novo bank charters, a source of healthy competition that helps offset the potentially anti-competitive effects from the substantial number of bank mergers.

The agencies already have vast powers to require banks to take affirmative action to correct deficiencies. The agencies have the powers under Sections 8(b) and 8(c) of the FDIC Act to prevent unsafe and unsound banking practices and violations of law, regulation, formal agreements, cease and desist orders, and conditions to approvals. They also may issue capital directives requiring banks to raise capital and limiting their growth and activities until such time as the banks have complied with the capital directives.

The legislation also comes at a time of great prosperity and success in the banking industry. The banking industry by all accounts is strong and getting stronger.

AABD opposes this legislation. The agencies have not proffered any legitimate justification or need for the legislation, and AABD has great concerns on how the new powers will be used against bank directors and other institution-affiliated parties.

See American Banker article on May 18, 2006, Appendix III.