LETTER TO THE HONORABLE JOHN REICH

Dated: June 8, 2006

VIA FACSIMILE  (202-906-7477)
The Honorable John Reich
Director
Office of Thrift Supervision
1700 G Street, NW
Washington,  D.C.  20552

Subsection (a) of Section 405 materially mischaracterizes the amendment. It refers to it as a "clarification." In fact, it is a partial repeal of the protections of 12 U.S.C. 1818(b)(6).  That provision was added by the U.S. Congress in 1989 to protect bank directors and other institution-affiliated parties from being forced to contribute to the capital of their institution or make other restitution or monetary payments without a showing by the agency that the director or other party was unjustly enriched or that the practice in which they participated involved a reckless disregard for the law. Under Section 405, the agencies no longer will need to prove that the director or other party did anything wrong.  All they need to do is impose a condition on "any application, notice, or other request concerning a depository institution" that the directors or other parties provide financial guarantees such as maintaining capital levels, and when the condition is triggered, enforce the condition by requiring the director to pay on the financial guarantee

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 that would effectively require the board or others to guarantee the financial success of the bank.  Section 405 also provides authority for the agencies to impose conditions on "notices" and "requests", without defining those terms, that would be enforceable against bank directors and other institution-affiliated parties that could result in substantial payments ultimately being made by the institution-affiliated party to the institution.

The organizers or directors could refuse to accept the condition. But the agency could then refuse to grant the charter or deposit insurance or other corporate application, 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.  If they did and if, following the effectiveness of the corporate or other 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.

If Section 405 becomes law, the federal banking agencies, knowing that such conditions are enforceable without having to prove anything other than a breach of the condition, will have a strong incentive to utilize such conditions frequently, perhaps even indiscriminately.

Section 405 also permits the agencies to enforce written agreements entered into between the agency and an institution-affiliated party that call for financial guarantees or monetary payments without proving any wrongdoing by the institution-affiliated party. What's wrong with enforcing a written agreement against a party that has breached the written agreement?  There is nothing wrong if both parties are private parties acting on relatively equal footing. Each will negotiate the agreement on an arms-length basis.   The parties to such an agreement should adhere to the agreement, and if one of them breaches the agreement, the other should have the right to enforce it.

However, a written agreement between a federal banking agency and an institution-affiliated party calling for the institution-affiliated party to undertake financial guarantees to the bank has an entirely different character to it. The agency and the institution-affiliated party are not equal, and many such written agreements likely would be entered into through compulsion and pressure. Authorizing the agencies to enforce such agreements without a showing that the party did anything wrong will provide the agencies a strong incentive to use such agreements frequently.

In the late 1980's, at a time when the agencies believed that they could enforce such conditions or agreements, at least one of them utilized that authority. The Office of Thrift Supervision tried to enforce agreements relating 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 (Section 8(b)(6) of the FDI Act) that Section 405 will override. Having been unsuccessful in enforcing these agreements, OTS stopped utilizing them.  But once Section 405 becomes law, AABD expects that OTS and one or more of the other federal banking agencies will begin to utilize both written agreements and written conditions that will require bank directors and other institution-affiliated parties to commit to financial guarantees.

In a D.C. 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.

Nothing in the legislative history of H.R. 3505 or S. 2856 suggests that the House or Senate had any idea that they might be creating a potential nightmare for bank directors, officers, investors, and others who work with banks. No one testified as to the vital protections afforded bank directors and other institution-affiliated parties that the U.S. Congress incorporated into Section 8(b)(6) or the justification for gutting the protections of Section 8(b)(6). No one testified as to how the agencies would use, or intend to use, the exceedingly broad authority in Section 405 to override the protections in Section 8(b)(6).

This legislation seriously breaches the traditional separation of the liabilities of the corporation and the personal liabilities of a director. American corporate law 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 does not do well financially or even fails, the director should not be held financially responsible for what happened if the director acted in accordance with his or her fiduciary duties.

Section 405 is unwise legislation.  We do not know how the OTS and other federal banking agencies will use these new powers since none of the testimony of representatives of the federal banking agencies addressed this issue, but the powers granted are breathtakingly broad. The power to enforce conditions to applications, notices, and other requests encompasses many corporate and other activities in which banks are engaged. The power to enforce conditions and written agreements will encourage the federal banking agencies to impose such conditions and demand such written agreements.  Written agreements entered into between a federal banking agency and an institution-affiliated party has no resemblance to written agreements entered by independent private parties on an arms-length basis.  A federal banking agency is in a position to pressure an institution-affiliated party to sign an agreement that the institution-affiliated party would never have signed had the agreement been proposed by a private party.

Section 405 puts bank directors and other institution-affiliated parties at undue risk of personal liability once the agencies begin to use their new authority. The threat of potential liability may cause bank directors to resign or qualified candidates from accepting director positions. Section 405 will undermine the safety and soundness of financial institutions by eroding the base of qualified persons willing to serve as bank directors.

The federal banking agencies already have vast powers to assure the safety and soundness of the banking system.  Cease and desist orders, removal and suspension powers, capital directives, safety and soundness plans, and civil money penalties are part of their formidable arsenal. The agencies do not need additional authority that involves enforcement of conditions or written agreements with bank directors involving personal financial guarantees that they should not be asked to accept or agree to under any circumstances.

Please feel free to call me with any questions you might have on this injurious legislation.   Time is of the essence.

Sincerely,

David Baris
Executive Director