Bank directors caught in a legal crossfire.

U.S. bank directors are in a real pickle. They know they are potential targets if their institutions fail. They know that they can't rely on insurance to protect them if the FDIC sues them. And they are being told by nearly everyone that last year's banking law imposes additional duties on them.

They also know that banking is not a riskless business: Banks do take some risks in order to make money.

Therefore, it would be logical for directors (and officers) to want to know what they should do to avoid liability if, despite their efforts, the risks that they decide to take turn out disastrously or if large unforeseen risks arise.

Precise Answers Unavailable

Unfortunately, in many jurisdictions, it is hard to give directors a precise answer about their duties, much less one that will give them comfort.

For a great many years, lawyers would have had little difficulty advising bank directors about the standards of care to which they would be held.

The laws were general in nature, calling for directors to exercise the standard of care that would be exercised by a reasonably prudent person in the conduct of his (or her) own affairs.

And courts generally understood what that standard meant, regardless of whether they explained it in terms of "negligence," "gross negligence," or "fiduciary duty."

The director who was reasonably diligent, had no personal interest other than as a director or stockholder, and who cast his or her votes in good faith was protected.

The director who had a hand in the cookie jar or who didn't attend meetings, or read reports, or follow up on regulatory criticism could be held liable for the consequences.

The relatively uniform understanding of the meaning of the director's standard of required care was shattered in the 1980s by a combination of two kinds of hard cases: takeovers and bank failures.

In the takeover cases, which came first, the courts looked more closely than they had previously at the substance of what directors had voted for. And in cases like Smith v. Van Gorkum, they also looked more closely at what information directors had before them when they voted.

That trend in takeover cases caused directors to resign and directors' and officers' insurance premiums to skyrocket, and it also caused an upheaval in corporate law.

More than 40 states amended their corporation statutes either in an attempt to redefine corporate law to restore the old consensus or in an effort to add factors that directors are empowered to consider.

Some also tried to exculpate directors, in most cases with but in some cases without a requirement to amend the corporate charter by a stockholder vote.

Using |Business Judgment'

Takeover cases have focused on the "business judgment rule" and its development and codification.

That rule basically says what most lawyers thought the law on directors' duties was: If a director satisfies the procedural "duty of care" (did his or her job reasonably diligently), lacked a personal interest in the matter voted on, and made a judgment "in good faith," then the courts are not supposed to second-guess the decision and the director cannot be held liable for being mistaken.

So long as the business judgment rule is in force and courts adhere to its spirit, few directors will complain. And few will see unfairness in a standard that requires them to do their jobs and avoid - or disclose and abstain from voting on issues that involve - conflicts of interest.

In Smith v. Van Gorkum, the Delaware Supreme Court violated the spirit of the business judgment rule. That case, more than any other, prompted the flood of legislation trying to restore the balance obtained in earlier case law.

Regulators Join In

Now, in addition, some federal bank regulators have come forward. Directors, those regulators say, have a special duty to the deposit insurer: If directors merely acted in what they believed to be their stockholders' best interests, that would not protect them if they failed properly to consider the potential harm to the deposit insurer.

Moreover, of late, regulators have been suing directors based on allegations not that they didn't do their jobs or that they had an impermissible conflict of interest but, it appears, that they let the bank take too much credit risk.

Federal Law

The regulators do this, presumably, becauses as a result of savings and loan and bank failures, the taxpayers are out of pocket and Congress is on the regulators' backs.

Intervening in this process in 1989 was a provision of the Financial Institutions Reform, Recovery, and Enforcement Act that says, regardless of what any other law says, a director of a bank can be held liable for "gross negligence," as that term may be defined by state law.

This provision led director-defendants in many cases to claim that the law had established a federal standard of care for directors and that this standard preempted state laws.

The latter would have imposed a "negligence" or "fiduciary duty" standard, these defendants claimed, which generally is an easier standard for plaintiffs than "gross negligence" under which to obtain a judgment.

The smoke around that "gross negligence" provision is a bit thick at the moment. Several U.S. District courts have pointed out that the 1989 law has a "saving clause" under which state laws that impose more stringent standards than "gross negligence" are preserved.

Add the U.S. Court of Appeals for the 10th Circuit seemed to be following that lead until it agreed to a rehearing en banc in April.

FDIC's Scope Unknown

In consequence, it's not known whether the Federal Deposit Insurance Corp. can continue its lawsuits against directors based on state laws or state or federal common-law theories that impose more stringent standards than gross negligence.

But even if the FDIC could sue for less than gross negligence, many uncertainties will continue to exist. To begin with application of the business judgment rule is uncertain in many "negligence" or "fiduciary duty" states where the rule has not been codified.

Next, the business judgment rule is generally said to be inapplicable to nonactions - that is, it is said not to apply to failures to act.

And further, in states that have modernized their corporation laws to give directors a form of protection, the FDIC is likely to argue that that form of protection should be deemed to exculpate directors for "gross negligence." Since the 1989 law prohibits this degree of exculpation, these protections should be held void, the agency is likely to argue.

But if so, what would that mean?

Will the 1989 law's "gross negligence" test apply? Or will some more permissible part of state law apply?

And what of those cases that say a bank director is held to a "higher" standard than ordinary corporate directors? Are those decisions the law?

Next, what of the oaths that directors and officers take every year? Do they provide separate grounds for liability?

So far, the courts say "no," not under the National Bank Act. But only lower courts have spoken, and the same question arises under state laws.

Next, what is "gross negligence"? Does it involve intentional wrongdoing, or a complete lack of care that amounts to reckless conduct, or some more generalized form of exaggerated negligence?

The Questions Are Pragmatic

The case law in various states is inconsistent, and very little of it arises in a corporate or banking context. And finally, are directors (or officers) held to know all the laws and regulations that apply to banks? Can anybody meet that standard today?

These are not merely abstruse legal questions that bankers can worry about later. Later may be too late.

The wrong court decisions would make directors even more wary than they are today and threaten gridlock in the boardroom. A bank's ability to recruit good directors would also be threatened, to say nothing of the consequences imposed on those caught in the web while the lawyers fight it out.

What bankers now should do is support efforts to create state laws that honor the old consensus on directors' fiduciary duty. Such laws should create modern definitions that give directors sufficient guidance to make business judgments.

Protection for the Deserving

Most bankers and bank directors, I believe, are highly moral individuals who believe in a standard of care and a duty of loyalty to the corporation they serve.

They do not seek to be relieved of their duties, but they do seek protection against being second-guessed. That is a legitimate aim, and the law clearly should satisfy it.

The Conference of State Bank Supervisors has begun a project to define appropriate state-law provisions that would accord with the spirit of banking but offer protection to directors who use care, have no conflict of interest, and act in good faith. That project and the enactment of appropriate state laws merit bankers' support.

Mr. Lowy, counsel to the law firm of Rosenman & Colin, New York, has been vice chairman of Dollar Dry Dock Bank and is author of "High Rollers: Inside the Savings & Loan Debacle."

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