With the advent of a more competitive and technically complicated marketplace for all types of financial institutions, one of the most challenging tasks facing community banks is recruiting and retaining highly qualified representatives of the local community to serve as directors.
Few will dispute the crucial role of a strong, well-informed and proactive board of directors and the positive effects that such a directorate can have on the profitability and business reputation of the bank.
The problem today is that the task of recruitment and retention of good directors has been made that much more difficult with the adverse publicity regarding director liability that has been spawned by the massive number of bank and thrift failures that occurred in the past six years.
The efforts of the Federal Deposit Insurance Corp. and Resolution Trust Corp. to hold directors personally responsible for loan losses totaling billions of dollars have been well publicized. Those efforts have also served to raise the level of anxiety for those people who serve (or who may be asked to serve) as directors.
There have been numerous instances in which bank regulators and their legal representatives have sought to impose personal liability on bank directors for loan losses with little or no evidence of any actionable conduct by the director or any causal connection between the director's conduct and the losses sustained by the bank. In such cases, personal liability was seemingly imposed on the hapless director for being in the wrong place at the wrong time.
Because of the apparent incongruity between the degree of actual fault and the amount of personal liability sought to be imposed, there is a tendency to sensationalize the resulting apparent injustice. To be sure, such reports have a certain beneficial shock value that can serve to "awaken" the inattentive or lazy director.
All too often, however, they conjure strong negative images in the minds of those serving as directors of financial institutions, raising doubts as to the worth of their continued service. At the same time, such fatalistic accounts probably have an equally disturbing effect on anyone who has been invited to serve as a director for the first time.
The dramatization of such tales of doom and gloom also serve to highlight the legitimate concerns of bank directors who ask themselves: How can I effectively control and manage the risk of my personal liability?
In the face of well-publicized courtroom victories over bank directors for bank loan losses, there appears to be a growing consensus among some that the best method of avoiding liability for such losses is for the directors to remove themselves from the loan approval process and to delegate the authority to approve all "significant" commercial and real estate loans to professional senior executive loan officers or to executive loan committees composed of professional bankers.
The advocates of this method appear to champion the legal theory that if bank directors are not directly involved in the loan approval process, they can escape liability for any loss that might occur as a result of such loan. Unfortunately, director liability for loan losses is not that simple.
Bank directors can and should delegate certain operational responsibilities to qualified professional bank officer personnel (and, if they choose, to appointed committees composed of bank officers and/or directors); however, they cannot delegate their legal accountability as fiduciaries for the care and management of the bank. Liability cannot be avoided, as suggested by some, by simply delegating the responsibility to someone else.
There is a more positive and practical technique of managing the risk of liability for loan losses by bank directors. A simple, two-step approach is suggested. Directors should develop a clear understanding of the legal parameters of the duty in question, and they should develop a distinct set of procedures designed to ensure that all of the requisite elements related to that duty are satisfied. If these two steps are followed, no person sitting (or contemplating service) as a bank director should have any apprehension regarding their personal liability for breach of that duty.
A bank director has a multitude of legal duties. The specific duty under consideration here is the duty to direct and manage the lending function of the bank. What are the specific elements and parameters of that duty?
First, the board must adopt a strategic plan that synthesizes the corporate objectives of the bank with the economic and human resources of the bank and the community it serves. Such a plan should include an outline of the role and impact of the bank's lending activities.
Second, the board must adopt formal policies governing the lending practices of the bank. As a minimum, such policies should clearly delineate the bank's lending market, the types of loans offered, the credit underwriting criteria and documentation requirements, loan performance standards, and collection practices.
Third, the board must define the job responsibilities of and delegate the necessary authority to bank loan officer personnel (and any executive loan committee that might be formed) charged with implementing the lending policies adopted by the board.
Fourth, the board must monitor and supervise the actions of bank loan officers (as well as any loan committee) to determine that they are executing their duties and loan authority in accordance with the loan policies and delegations of authority granted by the board.
Fifth, the board must take appropriate corrective action if the monitoring process shows that the lending policies of the bank are not being followed or reveals other warning signs.
The board of directors should make a specific effort to develop a comprehensive understanding of each element and its relationship with the business judgment rule. In most instances, this will require the assistance of bank counsel or an experienced attorney who is familiar with commercial banking and the liability of bank directors.
The point to be emphasized here is that the various elements that make up the legal duty of a bank director to direct and manage the lending function of the bank are relatively easy to understand by any director even though that person may not be trained as a lawyer or professional banker. There are only two conditions: directors must ask and seek to understand their duty from someone qualified to teach, and they must make the personal commitment of time and effort needed to learn.
Once a director understands the nature the duty, the second step is the development of implementing procedures designed to ensure that the various elements of the duty are satisfied. The implementing procedures for the first three elements (namely, establishment of a strategic plan, adoption of loan policies, and development of job descriptions/delegations) are self-evident and need little elaboration. One point, however, deserves brief mention. Directors should adopt a procedure to ensure that the strategic plan, loan policies, and officer job descriptions and delegations are periodically reviewed for their effectiveness and relevance to current conditions.
The vast majority of cases holding directors liable for loan losses fall into one of two categories: losses involving insider abuse and self- dealing, and losses involving the failure to properly supervise the bank's loan officers and/or the failure to heed certain warning signs. For purposes of this discussion, only the second category will be considered.
Virtually all of the cases imposing liability for the failure to properly supervise the bank's loan officers can be traced to failures of implementing procedures to monitor the performance of the bank's loan portfolio. In this regard, bank directors are not expected to personally review and track every loan made by the bank. On the other hand, they must develop a review process by which they can determine the following: (1) whether the loan policies they established are being followed, (2) whether the lending duties and delegations of authority they assigned to the bank's loan officers are being observed, (3) whether the loans made by the bank's loan officers are performing assets of the bank, and (4) whether any remedial action is necessary or appropriate to correct any problems or deficiencies.
The structure and content of the implementing procedures are within the discretion of the board. Numerous articles have been written regarding the establishment of internal management information and reporting systems and loan quality control procedures to monitor the bank's lending activities. Many boards have obtained the assistance of outside experts with specialized training in reviewing such procedures - such as former bank examiners with extensive bank regulatory experience.
The implementing procedures do not have to be elaborate to be effective. For example, the credit underwriting standards and loan documentation requirements set forth in a bank's loan policy can be codified into simple checklists for the different types of loans made by the bank.
Such checklists can be used in a variety of ways. They can be used by the board for loans requiring their approval to ensure that such loans conform with current loan policy; they can be used as a final clearing mechanism to ensure that no loan is funded unless all items on the checklist are checked (or exempted by an authorized official); and they can be used by the board on a spot-check basis to evaluate the performance of loan officer personnel.
The most critical implementing procedure that is frequently overlooked or ignored by directors pertains to the recognition of loan deficiencies and other warning signs that require remedial action.
Most directors who have been held liable for loan losses were aware of their responsibility to be informed about the bank's loans. All too often, however, they failed to recognize problems and take corrective action because of missed opportunities to become better educated regarding the bank's operations. As a result, they were not equipped to take effective remedial action in the face of what should have been recognized as a warning sign.
Directors should establish specific review procedures for the entire report of examination, not just the summary findings and conclusions of the examiner in charge in the opening section of such reports.
One of my standing recommendations to directors of community banks is that they conduct a board meeting where the only topic of discussion is the most recent examination report, and where each page of that report is reviewed by the board with the principal executive officers of the bank.
Further, such review procedures should be recorded in the minutes of the board meeting. I also strongly recommend that each director maintain a personal "working file" in the bank.
As a minimum, that file should contain copies of the last three bank examination reports reviewed by the director, and each report should be annotated with the personal notes that the director took during the discussion of the report with the bank's executive officers and other directors. That file should also contain the director's copies of various briefing materials (again, with the personal notes of the director to reflect any discussion of those materials) used to consider any matters submitted for director approval.
The duty of bank directors to direct and supervise the lending function of the bank is a manageable responsibility if it is reduced and viewed in two parts. The first is the need to develop a clear understanding of the various components of their legal duty and their interrelationship with the business judgment rule.
The second is the need to develop specific implementing procedures and techniques (including a record-keeping system that will verify their existence) that are designed to ensure that the various elements of the duty are fulfilled. These are the basic ingredients of due diligence and have long served as the most effective shield against the imposition of personal liability of bank directors for loan losses.
There is no short-cut route for directors to escape liability for loan losses. The traditional path marked by diligence and personal commitment is straight and easy to follow with proper counsel and guidance. Mr. Woodrough is an attorney with Langford, Hill & Trybus, Tampa. He worked as counsel of the FDIC Atlanta region from 1973 to 1989.
