Banks Balk at Request for Details on Litigation Costs

Transparency is one thing. Giving ammunition to your adversaries is another.

That's the line the Federal Reserve Board is trying to draw as it figures out what next year's stress test will look like.

Under debate is how much detail a bank should have to disclose about the money it sets aside to cover losses stemming from lawsuits. Too much information arguably could help the people suing banks, including, ironically, the government, but not enough may hamper regulators' ability to assess the operational risks facing the country's largest financial institutions.

Litigation reserves are under growing scrutiny as the number of lawsuits against financial institutions has mushroomed in the wake of the mortgage foreclosure crisis.

The Securities and Exchange Commission has been pressing public companies, particularly financial institutions, to tell investors more about potential legal liabilities.

The Financial Accounting Standards Board has come at the broad issue twice, once in 2008 and again in 2010. Its "loss contingencies" project was uniformly opposed by the industry and on July 9 the FASB finally shelved it.

The Fed joined the fray in February when it asked the largest banks to break down their legal reserves for pending and probable litigation claims by amount, timing, and type of loss event as well as by the business line against which the claim was made.

The information request is just a small piece of the annual stress-testing exercise the Fed is required to do under the Dodd-Frank Act. But it may be the most contentious.

"This is really highly sensitive information," says Edward J. DeMarco Jr., general counsel and director of operational risk management at the Risk Management Association. "Disclosure of this data would wreak havoc on the system from a safety and soundness standpoint."

DeMarco, one of a handful of association executives working closely with the Fed to find some middle ground, is also worried the Fed's assessment of a bank's legal risks will end up trumping the bank's own lawyers or its outside counsel.

"A key issue is whether we are going to allow the Fed to analyze this data and substitute its judgment regarding the appropriateness of legal reserves for highly knowledgeable outside legal counsel," DeMarco says. "If so, you've gone from supervising to second-guessing."

Stress-testing is still a relatively new supervisory tool designed to determine how well a bank manages its capital needs. Dodd-Frank requires the Fed to conduct annual stress tests of all banking companies with more than $50 billion in assets.

The tests gauge how a bank's portfolios would perform under horrific scenarios, tote up the hypothetical losses and evaluate the company's ability to survive an economic storm. Lousy results might prevent a bank from paying a dividend or buying back its stock and could even force a capital raise. The Fed has done two rounds of these tests and it is working on the one that will be administered this fall.

Obviously, how much money a bank sets aside to cover potential litigation costs is relevant, and the industry wouldn't be so worried if the Fed was asking for one big fat number. But providing the Fed with the sort of details it is asking for has the industry — and its lawyers — seeing red.

The Fed has responded with some conciliatory moves.

On June 4, when the agency adopted other parts of its February proposal, it agreed to continue taking feedback through July 6, noting that the concerns raised by the industry "are justified."

Then on June 27, the Fed took the unusual step of extending the comment period a second time, to Aug. 6, noting the "range and complexity of the issues" involved in disclosing litigation reserves.

So what are these issues?

To start with, as DeMarco says, this is sensitive information. Only a select few executives inside these banks see the full picture of the company's legal exposure. Banks fear disclosure would not only set a floor for plaintiffs' demands but could even be used as evidence or an admission of guilt. Why stash millions into a legal reserve if you don't think your company did something wrong?

But the broader public policy consideration to weigh is the chilling effect potential disclosure of this information might have on a bank.

Think about it: when something goes wrong at a bank, executives typically unleash lawyers to investigate. Whatever those lawyers find is protected by attorney-client privilege and can't be used against the company in court.

But what if banks are forced to share that information with the Fed and the Fed inadvertently discloses it or is forced to release it via a congressional subpoena? What if the Fed shares it with the Consumer Financial Protection Bureau and it hands it over to state attorneys general?

Critics including the American Bar Association say these threats would undermine bank compliance efforts.

"The attorney-client privilege is a bedrock legal principle that enables individual and organizational clients to communicate with their lawyers in confidence and encourages clients to seek out and obtain guidance to conform their conduct to the law," Bill Robinson 3rd, the bar association's president, told the Fed in a letter last week. "The privilege also facilitates self-investigation into past conduct to identify shortcomings and remedy problems, to the benefit of society at large," Robinson wrote. "The work product doctrine underpins our adversarial justice system and allows lawyers to prepare for litigation without fear that their work product and mental impressions will be revealed to adversaries."

Fed officials and industry leaders have spent the last two months trying to work out a compromise, and a middle ground is emerging.

The Fed recently sent industry trade groups a document outlining five alternatives. The RMA, with the Clearing House, the American Bankers Association and the Financial Services Roundtable, responded to that document this week.

The trade associations said their members could live with what the Fed called "Method 4," but not surprisingly they included some ideas for improving it.

Under this method, the largest banks would disclose the legal events that occurred in each quarter broken down by three business lines: retail banking, trading and sales and asset management.

A bank would then slot each of these events into one of seven categories: internal fraud; external fraud; employment practices and workplace safety; clients, products and business practices; damage to physical assets; business disruption and system failures; and execution, delivery and process management.

So to illustrate, a bank might tell the Fed its retail banking unit was hit with three lawsuits connected to a client, product or business practice in the first quarter of 2012, four suits in its trading unit related to execution management and one suit in asset management dealing with internal fraud.

In addition to this quarterly event-level data, the Fed said it wants banks to report a gross dollar figure for legal reserves annually.

But the industry groups are worried this approach could still give plaintiffs too much information. Say a bank is hit with a high-profile lawsuit related to derivatives. A plaintiff, assuming it gained access to the data the bank provided the Fed, could see the increase in the gross reserve number and deduce that the extra cushion was related to the latest lawsuit.

So in a joint letter to the Fed this week, the groups suggested the disclosures cover the entire company with no breakouts by business unit. They also recommended that all loss reserves — not just litigation reserves — be bundled under the seven categories. In other words, all reserves for losses tied to internal fraud would be reported as one number. Ditto all reserves for losses tied to business practices and so on for the five other categories.

Whether the Fed will accept these changes is unclear. But it is remarkable that the government and the industry are working together so constructively. It's not happening on too many issues these days. Who knows, today litigation reserves, tomorrow the Volcker Rule.