What should a community bank do if faced with a class action or derivative lawsuit it feels is unjustified or even outrageous — settle or fight back?

This is no academic question in these litigious times. And while many such lawsuits are baseless and clearly aim to blackmail the bank, the accused still has to respond. In some cases the court will throw out a frivolous suit, but most judges will let it run its course if they find even a scintilla of justification.

How do class actions differ from derivative suits? In both cases the court allows the plaintiff to sue on behalf of everyone else in the same class, except those who opt out of it. If the plaintiff wins, the judgment goes to all members of the class. In a derivative suit, any settlement does not go to the plaintiffs; it goes back into the bank’s general funds.

Some suits are simply legalized blackmail. The law firm that brings such an action — no matter how spurious — has nothing to lose but its time, and if it wins it can get a windfall.

The courts could discourage these types of lawsuits by charging the plaintiff’s lawyers the costs of the case if they lose, as happens in England.

Of course, many suits are valid. If shareholders could not sue a company, they would have no remedy if it were expropriating their property. If an individual shareholder sued without being part of a class, the legal bills could vastly exceed any winning judgment.

Unfortunately, a great many suits are motivated by the expectation that the bank will settle — whether it feels the case is justified or not — simply because it would cost more to fight.

Should a community bank simply buy off the plaintiffs with a settlement, one that often is far more generous to the lawyers than to the shareholders, or should it pay the high legal fees required to defend itself?

While settling may seem to make more immediate bottom-line sense, it establishes a precedent that may encourage others to litigate over trivial matters.

Community banks need a firm policy on how to handle these suits, coupled with adequate insurance. Class actions are one of the hazards of running a bank, and management should be prepared to act on them.

Do you have such a policy? Has your bank found a novel way to resolve this type of action satisfactorily or had a bad experience that could have been avoided by better planning? If you have some ideas on this issue, it may be worthwhile to share them with other readers of this column.

As always, the person who sends the best response will be made president for a day of our Schmidlap National Bank and will receive a certificate to prove it.

And we will immunize you from any and all lawsuits Schmidlap may receive during your term as president.

Please fax your responses to (908) 273-7309, e-mail them to bnadler14@aol.com., or mail them to 14 Friar Tuck Circle, Summit, NJ 07901.

Mr. Nadler, an American Banker contributing editor, is a professor of finance at Rutgers University Graduate School of Management in Newark, N.J.

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