As a result of the economic downturn, a rising number of bank and bank holding company directors are experiencing business reversals, some to the point of declaring business or personal bankruptcy.

Few are well prepared to deal with what can be a very uncomfortable situation. Now is a good time to act.

Under the laws of a few states, a bank director who files for personal bankruptcy protection is automatically disqualified and removed from the board. No comparable provision governs bank holding companies or banks chartered under federal law or the banking laws of most other states. There, it is up to the individual bank, and its board of directors, to decide how to respond when a director or a director-owned business goes bankrupt.

When a bank itself is a creditor in a director bankruptcy, most bank directors recognize that the immediate resignation of the director concerned is usually appropriate, even if this is not required by law or a governing policy. The filing of a bankruptcy petition places the financial interests of the director, the bank, and the director's other creditors in direct and immediate conflict; it also potentially compromises the bank's position with respect to other troubled borrowers.

When the bank is not a creditor, the appropriate response to a director's bankruptcy may not be so obvious. Most banks lack director qualification bylaws or written policies that address the bankruptcy of a director or director-owned business. The director concerned may not immediately recognize that his or her financial difficulties can damage the bank's regulatory and community standing, as well as the director's own ability to contribute effectively as a board member.

The director may have contributed substantial service to the bank for a long period and feel that, in return, the bank owes him or her at least a short period of patience and understanding to work out personal or business financial difficulties. The other directors and senior managers also may feel a debt of personal loyalty to the director and a desire to help, or at least not to add to his or her difficulties.

On the other hand, a director's personal or business bankruptcy can have significant adverse effects on the bank, even when the bank is not itself a creditor. If the business is large, its failure can throw local residents out of work and leave businesses with uncollectible bills, adversely affecting the local economy and the ability of borrowers to repay the bank.

The failure of a prominent director-owned business also can embarrass the bank and adversely affect its reputation. And a director bankruptcy may create tensions between the director concerned and other bank directors, officers or employees who may be directly or indirectly affected. The failure of a director-owned business may also prompt regulatory questions that could hinder required regulatory approvals of desirable bank projects.

The touchstone for a bank director's actions in a personal or business bankruptcy is the director's fiduciary duty of loyalty to the bank. A director must always place the bank's interests ahead of the director's personal interests, and above feelings of personal loyalty to a fellow director.

If the director does not resign voluntarily, it will be up to the bank's board of directors to decide whether to request the resignation. Moreover, if the director's resignation is requested but not given, the bank may find itself in a difficult position. Most corporate and banking statutes do not contemplate the removal of directors by other directors in such circumstances. One alternative would be for the board to adopt in advance a policy requiring the immediate resignation of any director involved in personal or business bankruptcy proceedings. The board can then decide whether to accept a resignation.

Adopting a policy in advance can remove the appearance and reality of ad hoc, personal decision-making from a director bankruptcy situation. A board-approved policy can also sidestep the question of the board's legal authority to remove a director. By making the process more objective and less personalized, a written policy statement can promote consistency from one case to another and defuse the personal discomfort inherent in considering the financial distress of a fellow director.

It is crucial that the bank get an early warning — if possible, before the bankruptcy filing — so that it can take reasonable steps to protect itself from the reputational and other risks that may arise from a public proceeding. The director in question should make a full report, including a list of affected creditors, and answer any questions that management or the other directors may have.

After supplying any information requested, the director should be excused from the board's deliberations. Management should promptly review the creditor list to identify any bank customers, officers, directors or employees who may be personally affected. The bank should also alert its regulators and directors-and-officers insurance carriers and be guided by their instructions.

The bankruptcy of a bank director is inherently an awkward and difficult situation, but it can be made less so through a little preparation.

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