The last few years have seen unprecedented regulatory burdens imposed on rederally insured depository institutions. But none is more harmful to chances for long-term recovery of the struggling thrift industry than the web of liabilities that regulators have spun, entrapping even the most conscientious directors and officers.

Although the 1980s' regulatory failures required a strong response, recent legislation has gone too far. Congress and the administration have overcompensated for past regulatory laxity with a tangle of new rules.

These include potential criminal and civil liability for "institution-affiliated parties," or lAPs, as they are known in Washington.

The laws make service on a rederally insured depository institution's board or in its management one of the least attractive propositions in U.S. business. Recent legislation has made thrift directors and officers virtually the personal guarantors of the institution's financial health.

The regulatory pitfalls and potential liabilities - which can include not only civil money penalties but also criminal fines and lengthy prison terms for newly created financial crimes - are strong disincentives to qualified managers in the savings and loan industry.

Recent regulatory proposals that threaten severe restrictions on the permissible scope and availability of indemnification agreements and directors and ofricers liability insurance have added to the disincentives.

Under the rule proposals, it doesn't matter that a director or officer may have done no wrong. He could be crushed by legal fees that must be paid from personal resources before clearing himself.

Moreover, the disincentives are strongest where the need for top management is greatest - in borderline or turnaround situations where a good chance remains of restoring the institution to financial health.

Regulators' Power Burgeons

Beginning with passage of the Financial Institutions Reform, Rehabilitation, and Enforcement Act in 1989, Congress vastly expanded the power of regulators to impose sanctions on directors and officers of rederally insured depository institutions.

That law was followed by the Crime Control Act of 1990 and the Federal Deposit Insurance Corporation Improvement Act of 1991.

These statutes created three new criminal offenses, including something called "financial kingpin" liability, which is about as vague as it sounds.

The statutes required the FDIC to promulgate new rules restricting "golden parachute" and indemnification arrangements.

They also required the agency to take certain actions when an institution failed to meet minimum capital requirements, which could include the automatic discharge of directors and officers.

FDIC's Retroaetive Reach

The new laws provided that certain "institution-affiliated parties" cannot be discharged from their liabilities even in bankruptcy. And they allowed the FDIC to meddle retroactively in the personal financial affairs of an officer or director for the five years preceding an institution's failure.

Anyone invited to become an executive or director of a financial institution will obviously think long and hard whether the post is worth the risks.

The most troubling element of the equation is that, for most purposes, no distinction is made between officers and directors who may have been substantially responsible for an institution's problems and those who are not.

Even where the laws suggest that such distinctions should be considered, regulators have been ignoring that course.

For example, the Crime Control Act enumerates factors that regulators may consider in deciding whether to let officers and directors in regulatory proceedings use indemnification agreements that would ordinarily pay for their legal defense.

One such factor is whether the officer or director is "substantially responsible" for the institution's insolvency or troubled condition.

But when the FDIC promulgated its proposed rule on indemnification agreements last fall, it failed to distinguish among directors and officers.

In the FDIC's view, directors and officers should be permitted to have their legal expenses paid only if they can show a substantial likelihood that they will prevail - that is, if they can show that the regulatory proceeding against them lacks merit from the start.

Unfortunately, this procedure will make it virtually impossible for an officer or director to use an indemnification agreement when he most needs it - while defending himself.

A Self-Defeating Outcome

If he is cleared after years of litigation and legal fees, he can be reimbursed. But litigation at this level can deplete personal resources Well before an exculpatory finding, thus putting enormous pressure on blameless individuals to settle early and on onerous terms with regulators to avoid even more onerous legal expenses.

If the law punishes good and bad alike, it has neither the deterrent nor the enforcement effect intended. Regulators must be given more guidance by Congress to make distinctions.

Adoption of a "substantially responsible" standard for application of recent legislation would have several beneficial effects. It would:

* Preserve the ability of thrift institutions to attract and retain qualified management.

* Let management act in good faith without fear of regulatory second-guessing on the basis of 20-20 hindsight.

* Give recent legislation a reasonable chance of meeting its objectives of safeguarding the government's deposit insurance fund and deterring wrongdoing but without contributing to the demise of the industry it. is meant to safeguard.

Without such a Standard, qualified managers and directors will continue to be driven from the industry. And the decision-making ability of those who remain will be compromised.

Mr. Gaston is a lawyer practicing in Washington, D.C.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.