Bank directors have been inundated with information about the importance of establishing robust risk management practices and models.  The goal for many of these efforts is to achieve or maintain strong asset quality, assure an appropriate level of internal controls and more broadly to assure that the risk appetite of the institution is consistent with industry norms.

It now appears that there is another exposure for banks which further requires directors to be involved in risk management: the emerging – or, more appropriately, reemerging – issue of director and officer liability coverage. 

D&O coverage issues were quiet for over two decades as the number of bank failures was negligible and insurance was readily available.  It also appears that underwriting standards for D& O coverage were loosened as competition in the market became more intense.

In recent years, though, bank failures have become a more regular occurrence, and two concurrent factors have brought additional focus on the director's role in preserving D&O coverage. 

The first factor is the strategic intent of the Federal Deposit Insurance Corp. to bring suits against directors under a "simple negligence" standard as opposed to a "gross negligence" standard.  This reduced threshold will make it easier for the courts to find in favor of the FDIC in states where the lower standard is recognized. 

Second, problems of asset quality continue to place more banks at risk of failure – and therefore potentially subject to FDIC lawsuits. In addressing this issue, Howard Montgomery, managing director of the Renaissance Companies, an advisory firm, reminds us that the "duty of care" standard for directors includes both adopting and monitoring asset quality controls.  This means that the director's role does not stop with the adoption of appropriate risk management standards: it also includes monitoring the use of those standards and responsibility for testing them.  Failure to follow through in this fashion could jeopardize the recognition of D&O claims being filed and the availability of coverage.

Factors affecting the availability of this coverage are not limited to asset quality.  They could extend to management of a bank's capital liquidity positions and/or the rigor of its commercial lending loan approval and administration functions.  Directors should be particularly mindful of how banks are treating their marginal borrowers.  Regulators often find that lenders unwilling to address critically depressed collateral values and cash flow capabilities simply "kick the can down the road" by continually renewing the loans in order to keep them from becoming past due.  Regulators call this practice "extend and pretend" and consider it a critical red flag at examination time. 

We are continually reminded that some banks have yet to fully recognize the declines in real estate values. These institutions have accepted management assertions about property values without insisting on external corroboration.  When collateral values have diminished and that diminution has been recognized, capital levels have become impaired. In those instances, prudent directors are exploring ways to shed either real estate loans or repossessed properties in ways that will allow them to maintain their required capital levels.

D&O coverage is not a popular conversation at board meetings. Premiums for coverage have a direct impact on earnings, and during the periods when banks are healthy the need for D&O coverage seems remote.  But failure to address factors that can hurt such coverage would be a serious dereliction of a director's responsibility.

With that in mind, let's review the director's important role.  First of all, it is important to recognize that when a bank is in need of D&O coverage it is already past the time for making appropriate plans for such coverage.  Just as you could never buy fire insurance for a building in blazes, D&O coverage is not available for troubled institutions. 

Second, the director's role in maintaining coverage is not limited to authorizing payment of the annual premium. Representations are made for coverage approval stipulating that directors are to exercise appropriate care.  If a bank board does not exercise appropriate oversight over asset quality, it is possible that claims could be denied in the event of an FDIC lawsuit against directors. 

Keep in mind that lawsuits against directors in the aftermath of bank failures do not necessarily follow quickly after the failure. The suits may take years to be filed.  Thus, even though the rate of bank failures has declined in the last year, the numbers of FDIC lawsuits may well increase.  Now is not the time to let complacency set in again. 

Mark W. Olson's former positions include Federal Reserve Board Governor, chairman of the PCAOB, chairman of the American Bankers Association, and a bank president and CEO. He is a co-chair of Treliant Risk Advisors and can be reached at molson@treliant.com.