On Sept. 10, a federal judge ruled that Harry Potter would not be allowed to offer expert testimony in the Federal Deposit Insurance Corp.'s lawsuit against the directors and officers of Cooperative Bank. The North Carolina lender failed in June 2009; the FDIC was now suing senior management in the Eastern District of North Carolina over the making and handling of 86 loans.
Before you ask: no, the wizard Harry Potter was not moonlighting as an FDIC expert witness. But the court's dismissal of this case is significant because of the impact it will have on future cases against bank directors and officers.
In this case, Judge Terrence W. Boyle measured the credibility of the FDIC's allegations against Cooperative's senior management in light of the impact of the Great Recession. "[T]he FDIC claims that the defendants were not only more prescient than the nation's most trusted bank regulators and economists, but that they disregarded their own foresight of the coming crisis in favor of making risky loans. Such an assertion is wholly implausible."
To put this case in context, between 2008 and 2012, 465 banks were seized and placed into receivership with the FDIC. At the same time, some 707 banks received assistance from the Troubled Asset Relief Program. A variety of other large financial companies borrowed from the Federal Reserve, were acquired by large banks or entered bankruptcy if they could not find a safety net in the financial storm.
As a financial crisis unfolds, playbooks often get written on the fly. Decisive government actions are often necessary, with the details left to be sorted out once markets return to some semblance of normality. That is when aggrieved parties may challenge government actions as is the case when directors and officers of failed banks respond to lawsuits being filed by the FDIC by arguing that they were victims of the economy.
Amidst the legal sparring between the parties in the Cooperative Bank case, the court raised a critical question: Was it fair to bring this case given the overwhelming impact of the Great Recession and the seemingly arbitrary nature of which banks survived and which didn't? As Judge Boyle puts it, "It appears that the only factor between defendants being sued for millions of dollars and receiving millions of dollars in assistance from the government is that Cooperative was not considered 'too big to fail.' "
This logic is reinforcing the FDIC's reliance on bringing charges against bank management based on the fact that bad loans for which senior management are responsible caused the banks to incur losses, rather than the fact that a bank failed. This approach arguably skirts the examination of more troubling issues, such as why the bank in question was closed when others weren't, why regulators didn't see the crisis coming and why some directors and officers should be punished financially when others aren't.
At the same time, FDIC cases are being impacted by the fact that the agency will no longer enter into contractual agreements with defendants or rely on state laws to extend the three-year federal tort statute of limitations it has to bring a lawsuit. That can be a problem when the FDIC and its outside counsel take much of a three-year period to conduct the investigation, leaving bank management with little time to present a defense and avoid the filing of a lawsuit. Thus, bank management is caught on the horns of a dilemma. They can hand over available insurance or personal assets to the FDIC to settle before any meaningful discussion of the facts of the case. Or they can go to court and then debate the merits of the case.
In a financial crisis, bank regulators are on the front lines. They do what they believe needs to be done to in order to preserve the greater financial good. Often, battlefield triage approximates rough justice. Only after the crisis passes does the judicial process get to evaluate the legality and fairness of those decisions.
Directors and officers of failed banks are now fully engaged in that process, arguing that they shouldn't be singled out for lawsuits in what was effectively a financial force majeure. Judge Boyle put it this way: "Taking the position that a big bank's directors and officers should be forgiven due to its size and an unpredictable economic catastrophe while aggressively pursuing monetary compensation from a small bank's directors and officers is unfortunate if not outright unjust."
The challenge for regulators and policymakers is to construct solutions that solve problems in difficult times and remain fair when the crisis has passed. The Cooperative Bank case suggests that at least in this instance, the FDIC's allegations were unfair and therefore the judge could not allow the case to proceed.
Thomas Vartanian is the chairman of the financial institutions practice at Dechert LLP and a former official at two federal bank regulatory agencies.