John Gorman wrote commentary in the American Banker last week that ought to add to community bank directors’ already high level of angst. Gorman discussed a recent speech by Fed Governor Daniel Tarullo, in which Tarullo spoke favorably of a paper by two law school professors (the road to hell is paved with such papers) in which the good professors argue that directors of too big to fail banks should be held to a higher fiduciary duty than bank directors are held today. The focus of the professors was on the implied duty of “board oversight” of bank operations. The professors’ paper “proposed board oversight responsibility for the level of risk-taking by an institution, and the application of a simple negligence standard to this board responsibility.”
Shareholder loss and/or systemic harm in the traditional sense — decline in stock price or bankruptcy, for example — would not be required for a stockholder to sue the board. Rather, the triggering event would be a “significant loss” at the firm resulting from an alleged breach of a board’s risk oversight responsibilities. (The example given is the $6 billion “London Whale” trading loss incurred by JPMorgan Chase.) Judges would determine if the board-approved risk management processes, including its assessment of the appropriate level of risk and potential risk outcomes, were reasonable. This broadened fiduciary duty would apply only to those firms “capable of imposing systemic loss.”
As Gorman points out, the duty of “oversight” is an adjunct to the duty of loyalty rather than the duty of due care. The business judgment rule generally protects directors from judicial second-guessing as long as they aren’t “grossly negligent.” As it has been previously interpreted in most jurisdictions, the duty of oversight does not generally provide a sustainable basis for a claim of breach of fiduciary duty unless the directors of the bank , in effect, simply ignored red flags. The professors want to change all that for systemically important financial institutions.
Gorman notes the problem with this approach.
Broadening a board’s fiduciary responsibilities with respect to risk oversight would expose a board to liability for good faith judgments as to risk management, and would require boards to function in a management capacity. This would be expensive and inefficient, and would undoubtedly discourage capable persons from serving on bank boards. It will also ultimately be ineffective — risk and adverse risk outcomes cannot be eliminated, just as the business cycle has not and cannot be eliminated. Altering the fiduciary duty of oversight to require board “ownership” of risk management, would merely provide a prima facie basis for the filing of a lawsuit against many boards. As we know from the current corporate litigation environment, shareholder lawsuits that are not dismissed are settled (the risk that a judge or jury will rule against them and impose personal liability, is one that a board absolutely will not assume), and the primary beneficiaries of legal settlements seem to be the attorneys.
Many community bank directors who read this might be tempted to shrug it off. After all, if the enhanced duty of oversight applies only to the systemically important, why should I worry? Because as experience informs us, these heightened duties inevitably trickle down to the rest of the banks, even the “too small to save.” And it is a director of the too small to save that is most at risk of the FDIC pursuing litigation against him or her if the bank fails. The too big to fail don’t fail. Their directors may face litigation from shareholders, but they’ve got the policy coverage and financial heft to protect the directors. Community bank directors don’t have that near certainty. The only certainty they have is that if failure occurs, the FDIC will push every theory available to find a breach of fiduciary duty and a pot of gold at the end of the D&O policy rainbow.
It’s nice that Mr. Tarullo is intrigued by this new theory. However, let’s hope that his attention span is short and that his focus soon turns elsewhere. Like to regulatory relief, for example.