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What Good Banks Can Learn from Bad Banks – And What Every Director Needs to Know

April 04, 2012

If you’re reading this, you’re probably one of the “good” institutions – successful, well managed and stable. So, what could an institution like yours learn from the “bad” banks, those that have taken tumultuous tumbles into failure over the past several years? The answer may be: plenty.

“Every bad bank that failed was, at one time, a good bank, with the best of intentions,” explained Kevin J. Funnell, of counsel at Bieging, Shapiro & Barber, LLP. “But, many of these institutions had inherent defects, and, oftentimes, directors who ‘played nice’ instead of fulfilling their real obligations.”

All bank directors have two basic fiduciary responsibilities: the duty of loyalty and the duty of care. 

The duty of loyalty prohibits directors from any form of self-dealing – no insider transactions, no favorable loans to themselves, their associates or other directors, no promoting their individual interests to the detriment of the bank. Typically, this rule is not the one that’s scaring board members or causing lawsuits.

The duty of care is a different story. This fiduciary duty requires directors to act with prudence, diligence and to make reasonable business decisions on behalf of the institution it governs. Does this mean individual board members must make the correct decision all of the time? No. 

“The duty of care, and its subset, the duty to supervise, mean that board members have to be engaged and make informed decisions after due deliberation. They also need to oversee the management of the bank, as well as ensure it follows the established policies and procedures for safe and sound operation,” Funnel explained. “Although the FDIC has only filed 25 lawsuits to date, that pace is picking up. The directors most likely to be sued by the FDIC in duty of care cases aren’t the people who ‘guessed wrong’ or made cognitive errors. It’s the “honorific” board members who show up, but aren’t engaged, who are most at risk.” 

So, how can board members protect themselves? 

“As a basic starting point, I think every board member should familiarize himself or herself with the FDIC’s Pocket Guide for Directors, which clearly spells out a board member’s obligations,” Funnell said.

Funnell has also devised seven distinct rules for anyone who’s sitting, or aspires to sit, on an institution’s board of directors. While he’s given them tongue-in-cheek titles, there’s a serious lesson lurking beneath the laugh.

Rule #1: Don’t Bow Down to El Jefe
Every so often, an institution is run by a dominant leader who populates his or her board with passive colleagues, most of whom are just along for the ride. It’s a “Father Knows Best” approach to board management that is as outdated as a black-and-white rerun of Wally and “The Beav.”

“A director should never accept anything just because the CEO said it. If that person isn’t familiar with the issue being discussed, he or she has to do some research or ask for independent advice, to find out more, then become an active participant,” Funnell said. “Deferring completely to the self-proclaimed ’expert’ on the management team is always a bad idea.”

The FDIC’s Pocket Guide for Directors echoes the thought.

It states: “Effective corporate governance requires a high level of cooperation between an institution’s board and its management. Nevertheless, a director’s duty to oversee the conduct of the institution’s business necessitates that each director exercise independent judgment in evaluating management’s actions and competence. Critical evaluation of issues before the board is essential. Directors who routinely approve management decisions without exercising their own informed judgment are not adequately serving their institutions, their stockholders or their communities.”

Rule #2: “What Me Worry” is a Fantastic Motto if You Intend to Embrace a Lifetime of Poverty
The reality is, every member of an institution’s board is responsible for making an informed decision on every proposal. To be “informed,” a director first has to be “engaged,” attempt to fully understand the issues, and make reasonable decisions on the issues. In turn, that means that a director has to be vocal, and object to or question any recommendation that just doesn’t seem right.

Rule #3: As a Watchdog, It’s Better to Be a Rottweiler Than a French Poodle
The idea here is not that board members should be bullies, but diligent about making sure the institution continues to ‘do the right thing’ even in the face of internal opposition from management or other board members.

For example, the board should review loan policies and procedures to ensure they’re well-thought-out and don’t give any officer or group of officers unlimited power to make exceptions. Commonly, directors engage an unbiased, third-party vendor to periodically assess the institution’s adherence to specific policies and procedures, then present these findings to the board.

Without this type of diligence, a huge potential warning light could go unnoticed. If a warning light is lit, the directors have to investigate.

“Some directors are intimidated by senior management personnel, especially chief executive officers or other board members who have more experience in banking operations. Many times, this causes them to ‘go along to get along,”’ Funnell said. “Others are concerned about asking what might be a stupid question in front of their peers. You have to have the fortitude to stand up and do what you think is right.”

Rule #4: You There! Speak Up!
One of the many lessons learned from failed institutions is this: directors who have questions or concerns about management’s conduct, plans or recommendations need to speak up. Board minutes are critical to documenting this active participation.

“When a bank fails, the FDIC conducts an 18-to-24 month investigation of the causes of the failure and, in conducting that investigation, relies primarily on the written records of the bank, including, critically, the board of directors’ and board committee minutes,” Funnell said. “It’s imperative that board members carefully review board and committee minutes before they are adopted by the board, and insist on changes if these aren’t reflective of their actual participation. No matter what really happened, if it’s not documented in the minutes, in the FDIC’s mind, it doesn’t exist.”

In other words, each director should make sure that the questions he or she asks, the responses and the ensuing discussion are accurately recorded in the board minutes.

Rule #5: What Do you Mean “We,” Kemo Sabe?
“Every individual director on the board needs to act like he or she is the Lone Ranger, and be able to stand alone and defend his or her decisions as a board member,” Funnell said.

This is especially true for board members who sit on high-risk committees, such as the audit and commercial loan committees.

“When the going gets tough, people tend to save themselves,” Funnell said. “Ultimately, a board member should not count on any other board member or executive to ‘have his back.’ Each board member needs to watch his or her own back and constantly consider how the FDIC might evaluate what that individual did or did not do based solely on the written records of the institution.”

Rule #6: Although Prepared for Martyrdom, I Prefer That It Be Postponed
No matter how stressful the situation becomes and no matter what the perceived “provocations” might be, the institution and board must maintain amicable relationships with their regulators, unless they want to make lives more difficult than necessary. Keeping an open dialog, and responding to requests politely may sound more like the golden rule than a guidepost for a board of directors, but, it does make a positive difference.

“I’ve seen good institutions really stub their toes with regulators by interacting with them poorly – even rudely in some instances,” Funnell said. “That’s never a smart business strategy. And, in some cases, it makes you look guilty.”

The fact is, once you establish an antagonistic relationship, any chance of the regulators granting the bank some leeway, or giving it the benefit of the doubt, in any difficult situation, is greatly diminished.

Rule #7: When the Going Gets Weird, The Weird Turn Pro
In times of stress, those under pressure can begin to crack. Particularly if their reputations are on the line.

“Board members should anticipate that those senior managers or board members who exhibit ‘personality quirks’ during good times are most likely to have those quirks morph into unusual, even bizarre or self-destructive behavior, when the bank runs into financial difficulties and comes under fire from the regulators,” Funnel said. “Board members should recognize that bad times may necessitate leadership changes – and anticipate what might be required before the bad times happen.”

Ultimately however, the recent experiences of “bad banks” teach directors of “good banks” that the best defense against liability for breach of duty is staying true to yourself and taking your role on the board seriously.

In other words, be the kind of board member who makes sure a “good bank” stays “good”.


Mitch Lucas
Vice President of Product Management and Legal Compliance

Mitch Lucas is vice president of product management and legal compliance at D+H. He leads the compliance legal and product management departments, which are responsible for several dynamic (computerized) and static form and origination systems for commercial, consumer and real estate lending, and deposit account opening. Mitch joined D+H in October 2004 after 11 years as general counsel for a northwest financial institution. Prior to his role as general counsel, he was the managing shareholder of a firm representing 30 financial institutions in Washington State.