The collapse of Silicon Valley Bank (SVB), the failure of Signature Bank, the close-call of First Republic, and the bailout of Credit Suisse had many proclaiming earlier this year that banking was heading toward an industry-wide disaster. The chair of the FDIC reported in March of this year that American financial institutions incurred a total of $620 billion in unrealized mark-to-market losses. The stock markets certainly reflected those figures. The Nasdaq index for bank stocks dropped by a quarter within a week after SVB’s failure was announced. Gains accumulated over the past quarter century evaporated in just a few days, with U.S. regional lenders bearing the brunt of the impact. While last month saw the banking sector make a modest rebound, the sector gauge remains down by 20% so far this year.
Whether the pessimists or optimists turn out to have been right, one thing is clear: the banking industry has entered a new era of perceived financial fragility and distrust. In this new era, banks and their management stand to face intensified—and costly—scrutiny. In the wake of this year’s banking sector turmoil, the heads of both the FDIC and the Federal Reserve stated that they are considering imposing stricter capital rules on banks with over $100 billion in assets.
Increased scrutiny on the banking sector as a whole could result in greater D&O exposure for banks from investors and government regulators alike. Banks could see investors file securities class action and derivative suits with increased regularity, or make costly books and records demands that may not be covered under the terms of their existing D&O policies. Government regulators, like the FDIC or the Office of the Comptroller of the Currency (OCC), could similarly initiate costly investigations, bring forward enforcement actions, or—in some cases—declare that the entity has failed, take control of the company, and bring claims against the individual directors and officers for alleged mismanagement. For banks interested in reducing risk, a robust D&O coverage program targeted at minimizing the dual exposure to investor and regulatory risk will prove to be absolutely critical.
Meanwhile, D&O insurers will no doubt be looking to avoid or reduce coverage during these uncertain times. Indeed, D&O insurers have taken affirmative steps in recent years to mitigate their own risks, such as including broad Regulatory and/or Insured v. Insured Exclusions in standard D&O Policies to create potential coverage gaps and attaching lower sublimits for certain coverage grants to limit the amount of exposure. Additionally, some financial institutions have had more difficulty lately obtaining Side C coverage from their D&O insurers—i.e., coverage to protect the company itself against securities claims made directly against the company. In the absence of Side C coverage, securities claims brought against a bank itself would not be recoverable and a bank’s recovery would be limited to what coverage it is entitled to under any Side B coverage grant—i.e., costs the company incurs when it defends its directors and officers (not itself) against claims.
To understand what modifications to a D&O insurance program should be made to maximize coverage going forward, it is important to first understand the types of claims that investors and regulators are bringing that could result in uncovered losses.
Potential Investor Claims
On March 13, 2023, not long after the public saw headlines of SVB’s closure, a plaintiff shareholder filed the first of several securities class actions against SVB and its chief officers in the Northern District of California. The action, Vanipenta v. SVB Financial Group, purports to be filed on behalf of a class of shareholders who purchased SVB’s securities between June 16, 2021, and March 10, 2023. The complaint alleges that during the class period, SVB failed to disclose to investors the risks presented by impending rising interest rates; that, in an environment with high interest rates, SVB would be worse off than banks that did not cater to tech startups and venture capital-backed companies; and that, if its investments were negatively affected by rising interest rates, SVP was particularly susceptible to a bank run. Therefore, the complaint alleges, SVB’s public statements were materially false or misleading.
The Vanipenta complaint previews the types of claims that could flood the courts as more investors receive quarterly reports from banks. Of particular concern for investors is the risk of the interest rate environment and alleged failure to disclose those risks to investors. With interest rates escalating to as much as 5.25% and many banks under stress, investor anxiety is growing. Additionally, as the value of bank portfolios has fallen, balance sheets have not consistently reflected those losses. Investors likely will monitor quarterly reports, looking for anything that they might consider as masking of losses. If investors conclude that there are hidden losses, more shareholder securities actions against banks and their management could follow.
Shareholders could also be inclined to bring derivative actions on behalf of a bank, accusing that bank’s board of directors of breaching their fiduciary duties. They could also exercise their rights as security holders to serve demands for books and records, particularly if they are unsatisfied with the bank’s quarterly reports. The legal costs for these demands alone can range from a few hundred thousand to tens of millions of dollars. Should investor claims lead to litigation, settlements or judgments, the incurred costs would be exponentially higher.
Potential Government Regulation Claims
In the wake of this years’ bank failures, U.S. regulators have been quick to admonish banks and their management. In a bulletin last month, for example, the OCC announced a new policy of “increasingly severe” discipline for banks that face repeated enforcement action or otherwise fail to comply with regulatory mandates. As part of that policy, the OCC could order a bank’s board to create and execute an “enterprise-wide” corrective action plan. More recently, Acting Comptroller of the Currency Michael Hsu stated that the “starting block” for the failures of SVB and Signature Bank was poor risk management and governance. The implication is that the OCC has bank management in its crosshairs.
However, the OCC isn’t the sole regulatory player. Both the Securities and Exchange Commission and the FDIC have the authority to launch investigations and actions against banks and their management. These government investigations can prove highly costly and disruptive, potentially leading to million-dollar legal bills, even if no enforcement action is ultimately pursued.
Securing Robust D&O Coverage for Potential Investor and Government Claims
Given the multiple types of claims that a bank can face in the current investor and regulatory environment, risk management for banks should bolster their D&O insurance programs by taking the following steps:
First, banks should seek to remove any “Regulatory Exclusion” from their policies. Despite the FDIC’s efforts to warn banks to avoid them, Regulatory Exclusions are still found in some D&O policies, leaving potentially significant coverage gaps. These exclusions should be eliminated or curtailed, as is now the standard in the D&O insurance market.
Second, to guarantee that their D&O policies protect against early-stage investigations or pre-Claim proceedings (which is particularly important in light of government regulators’ recent admonitions), it is critical that banks ensure that their D&O policy’s definition for the term “Claims” encompasses these scenarios. While such coverage for specific individuals is usually offered under Side A or Side B coverage grants, it is not often accounted for under Side C coverage grants for entities. Insurers commonly attempt to exploit perceived coverage gaps such as this to deny coverage for investigations and pre-Claim proceedings. Banks should i) ensure that their policy includes Side C coverage, and ii) negotiate for entity coverage encompassing investigations and pre-Claim Inquiries including, if possible, coverage for costs associated with board-directed “enterprise-wide” corrective action orders, such as those issued by the OCC.
Third, to the extent Side C coverage is available, banks should seek broad coverage under any such provisions for any type of claim brought by a plaintiff in its role as a securities’ holder, not just for alleged violations of the Securities Exchange Act. Such coverage will help protect the bank in the (increasingly likely) event that securities and derivative actions are filed by plaintiff investors for a variety of concerns about representations to securities holders (e.g., accusing a bank’s management of fraud or breach of fiduciary duties for allegedly misleading shareholders about the risks presented by high interest rates, or hiding the resulting losses). Additionally, as concerns about the banks’ liquidity may also be part of the allegations, banks should ensure that their D&O policy does not contain an exclusion for claims related to liquidity crises.
Fourth, banks should seek Books and Records Request Coverage for any books or records demands that investors may bring. Not all D&O programs expressly provide this coverage and insurers frequently argue, in the absence of an express Books and Records Request Coverage provision, that a D&O policy does not cover the costs incurred in responding to such a demand. Banks should also beware that even when this coverage is expressly offered, it is typically subject to a modest sublimit that may well prove inadequate. Legal fees associated with a single books and records request can range from $250,000 to tens of millions of dollars. Knowing that investors will be particularly interested in digging deeper into bank balance sheets as quarterly reports are disclosed, there may be more than one books and records demand within a given policy period. As such, banks would be well served to negotiate a limit that provides meaningful security.
Finally, banks should protect themselves from potential applications of Insured v. Insured Exclusions, which exclude coverage for claims brought by one “insured” against another “insured,” including the company itself and its current and former directors and officers. In the event of a bank’s collapse, the FDIC may take over the bank as its receiver and then sue the bank’s directors and officers. Some carriers may seek to exploit this scenario by arguing that, through the takeover, the FDIC stands in the shoes of the bank and therefore becomes the insured under the D&O policy, such that the FDIC’s suit against bank officers triggers the Insured v. Insured Exclusion. While the application of exclusion in these circumstances is controversial, the case law on the insurability of FDIC claims following its takeover of a bank is mixed—as at least one court has noted. Moreover, resolution of the question can turn on the facts, particularly, on the allegations made by the FDIC. The FDIC’s statutory authority is broad: the FDIC can succeed to the rights of depositors, creditors and account holders, among others, not only those of the bank itself. As a result, the exclusion has not been applied, for example, in cases where the FDIC alleges that it is suing on behalf of creditors or as subrogee to the rights of depositors, rather than on behalf of the bank. But it is treacherous to count on facts being favorable. To avoid a drawn-out D&O coverage dispute in the event of a FDIC takeover, it is best to negotiate explicit language into the exclusion to preserve full coverage for FDIC claims.
Conclusion
While it might seem like the worst is over, with fewer bank failures in the headlines recently, this could merely be the calm before the storm. As quarterly reports hit the market, banks may soon see a flood of fresh shareholder demands, lawsuits, and regulatory probes. Accordingly, risk managers should act now to build a D&O program that is tailored to meet the challenges that may lie ahead.
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