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“Dos and Don’ts Of D&O Coverage According to the FDIC”

Law360 By Jeffrey O. Davis, Vincent R. Angermeier

The Federal Deposit Insurance Corporation has closed over 400 banks since the financial crisis began in 2008. And when the FDIC closes a bank, it may very well decide to pursue former officers and directors to recoup losses suffered by the institution. For bank officers and directors, especially those defending themselves from FDIC lawsuits, directors and officers liability insurance is an essential shield against financial ruin.

The FDIC also benefits from D&O insurance — it is another source for recovering the bank’s losses. This is why the FDIC recently issued an advisory statement to the banks it oversees, warning their directors and officers of some of the insurance pitfalls, and two in particular, that lurk in these policies in the area of FDIC-instituted litigation: the insured vs. insured exclusion and the regulatory exclusion. Regardless of its source and the motivation behind it, the message is important and should be heeded by financial institutions falling within the FDIC’s jurisdiction.

Turning first to the insured vs. insured exclusion, sometimes dubbed the "I vs. I exclusion," it began with good intentions: In the 1980s, insured companies began seeking to recoup ordinary business losses by claiming that the losses constituted a breach of fiduciary duty, then recovering them from their D&O policies following a lawsuit against their directors and officers. (The directors and officers typically colluded, shielded by the policies from any personal liability.) In response, insurers added exclusions to stop this practice, but these exclusions often contained excessively broad wording, leading to coverage denials that directors and officers never expected when they agreed to not receive coverage against lawsuits brought “by or on behalf of” their employer. Thus, insured directors and officers facing FDIC lawsuits following a FDIC takeover of their bank received claim denials from their insurers; the denials insisted that because the FDIC now “stood in the shoes” of the insured bank and sued “on behalf of” the bank, the situation was no different from the fiduciary suits of the 1980s and the I v. I exclusion-barred coverage. Suffice it to say that suits between directors and officers and a less-than-friendly regulatory body or receiver are rarely collusive.

The best way to avoid this situation is to avoid language at the procurement stage likely to lead to a court decision that would label an FDIC-driven suit one as being brought by an "insured." But if the language is already in an existing policy, directors and officers do have some advantages in fighting for coverage: First, if they can convince a court that the exclusion’s applicability to FDIC suits is at least ambiguous, they will typically secure coverage, because most courts will resolve ambiguous policies against the insurer. Also, some courts can be convinced that the insurance companies’ position is a stretch: The insured vs. insured exclusion was originally intended to combat collusive behavior and the courts recognize that collusion simply isn’t very likely between the FDIC and officers of a company in receivership. Furthermore, the FDIC frequently is not bringing suit from a position identical to that of the bank; it has the power to bring suit on behalf of parties that the bank cannot, such as the bank’s creditors and shareholders and the bank’s depositors as subrogee. So the insurers’ argument that, because the FDIC is in the exact same position as the bank, suits by the FDIC trigger the same policy exclusions that a suit by the bank would is far from airtight.

The I v. I exclusion received some scrutiny during the Savings and Loans Crisis, with mixed results, and this popularized the second exclusion on the FDIC’s watch list: the “regulatory exclusion,” which denies insurance coverage connected with an insured officer’s fights with the FDIC and other regulatory agencies. Unlike the I v. I exclusion, the regulatory exclusion more directly addresses FDIC litigation and, where negotiated into the policy, presents problems that can be difficult to surmount.

Notably, those problems may exist even where the exclusion is negotiated out of the policy, as illustrated by a recent case in a federal district court in Kansas, BancInsure Inc. v. McCaffree. A group of officers purchased a D&O policy that contained both an I v. I exclusion and a regulatory exclusion. They later paid to have the regulatory exclusion removed by endorsement. But when the bank was subsequently closed and placed into receivership, the officers were denied coverage for an anticipated FDIC lawsuit. The insurance company relied on policy language in the I v. I exclusion specifically bringing “receivers” into the ambit of what was encompassed within a lawsuit by an insured.

The officers sued, arguing that that the insurance company’s interpretation rendered meaningless the regulatory exclusion they had paid dearly to remove. The court sided with the insurance company, reasoning that regardless of what the regulatory exclusion had said, the “insured vs. insured” language was unambiguous: The exclusion applied to suits brought by “receivers” and the FDIC was undisputedly acting as the bank’s receiver, even if it also happened to be a regulator.

At least for now, BancInsure seems to be an outlier — it is relatively rare for I v. I exclusions to expressly bring “receivers” within their reach. Indeed, BancInsure likely added the language in response to previous lawsuits finding the “by or on behalf of” language referenced earlier to be ambiguous. Directors and officers should be on guard for renewed efforts by the insurance company to tighten up the language in these exclusions, and should ensure that efforts to add this exclusion be resisted, or at least that any concessions to the insurance companies in this area come with a price.

Similar caution must be exercised when an insurer seeks to add a regulatory exclusion. Such exclusions are not necessarily standard and are therefore subject to negotiation. If your policy has a regulatory exclusion, obtaining coverage in the face of a lawsuit by the FDIC as receiver will be difficult. Several federal appellate courts have enforced these exclusions in FDIC cases, finding the exclusions to be consistent with public policy and the Financial Institutions Reform, Recovery, and Enforcement Act. More disturbingly for policyholders, insureds have also had little success convincing courts that the exclusions don't cover private party suits merely brought in the wake of regulatory action, where the exclusion applies to claims “based on or attributable to” actions brought by regulatory agencies.

All of this shows once again the need to exercise extreme care at the policy procurement stage. While the regulatory exclusion is still vulnerable to the same attacks that all exclusions are — for instance, the exclusion could be invalidated if an endorsement adding it was not properly made part of the insurance contract — it is safe to say that financial institutions and their individual officers and directors face an uphill battle in obtaining coverage for FDIC litigation under policies containing such an exclusion. But such battles can be avoided with proper spadework. It cannot be emphasized enough that D&O coverage is not "standard." Language matters and insureds should be careful to make sure they are getting what they want and need in a D&O policy.

So the real lesson here lies in scrutinizing or avoiding these exclusions — or at least understanding that they are there and will need to be accounted for in managing D&O risk. In that regard, one final point is in order: Federal law flatly prohibits directors and officers from being indemnified against civil money penalties imposed by a federal banking agency, meaning the potential for such penalties should not be considered when deciding whether to accept a regulatory exclusion since coverage for such penalties will be denied in either event.

Originally published in Law360, June 3, 2014