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A checklist for bank directors.

Item from the New York Times earlier this year: "David Thomas, the chairman and founder of Wendy's fast-food chain, declined an offer to be a director of a savings bank in Ohio after his lawyer advised him of potential regulatory risks."

This type of action is becoming very common in the banking industry today. Having directors resign from bank boards, or decline to serve on bank boards, is not in the best interest of the regulators, the shareholders, or the industry in general. We have to maintain a system of corporate governance that allows directors and officers to take prudent risk without the fear of personal liability. I would like to address a couple of possible solutions to this dilemma.

Some directors and officers think that taking no action is the best way to avoid a lawsuit. Nothing could be further from the truth. Burying your head in the sand will only make a claim more credible. Today's regulatory and legal environment has demanded that directors and officers become more involved in overseeing the affairs of financial institutions.

One decisionmaking area that has given rise to substantial litigation in the banking industry is the adequacy of the loan loss reserve. To date, the board of directors has been able to delegate this function solely to management. In today's environment, the regulators are requiring the directors to understand the methodology used to establish the reserve for loan losses.

This includes, but is not limited to, the underlying loan review function, credit scoring system, and reserve allocations used to determine the level of such reserves. This is an area of growing concern, not only to the regulators but to the Securities and Exchange Commission and shareholders alike.

In today's troubled economic times it is not uncommon for a financial institution to have to increase its loan loss reserve in response to deteriorating economic conditions. Such additions can result in class action litigation alleging misrepresentation in previously filed public documents and/or criticism from the regulatory agencies. A director's best defense to such allegations is proper documentation that he or she was involved in the loan reserving process, understood it, and monitored it regularly.

But the problem for today's bank directors goes even further. Litigation can arise when in fact there may be no liability. In these cases, the institution needs to take the proper steps to ensure that proper directors and officers liability coverage is in place. Such coverage affords protection when indemnification is not available and also serves to reimburse the corporation for indemnification payments made. However, the breadth of coverage needs to be carefully reviewed by an institution's legal counsel and should be thoroughly understood by management.

I have a couple of suggestions for directors and officers when it comes to D&O liability coverage.

First, make sure that you have an experienced insurance broker who is very familiar and experienced in D&O liability coverage. No two D&O contracts are alike, and the market for D&O insurance constantly is changing. It never ceases to amaze me how many directors don't know to what extent they are protected from personal liability. In most cases they find out when it is too late, after the litigation has been filed.

Second, the management that is involved in the decision to buy D&O insurance should demand contact with your insurance company's underwriter. It is in the best interest of the institution to make sure that your insurance carrier understands your business. The quality of the insurance carrier should be paramount when making a decision about where to place your D&O coverage. Past claims-paying experience is a very important factor when choosing a carrier.

Here is a checklist of what to look for in your D&O policy:

* Do you have prior acts coverage? Many policies are written to provide coverage for wrongful acts from the date of inception forward. What needs to be understood here is that any liability arising out of wrongful acts committed in the past would not be covered.

* The discovery provision. This serves as protection for the insured in the event that the policy is cancelled or nonrenewed. It allows the insured to purchase a discovery period in which claims may be reported for wrongful acts that occurred prior to the expiration or cancellation date.

* All exclusions should be reviewed very carefully. More than 50% of D&O claims are a result of alleged violations of securities law. A policy that contains an exclusion that will not respond to such alleged violations carves out the majority of D&O coverage.

* Several institutions that may have gone through some recent financial difficulty may see a "delinquent loan exclusion" show up in their policy. If you think about it, the banking business is the lending business, and most litigation evolves from problems on the loan portfolio. The analogy that comes to mind is that a D&O policy with a delinquent loan exclusion is similar to a medical malpractice policy that excludes claims resulting in bodily injury.

* Finally, given the turbulence in the financial institutions industry, a regulatory exclusion is very common. In essence, this exclusion states that there will be no coverage afforded for any actions brought by a regulatory agency. Certainly, given the increased regulatory authority, this coverage is important to have. However, it is generally only available to very strong institutions.

My parting advice is that D&O liability coverage is far too important not to receive review from your legal counsel. Again, the breadth of coverage varies greatly, and an experienced, specialized insurance broker should be sought out to ensure that your bank receives the best coverage available -- and, with this coverage, hopefully you will have access to the best directors available.

Richard L. Porter is the Regional Financial Underwriting Manager for Executive Risk Management Associates, the directors and officers liability insurance underwriting manager for The Aetna Casualty & Surety Co. Prior to joining Aetna/Executive Risk, he was a bank examiner with the Federal Deposit Insurance Corp. for nearly 15 years.
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Title Annotation:D&O Liability; executives' liability insurance
Author:Porter, Richard L.
Publication:Directors & Boards
Article Type:Column
Date:Sep 22, 1992
Previous Article:In the land of rising quality.
Next Article:Smoothing the transition.

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