Outdated indemnity and insurance provisions relating to reimbursement of directors and officers may expose a financial institution to regulatory and financial risk

The time is right to make a fresh comparison of the indemnity obligations of a bank or bank holding company to its directors and officers and its coverage under director and officer liability insurance policies. Proper indemnities and insurance coverage are important to attract and retain people to serve as directors and officers.

Indemnities and directors and officers (D&O) coverage were targeted when lawsuits were filed against directors and officers as a result of bank failures and financial market collapses from the mortgage scandals. Where insurance is not available, a financial institution has to cover indemnity obligations to directors and officers from its own funds; and when indemnification is denied, the directors and officers are on their own to pay the defense costs and damages. Ideally, financial institutions should want indemnity obligations and insurance to work in tandem. While most community financial institutions have sat on the sidelines during the financial crisis, they do share the same indemnity and D&O coverage issues and can learn from that experience.

Qualifications for Indemnification

As a general rule, to qualify for indemnification under a financial institutions articles, bylaws or policies, a director or officer who is a party to a proceeding because of her/his position must have conducted her/himself in good faith and reasonably believed (i) in the case of conduct in an official capacity, that her/his conduct was in the best interests of the business entity; and (ii) in all other cases, that the individual’s conduct was at least not opposed to the best interests of the entity. In the case of any criminal proceeding, the individual has to show that s/he had no reasonable cause to believe her/his conduct was unlawful. A “proceeding” typically is described as any threatened, pending, or completed action, suit, or proceeding, whether civil, criminal, administrative, arbitrative, or investigative, and whether formal or informal.

Unless ordered by a court, a financial institution may not indemnify an individual (i) in connection with a proceeding brought by the institution against the individual, unless it is determined that s/he has met the relevant standard of conduct described in the preceding paragraph or (ii) in connection with any proceeding in which the individual was found to have received a financial benefit to which s/he was not entitled, whether or not acting in her/his official capacity.

A financial institution is likely to have to indemnify an individual who is wholly successful, on the merits or otherwise, in the defense of any proceeding to which s/he was a party because s/he was a director or officer of the financial institution. The termination of a proceeding by judgment, order, settlement, or conviction, or upon a plea of nolo contendere or its equivalent, is not, of itself, determinative that the individual did not meet the relevant standard of conduct.

Directors and Officers Insurance

D&O insurance policies are used by financial institutions to back stop their indemnity obligations. Directors and officers are insured for “loss” related to defense costs and damages from alleged “wrongful acts” which include breach of fiduciary duty and negligence. The definition of “loss” typically tends to be broad but excludes taxes, criminal or civil fines, restitution, disgorgement and any matter that is uninsurable under the law. The definition of “wrongful acts” can be equally broad including actual or alleged error, misstatement, misleading statement, act, omission, neglect, breach of duty by a person serving as a director or officer solely in such capacity. Most policies contain exclusions which list acts or circumstances that are not covered, and thus expose the financial institution’s own assets to the potential indemnity obligation.

Some examples of exclusions are:

• It is not uncommon for the standard D&O insurance policy to exclude coverage for claims arising under ERISA or federal or state securities laws or claims involving trust services or employment practices. Separate coverage can be purchased for those claims and the scope and amount should be reviewed to make sure it is adequate.
• Claims brought against a director or officer by the financial institution are also generally excluded. So, for example, if a financial institution brought an action against a director for receiving an improper financial benefit, but lost the case, the director would likely be entitled to be reimbursed by the financial institution for litigation expenses if she or he met the requisite standard of conduct. However, in this instance, if such a claim were excluded, then the institution would be on the hook for reimbursement.
• Some policies exclude claims involving an action brought by a regulator against a director or officer for breach of fiduciary duty. If the director or officer prevailed in the action and met the requisite standard of conduct, s/he is entitled to reimbursement of litigation expenses, but since the insurance policy excludes coverage, the financial institution would have to pay.

A Coordinated Examination

These examples demonstrate why the indemnity provisions set forth in articles, bylaws and policies and the scope of coverage in insurance policies need to be examined carefully and coordinated — some definitions or exclusions in an insurance policy may be at odds with indemnity obligations and can result in unintended consequences.

The FDIC also recognizes the importance of insurance coverage to help support the indemnity obligation. It has recently issued Financial Institution Letter (FIL-47-2013), which cautions banks that exclusionary provisions in D&O policies can reduce coverage for directors, officers and employees, but also reminds them that coverage for civil money penalties is prohibited. The FDIC’s obvious concern is that exclusions can adversely affect the amount of funds available for depositors if a financial institution fails. The FDIC is also concerned that insurance coverage of civil money penalties for directors and officers will not deter wrongful conduct.

FIL-47-2013 urges bank directors to carefully scrutinize their indemnity obligations and insurance coverage to make certain they will operate with intended effect. Not only do federal requirements have to be considered, but there may be state laws as well. An examination would begin by looking at statutory authority, reviewing the indemnity requirements of the articles, bylaws or policies and then comparing them with the insurance coverage. At the end of the day, neither the financial institution nor its directors and officers want any surprises.

Our firm has substantial experience in conducting such examinations of indemnities and insurance coverage for financial institutions and welcomes the opportunity to assist any institution engaged in that task.

For more information, please contact John Funk.

* John Funk is admitted in New Hampshire, Massachusetts and Vermont.