65 FDMLR 625

(Cite as: 65 Fordham L. Rev. 625)

Fordham Law Review

November, 1996

*625 THE CHAOS OF 12 U.S.C. SECTION 1821(K): CONGRESSIONAL SUBSIDIZING OF

NEGLIGENT BANK DIRECTORS AND OFFICERS?

Steven A. Ramirez [FNa]

Introduction

ON April 15, 1996, the United States Supreme Court granted certiorari to Atherton v. FDIC. [FN1] Atherton involves claims against the former directors of City Federal Savings Bank ("City Federal"), a federally-insured savings and loan ("S&L"). Beginning in 1985, the former directors of City Federal approved several large construction loans which had little prospect of being repaid. The loans entailed a high degree of risk because the bank failed to take reasonable steps to secure either sufficient collateral or borrower wherewithal to assure repayment. The Resolution Trust Corporation ("RTC") alleges that the bank did not verify financial information provided by the borrowers, did not obtain an adequate appraisal of the proposed collateral, and did not follow its own lending policies and procedures. [FN2] The loans resulted in $100 million in losses. [FN3] City Federal subsequently failed. The government stepped in, paid off all depositors of City Federal, and absorbed any losses resulting from a shortfall in City Federal's assets. The government brought director liability claims, based upon long-standing federal common-law authorities, for negligence against City Federal's former board. The district court dismissed the claims, *626 holding that only claims for gross negligence may be pursued. [FN4] The Third Circuit reversed. The Supreme Court will therefore address a pivotal question remaining from the bank crisis of the 1980s that has caused sharp division among the lower courts: Who should bear these types of losses--the negligent directors of the failed bank or the U.S. taxpayer?

The question before the Supreme Court cannot be understood without providing some perspective on the bank crisis of the 1980s and the government's response to the unprecedented taxpayer bailout of the federal deposit insurance fund. The government responded to the crisis by enacting a broad legislative revision of our nation's banking regulatory framework. This legislation is at the heart of the standard of liability for managers of failed banks, [FN5] and its meaning must be resolved by the Supreme Court.

In August, 1989, Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act ("FIRREA"). [FN6] At the time of this legislation, the long-brewing bank failure crisis only recently had splashed into the nation's consciousness; this subject was addressed directly only after the 1988 presidential election. [FN7] From the very incipiency of the federal government's remediation efforts, the issues underlying the allocation of the cost of, and responsibility for, the bank crisis dripped with political gamesmanship. [FN8] Although the banking *627 system has since stabilized, [FN9] the law applicable to bank director *628 and officer liability actions is more confusing than ever. [FN10] This Article *629 will examine why the law in this area is so chaotic and will attempt to propose a sensible approach to the interpretation of 12 U.S.C. s 1821(k), which is the primary provision of FIRREA addressing the liability of directors and officers of failed banks.

The government systematically has obscured the full cost of the 1980s bank crisis. Estimates of the total cost to the U.S. taxpayer now exceed $1 trillion. [FN11] Even estimates of losses discounted to present value are $150-215 billion. [FN12] In addition, the deposit insurance funds, maintained by premium payments paid by the banks, lost billions more. [FN13] The bank crisis also led to a total loss of stockholders' equity in failed banks, and caused approximately $400 billion in losses to the nation's stock of productive capital. [FN14] Ultimately, these staggering losses had macroeconomic effects that diminished the nation's gross national product ("GNP"); the Congressional Budget Office estimated that the S&L crisis led to a "whopping" $500 billion in forgone GNP. [FN15] Such enormous numbers obviously require context for full comprehension: If the total cost of the bank crisis is $1 trillion, then *630 that represents approximately eighteen percent of the entire annual output of the economy of the United States. [FN16]

It seems odd that, in light of this catastrophe, Congress would pass protective legislation insulating the managers of failed banks, specifically the directors and officers, from liability. [FN17] Protection of such managers is particularly strange given that the causes of the crisis included pervasive mismanagement. [FN18] Yet, the majority of circuit courts have reached this result when interpreting s 1821(k). [FN19]

Individuals were protected from the crisis by deposit insurance funds. The deposit insurance funds, backed by the full faith and credit of the United States, protected insured depositors, prevented bank runs, and forestalled the massive disintermediation, i.e., withdrawal of capital from the banking system, of the 1930s. [FN20] Consequently, the nation avoided a possible depression. The Federal Liquidators had rescued the depositors but were left holding an enormous tab. [FN21]

The government financed the taxpayer bailout over the course of thirty years, thereby obscuring the taxpayer burden. [FN22] Thus, there were no angry depositors or taxpayers to lead public outcry for reform or to demand that responsibility be appropriately borne by those who caused the crisis. Deposit insurance and the structure of the bailout *631 defused and diffused the type of political pressure for radical change that was present in the 1930s. Nevertheless, the bank crisis provoked public concern over the cost of the bail-out; no politician suggested that any action be taken except to lower the cost to the government. [FN23]

In contrast, directors and officers of failed banks actively sought to restrict their liability for the bank crisis. These individuals were being haled into court across the country to answer for the sins and excesses of the 1980s. [FN24] The directors and officers, by the nature of their positions, were both well-heeled and well-connected. They also had an incentive to take their plight to the press; in fact, numerous press reports attacked the government's efforts to recover losses from directors and officers. [FN25] Litigation is both expensive and unpleasant; thus, they also had a great incentive to exert political pressure to ease the efforts to enforce their duties in court. [FN26] Still, it seems more likely that confusion, rather than the directors' lobbying efforts, is responsible for the anomalous result that a majority of circuit courts have insulated officers and directors from preexisting liabilities.

On the eve of enactment of FIRREA, the circuit courts' approach to the issue of the source of law applicable to define the duties of bank managers was chaotic at best. For example, federally-insured failed banks could be chartered or incorporated either federally or in any of the fifty states. This raised questions as to the appropriate source of the law defining the duties of a bank's directors and officers. Courts were split, moreover, on the effect of federal deposit insurance on the *632 law applicable to directors and officers of failed banks. [FN27] Thus, federal courts have split sharply on whether federal common law applies to federally-chartered banks, as well as whether federal common law applies to state-chartered, federally-insured banks. [FN28]

The cyclical nature of bank failures exacerbated the confusion regarding the applicable law. Prior to the 1980s, there were small waves of failures in the sixties and the forties, but the last great wave of bank failures was in the 1930s, meaning that much of the case law governing the duties of directors and officers of federally-insured banks was well-seasoned. The Erie doctrine, [FN29] for example, did not exist when much of this case law was developed. Prior to Erie, federal courts did not engage in detailed analysis as to the source of the law being applied in a given case. Thus, much of the relevant case law does little to clarify the appropriate source of law.

Furthermore, by 1988, many states had reacted to lobbying by directors and officers to greatly restrict their liability. [FN30] The impact of *633 this insulating legislation on the duties of bank managers was uncertain and increased the confusion regarding the appropriate source of law. In short, even legal experts were unsure of the law applicable to directors of failed federally-insured banks. At the time of FIRREA's enactment, the executive branch and Congress could only have been confused by the state of the law on even such basic threshold issues as which law to apply. [FN31] This underlying uncertainty profoundly influences the meaning of the legislation.

One thesis of this Article is that when the political branches enacted FIRREA and s 1821(k) to address the issue of director and officer liability, the courts were so hopelessly divided that Congress could not enact legislation that would address each circuit's law. The political branches did not comprehend the state of the law at the time because of the extreme judicial confusion surrounding the issues; therefore, any interpretation assuming that Congress did is untenable. The political branches instead had only general policy objectives for FIRREA as a whole, and s 1821(k) was intended to vindicate these objectives in a limited way. These policy objectives included: minimizing the cost of resolving the bank crisis; recovering losses from those responsible for the crisis; retreating from the "lax" financial institution regulation of the 1980s; and preventing future bank failures. There is no indication *634 that the political branches desired to extend a subsidy to negligent directors and officers in the form of insulating legislation.

This Article examines issues critical to the recent jurisprudence of s 1821(k), including the intent of the political branches, Erie considerations, and the application of federal common law. Part I of this Article discusses the judiciary's interpretation of s 1821(k), highlighting the two main circuit court approaches to the statute's construction. Furthermore, part I explores the common law background of this issue, at both the state and federal level, and notes that common law has always imposed a standard of liability of ordinary care upon bank directors. [FN32] Once part I sets forth the complexity of the choice of law issues, two conclusions follow: first, s 1821(k) was enacted by the political branches in the face of great uncertainty over choice of law issues and in pursuit of general policy objectives that are utterly inconsistent with insulating directors and officers from duties for which they knowingly bargained; and second, s 1821(k) must operate to preserve preexisting federal common law duties of ordinary care for officers and directors of federally-insured banks. This, directors and officers fully expected. [FN33] Part II notes the compelling governmental interest in federally-insured banks and asserts that federal common law is consistent with s 1821(k). Thus, part II concludes that federal common law should apply to federally-insured banks, including banks that are state- chartered. Next, part III examines both the congressional and presidential intent behind FIRREA and s 1821(k), as well as several overlooked rules of statutory construction, all of which support the conclusion that FIRREA does not preempt federal common law. Finally, part IV considers a possible economic justification for the proposition that s 1821(k) supersedes federal common law. Part IV posits that the only logical economic conclusion is that s 1821(k) does not preempt federal common law. This Article concludes that s 1821(k) must be interpreted in light of the political branches' general policy objectives, which did not include an unstated and undebated subsidy to negligent bank directors and officers. Thus, irrespective of state law considerations, these directors and officers should be held personally liable if they negligently breach their duties under federal common law. Personal liability of directors and officers is the best way to *635 avoid another bank crisis and to protect the deposit insurance fund; in the context of the banking system this is the only sensible economic approach, particularly in the face of a historic bank crisis of monumental proportions.

I. Governmental Response to Disaster: Ease Long-standing and Settled Rules of

Director and Officer Responsibility?

This part compares the primary approaches courts have taken in interpreting s 1821(k) and the common law as it existed on the date of FIRREA's passage. In addition, this part explores the settled expectations and understandings of bank directors and officers regarding their duties.

Bank managers have been subject to a common law duty of ordinary care for at least a century. Bank managers have always been well-aware of this duty. It is unreasonable to conclude that the political branches intended to lessen these duties in the wake of the 1980s bank crisis. Nonetheless, the courts have varied in their interpretation of s 1821(k), and several have held that Congress did in fact lessen the duties of failed bank directors and officers. A comparison of RTC v. Gallagher, [FN34] which concludes that directors of failed federal banks do not have a federal common law duty of ordinary care with RTC v. Cityfed Financial Corp., [FN35] which concludes the opposite, illustrates the two primary approaches of the circuit courts to the construction of 12 U.S.C. s 1821(k).

12 U.S.C. s 1821(k) appears to be relatively straightforward, providing:

A director or officer of an insured depository institution may be held personally liable for monetary damages in any civil action by, on behalf of, or at the request or direction of the [Federal Liquidators] . . . acting as conservator or receiver of such