From the Board Room to Bankruptcy – Business Crisis-Risk™ in the Board Room
Business Crisis-Risk™ in the Board Rooms just increased: If you’re an officer or board member of a financial institution you need to be aware, and take steps to prepare today.
The Georgia Supreme Court has adopted the Business Judgment Rule with a very important nuance that requires officers and directors to not only be prepared when making their decisions, but to document their preparations in order to protect against potential liability. This is something every officer and director should put into practice now.
The banking community, especially in Georgia, took notice this week when the courts ruled in FDIC v. Loudermilk that the Business Judgment Rule is not a ‘get out of jail free’ card when it comes to bank boards. The result was a victory for the Federal Deposit Insurance Corporation (FDIC) and a warning-shot across bank board rooms everywhere.
Many board members and officers have been taught that the Business Judgment Rule protects them when a company fails. When I was an officer and corporate secretary of a public company, I was protected by the rule. The Business Judgment Rule, which has evolved through case law, says that:
“… in making business decisions or taking corporate action, directors and officers acted in a good-faith, informed manner, and that a business action was taken in the best interest of the company even if the decision ultimately resulted in company losses.”
Under this presumption, an officer or director is protected from personal liability unless it is proven that he or she acted in bad faith, showed disloyalty, engaged in self-dealing or abused his or her discretion. The ‘check the box’ strategy in the board room does not reduce the Business Crisis-Risk™; board members will be held liable for their actions if they act negligently.
So what went wrong? The bank in question is the Buckhead Community Bank located in Atlanta’s posh north side business sector. The bank was formed by some of the wealthiest Atlanta businessmen, including Charles Loudermilk, the successful retired founder of Aarons Rents, and David Allman, the Chairman of the Buckhead Community Improvement District.
The bank was formed in 1998, by Loudermilk and he was its largest shareholder. Between 2005 and 2007 the bank grew an astounding 240 percent, far outpacing the growth rate of similar sized banks.
The FDIC took notice and made recommendations about ways that the bank could reduce their risk posed by the bank’s high-risk loan segment, but the board seemingly ignored the FDIC’s suggestions. The FDIC alleged that the board knew of the peaking real estate market in 2006, but continued to make high risk loans.
According to the FDIC, the bank also made several loans to business acquaintances and associates. They had ‘recklessly’ approved millions of dollars of loans which violated bank policies, banking regulations and loaned money to borrowers who weren’t credit worthy, resulting in an unsafe concentration of risk.
The bank failed in 2009 and the FDIC sued the board and officers for personal liability for $21.8 million in damages. The board rallied around the Business Judgment Rule which raised their standard above the ‘negligence’ standard (i.e., failure to exercise the care of an ordinary prudent person under the same or similar circumstances). The FDIC needed to prevail. The FDIC has warned officers and directors of failed banks that they would be sued for their actions if they did not act in a prudent manner. The former officers and directors of Buckhead Bank realized that the FDIC could and would follow through on this threat.
Should the board at Buckhead Community Bank be surprised that they have endured a significant business crisis (the bank’s failure) and now a personal crisis (lawsuits, depositions, trial and judgment)? Had they examined the Business Crisis-Risk™ in their organization, they could have seen this as a very real probability.
The Business Crisis-Risk™ that resulted in financial personal liability of the board members was embedded in the board room. The structural make-up of the board, including the lack of influential independent banking expertise, made the probability of a governance-related crisis risk high. The Board should have recognized the Crisis-Risk indicators as they became apparent.
Crisis-Risk indicators are clues that reveal more information about an embedded crisis-risk. They can be behavioral or transactional, or process changes that are transmitted by verbal and non-verbal means.
The FDIC had warned the bank of its poor practices. The Board members and officers knew that the real estate market was at a peak. The company’s 240 percent growth rate must have put operational strains on the underwriting and loan servicing resources of the bank. The optics of having the chairman of the local Improvement District as a member in addition to the lack of an independent chairman – one other than the largest shareholder – increased the risk that undue influence over lending practices would be a concern.
These Business Crisis-Risk™ indicators were either ignored or underestimated. The officers and board members failed to appreciate the probability that one of these risks would be catastrophic to the business. They also over-estimated their ability to address the crisis-risk if it materialized. The result was a failed bank, personal liability and years of litigation.
So what does it mean to other boards? If a company has not performed a Business Crisis-Risk™ evaluation of the boardroom, do so immediately to evaluate if the form and function of the Board affords the best protection.
- Is the Board room dominated by one or two members who have undue influence due to ownership or stature?
- Are there influential, independent directors on the Board? It’s not enough just to be independent, you have to be influential.
- Is there healthy informed debate? Informed means materials have been issued well in advance of the discussion in time for research and preparation for debate and discussion.
- Are decisions made by the board ‘rubber stamped’ without serious debate?
- Do a select few influential board members hold ex parte discussions with members and inform the Board of their decision?
The courts did not tell one Board member that they were liable; they told all board members and officers that they were liable. If one is not an “equal” member of the board, the Crisis-Risk is high because the member will be bound by the decisions of the group. This liability extends to when the decisions were made. Whether currently a board member or officer is irrelevant; fleeing a bad board is not protection enough.
The FDIC decision should have a sobering impact on all boards. Board governance and decision making processes should be re-examined. The prevailing point-of-view should be from a governance and operations perspective, not solely from a legal counsel perspective. I can imagine Buckhead Bank’s attorneys are telling them how ‘wrong and unjust’ this verdict was, but they’re not the ones cutting the checks or suffering the reputational loss. It’s up to each board member to protect their reputation and personal assets when serving on a bank board. If you are not a lead director, your first step is to acknowledge the Business Crisis-Risk™ which is imbedded in your board room.
Jack Healey CPA/CFF, CFE has researched and created the Business Crisis Predictive Diagnostic ModelTM which identifies the hidden crisis-risks imbedded in businesses. As a former public company officer, audit and forensic assurance partner, trained negotiator, board member and lecturer in the areas of operational and financial performance, occupational fraud and governance best practices, he has joined Firestorm as the Managing Director of the Business Crisis-Risk Prevention & Performance Group. Contact Jack at [email protected] or 678.892.4110 or [email protected]