Wednesday, September 17, 2014

Bank Directors May Find Themselves With a Heightened Standard of Care

To What Extent Should Regulators Dictate How Bank Boards Oversee Risk?

While regulators should have clear expectations for boards, we need to make sure that we are creating expectations that lead to boards spending more time overseeing  . . . risk-management and control functions  . . 

A recent address by Federal Reserve Governor Daniel Tarullo has raised the specter of expanded fiduciary duties for bank directors.  Referencing a recent academic paper proposing a simple negligence standard for expanded board oversight responsibility for risk-taking by systemically important financial institutions, Mr. Tarullo discussed how the nature of finance and financial regulation affects corporate governance and why, in turn, special corporate governance measures are needed as part of an effective prudential regulatory system.

Mr. Tarullo said that he feels regulators should encourage bank boards to pay greater attention to risk management. While understanding that broadening a board's fiduciary responsibilities with respect to risk oversight would expose a board to liability for their good faith judgments regarding risk management, Mr. Tarullo sees this as a natural evolution of board responsibilities.  He also stated that regulators see directors as the first line of oversight, and more engaged director involvement in risk management oversight is key to helping regulators safeguard the greater financial system.

One might ask how the strengthening of systems of controls and risk-appetite decision processes can promote achievement of regulatory interests beyond those shared with the owners of firms. One answer is that it clearly improves the supervisory line-of-sight into the safety and soundness of financial firms. The more timely and accurate the information that can be aggregated by supervisors, the more responsive our supervisory and financial stability oversight can be. A well-developed set of risk and control functions also allows an effective point of entry for pursuing certain regulatory objectives.

Not coincidentally, Mr. Tarullo's June 9 comments were followed on September 3, 2014 by final regulations from the OCC touching on board oversight of risk management for large banks.  Issued as an appendix to its safety and soundness standards regulations, establishing minimum standards for the design and implementation of a risk governance framework for large insured national banks, insured Federal savings associations, and insured Federal branches of foreign banks with average total consolidated assets of $50 billion or more, the OCC included minimum standards for a board of directors in overseeing the new framework’s design and implementation. The new rules direct boards of affected banks to:

  1. require management to establish and implement an effective Framework that meets the minimum standards described in the guidelines;
  2. question, challenge, and, when necessary, oppose management’s proposed actions that could cause the bank’s risk profile to exceed its risk appetite or threaten the bank’s safety and soundness;
  3. exercise sound, independent judgment;
  4. have at least two independent board members; and
  5. conduct an annual self-assessment that includes an evaluation of the board’s effectiveness in meeting the standards.

Not surprisingly, many have criticized these new bank board guidelines and Gov. Tarullo's suggestions for expanded board oversight for straying too far from risk oversight and veering into management. John Gorman of the American Banker sees this as "the next sensational risk management failure away from a legislative push to modify directors' oversight responsibilities, which would add significant additional expense, open the litigation flood gates, and discourage capable persons from serving as bank directors."  Kevin Lacroix of the D&O Diary echoes Gorman's criticisms, and fears that elevating the fiduciary burden on bank directors will only serve to inflame already high levels of litigation with little positive effect on overall financial stability.

[T]he overall level of litigation aimed at bank directors is both excessive and socially inefficient, particularly with respect to the litigation that so often follows after banks’ failures. So often the failed bank lawsuit allegations consist of little more than scapegoating and hindsight second-guessing. Creating a liability regime that would encourage further litigation and expand the potential liabilities of bank directors would accomplish little except enlarging the litigation burden that prospective directors would have to consider before accepting a seat on a bank board.