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Serving as an Outside Director of a Financial Institution: Challenges for Change

by Robert S. Apfelberg

By Robert S. Apfelberg E-mail:

The winds of change are blowing in bank boardrooms. This experienced director shows how to set sail in a prudent, yet profitable direction.

Effective corporate governance ensures that long-term strategic objectives and plans are established, and that the proper management and management structure are in place to achieve those objectives, while at the same time making sure that the structure functions to maintain the corporation’s integrity, reputation, and accountability to its relevant constituencies.

Recently there have been disturbing changes in the attitudes of shareholders, regulators, legislators, and the courts relative to bank and savings and loan ("bank") management and outside directors. Major pension and mutual funds have begun acquiring substantial blocks of bank securities, bringing with them the influence of the emerging changes in non-bank corporate governance rules. Regulators have increased their legal attacks on directors of failed banks, backed not only by the support of Congress and the Administration, but also a virtually unlimited litigation budget. Meanwhile, a long planned measure to merge bank regulatory agencies appears to be well on its way to passage. For their part, courts continue to hear a significant number of thrift director suits, now that Congress has lengthened the statute of limitations suits to five years, and handing down decisions that reveal continuing legal confusion over whether the federal culpability standard is gross or ordinary negligence. These developments have resulted in directors experiencing considerable discomfort and, appropriately, requiring changes in bank board organization and activities.

(Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), 12 USC 1821(k) P.L. 101-73, 103 Stat. 183 (1989).)

Because regulators have such large litigation coffers, banking industry analysts observe, law firms representing regulators have no incentive to analyze carefully or settle cases against failed banks' directors. Investigators customarily hired by the regulators have indicated that they routinely recommend suing failed banks' directors in cases where: (1) the directors have substantial personal net worths, (2) the board minutes are sufficiently general and non-descriptive to create a prima facie case for director inactivity or omission, or (3) the directors have director's and officer's professional liability insurance ("D & O") coverage. They have candidly admitted that they often obtain further investigatory assignments by participating in aggressive regulatory agency recoveries that ignored the costs expended. Both attorneys and investigators have acknowledged that their personal rationale for these actions was to create vivid public examples that would send clear messages to bank directors and discourage future inappropriate conduct. With such a strong show of force by regulators and their agents, it is not surprising that there is a general reluctance to serve as a bank director.

This increasingly risky climate for service on a bank board has been well documented. What remains unexplored is the toll these developments have taken on the governance of financial institutions, which have now become risk-averse to an extreme.

Directors are accustomed to taking risks and encouraging entrepreneurial activities in their own businesses. Under the right conditions, they might wish to encourage assertive marketing or lending practices in banks when they believe these practices will create better earnings and market share. However, regulators discourage such lending practices, no matter how appropriate they may be in a well-managed bank. Indeed, regulators appear to be able to discern risky bank lending procedures more easily than management incompetence. In the face of such resistance, directors are unlikely to encourage bank managers to take any "risks" at all - - even well-advised and cautious forward steps. Besides, directors are often too busy with their own businesses to want to intervene in bank operating decisions, particularly where management is resistant to significant director involvement. As a result, bank directors have been forced to be satisfied with choosing apparently competent management and responding appropriately to management's information and reports. As a result of these conditions, bank directors often refrain from offering the full extent of their wisdom and experience.

This lack of full service from their directors has not fazed bank managers. Indeed, bank management has typically scolded directors who get involved in any management decisions by calling that micro-management. As a result of all of these developments, banks have thus far resisted the corporate governance reforms that have begun in non-bank corporations.

Shareholder Pressures

The recent shift in bank securities ownership concentrations to major pension and mutual funds has brought with it non-bank corporate governance reforms. Recent surveys have asserted that shareholder activism has substantially increased earnings, thus providing further justification for this trend. Bank managers prefer their present decision making exclusivity. Directors elected as a result of major shifts in bank securities ownership must become more involved in policy creation and monitoring management. However, traditional bank board members typically support the continuance of management preeminence. Thus, the role of an ethical, careful but activist director "dissident" is not easy to perform, especially when management and traditional directors act under the same banner of "maximizing shareholder value" and "safe and sound practices."

In their Business Lawyer magazine article entitled: "A Modest Proposal for Improved Corporate Governance" (November 1992), attorney Martin Lipton and Harvard professor Jay W. Lorsch provide cogent, strong and creative suggestions for changing non-bank boards' structure and activities in response to shareholder pressure. Basically, they recommend that management should have daily responsibility for operations while directors are responsible to carefully and creatively evaluate management's plans and results. Although this recommendation appears to be consistent with recently promulgated statements by the Federal Deposit Insurance Corporation (FDIC) and Office of Thrift Supervision (OTS), its practical implementation, as explained by Lipton and Lorsch, differ substantially from those that presently exist in banks.

Regulatory Pressures

In an attempt to assuage potential bank directors' fears and to provide clear guidelines for director conduct, FDIC and OTS each issued its own official statement concerning the responsibilities of bank directors and officers. Although the OTS and FDIC statements and accompanying press releases were not identical, they were strikingly similar for these two very different organizations. This similarity stems in part from conscious efforts to create consistent guidelines. In one respect this makes directors' life easier since directors certainly don't need inconsistent guidelines. On the other hand, this joint action and attitude creates greater pressure on directors to comply with these directives or risk being accused of inactivity. Careful analysis of these statements reveals the clear need for most bank's boards to undergo a major overhaul of their activities, composition, and structure. Both the FDIC and OTS statements include, word for word, the following description of director responsibility:

"This means that directors are responsible for selecting, monitoring, and evaluating competent management; establishing business strategies and policies; monitoring and assessing the progress of business operations; establishing and monitoring adherence to policies and procedures required by statute, regulation, and principles of safety and soundness; and for making business decisions on the basis of fully informed and meaningful deliberation."

Bank management's responsibilities, in both statements, are as follows:

"Officers are responsible for implementing the policies and business objectives set by the board; for running the day-to-day operations of the institution consistent with those policies and objectives and in compliance with applicable laws, rules, regulations and the principles of safety and soundness. Directors must require and management must provide the directors with timely and ample information to discharge board responsibilities."

Office of Thrift Supervision, Department of the Treasury: Statement Concerning the Responsibilities of Directors and Officers of Insured Depository Institutions, November 16, 1992. Federal Deposit Insurance Corporation: Statement Concerning the Responsibilities of Bank Directors and Officers, December 4, 1992.

Both of these regulatory agencies further stated that most director lawsuits involve situations where directors failed to take reasonable steps to respond to either: (1) criticisms from regulators, or (2) problems brought to their attention by outside advisers. At their peril, directors must now analyze these regulatory guidelines in light of their wording, the current political climate, and the realities of regulatory enforcement procedures, personnel and organizations.

Congressional Actions and Consumer Dissatisfaction

There are increased pressures from both congress and consumers relative to bank activities. Recently passed House and Senate bills removed many of the current barriers to interstate banking and branching. However, the Senate bill requires bank holding companies to be adequately capitalized and adequately managed. Since these apparently clear words are subject to complex interpretation they create additional danger for bank directors. The House bill contains limits on the percent of insured deposits in a state that interstate banks may control. Other contemplated legislation would alter banks use and providing of credit information on their borrowers. Other legislation provides greater regulation of bank mutual funds sales and banks investments in "derivatives." Directors, presumably, will be subject to liability if their banks violate any of these provisions.

Consumers are becoming increasingly vocal in the demand for better service and for banks to be more involved in socially beneficial activities. Recently, major banks have been subject to publicly reported complaints about there lack of active lending in ethnic or impoverished communities. Bank's community activities include affirmative action hiring programs and lending in a manner, and in areas, which have not traditionally satisfied traditional bank guidelines. Neighborhood associations have become increasingly vociferous in their support, of objection to, bank branch locations. Individual shareholders, as well as consumer advocates, have been appearing at bank's annual meetings to publicly display their individual displeasures.

The obvious result of all these new pressures is that cautious bank directors can no longer safely rely upon senior management as their sole source of information and advice regarding bank's operations and activities. Instead, it appears that now directors are being held to a higher standard. Directors now appear to have an affirmative duty to: (1) be fully aware of the bank's actual operations, including the bank's products and services, (2) initiate appropriate business strategies and policies, and (3) monitor and evaluate management through personal involvement, experience, expertise and advice from professional advisers.

It would be tempting for bank professionals to disregard these guidelines and their apparent "messages" in the belief that they may be replaced with others more attuned to the present actual bank governance process, or to a future, more lenient, regulatory framework. However, this would be naive. The cumulative effect of shareholder, consumer, regulatory, congressional and judicial attention suggests that vigilance, not complacency, has become the new order of the day for bank directors.

In response to this conflicting and overwhelming shift in pressures placed upon the banking industry, the following recommendations are offered. They are intended as a new vision for the composition, structure and activities of bank boards. These recommendations present a synthesis of the recent non-bank corporate governance changes and suggestions previously described as well as both the bank and non-bank board experiences of this writer.

I. Board Composition

1. Bank boards should be composed of no more than nine members of which at least eight are outside independent directors. Any greater number would prevent full airing of strong opinions thus impeding the accomplishment of board goals within appropriate time frames. An even mix among the following categories of directors is suggested:

A. Banking Professionals: Professional bankers, from both the local area and other parts of the country, who have recently left banking, are involved in Bank consulting or non-bank companies, and have recently been involved in various highly complex bank and non-bank issues. These individuals may provide ideas from other banks, and other parts of the country, where similar problems had been encountered or new opportunities had been developed. They may, in hindsight, be more capable of identifying danger signs or trends in this bank's local area.

B. Entrepreneurs: Assertive businesspersons divided into those who have local experience and knowledge of the market and those that operate nationally. Particularly desirable are business-persons who have reorganized real estate and/or manufacturing, service, and sales entities in coordination with institutional lenders. They are accustomed to questioning an unsuccessful status quo and can contribute to the board's understanding both loan adjustment and lending activities.

C. Financial Advisors: Financial persons who have the ability to command capital on a local and national scale. They can provide new ideas for products, services and structuring that will make the bank more attractive to investors needed for the growth of the bank or to make it more desirable to potential merger candidates.

D. Professionals: An attorney and an accountant familiar with bank regulations, legislation, regulatory relations and audit. They should not presently be with any firm that can compete for the bank's business and must be the kind that know how to say yes as well as no. They can provide regulatory and analytical guidance and can help control outside professionals' fees.

II. Board Structuring and Activities

Bank boards must be structured to create a synergistic relationship between management and the board and to deal quickly with unsuccessful policies, personnel and board members. The following structure is suggested:

1. The board should have a chairperson who is not a member of management, and whose responsibilities are to set meeting agendas, ensure timely, appropriate and adequate information to directors and coordinate the supervision, choice and evaluation of both management and directors. A less drastic, and less effective, alternative is to appoint a "lead" director from the group of outside directors. (This is similar to the new bylaws recently adopted by General Motors.)

2. The vice-chairperson should be the bank's chief executive officer who manages the daily operations of the bank, coordinates the information flow and employee availability to directors, and represents the bank at public functions.

3. Individual directors should be assigned to perform the appropriate oversight of management in the specific areas where those directors have expertise. Board subcommittees should consist of outside directors who, to the extent possible, have related expertise in the subcommittees' specialized area. These subcommittees should meet monthly and require line management to present pertinent information.

4. Subcommittee information should be highly descriptive, yet brief and to the point. It should be provided to all directors in advance of the full board meeting.

5. At monthly board meetings, the outside directors should meet first, with line management possibly being required to present reports at such a meeting. The full board meeting's agenda may then be revised.

6. No outside director should be a member of the board for more than five years, whether consecutive or otherwise.

7. Annual off-site retreats or weekends should be organized and should include all directors, both senior and some junior management, and a limited number of the separate consultants to directors and management. These weekends are intended to establish professional personal relationships and an opportunity for candid conversations between directors and management.

8. A nominating and evaluating board subcommittee, composed of only outside directors, should be established. This subcommittee should meet at least every six months. Its purpose would be to evaluate each director's contribution and effectiveness and senior management's attainment of agreed upon strategic goals. It should first suggest remedial activities and provide warnings. If directors have been inactive or ineffective, then they should not be recommended for re-election. However, this should not be allowed to become a popularity contest. This subcommittee should be the primary source and forum for any suggestions to improve or replace senior management.

9. The board calendar should allocate a portion of each meeting for a revolving specific evaluation of the bank's functional areas. These areas include:

  • selection, evaluation, and compensation of senior management
  • corporate strategy and strategic planning
  • legal and regulatory compliance
  • capital allocation
  • staffing
  • special or classified assets
  • asset and liability management
  • marketing and business development.

10. Directors should be compensated primarily through stock options and reasonably low fee payments. Executive compensation should be primarily through incentives awarded for:

  • profitability
  • market position
  • productivity
  • product leadership
  • personnel development
  • employee attitudes
  • compliance with public responsibility and regulations
  • investor and customer relations
  • achievement of strategic goals (which are agreed to each six months by the CEO and the directors.)

11. The directors should be advised by independent consultants and attorneys. These professionals will:

  • evaluate management's reports
  • do independent research to reveal issues and problems
  • suggest alternatives used by other banks or required by regulators.

Those professionals should report directly to the directors, however, generally, their reports should be shared with senior management.

12. Outside directors and senior management, supported by professional advisors, should jointly prepare reports for public dissemination.

13. Special annual full board meetings should be held with the ten largest shareholders who are given the opportunity to critique, and suggest alternatives to, Directors and senior management. Reports of these suggestions should be disseminated to all shareholders.

Bank management understands bank regulations and often has developed friendly relationships with local regulators. Customarily only bank management has personal contact with the regulators. Although the nationwide pressures described above appear to require more active participation by directors in bank decisions, management is resistant to this change. Local regulators, who are accustomed to the traditional relationship between management and directors, may not support directors in their demand for greater involvement. This places directors into the difficult position of being subject to conflicting pressures and the potential for legal liability through attacks initiated by entities whose interests conflict with each other.

In the past, there has been a distant relationship between a bank's management and its directors. Management has been unable to take advantage of directors' experience and overview because they feared directors' over involvement in management's decisions. This is a new era of heightened shareholder activism and awareness, regulatory dominance, and consumer and customer dissatisfaction. Bankers must now compete aggressively, yet retain their traditional conservatism. The best way to harmonize these apparently inconsistent goals is for management and directors to forge a working partnership to better achieve the preeminent goal of increasing shareholder value in keeping with safe and sound practices.

Only through the creation of such a mutually respectful partnership can directors truly represent the interests of the bank's owners, effectively evaluate management's activities, and monitor and supervise the creation of assertive, yet conservative, products, activities and restructuring. Through an operative partnership with directors, management can best utilize directors' skills to enhance management's successes. Within this new industry environment of synergistic tension between management and directors, bankers can anticipate receiving constructive suggestions for change. However, management will soon discover that the correct utilization of this new interrelationship is the best way to produce both compliments and financial remuneration for their achievements.

The suggestions for change incorporated in this article are intended to begin the reforms in formal structuring that will eventually result in the alteration of attitudes necessary to achieve the actual "partnership." This process will not be easy or rapid, because of the conflicting and traditional pressures described here. However, an era of fundamental change has begun, and it is preferable for directors to lead and orchestrate appropriate reforms than to follow them from far behind.