If the shoe fits: sizing up the applicability of IvI exclusions to the FDIC.

• Author: DeLeo, Julianne
• Position: Insured vs. insured, Federal Deposit Insurance Corporation

"Want to spook out a local business leader? Ask him or her to serve on a bank board." (1)

1. INTRODUCTION

   In 2010, 157 institutions insured by the Federal Deposit Insurance Corporation (FDIC) failed in the United States. (2) That year, the FDIC categorized an additional 884 institutions as "problem institutions," a collection representing $390 billion in assets that were at risk. (3) These figures reflect the height of the bank failure trend that occurred during the United States' financial crisis in the late 2000s. (4)

   Fortunately, the number of failed banks has decreased every year since 2010, falling to a total of sixteen bank failures in 2013. (5) Nonetheless, the first seven months of 2014 resulted in fourteen banks closing and millions of dollars that stood to be recovered. (6) The FDIC has expanded its efforts to recoup losses resulting from bank failures, ultimately seeking recovery from the banks' directors and officers. (7) Since the 2008 financial crisis, the agency has filed more than ninety lawsuits against directors or executives of failed banks. (8) To accommodate the ramped-up recovery efforts, the FDIC has increased its staffing and available resources, despite the current federal budgetary constraints. (9)

   When an FDIC-insured bank closes, the FDIC frequently becomes the bank's receiver. (10) As such, the FDIC is responsible for collecting the bank's assets, liquidating those assets, and distributing the proceeds to the bank's creditors. (11) Additionally, the FDIC launches investigations to determine why the bank failed. (12) During the investigation, the FDIC determines whether to pursue claims against directors, officers, or other third parties. (13) The FDIC may bring actions against directors and officers, hereinafter referred to collectively as directors, for corporate waste, breaches of fiduciary duty, and negligence or gross negligence. (14)

   The risk of litigation confronts directors with each decision they make in their official capacities, so banks routinely obtain directors and officers liability insurance (D&O) policies. (15) These policies aim to shift the risk of personal liability from the directors to a third-party insurance carrier. (16) Today, D&O policies are necessary because FDIC lawsuits have adversely affected directors' willingness to serve on a bank board. (17) According to an American Association of Bank Directors (AABD) survey, the ill effects of bank directors' fear of personal liability are widespread. (18) The survey indicated that almost onequarter of bank respondents have lost directors, been told "no" by director candidates, or lost members or potential members of their board loan committees from fear of personal liability. (19)

   Failed banks typically lack valuable assets. (20) A company's D&O policy (and the policy's proceeds) is frequently one of the few valuable assets left. (21) Therefore, when the FDIC seeks to recover losses to its own insurance fund, it targets the proceeds from the failed bank's D&O policy. (22) Consequently, the strength of the D&O policy is critical for a bank's directors, as well as the FDIC. (23)

   Holes in the bank's D&O policy's coverage are perilous. (24) They may require the directors to pay out-of-pocket damages, and the FDIC may forego payment. (25) One of the common gaps that exists in the D&O policy's coverage is the Insured v. Insured (IvI) exclusion. (26) Generally, the IvI exclusion excuses the insurer from payment when a claim is brought by, or on behalf of, an insured party against an insured party. (27) This Note will consider the circumstances in which an IvI exclusion to a D&O policy may excuse an insurer from coverage when the FDIC brings claims against the directors of a failed bank. (28)

   This Note will begin with the history of D&O policies and the IvI exclusion. (29) In doing so, the Note will discuss the creation of the FDIC and the need for D&O policies, the so-called D&O insurance crisis, and the role of the Savings and Loan (S&L) crisis of the 1980s and early 1990s in creating the IvI exclusion. (30) Next, the Note will explore the current disagreement within the United States over the treatment of IvI exclusions. (31) Within this discussion, the Note will address major arguments both for and against the application of the IvI exclusion. (32) Finally, this Note will present suggestions for a uniform approach to the application of the IvI exclusion. (33)

2. HISTORY

   1. Creation of D&O Policies

      The current state of affairs regarding D&O policies is a product of nearly a century's worth of U.S. economic history. (34) D&O policies were first introduced following the 1930s stock market crash and ensuing Great Depression to protect directors from liability imposed by shareholder lawsuits. (35) At that time, however, most directors felt no need to purchase liability insurance, which, therefore, remained readily available and affordable. (36)

   2. A History of the Stock Market Leading to the Great Depression

      The decade preceding the Great Depression, the "Roaring Twenties," experienced general prosperity, low unemployment, heavy consumer spending, and newfound wealth. (37) The stock market appeared to be thriving too; the Dow began its postwar boom at 63.90 points in August 1921, broke 100 points for the first time on August 22, 1922, and rose by 400% between 1922 and its peak in 1929. (38) This was accompanied by an increase in borrowing, however, and banks offered installment loans, mortgages, and loans to stock market speculators on 90% margins. (39)

      When buying on a margin, a debtor borrows money to make an investment and uses the investment as collateral. (40) Buying on a margin is risky because in unstable markets, investors who make initial margin payments for stock may have to provide additional cash if falling stock prices devalue the security. (41) Additionally, these bank loans were used for stock speculation--buying and selling stock without regard for the stock's actual value or the health of the company that issued it. (42) Thus, by March 1929, some financial experts worried banks were making too many loans for stock speculation, but the stock market continued to rise, despite financial experts' warnings. (43)

      The financial environment of the 1920s created new financial products, which spawned corporate securities issues. (44) Meanwhile, the United States lacked insider trading laws, national economic planning, or any significant watchdog agency to monitor the economy. (45) Further, the government adopted a laissez-faire approach to economic regulation that caused market instability through the fall of 1929, and subsequently, the Great Depression. (46)

      The Great Depression was a worldwide economic crisis that lasted until 1939 and carried severe consequences. (47) Unemployment spiked, and wages fell for those fortunate enough to remain employed. (48) Americans' heavy use of credit in purchasing homes, cars, furniture, and household appliances in the preceding years led to foreclosures and repossessions when homeowners could not repay what they had borrowed. (49) Many banks failed because they made loans to stock market speculators, who never repaid them. (50) President Herbert Hoover was in office during the worst years of the Great Depression, but because he did not believe in directly intervening with the economy, his response to the Great Depression was ineffective. (51)

   3. Recovering from the Great Depression

      On March 6, 1933, newly elected President Franklin Delano Roosevelt declared a nationwide bank holiday and closed all banks--a decision that allowed banks to regain their equilibrium. (52) He introduced a series of emergency measures called the New Deal. (53) The New Deal's major initiatives included stock market reform, unemployment aid, and fortification of the banking system. (54)

      During the Great Depression's height between 1932 and 1933, the government developed regulatory legislation and created agencies with new and emergency functions. (55) For example, Congress enacted the Reconstruction Finance Corporation Act of 1932 (RFC), (56) the Federal Home Loan Bank Act of 193 2, (57) the Securities Act of 193 3, (58) the Banking Act of 193 3, (59) the Securities Exchange Act of 1934, (60) and the Banking Act of 1935. (61) Unfortunately, not all of these reforms were effective. (62) For instance, the Hawley-Smoot Tariff Act of 1930 may have lengthened the Great Depression. (63) It drastically raised U.S. tariffs on imports, prompting foreign governments to retaliate and hinder free trade. (64)

      The Banking Act of 1933, however, was particularly important. (65) It established the FDIC as a temporary government organization with the authority to provide deposit insurance to banks, and it funded the FDIC with initial loans of $289 million through the U.S. Treasury and the Federal Reserve Board (FRB). (66) The Banking Act of 1933 vested the FDIC with the power to regulate and supervise state nonmember banks and extended federal oversight to all commercial banks. (67) Since the FDIC's creation in 1933, no depositor has lost a penny in FDIC-insured institutions. (68)

      Before the Great Depression exposed the repercussions of speculation, business leaders faced minimal accountability for risky decision-making. (69) After the stock market crash and the enactment of federal securities laws, everything changed, and business leaders finally acknowledged their defenselessness. (70) Directors of for-profit corporations could face claims from two sources: shareholders and third-party claimants. (71) Shareholders could sue on the corporation's behalf in a derivative suit or in the shareholder's own right. (72) Third-party claimants could now include the corporation's employees, creditors, suppliers, customers, and government agencies. (73)

   4. D&O Policies After the Great Depression

      D&O policies were introduced in the 1930s as a tool to protect corporate directors from liability threatened by shareholder...