The Evolution of a More Stringent Business Judgment Rule in Banking
The Minimilization of Director Deference
Jon Canfield
Posted Monday, May 1, 2006
6 U.C. Davis Bus. L.J. 17 (2006)

I. Introduction

With an increased focus on corporate governance procedures, courts rely heavily on the use of the business judgment rule in the corporate setting.[1] The business judgment rule is purely a case law derived concept whereby a court will not review the management decisions of a corporation's board of directors absent some sort of showing that the board of directors violated their duty of care or loyalty.[2] Authors of corporate literature and commentators assume that the courts will only cut against the business judgment rule in extraordinary circumstances, such as mergers or changes in management control.[3] Although courts frequently rely on the business judgment rule in corporate litigation, courts generally do not afford the same amount of deference to directors in regard to banking and finance law.

Since the late nineteenth century, courts have second-guessed the decisions of bank directors in negligence actions. Courts have scrutinized substantive bank decisions, therefore, to protect depositors and deposit insurance funds from excessive exposure to risk.[4] As this paper will discuss, courts frequently turn to common law, banking and corporate codes, and both federal and state regulations. Accordingly, courts hold bank directors and officers liable for decisions arguably well within the permissible bounds of what should not be considered "unduly risky."

The banking industry continues to be uniquely complex despite several decades of deregulation.[5] The Federal Government subjects banks to one of the most comprehensive and extensive regulatory schemes in the American economy.[6] Because of this, some commentators and scholars have pointed out the mere existence of the business judgment rule in the bank setting can be questioned.[7] This means that courts should not afford even the smallest amount of deference to the decisions of bank directors and officers.[8] This beckons the query: does the business judgment rule exist in the modern banking world?

The business judgment rule continues to exist in the modern banking world. However, over the last century, both federal and state courts have slowly cut away at the force of the business judgment rule as it applies to financial institutions.[9] In doing so, courts have inadvertently implemented a more stringent, less generalized form of the business judgment rule as it applies to banks. In analyzing the development of regulations and the inconsistency of court decisions dealing with director negligence where the business judgment rule should arguably apply, it is evident that courts, although struggling to with what extent to implement the business judgment rule, still believe the rule is important. Furthermore, government regulation of banks through a more stringent form of business judgment is not the right way of achieving tighter control over banking directors and officers' decisions. Courts should not have full discretion to impose their own form of the business judgment rule in an industry-specific way.[10]

As recently as April of 2005, prominent legal practitioners expressed their support for the continued existence of business judgment deference in the banking industry. Practitioners expressed their support for the rule despite its more stringent application in the banking industry than in the corporate context.[11] For example, Bank Directory Magazine interviewed James M. Rockett and Neal J. Curtin, two attorneys from Bingham McCutchen LLP.[12] These two leading experts spoke about the regulatory landscape, director liability, and boardroom challenges that bank boards will face in the years to come.[13] When asked whether they believed that the protection afforded by the business judgment rule had eroded, both Rockett and Curtin answered in the affirmative.[14] Rockett stated, "[t]here has been a tightening of the application of the business judgment rule, and it no longer provides the barriers to liability it once did."[15] Curtin echoed this sentiment, saying, "courts have begun to examine whether directors have truly been loyal or not, looking at conduct or the lack of it, and concluding that the actions or inactions were not in good faith and therefore not loyal."[16]

In order to accomplish a thorough inspection of the evolving role of business judgment deference in the banking marketplace, Part II briefly analyzes the business judgment rule as one of the fundamental principles in corporate governance.[17] Part III discusses the transition of banking regulation over the last one-hundred years, and looks broadly at the development of banking industry regulations.[18] Part IV analyzes proposed justifications for holding bank directors to a different standard of business judgment deference as compared to their corporate counterparts.[19] Part V considers the pragmatic effects of a more stringent business judgment rule for bank directors and offers insight as to why weakening the business judgment rule is a necessity. Part V also argues that the legislature, not the courts, should regulate banking practices.[20] Finally, Part VI discusses the nature of regulatory intervention and the future of banking institutions and director liability.[21]

II. The Role of the Business Judgment Rule in Bank Practices

The business judgment rule is one of the most fundamental principles in corporate governance. Under Delaware law, the directors of a corporation have the responsibility of supervising the business and affairs of the corporation.[22] In carrying out this responsibility, directors of a corporation owe fiduciary duties to the corporation and its constituents.[23] These fiduciary duties include both the duty of care and the duty of loyalty.[24] If either of these duties is breached, the directors of the corporation may be, and often times are, personally liable for the harmful consequences of their actions.[25]

When a business decision turns bad, shareholders may bring a negligence suit against the corporate directors for violating their duties of care or loyalty.[26] Generally, a negligence action arises when shareholders accuse the board of making a decision that an ordinarily prudent person would not have made.[27] However, the business judgment rule shields directors from liability from such decisions. Under the business judgment rule, courts exempt decisions made by a disinterested board of directors from liability.[28] Accordingly, courts will not penalize the board of directors for calculated risks that turn out to be wrong or unprofitable.[29]

In order to qualify for exemption under the business judgment rule, the disputed decision must also satisfy the duty of loyalty.[30] The board of directors' decision cannot be illegal.[31] The board of director's decision must not violate the corporate charter or offend the by-laws.[32] If these requirements are satisfied, courts give imprudent board decisions immunity from negligence liability.[33]

The purpose of the business judgment rule is simple. If directors feared liability when making decisions that could be unprofitable or wrong, the market would be risk-adverse. As one academic suggested, "[t]he business judgment rule seeks to temper concerns that the duty of care will make directors unduly risk-averse by immunizing many of the substantive board decisions that the duty of care might otherwise proscribe."[34]

The business judgment rule garnered force in the banking industry as a result of the U.S. Supreme Court's landmark formulation of the duty of care in Briggs v. Spaulding.[35] In Briggs, the court ultimately concluded that a bank director must exercise:

[O]rdinary care and prudence in the administration of the affairs of a bank, and that this includes something more than officiating as figure heads. [Bank directors] are entitled under the law to commit the banking business, as defined, to their duly-authorized officers, but this does not absolve them from the duty of reasonable supervisions, nor ought they [] be permitted to be shielded from liability because of want of knowledge of wrong-doing, if that ignorance is the result of gross inattention.[36]

Furthermore, the Supreme Court found that bank directors are bound to the same duty of care which ordinarily prudent individuals would exercise in similar situations.[37] In determining this duty, both the restrictions imposed by the statute and the usages of business should be taken into account.[38] Ostensibly, the majority of the states continue to apply the Briggs rule.[39]

III. A Shift to a More Rigid Business Judgment Rule Afforded to Bank Directors

To understand the modern business judgment rule as the more stringent creation that is intertwined in the regulation of the financial industry, it is important to trace the main development of banking regulation back to its inception. Similarly, it is important to examine the evolving case law that corresponds to director liability for decisions that arguably fall under the auspices of business judgment deference. The post-depression era saw a shift in regulatory focus aimed at protecting the banking industry.[40] This trend of eroding the business judgment rule continued from the 1940's through the 1970's. The greatest change from a "hands-off" approach of bank decisions to the microscope-like analysis that exists today began a little over twenty-five years ago.

A. The Beginning of Forceful Regulation - The Post Great Depression Era

In the years following the stock market crash of 1929 and the beginning of the Great Depression, financial institutions were in a state of disarray.[41] By 1933, more than 9000 commercial banks had failed as a direct result of the stock market crash, and also because of "speculative investments."[42] In response, Congress enacted two pieces of legislation to deal with the massive failures in financial institutions during the Great Depression.[43]

Congress passed the Banking Act of 1933, or the Glass-Steagall Act ("GSA") to respond to the Great Depression.[44] The purpose of the GSA was to separate commercial and investment banking activities to ensure that the magnitude of the banking industry's failures would never happen again.[45] One of the principle accomplishments of this piece of regulation was to establish the Federal Deposit Insurance Corporation ("FDIC") (albeit only as a temporary agency).[46] It is the FDIC that has played a major role in weakening the business judgment rule and reducing the amount of deference courts afford to bank directors.

During the 1920's and early 1930's, overzealous commercial bank involvement in stock market investment, deemed "improper banking activities," has been blamed for the stock market failures in 1929 according to members of Congress and various scholars.[47] The consensus among these people was that commercial banking institutions took on too much risk with depositors' money.[48] Mainly investigators accused commercial banks of being too speculative since they were investing their assets while also buying new issues for resale to the public.[49] Accordingly, banks took on increasing risks with the hopes of reaping large financial rewards.[50] This ultimately led to a break down in banking industry safeguards.[51] Banks would also issue risky loans to financially distressed companies they had invested in.[52] These lending institutions encouraged their clients to invest in those same stocks.[53]

In order to combat these problems, Senator Carter Glass[54] and Henry Bascom Steagall[55] encouraged Congress to enact the Glass-Steagall Act ("GSA").[56] The GSA implemented many protectionist schemes, including a "regulatory firewall" between commercial and investment bank activities.[57] Accordingly, the GSA gave banks one year to decide whether they would specialize in commercial or in investment banking.[58] Furthermore, only 10% of commercial banks' total income could come from securities, although an exception did allow for commercial banks to underwrite government-issued bonds.[59] Congress intended these barriers on securities to prevent the banks from using customer deposits in the case of failed underwritings.[60] In other words, Congress restricted banks from engaging in a large amount of securities transaction to protect consumer deposits in the event the underwritings failed.

In sum, the GSA completed three important tasks. First, it separated the activities of banks and securities firms by prohibiting commercial banks from owning brokerages.[61] Second, the GSA introduced depositors' insurance through the FDIC.[62] Finally, the GSA ratified "Regulation Q", which prohibited banks from paying interest on commercial demand deposits, and capped the interest rate on savings deposits.[63]

Banking executives considered the GSA to be an overreaction to the banking crisis.[64] Accordingly, the Federal Reserve Board often exercised lax implementation of the GSA.[65] Despite this criticism, Congress extended banking industry regulation in 1956 by creating the Bank Holding Company Act, an extension of the GSA.[66] The Bank Holding Company Act targeted insurance companies and disallowed underwriting by banks.[67] However, banks could sell insurance and insurance related products.[68]

These restrictions on the banking sector sparked an intense debate over how much restriction is healthy for the banking industry.[69] Consequently, Congress repealed the GSA in November of 1999, and enacted the Gramm-Leach-Bliley Act.[70] The Gramm-Leach-Bliley Act eliminated the former GSA restrictions against affiliations between commercial and investment banks.[71] In addition, the Gramm-Leach-Bliley Act allowed banking institutions to provide a multitude of banking services originally banned by the GSA and Bank Company Holding Act, including underwriting.[72]

Although overshadowed by the GSA, another piece of extremely important legislation was the Federal Deposit Insurance Act of 1950.[73] This Act revised and consolidated the earlier FDIC legislation into one single, comprehensive act.[74] Essentially, the Federal Deposit Insurance Act of 1950 defined the FDIC's authority into a discernable form.[75]

B. The Savings and Loan Crisis of the 1980's - Modern Day Changes in Regulations

Congress has dramatically increased its regulatory authority over the banking industry since the mid 1980's.[76] In response to fears of fraud, Congress increased numerous federal banking agencies' authority, including the FDIC, the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTC), and the Federal Reserve Board.[77] According to one prominent academic, "[i]n the 1980's and early 1990's, courts second-guessed financial institution decisions with respect to a new range of loan activities that had previously gone unquestioned."[78] Directors and managers now found themselves faced with common law negligence liability for under-securitized loans, over reliance on risky types of collateral, failure to perfect a security, and roll-over and delinquent loans.[79] For example, in Resolution Trust Corp. v. O'Connell, the court refused to dismiss gross-negligence claims against a bank for issuing under-securitized loans.[80] Furthermore, in FDIC v. Gaziano, the FDIC brought suit against the directors of a failed bank for negligence, breach of implied contract and breach of fiduciary duty.[81] These cases highlight the plurality of claims brought against banking directors during this time period.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was one of the more important regulations levied against the financial industry.[82] The FDICIA appeared in final form in December of 1992.[83] This Act required federal regulators to adopt uniform code-based regulations governing loan practices formerly under the purview of the business judgment rule.[84] These new regulations affected the business judgment rule in two distinct ways.[85] First, the new regulations mandated bank managers to adopt underwriting standards that would result in agency sanctions if they were violated.[86] More importantly, the regulations created a codified standard of care, which would result in a per-se negligence standard of common law liability in the event of breach.[87]

The FDICIA also aimed to put federal deposit insurance and other governmental bank safeguards on a more incentive-compatible basis.[88] The FDICIA accomplished this objective by providing a graduated series of regulatory sanctions that mimicked market discipline within the banking industry.[89] The FDICIA applied sanctions to the regulators of distressed banks.[90] The FDICIA also mandated federal bank directors to adopt standards for real estate loans.[91] These new standards included strict loan-issuing requirements that added repayment assurance and loan-to-value ceilings of sixty-five to eighty-five percent.[92]

This codification of state common-law principles also relates to the recent trend of federal bank agencies replacing shareholders as plaintiffs in suits against bank regulators.[93] As a result, federal courts rather than state courts determine the amount of deference afforded to banks under the business judgment rule.[94] Bank regulators now make the rules that later provide for the standard of care applicable to bank directors and officers.[95] Federal courts generally apply state law, which affords greater deference to the decisions of bank directors.[96] However, federal law now largely defines the duty of care that governs the conduct of bank officers and directors.[97]

During the last century, bank directors began to feel the effects of a slowly evolving business judgment rule. The multitude of regulations and the expansion of congressional authority demonstrate that courts held bank directors to a more stringent standard than their corporate counterparts following the stock market crash.[98] Courts, in analyzing the bank directors' decisions, turned away from the traditional formulation of the business judgment rule.[99] Instead, courts examined the directors' decisions to determine whether the directors had breached the duty of care and the duty of loyalty.[100] Also, courts examined the substance of bank directors' decisions and the consequences of their actions.[101]

C. Case Law Analysis of Bank Director Liability

As regulatory oversight eroded the business judgment deference afforded to the banking industry, judicial treatment of the business judgment rule also evolved. A brief investigation of case law demonstrates the erosion of business judgment deference afforded to bank directors. Courts ultimately assigned liability to bank directors for decisions that arguably should be protected by the business judgment rule. In numerous cases, courts have found bank directors' decisions to be negligent despite the business judgment rule. This illustrates that courts have generally applied a more stringent business judgment rule to the banking industry.

In Hun v. Cary, the New York Central Savings Bank receiver brought an action against the bank directors, alleging breaches of fidelity, care, and diligence.[102] Even though the bank was essentially insolvent, the directors voted to build a new headquarters, hoping that it would attract new business and increase profitability.[103] The court ultimately found the directors liable, since the building of a new headquarters had no potential for profitability but could have crippled the bank.[104] Similarly, In Litwin v. Allen, the directors of Guaranty Trust voted to purchase Missouri Pacific debentures at a fixed-interest rate.[105] Alleghany Corporation, the parent company of Missouri Pacific, contracted for a "call" option during the first six months of the deal.[106] However, Guaranty did not contract for a reciprocal "put" option in case the price of the debentures declined during the six-month period.[107] Ultimately, the price of the debentures declined, and Alleghany failed to exercise their call option.[108] The court found the directors liable, holding that the directors were negligent because Guaranty failed to buy a "put" option.[109] Accordingly, Guaranty bore all the risk of capital loss without any possibility for capital gain.[110] Therefore, the directors were not shielded by the protections of the business judgment rule.

Cary and Allen stand for the principle that, absent a decision's rational relationship to potential profit, a bank director's decision may be subject to liability.[111] The court's justification for what is profitable and what is not profitable is attenuated, making a set standard near impossible to determine. For example, in Allen, the debentures purchased by the directors paid a fixed interest rate to Guaranty Trust.[112] This is profit, and the directors' decision to not contract for a "put" option should arguably have been shielded by the business judgment rule in that the court would not have assigned liability to them.

Although Cary and Allen addressed director negligence in cases where the courts held that profitability was not possible, courts began to find directors liable for decisions deemed to be "too risky," even where there was a large potential for profit. For example, in FDIC v. Robertson, the district court found the bank directors negligent for extending credit to new business without a proven record of profitability, no accurate financial statement, and no repayment program.[113] Conversely, in FDIC v. Stanley, the district court found that bank directors who issued a loan to a new business with no prior history of profitability were not liable.[114] The court concluded that as long as the loan was secured, and the financial situation of the borrower appeared to be improving, a bank director would not be liable.[115] Therefore, not all courts will not assign liability to directors who loan money to a new business without a track-record of profitability.

If directors face liability for loaning money to new businesses without a history of profitability, courts would severely hamper the economic growth of new businesses.[116] Furthermore, lending institutions profit from growing businesses.[117] Thus, although the court will not find directors liable for loans made to businesses without a record of past profitability, the courts will find liability when a borrower is not adequately secured, or when the borrower's financial position is not improving over time.[118] In determining liability, courts consider directors' failure to provide accurate financial statements and implement repayment programs, even though the borrower may represent the potential for significant profit.[119] Significant profit alone, however, will not protect a bank director's decision under the business judgment rule.[120] Thus, without a clear definition of "adequate security" or "improving financial situation," courts question director decisions that should be shielded by the business judgment rule. Essentially, the courts are applying a more stringent business judgment rule.

Courts also subject banks to considerable scrutiny in the field of commercial real estate loans. This paper has already briefly described the prohibitions imposed on the granting of such loans under the 1991 FDICIA.[121] Although courts frequently intervene in bank transactions regarding commercial real estate loans, these loans have been heavily scrutinized in recent years.[122] Increased judicial intervention may be explained by the fact that commercial real estate loans accounted for substantial losses during the savings and loan crisis of the 1980's.[123] It was these losses that led to the enactment of the FDICIA.[124] In FDIC v. Wheat,[125] the court even went as far as to say, "[t]he FDIC faces a massive effort to control losses stemming from the excesses of the 1980's. Most of this hemorrhaging resulted from bad real estate loans and unscrupulous deals made by bankers. . . . [C]ourts shall give full support to the FDIC's enforcement of the banking laws found throughout this country."[126]

Recently, courts have held bank directors' negligent for taking a security interest or issuing a loan outside of the bank's "geographical area." [127] In FDIC v. Stanley, the court found the bank directors liable for acquiring a lease secured by machinery located outside the bank's area.[128] Likewise, in RTC v. Hess, the Resolution Trust Corporation ("RTC") brought an action under both state and federal law for negligence and, breach of fiduciary duty against the American Savings and Loan Association's directors.[129] The plaintiffs alleged that the directors proximately caused damages in excess of $80 million by failing to, among other things, restrict lending to a certain geographic area.[130] In addition to denying American Savings and Loan Association's motion to dismiss the plaintiff's negligent mismanagement claims under Utah law, the court also dismissed the plaintiff's claims for negligence per se under federal common law and the plaintiff's claim for breach of fiduciary duty.[131]

Cases concerning adequate collateral are also hotly debated. Court decisions indicate difficulty in determining the amount of deference that should be afforded to a bank director's decision to loan capital to a borrower. For example, in FDIC v. Wheat, the Fifth Circuit found a bank director liable for negligence, breach of contract, and breach of fiduciary duty for approving a loan based solely on a personal guaranty of repayment.[132] However, this case can be contrasted with the decisions of Starrels v. First Nat'l Bank of Chicago[133] and Noble v. Baum.[134] In Starrels, the court ultimately held that, despite the fact that loans approved by the bank lacked collateral, the director's decision to issue the loans fell within purview of business judgment deference.[135] Similarly, in Noble, the court concluded that the director's decision to issue a loan without borrower equity was protected by the business judgment rule.[136]

Courts scrutinize bank directors' decisions more carefully than decisions of corporate directors. The slow progression of more detailed court scrutiny of bank directors' decisions, beginning with the Hun decision, characterizes the transition of the business judgment rule in the banking context. Furthermore, recent banking decisions demonstrate the courts' current struggle with the amount of deference that courts should afford to bank directors' decisions. Circuit splits demonstrate the lack of uniformity in applying the business judgment rule, and highlight the heightened scrutiny many courts have adopted. This beckons the question: are there reasons for why courts should treat bank directors differently than other corporate directors?

IV. Why "Discriminate" Between the Amount of Deference Given to Corporations or Banks?

Banks and other financial institutions play a vital role in the health and welfare of the U.S. economy.[137] Large and small corporations, private businesses, and the public all rely on financial institutions to fulfill not only essential depository needs, but also intermediary functions such as mortgage and loan transactions.[138]

In light of the Enron and Worldcom scandals, there is an increased focus on corporate executive regulation and modern corporate governance. Similarly, in the 1980's, the media and press highly popularized a fear of bank executives "lining their pockets with the hard-earned savings of American depositors [and] . . . raiding the coffers of a bank on the brink of insolvency…"[139] Why is it then that in the last twenty-five years the business judgment rule has undergone major changes in the banking industry, while the corporate world enjoys the same degree of deference to director decisions? Both banks and major corporations alike have been plagued by scandal, so it would seem logical that an evolution in business judgment deference would affect all parties equally.

The erosion of the banking industry's business judgment safeguard is not a new concept. Rather, the business judgment rule has evolved over time. This "double standard" of executive deference can most likely be attributed to the special problems exclusive to banks. Banks are unlike any other type of firm or corporation. John Macey and Maureen O'Hara have identified four such problems of banks; liquidity production, deposit insurance, the conflict between fixed claimants and shareholders, and the asset structure and loyalty problem.[140] These four problems are also characterized, in relatively undefined fashion, by Patricia McCoy in her study of the political economy of the business judgment rule as it applies to banking.[141] Besides these four, I have also identified a fifth problem of financial institutions, one that I have coined the "stereotypical view" problem.

A. The Liquidity Production Problem

Because of their unique capital structure, banks face a unique problem.[142] In contrast to other firms, banks have very little equity.[143] Whereas typical firms often solicit financing through both equity and debt, banks generally use at least 90% debt funding to finance themselves.[144] Banks' liabilities generally take the form of deposits while banks' assets often take the form of loans with longer maturities.[145]

Whenever a business employs a debt-financing structure, "information asymmetries" create incentives for shareholders and the board of directors to take on increased risks.[146] In banking, however, assuming such risks from debt-financing may result in undesirable consequences such as bank runs, bank panics, and an ensuing shrinkage in money supply.[147] Stated differently, this structure could cause a collective-action problem among the depositors.[148] At any given time, banks only have a small fraction of the deposited funds on hand for repayment to their depositors.[149] Banks re-loan most of the deposits they receive to borrowers.[150] As a result, if large, unanticipated withdrawals at a bank occurred simultaneously, even the most solvent banks would be broke.[151] Banks simply do not carry enough cash on hand to repay all deposits at once.[152]

Because of the possible dire economic consequences resulting from banks' capital structure, market discipline is essential. Federal insurance of deposited funds practically eliminates public fear of bank runs, but the mere possibility of one may be enough to justify special regulatory treatment of financial institutions.[153] One of the easiest ways to increase regulation of banks is to decrease the amount of deference afforded to director decisions, hence weakening the business judgment rule as it applies to banks.[154]

B. The Deposit Insurance Fund Problem

The second unique problem facing banks derives from the establishment of the FDIC. Congress passed the Banking Act of 1933 in response to the mass failure of depository institutions following the stock market crash of the late 1920's.[155] The Banking Act of 1933 established the FDIC, which federally insured depositors' money in approved financial institutions.[156] Insuring deposited funds has helped prevent liquidity production problems.[157] However, as Macey and O'Hara point out, FDIC insurance is not free of problems.[158]

A federally regulated insurance policy that protects depositors, shareholders and managers' funds gives participating banks an incentive to engage in excessive risk taking.[159] Essentially, risky decisions by bank managers do not affect depositor's funds.[160] Instead, depositors' funds are insured, so consumers will not suffer any loss.[161]

This cost-benefit inefficiency occurs for two reasons. First, bank losses ultimately come at the expense of healthy banks and federal taxpayers.[162] Healthy banks and federal tax dollars fund the FDIC.[163] When a bank fails, the losses are essentially passed off to healthy banks, because the healthy banks' FDIC contributions go to the depositors of the failed bank.[164] Furthermore, taxpayers bear the ultimate cost, because tax dollars replenish the depleted FDIC fund.[165]

The second reason for this inefficiency is due to the inequity between deposit insurance premiums and full compensation to the FDIC for increased risks posed by an unhealthy bank.[166] Macey and O'Hara discuss how this problem "is exacerbated in situations where a bank is at or near insolvency."[167] When a bank nears the point of insolvency, shareholders have an increased incentive to take on unacceptable risk.[168] In doing so, the shareholders may be able to profit from this risky behavior, while being insured by the FDIC from any losses that result from the behavior.[169]

Patricia McCoy echoes this sentiment by stating that depository insurance has the "salutary effect of bolstering depositors' confidence", but also leads to the undesirable effect of dampening market restraints on undue bank risks.[170] Here again, weakening the business judgment rule may be an effective way of restricting such action. If excessive risk taking directors face penalties and liability, they will be less likely to engage in risky behavior in the future.

C. The Problem between Fixed Claimants and Shareholders

The third problem facing bank entities is conflicting interests between debt-holders and the shareholders of a firm.[171] Any risky investment will transfer wealth from fixed claimants to residual claimants, but this phenomenon is magnified in the banking context.[172] In a typical corporation, a variety of factors discourage excessive risk-taking First, various safety nets and devices are in place to protect fixed claimants against excessive risk-taking.[173] For example, corporate lenders will institute protectionist-devices over their fixed claims to ensure that managers will not threaten their investment.[174] Secondly, an imperfect agency relationship exists between managers and risk-happy shareholders.[175]

Banks are similar to typical corporations in that bank managers tend to be more risk adverse than bank shareholders. However, very little incentives exist for fixed claimants to be risk adverse. FDIC insurance does not create sufficient incentive for depositors to refrain from making truly risky decisions.[176] By allowing deposit guarantees, depositors have no incentive to research bank risk profiles or demand higher rates of return in compensation for risk.[177]

In a typical corporation, shareholders scrutinize managers' decisions since the shareholders have a stake in the outcome of those decisions. A risky decision may lead to a decline in stock value, which greatly affects the investment potential of the shareholder. In a bank, however, the FDIC insures the depositor's fund.[178] Any loss for excessive risky behavior is insured.[179] This breaks down the barriers and monitors that would normally exist.[180] As Macey and O'Hara highlight, the depositor's adverse incentive for risk-taking control caused by the FDIC is one reason to increase the accountability requirements for directors of banks.[181]

D. The Asset Structure and Loyalty Problem

The fourth problem the banking industry faces is the increased risk of fraud and self-dealing caused by federal insurance's reduced incentives to monitor.[182] Although the problem of effectively monitoring of all employees is inherent in any institution, the risk is considerably higher in a banking institution because the assets are highly liquid.[183] The same breakdown in monitoring of excessively-risky investments also leads to a breakdown in control over fraud and self-dealing.[184] Shareholders have an incentive to prevent fraud and self-dealing in banks, but shareholder controls are generally inefficient.[185] Furthermore, there is a collective-action problem for individual depositors.[186]

So how does this lack of monitoring justify an increased standard for business judgment deference over bank managers' decisions? Macey and O'Hara argue that state and federal regulators are more financially sophisticated than normal depositors, and thus are in a better position to monitor bank directors.[187] This argument may be supported by mandatory federal and state periodic reports and on-site bank inspections.[188] Furthermore, federal regulation also has the advantage of curbing unsafe and unsound banking practices.[189] Courts liberally construe what is "unsafe" or "unsound", so bank regulators generally have discretion to correct problems in banking practices before they balloon into major problems.[190]

The federal inspector generally has five different enforcement tools at his disposal: cease and desist powers, removal powers, money penalty powers, withdrawal or suspension of insurance powers, and prompt correction-action powers.[191] Each of these powers gives the federal regulator not only the ability to prevent and maintain safe banking practices, but also removes the disincentive of monitoring created by federal insurance.[192]

E. The Stereotypical View Problem

The final problem facing banks is what I refer to as the "stereotypical view" problem. This problem is inherent in banking practices and pervades the public perception of banking institutions. The stereotypical view problem refers to the public's discernment of the relative safeness of their money being deposited in a financial institution. This problem is demonstrated by typical rhetoric such as "you can bank on that" or "as good as money in the bank." This public perception is largely due to federal insurance and bank regulation. But, as true as these phrases may be, they impose pressure on the government and the courts to live up to the expectations of the banking public.

In order to meet the expectations of the banking public, regulations must evolve in order to safeguard savings deposits. Inevitably, the government and the public do not want to revert back to the atmosphere of the stock market crash of the late 1920's and 1930's, or the savings and loan crisis of the 1980's. This fear has inevitably led to increased federal regulation after times of crisis, and also to the "trickle down" effect of subsequent regulations in the years following the initial regulation.[193] Thus, courts implement their own more-detailed examination of banking practices in order to help strengthen the effect of financial institution regulation, and also to alleviate any public concern about the safety of their deposits.

V. The Pragmatic Effects of a More Stringent Business Judgment Rule of Banks

Having explored the court's unwillingness to respect financial institutions' practices and investment decisions arguably protected by the business judgment rule, it is important to consider the effect that this more rigid rule will have on future risky bank decisions. In other words, how detrimental will the court's increased scrutiny of banking decisions be?

At first glance, it appears as though tightening the business judgment rule will have a negative impact on shareholders. After all, the Anglo-American model of corporate governance believes that the exclusive focus of business practices should be maximizing shareholder wealth.[194] The logical presumption is that curtailing business judgment deference would make bank directors unduly risk-adverse.[195] However, the effects of a tougher business judgment rule might not significantly impact banking practices.

Recently, some legal scholars have argued that banking decisions should, in fact, be regulated with a heavier hand. John Macey and Maureen O'Hara suggest that the "scope of the duties and obligations of corporate officers and directors should be expanded in the special case of banks."[196] Furthermore, Macey and O'Hara feel that "directors and officers of banks should be charged with a heightened duty to ensure [the] safety and soundness of [financial institutions]."[197] Indeed, Macey and O'Hara have suggested a "hybrid approach", in which the traditional shareholder wealth maximization model governs corporations, while a variant of the Franco-German model governs banks.[198] The Franco-German model holds bank directors accountable not only for shareholders, but also the institution's creditors.[199] The hybrid approach set out by Macey and O'Hara calls for stricter regulation of director decisions without allowing directors to escape liability through the business judgment rule.[200] Specifically, this hybrid approach to bank regulation attaches personal liability to bank directors for failing to systemically factor solvency risk into their decisions.[201]

Other scholars approach a more stringent business judgment rule differently, concluding that the practices of bank directors have remained unchanged.[202] Proponents of this argument argue that there has been no tilt towards overly risky decisions or overly risk-adverse decisions.[203] Thus, despite the complexities in statutory bank regulation, periods of heightened judicial scrutiny and judicial activism generally precede periods of judicial backlash, in which courts repudiate the views taken by the more restrictive courts.[204] This "two steps forward - one step back" approach has limited the amount of business judgment deference afforded to director decisions. However, banks have actually modified their approach to making such decisions, in order to maximize wealth without being unduly risk adverse.[205]

Putting aside Macey's and O'Hara's assertions that bank regulation should be regulated more rigorously, my own perspective on this subject raises a tension that seems to be developing within the corporate governance regime. The aim of this paper is not to discuss the breadth of current bank regulation or to even champion a call for strengthened bank regulation through an analysis of degregulatory techniques. However, despite the problems associated with bank governance and the possibilities that directors may engage in risky behavior because of the protection afforded by FDIC insurance, it is not the courts' responsibility to curb bank director behavior by implicitly weakening the business judgment rule.

Commentators and scholars will argue that it is "good" and "necessary" that courts have intervened. However, this is at odds with the principles behind the business judgment rule. The business judgment rule is founded on the assertion that in the absence of a showing that the directors breached some sort of fiduciary duty to the company, the courts will not interfere with the business judgment of the directors.[206] Stated differently, Chancellor Chandler has lamented that "[t]he redress for failures that arise from faithful management must come from the markets … and not from this Court."[207] As a result, in order to police the market and prevent risky behavior stemming from deposit insurance, regulation should come from the FDIC or another federal government agency. If the courts assume this responsibility by changing the business judgment rule, the inevitable result will be an industry specific modification of business judgment standards. What is within the scope of permissible behavior in the corporate setting will not be permissible in the bank setting, and so on. Eventually, the different levels of deference afforded to each specific industry will transcend boundaries, resulting in a "mixed-bag" of deference levels applied by the courts without any sort of established standard. In other words, the eventual outcome of industry specific deference will result in courts borrowing a stricter form of business judgment from the banking industry in order to punish a corporate decision they find offensive. This leads to inequities and disparities, making it necessary, yet impossible, to determine which markets have what amount of deference afforded by the courts for director decisions.

VI. Conclusions

In the last decade, corporate governance norms have undergone a tremendous change. Even the last five years has shown us that the world's largest corporations can create strife and upheaval in the market place when directors and officers; those ultimately in charge - break their bonds of loyalty to the shareholders and the corporation as a whole. The results of these actions have been devastating, and the law has responded with force. Our corporate regulatory culture has seemingly changed into one of compliance, a culture of safeguards for the safeguards. All of this, although relatively new to the corporate world in general, has existed and evolved in the banking world for some time now.

The safeguards enacted to control banking practices are of significant importance in today's society. This importance stems from the unique position that financial institutions play not only in the economy, but also in the economy's reliance upon banks and financial institutions for key functions such as depository and loan services.[208] As this paper has highlighted, public interest in sound banking practices is very important to society.

In the last one hundred years, corporate law has bared witness to a slow, yet ever evolving transformation of bank director negligence law. As Patricia McCoy points out, this "fundamental shift" was "scarcely imaginable in general corporate law today."[209] It is but little doubt that director liability has increased, leaving decisions once thought safe for being under the auspices of the business judgment rule, now exposed to liability for breach of fiduciary duties.

So where does this leave us? It is my contention that court-based regulation will dictate a new standard of care in the banking world, effectively making the business judgment rule a more stringent form of deference. In a sense, federal bank regulators have defined the line between violations for breach of duty of care, and the business judgment rule as applied in a bank setting.[210] Although courts seem willing to apply their own form of business judgment deference in banking cases, the role of regulation must inevitably take over for a uniform result to occur.

[1] See, e.g., Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971) (holding that the court will not substitute its' own opinions as to what business decisions a corporation should make since the "board of directors enjoys a presumption of sound business judgment, and its decisions will not be disturbed if they can be attributed to any rational business purpose".)

[2] See, available at

[3] Patricia A. McCoy, The Notional Business Judgment Rule in Banking, 44 Catholic U. L. Rev. 1031, 1032 (1995).

[4] Id. at 1032-33.

See generally Kevin J. Stiroh & Philip E. Strahan, Competitive Dynamics of Deregulation:

Evidence from U.S. Banking (2002),

(providing insight into the changing scheme of bank regulation over time.)

[6] Mark E. Van Der Weide & Satish M. Kini, Subordinated Debt: A Capital Markets Approach to Bank Regulation, 41 B.C. L. Rev. 195, 197 (2000). See infra Part III.A-B for a more detailed discussion of these regulatory schemes.

[7] See infra Part III for a more detailed discussion of this notion.

[8] See, e.g., McCoy, supra note 3, at 1031.

[9] While this notion is explored throughout this paper, an examination of case law will lend credence to this statement. For example, if one was to examine court decisions beginning with that of Hun v. Cary, 82 N.Y. 65, (1880), a trend emerges where banking directors are found liable for decisions that arguably should be covered by the business judgment rule.

[10] By using the term "industry-specific", I am referring to courts implementing different degrees of business judgment deference for various industries such as banking (as compared to corporate governance).

[11] Interview with James M. Rockett & Neal J. Curtain, attorneys, Bingham McCutchen LLP, Legal and Regulatory Challenges for 2005: What Bank Boards Should Prepare for in the Year Ahead, Bank Director Magazine, 2d Quarter 2005, available at

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Id.

[17] See infra Part II.

[18] See infra Part III.

[19] See infra Part IV.

[20] See infra Part V.

[21] See infra Part VI.

[22] Jonathan R. Macey & Maureen O'Hara, The Corporate Governance of Banks, Fed. Res. Bank of N.Y. Econ. Pol'y R. 91, 92 (2003).

[23] Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1280 (Del. 1989).

[24] Macey and O'Hara give a good summary of both the duty of care and the duty of loyalty in modern-day corporate governance. [I would still like a citation here to the summary] Simply stated, the duty of care "requires that directors exercise reasonable care, prudence, and diligence in the management of the corporation" and the duty of loyalty calls for "'an undivided and unselfish loyalty to the corporation [that] demands . . . there shall be no conflict between duty and self interest'". Macey & O'Hara, supra note 22, at 93-94.

[25] Id.

[26] Macey & O'Hara, supra note 22, at 93.

[27] Id.

[28] Hun v. Cary, 82 N.Y. 65, 70 (1880).

[29] Id.

[30] Id.

[31] Macey & O'Hara, supra note 22, at 93-94.

[32] See McCoy, supra note 3, at 1036 and accompanying footnotes.

[33] See McCoy, supra note 3, at 1036.

[34] Id.

[35] 141 U.S. 132, 165-66 (1891).

[36] Id. at 165-66.

[37] Id.

[38] Id. at 152.

[39] Patricia A. McCoy, A Political Economy of the Business Judgment Rule in Banking: Implications for Corporate Law, 47 Case W. Res L. Rev. 1, 6 (1996).

[40] Jonathan Zubrow Cohen, Comments: The Mellon Bank Order: An Unjustifiable Expansion of Banking Powers, 8 Admin. L.J. Am. U. 335, 336 (1994) (discussing concern focused on the banking industry and its' overall soundness since the post-Great Depression era.).

[41] Id. (citing Matthew Clark & Anthony Saunders, Judicial Interpretation of Glass-Steagall: The Need for Legislative Action, 97 Banking L.J. 721(1980)).

[42] See generally Matthew Clark & Anthony Saunders, Judicial Interpretation of Glass-Steagall: The Need for Legislative Action, 97 Banking L.J. 721 (1980)(discussing the numbers of commercial banks that had failed and the reasons for their failures); see also William A. Lovett, Banking and Financial Institutions Law In A Nutshell 50 (1997).

[43] Cohen, supra note 40 at 336.

[44] The Banking Act of 1933, ch. 89, 48 Stat. 162 (1933 ).

[45] Cohen, supra note 40, at 336.

[46] Sidney Mandell, Laws Governing Banks and Their Customers 11-12 (1975); see also Important Banking Legislation, Federal Deposit Insurance Corporation, http:/ (last visited November 19, 2005)

[47] See Edward J. Kelly, Legislative History of the Glass-Steagall Act 41-65 (1985); Heakal, supra note 47.

[48] Id.

[49] Kelly, supra note 47, at 43-50.

[50] Id.

[51] Id.

[52] See Kelly, supra note 47; Heakal, supra note 47

[53] Id.

[54] Senator Glass was a former Treasury secretary and the founder of the U.S. Federal Reserve System.

[55] Steagall was a House of Representatives member and chairman of the House Banking and Currency Committee.

[56] Heakal, supra note 47; see also, (last visited April 14, 2006).

[57] Heakal, supra note 47; see also, (last visited April 14, 2006).

[58] Heakal, supra note 47; see also, (last visited April 14, 2006).

[59] Heakal, supra note 47.

[60] Id.

[61] Richard N. Cooper & Jane Little, Competition & Opportunity: How International Forces Spurred Innovation in U.S. Banking, Regional R. 18, 21-22 (Quarter 3, 2001).

[62] See Kelly, supra note 47.

[63] MANDELL, supra note 46, at 16; see also George J. Bentson, The Separation of Commercial and Investment Banking (1990); Lovett, supra note 39, at 56-60.

[64] See generally Bentson, supra note 63 (giving an introspective look at GSA and the effects of it).

[65] See Kelly, supra note 47; see also Heakal, supra note 47.

[66] See Kelly, supra note 47; see also Heakal, supra note 47.

[67] Heakal, supra note 47.

[68]See Kelly, supra note 47; see also Heakal, supra note 47.

[69] See Kelly, supra note 47.

[70] Id.

[71] Id.

[72] Id.

[73] Federal Deposit Insurance Act of 1950, P.L. 81-797, 64 STAT. 873.

[74] Important Banking Legislation, Federal Deposit Insurance Corporation, available at http:/

[75] Id.

[76] See Heidi Mandanis Schooner, Who Determines When Enough Is Enough? Refocusing Regulatory Limitations on Banks' Compensation Practices, 37 B.C. L. Rev. 861 (1995-1996).

[77] Id.

[78] McCoy, supra note 39, at 48-49.

[79] Id.

[80] See Resolution Trust Corp. v. O'Connell, No. 94 C 4186, U.S. Dist. Lexis 3999 (N.D. Ill. Mar. 29, 1996)(holding in part that defendants' conduct while a state-charted financial institution constituted negligence); see also McCoy, supra note 39, at 48-49 n. 160.

[81] See FDIC v. Gaziano, No. 96-11361-MEL, 1998 U.S. Dist. Lexis 2150 (Mass. Dist. Ct. Jan. 29, 1998).

[82] See generally McCoy, supra note 39, at 50 (discussing how case law has been overshadowed by events taking place on Capital Hill, specifically the enactment of the FDICIA).

[83] McCoy, supra note 39, at 50-51.

[84] Id.

[85] Id. at 51.

[86] Id.

[87] Id.

[88] See George J. Benston & George G. Kaufman, Deposit Insurance Reform in the FDIC Improvement Act: The Experience to Date, The Federal Reserve Bank of Chicago (1998), available at

[89] Id. at 2.

[90] Id.

[91] Id.

[92] See, e.g., McCoy, supra note 3, at 1048.

[93] McCoy, supra note 39 at 53.

[94] Id.

[95] Id.

[96] Id. at 56.

[97] Id.

[98] Macey & O'Hara, supra note 22, at 97-99.

[99] Id.

[100] Id.

[101] Id. Macey and O'Hara discuss that the justification for this higher standard rested in the need for greater shareholder protection due to the personal liability. During the 1800's, many states had double-liability standards. In effect, these contractual arrangements made each shareholder liable for their share of deposits paid into a now insolvent bank, and sometimes shareholders would have to pay up to double or triple the amount of their initial deposit. Contrast this with that of a normal shareholder, who would only be out his initial contribution. Following the massive bank failures that occurred between 1929 and 1933, many bank shareholders could not weather the liability strains now assessed to them from bank failures since these shareholders were already in dire financial difficulty. For a complete discussion of this, see Macey & O'Hara, supra note 22, at 99-102.

[102] Hun v. Cary, 82 N.Y. 65, 66-71 (1880).

[103] Id. at 70-77.

[104] Id. at 77-79.

[105] Litwin v. Allen, 25 N.Y.S.2d 667, 691-93 (1940).

[106] Id. at 690-94.

[107] Id.

[108] Id. at 691-92.

[109] Id. at 737.

[110] Id. at 697-98.

[111] McCoy, supra note 3, at 1037-40.

[112] Id. at 1039.

[113] FDIC v. Robertson, No. 87-2623-S, 1989 U.S. Dist. LEXIS 9292 at *16-18

(D. Kan. July 24, 1989).

[114] FDIC v. Stanley, 770 F. Supp. 1281, 1293-1304 (N.D. Ind. 1991). Id. at 1293-1304.

[115] Id.

[116] McCoy, supra note 3 at 1045.

[117] Id at 1045-46.

[118] Id.

[119] Id. at 1044-46

[120] Id.

[121] See infra Part III.B.

[122] See, e.g, Williams v. McKay, 18 A. 824 (N.J. Ch. 1889), Medford Trust Co. v. McKnight, 197 N.E. 649 (Mass. 1935), and Michelsen v. Penney, 135 F.2d 409 (2d Cir. 1943).

[123] R. Dan Brumbaugh, Jr., The Collapse of Federally Insured Depositories - The Savings and Loans as Precursor 95, 119-125 (1993); Lawrence H. White, Why Is the U.S. Banking Industry in Trouble? Business Cycles, Loan Losses, and deposit Insurance, in The Crisis in American Banking 12-13 (Lawrence H. White, ed., 1993).

[124] McCoy, supra note 3 at 1046-48.

[125] FD970 F.2d 124 (5th Cir. 1992).

[126] FDIC v. Wheat, 970 F.2d 124, 132 (5th Cir. 1992)

[127] McCoy, supra note 3 at 1053.

[128] See generally, FDIC v. Stanley, 770 F. Supp. 1281 (N.D. Ind. 1991) (holding directors of a bank liable for acquiring a lease secured by machinery that was located outside the bank's geographical area).

[129] RTC v. Hess, 820 F. Supp 1359, 1360-69 (D. Utah 1993).

[130] Id. at 1361-62.

[131] Id. at 1371.

[132] Wheat, 970 F.2d at 129

[133] Starrels v. First Nat'l Bank of Chicago, 870 F.2d 1168 (7th Cir. 1989)

[134] Nobel v. Baum, No. CV 89 0265 920 S, 1991 Conn. Super. LEXIS 1231, at *2 (Conn. Super. Ct. May 6, 1991).

[135] Starrels, 870 F.2d at 1171-72.

[136] Noble, LEXIS 1231, at *7, *40-41.

[137] Vincent Di Lorenzo, Public Confidence and the Banking System: The Policy Basis for Continued Separation of Commercial and Investment Banking, 35 Am. U.L. Rev. 647, 647 (1986).

[138] Id.

[139] Schooner, supra note 76, at 861.

[140] Macey & O'Hara, supra note 22, at 97-99.

[141] See generally, McCoy, supra note 39, at 13-61 (discussing the four problems that Macey and O'Hara identify).

[142] Macey & O'Hara, supra note 22, at 97-99.

[143] Id. at 97.

[144] Macey & O'Hara, supra note 22, at 97.

[145] Id.

[146] McCoy, supra note 39, at 14.

[147] Id.

[148] Macey & O'Hara, supra note 22, at 97.

[149] Id.

[150] Id.

[151] Id.

[152] Id.

[153] Id.

[154] Id.

[155] See supra part III; Macey & O'Hara, supra note 22, at 97-99.

[156] Macey & O'Hara, supra note 22, at 97-99.

[157] Id. at 97-98

[158] Id.

[159] Id. at 98.

[160] Id.

[161] Id.

[162] Id.

[163] Id.

[164] Id. at 97.

[165] Id.

[166] Id.; See also George Hanc, Deposit Insurance Reform: State of the Debate, 12 FDIC Banking Rev. 4 (1999).

[167] Macey & O'Hara, supra note 22, at 97.

[168] Id.

[169] Id. For a more thorough explanation of this second "moral hazard", please consult Macey & O'Hara, supra note 22, at 97-98.

[170] McCoy, supra note 39, at 14-15.

[171] Macey & O'Hara, supra note 22, at 98.

[172] Id.

[173] Id.

[174] Id.

[175] Id.

[176] Id.

[177] McCoy, supra note 39, at 15.

[178] Macey & O'Hara, supra note 22, at 98.

[179] Id.

[180] Id.

[181] Id.

[182] Id.

[183] Id.

[184] Id.

[185] Id.

[186] Id.

[187] Id.

[188] Id. at 99.

[189] Id.

[190] Id.

[191] Id.

[192] Id.

[193] For example, Congress implemented the Bank Act of 1933 in the wake of the stock market crash of 1929. P.L. 73-66, 48 STAT. 162), which was followed by the Banking Act of 1935 (P.L. 74, 305, 49 STAT. 684), as well as a plethora of other acts leading up until the 1950's. The savings and loan crisis of the 1980's saw the Depository Institutions Act of 1982 (P.L. 97-320, 96 Stat. 1469), the Competitive Equality banking Act of 1987 (P.L. 100-86, 101 STAT. 552), the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (P.L. 101-73, 103 STAT. 183), the Federal Deposit Insurance Corporation Improvement Act of 1991 (P.L. 102-242, 105 STAT. 2236) and so on.

[194] Macey & O'Hara, supra note 22, at 91.

[195] McCoy, supra note 39, at 4.

[196] Macey & O'Hara, supra note 22, at 92.

[197] Id. at 92.

[198] Id.

[199] Id. The Franco-German approach to corporate governance considers corporations to be "industrial partnerships" in which long term stakeholders and shareholders are afforded equal respect. Id. at 91.

[200] Id.

[201] Id.

[202] McCoy, supra note 39, at 4-5.

[203] Id.

[204] Id.

[205] Id.

[206] Kaplan v. Centex Corp., 284 A.2d 119, 124 (Del. 1971).

[207] In re The Walt Disney Company Derivative Litigation, 2005 Del. Ch. LEXIS 113 *1, *11.

[208] Di Lorenzo, supra note 137, at 649.

[209] McCoy, supra note 39, at 54.

[210] Id.