Kerry K. Killinger, who led Washington Mutual as it ballooned and imploded, calls claims against him "political theater."
---
By Law Professor Peter Henning
Reprinted with permission.
A common complaint has been the absence of prosecution of financial executives for their role in the economic crisis in 2008, but what is equally striking is the large compensation those executives received while their companies pursued increasingly risky policies that led to the crisis.
The Federal Deposit Insurance Corporation has taken small steps to address this issue. It is pursuing claims for damages against former top executives at Washington Mutual, which became the largest bank failure in history. The F.D.I.C. has also adopted a new clawback rule for failed banks that would allow it to try to reclaim two years worth of executive compensation.
The F.D.I.C. is pursuing its case against Kerry K. Killinger, Washington Mutual’s onetime chief executive, and two other executives at the bank for risky lending practices that led to its shutdown in September 2008. The complaint alleges they were grossly negligent and breached their fiduciary duty for undertaking a so-called “higher-risk lending strategy” that increased the bank’s exposure to subprime mortgages concentrated in California and Florida, undermining its capital base when the housing market collapsed.
The defendants have assailed the F.D.I.C. claims as a public relations move, asking for dismissal of the lawsuit because they exercised reasonable business judgment in shifting the bank into subprime loans. A brief filed by Stephen J. Rotella, Washington Mutual’s former chief operating officer, contends that the case “amounts to a pure public relations stunt designed to deflect criticism away from the F.D.I.C., which has been — and continues to be — under fire for its regulatory failures with respect to WaMu and refuses to take any responsibility for its central role in the financial crisis.”
A crucial issue in the suit is whether the executives are protected by the “business judgment rule,” which prevents a corporate officer or director from being held liable for poor decisions that end up harming the company so long as the person acted with due care. Chancellor William B. Chandler III of the Delaware Chancery Court summarized quite well how the rule protects executives from judicial second-guessing in In re Citigroup Shareholder Derivative Litigation:
Whether a judge or jury considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through “stupid” to “egregious” or “irrational,” provides no ground for director liability, so long as the court determines that the process employed was either rational or employed in a good faith effort to advance corporate interests.
Mr. Killinger led Washington Mutual’s corporate strategy to concentrate on subprime mortgages in the apparent belief that as more loans were made, they would actually lower the bank’s risk by spreading it across a large base of borrowers. Unfortunately, that approach depended on the real estate market continuing its upward price trend indefinitely, so that when the housing bubble collapsed the bank suffered rapidly increasing losses across its portfolio.
It is not clear where on Chancellor Chandler’s spectrum of bad decisions the high-risk lending strategy fell, probably somewhere between stupid and irrational, but it certainly appears to be something that came within the discretion of corporate managers, no matter how ill-fated it was.
Washington Mutual was based in Seattle, so F.D.I.C.’s suit is governed by Washington State’s business judgment rule. If the subprime mortgage strategy was undertaken in good faith and on the basis of some investigation by the executives, then regardless of how disastrous it was there is a good chance the claims for negligence and breach of fiduciary duty will be dismissed. This would be another example of what the Deal Professor pointed out recently, that corporate executives “have about the same chance of being held liable for their poor management of a public firm as they have of being struck by lightning.”
Mr. Killinger received more than $65 million in compensation from 2005 to 2008, a significant sum for presiding over an institution that ultimately failed. Under rules completed by the F.D.I.C. last week, the agency can recoup two years worth of executive compensation for banks that fail in the future under authority granted by the Dodd-Frank financial regulatory law.
The new rules allow the F.D.I.C. to reclaim compensation from senior executives if they were “substantially responsible” for the bank’s failure. An important facet of the rule creates a presumption that the chairman of a company’s board, the chief executive, the president and the chief financial officer, or someone removed from one of those positions by the F.D.I.C., is substantially responsible for the bank’s demise if the person had authority over “strategic, policymaking or companywide operational decisions.”
The presumption can be rebutted if the executive shows he or she performed with the “requisite degree of skill and care required by the position.” This effectively turns the business judgment rule on its head by requiring the executive to show that due care was exercised, not that the decisions should be protected from after-the-fact second-guessing regardless of how stupid it was.
Shifting the burden to an executive to show that this person did not contribute to the failure will be difficult — maybe even impossible — because the fact that F.D.I.C. took over the bank goes a long way toward showing that questionable decisions were made.
Unlike the suit against the Washington Mutual executives, which puts the burden of proof on the F.D.I.C. to establish a lack of due care, this new authority means reclaiming two years of executive compensation will be the default option. And the business judgment rule will no longer shield decisions from subsequent scrutiny by the courts assessing whether an executive was substantially responsible for a bank’s demise because now executives must show they acted with due care.
Stupidity is not a federal crime, which may well explain why there have not been any prosecutions of bank and Wall Street executives to this point. While the business judgment rule protects executives from being held liable for bad decisions under state corporate law, those who work for banks now face a bit more risk of being struck by lightning by the F.D.I.C.
F.D.I.C.'s Complaint Against Washington Mutual Executives
Peter J. Henning, who writes White Collar Watch for DealBook, is a professor at Wayne State University Law School.