UK: Avoiding Lightning Strikes - Implications Of The Sub-Prime Crisis For Directors

A lot (perhaps too much) has been written about the wider implications of problems originating in the US associated with the practice of providing so-called sub-prime mortgages to high risk borrowers with poor credit histories. There is also plenty of speculation about the potential exposures for directors, banks and professional advisers. We have already witnessed some very high profile departures, including Stan O'Neal, former chairman and chief executive of Merrill Lynch and Citigroup's Charles Prince, who recently "retired" following the US banking giant's announcement that Citigroup faced an US$11 billion write-down. There has, however, been very little detailed examination of how claims against directors could be made to stick and what defences might be open to them. In this article, we use the sub-prime mortgage crisis (or more accurately the structured finance crisis) as the background for an examination of directors' duties and liability exposures. We also suggest some practical steps directors can take to limit such exposures.

What is all the fuss about?

At the risk of over-simplification, financial institutions affected by the structured finance crisis can be divided into the following three main groups. The analysis as to the directors' exposure varies to some extent for each:

  • Lending institutions
  • Investment banks
  • Retail banks, hedge funds and asset managers.

Lending institutions
At the sharp end of the crisis are the lending institutions themselves. Some such institutions (particularly in the US) pursued a business strategy of lending ever greater sums of money to high risk borrowers with poor credit histories, often offering inducements such as teaser loans. Well documented examples include Countrywide, New Century and Washington Mutual.

Other lending institutions with better quality loan portfolios have also found themselves caught up in the crisis. By far the best example in this category is Northern Rock which suffered the peril of a run as a consequence of the impact of the credit squeeze on its aggressively pursued policy of lending long and borrowing short. If the US economy continues towards recession with a consequent and continuing fall in property prices, there must be a risk that lending institutions will suffer further losses. Should inter-bank credit dry up once more, this will also have a damaging effect on those institutions which have pursued a "lend long/borrow short" policy. It goes without saying that those institutions which have both (a) loan portfolios of questionable quality; and (b) an aggressive "lend long/borrow short" strategy are particularly vulnerable.

Investment banks
In the eye of the structured finance storm lie the investment banks themselves. It is no accident that over the last few months it has been these institutions which have been reporting the most serious losses.

The investment banks have, over the last 10 years and more, invented ever more complicated and intricate ways of structuring financial instruments out of bundles of debt generated by (mainly) US mortgages provided by the lending institutions. Such instruments include asset-backed securities (ABSs), including mortgage-backed securities, issued by special purpose vehicles ("SPVs") set up in offshore jurisdictions by investment banks. Investment banks have also acquired ABSs and bundled these up for the purposes of selling other instruments known as collateralised debt obligations ("CDOs"). These are securities, usually with long maturity dates, which are sold through SPVs. Alternatively, investment banks sell instruments through structured investment vehicles ("SIVs") which issue short term commercial paper and which seek to exploit the differences in yields between long term investments and short term borrowing. More recently, the "SIV Lite" was introduced, which was said to combine aspects of SIVs and CDOs. These highly complex financial instruments were then either offered for sale to other financial institutions or used as investment vehicles by the investment banks themselves. The vehicles used were largely unregulated, off balance sheet and offshore.

The much-publicised CDO forms a type of ABS which has commonly been used to fund investment in fixed income assets1 (e.g. sub-prime mortgages). CDOs divide risk into different tranches according to the order of priority of payment at maturity. These tranches are not directly linked to the value of the underlying mortgage asset. Thus it is entirely possible to buy a triple A-rated tranche of a CDO for which the security is provided by ABSs that in turn securitise mortgages which include sub-prime mortgages in default.

Retail banks etc.
The structured finance market comprises the investment banks which generate the products and invest in and sponsor them themselves and the "consumers" (i.e. the purchasers of the investments). For the most part, these are retail banks and/or hedge funds and/or asset managers on behalf of sophisticated investors and others. Structured finance instruments are not generally offered for sale to members of the public. To a large extent, this accounts for the fact that the market is largely unregulated.

An irony at the heart of the structured finance market is that many of the banks which purchased these instruments saw them as a safer form of investment than equities. They seemed to offer the security of fixed interest assets. It was not just the retail banks, hedge funds and asset managers who thought they were on to a safe bet. The credit agencies themselves seemed to have been beguiled into awarding SIVs "triple A" ratings to the senior tranches of CDOs and to commercial paper issued by SIVs, if launched by a financial institution of a similar rating. Just three years ago, Moody's described the SIV sector in the following terms:

"SIVs were founded in the late 1980s in response to investor demand for steady returns on capital and highly rated portfolios that are immunised against substantial downgrades, interest rates, currency and liquidity risks".

The immunisation proved not to be very effective!

The total value of all outstanding US mortgage backed securities in early 2006 was reported to be US$ 6.1 trillion. Over the course of 2006, the value of new ABS-backed CDOs issued was US $200 billion. According to Moody's, SIVs account collectively for approximately US$400 billion worth of assets. The problem is not small.2

Which institutions run the greatest risk of receiving D&O claims?
Against that background we now turn to examine some potential claims scenarios/defences available to directors of the three groups of financial institutions identified above who may encounter claims.

Lending institutions
By far the best domestic example of the problems encountered by lending institutions is provided by Northern Rock. As summarised above, it was a combination of Northern Rock's aggressive "lend long/borrow short" strategy and the credit squeeze which led directly to a run on that bank and the unfortunate consequences for its share price and for its future viability.

Those looking to apportion blame (albeit with the benefit of hindsight) are not likely to overlook the fact that the non-executive directors of Northern Rock include the former chief executive of NatWest Bank, the first independent Complaints Commissioner for the Financial Services Authority (FSA) and the chief executive of the financial group J O Hambro. These were experienced individuals, no doubt hand picked because of the particular knowledge, skill and experience which they possessed.

Potential claimants will seek to turn this skill and experience to their advantage by focusing on the legal duty owed by all directors to display, not only a reasonable level of skill, care and diligence in the discharge of their functions, but also to bring to bear such knowledge, skill and experience as they have. They will also not have lost sight of the fact that, as non-executive directors of a public company, according to the Combined Code, their responsibilities included (among others) ensuring the integrity of the company's financial information. Moreover, those non-executive directors who served on Northern Rock's audit committee had the additional obligation under the Combined Code to "satisfy themselves that the financial controls and systems for risk management were robust and defensible".

It may be that the non-executive directors of Northern Rock never find themselves in the same position as the non-executive directors of Equitable Life. They, it will be recalled, were forced following a regime change at the board of Equitable, to enter the witness box in the context of a £2 billion claim against them to defend their actions. In the Equitable Life case, one of the main planks of the defence run by the non-executive directors was to the effect that the risks surrounding guaranteed annuity rates were a highly technical matter on which they had to rely on the good judgement of the actuaries, the other professionals and the executive. The defence was summed up in an exchange from the witness box between Counsel for Equitable Life and Mr Tritton, a former non-executive director and chairman of Equitable Life's Audit Committee:

"Q. When you looked at this paper, can you recollect now whether or not you tried to understand paragraph 72?

A. No, I have no recollection at all, it is 12 years ago, and I am pretty ancient now, but I have absolutely no recollection ... if I had been unhappy with it and, and I cannot remember one way or another whether I was unhappy, I would have asked the management "is there anything" .. which I have always said at most meetings, "is there anything here you wish to draw the non-executive directors' attention to". That, I think, as a non-executive director one was perfectly entitled to say".

This kind of defence would not seem to be open to the non-executive directors of Northern Rock because the issue which contributed to the crisis (i.e. its aggressive "lend long/borrow short" business strategy) must have been front and centre at the regular board meetings which took place. That being so, it seems probable that the defence which the Northern Rock non-executive directors would have to deploy would be likely to take one of the following two forms. Either they would maintain that the credit squeeze which occurred in August 2007 was not reasonably foreseeable or, alternatively, that they warned the executive of Northern Rock about these risks but that they took no action.

In running an "unforeseeable" defence, no doubt the non-executive directors (and the executive directors for that matter) would regard themselves as being in the good company of their regulators, the FSA. In their recent evidence to the House of Commons Treasury Select Committee, senior members of the FSA conceded that the impact of a sudden and severe credit squeeze on Northern Rock's business was not a risk on which they had focused. In and of itself, that might not, however, be a complete defence to the allegation that the Northern Rock directors were in breach of their duties of skill and care. Although courts strive not to apply the benefit of hindsight, there is often a tendency to do so.

It should be said that it is very far from clear that the Northern Rock directors will ever find themselves in the invidious position of facing cross examination in a witness box. A regime change at board level of the sort which occurred in Equitable Life remains, one supposes, a possibility but the risk of insolvency appears at this stage to be fairly remote despite (and no doubt because of) the vast sums being pumped into it by the Bank of England.

Another crumb of comfort for the Northern Rock directors is that they will not have to face a derivative claim under section 260 of the Companies Act 2006. Section 260 and related provisions of the Act came into force on 1 October 2007. Transitional arrangements provide that a derivative claim will be stopped unless it would have been allowed to proceed under the law in force at the relevant time of the act or omission which forms the subject of the claim. Had section 260 been in force a few months earlier, it is not beyond the bounds of possibility that a shareholder might have sought leave of the court to pursue a derivative claim against members of the Northern Rock board for breach of duty in respect of their actions prior to 1 October 2007.

For the sake of completeness, we should add that there have been reports in the press that law firms have been looking at the possibility of pursuing a class action type shareholder claim against the directors of Northern Rock based on the suggestion that they were responsible for the creation of a false market in Northern Rock shares at some stage in what one assumes is a narrow window of time in August 2007. There would seem to be formidable obstacles to such a claim but the possibility exists.

Investment banks
The world of structured financial instruments is a complex and arcane one. ABSs, CDOs, SIVs, and credit derivative swaps are not easily understood. Very large sums of money are involved. The sheer scale of reported write-downs following sub-prime related investments has sent shockwaves across the banking industry. Key examples include Merrill Lynch and UBS, whose combined losses reputedly total approximately US$12 billion, and Citigroup (a further US$11 billion), the latest casualty in a long line of credit crunch victims. Credit Suisse and Deutsche Bank have managed rather better so far, although they still reported significant write-downs of US$1 billion and US$1.5 billion respectively. Does this matter from the point of view of the directors of the investment banks? The answer is that if things go very wrong it may well matter although, in reality, most investment banks are probably big enough to be able to (and to wish to) weather the storm without recourse to litigation. In a disaster scenario, however, the best UK precedent as to what can happen to directors is the case of Barings plc.

In many ways, the parallels are stark. In 1995, Barings plc, formerly Britain's oldest merchant bank, collapsed abruptly in the face of losses on derivatives contracts to the tune of £927 million. The losses were attributed to a single employee, Nick Leeson, who traded huge volumes of Japanese stock-index futures contracts on the Osaka futures market and the Singapore International Monetary Exchange (SIMEX), exposing the bank to substantial losses when the market turned.

The debacle came to the attention of the English courts in a variety of different proceedings but, for present purposes, the most relevant one is perhaps Re Barings Plc (No. 6) (1999). This was the case in which the Secretary of State sought disqualification orders against three directors of the collapsed bank for serious management failures. The allegations faced by the directors concerned were to the effect that they had demonstrated a high degree of incompetence, making them unfit to be involved in the management of the company and justifying their disqualification. In deciding against the directors in that case, the judge concluded that:

"(i) Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company's business to enable them properly to discharge their duties as directors;

(ii) Whilst directors are entitled (subject to the articles of association of the company) to delegate particular functions to those below them in the management chain, and to trust their competence and integrity to a reasonable extent, the exercise of the power of delegation does not absolve a director from the duty to supervise the discharge of the delegated functions;

(iii) No rule of universal application can be formulated as to the duty referred to in (ii) above. The extent of the duty, and the question whether it has been discharged, must depend on the facts of each particular case, including the director's role in the management of the company."

This extract from the Barings judgment has subsequently been cited by the courts with approval as an accurate statement of the law on directors' duties. Indeed, in the Equitable Life case itself, Mr Justice Langley quoted the above extract in his judgment on the unsuccessful application by the directors in that claim to have the case against them dismissed.

The problem for the main board directors of Barings was that they were too willing (for too long) to assume all was well. In effect, directors (and in particular non-executive directors) are often caught in something of a bind here. When things seem to be going well based on what seem to be regular, reliable and comprehensive reports provided by the professionals and the executive, an entirely reasonable assumption is made that things are in fact going well. It is only when serious problems or potential problems begin to surface that more questions need to be asked and action may become necessary. It is when directors do not have "sufficient knowledge and understanding" or indeed time to detect the problems that they run the risk of liability. The very complexity of the structured finance market makes the task of gaining sufficient knowledge and understanding all the more challenging. When one considers that non-executive directors are held to the same standard of care as their executive colleagues and that their own subjective skill and experience are taken into account in assessing whether they have discharged their duty, the potential risk of liability for them is appreciably greater.

It is too early to tell whether any non-executive directors of any UK-based investment banks will find themselves having to explain and justify to a court how they got the balance right between allowing themselves to "trust the competence and integrity of management" and the need to discharge their duty to supervise.

Retail banks, hedge funds and asset managers
The problem for directors of institutions which purchased sophisticated structured financial instruments from investment banks is similar to those of the directors of the investment banks themselves. In a disaster scenario, the case they would need to meet is that they failed to take any or any sufficient steps to understand the nature of the investments in which their companies were investing heavily or to understand the potential risks associated with such investments. The "Emperor's new clothes" defence (i.e. "everyone else in the crowd thought that these instruments were a safe and reliable form of investment. The credit agencies seemed to agree. We never studied the small print too carefully but then neither did anyone else") is never an easy or attractive one to run.

Again, it is difficult to assess the likelihood that any directors of retail banks which have large exposures to structured financial instruments will face shareholder or derivative type proceedings. Although not beyond the bounds of possibility, the underlying facts, i.e. the warning signs (and size and scale of losses) would need to be fairly extreme.

We suspect that in the short to medium term, there is a greater likelihood of professional indemnity claims rather than directors and officers liability claims as a result of losses suffered by investors in the structured finance market. It is entirely possible for example to envisage that sophisticated investors who gave their money to hedge funds and asset managers to look after, will wish carefully to scrutinise the steps taken by such managers and funds properly to understand and explain the risks associated with the investments they were undertaking on behalf of their clients.

How to avoid the lightning

Whilst it is impossible to know where lightning will strike, there are a number of factors which directors can and should bear in mind when considering their own personal exposure to liability. Although the focus in the steps set out below is on directors of financial institutions, the territory covered might serve as a useful checklist in the context of board appointments more generally. These might include:

  1. Consider carefully what the specific implications for you as a director are of the standard of care expected of directors as summarised in the Barings case quoted above. Above all, are you satisfied that the company's systems, structures and advisers are adequate and competent to enable you both to "acquire and [to] maintain a sufficient knowledge and understanding [of that company's business] to enable [you] properly to discharge [your] duties"?
  2. As a director (or prospective director) are you able to assess the nature and scale of the operational risk faced by the company? There may be transaction-linked risks associated with the complexity of investment products. Alternatively, there may be risks attached to the business strategies adopted by the company. Is there evidence that the company has taken appropriate steps to identify, quantify and address these risks? Would a report on these issues from an independent professional source be appropriate and/or desirable?
  3. Can you see the wood for the trees? It is all very well receiving reassurances as a main board director that you will gain access to regular, comprehensive and detailed reports on the company's affairs but how much practical use will all this material be to you? If you are a non-executive director, should you be receiving board packs with large volumes of appendices attached to them? The chances are that some problems and/or risks (including possibly serious ones) are buried in such material. (This is what happened in Equitable Life where reference to guaranteed annuity rates was buried in the board packs). Consider the appropriateness of rejecting or limiting this material and asking for a summary of key issues. Ideally, there will be a process in place for bringing risks of the nature (identified in (2) above) to your attention together with proposed solutions so that you are able to take informed decisions in light of such information and have an informed opportunity to consider the need for further action.
  4. Consider the scope for individual letters of engagement specifying the particular functions which you, as a non-executive director, are expected to discharge by reference to the number of days you are contracted to dedicate each year to the company's affairs. Such letters of engagement might also specify (importantly from a personal risk management perspective) what you, as a director, are not being retained to do.
  5. Consider, when faced with unsatisfactory or contradictory evidence, in response to enquiries, the need to probe more deeply, to minute objections and/or to obtain independent legal advice.
  6. Check and, if necessary, negotiate better indemnification provisions from the company to include loans in respect of the need for separate legal representation, either in the defence of claims or in the context of regulatory investigations or enquiries.
  7. Check D&O insurance terms and conditions. Although very much beyond the scope of this article, there is a whole range of coverage issues to consider when purchasing or joining a D&O insurance programme. Seek expert advice.

If you are a director of a financial institution which is a plc, the best means of protecting yourself from liability claims is to have a clear understanding as to the nature and likely genesis of such claims. The structured finance crisis provides an excellent opportunity to make this kind of assessment. It still may not be too late!

Conclusion

There is inevitably a large amount of crystal ball gazing involved in the process of trying to assess exposure of directors arising out of the structured finance crisis. The suspicion is that it is the directors of the lending institutions at the sharp end of the crisis who are more likely to find themselves facing claims in the short term than the directors of the investment and retail banks which produced and purchased the instruments themselves. As the Barings case shows, however, directors of such banks are not immune from claims depending on the size and scale of the losses suffered.

Footnotes

1. "Fixed interest" is not the same as "guaranteed interest". If the asset which is secured is worthless, no income - fixed or otherwise - is produced.

2. Whilst beyond the scope of this article, the jury remains out on the question as to whether the credit agencies have any exposure arising out of the structured finance crisis. Investigations have been launched by both the US Securities & Exchange Commission and the Europe Commission as to the nature of the role they played.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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