We recently notified you of the FDIC’s Financial Institution Letter 47-2013 , which urges directors and officers of financial institutions to examine their institutions’ directors and officers (D&O) insurance coverage to ensure adequate protection for themselves as well as their depositors and shareholders. As we explained, in addition to urging financial institutions to evaluate their insurance coverage, the FDIC reminded financial institutions that they may not purchase insurance coverage that indemnifies institution-affiliated parties (IAPs) for civil money penalties (CMPs) assessed against them. In response to questions regarding CMP coverage, we are providing this supplemental alert.
Federal law and FDIC regulations govern the purchase of insurance coverage for CMPs. The federal statute, 12 U.S.C. § 1828(k)(1), authorizes the FDIC to prohibit “indemnification payments.” Indemnification payments include “any payment (or any agreement to make any payment) by any insured depository institution or covered company for the benefit of any person who is or was an institution-affiliated party, to pay or reimburse such person for any liability or legal expense with regard to any administrative proceeding or civil action instituted by the appropriate Federal banking agency which results in a final order under which such person—(i) is assessed a civil money penalty.” See 12 U.S.C. § 1828(k)(5)(A)(i) (emphasis added).
Although financial institutions may not indemnify IAPs for CMPs, they may purchase commercial insurance coverage for their liabilities—but that insurance may not pay the cost of CMPs:
No provisions of this subsection shall be construed as prohibiting any insured depository institution or covered company, from purchasing any commercial insurance policy or fidelity bond, except that, subject to any requirement described in paragraph (5)(A)(iii), such insurance policy or bond shall not cover any legal or liability expense of the institution or covered company which is described in paragraph (5)(A).
See 12 U.S.C. § 1828(k)(6). Paragraph (5)(A) prohibits payment of CMPs.
The FDIC enacted enforcement regulations in 12 C.F.R. 359 (Part 359). The FDIC’s explanation of Part 359’s purpose sheds light on the relationship between insurance coverage and CMPs:
Generally, this part prohibits insured depository institutions, their subsidiaries and affiliated holding companies from indemnifying an IAP for that portion of the costs sustained with regard to an administrative or civil enforcement action commenced by any federal banking agency which results in a final order or settlement pursuant to which the IAP is assessed a civil money penalty. . . . However, there are exceptions to this general prohibition. First, an institution or holding company may purchase commercial insurance to cover such expenses, except judgments and penalties.
Like the federal statute, Part 359 defines a “prohibited indemnification payment” to include reimbursement for CMPs. See Part 359.1(l)(1)(i). The definition of “prohibited indemnification payment” allows financial institutions to purchase insurance but prohibits the purchase of insurance to pay the cost of CMPs:
The term prohibited indemnification payment shall not include any reasonable payment by an insured depository institution or depository institution holding company which is used to purchase any commercial insurance policy of [sic] fidelity bond, provided that such insurance policy or bond shall not be used to pay or reimburse an IAP for the cost of any judgment or civil money penalty assessed against such person in an administrative proceeding or civil action commenced by any federal banking agency.
The definition of “prohibited indemnification payment” authorizes financial institutions to purchase insurance to pay defense costs for a CMP claim:
Such insurance policy or bond . . . may pay any legal or professional expenses incurred in connection with such [CMP] proceeding or action.
Because Part 359 focuses on payment, financial institutions typically purchase CMP coverage through a CMP endorsement to D&O policies and require their directors and officers to reimburse them for the cost of the CMP endorsement. This has been the practice since 1993, when the FDIC enacted Part 359.
Beginning in 2011, however, the FDIC took the position that a financial institution’s insurance policy may not incorporate a CMP endorsement, even if the IAPs pay for the CMP coverage. That year, the FDIC cited several financial institutions because their policies included CMP endorsements.
In 2012, in response to a letter request submitted by David Baris, Executive Director of the American Association of Bank Directors, the FDIC re-emphasized its position. Mr. Baris argued that financial institution policies could include CMP endorsements provided that the IAPs paid for the coverage. The FDIC, through its General Counsel, rejected that interpretation:
Under Part 359, an insured institution simply cannot purchase an insurance policy with CMP coverage for IAPs. No exception exists under Part 359 for cases in which the insured institution purchases an impermissible insurance policy but then collects reimbursement from the IAP for some portion of the institution’s insurance premiums. . . . An insured depository institution or holding company cannot purchase CMP coverage for IAPs under Part 359, even if the IAP offers to reimburse the depository institution for the designated cost of a CMP “endorsement.”
The FDIC reiterated its position in Financial Institution Letter 47-2013:
Additionally, the FDIC is issuing a reminder that an insured depository institution or depository institution holding company may not purchase an insurance policy that would indemnify institution-affiliated parties (IAPs) for civil money penalties (CMPs) assessed against them. Even if the IAP agrees to reimburse the depository institution for the cost of such coverage, the purchase of the insurance policy by the depository institution is prohibited.
Thus, financial institutions may not purchase CMP coverage for their IAPs—even if the IAPs pay the cost of the CMP endorsement, as has been the practice. In the past, a CMP endorsement to a financial institution D&O policy typically added only a very small premium for each D&O, thus allowing directors and officers to fund the CMP coverage and seemingly comply with federal law and regulations. This is no longer a viable approach in light of the FDIC’s unequivocal warnings.
Insurers have discussed the possibility of offering standalone CMP policies, but the pricing may prove to be an obstacle. Pricing for a standalone CMP policy would be more expensive than adding a CMP endorsement to an existing D&O policy. Unless such coverage is available and affordable, directors and officers should consider purchasing an individual umbrella policy that incorporates a CMP endorsement. Directors and officers must fully fund the policy, however, for any contribution by financial institutions would violate Part 359.
Fortunately, the FDIC has not prohibited the purchase of insurance to defend against a claim seeking CMPs but instead expressly permits such coverage. Part 359 contemplates defense coverage by permitting financial institutions to purchase insurance that excludes coverage for CMPs but pays “any legal or professional expenses incurred in connection with such [CMP] proceeding or action.” See Part 359.1(l)(2)(i). Defense cost coverage for CMP claims could be valuable to directors and officers of insured financial institutions.
To ensure defense CMP coverage, financial institutions should insist that their D&O policies incorporate a broad duty to defend that requires the insurer to defend against all claims if at least one claim is insured. The insurer would defend directors and officers from a claim seeking CMPs if the FDIC also sought other covered damages. Some D&O policies allocate defense, however, and require the insurer to defend only covered claims instead of all claims. Financial institutions with narrow defense coverage should request a manuscript endorsement modeled on the CMP endorsement that provides defense cost coverage only. If the insurer previously was willing to offer CMP defense and indemnity coverage, then it should agree to offer CMP defense-only coverage to avoid running afoul of Part 359.
The bottom line: financial institutions purchasing standard form D&O coverage should (1) confirm that their D&O policies do not include the CMP endorsement and (2) determine the scope of their insurers’ duty to defend. If the defense obligation is allocated between covered and uncovered claims, the financial institution should request a CMP defense-only manuscript endorsement. Financial institutions should also consult their brokers to determine whether any insurers will offer standalone CMP coverage for directors and officers of financial institutions. Directors and officers should consult with their brokers to determine whether they can purchase CMP coverage as an endorsement to an umbrella policy for which they pay the premiums without assistance from their financial institutions.