FDIC Professional Liability Claims by Michele R. Jones Carlock, Copeland & Stair, LLP

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1 FDIC Professional Liability Claims by Michele R. Jones Carlock, Copeland & Stair, LLP Overview When the Federal Deposit Insurance Corporation (FDIC) closes a bank and becomes receiver, it considers making claims against the bank's directors, officers, accountants, and attorneys. To our knowledge, the FDIC has not yet brought any claims against accountants or attorneys arising out of the many banks closed in the past couple of years. However, the FDIC has hired more in-house counsel to work on professional liability matters. For information and guidance on handling any such claims that may arise, we looked back at claims made by the Resolution Trust Corporation (RTC) during the savings and loan crisis. In this paper, we first briefly discuss the FDIC's claim procedures. Then we review the history of FDIC and RTC claims against professionals. Finally we look at relevant statutes and case law regarding possible defenses available in FDIC actions. FDIC claim process (per 2002 Office of Inspector General Audit Report) The FDIC's Division of Resolutions and Receiverships' Investigations Unit focuses on closing failed institutions and investigating possible professional liability claims. The FDIC Legal Division's Receivership Litigation and Policy Section (f/k/a PLU) focuses on the litigation phase. Once both agree to pursue a claim, a PLU attorney prepares an Authority to Sue. The FDIC's goal is to complete 80% of investigations within 18 months of a bank closure. A FDIC lawsuit on any professional liability claim is filed only after attempting to settle. History of FDIC professional liability claims (per FDIC publication and news articles) During the savings and loan debacle in the late 1980's and early 1990's, the FDIC occasionally sued the same law and accounting firms that it hired. The FDIC was reluctant to provide its own reports and workpapers to its targets. According to the RTC's Tom Hindes, more than 20% of claims were settled before suit. Common defenses included: fault of others, regulator fault, imputation, and statute of limitations. Some courts allowed affirmative defenses, and some courts did not. State law generally governed whether a defendant could assert an imputation defense against the FDIC. As of January 1991, the FDIC had tried three legal malpractice cases, and its recovery was minimal. As of March 1992, the FDIC had filed 47 legal malpractice and 24 accounting malpractice cases (and many more against directors and officers). Of the four verdicts in 1992, the FDIC lost two and won two. As of September 1994, the FDIC had won 13 and lost 32 professional malpractice cases since the beginning of 1992; the RTC had a similar record. Between 1990 and 1995, the FDIC collected around $1.1 billion on accounting liability claims arising out of savings and loan closures. Global settlements with four national accounting

2 firms provided $1 billion of that amount. Ernst & Young settled all possible claims, arising out of its work for 300 savings and loans, for $400 million. Arthur Andersen settled for $65 million. The FDIC (and RTC) filed around 200 attorney malpractice lawsuits and recovered $500 million, averaging $2.5 million for each suit filed. Two large bank closures led to recovering $168 million of that amount. Most legal malpractice cases were settled early in litigation. The Office of Thrift Supervision (OTS) sued large law firm Kaye Scholer and froze the firm's assets. The firm then settled the $275 million case for $41 million. In 1993, Paul Weiss settled for $45 million, and Jones Day settled for $51 million. Federal statute The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) provides that the FDIC succeeds to all rights and records of the failed institution. 12 U.S.C. 1821(d)(2)(A). In a proceeding against an attorney, accountant, etc., recoverable damages resulting from the improper use of institution assets shall include principal losses and appropriate interest. 12 U.S.C. 1821(l). The Fourth Circuit held that a district court properly looked at the applicable state law to determine whether prejudgment interest was appropriate, and it found no abuse of discretion in the determination that it was not warranted. Grant Thornton, LLP v. FDIC, unpub., 2011 WL (4th Cir. June 17, 2011). Statute of limitations--adverse domination may not toll the statute of limitations in Georgia The statute of limitations for any action brought by the FDIC as conservator or receiver shall be (i) in a contract claim, the longer of six years beginning when the claim accrues, or the period applicable under state law; and (ii) in a tort claim, the longer of three years beginning when the claim accrues, or the period applicable under state law. 12 U.S.C. 1821(d)(14)(A). The date when the statute of limitations begins is the later of the date of the FDIC's appointment as receiver or the date when the cause of action accrues. 12 U.S.C. 1821(d)(14)(B). In a tort claim arising from fraud, where the statue statute of limitations expired not more than five years before appointment, the FDIC can sue as receiver on the claim, regardless of the expiration of the statute. 12 U.S.C. 1821(d)(14)(C). Under the doctrine of adverse domination, the statute of limitations is tolled as long as a corporate plaintiff is controlled by wrongdoers. RTC v. Farmer, 865 F.Supp. 1143, 1151 (E.D.Pa. 1994). That district court adopted the doctrine since it was aligned with Pennsylvania's discovery rule, which Georgia does not follow. See also RTC v. Gardner, 798 F.Supp. 790 (D.D.C. 1992) (SOL was tolled). Eleventh Circuit case The RTC sued former officers and directors of a bank of which the RTC was receiver, in Resolution Trust Corp. v. Artley, 28 F.3d 1099 (11th Cir. 1994). The defendants moved for partial summary judgment and argued that most of the RTC's claims were time-barred. The court noted 2

3 that FIRREA does not revive stale state law claims acquired by the FDIC. Georgia's four-year statute of limitations governed the RTC's claims for negligence, breach of fiduciary duty, and breach of contract. Unless the statute was tolled, the defendant could not be sued for loans closed more than four years before the RTC's appointment as receiver. The court held that adverse domination did not apply to this case, so there was no tolling. The court also held that even if the RTC's claim for gross negligence was a federal claim, Georgia law applied to determine whether they were barred. Thus all of the RTC's claims except one were barred under Georgia law. This rationale should also apply to a claim against accountants or attorneys. Other jurisdictions Where the state statute of limitations expired before the bank sued the auditor, and before the FDIC took over the bank, the auditors were entitled to summary judgment. FDIC v. Regier Carr & Monroe, 996 F.2d 222 (10th Cir. 1993). FIRREA's longer limitations period did not apply retroactively to revive a claim already barred by a state statute of limitations. FDIC v. Regier, 225. The Fifth Circuit held that the adverse domination doctrine was limited to suits against officers and directors, and the FDIC could not use it in a suit against a law firm. FDIC v. Shrader & York, 991 F.2d 216 (5th Cir. 1993). FDIC actions/affirmative defenses It remains to be seen if Georgia professionals can escape liability by pointing fingers at the bank and/or the FDIC. Depending on the FDIC's capacity, professional defendants might be able to assert the FDIC's fault as a defense. Accountants and attorneys may be able to raise an affirmative defense against the FDIC based on the bank's conduct. Georgia federal court The Northern District of Georgia held that a bank's directors and officers could not raise affirmative defenses based on the RTC's conduct, in Resolution Trust Corp. v. Youngblood, 807 F.Supp. 765 (N.D.Ga. 1992). The RTC as receiver sued former officers and directors. The court held that acts of the RTC in its corporate capacity could be subject to affirmative defenses, but the RTC's acts in its receivership capacity were not. The RTC owed no duty to former officers and directors. Thus the court struck the defendants' affirmative defenses including acts by the RTC. This court's rationale might also apply in a suit against accounting or legal professionals, but professionals would have an additional argument that bank officers were liable for the alleged damages. Florida district courts--defendants may assert the fault of the FDIC and/or bank as affirmative defenses. The Southern District of Florida held that third-party professionals like lawyers could assert affirmative defenses against the RTC, in RTC v. Holland & Knight, 832 F.Supp. 1532, 1540 (S.D.Fla. 1993). The Florida district court reasoned that the Eleventh Circuit did not 3

4 take a wide view of FIRREA's public policy considerations, and the RTC should be treated "as an ordinary private plaintiff." RTC v. Holland, 1538, The Middle District of Florida held that defendant accountants could assert the comparative negligence of both bank officers and the FDIC, where the FDIC sued as assignee, not as receiver. FDIC v. Cherry, Bekaert & Holland, 742 F.Supp. 612 (M.D. Fla. 1990). Other jurisdictions--conflicting decisions on affirmative defenses and standing The Ninth Circuit held that the FDIC as receiver was not barred by the bank's inequitable conduct from suing the bank's former counsel. Federal Deposit Ins. Corp. v. O'Melveny & Myers, 61 F.3d 17 (9th Cir. 1995). The Fourth Circuit concluded that management's wrongful conduct was not a superseding cause, since without the negligent audit report, the management conduct could not have happened. Grant Thornton, LLP v. FDIC, unpub., 2011 WL (4th Cir. June 17, 2011). A district court held that accountants could not impute the bank's knowledge to the FDIC to argue contributory negligence or indemnity. Comeau v. Rupp, 810 F.Supp. 1127, (D.Kan. 1992). But the accountants stated indemnity claims against the directors and officers. Comeau, Another district court also held that a defendant accounting firm could not raise a defense based on the bank's conduct, in a RTC lawsuit. RTC v. KPMG Peat Marwick, 845 F.Supp. 621, 625 (N.D.Ill. 1994). The RTC could sue a bank's auditor for negligence both as receiver and on its own behalf. RTC v. Coopers & Lybrand, 915 F.Supp. 584 (S.D.N.Y. 1996). The RTC alleged that if C&L's audit report had been accurate, then the regulators would have immediately shut down the bank and prevented further losses. On the other hand, an Arkansas district court held that the FDIC cannot sue a bank's auditor on behalf of creditors or depositors but only as receiver. FDIC v. Deloitte & Touche, 834 F.Supp. 1129, 1136 (E.D. Ark. 1992); see also FDIC v. Ernst & Young, LLP, 256 F.Supp.2d 798 (N.D. Ill. 2003) (the FDIC in its corporate capacity had no standing to sue the bank's auditor, although it could sue as receiver). The defendant accounting firm could assert proximate cause and comparative negligence defenses based on the bank's conduct and knowledge. FDIC v. Deloitte, Likewise, the Utah district court held that an attorney defendant could assert affirmative defenses against the bank's former officers and directors. FDIC v. Lowe, 809 F.Supp. 856 (D. Utah 1992). However, the attorney could not raise defenses against the FDIC as regulator or receiver. FDIC v. Lowe, 857. A defendant attorney can raise imputation and contributory negligence of the failed bank as a defense against the FDIC. FDIC v. Gantenbein, not reported in F.Supp., 1992 WL (D. Kan. Sept. 30, 1992). But criminal conduct by directors and officers could not be imputed to the FDIC. Gantenbein, *7. The Kansas district court held that state law regarding affirmative defenses applied when the FDIC sues an attorney as successor and assignee of the bank. FDIC v. Gantenbein, 811 F.Supp. 593, 595 (D. Kan. 1992). Where the FDIC sues on its own behalf, federal law governs defenses. Id. at

5 Where the FDIC sued as a bank's assignee, not in its own behalf, the FDIC is subject to the defense of no reliance, so there was no negligence by the defendant auditor. FDIC v. Ernst & Young, 967 F.2d 166 (5th Cir. 1992). No fiduciary duty The RTC sued a failed bank's auditor, alleging negligence, breach of contract, and breach of fiduciary duty, in RTC v. KPMG Peat Marwick, 844 F.Supp. 431 (N.D. Ill. 1994). The court concluded that an auditor was not a fiduciary of its client and dismissed the fiduciary duty claim. RTC v. KPMG, 436. This argument should also be successful in Georgia. See R.W. Holdco, Inc. v. Johnson, 267 Ga. App. 859 (2004). Non-party fault A district court held that a defendant accounting firm could use a state law regarding designation of non-party fault, in a RTC suit. RTC v. Deloitte & Touche, 818 F.Supp. 1406, 1408 (D.Col. 1993). In Georgia, a defendant may designate a non-party as at fault, and then the jury should consider the non-party's fault in assessing percentages of fault. O.C.G.A The comparative negligence defense applies in professional malpractice actions. Georgia courts often apply comparative and contributory negligence to bar a plaintiff's recovery as a matter of law. MacIntyre & Edwards, Inc. v. Rich, 267 Ga. App. 78, 82 (2004); Garrett v. NationsBank, N.A. (South), 228 Ga. App. 114 (1997). Where a plaintiff's negligence is equal to or greater than the defendant's, the plaintiff cannot recover. O.C.G.A (g); Union Camp Corp. v. Helmy, 258 Ga. 263 (1988); Custer v. Terex Corp., 196 Fed.Appx. 733 (11th Cir. 2006). If a plaintiff by ordinary care could have avoided the consequences caused by the defendant's negligence, then it cannot recover. O.C.G.A Georgia courts have applied the comparative negligence principle to professional malpractice actions. See, e.g., Tisdale v. Johnson, 177 Ga. App. 487 (1986); Roberts v. Aderhold, 263 Ga. App. 642 (2005); First Bancorp Mortgage Corp. v. Giddens, 251 Ga. App. 676, 680 (2001). Allowing an accountant to raise the defense of comparative negligence gives both parties an incentive to use due care. See, e.g., Standard Chartered PLC v. Price Waterhouse, 945 P.2d 317 (Ariz. 1996); American Nat'l Bank v. Touche Ross & Co., 659 N.E.2d 1276 (Ohio 1996); Halla Nursery, Inc. v. Baumann-Furrie & Co., 454 N.W.2d 905 (Minn. 1990). For example, in Wegad v. Howard Street Jewelers, the court concluded that a plaintiff's reliance on its accountant's reports was not reasonable and amounted to negligence, so the plaintiff could not hold the accountant liable for an employee's embezzlement. Wegad v. Howard Street Jewelers, Inc., 605 A.2d 123 (Md.App. 1992). A plaintiff's failure to exercise ordinary care prevents it from recovering damages from a defendant. O.C.G.A ; O.C.G.A In pari delicto Georgia cases--it is not clear whether in pari delicto would bar FDIC claims against professionals. 5

6 The in pari delicto doctrine provides that a plaintiff who has participated in wrongdoing may not recover damages from the wrongdoing. Official Committee of Unsecured Creditors of PSA v. Edwards, 437 F. 3d 1145 (11th Cir. 2006); Wofford v. Chambers Lumber Co., 226 Ga. 213, 215 (1970). For example, a plaintiff who was a director of a corporation had no claim against another director or the corporation for wrongfully selling stock. Nicholson v. Harris, 179 Ga. App. 35, 36 (1986). Federal courts in Georgia have applied in pari delicto to bar a suit by a bankruptcy trustee for a debtor who ran a Ponzi scheme, since the plaintiff should not recover for its own wrongdoing. PSA v. Edwards, 437 F. 3d at ; In re Stewart, 339 B.R. 524 (M.D.Ga. 2006); Laddin v. Edwards, not reported in F.Supp.2d, 2006 WL (N.D.Ga. Apr. 21, 2006). In PSA v. Edwards, the bankruptcy trustee for ETS, an entity that operated a Ponzi scheme, sued third parties that allegedly assisted ETS in its fraudulent scheme. The trustee sued banks for RICO violations, alleging that the banks funneled investor funds into investments. The Eleventh Circuit held that because the defense of in pari delicto bars recovery by a central and active violator of RICO, the complaint must stand dismissed. The court reasoned that the trustee was subject to defenses that were available against the debtor, and noted that individual creditors could separately sue the banks for their participation in the Ponzi scheme. Also, the allegations of the trustee's complaint made clear that ETS actively participated with the defendant banks in the Ponzi scheme. The Eleventh Circuit earlier held that neither the debtor nor its bankruptcy trustee could sue third parties for Ponzi scheme torts. O'Halloran v. First Union Nat'l Bank of Florida, 350 F.3d 1197 (11th Cir. 2003). However, the trustee had standing to sue a thirdparty bank for an injury to the debtor corporation by the debtor's officer, and the doctrine of in pari delicto was inapplicable. Conversely, the Northern District of Georgia held that a receiver of assets of parties involved in a Ponzi scheme could sue a third party for fraudulent conveyance of funds under state law. Stenger v. World Harvest Church, Inc., 2006 U.S. Dist. Lexis (N.D.Ga. Mar. 31, 2006). The court reasoned that the receiver sued on behalf of the Ponzi entities, not creditors. That court cited with approval Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995), which held that a receiver had standing to sue third parties to recover fraudulent conveyances, reasoning that the receiver had done no wrong, so in pari delicto did not apply. In Edwards, supra, the Eleventh Circuit distinguished Scholes by noting that Scholes concerned state law regarding fraudulent conveyances and receiverships and not the federal Bankruptcy Code. The Northern District also held that a bankruptcy trustee had standing to sue the debtor's former accountants for malpractice and fraud, where the debtor was operated as a Ponzi scheme, in Gordon v. Basroon, 187 B.R. 37 (N.D.Ga. 1995). That court clarified that a trustee must not plead for recovery based on any injury to the investors/creditors, and a trustee must not plead damages as an amount equal to funds invested in the Ponzi scheme, but should allege damages as funds improperly paid by the debtor. That court expressly did not decide whether the trustee was subject to the in pari delicto defense. 6

7 The Southern District of Georgia held that in pari delicto did not apply in a creditor trust's suit against a law firm, but noted that the firm could litigate that defense. In re Friedman's, Inc., 394 B.R. 623 (S.D.Ga. 2008). Other jurisdictions Other circuit courts have held that in pari delicto applies to a bankruptcy trustee as to a debtor. See, e.g., Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3rd Cir. 2001) (committee barred from suing third parties for fraud and negligence, as wrongdoing was imputed to the debtor), Terlecky v. Hurd, 133 F.3d 377 (6th Cir. 1997) (in pari delicto barred trustee's claim for malpractice and fraud against the debtor's attorneys, as the debtor was at least as culpable as its attorneys), and Official Committee of Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, LLP, 322 F.3d 147 (2d Cir. 2003) (court affirmed dismissal of committee's breach of fiduciary duty claims against accountants based on in pari delicto defense). Several district and bankruptcy courts have held that a trustee could not sue third parties, because the debtor acted in pari delicto with the third parties. See Securities Investor Protection Corp. v. Munninghoff Lange & Co., 2003 Bankr. Lexis 964 (S.D.Ohio 2003); Merrill, Lynch v. Nickless, 324 B.R. 10 (D.Mass. 2005); Nat'l City Bank of Minneapolis v. Lapides, 296 B.R. 343 (D.Md. 2003); Lutz v. Chitwood, 304 B.R. 797 (S.D.Ohio 2003); Knauer v. Jonathon Roberts Financial Group, 2002 U.S. Dist. Lexis (S.D.Ind. 2002); Baena v. KPMG LLP, 289 F.Supp.2d 112 (D.Mass. 2005); Hill v. Gibson Dunn & Crutcher, LLP, 2006 Bankr. Lexis 262 (D.Colo. Feb. 28, 2006); Seitz v. Detweiler, Hershey & Assocs., 2005 U.S. Dist. Lexis (E.D.Pa. 2005); Schnelling v. Thomas, 2005 U.S. Dist. Lexis 6466 (D.Nev. 2005); Miller v. Ernst & Young, 938 S.W.2d 313 (Mo.App. 1997). On the other hand, other courts have allowed claims by a receiver or trustee against third parties. The Ninth Circuit held that equitable defenses good against a debtor were not available against the FDIC, an innocent receiver. Federal Deposit Ins. Corp. v. O'Melveny & Myers, 61 F.3d 17 (9th Cir. 1995). The Fourth Circuit also concluded that an auditor could not raise affirmative defenses including in pari delicto and comparative negligence against the FDIC. Grant Thornton, LLP v. FDIC, unpub., 2011 WL (4th Cir. June 17, 2011). A district court held that a bankruptcy trustee could sue the debtor's accountants for negligence. Smith v. Arthur Andersen LLP, 175 F.Supp.2d 1180 (D.Ariz. 2001). The Smith court held that in pari delicto did not apply, as the debtor's board had innocent members who were not aware of any fraud. Other courts held that the in pari delicto doctrine applied to a bankruptcy trustee only in his "debtor" status, but not to his standing as a creditor. Sender v. Porter, 231 B.R. 786 (D.Colo. 1999); Anstine v. Alexander, 128 P.3d 249 (Colo. Ct. App. 2005). Another court held that a bankruptcy trustee has no standing to sue an auditor for fraud, as that claim belongs to the creditors, but the trustee could sue the auditor for negligence. Ernst & Young v. Bankruptcy Services, Inc., 311 B.R. 350 (S.D.N.Y. 2004). That court reasoned that the allegations of negligence were "clearly distinct" from the allegations of fraud, and the debtor sought its own damages, not contribution. 7

8 Imputation of agent conduct to corporation An employee's conduct should be imputed to the company where (1) the wrongdoing involved top management and (2) the fraud was aimed to benefit the corporation, not harm it. See, e.g., Cenco Inc. v. Seidman & Seidman, 686 F.2d 449, 454 (7th Cir. 1982); Grove v. Sutliffe, 916 S.W.2d 825 (Mo.App. 1995); Miller v. Ernst & Young, 938 S.W.2d 313 (Mo.App. 1997). In the seminal case Cenco v. Seidman, the court held that where fraud permeated the plaintiff company's top management, the defendant auditors could not be responsible for the company's fraud. Cenco v. Seidman, 686 F.2d at 456 ("Fraud on behalf of a corporation is not the same thing as fraud against it. Fraud against the corporation usually hurts just the corporation..."). The Cenco court noted that the "honest owners...were slipshod in their oversight and so share responsibility for the fraud" that the auditor did not detect. Id. Other courts have also refused to allow a guilty plaintiff to recover damages. For example, a Florida district court held that the imputation doctrine applied where the plaintiff company received benefits, such as appearing healthy and extending its life. Brandt v. Lazard Freres & Co., 1997 WL , *3-4 (S.D.Fla. 1997). See also Banco Latino Int'l v. Lopez, 95 F.Supp.2d 1327, 1336 (S.D.Fla. 2000); Mid-Continent Paper Converters, Inc. v. Brady, Ware & Schoenfeld, Inc., 715 N.E.2d 906 (Ind.App. 1999). However, imputation may not be available in situations involving secretive collusion between officers and auditors. Official Committee of Unsecured Creditors of Allegheny Health Education and Research Foundation v. PriceWaterhouseCoopers, LLP, 989 A.2d 313 (2010) v.1 8