By Matt McLellan ,
D&O Product Leader
14/03/2023 · 5-minute read
Recent challenges faced by the banking industry have raised concerns throughout the financial system, technology and life sciences sectors, and many aspects of the economy. Worries of banking failures spreading to institutions beyond Silicon Valley Bank (SVB) and Signature Bank have alarmed investors and accountholders alike. While the US government has stepped in to support depositors, some questions and uncertainty remain.
SVB’s collapse resulted in part from the Federal Reserve’s sharp interest rate increases over the last few months. The bank had massive growth in deposits from its client base, largely comprised of startups, venture-backed companies, and organizations that recently completed initial public offerings (IPOs). The bank could not lend all of these customer deposits out to other clients, so it bought billions of dollars of treasuries and other bonds — historically considered to be conservative investments and a common practice by banks. When the Federal Reserve raised interest rates, the value of these bonds sunk.
At the same time, SVB’s clients, now facing higher borrowing costs, began to withdraw cash faster than anticipated. This caused the bank to sell its treasuries for a large loss — beginning the chain reaction that led to the bank’s failure.
Since March 9, there has been a focus on other banks with comparable exposures, as well as concern over the ripple effects on technology companies, fintechs, life sciences organizations, and other businesses or startups that rely on regional banks.
While insurance solutions cannot eliminate every risk, they can serve as an important tool for at-risk or failed banks, their client companies, and firms providing professional auditing, legal, or other services to those banks.
Below are six key insurance considerations for companies impacted by a failed or at-risk bank.
Shareholders have already brought claims against SVB and Signature Bank arising from the recent events. Board members, C-suite executives, and other bank officers at these institutions or at-risk banks should confirm that they have suitable directors and officers (D&O) insurance to fund the defense and possible settlement of shareholder litigation.
Shareholders may accuse bank executives of fraud for allegedly misleading investors about the risks of the interest rate environment or other factors, leading to a stock drop when the market recognizes those risks. Alternatively, shareholders could bring a derivative action on behalf of a failed bank against the board accusing it of breaching fiduciary duties. Both types of actions can give rise to significant defense costs and settlements.
In addition to shareholders, government regulators at the state and federal level may bring investigations or enforcement actions against banks or individual executives. These investigations can focus on insider trading allegations, alleged fraudulent transfers ahead of a bankruptcy, and purported conflicts of interest, among other matters.
Banks and executives facing claims from shareholder or regulators should familiarize themselves with their D&O policies to prepare to submit claims properly. In addition to defense and settlement costs, many D&O policies reimburse executives for legal fees associated with interviews, depositions, and other pre-claim inquiries by government regulators. Organizations may also be able to seek reimbursement, depending on policy terms, for shareholder books and records requests and shareholder derivative investigation expenses.
Companies that engage failed or at-risk banks for banking, payroll, credit lines, and other services could experience negative financial impacts. While customers of recently-failed banks have not lost their deposits due to the government's intervention, it is possible that other harms could materialize.
Customers heavily reliant on additional services could see their own stock prices decline when they no longer have access to an important banking relationship. Shareholders may bring suit alleging that a bank’s customer misled its own investors about exposure to a particular bank or the broader interest rate environment, among other factors, or otherwise breached fiduciary duties.
Finally, where distressed banks or companies file for bankruptcy protection, the proceeds of their insurance policies may be made an asset of the bankruptcy estate. This may require special permission from a receiver, trustee, or bankruptcy judge to access policy proceeds. An important feature of D&O coverage that is not expected to be made part of the bankruptcy estate is dedicated Side A coverage. Companies should review their Side A coverage, which is a safeguard against executives’ personal liability.
In addition to shareholder claims, failed banks likely will face litigation brought by customers accusing the bank of errors and omissions that caused the bank to fail. The government has announced that it will backstop customer deposits — even beyond the FDIC insured amount — for the two failures so far. However, it is not clear whether a similar backstop will exist in every circumstance and failed bank customers could claim other types of harm. Relatedly, government regulators could bring claims and enforcement actions against failed banks on behalf of injured consumers. Banks should look to their bankers’ professional liability insurance policies as a potential source of coverage against these claims.
Lawyers, accountants, consultants, auditors, and other organizations that provided professional services to a bank that later failed could also face exposure. A failed bank, the FDIC as receiver, or a bankruptcy estate may bring a claim against professional service providers, claiming that bad financial or legal advice contributed to the bank’s collapse.
Finally, private equity companies, hedge funds, asset managers, and other organizations that may have directed client investments into failed bank stocks could face claims by their customers accusing them of mismanagement and other errors. Miscellaneous errors and omissions (E&O) policies may protect these service providers against these types of claims.
As noted above, clients of SVB and Signature Bank were given prompt access to their deposits, thus largely avoiding payroll lapses and other limitations on their ability to operate. However, companies relying on other distressed banks could face challenges meeting payroll obligations down the road.
An employment practices liability (EPL) policy typically does not protect against late or non-payment of wages or benefits. Some of the EPL policies may, however, contain a modest sublimit for defense costs incurred to defend against a wage and hour (W&H) claim. The language, however, should be carefully reviewed to determine if the defense costs coverage may extend to violations of laws governing the payment of wages to employees. Nevertheless, any such coverage generally would not provide reimbursement of the unpaid wages.
A W&H policy offers protection against late or unpaid wages, but it generally does not cover an employer’s payroll obligation when the employer fails to pay due to a lack of access to funds. There could, however, be potential coverage for fines and penalties if the employer is found to have violated any laws governing the payment of wages.
When distressed companies engage in reductions in workforce, layoffs, or furloughs, coverage under EPL and W&H policies could respond. Alleged violations of a salaried employee’s exempt status due to a furlough or failure to comply with any Worker Adjustment and Retraining Notification (WARN) Act or equivalent state laws due to a reduction in force could trigger coverage under such policies.
Employers should also be mindful of any potential breach of contract issues related to employment contracts or severance agreements. An employer may be obligated to continue paying an employee or maintaining their employment under the terms of an agreement. An EPL policy — particularly defense costs coverage — may potentially respond to such claims.
Side A coverage under a D&O policy may also respond to claims against executives for alleged payroll violations.
Banks and other financial institutions can purchase a financial institution bond (FI bond), which is an industry-specific type of crime insurance policy. The FI bond covers loss of money, securities, and other specified financial assets — whether owned by the insured or owned by any third party (including customers), but in the insured’s care, custody, or control — due to theft, fraud, disappearance, or destruction.
Significantly, the FI bond will terminate immediately upon the insured being taken over by a receiver, liquidator, or other state or federal official. Because the FI bond only responds to losses that are discovered prior to its termination, this provision may forestall claims by a receiver for a loss that is discovered during the course of a liquidation process.
At-risk banks may face heightened exposure to internal and external fraud. Low morale and reductions in staff, especially among those performing control functions, may leave the bank more vulnerable to theft by disgruntled employees. Similarly, outside bad actors may seek to take advantage of this vulnerability via various attack vectors, such as computer fraud, funds transfer fraud, social engineering, or on-premises theft.
The FDIC insures bank deposits up to $250,000. Though the federal government announced that it will make depositors of the two recently failed banks whole, there is no guarantee it will take similar actions with respect to future bank failures.
At present, the only available form of coverage that mimics the protection provided by the FDIC is a surety instrument known as a depository bond.
This type of instrument protects the deposits of an identified depositor or group of depositors from loss of deposits not reimbursed by the FDIC.
These recent events may prompt banks to revisit their risks and risk management approaches. Below are some considerations for banks:
An unexpected situation like the SVB and Signature Bank failures highlights potential credit risk gaps and the need to address them before a situation deteriorates.
Banks and other companies impacted by recent bank failures or at-risk banks face a range of risks and challenges. Organizations should focus on reviewing their insurance coverages to understand fully the protections they have for liabilities resulting from such institutions, customers, or other possible losses.
Working with your insurance and risk advisory professional to gain that understanding, to develop strategies to maximize recovery in the event of a claim or a loss, and to consider new risk management approaches are critical steps.