Jeff Judy

Jeff's Thoughts - November 25, 2009

The New World of Legal Risk

The universe of risk we face in community banking is expanding in many ways, and as we climb out of the recession, the "risk spectrum" we must manage will be quite different from what we dealt with just a couple of years ago.

We have always faced the risk of running afoul of the legal system, of course. Beyond technical compliance with governing regulations, documentation issues and inconsistent practices cost our industry significant sums every year, and that is part of doing business.

But going forward, both the explicit rules of the game, and the more nebulous legal risks associated with credit, will change, and we have to be ready for those changes.

After the problems in financial services of the last couple of years, new guidelines and requirements from regulators are part of the response from both federal and state levels of government, and existing rules will be applied more tightly, to ever smaller banks. While new regulations are generally clear enough, there is always added risk when the rules of the game change. Some banks will, quite simply, make mistakes as they adapt to the new regulatory landscape, but that really produces only a minor increment in legal risk.

The more significant hazard is in areas like "lender liability," where your "course of dealing," your patterns of behavior in working with commercial credit customers, can lead to litigation. This source of legal risk has always been more difficult to manage, because getting hammered over lender liability is not a simple matter of crossing a clear line, or falling on the wrong side of a black-and-white definition.

Rather, inconsistency in how you handle different customers most often leads to these kinds of lawsuits. When certain borrowers face more or fewer hurdles, or enjoy greater or lesser access to credit, and those differences are not clearly tied to creditworthiness, painful legal consequences can follow.

And now, due to the recession, two factors can significantly magnify those consequences, even when the underlying facts of any given case are the same as they might have been a couple of years ago.

The first factor is that borrowers may be more willing to view legal action as a tool for survival in very tough times. Faced with serious threats to their very existence, some companies (with the encouragement, in some cases, of their legal counsel) are going to see opportunities to reduce their debt load by contesting, in court, the practices of their creditors. To put it simply, some borrowers are desperate for relief, and that lowers the threshold at which some of them will attempt to use the legal system to reduce their burdens.

The second factor is the current public image of our industry. Regardless of how most community banks have conducted themselves in general, media coverage has tarred all of us with the brushes of greed, incompetence, and imprudence. Images of bailouts and bonuses, failures in every market, and the feeling that the banking industry has received a lot of help -- help that it hasn't always passed along to customers -- are just part of the current landscape.

In that environment, no matter how objective judge and jury are supposed to be, do you really want to end up in court arguing that you acted in the best interests of the customer?

If you think "managing legal risk" means simply obeying the most explicit regulations that apply to our business, you have vastly underestimated how widely, and quickly, the nature of legal risk has been altered by the conditions of the last couple of years.