One pernicious effect of the recession on the banking industry has been that dozens of institutions and their officers have been named in the past two years as defendants in class actions alleging that banks have violated federal securities laws by understating loan-loss reserves.
One recent complaint is typical. It asserted that defendants portrayed the institution in "glowing terms, with great prospects for future growth and earnings" in filings with the Securities and Exchange Commission and other public statements, while they "misrepresented and concealed the deterioration of the quality of the institution's loan portfolio, the likelihood of increases in nonperforming assets, and the failure to set appropriate levels of loan-loss reserves on loans experiencing problems."
Later Provisions Cited
The basis for the charges of misconduct was the defendants' later announcements of increases in reserves and the institution's difficult financial condition. The plaintiffs then asserted that officers "knew or should have known" that reserves would be inadequate to cover actual losses.
This sort of reasoning is open to serious question. There is no mystery about the nature of a reserve.
Generally, a reserve is a charge made to provide for a loss or liability where (1) the occurrence of a loss or …