Defending against 'Fraud by Hindsight' Cases

By Kaplan, Lewis A.; Quinones, Roberto C. | American Banker, March 31, 1992 | Go to article overview

Defending against 'Fraud by Hindsight' Cases


Kaplan, Lewis A., Quinones, Roberto C., American Banker


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 liability is known but the amount is uncertain, (2) the amount is known but the occurrence of the loss or liability is uncertain, or (3) both the occurrence and the amount are uncertain. Reserves are thus estimates.

Loan-loss reserves are no different. The Comptroller's "Handbook for National Bank Examiners" provides that institutions must maintain an allowance for loan and lease losses at a level adequate to absorb expected losses in the institution's loan portfolio.

Guideline for Examiners

Further, federal regulatory agencies in a recent joint policy statement advised their examiners that "even when an institution maintains sound loan administration and collection procedures and effective internal systems and controls, the estimation of anticipated losses may not be precise because of the wide range of factors that must be considered."

The Federal Rules of Civil Procedure impose a special burden on plaintiffs claiming fraud, which may be used to seek early dismissal of "fraud by hindsight" cases.

The rule requires that the circumstances constituting fraud be stated with particularity. In the case of reserve litigation, the complaint must set forth specific facts from which it may be readily inferred that the institution knew or should have known that reserves were inadequate.

A Defining Case

The phrase "fraud by hindsight" was coined in a 1978 case to describe a meritless claim against a bank holding company, the Chase Manhattan Corp. In that case, Denny v. Barber, the bank had expanded into then popular areas of lending that had proved less rewarding than expected - loans to foreign and domestic governmental entities and to real estate investment trusts.

When the bank's earnings were adversely affected, the problems and their source were disclosed.

The plaintiff then sued, alleging that the disclosures should have been made earlier and that the bank's reserves had been inadequate.

The court in Denny stressed that the plaintiff's negative characterizations of the bank's business conduct did not establish fraud:

"Thus it is said that the bank's foreign operations and loans, which are indeed depicted with enthusiasm in the 1973 [annual] report, were 'speculative and risky.' Yet there is no specification of what loans, at what times, and in what amounts were 'risky.'

In the absence of such particulars, and given the myriad of foreign loans made by the bank during the early 1970s, the simple use of the epithet 'risky' is no better than a 'mere conclusory allegation to the effect that defendant's conduct was fraudulent,' which we have held to be insufficient . …

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