Guidance Regarding Indemnification Agreements and Payments

FRB: Supervisory Letter SR 02-17 on guidance regarding indemnification agreements and payments -- July 8, 2002

BOARD OF GOVERNORS

OF THE

FEDERAL RESERVE SYSTEM

WASHINGTON, D. C.  20551

DIVISION OF BANKING

SUPERVISION AND REGULATION

SR 02-17

July 8, 2002

TO THE

OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE SUPERVISORY AND EXAMINATION STAFF AT EACH FEDERAL RESERVE BANK AND TO BANKING ORGANIZATIONS SUPERVISED BY THE FEDERAL RESERVE

SUBJECT:

Guidance Regarding Indemnification Agreements and Payments

Recently, some merger and acquisition applications filed with the Federal

Reserve have included broad scope indemnification clauses in the agreements

between the parties to the proposed transactions.  Some of these

indemnification clauses seek to indemnify the target financial institution's

officers, directors, and employees from any judgments, fines, claims or

settlements whether civil, criminal, or administrative that relate to

"conduct before the merger or acquisition." Some state member

banks and bank holding companies have also adopted broadly worded

indemnification provisions in their by-laws or entered into separate

indemnification agreements that cover the on-going activities of their own

institution-affiliated parties.

1

Federal Reserve staff has found that

many of the indemnification provisions are inconsistent with federal

banking law and regulations, as well as safe and sound banking practices,

and has advised applicants and supervised institutions about the

deficiencies.

The purpose of this letter is to remind Reserve Bank examination and

applications staff, and state member banks and bank holding companies of

the limitations on indemnification imposed by section 18(k) of the

Federal Deposit Insurance Act, which was added by the Crime

Control Act of 1990, and the regulations issued thereunder by

the FDIC

utions about the

deficiencies.

The purpose of this letter is to remind Reserve Bank examination and

applications staff, and state member banks and bank holding companies of

the limitations on indemnification imposed by section 18(k) of the

Federal Deposit Insurance Act, which was added by the Crime

Control Act of 1990, and the regulations issued thereunder by

the FDIC.  The law and regulations apply to indemnification agreements

and payments made by any bank or bank holding company to any

institution-affiliated party, regardless of the condition of the financial

institution.  The purposes of the law and regulations are to

preserve the deterrent effects of administrative enforcement actions by

ensuring that individuals subject to final enforcement actions bear the

costs of any judgments, fines, and associated legal expenses, and to

safeguard the assets of financial institutions.

The FDIC's regulations define a "prohibited indemnification

payment" to include any payment or agreement to make a payment by a

bank or a bank holding company to an institution-affiliated party to pay or

reimburse such person for any liability or legal expense in any

administrative proceeding brought by the appropriate federal banking

agency that results in a final order or settlement in which the

institution-affiliated party is assessed a civil money penalty, is removed

or prohibited from banking, or is required to cease an action or take

any affirmative action, including making restitution, with respect to the

bank or bank holding company.

2

Under the FDIC's regulations, a

bank or bank holding company may make a reasonable payment to purchase

commercial insurance to cover certain costs that the institution incurs

under an indemnification agreement.  Costs that may be covered by

insurance include legal expenses and restitution that an individual may be

ordered to make to the institution or receiver

g company.

2

Under the FDIC's regulations, a

bank or bank holding company may make a reasonable payment to purchase

commercial insurance to cover certain costs that the institution incurs

under an indemnification agreement.  Costs that may be covered by

insurance include legal expenses and restitution that an individual may be

ordered to make to the institution or receiver.  The insurance may

not, however, pay or reimburse an institution-affiliated party for any

final judgment or civil money penalty assessed against such

individual.

The FDIC's regulations provide criteria for making permissible

indemnification payments.  A bank or a bank holding company may make

or agree to make a reasonable indemnification payment if

all

of the

following conditions are met: (i) the institution's board of

directors determines in writing that the institution-affiliated party

acted in good faith and the best interests of the institution;

(ii) the board of directors determines that the payment will not

materially affect the institution's safety and soundness; (iii) the

payment does not fall within the definition of a prohibited indemnification

payment; and (iv) the institution-affiliated party agrees in writing

to reimburse the institution, to the extent not covered by permissible

insurance, for payments made in the event that the administrative action

results in a final order or settlement in which the institution-affiliated

party is assessed a civil money penalty, is removed or prohibited from

banking, or is required, under a final order, to cease an action or take

any affirmative action.

The law and FDIC's regulations, which apply to all state member banks and

bank holding companies, reinforce the Federal Reserve's longstanding policy

that an institution-affiliated party who engages in misconduct should not

be insulated from the consequences of his or her misconduct

banking, or is required, under a final order, to cease an action or take

any affirmative action.

The law and FDIC's regulations, which apply to all state member banks and

bank holding companies, reinforce the Federal Reserve's longstanding policy

that an institution-affiliated party who engages in misconduct should not

be insulated from the consequences of his or her misconduct.  From a

safety and soundness perspective, a state member bank or bank holding

company should not divert its assets to pay a fine or other final judgment

issued against an institution-affiliated party for misconduct that

presumably violates the institution's policy of compliance with

applicable law, especially in cases where the individual's misconduct

has already harmed the institution.  Although state corporate laws may

allow a company to adopt by-laws indemnifying its institution-affiliated

parties, any indemnification provisions or agreements adopted by a state

member bank or bank holding company must comply with federal law and the

FDIC's regulations concerning indemnification.

In addition, bank holding companies that issue securities to the public

under a prospectus declared effective by the U.S. Securities and Exchange

Commission should note that the SEC's

Regulation S-K (17 CFR 229.512) requires that the

prospectus include the following statement:

Insofar as

indemnification for liabilities arising under the Securities Act

of 1933 may be permitted to directors, officers, or persons

controlling the registrant, the registrant has been informed that in

the opinion of the SEC such indemnification is against public policy as

expressed in the Act and is therefore unenforceable.

State member banks and bank holding companies should review their

by-laws and any outstanding indemnification agreements, as well as

insurance policies, to ensure that they conform with the requirements of

federal law and regulations

informed that in

the opinion of the SEC such indemnification is against public policy as

expressed in the Act and is therefore unenforceable.

State member banks and bank holding companies should review their

by-laws and any outstanding indemnification agreements, as well as

insurance policies, to ensure that they conform with the requirements of

federal law and regulations.  In the event that a state member bank

or bank holding company fails to take appropriate action to bring its

indemnification provisions into compliance with federal laws and

regulations, appropriate follow-up supervisory action may be

taken.  Applications involving banks or bank holding companies

with indemnification-related issues identified in the supervisory process

will be reviewed by Federal Reserve staff for compliance with federal

law and regulations.

Reserve Banks are asked to distribute this letter to all state member

banks and bank holding companies in their districts, as well as their

examination and applications staff.  Should you have any questions

regarding this matter, please contact Nancy Oakes, Counsel,

Division of Banking Supervisions and Regulation, at (202) 452-2743.

Richard Spillenkothen

Director

Note:

The term �institution-affiliated party� includes any officer, director,

employee, and controlling stockholder, as well as others who participate

in the affairs of a financial institution.  The term is defined in

the law at 12 U.S.C. 1813(u).

Return to text

Refer to 12 CFR Part 359.

Return to text

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Last update: July 8, 2002