With this economic downturn, financial institutions can expect credit defaults, insolvencies, and misconduct by borrowers, depositors, and other customers. Cash-strapped borrowers may manipulate financial covenants, misstate borrowing base reports to avoid covenant violations, and misappropriate assets. Without new money coming in, existing frauds like Ponzi schemes will collapse and come to light. Banks and other financial services companies face the added risk of litigation by third parties who allegedly suffered losses due to the customer’s misconduct. What are those risks and what steps may financial institutions consider mitigating them?

Civil Litigation Risks of Customer Misconduct

The potential civil claims against a bank arising from customer misconduct depend on multiple factors, such as the financial institution’s role and relationship with the customer, and the specific facts of the customer’s wrongdoing.

1. Aiding and abetting. Among the most common claims are aiding and abetting fraud and/or breach of fiduciary duties by company insiders. Plaintiffs may include the trustee or receiver for the estate of the now-insolvent company. The law varies by state but aiding and abetting generally requires that the defendant had actual knowledge of the underlying fraud or breach and provided substantial assistance. A bank’s negligent failure to identify warning signs of potentially fraudulent activity typically does not suffice. Nor does the provision of routine banking services in the midst of a continuing fraud.

   However, aiding and abetting claims have proceeded to discovery where the plaintiff alleged that the bank knowingly assumed a more active role in the customer’s fraud. In one example, the plaintiffs alleged that the lender bank terminated its loans on discovering the borrower’s Ponzi scheme—but then continued to provide other services that furthered the fraud and facilitated repayment on the loan. In another case, the plaintiff alleged that instead of just servicing a Ponzi schemer’s deposit and checking accounts, the bank entered into account control agreements to help assure skittish investors.

2. Misrepresentation. Also common are claims of misrepresentation, alleging that the financial services company made statements about the customer’s finances and operations that are now known to be inaccurate. Buyers of interests in participation loans have sued the originators or lead lenders after the corporate borrower dissolved in fraud, alleging affirmative misstatements and the concealment of material facts despite a purported duty to disclose. Arrangers of syndicated credit facilities have faced similar suits. Defendants often have invoked the participants’ and syndicate members’ responsibility to conduct their own diligence and make independent credit determinations.

   Financial institutions also have faced claims for inaccurate asset values and descriptions in account statements—typically where the plaintiff alleged that the bank knew or recklessly disregarded the assets’ true value or nature. Misrepresentation claims, whether negligent or intentional, are fact-intensive, and may also depend on the financial institution’s exact role and obligations under contract.

3. Breach of contract. Where a corporate wrongdoer has established an account for the benefit of a third party—such as a trust account, escrow account, or control account—beneficiaries have sought to hold the bank liable for depleted assets by claiming breach of contract. The specifics depend on the contract terms and the individual facts. For example, plaintiffs have asserted that the bank disbursed assets at the wrongdoer’s direction even though not all contractual requirements for release were met and there was no notice to other stakeholders. Also, plaintiffs have tried to identify language in which, they have claimed, the bank took on some responsibility for the value, form, or suitability of the assets.

Circumstances that have Accompanied Customer Misconduct

The circumstances accompanying customer misconduct may resemble a jigsaw puzzle—almost impossible to recognize before all the pieces are in place. Investors laud the hard-charging CEO who demands results, fast; but looking back, many high-profile frauds have featured such a domineering executive. Each situation is unique, and banks do not operate in hindsight. However, the following circumstances—particularly in combination—have accompanied customer frauds that gave rise to civil suits against financial services companies.

1.  Management. According to the Association of Certified Fraud Examiners (ACFE), fraud by a corporate owner or executive is the costliest and takes the longest to detect. Instances of fraud involving top management have included:

• Companies where one person dominated the decision-making and insisted on control over external communications.

• Efforts by management to intimidate lenders, auditors, and other financial service providers.

• Refusals to allow due diligence, answer questions, and provide documentation.

• High churn in banking relationships, auditing firms, and CFOs or accounting staff.

2. Transactional. Fraudulent financial transactions are varied and designed to avoid notice. Previous financial frauds have involved:

• The rapid movement of funds with no apparent business purpose, such as round-trip transactions and successive refinancing.

• A spike in transactions, particularly at quarter- or year-end.

• Account activity at odds with the customer’s stated expectations when opening the account—for instance, in terms of dollar amounts, transaction volume, and location or type of counterparties.

Steps to Consider

Typically, the sooner a corporate fraud is detected, the greater the opportunity to mitigate losses. According to the ACFE, tips are by far the most common method of initial detection. What can a financial institution do if an employee actively and actually suspects possible customer misconduct?

Concerns may be escalated to the institution’s risk, compliance, and legal professionals. Among the primary considerations may be whether to file a suspicious activity report (SAR). The Bank Secrecy Act and its implementing regulations require a bank timely to report certain transactions that the bank “knows, suspects, or has reason to suspect” are suspicious. A transaction need not involve money laundering to trigger a SAR, and instead may involve fraud or other unlawful acts.

The specific steps in response to potential customer misconduct vary by the individual facts. But financial institutions should try to ensure that employees, both front-office and back, are aware of their roles, and the appropriate personnel are involved from the start. Banks may face difficult decisions about of a host of topics, such as:

• Further internal inquiry;

• Their relationship with the customer and any other counterparties;

• Asset preservation and recovery;

• Potential disclosures; and

• Government investigations or regulatory examinations.

Risk, compliance, and legal professionals may be best-equipped to help make reasoned, but timely, decisions in an effort to mitigate losses and liability.