Bank Failure Highlight Need for Due Diligence on Deposit Insurance

Published on: November 20, 2008

When Indy-Mac, the California bank giant, failed in July, an estimated $600 million of its $19 billion in deposits were not insured. Based on historical patterns, the consumers, businesses (and homeowner associations, if any) holding those uninsured deposits could expect to recover about 72 cents of every dollar.

Think about that. Would you want to be a member of an HOA board that had to inform owners that the association’s reserves or operating funds had been reduced by almost 25 percent? The news would not be well-received and the board members responsible might well face legal liability for failing to make sure the association’s funds were protected.

The federal government, through the Federal Deposit Insurance Corporation (FDIC), automatically insures up to $250,000 in deposits held in commercial banks and savings institutions. (The National Credit Union Share Insurance Fund provides the same coverage for credit union deposits.) The $250,000 limit is new and temporary. Congress increased the coverage from $100,000 as part of the massive financial industry bail-out bill enacted a few weeks ago, subject to a sunset provision under which the cap will revert to the lower limit at the end of next year.

Uncomfortable Exposure

Many community associations – and not just the largest ones – have reserves and operating funds, which, separately or combined, would exceed $100,000. Even if lawmakers decide to keep the $250,000 limit in place beyond next year, as seems more likely than not, some associations would still fall outside the federal insurance umbrella and suffer a financial loss in a bank failure. Associations whose funds are fully insured might also encounter problems if their bank failed, because it could take several days or longer for the FDIC to process insurance claims.

The obvious advice for community association boards is to make sure association funds are fully insured and avoid financially wobbly banks. This isn’t just a recommended course of action for board members; it’s a fiduciary obligation, and the liability concerns are real. An attorney was sued for malpractice a few years ago, when he deposited nearly $3 million from the proceeds of a real estate transaction in a client funds account in a bank that subsequently failed. A New York Appellate court ultimately ruled that the attorney wasn’t responsible for verifying the condition of the bank, but that court and others might reach a different conclusion today, given the recent high-profile bank failures we’ve seen and the rumors that more are likely to follow.

Admittedly, this case (Bazinet v. Kluge) involved attorneys and their responsibility for client funds accounts, but board members have the same fiduciary obligation to protect association funds. A board that fails to obtain full deposit insurance coverage and makes no effort to assess the condition of the bank with which it does business would almost certainly be sued by angry owners. And board members could not count on the association’s Directors and Officers insurance to cover their litigation expenses or any judgment levied against them, any more than they could expect coverage if they failed to obtain adequate property insurance for the community. Most D&O policies specifically exclude protection for negligence of this kind.

Three Essential Steps

Fortunately for board members, the due diligence required to protect themselves and their communities in the deposit insurance area is neither complicated nor extensive. Three steps are essential:

  • Make sure any institution in which you deposit association funds is federally insured. Any state- or federally-chartered deposit institution is required to have that coverage and will display the FDIC (or NCUSIF) insurance logo conspicuously in branches and in advertising material.
  • Review the institution’s financial condition. You can do this easily by checking any one of several sources (TheStreet.com, veribanc.com, and bankrate.com are a few examples) that use a comparative rating system to describe the safety and soundness of financial institutions. It is also useful to check the reports of national rating firms, such as Moody’s, Standard & Poor’s and Fitch. As we have seen recently, there is no guarantee that a bank rated highly today won’t fail next week or six months from now. But boards that review these ratings periodically will have a strong defense against allegations that they failed to exercise reasonable care in selecting institutions in which association funds were deposited.
  • Monitor association accounts to make sure they remain within the federal insurance limits. Interest earned on an account could push it over the line. Also, remember that the $250,000 applies to each depositor, not to each account. If the association has two certificates of deposit, one for $250,000 and the other for $100,000 in a single institution, only the first CD (for $250,000) would be insured.

Above the Limits

Communities with more than $250,000 have several options for insuring those funds. One is to open separate accounts in (or purchase deposit instruments from) several different institutions in amounts below the insurance limit.   Boards can achieve that goal (multiple accounts in multiple institutions) more easily by using CDARS — the Certificate of Deposit Account Registry Service.  CDARS provides a kind of one-stop-shopping arrangement for customers who want to break up a large sum into several, smaller, insurable CDs. Customers contact one of the approximately 2,300 participating banks nationwide. The lead bank structures the deposits and prepares a single statement for the customer identifying all the institutions at which the CDs have been placed, the interest earned and the maturity dates. Instead of dealing with multiple statements and multiple signature cards which have to be re-signed every time the board changes), boards deal with a single bank, a single set of documents and a single statement.

Kenneth Bloom, a CPA with Bloom, Cohen, Hayes LLC, notes a potential disadvantage of using this service – board members relinquish control over the selection of of banks at which their funds are placed. They can address this concern by reviewing (or having someone review for them) the ratings of participating CDARS banks, or by insisting on an opportunity to review and approve the institutions with which association funds are to be placed.

As an alternative to purchasing multiple CDs to keep funds under the deposit insurance limit, Bloom suggests, associations can purchase a single large Treasury security. Treasuries are available in different amounts with varied terms, and are insured in full by the federal government. The yields will be lower than on bank CDs, but the federal coverage is complete and you don’t have to purchase several different securities to achieve it.

Community associations in Massachusetts have another avenue for insuring deposits above the FDIC limit. All state-chartered depository institutions are required to contribute to the Deposit Insurance Fund, which covers excess deposits if an institution fails. A couple of key points about this coverage:

  • It is available only at state-chartered depository institutions; federal banks and savings institutions do not participate.
  • DIF is a private fund, financed entirely by mandatory contributions from the financial institutions; there is no state or federal guarantee behind it.  And that could be a problem, according to Bloom, who notes that the fund guarantees, without limit, all deposits exceeding the FDIC limit.  If a single institution fails, depositors could count on recovering excess funds.   But if all the covered banks failed simultaneously, the DIF could not possibly cover all the excess deposit claims.  That is not likely to happen, Bloom agrees, “but the question you have to ask is, how many failures would it take to wipe out the fund?”  Even with the possibility of excess insurance coverage through DIF, Bloom suggests that community associations keep their deposits under the FDIC/NCUSIF limit.

Recent bank failures and continuing economic jitters have forced association boards (along with everyone else) to focus more intently on deposit insurance, which is all to the good. This is an area that has not received as much attention as it deserves or as much vigilance as it requires.  But there is another equally important message that HOA board members should heed:  Safety first.  Economic conditions change, as we’ve seen, but the board’s obligation to preserve and protect association funds does not.