Damages Theories for Financial Institutions Injured by Changes in Government Regulation
By: David T. Case, Brendon P. Fowler
With the nearly unparalleled upheaval in world financial markets and the resulting impact on the nation’s financial institutions, many entities have either gone bankrupt or become subject to increasing levels of Government intervention, regulation, and oversight. The Government also continues to consider actions to address “toxic” assets and to stimulate financial activity. While Government action may ultimately lead the way to financial recovery for the broad economy, in some instances the Government may take actions, such as changing federal regulatory schemes and related contracts, that nonetheless inflict harm on individual companies. In those situations, developments in a series of cases relating to an earlier financial crisis may provide guidance in navigating the risks of increased Government regulation and oversight, and the measure of any damages that might be recovered.
During the Great Depression, forty percent of the nation’s home mortgages went into default, and 1,700 of the nation’s approximately 12,000 savings institutions failed. This led to significant Government oversight of the savings and loan, or "thrift" industry, in the form of the Federal Home Loan Bank Board and the Federal Savings and Loan Insurance Corporation, as well as the passage of numerous laws such as the Home Owners’ Loan Act of 1933. This regulatory regime remained in place until the financial crisis of the late 1970s and early 1980s, when, in order to retain deposits, thrifts were compelled to offer interest rates to depositors that exceeded the stream of income from the thrifts’ long-term, low-rate mortgages. Over 400 thrift institutions failed by 1983, and by the mid-1980s, it became clear that Government regulatory efforts to resolve the crisis were not succeeding. As a result, Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), which resulted in regulations that imposed more stringent capital standards on thrifts. Many thrifts, particularly ones that had acquired failed thrifts under agreements with the Government, were immediately thrown out of compliance with regulatory capital requirements and became subject to seizure by thrift regulators.
A number of thrifts adversely affected by the new regulations sued the Government, alleging that the passage of FIRREA breached the contracts under which the thrifts had previously agreed to acquire other failed institutions. In United States v. Winstar Corporation, 518 U.S. 839, 843 (1996), the Supreme Court held that where the Government entered into contracts with regulated financial institutions, promising to provide particular regulatory treatment in exchange for the assumption of liabilities, the risk of regulatory change fell to the Government, even though Congress subsequently changed the law and barred the Government from honoring its agreements. Following this ruling, the United States Court of Federal Claims and the United States Court of Appeals for the Federal Circuit addressed a series of cases where the allegations were that the Government had indeed breached its contractual obligations to various thrifts through the passage of FIRREA. This group of cases, which is often denoted as the “Winstar-related cases,” may provide significant guidance for any cases that derive from the present crisis.
As a general matter, damages in the Winstar-related cases are based on one of three damages theories: expectancy damages, reliance damages, or restitution damages.
Expectancy, or “lost profit” damages, protect a bank’s expectation interest by seeking to put that institution in as good a position as it would have been had the institution’s contract with the Government been fully performed, without also providing plaintiff with a windfall. If successful, this theory for recovery typically produces the largest quantum of damages for an injured bank, but lost profits have historically been difficult to prove and recover in the Winstar-related context. Nevertheless, a recent Winstar-related decision by the United States Court of Appeals for the Federal Circuit (“Federal Circuit”) upheld the trial court’s acceptance of a lost profits theory that established, by way of expert testimony and models, that the Government’s implementation of FIRREA caused lost profit damages to the affected thrift. See First Federal Sav. and Loan Ass’n of
Reliance damages, often sought or pled in the alternative to expectation damages, are intended to address harm resulting from the thrift’s change of position in reliance on its contract with the Government. The underlying principle in reliance damages is that a party who relies on another party’s contractual promise is entitled to damages for any losses actually sustained as a result of the breach of that promise. Glendale Federal Bank v. United States, 239 F.3d 1374, 1382 (Fed. Cir. 2001). In Glendale, the Federal Circuit affirmed the use of a reliance damage calculation because “for purposes of measuring the losses sustained … as a result of the Government’s breach, reliance damages provide a firmer and more rational basis” than the alternative theories argued by the parties in that case.
Restitution damages may be sought when proof of lost profits or reliance damages fails. The idea behind restitution is to restore the non-breaching party to the position he would have been in had there never been a contract to breach. Specifically, a restitution theory seeks to recover any benefit that the non-breaching party may have given to the breaching party, but such damages should not be awarded if the award would result in a windfall to the non-breaching party. See Southwest Investment Co., Inv. v. United States, 63 Fed. Cl. 182, 197 (Fed. Cl. 2004). Accordingly, an institution must carefully consider whether benefits conferred on the Government might nonetheless be offset fully by benefits received from the Government, as “the non-breaching party is not entitled, through the award of damages, to achieve a position superior to the one it would reasonably have occupied had the breach not occurred.” Glendale Federal Bank v. United States, 239 F.3d 1374, 1382 (Fed. Cir. 2001). In addition, restitution can be a challenging theory to pursue, for while a party may often be able to show benefits given to the Government, establishing an actual dollar value conferred can be difficult. Id. at 1382 (under theory that thrift assumed risk and relieved Government of liabilities for a period of time in which the Government was able to deal with other failing thrifts, the value of Government’s time was more than zero but there is no proof of what in fact it was worth). Where a specific dollar amount is clearly established, however, restitution may be awarded. See 1st Home Liquidating Trust v. United States, 76 Fed. Cl. 731, 744 (Fed. Cl. 2007).
In sum, the numerous Winstar-related decisions provide a body of law for institutions faced with a rapidly changing bank regulatory environment and possible breaches by the Government with respect to current contracts. Familiarity with the types of damages theories and models employed by past thrift litigants against the Government may help today’s institutions develop a viable remedy if they are harmed by Government action.
