Bank Expert

A bank brought action against an accounting firm and its partner for aiding and abetting former bank directors in breach of statutory duties, professional negligence, breach of fiduciary duty, and statutory violations.  The Court of Appeals, held that statutory language stating a bank director’s duties did not make an accounting firm’s expert witness’s testimony unnecessary with regard to the specific duties of the directors.

A bank in Kentucky (“the Bank”) appealed a judgment of the trial court in favor of CH and WBB, the accountants and auditors of the Bank.  The Bank argued, among other things, that it was error to permit expert testimony regarding the duties of the Bank’s board of directors.

From 1991 through 2002, JF served as the Bank’s president and CEO and MM worked as chief commercial loan officer.  Both were also members of the board of directors.  In 1996, E&G became the accountants and auditors for the Bank.  As a partner with E&G (and its successor “CH”), WBB had primary responsibility for providing independent accounting and auditing services to the Bank.

JF and MM supervised the Bank’s largest loan customer, real estate developer WE and the entities he controlled (collectively “WE”).  The three developed a close personal and business relationship.  In 1997, JF and MM created JAMS Properties, which purchased homes by WE at cost.  However, the parties created fictitious purchase contracts with higher costs, false loan applications were submitted to out-of-town banks, and mortgages were secured based on these misrepresentations.  The excess loan proceeds were divided between WE and JAMS.  Erpenbeck rented the properties from JAMS, and they used the rent payments to pay the mortgages.  By 2000, JAMS was in debt from this scheme for roughly $3.9 million.

JF and MM hired CH to perform tax services for JAMS.  CH prepared the tax returns for several years.  JAMS maintained its bank accounts with the Bank.  Later WE was not able to make the rent payments to JAMS; and, as a result, JAMS could not make the mortgage payments. WE also caused a kite of insufficient funds checks to be conducted among various accounts, including his account at the Bank. When the kiting scheme was discovered by another bank, WE’s account at the Bank became substantially overdrawn. JF and MM authorized additional loans to WE to cover the overdrafts.

JF then told WBB of WE’s check conversion and check kiting schemes.  After investigating, WBB discovered the relationship among WE, JF, ME and JAMS.  He advised JF to inform the Bank board of the relationship and potential conflict of interest. Upon learning of this, the Bank’s board notified authorities and hired a law firm to conduct an internal investigation, which revealed the extent of the dealings, the extent of the check kiting and check conversion schemes, the post–2001 loans to WE, and WE’s default on the loans from the Bank and other banks.  JF and MM then resigned.  Customers withdrew funds from the Bank, and it closed in late 2002, selling its remaining assets at a substantial loss.  WE was convicted on numerous federal bank fraud charges, and JF and MM  pleaded guilty to other federal bank fraud charges.

At trial, the Bank presented expert testimony that because of the significant financial risk to the Bank, CH should have earlier disclosed the personal business relationship between WE, JF and MM and that CH acted in a grossly negligent manner in performing its auditing work.  Over the Bank’s objection, CH presented Dr. H as an expert on the standard that the directors were required to observe while serving on the Bank’s board and his opinion that the directors violated those standards.

On appeal, Court of Appeals Judge Kelly Thompson explained the specifics of Rule 702 and noted that the Bank did not challenge Dr. H’s qualifications but argued that expert testimony was not required because state statute defined a bank director’s duties. The Bank claimed that it was a matter within the common knowledge of a jury. Judge Thompson disagreed.  The Kentucky statute, the judge said, provides general guidelines regarding a director’s duties.  But here Dr. H described the specific duties required by bank directors and especially the Bank’s directors.  He testified that the directors had a duty to supervise JF’s and MM’s lending activities, establish internal control and auditing, and review and respond to audit and examination reports.  In addition to ensuring that the board minutes were complete and accurate, the directors had the basic function of placing the Bank’s interests before their own.

The appellate court cited the 1995 Northern District of Indiana in Resolution Trust Corp. v. O’Bear, Overholser, Smith & Huffer, that the “nature and scope of the duties owed a financial institution by its directors is a matter beyond the ken of the average juror, or the court.”  Judge Thompson explained that “[t]he average juror has no experience with the duties of a bank director including supervising management, establishing and monitoring internal control and a suitable internal audit program, supervision of lending activities, interacting with outside auditors, board procedures, and placing the bank’s interest above personal interest.”

As a result, the trial court did not abuse its discretion when it admitted Dr. H’s testimony.

Case: 390 S.W.3d 830 (Ky.App. 2012), Discretionary Review Denied by Supreme Court Feb. 13, 2013.

By: Kurt Mattson, J.D., LLM