Federal oversight of the banking industry generally takes place through bank examinations. A bank examination is a confidential, non-public dialogue between a regulator and a bank about the bank’s policies and practices. During this dialogue, bank examiners and banks depend on a federal rule known as the bank examination privilege. However, this rule is beginning to break down because of the way it interrelates with state law. The erosion of this rule threatens to undermine bank supervision. I summarize this problem below. This problem in reviewed in greater detail in my legal treatise, The Bank Examination Privilege, which was published earlier this year by the American Bar Association as well as in my recent essay in the Yale Journal on Regulation Bulletin.
The overall purpose of the bank examination privilege is to keep a bank’s federal regulatory examination records confidential when the bank is involved in a lawsuit. Specifically, the privilege is concerned with keeping such records out of the hands of nongovernmental parties, such as customers, who are not part of the examination process.
If this rule didn’t exist, it would be easy for a customer, upon suing a bank, to obtain the bank’s examination records through pre-trial discovery. The customer could then attempt to use such records as evidence against the bank on a motion for summary judgment or at trial. For example, a customer suing a bank on a Truth in Lending Act (“TILA”) claim would scour the bank’s examination records for evidence of TILA violations.
Of course, if examination records were so easily discoverable during litigation, bank supervision simply wouldn’t work. Banks and regulators would be reluctant to communicate candidly with each other out of fear that their communications could later be wielded against the bank. Once used in litigation, such records also could enter the public domain, where they might be misunderstood by a bank’s customers or investors.
Surprisingly, no federal statute or regulation shields a bank’s regulatory examination records in the litigation context. As a result, federal courts developed their own rule, known as the bank examination privilege, to address this issue. Because the privilege is not grounded in a federal statute or regulation, it is considered to be a federal common-law rule. The privilege shields bank examiners’ opinions, recommendations and deliberations from pre-trial discovery – unless a bank’s adversary can demonstrate a sufficiently strong need, known as good cause, to obtain that information. Thus, in the majority of cases, the privilege keeps the most sensitive aspects of a bank’s examination records confidential.
The problem lies in the fact that the privilege is a common law rule, rather than a statutory rule. Under Federal Rule of Evidence 501, federal statutory privileges can apply in all types of federal cases. But under Rule 501, federal common law privileges apply only in federal-question cases – i.e., cases that involve federal law claims or defenses. In pure diversity-jurisdiction cases – i.e., cases that exclusively involve state law claims and defenses – state privilege law replaces federal common law privileges.
Thus, Rule 501 activates the bank examination privilege in federal-question cases. But in diversity-jurisdiction cases, Rule 501 deactivates the privilege and replaces it with state privilege law. State privilege law in this area often departs significantly from the federal approach. Some states, such as Delaware, go well beyond the bank examination privilege by strictly protecting all bank examination records in all cases. See, e.g., 5 Del. C. § 145. On the other hand, some other states, such as Michigan, generally do not treat bank examination records as privileged.
By now, the problem is likely becoming clear. As a practical matter, because of Rule 501, the bank examination privilege cannot achieve its original purpose, which is to reassure federal regulators and banks that their communications will stay confidential. The privilege also thwarts strict confidentiality rules that some states have created.
Two recent decisions help to illustrate this problem. SBAV v. Porter Bancorp was a diversity-jurisdiction case litigated in the U.S. District Court for the Western District of Kentucky. SBAV LP v. Porter Bancorp, Inc., 2015 U.S. Dist. LEXIS 41162 (E.D.Ky. Mar. 31, 2015). During discovery, the plaintiff sought examination records from the FDIC and Federal Reserve. The Court held that, because this was a diversity-jurisdiction case, the bank examination privilege was inapplicable, even though the FDIC and Federal Reserve are federal regulators. Instead, the Court looked to the privilege law of the state, Kentucky, where the Court was situated. The Court found that Kentucky does not consider bank examination records to be privileged. Therefore, the federal records were unprotected.
By contrast, Fisher v. Ocwen Loan Servicing, LLC was a federal-question False Claims Act (“FCA”) case litigated in the U.S. District Court for the Eastern District of Texas. Fisher v. Ocwen Loan Servicing, LLC, 2016 U.S. Dist. LEXIS 73759 (E.D.Tx. Jun. 7, 2015). During discovery, the plaintiff sought records of bank examinations conducted by the West Virginia Department of Financial Institutions (“WVDFI”). The Court found that, under West Virginia law, the documents would be non-discoverable. As the Court noted: “Clearly, these communications originated with an understanding that they would not be disclosed under state law.” Id. at *13. But, the Court held, “there is no reason for WVDFI to assume that these document[s] would be protected in an FCA action based on a federal question, especially given the broad range of permissible discovery.” Id. Thus, the Court applied the bank examination privilege instead of West Virginia privilege law. The Court held that the records were discoverable based on the good cause exception to the bank examination privilege.
In summary: In SBAV, the privilege failed to protect examination records belonging to federal regulators. In Fisher, the privilege governed – however, it only served to counteract state privilege law. These outcomes are arguably true to Rule 501. But they also raise questions about whether the privilege is serving a useful purpose.
What can be done about this problem? One solution would be for Congress to pass a bank examination privilege statute. But in the absence of such a statute, the solution may take the form of a preemption argument. In general, federal common-law rules do not preempt state law. But federal common-law rules can preempt state law “where there are uniquely federal interests at stake.” Ungaro-Benages v. Dresdner Bank AG, 379 F.3d 1227, 1233 (11th Cir. 2004). For example, “[o]ne such exception applies to litigation that implicates the nation’s foreign relations.” Id. In such cases, “[b]ecause our foreign relations could be impaired by the application of state laws, which do not necessarily reflect national interests, federal law applies . . . even where the court has diversity jurisdiction.”
The bank examination privilege implicates a uniquely federal interest: specifically, the interest in effective federal regulation of the banking industry. Like foreign relations, this uniquely federal interest could be impaired if “left to divergent and perhaps parochial state interpretations.” Banco Nacional De Cuba v. Sabbatino, 376 U.S. 398, 401 (1964).Therefore, in cases like SBAV, when litigants seek to uncover confidential federal examination records, the privilege should preempt state law – even if a literal reading of Rule 501 might suggest that state privilege law should apply.
What should judges do in cases like Fisher? In such cases, courts could mold the bank examination privilege to match state law. That is, courts could find that, when state examination records are at issue, the intent of the privilege is to offer the same protection that the bank and its state regulator expected when the examination was conducted.
For the time being, however, banks should be aware that the bank examination privilege does not consistently protect either federal or state bank examination records. Thus, to assess the risk that its examination records will be used as evidence in a future lawsuit, a bank needs to consider both federal and state law. The federal rule – the bank examination privilege – is an important part of the equation. But a bank also needs to consider the privilege laws of the states in which the bank is examined, and in which it litigates cases.
Mr. Epstein is a partner in the New York Office of Dorsey & Whitney LLP. He is the lead author of a new legal treatise, The Bank Examination Privilege, which was published in January by the American Bar Association. He also is a lecturer in law at Columbia Law School.