The nightmare may soon get worse for the directors and officers at the helm last year when Irwin Union Bank and Trust failed.

Court papers reveal that the bankruptcy trustee for Irwin Financial Corp., the bank’s parent, is preparing to sue insiders for more than $40 million, charging mismanagement and breaches of fiduciary duty.

Trustee Elliott Levin and members of his legal team at Indianapolis-based Rubin & Levin did not respond to requests for comment. But new court filings show the trustee first threatened legal action last fall, and last month he hired attorneys to pursue a lawsuit on a contingency-fee basis. Atlanta-based Kilpatrick Stockton would get at least 30 percent of any net recovery, and Rubin & Levin would pocket 5 percent.

“As a result of the actions and inactions by the officers and directors of [Irwin Financial], the debtor and its bankruptcy estate have been damaged by an amount to be determined, but that is no less than $43.5 million,” a filing said.

The end game, legal observers say, is to reap millions from the company’s directors’ and officers’ liability insurance. It’s not clear from court records how much D&O coverage Irwin carried, but a company of its size probably would have at least $10 million and possibly more than $25 million, said Kevin LaCroix, an insurance expert in Beachwood, Ohio.

LaCroix, an attorney and partner with OakBridge Insurance Services, said the assets of individual executives and board members could be on the line if a court judgment exceeded the amount of coverage. He said it would be up to the trustee whether to aggressively pursue individuals’ assets.

Any recoveries would go to Irwin Financial’s beleaguered creditors. The company lists assets of $13 million and liabilities of $230 million. The bulk of the money is owed to holders of debt securities issued by Irwin over the past decade.

Irwin Financial filed for Chapter 7 liquidation on Sept. 18, 2009, the same day the Federal Deposit Insurance Corp. seized Columbus, Ind.-based Irwin Union Bank and Trust, which had $2.7 billion in assets, and Louisville-based Irwin Union Bank FSB, which had $493 million.

IUBT, founded in 1871, was one of Indiana’s oldest banks, and it’s the only Hoosier financial institution to fail since the nation’s economy tanked in 2008. Over the past three years, 308 banks have failed nationally.

At the helm was Chairman and CEO Will Miller, son of legendary Cummins Inc. chief J. Irwin Miller and the fifth generation to run the bank. Other heavyweights on the 10-member board included Dayton Molendorp, CEO of Indianapolis-based OneAmerica Financial Partners Inc., and David Goodrich, retired CEO of the Central Indiana Corporate Partnership. None of the three responded to requests for comment.

Irwin executives said weeks before the FDIC stepped in that all they needed to get back on their feet was a little help from the federal Troubled Asset Relief Program, or TARP. The infusion of federal dollars, Will Miller said in an August 2009 conference call, would pave the way for Irwin to close on $34 million in financing from outside investors, including Columbus, Ind.-based Cummins.

“We have been advised that Treasury is in active discussions with other banking agencies as part of a Plan C about a new program to make additional TARP capital available to community banks,” Miller said at the time, with a hint of optimism.

But a report issued by the Federal Reserve’s inspector general this April blamed the failure on Irwin’s adoption of an aggressive growth strategy early this decade, and on regulators’ failure to take strong supervisory action despite red flags.

As IUBT tripled in size from 2000 to 2005 and began granting increasingly risky mortgage loans, some for as much as 125 percent of a home’s value, “the board of directors and management failed to ensure that the bank’s key corporate control functions and risk management practices kept pace,” the report said.

Indeed, a letter that bankruptcy trustee Levin sent to all officers and directors last fall accused insiders of frittering away assets through improper dividends to shareholders and misguided share repurchases. It also alleges that the officers distributed “materially misleading” financial statements.

The failure of IUBT resulted in estimated losses to the FDIC’s deposit insurance fund of more than $550 million, according to the Inspector General’s report.

The bankruptcy trustee last month filed a federal lawsuit against the FDIC, as receiver of the two banks, in an effort to resolve disagreements over tens of millions of dollars in claims. The FDIC says it’s owed more than $125 million in the bankruptcy; the trustee disagrees and says the FDIC owes the bankruptcy estate more than $74 million.

Levin said in that suit that he expects the FDIC to try to collect on the same D&O coverage he’s after.

That’s to be expected, said LaCroix, who believes federal banking law may give the government first dibs. But neither side is likely to cede anything.

“It’s a scramble,” he said. “Like any salvage operation, there is a fight over scarce assets.”•