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FDIC Enforcement Decisions and Orders

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   [10,083] In the Matter of Alan L. Lerberg and Peoples Bank and Trust, Parshall, North Dakota, Docket No. FDIC-90-101b (6-13-90).

   Bank and Institution-Affiliated Party of the Bank to cease and desist from practices such as operating with an excessive volume of adversely classified assets; engaging in hazardous and lax collection practices; engaging in violations of applicable laws and regulations; operating with management whose policies and practices are detrimental to Bank; operating with deficient or inadequate loan documentation; engaging in practices which produce inadequate operating income; failing to provide adequate supervision and direction over the affairs of the Bank to prevent unsafe or unsound practices; operating with an inadequate allowance for loan and lease losses; and failing to submit Reports of Condition and Income in accordance with prevailing instructions. (This order was terminated by the order of the FDIC dated 10-21-92; see p 15,540.)
   [.1] Management—Qualifications—Compliance
   [.2] Board of Directors—Management Plan—Minimum Requirements— Review
   [.3] Board of Directors—Candidate List—Review
   [.4] Definition—"Independent with Respect to the Bank"
   [.5] Assets—Adversely Classified—Reduce
   [.6] Equity Capital—Calculation of Ratio—Written Plan
   [.7] Loan Loss Reserve—Adequacy—Report of Condition
   [.8] Loans—Risk Position—Minimum Requirements
   [.9] Loans—Extensions of Credit—Curtail
   [.10] Loans—Interest Accrual—Exception
   [.11] Loan Policy—Written Plan—Review
   [.12] Profit Plan—Minimum Requirements—Review
   [.13] Funds management—Minimum Requirements—Review
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   [.14] Investment Policy—Minimum Requirements—Review
   [.15] Shareholders—Disclosure—Cease and Desist Order
   [.16] Technical Exceptions—Internal Routine and Controls—Correct
   [.17] Collateral—Appraisal—Title and Lien Search
   [.18] Definition—Qualified Appraiser—Title Insurer
   [.19] Violations of Law—Eliminate/Correct
   [.20] Subsidiary of Affiliated Organizations—Prohibited Payments— Exception
   [.21] Loans—Extension of Credit—Curtail—Exception
   [.22] Subsidiary or Affiliated Organizations—Prohibited Transactions— Audit Review
   [.23] Audit—Statement of Policy—Minimum Requirements—Review
   [.24] Trust Department—Statement of Principles—Review—Correct Deficiencies
   [.25] Loans—Adversely Classified—Restitution
   [.26] Compliance—Progress Reports—Frequency

In the Matter of
ALAN L. LERBERG,
INDIVIDUALLY,
AND AS AN INSTITUTION-
AFFILIATED PARTY OF PEOPLES
BANK AND TRUST,
PARSHALL, NORTH DAKOTA
AND
PEOPLES BANK AND TRUST,
PARSHALL, NORTH DAKOTA
(Insured State Nonmember Bank)
ORDER TO CEASE AND DESIST

   Peoples Bank and Trust, Parshall, North Dakota ("Bank") and Alan L. Lerberg ("Individual Respondent"), individually, and as an Institution-Affiliated Party of the Bank as the term Institution-Affiliated Party is defined in section 3(u) of the Federal Deposit Insurance Act ("Act'), 12 U.S.C. § 1813(u), having been advised of their right to a Notice of Charges and of Hearing detailing the unsafe or unsound banking practices and violations of law and/or regulations alleged to have been committed by the Bank and the Individual Respondent and of their right to a hearing on such alleged charges under section 8(b) of the Act, 12 U.S.C. § 1818(b), and having waived those rights, entered into a STIPULATION AND CONSENT TO THE ISSUANCE OF AN ORDER TO CEASE AND DESIST ("CONSENT AGREEMENT") with counsel for the Federal Deposit Insurance Corporation ("FDIC"), dated June 4, 1990, whereby solely for the purpose of this proceeding and without admitting or denying any unsafe or unsound banking practices or violations and law and/or regulations, the Bank and the Individual Respondent consented to the issuance of an ORDER TO CEASE AND DESIST ("ORDER") by the FDIC.
   The FDIC considered the matter and determined that it had reason to believe that the Bank and the Individual Respondent have engaged in unsafe or unsound banking practices and have violated laws and/or regulations. The FDIC, therefore, accepted the CONSENT AGREEMENT and issued the following:
ORDER TO CEASE AND DESIST
   IT IS HEREBY ORDERED, that the Bank, its Institution-Affiliated Parties, and its successors and assigns cease and desist from the following unsafe and unsound banking practices and violations of law and regulations:
   A. operating with an excessive volume of adversely classified assets;
   B. engaging in hazardous lending and lax collection practices, including maintaining an excessive volume of adversely classified loans;
   C. engaging in violations of applicable laws and regulations;
   D. operating with management whose policies and practices are detrimental to the Bank;
   E. operating with deficient or inadequate loan documentation, including but not limited to current financial statements, insurance coverage, title searches or legal opinions, and cash flow and/or operating information;
{{4-1-90 p.C-419}}
   F. engaging in practices which produce inadequate operating income;
   G. failing to provide adequate supervision and direction over the affairs of the Bank to prevent unsafe or unsound practices;
   H. operating with an inadequate allowance for loan and lease losses for the volume, kind and quality of loans held; and
   J. failing to submit Reports of Condition and Income in accordance with prevailing instructions.
   IT IS FURTHER ORDERED, that the Bank, its Institution-Affiliated Parties, and its successors and assigns, take affirmative action as follows:
   [.1] 1. (a) (i) No more than 60 days from the effective date of this ORDER, the Bank shall have and thereafter retain qualified management. Such management shall include a qualified chief executive officer who shall be given stated written authority by the Bank's board of directors, including responsibility for implementing and maintaining the policies of the Bank. The chief executive officer shall have an appropriate level of experience including, but not limited to, lending, collection and loan supervision experience, to perform the duties assigned to that individual by the Bank's board of directors. The Bank shall promptly notify the Regional Director of the FDIC's Kansas City Regional Office ("Regional Director") of the identity of said chief executive officer. Prior to the addition of any individual to the board of directors, or the employment of any individual as a senior executive officer, the Bank shall comply with the requirements of section 32 of the Act, 12 U.S.C. §1831(i) and section 303.14 of the FDIC's Rules and Regulations, 54 Fed. Reg. 53040 and 53043 (to be codified at 12 C.F.R. §303.14).
   (ii) The assessment of whether the Bank has "qualified management" shall be based upon management's conduct, both individual and joint, with respect to the Bank in: (A) complying with the requirements of this ORDER; (B) complying with applicable laws and regulations; and (C) not engaging in any unsafe or unsound banking practice which has an adverse effect on the Bank's asset quality, capital adequacy, earnings, or liquidity.

   [.2] (b) The board of directors shall in no more than 30 days from the effective date of this ORDER develop a written analysis and assessment of the Bank's management and staffing needs ("management plan"), which shall include, at a minimum:

       (i) identification of both the type and number of officer positions needed to manage and supervise properly the affairs of the Bank;
       (ii) identification and establishment of such Bank directors as are needed to provide guidance and oversight to active management;
       (iii) evaluation of each Bank officer, and in particular the chief executive officer, and staff member to determine whether these individuals possess the ability, experience and other qualifications required to perform present and anticipated duties, including adherence to the Bank's established policies and practices, and maintenance of the Bank in a safe and sound condition; and
       (iv) a plan of action to recruit and hire any additional or replacement personnel with the requisite ability, experience and other qualifications, which the board of directors determines are necessary to fill Bank officer or staff member positions consistent with the board's analysis, evaluation and assessment as provided in paragraphs 1(b)(i) and 1(b)(iii) of this ORDER.
   (c) The written management plan and any subsequent modification thereto shall be submitted to the Regional Director for review and comment. No more than 30 days from the receipt of any comment from the Regional Director, and after consideration of such comment, the board of directors shall approve the written management plan and/or any subsequent modification thereto which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank and its Institution-Affiliated Parties shall implement and follow the written management plan and/or any subsequent modification.

   [.3] (d) (i) Within 90 days from the effective date of this ORDER, the board of directors shall prepare a list of potential candidates for the board of directors for {{4-1-90 p.C-420}}consideration by the shareholders of the Bank. The list of candidates shall include individuals who are independent with respect to the Bank, in such number that, if elected, would cause at least two directors to be independent with respect to the Bank. The actions taken in identifying potential candidates, including any communication with such individuals, shall be documented and made a part of the minutes of the board of directors. Copies of these board minutes shall be provided to the Regional Director within 120 days from the effective date of this ORDER.
   (ii) At the next meeting of the shareholders of the Bank, and at each succeeding meeting of the shareholders at which Bank directors are to be elected, the members of the board of directors who are also shareholders shall nominate and support the election of candidates to the board of directors who are independent with respect to the Bank and who have agreed to stand for election to the board of directors, in such number as are necessary to cause at least two directors to be and to remain independent with respect to the Bank.

   [.4] (iii) For purposes of this ORDER, an individual who is "independent with respect to the Bank" shall be any individual (A) who is not an officer of the Bank, any subsidiary of the Bank, or any of its affiliated organizations and who does not own more than 5 percent of the outstanding shares of the Bank or any of its affiliated organizations, (B) who is not related by blood, marriage or common financial interest to an officer of the Bank, any subsidiary of the Bank, or any of its affiliated organizations or to any stockholder owning more than 5 percent of the outstanding shares of the Bank, any subsidiary of the Bank, or any of its affiliated organizations, and (C) who is not indebted to the Bank, directly or indirectly (including the indebtedness of any entity in which the individual has a substantial financial interest), in an amount exceeding 5 percent of the Bank's total equity capital and allowance for loan and lease losses.
   (e) Effective the date of this ORDER, the Bank's board of directors shall meet at least monthly. The board shall prepare in advance and shall follow a detailed written agenda at each meeting, which shall include consideration of actions of any committees. Nothing in the foregoing sentence shall preclude the board from considering matters other than those contained in the agenda. Detailed written minutes of all board meetings shall be maintained and recorded on a timely basis.

   [.5] 2. No more than 10 days from the effective date of this ORDER, the Bank: (a) shall eliminate from its books, by charge-off, collection, or other proper entries, all assets or portions of assets classified "Loss" as of August 7, 1989; and (b) shall either (i) eliminate from its books by charge-off, collection, or other proper entries, or (ii) if the asset is an extension of credit or lease, increase its allowance for loan and lease losses by an amount equal to, 50 percent of those assets or portions of assets classified "Doubtful" as of August 7, 1989, which have not been previously collected, charged off, or otherwise eliminated by other proper entries. Reduction of these assets through use of proceeds of loans made by the Bank does not constitute collection for the purpose of this paragraph.

   [.6] 3. (a) (i) No more than 60 days from the effective date of this ORDER, the Bank shall have equity capital, exclusive of the allowance for loan and lease losses, at or in excess of 6 percent of the Bank's average total assets ("equity capital ratio") and shall thereafter maintain its equity capital ratio at or in excess of such level as calculated herein while this ORDER is in effect.
   (ii) For the purposes of calculating the equity capital ratio required by paragraph 3(a)(i) of this ORDER: (A) The Bank's average total assets shall be the quarterly average of total assets reported in the Bank's Report of Condition for the quarter ending June 30 or December 31, whichever nearest precedes the date of calculation; and (B) The terms "equity capital", "allowance for loan and lease losses" and "total assets" shall have the same meaning as those terms have in the prevailing Instructions for Preparation of Reports of Condition. Subsequent to the effective date of this ORDER, the equity capital ratio shall be computed as of June 30 and December 31, as appropriate.
   (b) If, during the period this ORDER is in effect, the equity capital ratio, exclusive of the allowance for loan and lease losses, declines below 6 percent, the Bank, within 30 days after the date on which the said ratio {{4-1-90 p.C-421}}so declined, shall develop and implement a written plan to increase such ratio up to or in excess of 6 percent. No more than 60 days after the implementation of the written plan, the Bank's equity capital ratio, exclusive of the allowance for loan and lease losses, shall equal or exceed 6 percent and the Bank shall thereafter maintain its equity capital ratio at or in excess of such level as calculated herein while this ORDER is in effect.
   (c) The Bank's board of directors shall maintain in its minutes a written record of any action taken by the Bank to comply with the capital requirements of paragraphs 3(a) through 3(b) of this ORDER.
   (d) Nothing in this ORDER shall operate to subject any individual director of the Bank to a Federal District Court order of enforcement pursuant to section 8(i)(1) of the Act, 12 U.S.C. §1818(i)(1), or imposition of civil money penalties pursuant to section 8(i)(2) of the Act, 12 U.S.C. §1818(i)(2), for failure to utilize such director's personal assets to satisfy the capital requirements of paragraphs 3(a) through 3(c) of this ORDER; provided, however, that the sale of new offerings of common stock or perpetual preferred stock shall not be considered to be a utilization of such director's personal assets, even if such sale may result in the diminution in value of stock held by any director.

   [.7] 4. (a) The Bank shall maintain an allowance for loan and lease losses in accordance with the prevailing requirements of the Instructions for the Reports of Condition and Income ("Instructions").
   (b) Reports of Condition and Income required to be submitted by the Bank as of each Report date, as that term is used in the Instructions, between and including August 7, 1989, and the effective date of this ORDER, shall, at a minimum, reflect an allowance for loan and lease losses that should have been maintained in accordance with the Instructions. If necessary to comply with this paragraph 4(b), the Bank shall file amended Reports of Condition and Income within 10 days from the effective date of this ORDER.
   (c) Prior to the submission of any Report of Condition or Report of Income required to be filed by the Bank after the effective date of this ORDER, the board of directors of the Bank shall: (i) review the adequacy of the Bank's allowance for loan and lease losses, (ii) provide for an adequate allowance, and (iii) accurately report the allowance in any such Report of Condition and Income. The minutes of the board meeting at which such review is undertaken shall indicate the results of the review, including any increases in the allowance, and the basis for determining the amount of allowance provided.

   [.8] 5. (a) Within 30 days from the effective date of this ORDER, the board of directors shall develop a written plan of action to lessen the Bank's risk position in each line of credit aggregating $80,000 or more which was classified "Substandard" or "Doubtful" as of August 7, 1989. In developing such plan, the Bank shall, at a minimum:

       (i) review the financial position of each such borrower, including source of repayment, repayment ability, and alternative repayment sources; and
       (ii) evaluate the available collateral for each such credit, including possible actions to improve the Bank's collateral position.
Based upon such review and evaluation, the written plan of action shall: (A) establish target dollar levels to which the Bank shall reduce the aggregate dollar volume of "Substandard" or "Doubtful" classifications within 6 and 12 months from the effective date of this ORDER; and (B) provide for the submission of written monthly progress reports to the Bank's board of directors for review and notation in the board minutes. As used in this paragraph 5, "reduce" means to (1) collect, (2) charge off, or (3) improve the quality of such assets so as to warrant removal of any adverse classification by the FDIC.
   (b) The written plan of action described by paragraph 5(a) and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner of Banking and Financial Institutions for the State of North Dakota ("Commissioner") for review and comment. No more than 30 days after the receipt of any comment from the Regional Director, the board of directors shall approve the written plan of action, which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank and its Institution-Affiliated Parties shall follow the written plan {{4-1-90 p.C-422}}of action and/or any subsequent modification.

   [.9] 6. Effective the date of this ORDER, the Bank shall not extend, directly or indirectly, credit to, or for the benefit of, any borrower who has a loan or other extension of credit with the Bank that has been charged off or classified, in whole or in part, "Loss," "Doubtful," or "Substandard," and is uncollected, unless a majority of the Bank's board of directors first (a) determines that such advance is in the best interest of the Bank, (b) determines that the Bank has satisfied the requirements set out in paragraph 5 of this ORDER as to such borrower, and (c) approves such advance. A written record of the board of directors' determination and approval of any advance under the terms of this paragraph 6 shall be maintained in the credit file of the affected borrower(s) as well as the minutes of the board of directors. The requirements of this paragraph 6 do not prohibit the Bank from renewing any credit already extended to the borrower.

   [.10] 7. Effective the date of this Order, the Bank shall not accrue interest on any loan that is, or becomes, ninety (90) days or more delinquent as to principal or interest, unless the loan is both well secured and in the process of collection; "well secured" and "in the process of collection" shall have the same meaning as those terms have in the prevailing Instructions for the Reports of Condition and Income. The Bank shall reverse on its books all previously accrued but uncollected interest on any loan that has ceased to accrue interest pursuant to this provision.

   [.11] 8. No more than 90 days from the effective date of this ORDER, the Bank shall revise its written loan policies. The revised written loan policies and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner for review and comment. No more than 30 days after the receipt of any comment from the Regional Director, the board of directors shall approve the written loan policies and/or any subsequent modification thereto which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank and its Institution-Affiliated Parties shall follow the written loan policies and/or any subsequent modification thereto.

   [.12] 9. (a) No more than 60 days from the effective date of this ORDER, the Bank shall develop a written profit plan consisting of goals and strategies for improving the earnings of the Bank, which written profit plan shall include, at a minimum:

       (i) identification of the major areas in, and means by, which the board of directors will seek to improve the Bank's operating performance;
       (ii) realistic and comprehensive budgets;
       (iii) a budget review process to monitor the income and expenses of the Bank to compare actual figures with budgetary projections; and
       (iv) a description of the operating assumptions that form the basis for, and adequately support, major projected income and expense components.
   (b) The written profit plan and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner for review and comment. No more than 30 days after the receipt of any comment from the Regional Director, the board of directors shall approve the written profit plan and any subsequent modification thereto which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank and its Institution-Affiliated Parties shall follow the written profit plan and/or any subsequent modification thereto.

   [.13] 10. (a) No more than 60 days from the effective date of this ORDER, the Bank shall develop a written funds management policy which shall, at a minimum:

       (i) establish adequate recordkeeping systems to track the volume of (A) rate-sensitive assets and (B) rate-sensitive liabilities. Rate-sensitive assets and liabilities are generally defined as those that either mature or can be repriced during a specified time period (90 days, 180 days, one year);
       (ii) establish a range of acceptable ratios for rate-sensitive assets to rate-sensitive liabilities sufficient to protect the bank against excessive interest-rate risk and ensure that an adequate net interest margin is maintained;
       (iii) establish adequate recordkeeping systems to track the volume of (A) stable or core deposits and (B) volatile deposits;
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       (iv) establish guidelines for offsetting a substantial portion of the Bank's volatile deposits and borrowings with liquid, short-term assets;
       (v) establish investment guidelines for funds derived from negotiable-rate certificates of deposit and borrowings, including a maximum large liability dependency ratio. A large liability dependency ratio means the percentage of loans plus other long-term earning assets that may be funded by negotiable-rate certificates of deposit and borrowings;
       (vi) establish a range of acceptable loan-to-deposit ratios, taking into account seasonal deposit fluctuations;
       (vii) establish a borrowing policy which addresses: (A) when or under what conditions the bank may borrow, (B) maximum amounts that may be borrowed, (C) a list of acceptable creditors, and (D) which officers are authorized to borrow;
       (viii) establish contingency plans for meeting large, unexpected withdrawals, which should include: (A) curtailing lending activity with priority given to specific types of credit and (B) establishing lines of credit with other financial institutions which will advance funds on short notice; and
       (ix) establish a funds-management committee to meet at least monthly to determine how best to allocate the Bank's available funding sources among various asset categories after reviewing: (A) the Bank's liquidity position, (B) outstanding commitments such as loan commitments and letters of credit, and (C) the Bank's rate-sensitivity position and net interest margin.
   (b) The funds management policy shall be coordinated with the Bank's loan, investment, operating, and budget and profit planning policies.
   (c) The written funds management policy and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner for review and comment. No more than 30 days from the receipt of any comment from the Regional Director, the board of directors shall approve the written funds management policy and any subsequent modification thereto, which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank and its Institution-Affiliated Parties shall follow the written funds management policy and/or any subsequent modification thereto.

   [.14] 11. No more than 30 days from the effective date of this ORDER, the Bank shall develop a written investment policy consisting of goals and strategies for improving the investments of the Bank. The written investment policy and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner for review and comment. No more than 30 days from the receipt of any comment from the Regional Director, the board of directors shall approve the written investment plan and any subsequent modification thereto, which approval shall be recorded in the minutes of the board. Thereafter, the Bank and its Institution-Affiliated Parties shall follow the written investment plan and/or any subsequent modification thereto.
   12. The Bank shall not declare or pay any dash dividends unless:
   (a) such declarations and payments are made in accordance with applicable State and Federal laws and regulations;
   (b) after payment of such dividends, the equity capital ratio specified in paragraph 3(a)(i) shall not be less than 6 percent and the Bank's allowance for loan and lease losses shall be adequate as described in paragraph 4(a) of this ORDER;
   (c) such declaration and payment of dividends shall be approved in advance by the board of directors of the Bank; and
   (d) at least 30 days prior to the declaration of a cash dividend, written notice of the intention to declare such a dividend shall be given to the Regional Director and the Commissioner for review and comment.
   (e) For purposes of this paragraph, the Bank shall not be required to receive the written approval of, or consent to, the proposed dividend from the Regional Director and/or the Commissioner prior to the payment or the declaration of such dividend, PROVIDED HOWEVER, that:

       (i) nothing shall prohibit the Regional Director and/or the Commissioner from criticizing or adversely commenting upon the proposed dividend,
    {{4-1-90 p.C-424}}
       (ii) failure of the Regional Director and/or the Commissioner to criticize or adversely comment upon the proposed dividend shall not be construed as an admission that the Bank is in, or after payment of the proposed dividend will be in, compliance with the requirements of paragraphs 3 and/or 4, or any other requirements of this ORDER, and
       (iii) failure of the Regional Director and/or the Commissioner to criticize or adversely comment upon a particular proposed dividend shall neither be a waiver of the right to comment nor preclude the Regional Director and/or the Commissioner from criticizing or adversely commenting upon any dividend which is subsequently proposed.

   [.15] 13. Following the effective date of this ORDER, the Bank shall send to its shareholders a description of this ORDER, (a) in conjunction with the Bank's next shareholder communication, and also (b) in conjunction with its notice or proxy statement preceding the Bank's next shareholder meeting. The description shall fully describe the ORDER in all material respects. The description and any accompanying communication, statement, or notice shall be sent to the FDIC, Registration and Disclosure Unit, Washington, D.C. 20429, for review at least 20 days prior to dissemination to shareholders. Any changes requested to be made by the FDIC shall be made prior to dissemination of the description, communication, notice, or statement.

   [.16] 14. (a) No more than 60 days from the effective date of this ORDER, the Bank shall use its best efforts to correct the technical exceptions on loans noted on pages 2-d to 2-d-6 of the FDIC's Report of Examination of the Bank as of August 7, 1989.
   (b) No more than 60 days from the effective date of this ORDER, the Bank shall correct the cited deficiencies in the loans listed for "Special Mention" on pages 2-b to 2-b-4 of the FDIC's Report of Examination of the Bank as of August 7, 1989.
   (c) No more than 90 days from the effective date of this ORDER, the Bank shall correct the internal routine and controls deficiencies noted on page 6-a of the FDIC's Report of Examination of the Bank as of August 7, 1989. The Bank shall provide the Regional Director and the Commissioner with a written statement detailing the form and manner of any action taken, or to be taken, to correct said deficiencies.

   [.17] (d) No more than 60 days from the effective date of this ORDER, the Bank shall:

       (i) on collateral held by the Bank as security for the * * * line of credit:
         (A) obtain a collateral lien search,
         (B) obtain a valuation, and
         (C) conduct a physical inspection of any tangible property.
       (ii) on real estate held as collateral for the * * * line of credit:
         (A) obtain an appraisal from a qualified appraiser, and
         (B) obtain a title search and/or a lienholder's title insurance policy.
       (iii) for purposes of this ORDER:

   [.18] (A) a qualified appraiser shall be an individual certified by and a member of at least one of the nationally recognized professional appraisal organizations. The qualifications and background of each appraiser selected shall be submitted to the Regional Director for review and comment.
   (B) any firm providing a title insurance policy shall be duly licensed to operate in the State of North Dakota. Any individuals performing the collateral lien search, title search, and/or collateral valuation required herein shall be a person who performs said services in the normal course of their employment.
   (C) said individuals shall be independent with respect to the Bank and any of its Institution-Affiliated Parties.

   [.19] 15. No more than 60 days from the effective date of this ORDER, the Bank and the Individual Respondent shall eliminate and/or correct all violations of law and regulations committed by the Bank as described on pages 6-1 to 6-1-q of the FDIC's Report of Examination of the Bank as of August 7, 1989, except for any violations related to the * * * line of credit, which the Bank and the Individual Respondent shall eliminate and/or correct no more than 90 days from the effective date of this ORDER.

   [.20] 16. As of the effective date of this ORDER, the Bank shall not make any pay- {{4-1-90 p.C-425}}ments to, or for the benefit of, any subsidiary or affiliated organization without the prior written consent of the Regional Director and the Commissioner, except for payment of the Bank's allocated share of the consolidated income tax obligation to its holding company in conformance with the FDIC's Statement of Policy on Income Tax Remittance by Banks to Holding Company Affiliates, 43 Fed. Reg. 22241.

   [.21] 17. (a) Effective the date of this ORDER, neither the Bank nor its Institution-Affiliated Parties shall make or cause to be made any extension of credit to:

       (i) any officer, director, or principal shareholder of the Bank;
       (ii) any related interest of an officer, director, or principal shareholder, or
       (iii) any subsidiary or any affiliate, unless the extension of credit;
         (A) Is in compliance with all applicable provisions of Part 215 of the Federal Reserve Board's Regulation O, 12 C.F.R. Part 215;
         (B) Is in compliance with all applicable provisions of sections 23A and 23B of the Federal Reserve Act, 12 U.S.C. §§371c and 371c-1;
         (C) Is in compliance with any other applicable state or federal banking laws and/or regulations;
         (D) If secured by real or personal property:
           (1) is supported by an appraisal of such security, which appraisal shall be conducted by a qualified appraiser who is independent with respect to the Bank, and
           (2) is supported, as appropriate, by a collateral lien search or title search of any property securing said extension of credit. Any title search which is appropriate shall be conducted by such person or persons who are independent with respect to the Bank;
         (E) Is supported by current documentation, including without limitation, property, financial and/or operating statements;
         (F) Is supported by an adequate and realistic repayment plan.
   (b) For purposes of this ORDER:
       (i) "extension of credit" shall be defined as provided in Section 215.3 of Regulation O of the Board of Governors of the Federal Reserve System, 12 C.F.R. §215.3 ("Regulation O");
       (ii) "officer" shall be defined as provided in §215.2(d) of Regulation O;
       (iii) "director" shall be defined as provided in §215.2(c) of Regulation O;
       (iv) "principal shareholder" shall be defined as provided in §215.2(j) of Regulation O;
       (v) "subsidiary" shall be defined as provided in §215.2(I) of Regulation O;
       (vi) "affiliate" shall be defined as provided in §23A(b)(1) of the Federal Reserve Act, 12 U.S.C. Section 371c.

   [.22] 18. (a) Effective the date of this ORDER, the Bank shall not cause or permit * * * :
       (i) to use, in any manner whatsoever, any equipment, property or assets of the Bank; and
       (ii) during regular banking hours, to use, in any manner whatsoever, any Bank officers or employees.
   (b) Within 30 days from the effective date of this ORDER, the Bank shall make, or cause to be made, an independent study or audit of all transactions between the Bank and * * * from January 1, 1987 forward. The Bank's study or audit shall include special emphasis on the utilization in the operation of * * * of (i) real property owned by the Bank, and (ii) the Bank's equipment and personnel (including personnel benefits).
   (c) Within 30 days of the completion of the study or audit, the Bank's board of directors shall hold a meeting of the board to review the findings of the study or audit, and shall report those findings in the minutes of that board of directors meeting. Based on the actual findings of the study or audit, the Bank's board of directors shall as part of its review at the said meeting, make a specific allocation of any real property maintenance and upkeep costs, equipment costs, personnel costs, salary or wages (including personnel benefits) and any other costs or expenses which were incurred by the Bank on behalf of * * * between January 1, 1987, and the date of the study or audit. The Bank's board of directors shall expressly record in the minutes for the said {{4-1-90 p.C-426}}meeting the dollar amount of its allocation of cost for each such item. In no event shall said allocations be less than the actual cost to the Bank of each such item. Promptly after making the allocation of costs, the Bank's board of directors shall take all reasonable action to obtain reimbursement from * * * for any and all costs or expenses incurred by the Bank in excess of payments received from * * *

   [.23] 19. (a) No more than 90 days from the effective date of this ORDER, the Bank shall finalize and implement a written auditing procedure in accordance with the FDIC's Statement of Policy Regarding Independent External Auditing Programs of State Nonmember Banks, 53 Fed. Reg. 47871, and the FDIC's Statement of Policy Providing Guidance on External Auditing Procedures for State Nonmember Banks, 55 Fed. Reg. 2142, copies of which are attached to this Order as Appendices "A" and "B", respectively, and are incorporated herein by reference. The written auditing procedures shall at a minimum provide that the Bank;

       (i) follow the "Basic External Auditing Procedures" prescribed under the headings "Loans", "Allowance for Loan Losses", "Insider Transactions", "Internal Controls", and "Electronic Data Processing Controls" in Appendix B (FDIC's Statement of Policy Providing Guidance on External Auditing Procedures for State Nonmember Banks), and
       (ii) engage an independent auditor to perform an audit of the Bank in accordance with the Bank's written auditing procedures: (A) within 90 days of the effective date of this ORDER, and (B) thereafter at least once during each 12 month period.
   (b) The written auditing procedures and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner for review and comment. No more than 30 days from the receipt of comment from the Regional Director, the board of directors shall approve the written auditing procedure and any subsequent modifications thereto, which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank and its Institution-Affiliated Parties shall follow the written auditing procedures and/or any subsequent modification thereto.
   (c) While this ORDER is in effect the Bank shall provide the Regional Director and the Commissioner with a copy of any auditor's report and any management letter received from the auditor. The Bank shall notify the Regional Director and the Commissioner at least 7 days in advance of the time and date of any meetings between management and the auditor at which any auditing findings are to be discussed and/or presented so that a representative of the FDIC and the Commissioner's Office may attend, if they choose to do so. No more than 90 days after receipt of any auditor's report and any management letter, the Bank shall provide the Regional Director and the Commissioner with a written statement detailing the form and manner of any action taken or to be taken, by the Bank and or the Institution-Affiliated Parties to correct any deficiencies noted in the auditor's report and/or management letter.

   [.24] 20. (a) No more than 90 days from the effective date of this ORDER, the Bank shall develop a written trust policy in accordance with the FDIC's Statement of Principles of Trust Department Management, a copy of which is attached to this ORDER as Appendix "C" and incorporated herein by reference.
   (b) The written trust policy and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner for review and comment. No more than 30 days from the receipt of comment from the Regional Director, the board of directors shall approve the written trust policy and any subsequent modifications thereto, which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank and its Institution-Affiliated Parties shall follow the written trust procedures and/or any subsequent modification thereto.
   (c) No more than 90 days from the effective date of this ORDER, the Bank shall correct the deficiencies commented upon on page 1 and explained in detail on pages 3 through 3-C-1 of the FDIC's Report of Examination of the Trust Department as of August 15, 1989. The Bank shall provide the Regional Director and the Commissioner with a written statement detailing the form and manner of any action taken, or to be taken, by the Bank and/or its Institution-Affiliated Parties to correct said deficien-cies.
{{4-1-90 p.C-427}}

   [.25] 21. (a) The Individual Respondent shall make restitution or provide reimbursement to the Bank in the event any part of the following outstanding loans or lines of credit is adversely classified "Loss" in any Report of Examination received by the Bank from the FDIC or the Commissioner after the effective date of this ORDER or is charged off by the Bank at any time subsequent to August 7, 1989.

Party Loan Number Approximate Adverse Class.
Amount as of 8/7/89
* * * Loans 48229 $52,000 Substandard
49776 16,000 Substandard
50021 28,000 Substandard
50099 93,000 Substandard
50212 16,000 Substandard
50711 22,000 Substandard
Standby Letters 76 10,000 *
of Credit 83 35,000 *
89 25,000 *
* * * 48298 284,000 Substandard
    * Outstanding irrevocable standby letters of credit. These were unfunded on August 7, 1989 and are therefore not adversely classified at this time.
    (b) Such restitution or reimbursement:
         (i) shall be made or provided from Respondent's personal assets; and
         (ii) shall not be paid for or funded in any manner whatsoever from or by the use of the Bank's assets, including, without limitation, by means of any extension of credit from said Bank;
   (c) The prohibition against the use of Bank assets to pay for or fund the restitution or reimbursement required shall not include the regular and customary payment by the Bank of salaries and director's fees for work performed for participation in the conduct of the affairs of the Bank.

   [.26] 22. The Bank shall furnish written progress reports to the Regional Director and the Commissioner detailing the form and manner of any action taken to secure compliance with this ORDER and the results thereof every 90 days, beginning 90 days from the effective date of the ORDER. In addition, the Bank shall furnish such reports on request of either the Regional Director or the Commissioner. All progress reports and other written responses to this ORDER shall be reviewed by the board of directors of the Bank and made a part of the minutes of the board meeting.
   23. This ORDER shall become effective ten (10) days from the date of its issuance.
   The provisions of this ORDER shall be binding upon the Bank, its Institution-Affiliated Parties, successors and assigns.
   The provisions of this ORDER shall remain effective and enforceable except to the extent that, and until such time as, any provisions of this ORDER shall have been modified, terminated, suspended, or set aside by the FDIC.
   Pursuant to delegated authority.
   Dated this 13th day of June, 1990.

Appendix A

STATEMENT OF POLICY REGARDING INDEPENDENT EXTERNAL AUDITING PROGRAMS OF STATE NONMEMBER BANKS
   1. In view of its interest in the financial soundness of banks and the banking system, the FDIC believes that a strong internal auditing function combined with a well-planned external auditing program1 substantially lessens the risk that a bank will not detect potentially serious problems. An external auditing program is a set of procedures designed to test and evaluate high risk areas of a bank's business which are performed by an independent auditor who may


1Terms defined in Appendix A are italicized the first time they appear in this statement of policy.
{{4-1-90 p.C-428}}or may not be a public accountant. The failure to detect and correct potentially serious problems increases the risk a bank poses to the FDIC's insurance fund. A strong internal auditing function establishes the proper control environment and promotes accuracy and efficiency in a bank's operations. An external auditing program complements this function by providing an objective outside view of the bank's operations.
   2. Regardless of the strength of a bank's internal auditing procedures, the FDIC believes that an external auditing program should be considered by a bank's board of directors as part of the cost of operating a bank in a safe and sound manner. An external auditing program assists the bank's board of directors in safeguarding assets and identifying risks inherent in its operation. In addition, an external auditing program may tend to assist directors in the event of litigation on whether an institution's board has exercised reasonable care in protecting the assets of the bank. Thus, the FDIC urges all state nonmember banks to establish and maintain a sound external auditing program.
   3. The FDIC strongly encourages the board of directors of each state nonmember bank to establish an audit committee consisting, if possible, entirely of outside directors. The audit committee or board of directors of each state nonmember bank generally should analyze the extent of the external auditing coverage needed by the bank annually. They should determine whether the bank's needs will best be met by an audit of its financial statements or by an acceptable alternative (described in paragraphs 8 and 9 below). When selecting the scope of the planned external auditing program for the year, the committee or board should ensure that the program will provide sufficient substantive external coverage of the bank's risk areas and any other areas of potential concern, such as compliance with applicable laws and regulations.
   If not, additional external auditing procedures conducted by an independent auditor may be appropriate for a specific year or several years to cover particularly high risk areas of the bank. The decisions resulting from these deliberations should be recorded in the committee's or board's minutes.
   4. If the audit committee or board of directors of a bank, after due consideration, determines not to engage an independent public accountant to conduct an annual audit of the bank's financial statements (or whose parent holding company's consolidated financial statements are not audited), the reasons for the committee's or board's conclusion to use one of the acceptable alternatives or to have no external auditing program should be documented in its minutes. In the evaluation, the committee or board generally should consider not only the cost of an annual audit of the bank's financial statements, but also the potential benefits.
   5. A review of both a bank's internal and external auditing programs has been and will continue to be a part of the FDIC's examination procedures. FDIC examiners will review the nature of each bank's external auditing program in conjunction with the risk areas perceived in that particular bank's business and operations, and they will exercise their judgment and discretion in evaluating the adequacy of a bank's external auditing program. Examiners will not automatically comment negatively to the board of directors of a bank with an otherwise satisfactory external auditing program merely because it does not engage an independent public accountant to perform an audit of its financial statements.

Audit by an Independent Public
Accountant

   6. The FDIC strongly encourages each state nonmember bank to adopt an external auditing program that includes an annual audit of its financial statements by an independent public accountant. A bank that does so would generally be considered to have a satisfactory external auditing program. An external audit of a bank's financial statements benefits management by assisting in the establishment of the accounting and operating policies, internal controls, internal auditing programs, and management information systems necessary to ensure the fair presentation of these statements. An audit also assists boards of directors in fulfilling their fiduciary responsibilities and provides them greater assurance that financial reports are accurate and provide adequate disclosure.
   7. An audit of a bank's financial statements performed by the independent public accountant as of a quarter-end date when the Reports of Condition and Income are prepared is preferable and would permit the {{4-1-90 p.C-429}}bank to use the audited financial statements in the preparation and/or subsequent review of those reports. A bank may also find it more cost effective to be audited during accounting firms' less busy periods. The independent public accountant chosen should be experienced in auditing banks and knowledgeable about banking regulations in order to provide the bank with the most effective service.

Alternatives to an Audit by a Public
Accountant

   8. The FDIC recognizes that a bank's audit committee or board of directors may determine that the external auditing program that will best meet its individual needs for that particular year will be other than an audit of its financial statements by an independent public accountant. The committee or board, after a full review of alternative and/or supplemental approaches for an adequate independent external auditing program, may decide on a well-planned directors' examination, an independent analysis of internal controls or other areas, a report on the balance sheet, or specified auditing procedures by an independent auditor. If the bank has an outside auditing firm that is simply obtaining confirmations of deposits and loans, for example, the committee or board should normally expand the scope of the auditing work performed to include additional procedures to test the bank's high risk areas.
   9. Nonaccounting firms with bank auditing experience and expertise that are independent of the bank are available in some geographic locations. They may provide acceptable directors' examinations, analyses, or specified auditing work at a reasonable cost. In some instances, these firms' services include nonauditing work which enables them to provide suggestions on compliance issues and operational efficiencies. Depending upon the expertise of the firm and the scope of the engagement, these non-accounting firms may be an appropriate choice for an external auditing program.

Newly Insured Banks

   10. The FDIC believes that an adequate external auditing program performed by an independent auditor should be an integral part of the safe and sound management of a bank. Thus, applicants for deposit insurance coverage after the effective date of this statement of policy will generally be expected to commit their bank to obtain an audit of their financial statements by an independent public accountant annually for at least the first three years after deposit insurance coverage is granted.2 The FDIC may determine on a case-by-case basis that an independent audit of financial statements is unnecessary where an applicant can demonstrate that the benefits derived from such an external audit will be substantially provided by other outside sources, or where the applicant is owned by another company and will undergo an audit performed by an independent public accounting firm as part of an audit of the consolidated financial statements of its parent company.

Notification and Submission of
Reports

   11. Whether currently or newly insured, the FDIC requests each state nonmember bank that undergoes any external work, regardless of the scope of the work, to furnish a copy of any reports by the public accountant or other external auditor, including any management letters, to the appropriate FDIC regional office as soon as possible after their receipt by the bank.
   12. In addition, the FDIC requests each bank to promptly notify the appropriate FDIC regional office when any public accountant or other external auditor is initially engaged to perform external auditing procedures and when a change in its accountant or auditor occurs.

Holding Company Subsidiaries

   13. When the audit committee or board of directors of any state nonmember bank owned by another company (such as a bank holding company) considers its external auditing program, it may find it appropriate 2Operating non-FDIC insured institutions should also note that the FDIC expects, unless waived in writing by the FDIC, any applicant for insurance with more than $50 million in assets to have an audit of its financial statements prior to submitting an application, and requests that a copy of the auditor's report be included as part of the application. The FDIC may require such an audit, on a case-by-case basis, for applicants with assets of $50 million or less. Refer to the June 9, 1987 Statement of Policy Regarding Applications for Federal Deposit Insurance by Operating Non-FDIC Insured Institutions, as amended June 24, 1987.
{{4-1-90 p.C-430}}to express the scope of its program in terms of the bank's relationship to the consolidated group. No section of this statement of policy is intended to imply that any state nonmember bank owned by another company is expected to obtain a separate audit of the financial statements of the individual bank. Where the state nonmember bank is directly or indirectly included in the audit of the consolidated financial statements of its parent company performed by an independent public accounting firm, the state nonmember bank may send one copy of the comparable reports by the public accountant or notification of change in accountants for the consolidated company to the appropriate regional director. If several banks supervised by the same FDIC regional office are owned by one parent company, a single copy of each report applicable to the consolidated company may be submitted to the regional office on behalf of all of the affiliated banks.

Troubled Banks

   14. An annual independent external auditing program complements both the FDIC's supervisory process and bank internal auditing programs by further identifying or clarifying issues of potential concern or exposure. It can also greatly aid management in taking corrective action, particularly when weaknesses are detected in internal control or management information systems. For these reasons, an annual audit of bank financial statements performed by an independent public accounting firm or, if more appropriate, specified auditing procedures will be a condition of future enforcement actions, when deemed necessary, or if it appears that any of the following conditions may exist:
   (a) Internal controls and internal auditing procedures are inadequate;
   (b) The directorate is generally uniformed in the area of internal controls;
   (c) There is evidence of insider abuse;
   (d) There are known or suspected defalcations;
   (e) There is known or suspected criminal activity;
   (f) It is probable that director liability for losses exists;
   (g) Direct verification is warranted; and/or
   (h) Questionable transactions with affiliates have occurred.
   15. Such an enforcement action may also require that (a) the bank provide to the appropriate FDIC regional office a copy of the auditor's report and any management letter received from the auditor promptly after the completion of any auditing work and that (b) the bank notify the regional office in advance of the time and date of any meeting between management and the auditor at which any auditing findings are to be presented so that a representative of the FDIC may be present if the FDIC so chooses.

Definitions

   Audit. An examination of the financial statements, accounting records, and other supporting evidence of a bank performed by an independent certified or licensed public accountant in accordance with generally accepted auditing standards and of sufficient scope to enable the auditor to express an opinion on the bank's financial statements as to their presentation in accordance with generally accepted accounting principles (GAAP).
   Audit Committee. A committee of the board of directors, consisting, if possible, entirely of outside directors. To the extent possible, members of the committee should be knowledgeable about accounting and auditing. They should be responsible for reviewing and approving the bank's internal and external auditing programs or recommending adoption of these programs to the full board. Both the internal auditor and the external auditor should have unrestricted access to the audit committee without the need for any prior management knowledge or approval. Other duties of the audit committee should include reviewing the independence of the external auditor annually, being consulted by management when it seeks a second opinion on an accounting issue, overseeing the quarterly regulatory reporting process, and reporting its findings periodically to the full board of directors.
   Directors Examination. A review by an independent third party that has been authorized by the bank's board of directors and is performed in accordance with the board's analysis of potential risk areas. Certain procedures may also be required as a result of state law. A directors' examination consisting solely of such procedures as cash {{4-1-90 p.C-431}}counts and confirmations of loans and deposits would not normally be considered a well-planned director's examination. (Sometimes directors' examinations are similar to so-called "engagement audits" or "operational audits." Nevertheless, no widely accepted national standards exist for the specific procedures that must be performed in directors' examinations or these "audits.")
   External Auditing Program. The performance of procedures to test and evaluate high risk areas of a bank's business by an independent auditor, who may or may not be a public accountant, sufficient for the auditor to be able to express an opinion on the financial statements or to report on the results of the procedures performed.
   Financial Statements. The statements of financial position, income, cash flows (changes in financial position), and changes in shareholders equity together with related notes.
   Independent. No certified public accountant, public accountant, or other auditor will be recognized as independent who is not in fact independent. (Reference is made to §335.604 of the FDIC rules and regulations for the complete definition of the term "independent.")
   Outside Directors. Members of the bank's board of directors who are not officers, employees, or principal stockholders of the bank, its subsidiaries, or its affiliates, and do not have any material business dealings with the bank, its subsidiaries, or its affiliates.
   Public Accountant. A certified public accountant or licensed public accountant who is duly registered and in good standing as such under the laws of the place of his/her residence or principal office, who is licensed by the accounting regulatory authority of his/her state, and who possesses a permit to practice public accountancy.
   Report on the Balance Sheet. An examination of the balance sheet, accounting records, and other supporting evidence performed by an independent certified or licensed public accountant in accordance with generally accepted auditing standards.
   Risk Areas. The risk areas are those particular activities of a specific bank that expose the bank to potential losses if problems were to exist and go undetected. The highest risk areas in banks generally include, but are not necessarily limited to, the valuation of collectibility of loans (including the Reasonableness of the allowance for loan losses, investments, and repossessed and foreclosed collateral; internal controls; and insider transactions.
   By order of the Board of Directors, November 16, 1988.
[Source: 53 Fed. Reg. 47871, November 28, 1988, effective December 28, 1988]

APPENDIX B

STATEMENT OF POLICY PROVIDING
GUIDANCE ON EXTERNAL AUDITING
PROCEDURES FOR STATE
NONMEMBER BANKS
   In its Statement of Policy Regarding Independent External Auditing Programs of State Nonmember Banks that became effective December 28, 1988, the FDIC strongly encourages each state nonmember bank to have an annual audit1 of its financial statements performed in accordance with generally accepted auditing standards by an independent public accountant. Nevertheless, the board of directors of each state nonmember bank is ultimately responsible for safeguarding the bank's assets and ensuring the integrity of its financial statements. The audit committee or board of directors of the bank may determine not to engage an independent public accountant to perform an audit for various reasons. In those instances, the FDIC recommends that each state nonmember bank have an independent external auditor2 (who need not be an independent public accountant) annually perform the auditing procedures3 set forth below as part of its external auditing program.
   Although the purpose of this policy statement is to encourage certain basic external
1Reference is made to Appendix A to the Statement of Policy Regarding Independent External Auditing Programs of State Nonmember Banks for the definitions of terms used in this statement of policy.
2Ibid.
3When a bank engages an independent public accountant to perform less than a full financial statement audit, the engagement letter describing the procedures for which the bank has contracted generally refers to the work as "agreed-upon procedures." The term "auditing procedures" used throughout this statement of policy in meant to encompass these "agreed-upon procedures."
{{4-1-90 p.C-432}}auditing procedures as a less costly alternative for banks choosing not to have a financial statement audit, the auditing procedures recommended in this guidance are basic to any sound external auditing program. For that reason, they should also be among the procedures performed by an independent public accountant in an audit in which an opinion is expressed on a bank's financial statements. Thus, if a bank chooses to have an audit of its financial statements performed by an independent public accountant, such an opinion audit will generally satisfy the objectives of this statement of policy.
   The auditing procedures contained in this statement of policy are intended to address high risk areas common to all banks. However, they do not address all possible risks in a banking organization and each bank must review the risks inherent in its particular business to determine if additional procedures are needed to cover other high risk areas in which it has activities. For example, if a bank or its subsidiaries has significant real estate investments, securities broker-dealer or similar activities (including those described in section 337.4 of the FDIC rules and regulations), or trust department operations, among others, the FDIC urges the bank to consider expanding the scope of its external auditing program so that it includes auditing procedures in these other high risk areas. (Information on external auditing procedures applicable to other banking activities is available from banking industry trade associations and auditing organizations.)
   The independent auditor (or the public accountant) should be informed of and permitted access to all examination reports, administrative orders, and any additional written communication between the bank and the FDIC or state banking authorities.4 The auditor should obtain bank management's written representation that he has been informed of and granted access to all such documents prior to the completion of his field work.
   A review of both a bank's internal and external auditing programs will continue to be part of the FDIC's examination procedures, but examiners will not automatically comment negatively upon a bank that does not have an audit or all of these auditing procedures performed annually by an independent auditor. The examiner will review the risks in each bank's business and operations, and will comment negatively if internal auditing is deficient and/or sufficient external auditing procedures are not performed as often as necessary to assure the safe and sound operation of the bank under examination.

Extent of Testing

   Where the procedures set forth below require testing or determinations to be made, sampling may be used. Both judgmental and statistical sampling may be acceptable methods of selecting samples to test. Judgmental sampling may be particularly suitable for small banks, and sample sizes should be selected consistent with generally accepted auditing standards (for the certified public accountant) or as agreed upon by the auditor and bank client. In any event, the sampling method and extent of testing (including the minimum sample size(s) used) should be disclosed in the auditor's report.
   As with any auditing program under generally accepted auditing standards or otherwise, if an auditing procedure that is set forth below deals with an area or account of the bank in which the amounts and/or risks are not material to the bank's operations and financial results based on the experience and judgment of the auditor, the procedure may be omitted from that year's auditing program. Nevertheless, the auditor would have to review each such area or account each year in order to determine whether to reaffirm his/her conclusion.

Reports to be Filed with the FDIC

   The FDIC's Statement of Policy Regarding Independent External Auditing Programs of State Nonmember Banks requests that each bank that undergoes any external
4In this regard, section 931 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 provides that "Each insured depository institution which has engaged the services of an independent auditor to audit such depository institution within the past 2 years shall transmit to such auditor...a copy of the most recent report of examination received by such depository institution." In addition, each depository institution is required by section 931 to provide such auditor with a copy of any supervisory memorandum of understanding with the depository institution, any written agreement between any federal or state banking agency and the institution, and any report of any action initiated or taken by a federal banking agency under Section 8 of the Federal Deposit Insurance Act (or similar state action) or any civil money penalty assessed against the depository institution or any institution-affiliated party.
{{4-1-90 p.C-433}}auditing work, regardless of the scope of the work, furnish a copy of the reports pertaining to the external auditing program, including any management letters, to the appropriate FDIC regional office as soon as possible after their receipt by the bank. In addition, that policy statement requests each bank to promptly notify the appropriate FDIC regional office when any independent public accountant or other external auditor is initially engaged to perform external auditing procedures and when a change in its accountant or auditor occurs.

External Auditing Procedures
Required by State Banking Regulators

   Some state statutes or state banking authorities require certain auditing procedures (often called "Directors' Examinations") to be performed each year with a report submitted to the state authority. Assuming the state requirements on scope and reporting correspond to or exceed those recommended in this statement of policy and the auditing procedures are performed by an independent external auditor, the bank may satisfy this statement of policy when its state-mandated external auditing program is performed. A copy of the auditor's report prepared for the state may be submitted in lieu of a separate report to the FDIC.

Holding Company Subsidiaries

   When the audit committee or board of directors of any state nonmember bank owned by another company (such as a bank holding company) considers its external auditing program, it may find it appropriate to express the scope of its program in terms of the bank's relationship to the consolidated group. If the state nonmember bank is directly or indirectly included in the audit of the consolidated financial statements of its parent company performed by an independent public accounting firm, this statement of policy is not intended to imply that the bank is expected to have separate external auditing procedures performed. Nevertheless, if the board of directors of the subsidiary bank determines that the bank has activities that involve unusual risks to the subsidiary and these activities were not addressed by the audit of the consolidated entity (because these risks may be immaterial to the consolidated entity), appropriate additional external auditing procedures may need to be considered for the subsidiary bank.
   As provided in the FDIC's Statement of Policy Regarding Independent External Auditing Programs of State Nonmember Banks, where a bank is directly or indirectly included in the audit of a consolidated entity's financial statements, the bank may send one copy of the comparable reports by the public accountant or the notification of a change in accountants for the consolidated company to the appropriate regional director. If several banks supervised by the same FDIC regional office are owned by one parent company, a single copy of each report applicable to the consolidated company may be submitted to the regional office on behalf of all the affiliated banks.

Basic External Auditing Procedures:

LOANS
   1. Inquire as to whether the bank has policies that address the lending and collection functions. Review the bank's loan policies to ascertain whether they address the following items:
   a. General fields of lending in which the bank will engage and the types of loans within each field:
   b. Descriptions of the bank's normal trade area and circumstances under which the bank may extend credit to borrowers outside of such area;
   c. Limitations on the maximum volume of each type of loan product in relation to total assets;
   d. Responsibility of the board of directors in reviewing, ratifying or approving loans;
   e. Lending authority of the loan or executive committee (if such a committee exists) and individual loan officers or classes of officers;
   f. Adherence to legal lending limits;
   g. Types of loans, specifying whether secured and unsecured, which will be granted;
   h. Circumstances under which extensions or renewals of loans are permitted;
   i. Guidelines for rates of interest and terms of repayment for loans;
   j. Documentation required by the bank for each type of loan;
   k. Limitations on the amount advanced in relation to the value of various types of collateral;
{{4-1-90 p.C-434}}
   l. Limitations on the extension of credit through overdrafts;
   m. Level or amount of loans granted in specific industries or specific geographic locations;
   n. Guidelines for participations purchased and/or sold;
   o. Guidelines for documentation of new loans prior to approval, updating loan files throughout the life of the loan, and maintenance of complete and current credit files on each borrower;
   p. Guidelines for loan review procedures by bank personnel including:

       (i) An identification or grouping of loans that warrant the special attention of management;
       (ii) For each loan identified, a statement or indication of the reason(s) why the particular loan merits special attention; and
       (iii) A mechanism for reporting periodically to the board on the status of each loan identified and the action(s) taken by management.
   q. Collection procedures, including, but not limited to, actions to be taken against borrowers who fail to make timely payments;
   r. Guidelines for nonaccrual loans (i.e., when an asset should be placed in nonaccrual status, individuals responsible for identifying nonperforming assets and placing them in nonaccrual status, and circumstances under which an asset will be placed back on accrual);
   s. Guidelines for loan charge-offs;
   t. Guidelines for in-substance foreciosures.
   2. Read the board of directors' minutes to determine that the loan policies have been reviewed and approved. Through review of the board of directors' minutes and through inquiry of executive officers, determine whether the board of directors revises the policies and procedures periodically as needed.
   3. Obtain the minutes of the board of directors and/or loan committee, as appropriate, and, through a comparison of a sample of loans made throughout the period with lending policies, test whether loans funded during the previous year were properly authorized by the appropriate committee or loan officer(s) within the bank's lending limits.
   4. Select a sample of borrowers (including loans from each major secured and unsecured loan category) and determine through examination of loan files and other bank reports whether lending and collection policies are being followed (e.g., type of loan and any extension or renewal of a previous loan are in accordance with loan policy, funds were not advanced until after loan approval was received from proper loan authorization level, and insurance coverage is adequate with the bank named as loss payee).
   5. Using the sample of borrowers selected from each major category of secured loans, determine through examination of files and other bank reports whether collateral policies are being followed (e.g., loan is adequately collateralized, documentation is present and properly prepared, and assignments are perfected).
   6. If material, review policies for lending on floor plan merchandise, warehouse inventory, and accounts receivable to determine that limitations on such loans and directions on verification of collateral by bank inspection are included in the policies. Ascertain that implementing procedures have been established and test for compliance by responsible bank personnel.
   7. Determine whether participations purchased and participations sold transactions have been reported to and authorized by the board of directors or loan committee, if applicable, through review of appropriate minutes.
   8. Confirm a sample of participations purchased and participations sold with participating banks to verify that they are legitimate transactions and that they are properly reflected as being with or without recourse in the bank's records.
   9. Balance detail ledgers or reconcile computer-generated trial balances with the general ledger control accounts for each major category of loans, including loans carried as past due or in a nonaccrual status.
   10. Confirm a sample of all loans within each major category, including past due and nonaccrual loans.
   11. From reports to the board on the status of loans identified as warranting special attention, review the disposition of a sample of loans no longer appearing on these reports.
   12. Test loan interest income and accrued interest by:
{{4-1-90 p.C-435}}
   a. determining the bank's method of calculating and recording interest accruals;
   b. obtaining trial balances of accrued interest;
   c. testing the reconciliation of the trial balances to the general ledger;
   d. determining that interest accruals are not made on nonaccrual loans;
   e. selecting sample items from each major category of loans and:
       (i) determining the stated interest rate and appropriate treatment of origination fees and costs,
       (ii) testing receipt of payments and correctness of entries to applicable general ledger accounts,
       (iii) calculating accrued interest and comparing it to the trial balance, and
       (iv) reviewing recorded book value for appropriate accretion of discount (net origination fees) and amortization of premium (net origination costs); and
   f. performing an analytical review of yields on each major category of loan for reasonableness.

ALLOWANCE FOR LOAN LOSSES

   1. Test charge-offs and recoveries for proper authorization and/or reporting by reference to the board of directors' minutes. Review charged-off loans for any relationship with bank insiders or their related interests.
   2. Review the bank's computation of the amount needed in the allowance for loan losses as of the end of the most recent quarter. Documentation should include consideration of the following matters:
   a. General, local, national and international (if applicable) economic conditions;
   b. Trends in loan growth and depth of lending staff with expertise in these areas;
   c. Concentrations of loans (e.g., by type, borrower, geographic area, and sector of the economy):
   d. The extent of renewals and extensions to keep loans current;
   e. The collectibility of nonaccrual loans;
   f. Trends in the level of delinquent and classified loans compared with previous loan loss and recovery experience;
   g. Results of regulatory examinations; and
   h. The collectibility of specific loans on the "watch list" taking into account borrower financial status, collateral type and value, payment history, and potential permanent impairment.

SECURITIES

   1. Review the investment policies and procedures established by the bank's board of directors (BOD). Review the BOD (or investment committee) minutes for evidence that these policies and procedures are periodically reviewed and approved. The policies and procedures should include, but not be limited to:
   a. Investment objectives, including use of "held for sale" and trading activities;
   b. Permissible types of investments;
   c. Diversification guidelines to prevent undue concentration;
   d. Maturity schedules;
   e. Limitation on quality ratings;
   f. Hedging activities and other uses of futures, forwards, options, and other financial instruments;
   g. Handling exceptions to standard policies;
   h. Valuation procedures and frequency;
   i. Limitations on the investment authority of officers; and
   j. Frequency of periodic reports to the BOD on securities holdings.
   2. Test the investment procedures and ascertain whether information reported to the BOD (or investment committee) for securities transactions is in agreement with the supporting data by comparing the following information on such reports to the trade tickets for a sample of items (including futures, forwards, and options):
   a. Descriptions
   b. Interest rate
   c. Maturity
   d. Par value, or number of shares
   e. Cost
   f. Market value on date of transaction (if different than cost)
   3. Using the same sample items, analyze the securities register for accuracy and confirm the existence of the sample items by examining securities physically held in the bank and confirming the safekeeping of those securities held by others.
{{4-1-90 p.C-436}}
   4. Balance investment subledger(s) or reconcile computer-generated trial balances with the general ledger control accounts for each type of security.
   5. Review policies and procedures for controls which are designed to ensure that unauthorized transactions do not occur. Ascertain through reading of policies, procedures, and BOD minutes whether investment officers and/or appropriate committee members have been properly authorized to purchase/sell investments and whether there are any limitations or restrictions on delegated responsibilities.
   6. Obtain a schedule of the book, par, and market values of securities as well as their rating classifications. Test the accuracy of the market values of a sample of securities and compare the ratings listed to see that they correspond with those of the rating agencies. Review the bank's documentation on any permanent declines in value that have occurred among the sample of securities to determine that any recorded declines in market value are appropriately computed. Examine the bank's computation of the allowance account for securities, if any, for proper presentation and adequacy.
   7. Test securities income and accrued interest by:
   a. determining the bank's method of calculating and recording interest accruals;
   b. obtaining trial balances of accrued interest;
   c. testing the reconciliation of the trial balances to the general ledger;
   d. determining that interest accruals are not made on defaulted issues;
   e. selecting items from each type of investment and money market holdings and:

       (i) determining the stated interest rate and most recent interest payment date of coupon instruments by reference to sources of such information that are independent of the bank,
       (ii) testing timely receipt of interest payments and correctness of entries to applicable general ledger accounts,
       (iii) calculating accrued interest and comparing it to the trial balance,
       (iv) reviewing recorded book value for appropriate accretion of discount and amortization of premium;
   f. performing an analytical review of yields on each type of investment and money market holdings for reasonableness.
   8. Review investment accounts for volume of purchases, sale activity and length of time securities have been held. Inquire as to the bank's intent and ability to hold securities until maturity. (If there is frequent trading in an investment account, such activity may be inconsistent with the notion that the bank has the intent and ability to hold securities to maturity.) Test gains and losses on disposal of investment securities by sampling sales transactions and:
   a. determining sales prices by examining invoices or brokers' advices;
   b. checking for the use of trade date accounting and the computation of book value on trade date;
   c. determining that the general ledger has been properly relived of the investment, accrued interest, premium, discount and other related accounts;
   d. recomputing the gain or loss and compare to the amount recorded in the general ledger; and
   e. determining that the sales were approved by the BOD or a designated committee or were in accordance with policies approved by the BOD.

INSIDER TRANSACTIONS

   1. Review the bank's policies and procedures to ensure that extensions of credit to and other transactions with insiders5 are addressed. Ascertain that these policies include specific guidelines defining fair and reasonable transactions between the bank and insiders and test insider transactions for compliance with these guidelines and statutory and regulatory requirements. Ascertain that the policies and procedures on extensions of credit comply with the requirements of Federal Reserve Regulation O.
   2. Obtain a bank-prepared list of insiders, including any business relationships they may have other than as a nominal customer. Also obtain a list of extensions of credit
5For purposes of this section of the auditing procedures, insiders include all affiliates of the bank (including its parent holding company) and all subsidiaries of the bank, as those terms are defined in section 23A of the Federal Reserve Act, as well as the bank's executive officers, directors, principal shareholders, and their related interests, as those terms are defined in section 215.2 of Federal Reserve Regulation O.
{{4-1-90 p.C-437}}to and other transactions that the bank, its affiliates, and its subsidiaries have had with insiders that are outstanding as of the audit date or that have occurred since the prior year's external auditing procedures were performed. Compare these lists to those prepared for the prior year's external auditing program to test for completeness.
   3. Review the board of directors' minutes, loan trial balances, supporting loan documentation, and other appropriate bank records in conjunction with the list of insiders obtained from the bank to verify that a sample of extensions of credit to and transactions with insiders were:
   a. in compliance with bank policy for similar transactions and were at prevailing rates and terms at that time;
   b. subjected to the bank's normal underwriting criteria and deemed by the bank to involve no more than a normal degree of risk or present no other unfavorable features;
   c. approved by the board of directors in advance with the interested party abstaining from voting; and
   d. within the aggregate lending limits imposed by Regulation O or other legal limits.
   4. Review the bank's policies and procedures to ensure that expense accounts of individuals who are executive officers, directors, and principal shareholders are addressed and test a sample of the actual expense account records for compliance with these policies and procedures.

INTERNAL CONTROLS

General Accounting and
Administrative Controls

   1. Review the board of directors' minutes to verify that account reconciliation policies have been established and approved and are reviewed periodically by the BOD. Determine that management has implemented appropriate procedures to ensure the timely completion of reconciliations of accounting records and the timely resolution of reconciling items.
   2. Determine whether the bank's policies regarding segregation of duties and required vacations for employees (including those involved in the EDP function) have been approved by the BOD, and verify that these policies and the implementing procedures established by management are periodically reviewed, are adequate, and are followed.
   3. Confirm a sample of deposits in each of the various types of deposit accounts maintained by the bank. Inquire about controls over dormant deposit accounts.
   4. Test to determine that reconciliations are prepared for all significant asset and liability accounts and their related accrued interest accounts, if any, such as "due from" accounts; demand deposits; NOW accounts; money market deposit accounts; other savings deposits; certificates of deposit; and other time deposits. Review reconciliations for:
   a. timeliness and frequency;
   b. accuracy and completeness; and
   c. review by appropriate personnel with no conflicting duties.
   5. Compare a sample of balances per reconciliations to the general ledger and supporting trial balances.
   6. Examine detail and aging of a sample of reconciling items from those accounts whose reconciliations have been tested and reviewed and a sample of items in suspense, clearing, and work-in-process accounts by:
   a. testing aging;
   b. determining whether items are followed up on and appropriately resolved on a timely basis; and
   c. discussing items remaining on reconciliations and in the suspense account with appropriate personnel to ascertain whether any should be written off.
   Review a sample of charged-off reconciling and suspense items for proper authorization.
   7. Verify through inquiry and observation that the bank maintains adequate records of its off-balance sheet activities, including, but not limited to, its outstanding letters of credit and its loan commitments. Review the bank's procedures for monitoring the extent of its credit exposure from such activities to determine whether probable or reasonably possible losses exist.

Electronic Data Processing Controls

   1. Read the BOD's minutes to determine whether the BOD has reviewed and approved the bank's electronic data processing (EDP) policies (including those regarding outside servicers, if any, and the in {{4-1-90 p.C-438}}house use of individual personal computers (PCs) and personalized programs for official bank records) at least annually, confirm that management has established appropriate implementing procedures, and verify the bank's compliance with these policies and procedures.
   1. The policies and procedures for either in-house processing or use of an outside service center should include:

       (i) a contingency plan for continuation of operations and recovery when power outages, natural disasters, or other threats could cause disruption and/or major damage to the institution's data processing support (including compatibility of servicer's plan with that of the bank);6
       (ii) requirements for EDP-related insurance coverage which include the following provisions:
         (1) extended blanket bond fidelity coverage to employees of the bank or servicer;
         (2) insurance on documents in transit, including cash letters; and
         (3) verification of the insurance coverage of the bank or service bureau and the courier service;
       (iii) review of exception reports and adjusting entries approved by supervisors and/or officers;
       (iv) controls for input preparation and control and output verification and distribution;
       (v) "back-up" of all systems, including off-premises rotation of files and programs;
       (vi) security to ensure integrity of data and system modifications; and
       (vii) necessary detail to ensure an audit trial.
   b. When an outside service center is employed, the policies and procedures should address the following additional items:
       (i) the requirement for a written contract for each automated application detailing ownership and confidentiality of files and programs, fee structure, termination agreement, and liability for documents in transit;
       (ii) review of each contract by legal counsel; and
       (iii) review of each third party review of the service bureau, if any.7
   2. In the area of general EDP controls, determine through inquiry and observation that policies and procedures have been established for:
   a. Management and user involvement and approval of new or modified application programs;
   b. Authorization, approval and testing of system software modifications;
   c. The controls surrounding computer operations processing;
   d. Restricted access to computer operations facilities and resources including:
       (i) off-premises storage of master disks and PC disks;
       (ii) security of the data center and bank's PCs; and
       (iii) use and periodic changing of passwords.
   3. With respect to EDP applications controls, inquire about and observe:
   a. The controls over:
       (i) Input submitted for processing,
       (ii) Processing transactions,
       (iii) Output,
       (iv) Applications on PCs, and
       (v) Telecommunications both between and within bank offices;
   b. The security over unissued or blank supplies of potentially negotiable items; and
   c. The control procedures on wire transfers including:
       (i) Authorizations and agreements with customers, including who may initiate transactions,
       (ii) Limits on transactions, and
       (iii) Call back procedures.

Auditor's Report to the Bank's Board
of Directors

   After the completion of the auditing procedures (or agreed-upon procedures) set forth above, the independent auditor should evaluate the results of his/her auditing work. The auditor should prepare and promptly submit a report addressed to the
6For further guidance, see the July 1989, FFIEC Policy on Contingency Planning for Financial Institutions and Section 7 of the FFIEC EDP Examination Handbook.
7For further guidance on using a third-party report, see the American Institute of Certified Public Accountant's Audit and Accounting Guide, Audits of Service-Center Produced Records.
{{2-28-93 p.C-439}}board of directors (or audit committee) of the bank detailing the findings and suggestions resulting from the performance of these auditing procedures.
   Independent auditors should include in their report, as a minimum, (1) the accounts or items on which the procedures were applied; (2) the sampling method(s) used; (3) the procedures and agreed-upon extent of testing performed; (4) the accounting basis (either generally accepted accounting principles [GAAP] or the instructions for the preparation of the Reports of Condition and Income [Call Reports]) on which the accounts or items being audited are reported; (5) the auditor's findings; and (6) the date as of which the procedures were performed. The auditor should sign and date the report, which should also disclose the auditor's business address. The report submitted by an independent auditor who is a certified public accountant should be rendered in accordance with the requirements of Statement on Auditing Standards (SAS) No. 35, "Special reports — Applying Agreed-upon Procedures to Specified Elements, Accounts, or Items of a Financial Statement," and SAS No. 62, "Special Reports." Other independent auditors may with to refer to these auditing standards for guidance in preparing their reports.
   The bank is requested to send a copy of this report to the appropriate FDIC regional office as soon as possible after its receipt.
   By order of the Board of Directors. Dated at Washington, D.C., this ___ day of ___, 1990.

APPENDIX C

STATEMENT OF PRINCIPLES OF
TRUST DEPARTMENT MANAGEMENT

   The minimum requirements for sound banking practices in the operation of a Trust Department, and as safeguards for the protection depositors, fiduciary beneficiaries, creditors, stockholders and the public, should include:
   (1) Operation of the Trust Department separate and apart from every other department of the bank, with trust assets separated from other assets owned by the bank and the assets of each trust account separated from the assets of every other trust account; and
   (2) Maintenance of a separate set of books and records for the Trust Department in sufficient detail to properly show all Trust Department activities.
   The board of directors should, by proper resolution included in its minutes:
   (1) Designate an officer, qualified and competent, to be responsible for and administer the activities of the Trust Department, and define his duties;
   (2) Name a trust Committee consisting of at least three directors, at least one of whom shall not be an officer of the bank, to be responsible for and supervise the activities of the Trust Department.
   The Trust Committee should:
   (a) Meet at least once every month;
   (b) Review the assets of each trust account at least once during each period of twelve months;
   (c) Approve all purchases, sales and changes of trust assets;
   (d) Approve the opening of all new trust accounts;
   (e) Approve the closing of trust accounts;
   (f) Keep full minutes of its actions, including its actions on matters included in (a) through (e) above;
   (g) Make periodic reports to the board of its actions.
   (3) Provide competent legal counsel to advise the Trust Officers and the Trust Committee on legal matters pertaining to the administration of the Trust Department;
   (4) Provide for joint custody of trust assets under at least two or more officers and employees;
   (5) Receive the report of the Trust Committee and record its actions thereon in its minutes;
   (6) Make or cause to be made an annual audit of the Trust Department at least once during each period of twelve months and, when possible and practical; provide for internal controls over the Trust Department; and
   (7) Review the examination reports of the Trust Department by Supervisory Agencies and record its action thereon in its minutes. Nothing herein is intended to prohibit the board of directors from acting as the Trust Committee, from designating additional officer administer the operations of the Trust Department and defining their duties, or from appointing additional com {{2-28-93 p.C-440}}mittees for the Trust Department operation and defining the duties of such committees.
______________
   CONTINGENT LIABILITIES represent an estimation by the examiner of the gross possible liability of the institution resulting from purchase of nonconforming investments for trust accounts, unwarranted retention of nonconforming assets, self-dealing, questionable practices and procedures, or other acts of omission or commission which appear not to comply with the terms of governing to instruments or applicable provisions of law and which on accounting may be subject to objection by interested parties. Until appropriate consents, waivers, or releases of liability are obtained from interested parties or nonliability is determined by a court of competent jurisdiction, the liabilities are regarded as "contingent."
   POTENTIAL LOSSES represent the examiner's estimates of those portions of the contingent liabilities, as defined above, which may develop into losses to the institution. The amount of loses indicated is potential rather than definite and fixed, pending settlement of trusts.
   ESTIMATED LOSSES represent the amount of losses which, in the examiner's opinion, appears certain to be sustained by institution as a result of its fiduciary activities.

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