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FDIC Enforcement Decisions and Orders



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[12,424] In the Matter of Heron Lake State Bank, Heron Lake, Minnesota, Docket No. 05-084b (7-7-05).

A cease and desist order was issued, based on findings by the FDIC that it had reason to believe that respondent was engaged in unsafe and unsound practices.

[.1] Board of Directors—Supervision of Bank Affairs, Written Plan

[.2] Management—Qualifications Specified
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[.3] Capital—Tier 1 Capital Increase/Maintain

[.4] Dividends—Dividends Restricted

[.5] Loan Loss Reserve—Establishment of or Increase in Required

[.6] Assets—Charge-off or Collection

[.7] Loans—Extensions of Credit—To Borrowers with Existing Adversely Classified Credits

[.8] Assets—Adversely Classified Assets—Reduction Required

[.9] Loans—Overdue—Written Plan for Reduction Required

[.10] Loans—Risk Position—Correction of Technical Deficiencies Required

[.11] Assets—Special Mention

[.12] Loan Committee—Duties Specified

[.13] Loan Policy—Preparation or Revision of Policy Required

[.14] Internal Loan Review and Grading System—Establishment of Required

[.15] Funds Management and Liquidity—Preparation or Revision of Funds Management Policy Required

[.16] Profit Plan—Preparation of Plan Required

[.17] Audit—Written Policy Required

[.18] Violations of Law—Corrections of Violations Required

[.19] Shareholders—Disclosure of Cease and Desist Order Required

[.20] Compliance Program—Written Compliance Plan Required

[.21] Progress Report—Written Report Required

In the Matter of
HERON LAKE STATE BANK
HERON LAKE, MINNESOTA
(Insured State Nonmember Bank)
ORDER TO CEASE AND DESIST

FDIC-05-084b

Heron Lake State Bank, Heron Lake, Minnesota ("Bank"), having been advised of its right to a NOTICE OF CHARGES AND OF HEARING detailing the unsafe or unsound banking practices and violations of law and regulations alleged to have been committed by the Bank, and of its right to a hearing on such charges under section 8(b) of the Federal Deposit Insurance Act ("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") dated June 30, 2005, with counsel for the Federal Deposit Insurance Corporation ("FDIC"), whereby, solely for the purpose of this proceeding and without admitting or denying any unsafe or unsound banking practices or violations of law or regulations, the Bank consented to the issuance of an ORDER TO CEASE AND DESIST ("ORDER") by the FDIC.

The FDIC considered the matter and determined that it has reason to believe that the Bank has engaged in unsafe and unsound banking practices and violations of law and regulations. The FDIC, therefore, accepts the CONSENT AGREEMENT and issues the following:

ORDER TO CEASE AND DESIST

IT IS HEREBY ORDERED that the Bank, its institution-affiliated parties, as that term is defined in section 3(u) of the Act, 12 U.S.C. §1813(u), and its successors and assigns, cease and desist from the following unsafe or unsound banking practices and violations of law and regulations:

    A. operating with management whose policies and practices are detrimental to the Bank and jeopardize the safety of its deposits;

    B. operating with a board of directors that


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    has failed to provide adequate supervision over and direction to the management of the Bank;

    C. operating with an inadequate level of capital protection for the kind and quality of assets held;

    D. failing to make provision for an adequate allowance for possible loan and lease losses;

    E. operating with an inadequate allowance for loan and lease losses for the volume, kind, and quality of loans and leases held;

    F. engaging in hazardous lending and lax collection practices, including, but not limited to:

      (1) extending and renewing credit in contravention of the Bank's loan policy;

      (2) failing to obtain proper loan documentation;

      (3) failing to obtain adequate collateral;

      (4) failing to establish and monitor collateral margins of secured borrowers;

      (5) failing to monitor and control the disbursement of loan proceeds to ensure that loan proceeds are used for the approved purpose of the loan;

      (6) failing to establish and enforce adequate loan repayment programs; and

      (7) extending and renewing credit without obtaining current and complete financial information;

    G. failing to properly identify risk and assess the level of risk in problem loans;

    H. operating with an excessive level of adversely classified loans and assets, delinquent loans, and non-accrual loans;

    I. operating with an excessive level of assets with credit data or collateral documentation deficiencies;

    J. operating with an inadequate funds management policy;

    K. failing to adequately monitor and control the Bank's compliance with established interest rate risk limits; and

    L. violating laws and regulations, including:

      (1) the legal lending limit restrictions of the State of Minnesota as set forth in M.S.A. §48.24;

      (2) internal audit controls as set forth in in Minnesota State Rules 2675.2600;

      (3) loan participation rules as set forth in Minnesota State Rules 2675.0400;

      (4) section 215.4(a)(1) of Regulation O of the Board of Governors of the Federal Reserve System, 12 C.F.R. §215.4(a)(1);

      (5) section 23B of the Federal Reserve Act, 12 U.S.C. §371c-1;

      (6) the Bank Secrecy Act requirements of section 326.8 of the FDIC Rules and Regulations, 12 C.F.R. §326.8; and

      (7) the requirements of Part 103 of the Treasury Department's Financial Record-Keeping and Reporting of Currency and Foreign Transactions regulations, 31 C.F.R. Part 103.

IT IS FURTHER ORDERED that the Bank, its institution-affiliated parties, and its successors and assigns, take affirmative action as follows:

BOARD SUPERVISION

[.1] 1. (a) Within 30 days from the effective date of this ORDER, the board of directors shall establish specific policies and procedures requiring active management to report in writing to the board regarding the management, operation, and financial condition of the Bank. The reports shall: (1) be made at regular intervals, no less than quarterly; (ii) be in a consistent format; and (iii) contain sufficient detail to enable the board to fully monitor and ensure management's compliance with the Bank's policies, including without limitation, the lending, investment, liquidity, and funds management policies, and the Bank's profit plan and budget.

(b) The board of directors shall completely and accurately record in its minutes all matters considered at each board meeting, including all reports received, all discussions had, all votes taken, and all actions, including policy exceptions, considered and approved.

MANAGEMENT

[.2] 2. (a)(i) No more than 120 days from the effective date of this ORDER, the Bank shall have and thereafter retain qualified management, who shall be provided the necessary written authority to implement the provisions of this ORDER. At a minimum, such management shall include a chief executive officer with proven ability in managing a bank of comparable size and experience in upgrading a low-quality loan portfolio and a senior lending officer with an appropriate level of lending, collection, and loan supervision experience for the type and quality of
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the Bank's loan portfolio. The chief executive officer and the senior lending officer may be the same individual. Each member of management shall have qualifications and experience commensurate with his or her duties and responsibilities at the Bank. The qualifications of management shall be assessed on its ability to:

    (A) operate the Bank in a safe and sound manner;

    (B) comply with the requirements of this ORDER;

    (C) comply with the Bank's established policies and procedures;

    (D) comply with applicable laws and regulations; and

    (E) restore all aspects of the Bank to a safe and sound condition, including asset quality, capital adequacy, earnings, management effectiveness, liquidity, and sensitivity to market risk.

(ii) The Bank shall notify the FDIC's Kansas City Regional Office ("Regional Office") and the Commissioner of the Minnesota Department of Commerce ("Commissioner") (collectively "Supervisory Authorities"), in writing, of the resignation or termination of any of the Bank's directors or senior executive officers within ten days of the event. "Senior executive officer" shall be defined as in section 32 of the Act, 12 U.S.C. §1831(i), and section 303.101(b) of the FDIC Rules and Regulations, 12 C.F.R. §303.101(b).

(iii) Prior to the addition of any individual to the board of directors, the employment of any individual as a senior executive officer, or changing the responsibilities of any senior executive officer so that the person would assume a different senior executive officer position, the Bank shall comply with the requirements of section 32 of the Act, 12 U.S.C. §1831(i), and Subpart F of Part 303 of the FDIC Rules and Regulations, 12 C.F.R. §§303.100–303.104.

(b) Within 30 days from the effective date of this ORDER, the Bank shall develop a written plan ("Management Plan") for the purpose of providing qualified management for the Bank. The Management Plan shall include, at a minimum:

    (i) identification of both the type and number of officer positions needed to properly manage and supervise the affairs of the Bank;

    (ii) identification and establishment of such Bank committees as are needed to provide guidance and oversight to active management;

    (iii) evaluation of all Bank officers and staff members 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 restoration and maintenance of the Bank in a safe and sound condition; and

    (iv) a plan to recruit and hire any additional or replacement personnel with the requisite ability, experience and other qualifications necessary to fill officer or staff member positions consistent with the board's evaluation and assessment pursuant to this paragraph.

(c) The Management Plan shall be submitted to the Supervisory Authorities for review and comment. Within 30 days after receipt of any comments from the Regional Office and after adoption of any changes required by the Regional Office, the board of directors shall approve the Management Plan, 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 Management Plan. Any subsequent modification of the Management Plan shall be submitted to the Supervisory Authorities for review and comment and shall not be implemented without the prior written approval of the Regional Office.

CAPITAL ADEQUACY

[.3] 3. (a) For purposes of this ORDER, "capital ratio" means the level of Tier 1 capital as a percentage of total assets. Tier 1 capital and total assets shall be calculated in accordance with Part 325 of the FDIC Rules and Regulations ("Part 325"), 12 C.F.R. Part 325.

(b) After appropriate entries for an adequate allowance for loan and lease losses ("ALLL") are made in accordance with the requirements of this ORDER, but no later than 30 days from the effective date of this ORDER, the Bank shall have and thereafter maintain a capital ratio in excess of 7 percent.
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(c) Within 30 days from the last day of each calendar quarter after December 31, 2004, the Bank shall determine, from its Reports of Condition and Income, its capital ratio for that calendar quarter. If its capital ratio is less than 7 percent, within 30 days from said required determination, the Bank shall submit a written plan to the Supervisory Authorities, describing the means and timing by which the Bank shall increase such ratio up to or in excess of 7 percent.

(d) The capital ratio analysis required by this paragraph shall not negate the responsibility of the Bank and its board of directors for maintaining throughout the year an adequate level of capital protection for the kind, quality and degree of market depreciation of assets held by the Bank.

RESTRICTION ON DIVIDENDS

[.4] 4. The Bank shall not declare or pay any cash dividend, capital distribution or earnings distribution without the prior written consent of the Supervisory Authorities.

ALLOWANCE FOR LOAN AND LEASE LOSSES

[.5] 5. (a) For purposes of this ORDER and in making the determinations mandated by this paragraph, the board of directors of the Bank shall consider the Federal Financial Institutions Examination Council's Instructions for Preparation of Consolidated Reports of Condition and Income, the Interagency Statement of Policy on the Allowance for Loan and Lease Losses ("ALLL") and any analysis of the Bank's ALLL provided by the FDIC.

(b) Prior to the submission of any Report of Condition and Income required by the FDIC after the effective date of this ORDER, the board of directors of the Bank shall review the adequacy of the Bank's ALLL, provide for an adequate ALLL, and accurately report the same. The minutes of the board meeting at which each review is undertaken shall indicate the findings of the review, the amount of increase in the ALLL recommended, if any, and the basis for determination of the amount of the ALLL provided.

(c) The Bank shall submit to the Supervisory Authorities the analysis supporting the determination of the adequacy of its ALLL. These submissions shall be made with the progress reports otherwise required by this ORDER.

(d) The Bank shall provide for an adequate ALLL prior to any Tier 1 capital determinations required by this ORDER.

ASSET CHARGE-OFF

[.6] 6. No more than 10 days from the effective date of this ORDER, the Bank shall:

(a) eliminate from its books, by charge-off or collection, all assets or portions of assets classified "Loss" as of February 28, 2005; and

(b) eliminate from its books, by charge-off or collection, 50 percent of all assets or portions of assets classified "Doubtful" as of February 28, 2005, that have not been previously collected or charged off.

Elimination or reduction of assets with the proceeds of other Bank extensions of credit is not considered collection for the purpose of this paragraph.

REDUCTION OF SUBSTANDARD ASSETS

[.7] 7. (a) For purposes of this ORDER and as used in this paragraph, "reduce" means to collect, charge off, or improve the quality of "Substandard" assets so as to warrant removal of any adverse classification by the FDIC and the term "asset" shall include the Bank's entire direct and indirect lending relationship with the borrower, including extensions of credit to related interests, as that term is defined in 12 C.F.R. §215.2(n), of the borrower. Furthermore, in developing the plan mandated by this paragraph, the Bank shall, at a minimum, review the financial position of each such borrower, including source of repayment, repayment ability, and alternative repayment sources, and evaluate the available collateral for each such credit, including possible actions to improve the Bank's collateral position.

(b) Within 60 days from the effective date of this ORDER, the Bank shall submit to the Supervisory Authorities, for review and comment, a written plan to reduce the Bank's risk position in each asset in excess of $50,000 which is classified "Substandard" or "Doubtful" in the FDIC's Report of Examination as of February 28, 2005. Within 30 days from the receipt of any comment from the Regional Office, and after due consideration of any recommended changes, the Bank shall approve the plan, which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank shall implement and follow the plan.
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(c) The plan mandated by this paragraph shall include, but not be limited to, the following:

    (i) the dollar levels to which risk in each classified asset will be reduced;

    (ii) a description of the risk reduction methodology to be followed;

    (iii) provisions for the submission of monthly written progress reports to the Bank's board of directors;

    (iv) provisions requiring the board of directors to review the progress reports; and

    (v) provisions requiring the board review to be recorded by notation in the minutes of the board of directors.

PROHIBITION OF ADDITIONAL LOANS TO CLASSIFIED BORROWERS

[.8] 8. The Bank shall not, directly or indirectly, extend any additional credit to, or for the benefit of, any borrower who is already obligated in any manner to the Bank on any extension of credit that has been charged-off the books of the Bank or classified "Loss," in whole or in part, so long as such credit remains uncollected. Additionally, the Bank shall not, directly or indirectly, extend any additional credit to, or for the benefit of, any borrower whose loan or other credit has been classified "Substandard" or "Doubtful," or is listed for Special Mention, and remains uncollected, unless the board of directors adopts a detailed written statement giving the reasons why such extension of credit is in the best interest of the Bank. A copy of such statement shall be placed in the appropriate loan file and shall be incorporated in the minutes of the board of directors.

REDUCTION OF DELINQUENCIES

[.9] 9. Within 60 days from the effective date of this ORDER, the Bank shall adopt and implement a written plan for the reduction and collection of delinquent loans. The plan shall include, but not be limited to, provisions which:

(a) prohibit the extension of credit for the payment of interest;

(b) delineate areas of responsibility;

(c) establish acceptable guidelines for the collection of delinquent credits;

(d) establish dollar levels to which the Bank shall reduce delinquencies within three and six months from the effective date of this ORDER; and

(e) provide for the submission of monthly written progress reports to the Bank's board of directors for review and notation in the minutes of the board of directors.

CORRECTION OF TECHNICAL DEFICIENCIES

[.10] 10. (a) Within 60 days from the effective date of this ORDER, the Bank shall correct the deficiencies in the assets noted on pages 62 through 66, "Assets with Credit Data or Collateral Documentation Exceptions," in the FDIC Report of Examination of the Bank as of February 28, 2005. "Correct" shall encompass documented attempts to collect missing information if not obtained due to circumstances beyond the bank's control.

(b) Within 30 days from the effective date of this ORDER, the Bank shall implement a program to ensure its credit files contain complete, adequate and current documentation.

SPECIAL MENTION

[.11] 11. Within 60 days from the effective date of this ORDER, the Bank shall correct all deficiencies in the assets listed for "Special Mention" in the FDIC Report of Examination of the Bank as of February 28, 2005.

LOAN COMMITTEE

[.12] 12. (a) The Bank's loan committee shall meet at least monthly.

(b) The loan committee shall, at a minimum, perform the following functions:

    (i) evaluate, approve and/or deny loans in accordance with the Bank's loan policy;

    (ii) provide a thorough written explanation of any deviations from the loan policy which shall:

      (A) address how such exceptions are in the Bank's best interest;

      (B) be included in the minutes of the corresponding loan committee meeting; and

      (C) be maintained in the borrower's credit file;

    (iii) review and monitor the status of repayment and collection of past due and maturing loans, of all loans classified "Substandard" or "Doubtful" in the FDIC's February 28, 2005, Report of Examination


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    of the Bank or subsequent regulatory examination, and of all loans included on the Bank's internal watch list;

    (iv) prepare and implement a written plan to lessen the Bank's risk position in each loan classified "Substandard" or "Doubtful" in the FDIC's February 28, 2005, Report of Examination of the Bank and each loan included on the Bank's internal watch list; and

    (v) maintain written minutes of the committee meetings, including a record of the review and status of the loans considered.

(c) All loan committee minutes shall be submitted to, and reviewed by, the Bank's board of directors at their next scheduled meeting.

ADHERENCE TO LOAN POLICY

[.13] 13. Within 30 days from the effective date of this ORDER, the board of directors of the Bank shall:

    (a) establish review and monitoring procedures to ensure that all lending personnel are adhering to established lending procedures and that the directorate is receiving timely and fully documented reports on loan activity, including any deviations from established policy; and

    (b) establish procedures to ensure that the loan committee reviews and monitors the status of repayment and collection of past due and maturing loans, loans classified "Substandard" and "Doubtful" in reports of examination by the Supervisory Authorities, and loans identified as problem loans on the Bank's internal watch list.

LOAN REVIEW SYSTEM

[.14] 14. (a) Within 60 days from the effective date of this ORDER, the Bank shall establish an effective loan review and grading system ("System") to periodically review the Bank's loan portfolio and identify and categorize problem credits. At a minimum, the System shall require:

    (i) evaluation of the overall quality of the loan portfolio;

    (ii) the identification and amount of each delinquent loan;

    (iii) the identification of loans that warrant the special attention of management, and for each loan identified, a statement of the amount and an indication of the degree of risk that the loan will not be fully repaid according to its terms and the reason(s) why the particular loan merits special attention;

    (iv) the identification of credit and collateral documentation exceptions;

    (v) the identification and status of each violation of law, rule or regulation;

    (vi) the identification of loans not in conformance with the Bank's lending policy and exceptions to the Bank's lending policy;

    (vii) the identification of insider loan transactions; and

    (viii) a mechanism for reporting periodically, no less than quarterly, to the board of directors on the status of each loan identified and the action(s) taken by management.

(b) A written report of the Bank's loan review shall be submitted to the board of directors quarterly, as well as documentation of the action taken by the Bank to collect or strengthen assets identified as problem credits. The quarterly internal loan review and grading report shall be kept with the minutes of the board of directors.

FUNDS MANAGEMENT

[.15] 15. (a) Within 60 days from the effective date of this ORDER, the Bank shall:

    (i) establish a management reporting mechanism to project liquidity needs, monitor compliance with the Bank's funds management policies, and define approval procedures for exceptions to policy limits; and

    (ii) adopt and implement the recommendations detailed on pages 10–12 of the FDIC's February 28, 2005, Report of Examination of the Bank for improving the Bank's funds management and liquidity policies.

(b) The Bank shall review its funds management and liquidity policies for adequacy at least annually and, based upon such review, shall revise the policies if necessary to strengthen funds management procedures and maintain adequate provisions to meet the Bank's liquidity needs.

PROFIT PLANS AND BUDGETS

[.16] 16. (a) Within 60 days from the effective date of this ORDER, and within the first 30 days of each calendar year thereafter, the board of directors shall develop a written profit plan consisting of goals and strategies for improving the Bank's earnings
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for the ensuing calendar year. The 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 for all categories of income and expense;

    (iii) a budget review process by which the board of directors will monitor income and expenses and compare actual figures with budgetary projections on not less than a quarterly basis; 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 shall be submitted to the Supervisory Authorities for review and comment. Within 30 days after the receipt of any comment from the Regional Office and after adoption of any changes required by the Regional Office, the board of directors shall approve the written profit plan, 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 profit plan. Any modification of an approved profit plan shall be submitted to the Supervisory Authorities for review and comment and shall not be implemented without the prior written approval of the Regional Office.

AUDITS

[.17] 17. Within 60 days from the effective date of this ORDER, the board of directors shall formulate and submit to the Supervisory Authorities for review and comment a comprehensive written program for internal and external audits. The audit program shall comply with the Interagency Policy Statement on the Internal Audit and Its Outsourcing and the Interagency Policy Statement on External Auditing Programs of Banks and Savings Associations. Within 30 days after the receipt of any comments from the Regional Office and after adoption of any changes required by the Regional Office, the board of directors shall approve the audit program, which approval shall be recorded in the minutes of the board of directors. Thereafter, the Bank shall implement and enforce an effective system of internal and external audits. The internal auditor shall make written monthly reports of audit findings directly to the Bank's board of directors. The minutes of the board of directors shall reflect consideration of these reports and describe any action taken as a result thereof.

VIOLATIONS OF LAW AND REGULATION

[.18] 18. Within 30 days from the effective date of this ORDER, the Bank shall take all feasible steps to eliminate and/or correct all violations of law and regulations listed on pages 22 through 28 of the FDIC's February 28, 2005, Report of Examination of the Bank.

DISCLOSURE TO SHAREHOLDERS

[.19] 19. Following the effective date of this ORDER, the Bank shall send, or otherwise furnish, to its shareholders a description of this ORDER in conjunction with the Bank's next shareholder communication, and 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, notice or statement shall be sent to the FDIC Registration and Disclosure Section, 550 17th Street, N.W., Room F-6043, Washington, D.C. 20429, for review at least 20 days prior to dissemination to shareholders. Any requests for changes made by the FDIC shall be made prior to dissemination of the description, communication, notice or statement.

COMPLIANCE WITH ORDER

[.20] 20. Within 30 days from the effective date of this ORDER, the Bank's board of directors shall have in place a program that will provide for monitoring of the Bank's compliance with this ORDER. Following the adoption of said program, the Bank's board of directors shall review the Bank's compliance with this ORDER and record its review in the minutes of each regularly scheduled board of directors' meeting.

PROGRESS REPORTS

[.21] 21. Within 30 days from the end of each calendar quarter following the effective date of this ORDER, the Bank shall furnish written progress reports to the Regional Director and the Commissioner, signed by each member of the Bank's board of directors, detailing the form and manner of
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any actions taken to secure compliance with this ORDER. Such reports may be discontinued when the corrections required by this ORDER have been accomplished and the Regional Director has, in writing, released the Bank from making further reports.

The effective date of this ORDER shall be 10 days after its issuance by the FDIC.

The provisions of this ORDER shall be binding upon the Bank, its institution-affiliated parties, and any successors and assigns thereof.

The provisions of this ORDER shall remain effective and enforceable except to the extent that, and until such time as, any provision has been modified, terminated, suspended, or set aside by the FDIC.

Issued Pursuant to Delegated Authority

Dated: July 7th, 2005



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