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FDIC Enforcement Decisions and Orders

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   [5007] FDIC Docket No. FDIC-80-33a(5-28-81).

   Bank engaging in unsafe or unsound practices was issued an Order of Correction. The bank did not comply with the order within 120 days. As a result, the FDIC Board entered an order terminating federal deposit insurance for the bank, which will be set aside if the bank complies with an order to increase its capital.

   [.1] Order of Correction—Time for Compliance
   Federal Deposit Insurance Act, 12 U.S.C. § 1818(a) requires that a bank be returned to a safe and sound condition within 120 days of issuance of an order of correction, unless a shorter period has been fixed by the appropriate supervisory authorities.

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   [.2] Termination of Insurance—Failure to Comply with Order of Correction
   Bank's failure to comply with an Order of Correction can result in an order terminating federal deposit insurance.

   [.3] Termination of Insurance—Failure to Increase Capital
   When an order of correction required a bank to increase its capital by the expiration of the corrective period (120 days), and when the bank failed to comply with the order, it is within the discretion of the FDIC Board to terminate the bank's federal deposit insurance.

   [.4] Capital—Adequacy—Purpose
   Since at least some losses on loans are inevitable, commercial banks, to avoid placing their depositors at risk, need a capital account against which to charge losses. This is the most important function of capital. The other functions are to provide funds for the purchase of nonearning assets, and to serve as a source of confidence to the public, the investment community, and depositors. The source of capital may be subordinated debt or equity.

   [.5] Capital—Subordinated Debt
   The FDIC has never permitted a bank to satisfy its capital needs by using only subordinated debt.

   [.6] Capital—Debt to Equity Ratio
   Debt capital in commercial banks is not unusual, but the ratio of debt capital to equity capital in banks that use debt capital usually does not exceed one-third.

   [.7] Constitutionality of Federal Deposit Insurance Act
   Neither the FDIC nor an Administrative Law Judge has the authority to rule on the constitutionality of the Federal Deposit Insurance Act.

   [.8] FDIC—Rulemaking Authority
   Instead of determining what an adequate level of bank capital is by the process of case-by-case adjudication, the FDIC could institute a rulemaking proceeding which would provide a definition applicable to all banks subject to its jurisdiction. The FDIC has apparently decided, however, that the definition is so dependent on the circumstances of each bank that no rule of general applicability can be devised.

   [.9] FDIC—Opinions of Commissioners
   Agency commissioners, as well as staff members, are entitled to express their own views on matters of interest to it and to those businesses which it regulates.

   [.10] Capital—Unsafe or Unsound Practices
   Operating with inadequate capital is an unsafe or unsound banking practice.

In the Matter of * * * BANK (INSURED
STATE NONMEMBER BANK)




DECISION
FDIC-80-33a

   Pursuant to its authority under Section 8(a) of the Federal Deposit Insurance Act (12 U.S.C. § 1818(a)), on September 17, 1979, the Federal Deposit Insurance Corporation (the "FDIC") notified * * * (the "Bank") that the Board of Directors of the FDIC (the `Board") had found that the Bank and its board of directors had engaged and were engaging in unsafe or unsound practices in conducting the business of the Bank, that the Bank was in an unsafe or unsound condition to continue operations as an insured bank, and by reason of such conduct and condition the insurance risk of the FDIC was unduly jeopardized. In brief, the unsafe or unsound practices and condition were alleged to be: (1) operating with an inadequate level of capital; (2) operating with excessive loan classifications; and (3) operating in such a manner as to result in deficit earnings.
   An Order of Correction was issued with the Findings of Unsafe or Unsound Practices and Condition which required corrections to be accomplished within 120 days from the receipt of the Order. The Order of Correction required, among other things, (1) that the Bank shall increase its capital and reserves by not less than $5,000,000, with such increase to be accomplished by the sale of common stock, the reduction in {{4-1-90 p.A-67}}classified assets, the direct contribution in cash or any combination of the above and (2) that the Bank maintain adjusted capital, reserves and subordinated debt equal to at least 7 percent of adjusted gross assets (the Order of Correction consisted of eight parts, but these two are the major ones in dispute). After this period had expired, the Bank was reexamined and it was determined that as of the close of business on January 21, 1980, the Bank was still in an unsafe or unsound condition and had not fully complied with the Order of Correction (it was determined that the Bank had not complied with four of the provisions, had complied with three and partially complied with one). Thereafter, on April 28, 1980, the Board issued to the Bank a Notice of Intention to Terminate Insured Status. An order was also issued setting a hearing on the notice. After one continuance, an administrative hearing was held in * * * before Administrative Law Judge Lewis F. Parker. On December 24, 1980, the Administrative Law Judge forwarded to the FDIC his recommended decision and proposed order (the "Recommended Decision"). Both the Bank and the FDIC duly filed exceptions to the Recommended Decision. The case was officially submitted to the Board for decision on March 6, 1981. The Bank's motion for oral argument was denied prior to submission to the Board, but subsequently said motion was granted and oral argument was held on May 20, 1981. On May 19, 1981, the Bank filed a submission of supplemental evidence, which the Board received and added to the record of the case.
   The Board, having considered the matter, concludes that an Order terminating the Bank's federal deposit insurance should be entered, as hereinafter set out.

FINDINGS OF FACT AND CONCLUSIONS OF LAW

   1. The Board adopts as findings the Findings of Fact recommended by Administrative Law Judge Lewis F. Parker in the Reccommended Decision dated December 24, 1980, said Recommended Findings of Fact being numbered 1 through 49, (a copy of which is attached hereto and incorporated herein by reference), save and except the following:

       a. Recommended Finding 14 is deleted in its entirety and the following finding is substituted in lieu thereof:
         "In the 120 days following the issuance of the April 1978 8(a) order, * * * Banks capital ratio dropped to 2.6% and the ratio of classified assets to capital increased to 217%. The FDIC did not initiate a hearing at the end of the correction period."
       b. The last sentence of Recommended Finding 15 is deleted and the following sentence substituted therefor (with the remainder of Recommended Finding 15 being adopted):
         "The phrase `clean bank' generally refers to assets to be acquired in a purchase and assumption transaction."
       c. Recommended Finding 16 is deleted in its entirety and the following finding substituted in lieu thereof:
         "On September 22, 1978, Mr. * * * had a brief meeting with the FDIC in which Mr. * * * advised the FDIC that he had investors who might be interested in acquiring * * * Bank and generally suggested their thoughts on a business plan and a recapitalization program."
       d. Recommended Finding 17 is adopted with the exception that the words "memorandum of understanding" are substituted for the words "written agreement" in the second line thereof.
       e. Recommended Finding 19 is deleted in its entirety and the following finding is substituted in lieu thereof:
         "Thereafter, * * * Bank dismissed its lawsuit challenging the 8(c) Order and agreed to a Stipulated 8(b) Order."
       f. Recommended Findings 36 and 37 are deleted in their entirety.
       g. Recommended Finding 39 is adopted with the exception that the following words are deleted:
         "however, its decision to do so was hardly irrational in light of the problems are likely to be encountered when stock is issued to the public,"
    and the following words are substituted therefor:

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      "The Bank gave as its reason for so acting in defiance of the Order of Correction that it would have the following problems in connection with a public stock issue:"
       h. In the last sentence in Recommended Finding 40, the word "destroyed" is deleted and the word "closed" is substituted. The remainder of said Recommended Finding is adopted with the following additional sentence:
      "However, * * * testified that he could not imagine any situation involving * * * Bank's equity capital being so low that the bank would be closed that he could not correct."
   2. The Board adopts the following Conclusions of Law as findings:
   a. It has been established that as of May 21, 1979, in view of (1) * * * Bank's capital account, (2) the quality of its assets, (3) the probability of future losses and (4) the ratio of its capital to its assets, * * * Bank was in an unsafe and unsound condition to continue operations as an insured bank.

   [.1] b. Section 8(a) of the Federal Deposit Insurance Act, 12 U.S.C. § 1818(a) (Supp. III 1979) requires that a bank be returned to a safe and sound condition within 120 days of issuance of an order of correction, unless a shorter period has been fixed by state authorities. No shorter period was fixed by state authorities in this case.

   [.2-.3] c. As of January 21, 1980, after the expiration of the 120-day corrective period, * * * Bank had not complied with paragraphs 1 and 8 of the Order of Correction. Although * * * Bank had not literally complied with paragraphs 3 and 7 of the order, its failure to do so has not contributed to its unsafe and unsound condition. * * * Bank has complied with the other paragraphs of the order. The failure to comply with paragraph 8 was a technical failure and the Bank has now produced evidence that the capital notes are in fact subordinated in full to the claims of the bank's depositors. However, * * * Bank's failure to comply with paragraph 1 of the Order of Correction was done wilfully. As a result, as of January 1, 1980, * * * Bank remained in an unsafe and unsound condition to continue operations as an insured bank and remains so at this time.
   The Board notes that perhaps there is some ambiguity in the Recommended Decision on the issue of whether the Administrative Law Judge's recommended conclusion that the Bank was in an unsafe and unsound condition as of January 21, 1980 is based solely on the fact that the $5 million in capital notes were not technically subordinated. Recommended Conclusion of Law No. 3 uses the word "principally." The opinion (at page 32) uses the word "primarily." However, elsewhere the opinion (at page 31) states that "* * * Bank's capital ratio is inadequate, is contrary to accepted standards of prudent operation and presents an abnormal risk of loss." This statement is made in the context of equity capital. In this decision, the Board is not relying on the technical issue of whether or not the capital notes were or were not subordinated on January 21, 1980. As previously noted, the Board allowed the Bank to submit supplementary evidence on May 20 1981, which evidence establishes that the capital notes are now subordinated. The Board decision is based on the Bank's failure (and indeed refusal) to comply with paragraph 1 of the Order of Correction. Although such a finding is not required, the Board further notes that the Bank is at this time in violation of paragraph 1 of the Order of Correction.

ORDER

   At this time, a separate Order Terminating Federal Deposit Insurance is being entered by direction of the Board. Said order will terminate the Banks' deposit insurance effective as of the close of business December 31, 1981. The order will also provide, inter alia, that it will be set aside if, by December 1, 1981, the Bank has increased its capital, reserves and subordinated debt by not less than $5,000,000, such increase to be accomplished by: (1) the sale of new common capital in the form of common stock; or (2) the direct contribution of cash by the directors of the Bank; (3) the sale of notes which are subordinated in full to the claims of the depositors of the Bank, PROVIDED, that for the purposes of satisfying this requirement, the total amount of such subordinated debt shall not be in excess of one-third the combined total capital, reserves and subordinated debt of the Bank, AND FURTHER PROVIDED that the form and content of any subordinated notes so used by the Bank must be approved by the FDIC; or (4) any combination of the above means.

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   By order of the Board of Directors, dated May 28, 1981.
/s/ Hoyle L. Robinson
Executive Secretary

II. FINDINGS OF FACT

   A. History of * * * Bank Prior to the FDIC's May 21, 1979 Examination
   1. * * * Bank is a corporation existing and doing business under the laws of the State of * * * and its principal place of business is in * * *.
   2. * * * Bank has been and is an insured State nonmember bank subject to the provisions of the Federal Deposit Insurance Act (12 U.S.C. § 1811 et seq. (Supp. III 1979)) and the rules and regulations of the FDIC (12 C.F.R. Part 301 et seq. (1980)). The FDIC has jurisdiction over the bank and the subject matter of this proceeding.
   3. In 1973, * * * Bank, which was then under different ownership than now, was obligated by the FDIC as a condition to the approval of a branch office, to raise an additional $3 million of capital (TR. 695).1
   4. On September 12, 1975, the ratio of * * * Bank's adjusted capital, reserves, and subordinated debt to adjusted total assets ("capital ratio") was 5.1% (TR. 352-54).
   5. In December 1975, the FDIC liquidated the * * * Bank of * * *. As part of the liquidation proceeding, the assets of that bank were sold to * * * Bank (TR. 231). * * * Bank paid a "premium" for these assets and was thereafter required to write the amount of the premium off against its capital (TR. 358). The effect of this writeoff was that the total capital of * * * Bank, and therefore its capital ratio, was decreased (TR. 695-96).
   6. According to an August 31, 1976 FDIC examination, * * * Bank had an adjusted capital ratio of 3.0% (TR. 357).
   7. After this examination, the FDIC commenced a cease-and-desist proceeding (12 U.S.C. § 1818(b)) to require * * * Bank to comply with the $3 million capital requirement imposed three years before (Finding 3, supra., "The 1976 8(b) order", TR. 698-99).
   8. * * * Bank responded to the 1976 8(b) order, with the consent of the FDIC, by selling $1 million of subordinated notes and $2 million of preferred stock (TR. 729). The addition of $3 million in senior capital (subordinated debt and preferred stock. FDIC Manual or Examination Policy, Section D, p. 4) left * * * Bank with 91% senior capital and 9% equity capital (TR. 732). * * * Bank's capital ration, including all of its subordinated debt, was 4% on December 30, 1977 (FDICX 3 p. 2).
   9. * * * Bank was on the brink of liquidity insolvency in January of 1978 as the result of a "run" on the bank which was most likely created by public disclosures of the FDIC's actions with respect to it. Those disclosures were required by the sale of new stock (FDICX 23B).
   10. On January 31, 1978, because of its liquidity crisis, * * * Bank was labelled "serious problem-potential payoff' by the FDIC2 (FDICX 23C; TR. 531). Mr. * * *, the * * * superintendent of banks, was prepared to take possession of * * * Bank on January 31, 1978 if it could not immediately solve its severe liquidity crisis (FDICX 23C). On February 14, 1978, because the bank had alleviated its liquidity crisis, the FDIC redefined the bank as a "serious problem"3 (FDICX 23D).
   11. Before the current group of investors acquired control of * * * Bank, the controlling stockholder was Mr. * * * (TR. 142-43, 1018-19). According to a FDIC report of examination, Mr. * * * and his managers were most responsible for the bank's distressed condition as of May 21, 1979 (FDICX 1, p. A-1).
   12. On April 19, 1978, the FDIC issued findings of unsafe or unsound practices and conditions and its order of correction. The findings stated that under its former management:

       a. The bank had operated with an inadequate level of capital protection.
       b. The bank had extended numerous lines of credit where credit information


1 Abbreviations used in this recommended decision are: TR.: Transcript of the hearing; FDICX: FDIC exhibit; RX : Respondent's exhibit.

2 Defined as "An advanced Serious Problem state presenting a 50% chance of requiring [FDIC] financial assistance in the near future" (FDICX 23A).

3 Defined as "A bank that threatens to ultimately involve the [FDIC] in a financial outlay unless drastic changes occur" (FDICX 23A).
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    and other documentation have been incomplete or outdated, and lines of credit were extended when loans were inadequately secured.
       c. The bank had failed actively and aggressively to seek repayment of delinquent loans or to enforce programs for the repayment of loans once such programs had been set up.
       d. The bank had failed to establish or follow written loan policies.
       e. The bank had allowed an excess of loans in relation to its total deposits and assets.
       f. The bank's hazardous lending and loan collection practices had resulted in an excessive and disproportionately large volume of poor quality loans in relation to its total assets.
       g. The bank had operated with excessive concentrations of credit extended to three borrowers and their interests. Mr. * * * was specifically named as one of these borrowers.
       h. The bank had operated with inadequate provisions for liquidity (RX 6, pp. 3-6).
   13. The April, 1978 order of correction resulting from the finding of unsafe and unsound practices and conditions included the following paragraph:
       8.(a) By the expiration of the corrective period provided for in this ORDER [120 days from receipt of the order], the Bank shall increase capital, reserves and subordinated debt by not less than $3,000,000. Such increase in capital, reserved and subordinated debt may be accomplished by:
         (i) the sale of new capital in the form of capital stock, notes or debentures; or
         (ii) the reduction of all or part of the assets classified "Loss" specified in paragraph 2 of this ORDER without loss or liability to the Bank; or
         (iii) the direct contribution of cash by the directors of the Bank; or
         (iv) any combination of the above means.
         (RX 6, pp. 9–10).
   14. In the 120 days following the issuance of the April 1978 8(a) order, the bank's capital ratio dropped to 2.6% and the ratio of classified assets4 to capital increased to 271% (FDICX 2, p. 2), but the FDIC did not initiate a hearing at the end of the correction period apparently because it hoped that new investors would take over the bank (TR. 1029-30).
   15. In a meeting between Mr. * * * of FDIC's * * * Regional Office on September 22, 1978, and Mr. * * * representing new investors (some of whom were connected with the * * * Bank of * * * (TR. 1217-19)) interested in purchasing * * * Bank, he was told that * * * Bank would be a "clean bank" at the end of the examination that had begun on September 5, 1978 (TR. 1030-31). The phrase "clean bank" is generally understood to mean that it is impossible that any of the assets being acquired are subject to adverse classification (TR. 699–700).
   16. At the September 22, 1978 meeting, the new investors and the FDIC discussed a proposal to recapitalize * * * Bank with $2.5 million in subordinated debt (TR. 1030). One of the investors, Mr. * * *, testified that he and the other investors believed that there would be no problem putting such a plan for recapitalization into effect (TR. 1034, 1047).`    17. On December 29, 1978, FDIC representatives and the new investors entered into a written agreement under which the FDIC agreed to the injection of $3 million of debt capital into * * * Bank with the understanding that that amount would be replaced by non-preferred equity capital at a ratio of 110% within five years from the date of the injection of the debt capital provided that at the end of five years if the bank did not have a capital-asset ratio of 7% the owners would insert as common stock an amount sufficient to reach the 7% ratio. The agreement also stated that the owners would not be required to insert in excess of $3,300,000. The bank agreed to cause a lawsuit contesting the validity of an FDIC 8(c) order to be dismissed with prejudice and agreed that the 8(c) order

4 There are three categories of adverse classifications which may be assigned to an asset of portion thereof. A "substandard" classification is applied to assets which have certain identifiable shortcomings, such as inadequate collateral or incapacity for repayment which appear to jeopardize their ultimate repayment (FDICX 1, p.3; TR. 48). "Doubtful" assets or loans are similar to substandard except that the weaknesses have progressed to the point that full collection appears to be improbable (TR. 48). A "loss" asset is one not presently deemed collectible, and its maintenance on the bank's books is unwarranted (TR. 49).
{{4-1-90 p.A-71}}would become an 8(b) order which would prevent the sale of classified loans to Mr. * * * or any former or present insider. The regional director of FDIC's * * * Regional office, Mr. * * * indicated his willingness to recommend a resolution of the existing problems by making a favorable recommendation in connection with the application which would be filed by the Bank for the issuance of the $3 million capital note. Mr. * * * also agreed to tell the FDIC's Board that "in his opinion the $3 million capital note referred to does satisfy the capital requirement of the existing 8(a) order against * * * Bank" (FDICX 43).
   18. Although the December 29, 1978 agreement did not limit who could be the lender, when Mr. * * * realized that * * * Bank would be the creditor of the capital notes, he recommended that * * * Bank's application for issuance and retirement of $3 million in capital notes be denied (TR. 1265-67):5
       It is recognized that the bank's proposal seems to meet the technical requirements of the Section 8(a) Order regarding capital. However, the Regional Office continues to be concerned about the relationship between the insiders of * * * Bank and the insiders of * * * Bank. The fact that a transaction involving * * * Bank was never contemplated and had been diligently avoided is significant, since the insiders of * * * Bank were instrumental in the issuance of the Section 8(c) against * * * Bank in December, 1978. Because of this relationship, it is the recommendation of the Regional Office that the bank's capital note proposal be denied.
       (FDICX 50).
   19. Pursuant to the December 29, 1978 agreement, * * * Bank dismissed its lawsuit challenging the 8(c) order and agreed to a stipulated 8(b) order (FDICX 38; TR. 1292).
   20. On April 23, 1979, Mr. * * *, the FDIC's director of the division of bank supervision, wrote a memorandum to the Board discussing the proposed injection of new capital in which he stated that "the proposed debenture issue and the length of the time frame for ultimate capital rehabilitation are considered inappropriate for a bank in this condition. Based on financial data of March 30, 1979, equity capital and reserves represented only $961,000 or 0.9% of total assets" (FDICX 26).
   21. On May 9, 1978, the Board rejected the 8(b) consent and stipulation and terminated the 8(a) proceeding of April 19, 1978 (FDICX 38A-B) because of disagreement among the staff as to the capital requirement language in the order of correction (RX 7; TR. 747).6
   22. On May 21, 1979, the FDIC began a new examination of * * * Bank and, shortly thereafter, the present 8(a) proceeding, was initiated (TR. 747-48). The new order of correction accompanying the findings would require the injection of $5 million of equity capital into * * * Bank. Unlike the Order of Correction of April, 1978, this new order would not permit the use of subordinated debt (FDICX 6, p. 4).
   23. Immediately after * * * Bank was informed of the new 8(a) proceeding, it acquired an additional $5 million in debt capital (RX 23, 24, 25, 26).
   B. The FDIC Examination of * * * Bank As of May 21, 1979
   24. * * * was examined as of the close of business May 21, 1979 by Mr. * * *, who has been a bank examiner for 25 years and who, during that time, has participated in 250 bank examinations (FDICX 1, Cover Page; TR. 23, 24, 26, 31).
   25. As of May 21, 1979:


5 Section 18(i)(1) of the ACT provides that:
   No insured state nonmember bank except a district bank shall, without the prior consent of the Corporation, reduce the amount or retire any part of its common or preferred capital stock or retire any part of its capital notes or debentures.

6 Mr. * * *, assistant director, division of bank supervision, testified about the recommendation that * * * Bank's proposed stipulation and consent be rejected (FDICX 26):
   Okay. This memo [FDICX 26] is the covering document that went to the board of directors of the FDIC with a proposed stipulation and consent to a cease and desist order, and we were recommending that the board of directors refuse to accept that consent. Part of that consent had a capital condition in it which contemplated the sale of subordinated debt of $3 million. The question was clearly unsettled among the various staff people as to whether or not if the bank went ahead and sold that $3 million note whether or not the 8(a) order would have been technically complied with, and we would then, you know, have to accept compliance (TR. 742).
   Mr. * * * described the Board's action as wiping the slate clean (TR. 747).
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       a. * * * Bank's total assets were $96,093,100 (FDICX 1, p. 2).
       b. The net amount of its loans was $54,078,700 (FDICX 1, p. 2).
       c. The total dollar amount of assets subject to adverse classifications was $7,834,700 (FDICX 1, p. 2; TR. 53; see also footnote 4).
       d. The total dollar amount of assets subject to the various adverse classifications was $6,742,100 substandard, $114,900 doubtful, and $977,700 loss (FDICX 1, p. 2; TR. 53–54).
       e. The total dollar amount of loans which were subject to adverse classification was $5,814,900 (FX 1, p. 2; TR. 53).
       f. The total dollar amount of loans subject to the various adverse classification was $4,970,100, substandard, $114,900 doubtful, and $729,000 loss (FDICX 1, p. 2).
       g. Adjusted total assets were $95,911,800. Adjusted total assets were computed by subtracting from the total assets 100% of assets classified loss, 50% of assets classified doubtful and differences in accounts (FDICX 1, p. 2; TR. 75).
       h. Total unadjusted capital and reserves, including the loan valuation reserve, were $3,506,700 (FDICX 1, p. 2; TR. 74).
       i. Adjusted capital and reserves were $2,455,300. Adjusted capital and reserves were computed by subtracting from total capital and reserves 100% of assets classified loss, 50% of assets classified doubtful and differences in accounts (FDICX 1, pp.1, 2; TR. 75).
       j. Adjusted capital and reserves as a percent of adjusted gross assets was 2.6% (FDICX 1, pp. 1, 2; TR. 76). A capital to assets ratio of 2.6% is considered by Mr. * * * to be low. The ratio in banks recently examined by him prior to his testimony ranged between 7.0% and 7.5% (FDICX 1, p. 1; TR. 76–78).
       k. Adversely classified assets of $7,834,700 represented 223.4% of total capital and reserves (FDICX 1, p. 2; TR. 65). According to the examiner, a classified asset to total capital and reserves ratio of 223.4% is high. In banks examined by him during the past several years it would have been unusual for that ratio to be in excess of 50% (TR. 65). Mr. * * *, an FDIC bank examiner who examined the bank at a later date testified that the ratio in well-run non-problem banks examined by him is usually 25% to 35% (TR. 162, 216).
       1. The total capital account, as shown on the books of the bank was $3,506,700, consisting of $2.5 million in capital notes, $2 million in preferred stock, $1.15 million in common stock, $1.65 million in surplus, $853,900 in loan valuation reserves and $4,647,200 in accumulated losses. Thus, the book capital consisted of $2.5 million in debt capital and $1,006,700 in preferred stock (FDICX 1, p. 2; FDICX 4; TR. 73–74).
       m. The debt capital shown on * * * Bank's books, $2.5 million, was impaired by $44,700. The entire amount of the remaining components (preferred stock, common stock, surplus, undivided profits, valuation reserve, and reserve for contingencies and other capital reserves) of the capital account was impaired. Thus, respondent's adjusted capital account consisted entirely of debt capital, which, after deducting, $44,700, totalled $2,455,300 (FDICX 1, pp. 1, 2. FDICX 4; TR. 75, 87-88).
       n. Assets classified substandard, totaling $6,742,100, and 50% of the assets classified doubtful, totaling $57,450, were not considered in computing respondent's adjusted capital account (FDICX 1, p. 2; TR. 80). Historically, the substandard category has been a reliable predictor of future losses. FDIC research indicates that between 25% and 33.3% of loans classified substandard usually become losses (TR. 80).
       o. * * * Bank's loan portfolio showed 40 loans, totaling $1,267,900, which were overdue 6 months or more, and 468 loans, totaling $5,851,100, which were overdue one month or more. The total of all overdue loans was $7,119,000, and that amount was 12.5% of the total loans. In Mr. * * *'s opinion, such a volume of overdue loans is excessive, and indicates material future loan losses (TR. 68-70).
       p. Debt capital in commercial banks is not unusual. Fifty percent of the banks Mr. * * * has examined in the past ten years have had debt capital; however, the ratio of debt to equity capital, in those banks which used debt capital, usually did not exceed 25% to 33% of their total {{4-1-90 p.A-73}}capital account (TR. 89-90; see also TR. 213-14).
       q. Mr. * * * testified that the adjusted capital account of * * * Bank, which consisted 100% of debt capital, was not available for the absorption of future losses and did not provide a capital cushion for the protection of its depositors (TR. 87–88).
       r. According to Mr. * * *, * * * Bank's capital account was inadequate, and an infusion of capital, in the form of equity capital rather than debt capital, was necessary to restore it to a reasonable condition (TR. 88-90). An infusion of $5 million in equity capital, as of June 2, 1979, would have produced an adjusted capital account of $6,955,300, with a debt to equity ratio of 29% (FDICX 4; TR. 90-91) and an adjusted capital to adjusted assets ratio of 6.9% (FDICX 4; TR. 90-93).
       s. The bank's reserve for loan losses was $853,900; there was no other reserve account. The reserve for loan losses was sufficient to cover, or absorb, the loss loans of $729,900 and 50% of the doubtful loans which was $57,450; however, the reserve was not sufficient to cover, or absorb, the total dollar amount of assets classified loss, 50% of assets classified doubtful, and "other liabilities not shown on on bank's books," totaling $1,051,400. The writeoff of that amount therefore exceeded the total amount of the bank's reserves, and further eroded its capital account. It is unusual to exhaust a bank's reserve account by the writeoff of assets, and this fact was taken into account in Mr. * * * decision that the bank's capital was not adequate (FDICX 1, pp. 2, 6; TR. 86-88).
       t. Net loans charged off by * * * Bank during the years 1976 through 1978 far exceeded available reserves for loan losses, resulting in a steady erosion of the bank's capital account, as large losses required transfers to the loan loss reserve account from the capital account (FDICX 1, pp. 1, 1-a, 4; TR. 86).
       u. * * * Bank experienced operating losses of $742,300 in 1976, $4,306,800 in 1978, and $83,200 to May 21, 1979. An operating profit of $87,200 was experienced in 1977. Net operating earnings before taxes for the three years ending December 31, 1978 resulted in an aggregate deficit of $3,636,800 (FDICX 1, p. A-1).
       v. * * * Bank experienced diminutions of its capital account as a result of operating losses and other adjustments, of $2,522,600 in 1976, $4,538,300 in 1978, and $83,200 in 1979 up to May 21, 1979; the net decrease in its capital account for the period January 1, 1976 through May 21, 1979 was $5,280,300 (FDICX 1, pp. 4, 4-a).
       w. * * * Bank's operating losses in 1976 and 1978 resulted primarily from loan losses during those years (FDICX 1, pp. 1-a, 4).
       x. Considering the four previous FDIC examinations of * * * Bank, and the FDIC examination as of May 21, 1979, the table below shows the bank's total classified assets, the percentage relationship between total classified assets and respondent's total capital account:

Date of Examination 8-31-764-04-77 12-30-779-05-78 5-21-79
Total Classified Assets $7,528,000$7,808,000 12,156,000$15,471,000 $7,835,000
Percent of Capital Re-
serves and Sub-ordi-
nated Debt Represent-
ed by Classified As-
sets 131%157% 165%217% 223%

{{4-1-90 p.A-73}}
(FDICX 1, p.1)
   y. Mr. * * * report of examination stated that * * * Bank was technically insolvent7 and he concluded that its directors and officers were engaging in undesirable and objectionable practices. He recommended Section 8 action to remedy the bank's practice of:
   (1). Operating the bank with an inadequate capital base:
   (2). Operating the bank with an excessive volume of classified assets; and
   (3). Operating the bank with inadequate earnings (FDICX 1, pp. A, A-1).
   C. The FDIC Examination of * * * Bank As Of January 21, 1980
   26. After the expiration of the 120-day corrective period required by the September 17, 1979 8(a) order, * * * Bank was examined by * * * who has examined some 150 banks during his 15 years as a bank examiner (TR. 163, 166).
   As of the close of business on January 21, 1980:

       a. The total dollar amount of * * * Bank's assets subject to adverse classification was $4,914,100 (FDICX 5, p. 2; TR. 215).
       b. The dollar amount of its assets subject to the various adverse classifications were $4,118,500 substandard, $30,000 doubtful and $765,600 loss (FDICX 5, p. 2).
       c. The total dollar amount of loans subject to adverse classification was $3,108,200 (FDICX 5, p. 2).
       d. The dollar amounts of loans subject to the various adverse classifications were $2,331,600 substandard, $30,000 doubtful and $746,600 loss (FDICX 5, p. 2).
       e. Nineteen thousand dollars ($19,000) in "Other Assets" were classified loss (FDICX 2, p. 2).
       f. The percentage of * * * Bank's adversely classified loans to its total loan was 5.2% (FDICX 5, p. 6).
       g. The dollar amount of total capital, reserves and subordinated debt was $3,788,800 (FDICX 2, p. 2; TR. 202).
       h. * * * Bank's adversely classified assets of $4,914,100 were 129.7% of its total capital and reserves of $3,788,800 (FDICX 5, p. 2; TR. 215-16).
       i. Adjusted capital, reserves and subordinated debt were $2,901,800 (FDICX 2, p. 2; TR. 202).
       j. Adjusted total assets were $90,828,500 (FDICX 5, p. 2).
       k. * * * Bank's capital ratio (adjusted capital and reserves to adjusted total assets) was 3.2% (FDICX 5, p. 2; TR. 202).
       l. * * * Bank's ratio of equity capital to adjusted total assets was 0.99% (FDICX 7; TR. 211).
       m. Adversely classified assets not considered in computing the bank's adjusted capital and reserves were $4,118,500, which represented approximately 142% of its adjusted capital and reserves of $2,901,800 (FDICX 5, p. 2).
       n. Eight hundred fifty-six (856) loans were overdue at least one month (FDICX 5, p. 6).
       o. The total dollar amount of overdue loans was $4,618,000 (FDICX 5, p. 6).
       p. Out of the total overdue loans, 153 loans were overdue six months or more (FDICX 5, p. 6).
       q. The dollar amount of loans overdue in excess of six months was $852,700 (FDICX 5, p. 6).
       r. During the eight-month period between the examinations of May 21, 1979 and January 21, 1980, $653,559 in assets were newly classified (FDICX 5, p. 3-d).
       s. Considering the three previous FDIC examinations of * * * Bank, and ending with the examination of January 21, 1980, the adjusted assets, the total book capital, the adjusted capital, the ratio of adjusted capital to adjusted assets, and the ratio of equity capital to adjusted assets were as follows:

7 "All of [the bank's] remaining capital is represented by subordinated notes which are impaired by $44,700. For the purpose of capital analysis on page 2, this placed the bank in a technically insolvent condition as of the examination date, since debt capital is obviously unavailable for the absorption of losses" (FDICX 1, p. 1).
Date of Examination12-30-779-05-785-21-791-21-80
Adjusted Assets$123,126,900$110,053,900$95,911,800$90,828,500
Total Book Capital$7,352,500$7,133,500$3,506,700$3,788,800
Adjusted Capital$4,919,400$2,840,500$2,455,300$2,901,800

{{4-1-90 p.A-75}}

Capital Ratio (Including
Debt Capital)4.0%2.6%2.6%3.2%
Capital Ratio (Equity
Capital Only)1.98%0.47%0.0%0.99%

(FDICX 7, 8; TR. 208-13).
   27. Although Mr. * * * believes that * * * Bank's present directors had not addressed what he termed the "critical problem" of the bank—its capital position—he testified that, on the basis of his experience gained during three prior examinations, the bank's new management team (which was hired by the present ownership) was doing a "reasonably competent job in supervising the assets of the bank, particularly the loans" (TR. 217-18). Mr. * * * agreed that the bank's credit files had been significantly improved by the new management team (TR. 99). Also, * * * Bank's equity had increased by $946,800 between Mr. * * * and Mr. * * * examination (TR. 324).
   28. Mr. * * * , * * * Bank's executive vice president, along with other new management personnel, was transferred to * * * Bank from * * * Bank in January of 1979. He was instructed to evaluate * * * Bank's loan portfolio (TR. 99, 832-34). Since that time, one of his primary functions has been to maintain control over the Bank's loan (TR. 836). In his opinion, the quality of the bank's loan portfolio has vastly improved and their loss potential is low (TR. 837-38).
   29. RX 27, prepared by * * * Bank's management indicates that between the January 21, 1980 examination and June 30, 1980, the bank had a profit of $746,700.
   D. The Adequacy Of * * * Bank's Capital

   [.4] 30. Since at least some losses on loans are inevitable, commercial banks, to avoid placing their depositors at risk, need a capital account against which to charge losses which occur (TR. 72). This is the most important function of capital. The other functions are: to provide funds for the purchase of nonearning assets; and to serve as a source of confidence to the public, the investment community and depositors (TR. 71–72, 555). The source of capital may be subordinated debt or equity.8
   31. Mr. * * * , an FDIC employee who supervises activities relating to problem banks, testified that while losses can be charged against subordinated debt in the liquidation process after a bank has been declared insolvent and has been closed, the weakness of subordinated debt is that it is not available to absorb losses in an operating bank;9 only equity capital is available for that purpose (TR. 555-56; see also, TR. 82, 428, * * * , 813-14) Subordinated debt does, however, serve the other functions of capital—i.e., for investment and, to some degree, as a source of confidence (TR. 555).
   32. Another weakness of subordinated debt as capital, according to Mr. * * * is that it involves a fixed interest cost that must be paid to the creditor regardless of the conditions or the earnings of the bank (TR. 556).

   [.5] 33. In view of the opinion expressed by Mr. * * * and other staff members, it is not surprising that the FDIC has adopted a guideline that subordinated debt may not exceed 33.3% of a bank's total capital. This guideline, according to Mr. * * * is relaxed very infrequently, and then only as a stopgap measure, for short periods of time such as 30, 60 or 90 days (TR. 554, 557, 584-85). The FDIC has never permitted a bank to satisfy its capital needs by using only subordinated debt (TR. 585).

   [.6] 34. Debt capital in commercial banks is not unusual, but the ratio of debt capital to equity capital in banks which use debt capital usually does not exceed one-third (TR. 89–90, 213-14).
   35. The FDIC, the Comptroller of the Current and the Board of Governors of the Federal Reserve System take the position that the maximum amount of debt capital in the capital structure of a bank may not exceed one third of the bank's total capital (TR. 644-65). The reason why these agencies


8 The FDIC Manual of Examination Policy (Section D, p. 4) defines capital as "common and preferred stock and subordinated capital notes and debentures."

9 Absent an agreement by the holders of the debt to the contrary. No such agreement between * * * Bank and the holders of subordinated debt has been made.
{{4-1-90 p.A-76}}have chosen this particular ratio is not explained in this record, but Mr. * * * argued that while there is fluctuation around the guidelines: "The fact that the industry has adopted that as somewhat of a standard is indicative that it at least meets some sense of what's acceptable." However, there have been no studies done by the FDIC to prove the validity of its one- third ceiling (TR. 717-18).
   36. The FDIC has not always adhered to its guidelines. Under Section 13 of the FDIA, 12 U.S.C. §1823(c), it has the authority to aid banks threatened with closing by issuing subordinated notes (TR. 759-60). In the case of * * * Bank, a news release announced that:
       A $500-million assistance package designed to assure the viability and continued strength of * * * Bank, N.A., to be provided jointly by the Federal Deposit Insurance Corporation and a group of banks, including many of the nation's largest, was announced today . . . . Assistance to the * * * bank is in the form of five-year subordinated debt which will enable the bank to strengthen its capital account, improve operating performance, and continue its service to the community.
(RX 8).
   37. The purpose of the infusion of $500 million of debt capital into * * * was to strengthen its capital position "through its improved earnings and, potentially, through an infusion of equity from exercise of warrants to purchase holding company stock" (RX 8). Although the eventual hope is that much of * * * * * * debt capital will be converted to equity capital, there is no guarantee that the warrants will be exercised (TR. 764). In the case of another bank,10 the FDIC has lent it money under the "emergency bail-out" provision of Section 13(c) in 1971 and 1976. The debt is subordinated (TR. 679-80).
   38. One advantage which debt capital has over equity capital is that tax laws permit a bank to deduct interest payments as a business expense but do not allow a similar deduction when dividends are paid (TR. 465). Mr. * * * , a professor of finance at the University of * * * (TR. 807), testified that at a "normal" level of interest rates (8-12%), debt capital might not be any more costly to the bank than equity because:
       You would be paying dividends to the equityholders, and hence the interest payment is not necessarily a 100 percent drain on the bank because you would have to offset those with the amount of dividends that you would pay on the alternate common stock which possibly could be in the same range or may even be more. And, in fact, if you were to pay dividends, you would have to earn—assuming that you ran out of your tax benefits, you would then have to earn a considerable amount more to pay the dividends than you would just to pay the subordinated debt, assuming that you didn't have a tax break which they currently are now enjoying . . . .
(TR. 826).
   39. * * * Bank chose, in defiance of the FDIC's guidelines, to raise $5 million of capital through debt rather than through the issuance of stock; however, its decision to do so was hardly irrational in light of the problems likely to be encountered when stock is issued to the public:
       a. The public disclosures necessitated by an offering might cause a decline in deposits and a liquidity crisis (TR. 133, 822-23);
       b. The cost of issuing stock might be greater than the cost of issuing subordinated notes because of underwriting costs and the degree to which stock might have to be discounted (TR 815-16)
       c. Several more months might be needed to raise capital from stock (RX 7; TR. 1105-06);
       d. The bank would have to be reorganized if the stock sold below par value (TR. 820-21); and
       e. The interests of minority stockholders would be "swamped" (TR. 820).
   40. Dr. * * * , who is familiar with the * * * area, concluded that "with full disclosure of all the things that are going on in [* * * Bank], I would say that the prospect of selling $5 million of common stock in * * * is not very good" (TR. 820). If * * * Bank's FDIC deposit insurance were terminated, Mr. * * * agreed that there was "a pretty high probability" that it would be destroyed (TR. 664).

10 Its name is not revealed in the record.
{{4-1-90 p.A-77}}
E. * * * Bank's Capital Structure
   41. Ms. * * * , a financial economist in the FDIC's division of research, prepared exhibits comparing * * * Bank and nine other banks which are similar to it in size, deposit structure and the makeup of their loan portfolios. The exhibits were based on Reports of Condition filed by these banks as of March 31, 1980. The exhibit reveals that * * * Bank's ratio of total equity capital to total assets was 1.2%. The ratios for the other nine banks ranged from 6.2% to 11.7% (FDICX 12–18; TR. 411).
   42. After analyzing liquidity, interest rate sensitivity and earnings, Ms. * * * concluded that * * * Bank and the nine other banks faced substantially the same degree of risk and that there was, therefore, no apparent justification for * * * Bank's equity to total asset ratio of 1.2% as compared to that of the nine other banks (FDICX 12-18; TR. 426).
   43. Ms. * * * also conducted a computer screening of all banks in the United States and found that of the some 15,000 banks in the country, only four (one of which was * * * Bank) had equity to total asset ratios of less than 2.0% (TR. 445).
   44. An exhibit entitled "Condensed Statement of Reports of State and National Banks of America," dated March 31, 1980 reveals that the amount of * * * Bank's equity capital was $1,027,000 and its assets were $87,869,000, producing an equity capital to assets ratio of 1.1%. This compares to similar ratios, for all banks in the State of * * * ranging upward from approximately 4.0%. Compared with * * * Bank, which had approximately the same assets, the equity capital of * * * Bank was less than one-third that of * * * Bank. Compared with the Bank of * * *, which had approximately the same amount of equity capital, the assets of * * * Bank were approximately 14 times larger (RX 9; TR. 795-96). Nine of the twenty-two banks referred to in RX 9 have some debt capital as part of their capital structure; however, in all of these banks (except * * * Bank) the amount of debt capital was less than one-third of the total capital.
   F. The Status Of * * * Bank's Debt Capital
   45. Mr. * * * , a director of * * * Bank and a director and the chief operating officer of the * * * Bank of * * * (TR. 1012) testified about the capital note agreements (RX 23, 25) and the capital notes totalling $5 million (RX 24, 26) which are the central issue in this proceeding.
   Paragraph 2, p. 1 of the capital note (RX 24) states:
    Notwithstanding that this Note is denominated as a Capital Note, this Note is not to be treated as a Capital Note (capital obligation) unless and until it has been approved as such pursuant to * * * Revised Statutes §6-189 by the * * * Superintendent of Banks. Upon approval by the * * * State Superintendent of Banks, this Note shall automatically become a subordinated Capital Note and all provisions of this Note applicable by reasons of this Note being a subordinated Capital Note shall automatically become effective.
   The * * * superintendent of banks has not approved these notes as capital notes (TR. 1196), and I find, therefore, that they are not subordinated.
   46. Because of the questions raised by the refusal of the * * * superintendent of banks to approve the notes as capital notes, the noteholders, * * * Bank and * * * advised * * * Bank that:
       This will confirm the understanding which we have held at all times that indeed the promissory notes are, and have been at all times from the date of execution fully subordinated notes, subordinated in full to the claims of the depositors of * * * Bank and to all others who, in the normal course of events, would take priority over any other subordinated obligation of * * * Bank. The undersigned stands ready to execute any documents, or to place upon the face of the promissory notes any legend or notation which you might consider necessary to give notice to one and all, and thereby make absolutely clear, that the promissory notes in issue are now and have been at all times fully subordinated notes (RX 28, 29).
   G. * * * Bank's Compliance With Order of Correction
   47. * * * Bank was examined by Mr. * * * at the end of the 120-day corrective period for compliance with the order of correction issued by the FDIC on September {{4-1-90 p.A-78}}    17, 1979. Mr. * * * concluded in his report of examination that as of January 21, 1980 * * * Bank:
   a. Had not complied with the provisions of paragraph 1 of the order of correction (FDICX 5, pp. A, A-1; Tr. 183-87) which states in part:
       1.(a) By the expiration of the corrective period provided for in this ORDER, the Bank shall increase its capital and reserves by not less than $5,000,000. Such increase in capital and reserves may be accomplished by:
         (i) the sale of new common capital in the form of common stock, or
         (ii) the reduction of all or part of the assets classified "Loss" and 50 percent of the assets classified "Doubtful" as specified in paragraph 3 of this ORDER without loss or liability to the Bank; or
         (iii) the direct contribution of cash by the directors of the Bank; or
         (iv) any combination of the above means.
   b. Had not complied with the provisions of paragraph 2 of the order of correction (FDICX 5, p. A-2; TR. 187-92) which states:
       2. The Bank shall establish and continue to maintain an adequate reserve for loan losses and such reserve shall be established by charges to current operating income. In complying with the provisions of this paragraph, the board of directors of the Bank shall review the adequacy of the Bank's reserve for loan losses prior to the end of each calendar quarter. The minutes of the board meeting at which such review is undertaken shall indicate the results of the review, the amount of any increase in the reserve recommended, and the basis for determination of the amount of reserve provided.
   c. Had partially complied with the provisions of paragraph 3 of the order of correction (FDICX 5, p. A-2; TR. 192-93) which states:
       3. The Bank shall eliminate from its books, by charge-off or collection, all assets or portions of assets classified "Loss," and 50 percent of those assets classified "Doubtful" in the Report of Examination of the FDIC as of May 21, 1979, and not previously collected or charged-off.
   d. Had complied with the provisions of paragraph 4 of the order of correction (FDICX 5, pp. A-2, A-3; TR. 193-95) which states:
       4. The Bank shall reduce the total of the remaining assets classified "Doubtful" and the assets classified "Substandard," in the Report of Examination as of May 21, 1979, to not more than $3,500,000. This requirement is not to be construed as a standard for future operations of the Bank. It is the intention of this requirement that, in addition to the foregoing schedule of reductions, the Bank shall eventually reduce all adversely classified assets. As used in Paragraph 4 of this Order, the word "reduce" means (1) to collect, (2) to charge-off, or (3) to improve the quality of assets adversely classified to warrant removing any adverse classification, or in the case of assets classified "Doubtful," to improve the quality of the assets sufficiently to warrant upgrading to the "Substandard" classification, as determined by an examination by the FDIC.
   e. Had complied with the provisions of paragraph 5 of the order of correction (FDICX 5, pp. A-3, A-4; TR. 195-96) which states:
       5. Following the date of this ORDER, the Bank shall not extend, directly or indirectly, any additional credit to or for the benefit of any borrower who has a loan or other extension of credit with the Bank that has been classified, in whole or in part, "Loss" or "Doubtful" in the FDIC's Report of Examination as of May 21, 1979, so long as such loan or extension of credit remains classified "Loss" or "Doubtful," or is uncollected. The requirement of this paragraph does not prohibit the Bank from renewing (after collection of interest due from borrower) any credit already extended to any borrower.
   f. Had complied with the provisions of paragraph 6 of the order of correction (FDICX 5, p. A-4; TR. 196-97) which states:
       6. Following the date of this ORDER, the Bank shall not extend, directly or indirectly, any additional credit to or for the benefit of any borrower obligated in any manner to the Bank on any extension
{{4-1-90 p.A-79}}
    of credit (including any portion thereof) that has been charged off the books of the Bank so long as the charged-off credit remains uncollected.
   g. Had not complied with the provisions of paragraph 7 of the order of correction (FDICX 5, p. A-4; TR. 197) which states:
       7. The Bank shall establish a plan to control expenses in order to eliminate operating losses. The Bank shall submit to the Regional Director or the * * * Regional Office of the FDIC and the Superintendent of Banks of the State of * * * in writing a plan of objectives for controlling expenses and improving operating efficiency.
   h. Had not complied with the provisions of paragraph 8 of the order of correction (FDICX 5, p. A-4; TR. 198-99) which states:
       8. In addition to the above requirements, the assets of the Bank shall be put in such form and condition as to be acceptable to the FDIC and the Superintendent, and the Bank shall maintain adjusted capital, reserves, and subordinated debt equal to at least 7 percent of adjusted gross assets. The total adjusted capital, reserves, and subordinated debt shall take into consideration classifications of assets made by the FDIC at the first examination of the Bank following the termination of the correction period provided for by this ORDER. Classifications shall be in accord with the FDIC's stated standards of classification and shall include assets which are adversely classified as a result of said examination. Adjusted capital, reserves, and subordinated debt shall be determined by the methods and with the calculations set forth in the Analysis of Capital, Reserves and Subordinated Debt on page two of the Report of Examination of the FDIC.
   48. Mr. * * * concluded that paragraph 1 had not been complied with because $5 million of equity capital had not been injected into * * * Bank (TR. 185); that * * * bank had failed to satisfy paragraph 2 because the bank's reserve for loan losses was not adequate since it was not approximately 1% of outstanding loans (TR. 189); that paragraph 3 had been only partially satisfied because although most loss loans had been written off, two which totalled $103,000 had not been written off (TR. 193); that paragraph 7 had not been satisfied because a plan to control expenses had not been submitted to the FDIC (TR. 197); and finally, that the bank had not complied with paragraph 8 because its capital ratio was 3.2% and adversely classified assets equalled 129% of the bank's capital account (TR. 199).
   49. Mr. * * * responded to Mr. * * * charge relating to writeoffs by claiming that his recommendation for immediate writeoffs was not followed for tax reasons (TR. 1012-15) and FDIC's counsel conceded that there is no legal requirement that loans be written off within a given period of time (TR. 1003). * * * Bank's answer to Mr. * * * claim that its loan loss reserve was inadequate is that its reserve was 1.54% as of June 30, 1980, which exceeds Mr. * * * 1% standard (RX 18). Although * * * has not adopted a written plan to control expenses, Mr. * * * has projected the bank's expenses and income for several years (RX 12–16; TR. 876-92). Finally, * * * Bank fails to meet the order's requirement that it maintain adjusted capital, reserves and subordinated debt equal to at least 7% of adjusted gross assets because the $5 million in capital notes it issued are not subordinated. If they had been subordinated, * * * Bank's capital ration as of January, 1980 would have been 8.7% (FDICX 5).

RECOMMENDED DECISION

Lewis F. Parker
Administrative Law Judge
December 24, 1980
FDIC-80-33a
Before Lewis F. Parker, Administrative Law Judge

RECOMMENDED DECISION

I. INTRODUCTION

   On September 17, 1979, the Federal Deposit Insurance Corporation ("FDIC"), pursuant to Section 8(a) of the Federal Deposit Insurance Act ("the Act") (12 U.S.C. § 1818(a) (Supp. III 1979) and its Rules and Regulations, issued findings of unsafe or unsound practices and conditions and an order of correction to * * * Bank, * * *
   The FDIC's Board of Directors based its findings on the joint report of examination of FDIC examiner * * * and State of * * * examiner * * * as of May 21, 1979. The {{4-1-90 p.A-80}}findings stated that * * * Bank was in an unsafe or unsound condition and should not continue to operate as an insured bank, within the meaning of Section 8(a) of the Act by reason of the following:

       1. Operating with adjusted capital, reserves and subordinated debt which are inadequate in relation to the kind and quality of the bank's assets;
       2. Operating with excessive loan classifications as a result of failure to follow sound and prudent lending practices; and
       3. Operating the Bank in such a manner as to result in deficit earnings.
   The order directed * * * Bank to comply with eight specified corrective measures within 120 days if it desired to continue its status as an insured bank.
   On April 28, 1980, the Board issued a notice of intention to terminate * * * Bank's insured status and set a hearing for June 17, 1980 in * * *. On June 8, 1980, * * * Bank filed a motion asking for a change in the place of hearing. On June 11, 1980, after FDIC's counsel consented, I set the hearing for * * * , to begin on July 8, 1980.
   Hearings in this case were held in * * * between July 8 and July 18, 1980. At the conclusion of the hearing, counsel stipulated to a 45-day period after certification of the record (with a possible 15-day extension), for the submission of opening briefs, and an additional 15 days thereafter for the submission of reply briefs. At my request, the FDIC granted me an extension of time to December 31, 1980 to file my recommended decision.
   The following findings of fact, conclusions of law and recommended decision are based on the record and the proposed findings of fact, conclusions of law, recommended orders and replies filed by the parties Proposed findings not adopted verbatim or in substance have been rejected because they are either irrelevant or are not supported by the record.

II. FINDINGS OF FACT

   A. History of * * * Bank Prior to the FDIC's May 21, 1979 Examination
   1. * * * Bank is a corporation existing and doing business under the laws of the State of * * * and its principal place of business is in * * *.
   2. * * * Bank has been and is an insured State nonmember bank subject to the provisions of the Federal Deposit Insurance Act (12 U.S.C. § 1811 et seq. (Supp. III 1979)) and the rules and regulations of the FDIC (12 C.F.R. Part 301 et seq. (1980)). The FDIC has jurisdiction over the bank and the subject matter of this proceeding.
   3. In 1973, * * * Bank, which was then under different ownership than now, was obligated by the FDIC as a condition to the approval of a branch office, to raise an additional $3 million of capital (TR. 695).1
   4. On September 12, 1975, the ratio of * * * Bank's adjusted capital, reserves, and subordinated debt to adjusted total assets ("capital ratio") was 5.1% (TR. 352-54).
   5. In December 1975, the FDIC liquidated the * * * of * * *. As part of the liquidation proceeding, the assets of that bank were sold to * * * Bank (TR. 231). Bank paid a "premium" for these assets and was thereafter required to write the amount of the premium off against its capital (TR. 358). The effect of this writeoff was that the total capital of * * * Bank, and therefore its capital ration, was decreased (TR. 695-96).
   6. According to an August 31, 1976 FDIC examination, * * * Bank had an adjusted capital ratio of 3.0% (TR. 357).
   7. After this examination, the FDIC commenced a cease-and-desist proceeding (12 U.S.C. § 1818(b)) to require * * * Bank to comply with the $3 million capital requirement imposed three years before (Finding 3, supra., "The 1976 8(b) order", TR. 698-99).
   8. * * * Bank responded to the 1976 8(b) order, with the consent of the FDIC, by selling $1 million of subordinated notes and $2 million of preferred stock (TR. 729). The addition of $3 million in senior capital (subordinated debt and preferred stock, FDIC Manual or Examination Policy, Section D, p. 4) left * * * Bank with 91% senior capital and 9% equity capital (TR. 732). * * * Bank's capital ratio, including all of its subordinated debt, was 4% on December 30, 1977 (FDICX 3, p. 2).
   9. * * * Bank was on the brink of liquidity insolvency in January of 1978 as the


1 Abbreviations used in this recommended decision are: TR.: Transcript of the hearing FDICX: FDIC exhibit RX: Respondent's exhibit
{{4-1-90 p.A-81}}result of a "run" on the bank which was most likely created by public disclosures of the FDIC's actions with respect to it. Those disclosures were required by the sale of new stock (FDICX 23B).
   10. On January 31, 1978, because of its liquidity crisis, * * * Bank was labelled "serious problem-potential payoff" by the FDIC2 (FDICX 23C; TR. 531). Mr. * * *, the Arizona superintendent of banks, was prepared to take possession of * * * Bank on January 31, 1978 if it could not immediately solve its severe liquidity crisis (FDICX 23C). On February 14, 1978, because the bank had alleviated its liquidity crisis, the FDIC redefined the bank as a "serious problem"3 (FDICX 23D).
   11. Before the current group of investors acquired control of * * * Bank, the controlling stockholder was Mr. * * * (TR. 142-43, 1018-19). According to a FDIC report of examination, Mr. * * * and his managers were most responsible for the bank's distressed condition as of May 21, 1979 (FDICX 1, p. A-1).
   12. On April 19, 1978, the FDIC issued findings of unsafe or unsound practices and conditions and its order of correction. The findings stated that under its former management:
       a. The bank had operated with an inadequate level of capital protection.
       b. The bank had extended numerous lines of credit where credit information and other documentation have been incomplete or outdated, and lines of credit were extended when loans were inadequately secured.
           c. The bank had failed actively and aggressively to seek repayment of delinquent loans or to enforce programs for the repayment of loans once such programs had been set up.
       d. The bank had failed to establish or follow written loan policies.
       e. The bank had allowed an excess of loans in relation to its total deposits and assets.
       f. The bank's hazardous lending and loan collection practices had resulted in an excessive and disproportionately large volume of poor quality loans in relation to its total assets.
       g. The bank had operated with excessive concentrations of credit extended to three borrowers and their interests. Mr. * * * was specifically named as one of these borrowers.
       h. The bank had operated with inadequate provisions for liquidity (RX 6, pp. 3-6).
   13. The April, 1978 order of correction resulting from the finding of unsafe and unsound practices and conditions included the following paragraph:
       8.(a) By the expiration of the corrective period provided for in this ORDER [120 days from receipt of the order], the Bank shall increase capital, reserves and subordinated debt by not less than $3,000,000. Such increase in capital, reserved and subordinated debt may be accomplished by:
         (i) the sale of new capital in the form of capital stock, notes or debentures; or
         (ii) the reduction of all or part of the assets classified "Loss" specified in paragraph 2 of this ORDER without loss or liability to the Bank; or
         (iii) the direct contribution of cash by the directors of the Bank; or
         (iv) any combination of the above means.
      (RX 6, pp. 9–10.
   14. In the 120 days following the issuance of the April 1978 8(a) order, the bank's capital ratio dropped to 2.6% and the ratio of classified assets4 to capital increased to 271% (FDICX 2, p. 2), but the FDIC did not initiate a hearing at the end of the

2 Defined as "An advanced Serious Problem state presenting a 50% chance of requiring [FDIC] financial assistance in the near future" (FDICX 23A).

3 Defined as "A bank that threatens to ultimately involve the [FDIC] in a financial outlay unless drastic changes occur" (FDICX 23A).

4 There are three categories of adverse classifications which may be assigned to an asset or portion thereof. A "substandard" classification is applied to assets which have certain identifiable shortcomings, such as inadequate collateral or incapacity for repayment which appear to jeopardize their ultimate repayment (FDICX 1, p. 3; TR. 48). "Doubtful" assets or loans are similar to substandard except that the weaknesses have progressed to the point that full collection appears to be improbable (TR. 48). A "loss" asset is one not presently deemed collectible, and its maintenance on the bank's books is unwarranted (TR. 49).
{{4-1-90 p.A-82}}correction period apparently because it hoped that new investors would take over the bank (TR. 1029-30).
   15. In a meeting between Mr. * * * of FDIC's * * * Regional Office on September 22, 1978 and Mr. * * *, representing new investors (some of whom were connected with the * * * (TR. 1217-19)) interested in purchasing * * * Bank, he was told that * * * Bank would be a "clean bank" at the end of the examination that had begun on September 5, 1978 (TR. 1030-31). The phrase "clean bank" is generally understood to mean that it is impossible that any of the assets being acquired are subject to adverse classification (TR. 699–700).
   16. At the September 22, 1978 meeting, the new investors and the FDIC discussed a proposal to recapitalize * * * Bank with $2.5 million in subordinated debt (TR. 1030). One of the investors Mr. * * *, testified that he and the other investors believed that there would be no problem putting such a plan for recapitalization into effect (TR. 1034, 1047).
   17. On December 29, 1978, FDIC representatives and the new investors entered into a written agreement under which the FDIC agreed to the injection of $3 million of debt capital into * * * Bank with the understanding that that amount would be replaced by non-preferred equity capital at a ratio of 110% within five years from the date of the injection of the debt capital provided that at the end of five years if the bank did not have a capital-asset ratio of 7% the owners would insert as common stock an amount sufficient to reach the 7% ratio. The agreement also stated that the owners would not be required to insert in excess of $3,300,000. The bank agreed to cause a lawsuit contesting the validity of an FDIC 8(c) order to be dismissed with prejudice and agreed that the 8(c) order would become an 8(b) order which would prevent the sale of classified loans to Mr. * * * or any former or present insider. The regional director of FDIC's * * * Regional office, Mr. * * *, indicated his willingness to recommend a resolution of the existing problems by making a favorable recommendation in connection with the application which would be filed by the Bank for the issuance of the $3 million capital note. Mr. * * * also agreed to tell the FDIC's Board that "in his opinion the $3 million capital note referred to does satisfy the capital requirement of the existing 8(a) order against * * * Bank" (FDICX 43).
   18. Although the December 29, 1978 agreement did not limit who could be the lender, when Mr. * * * realized that * * * Bank would be the creditor of the capital notes, he recommended that * * * Bank's application for issuance and retirement of $3 million in capital notes be denied (TR. 1265-67):5
    It is recognized that the bank's proposal seems to meet the technical requirements of the Section 8(a) Order regarding capital. However, the Regional Office continues to be concerned about the relationship between the insiders of * * * Bank and the insiders of * * * Bank. The fact that a transaction involving * * * Bank was never contemplated and had been diligently avoided is significant, since the insiders of * * * Bank were instrumental in the issuance of the Section 8(c) against * * * Bank in December, 1978. Because of this relationship, it is the recommendation of the Regional Office that the bank's capital note proposal be denied.
    (FDICX 50).
   19. Pursuant to the December 29, 1978 agreement, * * * Bank dismissed its lawsuit challenging the 8(c) order and agreed to a stipulated 8(b) order (FDICX 38; TR. 1292).
   20. On April 23, 1979, Mr. * * * , the FDIC's director of the division of bank supervision, wrote a memorandum to the Board discussing the proposed injection of new capital in which he stated that "the proposed debenture issue and the length of the time frame for ultimate capital rehabilitation are considered inappropriate for a bank in this condition. Based on financial data of March 30, 1979, equity capital and reserves represented only $961,000 or 0.9% of total assets" (FDICX 26).
   21. On May 9, 1978, the Board rejected the 8(b) consent and stipulation and terminated the 8(a) proceeding of April 19, 1978 (FDICX 38A-B) because of disagreement among the staff as to the capital requirement


5 Section 18(i)(1) of the ACT provides that:
   No insured state nonmember bank except a district bank shall, without the prior consent of the Corporation, reduce the amount or retire any part of its common or preferred capital stock or retire any part of its capital notes or debentures.
{{4-1-90 p.A-83}}language in the order of correction (RX 7; TR. 747).6
   22. On May 21, 1979, the FDIC began a new examination of * * * Bank and, shortly thereafter, the present 8(a) proceeding, was initiated (TR. 747-48). The new order of correction accompanying the findings would require the injection of $5 million of equity capital into * * * Bank. Unlike the Order of Correction of April, 1978, this new order would not permit the use of subordinated debt (FDICX 6, p. 4).
   23. Immediately after * * * Bank was informed of the new 8(a) proceeding, it acquired an additional $5 million in debt capital (RX 23, 24, 25, 26).

B. The FDIC Examination of * * * Bank As Of May 21, 1979

   24. * * * Bank was examined as of the close of business May 21, 1979 by Mr. * * *, who has been a bank examiner for 25 years and who, during that time, has participated in 250 bank examinations (FDICX 1, Cover Page; TR. 23, 24, 26, 31).
   25. As of May 21, 1979:
   a. * * * Bank's total assets were $96,093,100 (FDICX 1, p. 2).
   b. The net amount of its loans was $54,078,700 (FDICX 1, p. 2).
   c. The total dollar amount of assets subject to adverse classifications was $7,834,700 (FDICX 1, p. 2; TR. 53; see also footnote 4).
   d. The total dollar amount of assets subject to the various adverse classifications was $6,742,100 substandard, $114,900 doubtful, and $977,700 loss (FDICX 1, p. 2; TR. 53-54).
   e. The total dollar amount of loans which were subject to adverse classification was $5,814,900 (FX 1, p. 2; TR. 53).
   f. The total dollar amount of loans subject to the various adverse classifications was $4,970,100, substandard, $114,900 doubtful, and $729,000 loss (FDICX 1, p. 2).
   g. Adjusted total assets were $95,911,800. Adjusted total assets were computed by subtracting from the total assets 100% of assets classified loss, 50% of assets classified doubtful and differences in accounts (FDICX 1, p. 2; TR. 75).
   h. Total unadjusted capital and reserves, including the loan valuation reserve, were $3,506,700 (FDICX 1, p. 2; TR. 74).
   i. Adjusted capital and reserves were $2,455,300. Adjusted capital and reserves were computed by subtracting from total capital and reserves 100% of assets classified loss, 50% of assets classified doubtful and difference in accounts (FDICX 1, pp. 1, 2; TR. 75).
   j. Adjusted capital and reserves as a percent of adjusted gross assets was 2.6% (FDICX 1, pp. 1, 2; TR. 76). A capital to assets ratio of 2.6% is considered by Mr. * * * to be low. The ratio in banks recently examined by him prior to his testimony ranged between 7.0% and 7.5% (FDICX 1, p. 1; TR. 76–78).
   k. Adversely classified assets of $7,834,700 represented 223.4% of total capital and reserves (FDICX 1, p. 2; TR. 65). According to the examiner, a classified asset to total capital and reserves ratio of 223.4% is high. In banks examined by him during the past several years it would have been unusual for that ratio to be in excess of 50% (TR. 65). Mr. * * *, an FDIC bank examiner who examined the bank at a later date testified that the ratio in well-run non-problems banks examined by him is usually 25% to 35% (TR. 162, 216).
   1. The total capital account, as shown on the books of the bank was $3,506,700, consisting of $2.5 million in capital notes, $2 million in preferred stock, $1.15 million in common stock, $1.65 million in surplus, $853,900 in loan valuation reserves and $4,647,200 in accumulated losses. Thus, the book capital consisted of $2.5 million in debt capital and $1,006,700 in preferred stock (FDICX 1, p. 2; FDICX 4; TR. 73–74).


6 Mr. * * *, assistant director, division of bank supervision, testified about the recommendation that * * * Bank's proposed stipulation and consent be rejected (FDICX 26):
   Okay. This memo [FDICX 26] is the covering document that went to the board of directors of the FDIC with a proposed stipulation and consent to a cease and desist order, and we were recommending that the board of directors refuse to accept that consent. Part of that consent had a capital condition in it which contemplated the sale of subordinated debt of $3 million. The question was clearly unsettled among the various staff people as to whether or not if the bank went ahead and sold that $3 million note whether or not the 8(a) order would have been technically complied with, and we would then, you know, have to accept compliance (TR. 742).
   Mr. * * * described the Board's action as wiping the state clean (TR. 747).
{{4-1-90 p.A-84}}
   m. The debt capital shown on * * * Bank's books, $2.5 million, was impaired by $44,700. The entire amount of the remaining components (preferred stock, common stock, surplus, undivided profits, valuation reserve, and reserve for contingencies and other capital reserves) of the capital account was impaired. Thus, respondent's adjusted capital account consisted entirely of debt capital, which, after deducting, $44,700, totalled $2,455,300 (FDICX 1, pp. 1, 2, FDICX 4; TR. 75, 87–88).
   n. Assets classified substandard, totaling $6,742,100, and 50% of the assets classified doubtful, totaling $57,450, were not considered in computing respondent's adjusted capital account (FDICX 1, p. 2; TR. 80). Historically, the substandard category has been a reliable predictor of future losses. FDIC research indicates that between 25% and 33.3% of loans classified substandard usually become losses (TR. 80).
   o. * * * Bank's loan portfolio showed 40 loans, totaling $1,267,900, which were overdue 6 months or more, and 468 loans, totaling $5,851,100, which were overdue one month or more. The total of all overdue loans was $7,119,000, and that amount was 12.5% of the total loans. In Mr. * * * opinion, such a volume of overdue loans is excessive, and indicates material future loan losses (TR. 68–70).
   p. Debt capital in commercial banks is not unusual. Fifty percent of the banks Mr. * * * has examined in the past ten years have had debt capital; however, the ratio of debt to equity capital, in those banks which used debt capital, usually did not exceed 25% to 33% of their total capital account (TR. 89–90; see also TR. 213-14).
   q. Mr. * * * testified that the adjusted capital account of * * * Bank, which consisted 100% of debt capital, was not available for the absorption of future losses and did not provide a capital cushion for the protection of its depositors (TR. 87–88).
   r. According to Mr. * * *, * * * Bank's capital account was inadequate, and an infusion of capital, in the form of equity capital rather than debt capital, was necessary to restore it to a reasonable condition (TR. 88–90). An infusion of $5 million in equity capital, as of June 2, 1979, would have produced an adjusted capital account of $6,955,300, with a debt to equity ratio of 29% (FDICX 4; TR. 90–91) and an adjusted capital to adjusted assets ratio of 6.9% (FDICX 4; TR. 90–93).
   s. The bank's reserve for loan losses was $853,900; there was no other reserve account. The reserve for loan losses was sufficient to cover, or absorb, the loss loans of $729,900 and 50% of the doubtful loans which was $57,450; however, the reserve was not sufficient to cover, or absorb, the total dollar amount of assets classified loss, 50% of assets classified doubtful, and "other liabilities not shown on banks' books," totaling $1,051,400. The writeoff of that amount therefore exceeded the total amount of the bank's reserves, and further eroded its capital account. It is unusual to exhaust a bank's reserve account by the writeoff of assets, and this fact was taken into account in Mr. * * * decision that the bank's capital was not adequate (FDICX 1, pp. 2, 6; TR. 86–88).
   t. Net loans charged off by * * * Bank during the years 1976 through 1978 far exceeded available reserves for loan losses, resulting in a steady erosion of the bank's capital account, as large losses required transfers to the loan loss reserve account from the capital account (FDICX 1, pp. 1, 1-a, 4; TR. 86).
   u. * * * Bank experienced operating losses of $742,300 in 1976, $4,306,800 in 1978, and $83,200 to May 21, 1979. An operating profit of $87,200 was experienced in 1977. Net operating earnings before taxes for the three years ending December 31, 1978 resulted in an aggregate deficit of $3,636,800 (FDICX 1, p. A-1).
   v. * * * Bank experienced diminutions of its capital account as a result of operating losses and other adjustments, of $2,522,600 in 1976, $4,538,300 in 1978, and $83,200 in 1979 up to May 21, 1979; the net decrease in its capital account for the period January 1, 1976 through May 21, 1979 was $5,280,300 (FDICX 1, pp. 4, 4-a).
   w. * * * Bank's operating losses in 1976 and 1978 resulted primarily from loan losses during those years (FDICX 1, pp. 1-a, 4).
   x. Considering the four previous FDIC examinations of * * * Bank, and the FDIC examination as of May 21, 1979, the table below shows the bank's total classified assets, the percentage relationship between total classified assets and respondent's total capital account:

{{4-1-90 p.A-85}}

Date of Examination8-31-764-04-7712-30-779-05-785-21-79
Total Classified Assets$7,528,000$7,808,000$12,156,000$15,471,000$7,835,000
Percent of Capital Re-
serves and Sub-Ordinat-
ed Debt Represented by
Classified Assets131%157%165%217%223%

(FDICX 1, p.1)
   y. Mr. * * * report of examination stated that * * * Bank was technically insolvent7 and he concluded that its directors and officers were engaging in undesirable and objectionable practices. He recommended Section 8 action to remedy the bank's practice of:

       (1). Operating the bank with an inadequate capital base;
       (2). Operating the bank with an excessive volume of classified assets; and
       (3). Operating the bank with inadequate earnings (FDICX 1, pp. A, A-1).
   C. The FDIC Examination of * * * Bank As of January 21, 1980
   26. After the expiration of the 120-day corrective period required by the September 17, 1978 8(a) order, * * * Bank was examined by * * *, who has examined some 150 banks during his 15 years as a bank examiner (TR. 163, 166).
   As of the close of business on January 21, 1980:
       a. The total dollar amount of * * * Bank's assets subject to adverse classification was $4,914,100 (FDICX 5, p. 2; TR. 215).
       b. The dollar amount of its assets subject to the various adverse classifications were $4,118,500 substandard, $30,000 doubtful and $765,600 loss (FDICX 5, p. 2).
       c. The total dollar amount of loans subject to adverse classification was $3,108,200 (FDICX 5, p. 2).
       d. The dollar amounts of loans subject to the various adverse classifications were $2,331,600 substandard, $30,000 doubtful and $746,600 loss (FDICX 5, p. 2).
       e. Nineteen thousand dollars ($19,000) in "Other Assets" were classified loss (FDICX 2, p. 2).
       f. The percentage of * * * Bank's adversely classified loans to its total loans was 5.2% (FDICX 5, p. 6).
       g. The dollar amount of total capital, reserves and subordinated debt was $3,788,800 (FDICX 2, p. 2; TR. 202).
       h. * * * Bank's adversely classified assets of $4,914,100 were 129.7% of its total capital and reserves of $3,788,800 (FDICX 5, p. 2; TR. 215-16).
       i. Adjusted capital, reserves and subordinated debt were $2,901,800 (FDICX 2, p. 2; TR. 202).
       j. Adjusted total assets were $90,828,500 (FDICX 5, p. 2).
       k. * * * Bank's capital ratio (adjusted capital and reserves to adjusted total assets) was 3.2% (FDICX 5, p. 2; TR. 202).
       l. * * * Bank's ratio of equity capital to adjusted total assets was 0.99% (FDICX 7; TR. 211).
       m. Adversely classified assets not considered in computing the bank's adjusted capital and reserves were $4,118,500, which represented approximately 142% of its adjusted capital and reserves of $2,901,800 (FDICX 5, p. 2).
       n. Eight hundred fifty-six (856) loans were overdue at least one month (FDICX 5, p. 6).
       o. The total dollar amount of overdue loans was $4,618,000 (FDICX 5, p. 6).
       p. Out of the total overdue loans, 153 loans were overdue six months or more (FDICX 5, p. 6).
       q. The dollar amount of loans overdue in excess of six months was $852,700 (FDICX 5, p. 6).

7 "All of [the bank's] remaining capital is represented by subordinated notes which are impaired by $44,700. For the purpose of capital analysis on page 2, this placed the bank in a technically insolvent condition as of the examination date, since debt capital is obviously unavailable for the absorption of losses" (FDICX 1, p. 1).
{{4-1-90 p.A-86}}
       r. During the eight-month period between the examinations of May 21, 1979 and January 21, 1980, $653,559 in assets were newly classified (FDICX 5, p. 3-d).
       s. Considering the three previous FDIC examinations of * * * Bank, and ending with the examination of January 21, 1980, the adjusted assets, the total book capital, the adjusted capital, the ratio of adjusted capital to adjusted assets, and the ratio of equity capital to adjusted assets were as follows:

Date of examination12-30-779-05-785-21-791-21-80
Adjusted Assets$123,126,900$110,053,900$95,911,800$90,828,500
Total Book Capital$7,352,500$7,133,500$3,506,700$3,788,800
Adjusted Capital$4,919,400$2,840,500$2,455,300$2,901,800
Capital Ratio (Including
Debt Capital)4.0%2.6%2.6%3.2%
Capital Ratio (Equity
Capital Only)1.98%0.47%0.0%0.99%

(FDICX 7, 8; TR. 208-13).
   27. Although Mr. * * * believes that * * * Bank's present directors had not addressed what he termed the "critical problem" of the bank—its capital position—he testified that, on the basis of his experience gained during three prior examinations, the bank's new management team (which was hired by the present ownership) was doing a "reasonably competent job in supervising the assets of the bank, particulary the loans" (TR. 217-18). Mr. * * * agreed that the bank's credit files had been significantly improved by the new management team (TR. 99). Also, * * * Bank's equity had increased by $946,800 between Mr. * * * and Mr. * * * examination (TR. 324).
   28. Mr. * * *, * * * Bank's executive vice president, along with other new management personnel, was transferred to Bank from * * * Bank in January of 1979. He was instructed to evaluate * * * Bank's loan portfolio (TR. 99, 832-34). Since that time, one of his primary functions has been to maintain control over the Bank's loans (TR. 836). In his opinion, the quality of the bank's loan portfolio has vastly improved and their loss potential is low (TR. 837-38).
   29. RX 27, prepared by * * * Bank's management indicates that between the January 21, 1980 examination and June 30, 1980, the bank had a profit of $746,700.

   D. The Adequacy of * * * Bank's Capital

   30. Since at least some losses on loans are inevitable, commercial banks, to avoid placing their depositors at risk, need a capital account against which to charge losses which occur (TR. 72). This is the most important function of capital. The other functions are: to provide funds for the purchase of nonearning assets; and to serve as a source of confidence to the public, the investment community and depositors (TR. 71–72, 555). The source of capital may be subordinated debt or equity.8
   31. Mr. * * *, an FDIC employee who supervises activities relating to problem banks, testified that while losses can be charged against subordinated debt in the liquidation process after a bank has been declared insolvent and has been closed, the weakness of subordinated debt is that it is not available to absorb losses in an operating bank;9 only equity capital is available for that purpose (TR. 555-56; see also, TR. 82, 428, * * * 813-14). Subordinated debt does, however, serve the other functions of capital—i.e., for investment and, to some degree, as a source of confidence (TR. 555).
   32. Another weakness of subordinated debt as capital, according to Mr. * * *, is that it involves a fixed interest cost that must be paid to the creditor regardless of the conditions or the earnings of the bank (TR. 556).
   33. In view of the opinion expressed by Mr. * * and other staff members, it is not


8 The FDIC Manual of Examination Policy (Section D, p. 4) defines capital as "common and preferred stock and subordinated capital notes and debentures."

9 Absent an agreement by the holders of the debt to the contrary. No such agreement between * * * Bank and the holders of subordinated debt has been made.
{{4-1-90 p.A-87}}surprising that the FDIC has adopted a guideline that subordinated debt may not exceed 33.3% of a bank's total capital. This guideline, according to Mr. * * *, is relaxed very infrequently, and then only as a stopgap measure, for short periods of time such as 30, 60 or 90 days (TR. 554, 557, 584-85). The FDIC has never permitted a bank to satisfy its capital needs by using only subordinated debt (TR. 585).
   34. Debt capital in commercial banks is not unusual, but the ratio of debt capital to equity capital in banks which use debt capital usually does not exceed one-third (TR. 89–90, 213-14).
   35. The FDIC, the Comptroller of the Currency and the Board of Governors of the Federal Reserve System take the position that the maximum amount of debt capital in the capital structure of a bank many not exceed one third of the bank's total capital (TR. 644-65). The reason why these agencies have chosen this particular ratio is not explained in this record, but Mr. * * * argued that while there is fluctuation around the guidelines: "The fact that the industry has adopted that as somewhat of a standard is indicative that it at least meets some sense of what's acceptable." However, there have been no studies done by the FDIC to prove the validity of its one-third ceiling (TR. 717-18).
   36. The FDIC has not always adhered to its guidelines. Under Section 13 of the FDIA, 12 U.S.C. § 1823(c), it has the authority to aid banks threatened with closing by issuing subordinated notes (TR. 759-60). In the case of * * *, a news release announced that:
       A $500-million assistance package designed to assure the viability and continued strength of * * * Bank, N.A., to be provided jointly by the Federal Deposit Insurance Corporation and a group of banks, including many of the nation's largest, was announced today . . . .
       Assistance to the * * * bank is in the form of five-year subordinated debt which will enable the bank to strengthen its capital account, improve operating performance, and continue its service to the community.
(RX 8).
   37. The purpose of the infusion of $500 million of debt capital into * * * was to strengthen its capital position "through its improved earnings and, potentially, through an infusion of equity from exercise of warrants to purchase holding company stock" (RX 8). Although the eventual hope is that much of * * * debt capital will be converted to equity capital, there is no guarantee that the warrants will be exercised (TR. 764). In the case of another bank,10 the FDIC has lent it money under the "emergency bail-out" provision of Section 13(c) in 1971 and 1976. The debt is subordinated (TR. 679-80).
   38. One advantage which debt capital has over equity capital is that tax laws permit a bank to deduct interest payments as a business expense but do not allow a similar deduction when dividends are paid (TR. 465). Mr. * * *, a professor of finance at the University of * * * (TR. 807), testified that at a "normal" level of interest rates (8-12%), debt capital might not be any more costly to the bank than equity because:
       You would be paying dividends to the equityholders, and hence the interest payment is not necessarily a 100 percent drain on the bank because you would have to offset those with the amount of dividends that you would pay on the alternate common stock which possibly could be in the same range or may even be more. And, in fact, if you were to pay dividends, you would have to earn—assuming that you ran out of your tax benefits, you would then have to earn a considerable amount more to pay the dividends than you would just to pay the subordinated debt, assuming that you didn't have a tax break which they currently are now enjoying....
(TR. 826).    39. * * * Bank chose, in defiance of the FDIC's guidelines, to raise $5 million of capital through debt rather than through the issuance of stock; however, its decision to do so was hardly irrational in light of the problems likely to be encountered when stock is issued to the public:
       a. The public disclosures necessitated by an offering might cause a decline in deposits and a liquidity crisis (TR. 133, 822-23);


10 Its name is not revealed in the record.
{{4-1-90 p.A-88}}
       b. The cost of issuing stock might be greater than the cost of issuing subordinated notes because of underwriting costs and the degree to which stock might have to be discounted (TR 815-16);
       c. Several more months might be needed to raise capital from stock (RX 7; TR. 1105-06);
       d. The bank would have to be reorganized if the stock sold below par value (TR. 820-21); and
       e. The interests of minority stockholders would be "swamped" (TR. 820).
   40. Dr. * * *, who is familiar with the * * * area, concluded that "with full disclosure of all the things that are going on in [* * * Bank], I would say that the prospect of selling $5 million of common stock in * * * is not very good" (TR. 820). If * * * Bank's FDIC deposit insurance were terminated, Mr. * * * agreed that there was "a pretty high probability" that it would be destroyed (TR. 664).

   E. * * * Bank's Capital Structure

   41. Ms. * * *, a financial economist in the FDIC's division of research, prepared exhibits comparing * * * Bank and nine other banks which are similar to it in size, deposit structure and the makeup of their loan portfolios. The exhibits were based on Reports of Condition filed by these banks as of March 31, 1980. The exhibit reveals that * * * Bank's ratio of total equity capital to total assets was 1.2%. The ratios for the other nine banks ranged from 6.2% to 11.7% (FDICX 12–18; TR. 411).
   42. After analyzing liquidity, interest rate sensitivity and earnings, Ms. * * * concluded that * * * Bank and the nine other banks faced substantially the same degree of risk and that there was, therefore, no apparent justification for * * * Bank's equity to total asset ratio of 1.2% as compared to that of the nine other banks (FDICX 12–18; TR. 426).
   43. Ms. * * * also conducted a computer screening of all banks in the United States and found that of the some 15,000 banks in the country, only four (one of which was * * * Bank) had equity to total asset ratios of less than 2.0% (TR. 445).
   44. An exhibit entitled "Condensed Statement of Reports of State and National Banks of America," dated March 31, 1980 reveals that the amount of * * * Bank's equity capital was $1,027,000 and its assets were $87,869,000, producing an equity capital to assets ratio of 1.1%. This compares to similar ratios, for all banks in the State of * * *, ranging upward from approximately 4.0%. Compared with * * * Bank, which had approximately the same assets, the equity capital of * * * Bank was less than one-third that of * * * Bank. Compared with the Bank of * * *, which had approximately the same amount of equity capital, the assets of * * * Bank were approximately 14 times larger (RX 9; TR. 795-96). Nine of the twenty-two banks referred to in RX 9 have some debt capital as part of their capital structure; however, in all of these banks (except * * * Bank) the amount of debt capital was less than one-third of the total capital.

   F. The Status Of * * * Bank's Debt Capital

   45. Mr. * * *, a director of * * * Bank and a director and the chief operating officer of the * * * Bank of * * * (TR. 1012) testified about the capital note agreements (RX 23, 25) and the capital notes totalling $5 million (RX 24, 26) which are the central issue in this proceeding.
   Paragraph 2, p. 1 of the capital note (RX 24) states:

       Notwithstanding that this Note is denominated as a Capital Note, this Note is not to be treated as a Capital Note (capital obligation) unless and until it has been approved as such pursuant to * * * Revised Statutes § 6–189 by the * * * State Superintendent of Banks. Upon approval by the * * * State Superintendent of Banks, this Note shall automatically become a subordinated Capital Note and all provisions of this Note applicable by reasons of this Note being a subordinated Capital Note shall automatically become effective.
   The * * * superintendent of banks has not approved these notes as capital notes (TR. 1196), and I find, therefore, that they are not subordinated.
   46. Because of the questions raised by the refusal of the * * * superintendent of banks to approve the notes as capital notes, the noteholders, * * * Bank and * * * , advised * * * Bank that:
       This will confirm the understanding which we have held at all times that indeed the promissory notes are, and have been at all times from the date of
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    execution fully subordinated notes, subordinated in full to the claims of the depositors of * * * Bank and to all others who, in the normal course of events, would take priority over any other subordinated obligation of Bank. The undersigned stands ready to execute any documents, or to place upon the face of the promissory notes any legend or notation which you might consider necessary to give notice to one and all, and thereby make absolutely clear, that the promissory notes in issue are now and have been at all times fully subordinated notes (RX 28, 29).

   G. * * * Bank's Compliance With Order of Correction

   47. * * * Bank was examined by Mr. * * * at the end of the 120-day corrective period for compliance with the order of correction issued by the FDIC on September 17, 1979. Mr. * * * concluded in his report of examination that as of January 21, 1980 * * * Bank:
   a. Had not complied with the provisions of paragraph 1 of the order of correction (FDICX 5, pp. A, A-1; Tr. 183-87) which states in part:

       1.(a) By the expiration of the corrective period provided for in this ORDER, the Bank shall increase its capital and reserves by not less than $5,000,000. Such increase in capital and reserves may be accomplished by:
         (i) the sale of new common capital in the form of common stock, or
         (ii) the reduction of all or part of the assets classified "Loss" and 50 percent of the assets classified "Doubtful" as specified in Paragraph 3 of this ORDER without loss or liability to the Bank; or
         (iii) the direct contribution of cash by the directors of the Bank; or
         (iv) any combination of the above means.
   b. Had not complied with the provisions of paragraph 2 of the order of correction (FDICX 5, p. A-2; TR. 187-92) which states:
       2. The Bank shall establish and continue to maintain an adequate reserve for loan losses and such reserve shall be established by charges to current operating income. In complying with the provisions of this paragraph, the board of directors of the Bank shall review the adequacy of the Bank's reserve for loan losses prior to the end of each calendar quarter. The minutes of the board meeting at which such review is undertaken shall indicate the results of the review, the amount of any increase in the reserve recommended, and the basis for determination of the amount of reserve provided.
   c. Had partially complied with the provisions of paragraph 3 of the order of correction (FDICX 5, p. A-2; TR. 192-93) which states:
       3. The Bank shall eliminate from its books, by charge-off or collection, all assets or portions of assets classified "Loss," and 50 percent of those assets classified "Doubtful" in the Report of Examination of the FDIC as of May 21, 1979, and not previously collected or charged-off.
   d. Had complied with the provisions of paragraph 4 of the order of correction (FDICX 5, pp. A-2, A-3; TR. 193-95) which states:
       4. The Bank shall reduce the total of the remaining assets classified "Doubtful" and the assets classified "Substandard," in the Report of Examination as of May 21, 1979, to not more than $3,500,000. This requirement is not to be construed as a standard for future operations of the Bank. It is the intention of this requirement that, in addition to the foregoing schedule of reductions, the Bank shall eventually reduce all adversely classified assets. As used in Paragraph 4 of this Order, the word "reduce" means (1) to collect, (2) to charge-off, or (3) to improve the quality of assets adversely classified to warrant removing any adverse classification, or in the case of assets classified "Doubtful," to improve the quality of the assets sufficiently to warrant upgrading to the "Substandard" classification, as determined by an examination by the FDIC.
   e. Had complied with the provisions of paragraph 5 of the order of correction (FDICX 5, pp. A-3, A-4; TR. 195-96) which states:

{{4-1-90 p.A-90}}

       5. Following the date of this ORDER, the Bank shall not extend, directly or indirectly, any additional credit to or for the benefit of any borrower who has a loan or other extension of credit with the Bank that has been classified, in whole or in part, "Loss" or "Doubtful" in the FDIC's Report of Examination as of May 21, 1979, so long as such loan or extension of credit remains classified "Loss" or "Doubtful," or is uncollected. The requirement of this paragraph does not prohibit the Bank from renewing (after collection of interest due from borrower) any credit already extended to any borrower.
   f. Had complied with the provisions of paragraph 6 of the order of correction (FDICX 5, p. A-4; TR. 196-97) which states:
       6. Following the date of this ORDER, the Bank shall not extend, directly or indirectly, any additional credit to or for the benefit of any borrower obligated in any manner to the Bank on any extension of credit (including any portion thereof) that has been charged off the books of the Bank so long as the charged-off credit remains uncollected.
   g. Had not complied with the provisions of paragraph 7 of the order of correction (FDICX 5, p. A-4; TR. 197) which states:
       7. The Bank shall establish a plan to control expenses in order to eliminate operating losses. The Bank shall submit to the Regional Director or the * * * Regional Office of the FDIC and the Superintendent of Banks of the State of * * * in writing a plan of objectives for controlling expenses and improving operating efficiency.
   h. Had not complied with the provisions of paragraph 8 of the order of correction (FDICX 5, p. A-4; TR. 198-99) which states:
       8. In addition to the above requirements, the assets of the Bank shall be put in such form and condition as to be acceptable to the FDIC and the Superintendent, and the Bank shall maintain adjusted capital, reserves, and subordinated debt equal to at least 7 percent of adjusted gross assets. The total adjusted capital, reserves, and subordinated debt shall take into consideration classifications of assets made by the FDIC at the first examination of the Bank following the termination of the correction period provided for by this ORDER. Classifications shall be in accord with the FDIC's stated standards of classification and shall include assets which are adversely classified as a result of said examination. Adjusted capital, reserves, and subordinated debt shall be determined by the methods and with the calculations set forth in the Analysis of Capital, Reserves and Subordinated Debt on page two of the Report of Examination of the FDIC.
   48. Mr. * * * concluded that paragraph 1 had not been complied with because $5 million of equity capital had not been injected into * * * Bank (TR. 185); that * * * bank had failed to satisfy paragraph 2 because the bank's reserve for loan losses was not adequate since it was not approximately 1% of outstanding loans (TR. 189); that paragraph 3 had been only partially satisfied because although most loss loans had been written off, two which totalled $103,000 had not been written off (TR. 193); that paragraph 7 had not been satisfied because a plan to control expenses had not been submitted to the FDIC (TR. 197); and finally, that the bank had not complied with paragraph 8 because its capital ratio was 3.2% and adversely classified assets equalled 129% of the bank's capital account (TR. 199).
   49. Mr. * * * responded to Mr. * * * charge relating to writeoffs by claiming that his recommendation for immediate writeoffs was not followed for tax reasons (TR. 1012-15) and FDIC's counsel conceded that there is no legal requirement that loans be written off within a given period of time (TR. 1003). * * * Bank's answer to Mr. * * * claim that its loan loss reserve was inadequate is that its reserve was 1.54% as of June 30, 1980, which exceeds Mr. * * * 1% standard (RX 18). Although * * * Bank has not adopted a written plan to control expenses, Mr. * * * has projected the bank's expenses and income for several years (RX 12-16; TR. 876-92). Finally, * * * Bank fails to meet the order's requirement that it maintain adjusted capital, reserves and subordinated debt equal to at least 7% of adjusted gross assets because the $5 million in capital notes it issued are not subordinated. If they had been subordinated, * * * Bank's capital ratio as of January, 1980 would have been 8.7% (FDICX 5).

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   III. LEGAL DISCUSSION

   A. * * * Bank's Constitutional Rights Have Not Been Denied

   In addition to challenging the factual basis of the FDIC's case against it, * * * Bank questions the constitutionality of Section 8(a) of the Act and claims that the FDIC's actions have denied it due process.

   1. The Constitutionality of Section 8(a) Cannot be Decided By the FDIC

   * * * Bank asserts that Section 8(a) of the Act is so vague that "a bank cannot objectively judge whether it has violated Section 1818(a)" (Brief at 41, citing Brennan v. Occupational Safety & Health Rev. Commission, 505 F.2d 869, 872 (10th Cir. 1975). The FDIC responds that the words "unsafe or unsound practices" or "unsafe or unsound conditions" are no more vague than those used in other statutes regulating business conduct which have withstood constitutional challenge. See, Federal Trade Commission v. R.F. Keppel & Bro., 291 U.S. 304, 314 (1914) ("unfair methods of competition").

   [.7] * * * Bank's argument on this point is addressed to the wrong tribunal, for neither the FDIC nor I have the authority to rule on its petition. Buckeye Industries, Inc. v. Secretary of Labor, 587 F.2d 231 (5th Cir. 1979): "No administrative tribunal of the United States has the authority to declare unconstitutional the Act which it is called upon to administer. Id. at 235. See also Public Utilities Commission of California v. United States, 355 U.S. 534, 539 (1958); American Stevedores, Inc. v. Salzano, 538 F.2d 933, 936 (2d. Cir. 1976).

   2. The FDIC's Actions Were Not A Violation of Due Process

   While challenges to the constitutionality of the Act are not properly addressed to me, I can decide, because they raise factual as well as legal issues, whether the FDIC's actions leading to the issuance of the findings and order of correction violated * * * Bank's right to due process.

   (a) The FDIC May Define "Adequate Bank Capital" In This Proceeding Rather Than Through Rule Making

   [.8] Instead of determining what an adequate level of bank capital is by the process of case-by-case adjudication, the FDIC could have instituted a rule making proceeding which would have provided a definition applicable to all banks subject to its jurisdiction. As this case reveals, however, that question is not simple, and the FDIC has apparently decided that the definition is so dependent on the circumstances of each bank that no rule of general applicability can be devised. This decision is one which the FDIC clearly has the authority to make. To hold otherwise would deprive it of the power to deal with the problems before it in the most effective way. See Securities and Exchange Commission v. Chenery Corp., 332 U.S. 194, 203 (1947):

    ...the agency must retain power to deal with the problems on a case-to-case basis if the administrative process is to be effective. There is thus a very definite place for the case-by-case evolution of statutory standards. And the choice made between proceedings by general rule or by individual, ad hoc litigation is one that lies primarily in the informed discretion of the administrative agency.

   3. Staff Bias, If It Exists, Is Not A Constitutional Infirmity

   * * * Bank claims that Mr. * * * and Mr. * * * are biased and prejudiced against it, as evidenced by Mr. * * * staunch defense of the one-third to two-thirds ratio of debt-to-equity principle, and by Mr. * * * animosity toward the principals of * * * Bank and * * * Bank of * * * .

   [.9] Agency commissioners, as well as staff members, are entitled to express their own views on matters of interest to it and to those businesses which it regulates. See Federal Trade Commission v. Cement Institute, 333 U.S. 683, 702-03 (1948). As FDIC representatives with authority, Mr. * * * and Mr. * * * are entitled to—indeed, they would not be doing their job if they did not —express their views on the adequacy of debt as capital, and * * * Bank cites no cases which stand for the proposition that staff members of any agency cannot testify, and give their opinion, in agency proceedings. Thus, * * * Bank's argument essentially boils down to a complaint that Mr. * * * and Mr. * * * were unwilling to concede that * * * Bank's capital structure was adequate. They may or may not be correct but their testimony is on the record and * * * Bank was given the right to meet that {{4-1-90 p.A-92}}
   testimony through cross-examination and the presentation of rebuttal evidence. * * * Bank's constitutional challenge is rejected.
   4. * * * Bank Was Not Denied Equal Protection Of The Law
   * * * Bank argues that the FDIC's assistance to other banks such as * * * , when compared with its adamant stand with respect to * * * Bank's debit-equity ratio denies it the equal protection of the law.
   The Constitution's equal protection guarantee applies to actions of the federal government through the fifth amendment, Bolling v. Sharpe, 347 U.S. 497 (1954); Bolton v. Harris, 395 F.2d 642, 645 n.3 (D.C. Cir. 1968) and insures that individuals or businesses, be treated evenhandedly, but equal protection need only be accorded to those individuals or businesses which are similarly situated. There is no constitutional impediment to treating dissimilar entities in different ways. See Tigner v. Texas, 310 U.S. 141 (1940): "The Constitution does not require things which are different in fact or opinion to be treated in law as though they were the same." Id. at 147.
   To be sure, * * * Bank and * * * conduct the same type of business, but * * * Bank has not established that they are similar enough in some attributes which are significant—size, capital structure and importance to their community—that the FDIC was under a constitutional mandate to treat them equally. The FDIC's present action against * * * Bank does not deny it the equal protection of the law.

   [.10] B. * * * Bank's Capital Inadequacy Makes It Unsafe And Unsound Within The Meaning of Section 8(a)

   1. The Authority of the ALJ In Section 8(a) Proceedings

   I believe that an administrative law judge has the authority to examine the factual basis of an action to terminate the insured status of a bank. In this proceeding the Order of Correction clearly constitutes the underpinning for the FDIC action under Section 8(a) to withdraw its insurance from * * * Bank. To deny an administrative law judge the authority to examine and rule upon the validity of the order would, I believe, raise serious constitutional questions.
The issues raised in this case by the Order of Correction are properly before me since they are issues of fact and law rather than matters committed to agency discretion, as the case cited by FDIC counsel exemplifies. First Buckingham Community, 73 F.T.C. 938, 23 Ad. L. 2d 423 (1968).

   2. Capital Adequacy

   In their Bank Capital (1976), Yair E. Orgler and Benjamin Wolkowitz 11 state:

       The task of intermediating between a nation's lenders and borrowers has historically been best handled by banks. Responsibility for this complex task has placed banks in a position where the soundness of the industry and the public's confidence in banking institutions have been matters of public interest .... ....
       Since banking has a pivotal role in the functioning of the economy, and since public confidence is a major factor in the efficient operation of the banking industry, this industry has been and continues to be publicly regulated and closely supervised. Because of the integral association of capital with bank soundness, one of the main tools of regulators is the periodic evaluation of the adequacy of bank capital. This complex and demanding task relies heavily on subjective elements. Disagreement between bankers and regulators over the judgmental aspects of evaluating bank capital adequacy has led to a protracted controversy.

(Id. at 3).

   * * * Bank does not disagree that a bank must have capital and that it must be "adequate" but it argues that the FDIC's capital adequacy standards—a capital to assets ratio of around 7% (Finding 47(h)) and a one-third to two-thirds debt-equity ratio (Findings 33, 35) have not been adopted after careful study but are based on guesswork, and that violation of the standards cannot, therefore, constitute and "unsafe or unsound" practice12 within the meaning of Section 8(a) of the Act.


11 Respectively, visiting professor, Board of Governors of the Federal Reserve System and senior economist, Board of Governors of the Federal Reserve System.
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   * * * Bank makes too much of the fact that the FDIC has never commissioned any scientific studies which would define the term "adequate capital" or determine whether the FDIC's standards are necessary (Finding 35), for the statute leaves the question of defining "unsafe and unsound" to the sound discretion of the agency. That the agency has not articulated its standards after a scientific study is of no moment, so long as the standard is not unreasonable.
   The accepted definition of an "unsafe or unsound practice" is one which is contrary to accepted standards of prudent operation and present an abnormal risk of loss.13
   In First National Bank of Eden v. Department of Treasury, 568 F.2d 610, 611 n. 2 (U.S. 8th Cir. (1978)), the court, referring to Section 8(b) of the Act, said:
       Congress did not define unsafe and unsound banking practices in § 1818(b).
       However, the Comptroller suggests that these terms encompass what may be generally viewed as conduct deemed contrary to accepted standards of banking operations which might result in abnormal risk or loss to a banking institution or shareholder.
   See also Groos National Bank v. Comptroller of the Currency, 573 F.2d 889 (5th Cir. 1978).
   The FDIC employees who testified about * * * Bank's capital adequacy have many years of experience in bank regulation and explained the FDIC's interpretation of the phrase "unsafe or unsound." Such interpretation, developed over many years and based upon the examination of many banks, is entitled, like all thoughtful agency pronouncements on matters within their jurisdiction, to great weight. E.I. du Pont de Nemours & Co. v. Collins, 432 U.S. 46, 54–55 (1977); Red Lion Broadcasting Co. v. Federal Communications Commission, 395 U.S. 367, 381 (1969); Johnson, Administrator of Veterans' Affairs v. Robison, 415 U.S. 361, 367 (1974).
   a. * * * Bank's Operation With Excessive Subordinated Debt Is Contrary To Accepted Standards Of Prudent Operation And May Result In An Abnormal Risk Of Loss
   With few exceptions, banks in the United States do not operate with subordinated debt which exceeds one third of their capital account (Finding 25p) and the standard announced by the FDIC is also embraced by other federal bank regulating agencies (Finding 35).
   * * * Bank points to statements in banking literature which question the usefulness of ratio requirements in preventing bank failures14 and argues that one of the alleged weaknesses of debt capital—its unavailability to absorb losses—is "a mere accounting fiction" since it was able to operate profitably even though its equity capital was zero and its debt capital was impaired (Brief, p. 28). That may be, but it is a "fiction" which is universally accepted, even by * * *


12 Which states in part:
   Whenever the Board of Directors shall find that an insured bank or its directors or trustees have engaged in or are engaging in unsafe or unsound practices in conducting the business of such bank or is in an unsafe or unsound condition to continue operation as an insured bank....

13 The then chairman of the federal Home Loan Bank Board, at hearings on S. 3158 before the House Committee on Banking and Currency, 89th Cong., 2d Sess. 50 (1966) defined this phrase:
   Like many other generic terms widely used in the law, such as `fraud,' `negligence,' `probable cause,' or, `good faith,' the term `unsafe or unsound practices' has a central meaning which can and must be applied to constantly changing factual circumstances. Generally speaking, an `unsafe or unsound practice' embraces any action or lack of action which is contrary to accepted standards of prudent operation, the possible consequences of which, if continued, would be an abnormal risk of loss or damage to an institution, its shareholders, or the agencies administering the insurance funds.
   Members of the Senate and House quoted this definition with approval in deliberations on the Financial Institutions Supervisory Act. 112 Cong. Rec. 25008, 26474 (1966).

14 Apilado and Gies, "Capital Adequacy and Commercial bank Failure," The Bankers Magazine, Vol. 55, no. 3, pp. 25, 30:
   The practice is widespread of using various formulae in assessing capital adequacy. The problem concerns the utility of these formulae. Assuming that capital adequacy is an important determinant of bank failure, the general hypothesis is that there exists a statistically significant difference in capitalization between `successful' banks and banks which failed. Ratio analysis, coupled with differential analysis of sample means, will be utilized in examining the hypothesis....
   It cannot be unequivocally concluded from this limited study that ratio analysis is useful in measuring capital adequacy. While the approaches examined were found to be generally serviceable on an aggregate basis, their performance in group comparisons was spotty. Their usefulness needs to be proven at the group level as well, before they can be relied upon to any degree as indicators of capital adequacy. Although the Excess Capital approach did show consistent group differences, the consistency decreased as the level of significance decreased.
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   Bank's expert, Dr. * * * (Finding 31). See also Orgler and Wolkowitz, supra at 16.
       To avoid bankruptcy, the capital account must be sufficient to absorb losses and sustain continued bank operations. Both equity and reserves on loans and securities can fulfill this function. Long-term debt does not function as capital in this particular role, since losses cannot be written off against this account.
   Although equity may not have all of the advantages over debt which the FDIC claims it has when interest rates are normal (Finding 38), the interest cost on subordinated debt "may be the very cause of the failure that their existence is intended to cushion." Horvitz, A Compromise Between Debt and Equity, The American Banker, November 3, 1980, p. 4. Horvitz adds that:
       This objection to capital notes was not important when such obligations were a trivial part of bank capital, but when they represent 30% or more of total capital (as they do for some banks now, and would for more banks in the absence of supervisory constraints), the problem becomes more serious.
   The 33% standard may be a very rough estimate of the ideal debt-equity ratio, and it may be that some banks which exceed the standard are safe and sound depositories of their depositors' funds, but the accumulated experience of the FDIC witnesses indicates that permitting banks, as a general rule, to set their debt-equity ratio at any level which they see fit would place their depositors at risk (Findings 30-35).
   * * * Bank's subordinated debt represented one hundred percent of its adjusted capital, reserves and subordinated debt on May 21, 1979 (TR. 558). On January 21, 1980 its subordinated debt represented two thirds of its adjusted capital, reserves and subordinated debt (TR. 559). While these figures do not take into account the $5 million which * * * Bank has acquired, it is properly excluded, however, because * * * Bank's debt is not subordinated (Finding 45).15
   Taking into consideration the drawbacks of subordinated debt which are amply established in this record and * * * Bank's debt-equity ratio which far exceeds the FDIC's standards, I conclude that its capital structure is contrary to accepted standards of prudent operation and presents an abnormal risk of loss (see TR. 552-60).
   b. * * * Bank's Capital Ratio Is Inadequate
   * * * Bank's capital ratio (considering only equity capital) as of January 21, 1980 was 0.99% (Finding 26). As of March 31, 1980, its capital ratio was 1.2% (Finding 41). Only four banks in the United States, including * * * Bank, have equity to total assets ratios of less than 2.0% (Finding 43), and all banks in * * * have a capital ratio of at least 4.0% (Finding 44).
   The amount of * * * Bank's equity capital is so low that it would offer little protection against emergencies, and because of the weaknesses of debt capital (Findings 30-35) the $5 million which * * * Bank has borrowed is considered by the FDIC's witnesses to offer little additional cushion against interest rates, liquidity, credit and earning risks, and the risks of fraud and embezzlement, the last two of which are a major cause of bank failure (TR. 479, 1499). Therefore, * * * Bank's capital ratio is inadequate, is contrary to accepted standards of prudent operation, and presents an abnormal risk of loss.
   c. * * * Bank Has Not Complied With All Requirements of The Order Of Correction
   * * * Bank has not acquired $5 million in equity capital and its capital ratio (since the $5 million is not subordinated) is less than 7%; * * * Bank has therefore not complied with paragraphs 1 and 8 of the order of correction. Its reserve for loan losses is now adequate and it has complied with paragraph 2 of the order. While paragraph 3 has not literally been complied with, * * * Bank's explanation satisfies me that it has complied with the spirit of that paragraph. Finally, although a plan of action to control losses has not been presented to the FDIC, * * * Bank is, in fact, now making every effort to do so (Finding 49).

IV. RECOMMENDATION

   Although * * * Bank is presently operating in an unsafe and unsound condition primarily because its recently acquired debt is not subordinated and cannot be treated as debt capital. If it were subordinated, * * * Bank's capital ratio would exceed the 7% standard imposed by paragraph 8 of the order of correction (Finding 49).


15 The addition of $5 million debt increased * * * Bank's debt to 87.5% of total capital (TR. 559).
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   Of course, the addition of $5 million of subordinated debt would not satisfy the requirements of paragraph 1 of the order of correction, and the FDIC's staff is adamant in their position: Since * * * Bank has not complied with the order of correction within the 120-day period, its insured status must be terminated, even if this means that the bank will almost certainly be destroyed (Brief, pp. 22-23; Finding 40).
   This result is not mandated by the Act. The FDIC has discretion in this regard16 and based on the past history of * * * Bank's dealings with the FDIC's staff, I recommend that * * * Bank be given an opportunity to convert its $5 million debt to subordinated debt and, after that is accomplished, to gradually obtain enough equity capital to satisfy the FDIC's one-third to two-thirds debt-equity standard.
   This cannot be accomplished overnight. It will take several years, but I am convinced that this plan is far preferable to the almost inevitable destruction of the bank if the staff's proposal is accepted. Perhaps, as Mr. * * * claims, the destruction of the bank will signal other banks that the FDIC will seriously enforce its capital requirements (TR. 664-65), but, given the past history of the FDIC's regulation of * * * Bank I do not believe that this is the case which should be used to give that signal, for the staff's position is one which gives me concern over the fairness of its proposals. While I agree that $5 million in equity would offer more protection to its shareholders than the same amount of debt capital, the staff ignores the fact that because of its past problems, the present owners of * * * Bank simply could not have made a public offering of stock which would have been successful (Findings 39–40). These problems has been evident for several years, yet the FDIC did nothing about them because new ownership gave hope of a turnaround in the bank's fortunes (Findings 6-14).
   In fact, when the new owners proposed a recapitalization plan which was tentatively accepted by the FDIC's regional director, subordinated debt was apparently thought of as offering adequate protection to the depositors during the five-year period given under that proposal to acquire equity capital (Finding 17).
   Mr. * * * made no firm commitment to the new investors and the FDIC had the right to reject the proposal after further consideration, but the fact that the plan was seriously considered by responsible FDIC officials undercuts the staff's present position that the bank must immediately acquire $5 million in equity capital or face destruction.
   The FDIC's position with respect to * * * also gives me pause, for in that case debt capital was believed to provide adequate depositor protection until some unspecified later time when equity capital might be acquired (Finding 37). Although there are obvious differences between the two banks, the staff has not convinced me that in the most important characteristic— risk of loss—there is that much difference between them. * * * Bank is in a better position now to improve its earnings, and the $5 million debt capital which it has acquired should offer the opportunity for further improvement.17
   In conclusion, while the FDIC could terminate * * * Bank's insured status, I believe that the debt capital which it has acquired should permit its continuing operation until—at some later time—equity investors can be attracted by its improved position, and I recommend that the FDIC order * * * Bank to:
       1. Take all necessary steps to ensure that the $5 million in debt will be treated as subordinated by its noteholders.18
       2. Acquire enough equity investment within three years to satisfy the one-third to two-thirds debt-equity standard.
   The other violations of the order of correction are minor and I see no need for any further action with respect to them.

CONCLUSIONS OF LAW

   1. As of May 21, 1979, in view of (1) * * * Bank's capital account, both from the standpoint of total capital and equity capital,


16 Section 8(a) states that the Board "may order that the insured status of the bank be terminated...."

17 Although the staff believes that debt capital cannot alter a bank's prospects for survival (Brief, p. 21), I note that the * * * press release stated that the infusion of debt capital would strengthen that bank's position "through its improved earnings" (Finding 37).

18 The noteholders have stated a willingness to execute any documents making it clear that the promissory notes are subordinated to the claims of * * * Bank's depositors (Finding 46).
{{4-1-90 p.A-96}}
   (2) the quality of its assets, (3) the probability of future losses and (4) the ratio of its total capital to its assets and of its equity capital to its assets, * * * Bank was in an unsafe and unsound condition.
   2. Section 8(a) of the Federal Deposit Insurance Act, 12 U.S.C. § 1818(a) (Supp. III 1979) requires that a bank be returned to a safe and sound condition within 120 days of issuance of an order of correction, unless a shorter period has been fixed by state authorities. No shorter period was fixed by state authorities in this case.
   3. As of January 21, 1980, after the expiration of the 120-day corrective period, * * * Banks had not complied with paragraphs 1 and 8 of the order of correction. Although * * * Bank has not literally complied with paragraphs 3 and 7 of the order, its failure to do so has not contributed to its unsafe and unsound condition. * * * Bank has complied with the other paragraphs of the order. * * * bank was in an unsafe and unsound condition as of January 21, 1980 principally because the $5 million debt which it acquired is not subordinated.

ORDER

   NOW THEREFORE, in conformance with the above findings of fact and conclusions of law, and pursuant to Section 8(a) of the Federal Deposit Insurance Act,
   IT IS ORDERED that * * * Bank shall, within thirty days of receipt of this order, obtain from * * * Bank of * * * and * * *, in place of the existing promissory notes for $5 million, new notes which state that the notes are subordinated in full to the claims of the depositors of * * * Bank.
   IT IS FURTHER ORDERED that * * * Bank shall, within ninety days of receipt of this order, submit to the Board a plan under which * * * Bank shall, within three years from the date of this order, obtain enough equity capital so that the amount of its equity capital, at the end of the three-year period shall be no less than sixty-seven percent of its total capital, reserves, and subordinated debt.
   IT IS FURTHER ORDERED that in the event * * * Bank does not satisfy the obligations of this order, the Board may terminate its insured status.
/s/ Lewis F. Parker
Administrative Law Judge
Dated: December 24, 1980

CERTIFICATE OF SERVICE

   I hereby certify that I caused one copy of the attached document in FDIC-80-33a to be mailed this date to the following persons at the addresses given below:

Arthur L. Beamon, Esq.
Federal Deposit Insurance Corporation
550 17th St., NW
Washington, DC 20429
* * *

Regional Counsel

* * * for bank
   The original of the foregoing was delivered this day to:
Mr. Hoyle L. Robinson
Executive Secretary
Federal Deposit Insurance Corporation
550 17th St., NW
Washington, DC 20201

/s/ Ramona C. Luckel
Secretary to
Lewis F. Parker
Administrative Law Judge
Federal Trade Commission
6th and Pennsylvania Ave., NW
Washington, DC 20580
Date: December 29, 1980

ORDER TERMINATING THE ORDER
TO CEASE AND DESIST
AND
ORDER TERMINATING SECTION 8(a)
PROCEEDING
FDIC-80-33a

   IT IS HEREBY ORDERED, that the Order to Cease and Desist issued against * * * Bank, * * * ("Bank"), pursuant to Section 8(b) of the Federal Deposit Insurance Act on August 6, 1979, be and hereby is terminated nunc pro tunc.
   IT IS HEREBY FURTHER ORDERED, that the proceedings against * * * Bank, * * * pursuant to Section 8(a) of the Federal Deposit Insurance Act, be, and hereby are, terminated and that the Order Terminating Federal Deposit Insurance issued against the Bank on May 28, 1981, be, and hereby is, terminated.
   Dated at Washington, D.C., this 28th day of September, 1981. By direction of the Board of Directors.
/s/ Hoyle L. Robinson
Executive Secretary

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