Federal Deposit
Insurance Corporation

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   [¶5052] FDIC Docket No. FDIC-84-191b (12-8-85).

   FDIC issued a cease and desist order to a bank that engaged in the following unsafe or unsound banking practices: hazardous lending and lax collection practices, including extending credit to borrowers whose ability to repay was in doubt and when collateral for the loans was inadequate; operating with excessive "other operating expenses" resulting from its improper payment of certain expenses attributable to its bank holding company; operating with excessive loan losses; maintaining inadequate loan loss reserves; operating with inadequate capital; and operating with inadequate management and supervision both from its officers and from its board of directors. FDIC also ordered the bank to take affirmative action to correct the unsafe or unsound banking practices.

   [.1] Cease and Desist Orders—Affirmative Remedies—Unsafe or Unsound Practice
   A cease and desist order is appropriate when a bank fails to take remedial action to remedy unsafe or unsound banking practices until specific problems are pointed out to the bank by FDIC examiners or others.

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   [.2] Cease and Desist Orders—FDIC Authority to Issue
   FDIC has the authority to take affirmative action to correct the conditions resulting from any violations of law or unsafe or unsound banking practices.

   [.3] Definitions—Brokered Deposits

   Brokered deposits are deposits received by a bank for the account of others (either directly or ultimately) from a person in the business of placing funds or facilitating the placement of funds in return for a commission. Brokered deposits often carry higher interest rates and shorter maturities than alternative funding from local sources. Consequently, they are very rate sensitive and extremely volatile.

   [.4] Deposits—Brokered—Limitation on Amounts
   A bank that has engaged in unsafe or unsound banking practices may be limited in the amount of brokered deposits it takes. A bank may also be required to give notice to the Regional Director before it accepts brokered deposits, giving the Regional Director the right to prohibit the bank's use of brokered deposits if, at that time, circumstances indicate that the bank should not be using brokered deposits.

   [.5] Cease and Desist Orders—FDIC Authority to Issue
   The FDIC may issue a notice of charges if, in its opinion, any insured bank or any agent thereof is engaging, or has engaged, in an unsafe or unsound practice in conducting the business of such bank, or when the FDIC has reasonable cause to believe that the bank or any director, officer, employee, agent, or other person participating in the conduct of the affairs of the bank is about to engage in such a practice.

   [.6] Cease and Desist Orders—Defenses—Cessation of Violation
   The voluntary cessation of conduct that is subject to a cease and desist order does not prevent the appropriate issuance of such an order.

   [.7] CAMEL Rating—"4" Defined
   Banks with a CAMEL rating of 4 have an immoderate volume of serious financial weaknesses or a combination of other conditions that are unsatisfactory. Major and serious problems or unsafe and unsound conditions may exist that are not being satisfactorily addressed or resolved. Unless effective actions is taken to correct these conditions, they could reasonably develop into a situation that could impair future viability, constitute a threat to the interests of depositors, or pose a potential for disbursement of funds by the insuring agency. A higher potential for failure is present, but it is not yet imminent or pronounced.

   [.8] Examination of Banks—Purpose
   The purpose of a bank examination is to maintain confidence in the banking system, provide a report of the bank's condition to the bank's management and to the FDIC, to protect the FDIC's insurance fund, and to ensure compliance with various laws and regulations.

   [.9] Lending and Collection Policy and Procedures—Inadequate Documentation
   Adequate minimal documentation in support of a loan consists of a current financial statement of the borrower, a financing statement, lien search, current appraisal, and a repayment program.

   [.10] Lending and Collection Policy and Procedures—Lax Collection Practices
   Lax collection practices comprise failure to establish repayment programs, not correcting previously criticized or classified loans, not monitoring a borrower's cash flow position, not obtaining additional collateral, extending additional credit to a criticized borrower, and otherwise not following or tracking a borrower's ability to repay.

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   [.11] Lending and Collection Policy and Procedures—Lax Collection Practices
   An out-of-territory loan can be a lax collection practice because the bank is not as able to service the loan or monitor the collateral at a distant location.

   [.12] Definitions—Participation Sold
   A "participation sold" represents an amount or portion of a loan made by one bank that is sold to another bank.

   [.13] Loan Loss Reserve—Purpose
   The purpose of a loan valuation reserve is to absorb unexpected loan losses in those loans classified substandard and all other unacceptable or unrecognized losses in the loan portfolio.

   [.14] Capital—Adequacy—Capitalization Should Reflect Risk
   A bank's adjusted capital is calculated by subtracting from a bank's total capital and reserves those assets classified loss and 50% of those classified doubtful.

   [.15] Capital—Adequacy—Unsafe or Unsound Practices
   A bank operating with an adjusted capital ratio of 6.8% is engaged in an unsafe or unsound banking practice when banks with a similar customer base operate with a ratio of approximately 8%.

   [.16] Directors—Duties and Responsibilities—Supervision of Banks Affairs
   The board of directors of a bank has a duty to supervise the affairs of the bank.

   [.17] Bank Holding Companies—Payment of Expenses
   It is improper for bank management to permit the bank to pay for expenses of the bank's holding company.

   [.18] Directors—Duties and Responsibilities
   A bank's directors have a duty to regularly review the banks loan valuation reserve.

   [.19] Directors—Duties and Responsibilities—Adequacy of Employees
   It is an unsafe or unsound banking practice to permit the bank to operate with inadequate staff in both the lending and operations areas.

   [.20] Directors—Duties and Responsibilities—Supervision of Lending Practices
   Bank management is responsible for the bank's lending practices.

In the Matter of BANK OF * * * ,
(Insured State Nonmember Bank)


DECISION
FDIC-84-191b

STATEMENT

   This proceeding arises under Section 8(b) of the Federal Deposit Insurance Act (the "Act"). 12 U.S.C. § 1818(b). On November 7, 1984, the Board of Directors of the Federal Deposit Insurance Corporation (the "Board" and the "FDIC", respectively) issued a written Notice of Charges and of Hearing to Bank of * * * (the "Bank"), pursuant to Section 8(b) of the Act and the FDIC's Rules of Practice and Procedures. 12 C.F.R. Part 308. The Notice of Charges and of Hearing (the "Notice") charged the Bank with having engaged in unsafe or unsound banking practices. More specifically, the Notice alleged that Bank engaged in the following unsafe or unsound practices: (1) hazardous lending and lax collection practices, (2) practices that produced excessive "other operating expenses" and excessive loan losses, (3) operating with an inadequate level of capital protection for the kind and quality of assets held by Bank, (4) operating with an inadequate loan valuation reserve, (5) operating with management whose policies and practices are detrimental to the Bank and jeopardize the safety of its deposits, and (6) failure by the Bank's board of directors to provide for the hiring and retention of a sufficient number of adequately trained employees and failure to provide adequate supervision over and direction to the active officers of the Bank. The Notice sought an Order under Section 8(b)(1) of the Act requiring Bank to cease and desist from these unsafe or unsound {{4-1-90 p.A-669}}practices, and requiring Bank to remedy the conditions resulting from these practices.
   A formal hearing was held before Administrative Law Judge Alan M. Wienman (the "ALJ"). Both parties were afforded an opportunity to submit to the ALJ proposed Findings of Fact, Conclusions of Law, briefs, and responses to each others papers and to the ALJ's recommendations. The ALJ issued his Findings of Fact, Conclusions of Law, and Recommended Decision on August 15, 1985.
   In his Recommended Decision and Finding of Fact, the ALJ made the following findings: (1) Bank engaged in hazardous lending and lax collection practices, including extending credit to borrowers whose ability to repay was in doubt and when collateral for the loans was inadequate; (2) Bank had excessive "other operating expenses" resulting at least in part from its improper payment of certain expenses attributable to its bank holding company; (3) as a result of its lending practices, Bank had excessive loan losses; (4) Bank did not adequately monitor its loan valuation reserve, and maintained inadequate loan valuation reserves in light of the quality of its loan portfolio; (5) Bank operated with inadequate capital in light of the quality and amount of Bank's assets; and (6) Bank operated with inadequate management and supervision both from its officers and from its board of directors. The ALJ specifically identified twelve borrowers whose loans reflected one or more unsafe and unsound banking practices. These unsafe and unsound practices are dealt with in detail in the ALJ's Recommended Decision and Findings of Fact, which need not be repeated here.
   The ALJ concluded that the Bank's practices constituted unsafe or unsound banking practices within the meaning of Section 8(b) of the Federal Deposit Insurance Act, and he recommended entry of a Cease and Desist Order.

OPINION

The ALJ's Recommendations

   The Boards finds that the ALJ's recommended Findings of Fact¹ are supported in all material respects by substantial evidence in the record. Therefore the Boards adopts and incorporates by this reference the ALJ's Findings of Fact.² On the evidence in the record, and based on the analysis set forth below, the Board also makes limited Additional Findings of Fact that are set forth below.
   The factual and legal conclusions set forth in the ALJ's Recommended Decision and Conclusions of Law are, with limited exceptions discussed below, supported by substantial evidence in the record and by statute and established precedent. Therefore, except as to the matters expressly noted below, the Board adopts and incorporates by this reference the ALJ's Recommended Decision, including its analysis of the need for each provision the ALJ recommended be included in an Order. The Board adopts and incorporates by this reference the ALJ's Conclusions of Law.
   The bulk of the Board's Order is taken from the ALJ's Recommended Order. Additions were made in two instances in which the Board's conclusions as to the proper scope of a Section 8(b) Order applicable to Bank differed from the recommendation of the ALJ. Those matters are discussed below. The Board made limited, additional changes intended to remove unnecessary sources of ambiguity or dispute. To assure clarity, the Board has set forth its Order in full text. That Order is appended hereto.

Scope of the Order

   Determining the proper scope of the Board's Order in this case begins with the fact that Bank has engaged in a number of specific unsafe or unsound banking practices. The specific instances of unsafe and unsound practices found in this record are of concern because they have led to losses or increased risk of loss on specific loans.

   [.1] Bank's practice of often failing to take remedial action until specific problems were pointed out to Bank (by FDIC examiners or others) makes clear that a broad remedial cease and desist Order is appropriate here. To deal with the lack of planning and monitoring found in Bank, the Order must be broader than simply ordering short-term attention to the specific, detailed, problems found in the May 31, 1984 examination.³ This conclusion concerning the appropriate scope of our Order leads to the inclusion in the Order of two material provisions that were not recommended by the ALJ.
   Repurchasing Loan Participations: Bank has total assets of approximately $10 million. As of the May 31, 1984 examination Bank has sold loan participations equal to 20% of its total assets. Most of those participations were sold to two banks with which Bank's president is affiliated. Roughly half of the loans involved in those participations were adversely classified by FDIC examiners. Although Bank has repurchased one loan participation, there is no evidence in the record that Bank has repurchased any adversely classified loan participations. However, experience elsewhere indicates that, particularly when participations are sold to banks with which there is some form of affiliation, it is not uncommon for those banks to shift adversely classified assets among themselves.⁴

   [.2] In light of Bank's history of inadequate supervision by its directors, Bank's capital position, the high volume of classified loans that Bank has sold under participation agreements, and the relationship of Bank's president to purchasers of these participations, the Board concludes that it is prudent to limit Bank's ability to repurchase loan participations involving loans classified "Substandard," "Doubtful," or "Loss." Absent a limitation, by the time the FDIC learned of Bank's repurchase of a low quality participation, it would be too late for the FDIC to act to prevent harm to Bank. The Board has this authority under Section 8(b) of the Act which authorizes it to "take affirmative action to correct the conditions resulting from any such violations or practice." This statutory authorization for cease and desist orders that go beyond the four corners of the established violations is most needed when, as in the case here, the FDIC finds it necessary to redirect a bank's method of doing business away from a series of unsafe and unsound practices.⁵ Appropriate Additional Findings of Fact, and a provision in the Order, address this matter.
   Insofar as the ALJ's Recommended Decision did not recommend limitations on repurchase of loan participations, the Board declines to accept that portion of the Recommended Decision, and finds that in this case the Board should exercise its broad remedial powers by including this provision in the Order.

   [.3] Brokered Deposits: In general, brokered deposits are deposits received by a bank for the account of others (either directly or ultimately) from a person in the business of placing funds or facilitating the placement of funds in return for a commission. Brokers commonly place relatively large sums with each bank they do business with. Brokered deposits often carry higher interest rates and shorter maturities than alternative funding from local sources. Consequently, they are very rate sensitive and extremely volatile.
   Bank has not to date solicited or obtained brokered deposits. However, Bank has op-

   [.4] In light of the specific facts on the record relating to Bank, including Bank's pattern of not doing sufficient planning to avoid reaching crisis or near crisis situations before action is taken, the Board concludes that an Order limiting Bank's ability to take brokered deposits should be entered. An appropriate provision to that effect is included in the Board's Order. That provision is not a flat prohibition on brokered deposits. Rather, it requires that Bank give notice before it accepts brokered deposits, and gives the Regional Director the right to prohibit Bank's use of brokered deposits if at that time circumstances indicate that Bank should not be using brokered deposits.
   In so far as the ALJ's Recommended Decision is inconsistent with our conclusion concerning brokered deposits, the Board declines to adopt that portion of the ALJ's decision, and finds that the Board should exercise its broad remedial powers by including this provision in the Order.
   Other Items: Two other items require brief comment. First, although Bank has not paid cash dividends to its stockholders, evidence in the record shows that Bank paid several thousand dollars in expenses for a brokerage business owned by Bank's holding company. That bank holding company owns 98% of Bank's stock. Payment of those expenses had virtually the same practical effect as paying a cash dividend to Bank's stockholders. This is particularly troubling since Bank had agreed with FDIC in a Memorandum of Understanding that Bank would not pay cash dividends.¹ Additionally, Bank paid $24,000 per year in directors' fees not to the directors, but to Bank's holding company. The record does not demonstrate conclusively that payment of these directors' fees is the equivalent of a cash dividend, but the purpose and effect of these payments is at best suspect. Particularly in light of these specific facts, the Board has included in its Order restrictions on the payment by Bank of the equivalent of cash dividends.
   Second, based on Bank's financial condition as of May 31, 1984, the Order requires that Bank obtain a capital infusion of not less than $100,000. To avoid any possible ambiguity, the Order also provides that net infusions of equity capital received between May 31, 1984 and the effective date of the Order will be credited toward this $100,000 requirement.
   In sum, evidence in the record clearly shows that Bank has engaged in unsafe and unsound banking practices. Having found that Bank has engaged in unsafe and unsound banking practices, the Board hereby

ADDITIONAL FINDINGS OF FACT

   1. Subsequent to May 31, 1984, Bank repurchased one loan participation. That repurchase was from a bank that is affiliated with Bank's president.
   2. Bank's financial condition would be at risk should it repurchase any significant amount of the low quality loan participations that it has sold to other banks.
   3. The ALJ Finding of Fact number 52 is modified by striking the second sentence of that paragraph. That finding is adopted as modified.
   By direction of the Board of Directors. Dated at Washington, D.C., this 9th day of December, 1985.
/s/ Hoyle L. Robinson
Executive Secretary

ORDER TO CEASE AND DESIST
FDIC-84-191b

   IT IS HEREBY ORDERED, that the Bank of * * * ("Bank"), its directors, officers, employees, agents, successors, assigns, and other persons participating in the conduct of the affairs of the Bank, cease and desist from the following unsafe or unsound banking practices:

   1. Operating with an inadequate level of equity capital protection;
   2. Engaging in hazardous lending and lax collection practices;
   3. Operating with an inadequate loan valuation reserve;
   4. Operating in such a manner as to produce excessive "other operating expenses" and excessive loan losses resulting in deficit earnings;
   5. Operating with a management whose policies and practices are detrimental to the Bank and jeopardize the safety of its deposits; and
   6. Operating with a board of directors which has failed to provide a sufficient number of adequately trained employees and which has failed to provide adequate supervision and direction to the active management of the Bank.

   (i) The sale of equity securities; or
   (ii) The elimination of all or part of the "Loss" assets and that portion in excess of one-half of the "Doubtful" assets referred to in paragraph 3 of this ORDER, without loss or liability to the Bank, or
   (iii) The collection in cash of assets previously charged off; or
   (iv) The direct contribution of cash by the directors of the Bank or * * *; or
   (v) Any other means acceptable to the Regional Director of the Federal Deposit Insurance Corporation's ("FDIC") * * * Regional Office ("Regional Director"); or
   (vi) Any combination of the above means.

Certification of Record by Administrative
Law Judge
FDIC-84-191b

TO THE BOARD OF DIRECTORS OF
THE FEDERAL DEPOSIT INSURANCE
CORPORATION:
   Pursuant to section 308.13(b) of the FDIC Rules and Regulations [12 C.F.R. § 308.13(b)], the undersigned herewith certifies the record of the hearing in this matter. This record consists of the Findings of Fact, Conclusions of Law, and Recommended Decision of the undersigned, dated today [hereinafter, "the Recommended Decision"]; a copy of the notice to counsel for the parties advising them of this Certification and transmitting a copy of the Recommended Decision; and the evidence, procedural documents, and other materials described in that part of the Recommended Decision defining the record upon which it is based.
   On this date, the record is being sent by mail to the Executive Secretary for filing.
/s/ Alan M. Wienman
U.S. Administrative Law Judge
1004 Savings Center Tower
411 Hamilton Boulevard
Peoria, Illinois 61601
August 15 1985

Notice of Filing and Certification of the
Record with a Recommended Decision
and Proposed Order
FDIC-84-191b

To:
* * *
Attorney at Law
* * *
(Counsel for Bank of)
and
* * *
Regional Counsel
Federal Deposit Insurance Corporation
* * *
(Counsel for the Federal Deposit Insurance
Corporation)
   PLEASE TAKE NOTICE that the undersigned has this date filed with the Executive Secretary and certified to the Board of Directors of the Federal Deposit Insurance Corporation the record of the hearing in this case, pursuant to the provisions of section 308.13(b) of the Rules and Regulations of the FDIC [12 C.F.R. § 308.13(b)]. In- {{4-1-90 p.A-676}}cluded in the record as certified are the Findings of Fact, Conclusions of Law, Recommended Decision, and Proposed Order rendered by the undersigned. A copy of said Findings of Fact, Conclusions of Law, Recommended Decision, and Proposed Order is attached hereto, as required by the same regulation.
/s/ Alan M. Wienman
U.S. Administrative Law Judge
1004 Savings Center Tower
411 Hamilton Boulevard
Peoria, Illinois 61601
August 15 1985

Findings of Fact Conclusions of Law, and
Recommended Decision of the
Administrative Law Judge
FDIC-84-191b

   On November 7, 1984, the Federal Deposit Insurance Corporation (hereinafter FDIC), acting through its Board of Review and its Deputy Executive Secretary, issued a notice of charges and of hearing to the Bank of * * * (hereinafter the Bank), advising it of its right to a hearing with respect to a proposed cease-and-desist order. The hearing was held before the undersigned Administrative Law Judge in * * * , on April 2 and 3, 1985. The parties have been given the appropriate time set forth in the Regulations for the filing of post-hearing briefs, proposed findings of fact, and proposed conclusions of law, as well as for the filing of any reply briefs. The undersigned having considered the entire record and the arguments of the parties, now makes his findings of fact and conclusion of law and to recommend a decision and propose an order to the Board of Directors of the FDIC.
STATUTORY AND REGULATORY
PROVISIONS

   [.5] Section 8(b)(1) of the Federal Deposit Insurance Act [12 U.S.C. § 1818(b)(1)] provides, as pertinent here, that the FDIC may issue a notice of charges if, in its opinion, any insured bank or any agent thereof is engaging or has engaged in an unsafe or unsound practice in conducting the business of such bank. A notice of charges may also issue when "the agency has reasonable cause to believe that the Bank or any director, officer, employee, agent, or other person participating in the conduct of the affairs of such bank is about to engage" in such a practice. This notice shall include a statement of the facts constituting the alleged unsafe or unsound practice or practices and shall provide for a hearing on the matter. If the record of such a hearing establishes the fact of any unsafe or unsound practice specified in the notice of charges, the FDIC may issue an order requiring the Bank and its agents to cease and desist from the practices involved. Such order may further provide for affirmative action to correct the condition resulting from the unsafe or unsound practices.
   The FDIC has adopted regulations to implement Section 8(b) of the Federal Deposit Insurance Act which are codified at 12 CFR 308.32 through 308.38.

THE RECORD

   The record upon which the findings of fact, conclusions of law, and recommended decision are based consists of the following:

   1. The transcript of the hearing held before the undersigned on April 2 and 3, 1985. This transcript consists of two volumes. Volume 1 contains a record of the testimony heard on April 2, and consists of 224 pages, including the certificate of the reporter. Volume 2 contains a record of the testimony received on April 3, and consists of 225 pages, also including the certificate.
   2. Eight exhibits offered as evidence by the FDIC, numbered 1 through 8, and described in Appendix 1 attached hereto.
   3. Four exhibits offered in evidence by the Bank, numbered 2 through 5, described in Appendix 2 attached hereto.
   4. The briefs and memoranda of the parties and various jurisdictional documents and items of correspondence described in Appendix 3 attached hereto.

   [.6] In its arguments, particularly in its post-hearing memorandum, the FDIC has cited numerous cases holding that the voluntary cessation of conduct that is subject to a cease-and-desist order does not prevent the appropriate issuance of such an order under the Federal Deposit Insurance Act and under several similar federal statutes. The authority cited is quite persuasive. Little in the way of contrary argument has been raised by the Bank. It is also noteworthy that the statute in question clearly provides for the issuance of such an order where unsafe or unsound practices have occurred, without any requirement that the practices continue to the present time.
   On the other hand, it is quite clear that events taking place after a given date may well shed light on the earlier situation. Thus, the subsequent repayment of a loan is arguably relevant to the question of the appropriate classification of a loan in an earlier examination of a bank. This would be particularly true in the event that a loan was classified as doubtful or as a loss. As was argued at the hearing, the repayment of a loan would not by itself establish that the original granting of the loan was not "unsafe or unsound," but one can hardly deny the logical relevance of that repayment to the question. Moreover, even evidence as to the actions of the Bank's directors or management subsequent to the examination may have some arguable relevance to the issue involved here. While this evidence would be irrelevant to the extent that it merely established that a questionable practice had ceased, the evidence could be relevant in establishing the qualifications of the Bank management, to the extent the management had not changed since the relevant time period; it could be relevant in establishing a continued pattern of questionable practices; or it could in some other way shed light on the Bank's operations at the time that is actually at issue. Admittedly, it is difficult to see any of this evidence as particularly weighty. Nevertheless, given the nature of these proceedings where the trier of fact may discount marginally material matter, there is little need to exclude the proffered evidence from the record.

ISSUES

   Under the provisions of Section 8(b)(1) of the Federal Deposit Insurance Act, the general issue with respect to which the undersigned is to issue a recommended decision is whether an order should issue directing the Bank and its management to cease and desist from certain unsafe and unsound practices and to take affirmative action to correct any damage caused by these practices. The specific issues are whether the record establishes that the Bank has engaged in any unsafe and unsound practices, is engaging in such practices, or can be shown to be about to engage in such practices. Additional issue include the exact contents of a cease-and-desist order, if such an order would be appropriate. The unsafe and/or unsound banking practices alleged by the FDIC are set forth in paragraphs 3 through 9 of the Notice of Charges, dated November 7, 1984. These allegedly improper practices are further specified in the FDIC's pre and post-hearing memoranda, the testimony of its witnesses, and its proposed findings of fact.
   In the interest of expeditiously disposing of the matters before him, the Administrative Law Judge will proceed according to the following outline. First, the specific practices which the FDIC alleges are unsafe or unsound will be discussed in some detail. Second, the findings of fact proposed by the parties and the exceptions thereto are evaluated with a view to providing a ruling with respect to each finding, as required by 5 U.S.C. 557(b). Third, a similar treatment will be made of the conclusions of law proposed. The undersigned will discuss the specific provisions of the order proposed by the FDIC. Finally, the Administrative Law Judge will then make his findings of fact, {{4-1-90 p.A-678}}conclusions of law, and recommended decision.

ALLEGED UNSAFE OR UNSOUND PRACTICES

   The FDIC asserts that, as of its May 31, 1984 examination, the Bank engaged in certain unsafe or unsound banking practices. The Bank contends that, in general, the conduct involved did not constitute unsafe or unsound banking practices. Basically, the dispute is not over the fact of the conduct as much as over its characterization as unsafe or unsound. We will discuss the major allegations individually.

   I. Hazardous Lending and Lax Collection Practices

   The FDIC alleges that these practices have taken place with respect to several loans and lines of credit. The specific allegations will be grouped under the particular loan or loans involved.
   A. The * * * Loans. These loans were made to * * * and his son, * * *. At the time of the examination, there was an outstanding loan of $187,488 to the father, of which a participation had been sold to the * * * State Bank in the amount of $147,488. The remaining $40,000 was classified as a substandard loan by the examiner. The balance owed by the son at the time of the examination was $34,150, and this loan was also classified as substandard.
   With respect to these loans, the FDIC alleges that the Bank failed to properly analyze the credit risk before extending credit to the * * *. It was noted that * * * was a tenant farmer on 485 acres, of which 200 acres was owned by his father. His line of credit consisted of three notes secured by farm machinery and equipment, livestock, and crops. His financial statement, dated January 24, 1984, reflected a deficit working capital position, heavy debts, and a net worth of only $24,000. The father was reported to be retired. The loan was secured by collateral including a mortgage on 80 acres of real estate. No appraisal of the real estate was contained in the Bank's files. The examiner was of the opinion that the Bank's vice president overestimated the value of the property. He stated that the vice president, Mr. * * * , had estimated the land as being worth about $2,400 per acre. The examiner testified, however, that similar land was selling at about $1,800 an acre in the area. In addition, it was noted that * * *'s cash flow was insufficient to pay back the loan but that repayment was expected from the cash flow of his son's farming.
   In response to these allegations, in its post-hearing arguments, the Bank merely indicates that * * *'s loan value has been reduced to $12,000, and is secured by $65,000 worth of collateral and that * * * loan now has some additional security. Mr. * * * testified that at the time of an earlier examination by the FDIC, in September 1983, the loan to * * * was some $12,500 less but was secured only by machinery and equipment. Between the two examinations, the additional $12,500 was advanced, and the Bank received a mortgage on the 80 acres of land. In addition, Mr. * * * testified that the FDIC's examiner may have been mistaken in his estimate of land values because of a greater familiarity with land south of the * * * , where be believes the land is poorer. Mr. * * * testified to having personal knowledge of three sales within 90 days of the hearing of farmland in the area in question for prices in excess of $2,250 per acre. He further noted that the FDIC did not classify this loan at the time of the 1983 examination.
   On the basis of the record, the undersigned concludes that at the time of the May 1984 examination, the Bank has not been shown to have been engaged in a particularly hazardous practice with respect to the security on the * * * loan. On the other hand, it would not be unreasonable to consider it unsound on the part of the Bank to have made the * * * loans with inadequate cash flow for timely repayment. While the ultimate recovery of the Bank's money may well have been assured, timely payment with appropriate interest without inordinate cost was hardly certain. Thus, the allegation with respect to faulty credit risk and analysis would seem to be supported by this record.
   In a separate allegation, the FDIC has alleged that the * * * loans were supported by insufficient or illiquid collateral. For the reasons stated above, this allegation is not supported with respect to the * * * loan. With respect to the * * * loan, the FDIC has apparently give little weight to the crop lien which the Bank holds. Given the liquidity and significant value of this asset the Bank's contention that the collateral on the * * * loan was sufficient would appear {{4-1-90 p.A-679}}more plausible than the contrary contention.
   A third allegation of unsafe or unsound practices with respect to the * * * specifies that the Bank was lax in failing to establish a repayment program on the * * * loan at the time of its recent restructuring and consolidation. In support of this allegation the FDIC examiner testified that there was no repayment plan in the file at the time of the last examination. Mr. * * * , however, testified in some detail that a new note signed by Mr. * * * included a requirement for payments to amortize the loan over a 15-year period. Since the FDIC bears the burden of proof under 5 U.S.C. 556(d), the lack of any real preponderance of the evidence results in a finding that the existence of an unsafe or unsound practice relative to this specific issue was not established.
   The * * * Loan. This was a loan made to a corporation co-made by * * * and * * * in connection with a bulldozer salvage operation. The alleged unsafe or unsound practices consists of a failure on the part of the Bank to properly analyze credit risks and to secure adequate documentation for the loan. Specifically, it was noted there was no financial statement of the co-makers in the Bank's file and no independent documentation of the value of certain personal property (tools) provided as security. It was also noted that the corporate financial statement showed a debt of $218,900 and a net worth of only $20,000. There were other allegations made with respect to this loan in the examination report which sought to support the classification of the loan as substandard, but, apparently as a result of the testimony at the hearing, only two allegations survived in the FDIC's post-hearing memorandum. Originally, the FDIC objected to the lack of an onsite appraisal of the commercial real estate involved here, but they later limited their complaint regarding appraisals to the lack of documentation of the value of the machinery and equipment. The need for an outside appraisal of this equipment was felt to be all the more necessary because the enterprise was not the type of business the Bank normally dealt with; and, therefore, the value of the tools and equipment would probably be outside the bank officer's expertise. Moreover, the need for a financial statement by the co-makers of the loan was particularly crucial in light of the somewhat deficient corporate financial statement, which was prepared by a CPA who disclaimed full liability for its accuracy, and of the undercapitalization of the corporation.
   By way of response in its post-hearing memorandum, the Bank merely reported that the entire loan committee did an onsite appraisal of the business property and that performance by the borrowers had been timely. Thus, it appears the Bank does not deny the specifics of the allegations now asserted by the FDIC with respect to this loan, nor did the Bank refute the evidence set forth in the testimony of the FDIC examiner and the text of his report. The Administrative Law Judge will, therefore, find that this particular allegation has been proven.
   C. The * * * Loan. This loan represented a line of credit in connection with farming operations. It was classified in the September 1983 examination. The * * * a financial statement indicated a heavily leveraged position with debts of $653,000 and a net worth of only $58,000. Moreover, the borrowers' net worth may well have been overstated by the use of exaggerated values for the real estate involved (testimony of Mr. * * * , Vol. 1, page 96). The Bank has not refuted these allegations. Some dispute exists, however, with respect to developments relative to this line of credit between the September 1983 and May 1984 examinations. Apparently, some additional funds were expended, but some additional collateral was obtained. The FDIC expressed concern with the fact that the additional collateral was in the form of a junior mortgage on some real estate. With respect to these allegations, however, Mr. * * * testified that the Bank was looking to shore up its position between the two examinations. The additional extensions of credit apparently were as the result of some contractual obligations. These additional extensions were followed by prompt collection action (TR, Vol. 2, pages 86 and 106). In light of this testimony, the Administrative Law Judge is not persuaded that the Bank engaged in any unsafe or unsound practice with respect to this loan after the September 1983 examination. The inadequate risk assessment at the time the line was established, however constitutes such a practice.
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   D. The * * * Loan. This was a line of credit to a storekeeper. The FDIC's objection to the loan was due to the lack of an appraisal of the property that secured part of the loan and the lack of a current financial statement of the borrower. In its post- hearing memorandum, the Bank replied that the loan was part of a participation purchased from another bank and that the credit information was subsequently received from the selling bank. Apparently, the Bank's reliance on the originating bank's credit file was misplaced. Moreover, when the financial statement was obtained, it showed a deficit net worth. Since there is no evidence to refute the proof the FDIC has submitted in support of these allegations, they will be considered established. It is noted that part of the amount classified for the * * * loan had to do with certain check overdrafts which had been paid by the Bank. Originally, the FDIC suggested that there was an unsafe or unsound practice involved here with respect to inadequate supervision and an overbroad grant of authority to the employee who paid the overdrafts. However, the FDIC post-hearing memorandum does not mention these allegations. There was testimony that the employee involved was adequately bonded, the surety completely covered the loss, and the employee was promptly discharged after the loss was discovered. These facts refute a finding that the overdraft involved any significant unsafe or unsound practice.
   E. The * * * Loan. Mr. * * * is a hog farmer who filed for bankruptcy 6 days before the May 1984 examination. The note was dated February 28, 1980. Security was a junior mortgage on farm buildings and 57 acres of land subject to a first mortgage owned by the Federal Land Bank. In its post-hearing memorandum, the Bank states, "The real estate was taken as security to secure the loan already on the books; no additional funds were advanced, and any security gained was done with no expense to the Bank." This was apparently in response to a finding proposed by the FDIC which alleged that the Bank's files showed no appraisal for the property or on the personal property which formed another portion of the security on the loan. It appeared that the Bank is referring to the time of the later foreclosure on the Bank's mortgage—when the real estate was actually taken—a proceeding complicated by another bank's assertion of an interest in the property. As of the time of the hearing, apparently the Bank owned the real estate involved. In his testimony, Mr. * * * agreed that "this line of credit deserved classification" (Vol. 2, page 82). Given the lack of appraisal of the security taken at the time that the loan was made, particularly in light of the junior nature of the real estate lien, the Administrative Law Judge concludes that this loan supports the FDIC's allegations of unsafe or unsound practices. On the other hand, the FDIC's contention that the mere fact that the lien the Bank held was inferior to another mortgage thereby makes the collateral undesirable is without merit. Certainly, all things being equal, a first mortgage is preferable to a second. On the other hand, depending upon the value of the property involved and the amount of the first mortgage, a second mortgage could well provide adequate security in a given instance.
   F. * * * Estates. Lax collection practices were the substance of the FDIC's complaint with respect to the loan to this corporation. However, in its post-hearing memorandum, the FDIC's sole allegation is that the Bank's file was deficient in not documenting the value of the commissions expected on the sale of coal refuse which was to repay the loan. In response the Bank argued that the coal refuse commissions did not constitute the security upon which the loan was granted but merely some additional security acquired in the course of structuring a repayment schedule. It would seem, however, that the FDIC's misgivings in this regard relate to the fact that, at the time of the May 1984 examination, the repayment schedule was based almost exclusively on these commissions. To the extent that the value of these commissions, although unknown, was the basis for not further pursuing collection efforts at that time, the Banks practices reflect some laxity.
   G. * * * Dental Labs. This is another complaint by the FDIC of a lack of documentation of the value of security. In response the Bank submits that it did an onsite appraisal to verify a financial statement. Given the fact that the security included a patent, which would be difficult to evaluate by the Bank without an outside appraiser and the likelihood that the same would be true of some of the equipment involved, the FDIC has carried its point. (As it developed, the Bank apparently was paid by a life insurance policy on the life of the borrower.)
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   H. * * * Explorations. This line of credit was extended to a company well known to the president of the Bank. Apparently, the loan was accepted on the basis of that reference alone. The loan files contained no financial information on the company or the value of the equipment that was security for the transaction. While the loan involved here could well have been sound from a banking standpoint, the soundness is not reflected in the Bank's files. It is elementary that a bank must not only engage in safe and sound practices with respect to its loans, as well as with respect to the rest of its business, but it must also document those practices adequately so that those who look over the books of the bank may see the soundness of its operation. In the absence of such documentation, the FDIC, the State banking authorities, and other interested parties have no reason to assume that everything is in good order. It is only by requiring adequate documentation, as well as sound practices, that the FDIC can protect the insurance fund, that the appropriate banking authorities can protect the depositors, and that the minority stockholders can protect themselves. It would, therefore, appear that the FDIC's misgivings in this regard are well founded.
   I. * * * and * * *. This loan consists of four notes made to friends of a former officer of the Bank. It was secured by first real estate mortgages on two dwellings with a combined value of $63,700, according to the Bank's own appraisal. The total amount of the loan is slightly in excess of $55,000. The examiner's testimony at the hearing (Vol. 1, page 101) was that the appraisal of one of the two properties was $10,000 higher than the cost of the property, which had been purchased shortly before. When it became obvious that there was going to be a default on the loan, the Bank would agree to forgive only $45,000 of the loan if the property were conveyed outright to the Bank. The Bank argues that its records, indicated that the real estate was worth more than the principal of the loan. However, the testimony, which has not seriously been attacked by the Bank, would indicate that the Bank's appraisal of the property was excessively high and that the Bank should have known that it was. Accordingly, the FDIC's allegations in this regard are proven.
   J. * * * Farms. Lax collection practices are alleged by the FDIC with respect to a loan to a joint-venture farming operation, i.e. no formal repayment program had been established for an overdue loan despite an apparent deterioration in the borrower's financial position. The examiner reported that the Bank management was unaware as to whether part of the collateral, 1982 crops, had been sold when questioned at the time of the examination. Some of the credit on this loan had been renewed after a prior classification by the FDIC. Although the testimony would indicate that payments on this loan are current and there is now a guarantee by the Farmer's Home Administration, the fact that this rehabilitation was possible does not refute the obvious inadequacies of this loan at the time of the examination.
   K. * * *. With respect to this loan, the FDIC alleges that the Bank failed to take corrective action when the borrower's net worth was deteriorating by establishing a repayment program or otherwise and that it failed to notify the guarantor on the loan when the loan was renewed. At the time of the examination, the Bank's records indicated that the loan was guaranteed to an amount of $140,000 by the borrower's mother. In addition, there was some security in the form of a lien on machinery, equipment, and livestock. The deterioration in the borrower's financial position was as the result, in part, of tornado damage to under-insured buildings. At the time of the examination, the total principal on the loan was $201,300, of which $158,066 had been sold as participations to the other two banks in which the President of the Bank of * * * also has an interest. Bank officials testified that the guarantor had established her net worth to the satisfaction of the Bank. She was reported to have 640 acres of prime farm land, $200,000 in various certificates of deposit, plus some residential real estate, with no debts other than her liability on her son's loans from this Bank. She had stated adamantly that the borrower was her son, and she "was going to take care of him."
   In its post-hearing arguments, the Bank merely indicated that the Borrower's present liability to the Bank of * * * is only $15,000, which is well secured. Even assuming the accuracy of this final statement {{4-1-90 p.A-682}}and the testimony concerning the guarantor, the Bank's failure to take corrective action—in the form of a repayment plan or otherwise—while the borrower's net worth was seriously deteriorating and its failure to be certain that the guarantor was aware of all renewals of credit would certainly seem to be a questionable practice.

   II. Excessive Other Operating Expenses and Excessive Loan Losses

   The FDIC contends that the excessive loan losses would logically follow from the Bank's lending practices, discussed above. It points out that the Bank's loan losses from 1983 totaled $100,000. It contends that, for a bank this size, this would be clearly excessive. The Bank's counterallegation that the FDIC has seen losses this large in a bank this size certainly does not refute the FDIC's position that they are excessive.
   With respect to other operating expenses, the FDIC makes reference to the specific expenses of the operation of a discount brokerage service owned by the Bank's holding company and expenses related to a gun promotion which the Bank conducted. The Bank contends that the discount brokerage expenses were repaid to the Bank, but this apparently occurred after the examination that gave rise to the present proceedings. For the Bank to assume expenses incurred by the holding company would clearly be improper and inconsistent with the Bank's duties to its depositors and to its minority shareholders. The explanation offered in the testimony that there was some quid pro quo in the form of data processing services simply fails to justify the practice.
   Regarding the expenses attributable to the gun promotion, there is certainly nothing improper with the Bank's paying the expenses of its promotion. Allegations that these expenses were excessive relate to the question of management judgment in originating the promotion, which is discussed below.

   III. Inadequate Loan Valuation Reserve

   The FDIC argues that the Bank should maintain a loan valuation reserve of 1.25 percent of total loans. This was a figure set forth in The Memorandum of Understanding that resulted from the September 1983 examination, to which the bank agreed. In the present proceedings, the Bank has not seriously challenged the reasonableness of a 1.25 percent reserve, although it contends that it has always had an adequate reserve. There is no question but that, at the time of the May 1984 examination, the Bank's loan reserve was approximately half that level. Nevertheless, the Bank points out that it has been able to replenish its loan reserve periodically from its earnings, as needed. It seems to argue also that whether money is carried on the Bank's books as a loan valuation reserve or as some other form of capital, the important thing is that the funds are available to protect against loan losses. Finally, the Bank does point out that, prior to writing off the loans classified by the FDIC in May 1984, its loan valuation reserve was at 1.25 percent of total loans or higher.
   On the record before him, the Administrative Law Judge must conclude that a 1.25 percent loan valuation reserve for a Bank such as this is certainly reasonable. Undeniably it is of highest importance that the Bank have capital available to offset loan losses without jeopardizing its depositors' interests, and the designation of specific funds as a loan valuation reserve is not a meaningless bookkeeping detail. As the FDIC points out, a failure to set aside adequate funds to offset unpredictable loan losses tends to overstate the other capital of the Bank. This overstatement is reflected in the quarterly call reports which the Bank must file and which are available to the public. The Bank's argument that its loan reserve was adequate until the FDIC directed it to charge off certain loans raises another problem. As the FDIC rightly points out, the Bank has a responsibility to review its loan portfolio periodically and to cease carrying worthless loans as assets. A failure to do so, once again, results in an overstatement of capital in the call reports and elsewhere. While the Bank has argued that the FDIC in its proposed cease and desist order, is preempting some of the management responsibilities of the Bank and going beyond what is necessary to protect the agency's limited interest, paradoxically it seems to have relied on FDIC examinations to do its work in reviewing its loan portfolio. The minutes of the Board of Directors of the Bank fails to disclose a review of the loan portfolio with an eye towards charging off bad loans. The lack of any recorded effort on the part of the Bank to identify losses in a timely fashion undermines its argument that its loan valuation reserve has been adequate because the reserve was promptly replenished after the FDIC identified losses in the loan portfolio.

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   IV. Inadequate Equity Capital and Reserves

   At the time of the May 1984 examination, the ratio of adjusted equity capital and reserves to adjusted total assets was 6.78. In September 1983 it had been 5.87. The increase was due to the sale of $250,000.00 worth of stock in the Bank at the urging of the FDIC after the earlier examination. The FDIC contends that the present ratio is inadequate for the particular type of bank in question. It has called the Administrative Law Judge's attention to its statement of policy on capital adequacy (46 Federal Register 62694, December 28, 1981). This statement defines this particular ratio and sets certain objective standards to provide a benchmark for evaluating capital adequacy.
   The FDIC, in this statement, establishes a "threshold" level of adjusted equity and capital for all insured nonmember commercial banks at 6 percent of adjusted total assets. Failure to maintain this ratio would result in a required submission of a comprehensive capital plan. The policy statement also establishes a "minimum acceptable" level at 5 percent. Failure to maintain this level would result in the FDIC requiring a specific program for remedying the equity capital deficiency. The statement does provide, however, that some higher limit may be determined "through an analysis of the overall condition of the institution." It further states that the percentage guidelines "are for financially sound, well managed, diversified institutions with established records of adequate capital formation relative to asset growth [emphasis in original]."
   The testimony at the hearing by the FDIC's examiner was that a ratio of about 8 percent would be appropriate for the instant bank. Certainly, if a 6 percent threshold level is appropriate for a sound, well managed, diversified institution, a higher level would be appropriate for a bank which admittedly has special problems as a small agricultural bank. Moreover, the Bank of * * * could hardly be characterized as having an established record "of adequate capital formation relative to asset growth." It should be noted, however, that this deficient ratio of equity capital to assets relates to the Bank's earnings history, which has involved losses recently. The poor earnings are the result of many factors, both internal and external to the Bank. Nevertheless, the situation rightly gives rise to concern on the part of the FDIC and justifies specific, immediate remedial action.

   V. Unsatisfactory Bank Management

   Clearly, the present financial situation of the Bank of * * * leaves much to be desired. The Bank contends that its problems are basically due to the present state of the agricultural economy in central * * *, a circumstance over which the Bank has no control. The FDIC argues, on the other hand, that the Bank could and should have taken appropriate measures to deal with those problems. The record is not lacking in support for this contention. The Bank's Board of Directors should certainly have not permitted the lax lending practices noted above. It would appear that major management responsibility for Bank operations devolves upon its president, who is available less than 40 percent of the time because of his responsibilities to two other banks in which he has an interest. The testimony indicated that the Bank's management in time past involved individuals whose performance was less than adequate in carrying out serious responsibilities. There is also testimony that Bank management attempted to cope with some of its problems by eliminating staff in a way that only compounded its problems. A lack of adequate supervision by the Board of Directors is reflected in the Bank's loan policy in effect at the time of the May 1984 examination. This loan policy delegated loan approval authority to three officers of the Bank by name. At the time of the examination, two of those individuals were no longer employed by the Bank. Rather, the individuals who were providing day to day to management of the Bank's loan department enjoyed no specific delegation of authority by the Board of Directors. This certainly does not reflect appropriate attention by the Board.
   The FDIC also point to the handling of the Bank's promotion of new business by giving away guns to depositors as demonstrating a lack on the part of management. The FDIC's objections are that the Bank engaged in a nationwide promotion for deposits without an adequate plan to invest those funds or to provide for adequate growth in equity capital to keep pace with the growth in deposits. The record is not entirely clear, however, that this episode {{4-1-90 p.A-684}}demonstrated poor management. The promotion was not originally intended to be nationwide. Apparently a single advertisement was placed in a local newspaper. Interest spread beyond the Bank's area when national news services reported the promotion as a news item. Deposits, far beyond the Bank's expectations, began to come in from all over the country, and even from overseas. Because of difficulties in meeting the demand for the premiums that the Bank was giving away, the Bank apparently ordered a large number of guns in advance. When the novelty of the promotion wore out, after generating about $2.5 million in deposits, the Bank was left with a sizable inventory of guns.
   Thus this promotion, although generating a large amount of additional deposits, also generated sizable expenses for this small Bank. Contrary to the FDIC's contention, however, the Bank did not appear to initiate this promotion as a nationwide solicitation of business. An advertisement was placed in a national magazine, but apparently only when it appeared that the Bank was going to be left with a sizable inventory of firearms. It does not appear that the results of this promotion, plus and minus, were necessarily foreseeable even by the best of management. Thus, promotion itself has not been shown, at least on this record, to have represented unsound management on the part of the Bank.
   With respect to the investment of the funds generated by the promotion, the FDIC's criticism is two-fold: first, there was a lack of a prior plan as to what to do with the funds, and second, the investments that were made had inordinately long maturity dates. For the reasons stated above with respect to the foreseeability of the course of the promotion, the lack of a prior plan does not appear surprising. The evidence with respect to the long term investments is not altogether clear, despite some request for clarification by the undersigned in the course of the hearing. The record would indicate that the deposits generated by the gun promotion were of relatively long term. Some of the funds were used by the Bank to purchase certain government securities. Although the securities bore relatively low interest on their face, the record suggests that they were purchased at unspecified discounts. The Bank's president testified that they generated interest several percentage points above the cost of the money to the Bank. The record did not establish what portion of the securities have maturity dates extending beyond the maturity dates on the certificates of deposit which the Bank issued. In short, the record provides an insufficient basis to make a finding that the Bank's management was lax in purchasing the long term securities held by the Bank.
   Although not all of the FDIC allegations of unsatisfactory bank management are supported by this record, some of them are established. Certainly with the problems in the economy in the * * * area which the Bank is so quick to point out, there is a need for capable management for this Bank if its problems are to be resolved. Thus, the need for a provision in a cease and desist order for some assurances with respect to Bank management would appear to be well established.

FINDINGS OF FACT PROPOSED
BY THE PARTIES

   Although both parties had an opportunity to submit proposed findings of fact and conclusions of law, as provided by the FDIC Regulations and the sections of Title 5 of the United States Code relating to administrative procedures, only the FDIC did so. The Bank, however, did file certain exceptions to the findings proposed by the FDIC. We will now proceed with a discussion of the findings of fact with an eye toward adopting, rejecting, or modifying each of them.
   The Bank has admitted the allegations of proposed findings one through five and these findings are adopted as findings one through five set forth below.

   [.7] Proposed finding number 6 was a finding with respect to the composite rating given the Bank in its examination by the FDIC under the uniform financial institution's rating system. In response, the Bank does not deny the fact that the FDIC assigned that rating, but points out that these ratings "are discretionary with FDIC." While the Administrative Law Judge is not certain that "discretionary" is the appropriate term, it is clear that this rating is merely the FDIC's opinion of the Bank's condition. A finding that a given rating was assigned to the Bank says no more than that this is what the FDIC rated the Bank on the basis of the expert opinion of its examiners. With respect to this finding, however, the Bank also objects to the language in the proposed {{4-1-90 p.A-685}}finding that "the Bank's future prospects are bleak and it may eventually fail." This objection is well taken. The meaning of a composite rating of 4 under the uniform financial institution's rating system, as set forth in the FDIC's statements of policy, makes no reference to a bleak future. The reference that the Bank "may eventually fail" has little meaning. Obviously any enterprise "may eventually fail." A composite 4 rating is described as follows:

   "Institutions in this group have an immoderate volume of serious financial weaknesses or a combination of other conditions that are unsatisfactory. Major and serious problems or unsafe and unsound conditions may exist which are not being satisfactorily addressed or resolved. Unless effective action is taken to correct these conditions, they could reasonably develop into a situation that could impair future viability, constitute a threat to the interests of depositors and/or pose a potential for disbursement of funds by the insuring agency. A higher potential for failure is present but is not yet imminent or pronounced. Institutions in this category require close supervisory attention and financial surveillance and a definitive plan for corrective action."

PROPOSED CONCLUSIONS OF LAW

   The FDIC has proposed nine specific conclusions of law. The Bank has proposed none but replied that, "The FDIC has failed to prove the allegations contained" in those proposed conclusions. A careful review of the nine proposed conclusions would indicate that they flow from the findings made above and the plain reading of Section 8(b)(1) of the Federal Deposit Insurance Act. The Administrative Law Judge will, therefore, adopt these proposed conclusions. Proposed conclusion No. 2, however, would seem to result from the conclusions subsequent to it, since the FDIC would not have authority to issue a cease-and-desist order without establishing the unsafe or unsound banking practices. Accordingly, the conclusions will be rearranged to put the second proposed conclusion last.

PROPOSED RECOMMENDED ORDER
TO CEASE AND DESIST

   Pursuant to its rights under the applicable statutory and regulatory law, the FDIC has submitted a proposed text of an order for the undersigned to recommend to the board of directors. The Bank has proposed that the undersigned recommend an order dismissing the notice of charges. For the reasons stated above, the findings of fact and conclusions of law reached herein lead to a conclusion that a cease-and-desist order is proper. Indeed, most of the provisions of the order proposed by counsel for the FDIC appear to be warranted. Some modification, however, is appropriate.
   The proposed order begins with a rather general provision that the Bank cease and desist from six unsafe or unsound banking practices. Each of the six practices is supported by specific findings of fact set forth herein. These relate to an inadequate level {{4-1-90 p.A-693}}of equity capital protection, hazardous lending and lax loan collection practices, inadequate loan valuation reserve, excessive operating expenses and loan losses, inadequate management, and inadequate staffing. Following these general provisions in the proposed order, there are 14 specific provisions which will be discussed separately.
   Paragraph 1 of the second part of the order requires the Bank to take all steps necessary to increase the Bank's total equity capital in reserve by an amount not less than $100,000. It is indicated that the Bank can choose from one of several different means to accomplish this purpose. If the Bank chooses to accomplish this purpose through the sale of securities, there are provisions requiring disclosure of certain information according to a certain time schedule to the FDIC so that the agency can be assured that everything is in order. In light of the finding reached herein with respect to equity capital and reserves, these provisions appear to be well founded.
   Paragraph 2 deals with staffing of the Bank and, specifically, with management personnel. It requires that the Bank provide management acceptable to the regional director, including a qualified principal lending officer with collection experience. It further provides that the authority of such a lending officer shall be specified in writing by the board of directors. Additionally, this provision would require the board to review the Bank's staffing requirements in order to determine that these requirements are adequately met. In light of the Bank's problems, as set forth in the findings made herein, these provisions appear to be reasonable. In adopting this provision in the order he recommends to the Board of Directors, however, the Administrative Law Judge does not mean to imply that any particular present employee of the Bank, including Vice President * * * , may or may not meet the qualifications for the principal lending officer set forth in the order. One would expect the FDIC's regional director to review the qualifications of any such employee selected by the Bank's board, taking into account all of his qualifications including the adequacy of any services provided to the Bank of * * * in the time that has elapsed since the May 1984 examination.
   Paragraph 3 merely requires charge-off or collection of all assets classified as loss and 50 percent of all assets classified as doubtful in the last examination. This provision would appear to need little discussion, particularly in light of the testimony at the hearing that it may have already been done.
   Paragraph 4 requires replenishment of the Bank's loan valuation reserve and maintenance of it at a minimum level of at least 1.25 percent of total loans. It requires that all Reports of Condition and Income requested by the FDIC filed by the Bank since May 1984 be amended and refiled if they did not make a provision for loan losses and a loan valuation reserve that is adequate. This section further requires a review of the loan portfolio and the adequacy of the loan valuation reserve prior to any future Reports of Condition and Income. For reasons well discussed above, this would appear to be an appropriate provision for the cease-and-desist order.
   Paragraph 5 requires a reduction in remaining assets classified as substandard and doubtful as of May 1984. In light of the findings that these amounts have been excessive, this provision is merely a reasonable measure to correct the damage of past unsafe or unsound practices.
   Paragraph 6 prohibits the Bank from declaring or paying a cash dividend without the prior written consent of the regional director of the FDIC. The Bank has argued that it has not, in recent years, declared any such dividends. Therefore, this provision of the proposed order would not address the cessation of any past practices. Moreover, there is no evidence that the Bank is about to declare any such dividend. Nevertheless, the payment of any such dividend by a bank so closely held would be so clearly self-serving on the part of the individuals principally involved that it could hardly be unattractive; and, at the same time, it could be immediately detrimental to the Bank's financial condition. Given these factors, the requirement that the Bank seek prior approval from the FDIC before paying a dividend would appear to be a reasonable measure to assure the correction of the Bank's situation.
   Paragraph 7 requires a review of the Bank's loan policy by the board of directors leading to any revisions that may be appropriate and necessary to strengthen lending {{4-1-90 p.A-694}}procedures. It also requires that this review be documented in the minutes of the board. The need for this measure is clearly established on the basis of the findings and conclusions set forth herein.
   Paragraph 8 deals with the prohibition against the Bank's repurchasing any lowquality asset previously sold as a loan participation. As is apparent in the record, this does not address any practice in which the Bank has engaged. While any such repurchase could arguably be considered detrimental to the Bank, there is no evidence that the Bank is about to do this. Moreover, it would be difficult for the Bank to do this, even if prior consent of the FDIC were not required, and still meet the other provisions of the proposed order. Since the statute only permits a cease-and-desist order to address prior unsafe or unsound practices or affirmative action reasonably necessary to correct the damage of such practices, it would appear that this provision is not appropriate. The mere allegation that a particular practice, if engaged in, would be detrimental is not sufficient to justify a specific provision in a cease-and-desist order. If so, the order could include a very long list of all the imaginable actions of a bank and its management that could affect its solvency. For these reasons, the Administrative Law Judge will not include such a provision in his recommended order.
   Paragraph 9 deals with a required review of the Bank's investment/liquidity policy and funds management practices. Recording of this review in the minutes of the board is also mandated. In light of the findings of fact and conclusions of law herein, this provision is clearly appropriate for a cease-and-desist order in this case.
   Paragraph 10 makes similar provisions with respect to the Bank's budget and is similarly appropriate. For obvious reasons, the provision does require communication of the budget to the regional director of the FDIC and a quarterly review of the Bank's performance in relation to the budget.
   Paragraph 11, like paragraph 8 above, deals with a practice in which the Bank has not engaged—the use of brokered deposits. Once again, it provides that the Regional Director of the FDIC shall receive prior notice of any intention to take such action and shall have the right to veto it. For the reasons set forth in connection with paragraph 8 above, the Administrative Law Judge will not include this provision in his recommended order.
   Paragraph 12 deals with the requirement that the substance of the cease-and-desist order be communicated to all shareholders of the Bank, including its minority shareholders. This would seem to be one of the greatest concerns of the Bank with respect to these proceedings. While the Bank's officers have almost stated that they would have entered into a memorandum of understanding with the FDIC with respect to most of the provisions of the proposed recommended order, they expressed grave fears about the impact of a cease-and-desist order on the Bank's image in the community upon which it depends for its business. With approximately four to five percent of the Bank's stock owned by small investors in this small town, communication to the shareholders is thought to create a likelihood of a run on the Bank or some similar misfortune. On the other hand, one could hardly justify not advising the minority shareholders when action such as this is taken by the FDIC. The adverse impact of this disclosure is something that has to be considered by those in the FDIC charged with exercising the agency's discretion. The language of Section 8(b) of the Federal Deposit Insurance Act indicates that, under the appropriate circumstances, the notice of charges "may" be issued. Presumably, before issuing its notice of charges, the FDIC decided that such an approach was in accord with sound discretion. Similarly, the statute provides that, if the charges are proven, the Board of Directors of the FDIC "may" issue a cease-and-desist order. It would, therefore, seem that the Directors, in their discretion, could agree with the findings of fact and conclusions of law herein and still refrain from issuing a cease-and-desist order. Nevertheless, the Administrative Law Judge is not involved in the exercise of any such discretion, and his opinion with regard thereto has not been asked. Therefore, the Bank's arguments in this regard might properly be addressed to the Board of Directors, but they provide no reason for the undersigned not to include this provision in the recommended order.
   Paragraph 13 of the order requires written progress reports on a monthly basis with respect to compliance with the order. This is clearly reasonable and will be included in the recommended order.
{{4-1-90 p.A-695}}
   Finally, paragraph 14 basically repeats the provisions of Section 8(b)(2) of the Federal Deposit Insurance Act, which is applicable to these proceedings. Accordingly, this paragraph will also be adopted by the undersigned in his recommended order.

FINDINGS OF FACT

   After carefully considering all of the evidence of record, both documentary and testimonial and having heard the arguments of counsel for the parties, for the reasons set forth above, the Administrative Law Judge makes the following findings:

General Findings

   1. The Bank is a corporation existing and doing business under the laws of the State of * * * and has its principal place of business at * * *. It is, and has been, at all times pertinent to this proceeding, an insured State nonmember bank. The Bank is subject to the Act (12 U.S.C. §§ 1811-1831d), the Rules and Regulations of the FDIC (12 C.F.R. Chapter III), and the laws of the State of * * *. The FDIC has jurisdiction over the Bank and the subject matter of the proceeding.
   2. As of May 31, 1984:
   (a) The Bank's total equity capital and reserves equaled $824,000;
   (b) The Bank's adjusted equity capital and reserves equaled $696,000;
   (c) The Bank's adjusted total assets equaled $10,262,000;
   (d) The Bank's total deposits equaled $9,488,000;
   (e) The Bank's total loans (after adjustment for unearned income of $76,000) equaled $5,633,000; and
   (f) The Bank's gross loans equaled $5,709,000.

Lending Practices

   7. The Bank's loan policy in effect as of May 31, 1984, is deficient because it did not reflect the lending limit of loan officers hired in 1983.
   8. The Bank failed to properly analyze the credit risk before extending credit to the following borrowers:

   * * *. His financial statement indicated a deficit working capital position and a net worth of $24,000.
   * * * : His financial statement indicated inadequate cash flow, and the Bank was dependent on * * * for repayment.
   * * * : The company's financial statement indicated a net worth of $20,000 and debt of $218,900. The company was grossly under capitalized.
   * * * : His financial statement indicated a heavily leveraged financial position with debts of $653,000 and a net worth of $58,000. His net worth may be overstated because real estate was carried on his financial statement at a higher value than that indicated by Bank management.

   * * * : There was no appraisal in the Bank's loan file relating to 80 acres of land held as collateral.
   * * * : There was no financial statement in the Bank's loan file on co-makers * * * and * * *. There was no independent documentation of the value of other unique security (tools).
{{4-1-90 p.A-696}}
   * * *: There was no appraisal in the Bank's loan file on property partly securing the loan or on other security involved. The Bank did not obtain a current financial statement until after the loan was made and the statement showed a deficit net worth.
   * * *: There was no appraisal in the Bank's loan file for real estate held as security.
   * * * Estates: The Bank did not document the value of the commission on the sale of coal refuse which was to repay the loan.
   * * * Dental: The Bank did not document the value of the patent and laboratory equipment and fixtures held as security.
   * * *: The Bank did not obtain financial information on the company or on the value of the oil rigs which are security for the loan.

   [.10,.11] 12. Lax collection practices comprise failure to establish repayment programs, not correcting previously criticized or classified loans, not monitoring a borrower's cash flow position, not obtaining additional collateral, extending additional credit to a criticized borrower, and otherwise not following or tracking a borrower's ability to repay. An out-of-territory loan can be a lax collection practice because the Bank is not as able to service the loan or monitor the collateral at a distant location. An acceptable repayment program consists of a formal agreement with the borrower as to how and when the obligation is to be repaid.
   13. The Bank engaged in lax collection practices in the following instances:

   * * *: The Bank rewrote the loan and advanced additional funds without an appraisal on the real estate collateral. The loan was made outside the Bank's normal lending area.
   * * *: The Bank took no action to monitor or improve its position in a loan classified at a previous FDIC examination. The debtor is now in bankruptcy.
   * * * Estates: The Bank failed to update financial information concerning the borrower after the loan was made.
   * * *: The Bank failed to establish a repayment program.
   * * *: Farms: The Bank failed to establish a repayment program while the financial position of the borrower deteriorated. The Bank was unaware whether part of the collateral had been sold. The Bank had renewed the credit since the prior FDIC examination.
   * * *: The Bank failed to take corrective action when the borrower's net worth was deteriorating by establishing a repayment program or otherwise. The Bank failed to notify the guarantor when the loan was renewed.
   * * *: The Bank should have been aware that the appraisal on the real estate securing the loan was overstated, since the appraisal was performed on a Bank officer and the Bank gave substantially less value on default.

Conditions Resulting From Lending
Practices

   17. The overall condition of the Bank's loan portfolio is quite poor, and there is a significant likelihood of future deterioration.
   18. The poor condition of the Bank's portfolio resulted from improper and imprudent lending practices.
   19. As of May 31, 1984, the Bank's adversely classified loans equaled $887,000, or 15.8 percent of the Bank's total loans and 107.6 percent of the Bank's total equity capital and reserves.
{{4-1-90 p.A-697}}
   20. The total of the Bank's adversely classified loans is excessive.
   21. As of May 31, 1984, loans were adversely classified by the FDIC as $745,000 Substandard, $104,000 Doubtful, and $38,000 Loss.
   22. The increase in "Special Mention" and "Doubtful" classified loans reported on May 31, 1984, represents a deterioration from the Bank's September 12, 1983 FDIC examination.
   23. Other real estate is real estate held by the Bank that formerly secured a loan to the borrower who defaulted on that obligation.
   24. As of May 31, 1984, the Bank's other real estate, income earned but not collected, and other assets adversely classified totaled $196,000 "Substandard" and $38,000 "Loss."
   25. Income earned but not collected represents accrued interest on a loan that a bank has taken into its income but not yet collected in cash from the borrower.
   26. Income earned but not collected is given an adverse classification by the FDIC when the loan itself is adversely classified or is delinquent.
   27. As of May 31, 1984, 58 of the Bank's loans in the aggregate amount of $560,000, or 9.8 percent of the Bank's gross loans, were overdue.
   28. As of May 31, 1984, the Bank had 22 loans in the aggregate amount of $249,000, or 44.5 percent of total overdue loans, that were overdue 90 days or more with interest continuing to be accrued by the Bank.
   29. The practice of accruing interest on loans 90 days or more overdue may distort a bank's earnings and is, therefore, inconsistent with FDIC instructions for the preparation of call reports.
   30. The past-due status of a significant number of loans is an indicator of weaknesses in a bank's loan portfolio and the bank's collection abilities.
   31. As of May 31, 1984, the Bank had eight loans in the aggregate amount of $48,000, or 8.6 percent of total overdue loans, 6 months or more overdue.

Loan Participations

   [.12] 32. A "participation sold" represents an amount or portion of a loan made by one bank that is sold to another bank.
   33. The Bank sold participations of approximately $2 million to The * * * Bank, * * *, or to * * * Bank.
   34. Approximately one-half of the participants sold by the Bank are subject to adverse classification by the FDIC as of May 31, 1984. * * * is associated with both banks to which the participations were sold.
   35. The Bank had not, as of May 31, 1984, repurchased any of the participations sold to other banks.

Other Operating Expenses and Loan
Losses

   36. For 1983 and the period ending May 31, 1984, the Bank reflected net operating losses of $68,000 and $20,000, respectively. The Bank also lost $25,000 in 1981. The Bank lost approximately $200,000 in 1984.
   37. As of December 31, 1983, the Bank's after-tax net operating income to its average assets was inadequate, at negative .63 percent.
   38. The Bank's loan losses in 1983 totaled $100,000, an amount which is far in excess of what the FDIC typically sees.
   39. The Bank's other operating expenses are a component of its overhead expenses.
   40. The Bank's other operating expenses were $149,000 in 1983 and $66,000 for the period ending May 31, 1984.
   41. The Bank's total overhead expenses to average assets as of December 31, 1983, were much higher than average with a ratio of 4.18 percent.
   42. The Bank's other operating expenses included Bank-paid expenses for the gun promotion and a Bank holding company- owned discount brokerage service.
   43. The poor earnings and poor earnings prospects of the Bank are caused by excessive loan losses and other operating expenses.

Loan Valuation Reserve

   [.13] 44. The purpose of a loan valuation reserve is to absorb unexpected loan losses in those loans classified Substandard and all other unacceptable or unrecognized losses in the loan portfolio.
   45. As of May 31, 1984, the Bank's loan valuation reserve was $71,000.
   46. The Bank's loan valuation reserve as of May 31, 1984, was inadequate, in that it {{4-1-90 p.A-698}}equaled only 0.67 percent of the Bank's total loans after elimination of loans classified "Loss" and one-half of those classified "Doubtful."
   47. As of May 31, 1984, the Bank had provided only $20,000 for possible loan losses. This amount is inadequate in view of the Bank's loan losses as of May 31, 1984.
   48. An inadequate loan valuation reserve misstates a bank's earnings and capital.

Capital

   [.14] 49. A bank's adjusted capital is calculated by subtracting from a bank's total capital and reserves those assets classified loss and 50 percent of those classified doubtful.
   50. A bank's adjusted assets are the bank's total assets plus its loan valuation reserve less 50 percent of assets classified doubtful and assets classified loss.

   [.15] 51. As of May 31, 1984, the Bank's adjusted equity capital and reserves represented 6.8 percent of its adjusted total assets.
   52. As of May 31, 1984, adversely classified assets of the Bank not reflected in the Bank's adjusted capital and reserves totaled $993,000, an amount greatly in excess of the Bank's adjusted equity capital. This amount represents $865,000 in assets classified Substandard, $76,000 in assets classified Doubtful, and $52,000 in assets classified Loss.
   53. The equity capital ratio of banks with a similar customer base as the Bank is approximately eight percent.
   54. The Bank is not in compliance with the FDIC's Statement of Policy on Capital Adequacy.
   55. As of May 31, 1984, the Bank's total of $1,121,000 in adversely classified assets was 136.0 percent of the Bank's total equity capital and reserves. This percentage is very high.
   56. The Bank is engaged in an unsafe or unsound banking practice by operating with an adjusted capital ratio of 6.8 percent.

Management Supervision

   57. As of May 31, 1984, the management of the Bank consisted of its Board of Directors and active management in the names of * * *, * * *, and * * *.

   [.16] 58. The duties of the Bank's Board of Directors were to generally supervise the affairs of the Bank.
   59. * * * is the chief executive officer of the Bank and its chief lending and investment officer.
   60. All directors of the Bank signed a memorandum of understanding with the FDIC and the Commissioner of Banks and Trust Companies for the State of * * *, dated January 12, 1984.
   61. The condition of the Bank deteriorated despite Bank management's promises and commitments contained in the memorandum of understanding.

   [.17] 62. It was improper for Bank management to permit the Bank to pay for expenses of the Bank's holding company.

   [.18] 63. The Bank's Board of Directors failed to regularly review its loan valuation reserve despite an obligation and responsibility to do so.

   [.19] 64. The Bank's management permitted the Bank to operate with inadequate staff in both the lending and operations areas.
   65. The Bank's management attempted to reduce its high overhead expense by inappropriately reducing needed staff rather than by reducing its high other operating expenses.
   66. The Bank's management operated with an inadequate budget that was not monitored.
   67. The Bank's management was responsible for a Bank investment policy that gave * * * excessively discretionary investment powers.
   68. The Bank's management failed to promulgate an adequate funds management and liquidity policy.
   69. As of May 31, 1984, the minutes of the Bank's Board of Directors did not document a review of the Bank's loan policy since April 14, 1983.
   70. As of May 31, 1984, the minutes of the Bank's Board of Directors did not document a review of the Bank's compliance with its loan policy.
   71. It was inappropriate for the Bank's management to restate the * * * loan on the Bank's books as an earning asset.
   72. Bank management acted in an unsafe and unsound manner by providing only {{4-1-90 p.A-699}}$20,000 for potential loan losses as of May 31, 1984.
   73. As of May 31, 1984, * * * was present at the Bank approximately 2 days a week. He was the only Bank employee shown to have the expertise necessary for proper onsite management. His absence and the lack of any comparable manager provided inadequate supervision of the Bank's operations.

   [.20] 74. Bank management is responsible for the Bank's lending practices.

CONCLUSIONS OF LAW

   After careful consideration of the entire record, including the evidence and the arguments of counsel for the parties, in view of the foregoing findings, the Administrative Law Judge reaches the following conclusions of law:
   1. The FDIC has jurisdiction over the Bank and the subject matter of this proceeding.
   2. The Bank has engaged in unsafe or unsound practices within the meaning of Section 8(b)(1) of the Federal Deposit Insurance Act by engaging in hazardous lending and lax collection practices as follows:

   (a) by making loans supported by insufficient or illegal collateral;
   (b) by making loans with inadequate documentation;
   (c) by making loans with inadequate credit analysis; and
   (d) by following inadequate loan collection practices.

RECOMMENDED DECISION

   In view of the foregoing, the undersigned Administrative Law Judge recommends to the Board of Directors of the Federal Deposit Insurance Corporation that its decision hold that an order should issue against the Bank of * * * under the provisions of Section 8(b) of the Federal Deposit Insurance Act incorporating the provisions of the following PROPOSED ORDER:
   "IT IS HEREBY ORDERED, that the Bank, its directors, officers, employees, agents, successors, assigns, and other persons participating in the conduct of the affairs of the Bank, cease and desist from the following unsafe or unsound banking practices:

   1. Operating with an inadequate level of equity capital protection.
   2. Engaging in hazardous lending and lax collection practices.
   3. Operating with an inadequate loan valuation reserve.
   4. Operating in such a manner as to produce excessive `other operating expenses' and excessive loan losses resulting in deficit earnings.
   5. Operating with a management whose policies and practices are detrimental to the Bank and jeopardize the safety of its deposits.
   6. Operating with a Board of Directors which has failed to provide a sufficient number of adequately trained {{4-1-90 p.A-700}}employees and which has failed to provide adequate supervision and direction to the active management of the Bank.

   (i) The sale of equity securities; or
   (ii) The elimination of all or part of the `Loss' assets and that portion in excess of one-half of the `Doubtful' assets referred to in paragraph 3 of this ORDER, without loss or liability to the Bank; or
   (iii) The collection in cash of assets previously charged off; or
   (iv) The direct contribution of cash by the directors of the Bank or * * *; or
   (v) Any other means acceptable to the Regional Director of the FDIC's * * * Regional Office (`Regional Director'); or
   (vi) Any combination of the above means.

Appendix 1

EXHIBITS SUBMITTED BY THE FDIC

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Appendix 2

EXHIBITS SUBMITTED BY THE BANK

Appendix 3

BRIEFS, MEMORANDA,
JURISDICTIONAL DOCUMENTS, AND
CORRESPONDENCE

Briefs and Memoranda

   Pre-hearing Memorandum of the Bank, with cover letter from counsel dated March 14, 1985.
   Pre-hearing Memorandum of the FDIC, with cover letter from counsel dated March 22, 1985.
   Post-hearing Memorandum of the Bank and Proposed Order, with cover letter from counsel dated June 13, 1985.
   Proposed Findings of Fact, Conclusions of Law, Recommended Order to Cease and Desist, and Post-hearing Brief of the FDIC, with cover letter from counsel dated June 17, 1985.
   Response of the Bank to the FDIC's Proposed Findings of Fact, Conclusions of Law, Recommended Order, and Brief, with cover letter from counsel dated July 2, 1985.