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FDIC Enforcement Decisions and Orders

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{{4-1-90 p.A-1353}}
   [5120] Docket No. FDIC-87-203b(10-18-88).

   Bank to cease and desist from practices such as operating in a manner as to produce a low net interest margin and unsatisfactory earnings and with management whose policies and practices are detrimental to Bank; failing to properly account for securities trading activities, to maintain adequate documentation of business expenses, to have a formal policy limiting payment of medical expenses to offices and directors, and to monitor transactions of officers and directors; and violating federal law and regulations. (A Motion for Stay Pending Review was denied 12-13-88. See [¶ 5123]. This case has been appealed to the United States Court of Appeals for the Seventh Circuit.)

   [.1] Securities Trading—Intent to Trade
   Determination whether Bank was engaged in securities activities depends upon purpose for which securities were acquired and Bank's intent regarding such securities.

   [.2] Loans—Classification of Adverse—Loss
   Adversely classified assets included an unreconciled balance with a correspondent bank.

{{4-1-90 p.A-1354}}
   [.3] Lending and Collection Policy and Procedures—Inadequate Collateral— Appraisal Methods
   Loans to President and Chairman were listed for Special Mention due to inadequate appraisal methods used for valuing collateral. Bank also failed to verify its lien position, to obtain insurance on property, and to obtain a delinquent repayment history.

   [.4]] Capital—Adequacy—Securities Trading Activity
   Bank's capital was inadequate due to low net interest margin, reliance on securities gains, and payment of dividends exceeding 50% of net income. Securities trading requires higher capital level due to higher risk.

   [.5] Directors—Independent Directors Added to Board
   Bank's management practices were unsafe, unsound and placed depositors in jeopardy by virtue of the volume of adversely classified assets, poor earnings, overreliance on securities gains, violations of Regulation O, and failure to limit business and medical expenses and to amend Bank policies to reflect current practices. FDIC ordered that the majority of Board of Directors be comprised of independent members.

   [.6] Board of Directors—Reorganization of Board—Independent Directors
   [.7] Earnings Performance, Investment and Funds Management—Qualified Consultant Study—Review
   [.8] Investment and Funds Management—Minimum Requirements—Review
   [.9] Investment Committee—Compliance—Review
   [.10] Securities Trading—Accounting Procedure—Review
   [.11] Bank Operation—Annual Budget and Strategic Plan—Review
   [.12] Management Fees—Written Plan—Minimum Requirements
   [.13] Primary Capital—Determination—Methods to Increase
   [.14] Shareholders—Dividends—Approval
   [.15] Assets—Adversely Classified—Reduce
   [.16] Loan Loss Review—Increase
   [.17] Violations of Law—Eliminate/Correct—Compliance
   [.18] Special Mention Deficiencies—Correct
   [.19] Financial Condition—Amendment—Filing
   [.20] Shareholders—Disclosure—Cease and Desist Order
   [.21] Compliance—Progress Reports—Frequency

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


DECISION AND ORDER

   This proceeding arises under Section 8(b) of the Federal Deposit Insurance Act ("Act"), 12 U.S.C. §1818(b). On October 23, 1987, the Federal Deposit Insurance Corporation ("FDIC") issued a Notice of Charges and of Hearing ("Notice") against *** Bank *** ("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 charged the Bank with having engaged in unsafe or unsound banking practices and violating law and regulation. An Order was sought under section 8(b)(1) of the Act requiring the Bank to cease and desist from its unsafe and unsound banking practices and to take specific action to prevent future reoccurrences.
   A formal hearing was held before Administrative Law Judge Steven M. Charno ("ALJ") from February 29 to March 3, 1988. The ALJ issued his Recommended Decision ("RD") on June 27, 1988 and recommended entry of a Cease and Desist Order. Exceptions were filed by FDIC Enforcement Counsel on July 20, 1988.
   Based upon its review of the record, the Board of Directors of the FDIC ("Board") agrees with the majority of findings of the ALJ, but finds several with which it disagrees. The ALJ's recommendations are adopted, therefore, with several material modifications as set forth herein. Specifically, the Board finds that the Bank was actively engaged in securities trading without ob- {{4-1-90 p.A-1355}}serving generally accepted accounting procedures or adhering to FDIC reporting requirements. The capital adequacy of the Bank was thus jeopardized by the risk inherent in the securities trading activity, as well as by the Bank's reliance upon securities gains to make an operating profit. The Board further concludes, contrary to the ALJ's finding, that poor management practices and policies by officers and directors imperiled the Bank's safety and soundness and jeopardized its deposits. The Board has also reinstated two loans listed for "Special Mention" disallowed by the ALJ. However, the Board concurs with the finding of the ALJ that the evidence does not establish that the loan valuation reserves were inadequate to protect the Bank in view of the Bank's loss classifications and its loan loss history. (See FDIC Ex. 1.)

A. The Bank Was Engaged in Securities
Trading

   Enforcement Counsel took exception to the ALJ's conclusion that the Bank was not engaged in securities trading and had properly reported its securities activities as an investment account. (FDIC Exceptions at 7.) The ALJ determined that "trading" was defined by the length of time a security was held before sale. In doing so, he credited the testimony of the Bank's expert that the sale of any security held less than 90 days would constitute trading activity. After analyzing the Bank's trades in 1986, the ALJ concluded that more than 60 percent of the securities were held for more than 90 days. He also relied upon the characterization of the securities account as an investment portfolio in the Bank's certified financial statement. (RD at 8, 9.)

   [.1] The Board believes that an analysis of trading activity based simply on the length of the holding period is mechanical and overlooks the purpose for which securities are acquired by a financial institution. Both the examiner and the Bank's expert testified that intent was a critical factor in determining whether trading activity was present. (Tr. at 135-39 and 597–600.) Moreover, the Bank's president testified that he manipulated the securities portfolio depending upon market conditions. (Tr. at 661-63.)
   Close examination of the securities, their maturity dates, and trading activity reveals an intent and a practice by the Bank to trade securities. In all but three cases, the securities had maturity dates of two or more years but were sold on average after 194 days. (FDIC Ex. 1 at 59.) Securities transactions doubled in volume between 1985 and 1986, and there were several pairoff transactions.1 Although the Bank had approximately $62 million in total assets in 1986, it sold securities in the amount of $52 million and purchased $68 million. In addition, the Bank sold its entire portfolio of appreciated securities on July 11, 1986, keeping only $2 million which reflected a depreciation in value. The Board, therefore, concludes that the Bank engaged in securities trading activity during 1986 and failed to properly account for it under generally accepted accounting principles and FDIC reporting requirements.

B. Adversely Classified Assets Included An
Unreconciled Bank Balance

   [.2] The ALJ found that total assets adversely classified "Loss" equalled $114,300. He then used this figure in determining that the Bank's capital ratio was 5.87 percent, below the minimum 6 percent required for safety and soundness. The Board concludes that "Loss" classifications totalled $131,300, resulting in a capital ratio of 5.85 percent. The Board reinstates a $17,000 "Loss" classification improperly rejected by the ALJ.
   The ALJ concluded that the $17,000 unreconciled balance with a correspondent bank had been improperly classified "Loss" although it had been outstanding for a period of six months. The ALJ credited testimony by the Bank's expert witness that six months was not an unusual period of time for the reconciliation of correspondent bank balances and that up to a year was often required to clear certain items with the Federal Reserve.
   The examiner testified that, in a Bank being operated in a safe and sound manner, reconcilement normally should be done on a monthly basis and that the Bank had not produced any documentation indicating special problems were in the process of resolution with the correspondent bank that


1 A pair-off transaction is the purchase and sale of a security on the same date by a party who does not intend to take possession of the security. (Trans. at 136.)
{{4-1-90 p.A-1356}}would explain the delay. Given the lengthy unexplained period of time in which the Bank failed to take steps to reconcile the account, the amount of the unreconciled balance was properly classified "Loss."

C. The *** and *** Loans

   [.3] The Board reinstates the listing of "Special Mention" for two loans in the amount of $419,000 each to the Bank's president, ***, and its chairman of the board of directors, ***. The loans were criticized primarily due to inadequate appraisals of two properties held as collateral. The ALJ, however, concluded that because the Bank's lending policy required a loan to value ratio of 80 percent, a pledge of additional collateral (sought by the examiner) would lower, rather than raise, the loan to value ratio. He also concluded that "the record does not demonstrate that [[the Bank]] violated its policy or that a potential for loss was created by inadequacy of the collateral appraisals." (RD. at 3.)
   he Board finds that the collateral appraisals were based upon inaccurate, stale information and were, therefore, unreliable. Consequently, the appraisals provided no meaningful assessment of the collateral's value for the purposes of securing the underlying loans and exposed the Bank to potential loss.
   Careful review of the Examination Report and the examiner's testimony reveals that the ALJ misinterpreted the evidence. In his analysis of the method and figures used in the *** Hotel and *** appraisals, the examiner noted the income figures on the properties were not the same as those reflected in the borrowers' most current financial statements. In fact, the examiner recalculated only the *** Hotel appraisal substituting more current financial information, including its income stream, to demonstrate that appraisal's inadequacy. (FDIC Ex. 1 at 46.)
   As to the *** property, the examiner pointed out that no explanation had been given for increasing the actual rental income, or for failing to include insurance, janitorial, or management expenses. He noted that the *** appraisal was based on the highest gross income multiplier and price per unit valuations of comparable properties without explanation. Furthermore, the examiner testified that the appraisal was "seriously flawed," based on stale financial data, and unjustified income figures and comparables. (Tr. at 86–87 and 90–95.)
   Although this issue was inartfully stated both in testimony and the examination report, the evidence supports a finding that the appraisals did not reflect the properties' actual values. Without an accurate valuation of the properties, the examiner could not substantiate a loan to value ratio not in excess of 80 percent as required by Bank policy.
   In addition, the existence of at least one lien superior to the Bank's security interest on the *** property along with the absence of a current insurance certificate, and a delinquent repayment history on both loans also supports the Special Mention listing. (FDIC Ex. 1 at 48, 49.)
   In summary, the Board finds that the examiner's explanation for discrediting the appraisal methodology was correct and supported the listing for "Special Mention." Additional support for the Board's conclusion is found in the Bank's failure to protect itself from loss both in verifying its lien position and securing insurance on the *** property, as well as the undisputed repayment history. Given the expert testimony supporting the listing, the ALJ should have deferred to the examiner's characterization of the loan. See Sunshine State Bank v. FDIC, 783 F.2d 1580, 1583 (11th Cir. 1986).

D. The Bank Was Inadequately
Capitalized

   [.4] The Board agrees with the ALJ's conclusion that the Bank was engaged in an unsafe and unsound practice by operating with a capital ratio of less than six percent and was in violation of 12 C.F.R. §325.3. (RD at 7.) Further, the Board agrees with the ALJ that the Bank should maintain a capital ratio of 6.5 percent. The Bank's undercapitalization for the past three years is attributable to its low net interest margin, an inability to make an operating profit without reliance upon securities gains, and the payment of dividends out of net income in amounts exceeding 50 percent of net income. The Board agrees with the ALJ's description of the Bank's poor earnings performance:

    In July of 1986, [[the Bank]] sold virtually its entire securities portfolio, paid dividends and bonuses and reinvested the remaining proceeds in federal funds {{4-1-90 p.A-1357}}which yielded significantly less than the securities [the Bank] had sold. The effect of this reinvestment at lower rates was to reduce [[the Bank's]] net interest margin. . .to 2.58 [[percent]]. This rate of return did not produce sufficient income to make a profit, and [[the Bank's]] net interest income was insufficient to meet its overhead expenses in each of the final six months of 1986. The fact that [[the Bank]] had a positive net income for 1986 was due entirely to the extraordinary income it received as a result of gains on the sale of securities.
(RD at 5, footnotes omitted.)
   The Board also notes that the Bank's securities gains occurred during a period when interest rates were generally declining. There is no assurance that such a favorable interest rate environment will occur in the future. In fact, during a period of generally rising interest rates, the Bank could suffer trading losses, and/or depreciation in the securities account. The Board emphasizes that the higher risk presented by large volume trading securities requires a higher capital level and underscores the fact that normal bank activities were not generating enough income. The Bank's poor earnings performance and securities activities fully support a requirement that the Bank maintain a capital ratio of 6.5 percent.

E. Directors and Management

   [.5] Upon consideration of the record as a whole, the Board agrees with the ALJ's conclusion that the Bank has failed to supervise its officers, but rejects the finding that management practices and policies did not jeopardize the safety of deposits. The volume of adversely classified assets, poor earnings without reliance on gains from excessive securities trades, violations of Regulation O of the Board of Governors of the Federal Reserve System resulting from careless supervision of staff, together with a persistent failure to properly limit and document business and medical expenses, and other consistently poor business record maintenance, and the failure to properly amend Bank policies to reflect current practices require the Board to find that the Bank's officers and directors failed to pay proper heed to the safety and soundness of the Bank and placed its depositors in jeopardy. (RD at 9–11.)
   The record is replete with evidence that the Bank's board of directors and current management failed to establish prudent policies and ensure compliance with them. The failure of management and directors to take required action, despite regulatory warnings during past examinations, makes clear that a broad remedial order is required. Although the Board disagrees with the ALJ's reasoning that a clause to retain management acceptable to the FDIC was arbitrary and unnecessary, it nevertheless adopts the ALJ's modification of the proposed order to require that a majority of the Bank's board of directors be comprised of independent members. As the ALJ pointed out, three senior officers constitute half of the board of directors resulting in self-supervision of management: "independent supervision of management is required in order to eliminate [[the Bank's]] longstanding disdain for regulatory governance." (RD at 18.) The Board is of the opinion that an independent board of directors that complies with the remedial provisions of this Order is likely to restore the Bank to safe operation and a sound financial condition. Because an independent board will have the authority to make management changes as needed, the management clause proposed by Enforcement Counsel is not viewed as necessary in this instance.
   The Board emphasizes that it is the responsibility of the Bank's board of directors to take appropriate action to ensure that the Bank is operated in a safe and sound manner. Any changes beyond those required by this Order should be taken promptly in accordance with the board of directors' fiduciary duties.

Conclusion

   For the reasons stated in the ALJ's Recommended Decision as modified herein, the Board adopts the Findings of Fact and Conclusions of Law set forth infra. The Board further adopts the Cease and Desist Order set forth herein at pages 16 through 26, which has been modified consistent with the foregoing discussion to require relief deemed necessary to correct the unsafe or unsound practices engaged in by the Bank.

{{4-1-90 p.A-1358}}
FINDINGS OF FACT

   1. At all times relevant to this proceeding, the Bank is and has been an insured state nonmember bank organized and chartered under the laws of ***, having its principal place of business in ***.
   2. The Bank's independent auditor provided the examiner with an average total asset figure of $61,376,000 as of December 31, 1986.
   3. As of December 31, 1986, the Bank's Part 325 total capital (without subtracting assets classified "loss") equaled $3,720,000.
   4. As of December 31, 1986, the Bank's reserve for loan losses was $115,000.
   5. In the December 31, 1986 FDIC Report of Examination, a $17,000 open item on the Bank's correspondent account with *** National Bank was properly classified "loss."
   6. Using the average total asset figure of $61,376,000 provided by the Bank's independent auditor and subtracting all properly classified "loss" identified in the December 31, 1986 FDIC Report of Examination, the Bank's total capital to total asset ratio equaled 5.85%.
   7. As of December 31, 1986, the Bank's net interest margin, exclusive of securities gains, was 2.58 percent.
   8. From January through June of 1986, the Bank was able to operate at a profitable level on a monthly basis before any securities gains or losses. In July of 1986, the Bank suffered a large operating loss and continued to suffer monthly operating losses through December of that year.
   9. On July 11, 1986, the Bank sold all of its securities which had appreciated, keeping only the depreciated securities in the amount of $2,000,000.
   10. During 1986 the Bank's volume of securities activities totalled $55,000,000 in sales and $68,000,000 in purchases, although its assets totalled $61,376,000.
   11. Securities purchased by the Bank generally had a maturity date of two or more years, but on average were sold after 194 days.
   12. Based on the poor earnings and large volume of securities activities of the Bank, a capital to asset ratio of 6.5 percent is appropriate.
   13. The Bank failed to account for its securities transactions during 1986 as a trading account in compliance with generally accepted accounting practices and with the FDIC's reporting instructions.
   14. As of December 31, 1986, the Bank had $10,448,000 in total loans outstanding.
   15. As of December 31, 1986, the Bank had $30,300 in loans classified "loss."
   16. Total assets classified loss as of December 31, 1986, equaled $131,300.
   17. The Bank regularly paid medical expenses of its officers and their families outside of its insurance plan. The Bank had no formal written plan for the payment of such expenses, and there was no limit to the expenses that it would pay outside of the health insurance policy.
   18. Between November 11, 1985, and December 31, 1986, the Bank paid the following management entertainment expenses without receiving or maintaining any documentation of business purpose or the person entertained: *** in the amount of $11,076.58 for Director ***; *** in the amount of $4,788 for Director ***; and the *** in the amount of $1,544.15, the *** in the amount of $735.73 and the *** in the amount of $606.11 for Director ***.
   19. Lack of documentation for business expenses was criticized in the November 11, 1985 FDIC Report of Examination and by the Bank's auditors.
   20. The Bank purchased a 1982 Cadillac Cimarron for the use of Vice President ***.
   21. The 1982 Cadillac Cimarron was sold to Vice President ***'s son for $2,000, which represented fair market value.
   22. The Bank's records related to the sale of the automobile to Vice President ***'s son are virtually non-existent.
   3. The apparent extension of credit on October 20, 1986, by the Bank to Vice President *** and his son resulted from a clerical error.
   24. The seven commercial loans to Vice President *** outstanding on December 31, 1986, were secured by stock in a closelyheld corporation, which represents an unfavorable feature.
   25. The effect of the "restraint" on the accounts of Director ***, *** and *** was to give them additional float in their accounts, to prevent overdrafts from being reflected in their accounts, and to grant *** and *** unsecured loans from October 3 to October 16, 1986.
{{4-1-90 p.A-1359}}
   26. The Bank was not shown to have been in material violation of its policy controlling teller cash levels, although it had not amended its written policy to reflect the authorization of higher cash levels.
   27. In approximately 1985, the Bank installed a new alarm system under contract with a firm specializing in bank security, and did not record its consultation with that firm.
   28. As of December 31, 1986, the Bank held title to the *** and *** properties in excess of five years with an extension from the *** Commissioner of Banks

CONCLUSIONS OF LAW

   1. The Bank is subject to the Federal Deposit Insurance Act, 12 U.S.C. §§1811-1831d, the Rules and Regulations of the FDIC, 12 C.F.R. Ch. III, and the laws of ***.
   2. The FDIC has jurisdiction over the Bank and the subject matter of this proceeding.
   3. The Bank violated 12 C.F.R. §325.3(a) and (b) by failing to maintain a ratio of total capital to total assets of six percent as of December 31, 1986.
   4. As of December 31, 1986, the Bank was engaged in unsafe or unsound banking practices by operating with unsatisfactory earnings and inadequate capital.
   5. The Bank engaged in unsafe or unsound banking practices by failing to maintain either adequate documentation for business expenses or a formal policy governing the payment of medical expenses for bank officers and directors.
   6. The Bank has not been shown to have engaged in an unsafe or unsound banking practice by failing to prepare and retain adequate documentation concerning its sale of an automobile.
   7. The Bank has engaged in an unsafe or unsound banking practice by failing to account for the trading activities in its security portfolio in accordance with generally accepted accounting practices.
   8. The Bank violated 12 C.F.R. §304.4 by failing to report its securities transactions in accordance with the instructions for the Report of Condition and Income.
   9. The Bank did not violate section 32 of the *** Banking Act by extending credit to Vice President *** which exceeded the Bank's legal lending limit.
   10. The Bank did not violate 12 C.F.R. §337.3(b) by extending credit to Vice President *** without the prior approval of a majority of the Bank's board of directors.
   11. The Bank violated 12 C.F.R. §215.4(a)(2) by extending credit to Director *** which presented an unfavorable feature.
   12. The Bank violated 12 C.F.R. 215.4(a)(2) by extending credit to Directors ***, *** and *** which presented unfavorable features.
   13. The Bank did not violate 12 C.F.R. §326.4(b)(2) by keeping unreasonably high levels of cash at teller stations.
   14. The Bank did not violate 12 C.F.R. §326.5(c) by failing to maintain records of consultation with law enforcement officers.
   15. The Bank did not violate section 5(9) of the *** Banking Act by holding real estate in excess of five years plus any extensions granted by the *** Commissioner of Banks.
   16. The Bank engaged in an unsafe and unsound banking practice by failing to adequately supervise its officers in order to prevent unsafe or unsound banking practices and violations of regulations.

ORDER TO CEASE AND DESIST

   IT IS ORDERED that the Bank, *** Bank, ***, its directors, officers, employees, agents, successors, assigns, and other persons participating in the conduct of its affairs, cease and desist from the following unsafe or unsound banking practices and violations of regulation:
   1. (a) Operating in such a manner as to produce a low net interest margin and unsatisfactory earnings;
   (b) Operating with an inadequate level of equity capital protection;
   (c) Operating with a management whose policies and practices are detrimental to the Bank and jeopardize the safety of its deposits;
   (d) Failing to account properly for securities trading activities in accordance with generally accepted accounting principles;
   (e) Failing to maintain adequate documentation of business expenses;
{{4-1-90 p.A-1360}}
   (f) Failing to have a formal written policy limiting payment of the medical expenses of officers and directors;
   (g) Failing to monitor in a prudent manner transactions involving its officers and directors;
   (h) Operating in violation of section 215.4 of Regulation O of the Board of Governors of the Federal Reserve System (12 C.F.R. §215.4); and
   IT IS FURTHER ORDERED that the Bank, its directors, officers, employees, agents, successors, assigns or other persons participating in the conduct of its affairs, take the following affirmative action:

   [.6] 1. Within 90 days from the effective date of this ORDER, the Bank shall add at least three "independent" members to its board of directors. The addition of the independent directors required by this paragraph may be accomplished, to the extent permissible by state statute and the Bank's by-laws, by means of appointment or by election at a regular or special meeting of the Bank's shareholders. Further, the Bank shall take all steps necessary to insure that its board of directors is and remains composed of a majority of independent directors. As used in this ORDER, the term "independent" is defined as an individual who is not: (1) an employee or officer of the Bank or an employee, officer, or director of *** ("Holding Company") or any other affiliate of the Bank as that term is defined in section 23A of the Federal Reserve Act, 12 U.S.C. §371c, related by blood or marriage to any officer or director of the Bank, Holding Company, any other affiliate of the Bank or any stockholder owning more than five percent of the Bank's or Holding Company's outstanding shares or (2) indebted to the Bank or to any of its affiliates, directly or indirectly (including the indebtedness of any "related interest" as that term is defined at 12 C.F.R. §215.2(k)) in an amount exceeding five percent of the Bank's capital and unimpaired surplus as defined at 12 C.F.R. §215.2(f).

   [.7] 2. (a) Within 60 days from the effective date of this ORDER, the Bank shall have performed a detailed written study of its earnings performance and investment and funds management policies and practices. The study shall be performed by a qualified consultant, acceptable to the Regional Director of the FDIC's *** Regional Office ("Regional Director") and the Commissioner of Banks for the State of *** ("Commissioner"), and shall include written recommendations to improve the Bank's earnings performance and investment and funds management policies and practices.
   (b) When completed, the study required by this paragraph shall be submitted to the Regional Director and Commissioner for their review and an opportunity to comment.

   [.8] 3. (a) Within 90 days from the effective date of this ORDER, and quarterly thereafter during the life of this ORDER, the Bank's board of directors shall review the Bank's investment and funds management policies and practices for adequacy in coordination with the written study required by paragraph 2(a) and, based upon this review, shall make appropriate revisions in the policies that are necessary to strengthen investment and funds management practices. The minutes of the meeting of the board of directors at which each such review is undertaken shall expressly state the results of the review.
   (b) The initial revisions to the Bank's investment and funds management policies required by this paragraph shall, as a minimum, include (i) provisions which define rate sensitive assets and liabilities and which specify acceptable ranges for the Bank's rate sensitivity and gap ratios at various time horizons, which shall be at a minimum, three months, six months, twelve months, eighteen months, and twenty-four months; (ii) provisions, consistent with FDIC instructions for the preparation of Reports of Condition and Income, under which the Bank will properly segregate and account for trading securities; and (iii) provisions which limit the trading on both individual and aggregate transactions to a reasonable percentage of the Bank's primary capital as determined by the board of directors in writing.
   (c) The investment and funds management policies, when revised as required by this paragraph, shall be submitted to the Regional Director and Commissioner for their review and an opportunity to comment.

   [.9] 4. (a) Within 30 days from the effective date of this ORDER, the Bank shall establish an Investment Committee consisting of a least three board members. Within 90 days from the effective date of this OR- {{4-1-90 p.A-1361}}DER, the Investment Committee shall include a majority of "independent" board members as defined by paragraph 1 of this ORDER.
   (b) The Bank's Investment Committee shall provide general oversight as to compliance with the Bank's policy, including review on at least a monthly basis of the transactions in accordance with the Bank's new investment and funds management policies and the Bank's written plan and budget required by paragraph 6 of this ORDER.

   [.10] 5. Within 30 days from the effective date of this ORDER, the Bank shall:
   (a) Establish a securities trading account on its books;
   (b) At least monthly, account on a consistent basis for the inventory in the trading account at market value or the lower of cost or market value; and
   (c) Account for all Bank-owned securities on or after December 31, 1986, in accordance with Call Report instructions.

   [.11] 6. (a) The Bank shall formulate and fully implement on an annual basis written plans and a comprehensive budget for each succeeding year for all categories of income and expense. The written plan required by this paragraph shall consider the results of the written study required by paragraph 2 of this ORDER and shall contain formal goals and strategies to improve the Bank's net interest margin and its overall earnings.
   (b) The plans and budgets required by this paragraph, upon completion, shall be submitted to the Regional Director and Commissioner for their review and an opportunity to comment.
   (c) After the end of each calendar quarter while this ORDER is in effect, the Bank's board of directors shall evaluate the Bank's actual performance in relation to the plans and budgets required by this paragraph and expressly record the results of the evaluation, and any actions taken by the Bank, in the minutes of the meeting of the board of directors at which such evaluation is undertaken.

   [.12]] 7. (a) Within 90 days from the effective date of this ORDER, and in coordination with the written plans and budgets required by paragraph 6 of this ORDER, and the written study required by paragraph 2 of this ORDER, the Bank shall adopt and implement a detailed written policy covering expense reimbursements to its directors, officers, and employees. At a minimum, the policy shall include the following:

       (i) Provisions which specify the reasonable limitations for all categories of expenses related to customer entertainment and business development;
       (ii) Provisions which require complete documentation of all expenses related to customer entertainment and business development as recommended in the May 22, 1986 management letter from the Bank's external auditor, ***, ***, ***. At a minimum, the Bank shall require the submission of an original receipt, identification of the person or persons entertained, and the business purpose of the expense before a check is issued for payment by the Bank;
       (iii) Provisions prohibiting the reimbursement of personal expenses of the Bank's directors, officers, and employees;
       (iv) Provisions specifying reasonable limits on the number and cost of automobiles owned by the Bank and the rationale therefor; and
       (v) Provisions requiring that each individual utilizing an automobile owned by the Bank provide detailed monthly documentation regarding use of the automobile for the Bank's business.
   (b) While this ORDER is in effect, the Bank's board of directors shall conduct monthly reviews of all expenses submitted for customer entertainment, business development, and automobile usage, with the results of the reviews expressly stated in the minutes of the meetings of the board of directors at which such reviews are performed. On a monthly basis, the Bank will either seek reimbursement for any expenses paid which are not in conformance with the policy required by paragraph 7(a) or will expressly state in the minutes of the board of directors the full justification for deviations from the policy.

   [.13] 8. (a) Within 30 days from each June 30 and each December 31 following the effective date of this ORDER, the Bank's board of directors shall determine the Bank's level of primary capital as a percentage of its total assets, as of the respective June 30 and December 31 dates. If that percentage is less than 6.5 percent of {{4-1-90 p.A-1362}}total assets, the Bank's board of directors shall, within 60 days from the date of that determination, increase that capital/asset relationship to not less than 6.5 percent as of the end of that preceding semi-annual period. For the purpose of this ORDER, "primary capital" and "total assets" shall be defined as those terms are defined in Part 325 of the FDIC Rules and Regulations, 12 C.F.R. Part 325.
   (b) The requirements of paragraph 8(a) shall not negate the Bank's responsibility to maintain continuously throughout the year an adequate level of primary capital protection for the kind and quality of assets held by the Bank.
   (c) Any increase in primary capital necessary to comply with paragraph 8(a) of this ORDER may be accomplished by:

       (i) the sale of equity securities; or
       (ii) the elimination of all or part of the "loss" assets referred to in paragraph 10 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 Holding Company of the Bank's directors; or
       (v) any other means acceptable to the Regional Director and Commissioner.
   (d) If all or part of the increase in primary capital necessary to comply with paragraph 8(a) of this ORDER is to be accomplished by the sale of new securities, the Bank's board of directors shall forthwith take all steps necessary to adopt and implement a written plan for the sale of such additional securities, including the voting of any shares owned or proxies held or controlled by any of them in favor of said plan. Should the implementation of the plan involve public distribution of the Bank's securities, including a distribution limited only to the Bank's existing shareholders, the Bank shall prepare detailed offering materials fully describing the securities being offered, including an accurate description of the Bank's financial condition and the circumstances giving rise to the offering, and any other material disclosures necessary to comply with Federal securities laws. Prior to the implementation of the plan and, in any event, not less than 20 days prior to the dissemination of such materials, the plan and any materials used in the sale of the securities shall be submitted to the FDIC Registration and Disclosure Unit, Washington, D.C. 20429, for its review. Any changes requested by the FDIC shall be made prior to dissemination of the materials.
   (e) In complying with the provisions of paragraph 8(d) of this ORDER, the Bank shall provide to any subscriber and/or purchaser of the Bank's securities written notice of any planned or existing development or other change which is materially different from the information reflected in any offering materials used in connection with the sale of the Bank's stock. The written notice required by this paragraph shall be furnished within ten calendar days from the date any material development or change was planned or occurred, whichever is earlier, and shall be furnished to every purchaser and/or subscriber of the Bank's securities who received or was tendered the information contained in the Bank's original offering materials.

   [.14] 9. While this ORDER is in effect, the Bank shall not declare or pay any cash dividends without providing a minimum of 30 days advance written notice to the Regional Director and Commissioner.

   [.15] 10. Within 30 days from the effective date of this ORDER, the Bank shall eliminate from its books, by charge-off or collection, all assets or portions of assets properly classified "loss" as of December 31, 1986.

   [.16] 11. Within 30 days from the effective date of this ORDER, the Bank shall replenish its loan valuation reserve by an expense entry in an amount equal to those loans required to be charged-off by paragraph 10 of this ORDER.

   [.17] 12. (a) Within 60 days from the effective date of this ORDER, the Bank shall eliminate and/or correct all violations of regulation as of December 31, 1986. In addition, the Bank shall adopt procedures to insure future compliance with all applicable laws, rules, and regulations.
   (b) Within 30 days from the effective date of this ORDER, the Bank shall adopt and implement detailed written procedures designed to insure that all applicable extensions of credit are in conformance with Regulation O of the Board of Governors of the Federal Reserve System, 12 C.F.R. Part 215.
   (c) Within 30 days from the effective date of this ORDER, the written procedures {{4-1-90 p.A-1363}}adopted pursuant to paragraph 10(b) of this ORDER shall be submitted to the Regional Director and Commissioner for their review and an opportunity to comment.

   [.18] 13. Within 60 days from the effective date of this ORDER, the Bank shall correct all deficiencies in the loans properly listed for "special mention" as of December 31, 1986.

   [.19] 14. Within 50 days from the effective date of this ORDER, the Bank shall amend and refile Reports of Condition and Income for the periods ending December 31, 1986, and subsequently, if the original filings do not reflect all of the adjustments required by paragraphs 5, 10, and 11 of this ORDER.

   [.20] 15. Following the effective date of this ORDER, the Bank shall send to its shareholders or otherwise furnish a description of this ORDER (1) in conjunction with the Bank's next shareholder communication and (2) in conjunction with the Bank's notice or proxy statement preceding its next shareholder meeting. The description and any accompanying communication, statement, or notice shall be sent to the FDIC Registration and Disclosure Unit, Washington, D.C. 20429, for review at least 15 days prior to dissemination of the description, communication, notice, or statement.

   [.21] 16. On the last day of the second month following the date of issuance of this ORDER, and every second month thereafter, the Bank shall furnish written progress reports, signed by each member of the Bank's board of directors, to the Regional Director and Commissioner detailing the form and manner of any actions taken to secure compliance with this ORDER and the results thereof. Such reports may be discontinued when the corrections required by this ORDER have been accomplished and the Regional Director and Commissioner have released Respondent in writing from making further reports.
   17. The effective date of this ORDER shall be ten days after its issuance by the FDIC.
   18. The provisions of this ORDER shall remain effective and enforceable except to the extent that, and until such time as, any provisions of this ORDER shall have been modified, terminated, suspended, or set aside by the FDIC.
   By direction of the Board of Directors.
   Dated at Washington, D.C. this 18th day of October, 1988.

Hoyle L. Robinson
Executive Secretary

In the Matter of *** BANK
(INSURED STATE NONMEMBER
BANK)
***, Esq. of *** and of Washington, D.C.
for the Petitioner. ***, Esq. and *** of ***
for the Respondent.





RECOMMENDED DECISION
CHARNO, Administrative Law Judge:
   A Notice of Charges was issued by the Federal Deposit Insurance Corporation ("FDIC" or "Petitioner") on October 23, 1987, alleging that *** ("Bank" or "Respondent") has engaged in unsafe or unsound banking practices and in violations of laws and regulations. Respondent's Answer generally demurred as to both practices and violations.
   By Motion dated January 29, 1988, Petitioner sought to limit the temporal scope of permissible evidence relating to Respondent's "condition and activities." After argument, I issued an Order on February 5, 1988, which provided in relevant part that "evidence at the hearing shall be limited to matters, policies or practices which took place or were in effect on or before December 31, 1986. . .."1 Petitioner did not seek modification of or take exception to this ruling.
   This case was heard before me in ***, beginning on February 29 and concluding on March 3, 1988. Respondent's unopposed motion to strike Paragraph 4(g) of the Notice was granted at the outset of the hearing. Initial briefs were filed by Petitioner and Respondent under extended due date of May 19,2 and reply briefs were filed by both parties under due date of May 31, 1988.


1 I also permitted evidence of matters after December 31 relevant to the scope of affirmative relief sought by Petitioner, but the Order explicitly stated that such evidence would be without probative value on the question of whether a violation had occurred.

2 Initial briefs and proposed findings of fact and conclusions of law were initially due to be filed on May 13, 1988 but were not received until May 19. I have therefore enlarged the filing period as indicated above.
{{4-1-90 p.A-1364}}
DISCUSSION

A. Loan Loss Reserves

   Petitioner alleges that Respondent has "failed to maintain an adequate reserve for loan losses." Operating with inadequate loan loss reserves is an unsafe or unsound banking practice. Docket No. FDIC-83-172b, [1984]] F.D.I.C. Enf. Dec. (P-H) ¶5030, at 5657. It has been stipulated that Respondent had loans outstanding on December 31, 1986 of $10,488,000, while its loan loss reserve on that date amounted to $115,000. Petitioner contends that $79,000 of Respondent's outstanding loans should be classified "loss" and deducted from the reserve and that an "additional provision" (of unspecified amount) should be made to the reserve for $1,446,000 in loans classified "special mention." Respondent contests several of the classifications and the resulting diminution of its loan loss reserve.
   Turning first to the loans classified `loss," it is uncontested that the *** and *** loans were properly classified "loss" in amounts of $7,000 and $1,000, respectively. Classification of overdrafts on the *** account amounting to $71,000 is contested by Respondent. These overdrafts resulted from Respondent's crediting as cash two checks drawn on a *** bank which ultimately refused payment. *** withdrew the credited funds over an extended period due to several distinct failures on the part of Respondent to correct its initial error. On December 31, 1986, ***'s overdraft amounted to $22,300.3 Since additional losses could easily have been prevented by placing a hold on ***'s account and there was no indication on December 31 that further loss would occur,4 I find that only $22,300 of the *** overdraft may properly be classified "loss" as of December 31, 1986.5
   Petitioner has classified "special mention" a loan for $419,000 to ***, a Director and President of Respondent, and a loan for the same amount to ***, the Chairman of Respondent's board of directors. The loans are commonly secured by liens on the *** Hotel in *** and on a building on ***. Petitioner's expert witness, ***, based his classification of these loans on several factors which he believed demonstrated a potential for loss: (1) inadequate collateral appraisals resulting in a violation of Respondent's lending policy which requires a "loan to value ratio" of 80 percent; (2) a title search on the *** property listed three liens superior to Respondent's security interest; (3) the absence of a current insurance certificate on the *** property; and (4) a payment delinquency history on both loans ranging from one to 58 days over an 18-month period.
   In the Report of Examination, *** criticized a $1,105,000 appraisal of the *** Hotel as "severely overstated" because it was based on stale financial data. He corrected this flaw by using the borrowers' current financial statements to arrive at a value of $808,456. The Report of Examination similarly criticized the appraisal of the *** real estate and contained a revised value for that property. *** stated in the Report that the two properties had a net equity indicative of a "loan to value ratio" of 77 percent and recommended that additional property be pledged to bring that ratio to the 80 percent level required by Respondent's loan policy. Since an addition of collateral would lower, not raise, the loan to value ratio, I find that *** misperceived the nature of this requirement of Respondent's lending policy. Accordingly, I find that the record does not demonstrate that Respondent violated its policy or that a potential for loss was created by inadequacy of the collateral appraisals.6
   During the examination, *** was informed that the *** property was insured, that the first mortgage on that property had been reduced and that the apparent second and third mortgages on the building were no longer in effect. After the examination and pursuant to Petitioner's request, Respondent supplied confirming documentation. In the absence of any indication that


3 This finding is based on the Report of Examination, which I find to be more reliable than President ***' general testimony which was not confined to the period preceding December 31, 1986.

4 In fact, additional errors by Respondent resulted in further losses on and after January 20, 1987. Evidence of these losses and the reasons therefor is explicitly prohibited by my February 5, 1988 Order and is stricken from the record.

5 Petitioner's expert conceded that funds withdrawn in January could not be assumed to be a loss to Respondent in December.

6 This conclusion is not modified by consideration of the post-examination appraisal of the *** property. *** criticized that appraisal on grounds that its income methodology was questionable and both of its comparable property methodologies utilized the highest possible values. When these defects are cured by using the property's actual income of $79,500, a mid-range gross income multiplier and the lowest possible comparable price per unit, the net equity of the *** Hotel and *** properties is still indicative of a loan to value ratio of less than 80 percent.
{{4-1-90 p.A-1365}}*** had reason to disbelieve Respondent's representations during the examination, I find that he did not have a rational basis for his loss on this loan.7 Because the record contains no indication that *** would have classified these loans solely on the basis of their delinquency histories, I find that the record does not support a "special mention" classification on the loans to *** and ***.
   Also classified "special mention" were five loans totaling $131,000 to ***. *** characterized these loans as "undercollateralized" and made the following observations: (1) there was no repayment program in evidence for any of the loans; (2) the four secured loans lacked appraisals and title insurance policies for the pledged real estate; (3) one loan property from another lender for the outstanding loan balance; and (4) two loans were secured by uninsured real estate. Respondent argues that classification of these loans was inappropriate since they were all repaid after the examination. Evidence of such repayment is prohibited by my February 5, 1988 Order and is stricken. In any event, post-examination repayment has no relevance to ***'s evaluation of the loan as of December 31, 1986. I therefore find that this classification is fully supported by the record.
   Petitioner also alleges that seven loans totaling $426,500 to ***, a Director and Vice President of Respondent and Vice- Chairman of its board of directors, should be classified "special mention" because they were undercollateralized and lacked a formal repayment program. These loans were all single-payment, 90-day notes secured by shares in a closely-held corporation, the assets of which were not assigned to Respondent.8 *** indicated that he would have treated ***'s loans more severely but for the latter's significant net worth. ***'s current assets had declined significantly over a three-year period, and the remainder of his assets were relatively illiquid. For the foregoing reasons, I find that the record supports the "special mention" classification of ***'s loans.
   Finally, Petitioner alleges that a $50,360 loan purportedly made to *** and his son should be classified "special mention" because (1) it violated state law and federal regulation and (2) the loan file did not contain an appraisal or evidence of insurance. For reasons set forth later in this Decision,9 I find that the loan did not violate either law or regulation. In the absence of expert testimony that the loan merited classification solely due to the absence of documentation indicated above, I find that the "special mention" classification of this loan is not supported by the record.
   For the foregoing reasons, I find that loans amounting to $40,300 may properly be classified "loss" and loans totaling $557,500, "special mention." ***'s opinion concerning the inadequacy of Respondent's loan loss reserve was explicitly premised on a volume of classified loans well over twice that supported by the record. Because the record is bare of expert testimony indicating that the property classified volume of loans would result in an inadequate loan loss reserve,10 I find that Petitioner failed to meet its burden of proof on this issue.

B. Earnings

   Petitioner charges that Respondent was "operated in a manner which produces a low net interest margin and unsatisfactory earnings." Respondent denies that its earnings are unsatisfactory.
   In July of 1986, Respondent sold virtually its entire securities portfolio, paid dividends and bonuses and reinvested the remaining proceeds in federal funds which yielded significantly less than the securities Respondent had sold.11 The effect of this reinvestment at lower rates was to reduce Respondent's net interest margin (i.e., its net income divided by its average earning assets) to 2.58. This rate of return did not produce sufficient income to make a prof-


7 Even if *** questioned the candor of Respondent's explanation, the subsequent receipt of documentation should have resolved such questions. Petitioner has not explained why it continued to rely on these factors during the hearing and on brief.

8 Further findings concerning both the collateral for and repayment program applicable to these loans is found in Section G.2., infra.

9 See Section H, infra.

10 While it was Respondent's "goal" to maintain a one percent loan loss reserve, there is no indication in the record that *** adopted this level of reserves as a standard for measuring adequacy.

11 *** credibly so testified; Respondent's contention to the contrary on reply brief is in err.
{{4-1-90 p.A-1366}}it,12 and Respondent's net interest income was insufficient to meet its overhead expenses in each of the final six months of 1986.13 The fact that Respondent had a positive net income for 1986 was due entirely to the extraordinary income it received as a result of gains on the sale of securities.
Respondent argues that its net interest margin is immaterial since the Bank exhibits none of the characteristics of a failing institution. Because Respondent's demonstrated inability to make a profit without relying upon unpredictable shifts in interest rates does not augur financial stability, I reject this argument. Respondent further observes that all income is fungible under relevant accounting standards and contends that its earnings were satisfactory in 1986 because it experienced a net profit for the entire year. This argument ignores the fact that no one can consistently predict the movement of interest rates and that Respondent therefore cannot rely upon securities gains to offset a low net interest margin. In addition, the record is bare of evidence that Respondent could realize securities gains on its investments in federal funds.
   Respondent does not have a consistent income stream which is adequate to generate a profit or, indeed, to cover its overhead without depending on the speculative possibility of realizing securities gains. For that reason, I find that Respondent's operations during 1986 produced unsatisfactory risks, I conclude that Respondent's underlying operations represent an unsafe and unsound banking practice. See First Nat'l Bank of Bellaire v. Comptroller of the Currency, 697 F. 2d 674, 685 (5th Cir. 1983).

C. Capital Adequacy

   Plaintiff alleges that Respondent "failed to maintain a ratio of total capital to total assets of at least 6 percent," which failure is contended to be an unsafe or unsound banking practice as well as a violation of 12 C.F.R. §325.3. Petitioner further alleges that Respondent's December 31, 1986 ratio of capital to assets constituted an unsafe or unsound banking practice in light of Respondent's low net interest margin and inability to make an operating profit without relying on securities gains.
   The relevant ratio may be computed with the following formula:

total capital - identified loss
____________________________________
total assets + loan loss reserve - identified loss

It was stipulated that Respondent's total capital amounted to $3,720,000 and that its loan reserve was $115,000. Respondent's average total assets were shown to amount to $61,376,000.14 The remaining factor in the equation, the amount of loss properly identified in the December 31, 1986 Report of Examination, is contested.
   The loss properly attributable to the ***, *** and *** loans was previously found to be $33,300.15 It is uncontested that the loss associated with the *** and *** properties is $4,000.16 Petitioner alleges that $1,000 in pre-paid expenses for the opera tickets of one of Respondent's directors was properly classified "loss." Upon consideration of Respondent's arguments on this issue, I find that any evidence that this expense was reimbursed after December 31, 198617 is both immaterial and barred by my Order of February 5, 1988. Accordingly, I find the classification to be proper.
   Petitioner also alleges that $48,000 in "loss" was properly attributable to the *** property and $31,000, to the *** property. *** valued these properties at the high end of the range of prices for farmland because (1) the near-term development of both properties appeared unlikely due to the former's remoteness from city utilities and the latter's lack of public access; (2) the "preliminary evaluation estimates" on both properties did not indicate what, if any, appraisal method had been used; (3) both properties appeared to be under cultivation at the time of the examination; and (4) Respondent had been unable to sell either


12 ***testified that "the Bank could not make money" and could not "cover their overhead," ***, Respondent's expert, conceded that Respondent could not make a profit with a net interest margin of 2.58.

13 Consideration of Respondent's 1987 operations is explicitly precluded by my Order of February 5, 1988.

14 This finding is based on the calculations of Respondent's independent auditor, which I find more reliable than either the original or amended figure in Respondent's December 31, 1986 Report of Condition and Income.

15 See Section A, supra.

16 *** so testified.

17 It appears to have been Respondent's policy to incur objectionable expenses on behalf of certain of its management and to secure reimbursement only after these expenses had been questioned in a bank examination. See Section E, infra. Petitioner has not alleged that such expenditures constitute unlawful extensions of credit.
{{4-1-90 p.A-1367}}property for over ten years. All of the factual bases for these classifications are supported by the record, and I find irrelevant both the possible post-examination sale of these properties18 and the fact that they were acquired prior to the tenure of Respondent's present management. I therefore find the classifications to be proper.
   Finally, Petitioner alleges that an unreconciled balance due from a correspondent bank in the amount of $17,000 was properly classified "loss." *** based this classification on the fact that the balance had remained unreconciled for almost 5-1/2 months with "little or no" effort at collection by Respondent. ***, an independent auditor with extensive knowledge of banking practice, testified credibly as an expert that six months was "not an unusual period" for reconciling a major balance with a corresponding bank and that "oftentimes up to a year" was required to clear certain items when a Federal Reserve Bank was involved. This testimony was not refuted, and I accept it. In the absence of any explanation by *** as to why a 5-1/2 month delay in this case merited a "loss" classification, I find that the classification is not supported by the preponderance of the evidence.19
   For the foregoing reasons, I find that the Respondent's properly identified "loss" as of December 31, 1986 totaled $114,300.20 Using this figure, Respondent's capital to assets ratio on that date was 5.87 percent. Given the quality of Respondent's earnings,21 I conclude that Respondent's maintenance of a capital to assets ratio of less than six percent on December 31, 1986 was an unsafe and unsound banking practice22 and was violative of 12 C.F.R. §325.3.
   By way of remedy, Petitioner seeks an order requiring Respondent to maintain a capital to assets ratio of 6.5 percent. Respondent contends that Petitioner is barred by the parties' May 22, 1984 memorandum of understanding from requesting any ratio greater than six percent. I reject that argument because (1) Respondent is in breach of the terms of the memorandum; (2) the memorandum does not preclude Petitioner from seeking a higher ratio based on changed conditions over time; and (3) such a preclusion would be directly contrary to Petitioner's statutory mandate and would therefore be beyond its authority. Accordingly, I find the requested remedy to be appropriate.23

D. Securities Transactions

   Petitioner alleges that Respondent engaged in an unsafe or unsound banking practice by failing "to properly account for securities trading activities in accordance with generally accepted accounting practices. . ." Petitioner further alleges that such a failure constitutes a violation of its reporting requirements. See 12 C.F.R. §304.4. In partial remedy of both the alleged practice and violation, Petitioner seeks to require Respondent to account for the latter's entire security portfolio as of December 31, 1986 as a trading account. Respondent contends that it has not engaged in securities trading and that it has properly reported its securities holdings as an investment account.
   This issue turns on the appropriate definition of "trading" pursuant to generally accepted accounting practices and Petitioner's reporting requirements. An exposition of the relevant generally accepted accounting practices is found in the Financial Accounting Standards Board's Technical Bulletin No. 81-4, which provides that "usually trading account securities are held for extremely short periods of time—sometimes for only a few hours." Petitioner's reporting requirements provide:

    A trading account is a segregated account in which assets are held for resale by a bank that regularly engages in trading activities. Banks that only occasionally hold securities or other assets for possible resale are not required to segregate such assets into a trading account on the Report of Condition. Assets held in trading

18 Evidence of any such sales is prohibited by my February 5, 1988 Order and is stricken.

19 Evidence of the post-examination payment of the $17,000 balance is irrelevant, prohibited by my Order of February 5, 1988 and stricken.

20 The fact that Petitioner did not attempt to require Respondent to book any "loss" identified in the Report of Examination until March 31, 1987 is immaterial to the question of Respondent's condition on December 31, 1986.

21 See Section B, supra.

22 ***'s memorandum concerning Respondent's condition in 1983 is without demonstrated relevance to the Bank's condition 26 months later.

23 This finding is based on the credited testimony of Petitioner's experts *** and ***.
{{4-1-90 p.A-1368}}
    accounts are generally held for a short period of time.
The two definitions of trading are essentially the same.24 Thus, the crucial indicium of whether a particular securities transaction constitutes trading is the length of the holding period before sale.25 ***, the witness best qualified by education and experience to testify on the nature and scope of generally accepted accounting practices in the banking industry, opined that, absent any other information, the sale of any security held less than 90 days would constitute trading activity. I accept ***'s expert opinion on this matter.
   The Report of Examination indicates that over 60 percent of the securities Respondent sold during 1986 were held for more than 90 days. In addition, the Report indicates that over 60 percent of both the number and total dollar volume of 1986 transactions resulted from the virtual liquidation of Respondent's securities portfolio on July 11, 1986, a time when Respondent sought to generate both net and gross income in order to permit it to pay a dividend and bonuses.26 If these sales are eliminated from consideration, both the number and dollar volume of Respondent's security transactions during 1986 are far less than they were in 1985. Petitioner does not suggest that Respondent's securities transactions during 1985 constituted trading activities. I find that objective analysis of Respondent's transactions does not indicate that it "regularly" engaged in "trading activities" during 1986.27
   An audit of Respondent's financial statement for 1986 by a certified public accounting firm which specializes in banks indicated that Respondent's report of its security holdings as an investment portfolio, rather than a trading account, was "materially, properly stated" in terms of generally accepted accounting practices.28 Of even greater import, *** credibly opined that the application of generally accepted accounting practices to Respondent's securities transactions did not require the establishment of a trading account. For the foregoing reasons, I find that the overwhelming preponderance of the evidence establishes that Respondent properly accounted for its 1986 securities transactions in accordance with generally accepted accounting practices and with Petitioner's reporting requirements.

E. Documentation of Expenses

   Petitioner's Notice of Charges alleges that Respondent's failure "to prepare and maintain adequate supporting documentation for business and employee medical expenses" constituted an unsafe or unsound banking practice. Respondent denies the allegation.
   Cancelled checks demonstrate that, between the FDIC examinations on November 5, 1985 and December 31, 1986, Respondent paid the following entertainment expenses without securing or maintaining any documentation of the person entertained or the underlying business purpose: $1,076.58 to the *** for ***; $4,788.00 to the *** for Director ***; and $1,544.15 to the ***, $735.73 to the *** and $606.11 to the *** for Vice President ***.29 A comparable failure to document entertainment expenses was criticized in the report of Petitioner's November 11, 1985 examination of Respondent.
   There is no evidence that Respondent failed to document employee medical expenses, and this portion of the Notice appears to be the result of inartful draftsmanship. The December 31, 1986 Report of Examination and Petitioner's pre-hearing brief both allege that (1) Respondent paid


24 The testimony of Respondent's expert to this effect is echoed by Petitioner's brief.

25 Petitioner argues on brief that Respondent's trading activities are demonstrated by the avowed intention of Respondent's management to use the investment portfolio to generate profits, rather than to hold the securities to maturity. This argument is based on the erroneous premise that any security not held to maturity is being traded. That premise is controverted by the expert testimony concerning generally accepted accounting practices, and I reject Petitioner's argument.

26 Since this liquidation was not the result of any demonstrated intent to trade securities, I reject Petitioner's argument on brief that Respondent's trading activities were shown by the number or dollar volume of its transactions or by the face that it sold its "winners."

27 While the two pair-off transactions mentioned by Petitioner on brief may typify trading activity, they are clearly of an "occasional" nature. But see BANKING COMMITTEE, AM. INST. OF CERTIFIED PUB. ACCOUNTANTS, AUDITS OF BANKS 33 (2d ed. 1984).

28 *** credibly so testified. The audit report itself stated that Respondent's accounting policies "conform with general accepted accounting principles and with general practice within the banking industry."

*fd 29 The record also contains evidence of Respondent's payment of additional, properly documented expenses of $952.01 on behalf of ***.
{{4-1-90 p.A-1369}}certain medical expenses for its officers which were not covered by the Bank's health insurance policy and (2) Respondent has no written policy concerning or limiting such expenses.30 The veracity of these allegations is uncontested. Absent a formal policy limiting medical reimbursement, the catastrophic illness of one of Respondent's officers could deplete the Bank's capital.31
   Based on the foregoing findings and on ***'s expert opinion concerning the potential for abnormal risk or loss, I conclude that Respondent has engaged in unsafe and unsound banking practices by failing to maintain adequate business expense documentation and by failing to have a formal written policy for the payment of medical expenses of bank officers and directors. See Gulf Fed. Sav. & Loan Ass'n v. Fed. Home Loan Bank Bd., 651 F.2d 259, 264 (5th Cir. 1981).

F. The Automobile

   Petitioner alleges that Respondent engaged in an unsafe or unsound banking practice by failing to "prepare and retain documentation justifying a sale of a Bankcontrolled automobile to a relative of Bank management." The relief sought by Petitioner consists of an order requiring Respondent "to make an objective good faith review of the sale and possible reimbursement if warranted." Respondent denies engaging in an unsafe or unsound banking practice and contends that the automobile's sale price fairly reflected the car's value.
   Respondent purchased a 1982 Cadillac for Vice-President ***'s use.32 In 1985, *** attempted to trade in the Cadillac on a new Volkswagen and was quoted a trade-in price of $2,000 for the used car. During July of 1985, the car was offered for sale for $2,000 and was ultimately sold by Respondent to ***'s son for that amount. ***, a Vice-President of Respondent whose duties include the valuation of automobiles as loan collateral, later inspected the car, which he declared to be a "dog," and valued it at $2,000 based on the "Black Book" wholesale price.33 Except for the initial purchase of the car, none of the foregoing facts can be discerned from the documentation prepared and maintained by Respondent.
   Petitioner contends on brief that Respondent has engaged in "slipshod record-keeping practices, especially where `insider' transactions were involved." While I must agree with this analysis of Respondent's failure to document its sale of the 1982 Cadillac, I do not believe that the record supports a conclusion that Respondent is engaging in an unsafe or unsound banking practice. The record does not establish that Respondent's failure of documentation had "a reasonably direct effect on [the Bank's] financial soundness." Gulf Fed. Sav. & Loan Ass'n v. Fed. Home Loan Bank Bd., 651 F.2d at 264. Moreover, the failure under consideration has not been shown to amount to a practice which, if continued, must result in abnormal risk or loss. See First Nat'l Bank of Bellaire v. Comptroller of the Currency, 697 F.2d at 685; Docket No. FDIC-83-172b, [1984] F.D.I.C. Enf. Dec. (P-H) at 5656. It is not alleged and the record does not show that Respondent will be in a position to make further undocumented automobile sales to "insiders." In any event, the relief sought by Petitioner is moot. The record establishes the manner in which the 1982 Cadillac was sold and further establishes that reimbursement is not warranted. Accordingly, I conclude that Respondent's failure to document its sale of a single automobile does not constitute an unsafe or unsound banking practice.34


*fd 30 I therefore conclude that the error in Petitioner's pleading did not result in an absence of notice or a denial of due process to Respondent. See Citizens State Bank v. FDIC, 751 F.2d 209, 213 (8th Cir. 1984).

31 ***'s expert testimony to this effect is entitled to credence in the absence of any evidence concerning the coverage provided by Respondent's "typical health insurance policy."

32 Respondent and *** had an option agreement on the car which decreased Respondent's insurance cost by allowing *** to hold constructive title to the vehicle. I find that agreement to be without relevance to the issue before me.

33 While the issue of adequacy of consideration was not explicitly raised by the Notice of Charges, limited discussion is appropriate to preserve that issue for appeal. Because the "Black Book" takes into account a car's condition and is based on the wholesale market where Respondent would normally seek to sell a car, I find that guide to be a better source of fair market value than the "Blue Book" relied upon by Petitioner, which quotes only retail prices and makes no allowance for condition. The depreciated value of the Cadillac on Respondent's books has not been shown to bear any relationship to the vehicle's fair market value. I therefore find the car's depreciated value to be irrelevant to the issue before me.

34 As is evident from the foregoing discussion, this conclusion is necessitated by judicial authorities which establish definitional parameters for an "unsafe or unsound banking practice." In this context, I conclude that the degree of deference due the opinions of Petitioner's experts *** and *** has been circumscribed by the courts.
{{4-1-90 p.A-1370}}
G. Alleged Violations of Regulation O

   A provision of Regulation O of the Federal Reserve System, 12 C.F.R. §215.4(a)(2), prohibits any extension of credit by a bank to one of its directors where the extension presents "unfavorable features." Petitioner's Notice of Charges alleges that Respondent has violated this provision by (1) extensions of credit to its Directors ***, *** and *** in the form of cash items or unposted overdrafts which resulted from "restraints" on their respective checking accounts35 and (2) extensions of credit to *** which lacked a formal repayment program and were secured only by stock in a closelyheld corporation. Petitioner also alleges that Respondent engaged in an unsafe and unsound banking practice in that it "permitted Bank officers and directors to violate Regulation O. . .."

1. Overdrafts

   When Respondent places a "restraint" on a checking account, the account holder's checks are removed from Respondent's automatic processing system and are manually posted to the account. This practice causes a longer period to pass between payment and posting than would occur if the check had been automatically processed. Such a delay gives the account holder additional float and prevents overdraft from being reflected on Respondent's books.
   In response to complaints of lost checkbooks, "restraints" were placed on *** checking account on May 30, 1985, on ***'s account on March 10, 1986 and on ***'s account on an uncertain date in 1986. On October 3, 1986, Respondent issued a credit funded in part by $5,000 debits on the checking accounts of *** and ***. Between October 3 and October 15, neither account contained sufficient funds to cover such debit. Deposits were made to both accounts on October 15, and the debits were posted the following day. Based on these facts, I find that the effect of the "restraint" practice was to extend unsecured, interest-free loans to *** and *** from the third through the sixteenth of October.36
   Petitioner argues that the payment of overdrafts and provision of additional float are "unfavorable features" within the meaning of Regulation O. That argument is fully supported by ***'s credited expert opinion. Respondent's contention that the overdrafts were permitted by a since-discharged employee overlooks the fact that the mere existence of a "restraint" on a director's account gives that individual additional float. While Respondent correctly contends that a "restraint" does not grant a preference to the Bank's directors, the presence or absence of preference is immaterial to the existence of an "unfavorable feature." For the foregoing reasons, I conclude that a "restraint" on the checking account of one of Respondent's executive officers of directors constitutes a violation of 12 C.F.R. §215.4(a)(2).

2. ***'s Loans

   Petitioner contends that a series of loans made by Respondent to *** are not subject to a formal repayment program. *** executed seven single-payment, 90-day term notes in favor of the Bank between May 20, 1980 and February 26, 1986. All of these notes were thereafter renewed on a quarterly basis and were in effect on December 31, 1986. The notes originally executed on March 6, 1984 and February 15, 1986 contained explicit repayment provisions; the five remaining notes did not. On November 8, 1983, a memorandum was prepared for ***'s loan file which documented a repayment plan for all existing and future loans.37 *** also testified concerning an oral repayment agreement of uncertain date, which was inconsistent with the requirements of the 1983 memorandum. Since it was not demonstrated that the oral agreement postdated the 1983 memorandum, I find that the repayment plan set forth in the memorandum was applicable to each of ***'s loans which did not contain an explicit, subsequently executed repayment provision.38


35 Petitioner also requests a finding of fact that the "restraint" system, in and of itself, represents an unsafe or unsound banking practice. Because the Notice of Charges did not raise this issue and Petitioner first placed the allegation on post-hearing brief, I conclude that the requested finding is barred by due process considerations.

36 The FDIC suggested for the first time on brief that these loans violated 12 C.F.R. §215.4(f), but it did not propose a formal finding of fact to this effect. Such a finding would be precluded by Respondent's due process rights.

37 The fact that this plan was not made available to Petitioner's examiners before the December 31, 1988 examination is (1) not surprising given the repeatedly demonstrated inadequacy of Respondent's record-keeping and (2) not relevant to the question before me. I must determine whether a formal repayment plan existed, not whether Respondent produced documentation of such a plan during an examination.

38 Petitioner correctly points out that *** has not met the requirements of any of these repayment plans. The issue posed by the Notice of Charges, however, is whether a formal repayment program existed, not whether *** complied with such a program.
{{4-1-90 p.A-1371}}
   Petitioner also contends that collateralization of these seven loans with the stock of a closely-held corporation constitutes an "unfavorable feature." Respondent argues that the collateral's marketability and value have been established because ***'s business associate indicated on one occasion that he would buy the pledged stock for an amount in excess of the amount loaned to ***. Such an indication falls short of a contract to purchase the stock and would be meaningless if the associate reversed his position or was unable to make the purchase. I therefore find the record to be bare of probative evidence concerning the stock's marketability and fair market value. Accordingly, I accept ***'s expert opinion that use of the stock as the sole collateral for ***'s loans constitutes an extension of credit with an "unfavorable feature" violative of 12 C.F.R. §215.4(a)(2).

   3. The Alleged Practice

   Finally, we reach Petitioner's allegation that Respondent has permitted its officers and directors to commit the foregoing violations of Regulation O. While intent is of no relevance to the existence of a violation of the technical requirements of Regulation O, the same cannot be said with respect to the question of whether Respondent had a practice of allowing such violations. The record contains probative evidence that the checking account "restraint" system was administered by an individual since discharged for incompetence, and the possibility of a good faith difference of opinion over the marketability of ***'s stock is not without record support. In the absence of any probative evidence that Respondent was aware that its officers were in violation of Regulation O, I find that Respondent did not have a practice of permitting its officers and directors to commit such violations.

H. The October 20, 1986 Note

   Petitioner alleges that Respondent's extension of credit pursuant to a note executed on October 20, 1986 by Vice-President *** and his son violated the state law setting Respondent's lending limits, *** REV. STAT.ch. 17, §339, and Petitioner's regulation requiring prior approval of such loans by Respondent's board of directors, 12 C.F.R. §337.3(b). Respondent contests both allegations.
   At some point prior to 1986, Respondent originated a loan in the amount of $77,876.44 evidenced by a 90-day term note executed by a *** Bank Trust owned by Vice-President ***. This note was regularly renewed by Respondent and the Trust and was carried at a $51,744.85 balance on Respondent's Loans Liability Report for March 30 and for September 25, 1986. When the note matured on October 20, 1986, a renewal note for $51,378.76 was prepared. Due to a clerical error, the renewal note specified *** as the maker, rather than the Trust. When the renewal note was presented to *** among a group of papers requiring his signature, he executed it without noticing the error or, indeed, paying a great deal of attention to the matter. Respondent continued to carry the loan as an obligation of the Trust on its Loans Liability Report for October 25 and for November 25, 1986. Also unaware of the error, Respondent's board of directors subsequently approved the loan. When the December 31, 1986 bank examination revealed the error for the first time, Respondent immediately obtained a note from the Trust for the outstanding balance due.
   The violations of state law and federal regulation alleged by Petitioner are not crimes, but "civil offenses." Accordingly, Petitioner need not prove a mens rea or guilty intention to exceed the relevant lending limit. See Fitzpatrick v. FDIC, 765 F.2d 569, 576 (6th Cir. 1985). A civil offense may be established simply by proving an actus reus, i.e., a voluntary act proscribed by statute or regulation. See HOLMES, THE COMMON LAW 54 (1881). Here, the proscribed voluntary act would be an extension of credit to ***. There is not one scintilla of evidence which suggests that the October 20 note resulted from anything other than a clerical error by one of Respondent's employees. Accordingly, I find that Respondent did not undertake the positive, voluntary act of extending credit to ***.39


39 I further find that Respondent's possible negligence, when considered in the context of the reasonableness of the risk experienced, does not provide sufficient basis for inferring voluntariness.
{{4-1-90 p.A-1372}}The situation here might well be analogized to a lending limit violation predicated solely upon an arithmetic error in Respondent's books. The subsequent correction of that error would not eliminate a violation, because no violation ever existed.40 For the foregoing reasons, I conclude that Respondent did not commit the violations alleged by Petitioner.

I. Real Estate Holding Period

   Petitioner alleges that "[a]s of December 31, 1986, the Bank...violated section 5(9) of the *** Banking Act...by holding real estate in excess of five years and any extensions given by the *** Commissioner of Banks." Respondent demurs.41 A letter from the *** Commissioner of Banks granted Respondent an extension of the relevant real estate holding period until January 1, 1987. I therefore find the alleged violation of section 5(9) of the *** Banking Act to be without record support.
   On the last day of the hearing, Petitioner adduced certain evidence over Respondent's objection concerning the period after December 31, 1986. That evidence is explicitly barred by my February 5, 1988 Order and is stricken.42 After the close of evidence, counsel for Petitioner moved to amend the Notice of Charges by substituting "January 2, 1987" for "December 31, 1986." Respondent objected on due process grounds. I find that objection to be wellfounded in that Respondent did not receive timely notice of the new allegation and had no opportunity to present relevant evidence.43 Accordingly, Petitioner's motion to amend the Notice of Charges is denied.

J. Teller's Cash

   The Notice of Changes alleges that Respondent violated "12 C.F.R. Section 326.4(b)(2)...by keeping unreasonably high levels of currency at each teller's station." Petitioner's pleading is in error; section 326.4(b)(2) deals with currency kept at "each banking office," while section 326.4(b)(3) treats currency kept at "each teller's station." The Bank presented extensive evidence at the hearing concerning teller cash levels, and the record contains no indication that Respondent was prejudiced by Petitioner's pleading error.
   On brief, Petitioner concedes that "the Bank's own policy by regulation establishes what a reasonable level of currency shall be ...." Since at least November of 1985, it has been Respondent's de facto policy to restrict the amount of cash at each teller station to $15,000 on normal days and $18,000 on peak days.44 This policy only purports to limit a teller's opening and closing cash balances because it is very difficult, if not impossible, for a teller to determine the amount of cash on hand without balancing his or her drawer.45
   Respondent operates its teller stations between 7:00 a.m. and 7:00 p.m., but the cashroom to which tellers must sell cash is only open from 9:00 a.m. to 2:00 p.m. and from 3:00 to 5:00 p.m. Any sales of cash after 3:00 p.m. are not reflected until computation of the following day's balances. Respondent's tellers work three shifts: 7:00 a.m. to 3:00 p.m., 11:00 a.m. to 7:00 p.m. and 3:00 p.m. to 7:00 p.m. Given these facts, it becomes obvious that merely looking at a teller's "opening" and "closing" balances, without more, cannot establish whether that individual is in compliance with Respondent's policy. When the sale of cash by certain tellers after 3:00 p.m. and the inability of certain other tellers to sell cash between 5:00 and 7:00 p.m. are taken into account,46 the record evidences only


40 Accordingly, resolution of the instant issue is not controlled by the contractual doctrine of mistake of fact.

41 While Respondent's Answer admitted the allegation, Respondent contested the issue at hearing and on brief. Because the record provides no factual basis for the allegation, the erroneous portion of Respondent's Answer may be, and is, set aside.

42 Contrary to Petitioner's apparent contention on brief, my Order was not limited to evidence of Respondent's condition, but encompassed evidence of all "matters, policies or practices." The FDIC has not advanced a plausible rationale as to why that Order should bar only Respondent's evidence and not Petitioner's.

43 On brief, Petitioner appears to contend that it has conclusively demonstrated a violation as of January 2, 1987. This contention must be rejected because (1) the newly alleged violation is unsupported by permissible evidence and (2) it is not inconceivable that Respondent could have refuted the new allegation if given the chance to present evidence and argument.

44 The testimony of Respondent's Cashier *** to this effect was not controverted, and I credit it. Petitioner's argument that Respondent's written policy on December 31, 1986 did not reflect these limits misses the mark. While Respondent's failure to amend its written policy might be determinative of an issue based on inadequate documentation, Petitioner's allegation here deals only with the reasonableness of Respondent's cash levels.

45 *** credibly so testified without controversion.

46 The record also establishes a single instance in which Respondent's management instructed a teller not to sell cash so that an out-of-balance situation might be investigated. I find this situation to be without relevance to the issue before
{{4-1-90 p.A-1373}}four instances during December of 198647 when Respondent's tellers were not in compliance with its cash level policy. I therefore find that the cash levels at Respondent's teller stations have not been shown to be unreasonably high, and I conclude that Respondent has not violated 12 C.F.R. §326.4(b)(3).

K. Law Enforcement Consultation
Records

   Plaintiff alleges that Respondent violated 12 C.F.R. §326.5(b) by "failing to maintain records of consultation with law enforcement officers." The cited section of the regulations requires the recordation of any consultation which occurs between a bank's security officer and law enforcement officials concerning the future "installation, maintenance, and operation of appropriate security devices."48
   In 1984 or 1985, Respondent sought advice from and contracted with ***, a firm which specializes in bank security, to install a new security system. Shortly thereafter, ***, acting in conjunction with local law enforcement officers, installed a computerized alarm system with a direct connection to the local police department. Respondent's security officer had no direct consultations with local law enforcement officers concerning the system's installation.49
   If the relevant regulation is strictly construed, there was no violation because Respondent did not fail to record a consultation with law enforcement officers. Petitioner argues, however, that the regulation implicitly requires that such a consultation take place before a security system is installed. While hampered by the absence of any explicit indication of the regulatory intent underlying the promulgation of section 326.5(b), I infer from its content that its purpose is to encourage bank employees, who are not experts on the nature and scope of security systems, to seek advice from individuals believed to have such expertise. In this case, Respondent did exactly that when it sought advice from and contracted with a bank security specialist. For the foregoing reasons, I find that Respondent was in compliance with what I interpret to be the spirit of section 326.5(b) and further find that the Bank was not in violation of the letter of that regulation.

L. Respondent's Management

   Petitioner's Notice of Charges contains no final allegations by way of summation. First, it alleges that Respondent's failure "to adequately staff and/or supervise its officers" in order to prevent the offenses alleged in the Notice constitutes an unsafe or unsound banking practice. Second, the Notice alleges that the offenses set forth therein demonstrate that Respondent was "operated with management whose policies and practices are detrimental to the Bank and jeopardize the safety of the Bank's deposits."
   The Notice of Charges alleges eighteen instances of unsafe or unsound banking practices or violations of law or regulation. Petitioner demonstrated that Respondent engaged in the practices of operating with unsatisfactory earnings, operating with inadequate capital and failing to properly document and restrict management expenses. Respondent was also shown to have committed two violations of Regulation O's prohibition of extensions of credit with "unfavorable features." Thus, Respondent's actual misdeeds fall well short of the range and number of offenses relied upon by Petitioner to support the summary allegations.
   Nevertheless, it is clear that certain of Respondent's proven offenses evidence a failure by its board of directors to properly supervise its officers. Respondent's violations of Regulation O, its business expense practices and its consistent refusal to document its dealings with its management suggest a disdain for compliance with regulatory requirements which approaches license. Since there is no indication that this failure of supervision will not continue to Respondent's detriment, I find it to be an unsafe and unsound banking practice which deserves remedy.
   Turning to the second summary allegation, I do not believe that the record establishes that the management policies and


47 These instances involved *** and *** on December 30 and *** and "#20" on December 31.

48 I therefore find the purported existence of evidence concerning consultation on other matters to be immaterial to the matter alleged.

49 The foregoing findings are based on the uncontroverted and credited testimony of ***, Respondent's security officer.
{{4-1-90 p.A-1374}}practices in this case have created problems of a degree of severity sufficient to support a finding that the safety of Respondent's deposits is in jeopardy. In Docket No. FDIC-83-172b, [1984] F.D.I.C. Enf. Dec. (P-H) at 5654-56, the FDIC based such a finding on a record which demonstrated not only earnings difficulties, but a severe liquidity problem and high loan losses with classified assets amounting to more than fifteen times the bank's loan loss reserve and more than twice its total equity and capital. The record in this case contains neither allegation nor evidence suggesting that Respondent is in comparable straits. In the absence of any expert evidence that the practices and violations found herein would jeopardize Respondent's deposits, I reject Petitioner's allegation to that effect.
   To remedy alleged management deficiencies, Petitioner seeks affirmative relief requiring Respondent to modify its employee compensation policy, to add "independent" members to its board of directors and to retain "management acceptable" to the FDIC. The first element of this relief poses yet another due process problem. While management compensation was discussed in the December 31, 1986 Report of Examination, the Notice of Charges did not raise the issue and Petitioner first alleged that Respondent had "unreasonable compensation and benefit practices" on post-hearing brief. In response to Respondent's due process objections, Petitioner contends that the Bank should have been aware that this issue would be addressed at the hearing after receiving a proposed cease and desist order which contained provisions modifying Respondent's employee compensation policy. I disagree. The Bank could reasonably have concluded that the proposed relief was intended to remedy an offense alleged in the Notice of Complaint; Respondent was not required to assume that Petitioner intended to litigate an unpled charge. Moreover, Petitioner did not present evidence on this issue during the hearing. I therefore find that Petitioner is not entitled to an order remedying an offense which was neither pled nor provided.50
   In contrast, the necessity for adding "independent" members to Respondent's board of directors has been conclusively demonstrated. At present, Respondent's three senior officers constitute half of its six-man board of directors. As observed by Petitioner on brief, these individuals are "supervising themselves." The record convinces me that independent supervision of management is required in order to eliminate Respondent's longstanding disdain for regulatory governance. In order to increase the likelihood of securing independent supervision on a continuing basis, the relief sought by Petitioner will be modified to require that the majority of Respondent's board of directors remain comprised of "independent" members.
   The final element of relief proposed by Petitioner is a "management acceptable" clause. Such a provision appears to be arbitrary and unnecessary in this case for several reasons. Respondent's present condition is not solely the result of management's "policies and practices."51 More significantly, all of the offenses found herein can be remedied by the prohibitive provisions of a cease and desist order. The need for management which will operate the Bank in a safe and sound manner, while preventing violations of law and regulation, is met by the affirmative relief establishing an independent board of directors. That board can change Respondent's management if such a change is required. See Docket No. FDIC-85-42b, [1986] F.D.I.C. Enf. Dec. (P-H) ¶5062, at 6588. Accordingly, I find a "management acceptable" clause to be inappropriate in this case.

FINDINGS OF FACT52

   1. At all times relevant to this proceeding, Respondent was a commercial bank organized and chartered under the laws of ***, having its principal place of business in ***.


50 Petitioner argues in the alternative that there is a "reasonable relationship" between the relief sought and practices alleged in the Notice since the level of executive compensation has an effect on earnings and, therefore, upon capital. The major difficulty with this argument is that virtually every banking activity monitored by Petitioner has such an effect. If Petitioner's argument were sound, a bank's due process rights would be suspended whenever the FDIC fashioned relief. Accordingly, I find that Petitioner has not shown that modification of Respondent's employee compensation policy is either necessary or appropriate to remedy any of Respondent's demonstrated offenses.

51 For example, 70 percent of the assets properly classified "loss" were not acquired by Respondent's present management. Were these assets removed from consideration, Respondent's resulting capital to asset ratio of 5.9957 would approximate the level required by 12 C.F.R. §325.3.

52 The findings of fact requested by Petitioner have been modified, supplemented or deleted as required by the preceding discussion. Proposed findings hereinafter omitted but not discussed previously are either redundant or irrelevant.
{{4-1-90 p.A-1375}}
   2. The Bank's independent auditor provided the examiner with an average total asset figure of $61,376,000 as of December 31, 1986.
   3. As of December 31, 1986, Respondent's Part 325 total capital (without subtracting assets classified "loss") equalled $3,720,000.
   4. As of December 31, 1986, Respondent's reserve for loan losses was $115,000.
   5. In the December 31, 1986 FDIC Report of Examination, $7,000 of the loan to *** was properly classified "loss."
   6. In the December 31, 1986 FDIC Report of Examination, $1,000 of the loan to *** was properly classified "loss."
   7. In the December 31, 1986 FDIC Report of Examination, a $17,000 open item on Respondent's correspondent account with *** Bank was improperly classified "loss."
   8. In the December 31, 1986 FDIC Report of Examination, $22,300 in overdrafts to *** were properly classified "loss."
   9. In the December 31, 1986 FDIC Report of Examination, real estate held by Respondent identified as the Interim Investments property was properly classified $48,000 "loss" and $54,000 "substandard."
   10. In the December 31, 1986 FDIC Report of Examination, real estate held by Respondent identified as the *** property was properly classified $31,000 "loss" and $6,000 "substandard."
   11. In the December 31, 1986 FDIC Report of Examination, real estate held by Respondent identified as the *** property was properly classified $2,000 "loss."
   12. In the December 31, 1986 FDIC Report of Examination, real estate held by Respondent identified as the *** property was properly classified $2,000 "loss."
   13. In the December 31, 1986 FDIC Report of Examination, a $1,000 prepaid expense for opera tickets purchased for Director *** was properly classified "loss."
   14. Using the average total asset figure of $61,376,000 provided by Respondent's internal auditor and subtracting all properly classified "loss" identified in the December 31, 1986 FDIC Report of Examination, Respondent's total capital to total asset ratio equalled 5.87 percent.
   15. As of December 31, 1986, Respondent's net interest margin, exclusive of securities gains, was 2.58 percent.
   16. From January through June of 1986, Respondent was able to operate at a profitable level on a monthly basis before any securities gains or losses. In July of 1986, the Bank suffered a large operating loss and continued to suffer monthly operating losses through December of that year.
   17. A capital to asset ratio of 6.5 percent is appropriate.
   18. As of December 31, 1986, Respondent had $10,448,000 in total loans outstanding.
   19. Total properly classified loan losses as of December 31, 1986 equalled $40,300.
   20. As of December 31, 1986, Respondent had $557,500 in properly classified special mention loans for which some provision should be made in the loan valuation reserve.
   21. Respondent regularly paid medical expenses of its officers and their families outside of its insurance plan. Respondent had no formal written plan for the payment of such expenses, and there was no limit to the expenses that it would pay outside of the health insurance policy.
   22. Between November 11, 1985 and December 31, 1986, Respondent paid the following management entertainment expenses without receiving or maintaining any documentation of business purpose or the person entertained: *** in the amount of $11,076.58 for Director ***; ***, *** in the amount of $4,788.00 for Director ***; and the ***; the amount of $1,544.15, the *** in the amount of $735.73 and the ***, in the amount of $606.11 for Director ***.
   23. Lack of documentation for business expenses was criticized in the November 11, 1985 FDIC Report of Examination and by Respondent's auditors.
   24. Respondent purchased a 1982 Cadillac Cimarron for the use of Vice President ***.
   25. The 1982 Cadillac Cimarron was sold to Vice President ***'s son for $2,000.
   26. Respondent's records relating to the sale of the automobile to Vice President ***'s son are virtually non-existent.
   27. Respondent accounted for its securities transactions during 1986 as an invest- {{4-1-90 p.A-1376}}ment account in full compliance with generally accepted accounting practices and with the FDIC's reporting instructions.
   28. The apparent extension of credit on October 20, 1986 by Respondent to Vice President *** and his son resulted from a clerical error.
   29. The seven commercial loans to Vice President *** outstanding on December 31, 1986 was secured by stock in a closely-held corporation, which represents an unfavorable feature.
   30. The effect of the "restraint" on the accounts of Directors ***, *** and *** was to give them additional float in their accounts, to prevent overdrafts from being reflected in their accounts and to grant *** and *** unsecured loans from October 3 to October 16, 1986.
   31. Respondent was not shown to have been in material violation of its policy controlling teller cash levels.
   32. In approximately 1985, Respondent installed a new alarm system under contract with a firm specializing in bank security.
   33. As of December 31, 1986, Respondent did not hold title to the *** and *** properties in excess of five years without an extension from the *** Commissioner of Banks and Trust Companies.

CONCLUSIONS OF LAW

   1. Respondent is subject to the Federal Deposit Insurance Act, 12 U.S.C. §§1811-1831b, the Rules and Regulations of the FDIC, 12 C.F.R. Ch. III, and the laws of ***.
   2. The FDIC has jurisdiction over Respondent and the subject matter of this proceeding.
   3. Respondent violated 12 C.F.R. §325.3(a) and (b) by failing to maintain a ratio of total capital to total assets of six percent as of December 31, 1986.
   4. As of December 31, 1986, Respondent was engaged in unsafe or unsound banking practices by operating with unsatisfactory earnings and inadequate capital.
   5. Respondent has not been shown to have engaged in an unsafe or unsound banking practice by failing to maintain an adequate reserve for loan losses as of December 31, 1986.
   6. Respondent engaged in unsafe or unsound banking practices by failing to maintain either adequate documentation for business expenses or a formal policy governing the payment of medical expenses for bank officers and directors.
   7. Respondent has not been shown to have engaged in an unsafe or unsound banking practice by failing to prepare and retain adequate documentation concerning its sale of an automobile.
   8. Respondent has not been shown to have engaged in an unsafe and unsound banking practice by failing to account for the trading activities in its security portfolio in accordance with generally accepted accounting practices.
   9. Respondent did not violate 12 C.F.R. §304.4 by failing in report its securities transactions in accordance with the instructions for the Report of Condition and Income.
   10. Respondent did not violate section 32 of the *** Banking Act by extending credit to Vice President *** which exceeded Respondent's legal lending limit.
   11. Respondent did not violate 12 C.F.R. §337.3(b) by extending credit to Vice President *** without the prior approval of a majority of Respondent's board of directors.
   12. Respondent violated 12 C.F.R. §215.4(a)(2) by extending credit to Director *** which presented an unfavorable feature.
   13. Respondent violated 12 C.F.R. §215.4(a)(2) by extending credit to Directors ***, *** and *** which presented unfavorable features.
   14. Respondent did not violate 12 C.F.R. §325.4(b)(2) by keeping unreasonably high levels of cash at teller stations.
   15. Respondent did not violate 12 C.F.R. §326.5(c) by failure to maintain records of consultation with law enforcement officers.
   16. Respondent did not violate section 5(9) of the *** Banking Act by holding real estate in excess of five years plus any extensions granted by the *** Commissioner of Banks.
   17. Respondent engaged in an unsafe and unsound banking practice by failing to adequately supervise its officers in order to prevent unsafe of unsound banking practices and violations of regulations.
   Upon the foregoing findings of fact and conclusions of law, and upon the entire record in this case, I hereby issue the following recommended:

{{4-1-90 p.A-1377}}
ORDER TO CEASE AND DESIST

   IT IS ORDERED that Respondent, *** Bank ***, its directors, officers, employees, agents, successors, assigns and other persons participating in the conduct of its affairs, cease and desist from the following unsafe or unsound banking practices and violations of regulation:
   1. (a) Operating in such a manner as in produce a low net interest margin and unsatisfactory earnings.
   (b) Operating with an inadequate level of equity capital protection.
   (c) Failing to maintain adequate documentation of business expenses.
   (d) Failing to have a formal written policy limiting payment of the medical expenses of officers and directors.
   (e) Failing to monitor in a prudent manner transactions involving its officers and directors.
   IT IS FURTHER ORDERED that Respondent, its directors, officers, employees, agents, successors, assigns or other persons participating in the conduct of its affairs, take the following affirmative action:
   1. Within 90 days from the effective date of this ORDER, Respondent shall add at least three "independent" members to its board of directors. The addition of the independent directors required by this paragraph may be accomplished, to the extent permissible by state statute and Respondent's bylaws, by means of appointment or by election at a regular or special meeting of Respondent's shareholders. Further, Respondent shall take all steps necessary to insure that its board of directors is and remains composed of a majority of independent directors. As used in this ORDER, the term "independent" is defined as an individual who is not: (1) an employee or officer of Respondent or an employee, officer or director of *** ("Holding Company") or any other affiliate of Respondent, as that term is defined in section 23A of the Federal Reserve Act, 12 U.S.C. §371c, related by blood or marriage to any officer or director of Respondent, Holding Company, any other affiliate of Respondent or any stockholder owning more than five percent of Respondent's or Holding Company, any other affiliate of Respondent or any stockholder owning more than five percent of Respondent's or Holding Company's outstanding shares or (2) indebted to Respondent or to any of its affiliates, directly or indirectly (including the indebtedness of any of its affiliates, directly or indirectly (including the indebtedness of any "related interest" as that term is defined at 12 C.F.R. §215.2(k)) in an amount exceeding five percent of Respondent's capital and unimpaired surplus as defined at 12 C.F.R. §215.2(f).
   2. (a) Within 60 days from the effective date of this ORDER, Respondent shall have performed a detailed written study of its earnings performance and investment and funds management policies and practices. The study shall be performed by a qualified consultant, acceptable to the Regional study shall be performed by a qualified consultant, acceptable to the Regional Director and the Commissioner or Banks for the state of *** ("Commissioner"), and shall include written recommendations to improve Respondent's earnings performance and investment and funds management policies and practices.
   (b) When completed, the study required by this paragraph shall be submitted to the Regional Director and Commissioner for their review and opportunity for comment.
   3. (a) Within 90 days from the effective date of this ORDER, and quarterly thereafter during the life of this ORDER, Respondent's board of directors shall review Respondent's investment and funds management policies and practices for adequacy in coordination with the written study required by paragraph 2(a) and, based upon this review, shall make appropriate revisions in the policies that are necessary to strengthen investment and funds management practices. The minutes of the meeting of the board of directors at which each such review is undertaken shall expressly state the results of the review.
   (b) The initial revisions to the Bank's investment and funds management policies required by this paragraph shall, as a minimum, include provisions which define rate sensitive assets and liabilities and which specify acceptable ranges for the Bank's rate sensitivity and gap ratios at various time horizons, which shall be at a minimum, three months, six months, twelve months, eighteen months and twenty-four months.
   (c) The investment and funds management policies, when revised as required by {{4-1-90 p.A-1378}}this paragraph, shall be submitted to the Regional Director and Commissioner for their review and opportunity for comment.
   4. (a) Within 90 days from the effective date of this ORDER, Respondent shall formulate and fully implement a written plan and a comprehensive budget for 1988 for all categories of income and expense. The written plan required by this paragraph shall consider the results of the written study required by paragraph 2 of this ORDER and shall contain formal goals and strategies to improve Respondent's net interest margin and its overall earnings. For all subsequent years that this ORDER is in effect, Respondent shall formulate a written plan and a comprehensive budget prior to the commencement of each such year.
   (b) The plans and budgets required by this paragraph, upon completion, shall be submitted to the Regional Director and Commissioner for their review and opportunity to comment.
   (c) After the end of each calendar quarter while this ORDER is in effect, Respondent's board of directors shall evaluate Respondent's actual performance in relation to the plans and budgets required by this paragraph and expressly record the results of the evaluation, and any actions taken by Respondent, in the minutes of the meeting of the board of directors at which such evaluation is undertaken.
   5. (a) Within 90 days from the effective date of this ORDER, and in coordination with the written plans and budgets required by paragraph 4 of this ORDER, and the written study required by paragraph 2 of this ORDER, Respondent shall adopt and implement a detailed written policy covering expense reimbursements to its directors, officers and employees. At a minimum, the policy shall include the following:

       (i) Provisions which specify the reasonable limitations for all categories of expenses related to customer entertainment and business development.
       (ii) Provisions which require complete documentation of all expenses related to customer entertainment and business development as recommended in the May 22, 1986 management letter from Respondent's external auditor, ***. At a minimum, Respondent shall require the submission of an original receipt, identification of the person or persons entertained and the business purpose of the expense before a check is issued for payment by Respondent.
       (iii) Provisions prohibiting the reimbursement of personal expenses of Respondent's directors, officers and employees.
       (iv) Provisions specifying reasonable limits on the number and cost of automobiles owned by Respondent and the rationale therefor.
       (v) Provisions requiring that each individual utilizing an automobile owned by Respondent provide detailed monthly documentation regarding use of the automobile for Respondent's business.
   (b) While this ORDER is in effect, Respondent's board of directors shall conduct monthly reviews of all expenses submitted for customer entertainment, business development and automobile usage, with the results of the reviews expressly stated in the minutes of the meetings of the board of directors at which such reviews are performed. On a monthly basis, Respondent will either seek reimbursement for any expenses paid which are not in conformance with the policy required by paragraph 5(a) or will expressly state in the minutes of the board of directors the full justification for deviations from the policy.
   6. (a) Within 30 days from each June 30 and each December 31 following the effective date of this ORDER, Respondent's board of directors shall determine Respondent's level of primary capital as a percentage of its total assets, as of the respective June 30 and December 31 dates. If that percentage is less than 6.5 percent of total assets, Respondent's board of directors shall, within 60 days from the date of that determination, increase that capital/asset relationship to not less than 6.5 percent as of the end of that preceding semiannual period. For the purpose of this ORDER, the terms "primary capital" and "total assets" shall be defined as those terms are defined in Part 325 of the FDIC Rules and Regulations, 12 C.F.R. Part 325.
   (b) The requirements of paragraph 6(a) shall not negate the Respondent's responsibility to maintain continuously throughout the year an adequate level of primary capital protection for the kind and quality of assets held by Respondent.
   (c) Any increase in primary capital necessary to comply with paragraph 6(a) of this ORDER may be accomplished by:
{{4-1-90 p.A-1379}}
       (i) the sale of equity securities; or
       (ii) the elimination of all or part of the "loss" assets referred to in paragraph 8 of this ORDER, without losses or liability to Respondent; or
       (iii) The collection in cash of assets previously charged off; or
       (iv) The direct contribution of cash by the Holding Company or Respondent's directors; or
       (v) Any other means acceptable to the Regional Director and Commissioner.
   (d) If all or part of the increase in primary capital necessary to comply with paragraph 6(a) of this ORDER is to be accomplished by the sale of new securities, Respondent's board of directors shall forthwith take all steps necessary to adopt and implement a written plan for the sale of such additional securities, including the voting of any shares owned or proxies held or controlled by any of them in favor of said plan. Should the implementation of the plan involve public distribution of Respondent's securities, including a distribution limited only to the Bank's existing shareholders, Respondent shall prepare detailed offering materials fully describing the securities being offered, including an accurate description of Respondent's financial condition and the circumstances giving rise to the offering, and any other material disclosures necessary to comply with Federal securities laws. Prior to the implementation of the plan and, in any event, not less than 20 days prior to the dissemination of such materials, the materials used in the sale of the securities shall be submitted to the FDIC, Registration and Disclosure Unit, Washington, D.C. 20429, for its review. Any changes requested by the FDIC shall be made prior to dissemination of the materials.
   (e) In complying with the provisions of paragraph 6(d) of this ORDER, Respondent shall provide to any subscriber and/or purchaser of Respondent's securities written notice of any planned or existing development or other change which is materially different from the information reflected in any offering materials used in connection with the sale of Respondent's stock. The written notice required by this paragraph shall be furnished within ten calendar days from the date any material development or change was planned or occurred, whichever is earlier, and shall be furnished to every purchaser and/or subscriber of Respondent's securities who received or was tendered the information contained in Respondent's original offering materials.
   7. While this ORDER is in effect, Respondent shall not declare or pay any cash dividends without providing a minimum of 30 days advance written notice to the Regional Director and Commissioner.
   8. Within 30 days from the effective date of this ORDER, the Bank shall eliminate from its books, by charge-off or collection, all assets or portions of assets properly classified "loss" as of December 31, 1986.
   9. Within 30 days from the effective date of this ORDER, Respondent shall replenish its loan valuation reserve by an expense entry in an amount equal to those loans required to be charged off by paragraph 8 of this ORDER.
   10. (a) Within 60 days from the effective date of this ORDER, Respondent shall eliminate and/or correct all violations of regulation as of December 31, 1986. In addition, Respondent shall adopt procedures to insure future compliance with all applicable laws, rules and regulations.
   (b) Within 30 days from the effective date of this ORDER, Respondent shall adopt and implement detailed written procedures designed to insure that all applicable extensions of credit are in conformance with Regulation O of the Board of Governors of the Federal Reserve System, 12 C.F.R. Part 215.
   (c) Within 30 days from the effective date of this ORDER, the written procedures adopted pursuant to paragraph 10(b) of this ORDER shall be submitted to the Regional Director and Commissioner for their review and opportunity for comment.
   11. Within 60 days from the effective date of this ORDER, Respondent shall correct all deficiencies in the loans properly listed for "special mention" as of December 31, 1986.
   12. Within 50 days from the effective date of this ORDER, Respondent shall amend and refile Reports of Condition and Income for the periods ending December 31, 1986, and subsequently, if the original filings do not reflect all of the adjustments {{4-1-90 p.A-1380}}required by paragraphs 8 and 9 of this ORDER.
   13. Following the effective date of this ORDER, Respondent shall send to its shareholders or otherwise furnish a description of this ORDER (1) in conjunction with Respondent's next shareholder communication and (2) in conjunction with Respondent's notice or proxy statement preceding its next shareholder meeting. The description and any accompanying communication, statement or notice shall be sent to the FDIC, Registration and Disclosure Unit, Washington, D.C. 20429, for review at least 15 days prior to dissemination to shareholders. Any changes requested by the FDIC shall be made prior to dissemination of the description, communication, notice or statement.
   14. On the last day of the second month following the date of issuance of this ORDER, and every second month thereafter, Respondent shall furnish written progress reports, signed by each member of Respondent's board of directors, to the Regional Director and Commissioner detailing the form and manner of any actions taken to secure compliance with this ORDER and the results thereof. Such reports may be discontinued when the corrections required by this ORDER have been accomplished and the Regional Director and Commissioner have released Respondent in writing from making further reports.
   15. The effective date of this ORDER shall be ten days after its issuance by the FDIC.
   16. The provisions of this ORDER shall remain effective and enforceable except to the extent that, and until such time as, any provisions of this ORDER shall have been modified, terminated, suspended or set aside by the FDIC.
   Done at Washington, D.C., this 27th day of June, 1988.
Steven M. Charno
Administrative Judge

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