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   [5168] In the Matter of The Stephens Security Bank, Stephens, Arkansas, Docket No. FDIC-89-234b (8-9-91).

   FDIC issues cease and desist order upon finding that Bank engaged in numerous unsafe or unsound banking practices. (This order was terminated by order of the FDIC dated 2-25-93; see9014.)

   [.1] Practice and Procedure—Exceptions to Recommended Decision— Oral Argument
   The grant of a request for oral argument is discretionary with the board, granted only if it will aid the board in its determination or if a party would be prejudiced by the lack of oral argument.

   [.2] Evidence—Expert Opinion—Weight
   A former FDIC examiner who left the agency four years earlier has not had the benefit of current developments or recent training in FDIC examination policy or procedures and his opinion is not entitled to the deference accorded to current FDIC examiners.

   [.3] Loans—Classification—Examiner's Opinion
   Examiners' loan classifications are to be accorded deference unless they are without factual basis or are unreasonable in light of the factual basis.

   [.4] Loans—Classification—Post-Examination Evidence
   Evidence that a loan has come into compliance after the examination does not establish that the classification was incorrect and is not a basis for reversing that classification.

   [.5] Directors and Officers—Unauthorized Compensation—Fiduciary Duty
   Bank Chairman's receipt of loan origination fees is unauthorized compensation which breaches his fiduciary duty and is an unsafe or unsound banking practice.

   [.6] Cease and Desist Orders—Notice of Charges—Specificity
   Where disclosures in Notice of Charges and in Report of Examination are
{{10-31-91 p.A-1783}}sufficient to inform Respondent that he is charged with a violation of law, allegations of all details supporting the charge are not required.

   [.7] Cease and Desist Orders—Cessation of Violation
   Correction of violations during and after the examination period does not eliminate the need for an order not to commit such violations in the future.

In the Matter of

THE STEPHENS SECURITY BANK
STEPHENS, ARKANSAS
(Insured State Nonmember Bank)
DECISION
FDIC-89-234b

I. BACKGROUND

   This proceeding was brought pursuant to section 8(b)(1) of the Federal Deposit Insurance Act ("FDI Act"), 12 U.S.C. §1818(b)(1), against The Stephens Security Bank, Stephens, Arkansas ("Insured Institution" or "Respondent").
   On December 12, 1989, a Notice of Charges and of Hearing ("Notice") was issued against the Insured Institution, alleging certain unsafe or unsound banking practices, including hazardous lending and lax collection practices, diversion of portions of proceeds of extensions of credit to the chairman of the board and/or his related interests, generating an excessive volume of poor quality loans and other assets in relation to total assets, failing to maintain adequate capital, failing to maintain an adequate reserve for loan losses, operating with an excessive volume of poor quality loans and loan-related assets, and operating with management whose policies and practices are detrimental to and jeopardize the safety and soundness of the Insured Institution. A cease-and-desist order prohibiting the unsafe and unsound banking practices and requiring the Insured Institution to take affirmative action to correct the conditions resulting therefrom was sought.
   Following a hearing requested by Respondent, the Board of Directors ("Board") of the Federal Deposit Insurance Corporation ("FDIC") has reviewed the record, the parties' briefs, the recommended Decision and Order (collectively referred to as the "Recommended Decision") of the Administrative Law Judge ("ALJ"), and the parties' exceptions thereto. The Board agrees with the ALJ that the Insured Institution has engaged in unsafe or unsound banking practices by permitting payment to the Respondent's chairman in connection with its extension of credit to a third party and operating in violation of section 215.7 of Regulation O of the Board of Governors of the Federal Reserve System, 12 C.F.R. §215.7 ("Reg. O"). In addition, on the basis of this record, the Board modifies the Recommended Decision and finds that the Insured Institution engaged in certain other unsafe or unsound practices.
   Specifically, the Insured Institution has engaged in the following unsafe or unsound banking practices: 1) capitalizing loan interest; 2) extending credit in violation of the Insured Institution's written loan policy; 3) extending loans that were secured by insufficient collateral; 4) extending credit without adequate documentation; 5) extending credit without adequate credit analysis; 6) extending credit without adequate repayment agreements or failing to enforce repayment agreements; 7) diverting proceeds from extensions of credits to third parties to its chairman without the written approval of the Insured Institution's board of directors; 8) operating with an excessive volume of adversely classified loans and assets; 9) operating with an excessive number of loans with technical exceptions; 10) violating Reg. O; and 11) operating with management that failed to provide adequate supervision of the Insured Institution's officers.
   For the reasons set forth below, the Board concludes that a cease-and-desist order should issue in this proceeding,1and adopts,


1Citations to the record of this proceeding shall be as follows:
   ALJ's recommended Decision and Order, "R.D."
   Hearing Transcript, "Tr."
   Exhibits, "FDIC Ex. No." or "Resp. Ex. No."
   Exceptions, "FDIC Exc." or "Resp. Exc."
{{10-31-91 p.A-1784}}in part, the ALJ's Recommended Decision2and the proposed order with modifications consistent with the findings and conclusions herein.

II. STATEMENT OF THE CASE

   The FDIC Division of Supervision completed an examination of the Insured Institution as of July 21, 1989, determining that its overall condition had substantially deteriorated since the prior FDIC examination as of October 10, 1986. The examination found that adversely classified assets (loans and other real estate) had increased 424 percent since the prior examination to $3,432,000, of which $2,815,000 consisted of loans classified "Substandard," $143,000 "Doubtful," and $98,000 classified "Loss." Total adversely classified assets represented 14.41 percent of the Insured Institution's total assets and equalled 153.08 percent of total equity capital and reserves, or more than one and a half times the Insured Institution's capital. FDIC Ex. No. 1 at 1–3.3
   In addition to the large volume of adversely classified loans, other areas of supervisory concern identified in the July 21, 1989 Report of Examination were the Insured Institution's credit renewal practices, failure to follow written loan policies, inadequate capital position, insufficient loan loss reserve, poor earnings, and the failure of management to assess risk, recognize loss and take steps to address the Insured Institution's asset quality problems. The July 21, 1989 Report of Examination assigned the Insured Institution a Uniform Financial Institutions Rating of 4, indicating that it could pose a threat to the insurance fund if corrective action were not taken.4FDIC Ex. No. 1 at 1-a-2.
   On December 12, 1989, the Regional Director (Supervision) of the FDIC's Memphis Regional Office ("Regional Director"), pursuant to delegated authority, issued a Notice proposing that an order be issued under the FDI Act requiring the Insured Institution to cease and desist from engaging in the unsafe or unsound banking practices specified therein and to correct certain conditions. The Insured Institution filed an answer contesting the charges in the Notice, and a hearing was scheduled.
   A hearing commenced before Administrative Law Judge Steven M. Charno in Memphis, Tennessee, on July 16–18, 1990, and was continued upon Respondent's motion until November 27–28, 1990. The ALJ issued a Recommended Decision on April 18, 1991. Exceptions to the Recommended Decision were filed by the Insured Institution and by FDIC Enforcement Counsel.

III. THE ALJ'S RECOMMENDED
DECISION

   The Recommended Decision relies almost entirely on the ALJ's determination that the opinions of the Insured Institution's expert witness, a former FDIC examiner currently a law student and previously employed by Respondent's counsel as a summer law clerk, are entitled to deference and that Enforcement Counsel's proposed conclusions of law were "not supported by any citation of legal authority." R.D. at 4, n. 10. The ALJ also rejected the classification of 15 loans and reduced one loan classification made by the FDIC in the July 21, 1989 Report of Examination, on the basis of testimony by Respondent's expert. R.D. at 5–6.
   The ALJ did conclude, however, that the Insured Institution had engaged in an unsafe or unsound practice by "allowing the payment of money to a member of the board of directors with its extension of credit to a third party" and by "operating in violation of Section 215.7 of Regulation O." R.D. at 15. The ALJ also concluded that Respondent extended loans in violation of the Bank's written loan policy because they were not secured by sufficient collateral, were not adequately documented, were without adequate credit analysis, and were without adequate repayment agreements. Moreover, he found that the Insured Institution failed to enforce repayment agreements and capital


2The Board adopts Findings of Fact Nos. 1 through 14, 16, and 19 through 22 and Conclusions of Law Nos. 1 through 5, 7, 8, 12, and 13, as set forth in the Recommended Decision.

3The FDIC examiners noted that the Insured Institution demonstrates "[a] continuing trend of deterioration in asset quality . . . and now has reached a level of critical concern." FDIC Ex. No. 1 at 2.

4As of the July 21, 1989 examination, the loan loss reserve stood at $142,000, which was considered grossly inadequate given the volume ($3.5 million) of classified assets. Assets classified "Loss" and one-half of "Doubtful" alone were more than twice the reserve. Examiners requested an increase in the loan loss reserve by at least $400,000. FDIC Ex. No. 1 at 1-a. In addition, the Insured Institution's capital level had fallen by almost a full percentage point to 8.26 percent, down from 9.18 as of October 10, 1986. FDIC Ex. No. 1 at 3.
{{10-31-91 p.A-1785}}ized interest owed into renewed extensions of credit. R.D. at 2. The ALJ determined that
    the relevant portions of the examination report establish the facts in question on a prima facie basis and further [I] find that Respondent did not meet the shifted burden of proof by proffering probative evidence sufficient to rebut Petitioner's showing.

   R.D. at 2. However, the ALJ did not conclude that these facts established "unsafe or unsound banking practices . . . by engaging in hazardous lending and lax collection practices" because of what he stated was a failure to show the link between specific loans and consequences of those loans. R.D. at 2–3. Nothing that Enforcement Counsel presented no rebuttal to Respondent's expert, and granting deference to the opinions of Respondent's expert,5the ALJ concluded that Enforcement Counsel had "not established the requisite basis for the conclusion of law it proposed." Id. The ALJ also rejected Enforcement Counsel's proposed conclusions of law and findings of fact regarding the allegation that Respondent has "excessive poor quality and adversely classified loans and assets." R.D. at 6.6Additionally, in further reliance on Respondent's expert, the ALJ rejected the proposed conclusion that the "excessive volume of technical violations is an unsafe and unsound practice." R.D. at 6.7
   In considering the Insured Institution's loan loss reserves and earnings, the ALJ rejected the classification of certain loans based upon the testimony of Respondent's expert. The ALJ found that the FDIC examiner "appeared to rely on his incorrect classification of the * * * loan" in "formulating his opinion that Respondent's reserve was inadequate and its earnings overstated." R.D. at 7. The ALJ rejected Enforcement Counsel's proposed findings on the loan reserves and earnings.
   In regard to the alleged violations of law, the ALJ adopted Enforcement Counsel's proposed findings regarding the Reg. O violation, but rejected the proposed conclusion regarding violation of section 23A(c)(1) of the Federal Reserve Act, 12 U.S.C. §371c(c)(1) ("Section 23A"). The ALJ found that:
    [t]he Notice in this proceeding does not allege that Chairman Smith controlled Respondent, and Petitioner neither requested a finding of fact to that effect nor identified the portions of the record which would support a finding of affiliation, thereby waiving the right to request such findings.

R.D. at 8. As to the violations of Reg. O, the ALJ determined that a trust benefitting the children of the Chairman Smith is not a "related interest" under 12 C.F.R. §215.2(k). However, the ALJ found that Chairman Smith controlled two other related interests in violation of Reg. O.
   Finally, the ALJ rejected Enforcement Counsel's "requested conclusions that Respondent engaged in unsafe or unsound banking practices by (a) `operating with management whose policies and practices are detrimental' to the Bank and (b) operating with a board of directors which failed to provide supervision adequate `to prevent or abate the practices.'" R.D. at 10.
   Enforcement Counsel except to various findings of the ALJ relating to: 1) the degree of deference given to an FDIC examiner; 2) the standard for determining unsafe and unsound practices; 3) loan and asset quality; 4)
5Respondent's expert testified "that (a) not every deviation from Respondent's conservative, written lending policy is inherently a cause of abnormal risk, loss or damage, (b) not every unsecured or partially secured loan is inherently a cause of abnormal risk, loss or damage, (c) not every failure of documentation is inherently a cause of abnormal risk, loss or damage, (d) not every capitalization of interest is inherently a cause of abnormal risk, loss or damage, (e) Respondent did not fail to analyze credit in such a way as to cause abnormal risk, loss or damage, and (f) the absence of a repayment plan (beyond the terms of a note) is not inherently a cause of abnormal risk, loss or damage." R.D. at 3.

6The Board is at a loss to understand this reluctance since even assuming that the Respondent's expert witness was correct in not classifying certain loans, there still remained over $1.8 million in adversely classified assets and another half million dollars listed as special mention. This represents over ten times Respondent's loan loss reserves and is almost equal to its primary capital of just over $2 million. In an institution of Respondent's size (total assets of just under $24 million), this is a large amount of poor quality and adversely classified assets.

7A technical exception violation is not ipso facto an unsafe or unsound practice. However, when the number of such technical violations is significant, then the potential risks associated with such violations also increase. Here there was a large number of such violations (involving loans amounting to over $5 million and over 35% of total loans and leases), and the Board concludes that these numerous violations established a pattern and practice which does rise to the level of unsafe or unsound practice.
{{10-31-91 p.A-1786}}adequacy of loan loss reserves and earnings; 5) violation of Section 23A of the Federal Reserve Act; 6) violation of Section 22(h) of the Federal Reserve Act, 12 U.S.C. §375b, and Reg. O; and 7) management and Respondent's board. Enforcement Counsel also except to the ALJ's failure to adopt certain proposed findings of fact and conclusions of law, mostly concerning allegations of individual instances of unsafe or unsound practices. Further, Enforcement Counsel take exception to the ALJ's proposed cease-and-desist order.
   The Respondent excepts to the ALJ's proposed order concerning: 1) a requirement that management obtain written approval before disbursement of loan proceeds when a member of Respondent's board might be receiving a de minimis portion; and 2) the issuance of the proposed cease-and-desist order.

IV. MOTION FOR ORAL ARGUMENT

   [.1] Respondent submitted a Motion for Oral Argument before the Board with its Exceptions to the Recommended Decision. Pursuant to 12 C.F.R. §308.43, the grant of a request for post-hearing oral argument is an extraordinary matter within the sole discretion of the Board.
   As set forth in prior decisions of the Board (see In the Matter of Harold Hoffman, 2 P-H FDIC Enf. Dec. ¶5140 (1989); FDIC Docket No. FDIC-85-42b, 1 P-H FDIC Enf. Dec. ¶5062 (1986)), the factors considered in determining whether to exercise the Board's discretion to permit oral argument include whether (1) the factual and legal arguments are fully set forth in the parties' submissions, (2) oral argument will aid the Board in this matter, and (3) the Respondent will be prejudiced by the lack of oral argument. The request here fails to articulate any basis for oral argument before the Board. Further, it appears that the factual and legal arguments are fully set forth in the record. Accordingly, the Board declines to grant Respondent's request for oral argument.

V. DISCUSSION

   This proceeding involves an insured financial institution whose most recent FDIC examination indicates a disturbing increase in problem assets during the three years since the prior FDIC examination. The Board is now required to determine whether some remedial relief in the form of a cease-and-desist order is necessary and appropriate to halt certain alleged unsafe or unsound practices and violations of laws and regulation. As the Board has held on many prior occasions, such an order is not a punitive measure but is remedial and intended to focus the Insured Institution's attentions on actions necessary to end unsafe or unsound practices, to bring about correction of its financial problems and to implement procedures that will prevent their reoccurrence. The Board has carefully reviewed the entire record of this proceeding. For the reasons set forth below, the Board agrees in part with the ALJ's findings and conclusions but disagrees with certain of the ALJ's findings and conclusions, and disagrees with certain aspects of the ALJ's proposed relief. Accordingly, the Board adopts the ALJ's Recommended Decision only in part8and modifies the cease-and-desist order to reflect the discussion herein.

A. Deference to FDIC Examiners' Classification.

   [.1] The Recommended Decision is premised upon deference given by the ALJ to opinion testimony of Respondent's expert9regarding the classification of loans and other assets. The ALJ notes that:

    Respondent's expert was shown to have been commissioned as a bank examiner, and his opinion concerning asset classifications are therefore entitled to deference [citation omitted]. I find that this expert's part-time employment by Respondent's counsel does not render his testimony incredible.

R.D. at 3, n. 6. Considering all of the facts and circumstances, as well as prior Board decisions, the Board must disagree.
   Deference is to be given to FDIC examiners because "[a]fter extensive training, lengthy apprenticeship and careful evaluation, FDIC examiners are appointed as `commissioned examiners,' and thereby vested with authority to make informed predictions
8See n.2, p. 3, and pp. 21–22, infra.

9Respondent's expert witness served as an FDIC commissioned examiner until December, 1986, when he resigned to accept a position with a financial institution. He testified that he was commissioned as a bank examiner in 1980 by the FDIC. Tr. 429-30. He was employed as a summer law clerk for the law firm owned by Respondent's counsel and as a consultant for the bank consulting firm owned and managed by Respondent's counsel at the time of the hearing. Tr. at 429-30.
{{10-31-91 p.A-1787}}about the risk inherent in a bank's assets." Sunshine State Bank v. FDIC, 783 F.2d 1580, 1583 (11th Cir. 1986), reh'q denied 792 F.2d 1126 (11th Cir. 1986). As the United States Court of Appeals for the Eleventh Circuit noted in Sunshine:
    [bank examination] . . . is a kind of agency function that the Supreme Court has recognized to be primarily a question of probabilities, and thus peculiarly subject to the expert experience, discretion, and judgment of the Commission. In making a predictive judgment, the expertise of the Commission supplements, and may supplant, the projections placed in the record by the parties. . . . To hold otherwise would paralyze agencies merely because the future is not subject to proof.

Id. at 1582, citing Missouri-Kansas-Texas Railroad Co. v. United States, 632 F.2d 392, 406 (5th Cir. 1980) (emphasis added) (citations omitted). This judgment is exercised by FDIC examiners as part of the statutory responsibilities of the agency to safeguard the insurance fund. These examiners are not only trained initially but are required to participate in periodic refresher courses to keep abreast of the most current developments and techniques. In addition, the continuous performance of examinations by these commissioned FDIC examiners provides not only continuous on-the-job training, but also provides a constant comparative basis for the exercise of the examiner's judgment in classifying loans. Finally, agency examiners do not work alone but with other experienced commissioned examiners in performing examinations and their work and conclusions are subject to supervision and review by review examiners and other experienced supervisory officials in the regional offices who are also highly experienced commissioned bank examiners before an examination report is put into final form.

   [.2] In this case, Respondent's expert is a former FDIC examiner who left the agency in 1986 and has not had the benefit of current developments or recent training in FDIC examination policy or procedures. That the banking industry has changed substantially since Respondent's expert last examined a bank cannot be contested. It is the former examiner's lack of experience and training as to current FDIC examination practices and policies, the fact that he did not actually conduct an examination of the Insured Institution, his lack of recent examination experience which would provide a basis for comparison of loan classifications in a cross section of banks, and the absence of a comparative basis for his judgment, that leads the Board to conclude that he is not entitled to the deference accorded to current FDIC examiners under Sunshine. The ALJ's finding10to the contrary is inappropriate.

B. Loan and Asset Quality.

   The ALJ, relying on the testimony of Respondent's expert, substituted his own judgment regarding the classification of certain assets, completely ignoring the FDIC examiner's classifications. R.D. at 5–6. Under Sunshine, the FDIC examiner's classification is entitled to deference and is not to be over-turned unless shown to be based on incorrect facts or "shown to be arbitrary and capricious or outside a zone of reasonableness." Sunshine, 783 F.2d at 1581.

   [.3] Respondent's expert's testimony11is based on his assertion that the FDIC examiner classified "16 loans without considering the full range of material and determinative facts then extant concerning those loans." R.D. at 5. The FDIC examiner amply testified regarding the omission of documents and other evidence from the loan files at the time of the examination. Tr. at 158-60; FDIC Ex. No. 1, p. 2-e-2. The opportunity was afforded to the Insured Institution's management and board of directors to provide missing documentation during the examination process to support the appropriate classification of the assets. Tr. at 247-48, 324-28, 334-38, 360-61, and 702-06. This action is based on the findings


10Further, the Board has reservations as to the objectivity of Respondent's expert who is or has been an employee of Respondent's counsel. Unlike the situation where an independent expert is retained to provide an opinion in relation to a specific set of facts, the opinion of this "employee/expert" could be unduly influenced by other factors. Here, Respondent's expert had completed two and one-half years of law school, had been employed by Respondent's counsel as a "Summer Law Clerk," and had been involved in pre-hearing proceedings with Respondent's counsel as a law clerk, as well as functioning as a consultant. Tr. at 428-30 and 526-28. This necessarily affects the Board's view of the opinion of Respondent's expert.

11The record shows that Respondent's expert relied on documents placed in the Insured Institution's files after completion of the Report of Examination in concluding that 16 loans were improperly classified. See, e.g., Tr. at 529-41, 589, 591 and 699; Resp. Ex. 8, 20, 21, 35, 41, 43, and 45.
{{10-31-91 p.A-1788}}in the report of examination. That corrective action was taken or missing documentation obtained after the close of the examination does not render the classification judgments of the examination invalid, as the ALJ and Respondent's expert seem to imply, nor does it necessarily eliminate the need for a cease-and-desist order. This simply does not indicate that the classifications by the FDIC examiners were based on incorrect facts or are arbitrary or capricious. As the Board has held on numerous occasions, the examination is a snapshot picture of the financial condition and problems of a bank at one specific point in time. Establishing an accurate financial picture of a bank is a moving target that changes almost on a daily basis. Evidence that indicates that deficiencies noted during an examination have been corrected does not negate the findings and conclusions of the examination. See, e.g., In the Matter of * * * (Insured State Nonmember Bank), * * * and * * * (Individually and as Officers, Directors and/or Persons Participating in the Conduct of the Affairs of * * * Bank, * * *), FDIC-83-252b&c, FDIC-84-49b, and FDIC-84-50e (consolidated action), 1 FDIC Enf. Dec. ¶5049.5 & .39 (1985), aff'd sub nom. Sunshine State Bank v. FDIC, 783 F.2d 1580 (11th Cir. 1986); In the Matter of * * * Bank * * * (Insured State Nonmember Bank), FDIC-84-100b, 1 FDIC Enf. Dec. ¶5050.6 (1985); See also Bank of Dixie v. FDIC, 766 F.2d 175, 178 (5th Cir. 1985). In the absence of evidence that suggests that the FDIC's classifications at the time of the close of the examination are based on incorrect factual evidence or are arbitrary or capricious and/or outside the "zone of reasonableness," the judgment of the FDIC examiner should be accorded deference. Here the ALJ improperly failed to do so.

C. Lending and Collection Practices.

   Enforcement Counsel asserts that each of the FDIC's adversely classified extensions of credit involved one or more of the following unsafe or unsound practices: a) the capitalization of interest12in violation of a written loan policy, (b) the pledging of unlisted securities13in violation of a written loan policy, (c) loans in excess of 75 percent of the value of collateral in violation of a written loan policy,14(d) second liens on commercial real estate in violation of a written loan policy, (e) loans which involve a conflict of interest15in violation of a written loan policy, (f) making loans without adequate collateral,16without adequate documentation,17and without adequate credit analysis,18(g) making loans without adequate repayment agreements,19and (h) failing to enforce repayment agreements.20R.D. at 2.


12This practice, while not inherently unsafe and unsound, frequently indicates loan quality problems and may exacerbate already existing problems. When this is a frequent practice or become a pattern of operation, it is always a matter of serious concern and will often rise to the level of an unsafe or unsound practice. The Board previously has held that "[i]mprudent practices include . . . the propensity to permit borrowers to capitalize unpaid interest, that is to extend additional credit for the amount of interest owed when loans are renewed." In the Matter of * * * Bank (Insured State Nonmember Bank), FDIC-85-42b, 1 FDIC Enf. Dec. ¶5062.3 (1986).

13The Board has observed that "[o]ther types of collateral, such as restricted shares in a small, closely-held corporation may not be readily marketable." In the Matter of * * * (Insured State Nonmember Bank), * * * and * * * (Individually and as Officers, Directors and/or Persons Participating in the Conduct of the Affairs of * * * Bank, * * *), FDIC-83-252b&c, FDIC-84-49b, and FDIC-84-50e, 1 FDIC Enf. Dec. ¶5049.15 (1985), aff'd sub nom. Sunshine State Bank v. FDIC, 783 F.2d 1580 (11th Cir. 1985). In the context of this proceeding, unlisted stocks are difficult to value thereby making it difficult, if not impossible, to determine whether a loan is adequately collateralized.

14The Board upheld an FDIC examiner's classification of two loans which were not collateralized in violation of the Insured Institution's loan policy. In the Matter of * * * Bank (Insured State Nonmember Bank), FDIC-87-203b, 2 FDIC Enf. Dec. ¶5120.3 (1988).

15This violation of Reg. O is clearly an unsafe or unsound practice as a matter of law. See In the Matter of * * *, (Individually, as an Officer, Director, and as an Acquiring Party), and * * *, (Individually, and as a Participant in the Conduct of the Affairs of * * * Bank and * * * Bank), FDIC-85-25e, FDIC-85-112k, FDIC-85-113k, 1 FDIC Enf. Dec. ¶5082.1 (1987).

16This practice is unsafe or unsound. See First State Bank of Wayne County v. FDIC, 770 F.2d 81, 82 (6th Cir. 1985).

17See In the Matter of * * * Bank and * * * (Individually), FDIC-84-23b; In the Matter of * * * (Individually and in Their Capacities as Executive Officers, Directors or Principal Shareholders of * * * Bank), FDIC-84-67k (consolidated action), 1 FDIC Enf. Dec. ¶5061.1 (1986).

18This practice has been deemed unsafe or unsound. See in the Matter of * * * Bank (Insured State Nonmember Bank), FDIC-86-41b, 1 FDIC Enf. Dec. ¶5092.3 (1987).

19See First State Bank of Wayne County, 770 F.2d at 82.

20The lack of an enforceable repayment program can conceal poor credit quality. See, e.g., Midland Bank and Trust Company v. Fidelity and Deposit Company of Maryland, 442 F. Supp. 960, 964 (D. N.J. 1977).
{{10-31-91 p.A-1789}}

   [.3] Once testimony and documentary evidence was provided in support of the adverse classification, "the ALJ should have deferred to the training, experience, and expertise of the examiners and the exercise of their judgment regarding the classification of individual loans. Therefore, the Board finds that classifications assigned by the FDIC examiners are to be accorded deference unless it is shown they are without factual basis or are unreasonable in light of the factual basis." 1 FDIC Enf. Dec. ¶5061.1. (1986). Here, the Board finds ample factual support in the record for the determinations as to loan classifications made by the FDIC examiner. Where, as here, there is an excessively high volume of adversely classified loans and evidence that Respondent consistently has not established repayment schedules or plans and consistently has not required borrowers to adhere to existing repayment plans, the Board finds that there has necessarily been hazardous lending and lax collection practices which are unsafe or unsound practices.21As the United States Court of Appeals for the Eight Circuit has stated "[t]he inference of a causal connection between the unsafe lending practices and the poor state of the loan portfolio is quite logical." See e.g. Northwest Nat'l Bank v. Department of the Treasury, 917 F.2d 1111, 1115 (8th Cir. 1990) (finding a causal connection between unsafe practices and high level of classified loans).

D. Loan Reserves and Earnings.

   Respondent asserted that the classification of the extension of credit to * * * was incorrect citing the testimony of its expert and a subsequent Arkansas State Bank Department Examination.22The ALJ, relying on the testimony of Respondent's expert (who in turn relied upon post-examination documentation—see supra, n.11 at 13) coupled with the fact that the * * * Loan was less adversely classified by the Arkansas State Bank Department in a subsequent examination,23found that "the extension of credit to * * * was erroneously classified as `doubtful.'" R.D. at 7. The ALJ then concluded that $71,500 (one-half of doubtful classification would not be charged against capital and loan loss reserves. From this deduction, he concluded that there was no evidence that loan loss reserves were inadequate.

   [.4] First, the FDIC examiners classified the * * * Loan as "Doubtful," on the basis of the information found in the loan file during the examination. The ALJ's conclusion that the loan should be classified only as "Substandard" relied on after-acquired documentation. As discussed above, evidence that a loan comes into compliance after the close of the examination does not establish that the classification was incorrect and is not a basis for reversing that classification. In the Board's view, the record adequately supports the "Doubtful" classification at the close of the examination and the Board is unwilling to second guess the examiner based on later acquired information.24Second, even assuming arguendo that the * * * Loan


21See, e.g., In the matter of * * * (Insured State Nonmember Bank), FDIC-86-41b, 1 FDIC Enf. Dec. ¶5092.3 (1987). Respondent argues that the actions of Petitioner in pursuing this matter "for minuscule violations . . . undermines public confidence in the banking system." Resp. Exc. No. 2. The Board does not accept this argument. As set forth herein, supra, the existence of unsafe or unsound practices or violations of law, although corrected, nevertheless are a sufficient basis for the issuance of a cease-and-desist order.

22To the extent that a State examination was conducted after the issuance of the Notice of Charges, the State examination report can be presented to the Regional Director as evidence of compliance with the terms of a cease-and-desist Order. However, "[i]f the scope of FDIC's cease-and-desist order is allowed to be modified on the basis of subsequent practices, the FDIC is left without an effective remedy should the practices recur." In the Matter of * * * (Insured State Nonmember Bank), * * * and * * * (Individually and as Officers, Directors and/or Persons Participating in the Conduct of the Affairs of * * * Bank, * * *), FDIC-83-252b&c, FDIC-84-49b, and FDIC-84-50e, 1 FDIC Enf. Dec. ¶5049.15 (1985), aff'd sub nom. Sunshine State Bank v. FDIC, 783 F.2d 1580 (11th Cir. 1986).

23The loan was classified as "Substandard" during a modified examination by the Arkansas State Bank Department. However, the examination is evidence of an "act or event occurring after the date of the Notice" under the terms of 12 C.F.R. §308.38(a)(2). The examination by State officials after the Notice is not germane to the determination of the issues before this Board and does not criticize the classification made by the FDIC in the earlier examination.

24This information may be used to establish compliance with relief ordered in connection with this proceeding but not to contest the need for such relief. See In the Matter of * * * Bank (Insured State Nonmember Bank), FDIC-86-41b, 1 FDIC Enf. Dec. ¶5092.6 (1987), citing Bank of Dixie v. FDIC, 766 F.2d 175, 178 (5th Cir. 1985), citing Zale Corp. v. FTC, 473 F.2d 1317, 1320 (5th Cir. 1983). See also, In the Matter of * * * (Insured State Nonmember Bank), * * * and * * * (Individually and as Officers, Directors and/or Persons Participating in the Conduct of the Affairs of * * * Bank, * * *), FDIC-83-252b&c, FDIC-84-49b, and f-84-50e, 1 FDIC Enf. Dec. ¶5049.41 (1985).
{{10-31-91 p.A-1790}}should have been classified only as "Substandard," it does not follow that Respondent's loan loss reserves were adequate. The Report of Examination established loss classifications of $219,000 with the reserve only equally $142,000. This in-and-of-itself establishes the inadequacy of that reserve. Further, the FDIC examiner testified that if the reserve for loan loss was increased to a "more adequate level . . . earnings would essentially have been negated." Tr. at 192. As a consequence of the need to cover the chargeoff of the loss classifications in excess of the loan loss reserve and maintain a loss reserve to cover the over $3 million in "Substandard" loans, the Insured Institution's earnings25were clearly inadequate.

E. Self-Dealing by Chairman Smith.

   [.5] This Board adopts the ALJ's findings of fact and conclusions of law relating to the receipt of loan origination fees26by Chairman Smith. R.D. at 13–14. As the ALJ stated:

    This self-dealing, absent informed consent by Respondent's Board of Directors is inherently a breach of fiduciary duty and an unsafe or unsound banking practice because it creates a conflict between the interests of Respondent and those of Chairman Smith.

R.D. at 4. As the Board has stated previously regarding the self-dealing of Chairman Smith27in relation to another Insured Institution:
    The Board finds it particularly reprehensible for the Insured Institution and Chairman Smith to contend that the receipt of a payment from the proceeds of loans made to third parties was "incentive compensation" . . . use of such an incentive compensation scheme without approval of the Insured Institution's board of directors clearly constitutes a breach of fiduciary duty, as the ALJ found citing Hoffman v. FDIC, 912 F.2d 1172 (11th Cir. 1990).

In the Matter of Bank of Salem, FDIC-89-229b, 2 FDIC Enf. Dec. ¶5164 (February 28, 1991).

F. Violations of Law.

   1. Violations of Section 23A of the Federal Reserve Act.
   The FDIC Report of Examination establishes that Chairman Smith, principal shareholder of Smith Associated Banking Corporation which owns 98% of the Insured Institution's outstanding stock, is the owner of 25% of Health Care Training of Arkansas, Inc.'s ("HCTA") outstanding stock. FDIC Ex. No. 1, pp. 6, 6-a-1 and 6-a-2. HCTA received proceeds from an unsecured $50,000 line of credit on or about March 25, 1989. FDIC Ex. No. I, p. 6-b. Ms. Carol Reaves, Respondent's vice-president and cashier, testified to the existence of the loan to HCTA, the fact that Chairman Smith owned 25% of HCTA, and the actions taken by the Respondent to clear the violation. Tr. at 705-6.

   [.6] However, the ALJ found that:

    The Notice in this proceeding does not allege that Chairman Smith controlled Respondent, and Petitioner neither requested a finding of fact to that effect nor identified the portions of the record which would support a finding of affiliation, thereby waiving the right to request such finding.

   R.D. at 8. This ruling is premised on the ALJ's pretrial order of March 7, 1990, which he states was issued to "prevent `trial by surprise.'" R.D. at 8. However, to contend here that the Respondent was surprised by the alleged Section 23A violation is to defy reality. Under any standard of notice pleading, the disclosures in the Notice which initiated this action and in the Report of Examination make clear that Respondent is charged with a Section 23A violation as to the loan to HCTA because it is an affiliate of the Insured Institution through its control by the chairman and controlling shareholder of the Insured Institution's holding company.
   The Board does not object in general to the adoption by an ALJ of reasonable procedures governing the conduct of the pre-hearing proceedings and the hearing. Where, however, the effect of those procedures is to ignore a violation of law that the evidence of
25The Examination Report also establishes that the Insured Institution's earnings have been further reduced by "$1,000 per month payments associated with an airplane leased from an affiliated organization and payment of the salary of an individual reported to be the airplane's pilot." FDIC Ex. No. 1, p. 1-a.

26Respondent takes exception to the ALJ's determination, asserting that the language in the proposed Order "effectively prohibits the bank, under threat of the Draconian penalties for violation of a final Order, from granting any loan of any amount to anyone without a detailed statement from the customer disclosing prospective application of funds." Resp. Exc. No. 1. This Board finds that this exception is without merit.

27Chairman Smith is also chairman of the board of directors for the Bank of Salem, Salem, Arkansas.
{{10-31-91 p.A-1791}}record clearly establishes on the basis of a procedural technicality, the Board concludes that such procedures are not in the best interests of justice, the protection of the Bank Insurance Fund, or the Insured Institution's depositors and are therefore not appropriate. Therefore, on the basis of the evidence of record, the Board concludes that Respondent has violated Section 23A.
   2. Violation of Reg. O.
   The Board adopts the ALJ's findings and conclusions regarding violations of Reg. O by Respondent.28 The record establishes that Flying Star, Inc., and HCTA are related interests of Chairman Smith and that Respondent failed to maintain records identifying those relationships.
   3. Correction of the violation.

   [.7] The record in this proceeding indicates that most of these violations or law were corrected by the Insured Institution during or shortly after the examination period. However, the fact of correction does not excuse or eliminate the fact that the violations of law occurred. Nor does correction necessarily eliminate the need for appropriate relief in the form of an order not to commit such violations in the future. A cease-and-desist order is intended to be remedial in nature, to half unsafe or unsound practices or violations of law. To the extent that correction of the violation has occurred, evidence of that fact goes to compliance with the relief ordered in the proceeding.
G. Respondent's management and Board of Directors.
   In view of the discussion herein, the Board also cannot accept the ALJ's findings regarding the Respondent's management. Respondent's officers, with the apparent acquiescence or inattention of its board of directors, engaged in unsafe or unsound practices by failing to follow reasonable and prudent lending and collection practices, permitting the Insured Institution to operate with an excessive volume of adversely classified assets, permitting self-dealing by Chairman Smith, failing to maintain adequate loan loss reserves and permitting violations of section 23A and Reg. O to occur. The Board is well aware of the purported correction of these unsafe and unsound practices; however, in light of the history of this proceeding and the related proceeding involving the Bank of Salem, it is necessary to place Respondent's management, and especially its board of directors, on notice of these deficiencies29 and to issue a cease-and-desist order as a safeguard to depositors and the deposit insurance fund. Therefore, in light of the evidence in the record, the Board finds that the Insured Institution has operated with management whose practices and polices are detrimental to the Insured Institution and that its board of directors has failed to supervise the Insured Institution's officers properly to prevent the occurrence of or to correct the unsafe or unsound practices and violations of law found herein.

VI. EXCEPTIONS

   Enforcement Counsel's exceptions have been duly noted and addressed in this Decision where appropriate. Respondent's two exceptions have been reviewed and found to be without merit. It is the responsibility of the board of directors of an Insured Institution to provide adequate oversight of the institution and to ensure compliance with applicable laws and regulations by management and members of its board. The purpose for the issuance of a cease-and-desist order is remedial and to give the FDIC assurance that if the Insured Institution " `were free of the [FDIC's] restraint it would not continue its former course.'" Bank of Dixie v. FDIC, supra., quoting Zale Corp. v. FTC, supra.

CONCLUSION

   The Board has carefully reviewed the entire record in this proceeding, including the ALJ's Recommended Decision, the transcripts, briefs, and exceptions. Having determined that the Insured Institution has engaged in unsafe or unsound practices and violations of law and regulations as set forth above, the Board finds that the issuance of the order to cease-and-desist accompanying this decision to halt and remedy those prac-


28 The Board has considered the issue of whether the trust for the benefit of Chairman Smith's children is a "related interest." The Board concurs in the ALJ's finding that the trust is not a "related interest" but not for the reasons stated by the ALJ. The trust could be a related interest under the definition of that term in 12 C.F.R. § 215.2(k) as a "company" which is defined in section 215.2(a) to include a trust. However, the Board finds no evidence in the record that Chairman Smith "controlled" the trust as required by the definition of related interest.

29 See FDIC Exc. G, pp. 37–38.
{{10-31-91 p.A-1792}}tices and violations now and in the future is supported by substantial evidence and is in the best interest of the Insured Institution, its depositors, and the Bank Insurance Fund.
   By direction of the Board of Directors.
   Dated at Washington, D.C., this 9th day of August, 1991.
   /s/ Robert E. Feldman
   Deputy Executive Secretary

In the Matter of

THE STEPHENS SECURITY BANK
STEPHENS, ARKANSAS
(Insured State Nonmember Bank)
ORDER TO CEASE AND DESIST
FDIC-89-234b

   The Board of Directors ("Board") of the Federal Deposit Insurance Corporation ("FDIC"), having considered the record and the applicable law, finds and concludes that The Stephens Security Bank, Stephens, Arkansas ("Insured Institution"), as set forth in the Decision, has engaged in unsafe or unsound practices and has committed violations of law and regulation within the meaning of section 8(b)(1) of the Federal Deposit Insurance Act ("Act"), 12 U.S.C. § 1818(b)(1):
   Accordingly, IT IS HEREBY ORDERED, that the Insured Institution, its directors, officers, employees, agents, successors, assigns, and other institution-affiliated parties participating in the affairs of the Insured Institution, cease and desist from the following unsafe or unsound banking practices:
   (a) engaging in hazardous lending and lax collection practices;
   (b) operating with a large volume of poor quality loans;
   (c) operating with an inadequate loan loss reserve;
   (d) operating in such a manner as to produce low earnings;
   (e) permitting violations of regulations and the law;
   (f) operating with management whose policies and practices are detrimental to the Insured Institution and jeopardize the safety of its deposits; and
   (g) operating with a board of directors which has failed to provide adequate supervision and direction to the active management of the Insured Institution.
   IT IS FURTHER ORDERED, that the Insured Institution take affirmative action as follows:
   1. (a) During the life of this ORDER, the Insured Institution shall have management qualified to restore the Insured Institution to a sound condition. Such management shall include a chief executive officer and an experienced senior lending officer responsible for supervising the Insured Institution's overall lending function. The chief executive officer and the senior lending official may be the same individual.
   (b) Present management shall be assessed on its ability to:

       (i) comply with the requirements of this ORDER;
       (ii) improve and thereafter maintain the Insured Institution in a safe and sound condition, including asset quality, capital adequacy, liquidity adequacy, and earnings adequacy; and
       (iii) comply with all applicable State and Federal laws and regulations.
       (c) (i) During the life of this ORDER, the Insured Institution shall notify the Regional Director (Supervision) of the Memphis Regional Office ("Regional Director") and the Bank Commissioner for the State of Arkansas ("Commissioner") in writing of any resignations and/or terminations of any members of its board of directors and/or any of its senior executive officer(s).
       (ii) The Insured Institution shall comply with section 32 of the Act, 12 U.S.C. § 1831i, which includes a requirement that the Insured Institution shall notify the Regional Director and the Commissioner in writing of any additions to its board of directors and senior executive officers.
       (d) (i) To ensure both compliance with this ORDER and qualified management for the Insured Institution, the board of directors, within 60 days from the effective date of this ORDER, shall develop a written policy ("Management Policy") which shall incorporate an analysis of the Insured Institution's management and staffing requirements and shall, at a minimum, address (1) both the number and type of positions needed to properly manage the Insured Institution, (2) a clear and concise description of the needed experience and pay for each job, (3) an evaluation of present management, (4) a plan to recruit, hire, or replace personnel with
{{10-31-91 p.A-1793}}
    requisite ability and experience, (5) a periodic evaluation of each individual's job performance, and (6) the establishment of procedures to periodically review and update the Management Policy.
       (ii) The Management Policy and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner for review and comment. Within 30 days from receipt of any comment, and after consideration of such comment, the board of directors shall approve the Management Policy, which approval shall be recorded in the minutes of the meetings of the board of directors; officers and employees shall implement and follow the Management Policy and any modifications thereto.
   (e) Within 30 days from the effective date of this ORDER, the board of directors shall establish a committee of the board of directors with the responsibility to ensure that the Insured Institution complies with the provisions of the ORDER. At least two-thirds of the members of such committee shall be independent, outside directors as defined herein. The committee shall report monthly to the entire board of directors, and a copy of the report and any discussion relating to the report or the ORDER shall be included in the minutes of the meetings of the board of directors. Nothing contained herein shall diminish the responsibility of the entire board of directors to ensure compliance with the provisions of this ORDER.
   (f) For the purposes of this ORDER, an "outside director" shall be an individual:
       (i) who shall not be employed, in any capacity, but the Insured Institution or its affiliates other than as a director of the Insured Institution or an affiliate;
       (ii) who shall not own or control more than 5 percent or the voting stock of the Insured Institution or its holding company;
       (iii) who shall not be indebted to the Insured Institution or any of its affiliates in an amount greater than 5 percent of the Insured Institution's primary capital;
       (iv) who shall not be related to any directors, principal shareholders, or affiliates of the Insured Institution; and
       (v) who shall be a resident of, or engage in business in, the Insured Institution's trade area.
   2. (a) During the life of this ORDER, the Insured Institution shall have and maintain adjusted primary capital equal to or greater than seven and one-half (7.50) percent of the Insured Institution's adjusted Part 325 total assets.
   (b) Any increase in primary capital necessary to meet the ratio required by Paragraph 2(a) of this ORDER may be accomplished by the following:
       (i) the sale of new securities in the form of common stock; or
       (ii) the direct contribution of cash by the directors, shareholders, or parent bank holding company of the Insured Institution; or
       (iii) the collection in cash of assets classified "Loss" without loss or liability to the Insured Institution; or
       (iv) the collection of assets previously charged-off; or
       (v) any other method acceptable to the FDIC.
   (c) If all or part of the increase in primary capital required by Paragraph 2(a) of this ORDER is accomplished by the sale of new securities, the board of directors of the Insured Institution shall adopt and implement a plan for the sale of such additional securities, including the voting of any shares owned or proxies held or controlled by them in favor of the plan. Should the implementation of the plan involve a public distribution of the Insured Institution's securities (including a distribution limited only to the Insured Institution's existing shareholders), the Insured Institution shall prepare offering materials fully describing the securities being offered, including an accurate description of the financial condition of the Insured Institution and the circumstances giving rise to the offering, and any other material disclosures necessary to comply with the 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,
{{10-31-91 p.A-1794}}Registration and Disclosure Unit, Washington, D.C. 20429. Any changes requested to be made in the plan or materials by the FDIC shall be made prior to their dissemination.
   (d) In complying with the provisions of Paragraph 2 of this ORDER, the Insured Institution shall provide to any subscriber and/or purchaser of Insured Institution Securities written notice of any planned or existing development or other changes which are materially different from the information reflected in any offering materials used in connection with the sale of Insured Institution Securities. The written notice required by this paragraph shall be furnished within 10 days from the date such material development or change was planned or occurred, whichever is earlier, and shall be furnished to every subscriber and/or purchaser of Insured Institution Securities who received or was tendered the information contained in the Insured Institution's original offering materials.
   (e) For purposes of this ORDER the terms "primary capital," "total capital," and "Part 325 total assets" shall have the meaning ascribed to them in Part 325 of the FDIC's Rules and Regulations, respectively, subsection 325.2(h), 325.2(1), and 325.2(k) (12 C.F.R. 325.2(h), (1), (k)). The "Analysis of Capital" schedule on page 3 of the FDIC Report of Examination provides the method for determining the ratio of adjusted primary capital to adjusted Part 325 total assets as required by this ORDER.
   3. (a) Within 10 days from the effective date of this ORDER, the Insured Institution shall eliminate from its books, by charge-off or collection, all assets classified "Loss" and one-half of the assets classified "Doubtful" as of July 21, 1989, that have not been previously collected or charged-off. Reduction of these assets through proceeds of other loans made by the Insured Institution is not considered collection for the purpose of this paragraph.
   (b) Within 90 days from the effective date of this ORDER, the Insured Institution shall have reduced the assets classified "Substandard" as of July 21, 1989, and those assets classified "Doubtful" that have not previously been charged-off pursuant to this ORDER to not more than $2,500,000.
   (c) Within 180 days from the effective date of this ORDER, the Insured Institution shall have reduced the assets classified "Substandard" as of July 21, 1989, and those assets classified "Doubtful" that have not previously been charged-off pursuant to this ORDER to not more than $2,000,000.
   (d) Within 270 days from the effective date of this ORDER, the Insured Institution shall have reduced the assets classified "Substandard" as of July 21, 1989, and those assets classified "Doubtful" that have not previously been charged-off pursuant to this ORDER to not more than $1,600,000.
   (e) Within 360 days from the effective date of this ORDER, the Insured Institution shall have reduced the assets classified "Substandard" as of July 21, 1989, and those assets classified "Doubtful" that have not previously been charged-off pursuant to this ORDER to not more than $1,200,000.
   (f) The requirements of Paragraphs 3(a), 3(b), 3(c), 3(d), and 3(e) are not to be construed as standard for future operations and, in addition to the foregoing, the Insured Institution shall eventually reduce the total of all adversely classified assets. As used in Paragraphs 3(b), 3(c), 3(d), 3(e), and 3(f) the word "reduce" means (i) to collect, (ii) to charge-off, or (iii) to sufficiently improve the quality of assets adversely classified to warrant removing any adverse classification, as determined by the FDIC.
   4. (a) Beginning with the effective date of this ORDER, the Insured Institution shall not extend, directly, or indirectly, any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit with the Insured Institution that has been charge-off or classified, in whole or in part, "Loss" or "Doubtful" and is uncollected. The requirements of this paragraph shall not prohibit the Insured Institution from renewing (after collection in cash of interest due from the borrower) any credit already extended to any borrower.
   (b) Beginning with the effective date of this ORDER, the Insured Institution shall not renew any loan without the full collection of interest due. The issuance of separate notes, to the borrowing customer or a third party, the proceeds of which pay
{{10-31-91 p.A-1795}}interest due, shall not satisfy the requirements of this paragraph unless these separate notes receive the prior approval by the board of directors after the board's affirmative determination, as reflected in the minutes of the meeting, that the extension of credit is necessary to protect the Insured Institution's interest or is adequately secured, that credit analysis has determined the customer to be credit worthy, that all necessary loan documentation is on file, including satisfactory appraisal, title and lien documents, and that the extension complies with the Insured Institution's loan policy and applicable rates and regulations.
   5. (a) Within 60 days from the effective date of this ORDER, and within the first 30 days of each calendar year thereafter, the board of directors shall develop a written profit plan consisting of goals and strategies for improving the earnings of the Insured Institution for each calendar year. The written profit plan shall include, at a minimum:
       (i) identification of the major areas in, and means by, which the board of directors will seek to improve the Insured Institution's operating performance;
       (ii) realistic and comprehensive budgets;
       (iii) a budget review process to monitor the income and expenses of the Insured Institution to compare actual figures with budgetary projections on not less than a quarterly basis; and
       (iv) a description of the operating assumptions that form the basis for, and adequately support, major projected income and expense components.
   (b) Each written profit plan and any subsequent modification thereto shall be submitted to the Regional Director and the Commissioner for review and comment. Not more than 30 days after the receipt of any comment from the Regional Director, the board of directors shall approve the written profit plan and approval of the plan shall be recorded in the minutes of the board of directors. Thereafter, the Insured Institution, its directors, officers, and employees shall follow the written profit plan and/or any subsequent modification.
   6. (a) Within 60 days of the effective date of this ORDER, the Insured Institution shall revise, adopt, implement, and follow written lending and collection policies to provide effective guidance and control over the Insured Institution's lending function, which policies shall include specific guidelines for:
       (i) making unsecured extensions of credit;
       (ii) making extensions of credit secured by second mortgages on real estate;
       (iii) making emergency related extensions of credit; and
       (iv) establishing a maximum repayment schedule for each type of loan made by the Insured Institution.
   (b) Within 60 days of the effective date of this ORDER, the Insured Institution shall revise, adopt, and implement a written policy on real estate appraisals that conforms with the Interagency Appraisal Guidelines for Real Estate Appraisal Policies and Review Procedures as set forth in Bank Letter 29–88, dated September 8, 1988.
   (c) Beginning with the effective date of this ORDER, the Insured Institution shall initiate and implement a program to strengthen its credit files and correct the technical exceptions as detailed on pages 2-e, 2-e-1 and 2-e-2 of the July 21, 1989 Report of Examination. In all future operations, the Insured Institution shall ascertain that all documents or evidence thereof, properly completed, are obtained before credit is extended.
   7. (a) Within 30 days of the effective date of this ORDER, the board shall establish an internal loan review and grading system ("System") to periodically review the Insured Institution's loan portfolio and identify and categorize problem credits. At a minimum the System shall provide for:
       (i) identification of the overall quality of the loan portfolio;
       (ii) identification of the amount of each delinquent loan;
       (iii) identification or grouping of loans that warrant the special attention of management; for each loan identified, a statement of the amount and an indica-
{{10-31-91 p.A-1796}}
    tion of the reason(s) why the particular loan merits special attention;
       (iv) identification of credit and collateral documentation exceptions;
       (v) identification of the status of each violation of law, rule or regulation;
       (vi) identification of loans not in conformance with the Insured Institution's lending policy, and exceptions to the Insured Institution's lending policy;
       (vii) identification of insider loan transactions; and
       (viii) identification of a mechanism for reporting periodically to the board of directors on the status of each loan identified and the action(s) taken by management.
   (b) A copy of the reports submitted to the board, as well as documentation of the action taken by the Insured Institution to collect or strengthen assets identified as problem credits, shall be kept with the minutes of the meetings of the board of directors.
   (c) Within 60 days from the effective date of this ORDER, the Insured Institution's board of directors shall establish and appoint a loan committee to review and approve in advance all extensions of credit and/or renewals that, when aggregated with all other extensions of credit to that borrower, either directly or indirectly, exceed or would exceed $25,000. The review shall include values and lien information, repayment terms, past performance by the borrower, the purpose of the extension, and whether the extension complies with the loan policy and applicable rules and regulations. The loan committee shall meet at least twice monthly and shall maintain written minutes which document its review, conclusions, approvals, denials, and recommendations. At least two-thirds of the members of the loan committee shall be independent, outside directors as defined in Paragraph 1(f) of this ORDER.
   8. Within 30 days from the effective date of this ORDER, the Insured Institution shall establish and thereafter maintain an adequate reserve for loan losses. Such reserve shall be established by charges to current operating income, together with collection of assets previously charged-off, if any. In complying with the provisions of this paragraph, the board of directors of the Insured Institution shall review the adequacy of the Insured Institution's reserve for loan losses prior to the end of each quarter. The minutes of the board meeting at which such review is undertaken shall indicate the results of the review, the amount of any increase or decrease in the reserve, and the basis for determination of the amount of the reserve provided.
   9. Within 60 days from the effective date of this ORDER, the Insured Institution shall eliminate and/or correct all violations of law which are set out on pages 6-b, 6-b-1 and 6-b-2 of the Report of Examination of the Insured Institution as of July 21, 1989. In addition, the Insured Institution shall henceforth comply with all applicable laws and regulations.
       10. (a) Within 30 days from the effective date of this ORDER, the Insured Institution's board of directors shall review all Reports of Condition and Income which accurately reflect the financial condition of the Insured Institution as of the date of each such Report. At a minimum each such Report shall be amended to reflect elimination of all assets classified "Loss" and one-half of the assets classified "Doubtful" as required by Paragraph 3 of this Order and shall incorporate an adequate reserve for loan losses accurately reflecting the Insured Institution's loan portfolio as of July 21, 1989, as required by Paragraph 8.
       (b) In addition to the above, and during the life of this ORDER, the Insured Institution shall file with the FDIC Consolidated Reports of Condition and Income which accurately reflect the financial condition of the Insured Institution as of the reporting period. In particular such Reports shall include any adjustment in the Insured Institution books made necessary or appropriate as a consequence of any State or FDIC examination of the Insured Institution during that reporting period.
   11. While the ORDER is in effect, the Insured Institution shall not declare or pay any cash dividends on its capital stock without the prior written approval of the Regional Director and the Commissioner.
   12. Within 60 days from the effective date of this ORDER, the Insured Institution shall develop, adopt, and implement a written ethics policy and procedure with regard to the ethical conduct and other standards of conduct and responsibilities for its directors, of-
{{5-31-92 p.A-1797}}ficers, employees, agents and other persons participating in the conduct of the affairs of the Insured Institution ("Ethics Program"). At a minimum the Ethics Program shall address the following:
       (a) Ethical and other conduct and responsibilities of individuals in the acceptance of gifts, entertainment, favors and loans; use of official information; employment of relatives; use of Insured Institution property; travel expenses; and indebtedness to the Insured Institution or any other financial institution.
       (b) The financial interests and obligations of individuals that appear to conflict with that individual's duties and responsibilities including, but not limited to:
         (i) participating in any manner in any transaction or loan in which the individual, his spouse, child, partner, or organization is involved; or in any transaction with, or loan to, an entity in which the individual serves as an officer, director, trustee, partner, or employee, or has a financial interest;
         (ii) purchasing of Insured Institution property;
         (iii) providing goods or services to the Insured Institution;
         (iv) outside employment and other activities; and
         (v) receiving portions of the proceeds of extensions of credit made by the Insured Institution to third parties.
       (c) The written disclosure to the board of directors of all transactions with affiliates of the Insured Institution, prior to their consummation.
       (d) A periodic written method of reporting each individual's compliance with the Ethics Program to an Ethics Counselor and/or committee who shall review compliance of the Ethics Program and report his findings to the board of directors.
   13. Following the effective date of this ORDER, the Insured Institution shall send to its shareholders or otherwise furnish a description of this ORDER, (i) in conjunction with the Insured Institution's next shareholder communication, and also (ii) in conjunction with its notice or proxy statement preceding the next shareholder meeting. The description shall fully describe the ORDER in all material respects. The description and any accompanying communication, statement, or notice shall be sent to the FDIC, Registration and Disclosure Unit, Washington, D.C. 20429, for review at least 20 days prior to dissemination to shareholders. Any changes requested to be made by the FDIC shall be made prior to dissemination of the description, communication, notice, or statement.
   14. On the fifteenth day of the second month following the effective date of this ORDER, and on the fifteenth day of every third month thereafter, the Insured Institution shall furnish written progress reports to the Regional Director and the 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 has released the Insured Institution in writing from making further reports.
   The provisions of this ORDER shall be binding upon the Insured Institution, its directors, officers, employees, agents, successors, assigns, and other institution-affiliated parties of the affairs of the Insured Institution.
   This ORDER shall become effective 10 days from the date of its issuance.
   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 9th day of August, 1991.
   /s/ Robert E. Feldman
   Deputy Executive Secretary

_______________________________________________
RECOMMENDED DECISION

In the Matter of
The Stephens Security Bank
Stephens, Arkansas
(Insured State Nonmember Bank)
Docket No. FDIC-89-234b

Steven M. Charno, Administrative Law Judge:
   Pursuant to the provisions of the Federal
{{5-31-92 p.A-1798}}Deposit Insurance Act ("Act"), 12 U.S.C. §§ 1811-1831k, a Notice of Charges and of Hearing ("Notice") was issued by the Federal Deposit Insurance Corporation ("Petitioner") on December 12, 1989 alleging that The Stephens Security Bank ("Respondent") had engaged in unsafe or unsound banking practices and violations of law and regulation. Respondent's Answer denied all allegations of wrongdoing.
   This case was heard before me in Memphis, Tennessee on July 16 through 18 and November 27 and 28, 1990.1 Posthearing briefs, proposed findings of fact and proposed conclusions of law were filed by Petitioner and Respondent under due date of March 4, 1991, and reply briefs were filed by the parties on March 19, 1991.2

DISCUSSION

   As is apparent from the following discussion, this Decision turns largely on (a) Petitioner's failure to offer evidence in rebuttal of significant elements of Respondent's case and (b) Petitioner's waiver, pursuant to the posthearing briefing order issued February 1, 1991, of its right to assert certain factual positions and legal arguments in this proceeding. Cases involving significant public interest issues should not be decided on such bases.
   In the ensuing discussion, requests for conclusions of law concerning the existence of unsafe or unsound banking practices will be evaluated pursuant to the definition of such practices found in Hoffman v. FDIC, 912 F.2d 1172, 1174 (9th Cir. 1990):

    . . . an "unsafe or unsound practice" embraces any action or lack of action which is contrary to generally accepted standards of prudent operation, the possible consequences of which, if continued, would be abnormal risk or loss or damage to an institution, its shareholders, or the agencies administering the insurance funds.
Thus, for a practice to be proscribed, it must be either (a) held by judicial or administrative decision to be inherently unsafe or unsound under any and all circumstances, that is, a per se offense, or (b) shown by a preponderance of the evidence to create abnormal risk, loss or damage to the insured institution, its owners or its insurers.

A. Lending and Collection Practices

   Petitioner has requested findings of fact that Respondent made extensions of credit: (a) involving the capitalization of interest in violation of a written loan policy, (b) secured by unlisted securities in violation of a written loan policy, (c) for amounts in excess of 75 percent of the value of collateral in violation of a written loan policy, (d) secured by a second lien on commercial real estate in violation of a written loan policy, (e) which involve a conflict of interest in violation of a written loan policy, (f) without adequate collateral, (g) without adequate documentation, (h) without adequate credit analysis, (i) involving the capitalization of interest and (j) without adequate repayment agreements or without enforcing repayment agreements. Respondent correctly notes that Petitioner bears the burden of proof and argues that the only evidence of these alleged acts was Petitioner's July 21, 1989 examination report. I find that the relevant portions of the examination report establish the facts in question on a prima facie basis3 and further find that Respondent did not meet the shifted burden of proof by proffering probative evidence sufficient to rebut Petitioner's showing.
   Petitioner has requested a conclusion of law that Respondent "engaged in unsafe or unsound banking practices . . . by engaging in hazardous lending and lax collection practices as evidenced by" the extensions of credit described in the preceding paragraph. I take this to be an allegation that each of the ten lending practices described above (a) is per se unsafe or unsound or (b) was shown to create abnormal risk, loss or damage. Respondent correctly observes that the record


1 This proceeding was unnecessarily prolonged by Petitioner's failure to comply with the requirements of the prehearing scheduling Order issued March 7, 1990. In addition to causing the first day of the hearing to be spent in prehearing preparation which should have been completed weeks before, Petitioner's failure to identify with specificity its allegations and evidence prior to the hearing resulted in the otherwise unnecessary continuance of this proceeding from July 18 to November 27, 1990.

2 The unopposed transcript corrections submitted by Respondent are hereby adopted.

3 Petitioner's expert witness also offered limited, essentially duplicative, testimony concerning these facts.
{{10-31-91 p.A-1799}}contains no connection between the specific loans identified by Petitioner and "any realistic potential consequences." Petitioner's expert4 testified, without qualification, that it was an unsafe and unsound banking practice to extend credit either without adequate security, without adequate documentation, without adequate analysis, without an adequate repayment plan or with the capitalization of interest. He alternately testified that the extension of credit without adequate credit analysis "can be" and unqualifiedly "is" an unsafe and unsound banking practice.5
   These opinions fail to provide the necessary link between specific loans and the consequences of those loans for a number of reasons. First, they do not cover the full range of lending and collection practices which Petitioner alleges to be unsafe or unsound. Second, it was established through the uncontroverted and credited testimony of Respondent's expert6 that (a) not every deviation from Respondent's conservative, written lending policy is inherently a cause of abnormal risk, loss or damage, (b) not every unsecured or partially secured loan is inherently a cause of abnormal risk, loss or damage, (c) not every failure of documentation is inherently a cause of abnormal risk, loss or damage, (d) not every capitalization of interest is inherently a cause of abnormal risk, loss or damage, (e) Respondent did not fail to analyze credit in such a way as to cause abnormal risk, loss or damage,7 and (f) the absence of a repayment plan (beyond the terms of a note) is not inherently a cause of abnormal risk, loss or damage.8 Unfortunately, Petitioner's expert was not called in rebuttal to explain when or why the lending and collection practices found to exist in this proceeding might have consequences detrimental to Respondent. I therefore conclude that Petitioner has not established the requisite basis for the conclusion of law it proposed.
   In addition, Petitioner's request for this conclusion of law was explicitly premised on opinion testimony,9 rather than legal authority, thereby necessitating the rejection of Petitioner's request.10 For the foregoing reasons, the conclusion of law sought by Petitioner is rejected.
B. Alleged Self-Dealing
   Petitioner has requested a finding of fact that, without prior written authorization by Respondent's Board of Directors, portions of the proceeds of loans to * * * and * * * were diverted to the Chairman of Respondent's Board of Directors, R.T. Smith (Chairman Smith). Petitioner made an unrebutted prima facie showing that (a) a $1,250 origination fee payable to Respondent's holding company in connection with a $75,000 loans to * * * was endorsed over to Chairman Smith and (b) Chairman Smith received $250 in connection with a $49,896 extension of credit to * * * Respondent's request for a finding that the amounts in question were incentive compensation properly paid to a loan

4 Petitioner's expert was shown to have been commissioned as a bank examiner, and his opinions concerning asset classifications are therefore entitled to deference. See Sunshine State Bank v. FDIC, 783 F.2d 1580 (11th Cir. 1986). I find that this expert's employment by Petitioner does not render his testimony incredible.

5 Although internally inconsistent testimony of this nature has no probative value on the question of credit analysis, it does raise a question concerning the extent to which the witness' opinions merit reliance.

6 Respondent's expert was shown to have been commissioned as a bank examiner, and his opinions concerning asset classifications are therefore entitled to deference. See Sunshine State Bank v. FDIC, supra. I find that this expert's part-time employment by Respondent's counsel does not render his testimony incredible.

7 This finding is supported by the tacit admission of Petitioner's expert that not every failure to analyze credit is an inherent cause of abnormal risk, loss or damage.

8 Respondent's showing logically precludes any possibility of demonstrating the foregoing practices to be unsafe or unsound per se.

9 The unsupported opinion of Petitioner's expert concerning one of the ultimate legal questions in this case, i.e., the existence of an unsafe or unsound banking practice, is not entitled to deference. See Sunshine State bank v. FDIC, 783 F.2d 1580 (11th Cir. 1986). Even if it were possible to establish the existence of an unsafe or unsound practice solely by opinion evidence, the instant contravention of the views of Petitioner's expert by those of Respondent's expert would dictate the conclusion that Petitioner did not meet its burden of proof.

10 The second ordering paragraph of the February 1, 1991 posthearing briefing Order stated that "proposed conclusions of law (supported by citation of each and every authority therefor) should be filed on March 4 and explicitly provided that "[p]roposed...conclusions which are not supported as required above will be summarily rejected." Petitioner's proposed conclusion of law concerning Respondent's lending and collection practices was not supported by any citation of legal authority. Even Petitioner's brief only cited authority relating to three of the ten practices here at issue.
{{10-31-91 p.A-1800}}production office was not supported by citation to the record as required in my February 1, 1991 Order.11 For the foregoing reasons. Petitioner's finding is adopted and Respondent's proposal is rejected.
   Petitioner has requested a legal conclusion that the diversion of loan proceeds to Chairman Smith constitutes an unsafe or unsound banking practice, while Respondent argues that Petitioner has no jurisdiction over the compensation paid by a bank holding company to one of the holding company's employees. Respondent's argument must be rejected for want of factual support and because it fails to address the true vice of the practice under consideration. There is no question that Chairman Smith received monies in connection with loans ultimately made by Respondent. This self-dealing, absent informed consent by Respondent's Board of Directors, is inherently a breach of fiduciary duty and an unsafe or unsound banking practice because it creates a conflict between the interests of Respondent and those of Chairman Smith. See Hoffman v. FDIC, supra. Accordingly, the conclusion proposed by Petitioner is adopted.12

C. Loan and Asset Quality

   Petitioner has requested findings of fact that Respondent has excessive volumes of (a) adversely classified loans, (b) adversely classified assets other than loans and (c) loans with technical exceptions. Petitioner has also requested conclusions of law that each of the requested findings, as well as Respondent's alleged operation with excessive poor quality loans and assets, are unsafe or unsound practices. In support of these proposed findings, Petitioner offered the evidence of its expert witness who gave his reasons for adversely classifying a number of Respondent's loans and assets and for assigning technical exceptions to certain loans.13 That is, Petitioner made a prima facie showing that, as of July 21, 1989, Respondent had (a) adversely classified loans in the amount of $3,056,000, which represented 136 percent of Respondent's total equity and reserves, (b) adversely classified loans and assets other than loans in the amount of $3,432,000, which represented 153.08 percent of Respondent's total equity and reserves and (c) loans in the amount of $5,260,000 cited for technical exceptions, which equaled 35.78 percent of total loans.
   Through its expert witness, Respondent credibly demonstrated that Petitioner's expert adversely classified 16 loans without considering the full range of material and determinative facts then extant concerning those loans.14 Based on these omissions and upon his own evaluation of the credits in question, Respondent's expert credibly testified that 15 loans, which had a total face value of $1,599,000, should not have been adversely classified. Petitioner presented no evidence to rebut these showings, and its briefs discussed virtually none of Respondent's supporting evidence.15 For the foregoing reasons, I find that the challenged classifications were not shown to have been based on a rational consideration of all relevant facts. Given this determination, I further find that the record is devoid of evidence which would establish that the $1,457,000 worth of adversely classified credits in existence on July 21, 1989 con-


11 The second ordering paragraph of the February 1, 1991 posthearing briefing Order stated that "[p]roposed findings of fact (supported by record citations to each and every piece of evidence believed relevant thereto)" should be filed on March 4 and explicitly provided that "[p]roposed findings...which are not supported as required above will be summarily rejected."

12 The adopted conclusion must be distinguished from the previously rejected proposal that a conflict of interest which violates a loan policy is an unsafe or unsound practice. The rejected conclusion was based on the factually and legally undemonstrated position that any deviation from a loan policy is inherently unsafe or unsound.

13 Petitioner's expert adopted his examination report to this effect.

14 Petitioner's argument that Respondent's expert relied upon documents which were not in the relevant loan files at the time of the bank examination misses the point. The question before me in this proceeding is whether all material facts relating to a loan were considered, not whether all material facts were documented in a loan file. Respondent had every right to document facts for the first time at the hearing, as long as those facts were true and operative at the time of the examination. I therefore reject Petitioner's argument.

15 Petitioner apparently contends that the sole criticism of Respondent's expert was Petitioner's failure to "consider repayment source or management intentions" for the 16 loans. The most cursory review of the evidence reveals that Respondent's expert testified about individual circumstances specific to each of the challenged loan classifications. These circumstances were identified in Respondent's proposed findings of fact 1-d-1 through 1-d-15 (there are two findings numbered "1-d-6"), and Petitioner's failure to discuss these circumstances in its reply brief requires me to find that Respondent's findings of fact 1-d-1 through 1-d-15 are uncontested pursuant to the third ordering paragraph of my February 1, 1991 posthearing briefing Order: "A proposed finding or conclusion shall be deemed uncontested if (a) no statement of Disagreement is made with respect thereto or (b) no reason is given [for disagreement]."
{{10-31-91 p.A-1801}}stituted an excessive level of adversely classified loans. Accordingly, I reject the findings and conclusions sought by Petitioner concerning Respondent's excessive poor quality and adversely classified loans and assets.
   Respondent's expert testified that the technical exceptions which he studies were relatively minor and opined that exceptions of this nature were not unsafe or unsound banking practices.16 Expert testimony concerning the ultimate legal question before me is not entitled to deference,17 and the record contains no probative evidence that the technical exceptions here at issue would tend to cause abnormal risk, loss or damage. I therefore conclude that Respondent's operation with an excessive volume of technical exceptions has not been shown to be an unsafe or unsound banking practice. The related conclusion is rejected.
D. Loan Reserves and Earnings
   Petitioner has requested findings that (a) Respondent's loan loss reserve was inadequate, (b) Respondent's earnings were overstated because of an inadequate loan loss reserve and (c) Respondent's actual earnings were low.18 Petitioner also requests legal conclusions that operating with an inadequate reserve and "in such a manner as to produce" low earnings are unsafe and unsound banking practices.19 Respondent has requested a finding that the incorrect classification of the * * * credit" caused Petitioner to understate the size and adequacy of Respondent's reserve.20 Petitioner made a prima facie showing that a $143,000 extension of credit to * * * should be classified "doubtful."21 Half of the dollar amount of any "doubtful" classification must be charged off, thereby reducing a bank's outstanding loan loss reserve.22 Respondent demonstrated that Petitioner's expert had failed to consider all material and determinative facts in existence at the time of the classification,23 and the record establishes that, when all such fact are considered, the loan should be classified "substandard."24 The classification of an asset as "substandard" does not require a charge-off by a bank. Petitioner presented no evidence to rebut Respondent's showing, and Petitioner's reply brief failed to address Respondent's proposed finding concerning the erroneous classification of the * * * credit.25
   In formulating his opinions that Respondent's reserve was inadequate and its earnings overstated, Petitioner's expert appeared to rely on his incorrect classification of the * * * loan. He testified:
    Based on the findings in my Report, if the reserve were to be brought to an adequate level—that is, say if a provision were made as of the date of the examination which would have brought the reserve to a more adequate level—earnings would essentially have been negated.
Given my finding that the extension of credit to * * * was erroneously classified as "doubtful," it is necessary to eliminate the associated $71,500 charge-off and the consequent reduction of Respondent's reserves by this amount. In view of the testimony quoted-

16 See note 8, supra.

17 This conclusion is equally applicable to the mutually contradictory testimony of Petitioner's and Respondent's experts as to whether technical exceptions are inherently unsafe or unsound.

18 Petitioner cites its Exhibit 2 in support of all three proposals. During the hearing, counsel for Petitioner withdrew that exhibit from the record in response to an objection by Respondent. I am unaware of any cause for Petitioner's apparent confusion.

19 Petitioner's brief cites legal authority relating to the adequacy of reserves, but its request for a conclusion concerning the purported unsafe and unsound nature of having low earnings is not supported by any citation to legal authority, an omission which requires rejection of the latter conclusion. See note 10, supra.

20 Petitioner's unqualified representation in its reply brief that Respondent "offers no support" for the above finding is false. Respondent explicitly supports to requested finding, its number 13-b, by reference to its finding 1-d-10; the latter sets forth specific facts, and is supported by citations to the transcript and exhibits. I am unaware of any cause for Petitioner's apparent confusion.

21 Petitioner's expert adopted his examination report to this effect.

22 Official notice is taken of the requirements of Petitioner's examiner's manual to this effect.

23 Respondent's expert credibly so testified without controversion.

24 The credited testimony to this effect of Respondent's expert is supported by the State's classification of the loan as "substandard" during its February 1990 modified examination. There is no evidence that the circumstances surrounding the * * * loan changed during the period between the two examinations.

25 Had the weight of the evidence not established that Petitioner's expert did not take into account all data necessary to reach a rational opinion concerning the * * * loan, the failure of Petitioner's reply brief to threat Respondent's proposed finding number 1-d-10 would require me to find that the * * * credit was misclassified. See note 15, supra.
{{10-31-91 p.A-1802}}above, it would appear that properly classifying the * * * loan would result in Respondent's having an adequate loan loss reserve, as well as period-to-date income of at least $70,000.26 It should be noted that Petitioner's expert testified that, except for his contention that Respondent had inadequate reserves which lowered the institution's earnings, he did not maintain that Respondent's earnings were inadequate. For the foregoing reasons, I find that Petitioner did not establish by a preponderance of the evidence that Respondent's reserves were inadequate or that Respondent's earnings were overstated or low. Accordingly, the findings requested by Petitioner on these topics are rejected.
E. Alleged Violations of Law
   1. Section 23A
   Petitioner has requested a conclusion that Respondent violated Section 23A(c)(1) of the Federal Reserve Act, 12 U.S.C. § 371c(c)(1).27 That provision requires loans to the affiliates of certain banks to be fully secured by specified types of collateral. "Affiliate," as defined in Section 23A(b)(1), 12 U.S.C. § 371c(b)(1), includes any company which is controlled by a shareholder who also controls the bank. "Control" is defined in Section 23A(b)(3)(A) of the Act, 12 U.S.C. § 371c(b)(3)(A), as the ability to vote at least 25 percent of a company's stock or to control the election of a majority of a company's board of directors. Section 23A of the Federal Reserve Act has been made applicable to state banks which are not members of the Federal Reserve System by Section 18(j)(1) of the Act, 12 U.S.C. § 1828(j)(1).
   Petitioner alleges and the record establishes that Respondent extended an unsecured line of credit to Health Care Training of Arkansas, Inc. (HCTA), at a time when Chairman Smith had a 25 percent beneficial interest in that borrower.28 The Notice in this proceeding does not allege that Chairman Smith controlled Respondent, and Petitioner neither requested a finding of fact to that effect nor identified the portions of the record which would support a finding of affiliation, thereby waiving the right to request such findings.29 Accordingly, I find that Petitioner has not demonstrated by a preponderance of the evidence that HCTA is an affiliate of Respondent. Petitioner has therefore failed to establish a violation of Section 23A(c)(1), and its proposed finding and conclusion to the contrary are rejected.
   2. Regulation O
   Petitioner has requested a conclusion that Respondent violated Section 22(h) of the Federal Reserve Act, 12 U.S.C. § 375b, and the effectuating regulation, Section 215.7 of Regulation O of the Board of Governors of the Federal Reserve System, 12 C.F.R. § 217.7.30 As relevant, Part 215 of Regulation O "governs any extension of credit' by a bank to one of its directors. 12 C.F.R. § 215.1(b). Section 215.7 sets forth the following requirement:

26 The record is devoid of direct evidence that Respondent's reserve could be considered inadequate after being increased by $71,500.

27 Petitioner's failure to cite any legal authority in support of the proposed conclusion, other than the statutory provision allegedly violated, requires rejection of the conclusion. See note 10, supra.

28 Petitioner's expert adopted his examination report to this effect.

29 See note 11, supra.
   By Order of March 7, 1990, a comprehensive prehearing procedure was established in this proceeding in order to prevent "trial by surprise," to insure the protection of the parties' due process rights and to require the parties to prepare their cases in advance of the hearing. As part of that procedure, Petitioner was required to make a prehearing filing of its proposed findings of fact and, when that filing proved inadequate to place Respondent and the bench on notice concerning the elements of Petitioner's case, I required the filing on an "Expanded Proposed Findings of Fact of Federal Deposit Insurance Corporation" (Petitioner's Exhibit 7). At the hearing, I received Petitioner's examination report (Petitioner's Exhibit 1) in evidence subject to certain restriction: "The probative value of Petitioner's Exhibit 1 will be restricted to the specific allegations made in Petitioner's Exhibit 7." As relevant to the instant issue, the latter exhibit provides:
       Without restating proposed finding of fact #9(a), page 6-b of Petitioner's Exhibit 1 shows that the Bank violated Section 23A of the Federal Reserve Act by Extending credit to its affiliate, Health Care Training of Arkansas, Inc., without any collateral.
   Neither proposed finding #9(a) nor page 6-b of Petitioner's Exhibit 1 make reference to any fact which would support a finding that Chairman Smith controlled Respondent.

30 Petitioner's failure to cite any legal authority in support of the proposed conclusion, other than the provisions allegedly violated, operates as a waiver of its right to propose that conclusion. See note 10, supra. Because the prohibition set forth in Section 215.7 of Regulation O is clear, explicit and requires no interpretation by decisional authority, Petitioner's failure does not require the complete rejection of its proposed conclusion.
{{10-31-91 p.A-1803}}
    Each member bank shall maintain records necessary for compliance with the requirements of this part. These records shall (a) identify all...directors... of the member bank and the related interests of these persons and (b) specify the amount and terms of each extension of credit by the member bank to these persons and their related interests. Each member bank shall request at least annually that each... director...of the member bank identify the related interests of that person.
The various requirements of Regulation O have been made applicable to state banks which are not members of the Federal Reserve System by Section 18(j)(2) of the Act, 12 U.S.C. § 1828(j)(2).
   Petitioner has requested findings that (a) Chairman Smith controls Flying Star, Inc. which leases an aircraft to Respondent, (b) Chairman Smith controls HCTA, (c) Respondent extended an unsecured line of credit to HCTA, (d) Chairman Smith's minor children were beneficiaries of a trust which leases Respondent's premises to the bank and (e) Chairman Smith is a member of Respondent's Board of Directors. The record demonstrates the validity of these findings.31 Petitioner also requests findings that Chairman Smith "failed to disclose" his relationships with Flying Star, Inc., HCTA and his children's trust. The intended relevance of a major part of these findings is a mystery, unless they are meant to provide the basis for an inference that Respondent did not maintain records setting forth the relationships.32 Because there is direct evidence of Respondent's failure to maintain the required records,33 the utility of such an inference is moot.
   Flying Star, Inc. and HCTA clearly fall within the definition of "related interest," in that they were shown to the companies "controlled by a person" who is a director of a bank. 12 C.F.R. § 215.2(k)(1). The question of whether a trust benefitting Chairman Smith's minor children is a related interest is not so easily answered. While it is possible to construct an argument that the framers of Regulation O intended that the requirements of Part 215 would apply to relationships in addition to those explicitly set forth in the definition of "related interest" in Section 215.2(k) of the Regulation, Petitioner did not request such a conclusion nor cite any legal authority in support thereof.34 Accordingly, I conclude that Petitioner has not demonstrated that the trust is a related interest of Chairman Smith.
   Respondent has requested a finding that the alleged violations are "hypertechnical citations which have no material effect on the condition of the bank." That finding also incorporates two apparently uncontested facts: Respondent suffered no loss, and all of the alleged violations were corrected prior to the termination of the bank examination. Every element of Respondent's requested finding is immaterial to the question of whether a violation took place. Respondent argues that, "absent evidence of purposeful evasion or willful concealment," there is no basis for regulatory action. This argument cannot stand. Section 215.7, in pertinent part, specifically requires that a bank maintain records which identify the related interests of that bank's directors,35 and the presence or absence of intent is immaterial to the existence of a violation.
   Based on my finding that Chairman Smith is a director of Respondent, my conclusion that Flying Star, Inc. and HCTA are his related interests and my finding that Respondent did not maintain records identifying these relationships, I conclude that Re-

31 The first four facts were established by the adoption of relevant portions of the examination report by Petitioner's expert, while the final fact was admitted in Respondent's Answer to the Notice.

32 In the absence of a false answer or failure to respond to Respondent's annual request that Chairman Smith identify his related interests, a "failure to disclose" would not appear to provide evidence of a violation of Section 215.7. Petitioner neither alleged nor attempted to prove that (a) Respondent failed to make the required annual request to Chairman Smith or (b) Chairman Smith failed to respond or untruthfully responded to such a request. Indeed, it is not unreasonable to question whether a violation of Section 215.7 can occur where a bank actually makes the annual requests required by the regulation and records the answers it receives.

33 Petitioner's expert credibly so testified.

34 See note 10, supra.

35 I do not regard the use of a conjunction between the lettered phrases of Section 215.7 as requiring that records be maintained only when both of the following are true: (a) a director has a related interest and (b) the bank has made an extension of credit to that related interest.
{{10-31-91 p.A-1804}}spondent violated Section 215.7 of Regulation O.36
F. Management
   Petitioner has requested conclusions that Respondent engaged in unsafe or unsound banking practices by (a) "operating with management whose policies and practices are detrimental" to the Bank and (b) operating with a Board of Directors which failed to provide supervision adequate "to prevent or abate the practices" alleged by Petitioner to be unsafe or unsound.37 When one excludes from consideration those of Respondent's policies which were neither alleged in the Notice nor fully litigated at the hearing, support for the foregoing conclusions consists of allegations concerning six lending and collection practices, the practice of diverting loan proceeds, four practices relating to loan and asset quality, a practice relating to reserves and one relating to low earnings. Only one of the twelve alleged practices has been shown to exist and to be unsafe or unsound: the diversion of loan proceeds to Chairman Smith, which brought about an impermissible conflict of interest. I am forced to conclude that this demonstration falls short of that required to permit adoption of Petitioner's findings and conclusions. They are therefore rejected.

FINDINGS OF FACT

   1. At all time pertinent to this proceeding, Respondent has been a corporation existing and doing business under the laws of Arkansas with its principal place of business at Stephens, Arkansas.
   2. At all time pertinent to this proceeding, Respondent has been a state nonmember bank insured by the FDIC.
   3. At all times pertinent to this proceeding, Respondent has been subject to the provisions of the Act, the Rules and Regulations of the FDIC, 12 C.F.R. Pt. III, and the laws of Arkansas.
   4. Respondent violated its written loan policy by capitalizing the following amounts of interest in connection with extensions of credit: (a) $6,603.90 to * * *, (b) $5,694.44 to * * *, (c) $580.01 to * * *, and (d) $2,714.45 to * * *.
   5. Respondent violated its written loan policy by extending credit secured by unlisted securities in the following instances: (a) $42,500 to * * *, (b) $114,503 to * * *, and (c) $67,000 to * * *.
   6. Respondent violated its written loan policy by extending credit for amounts in excess of 75 percent of the value of the related collateral in its $52,245 loan to * * *.
   7. Respondent violated its written loan policy by extending credit secured by a second lien on commercial real estate in the following instances: (a) $63,334 to * * * and (b) $147,538 to * * *.
   8. Respondent violated its written loan policy by extending credit which involved a conflict of interest in the following instances: (a) $41,500 to HCTA, (b) $75,000 to * * *, and (c) $49,896 to * * *.
   9. Respondent extended credit without adequate collateral in the following instances: (a) $30,000 to * * *, (b) $148,000 to * * *, (c) $50,000 to * * *, (d) $208,000 to * * *, (e) $10,000 to * * *, (f) $15,000 and $70,000 to * * *, (g) $6,000 and $284,000 to * * *, (h) $80,000 to * * *, (i) $2,000 to * * *, (j) $200,000 to * * *, (k) $65,000 to * * *, (l) $95,000 and $57,000 to * * *, (m) $350,000 to * * *, (n) $43,000, $30,000 and $1,000 to * * *, (q) $143,000 to * * *, (r) $32,000 and $41,000 to * * *, (s) $52,000 to * * *, (t) $78,000 to * * *, (u) $10,000 and $3,000 to * * *, (v) $91,000 and $5,000 to * * *, (w) $50,000 to * * *, (x) $45,000 and $26,000 to * * *, (y) $56,000 to * * *, and (z) $65,000 to * * *.
   10. Respondent extended credit without adequate documentation in the following instances: (a) $150,000 to * * *, (b) $28,000 to * * * and * * *, (c) $10,000 to * * *, (d) $16,000 to * * *, (e) $34,000 to * * *, (f)


36 The holding in text notwithstanding, Petitioner's overall approach to the application of Regulation O appears conceptually flawed. Section 215.7, read in the context of Section 215.1(b), requires the maintenance of records only insofar as those records will prevent unauthorized extensions of credit to, as here relevant, the related interests of a bank's directors. While Respondent made an extension of credit, as defined in Section 215.3(a), to HCTA, the transactions between the trust and Flying Star, Inc., on the one hand, and Respondent, on the other, are not encompassed by any of the definitions of "extension of credit" set forth in Regulation O. In the absence of any authority that Regulation O was intended to address self-dealing other than loans to bank insiders, it appears probable that Respondent's transactions with the trust and Flying Star, Inc., are not within the intended ambit of Regulation O.

37 I infer from the fact that Petitioner's proposed conclusion is explicitly premised solely on alleged unsafe or unsound practices and does not rely on alleged violations of law that Petitioner, given the opportunity for reflection, has intentionally abandoned the position previously taken by its expert.
{{10-31-91 p.A-1805}}$61,000 to * * *, (g) $20,000 to * * *, (h) $148,000 to * * *, (i) $57,000 to * * *, (j) $64,000 to * * *, (k) $60,000 to * * *, (l) $42,000 to * * *, (m) $57,000 to * * *, (n) $20,000 to * * *, (o) $87,000 to * * *, (p) $12,000 to * * *, (q) $63,000 to * * *, (r) $43,000 to * * *, (s) $150,000 to * * *, (t) $208,000 to * * *, (u) $6,000 to * * *, (v) $18,000 to * * *, (w) $29,000 to * * *, (x) $47,000 to * * *, (y) $40,000 to * * *, (z) $95,000 to * * *, (aa) $64,000 to * * *, (bb) $48,000 to * * *, (cc) $74,000 to * * *, (dd) $10,000 to * * *, (ee) $91,000 to * * *, (ff) $10,000 to * * *, (gg) $50,000 to * * *, (hh) $4,000 to * * *, (ii) $62,000 to * * *, (jj) $80,000 to * * *, (kk) $32,000 to * * *, (ll) $42,000 to * * *, (mm) $80,000 to * * *, (nn) $200,000 to * * *, (oo) $75,000 to * * *, (pp) $200,000 to * * *, (qq) $43,000 to * * *, (rr) $7,000 to * * *, (ss) $85,000 to * * *, (tt) $350,000 to * * *, (uu) $150,000 to * * *, (vv) $35,000 to * * *, (ww) $77,000 to * * *, (xx) $62,000 to * * *, (yy) $43,000 to * * *, (zz) $268,000 to * * *, (aaa) $66,000 to * * *, (bbb) $115,000 to * * *, (ccc) $143,000 to * * *, (ddd) $19,000 to * * *, (eee) $40,000 to * * *, (fff) $14,000 to * * *, (ggg) $57,000 to * * *, (hhh) $129,000 to * * *, (iii) $130,000 to * * *, (jjj) $56,000 to * * *, (kkk) $42,000 to * * *, (lll) $243,000 to * * * and * * *, and (mmm) $65,000 to * * *.
   11. Respondent extended credit without adequate credit analysis in the following instances: (a) $208,000 to * * *, (b) $350,000 to * * *, (c) $77,000 to * * *, (d) $115,000 to * * *, (e) $143,000 to * * *, (f) $130,000 to * * *, and (g) $56,000 to * * *.
   12. Respondent capitalized the following amounts of interest in connection with extensions of credit: (a) * * * in the amount of $1,552.49, (b) * * * in the amount of $631.15, (c) * * * in amounts of $2,038.89, $2,322.22, $2,294.44 and $1,992.78, (d) * * * in the amount of $5,093.65, (e) * * * in the amount of $5,694.44, (f) * * * in the amount of $16,552.17, (g) * * * in the amount of $465.04 and (h) * * * in the amount of $2,714.45.
   13. Respondent extended credit without adequate repayment agreements or without enforcing repayment agreement in the following instances: (a) $50,000 to * * *, (b) $10,000 to * * * and * * *, (c) $15,000 to * * *, (d) $78,000 to * * *, (e) $284,000 to * * *, (f) $38,000 to * * *, (g) $200,000 to * * *, (h) $65,000 to * * *, (i) $350,000 to * * *, (j) $150,000 to * * *, (k) $14,000 to * * *, (l) $161,000 to * * *, (m) $114,000 to * * *, (n) $32,000 and $41,000 to * * *, (o) $52,000 to * * *, (p) $56,000 to * * *, and (q) $65,000 to * * *.
   14. Without prior written authorization by Respondent's Board of Directors, monies were paid to Chairman Smith in connection with Respondent's loans of $75,000 to * * * and $49,896 to * * *.
   15. Respondent has not been shown to have an excessive volume of (a) adversely classified loans, (b) adversely classified loans and other assets or (c) poor quality loans or other assets.
   16. Respondent has an excessive volume of loans with technical exceptions.
   17. Respondent's extension of credit to * * * in the amount of $143,000 was erroneously classified "doubtful" and should have been classified "substandard."
   18. Respondent has not been shown to have (a) an inadequate loan loss reserve, (b) earnings which were overstated because of an inadequate loan loss reserve or (c) earnings which were low because of an inadequate loan loss reserve.
   19. Respondent extended an unsecured line of credit to HCTA, at a time when Chairman Smith had a 25 percent beneficial interest in HCTA.
   20. At all times pertinent to this proceeding, Chairman Smith has been a member of Respondent's Board of Directors.
   21. Chairman Smith owned 100 percent of the stock of Flying Star, Inc.
   22. Respondent failed to maintain records identifying Flying Star, Inc. and HCTA as related interests of Chairman Smith.
   23. Respondent has not been shown to have operated with a management whose policies and practices are detrimental to the bank and jeopardize the safety of its deposits.
   24. Respondent has not been shown to have operated with a Board of Directors which failed to provide adequate or effective supervision over and direction of the management of the bank.
{{10-31-91 p.A-1806}}
CONCLUSIONS OF LAW

   1. Petitioner has jurisdiction over Respondent and the subject matter of this proceeding.
   2. At all times pertinent to this proceeding, Respondent was an insured state nonmember bank within the meaning of Section 3(e)(2) and 8(b) of the Act.
   3. Petitioner has authority to issue a cease and desist order against Respondent pursuant to Section 8(b) of the Act.
   4. Petitioner's burden of proof is one of a preponderance of the evidence.
   5. An unsafe or unsound banking practice embraces any action, or lack of action, which is contrary to generally accepted standards of prudent operation, the possible consequences of which, if continued, would be abnormal risk or loss or damage to an institution, its shareholders, or the agencies administering the insurance funds.
   6. Respondent has not been shown to have engaged in unsafe or unsound banking practices, within the meaning of Section 8(b) of the Act, by engaging in lending and collection practices consisting of extensions of credit: (a) with interest capitalized in violation of a written loan policy, (b) secured by unlisted securities in violation of a written loan policy, (c) for amounts in excess of 75 percent of the value of collateral in violation of a written loan policy, (d) secured by a second lien on commercial real estate in violation of a written loan policy, (e) which involve a conflict of interest in violation of the written loan policy, (f) without sufficient collateral, (g) without adequate documentation, (h) without adequate credit analysis, (i) with the capitalization of interest or (j) without adequate repayment agreements or without enforcing repayment agreements.
   7. Respondent has engaged in an unsafe or unsound banking practice, within the meaning of Section 8(b) of the Act, by allowing monies to be paid to Chairman Smith in connection with its loans to third parties.
   8. Respondent has not been shown to have engaged in an unsafe of unsound banking practice, within the meaning of Section 8(b) of the Act, by operating with an excessive volume of loans with technical exceptions.
   9. HCTA has not been shown to be Respondent's affiliate within the meaning of Section 23A(b)(1) of the Federal Reserve Act.
   10. Respondent has not been shown to have violated Section 23A(c)(1) of the Federal Reserve Act.
   11. The trust benefitting Chairman Smith's minor children has not been shown to be a related interest of Chairman Smith within the meaning of Section 215.2(k) of Regulation O.
   12. Flying Star, Inc. and HCTA are related interests of Chairman Smith within the meaning of Section 215.2(k) of Regulation O.
   13. By failing to maintain records identifying Flying Star, Inc. and HCTA as related interests of Chairman Smith, Respondent violated Section 215.7 of Regulation O.
   14. Respondent has not been shown to have engaged in an unsafe or unsound banking practice, within the meaning of Section 8(b) of the Act, by operating with a management whose policies and practices are detrimental to the bank and jeopardize the safety of its deposits.
   15. Respondent has not been shown to have engaged in an unsafe or unsound banking practice, within the meaning of Section 8(b) of the Act, by operating with a Board of Directors which has failed to provide adequate or effective supervision over and direction of the management of the bank.
   16. Respondent has not been shown to have otherwise engaged in unsafe or unsound banking practices, within the meaning of Section 8(b) of the Act, or in violations of law.
   Based on the foregoing findings of fact and conclusions of law, I hereby issue the following recommended:

ORDER

   IT IS ORDERED that Respondent, The Stephens Security Bank, Stephens, Arkansas, its directors, officers, employees, agents, successors, assigns and other institution-affiliated parties, cease and desist from the following unsafe or unsound banking practice and violation of law:

       (a) Without the prior written approval of its Board of Directors, allowing the payment of money to a member of the Board of Directors in connection with its extension of credit to a third party;38 and

38 Although Petitioner did not request such a remedial provision in its proposed order, I believe this prohibition to be required in light of the findings and conclusions set out above.
{{4-30-92 p.A-1807}}
       (b) Operating in violation of Section 215.7 of Regulation O of the Board of Governors of the Federal System, 12 C.F.R. §215.7, made applicable to state nonmember banks by Section 18(j)(2) of the Federal Deposit Insurance Act, 12 U.S.C. § 1828(j)(2).
   IT IS FURTHER ORDERED that Respondent take the following affirmative action: Within 60 days from the effective date of this ORDER, Respondent shall develop, adopt and implement a written ethics policy and procedure with regard to the ethical conduct and other standards of conduct and responsibilities for its directors, officers, employees, agents and other persons participating in the conduct of Respondent's affairs. At a minimum, this policy and procedure shall address the financial interests and obligations of an individual which appear to be in conflict with that individual's duties and responsibilities including, but not limited to:
       (a) Participating in any manner in any transaction or loan in which the individual, his spouse, child, partner, or controlled organization is involved; or in any transaction with, or loan to, an entity in which the individual serves as an officer, director, trustee, partner or employee, or has a financial interest; and
       (b) Receiving portions of the proceeds of extensions of credit made by Respondent to third parties.39
   Done at Rosslyn, Virginia, this 18th day of April, 1991.
   /s/ Steven M. Charno
   Administrative Law Judge
39 Because the record established that the violation found herein was remedied during the course of Petitioner's 1989 examination of Respondent, further affirmative relief would be inappropriate. See NLRB v. Express Pub. Co., 312 U.S. 426 (1941).

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