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FDIC Enforcement Decisions and Orders

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[5003] FDIC Docket No. ____, (7-14-80).

   Bank ordered to cease and desist from engaging in unsafe or unsound banking practices, including the payment of an excessive management fee, operating with an inadequate level of capital protection for the quality and volume of assets held, recapitalizing the bank largely by using the funds of its own depositors, maintaining an inadequate loan loss reserve, operating with an excessive volume of poor quality loans and assets, and failing to provide supervision over the active officers of the bank adequate to prevent the unsafe or unsound banking practices.

   [.1] Unsafe or Unsound Banking Practice—Case by Case Determination
   What constitutes an unsafe or unsound banking practice depends on the facts of each case.

   [.2] Management Services—Payment
   A bank may be ordered to cease and desist from paying management fees when a bank is paying considerably more for management services than most banks in the state, in spite of the bank's poor financial condition, and when the bank cannot afford the fee.

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   [.3] Cease and Desist Orders—Affirmative Remedies—Increase Capital
   The FDIC may require a bank to inject additional capital to protect depositors.

   [.4] Loans—Purchase of Common Stock of Bank
   The making of loans used for the purpose of purchasing common stock of the bank is an unsafe and unsound practice.

   [.5] Lending and Collection Policies and Procedures—Inadequate Security
   The making of inadequately secured loans (as reflected by the adversely classified loans and assets) is an unsafe and unsound banking practice.

   [.6] Directors—Duties and Responsibilities—Supervision of Bank's Affairs
   A board of directors has a duty to supervise the business of a corporation. The directors share in the responsibility for unsafe and unsound banking practices.

   [.7] Cease and Desist Order—Defenses—Cessation of Violation
   Improvement of a bank's condition subsequent to a bank examination does not mean that the FDIC is not entitled to a cease and desist order. Discontinuance of practices complained of in such an administrative proceeding does not render the controversy moot or require discontinuance of the agency proceeding.

In the Matter of, * * *


FINAL OPINION AND ORDER
   Pursuant to its authority under Section 8(b) of the Federal Deposit Insurance Act (12 U.S.C. § 1818(b)), the Federal Deposit Insurance Corporation (the "FDIC"), on May 7, 1979, issued a "Notice of Charges and of Hearing" (the "Notice") against * * * (the "Bank"). The Notice charged the Bank and its board of directors with having engaged in unsafe or unsound banking practices in conducting the business of the Bank.
   An administrative hearing on the charges was held in * * * on December 10, 1979 before Administrative Law Judge Dee C. Blythe. On April 18, 1980, Judge Blythe rendered a Recommended Decision with findings of fact, conclusions of law and a proposed order. On May 29, 1980, pursuant to FDIC regulations, this case was submitted to the Board of Directors of the FDIC for final decision.
   The Board of Directors, having considered the record and the applicable law, agrees with the findings and conclusions of the Administrative Law Judge. The Board also agrees with the proposed order of the Administrative Law Judge. The Board, therefore, adopts the findings and conclusions of the Administrative Law Judge, which are attached hereto and incorporated herein by reference, and adopts the proposed order, which also is attached and incorporated herein by reference, as a Final Order.
   This Order shall become effective at the expiration of 30 days after the service of the Order upon the Respondent.
   By order of the Board of Directors, dated July 14, 1980.
/s/ Hoyle L. Robinson
Executive Secretary

RECOMMENDED DECISION OF
ADMINISTRATIVE LAW JUDGE DEE
C. BLYTHE

PRELIMINARY STATEMENT

   This is a proceeding brought by the Federal Deposit Insurance Corporation ("FDIC") pursuant to § 8(b)(1) of the Federal Deposit Insurance Act, 12 U.S.C. 1818(b)(1)1 for an order requiring * * *

1 Section 8(b)(1) of the Act provides:
   If, in the opinion of the appropriate Federal banking agency, any insured bank or bank which has insured deposits is engaging or has engaged, or the agency has reasonable cause to believe that the bank is about to engage, in an unsafe or unsound practice in conducting the business of such bank, or is violating or has violated, or the agency has reasonable cause to believe that the bank is about to violate, a law, rule, or regulation, or any condition imposed in writing by the agency in connection with the granting of any application or other request by the bank, or any written agreement entered into with the agency, the agency may issue and serve upon the bank a notice of charges in respect thereof. The notice shall contain a statement of the facts constituting the alleged violation or violations or the unsafe or unsound practice or practices, and shall fix a time and place at which a hearing will be held to determine whether an order to cease and desist therefrom should issue against the bank. Such hearing shall be fixed for a date not earlier than thirty days nor later than sixty days after service of such notice unless an earlier or a later date is set by the agency at the request of the bank. Unless the bank shall appear at the hearing by a duly authorized representative, it shall be deemed to have consented to the issuance of the cease-and-desist order. In the event of such consent, or if upon the record made at any such hearing, the agency shall find that any violation or unsafe or unsound practice specified in the notice of (Continued)

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("the Bank") and its board of directors, * * *, to cease and desist from certain banking practices which are alleged to be unsafe or unsound and to take affirmative action to correct the conditions resulting therefrom.
   On the basis of an examination of the Bank as of the close of business December 22, 1978, by an FDIC examiner, the respondents on May 7, 1979, were served with a Notice of Charges and Hearing ("the Notice") under § 8(b) of the Act. An answer was filed by respondents on June 2, 1979. On July 30, 1979, the * * * Regional Office of the FDIC and respondents executed a Stipulation and Consent to the Entry of Findings of Fact, Conclusions of Law and Order to Cease and Desist ("the stipulation") for the consideration of the FDIC's Board of Directors ("the Board"). However, on or about August 29, 1979, the Regional Office was informed by the Board that certain provisions of the stipulation were not acceptable. Further negotiations with respondents failed to resolve the differences.
   Thereafter, the matter was referred to an administrative law judge designated by the Office of Personnel Management. The matter came on for hearing December 10, 1979, in * * *. Both parties have submitted posthearing briefs, and the matter is now ripe for decision.

THE ISSUES

   The jurisdictional allegations of the Notice were admitted by respondents' answer, which otherwise was essentially a general denial. The issues to be determined are:

       1. Whether the banking practices alleged in the Notice are unsafe or unsound;
       2. Whether changes in the Bank's practices and condition since the December 22, 1978, inspection should be considered; and
       3. Whether an order should issue requiring respondents to cease and desist from the practices complained of and to take affirmative action to correct the conditions resulting therefrom.

DISCUSSION AND OPINION

   The "unsafe or unsound banking practices" alleged by paragraphs 5 through 10 of the Notice are:
   5. The Bank and its management have engaged and are continuing to engage in unsafe or unsound banking practices in that the Bank has sustained net operating losses after taxes in the amount of $156,900 from January 1, 1975 through December 22, 1978, caused primarily by:

       (a) The payment of an excessive management fee in the amount of $276,300 to * * * (a partnership of * * *) from January 1, 1976 through December 22, 1978.
       (b) The providing of heavy loan loss provisions (in the amount of $168,800) through the Bank's earnings from January 1, 1975 through December 22, 1978. The amount of the provisions fell short of the Bank's actual net loan losses of $191,100 for that period by $22,300.
   6. The Bank and its management have engaged and are continuing to engage in unsafe or unsound banking practices in that the Bank has been and is being operated with an inadequate level of capital protection for the volume and quality of assets held. This inadequate capital level is disclosed by the fact that as of December 22, 1978, the Bank's adjusted capital, reserves, and subordinated debt of $502,400 was only 6.1 percent of its adjusted total assets of $8,297,800. Adversely classified assets not considered in computing adjusted capital, reserves, and subordinated debt totaled $499,300 which was 99.4 percent of adjusted capital, reserves, and subordinated debt.
   7. The Bank and its management have engaged and are continuing to engage in unsafe or unsound banking practices in that the Bank loaned $94,8002 of its funds for the purpose of purchasing common stock of the Bank, thereby in effect recapitalizing the Bank largely by using the funds of its own depositors.
   8. The Bank and its management have engaged and are continuing to engage in
1 Continued: charges has been established, the agency may issue and serve upon the bank an order to cease and desist from any such violation or practice. Such order may, by provisions which may be mandatory or otherwise, require the bank and its directors, officers, employees, and agents to cease and desist from the same, and, further, to take affirmative action to correct the conditions resulting from any such violation or practice.
2 This figure was corrected to $93,150 by stipulation at the hearing (Tr. 14).
 {{4-1-90 p.A-28}}unsafe or unsound banking practices in that there is an excessive volume of poor quality loans and poor quality assets which originated as loans. Loans adversely classified as of December 22, 1978, were $326,600 Substandard, $35,400 Doubtful and $34,100 Loss, for a total of $396,100 which represents 6.6 percent of total loans. In addition, other real estate is classified Substandard in the amount of $155,000 and other assets are classified Loss in the amount of $27,900.
   9. The Bank and its management have engaged in unsafe or unsound banking practices in that an adequate valuation reserve for loan losses has not been maintained. As of December 22, 1978, loans classified Loss and assets which originated as loans classified Loss totaled $62,000 while the balance in the valuation reserve for loan losses was only $9,300.
   10. The Bank's board of directors has engaged and is continuing to engage in unsafe or unsound banking practices in that it has failed to provide supervision over the active officers of the Bank adequate to prevent the above-described practices.
   The Bank contends that the charges contained in the Notice are primarily a description of conditions rather than "unsafe or unsound banking practices"; that the practices and conditions alleged in the Notice are the subject of a fully enforceable cease-and-desist order; and that the Bank's condition has improved substantially since the examination of December 22, 1978, and there is no danger of a reoccurrence of the practices and conditions complained of, hence no order to cease and desist or affirmative action is necessary.
   The facts are essentially undisputed although the Bank disagrees with some of the classifications of loans and assets and denies that unsafe or unsound banking practices have been alleged or proved. The Bank stipulated at the hearing to the accuracy of the figures contained in paragraphs 5(b) through 8 of the Notice (Tr.12–14), and Examiner * * * testified in detail in support of all the other allegations (Tr.17–122). The Bank adduced the testimony of its president, * * *, and a consultant, * * *.
   The Bank, located in a small (population 523) town in southeast * * *, is owned by 13 stockholders, with three of them (* * *) jointly owning 82 percent of the common stock (Tr.123). The Bank has had financial problems since about 1973 due to mismanagement by former executive officers. * * *, who became president in 1973, became active in the management of the Bank in December 1976. * * * is now executive vice president. * * *, a partnership composed of * * * and * * *, operates the Bank for a management fee of $10,000 per month.
   As the result of an FDIC examination of the Bank on May 9, 1977, an order (part 1-b of Corporation Exhibit 1) was negotiated between the parties and executed December 16, 1977, requiring the Bank to cease and desist from a number of "unsafe or unsound practices" and to take affirmative action to correct certain conditions.
   The December 22, 1978, examination disclosed that the December 16, 1977, order had not been complied with fully and that, in some respects, its condition had worsened. Rather than bring a proceeding to enforce the existing order, the FDIC elected to initiate this proceeding for a new order to terminate and rectify practices found in the later examination, some of which were not covered by the existing order.

Whether the Notice alleges "practices" or "conditions".

   The Bank contends that the Notice, rather than alleging unsafe or unsound banking practices, lists, primarily, conditions. The thrust of this argument is that § 8(b)(1) of the Act provides for the issuance of a cease-and-desist order against practices but not conditions, although it permits the order to require affirmative action to correct the conditions resulting from such practices. A literal reading of the last sentence of § 8(b)(1) lends some credence to this contention. However, the same section requires the Notice to "contain a statement of the facts constituting the alleged . . . unsafe or unsound practice or practices," and this in effect is what the FDIC has done. Paragraph 5 through 10 of the Notice allege repeatedly that the respondents have engaged (and in most instances are continuing to engage) in unsafe or unsound banking practices "in that" they did or failed to do certain things. It is true these acts or failure to act resulted in certain conditions, but that does not make the Notice fatally defec- {{4-1-90 p.A-29}}tive under the Act so that a cease-and-desist order will not lie.

The existence of an enforceable order.

   The FDIC of course could have elected to enforce the negotiated order of December 16, 1977. However, it was based on the examination of May 9, 1977, and this was to some extent obsolete. Also, it did not cover all of the practices now alleged to be unsafe or unsound—particularly the payment of allegedly excessive management fees.
   The FDIC had its choice of whether to enforce the existing order or to seek a new one. That the existing order covers most of the same ground is no reason to invalidate this proceeding.
   The term "unsafe or unsound banking practice" is not defined in the Act, and the case law on the subject is sparse. In Groos Nat. Bank v. Comptroller of the Currency, 573 F. 2d 889 (5th Cir. 1978), the Court was content to leave the definition to the regulatory agencies, saying at p. 897,

       The phrase "unsafe or unsound banking practices" is widely used in the regulatory statutes and in case law, and one of the purposes of the banking acts is clearly to commit the progressive definition and eradication of such practices to the expertise of the appropriate regulatory agencies.
   In Groos the court affirmed the District Court's decision sustaining administrative enforcement of a previous agreement which forbade further extension of credit to a majority stockholder and certain other individuals. This case thus is somewhat analogous to the present one.
   In First Nat. Bank of Eden v. Department of the Treasury, Comptroller of the Currency, 568 F. 2d 610 (8th Cir. 1978), the court said in a footnote on p. 611,
       Congress did not define unsafe and unsound banking practices in § 1818(b). However, the Comptroller suggests that these terms encompass what may be generally viewed as conduct deemed contrary to accepted standards of banking operations which might result in abnormal risk or loss to a banking institution or shareholder.
   In another footnote on the same page, the Court, in affirming the Comptroller, listed the "unsafe or unsound" practices from which the Comptroller had ordered the bank to cease and desist as follows:
       1. accumulation of certain unsafe assets in an amount constituting 37% of the Bank's gross capital funds;
       2. failure to implement adequate internal controls and auditing procedures;
       3. failure to maintain adequate credit information on certain Bank investments, contrary to 12 C.F.R. § 1.8;
       4. payment of excessive bonuses to Bank officers;
   Here again the practices found to be unsafe or unsound are similar to some of those here involved.

   [.1] It is apparent that what constitutes an unsafe or unsound practice must depend on the facts of each case. The matter was well stated by John F. Horne, Chairman of the Federal Home Loan Bank Board:

       At the outset, it should be noted that the term "unsafe or unsound", as used in the cease-and-desist provisions of S. 3158, is not a novel term in banking or savings and loan parlance. The words "unsafe" or "unsound", as a basis for supervisory action appear in the banking or savings and loan laws of 38 states. For more than 30 years, "unsafe or unsound practices" have been grounds for removal under section 30 of the Banking Act of 1933, of a director or officer of a member bank of the Federal Reserve System. See 12 U.S.C. 77. It has been grounds since 1935 for the termination of insurance of a bank insured by the Federal Deposit Insurance Corporation. See 49 Stat. 690, 12 U.S.C. 1818(a). "Unsafe or unsound practices" have also been grounds for termination of the insured status of an insured savings and loan association since the 1954 amendment to section 407 of the National Housing Act. See 68 Stat. 633, 12 U.S.C. § 1730.
       However, despite the fact that the term "unsafe or unsound practices" has been used in the statutes governing financial institutions for many years, the Board is not aware of any statute, either Federal or State, which attempts to enumerate all the specific acts which could constitute such practices. The concept of "unsafe or unsound practices" is one of general application which touches upon {{4-1-90 p.A-30}}the entire field of the operations of a financial institution. For this reason, it would be virtually impossible to attempt to catalog within a single all-inclusive or rigid definition the broad spectrum of activities which are embraced by the term. The very formulation of such a definition would probably operate to exclude those practices not set out in the definition, even though they might be highly injurious to an institution under a given set of facts or circumstances or a scheme developed by unscrupulous operators to avoid the reach of the law. Contributing to the difficulty of framing a comprehensive definition is the fact that particular activity not necessarily unsafe or unsound in every instance may be so when considered in the light of all relevant facts. Thus, what may be an acceptable practice for an institution with a strong reserve position, such as concentration in higher risk lending may well be unsafe or unsound for a marginal operation.
Hearings on S. 3158 Before the House Comm. on Banking and Currency, 89th Cong., 2d Sess., at 49 (1966).
   I turn now to the specific practices alleged in this case to be unsafe and unsound.

The management fee and loan loss provision.

   Paragraph 5 of the Notice alleges that the Bank's net operating losses of $156,900 from January 1, 1975, through December 22, 1978, were covered primarily by (a) an excessive management fee of $276,300 paid to * * * and (b) the providing of loan loss provisions which lacked $22,300 of being sufficient to cover the Bank's actual net loan losses.
   The management fee is the principal bone of contention in this proceeding. Except for this item, the parties negotiated a new order to replace that of December 16, 1977.
   Examiner * * * testified that the fee, which was $10,000 per month at the time of the last examination, in his opinion was unreasonable in view of the size of the bank and its condition (Tr.58–63). He supported his opinion by giving comparative performance figures (from Corporation Exhibit 4) for this Bank, its "peer group" (* * * banks of similar size operating under the same legal restrictions) and for all banks in the State (Tr.72, 74–76).
   The Bank charged the management fee to "other operating expenses", making this item 3.09% of total assets for 1978 as compared to a median of .76% for the peer group and .80% for all banks in the state (Tr.74).

   [.2] However, few banks pay management fees, so comparable expenses would normally be reflected under salaries. If this Bank's management fees were considered as salary, the "salary and employee benefits" item would be 2.77% of total assets for 1978, as compared to a median of 1.52% for the peer group and 1.53% for all banks in the state. This would also raise this Bank's average "salary and benefits" per employee to $19,727, as compared to $13,714 for the peer group and $13,969 for all banks in the state. (Tr.75). Thus it is clear that this Bank is paying considerably more for management services than most banks in the state in spite of its poor financial condition.
   The Bank makes the point that this comparison does not take into consideration the value of the services rendered in return for the management fee, but it introduced no evidence on this. The FDIC takes the position (and I agree) that the Bank cannot afford this fee regardless of the value of the services.
   The FDIC proposes to forbid the payment of management or consultant fees (or salaries for the same purpose) without prior approval by its regional director. An alternative would be to forbid such payments to the extent that they would cause the "other operating costs" or "salaries and employee benefits" expenses to exceed a specified percentage of the Bank's average assets, as was done in First National Bank of Eden, South Dakota v. Department of the Treasury, Comptroller of the Currency, 568 F. 2d 610 (8th Cir. 1978). The latter method would require less supervision, but the FDIC proposal is not unreasonable and will be recommended.
   The other factor alleged in Paragraph 5 of the Notice to be primarily responsible for the Bank's net operating loss (after taxes) of $156,900 from January 1, 1975, through December 22, 1978, is its failure by $22,300 to provide a sufficiently large provision for loan losses. At the hearing, Examiner * * * gave comparable figures for 1978 to the inspection date, showing that the {{4-1-90 p.A-31}}loan loss provision was $86,700 less than actual loan losses. * * * opined that the 1978 loan loss provision was inadequate but did not explain how this (or the lesser deficiency for the 4-year period) contributed to the net operating loss. While the failure to make an adequate loan loss provision may be an unsafe or unsound banking practice in itself, I find that the charge in ¶5(b) of the Notice has not been proved as alleged.

The need for additional capital.

   Paragraph 6 of the Notice alleges that "the Bank has been and is operated with an inadequate level of capital protection for the volume and quality of assets held." The Notice then gives figures the accuracy of which was stipulated.
   Examiner * * *, testifying from Corporation Exhibit 4, said that the Bank's total equity capital at the end of 1978 was 4.19%3 of total assets, compared to medians of 8.6% for the peer group and 8.49% for all banks in the state (Tr.72).
   The order of December 16, 1977, required the Bank within 90 days to increase total capital and reserves by not less than $200,000. President * * * testified that he had that amount of capital ready to inject into the Bank but had refrained from doing so on advice of counsel (Tr.137). The Bank contends here again that ¶6 describes a condition, not a practice, and that no cease-and-desist order can be issued to rectify it. It also contends, as discussed below, that the capital-to-assets ratio has improved. These contentions are without merit.

   [.3] If the FDIC cannot require additional equity capital to protect depositors, it is powerless indeed. However ill-suited a cease-and-desist order may be for this purpose, affirmative action also may be required under the specific provisions of the Act.

The use of Bank funds to purchase its common stock.

   Paragraph 7 of the Notice, as amended by stipulation, alleges that the Bank "loaned $93,150 of its fund for the purpose of purchasing common stock of the Bank, thereby in effect recapitalizing the Bank largely by using the funds of its own depositors."
   Seven unsecured loans in the amount of $10,350 each and one in the amount of $20,700 were made to directors and stockholders of the Bank, $64,350 of those loans being made to directors (Tr.85). Examiner * * * testified that making such loans is an unsafe or unsound practice and that he had never seen another case like it (Tr.54).
   Consultant * * * testified that these loans were bankable, that he would make an unsecured loan of $10,000 to any of the individuals involved (Tr.184), and that the loans did not violate the Bank's loan policy in his opinion (Tr. 185). He was referring to a written loan policy (Corporation Exhibit 3) adopted in compliance with the order of December 16, 1977. Under loans "not considered desirable" in this loan policy are "(u)nsecured loans to individual members of the Board of Directors. This does not prohibit the bank from renewing any credit already extended to any individual director." The heading of this part of the statement says loans of the types listed "will ordinarily be declined unless specifically approved by the Directors' Loan Committee for reasons which appear to justify an exception to the bank's general policy."
   The latter exception apparently is the one relied upon by Mr. * * *. However, there is nothing in the record to show that the Directors' Loan Committee made any finding of "reason which appear to justify an exception to the bank's general loan policy." Moreover, the provision for "renewing . . . credit already extended" to the directors appears to limit rather than extend the exceptions contemplated as far as this particular category of loan is concerned.
   This is not a proceeding to enforce the December 16, 1977, order. However, the fact that unsecured loans to directors were categorized as "undesirable" under the Bank's written loan policy enacted pursuant to that order is persuasive evidence that the making of such loans may be an "unsafe or unsound banking practice" when the bank concerned is in financial difficulties. The fact that Mr. * * * would make such a loan

3 This figure does not match the 6.1% capital-to-assets figure in ¶6 of the Notice. However, as * * * explained (Tr.72), the 6.1% figure, taken from his examination report, includes $152,000 of capital (including $93,150 loaned by the Bank as stated in ¶7 of the Notice) injected after December 31, 1978, but included in the report of the December 22, 1978, examination.
{{4-1-90 p.A-32}}to any of the individuals concerned is beside the point.

   [.4] The charge is that the making of the loans was an unsafe or unsound banking practice, not because the loans were unsound, but because the proceeds were used "for the purpose of purchasing common stock of the bank, thereby in effect recapitalizing the Bank largely by using the funds of its own depositors." Examiner * * * testified,

       Yes, I consider it to be an unsound practice. This is the only case I have ever seen where the bank actually lent its own funds to increase its capital account. It does not really provide what the depositors looked to as protection of their funds. It provides capital at a future date when the loans are collected. It does not provide a commitment by the stockholders.
       The stockholders are not paying out their funds to support the business. They are signing a note that they will pay in the future to support the business, but at the present time, actual funds to support and protect the depositors is not being paid by the stockholders. (Tr.54)
This testimony is essentially uncontradicted, and it adequately supports a finding that the making of these loans was an unsafe and unsound practice.

The quality of loans and assets.

   Paragraph 8 of the Notice charges that there was "an excessive volume of poor quality loans and poor quality assets which originated as loans." It goes on to state that loans in the amount of $396,100 (6.6% of total loans) and assets totalling $182,900 were adversely classified as of December 22, 1978. The loans so classified were $326,600 Substandard, $35,400 Doubtful, and $34,100 Loss. The adversely classified assets included $155,000 in "other real estate" classified Substandard and $27,900 in "other assets" classified Loss.
   Examiner * * * testimony supported these classifications (Tr.32–36). He also testified that the Bank's adversely classified loans increased from 5.1% of total loans in the previous examination to 6.6% in the one on December 22, 1978, and that in the banks he examined this figure runs 2% or less (Tr.36).
   The adverse classification of loans and assets was attacked indirectly by the Bank through testimony of Mr. * * * that since the examination the Bank had collected 48.65% of the loans and 80.77% of the assets classified Loss (Tr.161), as compared to a normal collection rate of 20% on such items over a one-year period (Tr.112). A direct attack was also made on the classification of one real estate asset, located at * * *, which was classified Substandard to the extent of $148,082 (Tr.99). An independent appraisal showed the value to be $143,500 (Tr.100), and * * * pointed out that one * * * had an option to purchase the property for $178,858, hence the Bank stood to make over $30,000. However, as * * * pointed out, even if the property is worth $178,858 the margin is still below that normally required by banks.
   The Bank's equity capital as a percentage of total assets at the end of 1978 was 4.19%, as compared to 8.60% for the peer group and 8.49% for all * * * banks (Tr.72). Thus a very small shrinkage in the value of the Bank's assets would wipe out the protection normally afforded depositors by the equity capital (Tr.39). The depositors basically had no protection since classified assets totalled $579,000 and were 99.5% of the total capital and reserves (Tr.41).

   [.5] I find that the making of inadequately secured loans as reflected by the adversely classified loans and assets was an unsafe and unsound banking practice, as alleged.

The valuation reserve for loan losses.

   Paragraph 9 of the Notice alleges that an adequate valuation reserve for loan losses has not been maintained, and, specifically that as of December 22, 1978, this reserve was only $9,300 whereas loans classified Loss totalled $62,000.
   Examiner * * * so testified (Tr.65), and he opined that this was an unsound practice in view of the Bank's condition (Tr.66). He conceded that some banks are not on a reserve basis and have no valuation reserve at all, but such banks have adequate earnings, assets and capital to absorb loan losses, he said (Tr. 66,113).
   * * * testimony on this item is uncontradicted, and I find the charge proved.

The "inadequate supervision" charge.

   Paragraph 10 of the Notice alleges that all of the foregoing unsafe and unsound banking practices were the result of the failure of the Bank's board of directors to provide {{4-1-90 p.A-33}}adequate supervision over its active officers.
   After reviewing the management policies and procedures, including lending policies and practices and the minutes of the director's and stockholders' meetings, Examiner * * * testified:

       In my opinion, the dominant influence on policies within the bank were * * * and * * *. They owned the number of shares necessary to elect the entire board of directors. They were the two executive officers present at the bank who had the final say in matters of the bank. And they were the dominant individuals in the discussion of loans and bank affairs at meetings which are held with the directors.
   As previously stated, * * * and * * * comprised the * * * partnership engaged by the Bank to provide management services, and they, together with * * *, jointly owned 82% of the Bank's common stock. Also, * * * is the president and * * * is the executive vice president of the Bank (Tr.122, 123, 132).
   President * * * testified Mr. * * *, who was hired as a consultant on recommendation of the state bank commissioner in May 1978, served on a full-time basis until October 1978, and since the latter date has served on a part-time basis (Tr. 132–134). * * * has veto power over all loans of over $5,000, * * * testified (Tr.134). * * * was paid by the Bank directly until October 1978, and since then by * * * (Tr.136).
   On the strength of * * * active role in the Bank's management, the respondents dispute the FDIC's contention that * * * and * * * were the dominant influence on the Bank's policies. However, it should be noted that since October 1978 * * * has been paid by * * *.

   [.6] There is nothing intrinsically wrong with the Bank's being controlled by its majority stockholders, through their undoubted power to elect directors of their own choosing. However, a board of directors has a duty to supervise the business of the corporation, and * * * sets a higher, stricter fiduciary standard for directors and officers of a corporation than some other jurisdictions. Delano v. Kitch, 542 F. 2d 550 (10th Cir. 1976).
   The Bank's charter is not in evidence, but under the * * * decisions cited in Delano v. Kitch the directors had a duty to exercise the "highest degree of fidelity, good faith, care and diligence." Thus they must share in the responsibility for the unsafe and unsound banking practices found herein.

The Bank's discontinuance of the practices charged.

   The Bank's principal "defense" is that most of the practices and conditions complained of have been eliminated since the December 22, 1978, FDIC examination. There was considerable testimony to this effect at the hearing, and since the hearing the Bank has moved alternatively to introduce a recent state bank examination report, which it claims substantiates its evidence, or to reopen the hearing. For the reasons which follow, this motion is denied. The evidence adduced by the Bank at the hearing regarding changes in its practices and conditions since December 22, 1978, was admitted over the FDIC's objections on the ground that it was entitled to have the matter heard strictly on the basis of the examination of that date. However, a final ruling on the relevance of such charges was reserved until the writing of this decision.
   I now conclude that the FDIC is correct as far as its entitlement to a cease-and-desist order is concerned but that the Bank's changes in practices and conditions should be considered in drafting an order requiring affirmative action.
   The state bank examination, according to the motion, occurred on December 17, 1979, just one week after the hearing. While it may be corroborative of the Bank's evidence regarding the changes, it is not deemed necessary to reopen the hearing for its admission. The FDIC declined to consent to its inclusion in the record of this proceeding. It also declined to make another examination of its own, pending this proceeding.
   The examination of December 22, 1978, was a joint examination by the FDIC and the state bank commissioner, but the FDIC did not join in the latest examination. In the interim, the FDIC examiner did visit the Bank on five or six occasions to check on classified loans (Tr.90, 97), so it is not entirely without knowledge of the changes in the Bank's condition; it also is in a posi- {{4-1-90 p.A-34}}tion to verify these changes through the latest examination by the state bank commissioner or by an examination of its own but chose not to do so. Under these circumstances, and since there seems to be no reason to doubt the testimony on these matters adduced by the Bank, I accept this evidence insofar as it affects the affirmative action portion of the order.
   This evidence shows that the Bank has to some extent complied with the proposed order negotiated by the Bank and the FDIC's regional office, the most notable exception being payment of management fees and injection of $200,000 of new capital, and as for the latter item President * * * testified that he had the funds available but had withheld it on advice of counsel (Tr.137). The other changes are summarized at pp. 2 and 3 of the Bank's memorandum brief as follows:

       a. From December 6, 1978, to December 6, 1979, loans were down $595,000 and deposits were up $240,000. Tr. p. 139 and Respondent's Exhibit 2.
       b. Over that period of time the ratio of loans to deposits was lowered 9% to 64.83%. The loans-to-deposits ratio had been maintained below 65% for several weeks prior to the December 10, 1979 hearing. Tr P. 140 and Respondent's Exhibit 8 at paragraph 5. (Of the 30 banks in the same region, 20 had loans-to-deposits ratios in excess of 65%. Tr. p. 181)
       c. Government bonds increased by $600,000 and federal funds sold rose by $550,000. Tr. p. 139 and Respondent's Exhibit 2.
       d. Expenses for 1979 were down $7,000, despite heavy expenses in the approximate amount of $30,000 attributable to these FDIC proceedings. Tr. pp. 139 and 140 and Respondent's Exhibit 2.
       e. The capital-to-deposits ratio has increased from 6.1%, at the time of the Examination, to nearly 7.1% as of the December 6, 1979. FDIC Exhibit 2 and Tr. p. 147.
       f. The Bank has collected $16,000 of the $34,000 in loans classified in the Examination as "loss", and $22,000 of the $27,000 in "other assets" classified as "loss". Tr. pp. 161 and 162. These collections were made despite the FDIC's evidence that a 20% collection rate for such matters is the norm. Tr. pp. 57 and 112. (Since 1973 the Bank has collected $240,000 or 57% of the total loans required by the FDIC to be charged off. Tr. p. 163.)
       g. The reserve for loan losses rose from approximately .16% ($9,300/$5,700,000 loan valuation reserves) to approximately 1.25%. FDIC Exhibit 1 at p. 2 and Tr. pp. 172-176.
   Additionally, all the unsecured loans to directors and stockholders to purchase the Bank's common stock have been eliminated (Tr.185).

   [.7] These improvements do not mean that the FDIC is not entitled to a cease-and-desist order. Literally dozens of cases might be cited to the effect that discontinuance of the practices complained of in such an administrative proceeding does not render the controversy moot or require discontinuance of the agency proceeding. Pike and Fischer, Administrative Law, 2nd Series, Consolidated Digest Vol. 2, § 8b.8. This is especially true where the cessation of the practice was not voluntary but was brought about by the administrative proceeding, Galter v. FTC, 186 F. 2d 810 (7th Cir. 1951), or even where the discontinuance took place some time prior to the filing of the complaint, since the agency is not obliged to assume that such practices will not be resumed, Arkansas Wholesale Grocers v. FTC, 18 F. 2d 866 (8th Cir. 1927), cert. den, 275 U.S. 533 (1927).
   Moreover, the Bank here has not discontinued the practice of paying excessive management fees and asserts the right to continue paying them. The FDIC is definitely entitled to cease-and-desist order on this item. See Galter v. FTC, supra.
   The Bank also contends that the passage of time, coupled with the changes in circumstances, makes a cease-and-desist order inequitable, pointing out that § 8(b)(1) of the Act provides,

    Such hearing [on the notice of charges] shall be fixed for a date not earlier than thirty days nor later than sixty days after service of such notice unless an earlier or a later date is set by the agency at the request of the bank.
The hearing in this case occurred some seven months after service of the Notice. Most of this delay was due to the inability of the first two administrative law judges designated by the Office of Personnel Management to hear the case. It was assigned to this judge as of October 1, 1979, and the {{4-1-90 p.A-35}}hearing date of December 10, 1979, was set by agreement. It is true, as stated by the Bank, that it did not request a setting later than sixty days after service of the Notice, but it did move at the hearing for a continuance (Tr.4–10). Furthermore, counsel for both sides requested more time than provided by FDIC rules for submission of their briefs (Tr.203–205). Thus neither side appeared to be pressing for an early resolution of the matter.
   The quoted language of the statute is explicit enough, but absent a showing of prejudice I conclude that the statute is directory rather than mandatory with regard to the hearing date.

RECOMMENDED FINDINGS OF FACT

   In view of the foregoing and all facts of record, it is recommended that the FDIC find that:
   1. Respondent, the * * * ("the Bank"), is a corporation existing and doing business under the laws of the State of * * *, with its principal place of business at * * *.
   2. Respondent, as an insured nonmember bank, is now and has been at all times pertinent to this proceeding subject to the provisions of the Federal Deposit Insurance Act (12 U.S.C. § 1811 et seq.) and the Rules and Regulations of the FDIC (12 C.F.R. Part 301 et seq.) (Notice at paragraph 1; Answer at paragraph 1).
   3. As of December 22, 1978, the Bank's board of directors consisted of * * *.
   (Notice at paragraph 2; Answer at paragraph 1).
   4. Examiner * * * examined the Bank as of the close of business December 22, 1978 (Tr.23).
   5. * * * is a partnership composed of * * *, which jointly owns approximately 82 percent of the outstanding common stock of the Bank (Tr. 58, 122–123). As of December 22, 1978, * * * was the Bank's president and chairman of the board of directors, * * *, was the Bank's executive vice president, and they were the dominant influence on the Bank's policies (Tr. 66–67).
   6. The Bank and its management caused the Bank to sustain net losses after taxes in the amount of $156,900 from January 1, 1975 through December 22, 1978. These losses were caused primarily by the payment of an excessive management fee in the amount of $276,300 to * * * from January 1, 1976 through December 22, 1978.
   7. The management fee amounted to $120,000 annually in 1978 (Tr. 58) and contributed greatly to the $165,000 loss which the Bank suffered during the year 1978, to the date of the examination (Tr. 59). The Bank's earnings, its capital and soundness of assets were not sufficient to pay such a management fee and permit the Bank to remain viable (Tr.58–59).
   8. The Bank's management fee was the primary component of the Bank's "other operating expenses" of $249,400 for the year 1978 to the date of examination (Tr.58; Corporation Exhibit 1, p. 4) and therefore was the primary cause for the Bank's "other operating expenses" being 3.09 percent of its total assets as of December 31, 1978. The median of "other operating expenses" for its "peer group" of banks was .76 percent. The Bank's percent was in excess of four times the percent for its peer group (Tr.73–74); Corporation Exhibit 4, table 2). Accordingly, Respondents' agreement to pay, and payment of, such management fee constitutes an unsafe and unsound banking practice.
   9. As of December 22, 1978, the Bank's loan loss provision of $115,200 was inadequate when compared to its net loans charged off of $139,900 (Tr.54–554; Corporation Exhibit 1, p.4).
   10. The Bank's net loans charged off for the years 1973 through 1978 to the date of examination were significantly higher than those experienced by the examiner in other banks, due in large part to the Bank's 10 percent recovery rate as compared to 20 percent for other banks (Tr.56–57). The Bank's net loan charge-offs compared to its total loans was 2.34 percent or 33 times the median net loans charged off to total loans for the Bank's peer group of .07 percent, as of December 31, 1978 (Corporation Exhibit 4, table 2). The Bank's excessive net loans charged off and the Bank's inadequate provision for loan losses constitutes an unsafe and unsound banking practice.
   11. As of December 22, 1978, the Bank was being operated with an inadequate level

4 Transcript is in error at page 55, line 16. The net charge-off for 1978, shown as $109,900, should be $139,900. See Corporation Exhibit 1, p.4.
{{4-1-90 p.A-36}}of capital protection for the volume and quality of assets held (Notice paragraph 6). The Bank's adjusted capital, reserves, and subordinated debt was $502,400 and its adjusted total assets were $8,297,800, which represents a ratio of 6.1 percent (Notice paragraph 6; Tr. 13, 37–39; Corporation Exhibit 1, p.2). As of December 31, 1978, the median adjusted capital was 8.60 percent for banks in the Bank's peer group, 8.68 percent for banks in the Bank's market area and 8.49 percent for all banks in the State of * * * (Tr.40, 72–73; Corporation Exhibit 4, table 4). The remaining adversely classified assets not used in computing the Bank's adjusted capital totalled $499,300, which represents 99.4 percent of adjusted capital reserves and subordinated debt, thereby almost completely eroding the Bank's depositor protection (Notice paragraph 6; Tr. 13, 40–42). The operation of the Bank with such an inadequate level of capital protection constitutes an unsafe and unsound banking practice.
   12. The Bank and its management lent $93,150 of the Bank's funds to certain of its directors and stockholders on an unsecured basis, which funds were used to purchase stock of the Bank (Notice paragraph 7; Tr. 14). These loans violated the Bank's loan policy and had the effect of recapitalizing the Bank using the funds of the Bank's depositors to protect the stockholders' investment instead of using the funds of the Bank's stockholders' to protect the Bank's depositors (Tr. 42–54). These loans had been repaid in full as of December 10, 1979.
   13. The loan policy was adopted by the board of directors of the Bank (Corporation Exhibit 3) pursuant to, and in satisfaction of, paragraph 5 of an outstanding Order previously issued against the Bank by the FDIC on December 16, 1977 (Corporation Exhibit 1, p. 1-b-1; Corporation Exhibit 2). The Order and loan policy required the Bank to reduce its loan volume to no more than 65 percent of total deposits (Corporation Exhibit 1, p.1-b-3, paragraph 9; Corporation Exhibit 3, loan policy, paragraph (k)).
   14. As of December 22, 1978, the Bank's loan volume was 76.9 percent of total deposits (Corporation Exhibit 1, p.6). Loans to directors and stockholders to purchase stock in the amount of $93,150 further increased such percentage (Tr. 46). The loans to directors and stockholders violated the provisions of the December 16, 1977, Order (Corporation Exhibit 1, pp. 1-b to 1-b-5). The Bank obtained no cash for its stock (Tr. 51) nor the operating flexibility that cash would have provided (Tr. 53–54); instead, it obtained a promise to pay with all of the inherent risks of collection associated with loans (Tr. 51–54). The practice of capitalizing the Bank by lending its own funds for the purpose of purchasing its own stock constitutes an unsafe and unsound banking practice.
   15. As of December 22, 1978, the Bank had an excessive volume of adversely classified assets. The adversely classified loans represented 6.6 percent of the Bank's total loans (Tr. 36; Corporation Exhibit 1, p. 6). This percentage is more than three times the percentage experienced by the examiner in other banks which Examiner * * * examined (Tr. 36). Furthermore, this percentage represents an increase of 1.5 percent over the previous examination, reflecting a deteriorating condition (Tr.36). The adversely classified loans amounted to $396,100 of which $326,600 was classified Substandard, $35,400 was classified Doubtful, and $34,100 was classified Loss. "Other real estate" was classified Substandard in the amount of $155,000 and "other assets" was classified Loss in the amount of $27,900 (Notice paragraph 8, Tr. 14–15, 40–42). Such excessive volume of adversely classified assets constitutes an unsafe and unsound banking practice.
   16. As of December 22, 1978, the Bank maintained a valuation reserve for loan losses of $9,300 (Tr. 64–65); Corporation Exhibit 1, p.4) while suffering losses of $62,000 as of the same date (Tr. 65; Corporation Exhibit 1, p. 2). Such inadequate reserve jeopardized the soundness of the Bank because the Bank's weak earnings and inadequate capital could not absorb the deficit of $52,700. Furthermore, the condition of the Bank assets indicated that additional excessive losses would materialize (Tr. 65–66). This practice constitutes an unsafe and unsound banking practice.
   17. The Bank's board of directors has engaged in unsafe and unsound banking practices in that it has failed to provide proper supervision over the active officers of the Bank to prevent the unsafe and unsound banking practices enumerated in Paragraphs 6 through 16 of these recommended findings of fact.

{{4-1-90 p.A-37}}
RECOMMENDED CONCLUSIONS OF LAW

   1. The FDIC has jurisdiction over respondents and the subject matter of this proceeding.
   2. The FDIC is authorized to impose broad orders requiring affirmative action in proceedings under Section 8(b) of the Federal Deposit Insurance Act.
   3. Cessation of unsafe or unsound banking practices or violations is not a defense in this proceeding.
   4. The Bank's directors breached their duties to the Bank by permitting unsafe or unsound practices.
   5. An appropriate order should be issued requiring respondents to cease-and-desist from the unsafe or unsound practices found herein and requiring respondents take affirmative action to correct the conditions resulting from such practices.
   6. The requested findings of fact and conclusions of law submitted by the parties, to the extent that they are inconsistent with this decision, should be denied.
   It is further recommended that the FDIC adopt an order in the form attached hereto.

/s/ Dee C. Blythe
Administrative Law Judge
April 18, 1980

ORDER

   IT IS ORDERED, that * * *, its directors, officers, employees, and agents, CEASE AND DESIST from the unsafe and unsound practices set forth in the findings of fact and conclusions of law, and further take affirmative action as follows:
   1. Following the effective date of this ORDER, the Bank shall pay no management, consultant or other fees or salaries of any nature directly or indirectly to or for the benefit of Bank directors or their interests, without obtaining the prior written consent of the Regional Director of the FDIC's * * * Regional Office ("Regional Director").
   2. (a) Within 60 days from the effective date of this ORDER, the board of directors of the Bank shall take all steps necessary to increase total capital and reserves by not less than $200,000. Such increase in capital and reserves shall be accomplished by:

       (i) the sale of new common stock;
       (ii) the elimination of all or part of the "Loss" or "Doubtful" assets specified in Paragraph 4(a) of this ORDER, without loss or liability to the Bank;
       (iii) the collection of any assets charged-off prior to December 22, 1978;
       (iv) the direct contribution of cash by the directors of the bank; or
       (v) any combination of the above.
   (b) Except as provided in Paragraph 2(a)(ii) and 2(a)(iii) of this ORDER, no part of the increase in capital and reserves required by this Paragraph 2 of the ORDER shall be funded by money lent by the Bank.
   (c) If all or part of the increase in total capital and reserves required by Paragraph 2(a) above of this ORDER is accomplished by the sale of new common stock, the board of directors of the Bank shall take all steps necessary to adopt and implement a plan for the sale of such additional stock, including the voting of any shares owned by them in favor of the plan. Should the implementation of the plan involve a public distribution of the Bank's securities (including a distribution limited to the Bank's existing shareholders), the Bank shall prepare offering materials fully describing the securities being offered, including an accurate description of the financial condition of the Bank 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 60 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 at Washington, D.C., for review. 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(c) of this ORDER, the Bank shall provide to any subscriber and/or purchaser of the Bank stock written notice of any planned or existing development or other change which is materially different from the information reflected in any offering materials used in connection with the sale of Bank stock. The written notice required by this paragraph shall be furnished within ten (10) calendar days from the date such material development or change was planned or occurred, whichever is earlier, {{4-1-90 p.A-38}}and shall be made to every purchaser and/or subscriber of Bank stock who received or was tendered the information contained in the Bank's original offering circular.
   3. Within 30 days from the effective date of this ORDER, the Bank shall establish and continue to maintain, through charges to current operating income, an adequate valuation reserve for loan losses. The adequacy of the reserve shall be determined in light of the Bank's past loss experience and evaluation of the potential for losses in the current loan portfolio. A written record shall be maintained indicating the method used in determining the amount of reserve needed.
   4. (a) Within 30 days from the effective date of this ORDER, the Bank shall eliminate from its books, by charge-off or collection, all assets or portions of assets classified "Loss" and 50 percent of those assets classified "Doubtful" as of December 22, 1978, which have not been previously collected or charged-off.
   (b) Within 180 days from the effective date of this ORDER, the Bank shall reduce the total of the remaining assets classified "Doubtful" and the assets classified "Substandard" as of December 22, 1978, to not more than $250,000.
   As used in this ORDER, the word "reduce" means (1) to collect, (2) to charge-off, or (3) to sufficiently improve the quality of assets adversely classified to warrant removing the designation.
   5. Following the effective date of this ORDER, the Bank shall not extend directly or indirectly, any additional credit to or for the benefit of any borrower who has a loan or other extension of credit with the Bank that has been classified, in whole or in part, "Loss" or "Doubtful" as of December 22, 1978, so long as such loan or extension of credit remains classified "Loss" or "Doubtful", or is uncollected. The requirement of this paragraph does not prohibit the Bank from renewing (after collection of interest due from the borrower) any credit already extended to any borrower.
   6. Following the effective date of this ORDER, the Bank shall not extend, directly or indirectly, any additional credit to or for the benefit of any borrower obligated in any manner to the Bank on any extension of credit (including any portion thereof) that has been charged-off the books of the Bank so long as the charged-off credit remains uncollected.
   7. On the tenth day of the second month following the effective date of this ORDER, and on the tenth day of every second month thereafter, unless and until each and every correction required by this ORDER is accomplished the Bank shall furnish to the Regional Director written progress reports 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 in writing released the Bank from making further reports.
   The provisions of this ORDER shall be binding upon * * * Bank, its subsidiaries, affiliates, directors, officers, agents, servants, employees, successors and assigns.
   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 Board.
   By direction of the Board of Directors of the Federal Deposit Insurance Corporation, (undated), 1980.

/s/ HOYLE L. ROBINSON
Executive Secretary

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