Federal Deposit
Insurance Corporation

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[¶5049] FDIC Docket No. FDIC-83-252b&c, FDIC-84-49b, FDIC-84-50e (8-19-85).
   FDIC ordered an insured state nonmember bank to cease and desist from unsafe or unsound banking practices and from violations of law. FDIC also required the bank to take affirmative action to correct the practices and violations. FDIC also removed several bank directors and officers from office and prohibited their further participation in the affairs of the bank. Specifically, over 42% of the bank's loans were adversely classified, 25.3% of total loans were overdue, 33% of the bank's loan files lacked complete or current documentation, the bank had an inadequate loan loss reserve, the bank's assets subject to adverse classification were 521.9% of its total equity capital and reserves, and the bank's ratio of total equity and capital and reserves to its adjusted total assets was only 4.37%. FDIC also stated that in order for a bank to show that a bank examiner is biased, the bank must prove the relevance of the bias, the existence of the bias, and the results of the bias. Finally, FDIC noted the special expertise of bank examiners and the FDIC itself, and stated that examiners' classifications of loans are entitled to deference, as is the FDIC's selection of remedies for violations of law and for unsafe or unsound banking practices. (This decision was affirmed by the U.S. Court of Appeals for the Eleventh Circuit, 783 F.2d 1580 (1986)).

   [.1] CAMEL Rating—Defined
   "CAMEL" is an acronym for capital, assets, management, equity, and liquidity. These five key categories are used by bank regulatory agencies to assess the performance of a bank. A uniform rating system, using a number scale of "1" through "5", in ascending order of supervisory concern ("1" being the highest rating, "5" the lowest), has been adopted and is used by all federal financial institutions regulatory agencies.

   [.2] FDIC—Supervisory Functions
   The FDIC role is to oversee the system of deposit insurance, the primary function of which is stabilizing or promoting the stability of banks.

   [.3] Cease and Desist Orders—FDIC Authority to Issue
   The primary vehicle available to the FDIC to implement its supervisory powers is the authority to issue and enforce cease and desist orders to stop current and to prevent future unsafe or unsound practices and violations of laws, rules, and regulations pursuant to section 8 of the Federal Deposit Insurance Act.

   [.4] Unsafe or Unsound Practices—Statutory Standard
   The term "unsafe and unsound banking practices" encompasses conduct which is contrary to the normal and accepted standards of banking operations that may result in abnormal risk of loss or actual loss to a bank or its shareholders.

   [.5] Cease and Desist Orders—FDIC Authority to Issue
   If a bank has engaged or is engaging in unsafe or unsound practices, or is violating or has violated a statute, rule, or regulation, the FDIC has broad discretion to exercise its expertise in fashioning appropriate relief to halt the practices or violations, to prevent future abuses and to correct the effects of the practices or violations.

   [.6] Unsafe or Unsound Practices—Defined Generally
   There are certain practices which are inherently unsafe or unsound, including the accumulation of an excessively high volume of adversely classified loans and other assets; making secured loans based on inadequate collateral; making loans without establishing or enforcing repayment programs; renewing loans without collection in cash of interest due (the "capitalization" of interest); maintaining an {{4-1-90 p.A-481}}
inadequate reserve for loan losses in view of the volume of adversely classified loans; maintaining an inadequate level of equity capital and surplus; making loans without regard for the borrower's ability to repay; and maintaining inadequate liquidity. Certain other practices also constitute unsafe or unsound banking practices, including failure to maintain adequate or current information on borrowers; making unauthorized insider loans; and failure to charge off loans classified loss.

   [.7] Examiners—Weight Given to Opinion
   The unique expertise of bank examiners leads the FDIC to conclude that the examiners' classifications of loans are entitled to deference, and may not be overturned unless they are shown to be arbitrary and capricious or outside a "zone of reasonableness."

   [.8] Examiners—Powers
   Bank examiners have the power to make a thorough examination of all of the affairs of the bank and its affiliates, and to make full and detailed reports of the condition of the bank to the FDIC.

   [.9] Examiners—Loan Classifications—Review by ALJ
   Bank examiners' conclusions are reviewable. An ALJ may not substitute his own subjective judgment for that of the bank examiner, but may set aside the classification if it is without objective factual basis or is shown to be arbitrary and capricious.

   [.10] Accounting—Bank Examiner's Function—CPA's Function
   Accounting procedures are almost totally unrelated to the functions performed by a commissioned bank examiner conducting a safety or soundness examination. The CPA's function is primarily limited to auditing the bank's controls, while internal controls play a different role in the bank examiner's assessment of the bank's safety and soundness.

   [.11] Accountants—Expertise
   Accountants do not have any training or experience assessing a bank's overall safety or soundness and do not assign classifications to individual loans. Bank accountants do not assess the significance of a bank's financial figures for the bank's safety and soundness.

   [.12] Loans—Classification of Adverse—Generally
   Loan classification requires the application of expert judgment to objective facts.

   [.13] Examiners—Loan Classification—Review by ALJ
   Unless loan classifications by bank examiners are shown to be arbitrary and capricious, or without factual basis, such classifications should be upheld by an ALJ.

   [.14] Earned Interest, Uncollected—Classification
   The interest earned and not collected on loans should not be classified more severely than the underlying loan.

   [.15] Lending and Collection Policies and Procedures—Unsafe or Unsound Practices—Excessive Risk of Loss
   The willingness and ability of a debtor to perform as agreed remains the primary measure of the risk of a loan. The borrower must have earnings or liquid assets sufficient to meet interest payments and provide for reduction or liquidation of principal as agreed at a reasonable and foreseeable date.

   [.16] Lending and Collection Policies and Procedures—Unsafe or Unsound Practices—Inadequate Collateral
   There are dangers in purely collateral-based lending. Collateral may decline in value, may not be readily marketable, and accumulating unpaid interest may diminish the collateral margin.

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   [.17] Lending and Collection Policy and Procedures—Unsafe or Unsound Practices—Inadequate Collateral
   In determining whether collateral is adequate, the following factors must be considered: risk; acquisition costs; and disposition costs of acquiring and marketing the collateral to be applied to the debt.

   [.18] Directors—Duties and Responsibilities—Supervision of Lending Practices
   Failure of a bank's management to give proper attention to credit files makes sound credit judgment difficult, if not impossible.

   [.19] FDIC—Rulemaking Authority
   All persons must conduct their banking affairs in accordance with the standards promulgated by the agency statutorily entrusted with protecting the safety and soundness of insured, state-chartered nonmember banks.

   [.20] Examiners—Bias
   If a bank can show the relevance of an alleged bias and show that the bias existed and that the bias caused a bank examiner to classify or more severely classify a loan, then an ALJ would be justified in setting aside specific classifications that were shown to have resulted from that bias.

   [.21] Examiners—Bias
   An ALJ's application of a presumption that the bank examiners were biased, without making specific findings, supported by evidence, that a specific examiner was biased and that specific classifications were the result of that bias, was erroneous.

   [.22] Examiners—Bias
   The mere occurrence of certain events, including the institution of criminal proceedings against bank directors and the issuance of a temporary cease and desist order against a bank for violations of law, is not sufficient to show bias of a bank examiner. To show evidence bias, it must be shown that such events occurred; that the examiner classifying a loan participated in (or at least was aware of) those events; that there exists some factual basis for concluding that the examiner actually acquired an adverse bias as a result of those events; and that there was the opportunity for the bias to have resulted in the examiner either classifying a loan which should not have been classified or classifying a loan more severely.

   [.23] CAMEL Rating—"5" Defined
   A bank with a "5" composite rating is considered unsatisfactory. The bank's performance is critically deficient and in need of immediate remedial attention. Such performance, by itself or in combination with other weaknesses, threatens the viability of the bank.

   [.24] FDIC—Rulemaking Authority
   The FDIC Manual of Examination Policies constitutes a general statement of policy and/or interpretive rule rather than a substantive rule that has the force of law. Therefore, the FDIC need not follow the notice and comment procedures of the Administrative Procedure Act in preparing the Manual.

   [.25] Cease and Desist Orders—When Appropriate
   The FDIC may order a bank to cease and desist from an unsafe or unsound practice if it is established that the bank has engaged in such a practice on even a single occasion.

   [.26] Lending and Collection Policy and Procedures—Unsafe or Unsound Practices—Hazardous Lending
   Hazardous lending and lax collection practices constitute unsafe or unsound banking practices.

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   [.27] Lending and Collection Policy and Procedures—Unsafe or Unsound Practices—Borrowers Unable to Repay
   Extending credit without regard to the ability of the borrower to make repayment is an unsafe or unsound banking practice.

   [.28] Assets—Unsafe or Unsound Practices
   Failing to charge off non-bankable assets is an unsafe or unsound banking practice.

   [.29] Loan Loss Reserve—Unsafe or Unsound Practices
   Failure to maintain an adequate reserve for loan losses constitutes an unsafe or unsound banking practice. A loan loss reserve should be large enough to cover all loans classified "Loss" and one half of those loans classified "Doubtful."

   [.30] Lending and Collection Policy and Procedures—Unsafe or Unsound Practices—Failure to Charge-off Losses
   Although Substandard loans need not be charged off against current income, failure to include some provision for future losses generated by such loans is an unsafe or unsound banking practice.

   [.31] Definitions—Substandard Loan
   Substandard loans are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

   [.32] Capital—Adequacy—Time for Determination
   It is error to consider post-examination events in determining the bank's level of capital. Consideration of post-examination evidence can only result in a distorted picture of the bank's true condition.

   [.33] Capital—Adequacy—Capitalization Should Reflect Risk
   Perhaps the single most important factor in assessing the adequacy of a bank's capital is the quality, type, liquidity, and diversification of assets, with particular reference to assets adversely classified.

   [.34] Capital—Debt Capital—Debt to Equity Ratio
   A higher level of capital is required for those banks that have volatile deposit accounts, concentrations in the deposit structure, and rapid deposit growth unaccompanied by sufficient earnings retention.

   [.35] Liquidity—Unsafe or Unsound Practices
   Failure to maintain adequate liquidity is an unsafe or unsound banking practice.

   [.36] Cease and Desist Orders—FDIC Authority to Issue—State Remedies
   The authority of a federal banking agency to issue a cease and desist order supersedes the authority of state banking regulatory agencies if a conflict as to the appropriate remedy and its enforcement develops between the two. A federal order prevails over a conflicting order of a state agency.

   [.37] FDIC—Supervisory Functions
   The FDIC functions as a federal banking supervisory agency that examines and regulates banks that are insured state nonmember banks. The FDIC also functions, unlike a state chartering authority which may also examine and regulate banks, as an insurer of deposits in banks with a fiduciary duty and statutory responsibility to protect the federal deposit insurance fund from risk of loss.

   [.38] FDIC—State Banking Authorities—FDIC Not Bound
   The FDIC is not required to follow a state's remedy and may formulate its own remedy.

   [.39] Cease and Desist Orders—Defenses—Cessation of Violation
   It is well established that the abandonment or cessation of an unlawful practice or compliance with a proposed order does not deprive an agency of the right to secure enforcement or issue a cease and desist order.

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   [.40] Cease and Desist Orders—Affirmative Remedies—Unsafe or Unsound Practices
   The FDIC may issue a cease and desist order for violations of law and unsafe or unsound practices that are ongoing at the time of the issuance of the order and those which have already occurred or may occur in the future. There need not be violations of law or unsafe or unsound practices occurring at the moment of issuance of a cease and desist order.

   [.41] Cease and Desist Orders—Affirmative Remedies—Unsafe or Unsound Practices
   The objectives of a cease and desist order are twofold: to correct existing conditions and to prevent the recurrence of unsafe or unsound practices and violations of law in the future.

   [.42] Cease and Desist Orders—FDIC Authority to Issue
   Both Statutory and Case Law authorize the FDIC to order a bank to take affirmative action to correct violations of law and unsafe or unsound banking practices.

   [.43] Cease and Desist Orders—FDIC Authority to Issue
   The FDIC should be accorded special deference in its selection of remedies for violations of law and for unsafe or unsound practices, since the fashioning of remedies requires expertise and policy judgments regarding how to maintain a safe and sound banking system.

   [.44] Deposits—Brokered—Problems Associated
   The problems associated with brokered deposits include the following: they are very rate sensitive and extremely volatile; they tend to undermine market discipline; they often represent consistent and heavy borrowings to support unsound or rapid expansion of loan investment portfolios, and tend to extend artificially the life of poorly managed banks; and they are general short-term, highly volatile liabilities which are often used to fund long-term assets. This poses a risk of severe liquidity problems in the event that assets are not available to meet a sudden withdrawal by a deposit broker.

   [.45] Deposits—Brokered—Problems Associated
   An increased volume of brokered deposits representing over 25% of total deposits of a bank raises the specter of "abnormal risk of loss" to the bank should the level of brokered deposits continue or increase.

   [.46] Capital—Adequacy—Dividend Distribution
   Since the distribution of excessive dividends will have a direct effect on the bank's capital adequacy, the FDIC may prohibit the distribution of dividends to shareholders without prior approval.

   [.47] Prohibition, Removal, or Suspension—Liability—Breach of Fiduciary Duty
   The FDIC may remove directors whose actions are seriously damaging an insured institution. The FDIC may also prohibit directors from further participation in the affairs of the bank.

   [.48] Directors—Duties and Responsibilities—Standard of Care
   Directors who are responsible for violations of law and for unsafe or unsound banking practices have breached their fiduciary duties as directors of the bank.

   [.49] Directors—Duties and Responsibilities—Standard of Care—Fiduciary Duties
   Directors of a bank have a fiduciary duty to the bank. They must act as prudent and diligent persons would act to safeguard the bank's property, comply with state and federal banking statutes and regulations, and ensure that the bank is operated properly.

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   [.50] Directors—Duties and Responsibilities—Supervision of Lending Practices
   Directors of a bank are legally responsible to see that the business and assets of the bank are managed in a prudent manner.

In the Matter of * * * (INSURED
STATE NONMEMBER BANK), AND
* * * , * * * and * * * (Individually and
as Officers, Directors and/or as Persons
Participating in the Conduct of the Affairs
of * * * Bank, * * *.


FDIC-83-252b&c
FDIC-84-49b
FDIC-84-50e
(Consolidated Action)
DECISION OF BOARD OF
DIRECTORS

August 19, 1985

INTRODUCTION

   These proceedings arise under sections 8(b)(1), (c)(1), and (e)(1) of the Federal Deposit Insurance Act (the "Act"), 12 U.S.C. § 1818(b)(1), (c)(1), and (e)(1).
   On August 3, 1983, the Federal Deposit Insurance Corporation (the "FDIC" and "Proponent") issued a Notice of Charges and of Hearing (the "First Notice") against the * * *, * * * (the "Bank"), pursuant to section 8(b)(1) of the Act and to Part 308 of the FDIC Rules of Practice and Procedures (12 C.F.R. Part 308). The First Notice, based upon the results of the February 4, 1983 examination of the Bank by the FDIC, charged the Bank with engaging and having engaged in unsafe or unsound banking practices (in particular, hazardous lending and lax collection practices), and with committing and having committed violations of law.
   On November 22, 1983, the FDIC issued a second Notice of Charges and of Hearing (the "Second Notice") pursuant to section 8(b)(1), and a Temporary Order to Cease and Desist (the "Temporary Order") pursuant to section 8(c)(1). The Second Notice was based upon the preliminary findings of a second FDIC examination of the Bank, begun on September 30, 1983, but still under way as of November 22, 1983, and charged the Bank with having engaged in further unsafe and unsound banking practices, and with having committed further violations of law.
   On March 12, 1984, the FDIC issued a third Notice of Charges and of Hearing (the "Third Notice") against the Bank, pursuant to section 8(b)(1) of the Act. The charges in the Third Notice were similar to those in the First Notice, except that the FDIC alleged that the conditions complained of in the First Notice had worsened, e.g., the volume of adversely-classified loans had substantially increased. Also on March 12, 1984, the FDIC issued a Notice of Intention to Remove from Office and to Prohibit from Further Participation (the "Removal Notice") against * * * , director and chairman of the board of the Bank; * * * , director and president of the Bank; and * * * , director and executive vice president of the Bank (hereinafter referred to collectively as "the * * *" or "the Respondents"). The Removal Notice charged the Respondents, in their capacities as officers and directors of the Bank, with engaging in unsafe or unsound banking practices, violations of laws and regulations, or breaches of their fiduciary duties evidencing a willful or continuing disregard for the safety and soundness of the Bank. The Removal Notice also alleged that the Bank had or probably would sustain substantial financial loss or other damage as a result of the Respondents' conduct. The Removal Notice was based upon findings of both the September 30, 1983 FDIC examination and the February 4, 1983 FDIC examination.
   On March 26, 1984, the FDIC issued an Amended Notice of Charges and of Hearing (the "Amended Third Notice") against the Bank, as well as an Amended Notice of Intention to Remove from Office and to Prohibit from Further Participation (the "Amended Removal Notice") against the Respondents. The amended notices were intended to correct technical matters.
   A pre-hearing conference was held on March 27, 1984. Following the pre-hearing conference, on April 10, 1984, Administrative Law Judge Alan W. Heifetz (the "ALJ") issued an Order directing consolidation of the actions initiated by the First, Second, Third, and Amended Third Notices and the Removal and Amended Re- {{4-1-90 p.A-486}}moval Notices. Hearing of the consolidated actions was to be limited to the allegations of the Second Notice, the Amended Third Notice, and the Amended Removal Notice.¹ The FDIC withdrew the First Notice on April 23, 1984.
   A formal hearing was held on the consolidated charges from June 11 to July 11, 1984, in * * *. The ALJ issued his Initial Decision (hereinafter, the "Recommended Decision") on November 20, 1984. The FDIC, the Bank, and the individual Respondents all submitted exceptions to the Recommended Decision. Pursuant to Orders of February 4 and February 25, 1985 of the FDIC's Board of Directors (the "Board"), each side also submitted a brief in response to the other side's exceptions to the Recommended Decision. The record closed and the matter was certified to the Board of Directors of the Federal Deposit Insurance Corporation on March 19, 1985. On May 23, 1985, the Board set aside the notice of certification, pursuant to Section 308.18(a) of the FDIC's Rules and Regulations (12 C.F.R. § 308.18(a)), reopened the record and remanded the matter to the ALJ for a further hearing to take testimony and evidence on the issue of violations by Respondents of the Temporary Order. The supplemental hearing was held on June 19, 1985, the ALJ submitted his supplemental recommended decision ("SRD") on July 15, 1985, and the parties filed exceptions to the SRD on July 25, 1985. The record closed and the matter was again certified to the Board of Directors on July 30, 1985.

STATEMENT OF THE CASE²

   The Bank is a state chartered commercial bank, which is not a member of the Federal Reserve System. Its one office is located in * * *. The Bank's deposits are insured up to $100,000 by the FDIC, which has the federal regulatory responsibility for the Bank (12 U.S.C. § 1811 et seq.). Bank was first organized in 1972 and acquired by the * * * family in May 1978. Since acquiring control of Bank, * * * and * * * have each served as officers and directors of the Bank through the time of the hearing. (RD at 5, 7-8; PFF 1.1, 2.1, 2.5; RPFF 0.0 - 0.1, 0.4, 1.1, 2.1 - 2.5)
   In November 1982, the State of * * * conducted an examination of the Bank. That examination resulted in the Bank being assigned by the FDIC a CAMEL³ rating of 3. (Tr. 2203) However, that examination was very abbreviated in that it was conducted only over a two-week time period. The examiners were limited by instructions from their superiors to review only large lines of credit, past-due loans, and loans to officers and directors of the Bank. (Tr. 2204, 4880-81) Furthermore, the state's examiner-in-charge of the November 1982 examination testified that he "didn't feel real confident" about the results of that examination. (Tr. 4882-83)

   (1) * * * and related interests;
   (2) * * *;
   (3) * * * and related interests; and
   (4) The * * * group and related interests.

   1. approval from Bank's board of directors was required for all loans greater than $250,000;
   2. overdrafts were to be limited to $5,000 per account or $20,000 per borrower;
   3. no additional extensions of credit were permitted to borrowers with loans classified loss or doubtful without State approval;
   4. no further credit extensions to any borrower with a classified loan unless all interest due was paid in cash, additional collateral was obtained or an independent guarantee of the loan was obtained;
   5. Bank was to adopt a new comprehensive loan policy including additional control mechanisms;
   6. total deposits were to be reduced to $100 million or less within 90 days, no increase was permitted without prior State approval or attainment by the Bank of a 6.5 percent capital to deposits ratio;
   7. submit a monthly report to the State of Bank's loan to deposit ratio and the daily report of condition for the last day of the month;
   8. maintain a loan to deposit ratio of 70 percent;
   9. reduce brokered deposits to 10 percent of total deposits within 45 days and maintain them at that level and file a report with the State every 30 days setting forth all brokered deposits in excess of 5 percent of total deposits;
   10. inject $2 million in new capital within 30 days and additional $1 million within 270 days;
   11. * * * was required to resign as president, and from all operating committees of the Bank, and to relinquish all lending authority within 5 days;
   12. Bank was required to employ a qualified new president and chief operating officer but no other senior officers without prior State approval;
   13. Bank was required to file with the State within 30 days, a plan for the reduction of statutory violations cited in the State's September 30, 1983 examination and to make no further loans in violation of federal or state law; and
   14. after 6 months, Bank was required to place all loans classified doubtful on which no principal or interest payments had been received in non-accrual status and to initiate legal enforcement proceedings on such loans.

STATUTORY AUTHORITY

   [.2—.3] The statutory scheme established by the Congress in the Federal Deposit Insurance Act, as amended, provides a comprehensive system of federal regulation of banks. The FDIC role is to oversee the system of deposit insurance, "the primary function of which is `stabilizing or promoting the stability of banks.'" First State Bank of Hudson County v. United States, 599 F.2d 558, 562 (3d Cir. 1979), affirming 471 F.Supp. 33 (D.N.J. 1978).⁹ As such, the FDIC is responsible for the protection of the insurance fund against undue risk of loss. One of the principal supervisory tools to achieve that end is the bank examination, which seeks to identify practices that could result in losses to banks and ultimately, perhaps, claims against the insurance fund. First State Bank of Hudson County, 471 F. Supp. at 35. The primary vehicle available to the FDIC, as well as the Comptroller of the Currency and the Federal Reserve System, to implement its supervisory powers is the authority to issue and enforce cease and desist orders to stop current and to prevent future unsafe or unsound practices and violations of laws, rules and regulations pursuant to Section 8 of the Act, 12 U.S.C. § 1818. First National Bank of Scotia v. United States, 530 F. Supp. 162, 166 (D.D.C. 1982).

   [.4] Section 8(b)(1) of the Act, 12 U.S.C. § 1818(b)(1), provides, in pertinent part:

   If, in the opinion of the appropriate Federal banking agency, any insured bank...is engaging or has engaged...in an unsafe or unsound practice in conducting the business of such bank, or is violating or has violated...a law, rule, or regulation...the agency may issue...
   . a notice of charges in respect thereof.
* * *

   .... 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 charges has been established, the agency may issue...
   . an order to cease and desist from any such violation or practice. Such order may...require the bank...to cease and desist from the same, and, further, to take affirmative action to correct the conditions resulting from any such violation or practice.

   [.5—.6] Once the appropriate federal banking agency has found that a bank has engaged or is engaging in unsafe or unsound practices, or violating or has violated a statute, rule or regulation, the agency has broad discretion to exercise its expertise in fashioning appropriate relief to halt the practices or violations, to prevent future such abuses and to correct the effects of the practices or violations. First National Bank of Bellaire v. Comptroller of the Currency, 697 F.2d 674, 680 (5th Cir. 1983); del Junco v. Conover, 682 F.2d 1338, 1340 (9th Cir. 1982), cert. denied, 459 U.S. 1146 (1983); Groos, 573 F.2d at 897. The Board and the other federal banking agencies have determined that there are certain practices which

LOAN CLASSIFICATIONS

   A threshold issue which assumed singular importance in the ALJ's decision was the accuracy of the loan classifications¹⁸ contained in the FDIC's September 30, 1983 Report of Examination of the Bank. Bank examiners for the FDIC classify loans with some defined risk of nonrepayment as "substandard", "doubtful" or "loss", with loans classified "loss" representing the greatest risk.¹⁹ The ALJ disagreed with a number of the FDIC examiners' loan classifications, and essentially conducted his own "examination" of the Bank, assigning to each loan the classification which he deemed appropriate. For reasons which follow, the Board finds that (1) the ALJ erred in re-examining the Bank and assigning his own loan classifications; and (2) based upon the objective record, the classifications that the ALJ assigned to a number of the loans are erroneous.
   The ALJ devoted a great deal of attention to the factors involved in the classification process, and made an attempt at arriving at his own conclusions regarding the appropriate classifications in this case. The results of the ALJ's efforts, however, graphically demonstrate the dangers of "second-guessing" the expert judgments of those entrusted with loan classification responsibilities on a full-time basis —commissioned bank examiners. In the September 30, 1983 examination conducted by the state of * * * , the state's commissioned examiners classified a total of $30,438,000 of the Banks assets. The FDIC's classifications in its September 30, 1983 examination report totaled $32,246,000. The state of * * * examination report of May 18, 1984 concluded that the Bank's classified assets had grown to $33,375,00. The ALJ's independent analysis of the bank's assets as of the September 30, 1983 examination led him to conclude that the state of * * * examiners and the FDIC examiners should only have classified assets in the amount of $18,614,300. (See Table IV, RD at 78) The ALJ's "de novo" review of the loan classifications at issue required him to find that three teams of experienced bank examiners from two separate bank regulatory agencies each made a mistake of almost 12 million dollars in arriving at their loan classifications.²⁰ The gross disparity between the to-

   [.9] After ascertaining the relevant facts, the examiner then applies his expertise and training to those facts to reach certain conclusions about the likelihood of a particular loan being repaid. It is with respect to this second step, where certain expert inferences and judgments are made, that the ALJ is required to defer to the examiner's expertise in reviewing the examiners' classification conclusions. The ALJ may not substitute his own subjective judgment for that of the examiner, but may set aside the classification if it is without objective factual basis or is shown to be arbitrary and capricious. The Board finds that in many cases the ALJ failed to meet either of these tests.²²

B. The ALJ's Rejection of the Examiners' Classifications Was Not Supported By Sufficient Evidence in the Record

   It should be noted that, with respect to loan classifications, none of the FDIC examiners taking part in the September examination were simply equivalent to "any other `expert' witness testifying in this matter", as the ALJ suggested. (RD at 35) The FDIC examination team spent 3,074 hours in a detailed examination of the Bank's assets. (Tr. 628) * * * , the FDIC examiner-in-charge of the September examination, had participated in approximately 500 bank examinations, and had served as examiner-in-charge of over 150 of those examinations. (Tr. 979-80) The other five examiners from the September examination who testified at the hearing in this matter had collectively participated in over 1650 bank examinations, and had served as examiner-in-charge on over 515 of those bank examinations.²³
   Of the loan lines which these examiners classified during the September examination, the Bank contested 106 adverse classifications. Of these 106 disputed classifications, the ALJ rejected the fdic examiners' conclusions with respect to 75 loan lines. Even this extraordinary number of reclassifications would not necessarily be cause for alarm if the ALJ had rejected the examiners' conclusions based upon persuasive testimony by disinterested experts with background, training and experience in bank

   [.10] Mr. * * * apparently does not believe that there are any major differences between performing an accounting audit and conducting a safety and soundness examination. (Tr. 4657) Perhaps if he were better acquainted with the functions performed by a commissioned bank examiner he would have a greater understanding of the very fundamental differences.³¹ Accounting procedures are almost totally unrelated to the functions performed by a commissioned bank examiner conducting a safety or soundness examination.
   The commissioned bank examiner evaluates the bank's capital adequacy, asset quality, management, liquidity position, and earnings capacity. (R.Ex. 1, Basic Examination Concepts and Guidelines, p. 1) "An appraisal of lending and collection policies, the bank's adherence thereto, and the evaluation of individual loans are among the most important aspects of the examination process." (R.Ex. 1, § A, p. 1)³² Although both a certified public accountant conducting an audit of the bank and a commissioned bank examiner conducting a safety and soundness examination may be concerned about the bank's internal controls, as detailed in section N of the Manual of Examination Policies ("Manual"), (see supra, note 32), the certified public accountant's function is primarily limited to auditing the bank's controls, while internal controls play a different role in the bank examiner's assessment of the bank's safety and soundness.

   [.11] Accountants do not have any training or experience assessing a bank's overall safety or soundness and do not assign classifications to individuals loans. Bank accountants may ensure that the figures relating to the bank's financial position are accurately stated in the bank's books and records, but they do not assess the significance of those figures for the bank's safety and soundness.

   Accordingly, the Board gives little weight to Mr. * * * testimony, to the extent that it consists of his personal opinion about those functions ordinarily performed by a commissioned bank examiner conducting a safety and soundness examination. To the extent that Mr. * * * testimony is limited to

internal controls or other accounting procedures, his testimony is entitled to the same weight given to an expert accounting witness.
   It appears, then, that the ALJ overturned more than 70% of the disputed classifications made by the FDIC examination team as a result of the testimony of the Respondents, statements by a certified public accountant who has never classified a loan or conducted a safety or soundness examination, and the ALJ's own "re-examination" of the Bank.³³
The Board therefore concludes that the ALJ erred in not giving proper deference to the classifications of the examiners. In the Board's opinion, this was plain error and cannot be sustained.

   The ALJ points to the "subjective" nature of the loan classification process to support his disregard for the judgments of the commissioned bank examiners. The ALJ stated: "It is because of the highly subjective nature of the FDIC examination process, as opposed to the more rigorous, formalized and objective approach, detailed by the Comptroller of the Currency for example (Tr. 4573), that such close scrutiny is required." (RD at 36) The ALJ's conclusion that the Comptroller of the Currency's ("OCC") classifications are "objective" while the FDIC's are "subjective" is based solely upon CPA * * * statement that he believes that to be the case. (Tr. 4573) For reasons previously detailed, Mr. * * * has no experience which would qualify him to make authoritative pronouncements on the subject of safety and soundness examinations. The basis for his "expertise" in comparing the safety and soundness examinations of the OCC and the FDIC is similarly unclear. Mr. * * * states that he has "reviewed" the FDIC's Manual (Tr. 4572), although his apparent inability to locate an entire chapter on internal routines and controls in that Manual suggests that his review must have been rather cursory.³⁴ He has presumably read the few sentences of the OCC manual quoted during his testimony. It is virtually impossible, however, to ascertain which other portions of the OCC Manual he may have reviewed, as his comparisons of the two manuals generally consisted of broad generalizations unsupported by citation to any specific section of either manual. Furthermore, the ALJ would not have had an opportunity to evaluate the reliability of Mr. * * * representations, since no part of the OCC Manual was offered or admitted into evidence.
   Contrary to Mr. * * * suggestion that the OCC and the FDIC apply different standards, the record shows that both the OCC and the FDIC (as well as the Federal Reserve Board and the Conference of State Bank Supervisors) have adopted a uniform statement on classification of bank assets, which contains identical classification definitions. (See R.Ex. 1, § A, p. 12) Although the wording of the OCC and FDIC manuals (and perhaps even their methodology) may differ in some respects,³⁵ the Board finds no merit in the conclusion that the FDIC

D. The Majority of the ALJ's Asset Classifications Were Incorrect

   [.13] As the Board has already noted, the ALJ erred in substituting his judgment for that of the commissioned examiners with respect to the loan classifications.³⁸ Unless such classifications were shown to be arbitrary and capricious, or without factual basis, they should have been upheld. The Board finds, however, that even if the ALJ had been entitled to second-guess every loan classification, the majority of his "de novo" classifications were erroneous. Because the ALJ conducted a "de novo" review of each loan classification, the Board has found it necessary to do the same.
   As previously noted, Respondents contested 106 of the loan classifications assigned by the examiners.³⁹ Of these disputed classifications, the ALJ upheld only 31. (See RD at 43–46)⁴⁰ The Board has reviewed the evidence with respect to these 31 loans, and finds itself in agreement with the ALJ's conclusion that the classifications assigned should be upheld. The findings of fact relating to these loans,⁴¹ coupled with parts of the ALJ's footnotes addressing

   [.14] The Board has also upheld the ALJ's conclusion that the interest earned and not collected ("IENC") on several classified loans should not have been classified more severely than the underlying loan. The ALJ reclassified the IENC to correspond to his reclassifications of the underlying loans, except that he did not adversely classify any IENC that was reported by the Respondents as being paid prior to December 16, 1983. The ALJ did not find sufficient evidence that interest classified "Loss" on a "Substandard" loan was less likely to be collected than the principal loan balance.
   In sum, the Board agrees with the ALJ's determination that, based upon asset quality alone, there is insufficient evidence to support classifying IENC more severely than the underlying loan. However, on those loans on which the Board disagrees with the ALJ's reclassifications, the Board also disagrees with his IENC classifications. A comparative summary is shown below:

   There are, however, circumstances in which a bank may be required to charge off IENC even when the underlying loan has not been classified "Loss." There was abundant testimony in the record explaining that it is improper to accrue uncollected interest which is overdue for ninety days or more as income unless it is both well secured and in the process of collection. (See, e.g., Tr. 4799-4806) The ALJ's discussion of this rule (RD at 41), known as the "Call Report Standard", contains a number of inaccuracies. Nevertheless, the Board agrees that there is insufficient evidence in this record to require the Bank to charge off IENC as "Loss" based solely upon failure to follow call report standards.⁴⁴ The FDIC charged that IENC should be adversely classified "Loss" based on poor credit quality. Because the FDIC did not expressly charge the Bank with failure to follow Call Report Standards, and most of the evidence presented by both parties therefore focused on credit quality rather than the Bank's adherence

1. Collateral

   [.15-.16] Probably the most frequent mistake made by the ALJ was his over reliance on collateral. The FDIC Manual of Examination Policies explains the factors which must be considered in assessing the credit quality of a loan:

   Each loan is appraised on the basis of its own characteristics. Consideration is given to the risk involved in the project being financed; the nature and degree of collateral security; the character, capacity, financial responsibility, and record of the borrower; and the feasibility and probability of its orderly liquidation in accordance with specified terms. The willingness and ability of a debtor to perform as agreed remains the primary measure of the risk of the loan. This implies that the borrower must have earnings or liquid assets sufficient to meet interest payments and provide for reduction or liquidation of principal as agreed at a reasonable and foreseeable date. However, it does not mean that borrowers must at all times be in a position to liquidate their loans, for that would defeat the original purpose of extending credit.⁴⁷

   [.17] In several cases, the ALJ ignored the risk, acquisition costs and disposition costs of acquiring and marketing the collateral to be applied to the debt. (See, e.g., Series #107, * * * infra, p. 136; Series #90, * * * , infra, p. 126) By failing to take these factors into account, the ALJ often erroneously determined that collateral was sufficient to protect the Bank against risk of loss when it was not.⁴⁹
   In other instances, the ALJ gave little consideration to the Bank's established lien position. (See, e.g., Series #28, * * * infra, p. 70; Series #94, * * * , infra, p. 127; Series #99, * * * , infra, p. 130) Collateral which might be sufficient if the Bank had a first lien may be wholly inadequate if the Bank holds a third or fourth mortgage on the property.
   Finally, the ALJ placed undue emphasis upon collateral appraisals, some of which were of dubious quality and some of which were rebutted by other evidence in the record. In some instances, the appraisals were by interested parties. (See, e.g., Series #36, * * * , 1 infra, p. 81) In other cases, appraisals were made for the borrower rather than for the Bank. (See, e.g., Series #114, * * * , infra, p. 142) In either case, one could expect a more optimistic appraisal than would be obtained if the Bank had retained its own appraiser.
   In addition, the ALJ flatly refused to consider a commissioned examiner's valuation of collateral when it differed from that of an M.A.I. appraiser. (RD at 40; See, e.g., Series #35, * * * , infra, p. 79) Although bank examiners do not apply for M.A.I. certification, their duties do require them to independently assess the value of collateral pledged to secure a loan. (See R.Ex. 1, § A, p. 3)
   The Manual of Examination Policies explains one major reason why examiner evaluation of collateral is so vital:

   The potential sale price of a property may or may not be the same as its appraised value. The current potential sale price or liquidating value of the property is of primary importance and the appraised value is of secondary importance.
There may be little or no current demand for the property at its appraised value and it may have to be disposed of at a sacrifice value.

2. Performance

   The Manual of Examination Policies provides that a borrower's willingness and ability to perform as agreed is the primary measure of the credit quality of a loan. (R.Ex. 1, § A, p.11.) As previously noted, the ALJ did not generally place sufficient emphasis on performance in conducting his own "de novo" review of the disputed classifications. (See, e.g., Series #41, * * * , infra, p. 86) Furthermore, even when the ALJ did consider performance he frequently failed to consider the source of funds for payments and whether payments made upon lines of credit were truly indicative of the borrower's ability to service the debt. (See, e.g., Series #63, * * * , infra, p. 106)
   The ALJ frequently confused satisfactory debt performance with continual refinanc-

3. Credit Information

   [.18] The Manual of Examination Policies explains the importance of obtaining and properly evaluating pertinent credit information: "Failure of a bank's management to give proper attention to credit files makes sound credit judgment difficult if not impossible." (R.Ex. 1, §A, p. 9) The ALJ failed to appreciate the importance of adequate credit information, and in many instances failed to properly evaluate the credit information which was available.
   In several instances the ALJ relied too greatly upon self-stated net worths, and overlooked obvious misstatements as to liabilities and asset values. (See, e.g., Series #109, * * * , infra, p. 139) In other cases, the ALJ failed to consider omissions of income information or failed to assess the adequacy of stated income to support the borrower's debt load. (See, e.g., Series #96, * * * , infra, p. 129) In addition, the ALJ frequently failed to analyze the composition of net worth. (See, e.g., Series #37, * * * , infra, p. 82) Even a borrower with a large net worth may have difficulty making principal and interest payments as they become due if his net worth consists primarily of illiquid assets and very little cash. (Tr. 1548-49, 1656)
   Perhaps the most significant error of the ALJ was his conclusion that * * * Bank was a "* * * bank", and was therefore not required to meet the same standards applied to all other banks regulated by the FDIC. The Board unequivocally rejects the suggestion that the ethnic character of a bank has any bearing whatsoever on the safety and soundness standards which must be applied to that bank.
   The Board is unsure what the ALJ had in mind when he ruled that FDIC examiners were required to show "consideration and sensitivity" and "some degree of forbearance in reviewing [ * * * ] loans." (RD at 39–40) THe ALJ seems to imply that a * * * borrower's "reluctance to reveal all personal assets on financial statements" and "concern for family name and reputation" justify the absence of adequate collateral and net worth statements which demonstrate the borrower's ability to repay the loan.
   This surprising assertion is perhaps a product of the ALJ's misunderstanding about the requirements of prudent banking. The ALJ stated that examiners are required to show "consideration of, and sensitivity to those characteristics of * * * or * * *; banks which differ from those of other banks, yet which do not impair safety or soundness." (RD at 39—emphasis added) The ALJ fails to recognize, however, that the standards set forth in the Manual of Examination Policies do have a direct relationship to the safety and soundness of the bank. The FDIC has determined, as a result of fifty years of experience in regulating banks, that a handshake and a smile is no substitute for adequate collateral, demonstrated repayment ability, and complete and accurate credit information which fully documents a borrower's financial condition. The soundness of this determination was amply demonstrated by the volume of overdue loans held by the Bank during the September examination.
   The ALJ's suggestion that the FDIC Manual of Examination Policies requires, or even permits, ethnic exemptions from these requirements is baseless. The language quoted by the ALJ at RD 38–39, when read in context, refers merely to the content of a bank's written lending policy, and in fact contradicts the ALJ's suggestion that any group is exempt from providing reliable and complete credit information:

A bank's lending policy should not be a static document, but must be reviewed periodically and revised in light of changing circumstances surrounding the borrowing needs of the bank's customers as {{4-1-90 p.A-503}}well as changes that may occur within the bank itself. To a large extent, the economy of the community served by the bank dictates the composition of the loan account. The widely divergent circumstances of regional economies and the considerable variance in characteristics of individual loans preclude establishment of standard or universal lending policies. There are, however, certain broad areas of consideration and concern that should be addressed in the lending policies of all banks regardless of size or location. These include the following, as minimums:
   * * *
   (8) Maintenance and review of complete and current credit files on each borrower;. . . .

The banking laws, of which all citizens are no notice, regulate banks' conduct of business generally, and if bank customers have any interest in or expectation of doing business with a bank, that interest or expectation is subject to the Comptroller's [or in this instance the FDIC's] legitimate regulatory authority over the bank.

   [.19] In summary, the Board rejects the ALJ's suggestion that the FDIC examiners were required to "show some degree of forbearance" in classifying so-called "* * *" loans. All persons, regardless of ethnic or other affiliation, must conduct their banking affairs in accordance with the standards promulgated by the agency statutorily entrusted with protecting the safety and soundness of insured, state-chartered nonmember banks.

4. Post-Examination Events

   In several instances, the ALJ's decision to reject an examiner's classification was based at least in part on information which was not available to the examiner during the examination. It is clear, however, that a bank's financial condition may be accurately assessed only in the context of a complete examination conducted during a discrete time period. The FDIC cannot feasibly conduct continual examination of the Bank. (Tr. 2543-44) Subsequent payments do not necessarily mean a classification was wrong. (Tr. 2421-22) Fragments of new information selectively presented after the close of an examination may convey a limited, and extremely distorted picture of the bank's overall financial condition. Obviously, the Bank, which is the repository for such postexamination information, will present information most favorable to its position, i.e., information showing improvements, but has no incentive to present other information reflecting areas of deterioration. Accordingly, the Board finds that the ALJ erred in considering post-examination evidence in determining the accuracy of the examiners' loan classifications.

5. The Board's Classification Conclusions

   As previously noted, the ALJ's "re-examination" of the Bank has made it necessary for the Board to conduct its own "de novo" review of each individual loan classification. The Board's analysis of each disputed classification which was rejected, in whole {{4-1-90 p.A-504}}or in part, by the ALJ is set forth in the following individual "write-ups" of each such loan.⁵¹The name of each borrower is preceded by the "series number" of the FDIC's Proposed Findings of Fact, and the Bank's Responses thereto, which address that particular loan. Each write-up sets forth a summary of the classifications assigned to that loan by the FDIC in the February and September, 1983 examinations; by the State of * * * in the September, 1983 and May, 1984 examinations; the ALJ's classification conclusion; and the Board's classification conclusion. Each write-up then contains a brief explanation and summary of the Board's classification conclusions, followed by a more detailed discussion of the reasons for the Board's classification.

Loan Write-ups

   #15 * * *

SUMMARY

   The ALJ disagreed with the "Substandard" classifications assigned by the state of * * * and the FDIC. His conclusion was based on the presence of collateral, * * * "credit history with the Bank", and funds received from * * * Bank which were applied to this line.
   For reasons which have been explained in Section D.1. of the Board's decision, supra, the presence of collateral⁵⁴does not preclude assignment of an adverse classification where other indicia of risk are present. In the instant case the presence of such other factors supports the "Substandard" classifications assigned by the state of * * * and the FDIC. In addition, the ALJ is in error to the extent that he holds that the application of funds from * * * Bank provide a basis for not classifying this line. In fact, the portion of the debt repaid by the funds from * * * Bank was not classified by the FDIC examiners.
   Mr. * * * is also obligated for an additional $840,000 of debt as a guarantor for * * * Corporation and * * * which has also been classified substandard.

DISCUSSION

   The ALJ notes the borrower's credit history with the Bank, but fails to recognize that such credit history is quite poor with respect to the classified lines. A substantial portion ($466,000) of the amount classified was delinquent at both the February and the September FDIC examinations. The borrower's apparent inability to service the debt as agreed is demonstrated by several factors. Certain loans were repeatedly renewed without reduction of principal, and

SUMMARY
   The Board agrees with the Recommended Decision of the Administrative Law Judge to classify $500,000 of the debt substandard and to pass on $10,000.

DISCUSSION

   The ALJ agreed with the Substandard classification assigned to the $200,000 loan and the $300,000 loan. As he correctly noted, repayment of those loans is dependent upon the Nigerian government's approval of the transfer of dollars out of Nigeria. Such approval has not, thus far, been forthcoming.⁵⁶No payment of principal has ever been made on either loan, and each loan has been renewed twice. (P.Ex. 17) Because performance has been lacking in these lines, collateral is not readily available, and source of repayment is uncertain, the Board agrees with the ALJ's conclusion that $500,000 of * * * indebtedness to the Bank should be classified "Substandard." The ALJ also concluded that a $10,000 installment loan to * * * should not have been classified. The basis for this conclusion was the ALJ's determination that the loan was "adequately collateralized" by a 1981 Cadillac of indeterminate value. The Board upholds the ALJ's conclusion that the loan should not have been classified, but does not uphold his reasoning. As previously noted, the mere presence of collateral does not preclude an adverse classification where other indicia of risk are present. In the instant case, past performance and likely ability to repay, coupled with the presence of collateral, support the ALJ's conclusion that the loan should not be classified. The loan in question was originated on August 12, 1981 at $24,887, and by the close of the September 30, 1983 FDIC examination had been reduced to $11,925 ($10,039 payoff balance). This past performance, coupled with the borrower's apparent ability to service this rather insubstantial debt and the presence of collateral, lead the Board to conclude that $10,000 of the $510,000 originally scheduled as "Substandard" should not have been classified.⁵⁷

SUMMARY

   The Board determines that a "Substandard" classification is warranted due to the existence of only a nominal equity investment by the borrowers, the limited margin of collateral protection, the extremely lenient loan terms, and the absence of a financial statement on the borrowers.

DISCUSSION

   The loan represents the financing of the sale of previously foreclosed property in the name of * * * Inc. The latest appraisal indicates a property value of $75,000 as of March 24, 1983, although the purchase price for the townhouse unit was only $70,000 on September 23, 1983. Scheduled monthly payments do not even cover interest. The loan will increase to $73,755 at the end of a three-year term. The borrower has only a nominal equity investment due to a down payment of only $3,000, (PFF 21.5) The facts and exhibits cited in the FDIC's Brief of Exceptions (P. Exceptions at 41) support the assigned "Substandard" classification.

   * * * GROUP
   #22 * * * $32,000
   #23 * * * $874,000
   #24 * * * $29,000

SUMMARY

   The above three lines are direct and guaranteed debts of * * * and make up the " * * * Group".
   The Board classification is based on unsatisfactory performance and the poor financial condition of the companies which are the major investments of the borrower and collateral deficiencies. The original collateral on * * * and * * * was not sufficient to preclude adverse classification and the direct debt of * * * is entirely unsecured.
   Additional collateral obtained during the examination consisted of the contract rights on two acres of land on the Boardwalk in Atlantic City ("Boardwalk" property) which was not initially supported by a formal appraisal. The appraisal obtained subsequent to the examination, was on "hypothetical" property which raised the question as to the protection provided by the Contract Rights. The Boardwalk property was assigned to the debt of * * * Corporation and * * * Group in addition to the "* * * Group". Total debt of the two groups increased from $8,864,000 to $10,329,000 during the examination. The uncertain realizable value of the collateral coupled with unknowns regarding its ultimate development and disposition were deficiencies that evidenced risk and warranted the adverse classification.
   #22 * * *

DISCUSSION

   The line was comprised of two loans extended on an unsecured basis. No performance on the $27,500 loan occurred as interest was paid during the examination with a check on an overdrawn checking account of * * * , a related interest of the borrower. (P.Ex. 17 at 66) The remainder of the line was a $4,790 * * * Account which was overdue three payments. The financial condition of the borrower was questioned due to a concentration of assets in closely held businesses which were also adversely classified as part of the "* * * Group". Those interests included * * * and * * * Inc. The failure of the borrower to properly make interest payments or principal reductions caused concern for his ability to repay. The purpose of the $27,500 loan was to cover personal expenses and overdrafts which could have indicated cash flow problems. The ALJ's analysis of the borrower's financial capacity failed to note these facts.
   A more severe classification of the line would have been appropriate had the Bank not obtained additional collateral in the form of the Boardwalk property. However, collateral alone should not have been con-

DISCUSSION

   The ALJ states that a "Substandard" classification is unwarranted since the overdraft used to pay interest on the $815,000 loan was later covered and a "large amount of collateral was pledged" PFF 23.9 states the subject overdraft was covered at a later date. However, there is no indication that the overdraft was cleared during the time period covered by the examination and, in fact, the overdraft increased from $58,621 to $66,848 on December 6, 1983.
   In regard to the large amount of collateral, the Bank's appraisal dated January 18, 1983 indicates a value of $4,037,000. Liens known to exist against the property are the Bank's $815,000 mortgage and the $2,500,000 note payable to the parent company, * * *. This valuation would leave net equity of $722,000 in the property. However, consideration should have been given to the fact that the Bank was not receiving any principal reduction on its first mortgage note and the terms of the parent company note called for annual installments of $500,000 beginning 24 months from date of closing (October 31, 1981). (P.Ex. 17 at 67) The ALJ also seems to have failed to recognize that repayment of the debt was to come from land sales of the * * * property on which there was no supporting information to indicate that there had been sales in recent periods. Liquidation of the debt could not be accomplished without lot sales.
   The examiners recognized the added collateral protection gained from the Boardwalk property which prevented the assignment of a more severe classification to the line. Having recognized the protection of collateral obtained during the examination, the line nevertheless remained a nonperforming asset deserving extra attention.
   #24 * * *

DISCUSSION

   Exceptions and comments (pages 44 and 45) of the Brief of Exceptions of the Federal Deposit Insurance Corporation to the Recommended Decision of the ALJ adequately describes the rationale for the "Substandard" classification of the line. The ALJ did not adversely classify the line because of the existence of a financial statement and collateral that he deemed to be adequate. The Board finds that the financial statement is not actual but is projected, and that the purported values of assigned accounts receivable and inventory are not supported by the Bank. A more severe classification would have been assigned were it not for the assignment of the contract rights for the Boardwalk property.
   The loan was guaranteed by * * * whose loss classified loan was upheld by the ALJ. The collateral was a seventh mortgage on undeveloped property with an appraisal of $1,300,000. (P.Ex. 17 at 73) RPFF 28.6 indicates the vacant site has a value of $1,400,000 according to real estate brokers, * * * Associates (there is no indication that this was a formal appraisal). Plans for reorganization under Chapter XI of the bankruptcy laws (P.Ex. 17 at 75) indicated recovery through development of the property was highly contingent on a number of factors and at best was a long-term solution to debt liquidation. The ALJ's inconsistent classification of this line as "Doubtful," without explanation, while others related interests which rely on the same source of repayment were considered "Loss," does not appear warranted.
   #28 * * *

SUMMARY

   The company filed for Chapter XI bankruptcy. Guarantor * * * added no support due to his weak financial condition and his own loan classified "Loss," which was upheld by the ALJ. The collateral for the loan was a seventh mortgage on 2.6 acres of land for which development was necessary to realize value and obtain a possible recovery of the debt. Such a recovery was highly contingent on a number of factors, including the bankruptcy proceedings. The loan appeared to be of no better quality than related debt on which the ALJ justifiably upheld "Loss" classifications.
{{4-1-90 p.A-508}}
   #30 * * *

SUMMARY

   Numerous documentation deficiencies existed, repayment terms were liberal, and performance had been less than satisfactory as indicated by renewals and late payments. Nevertheless, monthly payments had been made for many months and cash flow appeared adequate to permit their continuation. The Board agrees with the ALJ's finding of Special Mention.

DISCUSSION

   Credit terms appear liberal, especially in regard to the automobile portion of the debt, and the loans contained numerous documentation deficiencies. The property statement of the borrower contained certain errors in preparation (P.Ex. 17 at 76) but it was self-prepared, which may account for these inconsistencies. The FDIC examiner did not appear to have given adequate weight to the payment history. Included in the classification is $5,000 which was a loan funded subsequent to the examination date. The borrower's cash flow appears sufficient to make scheduled installment payments.
   The structure of the line and support information leaves much to be desired. However, these items are the responsibility of the bank management and do not directly impact on the borrower's ability to repay. The ALJ's recommendation of Special Mention for this loan appears to be warranted.

SUMMARY

   Excluded from the above figures are five separate lines of credit totaling $1,257,000 on which the ALJ agreed to the "Substandard" classifications. The ALJ recommended Special Mention on all of the borrowers listed above except for * * * and * * * on which he recommended no classification. The Board entirely disagrees with the ALJ by upholding the "Substandard" classification on all borrowers except * * * who is considered Special Mention.
   The key factors for classification of the loans are a combination of uncertain collateral protection, poor performance, inadequate financial information, and speculative loan purposes and/or repayment sources.
   Weaknesses in the collateral protection included the lack of adequate documentation, inferior lien positions, inadequate equity, extensive litigation, inflated appraisals on real estate, appraisals by insiders, lack of appraisals, collateral consisting of stocks of closely-held companies, and the Boardwalk property which consisted of assigned contract rights on a "hypothetical" two acres of vacant improved property appraised at $15 million. Eventually realizing an amount approaching the appraised value was dependent on many factors as discussed under the * * * line. The Boardwalk property also secured the * * * Group, $935,000 of which was classified "Substandard".
   In regard to performance, the noted deficiencies included delinquent payments, slow repayment, payment from sources other than the original obligor, and providing additional funds to previously identified high credit risks (i.e., borrowers with previously classified loans).
   Financial information was entirely lacking in some instances or was not supported by operating statements (profit and loss information) in others. Financial information was also found to be stale (out of date) and {{4-1-90 p.A-509}}asset/liability information was not factually supported. In some instances, the financial statements did not contain a complete list of all the borrower's liabilities.
   Undesirable purposes identified for this group of loans included funds extended for payment of checking account overdrafts or interest payments on other loans. There are also examples cited of loan proceeds being used for purposes other than those stated on the loan documents.
   #32 * * *

DISCUSSION

   The ALJ recognizes that the line contains "unique circumstances" but believes a less severe treatment of the line is in order due to value of the collateral. Therefore, a difference of opinion appears to surround the protection provided by the collateral that is described as follows:
   (1) 320 acres of land in * * * carried on the borrower's books at a cost of $166,000. (PFF 32.6) RPFF 32.6 states that the value far exceeds the cost, but support for a higher value is not indicated. The December 31, 1981 10-K report of * * * indicates in the description of the sale of * * * , that the borrower received "approximately 320 acres of property with a market value of $160,000." (P.Ex. 17 at 67) Thus, the actual cost and the indicated market value are closely related according to facts contained in these documents.
   (2) 130-acre parcel of land in * * * , known as * * * and appraised by the Bank at $6,750,000. The bank is in a third-lien position although RPFF 32.7 (a) indicates the second mortgage has been assigned to the Bank (the assignment was obtained during April, 1984 and therefore has no relevance for classification purposes in the subject report). RPFF 32.8 indicates a "recent offer" of $4,000,000 cash for the property by the State of * * * under the * * * program. The ALJ also fails to recognize that the protection provided by this property is somewhat clouded by the fact that the first lien holder, * * * Bank of * * * , * * * has taken action to foreclose on the property due to the $1,600,000 first mortgage which is in default. (PFF 32.9) Equity available to the Bank may be far less than the appraisal would indicate.
   (3) Contract rights on two acres of real estate located on the Boardwalk in Atlantic City, New Jersey, known as the Boardwalk property. A hypothetical two acres on the Boardwalk was appraised at $15,000,000. (RPFF 32.36(a)) The appraisal by * * * Realty Company dated January 17, 1984 occurred after the examination was closed. Eventually obtaining title to an actual two acres worth $15,000,000 is dependent on the ability to actually acquire the property, develop it into a casino, and numerous other legal conditions precedent (such as obtaining liquor and gambling licenses). Nevertheless, the property rights appear potentially to have substantial value. The property is not only assigned to the entire * * * Group, but also, is assigned as collateral to the * * * , and * * * Group, Inc. loans.
   However, the ALJ has ignored the detracting factors regarding the collateral. The collateral bears little relationship to the original purpose of the credit extended. Repayment is now anticipated from sale or refinancing of that collateral. Extensive litigation relating to the collateral is involved which will at a minimum slow the ultimate repayment of much of the debt. "Substandard" classification is a generous evaluation by the examiners and can only be justified by the additional collateral obtained during the examination consisting of the contract rights to the Boardwalk property.
   #33 * * *

DISCUSSION

   The ALJ apparently reclassified the line based on (1) additional collateral obtained in the form of the Boardwalk property valued at $15 million,⁵⁸(2) the fact that the debt was not classified prior to the February 1983 examination, and (3) improvement in the financial condition of the company.
   Classification of the debt in prior examination reports has no relevance to the facts or circumstances in the September 30, 1983 examination report.
   Finally, as to improvement in the financial condition of the borrower, the record contains no facts to indicate any such im-

DISCUSSION

   The company is part of the "* * * Group". The ALJ based reclassification as Special Mention on (1) collateral of 50 shares representing 100% of the stock of * * * Investment Company and assignment of two notes of $500,000 each from * * * respectively, (2) at the time of the extension of credit, * * * directed $3,000,000 in deposits to the Bank; and (3) hypothecation of the Atlantic City Boardwalk property worth $15 million.
   Collateral consisting of 750,000 shares of * * * Class A Common Stock worth $562,500 on the examination date was released during the examination. The ownership of the stock of * * * Company was in litigation and was carried in the * * *'s statement as of December 31, 1982 as "equity in net assets of former subsidiaries transferred under contractual agreements". (P.Ex 17 at 84, 93) The assignment of the two notes of the insiders also provided little support since * * * Corporation was also considered a weak credit.
   The deposits directed to the Bank by * * * were escrow funds and were later withdrawn by the trustees of the escrowed deposits. The Boardwalk property contract rights were discussed in connection with the * * * Corporation loans, supra. Were it not for the consideration given to the Boardwalk property, a "Loss" classification for the line would have been appropriate. The extension of an additional $400,000 to the line during the examination period is an indication of the poor judgment by the Bank's management.
   #35 * * *

DISCUSSION

   The ALJ took exception to the assigned classification based on the added protection of the contract rights to the Boardwalk property obtained at the conclusion of the examination and the $600,000 equity value in the * * * restaurant property. (RPFF 35.5(a) and 35.19) However, the ALJ failed to recognize:

(a) The Bank was in fifth position on the restaurant property with prior liens totaling $296,121 which, based on payments made from borrower's account during the examination, were believed to be in arrears.
   (b) The restaurant was not in operation and an on-site inspection by the examiner during the examination raised doubt as to the validity of the $900,000 appraised value for the property. (RPFF 35.5(a))
   (c) Additional funds of $200,000 extended during the examination for construction of improvements on the property were used instead to clear an overdraft and pay off outstanding judgments in order to obtain the Boardwalk property rights.
   (d) The line was nonperforming, collateral was a fifth lien position on nonearning real estate and the debt increased during the examination.
   (e) The protection gained from the Boardwalk property was uncertain since it covered all of the * * * group debt, as well as, the debt of * * * and related interests.

DISCUSSION

   The ALJ exception to the assigned classification was based on land valued on November 26, 1982 at $3.5 million consisting of approximately 2,600 acres of timberland (RPFF 36.3(a)) and contract rights to the $15 million Atlantic City Boardwalk property which was acquired during the examination. (RPFF 36.21)
{{4-1-90 p.A-511}}
   The debt was secured by a note receivable from * * * Corporation and assignment of a first mortgage on 2,600 acres of unimproved timber land in * * *. Proceeds of the loan were for the stated purpose of clearing a bankruptcy petition for * * * Corporation. However, Bank records indicate that the funds were credited to the account of * * * Corporation and it was uncertain how the bankruptcy claims were settled. The appraisal dated November 26, 1982 by * * * , was not properly considered an independent appraisal due to the relationship of its control shareholder, * * * , with the * * * Corporation which in turned owned * * * Corporation. The appraisal indicated $900,000 in timber value and $2,600,000 in land value for a total of $3,500,000. On a cost basis, * * * Corporation carries 4,400 acres of unimproved land at $1,197,000 on their property statement dated December 31, 1982. That appraisal values the land at $1,346 per acre as opposed to a cost of only $272 per acre. Since none of the proposed site improvements had been made by the date of the examination, the "market value" appraisal was considered to be inflated. The protection gained from the contract rights to the Boardwalk property were discussed in connection with the * * * Corporation line, and provided the only basis for the less severe classification of "Substandard".
   Other relevant factors which the ALJ failed to consider in the classification included (1) the line was nonperforming and delinquent according to the terms of the note, (2) the proceeds were not used for the purpose stated in the "Loan Instruction and Approval" sheet (P.Ex. 17 at 96), and (3) proper inclusion of the debt in the company's property statement dated February 28, 1983, would have resulted in insolvency of the borrower.
   #37 * * *

DISCUSSION

   The ALJ based his Special Mention on (1) collateral of 1,290 acres of land in * * * appraised on November 26, 1982 by * * * (RPFF 37.2(a)), (2) financial information on * * * Land and Timber Corporation which purchased the property and assumed the debt (RPFF 37.8(a)), and (3) additional security provided by the Boardwalk property. The FDIC examiners, who classified the debt "Substandard", indicated there was no appraisal in the Bank's file, documentation was not adequate to determine the number of acres involved, and the Bank's loan files did not contain financial information on the * * * , Land and Timber Corporation, although such information was requested from the Bank's management during the examination. (P.Ex. 17 at 98)
   Respondents' Exhibit 37.2 contains an appraisal on 1,290 acres of unimproved land in * * * by * * * (which is controlled by * * * , a borrower whose loans were also classified) dated November 26, 1982. The appraisal states, in part, ". . .the current Fair Market Value of this subject property as of November 26, 1982 is as follows: * * * 1290 acres @ $700/acre = $2,000,000". As can be seen, the calculations of the appraisal are incorrect (1,290 × $700 = $903,000). In regard to the property statement ("PS") dated October 15, 1983 on * * * Corporation, also part of Respondents' Exhibit 37.6 * * * purchased the property for $1,500,000, giving * * * Land Corporation a $250,000 purchase money mortgage. The * * * indicates a net worth of $505,000, including capital stock of $5,000 and a valuation surplus of $500,000. If the * * * were to utilize the appraisal value of $700 per acre, the land and timber would be valued at $903,000 and the company would actually show a deficit shareholders' equity of $592,000. It may be reasonably concluded that (a) the statements and/or appraisal are in error, in which case the documentation does not support the line, or (b) the * * * is correct, in which case, the borrower is heavily leveraged with only $5,000 of capital paid into a company with debt of $1,500,000. In addition, the notes to the financial statement which indicated that the timber would be cleared, christmas trees planted, and christmas tree farms sold at $5,000 per acre with a sellout time of less than 18 months, appeared to be highly speculative. Finally, the value assigned the Boardwalk property, discussed under the * * * Corporation line, is the only factor that prevents the line from being assigned a "Doubtful" classification.
   #38 * * *

DISCUSSION

   The ALJ based his classification on (1) interest payments of approximately {{4-1-90 p.A-512}}$17,000 received on the debt (RPFF 38.3), (2) the Bank holding title insurance in the amount of $250,000 (RPFF 38.4(a)), (3) a financial statement of the borrower that indicated a net worth of almost $2.5 million (RPFF 38.4(b)), (4) the assignment of collateral to this originally unsecured debt consisting of two lots in * * * and the contract rights on the Boardwalk property (RPFF 38.10(a)), and (5) the conflicting content of the examination report regarding the classification of the loan. (RPFF 38.12))
   Whether the property assigned as collateral was worth $75,000 as indicated by the borrower's financial statement (P.Ex. 17 at 98 and 99) or $250,000 as indicated by the title policy, the Bank had no margin of equity above the amount of the debt. Respondents' Exhibit 38.3 indicates that interest in the amount of $21,590 was paid on the debt during 1982, however, there had been no principal payments and the debt was extended without payment of interest on November 8, 1982. The title insurance policy referred to in RPFF 38.4(a) does not represent an appraisal value for the property and should not be construed as such. In addition, the policy was to * * * Bank, as insured, for the interest of * * * (R.Ex. 38.3) and refers to a mortgage dated July 7, 1982, recorded July 8, 1982, on block 317, lot 2, also known as * * *. The Bank's mortgage covers Block 88, lots 78 and 79 at the same location. It would appear the title policy referred to in Respondents' Exhibit 38.3 does not cover the same property. In regard to the substantial net worth of the borrower as set forth in the property statement dated June 30, 1983 (P.Ex. 17 at 99), the assets are concentrated in illiquid real estate. The lack of principal reduction on the debt and a renewal of the loan without interest payments, indicated a lack of capacity to properly service the obligation. The support gained by the real estate security and the Boardwalk property contract rights did not indicate a "risk free" asset. (See discussion of the Boardwalk property under * * * Corporation.) Finally, the conflicting information in the examination only pertains to the payment of interest during 1982.
   #39 * * *

DISCUSSION

   Brief of Exceptions of FDIC to Recommend Decision of ALJ adequately sets forth the basis for the assigned classification (at pages 55 and 56). In essence, the loan was seriously overdue since the borrower did not make the April 30, 1982 quarterly principal payment. The $800,000 appraisal on a house and farm held as collateral was not considered independent since the appraiser, * * * , had other financial dealings with the borrowers. Added collateral consisting of contract rights on the Boardwalk property has undeterminable realizable value and lacks liquidity. Without the existing collateral, a "Loss" classification would have been justified.
   #41 * * *

DISCUSSION

   The rationale for the ALJ's decision to pass the line was discussed in Brief of Exceptions of FDIC to Recommended Decision of ALJ (at pages 56 and 57).
   The debt represents a portion of an installment loan which originated August 27, 1982 in the amount of $264,928 ($198,297 net of unearned interest). (PFF 41.3) The Bank claimed that no payments were made for ten months due to a "computer error". This would seem to indicate poor internal operations at the Bank at best, but does not excuse the borrower for not making the scheduled $3,500 per month payments as required by the note.
   Upon discovery of the "computer problem" the Bank converted the debt to a commercial loan during the February examination (PFF 41.5), then on July 5, 1983, the debt was split with $67,368 going to the original obligor and $130,000 placed in the name of an affiliate, * * *. The examination report (P.Ex. 17 at 100) indicated that the reason for the split was that * * * held title to the accounts receivable, inventory, furniture, fixtures and shipment that was pledged as collateral for the note.
   The facts disclosed a great deal of activity in the account since its origination, both on the part of the obligor and with respect to the collateral pledged. However, the activity did not include reduction in the debt as originally agreed upon. The existence of a computer error provides no legitimate excuse. Of greater importance was (1) the Property Statement of the debtor dated February 23, 1983 which shows a highly leveraged position with no support for collectability of the accounts receivable, (2) interest and principal payments on the original debt having been minimal, (3) the PS of {{4-1-90 p.A-513}}* * * dated July 31, 1982 (P.Ex. 17 at 101) also being weak. Assignment of contract rights to the Boardwalk property was the only basis for assignment of the less severe "Substandard" classification.
   #42 * * *

DISCUSSION

   The ALJ's reasons for not classifying the line are set forth and discussed in the Brief of Exceptions of FDIC to Recommended Decision of ALJ (at page 58).
   The origination of this debt is described in the comments for affiliate * * *. The line was set up on an amortization schedule of $1,000 per month plus interest with the balance due at the end of one year. Had this schedule been met the principal would have been reduced from the original $130,000 to $118,000. Terms thus appeared to be somewhat lenient. Since the borrower only made the first two payments on the loan and no other payments were forthcoming during the remainder of the examination period, satisfactory performance could not be substantiated. (P.Ex. 17 at 101) The "loan instructions and approval" sheets indicated that the loan was secured by sound equipment with a value of $545,000. (PFF 42.4) The Bank in RPFF 42.4 refers to an equipment list that was in its loan file (R.Ex. 42.2). All that exhibit, however, shows a listing of equipment dated October 6, 1981 provided by the borrower. It would appear to be sheer speculation to assume that the equipment listed as of October 6, 1981 would remain static in view of the nature of the business (one which undergoes rapid technological changes) through the July 5, 1983 loan debt, without some factual support.
   The company's earnings record was certainly not supported by the property statement dated July 31, 1981 and was further suspect considering the lack of regular payments on the note. Although the value of the collateral may have previously supported the debt, documentation was too outdated to be reliable. The added protection gained from the Boardwalk property is discussed with respect to the * * * debt. Only this added support prevented a more severe classification at the time of the examination.
   #46 * * *

DISCUSSION

   The ALJ based his decision not to classify the debt on the fact that the contract rights to the Boardwalk property were assigned to the debt on December 9, 1983 and RPFF 46.3, 46.3(a), 46.6, 46.7(a), 46.8. RPFF 46.3 and 46.3(a) indicate collateral consisting of * * * option to purchase 100,000 shares of * * * common stock at $0.50 per share. During the preceding year that stock had traded between $1 and $1.50 per share establishing a minimum value of the collateral of $50,000 to $75,000.
   RPFF 46.6 details the borrower's financial statement as of February 28, 1982. Apparently the ALJ meant to refer to RPFF 46.6(a), which sets out a more current financial statement as of April 30, 1983 that the Bank claims was available to the examiners in the * * * credit file. RPFF 46.7(a) states that the borrower was not classified prior to the February, 1983 report when the loan balance was higher and credit information was less favorable. RPFF 46.8 references the additional collateral obtained during the September examination in the form of the Boardwalk property, previously discussed.
   Respondents' Exhibit 46.4 is a letter dated March 10, 1982 indicating * * * is the owner of options to purchase 100,000 shares of * * * stock at $0.50 per share and acknowledges assignment to the Bank. The exhibit also contains a pledge agreement dated November 26, 1979, signed by the borrower and his spouse indicating a pledge of options to purchase 50,000 shares of * * * common stock. Thus, there seems to be some question as to the actual number of options to purchase that are pledged on the debt, but if the lower number of 50,000 is used then RPFF 46.3(a) would be correct in the minimum value of $50,000 to $75,000 at a trading price of $1 to $1.50 per share. However, based on the poor financial condition of * * * (P.Ex. 17 at 79-90) the marketability of the options or shares to a disinterested informed purchaser would appear unlikely. The ALJ failed to recognize the financial difficulties of the company in valuing the pledged collateral and the limited liquidity which would make it difficult to sell the shares or options.
{{4-1-90 p.A-514}}
   Respondents' Exhibit 46.4 also contains a financial statement on * * * dated April 30, 1983 (signed September 27, 1983) which indicated assets of $3,710,000, liabilities of $140,000 and net worth of $3,570,000. (RPFF 46.6(a)) The major asset in the April 30, 1983 statement was securities comprised of 1,170,000 shares and options of * * * with a net market value of $2,569,000. This would indicate that * * * values the stock and options at $2.20 per share. The ALJ failed to analyze the statement which he uses as a basis for support of the line. There is no explanation given in the financial statements as to how * * * was able to increase his assets of $535,000 as of February 28, 1982 to $3,710,000 as of April 30, 1983, while total liabilities declined from $187,000 to $140,000 during the same period since his only known source of income was an annual salary of $100,000 as president of * * * (PFF 46.6 and RPFF 46.6(a)) These questions needed resolutions before any reliance could be placed upon * * * "substantial net worth" to support the debt.
   The support provided by the additional collateral of the Boardwalk property was discussed in the * * * Corporation line (PFF 32 Series) and was the only basis for not assigning a more severe classification.
   #48 * * *

DISCUSSION

   The ALJ based his decision not to classify the debt on the fact that the contract rights to the Boardwalk property were assigned to the debt of December 9, 1983 and RPFF 48.9 and Respondents' Exhibit 48.10. RPFF 48.9 indicated that the classification was unwarranted based on the financial information in the credit file, the collateral value of the automobile and the additional support from the Boardwalk property. Respondents' Exhibit 48.10 is a credit report on the borrowers dated November 10, 1982. The financial statement on * * * dated March 15, 1982 was set out in PFF 48.5. That statement indicated a substantial net worth of $799,500, based on a $750,000 concentration of assets in * * * common and preferred stock and stock options. The * * * stock options represented $600,000 of the total net worth. In addition, the liabilities were admitted to be understated. (RPFF 48.6) The examiner's conclusion that the statement reflected an illiquid position (P.Ex. 17 at 106) was justified. A 1981 Jaguar automobile secured an installment note with a net payoff of $16,066, but the remainder of the line was unsecured until the Boardwalk property rights were hypothecated to secure the line.
   The credit report (R.Ex. 48.10) indicated an excellent credit rating as of a year earlier. However, that report only covered consumer debt with a Visa and MasterCard with $1,600 limits each being the largest credit extension. The report would not provide support for the extension of $32,000 on an unsecured basis.
   Without the security of the Boardwalk property, a classification of "Doubtful" on the unsecured portion of the line would have been justified.
   #49 * * *

DISCUSSION

   The ALJ based his decision not to classified the debt on the fact that the rights to the Boardwalk property were assigned to the debt on December 9, 1983 and PFF 49.2. PFF 49.2 indicated the debt is an installment loan in the original amount of $33,175, payable in 23 monthly installments of $400 each and a final balloon payment of $23,957 on March 5, 1984. As of September 30, 1983, the loan was paid ahead with the next installment due January 5, 1984. Collateral for the loan was a 1981 Jaguar automobile.
   The examiner does not indicate if the borrower was making the regular monthly payments or if they are being made by * * * who paid off the borrower's $10,161 * * * Account debt on March 25, 1983. In addition, the value of the 1981 Jaguar was not stated.
   The line does not appear to be properly structured as most institutions would not extend credit for a used automobile beyond 48 months or 60 months for a new one. The terms of this note with the final balloon payment did indicate monthly payments that are too small to significantly reduce principal.
   However, the examination of report comments were too incomplete to determine many of the significant credit factors, and therefore, the "Substandard" classification cannot be substantiated. The unusual circumstances involved, however, do warrant a Special Mention designation.
{{4-1-90 p.A-515}}
   #50 * * *

DISCUSSION

   The debt represented the balance of the borrower's * * * Account #35-930-8 which was an overdraft line of credit with a maximum credit limit of $10,000. (R.Ex. 50.2) The Bank's records indicated that the account was overdue for four payments on the date of the examination. (P.Ex. 17 at 106) Under the FDIC's policy of uniform classification of consumer loans, open-end consumer installment credit delinquent 90 to 179 days (4 to 6 zero billing cycles) is to be classified "Substandard". (R.Ex. 1, §A, page 15) Facts presented in the examination report do not indicate a situation where an exception to the policy would be warranted.
   #51 * * *

SUMMARY

   The ALJ agreed with the FDIC's classification except for the borrower's overdrawn checking account which was classified as "Loss." The Board believes the "Loss" classification was not justified in that past overdrafts had been properly paid and the credit-worthiness of the guarantor was sufficient to protect against any future loss.

DISCUSSION

   The ALJ stated that there was no justification offered for classification of a portion of this line as loss. (See PFF 51.1 - 51.25 and RPFF 51.25(b)) RPFF 51.25(b) indicates that * * * and her family were well known to senior management of * * * Bank and the character of the borrower and her family was a major consideration for making this loan with the knowledge that it would be repaid without undue delay.
   While there may be circumstances where an unsecured portion of a line, such as an overdraft, may receive a more severe classification than a secured portion, the examination comments do not support the classification of "Loss". The examiner indicated that $100,000 of the line was reworked during the examination but that portion did not include the overdraft that had increased to $10,972 on November 30, 1983. However, the account had numerous overdrafts in the past, the largest being $19,065 on March 7, 1983. (PFF 17 at 110) Since past overdrafts had been paid there is no indication that the overdraft on the date of the examination was uncollectable.
   #54 * * *

DISCUSSION

   The amount classified represents the net payoff balance of two installment loans. A lien was held on a 1981 Mercedes 280 CD automobile with a cost of $24,000. One part of the line was consumer debt and could have passed upon the uniform policy for classification of consumer loans. The Board agrees with the ALJ that the collateral held was sufficient to preclude adverse classification for this loan.
   #55 * * *

SUMMARY

   The ALJ eliminated $155,000 of loss classification based on the overdrawn checking account being paid during the examination, and reduced the remaining loss classification to "Substandard" based on collateral consisting of the Boardwalk property and financial support of a third party after the conclusion of the examination. The Board agrees with the examiner's classification of "Loss" based on the overdrawn status of the borrower's checking account (at even higher levels) at the conclusion of the examination, the inability of the bor- {{4-1-90 p.A-516}}rower's or guarantor's financial position to support unsecured credit and the absence of a perfected lien on any collateral.

DISCUSSION

   The ALJ takes exception to the "Loss" classification based on RPFF 55.24 which indicates the amount classified should have been $775,000 "Substandard" instead of $930,000 "Loss" because a $155,156 overdraft was cleared during the examination. Additionally, the bank claims the line was secured by the Boardwalk property as a result of a transaction by which * * * obtained an interest in the * * *. While it is true that $155,156 overdraft was paid after a deposit of $200,000 on October 4, 1983, the account reverted back to an overdraft that even increased to $175,306 as of November 30, 1983. Thus, at the time the examiner was writing his comments, the Bank had actually more exposure than the amount on the examination date. The unsatisfactory method in which the account had been handled (including an average year to date overdraft balance of $97,279) (P.Ex. 17 at 117), justified the inclusion of the overdrawn checking account in the borrower's classified line.
   * * * was subject to an adverse classification and added no support to this line. Protection provided by the contract rights to the Boardwalk property was discussed in the * * * line. However, the examination report did not address this added protection since the additional documentation received by the examiners on December 15 and 16, 1983 did not mention a pledge of Boardwalk contract rights against * * * debt. Therefore, "Loss" was a proper classification based on the information made available to the examiners.
   Financial information does not support unsecured credit in the amount involved. (P.Ex. 17 at 118) The additional information provided the examiners on December 15, 1983 in the form of an unrecorded assignment of a hotel lease, which was later amended but not reassigned, added no support without profitability statements for the hotel. (P.Ex. 17 at 131) The growing debt of * * * , at the Bank and the continuing overdraft is evidence that the company was unprofitable and essentially operating from debt funding.
   #57 * * *

DISCUSSION

   The ALJ reduced this classification to "Substandard" based on the Bank's acquiring rights to Boardwalk property collateral after the conclusion of the examination. The FDIC based it's "Loss" classification on the borrower's inability to pay and the worthlessness of the originally pledged collateral. The Board agrees with the "Loss" classification in that the additional collateral was acquired after the examination was closed. If the examiners have been informed by the Bank of the assignment of the contract rights to the Boardwalk property as collateral prior to the close of the examination, the line may properly have been reclassified as "Substandard".
   #58 * * *

SUMMARY

   This line of credit was to enable the borrower to fund loans it extended to minority businesses who were awaiting settlement on direct loans from the Small Business Administration ("SBA"). Corresponding minority business notes and unrecorded collateral in favor of * * * were assigned to the Bank as collateral for this line of credit. The borrower's financial position was inadequate to support this credit and orderly payment was dependent upon SBA payment and/or the minority business performance on the assigned notes. The line had never been reduced and more than a third of the assigned notes were more than a year old. In addition, the examiners reported that many of the loan proceeds were never channeled to the corresponding minority businesses. The ALJ reduced his classifica- {{4-1-90 p.A-517}}tion to "Substandard" based on eventual SBA funding with some collateral deficiencies. The Board believes the collateral deficiencies to be of major proportion and that any SBA funding forthcoming would be far short of the loan balance. It therefore agrees with the "Doubtful" classification assigned.

DISCUSSION

   The ALJ based his "Substandard" classification on the delay of the borrower's funding sources from the SBA and some collateral deficiencies. (Tr. 4623-26; and RPFF 58.8(a)). RPFF 58.8(a)(new) stated that loans to * * * were principally for operating capital for purposes of funding loans pursuant to commitments to minority business enterprises, while * * * awaited funding from the SBA.
   The Report of Examination (P.Ex. 17 at 121) indicated that the purpose of the $950M loan was a warehousing line of credit to assist in carrying receivables while awaiting funding from SBA, with repayment expected from assignment of SBA funds and/or payments from loans pledged. (P.Ex. 17 at 121) The examiner did extensive tracing of the loan proceeds and found the following: $150,000 of the proceeds went to renew a note of that amount dated April 7, 1983, (the original note proceeds were paid to * * * also an interest of * * * with loans classified loss), $596,475 went to the ultimate benefit of * * * of * * * by way of a $300,000 extension to * * * and $300,000 to * * * , and $200,000 was deposited into an account of the borrower indicating "escrow for * * * State Bank" with ultimate disposition not determined. (P.Ex. 17 at 124) Eleven loan notes were assigned to the Bank as collateral. The original dates of the notes ranged from July, 1981, to June, 1983. Only one, the note dated April 27, 1983 in the amount of $300,000 to * * * , directly resulted from the warehousing loan. The stale dates on many of the notes raised questions as to the existence of actual SBA commitments to fund the loans. In addition, the examiner pointed out that the total face value of the assigned notes was $906,000 which did not cover the $950,000, advance. Payment terms set out in the assigned notes should have reduced the balances outstanding on the notes, since payment of this debt was to be from SBA funds and/or payments of the loan pledged. (P.Ex. 17 at 126) There was insufficient information to determine if the pledged notes were current or if * * * had used the loan payments for other purposes.
   Documentation, financial information and repayment history on the assigned notes was insufficient to determine the value of the underlying collateral. However, it was known that a loan to * * * was classified substandard (PFF 51 Series) and the loan to Mr. * * * , was past due. (P.Ex. 17 at 133)
   The certified financial statement, dated December 31, 1982, for * * * showed a significant corporate net worth; however, that net worth was entirely composed of * * * investments and notes receivable from these minority small businesses. Profitability of * * * and its retained earnings had been minimal as of the date of examination. (P.Ex. 17 at 136)
   Due to the preponderance of "unknown factors" involved in the line and the nebulous financial condition of the borrower, a doubtful classification was appropriate. The line clearly had greater risk potential than a "Substandard" classified asset.

   #61 * * *

SUMMARY

   The ALJ did not classify this line because he did not accept the examiners' assessment of the appraisal of the collateral and because the financial statements of the borrowers showed a very liquid position. The Board completely disagrees on both points. The $650,000 appraised value of the dwelling was $200,000 more than the previous appraisal. Considering the nature of the property, a 44% appreciation in only two and one-half years was considered unrealistic, especially since only $180,000 in fire insurance was carried on the property. The September 30, 1982 balance sheet showed $230,000 in cash but either that figure was inaccurate or the borrower's liquidity position had deteriorated since that date because the loan was delinquent from February 6, 1983.

{{4-1-90 p.A-518}}

DISCUSSION

   The ALJ based his conclusion not to classify the line on RPFF 61.10 and Tr. 3901-4, 4631-33. RPFF 61.10 indicated that the examiners had second-guessed the fee appraiser and also that the financial statements of * * * showed a very liquid position.
   The amount classified was the sum of two separate extensions of credit that were jointly secured by a first mortgage agreement that was modified to increase it to $500,000. The loan file contained an October 22, 1980 appraisal running to the borrower of $450,000 for the dwelling only (80% completed at the time). The Bank obtained an updated appraisal of March 13, 1983 that reflected a value of $650,000 (but it did not provide any breakdown between the land and the dwelling). The file also contained an expired (as of July 14, 1983) fire insurance policy on the dwelling for a value of $180,000. A self-prepared financial statement of the borrower dated September 30, 1982 (P.Ex. 17 at 136) listed the mortgaged property at a value of $400,000. The FDIC examiners believed these documents supported inconsistent valuations for the property. The history of the property indicated that it would have appreciated in value by $200,000, or 44%, in only two and one-half years. The examiners believed that the wide disparity in the available information as to the value of the mortgaged property and the rapid appreciation reflected in the documents raised concerns about the actual value. In an effort to obtain additional insight into the proper valuation for the mortgaged property, the examiners physically viewed it and the neighborhood in which it was located in a "drive-by." The examiners concluded after the drive-by that the $650,000 valuation was high and therefore the loans were only marginally collateralized. The report of examination reflects that the examiner's concerns were discussed with Bank officials who agreed to provide additional evidence as to the value of the mortgaged property (a current fire insurance policy). However, no further documentation was provided.
   The borrower's financial condition is discussed in Brief of Exceptions of FDIC to Recommended Decision of ALJ (at pages 63–64). The borrower's property statement ("PS") reflected a highly leveraged position. The ALJ failed to recognize that despite the large cash position displayed in the PS dated September 30, 1982, the $230,000 loan had been delinquent since February 6, 1983, and that an interest payment made during the examination of $11,168 was traced to an account in the name of * * * Corporation in which Mr. * * * reportedly has no interest. Based on the facts available to the examiners during the examination, the Board finds that the "Substandard" classification was warranted.

   #62 * * *

DISCUSSION

   The Board agrees with the ALJ that an adverse classification of this small consumer loan is not warranted. The loan is only one payment delinquent and would not be classified under to the policy governing the uniform classification of consumer debt. The borrower is the son of * * * who have $268,000 of "Substandard" classified debt, but that relationship does not justify adverse classification of this loan.

   #63 * * *

SUMMARY

   The ALJ decided not to classify any of this debt because (1) at the conclusion of the examination the Bank obtained new collateral consisting of a first mortgage on marina property appraised at $900,000; (2) the borrower's loans declined from $823,000 at the February 1983 examination to $433,000; and (3) the borrower's balance sheet showed acceptable liquidity and net worth. The Board disagrees with the ALJ's conclusions. First, numerous documentation deficiencies undermine the credibility of the support provided by the collateral, which according to a preliminary analysis had an estimated value of $850,000 to $900,000, but that value is necessarily subject to a formal appraisal. Second, the loan reduction came from transferring debt to * * * Corporation, a related company that {{4-1-90 A-519}}also has adversely classified loans, not from a cash payment. Third, a careful analysis of all available financial statements reveals inconsistencies between statements, a highly illiquid current position and troubling questions concerning net worth. However, the Board does not find support in the record to justify classifying the $3,000 overdraft more severely than the rest of the debt.

DISCUSSION

   The ALJ's decision not to classify the line was based on RPFF 63.11(a)(new) which indicates that the Bank obtained additional collateral in the form of a first lien on a marina facility appraised at $900,000; and RPFF 63.18(a)(new) which states that the borrower had loans outstanding of $823,000 as of the February, 1983 examination that were reduced to approximately $433,000 by the September, 1983 examination; and RPFF 63.19 which indicates that in addition to the added security, the borrower's current balance sheet showed acceptable liquidity and net worth. The ALJ also references the hearing transcript at pages 4629-31 and Respondents' Exhibit 63.1. The record shows that the FDIC examiners gave considerable deference to the assignment of a $425,000 unrecorded mortgage note of * * * to * * * , since the line had originally been considered $105,000 "Substandard" and $328,000 "Loss." However, documentation deficiencies were noted and cited by the examiners in regard to the note assignment. (P.Ex. 17 at 140) In addition, there was no loan supporting credit information on * * * in the loan file and the mortgage note was also assigned to secure a $300,000 note from * * * that in turn was assigned to secure the $950,000 debt of * * * Corporation at the Bank. (P.Ex. 17 at 122) The line was classified in the amount of $420,000 at the February, 1983 examination when total indebtedness was $823,065. While it is true that the balance at the September, 1983 examination of $433,000 shows significant reduction, the ALJ failed to recognize that the two $150,000 notes were not paid out, but taken over by * * * Corporation (an interest of Mr. * * *) and were part of the $950,0000 extension in the name of * * * (P.Ex. 17 at 122) In fact, the examiner pointed out that the * * * account was overdrawn in the amount of $475,188 the day before * * * received a $600,000 advance from * * * (P.Ex. 17 at 124) Therefore, rather than receiving a reduction in the line, as claimed by the Bank, the debt was merely transferred to another related company of the guarantor, * * *.
   Finally, the ALJ relied on the Bank's judgment that the current property statement as of September 30, 1983, obtained on December 15, 1983, showed acceptable liquidity and net worth. The PS showed cash of $15,000 in relation to total assets of $1,395,000 (P.Ex. 17 at 141); the accounts receivable from * * * and * * * in the amounts of $425,000 and $650,000, respectively, were not considered current assets for purposes of analysis; therefore, the liquidity position of the company was far from acceptable. In addition, the self-prepared statement had no additional factual support for the two receivables which represented $1,075,000 of total assets; therefore, the stated net worth of the company could not be considered acceptable. In addition, the examiner found that there was considerable change in the asset structure and liability mix from the CPA-prepared statement dated March 31, 1982 (Id.). Without profit and loss information on the company and additional information on the changes in the company statement, the figures were meaningless for purposes of analysis.
   There does not appear to be ample support provided in the Report of Examination or the record for treatment of the unsecured * * * overdraft of $3,000 as loss. Therefore, the Board finds that the entire line should have been afforded a "Substandard" classification.

   #64 * * *

SUMMARY

   The ALJ disallowed an $18,000 "Loss" classification on the portion of the loan that represented unpaid interest included in the loan balance because of the value of the collateral securing the loan. The Board agrees that the collateral appears adequate enough to substantiate a "Substandard" classification.

{{4-1-90 p.A-520}}
DISCUSSION

   The ALJ agreed with the "Substandard" classification based upon the lack of working capital and the slow turnover of receivables, but took exception to classification of the capitalized interest as loss because of the collateral pledged as security.
   The line was secured with company accounts receivable, inventory and equipment. The property statement as of July 31, 1983 (P.Ex. 17 at 143) indicated that the major value was in the inventory, property, plant and equipment. While these assets had a lower collateral value than trade receivables of similar amounts, the line would have been adequately secured, assuming that the inventory and equipment could be sold. The examiner's classification of the capitalized interest as "Loss" actually appears to be an accounting adjustment rather than a credit classification. Although the practice of capitalizing interest could be deemed an unsafe and unsound banking practice due to the increased exposure to the Bank in the event of default, normal procedure would be to classify the interest no worse than the most severe classification of the remainder of the debt. The Board upholds the ALJ's classification.

   #65 * * *

SUMMARY

   The ALJ rejected the "Loss" classification on the $39,000 portion of the debt that constituted unpaid interest. The Board agrees with the ALJ's treatment of the entire debt as "Substandard" since the estimated liquidation value of the collateral appears sufficient to preclude a "Loss" classification.

DISCUSSION

   The amount of the loan classified "Loss" represented the amount of interest that had been capitalized and added to the loan balance for both * * * and * * *. The two companies were related and both debts were guaranteed by * * * and * * *.
   The Bank believed the ultimate collection of the line would come from foreclosure on the real property and the sale of gems held as collateral. The portion classified as "Loss" represented an accounting adjustment rather than a credit judgment. While it would have been prudent for the Bank to have placed the line on non-accrual status and not included the interest in its income, the classification of the portion of the total debt which was used to pay interest in a more severe manner than the remainder of the line was not supported by the record.

   #70 * * *

SUMMARY

   The examiner classified as "Substandard" the $199,000 portion of the loan that constituted loan proceeds paid to the borrower. The $46,000 portion of the loan comprised of unpaid interest and a loan extension fee was classified "Loss". The examiner based the split classification on collateral consisting of second mortgages on two properties with combined equity of $158,000, an amount inadequate to protect the entire debt, and the undesirable and objectionable banking practice of including in its income the uncollected extension fee and interest on the loan. The ALJ classified as "Substandard" the entire $245,000 balance because of poor payment performance. The Board agrees with the ALJ because the degree of non-performance was sufficient to justify a "Substandard" classification.

DISCUSSION

   The Report of Examination (at page 153) indicated that a substantial amount of interest was capitalized and that the letter of credit extension fee was also capitalized. The value of the collateral serving the loan was not sufficient to cover the capitalized interest and fees and that amount was classified "Loss" in order to adjust the Bank's income for these amounts included but not collected in cash. The ALJ stated that a "Substandard" classification was justified by the past performance on the debt. However, the ALJ felt the "Loss" classification of $46,000 for the capitalization of interest was not justified and was in reality a punitive measure. While the Board does not agree that the "Loss" classification was a {{4-1-90 p.A-521}}"punitive measure" the classification does appear to be an accounting adjustment rather than based on a credit judgment.
   The examiner stated (P.Ex. 17 at 153) that the line was not sufficiently protected by assigned collateral. However, he also noted that there had been some performance on the loan noted in the form of a $120M principal reduction during the February, 1983 examination that led him to classify the unsecured portion of the line as "Substandard". The capitalized interest was part of the unsecured portion of the line and should not have been treated as being a greater risk than the remainder of the unsecured portion of the line.

   #75 * * *

SUMMARY

   The examiner classified $7,000 "Substandard" due to the questionable source of six payments made on September 22, 1983. The ALJ did not classify and the Board agrees. The loan was current and appeared to be secured by the title to an automobile.

DISCUSSION

   The balance classified represented the net payoff of an installment loan secured by a 1983 Toyota station wagon with a purchase price of $13,600. Six payments had been made, bringing the loan to a current status on September 22, 1983 (prior to examination date). The payments came from the checking account of * * *. The examiner apparently had some question as to whether the company was the same as the company which was the source of the payments. The line of * * * was not classified (although originally scheduled as "Substandard") due to the repayment of their $1,200,000 line with proceeds from * * * Company. The $7,000 automobile loan was current and appears adequately secured. Therefore, the "Substandard" classification does not appear justified.

   #76 * * *

SUMMARY

   The ALJ did not classify this debt because of a $150,000 note assigned as collateral, the borrower's satisfactory performance on other loans and his payment history on this loan which originated at $100,000. The examiner classified $70,000 "Substandard" partially because the assigned note from * * * had little, if any, collateral value as a result of the maker's weak financial statement and also because of * * *'s questionable financial strength substantially linked to the same company. The Board agrees with the ALJ not to classify since substantial performance had occurred and there appeared to be sufficient cash flow to permit servicing of the debt.

DISCUSSION

   The loan originated at $100,000 on April 7, 1983 and was renewed in the amount of $75,000 on August 5, 1983. The renewal note called for monthly payments of $5,000 plus interest with the first payment due October 5, 1983. The first payment was made during the examination and thus the balance classified was $70,000. RPFF 76.8(new) indicated that the line had been further reduced to a balance of $65,000. The value of the note assigned to the debt by * * * from the * * * in the amount of $150,000 may have had limited, if any, value based on the February 28, 1983 financial statement of the company. It was further noted that the financial strength of * * * was also highly dependent on the strength of the company since $1,000,000 of his own assets were in notes receivable and investment in that company, amounting to half of his net worth. (P.Ex. 17 at 160)
   Even though the financial strength of the company, and therefore the collateral note, was weak as depicted in the financial statements, the borrower had made significant reductions since the original date of April 7, 1983 and payments continued during the examination. There was no indication that the borrower was utilizing other borrowed {{4-1-90 p.A-522}}funds to pay the debt and it appeared that he had sufficient cash flow to service the required monthly amortization. The Board agrees with the ALJ in this instance.

   #77 * * *

SUMMARY

   The ALJ rejected the FDIC's classification because the borrower had a net worth of $7 million. The Board agrees with the examiner's $30,000 "Substandard" classification. The only reduction in the debt since its inception was from the sale of collateral leaving the remaining unpaid portion of the loan totally unsecured. Analysis of * * *'s balance sheet revealed questionable support since his major assets were in receivables and shares of closely held companies that also have loans from the Bank which are classified "Substandard".

DISCUSSION

   The loan was unsecured as a result of the sale of stock of * * * Corporation which had been held as collateral. The payment from the sale of the collateral was the only reduction in the debt since its inception. The ALJ stated that the "Substandard" classification was not warranted since the borrower had a net worth of $7 million. (PFF 77.15) In order properly to analyze the financial information the ALJ should have gone one more step and looked at the assets that represented the major portion of that $7 million net worth. In the case of Mr. * * * the major assets on his property statement dated July 1, 1983 (P.Ex. 17 at 162) were receivables and stocks of closely held companies, i.e. * * *; * * * (wholly-owned subsidiary of * * *) and * * * Each of those companies also had adversely classified loans which indicated a higher than normal degree of risk in these investments.
   The line should be considered "Substandard" until such time as the borrower demonstrates an ability to make reductions on the debt through normal operations or provides sufficient collateral to protect the Bank. Sale of the collateral was considered the exhaustion of a secondary source of repayment leaving a deficiency balance that was void of collateral protection.

   #78 * * *

   The ALJ did not classify this loan because automobiles pledged as collateral were valued at $40,000 and a guarantor with a net worth exceeding $7 million. The examiner classified $40,000 "Substandard" because one automobile was confiscated by the IRS leaving an estimated residual value in the remaining two automobiles of approximately $20,000. The borrower's performance had been unsatisfactory and its financial condition was weak. Loans to guarantor * * * were also classified "Substandard". The Board finds the "Substanddard" classifications to be justified.

   #79 * * *

SUMMARY

   The ALJ did not classify this line of credit because of the existence of adequate collateral. The examiner classified $180,000 "Substandard" because the collateral lacked liquidity, the company was financially weak and loan repayment terms were not extremely liberal. The Board agrees with the "Substandard" classification.

DISCUSSION

   The debt was part of the "* * * Group" and comments in regard to * * * and * * * (PFF 77 and 78 Series) also relate to * * *. The loan lacked a proper repayment schedule, the company was financially weak when analyzed in conjunction with * * *, and collateral value was limited by the lack of an existing market for it. P. Exceptions (at 72-73) adequately discuss the credit weaknesses and we will not restate them here. Those weaknesses fully support the "Substandard" classification.

{{4-1-90 p.A-523}}
   #83 * * *

SUMMARY

   The examiner assigned a "Loss" classification to the amount representing interest which was not substantiated by credit considerations. The ALJ classified the entire debt "Substandard based on collateral protection. The Board agrees with the ALJ because the examiner gave credit for purported additional collateral that is not formally pledged to the debt. Even so, realizable equity in both the primary and purported additional collateral may be less than the amount of the debt. This, coupled with documentation deficiencies and unsatisfactory performance, indicates a high risk loan.

DISCUSSION

   The "Loss" classification assigned by the examiner to the $42,000 portion of the line used to pay (capitalize) interest was in reality an accounting adjustment rather than a credit quality judgment. However, the inability of the borrower to adequately service the debt was a significant credit factor.
   The ALJ was of the view that the line was adequately collateralized. The primary collateral was a second lien position in a condominium unit with equity of $56,000. In order to realize this value, the prior lien of $219,000 and interest would have to be paid out. The Bank refers to the existence of additional collateral consisting of real estate at * * *. However, it was difficult to justify use of that property as collateral since * * * , its owner, was not personally liable on the * * * debt and the property was not pledged to the debt. In addition, the property had a prior lien with a pay-off balance of $118,933 (RPFF 83.7) and the reappraisal by * * * on June 1, 1981 (P.Ex. 17 at 171) at $300,000 was considered to be inflated. The $120,000 increase in appraised value over the original appraisal dated March, 1979, represented an extraordinary 66% increase in the appraised value in slightly over two years. A classification more severe than "Substandard" was averted only by taking into consideration the purported additional collateral.

   #85 * * *

SUMMARY

   The examiner classified as "Loss" the $35,000 portion of the line representing unpaid interest. Adding interest to debt principal in an undesirable banking practice but the "Loss" classification was not substantiated by the credit information presented. The Board agrees with the ALJ's finding of "Substandard for the entire $86,000 debt.

DISCUSSION

   The amount classified "Loss" represented the capitalization of interest on the lines of * * * and * * *. While this practice is considered to be undesirable, the classification was in reality an accounting adjustment rather than a credit quality judgment. The classification comments did not indicate evidence that the portion of the line used to cover the interest due had any greater exposure than the remainder.

   #86 * * *

   There was disagreement only as to the $8,000 * * * overdraft portion of the line; the examiner classified the overdraft "Loss" while the ALJ classified it "Substandard." The remainder of the line was secured by real estate but the overdraft portion is totally unsecured and overdue from June 1981. It is not a bankable asset and that fact was ultimately recognized by the Bank which charged it off in April 1984. The Board agrees with the examiner that $8,000 should be classified "Loss" and the remainder "Substandard."

{{4-1-90 p.A-524}}
   #89 * * *

SUMMARY

   This debt included $100,000 extended to pay off a loan from another bank and $359,000 to purchase, renovate and pay the interest and the loan fees for commercial property. No principal reductions were ever made. The collateral held was a real estate sales contract of questionable value and a mortgage covering the purchased property which was appraised at $530,000. The Bank's mortgage lien status was questionable. The guarantors' net worths were highly suspect based on inflated asset values and questionable asset interests. A "Substandard" classification was warranted based on the absence of interest and principal payments on the loan, the uncertainty surrounding the value of the collateral, limited financial support available from the guarantors and the uncertain prospects for future loan payments.

DISCUSSION

   This classification concerned two separate lines to the same borrower. A $100,000 loan was originally extended in May 1983, to pay off another bank. An expired real estate sales contract was assigned as collateral and the debt was guaranteed by * * *. (P.Ex. 17 at 177) A similar contract with a different buyer and a February 15, 1984 expiration date was acquired near the close of the examination. However, that contract was not properly assigned to the Bank. (PFF 89.3) By letter dated December 13, 1983, the Bank's attorney indicated he had documents showing that the Bank's interests were fully protected. The ALJ declassified the loan based on the sufficiency of the collateral and the * * * guaranty. (RPFF 89.12) The Board is of the opinion that a "Substandard" classification was totally justified by (1) the questionable performance of the sales contract dated December 12, 1983, and (2) the guarantors' obviously inflated net worth of $3,100,000. (P.Ex. 17 at 177)
   The second portion of this line concerned two notes totaling $359,000 used to purchase and renovate an apartment. A $400,000 real estate mortgage on property appraised at $530,000 was held as collateral. However, a title search predating the recording of the mortgage disclosed over $150,000 in prior tax liens. The Bank's present lien status was unknown. The Bank also held a note of * * * and * * * as additional collateral. (P.Ex. 17 at 177-178)
   The ALJ declassified these loans based on purported December 16, 1983, pay out. (Tr. 3915; R.Ex. 89.1) The pay out date was supported by a handwritten Loan Payment Card (R.Ex. 89.1) but questions are raised by the * * * testimony that the pay off occurred on the day before the examiners left the Bank (Tr. 3915) and Examiner * * * testimony that "I believe it was reduced $100,000, I'm not sure of the date." (Tr. 1317) Since the FDIC examiners had given substantial credit for collateral received the last day of the examination in the case of other loans (See, e.g., * * * , Series #94 through #103), it appears the examiners were not presented with bona fide evidence of pay out before they left the Bank.
   A "Substandard" classification of the $359,000 was also warranted based on (1) the questionable lien status of the real estate collateral, (2) the existence of prior tax liens (although later negated by P.Ex. 89.8), and (3) the limited value of the note of Mrs. * * * and * * * as collateral. Although not discussed by the examiners, the $7,273,000 net worth shown on the December 12, 1982 financial statement of Mr. and Mrs. * * * had limited value since Mr. * * * was not liable on the collateral note. (PFF 89.7; RPFF 89.7) The Brief of Exceptions, page 76, addresses only the pay out of the second portion as ". . . after the conclusions of the examination date."
   The subsequent pay off of the loan has no bearing on the validity of the "Substandard" classification as of the close of the examination.

   #90 * * *

{{4-1-90 p.A-525}}

SUMMARY

   The debt was a $4,500 deficiency balance remaining after the sale of collateral, and a $99,200 note collateralized by a junior mortgage lien on the borrower's residence on which the first lien holder was in the process of foreclosing. The classification was based on a March 1983 real estate appraisal, from which prior lien balances and the costs of liquidating the collateral were deducted. A new appraisal received in the last days of the examination reflected an inordinate amount of appreciation which was believed not to accurately reflect the likely market conditions in the event of a forced liquidation sale.

DISCUSSION

   This line consisted of a junior lien on real estate and a deficiency balance on an auto loan. The ALJ reduced the "Loss" classification to include only the deficiency balance, after taking into account the new $150,000 real estate appraisal dated December 12, 1983. (R.Ex. 90.4) The new appraisal was received one day before the examiners left the Bank. The 20% appreciation in the value of the property reflected in the new appraisal over the appraisal six months earlier on March 18, 1983, raised questions as to the accuracy of the new appraisal. The examiner's position that "[s]ince this property is being foreclosed the market will determine the actual value of the Bank's junior lien mortgage . . ." was reasonable. The FDIC alleged that the ALJ failed to consider the prior liens and the acquisition and the inherent costs involved in liquidating the collateral in determining his classification.

   #94 * * *

   The ALJ declined to accept the examiners' "Substandard" classification of the loan stating that the "borrower has cash in excess of the loan balance and the loan is well collateralized." The Board finds that the evidence does not support either conclusion.
   First, the ALJ's conclusion about the cash position of * * * was apparently based on an unverified cash statement prepared by the borrower itself. That statement was dated March 5, 1983, more than six months prior to the examination. On September 23, 1983, the date of the examination, the checking account of * * * was overdrawn by $2,454. In the absence of timely contrary information, the existence of the overdraft adequately supported the examiner's conclusion that the borrower's cash position was weak at the time of the examination.
   Collateral for the loan was an assigned note of * * *. The assigned note is secured by a fourth mortgage on real estate. The three senior mortgages established a total claim of $8,560,000 against the property, which exceeded the amount for which * * * purchased it by $513,000. (P.Ex. 17 at 185-86) The Bank asserted that the underlying property may be developed in the near future. The Board agrees that development could enhance the value of the underlying collateral but there was insufficient evidence in the record to establish a specific enhanced value or, indeed, to determine when or whether development of the property would in fact occur.
   The Board finds that the record supports the classification of "Substandard."

   #96 * * *

   The ALJ concluded that the $40,000 loan to * * * should be classified as "Substandard" rather than as "Loss." He based his conclusion on the borrower's employment, assets, "demonstrated performance capability," and assertions about Mr. * * * previ- {{4-1-90 p.A-526}}ous financial statements and a possible partial reduction in his indebtedness after the September 30, 1983 examination.
   We find that the ALJ did not have an adequate factual basis for disagreeing with the FDIC examiner's classification of the loan as "Loss." Mr. * * * income and other assets are inadequate to support this debt. His performance can be characterized as spotty at best.
   Mr. * * * may have been financially stronger in the past, but out-of-date financial statements are irrelevant to the current status of this loan. Mr. * * * conceded that the loan was unsecured. (Tr. 3898) The record reflects that Mr. * * * had not been able to keep current with his debt obligations. This loan was the third renewal of a prior note and was already delinquent at the time of the February 4, 1983 FDIC examination. Mr. * * * admitted net worth was only $62,700 on $230,900 in total assets which were mostly illiquid. His annual income was only $30,200. There was no basis in the record for the Bank to expect repayment of this loan. We find that the loan was properly classified as "Loss."

   #99 * * *

   The ALJ declined to accept the examiner's classification of $78,000 of this loan as "Substandard" because he concluded that a substantial portion of the debt was paid in September, 1983, the property was appraised at $4 million and the entire debt was eventually paid in full.
   Considering the facts as they existed at the time of the examination, however, the Boards finds that the loan was properly classified as "Substandard." In fact, the record raised so many questions that a larger portion of the delinquent loan could have been classified. Careful examination of the loan repayment card (R.Ex. 99.1), indicated that $18,000 of the principal was paid during the September, 1983 examination. The balance of the $31,248 which the Bank received during September, 1983, was overdue interest. This debt was formerly in the name of * * * Corporation. The * * * note was the second renewal of a note dated November 9, 1981 in the same amount. It had been overdue since its maturity date of May 9, 1983. Collateral for the debt were two assigned notes and an assigned mortgage in the total amount of $264,000. The assigned mortgage was a leasehold estate on 72 condominium units. There was no evidence of title insurance and there was ongoing litigation relating to land leases. It was impossible to determine the value of the Bank's financial interest in the collateral because of the absence of an independent appraisal of the underlying collateral in the loan file at the time of examination. (PFF 99.8, RPFF 99.8) Although the examiner did not rely on it, the Bank's Mortgage Deed dated November 15, 1979, (R.Ex. 99.1) indicated that three senior mortgages made the Bank's partial interest junior to those three prior liens. Even if the value of the collateral was $4,200,000, the Bank had only a fractional interest in it.
   Thus classification of $78,000 of the loan substandard was supported by the uncertainties of the land lease litigation and apparent absence of title insurance, (Tr. 1687-1703), the fact that repayment depended on the sale of the 72 condominium units and the lack of a formal appraisal of the collateral's value. The examiners took into account the sale of some units by reducing the portion of the loan classified and by reducing the classification from "Doubtful" to "Substandard." The fact that more of the units apparently were sold and the loan was repaid in full after the close of the examination is relevant only to compliance with the formal order. The Board is of the opinion that these events cannot be considered as a basis for not classifying the loan.

   #100 * * *

   We agree with the ALJ that the loan need not have been adversely classified. The loan file was not as complete as it should have been. However, the note was apparently secured by 20 lots in an active * * * development. It was evident at the time of the examination that the original $260,000 note dated June 15, 1983 had been paid to an {{4-1-90 p.A-527}}amount less than $45,000 by September, 1983. (PFF, 100.3, RPFF 100.3(a)) Although there was no independent appraisal of the lots, there was a large cushion between the amount of the debt ($44,000) and the alleged value of the assigned collateral notes ($174,000). Considering the apparent value of the collateral and the borrower's record of adequate performance, (P.Ex. 17 at 189; Tr. 4626-27), the Board agrees that adverse classification was unjustified.

   #102 26-12 * * *

   This debt, totaling $211,000, consisted of five notes and an overdrawn checking account. Contrary to the ALJ, the Board finds that classification of the debt as "Substandard" was justified.
   The ALJ based his finding on the payment history and allegation of ample collateral. The evidence is to the contrary. Two assigned notes (one for $100,000 and one for $50,000) from * * * provided collateral for part of the loan. However, only the $100,000 assigned note had been performing. (P.Ex. 17 at 194) There was no other payment history on this $100,000 debt except the admission that Mr. * * * obtained a new loan from the Bank to pay some interest due on the * * * Corporation debt. (PFF 102.19; RPFF 102.19; P.Ex. 17 at 194) In addition, payments on the $50,000 assigned note were apparently made directly to Mr. * * * without the Bank's knowledge. (P.Ex. 17 at 194) The ALJ cites no evidence in the record establishing that * * * Corporation had the ability to repay the debt by any means other than by sale of the property and collection of the assigned notes and mortgages which collateralized the debt.
   The Board is of the opinion that the debt should be classified "Substandard" because it was supported only by collateral and no other identifiable means to repay the debt.

   #103 * * *

   This debt originated as a $10,429 overdraft on the debtor's checking account on February 1, 1983 and increased to $26,243 during the examination. The ALJ found that the classified * * * debt should have been considered as "Substandard" rather than "Loss" because of a new appraisal on the collateral underlying Mr. * * * loans. The new appraisal was relied on by the examiner to upgrade the other * * * Group loans which had initially received classifications even more adverse than the final September, 1983 classifications, but not this overdraft. The Board disagrees with the ALJ.
   Presumably the ALJ was relying on the new $1,000,000 appraisal of units 2207 and 2208 of the * * *.;(P.Ex. 17 at 194) This appraisal did not enhance the * * * Incorporated debt because the new mortgage on it did not explicitly collateralize that debt. It only collateralized the debts of * * * and * * *. (P.Ex. 17 at 194) Moreover, there were prior liens on the units for $628,000 of debt leaving only $372,000 to collateralize total debt of $405,110 which was specified in the new mortgage. The new appraisal, then, provided no real basis for improving the loan classification.
   The most recent financial statement of * * * in the bank's files at the time of the examination did not reflect any interest in * * *. The financial statement of * * * , dated December 31, 1981 was too old to be relevant at the time of the September 30, 1983 examination.
   The $10,429 overdraft originated nearly eight months prior to the examination, and then nearly tripled. The Board finds that based on the record a classification of $10,000 as "Loss" was entirely justified and upholds the classification.

   #107 * * *

{{4-1-90 p.A-528}}

   The record clearly reflects that these loans were very poor performers. The total debt was $166,000. The Bank classified the entire amount as "Substandard." The FDIC examiner classified $29,000 as "Loss" and $137,000 as "Substandard." The ALJ based his opinion on an assertion that collateral values were higher than the FDIC report indicated. However, the Boards finds no support in the record for this conclusion. The examiner did not challenge the Bank's appraised values for the collateral. He classified as "Loss" only that portion of the loan that exceeded the value of the collateral after the estimated expenses of foreclosing on the loan and selling the real estate collateral for the loan were deducted.
   The Board agrees that the estimated expenses of foreclosure and sale of the collateral should be deducted from the expected proceeds. It, therefore, finds that the amount by which the net sale proceeds exceeds the debt, $29,000, was properly classified as "Loss."
   Two properties were assigned as collateral for these loans. One was 2.08 acres of improved property appraised in October, 1982 at $150,000.⁵⁹The second was a townhouse valued at $80,000. After other loan lines were accounted for, the Bank's equity interest in the unimproved property was $108,000 and its equity interest in the townhouse was $44,000. (P.Ex. 17 at 200)
   The Board believes that a 10% reduction in equity value from $152,000 to $137,000 to cover expenses was reasonable. Contrary to the assertion of the Bank in RPFF 107.8, this 10% figure is not merely an estimate of the real estate agent's commission. The Examination Report plainly states that the 10% deduction was for "real estate commissions, attorneys' fees etc." (P.Ex. 17 at 199) In fact, the 10% figure probably understates the likely cost of liquidating, the collateral. Accordingly, it was properly deducted from the Bank's alleged equity to determine how much of the loan should be classified as "Loss."

   #108 * * *

   This $10,000 debt consisted of a non-performing automobile loan and an overdrawn checking account. There was no dispute that the amount by which the debt exceeded the value of the collateral (a 1980 Chevrolet station wagon) should have been classified as "Loss" and the balance "Substandard." The ALJ accepted the Bank's assertion that the NADA Official Used Car Guide (R.Ex. 108.2) retail value of $5,500 should be the basis for the classification determination. The Board disagrees. The Bank ordinarily would not net full retail value for the car. It would incur expenses connected with repossessing the vehicle, repairing it if necessary, preparing it for sale, and selling it. Moreover there was no evidence in the record as to the current condition or mileage of the vehicle. Therefore, the Board finds that it was reasonable for the examiner to estimate that the Bank would net only $4,000 for the vehicle and to classify the balance of the debt as "Loss."

   #109 * * *

   This $4,000 debt was unsecured. It was partially used to cover an overdraft of a * * * Group company and partially to cover personal investments. (P.Ex. 17 at 202) The Bank conceded that the debt was "Sustandard" (RPFF 109.6), and the ALJ classi

   #110 * * *

   The $6,000 classified as "Loss" by the FDIC examiner resulted from an unsecured checking account overdraft which had existed since June 21, 1983. (P.Ex. 17 at 203) Although other * * * loans may have had some collateral protection there was no basis in the record to support the ALJ's apparent conclusion that there was enough collateral to cover this unsecured overdraft. (P.Ex. 17 at 203) The Board believes that the financial condition of * * * was so weak and the ability of Mr. * * * to pay was so doubtful that any debt not secured by adequate collateral must be classified as "Loss." Accordingly, we cannot accept the ALJ's classification of the entire $366,000 debt as "Substandard." Indeed, the Board finds that the $6,000 overdraft was properly classified "Loss."

   #111 * * *

   The $9,000 classified as "Loss" by the FDIC examiner resulted from a checking account overdraft which had existed since June 21, 1983. (P.Ex. 17 at 204-05) This debt, however, was secured by the assignment of a $135,000 * * * Corporation real estate equity position during the last few days of the examination. (P.Ex. 17 at 208-09) The assignment was made to secure "all existing indebtedness owed the Bank by * * *. It therefore provided collateral for the $9,000 checking account overdraft. Under these circumstances, the Board agrees with the ALJ's classification of the entire $189,000 as "Substandard."

   #113 * * *

   The ALJ based his conclusion that none of this $100,000 debt need be classified on the alleged existence of adequate collateral, absence of performance deficiencies and a January 4, 1984 payment which reduced the debt to $50,000. The Board disagrees with his conclusion. Although collateral may have been sufficient at the time of the examination, there was a very poor likelihood of repayment by any means other than liquidation of the collateral. * * * and its affiliates had financial statements on file at the Bank which showed a negative net {{4-1-90 p.A-530}}worth and sustained losing operations. (RPFF 113.10 and 113.11) Furthermore, the January 4, 1984 payment occurred after the examiners left the Bank. (RPFF 113.14) We find that it was incorrect for the ALJ to base his classification conclusion on events which occurred after the close of the examination. The $50,000 reduction in the outstanding principal of the loan would of course be relevant to the issue of compliance with a formal order. The Board finds that the loan was properly classified as "Substandard" as of the close of the September 30, 1983 examination.

   #114 * * *

   The FDIC examiner classified the $150,000 loan as "Doubtful." The ALJ accepted the Bank's classification of it as "Substandard." This loan was disbursed in two installments—$125,000 was disbursed on May 6, 1983 and $25,000 on July 29, 1983. Of the second disbursement $3,889 was used to pay the interest due on the first disbursement. Of the second disbursement $15,925 was used to pay up the interest through the maturity date of the loan. (PFF 114.2; RPFF 114.2) Extending credit to pay interest due is not a sound lending practice. Furthermore, the record indicated that the borrower was apparently in jail at the time of the examination. (PFF 114.6; RPFF 114.6) Repayment of the loan was dependent upon sale of the collateral—real estate located in * * * and subject to * * * state law with which Bank officers were not personally familiar.
   FDIC argued that the appraisal of the real estate collateral was inadequate. The real estate collateral included two properties. The first was the borrower's business property acquired October 29, 1982, for a purchase price of $65,000. The seller of the property had acquired it through foreclosure by sheriff's deed dated June 16, 1982. (R.Ex. 114.5)⁶⁰The FDIC correctly contended that the July 28, 1980 appraisal of $110,000 was too out of date to accurately indicate current market values. (Pr. Exceptions at 82) The second property was land with purported improvements appraised at $134,000 on March 25, 1983. (R.Ex. 114.3) The title policy to that property excludes "Possible claims of a spouse of the insured seeking equitable distribution of marital property." (R.Ex. 114.5) While the FDIC was apparently incorrect in questioning the value of that appraisal for not citing any comparable sales, the cloud presented by the spouse's claim would severely limit its value as collateral. Both properties were subject to a $74,500 first lien of * * * National Bank. Additional partial collateral was a lien on a liquor license, furniture and fixtures, and equipment. The priority of the Bank's lien on those items and whether transfer of the liquor license was possible were matters in dispute. (PFF 114.5) At combined face value, the $170,000 equity in the second real estate lien would provide only minimal margin for the $150,000 total debt. The Board believes that the 1980 appraisal of the subsequently troubled business property was not indicative of actual market value, and that there was a sufficient cloud on the deed to the second property as to require litigation to clear the cloud. The Board, therefore, agrees with the examiners and assigns a "Doubtful" classification.

   #119 * * *

SUMMARY

   The ALJ declined to accept classification of any portion of this loan. To support his conclusion the ALJ cited assertions that prior to the end of the September, 1983 examination, the loan was renewed in connection with a $10,000 payment of one-half of the principal and $1,300 interest (RPFF 119.1(a) and 119.2(a)), and the fact that the borrower "has had net worth exceeding $1,500,000." (RPFF 119.7) The Board

DISCUSSION

   The loan was overdue at the time of the examination. The borrower was a resident of * * *. The reduction in the principal was made by debiting the borrower's checking account. (PFF 119.5; RPFF 119.5) The loan extension was made by the Bank, pending Mr. * * * return to * * *. (R.Ex. 119.2(a)) Collateral for the loan was the assignment of an unsecured note dated February 15, 1983 from * * *. The Bank admitted that $332,000 of another * * * debt was properly classified as "Substandard." (RPFF 117.20) The ALJ accepted the FDIC's finding that the $650,000 * * * debt which * * * guaranteed was also classified "Substandard." Under these circumstances, the assignment of the unsecured * * * note was inadequate collateral for Mr. * * * loan. There was also no evidence in the record on Mr. * * * current financial position with the only information in the Bank's loan file being 18 months out of date. The fact that Mr. * * * may have had substantial assets at some time in the past was not relevant to the prospect of repayment of this debt. Therefore, the Board finds that the $10,000 was properly classified "Substandard."

   #122 * * *

   This loan was taken out to pay $8,295 of past due interest and the $197,955 principal of the loan of * * * (See #121). (P.Ex. 17 at 20; PFF 122.5; RPFF 122.5) The collateral for this loan consists of the same five vacant lots which collateralized the * * * loan. The borrower, a former limited partner of * * * , was a corporation registered in the * * * apparently owned by * * * investors. (P.Ex. 17 at 218, Tr. 3924) The ALJ declined to acknowledge classification of the loan because of the alleged adequacy of the collateral that secured the loan, the alleged financial condition of the borrowers and the performance as represented by interest payments made at the end of the examination.
   "Substandard" classification of this loan was warranted at the time of the examination. There was no current appraisal of the collateral in the Bank's file. (PFF 122.4; RPFF 122.4) Based on an appraisal report in the * * * file dated April 1, 1981 (ten vacant lots at $550,000), the value of the collateral was placed at $275,000 by the examiners. The Bank admitted that the lots were vacant and undeveloped (RPFF 122.3), yet the ALJ relied on testimony that the lots had "water and sewer, streets and sidewalks". (Tr. 3922-23.) No explanation for the inconsistency was given. The Board finds that this unexplained inconsistency raised doubts about the value of the collateral. The lots were not released from the * * * mortgage because the Bank did not want to release the borrower until * * * debt was totally satisfied. $58,000 of that debt remained which the Bank admitted was properly classified as "Substandard." There was no financial statement on the borrower in the loan file. (P.Ex. 17 at 218) There were no guarantees on file. One of the owners of the borrower, * * * was reportedly worth "over a million dollars" (Tr. 3924), but without verification of that fact and a binding obligation upon him to assume responsibility for the loan, contrary to the ALJ's conclusion, his possible wealth was irrelevant to the classification of this loan. The fact that interest was paid during the examination was not a sufficient basis to declassify the loan under these circumstances. The fact that additional financial information about borrowers may also have been received by the Bank after the examination was irrelevant to the proper classification of the loan at the close of the examination and should not have been considered by the ALJ.
   The Board finds that the record establishes that the loan was properly classified as "Substandard."

   #124 * * *

{{4-1-90 p.A-532}}
SUMMARY

   The FDIC classified this remaining balance due after a payment received during the examination based on the belief that the collateral had been released and that the guarantor offered no financial support because he was admittedly liable on other classified loans. The Board agrees with the ALJ that the record does not show that the collateral was released and that there was, therefore, sufficient equity in the real estate collateral to preclude adverse classification.

DISCUSSION

   The classified balance was the residual of a debt remaining after a principal payment was received during the examination ". . . in satisfaction of that (corresponding) mortgage . . . ." (R.Ex. 124.1) The ALJ reduced his classification based on the loan payment and the collateral's appraised value. The appraised value was substantiated by the borrower's testimony of a $900,000 purchase price for the pledged acreage. The FDIC justified its classification on the basis of * * * guarantee as being either admitted or upheld "Substandard" elsewhere in the report. The FDIC gave no consideration to the value of the collateral held, which does not appear to have been obligated to * * * other loans. That collateral was not released and was of sufficient value ($900,000 versus $407,000 first and second lien debts) to support this line. Also, the substantial payment received during this examination would indicate that additional financing would be available to pay out this smaller portion. The Board agrees with the ALJ's declassification of this loan.
   #126 * * *

SUMMARY

   The debt was the amount owed on the $100,000 purchase of the * * * condominiums. The ALJ declassified this loan based on a 15% equity in the property from the down payment and six months of satisfactory payment performance by the borrower. The Board finds that the FDIC properly classified this loan "Substandard" based on insufficient equity in the business property and the financial problems related to the * * * condominium project.

DISCUSSION

   The ALJ reduced this classification based on the $15,000 down payment, or 15% cash equity, and about six months adequate payment history. The FDIC adequately addressed the basis for this classification in that the payment history was considered too short a period of time, in connection with the absence of a known credit history for the borrower, to establish a satisfactory performance on a property previously held by the Bank as "Other Real Estate." (Pr. Exceptions at 84) The ALJ failed to recognize the seriousness of the business problems involved in "* * *" commercial condominium project. Three major items reflective of at least a "Substandard" classification include: (1) the eight unit project was previously unsuccessful and required foreclosure by the Bank on seven of the units at a book value of $648,000, (2) only four of the units were occupied, and (3) appraisals are based on sale prices for each of the five units sold that totaled $663,000; accuracy of the appraisals is considered questionable since the values cannot be supported by an income approach to value. (P.Ex. 17 at 220-221) While * * * appeared to be the best of the purchasers of project units, continued successful operation appeared to be questionable and a 15% equity position in the property, based on an apparently inflated sales price, was not a sufficient margin of protection for a property formerly in the Bank's Other Real Estate category.
   #127 * * *

SUMMARY

   The debt was the amount owed on the purchase price for Unit 4 of the * * * condominiums. The property was vacant and had produced no income for the borrower. The ALJ declassified the loan based on a 25% equity in the property from the down {{4-1-90 p.A-533}}payment on the property and the incorrect belief that the borrower had substantial deposits in the Bank. The FDIC properly classified the loan "Substandard" based on the non-income producing nature of the business property and the financial problems related to the * * * business condominium project.

DISCUSSION

   The ALJ reduced this classification based on a substantial down payment and loan reductions (RPFF 127.5), and the borrower's purported substantial checking account balances at the Bank. (RPFF 127.3(b)(new) and R.Ex 127.1) The FDIC adequately addressed this classification. (P. Exceptions at 84) Additional facts surrounding this line included (1) borrower's checking account did not reflect a substantial balance ($3,522 on November 28, 1983; $219 on December 27, 1983; $411 on January 26, 1984; $5,411 on February 27, 1984, $5,000 of which was in uncollected deposits; and $7,799 on March 26, 1984), (R.Ex 127.1), (2) The property had been vacant since purchase, and (3) the down payment and reductions amounted to only 25.5% of the sale price. The discussion under * * * (PFF 126 Series), supra, concerning the unsuccessful history of this project, its current lack of operations and prospects, and the actual value of these units versus Other Real Estate ("Ore") book value and/or income approach to evaluation also apply to this loan and undercut the "substantial" down payment and loan reduction factors. Therefore, the Board finds that this loan was properly classified "Substandard."
   #131 * * *

SUMMARY

   The borrower was an international concern whose financial position showed a high level of debt, relatively low capital and the existence of cash flow problems. The collateral pledged appeared to be extensive, at least in terms of book values, but was restricted by CPA opinion and was subject to foreign exchange and transfer risks. The ALJ agreed with the "Substandard" classification but not the $87,000 classified "Loss." The amount classified "Loss" represented interest charged to the borrower's checking account but not covered by sufficient funds in that account. That interest charge was included in the Bank's income despite the fact that it had not been collected. The Board does not find any reason for treating the $87,000 representing interest earned but not collected differently from the rest of the debt. The ALJ's classification of the entire debt as "Substandard" is accordingly upheld.

DISCUSSION

   The ALJ reduced the "Loss" classification to "Substandard" because he considered it collectible. Determining collectibility of this loan requires analysis of the value of the collateral securing the debt and the financial condition of company owner * * * who had $154,000 in loans classified "Substandard" (which classification was upheld by the ALJ). (RD at 45) The collateral consisted entirely of accounts receivable, inventory, furniture and fixtures, and machinery and equipment, assigned proceeds of letters of credit, a $50,000 certificate of deposit, a $200,000 mortgage on property appraised at $140,000 (but without a supporting title search or other documents), and a $50,000 assignment of a real estate second mortgage with $88,000 in equity. (RPFF 131.59; 131.73; 131.74; 132.6; and 132.7) Evaluation of the value of this collateral centers primarily on domestic controlled inventory with an $886,000 book value (RPFF.61), and $2,808,000 primarily on foreign accounts receivable (RPFF 131.62), which would appear to be sufficient for this line. However, prudent banking procedures limit the amount advanced against collateral consisting of inventory to a percentage of its book value based on risk factors such as staleness, control, "shopwear," obsolescence, marketability, etc. Industry percentages normally range between 50% to 60%. The level of control over the collateral in this instance could probably support loans up to 60% of book value.
{{4-1-90 p.A-534}}The same procedures are generally applicable to account receivables, but these include the additional risk factors, third party concentrations, right of offset, third party's ability to pay, and, in this case, foreign exchange and transfer risk. Industry percentages normally range from 60% to 90%. The risk factors involved in collateral consisting of both inventory and accounts receivable are generally considered very high. The accounts receivable collateral was further complicated by substantial amounts, $2,313,700 as reported July 31, 1983, of accounts receivable representing nonrecourse financing provided by the Bank to * * * customers and accounts receivables which the Bank's CPA eliminated from the parent company property statement of July 31, 1983. (RPFF 131.64) These facts raised serious questions about the value of the accounts receivable collateral for the line. A conservative estimate would have been that $2,000,000 of the accounts receivable were actually not available as collateral. The eligible accounts receivable should then have been utilized only to the extent of 60% of book value to take into account the associated risk factors, for a net $485,000 estimated collateral value. In summary, the Board finds that the collateral protection afforded this and the * * * lines of credit was marginal and justified a "Substandard" (but not a Loss) classification.
   #133 * * *

SUMMARY

   This was a nonaccrual loan whose source of repayment was the liquidation of the pledged collateral. The ALJ reduced the classification based on the Bank's absolute collateral values. The Board, however, recognizes the financial and acquisition risks involved in disposing of collateral consisting of a junior lien and properly classified the reduced loan balance as Substandard.

DISCUSSION

   This was a nonaccrual line whose principal was reduced to $98,000 during the examination from the proceeds of the sale of another real estate property. The classification was based on the liquidation of the collateral held. The ALJ declassified the line based on the Respondents' evaluation of the collateral. (RPFF 133.7(new)) The FDIC adequately addressed the risk involved in liquidating such collateral and the application of $106,000 insurance proceeds which are to be received by the court for distribution. Additional considerations indicating that this line was at least "Substandard" included: (1) there is a $30,000 claim by * * * Pictures against the insurance proceeds (addendum information, P.Ex. 17 at 237); (2) the Bank's interest in a second mortgage lien against the * * * property is limited to a half interest (PFF 133.3; RPFF 133.3) estimated to be worth approximately $19,500, (the ALJ accepted Respondents' $45,000, estimate); and (3) the difference between the FDIC's estimated $12,000 equity value in the second lien on 20 acres of land and the estimated $46,000 value by the Bank raised questions as to the value of the collateral. The Bank's estimate was based on a "new" appraisal which was apparently not introduced into evidence. (RPFF 133.3) The Board finds that a "Substandard" classification is warranted based on the questionable value of this junior lien position on the collateral.
   #134 * * *

   This debt included two installment loans. A total of nine payments —six prior to the examination and three during the examination —were made by creating or increasing an overdraft on the borrower's checking account. Nevertheless, the Bank held the title certificates on a 1979 Mercedes and a 1981 Pontiac. The margin of collateral protection appears sufficient to limit the Bank's exposure. Therefore, the Board agrees with the ALJ.
   #135 * * *

{{4-1-90 p.A-535}}

SUMMARY

   The essentially unsecured loan was made to enable the borrower to purchase a one-half interest in * * * developmental property from * * *. All interest and principal payments had been made by Mr. * * * through checking account overdrafts at this Bank. The borrower had not demonstrated either an ability or a willingness to service this line. The ALJ declassified these loans primarily based on the borrower's stated net worth of $1,523,000, and the reported acquisition of a financing package from another source to begin development of the * * * property. The Board finds this insufficient to justify removal of the "Substandard" classification for an unsecured credit.

DISCUSSION

   The debt was for the purchase of a one-half interest in * * * (classified "Substandard" under Series #136 in this report) from * * *. The proceeds of the unsecured $350,000 loan went into * * * account and * * * made the overdue interest payment on the loan on November 11, 1983. * * * continuing guaranty appeared to cover both loans. However, the guaranty was orally modified to exclude the $350,000 loan according to the ALJ. (RD at 71)
   The commercial loan that originated at $25,000 in 1981 was reduced to $17,500 during the examination. However, * * * , not * * * , made the interest and principal payments at the last two renewals. Collateral pledged was stock registered in * * * name, but was of unknown value and liquidity.
   The borrower's self-prepared financial statement was not sufficiently detailed to provide support for an unsecured debt of this magnitude since his total assets of $2.2 million consisted o $1.8 million of real estate for which no details were known. His net worth of $1.5 million reported on the statement was, therefore, impossible to verify. His reported income was $93,000.
   Mr. * * * had not demonstrated an ability or willingness to service either of the two loans nor were his proven assets sufficient to eliminate the risk inherent in these unsecured loans. The Board finds that the record supports the "Substandard" classification.
   #136 * * *

SUMMARY

   This line was to finance the purchase of property for speculative development and to provide for payment of the interest and principal due to the first lien holder and this Bank. The original financing package exceeded the purchase price by $513,000 and was expanded another $469,000 by a letter of credit and acceptances issued. The Bank holds a second mortgage on the purchased property. The ALJ declassified the entire line based on a $12 million development financing package acquired at another institution during the final days of the examination. However, the funds from that package were insufficient to pay out the first lien holder. In addition, there were numerous other impediments to development noted by the examiners. The Board recognizes those problems and assigns a "Substandard" classification.

DISCUSSION

   The ALJ found that the FDIC has not proven that classification was warranted. This was apparently based on purported collateral protection since numerous weaknesses cited by the examiners were not refuted. The collateral was a second mortgage on one block of property fronting * * *. The purchase price and appraisals for the property were:

   The purchase price was financed as follows:
{{4-1-90 p.A-536}}

   Present value of a sale transaction is a function of both price and terms offered. A substantial discount from the $8,047,000 was necessary to equate the purchase price to a cash deal since the seller placed himself at considerable risk in taking a third position on financing that exceeded the purchase price by $513,000. What the property recently sold for on a cash equivalent basis would normally be a truer indication of actual value than would be an appraisal.
   The ALJ was mistaken in stating that funding occurred. All that occurred was an arrangement for construction financing in the amount of $12.8 million. An allocation of funds sheet showed that $3.2 million of the amount would pay down existing liens, but no breakdown was given. Usual banking practice is to apply reductions first to the most senior debt in which case * * * Bank would receive no funds. In addition, if this was a typical construction loan, * * * Bank and the seller of the property would be required to subordinate their positions to that of the $12.8 million loan. This would result in the already questionable collateral protection prior to subordination becoming junior to the substantial new debt and make pay out of the Bank's loans contingent on successful completion of the construction project. Under these circumstances, the Board finds that the "Substandard" classification was justified.
   #140 * * *

SUMMARY

   The ALJ declassified this unsecured credit based on Respondents' findings of fact and exhibits which were erroneous and misleading. The Board classifies the debt "Substandard" based on significant discrepancies in the borrower's financial statement.

DISCUSSION

   This adverse classification was based on the "weak financial position" disclosed by the available financial information (P.Ex. 17 at 250) The ALJ reduced the classification to None based on the Respondents' findings of fact and exhibits which he believed successfully rebutted the FDIC contentions. (RD at 51) Debt performance of this relatively new credit was not an issue in the classification. The FDIC addressed the inaccuracy of the Respondents' findings of fact that showed the borrower's total assets of $12,295,000 (RPFF 140.4(b)), but omitted $2,000,000 of the borrower's liabilities. (RPFF 140.4) The $4,251,000 appraisal for the borrower's major asset (* * * undeveloped land) (RPFF 140.4(a)), cited by the Bank, was both misleading and invalid in that it was made "assuming" completion of certain development of the property (R.Ex 140.4), none of which had been accomplished. (RPFF 140.4) The ALJ's declassification of this credit based on such erroneous and misleading facts was unwarranted. The major discrepancies in the borrower's financial statements used to support this unsecured credit were as follows: (1) the financial statement was self-prepared and unsigned, which reduced its credibility, (2) the purchase price of $2,115,800 for * * * undeveloped land was a more accurate valuation for that asset than the misleading appraisal, thus reducing the borrower's stated net worth from $3,663,000 to about $1,663,000, (3) the overevaluation of this major asset raised questions about the accuracy of the valuation of borrower's second major real estate asset at $942,000, (4) the liabilities associated with the listed real estate equities were omitted from the borrower's liabilities, and (5) the borrower's 1981 income of $147,000 was not considered sufficient support to carry his extensive debt load. The Board finds that the examiners' classification of this unsecured credit was valid.
   #142 * * *

{{4-1-90 p.A-537}}

SUMMARY

   The examiners properly classified this line based on the borrower's unwillingness to make scheduled payments on all loans, the severely delinquent status of much of the line, the questionable real estate value of collateral consisting of a junior lien, and the unsecured nature of the overdraft on the borrower's checking account. The unsecured portion was classified "Loss" and $6,000 of the debt was not classified based on the value of an automobile pledged as collateral. The ALJ essentially agreed, but did not classify any "Loss" based on the borrower's position as a policeman and a respected member of the community, and his wife's position as a school teacher.

DISCUSSION

   This debt consisted of an unsecured overdraft and two installment loans, collateralized by a junior real estate mortgage lien with an appraised value of $38,000, and a six year old cadillac. The overdraft had been delinquent more than two years and the auto loan more than six months. The ALJ reduced the "Loss" classification to "Substandard" because the borrower was a policeman and a respected member of the community, and his wife was a school teacher. (RPFF 142.8) The FDIC did not address this loan. The ALJ failed to recognize that the equity in the real estate collateral was dependent on the amount of prior liens, that the overdraft was unsecured, and most importantly that the borrower had failed to make payments on the loans. The Board agrees that the unsecured portion of $6,000 was properly classified "Loss" and the remainder of the debt "Substandard."
   #143 * * *

   #143 and #144 * * *

SUMMARY

   These loans were related by the guarantee of * * * and were in the form of overdraft checking account advances, $38,000 of which was delinquent for more than a year. The FDIC classified the $120,000 combined balances "Substandard" based on the indicated delinquency, questionable lien status of the inventory, accounts receivable and equipment collateral, and the apparent weakened financial position of the borrower and guarantor. The ALJ declassified the entire portion based on testimony that the borrower was wealthy and there was plenty of collateral. The Respondents' allegation that the debt was secured by $60,000 cash collateral in the form of certificates of deposit was refuted by testimony, and it was apparent that a proper assignment of these certificates of deposit was never obtained.

DISCUSSION

   #143

   This debt was confined to an overdraft originating more than a year prior to examination. The ALJ removed the classification based entirely on Respondents' proposed findings of fact and the testimony of the * * * and the borrower (RPFF 143.1-.5; Tr. 3928-31, 4505-25), which focused on the existence of collateral in the form of certificates of deposit pledged to the Bank. (RPFF 143.1(a) (new)) The FDIC argued that the cash collateral was not presented to the examiners before the conclusion of the examination. However, testimony cited by the ALJ revealed two major items negating the support of the alleged collateral. First, the borrower stated that he only had $60,000 in certificates of deposit at the Bank in support of all his debts (which totalled $120,000). Second, both the Bank and the borrower testified that, in fact, there was no assignment of this purported cash as collateral. It was further stated that there was an understanding between the borrower and the Bank that the certificates could be used by the Bank for any purposes. (Tr. 3928-31, {{4-1-90 p.A-538}}4513-25) Absent a written assignment, with a proper "hold" on the deposit account, the borrower could exercise his option to withdraw the alleged collateral at any time, and the "understanding" would be meaningless despite the Bank's general right of offset of deposit accounts in the case of loan defaults. The subsequent events of partial pay out, further extension, then a refinancing only indicated that continued cash flow problems persisted. At least a "Substandard" classification was warranted.
   #144

   This debt was confined to a checking account overdraft. The comments under Series 143 apply equally to this line as both were guaranteed by * * *. Respondents' proposed findings of fact indicated that the Bank had a third lien on inventory, accounts receivable and equipment as collateral, and that the borrower had a strong financial statement. Since this line was classified "Substandard" based on the borrower's weak financial position, unsatisfactory debt performance and questionable perfection of lien status on inventory, accounts receivable and equipment, it would appear that no such documentation was available to the examiners that supported the Respondents' contentions. Respondents' Exhibit 144.3 showed an assignment of a UCC-3 financing statement by * * * Bank * * * to the Bank. However, the filing date for the financing statement was November 6, 1975, which would have expired in five years if not continued. There was no indication of such a continuation, thus raising questions as to whether the lien status of this collateral was perfected. "Substandard" classification was warranted based on the delinquency status of the overdraft checking account in Series 143, a suspected weakened financial position of the borrower and guarantor, and the absence of an assignment of certificates of deposit referred to in Series 143.
   #152 * * *

SUMMARY

   The Board finds that the evidence failed to support the FDIC's contention that the borrower was in a weak financial position and had not made payments on its loans.

DISCUSSION

   The FDIC classified this debt based on the borrower's weak financial position and an unsatisfactory debt performance. (P.Ex. 17 at 252) The classification was not addressed in the Brief of Exceptions. The ALJ was correct in citing substantial debt performance (PFF 152.1-.3) in reducing the classification. In addition, the FDIC presented no evidence of the borrower's weak financial position. The Board finds that no classification was warranted.
   #153 * * *

SUMMARY

   The Board classifies $2,000 as "Loss" and $2,000 as "Substandard" based on the Bank's own estimate of collateral value provided during the examination.

DISCUSSION

   This debt was a loan on an automobile. The auto was in the shop for repair, apparently to be repossessed and sold. (RPFF 153.1-.4) The basis for the "Loss" classification was the value "Management stated it would settle for . . ." (p.Ex. 17 at 252) The ALJ reduced the entire debt to "Substandard" based on the alleged fact that ". . . FDIC examiners apparently were unaware that the Bank's lien rights would have priority over the body shop bill . . .". (RPFF 153.5) However, the ALJ failed to recognize that the lien rights to collateral were not an issue. The "Loss" classification was based on Bank management's own estimate of the collateral value made during the examination.
{{4-1-90 p.A-539}}
   #158 * * *

SUMMARY

   The ALJ reclassified this loan based on the guarantor's financial capacity. However, the guarantor had not responded to the Bank's demand for payment. Therefore, a "Loss" classification was appropriate.

DISCUSSION

   This debt consisted of an automobile loan where the borrower skipped with the collateral. A payment demand was issued to the guarantor, but had not been honored. (RPFF 158.1-.3) The ALJ reduced the classification based entirely on the Respondent's proposed findings of fact and testimony that guarantor had sufficient financial capacity to pay. (RPFF 158.5) The ALJ failed to recognize that the guarantor had not responded to the Bank's demand. The Board finds that the classification of the loan as "Loss" was justified.
   #163 * * *

   The classification was based on an estimated value of a repossessed automobile. The ALJ reclassified the total based on the testimony that the collateral was sold after the examination and the loan was paid in full. The Board finds that the classification was warranted based on information that was available at the conclusion of the examination.
   #170 * * *