FDIC: 1988 - Docket No. FDIC-87-71k


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[¶5,115] FDIC Docket No. FDIC-87-71k (5-24-88).

Civil money penalties were assessed against an executive officer for extending an insider loan that involved more than the normal risk of repayment or other unfavorable terms and for exceeding the lending limit to insiders in violation of Regulation O. Civil money penalties were also assessed against directors who participated in a wrongful insider loan. (Related proceedings in this docket appear at [¶ 5099] This decision was affirmed in part and reversed and remanded in part by the U.S. Court of Appeals for the Fifth Circuit, 881 F.2d 1368 (1989)).

[.1] Regulation O—Loans to Executive Officers, Directors and Principal Shareholders—More Than Normal Risk
An insider loan that involves more than the normal risk of repayment and other unfavorable features, such as insufficient documentation and undercollateralization, violates Regulation O.

[.2] Civil Money Penalties—Amount of Penalties—Correction and Violation
In addition to the factors used in determining the appropriate amount of a civil money penalty stated by law, such as size of financial resources and good faith of member bank or person charged, gravity of the violation and history of previous violations, significant consideration should also be given to the financial or economic benefit gained from the violation and to the penalty amount as punishment and a deterrent to future misconduct.

[.3] Civil Money Penalties—Amount of Penalties—Personal Gain
Because there was no evidence of personal dishonesty and prior Reg. O violations by the chairman and because management acted to rid the bank of the overline, the civil money penalty assessed against the chairman in the amount of his personal gain is just and appropriate.

[.4] Regulation O—Definitions—Executive Officer
The chairman of the board of a bank is an executive officer of the bank unless he or she is excluded from policymaking functions by board resolutions or by the bank's by-laws.

In the Matter of * * *, individually and
as executive officer and director; and * * *, * * *, and
* * *, * * *,
individually and as directors of * * * BANK

(Insured State Nonmember Bank-In Receivership)
DECISION AND ORDER
FDIC 87-71k

This case involves the assessment of civil money penalties for violations of the insider loan prohibitions of section 22(h) of the Federal Reserve Act and Regulation O ("Reg. O") of the Board of Governors of the Federal Reserve System.¹ The Notice of Assessment of Civil Money Penalties, Findings of Fact and Conclusions of Law, Order to Pay and Notice of Hearing ("Notice") issued by the Federal Deposit Insurance Corporation ("FDIC") on April 8, 1987, sought civil money penalties in the amount of $290,000 against * * * ("Respondent"), individually and as an executive officer and director of * * * Bank, * * * (the "Bank") and $3,000 each against * * *, * * *, * * *, and * * * ("Respondents"), individually and as directors of the Bank.²
A hearing was held in * * *, during the period July 27-30, 1987, before Administrative Law Judge William A. Gershuny ("ALJ"). A Recommended Decision and Order ("Recommended Decision") was issued by the ALJ on January 23, 1988. The Recommended Decision found that, in connection with a $1.5 million extension of credit to * * * ("Partnership"), a related interest of Respondent * * *. Respondents had violated sections 215.4(c) and 215.2(f) of Reg. O, related to the Bank's insider lending limits. The ALJ found no violation of section 215.4(a)(2) which prohibits loans to insiders or their related interests that involve more than the normal risk of repayment or other unfavorable terms. The ALJ recommended the assessment of a $10,000 penalty against Respondent * * * and a penalty of $1,000 against each of the other Respondents. Both parties filed exceptions to the Recommended Decision.³

For the reasons set forth below, we concur in part and modify in part the ALJ's Findings of Fact and Conclusions of Law and assess a penalty in the amount of $125,000 against Respondent * * * and in the amount of $3,000 against each of the remaining Respondents.

Factual Background

Respondent * * * sought $1.5 million in financing for the construction, renovation, and operation of * * *, owned by the Partnership, of which he was the sole partner. To obtain this financing, a transaction was structured whereby low interest, multi-family housing revenue bonds in the amount of

¹ 12 U.S.C. § 375b and 12 C.F.R. Part 215. The statute and regulations are made to apply to insured state nonmember banks by Section 18(j)(2) of the Federal Deposit Insurance Act (the "Act"), 12 U.S.C. § 1828(j)(2).

² Initially the Notice joined other individuals as co-respondents. None of these other co-respondents remain as parties to this proceeding. A number filed no request for a hearing and, as to them, default judgments were entered. Others entered into settlement agreements with counsel for the FDIC and were not parties to the hearing.

³ Citations to the record herein shall be as follows:
—to the Recommended Decision: "R.D. at"; to the transcripts of testimony: "Tr. at". to the exhibits: "FDIC X - 1" and "* * * X - 1 or * * * X - 1".
{{4-1-90 p.A-1287}}$1,500,000 were issued by the * * * Public Facilities Authority ("Issuer"). The proceeds of this bond issue were to be loaned to the Partnership, to be used for improvements to the housing project, and to provide low cost rental housing in the community. * * * Bank * * * (succeeded by * * * Bank, * * *) served as bond trustee. Interest on the bonds was set at 75% of Chase Manhattan Prime with a 30-year amortization, callable after ten (10) years. The Partnership gave a $1.5 million promissory note and an assignment of rents to the Issuer, and Respondent * * * gave his personal guaranty of the indebtedness to the Issuer. Security for the Issuers' loan to the Partnership consisted of a first mortgage on * * * (purchased by the Partnership simultaneously with the closing of the bond trust indenture) and a $100,000 certificate of deposit. The Bank was the sole purchaser of the bond issue. Thus, the Bank's money was used to support the loan to the Partnership under the trust indenture, and, in effect, the Bank loaned the money to the Partnership. In fact, the purchase of the bonds was carried on the books of the Bank as a loan to the Partnership and Respondent * * *. It appears that the bond mechanism was utilized to enable Respondent * * * to obtain a low-interest loan which would otherwise not have been possible. The Bank's purchase of the bond issue avoided the delay in financing which a sale to the public would have required and provided Respondent * * * with the immediate financing he needed. All parties treated the transaction as if it were a commercial loan by the Bank to Respondent * * *., Tr. at 83, 108. On or about August 7, 1985, the board of directors of the Bank approved an extension of credit by actually purchasing the bonds.
The January 31, 1986, examination of the Bank by the FDIC resulted in the adverse classification of this loan—$794,000 as "Substandard," and $706,000 as "Loss." On or about June 19, 1986, $271,000 of the loan was charged off by the Bank. At approximately the same time, $275,000 of the loan (the amount by which the loan to the Partnership exceeded the Bank's legal lending limit under Reg. O) was "participated out" to others by having the bonds reissued and sold. The Bank failed on November 7, 1986.

Lending Limit Provisions of Regulation O

   We agree with the ALJ that, at all times relevant to these proceedings, Respondent * * *, as chairman of the board, was an executive officer of the Bank within the meaning of section 215.2(d) of Reg. O.R.D. at 9. In light of the record in this case we find Respondent * * *'s protestations to the contrary totally disingenuous.
   The Board of Directors ("Board") of the FDIC is concerned, however, with the ALJ's dictum which appears to chastise the FDIC for its "failure" to notify Respondent * * * that he was an executive officer and the FDIC's "failure" to cite him for failure to file the executive officer report. There is no affirmative obligation on the part of the FDIC to inform any bank officer of his or her status as an executive officer. Status as an executive officer, in and of itself, violates no statute or regulation. A businessperson sufficiently sophisticated to be chairman of the board of a bank and undertake the fiduciary responsibilities of that position is presumed to be capable of reading and understanding the regulatory definition of "executive officer", or of seeking advice of bank counsel or personal legal counsel. Moreover, according to sections 304.5(e) and 349.3(c) of the FDIC Rules and Regulations, 12 C.F.R. §§ 304.5(e) and 349.3(c), Form FFIEC 004 (the executive officer's report) is only a recommended form that may be used by executive officers and principal shareholders of an insured state nonmember bank to report to the board of directors of their bank on their indebtedness to correspondent banks. These reports are not required to be made available to the public and "shall not be filed with the FDIC unless specifically requested" (emphasis added).
   Because Respondent * * * was an executive officer of the Bank, we adopt the finding of the ALJ that the $1.5 million extension of credit to the Partnership exceeded the Bank's lending limits under sections 215.2(f) and 215.4(c) of Reg. O by $275,000.

Violation of Section 215.4(a)(2) of
Regulation O

   The Notice in this proceeding charged that the Bank's loan to the Partnership involved more than the normal risk of repayment or presented other unfavorable fea- {{4-1-90 p.A-1288}}tures in violation of section 215.4(a) of Reg. O. The Recommended Decision concluded that the loan to the Partnership was unsound and warranted the adverse classification assigned to it. Nonetheless, the ALJ dismissed this charge on the ground that the FDIC failed to establish that the Partnership loan was preferential in nature. R.D. at 6-8. The ALJ found and concluded that Reg. O pertains only to preferential loans to insiders. Therefore, no action for a civil money penalty can lie unless it is proved that an extension of credit to an insider was both (1) preferential in its terms, including interest rate and collateral, and (2) that the treatment or method used by the board of directors of the bank in determining the creditworthiness of the insider was preferential or differed in any way from the treatment or method used by the board in determining the creditworthiness of non-insiders. The ALJ reasoned, since the FDIC neither alleged nor demonstrated that the terms of the loan to the Partnership were preferential, and since the FDIC did not demonstrate that the Partnership loan was any more uncreditworthy than any other loan at the Bank, that the loan was not violative of section 215.4(a). The ALJ's reading and interpretation of section 215.4(a) are erroneous.
   The ALJ reads section 215.4(a) to require the FDIC to prove that the Partnership loan violated both subsection (a)(1) and (a)(2) in order to support a violation. However, this interpretation is in conflict with the plain language of the regulation. The use of the word "and," a conjunctive, in section 215.4(a) makes clear that the regulation presumes that loans to insiders will be made only if the conditions in both subsection (a)(1) and (a)(2) are met. Both of the conditions, i.e., non-preferential terms and normal risk of repayment or no other unfavorable terms, must be present in order for an insider loan to be acceptable. The absence of either one of the conditions is sufficient to create a violation of section 215.4(a).
   In reaching his erroneous interpretation of section 215.4(a), which limits its applicability to preferential insider loans, the ALJ justifies his conclusion by inserting into the regulation the phrase "such extensions of credit," where no such language appears.⁴
   The ALJ further reasons that, unless a loan is proven to be more unfavorable than other loans made by the subject bank, there can be no violation of Reg. O. This, too, is a misreading of the regulation. The phrase "more than normal risk of repayment" means the risk that a prudent lender would take—not the risk that a specific bank might take. In fact, the logical extension of the ALJ's reasoning leads to the absurd conclusion that, if a bank regularly made imprudent loans to its non-insider customers, an imprudent loan to an insider would be perfectly acceptable and would not run afoul of Reg. O. This is clearly neither the intent nor the plain meaning of Reg. O.

[.1] The record before us establishes that the loan to the Partnership involved more than the normal risk of repayment and presented other unfavorable features in violation of section 215.4(a). The loan and collateral files on the Partnership contained incomplete and insufficient documentation or completely lacked documentation; the asset collateralizing the loan could not support repayment of the loan; and the borrower and guarantor did not appear to be able to repay the loan based upon available financial information. Other unfavorable features included an interest rate equal to 75% of the Chase Manhattan prime interest rate. Although this interest rate was the usual rate charged on tax-free revenue bond projects and not preferential in nature, because of the Bank's lack of income, it was not able to fully benefit from the tax-free status. Consequently, as compared to the income which the Bank could have earned from taxable securities, the Bank lost substantial income. Accordingly for the reasons set forth, the Board finds and concludes that Respondents also violated section 215.4(a) of Reg. O.

The Civil Money Penalty

[.2] Section 18(j)(3)(A) of the Act authorizes the FDIC to impose a maximum civil penalty for each violation of $1,000 per day for each day during which a violation of section 22(h) of the Federal Reserve Act, 12 U.S.C. § 375b, or any lawful regulation promulgated thereunder, continues. In determining the amount of the assessment, section 18(j)(3)(B) of the Act, 12 U.S.C.

⁴ The ALJ describes subsection (1) [sic] of section 215.4(a) as prohibiting preferential insider credit extensions, "while subsection (2) [sic] joined with the conjunctive `and' goes on to prohibit abnormal risk of repayment in `such credit extensions'." R.D. at 7. The text of the regulation found at 12 C.F.R. § 215.4(a)(2) concludes with the phrase "or present other unfavorable features" following the word "repayment." {{4-1-90 p.A-1289}}1828(j)(3)(B), requires that certain factors be considered by the FDIC when it assesses civil penalties. Section 18(j)(3)(B) provides:

In assessing a civil money penalty, significant consideration should be given to the financial or economic benefit the respondent obtained from the violation, and, in some circumstances, it is appropriate that the penalty reflect some additional amount beyond the economic benefit derived as punishment for the offense and to provide a deterrent to future conduct. FDIC X-31, Interagency Policy Regarding the Assessment of Civil Money Penalties by the Federal Financial Institutions Regulatory Agencies.
   The ALJ recommended a penalty of $10,000 against Respondent * * * and a penalty of $1,000 each against the remaining Respondents. This conclusion appears to have been based on several factors. First, the ALJ is of the view that Respondents violated only the lending limits of Reg. O. Second, he found this single violation to be "not a grave violation" and stressed that "the issue here is not the `gravity' of the violation, but rather the mitigating effect of the circumstances under which it was made and later remedied". Third, the ALJ cites the "absence of government notice" to Respondent * * * of his status as an executive officer. Finally, the ALJ describes the violation as "inadvertent." R.D. at 9. The Board previously discussed its disagreement with the ALJ's conclusions regarding factors one through three, above. In addition, the Board strongly disagrees with the characterization of these violations as inadvertent. The amount of the loan in question was $1.5 million. This represented approximately 30% of the Bank's total equity capital and reserves. FDIC X-2-b; Tr. at 148. In light of the condition of the Bank at the time of this loan, "negligent" seems to be a better description of the actions of the board of directors in making a loan of this magnitude with the meager information presented to it at the board meeting or contained in the loan file.
   The ALJ discusses at great length the distinction between a respondent's present and potential ability to pay, and ultimately concludes that, even in the absence of present ability to pay, future ability to pay a penalty is sufficient basis to assess a penalty. The Board agrees, but on the record in this case sees no basis upon which to limit Respondent * * *'s future ability to pay a penalty to $10,000.
   As noted above, section 18(j)(4)(A) of the Act, 12 U.S.C. § 1828(j)(4)(A), authorizes the FDIC to impose a maximum civil penalty of $1,000 per day for each day during which a violation of section 22(h) of the Federal Reserve Act, or any lawful regulation promulgated thereunder, continues. The maximum fine which could have been statutorily imposed for the violations at issue here was $511,000.⁵ Tr. at 395-396.
   The FDIC is not required to prove the actual ability of a respondent to pay a civil money penalty. Rather, section 18(j)(4) only requires that the FDIC take into account a respondent's financial resources, among other factors, in determining the appropriate amount of a penalty. The record is clear regarding the FDIC's consideration of each respondent's financial resources as of the issuance of the Notice in accordance with section 308.71 of the FDIC Rules and Regulations, 12 C.F.R. § 308.71. Tr. at 382, 394-95, 432, 458-463.
   In addition to the request for financial information made in the FDIC's ten-day letter, FDIC X-2, the FDIC served all Respondents with a subpoena duces tecum signed by the ALJ requiring all Respondents to bring to the hearing specified financial records, including, inter alia, their most recent federal and state income tax returns and other relevant data bearing upon each Respondent's financial resources, FDIC X-50; Tr. at 586-591. Respondent * * * did not comply with the subpoena duces tecum. As a result, he will not be heard at this point in time to contradict the only evidence available to the

⁵ There is considerable confusion in the record regarding the number of violations involved in this proceeding. However, the Notice specifically alleges violations of sections 215.4(c) and 215.4(a)(2), and this calculation is limited to those alleged violations. {{4-1-90 p.A-1290}}FDIC in making its assessment of his ability to pay a civil money penalty. A party in possession of such evidence is in the best position to prove his or her own financial status, Lindahal v. OPM, 776 F.2d 280 (Fed. Cir. 1985). At the time the assessment was made the FDIC had in its possession the September 1986, personal financial statement of Respondent * * *, FDIC X-26, which indicated a net worth of $901,000, and Respondent * * *'s 1985 financial statement which reflected a net worth of $2.2 million, FDIC X-25. Even after taking into consideration discounting factors, such as the decrease in value of the Bank's stock, it is apparent that, at the time the assessment was made, Respondent * * * had the financial ability to pay a substantial penalty. Respondent * * * testified at the hearing that in 1987 he received $2,700 per month in rental income; that he purchased a home in Florida on the basis of a credit report without having to provide a financial statement or a statement of earnings, Tr. at 615-616; that he borrowed $177,000 from a savings and loan association, paid $115,000 in cash to the seller of the house and gave a second mortgage on his condominium in Alabama as security, Tr. at 741, 617. As discussed below, Respondent * * * continues to receive rental income from the * * *. Respondent * * * is optimistic about his future prospects in Florida, Tr. at 778, as is the ALJ, R.D. at 11. In light of Respondent * * *'s failure to provide current financial data, the Board's review of the existing record indicates that he has the ability to pay a substantial penalty.
Although the record concerning the financing of the loan and the operation of the housing project supported by the loan is far from clear, that Respondent * * * received a financial benefit as a result of this loan is clear. In accordance with the Interagency Policy Statement the Board believes that is an appropriate basis for assessing the penalty in this case.
First, the proceeds of the loan were used to pay off a $1,270,475 first mortgage loan on the townhouse complex owed by Respondent * * * to another institution. Considering that at the time this loan was extended, peer institutions were receiving an 11.43% interest rate on loans and that Respondent * * * received a 7.125% loan from the Bank, the Board finds that Respondent * * *, over the thirty-year mortgage term, would have reaped a savings benefit of $981,000. FDIC X-1 at 4-a; Tr. at 393-394. According to the annual amortization schedule on this loan, from January 1, 1986, to the commencement of the hearing, Respondent * * * benefited from this low interest transaction by some $73,600. Second, based on documentation submitted by Respondent * * * to the Bank or to the trustee it appears that Respondent * * * considers the gross monthly rent on the property to have been approximately $8,616 per month in 1986, FDIC X-44, and a total of $23,700 for February through July of 1987, * * * X-7. Respondent * * *, or one of his companies, received this rent, Tr. at 754. Respondent * * * also benefited from the payment of the 1986 Partnership ad valorem taxes by the bond trustee in the amount of $8,500, Tr. at 540. In total, it appears that the loan to Respondent * * * inured to his benefit in the gross amount of approximately $209,000.⁶ Our review of the record indicates that the evidence regarding Respondent * * *'s expenses for this period are not any more clear than the evidence regarding the income from the apartments. Nonetheless, based upon * * * X-7, Respondent's apartment-related expenses for the period February-July, 1987, appear to be approximately $11,300. Using that as a guide, an approximation of the expenses for the period January 1986 through July 1987, would be $34,000. Thus, Respondent * * * netted over $175,000 as a result of this transaction.

[.3] Assessment of a penalty in the amount of the personal gain of Respondent * * * is both reasonable and rational, and the Board would be justified in assessing a penalty in this amount. However, the Board has also taken into consideration several additional factors. This case does not involve personal dishonesty on the part of any Respondent; there has been no prior Reg. O violation; and management did take action to rid the Bank of the overline situation. Upon careful consideration of the entirety

⁶ To this sum, FDIC counsel would add $107,000 paid to * * *, a company owned by * * *, for renovations to the * * * townhouses, FDIC X-44. The evidence is at least unclear regarding the amount of work actually performed at the property, FDIC X-1 at 2-a-22, but the Board is not prepared to say, on the basis of this record, that the collateral was not improved at all. Accordingly, the Board has given Respondent * * * the benefit of the doubt and has excluded this amount from the calculation of the financial benefit to him.
{{4-1-90 p.A-1291}}of the record herein, the Board finds that a penalty against Respondent * * * in the amount of $125,000 is justified and appropriate.

Other Respondents

The Respondents other than Respondent * * *, though not beneficiaries of the violative loan and not the focus of this enforcement action, are nonetheless appropriately the subject of this civil money penalty for causing, participating in, aiding and abetting the violations of section 22(h) of the Federal Reserve Act and sections 215.4(a) and (c) and section 215.2(f) of Reg. O. In light of the continuing nature of the violations, the significant impact this loan had on the condition of this bank, and the statutory penalty which could be imposed, the assessed penalty is a minimum penalty and is assessed primarily for its deterrent effect.
With respect to Respondents * * *, * * *, * * *, and * * *, the Board finds that each has the present or future ability to pay a civil money penalty. Tr. at 24, 60, 585-86. A penalty in the amount of $3,000 each is justified and appropriate based on the record in this case.

ORDER TO PAY CIVIL MONEY
PENALTIES

   The Board of Directors of the FDIC, having considered the entire record in this proceeding, including briefs filed on behalf of Respondents and the FDIC, the ALJ's Recommended Decision and Order dated January 23, 1988, and exceptions to the Recommended Decision and Order filed by each party, and after taking into consideration the appropriateness of the penalties with respect to the financial resources and good faith of Respondents, the gravity of the violations, the history of previous violations, and such other matters as justice may require, makes the following findings. The Board finds on the record before it that Respondents violated section 22(h) of the Federal Reserve Act (12 U.S.C. § 375b) and sections 215.2(f), 215.4(c), and 215.4(a) of Regulation O, promulgated thereunder (12 C.F.R. §§ 215.2(f), 215.4(c), and 215.4(a)).
   ACCORDINGLY, IT IS HEREBY ORDERED, that by reason of the violations set forth above, a penalty of $125,000 be, and hereby is, assessed against * * *; and a penalty of $3,000 each be, and hereby is, assessed against * * *, * * *, * * *, and * * *, pursuant to section 18(j)(3) of the Act, 12 U.S.C. § 1828(j)(3).
   IT IS FURTHER ORDERED, that this Order shall be effective and the penalty ordered shall be final and payable twenty (20) days from the date of this Order. The provisions of this Order shall remain effective and enforceable except to the extent that, and until such time as, any provision of this Order shall have been modified, terminated, suspended or set aside by the Board.
   By direction of the Board of Directors.
   Dated at Washington, D.C., this 24th day of May, 1988

/s/ Hoyle L. Robinson
Executive Secretary

RECOMMENDED DECISION AND ORDER

FDIC 87-71k

   WILLIAM A. GERSHUNY, Administrative Law Judge: A hearing was conducted in * * *, during the period of July 27-30, 1987, on a Notice of Civil Money Penalties issued on April 8, 1987, assessing civil money penalties of $290,000 against Respondent * * * and of $3,000 against each of the remaining Respondents, * * *, * * *, * * * and * * *, based on violations of Regulation O noted during an examination as of January 31, 1986.
   Initially, the Notice joined other individuals as co-Respondents. A number filed no request for hearing and, as to them, default judgments were entered. Others entered into settlements with counsel for the FDIC, and they were not parties to the hearing.
   All Respondents adopted the evidence offered at the hearing by counsel for Respondents * * * and * * *.
   Upon the entire record, including my observation of witness demeanor, and pursuant to Sec. 308.13 of the FDIC Rules and Regulations, 12 CFR § 308.13, I hereby make the following:

Findings of Fact and Conclusions of Law

I. Jurisdiction

The Notice alleges, Respondents admit, and I find that Respondents, as chairman and/or directors of an insured State nonmember bank, are subject to the jurisdic- {{4-1-90 p.A-1292}}tion of the FDIC and its Rules and Regulations.

II. The Alleged Violations of Regulation O

A. Regulation O.

   Regulation O, 12 CFR § 215, promulgated by the Federal Reserve Board to implement Sec. 22(h)(3) of the Federal Reserve Act, 12 U.S.C. 375b, and made applicable to insured state nonmember banks by Sec. 18(j) of the Federal Deposit Insurance Act, 12 U.S.C. 1828(j), and Sec. 337.3 of the FDIC Rules and Regulations, 12 CFR § 337.3, one of many statutory and regulatory proscriptions imposed on FDIC-insured banks, is intended to curb the granting of unlimited credit and preferential credit terms to bank "insiders," e.g. executive officers and directors, to the detriment of shareholders and depositors.
   Sec. 215.4(a) requires that extensions of credit to an executive officer or director of a bank or their "related interest" (1) be made on "substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions by the bank with other persons" and (2) that such credit extensions "not involve more than the normal risk of repayment or present other unfavorable features." Secs. 215.4(c) and 215.2(f), read together, establish lending limits for such extensions of credit, in this case being 25% of the Bank's then total equity capital and reserves of $4,900,000, or $1,225,000.
   Sec. 215.2(d), in relevant part, defines "executive officer" of a bank as (1) any person "who participates or has authority to participate in major policymaking functions" whether or not the person has a title, and (2) the chairman of the board, unless that person "is excluded, by resolution of the board of directors or by the bylaws of the bank or company, from participation...in major policymaking functions of the bank...[and] does not actually participate therein."
   Sec. 215.2(k) defines "related interest" as "a company that is controlled by a person..."

B. The Allegations of the Notice.

   The Notice alleges that Respondent * * * was, at all relevant times, chairman of the board and an executive officer of the Bank, and that the remaining Respondents, * * *, * * *, * * * and * * *, were directors of the Bank; that * * * ("* * *") was solely owned and controlled by Respondent * * * who, guaranteed its debts to the Bank and thus was his "related interest;" that on November 22, 1985, the board of directors of the Bank extended credit to * * * in the amount of $1,500,000, which was $275,000 in excess of the lending limits of Secs. 215.4(c) and 215.2(f) of Regulation O; and that this credit extension involved more than the normal risk of repayment and had other unfavorable features, including a lack of documentation "and/or incomplete and insufficient documentation with respect to essential financial information," in violation of Sec. 215.4(a) of Regulation O. The Notice seeks penalties of $290,000 from * * * and $3,000 from each of the other Respondents.
   The Notice does not allege, and counsel for the FDIC does not contend, that the * * * loan was made on preferential terms, either as to interest rate or collateral, in violation of Sec. 215.4(a)(1).
   As will be discussed in greater detail below, this case is atypical of the many regulatory enforcement proceedings initiated annually by the FDIC, in that it has been blemished from the outset by considerable confusion and differing opinions within the FDIC as to the nature of the violations and the amount of the penalties to be assessed. Examiner * * *, in charge of the January 31, 1986 examination, found only lending limit and preferential interest rate violations, and he so advised the Bank's board of directors of his preliminary conclusions. Moreover, he miscalculated the amount of the overline by $25,000, causing a delay in the Bank's ability to eliminate the excess. And he never cited the Bank with a violation of Sec. 215.4(a)(2) ("more than a normal risk of repayment"), one of the principal theories on which the FDIC is now proceeding. Neither * * * nor any other examiner who examined this Bank ever cited * * * for his failure to file a Government reporting form required to be completed by Bank executive officers, and it was not until the January 31, 1986 examination that he was told he was an "executive officer" of the Bank. Yet, in this proceeding, the FDIC bases its case on the premise that * * * was at all times since the founding of the Bank * * * years earlier an executive officer for purposes of Regulation O. The Regional Director's "10-day letter" to * * *, dated May 13, 1986, advising him {{4-1-90 p.A-1293}}that civil money penalties were being proposed, refers to violations of Sections 215.4(a) and (b). Yet subsection (b), relating to prior board approval of insider loans, was never cited in the examination report. The Regional Director's memorandum of April 3, 1987, to the FDIC Board of Review in Washington, proposing civil money penalties, refers only to lending limit and abnormal repayment risk violations. At no time prior to the issuance of the Notice in this case did the examiner-in-charge or the Regional Director treat this case as one involving a violation of Section 215.4(a)(2) based on "other unfavorable features" of any kind. In his April 3, 1987 memorandum, the Regional Director whose staff is directly responsible for the continuing supervision of this and other troubled banks in this depressed area of the country proposed penalties well below the level specified in the Notice: $25,000 against Respondent * * * and $1,000 against each of the other Respondents here. Review Examiner * * * of the FDIC Headquarters Special Situation ("Problem Banks") Section, who made the final recommendation as to the penalties to be assessed, based his recommendation on the assumption that three Regulation O violations were involved in this case: (1) lending limits; (2) more than the normal risk of repayment; and (3) other unfavorable features, and admittedly took into account facts and opinions not offered by counsel for the FDIC or made a part of the record evidence in this case. The penalties he recommended were $290,000 against * * * (almost 12 times the penalty recommended by the Regional Director) and $3,000 against the other Respondents here (3 times that recommended by the Regional Director). And, finally, at the pretrial conference of June 8, 1987, counsel for the FDIC stated that the issues in the case were limited to allegations of one violation of Sec. 215.4(c) relating to lending limits, and two of Sec. 215.4(a)(2) relating to adnormal risk of repayment and lack of documentation for the loan.

C. The Contentions of Respondents.

Respondents admit the extension of credit to * * *, but deny that Respondent * * * was an executive officer of the Bank. In this connection, they point out that the January 31, 1986, report of examination on which the FDIC relies was the first time the FDIC took the position that * * * was an executive officer. They contend that, immediately upon being informed of the credit overline, steps were taken to eliminate the excess; that this process was delayed and required two steps because, initially, the FDIC under-calculated the overline, and because bond commission approval was required for reissuance of the * * * bonds; and that, when required to charge off $271,000, the loan was current in all respects. Respondents contend that, because they relied in good faith on the FDIC's prior treatment of * * * not being an executive officer, no civil money penalty is warranted.

D. The Extension of Credit to * * *.

   There is virtually no dispute as to the relevant facts relating to the Bank's extension of credit to * * *. On November 22, 1985, 10 weeks prior to the January 31, 1986, FDIC examination, the Bank extended credit to * * *, a related interest of Respondent * * *, by purchasing multifamily housing revenue bonds in the amount of $1,500,000 issued by the * * * ("Issuer"), with * * * Bank * * * (later succeeded by * * * Bank) as trustee ("Trustee"). Interest was pegged at 75% of Chase Prime with a 30-year amortization and a 10-year call. Security consisted of a first mortgage on * * * (purchased by * * * simultaneously with the closing of the loan) and a $100,000 certificate of deposit.
   In support of the loan, the Bank obtained an independent appraisal of the 24-unit * * * in the amount of $1,780,000 (based on the sale of the units). The Bank also obtained a current personal financial statement from * * * and his wife, dated October 2, 1985, which showed a net worth of $2.2 million, and included real estate holdings of $1.4 million and holding company and subsidiary stock holdings of $847,000. Appraised values of the real estate collateral were not provided.
   Also on November 22, 1985, * * * gave a $1.5 million promissory note and an assignment of rents to the issuer, both of which were assigned to the Trustee, and * * * gave his personal guaranty of the indebtedness.
   At all relevant times, the units were maintained as rental units, but, from the inception of the transaction which is the subject of this proceeding, * * * contemplated
{{4-1-90 p.A-1294}}their ultimate conversion to condominiums.
   The January 31, 1986 examination resulted in the adverse classification of this loan, $794,000 as substandard, and $706,000 as loss. On or about June 19, 1986, at a time when the loan was current both as to principal and interest, $271,000 of the loan was charged off. Within five months of the date of the examination, the overline in the amount of $275,000 was "participated out" to others by having the bonds reissued.
   The Bank failed on November 7, 1986, and at the time of the hearing all Bank records relating to the issues in this proceeding were in the exclusive control of the FDIC as receiver.

* * * an Executive Officer of the Bank.

   [.4] On this record, there can be no serious contention, and I find and conclude, that, at all relevant times, * * * was an executive officer of the Bank, within the meaning of Sec. 215.2(d). By virtue of his position as chairman of the board, * * *, by regulatory definition, is deemed to be an executive officer of the Bank, unless he is excluded from policymaking functions by resolution of the board or by the bylaws of the bank. There is no evidence in this record that any such resolution or bylaw was in effect at the time. * * *'s withdrawal from the board meeting which considered the * * * loan does satisfy the resolution/bylaw requirement of Sec. 215.2(d). In any event, * * * was in fact an executive officer because he participated in policymaking functions of the Bank: he appointed members of the executive committees of the board, and served as ex officio member of each committee; as chairman, he conducted most of the board meetings and signed the minutes; he was chairman of the executive loan committee; he brought business into the Bank; he executed employment contracts and other contracts on behalf of the Bank; and he presented loans to the board for approval.
   The fact that * * * never completed and filed the required bank executive officer report, together with the fact that he never was cited for a failure to do so, do not estop or prevent the FDIC from asserting the contrary in this proceeding. Those facts simply point to an oversight on the part of FDIC examiners, who (according to testimony in this record) are required to examine for compliance with this reporting requirement.
   Whether the FDIC's failure to cite * * * in the past is relevant to any civil money penalty issue is considered below.

F. * * * a Related Interest of * * *.

At the hearing, * * * stipulated that he was the general partner of * * *, a limited partnership, and that he had exclusive control and management of the company. Accordingly, I find and conclude that at all relevant times * * * was a related interest of * * * within the meaning of Sec. 215.2(k) and (b).

G. Lending Limit Provisions of Regulation O, Secs. 215.4(c) and Sec. 215.2(f), Violated.

The evidence is indisputable, and I find and conclude, that the * * *' $1.5 million extension of credit exceeded the Bank's lending limits under Sections 215.2(f) and 215.4(c) by $275,000. The regulatory 25% lending limit, when applied to the Bank's total equity capital and reserves of $4.9 million, is $1,225,000.

H. No Violation of "Repayment Risk" or "Other Unfavorable Terms" Provisions of Sec. 215.4(a)(2) of Regulation O.

   For reasons set forth herein, I find and conclude that counsel for the FDIC failed to establish an essential element of a Sec. 215.4(a)(2) violation—that the credit extension was a "preferential" one. Accordingly, I recommend dismissal of these allegations of the Notice.
   Sec. 22(h) of the Federal Reserve Act, and Regulation O which implements it, were intended to fill a hiatus in the regulatory enforcement scheme by curbing two widespread abuses in insider bank loans— unlimited credit and preferential credit terms. As is clearly evidence by the legislative history quoted at pages 34-35 of the FDIC brief, the preexisting law contained few restrictions on insider loans. Sec. 215.4(a) deals with the second of the abuses sought to be curbed, preferential credit terms. It provides that an insider loan is prohibited unless it is made on "substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable [non-insider] transactions...and...does not involve more than the normal risk of repayment or present other unfavorable features" (un- {{4-1-90 p.A-1295}}derscoring added). The legislative history and the statutory language (which the regulation tracks) together evidence a Congressional intent to deal only with preferential insider loans. Neither addresses non-preferential insider credit transactions. The language itself is clear. Subsection (1) of Sec. 215.4(a) describes the prohibited preferential insider credit extensions, while subsection (2), joined with the conjunctive "and," goes on to prohibit abnormal risk of repayment in "such credit extensions." The use of the word "such," in this case, clearly refers back to the preferential type of insider loans. Moreover, there was no need for Congress to deal with non-preferential insider transactions, since other statutory provisions already gave federal bank supervisory agencies ample authority to prohibit abusive credit practices in general. For example, a banking practice of extending credit with inadequate collateral, with inadequate documentation, or without a demonstrated ability of the borrower to repay is an unsafe or unsound one, and can be curbed under other statutory provisions by adversely classifying the asset, by seeking a cease-and-desist order, by removing or suspending the offending bank officials, or by terminating the insured status of the bank.
   Here, the FDIC seeks to curb an insider credit extension, not by establishing that any element of the transaction was preferential, but by showing that the Bank's credit file lacked documentation to show an ability to repay. Again, it must be underscored —the FDIC has offered no evidence whatever of preferential treatment of this insider loan. It has not alleged or established that the interest rate was preferential; it has not alleged or established that the nature or value of the collateral taken was preferential; it has alleged that the credit file contained inadequate documentation, but it has not shown or established that this practice was different than that followed in extending credit to non-insiders; it has alleged that, based on inadequate documentation, this insider credit extension presented a high risk of repayment, but it has not shown or established that this credit extension involved more than a normal risk of repayment, or differed in any way from the treatment given other comparable customers of the Bank. At best, the FDIC has established an unsafe or unsound banking practice, and it properly assigned an adverse classification to the loan. The FDIC could have sought a cease-and-desist order or the termination of the Bank's insured status, but elected not to do so for the obvious reason that the Bank already had closed. It could have sought to bar * * * and possibly others from participating in the conduct of the affairs of other FDIC-insured banks, but it chose not to do so. Rather, it proceeds here under Sec. 18(j)(3) of the Act, seeking to impose civil money penalties. However, that provision authorizes the imposition of civil money penalties only in the case of Regulation O and other statutory violations; unsafe or unsound banking practices are not included within its scope. The conclusion thus appears inescapable—the FDIC may not charge a violation of Section 215.4(a) of Regulation O based on an unsafe or unsound practice which it has not established as a preferential one, in order to impose upon bank officials a civil money penalty under Sec. 18(j)(3).

I. The Civil Money Penalty.

Having found and concluded above that Respondents violated the lending limit provisions of Regulation O, I now consider the issue of the amount of the civil money penalties to be assessed.

   In this case, the FDIC seeks penalties of $290,000 against Respondent * * * and $3,000 against each of the other Respondents. Presumably, these assessments were based on the recommendations of Review Examiner * * * of the FDIC Headquarters Special Situation Section. The record reflects that the Regional Director and his staff had earlier recommended penalties only of $25,000 and $1,000 respectively.
   Because Congress delegated to the FDIC overall enforcement responsibilities as to state nonmember insured banks, recommendations of the FDIC as to the amount of the penalties to be imposed are entitled
{{4-1-90 p.A-1296}}to great weight, provided they are based on facts which comprise "the record made at the hearing." Sec. 308.71, FDIC Rules and Regulations. To the extent they are based on facts outside the record or on opinions of persons not called to testify, the recommendations are not entitled to any weight. Moreover, FDIC administrative precedent is clear: it is the "responsibility[of the administrative law judge] under the FDIC Rules and Regulations to make an independent recommendation as to the amount of the penalty, based on the record evidence." Page 5, ALJ Decision, In the Matter of ***, FDIC-86-92k (12/5/86), affirmed by FDIC Board of Directors, March 17, 1987.
   There can be no serious contention that an extension of credit which exceeds bank lending limits by $275,000 is not a grave violation of Regulation O. It is a serious one, with significant consequences. However, the issue here is not the "gravity" of the violation, but rather the mitigating effect of the circumstances under which it was made and later remedied. In this connection, it should be stressed that the FDIC does not allege or suggest personal dishonesty on the part of any Respondent; it does not allege any concealment of the facts; and it does not allege a single prior violation of lending limit proscriptions under either State or Federal banking laws or regulations. In short, this lending limit violation was an isolated instance in the five-year history of this Bank. Moreover, it should be noted that Chairman * * * had never before been told by either Federal or State banking examiners that he was an "executive officer" of the Bank. Although the record evidence here clearly establishes that * * * was in fact an executive officer at all relevant times (and, therefore, presumed to know the legal requirements imposed on him as such), this absence of government notice to * * * is, I believe, a factor in mitigation of the gravity of the violation in that it negates any suggestion whatever that the violation was anything other than an inadvertent one. And, finally, it is relevant to a determination of the amount of the penalty to be assessed that Chairman * * * and the other Board members took prompt action to rid the Bank of the overline once it was informed of the FDIC's position as to the status of Respondent * * * . That this remedial action of the Bank took upwards of five months from the date of the commencement of the examination (the exact date of the action does not appear in this record) appears to be more the fault of Examiner-in-charge * * * (who originally understated the amount of the overline) and the requirement that new * * * bonds be issued by the state agency than by any hesitancy on the part of the Bank.
   As to the ability of the Respondents to pay a civil money penalty in the amounts sought by the FDIC, it should be noted at the outset that Respondents * * * and * * * each stipulated he had the requisite "ability to pay" a $3,000 penalty. The record evidence clearly demonstrates that Respondent * * * has no present ability to pay a penalty in whatever amount. He is 51 years of age, married, and with a son in college; his home and acreage were sold at sheriff's sale in July 1987, and he owns no other property, real or personal, other than a 1984 pickup truck; and for tax years 1985 and 1986 he earned only $2,100 and $2,166 respectively. The record evidence clearly demonstrates that Respondent * * * has the present ability to pay a penalty in the amount sought by the FDIC. It was stipulated that this unmarried man has a gross annual income of $46,000, a net monthly income of $2,400, and was discharged in bankruptcy in May 1987.
   The record evidence establishes that Respondent * * * has no present ability to pay a civil money penalty of $290,000, as proposed by the FDIC. Respondent * * * is 49 years of age, married, with two minor children. He has a Master's Degree in microbiology and a Ph.D. in food science and nutrition. For a number of years, he served as a high government official for the State of * * * , and since 1968 has been quite successful in the construction and real estate development business. He was an original founder of the Bank in 1981. He presently resides in Florida. His most recent financial statement, one dated September 9, 1986, shows a net worth of $901,000. Since that time, his residence in * * * has been given up in foreclosure proceedings, a Mercedes automobile has been given up in payment of a bank loan, a $14,000 life insurance policy has been cashed, other real estate has been given up to creditors or is the subject of current litigation and has no apparent value, and a residential condominium in Florida has little or no equity. Currently, * * * has reentered the construction business in * * * by forming a construction corporation which has no assets and which {{4-1-90 p.A-1297}}builds homes for other builders using their financing. At the time of the hearing, two homes were under construction in a 1,000 lot subdivision. Whatever income * * * presently derives from rents goes to satisfy underlying debts on those properties. There are a number of suits pending against him seeking damages in substantial amounts. It is anticipated that the FDIC, as receiver charged with liquidating the assets of this closed bank, will institute litigation against * * * seeking to recover losses sustained by the Bank as a result of the * * * credit extension. Clearly, Respondent * * * has no present ability to pay any but the most nominal civil money penalty. The inquiry, however, does not stop there, for the reason that there is no present order requiring this Respondent to make any payment whatever. The process leading to a final order of payment may very well be a long one, beginning with my recommended order, a review by the FDIC's Board of Directors, and concluded possibly by an appellate court review. To some extent, then, the fact-finder must make an educated guess as to a respondent's ability to pay at some future time, especially where, as here, the violation is a serious one for which Congress clearly evidenced an intention that some penalty be imposed as a deterrent against future violations. In this respect, I can think of no better basis for predicting the financial future of Mr. * * * than his own words:

[

]

future

   In fixing the amount of penalty to be assessed against Respondents, I have no choice but to reject the recommendations of Review Examiner * * * , despite the value of his opinions concerning the need for imposition of penalties in this case and his explanations of the factors to be considered. There are four principal reasons for rejection of his testimony in this regard. First, his recommendation of penalties of $290,000 and $3,000 respectively against * * * and the other directors is based on his assumption that Respondents engaged in three violations of Regulation O, whereas I conclude that only a single lending limit violation occurred. There is nothing in his testimony to indicate what his recommendation would have been if he considered only this single violation. Second, he based his recommendation on the assumption that each Respondent had the ability to pay penalties of those amounts. The record evidence, which is the only proper basis for the assessment of penalties, demonstrates otherwise. Third, Examiner * * * based his recommendations on factual information and opinions not a part of the record before me. This information and these opinions are largely unidentified and unspecified, but apparently their sources include FDIC bank liquidation officials and records and a review examiner in the Regional office. Again, the FDIC Rules and Regulations themselves require that the penalty be based on record evidence. And fourth, his recommendation was based on erroneous factual data used by Examiner * * * in the Report of Examination, e.g. that a cash flow statement "found" in the * * * loan file was a Bank record, whereas in fact there is no evidence whatever to authenticate this handwritten document and at the time the loan files were being handled by both State and Federal examiners; that the Bank granted a moratorium on principal payments on the * * * loan, whereas in fact the original amortization schedule provided for no principal payment for several months, and the loan was not in default; and that the MAI appraisal relied on by the Bank was inadequate in * * * 's opinion, based on his assumption that the handwritten cash flow statement was a Bank record, on his own estimate of market value as a recent home- {{4-1-90 p.A-1298}}owner in the * * * area, and on his "inspection" of the property.
   On the other hand, I find the recommendation of the Regional Director and his staff as to the amount of the penalties to be of considerably greater value in making my recommendation. Presumably, they were in a better position to judge the ability of each Respondent to pay a penalty, as well as the gravity of the violation, the effect of mitigating circumstances, and the need for a deterrent against future violations. I do note, however, that the Region's recommendation of penalties in the amounts of $25,000 and $1,000 is based on multiple violations of Regulation O, whereas I find only a single, non-recurring lending limit violation.
   In recommending the penalties to be assessed, I take into consideration a number of factors: that the Bank is now closed; that Respondents no longer hold any positions in insured banks and the need for a deterrent effect is lessened, if not eliminated entirely: that the FDIC as receiver of the Bank presumably will pursue collection and damage remedies against these Respondents for Bank losses, including the $270,000 written off the * * * loan as "loss;" that efforts to collect penalties of the size recommended by Review Examiner * * * will only serve to frustrate collection efforts against Respondents; that recovered penalties are for the benefit of the United States Treasury, whereas collections remain property of the Bank receiver; that at all times Respondents acted responsibly, openly, honestly and in good faith; that there is no evidence of any past Regulation O violations; that Respondents took prompt and effective action to eliminate the overline; and that, on the record evidence in this case, only a single Regulation O violation has been established.
   Pursuant to Sec. 18(j)(3) of the Act, and Sec. 308.13 of the FDIC Rules and Regulations, and based on the record evidence, I recommend that the Board of Directors of the Federal Deposit Insurance Corporation issue orders assessing a civil money penalty of $10,000 against Respondent * * * , and assessing civil money penalties of $1,000 each against Respondents * * * , * * * , * * * , and * * * .
Dated: January 23, 1988
/s/ WILLIAM A. GERSHUNY
Administrative Law Judge

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