Appeals of Material Supervisory
Determinations: Guidelines & Decisions
SARC-99-01 (February 4, 1999)
Your appeal of material supervisory determinations was
denied by the Supervision Appeals Review Committee (Committee) of the
Federal Deposit Insurance Corporation (FDIC) on January 28, 1999.
The State of California Department of Financial
Institutions (the State) Commissioner Walter J. Mix III was provided a
copy of your letter of appeal; Deputy Commissioner James E. Brodie has
responded that the State concurs with the ratings and overall findings of
the Report of Examination.
Before deciding your appeal, the Committee considered your
request to appear in person before the Committee for purposes of presenting
witnesses and evidence in support of your appeal. Based upon the
comprehensive nature of your October 18, 1998, appeal letter and December
14, 1998 supplement, the Committee concluded that the record relating to
your appeal was sufficiently complete and that an oral presentation would
not be productive.
The Committee has given careful consideration to the
issues raised in your letters related to the Management and Composite
ratings assigned at the March 9, 1998, joint Safety and Soundness
examination. After careful review, the Committee has concluded that the
Management rating of 4 and Composite rating of 3 are appropriate as
reflected in the report. Although the Committee recognizes the generally
satisfactory financial indicators at [Bank] (Bank), serious deficiencies
remain in management and board oversight that warrant the Management and
Composite ratings assigned. These deficiencies are described below.
The Committees conclusions on the general Report of
Examination findings appealed by the Bank are presented below along with an
explanation of the reason for the decision.
1. Board Supervision The Committee concluded that the corporate
governance exceptions listed are not merely technical in nature. Some of the
criticisms constitute a serious risk to the Bank. For example, allowing
Chairman *** to exercise the ESOPs proxy without appropriate authority
exposes the Bank to litigation risk. Furthermore, taken together, the
criticisms reflect a general failure by the board to appropriately involve
itself in the Banks affairs, to properly implement and execute its own
policies, and to supervise operating management. Concerns regarding lax
board oversight have been expressed at previous examinations. Corporate
governance criticisms were not uncovered due to an abnormally thorough
examination. FDIC and the State followed appropriate and established risk
2. Senior Management Deficiencies
The Committee notes your efforts in attempting to hire and retain senior
managers. However, management is responsible for assuring that overall
personnel policies and organizational structure are adequate. The Committee
concluded that deficiencies in these areas need managements attention. A
sound organizational structure is the foundation of a satisfactory internal
control system. In an environment with rapid turnover and ill-defined
responsibilities, it is difficult to ensure employees are properly trained,
which increases the chances for errors, limits personnel rotations, and
tends to concentrate knowledge in just a few employees.
3. Insider Transactions/Potential
Conflicts of Interest and Possible Breaches of Fiduciary Duty.
The two transactions cited in the examination involving sales of Bank assets
to Mr. *** X and Y -- are of serious concern. The Banks arguments regarding
the seemingly low bid on the X property are not persuasive. The case law
cited by the Bank does not hold that the Bank was legally prevented from
making a higher bid. Additionally, examiners reported that, contrary to the
Banks assertions, it is common practice for California lenders to bid the
full amount due on their books. In fact, the Bank did just that in the
auction regarding the Y notes. Furthermore, the State has disputed the
Banks assertions regarding cash bidding and indicated that no California
law prohibits cash bids.
The fact that Mr. *** ultimately purchased these assets,
or portions thereof, is not documented in board minutes. Lack of proper
documentation and discussion indicates that the board may not have fully
understood the transactions. The Committee is quite concerned with the
Banks statement that From the Banks standpoint it was immaterial whether
Partnership or Chairman *** personally made the payment as long as it got
paid. This statement is inconsistent with boards responsibility to comply
with sound banking practices and with the statutes governing insider
Bank transactions involving insiders must be conducted in
a manner beyond reproach. This includes ensuring and documenting that the
terms and conditions of the insider transaction are essentially the same as
those involving a disinterested third party and are clearly disclosed to the
board of directors. Anything less gives the appearance of conflict of
interest and exposes the Bank to litigation and regulatory risk. The
appearance of a conflict of interest certainly arises in this situation as
the transactions appear to have benefited Mr. *** at the Banks expense. The
board is urged to review these transactions and to take appropriate actions
to address this apparent conflict and to prevent others from occurring in
4. Apparent Violations of Law or
The Committee concurs that certain of the apparent violations cited are
correctable in the normal course of business and recognizes managements
efforts to seek those corrections. However, others, namely the Federal
Reserve Act Section 23(b) and the Employee Stock Option Plan-related
apparent violations raise issues regarding fiduciary duty that can expose
banks to litigation risk.
The findings on the Management component rating and
Composite rating assigned at the March 9, 1998 examination are presented
below along with an explanation for the reason for the decision.
The Uniform Financial Institution Rating Systems definition of a Management
rating of 4 follows:
A rating of 4 indicates deficient management and board
performance or risk management practices that are inadequate considering
the nature of an institutions activities. The level of problems and risk
exposure is excessive. Problems and significant risks are inadequately
identified, measured, monitored, or controlled and require immediate
action by the board and management to preserve the soundness of the
institution. Replacing or strengthening management or the board may be
necessary. (Emphasis added).
Serious management weaknesses were noted in the Report of
Examination. The board and operating management evidence deficiencies that
expose the Bank to risk and must be corrected. Board oversight is weak, and
management has failed to establish a proper control environment. Similar
criticisms were noted at previous examinations. Of particular concern at
this examination are the questionable insider transactions involving sales
of assets to Chairman ***. These transactions appear to be conflicts of
interest and deserve the boards prompt attention.
Management deficiencies cited in the Report of Examination
revolve around an inadequate board that has failed to implement appropriate
controls, including supervision of operating management featuring a very
dominant chairman. Management criticisms are similar to criticisms levied at
previous examinations, which demonstrates a general disregard for prudent
risk practices. Despite the Banks overall risk profile and noted
improvements since the previous examination, the Committee concludes that
the Management Component should remain a 4.
The Committee objects to the assertion that the
examination was abnormally thorough and if the same level of review was
exercised at each examination of comparable banks then these deficiencies
would exist. The examination was not abnormally thorough as the review
procedures were typical of those used for examinations of other institutions
with similar characteristics. The Committee also disputes the claim that the
level of administration sophistication sought is totally unrealistic and
that many, if not most, of the criticisms of reporting systems, controls,
and audit oversight could similarly be made at a very high percentage of
banks of comparable size. It is common for other institutions this size to
have acceptable practices and controls and reporting mechanisms. The
criticisms of administration are, to a large extent, dictated by an
institutions practices and board involvement and not its size.
The Uniform Financial Institutions Rating Systems definition of a Composite
rating of 3 follows:
Financial institutions in this group exhibit some
degree of supervisory concern in one or more of the component areas. These
financial institutions exhibit a combination of weaknesses that may range
from moderate to severe; however, the magnitude of the deficiencies
generally will not cause a component to be rated more severely than 4.
Management may lack the ability or willingness to effectively address
weaknesses within appropriate time frames. Financial institutions in this
group generally are less capable of withstanding business fluctuations and
are more vulnerable to outside influences than those institutions rated a
composite 1 or 2. Additionally, these financial institutions may be in
significant noncompliance with laws and regulations. Risk management
practices may be less than satisfactory relative to the institutions
size, complexity, and risk profile. These financial institutions require
more than normal supervision, which may include formal or informal
enforcement actions. Failure appears unlikely, however, given the overall
strength and financial capacity of these institutions. (Emphasis added).
As indicated, a Composite rating of 3 provides that
these institutions may exhibit supervisory concern in one or more component
areas. The Division of Supervision Manual of Examination Policies states:
When assigning a composite rating, some components may be given more weight
than others depending on the situation. It emphasizes that The quality of
management is probably the single most important element in the successful
operation of a bank and that the management component is given special
consideration when assigning a composite rating.
The board and operating management evidence deficiencies
that expose the Bank to risk. Board oversight is weak, and management has
failed to establish a proper control environment. While the Committee
recognizes that you have indicated that you have taken steps to correct some
of the individual deficiencies identified at the examination, we also note
that similar types of criticism were identified at previous examinations.
This pattern evidences a continuing disregard for adequate risk management
practices and the board and managements unwillingness or inability to
address criticisms in a timely manner. Of particular concern at this
examination are the questionable insider transactions involving sales of
assets to Chairman ***, which appear to be conflicts of interest and deserve
managements prompt attention. Given the foregoing, the Committee concludes
that the 3 Composite rating assigned at the examination is appropriate.
It has also come to our attention that during the
examination, examiners were required to direct all questions and requests
through the Banks general counsel, who is not a Bank employee. This is not
an acceptable requirement, as examiners must have complete and unfettered
access to all bank records and bank employees in order to properly perform
their duties. The Committee understands that the Regional Office staff has
already informed you that such examination obstacles are not tolerable. The
Committee reiterates this point.
The Banks allegations of bias and retaliation by Regional
Office staff were not specifically considered by the Committee. However, the
specific examination findings on which the Bank premises its allegations
were independently reviewed and are addressed above. The Bank may file a
complaint with the Office of the Ombudsman if it believes it has been
subject to examiner bias, retaliation, or impropriety. You may contact the
FDICs San Francisco Office of the Ombudsman at 25 Ecker Street, Suite 600,
San Francisco, California 94105.
The appeal requests that the Ombudsman as well as the
Committee process this appeal. Since the Ombudsman is a Committee member,
the Ombudsman has been involved in the process. The Banks appeal also
requests that the Ombudsman review the fairness and effectiveness of the
process which resulted in the CAMELS rating at issue, and of the appeal
process itself as applied to the Banks 1997 appeal and the present appeal.
This request has been forwarded to the Office of the Ombudsman.
The Banks appeal requested internal FDIC documents
regarding the appeal, and the bank filed a Freedom of Information Act (FOIA)
request for the documents. The request will be addressed pursuant to the
In accordance with the Guidelines for Appeals of Material
Supervisory Determinations, the scope of this review was limited to the
facts and circumstances that existed at the time of the examination; no
consideration was afforded any changes occurring after that date or to any
subsequent corrective action. However, the San Francisco Regional Office
will consider any such efforts in its determination of the proposed
This determination is considered the Federal Deposit
Insurance Corporations final supervisory decision.
By direction of the Supervision Appeals Review Committee
of the Federal Deposit Insurance Corporation.