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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.

Findings Appealed
The Committee’s 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 ESOP’s 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 Bank’s 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 scoping techniques.

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 management’s 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 Bank’s 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 Bank’s 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 Bank’s 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 Bank’s statement that “From the Bank’s standpoint it was immaterial whether Partnership or Chairman *** personally made the payment as long as it got paid.” This statement is inconsistent with board’s responsibility to comply with sound banking practices and with the statutes governing insider transactions.

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 Bank’s 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 the future.

4. Apparent Violations of Law or Regulations.
The Committee concurs that certain of the apparent violations cited are correctable in the normal course of business and recognizes management’s 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.

Management Rating
The Uniform Financial Institution Rating System’s 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 institution’s 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 board’s 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 Bank’s 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 institution’s practices and board involvement and not its size.

Composite Rating
The Uniform Financial Institutions Rating System’s 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 institution’s 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 management’s 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 management’s 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 Bank’s 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 Bank’s 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 FDIC’s 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 Bank’s 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 Bank’s 1997 appeal and the present appeal. This request has been forwarded to the Office of the Ombudsman.

The Bank’s 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 FOIA process.

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 supervisory response.

This determination is considered the Federal Deposit Insurance Corporation’s final supervisory decision.

By direction of the Supervision Appeals Review Committee of the Federal Deposit Insurance Corporation.