Wednesday, February 1, 2023

December 2022 OBA Legal Briefs

  • Insider Abuses

Insider Abuses

By Andy Zavoina

Bert Lance.

Many, or most of you will not know that name, but all of you know Regulation O. Briefly, this reg was implemented to prevent bank directors, executive officers, and principal shareholders from benefiting from favorable credit terms and treatment in a bank. This group we refer to as “insiders” is not to be treated to better terms than similarly qualified “civilians” we can refer to as the public. Lance and Reg O are a cause and an effect of an insider abusing their authority and position.

Before we discuss the details of Reg O, we need to set the stage on events attributed to the development of Reg O. Bert Lance was the central figure on that stage. He considered himself a country banker from Georgia. His claim to fame was that he went to Washington as President Jimmy Carter’s budget director at the Office of Management and Budget (OMB). Carter took office in 1977. As one of Carter’s closest advisers for almost two decades, he was approved for his political appointment with ease, but not without some criticism. William Proxmire, chairman of the Senate Banking Committee, opposed Lance’s nomination, saying, “He has had none — zero, zip, zilch, not one year, not one week, not one day” of experience at managing a federal budget then estimated at $400 billion.

Perhaps this was demonstrated in Lance’s financial condition at the time. Lance was a banker and his bank had $5 million in loans to Carter’s family business. Carter was known as a peanut farmer when he became president. As to financial condition, Lance had a net worth of almost $3 million but with that he carried more than $5 million in debt. Lance lived well as he owned three large homes in Georgia and rented a house in Georgetown as he worked in Washington, DC. His annual interest payments on the various loans amounted to $370,000. To cover this debt service, he had his public service salary as budget director of $57,500. It did not take long for the speculation and criticisms to start of Lance’s performance, but was this legitimate criticism, or politics? Federal investigators questioned his appointment process and eventually the Senate Governmental Affairs Committee questioned Lance over allegations that he had misused bank funds, obtained loans at favorable rates, and used a company plane to fly to University of Georgia football games, all abusing his position in the bank and living a lifestyle beyond his means.

Several senators called for his resignation, and under increasing pressure Lance did resign less than nine months after taking his position at the OMB. This was the first major internal scandal of the Carter presidency. One could still question if this was deserved or political, but it got worse.

Lance was arraigned on twelve federal charges that could have sent him to prison for 95 years for conspiracy, fraud, and assorted violations of banking laws. This was pre-Reg O and insider abuses were considered as contributing factors to the violations. Lance and three other conspirators were charged with illegally obtaining 383 loans for themselves, their families, and associates from 41 banks stretching from Atlanta to New York and Chicago and from there to Luxembourg and Hong Kong.

The 1979 indictment alleged Lance and three others showed a “reckless disregard for the safety of the banks” that extended credit to them when there was “no reasonable expectation of repayment.” The indictment alleged that Lance repeatedly used a “false and misleading” personal financial statement to obtain loans, including one for $3.4 million from the First National Bank of Chicago. That same financial statement, dated Jan 7, 1977, was the one submitted to the Senate Governmental Affairs Committee for  his confirmation to head the OMB.

To illustrate the issues prompting increased regulation, Lance’s financial statement failed to reflect a $14,000 loan that the National City Bank of Rome, Ga., had made to Lance’s wife. After he became budget director, the grand jury said, Lance got the Rome bank to transfer the loan from his wife’s name to Lancelot, which was a partnership actually consisting of Lance and his wife.

In one of his many legal cases, Lance was acquitted on nine of twelve charges and the remaining three were eventually dropped. Lance had also been charged with twenty-one other felonies, including misapplication of bank funds as president of the National Bank of Georgia (NBG) and the First National Bank of Calhoun, falsification of personal financial statements and making false entries on NBG records. The indictment indicated that Lance and two others used their positions in a few small Georgia banks to acquire the stock of still other banks by lending each other money without adequate collateral and, in some cases, no collateral at all.

It came out that in 1974 and 1975, Lance “caused Calhoun First National Bank” to make a total of $79,530 in unsecured loans to his son, David Lance, who was then a twenty-year-old student. On May 27, 1976, Lance got a $150,000 loan from the Chemical Bank of New York, putting up 14,811 shares of stock as collateral. However, that stock was already pledged as part of the collateral of another loan Lance had, this one for $2.6 million from the Manufacturers Hanover Trust Co. of New York.

As a side note, several years later, Lance was still in trouble and under investigation by a federal grand jury and the Securities and Exchange Commission after being charged with “unsafe and unsound” banking practices and misappropriation of funds. In this case he was fined $50,000 and barred from banking by the Office of the Comptroller of the Currency.

With the abundance of accusations and cases, such poor banking practices achieved a national spotlight. Sounds like the reason for the birth of a regulation, right?

Reg O is somewhat of a standard to follow. The case examples below are from consent orders from the Office of the Comptroller of the Currency (OCC) which has an “Insiders Activities” section in its Comptroller’s Handbook. This section includes various discussions of risk but also refers to the Federal Reserve’s Reg O as requirements which must be followed. The Handbook states, “Various state and federal laws and regulations govern insider activities. Unlike the broad standards of fiduciary duties, these laws and regulations are specific about how insiders are to conduct themselves. Since the statutory and regulatory restrictions on insider transactions do not apply uniformly to all insiders, the board and management must become familiar with each restriction and must pay careful attention to the scope and requirements of each.” This may well be stated by other regulatory agencies as it would be good advice for all banks other than national banks.

Reg O established reporting requirements for bank insiders which were included in previous financial laws. The Financial Institutions Regulatory and Interest Rate Control Act of 1978 contributed significantly to the first iteration of Reg O which was originally established in 1980. It later incorporated the Depository Institutions Act of 1982 and has been revised many times since.

Reg O set forth a new set of rules to stop the preferred treatment that Bert Lance and others took advantage of. Abuses such as was described above can threaten the safety and soundness of a bank in large or small ways, but a threat is a threat. This article will recap pertinent sections of Reg O requirements but is not an in-depth review. I will not address recordkeeping, executive officer requirements or risk management issues.

Reg O applies to insiders, which includes executive officers, directors, and principal shareholders and the related interests of these individuals of the bank and its affiliates. Reg O further defines executive officer as any person who participates or has the authority to participate in major policy making functions, regardless of title or compensation, though it specifically lists the chairman of the board, the president, every vice president, the cashier, the secretary, and the treasurer as executive officers, unless excluded through bylaws or by a resolution of the board of directors and in practice the individual does not participate in major policy making functions. Most banks’ boards of directors define the insiders in their Reg O policy. Those listed should meet the test of a “person who participates or has the authority to participate” in the major policymaking activities and the bank needs to ensure someone who meets this test is in fact listed.

Related interests of the insider include any company controlled by the insider. For Reg O, this results from directly or indirectly owning, controlling, or having the power to vote 25 percent or more of any class of voting securities of a company. It also includes controlling the election of a majority of the directors of a company or having the power to exercise a controlling influence over the management or policies of a company. There is a presumption of control for any director or officer of a company who directly or indirectly owns, controls, or has the power to vote more than 10 percent of any class of voting securities of that company, or for any person who directly or indirectly owns, controls, or has the power to vote more than 10 percent of any class of voting securities if no other person owns a greater percentage.

The bank needs to be able to track loans to insiders and the related interest of those insiders. Recordkeeping requires this but the accuracy is the burden of the bank, knowing the insiders and having them understand and identify their related interests.

This information is also useful when the bank is employing any of these related interests. While not directly related to Reg O, as you will read below if there are issues with paying an insider’s “side business” for work not completed, that is a safety and soundness issue as well as a violation of ethics requirements the bank should have. The related interest list can be used in the vendors due diligence process to identify the players. In a small town and transparent bank environment the bank will know who they are dealing with. It is not a violation to employ them, but the purpose here is not only to avoid a problem, but to avoid any appearance of a problem or preferential treatment.

There are limits placed on the loans to insiders both on an individual and an aggregate basis. The lending limit to an individual, including their related interests, is 15 percent of the bank’s unimpaired capital and surplus for loans that are not fully secured, and an additional 10 percent for loans that are fully secured by readily marketable collateral. Loans fully secured by obligations of the U.S. government or agencies, or loans secured by deposits held at the bank are not counted toward the limit. On an aggregate basis, loans to insiders are limited to the equivalent of the bank’s unimpaired capital and surplus, or up to two times unimpaired capital and surplus for banks with less than $100 million in deposits, as long as a signed resolution by the bank’s board justifies the higher limit. The higher limit for smaller banks is also conditioned on the bank meeting applicable capital requirements and having a satisfactory CAMELS rating from the bank’s most recent examination.

Reg O includes general prohibitions based on terms and creditworthiness. Loans made to insiders must be on substantially the same terms, such as interest rates and collateral, as loans made to non-insiders, with the same underwriting standards applied at origination. This is not to say if the bank made one other loan under similar terms, it could use that as justification to provide a credit product with otherwise more favorable terms to its directors. The comparisons must be real and authentic. In addition, the loan must not involve more than the normal risk of repayment or present other unfavorable features. Any loan to an insider of an amount more than $25,000 or 5 percent of unimpaired capital and surplus, whichever is higher, must be preapproved by a majority vote of the board of directors, and the insider must abstain from the approval process. Prior approval is required when an extension of credit, regardless of the amount, results in aggregate debt to the individual and their related interests exceeding $500,000.

An extension of credit includes making or renewal of a loan, a line of credit, or extending credit in any manner. Overdrafts are included in Reg O. Overdrafts of $5,000 or less are not considered extensions of credit when made pursuant to a written, preauthorized, interest-bearing extension of credit plan, or a written, preauthorized transfer of funds from another account.

Banks are prohibited from paying overdrafts to executive officers and directors. The prohibition on overdrafts does not apply to the payment of inadvertent overdrafts if the aggregate amount of overdrafts on an account does not exceed $1,000, the account is not overdrawn for more than five business days, and the executive officer or director is charged the same fee as any other customer. The prohibition on the payment of overdrafts does not apply to principal shareholders who are not also an executive officer or director, or to the related interests of insiders.

Reg O is designed to add controls to loan related issues even though it includes a lot of recordkeeping, and the focus is on preferential treatment of those in control of the bank. Deposit rates to employees and insiders is not a Reg O issue but could be preferential treatment issue. I will draw your attention to 12 U.S.C. Sec. 376 which says, no member bank shall pay to any director, officer, attorney, or employee a greater rate of interest on the deposits of such director, officer, attorney, or employee than that paid to other depositors on similar deposits with such member bank.” Note this rule applies to member banks. Nonmember banks may consider it a good practice, but not a regulatory requirement.

The following cases are real and are public information by virtue of regulatory enforcement orders. In some cases, the reader may make assumptions to fill in gaps not otherwise in the enforcement orders. Nonetheless as is commonly stated in a consent order, these were done by the subject who, “without admitting or denying any wrongdoing, desires to consent to the issuance of this Consent Order…”

James Ratcliff

Considering the abuses that lead to Reg O and its intended protections for bank deposits, the first case to exemplify why these protections need to be adhered to, monitored, and enforced is one in which the OCC took against James Ratcliff.

Ratcliff was an Executive Vice President and Vice Chairman at an Oklahoma bank which had $285 million in assets as of December 2020. The bank has since been acquired.  Ratcliff was an Executive Vice President from 2000 to 2020. He held the position of Vice-Chairman of the Board of Directors from 2016 until mid-2020, when he became Chairman of the Board. He then served as Chairman until November 2020. He was most certainly an insider and empowered by virtue of his position to direct the bank and its activities on a daily basis.

The enforcement order (AA-ENF-2022-32) says Ratcliff, “caused the Bank to engage and pay numerous entities owned by Respondent as third-party vendors. Respondent participated in setting the financial arrangements between the Bank and the entities he owned.” These are issues that involve self dealing and while these may not violate any lending issues, the practices should certainly be scrutinized by the bank under its ethics policy. This does not mean that may not be done, but if they are transparency should prevail. Again, there should be no impropriety and no appearance of any impropriety.

In this case, Ratcliff (and presumably the bank itself) failed to ensure that the services that were to be provided were in fact done. In fact, in these instances there are often no contracts to compare the work or services to be completed to, yet there were payments made and therefore this long seasoned employee, officer, insider was receiving payment directly or indirectly with no evidence of work performed.

Also cited in the enforcement order was the fact that Ratcliff failed to ensure employee compensation was commensurate with that person’s responsibilities and actual work performed for the bank. But mostly that he also directed bank employees and contractors to perform work for his non-bank entities at the expense of the bank. Here again, it can be difficult to challenge a senior officer in the bank, yet there are times for the good of the bank that a challenge is required.

On to the issue of lending, Ratcliff approved and/or made multiple unsafe or unsound loans that were “liberally underwritten” and included inaccurate credit memorandums which then contained insufficient financial statement and cash flow analysis. Ratcliff himself participated in the practice of helping borrowers create new corporate entities and transferred existing debt to these new entities without any positive change in that borrower’s ability to repay. Similar to the prohibited practice of flipping loans, here the intent was to disguise who the debt was owed to, and it may have been a tactic to avoid debt service requirements.

The bank extended loans to entities owned in whole or in part by Ratcliff. In this process he failed to disclose his ownership interest in any of these entities to the bank or the board. During loan approval processes he also did not recuse himself from approvals of these loans. Was the bank at fault? If Ratcliff failed to disclose his ownership interest the bank had no idea that his recusal was required. From a compliance perspective I would at this point want to know when the insiders were last trained or reminded of their responsibilities. While ignorance of the law is no excuse for a violation, it may serve as a defense. Compliance should note to itself that periodically formal or informal training is conducted even if it serves only as a reminder to insiders as to their responsibilities. Similarly, staff in the bank need to be reminded that they have an obligation to the bank, and not the insiders, to notify others in management if they happen to be aware of any violation such as these.

In this case Ratcliff was deemed to have, “engaged in violations of law, regulation, or order, recklessly engaged in unsafe or unsound practices, and breached his fiduciary duty to the Bank; which violations, practices, or breaches were part of a pattern of misconduct, caused or were likely to cause more than a minimal loss to the Bank; and demonstrated willful or continuing disregard for the safety and soundness of the Bank. loans.”

As a result of this consent order, Ratcliff was essentially banned from banking. Among other prohibitions, he may not participate in any manner in the conduct of an insured bank’s affairs, solicit, procure, transfer, attempt to transfer, vote, or attempt to vote any proxy, consent, or authorization with respect to any voting rights or vote for a director, or serve or act as an “institution-affiliated party.” That is part of the standard order used in such cases.

What is more, and imposes individual liabilities for his actions, is the civil money penalty Ratcliff has to pay off $100,000. The amount of money the bank may have lost paying third party vendors for services not provided is not known. Any losses due to questionable loans when Ratcliff had borrowers create a new entity to takeover the debt of a different borrower but essentially with the same beneficial owner is not known. Any problems with loans to Ratcliff’s own companies in which he failed to disclose his ownership is not known. And the costs the bank incurred auditing all of its records for many, many years trying to unravel all of these violations, is not known. Even though the bank in question was acquired between the events above and this consent order in August 2022, the order stipulates Ratcliff, “shall not cause, participate in, or authorize the Bank (or any subsidiary or affiliate of the Bank) to incur, directly or indirectly, any expense relative to the negotiation and issuance of this Order except as permitted by 12 C.F.R. § 7.2014 and Part 359.” Those sections define the limited circumstances under which a bank may indemnify an employee or offer a golden parachute. With the acquisition of the bank in the interim between the acts and the order, any possibility of that happening would seem unlikely.

Contrast some of Ratcliff’s activities to those of Bert Lance and others and we see similar breakdowns. The abuse of authority both against the bank and the bank’s employees hurts the bank and the banking industry. We may believe what is often referred to as “the good old boys’ network” is a thing of the past. But 1977 is really not that long ago when compared to abuses that were allowed to happen.

Tony Fritz

Was Ratcliff alone in this enforcement action? No. It would seem that there was another in his bank that in many ways facilitated the wrongdoing whether knowingly, inadvertently, or through acts of negligence. Tony Fritz is the former Chief Lending Officer and Director at Ratcliff’s bank.

In his Consent Order (AA-ENF-2022-34) it is noted that Fritz worked for the bank as a credit analyst from 2014 to 2015 and was promoted, and from 2015 through December 2019 he was both a Chief Lending Officer and a director. In his position, Fritz was expected to uphold certain standards, which was not done. He failed to ensure that credit administration and risk management practices and controls were effective and commensurate with the risk and complexity of the loan portfolio. Fritz also failed to develop a system to ensure ongoing monitoring of complex commercial credits and to ensure the bank kept adequate loan documentation. And he failed to formalize loan review and approval processes and failed to properly document lending decisions. From these comments in the consent order, it appears many loans, including those in Ratcliff’s portfolio or under his direct supervision were “rubber stamped” for approval and were not questioned if deficiencies were noted, or should have been noted.

In fact, the consent order goes on to say, Fritz, “failed to provide credible challenge to members of senior management who maintained loan portfolios and failed to maintain adequate oversight over their portfolios. And it goes on to say, Fritz, “approved and/or originated multiple unsafe or unsound loans that were liberally underwritten and included inaccurate credit memorandums containing insufficient financial statement and cash flow analysis. (Fritz) originated loans to cover customers’ overdrafts and overdraft fees. (Fritz) extended additional loans to borrowers who were not credit-worthy, sometimes through creating new entities, in order to make payments on such borrowers’ non-performing loans.” Here again, a process of rubber stamping does not offer the checks and balances that are required, nor the controls to all but ensure compliance with banking regulations and requirements.

What Fritz did, or more correctly did not do was a dereliction of duty. It was considered an unsafe or unsound banking practice and breached his fiduciary duty to the bank. It stated that this misconduct caused more than a minimal loss to the bank. Fritz was personally assessed a civil money penalty but his was less than Ratcliff’s, at $10,000. He also has additional prohibitions placed upon him essentially banning him from banking. Before he could accept a position of responsibility in a bank, he would be required to provide that bank’s president or chief executive officer with a copy of the consent order describing the above.

Orlando Romero

On this topic of insider activities and Reg O, I want to mention a third case which is from the Federal Reserve (Docket No. 22-002-B-1) against Orlando Romero. This is an order involving ethics more than traditional insiders’ activities. In this case the banker was not fined but was banned from banking because of his misconduct which violated internal bank policies and constituted violations of law or regulation and were considered unsafe or unsound practices and breaches of fiduciary duty.

This case is special in several ways. Firstly, when I have discussed this with many bankers, most have not heard of such an enforcement before, and many do not see it as a fundamental problem. It is something that many have heard of or done to some extent.

Romero was a client service specialist in a Global Technology area of his large bank. He had received a job offer letter from a competing institution. That letter provided him with some specific terms of employment one of which was his salary. I would assume it offered him an increase, but that would not seem to be enough for Romero. He altered the letter and increased the starting salary above that which was actually offered.

Romero added $28,000 to his current salary and presented that to his current bank in hopes for a raise and he would then remain at his current bank. That amount is significant to me. In this case his bank met that amount and Romero’s annual salary was increased. This is where many bankers would proclaim a “win” for the employee. Questions bankers may ask include, “if the bank thought he was worth that amount when a competitor offered it to him, why wasn’t he worth that before?” In fact, he was not offered that amount by a competitor. There would seem to be a fine line between ethically asking for a raise and fraudulently stating that a competitor has valued your work at more than your current employer. Regardless, some bankers take the position that Romero’s bank had a decision to make regardless of where an offer came from: “Was he worth that much considering his job duties, his performance, and the costs associated with bringing in a new employee to fill that position?” If the bank paid him the increase, then its answer was that he was worth it.

But in the end, somehow the bank discovered the scheme. Romero resigned from his bank two and a half years after receiving his increased salary. That would amount to $70,000 in “additional” income. The order did not state if the resignation was triggered by this knowledge, or it was learned afterward. As noted above what he did was deemed to be in violation of several policies, laws and or regulations. Before he could work at another bank there were certain requirements he would have to meet. This includes providing the Managing Director/Senior Vice President or equivalent level in the reporting line of the institution with notice and a copy of the Fed’s cease and desist order against him and fully familiarize himself with the policies and procedures of the institution that pertain to his duties and responsibilities, including, but not limited to, the employee Code of Conduct, and provide written notice to the Board of Governors, along with a written certification of his compliance with each provision required in his order. It may not be a permanent, but it would take a lot to meet this, in my opinion.

At the end of the day, I hope you will ensure that management, the board, and all bank staff are both informed or reminded of their responsibilities and duties under applicable laws, regulations, and policies. As we close 2022 and enjoy the holiday season, ethics is a good topic to revisit as gifts may be offered to staff and prohibitions should apply.