On January 31, 2011, the FDIC released revised guidance on payment processor relationships, spelling out with a lot more specificity its expectations for banks’ relationships with payment processors.
We have summarized below some highlights of what was added to the guidance by the FDIC, and also provide a redline showing the changes from the FDIC’s prior guidance, released in 2008. Of particular interest to many of our clients, the FDIC notes that some payment processors may target smaller community banks, based on a belief that they may be more willing to engage in higher-risk transactions in exchange for increased fee income and may lack the infrastructure to properly manage or control a third-party payment processor relationship.
Highlights of some additions to the guidance include the following (not an exhaustive list):
- Financial institutions should ensure their contractual relationships with payment processors provide them with access to necessary information in a timely manner. Agreements should also protect financial institutions by providing for immediate account closure, contract termination, or similar action, and establish adequate reserve requirements to cover anticipated chargebacks.
- Financial institutions should adequately oversee all transactions and activities that they process and appropriately manage and mitigate operational risks, BSA compliance, fraud risks, and consumer protection risks, among others. Financial institutions cannot rely solely on due diligence performed by the payment processor.
- Financial institutions that fail to adequately manage relationships may be viewed as facilitating the payment processor’s or merchant’s fraudulent or unlawful activity, and thus may be liable for such acts or practices. (Italicized portion is new.)
- Financial institutions should take reasonable steps to ensure they understand the type and level of complaints related to transactions that they process. Consumer complaints may be sent to the financial institution, as well as to the payment processor, the merchant, consumer advocacy groups, online complaint websites, or posted on blogs.
- Financial institutions should determine if there are any external investigations of or legal actions against a processor or its owners and operators, during initial and ongoing due diligence.
- Policies and procedures should outline the financial institution’s thresholds for unauthorized returns, the possible actions that can be taken against payment processors that exceed these standards, and methods for periodically reporting such activities to the financial institution’s board and senior management.
- Financial institutions should be aware of nested processing relationships, and obtain data on the nested processor and its merchant clients. Risk is significantly elevated with such relationships because nested processor and aggregator relationships may be extremely difficult to monitor and control.
- The more a financial institution relies on a processor for due diligence and monitoring of merchants without direct financial institution involvement and verification, the more important it is to have an independent review to ensure that the processor’s controls are sufficient and that contractual agreements between the financial institution and processor are honored.
- Board-approved policies and programs should assess the financial institution’s risk tolerance for payment processing activity, verify the legitimacy of the payment processor’s business operations, determine the character of the payment processor’s ownership, and ensure ongoing monitoring of payment processor relationships for suspicious activity, among other things. (Italicized portion is new.)
- Adequate routines and controls include sufficient staffing with the appropriate background and experience for managing third party payment processing relationships of the size and scope present at the institution, as well as strong oversight and monitoring by the board and senior management.
In its most recent lawsuit relating to a bank failure, the FDIC, in its capacity as receiver of the failed County Bank of Merced, California has filed a complaint against former officers of the bank. The complaint was filed on January 27, 2012, in the Eastern District of California. Interestingly, County Bank had failed on February 6, 2009, so the FDIC ultimately filed its complaint just short of the expiration of the three (3) year period from the date of receivership within which it can file claims. A copy of the FDIC’s complaint is available here.
The complaint names five (5) former officers of the bank all of whom served on the bank’s Executive Loan Committee. It essentially alleges that the defendants allowed the bank to make what it characterizes as “imprudent” real estate loans, especially loans for the construction and development of residences. The complaint alleges that the bank’s real estate lending policies were not safe and sound banking practices, that the bank disregarded its own credit policies and approved loans to non-credit worthy borrowers. It also alleges that the bank’s management continued to invest in risky commercial real estate lending even after the marker had begun to decline.
The complaint focuses on twelve (12) specific loans, and alleges claims against each of the defendants for negligence and breach of fiduciary duty. The loans were made between December 2005 and June 2008, and FDIC contends they caused the bank losses in excess of $42 million.
On January 18, 2012, the FDIC filed a complaint against former directors and officers of R-G Premier Bank of Puerto Rico, which was closed and put into receivership on April 30, 2010. A copy of the FDIC’s complaint is available here.
The roots of R-G Premier’s failure, the FDIC contends, can be traced to the 2001 strategic decision to increase its commercial real estate lending. According to the complaint, the board of directors appointed a new Chief Lending Officer, Victor Irizarry, and it structured the Bank to give Irizarry ”free rein” to make commercial real estate loans. Among the board’s alleged failings was its decision to give Irizarry supervisory control of the Bank’s credit risk management department. This reporting structure, the FDIC alleges, effectively squelched the credit risk personnel from voicing any concerns about the underwriting of loans or creditworthiness of borrowers. Internal audits and banking regulators both warned that the credit risk management function should be segregated from the loan department, but the board ignored those warnings.
The FDIC further alleges that the board itself essentially turned a “blind eye” to the Bank’s lending function. Specifically, the FDIC alleges that the board failed to institute effective loan reviews, which in turn “undermined its own ability to monitor the health and quality of its rapidly expanding commercial loan portfolio.” The board’s failure to institute appropriate procedures and controls, combined with its resistance to recommended reform, resulted in the Bank’s extension of over $350 million in loans that a “prudent banker should have known would probably never be repaid.”
On December 29, 2011, the FDIC filed suit against seven former directors of the Bank of Asheville in the Western District of North Carolina seeking to recover over $6.8 million in losses suffered by the bank prior to receivership. All of the directors named as defendants were members of the bank’s Loan Committee, the committee responsible “for the amplification, implementation and administration of the loan policy” and “management of the lending function”. The Complaint cites 30 specific commercial real estate and business loans approved by the defendants between June 26, 2007 and December 24, 2009 as causing loss to the bank and those loans form the subject matter of the Complaint. A copy of the FDIC’s complaint is available here.
In the Complaint, the FDIC as Receiver essentially cites the Bank’s rapid growth strategy concentrated in what it characterizes as “higher risk, speculative commercial real estate loans”. The Complaint alleges that the defendants had virtually no previous banking or commercial real estate lending experience, failed to implement even the most basic prudent lending controls, and neglected to adequately supervise inexperienced and under qualified lending personnel. The complaint further alleges that the defendants failed to heed warnings by State and Federal regulators as well as outside auditors of the increasing risk associated with the bank’s highly concentrated commercial real estate loan portfolio. The complaint alleges that once those risks began to manifest themselves, the defendants “took actions that masked the bank’s mounting problems” by approving additional loss loans and renewing and making additional advances on other non-performing loans, as well as replenishing interest reserves which allowed borrowers to pay interest with more borrowed funds.
In mid-November 2011, the FDIC filed a complaint against eleven former directors and officers of Westsound Bank (Bremerton, WA), which was closed in May 2009. The lawsuit is the FDIC’s seventeenth action against former D&Os of failed banking institutions since the advent of the Great Recession. A copy of the FDIC’s complaint is available here.
The FDIC’s core allegations resemble those asserted in its prior D&O lawsuits. Specifically, it alleges that the Westsound board embarked on a “reckless” business strategy focused on high-risk ADC and CRE lending. The FDIC further contends that the board and the Directors Loan Committee (“DLC”): (i) failed to properly manage and supervise the bank’s lending function; (ii) approved loans in violation of and without regard to the bank’s loan policy; (iii) ignored regulators’ warnings about excessive loan concentrations and lax oversight of the lending function; and (iv) approved additional loans and loan renewals and advances to mask non-performing credits.
The FDIC seeks to recover damages in excess of $15 million on claims for gross negligence (under FIRREA), and state law claims for negligence and breach of fiduciary duty. Its alleged damages are tied to 35 specific credits, including seven ADC/CRE loans, and seven other loans to insiders allegedly made without board approval in violation of Reg. O.
The FDIC sued the former directors and two former officers of Mutual Bank (Homewood, Illinois), along with Mutual Bank’s outside law firm, on October 25, 2011. Mutual Bank was placed into FDIC receivership in July 2009, and its failure currently is estimated to cost the Deposit Insurance Fund $775 million. A copy of the FDIC’s complaint is available here.
One of the unique aspects of this lawsuit is the FDIC’s allegations of corporate waste. For example, the FDIC alleges that the directors approved a $250,000 payment for sponsorship of a “bank function.” The bank function was actually the wedding of one of the directors, who was also the chairman’s and principal shareholder’s son. In another example, the FDIC alleges that the directors allowed $495,000 of Bank funds to be used to make payments to another director for his wife’s defense of a Medicare fraud case. In yet another example, the FDIC alleges that the directors permitted roughly $300,000 of Bank funds to be used to fund travel to an unnecessary directors’ meeting in Monte Carlo. In total, the FDIC is seeking to recover at least $1.09 million from the directors who approved the wasteful transactions.
The FDIC is also suing the directors for their approval of $10.5 million of illegal dividend payments in 2007 and 2008, at a time when the Bank was hemorrhaging and under severe regulatory criticism. The dividends were paid to the bank holding company, which in turn paid them to the shareholders, with 95% of the dividends being paid to the controlling family, which had four members on the Bank board.
The bulk of the FDIC’s complaint is devoted to its claims against the directors and senior officer defendants for approval of twelve loans that resulted in losses of over $115 million for the Bank. As a backdrop for those claims, the FDIC describes a litany of the Bank’s operational deficiencies and failures, including: (i) a “dangerous” concentration in CRE and ADC loans; (ii) a failure to maintain a proper credit administration staff; (iii) an inappropriate reliance on outside mortgage brokers to structure and facilitate large loans; (iv) a failure to establish procedures to ensure compliance with the Bank’s loan policy and prudent lending practices; (v) an inability to generate timely and accurate financial reports; (vi) a routine disregard of the Bank’s loan policy; and (vii) an arrogant disregard of bank regulators and their criticisms.
Each year it seems that someone or other will comment on the “green shoots” that seemingly presage the end of the banking crisis. More often than not, the green shoots were simply the product of an overactive imagination.
There was recent news from the FDIC though that I think qualifies pretty strongly as green shoots material. On September 14 the FDIC announced that it will be closing down its Midwest Temporary Satellite Office located in Schaumburg, IL toward the end of September 2012. The FDIC had previously indicated that the office would remain open until the end of the second quarter of 2013. The FDIC had announced earlier this year that its West Coast Satellite Office will close January 30, 2012.
The Southeast Temporary Satellite Office located in Jacksonville is theoretically scheduled to stay open until the end of 2013 due to the larger number of bank receiverships located across Georgia and Florida. I believe, however, there is a fair chance that the late 2013 date will, in fact, be moved up closer to early 2013 or even late 2012 based upon a review of the latest CALL Reports. While there are still a fair number of troubled banks moving through the FDIC pipeline toward receivership the numbers of troubled banks are definitely in the decline.
There is a corresponding decline in the number of new problem credits banks are seeing. Whereas a year ago bank special assets departments were bringing in two new credits for each one they resolved, now the ratio is one to one or even less. There is also much more internal pressure at institutions to rehabilitate credits if possible so that they can be moved out of special assets and back to the line.
On October 7, 2011, the FDIC filed a complaint against the former directors and senior officers of Alpha Bank & Trust (Alpharetta, Ga.), which was put into receivership on October 24, 2008. A copy of the FDIC’s complaint is available here. Alpha Bank & Trust (“Alpha” or the “Bank”) opened in May 2006 and operated for only thirty (30) months. Nevertheless, the FDIC estimates that the failure of Alpha will cause the Deposit Insurance Fund to lose $214.5 million.
According to the complaint, Alpha embarked on an aggressive growth strategy that focused on making risky loans in the acquisition, development and construction (“ADC”) and commercial real estate (“CRE”) sectors. The complaint also alleges that the Bank incentivized loans officers to generate loans, regardless of credit quality or loan performance, and that the Bank either disregarded or rejected warnings from regulators and third-party loan review consultants.
The complaint seeks to recover $23.92 million in damages directly tied to losses suffered on thirteen separate bad credits. The defendants were all members of the Director’s Loan Committee, and according to the complaint, they each voted to approve one or more of the subject loans. Their alleged failures and omissions included the following:
- failure to follow the Bank’s existing loan policies;
- failure to inform themselves and each other about the true nature and condition of the Bank’s loan portfolio;
- failure to adopt and enforce prudent underwriting procedures and appropriate loan-to-value ratios;
- approving loans to borrowers who were or who should have been known to be not creditworthy;
- approving loans to be made on an unsecured or under-secured basis;
- approving loans made on the basis of inadequate or non-existent appraisals;
- causing or permitting loans to be made without properly and promptly perfecting security interests in the loan collateral; and
- failure to exercise their duties to manage and supervise the affairs of the Bank in a safe, sound and prudent manner.
The complaint asserts a state law claim for negligence and a claim for gross negligence under FIRREA. Interestingly, the FDIC does not assert a separate state law claim for breach of fiduciary duty, even though it has consistently pled that claim in nearly every other D&O lawsuit to date.
On August 10, 2011, the FDIC sued nine former directors and officers of Cooperative Bank (Wilmington, NC), which was placed into receivership in June 2009. A copy of the FDIC’s complaint is available here.
In its complaint, the FDIC alleges that the board and senior management of Cooperative Bank instituted a strategy in 2001 to grow from the Bank’s assets from $443 million to $1 billion by the end of 2005. The Bank did not meet that goal, but the board and senior management reaffirmed the goal to become a $1 billion bank, and pursued an aggressive growth plan in furtherance of that goal. That aggressive growth plan, the FDIC alleges, caused the Bank to become over-concentrated in acquisition, development and construction (“ADC”) loans. Furthermore, the FDIC contends, the defendants “failed to manage the inherent risks associated” with the aggressive growth strategy. Specifically, the director defendants permitted a lax loan approval process that did not include a formal loan committee to review an analyze loans; instead, the Bank relied on various levels of loan approval authority, which were routinely violated. State and federal regulators repeatedly warned Cooperative’s management about the risks associated with its high concentration in speculative loans and weaknesses in its lending function, but the FDIC states those warnings were ignored.
The FDIC’s complaint seeks approximately $34.5 million of damages on negligence and breach of fiduciary duty theories. The alleged damages flow from two types of loan losses.
The first set of losses resulted from Cooperative’s “Lot Loan Program,” in which the Bank provided credit to borrowers to buy vacant lots for the purported purpose of eventually building vacation homes in developments along the North Carolina coast. In reality, the FDIC alleges, Cooperative provided lot loans to out-of-state, speculative buyers (many of whom intended to “flip” the lots) on artificially-inflated appraisals.
The Lot Loan program was particularly ill-advised, the FDIC contends, because the Bank’s senior management acknowledged from the start that the lot loans would not be profitable for the Bank. The senior managers viewed the Lot Loan Program as a “loss leader,” which would put the Bank in a better position to provide construction financing when the buyers were ready to build.
In the course of setting up the Lot Loan Program, the Bank’s senior management represented to the Bank’s ALCO Committee that the lot loans would be limited to a 90% loan-to-value ratio, and that payments would not be interest-only (which had been a concern of the regulators). Even at 90% LTV, the lot loans violated the Bank’s own Loan Policy, which allowed only a 65% LTV limit for raw land and a 75% LTV limit for land development. To make matters worse, the lot loans were no-equity loans, with interest-only payments, and the majority of the lot loans were “stated income” (no-document) loans.
In the second of three D&O lawsuits filed on successive days in August, the FDIC sued six former directors of Columbian Bank and Trust (Topeka, KS), which was placed into receivership in August 2008. A copy of the FDIC’s complaint is available here.
The FDIC’s complaint alleges that Columbian embarked on an aggressive commercial and CRE lending program in 2003 to drive up the Bank’s revenues. In furtherance of this lending program, the FDIC contends, Columbian incentivized its loan officers to generate loans, at the expense of credit quality. The FDIC further alleges that this “uncontrolled” lending campaign, combined with the defendants’ several other failures — most notably, the failure to heed regulators’ warnings and to follow the Bank’s own loan policies – caused the 40-year-old Columbian Bank to collapse in just five years.
The complaint focuses on losses resulting from loans to twelve sets of borrowers. The FDIC is seeking to hold the former directors for the total amount of those loan losses, which is over $52 million.
Aside from the FDIC’s contention that the loans at issue violated the Bank’s loan policy and were the product of a negligent underwriting and approval process, the loans bear few common characteristics. In one example, the FDIC alleges that Columbian made a series of loans ($18 million in total) to a newly-formed LLC to purchase and rehab a commercial office building in Kansas City that had no signed leases or tenants. Columbian apparently never prepared a DSC or cash flow analysis on the project; nor did it obtain financial statements on the borrower or its guarantors. The project failed, and the Bank ultimately suffered losses of nearly $8 million.
The FDIC’s complaint presents two case theories: (1) that the defendants were negligent and/or breached their fiduciary duty with respect to approval of the failed loans; and (2) that the defendants were negligent and/or breached their fiduciary duty in connection with their failure to properly supervise the Bank’s officers and employees. These two case theories are presented in the context of claims for gross negligence (under FIRREA), negligence under state law, and breach of fiduciary duty under state law.
Perhaps the most interesting aspect of the FDIC’s complaint is the allegation that the six defendants, along with “other culpable former directors,” constituted a majority of the Bank’s board. This clearly suggests that the FDIC has elected not to sue all of the former Columbian directors, despite its assertion that they are “culpable” for the Bank’s failure.