Have You Been 'Papered' Yet?

Mark Twain joked that a "banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain." Some of our bankers are beginning to feel the same about their regulators and are wondering if the enforcement actions under which some banks are operating do more harm than good. The dark humor question making the rounds in my circles is "Have you been papered yet?"

By "paper" we mean informal or formal supervisory actions issued by either state or federal banking agencies designed to provide a framework under which a bank is supposed to correct its deficiencies. Informal supervisory actions are often called "memoranda of understanding" and amount to something more than a contract between the bank's board of directors and the issuing regulatory agency. While an "MOU" is not enforceable by the imposition of civil money penalties for violating the agreement, if a bank does not comply, the next, draconian step is a "cease and desist order," a "written agreement," or a "consent order." There is no appreciable difference among these formal supervisory actions except the issuing agency's terminology.

These formal supervisory agreements are backed up by the agency's ability to issue civil money penalties for willful violations; by the almost certain imposition of restrictions on the ability to renew or purchase brokered deposits; by the liquidity-pinching drawback of not being able to pay more than 75 basis points over the national average on both in-market and out-of-market deposits; and other restrictions that often serve to hamper a bank's ability to survive and thrive.

Bankers rarely see the logic in the issuance of these supervisory actions, informal or formal, because they typically view them as standing in the way of recovery, not being the helpful yellow brick road that our regulatory friends describe. And who can blame them? Nevertheless, there are important public policy reasons for the imposition of certain types of enforcement actions in certain circumstances.

Statutory Enforcement Actions

Before 1966 banking regulators had two basic means of enforcement of the banking laws: "moral suasion and the death penalty," according to Professor Lissa L. Broome, Wachovia Term Professor of Banking Law and Director of the Center for Banking and Finance of the University of North Carolina School of Law, and Professor Jerry W. Markham of Florida International University. What Broome and Markham mean is that, before the enactment of the Financial Institutions Supervisory Act in 1966, the only enforcement power a bank regulator had was "jawboning" the bank into doing the right thing or shutting the bank down altogether. There was no middle ground legally available. By enacting FISA, Congress gave the federal banking regulators the authority to issue cease and desist orders and modified the agencies' removal and prohibition powers. In 1970 the National Credit Union Administration received comparable enforcement powers over credit unions, and in 1974 the Federal Reserve received similar authority over bank holding companies and state banks that are members of the Federal Reserve System.

Other important pieces of legislation over the years have further defined the banking agencies' authority to enforce the laws that govern state and national banks, including the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), which added to the agencies' powers the ability to bring actions against "institution-affiliated parties." Institution-affiliated parties can include a financial institution's directors, officers, employees, agents, principal shareholders, accountants and, yes, their lawyers, if it can be shown that the actions or inactions of these individuals caused the financial institution or the federal deposit insurance fund harm or loss.

The FDIC Improvement Act of 1991 (FDICIA) created the notion of "prompt corrective action," and gave the regulators the ability to require a financial institution to address its capital problems before the institution became technically insolvent. If the institution fails to comply with the capital plan, under PCA it can be precluded from engaging in certain activities, and the regulators can remove officers and directors.

Burn the Bank; Shoot the Banker

In the Nashville School of Law course I teach on banking law, when we discuss the enforcement actions available to regulators, I typically run through the litany found in 12 U.S.C.A.  §1818 "lettered (b) [cease and desist orders], (c) [temporary cease and desist orders], (e) [removal and prohibition orders] and (i) [civil money penalties]. As my students dutifully take notes and consult their texts, I always add, "Don't forget about 1818(z)." Page flipping and laptop keys tapping always ensue, followed by puzzled looks. "We don't see any reference in the code to subsection (z)," some brave student will admit. "Don't you see it in the footnote? It says, 'burn the bank; shoot the banker'." And for some of our banking clients, they might prefer that alternative to the process they must go through to comply with supervisory orders.

A typical supervisory order has components that address capital, asset quality, management, earnings, liquidity, sensitivity to market risks, violations of law, regulations and policy, and a schedule under which the bank must report its compliance progress to the regulators. Absent fraud, the same things get banks in trouble time and time again: not enough capital to support the risk profile of the bank; inadequate underwriting criteria and credit administration; lack of liquidity; inadequate supervision by the board of directors; and/or weak management. To read these orders on the Internet (and all the formal orders issued by a federal banking agency are available online), consumers might believe that all of the banks in the country are going to Hades in a hand basket. That is simply not true. In most instances, these orders are a one-size-fits-all product of the legal departments of the banking agencies with input on the details from the supervisory staff.

For reasons that lawyers can embrace, there is value in uniformity of pleadings, and semantics mean a lot when an agency is trying mightily to engage in consistent regulation. No agency wants to be accused of treating one bank better than another, similarly situated institution just because one banker is a nice guy and the other, a jerk. Lawyers for the federal banking agencies are not anxious to negotiate the terms of their orders because that deviates from the template. This is not a criticism as much as an observation. Each bank's situation may be unique, but the boilerplate is hard to change because it works; everyone knows what it means; and it sounds tough. Congress loves it when agencies are tough on banks.

For example, one of my clients under a consent order with a federal banking agency objected to the page-after-page list of elements that the regulators want in the bank's loan policy. In this instance, the bank's loan policy already contains all of the listed requirements. Nevertheless, the agency refused to take out the list, saying that the order was just outlining what should be in a good policy. The client's argument is that a customer reading the order on the Internet will not pay attention to the nuances of the order and will only see the six-page list of loan policy requirements and assume that the bank had no policy at all. This type of boiler plate is helpful only to the agency so that it can say it addressed everything that could possibly go wrong, not what is actually wrong. In fairness, the agency permitted us to insert the following amendatory language in front of its laundry list: "While the Bank's loan policies and procedures may already include some or most of the following, the Regional Director and the Commissioner will evaluate compliance with this paragraph based on the following ..." And the list follows. As lawyers, you and I might read that language and get the distinction, but my client still fears that its competition will wave this document around at the country club and do them harm. And who can blame them?

Public Policy Considerations

There are strong public policy considerations implicated in the consistent and fair issuance of supervisory actions that are designed to actually help a bank work through its weaknesses. Most of the problems suffered by community banks, in Tennessee and elsewhere, stem not from their own serious missteps but from the general downturn in the economy, the weakening of the credit markets that makes it harder to raise capital, and the ills created by the subprime mortgage meltdown of non-bank lenders and the Wall Street greed-is-good era. Nevertheless, community banks are stuck with the fallout, and, justified or not, some of them will be operating under either informal or formal supervisory actions for some time. Judging whether a bank is really in the muck or just a little dusty is more art than science, and simply reading the harsh words of a consent order on the Internet tells the average consumer of banking services little about the realities of any given situation. More often than not, I suspect, the average person gets lost on the first page or two of legalese, but bankers lose a lot of sleep wondering whether their deposits will disappear, their best loan customers will move their loans, or a plague of frogs and locusts will descend upon them.

The Time Lag Problem

Just like proponents of the death penalty abhor the delay between conviction of the accused and the depression of the needle, there is an extraordinarily long delay from the date bank examiners finish their examination of a bank and meet with the bankers to discuss preliminary findings (called an exit meeting) and the date on which the bank receives a proposed consent order " and lately, even longer before they receive the report of examination which is the basis for issuing the order. During the examination, bankers learn that the examiners will criticize certain loans, require additional funding of the allowance for loan and lease losses, and demand certain policy changes. Good bankers don't wait until they get the examination report back (usually several months later) to start correcting deficiencies. They dig right in, begin plans to raise additional capital, shore up loan files, correct technical exceptions, charge off loans that are uncollectible, and correct deficiencies in their policies and procedures. By the time the exam report shows up in the mail, the banker is feeling pretty good about the progress he's made, and the notion that the examination is a "snapshot in time," and that it reflects the condition of the bank on the date of the examination, is simply unacceptable. Nevertheless, like an audit that opines on the fairness of financial statements as of a date certain, a bank examination report describes the condition of the bank as of a date certain. By its nature, the report of examination does not typically reflect improvements between the date of exam and the issue date for the report. Those of us in the business have a stock speech we give our clients, but bankers want credit for all the good things they've done since the date the examiners entered the bank. And who can blame them?

It is not only conceivable but typical that the orders against some banks do not reflect the condition of the bank on the day the order hits the Internet. Additional capital may have been raised. The allowance for loan and lease losses has been replenished following the charge-off of any loans deemed a loss. Management has refocused attention on credit quality and attracting local deposits to replace out-of-market deposits which regulators deplore. Nevertheless, banking regulators are not wrong to want assurances that these improvements are systemic changes and not mere band-aids. Is there a better way to protect the deposit insurance fund (it's not a regulator's job to protect shareholders) and the consumer? Perhaps. But current law, and the new Financial Regulatory Reform Act, however it is finally manifested, demand strong responses by banking regulators regardless of the effectiveness of those responses in individual circumstances. My regulator friends will privately lament at times that the state of the economy and the national angst over preventing any future failures in the financial system combine to severely limit their discretion in finding creative solutions that might actually aid on recovery. And who can blame them?


Kathryn Reed Edge KATHRYN REED EDGE is a member of Miller & Martin PLLC, a regional law firm with offices in Nashville, Chattanooga, and Atlanta. She heads the firm’s Commercial Department and concentrates her practice in representing financial institutions. She is a past president of the Tennessee Bar Association and is a former member of the editorial board for theTennessee Bar Journal.