TBA Law Blog

Posted by: Kathryn Edge on Dec 1, 2016

Journal Issue Date: Dec 2016

Journal Name: December 2016 - Vol. 52, No. 12

The prevention of insider abuse of banks is one of the chief goals of state and federal banking agencies. In my more than 30 years of practice, both inside and outside of government, I have seen each of these types of insider fraud:

  • Nominee loans that are constructed to circumvent laws, regulations:
  • Conflicts of interest that go beyond laws governing insider interests;
  • Bribes and kickbacks arising from lending activities;
  • Loans tied to favors for friends and family, including non-monetary consideration;
  • Fictitious loans;
  • Manipulation in the sale and purchase of loan pools; and
  • Foreclosed real estate sold through preferential contracts that include favorable financing or otherwise are not at arm’s length.

Penalties for insider abuses range from civil monetary penalties to banning the wrong-doer from participating in the affairs of federally insured financial institutions altogether.

Nominee Loans

A “nominee loan” is one in which the borrower named in the loan document is not the party who receives the use or benefit of the loan proceeds. For example, Banker Sam would like to lend additional money to Borrower Joe, but Joe has already borrowed his legal borrowing limit from the bank. Banker Sam knows that Joe “is good for it,” so, instead, he makes a loan to Joe’s mother, Betty, who turns around and gives Joe the proceeds. In this situation, there are technically three wrong-doers: the banker, the person who needs the money and the facilitator. It is conceivable that neither the intended recipient of the proceeds nor his mom has any idea that what they are doing violates the law. Banker Sam should know better.

Does it make a difference if the bank doesn’t lose money on this nominee loan? The bank makes money from the interest charged on the loan. Joe gets to expand his business. Mom gets to do a good deed for her son. Regardless of the motive and the lack of loss to the bank, a nominee loan is illegal.

Conflicts of Interest

Most banks have codes of conduct that prohibit conflicts of interest and self-dealing that could lead to fraud. While an internal code of conduct is not law or regulation, examiners consider a bank’s conflicts of interest policy the first line of defense against insider fraud and abuse.

Consider this scenario: In the close-knit community of Any Town, certain members of the board of directors of Any Town Bank & Trust are frequently in business with other bank borrowers. Director John and Developer Dan, the director’s business partner, are in the market for financing of a subdivision. Dan makes application for permanent financing by the bank, but in the board’s discussion of the loan request, Director John does not disclose to the other members of the board that he is a limited (and silent) partner in the transaction. The application was made in the name of Dan Development LP, but no disclosure of John’s involvement is made during the application process or in the board meeting.

In this situation, Dan may be guilty of loan fraud for failing to disclose his partnership with John, and John is certainly in violation of the bank’s conflict of interest policy. John will receive the benefit of the loan without having informed his fellow directors of his interest in the transaction.

Bribes and Kickbacks; Loans Tied to Favors

It is a violation of both state and federal law for an employee of a bank to accept bribes or kickbacks in exchange for facilitating a loan transaction.[1] Each of the following is an example of an illegal bribe or kickback arising out of a lending transaction:

  • Lender accepts a cash payment from Borrower for rushing a loan application through committee.
  • Borrower tells Lender that he will help Lender with her mother’s doctor bills if Lender fudges the appraisal on the collateral for the loan so that the loan-to-value calculation meets the bank’s policy guidelines.
  • Borrower entertains Lender’s family by taking them on an expensive vacation directly before or after Lender’s facilitation of Borrower’s loan transaction.
  • Lender agrees to make the loan to Borrower in exchange for an interest in Borrower’s business.

A bribe doesn’t have to be money to be illegal.

Fictitious Loans

For those of us old enough to recall the infamous Butcher bank crisis in Tennessee, the term “fictitious” loan may not be foreign. In 1985, Jacob F. “Jake” Butcher, twice a candidate for governor, pled guilty, along with Jesse Barr and Jack Patrick, of having made loans for millions of dollars drawn up in the names of fictitious borrowers. Among those “borrowers” was Tri-State Mining Company, which did not exist. Instead, the funds were used to pay off loans to Natural Energy Mining, an interest of Messrs. Butcher and Patrick. In another instance, Messrs. Barr and Butcher were charged with defrauding the United American Bank in Hamilton County of $1.14 million through a loan to “Barr, Trustee” while Mr. Butcher was the actual beneficiary. Signatures were forged, collateral fabricated, shareholders defrauded, lives ruined, lawyers’ kids sent to fancy schools.

In a more recent, widely publicized case, we have Wells Fargo. For the bank’s participation in bank and credit card fraud, the embattled financial giant agreed to pay $190 million in settlement to the Consumer Financial Protection Bureau ($5 million of which is for consumer restitution). The fallout from the systemic fraud includes class action suits filed by consumers and at least one by Wells Fargo employees who were allegedly fired because they refused to participate in the scam. At this writing, at least 5,300 employees have lost their jobs, and the company’s CEO has resigned — all because of a scheme designed to open fictitious bank and credit card accounts of which customers were not aware. A corporate culture that rewarded employees for opening new accounts created this widespread fraud.

Manipulation of Sale and Purchase of Loan Pools

Market manipulation is a deliberate attempt to interfere with the free and fair operation the market, including creating artificial or misleading appearances with respect to a pool of loans.

The Justice Department announced on Feb.11, 2016, that Morgan Stanley would pay a $2.6 billion penalty to resolve claims related to the company’s marketing, sale and issuance of residential mortgage-back securities. As part of the agreement with Justice, Morgan Stanley acknowledged that it failed to disclose critical information to prospective investors about the quality of the mortgage loans underlying its RMBS. Investors, including banks, suffered billions of dollars in losses from investing in RMBS issued by Morgan Stanley in 2006 and 2007.

Sale of Foreclosed Real Estate

When a bank forecloses on a parcel of real property, it goes on the books as “other real estate owned” or OREO. Until that asset is removed from the bank’s books, it hangs out there, requiring additional reserves, draining capital and requiring personnel time to manage the property until it can be sold. Banks typically try to get rid of its OREO faster than a kid with a cold glass of milk. From time to time, when homes are foreclosed upon, a bank insider will want to purchase the property — not in itself illegal or unethical unless the contract is on terms that are preferential to the insider and therefore, unfair to the shareholders of the bank.

Selling a foreclosed home to an insider should require, at a minimum:

  • active marketing of the property for a reasonable length of time in order to minimize loss to the bank;
  • a current appraisal of the fair market value of the property that meets the regulatory guidelines for real property appraisals;
  • pristine underwriting of the loan, including ability to repay, loan-to-value, global cash flow, financial statement analysis, etc.;
  • absolute disassociation of the bank insider from the process;
  • documentation of the loan transaction performed by disinterested counsel;
  • review of the process by disinterested counsel to assure an arm’s length transaction;
  • approval by the full board of directors with the interested party and any of his or her related interests removed from the board room; and
  • documentation of the process in the board’s minutes.

Anything less invites regulatory angst.

Warning Signs of Insider Fraud

Among the fairly obvious signs that something in the bank is amiss are:

  • Banker begins taking lavish vacations that belie his compensation.
  • Flashy cars show up in the employee parking lot.
  • Banker never takes a vacation, works early and late, and on weekends (it takes time to cook the books).
  • Bank president is a micromanager who thinks that dual controls are too expensive.
  • Bank changes the firm that performs loan review with alarming frequency.
  • Bank’s external auditing firm is terminated for no apparent reason.
  • Lender resists changes in appraisers.
  • An insider refuses to let certain employees talk to bank examiners.
  • Bank experiences high turnover in lending or risk management personnel.
  • Insider takes loan documents out of the bank for customer signature, personally handles disbursement of loan proceeds, routinely cashes loan proceed checks for borrower, and insists on personally handling certain past due accounts.
  • Insider is responsible for resolving loan confirmation exceptions.

Again, this list is virtually limitless.

I’ve told this story so many times before that for some of our readers, it may be repetitive. Once upon a time, I was talking with a United States Attorney about my personal views about the death penalty. He asked whether there was an instance in which I thought the death penalty was appropriate, and without much hesitation, I said, “Yes. People who steal from the inside of my banks should get the chair.” And he thought I was kidding.


  1. See, Bank Bribery Act, as amended (18 U.S.C. 215); 18 U.S.C. Section 1344, Bank Fraud; and Tenn. Code Ann. Section 45-2-1704, Unlawful gratuity or compensation.

Kathryn Reed Edge KATHRYN REED EDGE is a member in the Nashville office of Butler Snow LLP with offices in Tennessee, Mississippi, Alabama, Colorado, Pennsylvania, Georgia, Louisiana, New York, New Mexico, Hong Kong, Singapore and London, England. She is a member of the firm’s Regulatory and Government Relations Group and concentrates her practice in representing regulated financial services companies. She is a past president of the Tennessee Bar Association and a former member of the editorial board for the Tennessee Bar Journal.