When directors are borrowers, who's on guard?

When Directors Are Borrowers, Who's on Guard?

As bank directors ponder the health of banks they oversee, new problems may be developing on their doorsteps.

Bank investment portfolios include many sizable loans to directors and their affiliated businesses - just as the quality of bank assets is drawing unprecedented attention from regulators.

Bestowing board seats on well-heeled corporate customers has long been a respected practice in the banking industry. It makes sense for banks to bring in professionals in areas where they are active lenders, the argument goes.

But investors could be forgiven for wondering if a fox has been guarding the henhouse. Loans to directors can create thorny conflicts of interest when board members feel torn between trying for optimal terms on their borrowings and acting in the interests of the bank's shareholders.

Growing Anxiety

Without alleging breaches of law, some industry observers are starting to wonder aloud whether a few banks are headed for embarrassment.

"This has definitely come to the forefront in the last year or two," said Sharon Cayelli, associate director of the Council of Institutional Investors, a group counting 65 large public pension funds among its members.

The knottiest problems arise when loans start to go sour.

"You can get into the situation where there might be a potential criticism about cross-purposes," if a director is acting as both a borrowere and an official with fiduciary responsibility to a bank's shareholders, said John Neff, managing partner at Wellington Management Co. and an active investor in bank stocks.

A Case Study

Consider the situation at Riggs National Corp.

The largest independent bank in Washington has extended loans to current and former directors and their affiliates that nearly equal Riggs' Tier 1 capital level. Riggs had as much as $234.9 million outstanding in loans to directors in the first two months of this year.

That sum was a whopping 88% of Riggs' Tier 1 capital of $268 million at yearend 1990.

Even more to the point these days, Riggs has lent substantial amounts to directors involved in real estate in the Washington area. Real estate values around the nation's capital have fallen sharply, and local banks are feeling the effects of that decline on their real estate loan portfolios.

Riggs has not reported any delinquencies in loans to directors. But with real estate values tumbling, lending to Washington-area real estate concerns - even healthy ones - is generally riskier today than in the past.

Greater Need for Watchfulness

One former director who heads a major real estate management firm concedes that current circumstances call for extra scrutiny.

"The most likely real estate people that are going to come on your board are those that are involved with the bank," said J. Roderick Heller, chief executive of the National Corporation for Housing Partnerships. To avert conflicts of interest, he warned: "There's a requirement on the part of the bank and the director to be vigilant."

Mr. Heller said he resigned from Riggs' board last December when a potential conflict of interest developed around a $22 million loan to his company. Riggs was the agent bank on the unsecured loan.

When another lender in the bank group pushed to secure the loan, and Riggs took up the cause, Mr. Heller saw a conflict between his duty to his own company and his responsibilities as a director of Riggs.

Riggs also extended $75 million in loans and credit lines to former director Robert Smith or his company, Charles E. Smith Construction, according to the bank's financial statements. Mr. Smith's company is one of the larger construction companies in the hard-hit D.C. area.

Mr. Smith left Riggs' board after his term expired in April. A spokesman for his company declined to comment. Local real estate sources indicate that his company is in good health.

Other Situations

Riggs is certainly not the only bank with loans to directors involved in real estate. During the first quarter, MNC Financial Inc., Baltimore, disclosed loans totaling $57 million to companies involved in real estate development and the restaurant industry, in which former director Oliver T. Carr Jr. is involved.

Mr. Carr resigned from MNC's board last October.

And Madison National Bank is currently being investigated by the U.S. Attorney's Office for the District of Columbia for, among other things, lending too much to directors, sources said.

To be sure, banks can legitimately benefit from having real estate professionals on their boards. Such directors can help a bank made sound decisions about lending policies.

"I don't see a problem as long as there are no significant issues," Mr. Heller said. "It's important for banks to get the expertise and advice."

To the extent that loans are performing, banks are arguably performing their basic function - making money by lending it.

"If the loans are not delinquent to the [directors], I would say more power to 'em," said Gerard Cassidy, an analyst at Tucker Anthony.

But the risk is high that conflicts of interest can develop, or at least that high-visibility loans can go sour.

Investors have their work cut out for them if they try to find out the status of loans to directors. Securities and Exchange Commission rules call on all companies to disclose any loans to directors - but if the loans are performing, additional information is generally not required.

A spokeswoman for the Federal Deposit Insurance Corp. said banks are required only to disclose loans to principal shareholders and executive officers.

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