WASHINGTON — After undergoing an exam in summer 2016, Builders Bank in Chicago received some bad news: Its Camels rating had reached a 4, the threshold at which an institution is considered a "problem bank" by regulators.
But the $41.4 million-asset institution did not take this setback sitting down. It took the unusual step of suing the Federal Deposit Insurance Corp., claiming in court that the agency’s risk profile determination for the bank had been “flawed.”
Against all odds, Builders Bank scored a critical victory in a case that could set a precedent for other financial institutions that feel they've been unfairly graded. In January, an appeals court found that Camels ratings — a risk-profile metric assigned by banking regulators that can affect how much an institution pays in insurance premiums — are challengeable in court.
“Generally, the courts just refuse to hear those cases, saying that it was completely within the discretion of the bank regulatory agencies,” said James M. Kane, an attorney at VedderPrice in Chicago. “If things work out, it could be a significant victory for the banking industry.”
In its decision, the Seventh Circuit Court of Appeals overturned a lower court's dismissal of Builders Bank’s lawsuit, arguing it had jurisdiction to review the case. The case has now been remanded, while the bank is pursuing a second lawsuit against the FDIC challenging the results of its latest examination.
The appeals court found that even though bank regulators are at a liberty to determine capital level requirements, Camels ratings can face legal challenges because they are calculated based on a number of other variables.
“The presence of capital as one of six components in a Camels rating does not necessarily mean that the rating as a whole is committed to agency discretion,” Judge Frank Easterbrook said in the ruling. “Suppose the FDIC’s team of examiners were to conclude that the bank had adequate capital deserving a rating of 1 but that other components were unfavorable, leading to an overall rating of 4."
“The examiners may be right or wrong about those other issues," Easterbrook continued, "but a district court could ask whether the FDIC’s final rating was arbitrary, or supported by substantial evidence, without making any inroad on the agency’s discretion to evaluate a bank’s capital adequacy.”
In his decision, the judge also resorted to a rare, if not unprecedented, move. He revealed the bank’s Camels rating to the public: a 4, which is one point shy of the worst possible grade.
“As a bank you're not supposed to reveal what the report of examination showed,” said Richard Grossman, the general counsel of Builders Bank.
Details on the institution’s rating were filed under seal, he said. But “the appellate court revealed what our rating was. They just did it!”
Still, Easterbrook’s decision suggested that the bank’s case had two other major weaknesses to overcome.
For one, the judge said, a Camels rating is not a final agency action. Because it is not an order, it is not appealable in and of itself, he argued.
“The Camels rating affects how much a bank must pay for deposit insurance, but the bank has not asked the court to order the FDIC to lower its rates,” Easterbrook said.
But Grossman, the lawyer representing Builders Bank, disputed the judge’s position. “He's obviously brilliant,” Grossman said, but “I think he's completely wrong.”
Grossman went on to cite a 2015 Supreme Court decision, U.S. Army Corps of Engineers v. Hawkes Co., in which Chief Justice John Roberts found that for an agency action to be considered final, it must be “one by which rights or obligations have been determined, or from which legal consequences will flow.”
Camels ratings have a direct consequence on the insurance premiums paid by banks, which should satisfy this last requirement, Grossman claimed.
Easterbrook also said Builders Bank had failed to appeal the Camels rating internally before taking it to the court, which could be another blow to the validity of the case.
The financial institution said in a court filing that the FDIC did not allow the bank to appeal the grade internally — that is, not until it filed its first lawsuit. The agency declined to comment on the case.
Regardless of the ultimate outcome of Builders Bank’s lawsuits, its recent win could embolden other financial institutions to fight their Camels ratings in court.
“The Seventh Circuit established a principle here — that other than capital, there is grounds for appeal even to the courts on the other criteria in the Camels rating,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics. “It's a fascinating precedent.”