A Chicago entrepreneur is suing the Federal Deposit Insurance Corp. to win back capital he invested in a bank in the months before it failed.

Pethinaidu Veluchamy, the chief executive of a direct marketing conglomerate, filed a complaint last week against the FDIC in federal court in Chicago, claiming that the regulator acted in a way that was "arbitrary, capricious [and] an abuse of discretion" in declining to approve a capital restructuring that would have benefited Mutual Bank in Harvey, Ill., before it was taken over last July.

Bank experts said the allegations echo criticism by ailing banks — highlighted in a congressional hearing two weeks ago — that regulators' overly rigid rule interpretations unnecessarily led to the demise of some community banks.

"There is no question that bank regulators in this market cycle have moved the goal posts for community banks in capital distress, giving banks significantly less time to work out problem loans and raise capital, while simultaneously increasing the minimum capital adequacy ratios for these same banks," said Justin A. Barr, the managing principal of Loan Workout Advisers, a consulting firm.

"This [was done] at a time when community bank capital-raising has never been more difficult," Barr added. "It's all beginning to read like an Ayn Rand novel."

Veluchamy is suing the FDIC to recover $23.6 million that he and his family invested in an attempt to keep the bank afloat. In all, they are seeking $33 million in damages. (The family's investment in Mutual stretches back to 1998.)

Experts say Veluchamy is unlikely to win. "This is a really fascinating story, but the chances of this group getting relief are slim to none," said Chip MacDonald, a partner in Jones Day in Atlanta.

The FDIC does not comment on litigation, but banking lawyers said the regulator has the law on its side in this fight. "It is very likely that the regulator's response is going to be that 'the laws and prompt-corrective-action [rules] required us to do these things, and Congress hasn't given us the ability to be flexible,' " said Thomas Bieging, a partner in Bieging Shapiro & Burrus LLP in Denver.

Lawyers said FDIC examiners are also feeling pressure from its inspector general, who has concluded in multiple material-loss reports that regulators did not act fast enough to seize some banks.

Veluchamy's claim of inflexibility is akin to the complaint that Michael Kelly, former FBOP Corp. chairman, made to a congressional hearing on Jan. 21 about the FDIC's takeover of his company's nine banks last fall. "They basically just did not want to extend more time," he said in the hearing.

Regulators responded to the comments in the hearing by saying that the banks' seizure was done according to the law.

"Our intent was never to look for any type of institution to fail, but the statute is very clear about us trying to protect the Deposit Insurance Fund," said Mitchell Glassman, director of the FDIC's division of resolutions and receiverships.

Though lawsuits against the FDIC by owners of failed banks are rare, MacDonald said, given the number of failures, it behooves the agency to vigorously defend this case. "They have every incentive to fight this one," he said.

Mutual Bank's problems began in the second quarter of 2008 when losses on construction loans drove it into "adequately capitalized" status, with a total risk-based capital ratio of 8.76%. Nonperforming assets then made up 8.66% of total assets.

In succeeding months, Veluchamy, along with other family members, bought $7.6 million of stock in First Mutual Bancorp of Illinois Inc., the bank's holding company. Veluchamy, along with the other plaintiffs, owned 93% of the mutual company. He also invested $23.6 million in the bank through subordinated debt.

Yet the bank's condition worsened as reviews moved more loans into nonperforming status. As of June 30, one-third of its loans were nonperforming.

In early July, when the bank was critically undercapitalized and had received a "Section 51 order" — which signals the regulator's intent to seize a bank — Veluchamy asked the FDIC to let him redeem the subordinated debt in exchange for keeping proceeds in a non-interest-bearing deposit in the bank. The deposit would have aided the bank's liquidity.

However, it also would have moved Veluchamy up the food chain on the FDIC's payout list should the bank fail. An uninsured depositor could seek repayment; a subordinated debtholder is typically wiped out, lawyers said.

Veluchamy also said he arranged for an investor to buy $5.9 million of subordinated debt with a loan from the bank. Though the complaint said regulators approved of this before dismissing it in 2009, banking experts called that a red flag. They cited the struggling Central Bank of Georgia in Ellaville and the failed Orion Bank in Naples, Fla., as institutions that were sanctioned for such actions.

"My suspicion is that the FDIC didn't totally know about it when it was first done," MacDonald said. "It goes against regulations involving transactions with affiliates. You can't create capital by lending someone money to buy capital. That defies gravity."

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