The pace and impact of regulatory enforcement action have grown dramatically in recent years. Congress has given regulators clear signals to toughen enforcement of legal safety-and-soundness standards with cease-and-desist orders, removal of insiders, and civil money penalties.
The vilification of lax enforcers that followed the savings and loan debacle has only served to encourage aggressive enforcement by regulatory agencies.
Even banks with good management are not immune to the initiation, or threat, of enforcement actions. Worse, strict legislative standards, coupled with a level of judicial deference to "regulatory expertise" and procedures, have left few of the protections that constitutional due process should require.
Unfortunately, few bankers or their lawyers have enough experience in dealing with this adversary environment to avoid unnecessarily harsh results.
This situation requires proper and timely application of a few common-sense tactical and strategic principles. Proper use of these principles can mitigate or avoid enforcement actions.
Before the Examination Begins
Almost all regulatory enforcement actions are initiated by the examination process. It is axiomatic that the best strategy is to position your bank so that the examiners will have no serious criticisms. Several hints can help you do this:
* Review critically whether the bank has corrected weaknesses identified in the last examination report.
* Be certain that your policies are up to date, covering at least the matters set forth in the manuals or handbooks for bank examiners published by the Federal regulatory agencies.
* Look at the key issues being focused upon by your regulator in recent enforcement actions or examinations of other banks.
* Establish good procedures to prevent violations of law and abuses involving insider dealings.
If there have been inadvertent violations, prompt identification of them by the bank, and action to both correct them and prevent recurrence, often convince regulators that enforcement is not necessary. Consider a legal audit of insider transactions before an examination.
During the Examination
Let's face it. Examiners have a great deal of power in today's environment, and they know it. You cannot afford to antagonize them, but neither can you let them ride roughshod over you.
The key to maintaining a fair balance in the examination process is knowledge. If the bank staffers dealing with the examiners understand the rules, attitudes and pressures under which the examiners operate, they can respond to potential problems.
You should take pains that only officers who know how to deal with examiners have direct contact with them. Consider having a skilled officer participate in contacts between examiners and other officers.
Caution to Officers
Let your officers know that, if they are unsure how to respond to an examiner's question, they can tell him that they will check into the matter and get back to him promptly. Senior management can then help the officer best present the bank's response on any sensitive issue.
Most bankers have probably seen an examiner take a position adverse to their bank that they thought was not supportable. Do not respond with anger, but do not just give up, either.
No Legal Training
Although legal violations are now a major focus of examinations, few examiners are trained as lawyers, and they often cite violations where none occurred.
Sometimes this results from a misunderstanding of the law; sometimes because the examiner has not reviewed (or been given) all the facts.
When a potential legal violation is identified by the examiners, or you suspect they are considering one, immediately involve counsel. Legal counsel may be able to help identify and explain facts or legal arguments that take the questioned conduct outside the area covered by any legal prohibition.
On classification issues, you need to be familiar with the 1979 joint statement by the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Federal Reserve Board, and the Conference of State Bank Supervisors on classification standards. This is particularly crucial when dealing with "substandard" assets.
There are situations involving workouts of well-secured loans, or with strong guarantors, that many examiners would classify as substandard yet the joint statement would not.
Getting out of the examination intact - without giving in on important issues or offending examiners you will need to work with in the future - is crucial. Consider using experienced legal counsel to make your points with the examiners.
They bring not only expertise, but a level of objectivity that helps bring more light than heat to the situation. Most examiners will consider well-reasoned arguments in your favor.
In addition, if the examiners become offended by the approach used by your professional adviser, you can disown him and hopefully deflect the anger toward him instead of the bank.
Always select an advocate to present your case to the examiner who is knowledgeable, experienced, and tactful, but not afraid to politely champion the bank's position.
If you are not successful with the examiner, but have a clearly supportable position, be prepared to use the appeals process.
After the Examination
Once the report of examination arrives, it should not be difficult to determine whether enforcement action will follow close behind.
A Camel "4" or "5" almost guarantees that the regulator will believe that a cease-and-desist order is appropriate. A Camel "3" usually means you are faced with either a memorandum of understanding or an order.
Repeated, or abusive, legal violations generally produce 15-day civil money penalty letters. Usually, the cover letter accompanying the report explicitly telegraphs the enforcement action to follow.
The "stitch in time" adage calls for an immediate, full-court press to counter enforcement action. Assemble a response team that includes the most knowledgeable members of your staff, experienced counsel, and a capable representative of your independent directors.
The first step of the response team is to identify the important issues and set realistic goals for the negotiation process. This enables the team to develop a coordinated strategy that is realistic.
Do not plan to contest every issue. There are some where you may be right, but where the regulatory environment makes it virtually impossible that the regulator will compromise. On other issues, your position may be so weak that you damage your credibility by contesting them.
Still Time for Action
If there are issues you should have won before the report was issued, respond promptly, fully, and professionally. There may still be a possibility that you can change the regional office's attitude about enforcement.
Where you do have a real problem, adopt corrective measures voluntarily before the regulator tries to force them upon the bank.
Demonstrate the bank's understanding of its problems. Show the regulator you are both willing and able to address them. It may be a long shot, but you may convince a regulator to let you clean your own house or get him to allow less-formal corrective action.
If you have not succeeded in avoiding the initiation of enforcement activity, you must be prepared to contest it or mitigate it. Unfortunately, the cards are stacked against you at this point.
As a result, a strictly adversary response, forcing the regulator to issue an notice of charges and conduct a hearing, is rarely productive. The standards and procedures in a hearing make it very difficult to establish that grounds for issuance of an order do not exist.
Time and Money Involved
Proper presentation of your case will involve considerable legal expense, as well as an immense investment of management time.
I rarely advise that a bank force a hearing on a cease-and-desist order. The only exceptions are where the proposed corrective action is so painful that the bank cannot in good knows it can fully cure its problems before the hearing process can be completed.
Instead, a strategy to negotiate the best result possible without a hearing must be developed for each case.
Generally, unless the regulator is entirely out of line, you can probably negotiate a better order than will result from a hearing. This has the added advantage of permitting management to concentrate more effort on correcting criticisms than on battling the regulator.
It also preserves a better working relationship with the regulator. Finally, it benefits the bottom line, saving thousands of dollars of legal expense.
Blind Acceptance Not Needed
Does this mean that you should accept the draft order and related stipulation as presented? The answer is a resounding no.
No matter what you are told about the non-negotiability of the "corrective action," most of the provisions are negotiable. Language can be clarified, exceptions to standard provisions can be arranged, compliance deadlines can he extended, capital requirements can be reduced, and the required asset-quality improvement can be adjusted.
While it may rarely be justified to actually force a hearing, you need to convey your willingness to do so if the regulator will not agree to reasonable terms. Unless you show that you cannot be pushed around, you invite the regulator to stiffen on every issue. On the other hand, you should not make every little issue a make-or-break one.
Bear in mind that the regulator wants a stipulated result. Even if he is confident that his agency would be successful at a hearing, he gets faster progress from a stipulated order.
Keys to Mitigation
He also needs to take into account the cost and time burden on his staff in a hearing, as well as the possibility. however remote, of an embarrassing loss.
Just as knowledge and experience were the keys to avoiding enforcement during the examination process, they are the keys to mitigate enforcement once commenced. There is considerable variation from order to order regarding terms, time periods, and requirements.
A knowledge of acceptable forms or levels of variation in other orders allows you to argue with precedent for the mitigation that best fits your situation.
Some of the changes you should seek are substantive. Frequently, the level of required capital can be adjusted, as can the step-down of classified assets. Burdensome requirements can sometimes be modified or eliminated entirely by showing that they are virtually impossible to achieve.
Other changes involve subtle modifications of the language in the order. A review of orders issued in 1992 throughout the nation demonstrates many banks accept either language that is vague or that requires unreasonable improvement.
Well-represented banks frequently succeed in modifying such language in ways that improve the bank's prospects to comply. Often, when the compliance impossibility under the proposed language is explained to a regulator, he promptly agrees to a change.
Generally, the negotiation process should precede the meeting at which the regulator will want the bank to stipulate. Resolve as many issues as possible before the meeting.
Consider a Compromise
If there remain other issues that your board just cannot accept, let the directors make their resolve clear at the meeting.
However. be ready to suggest compromises that meet the perceived needs of the regulator, without the evils perceived by your directors. Experience, creativity, persistence, and skillful presentation can often sway the most immovable regulator.
Before finally stipulating to any order, be sure that management and the board understand what it takes to comply. In some cases, while a regulator may refuse to modify language in the order, he will provide guidance, orally or in a side letter, as to what will constitute compliance.
He may also be induced to make commitments that good-faith efforts to comply will suffice to avoid the imposition of further penalties even if compliance is not achieved.
Civil Money Penalties
One of the most frightening pieces of regulatory correspondence is the 15-day civil money penalties letter. It advises officers and/or directors that the regulator intends to recommend penalties ranging from $5,000 to $1 million a day.
The penalties cannot be insured against, and will not be reimbursable through corporate indemnification. Expect calls from several concerned, angry,
First of all, do not panic. Most 15-day letters do not result in the imposition of penalties. Further, absent egregious abuse, the penalties that are imposed rarely reach the maximum levels allowed by statute. But never take a 15-day letter lightly.
Most 15-day letters are motivated by perceived legal violations, particularly those involving insider abuse or repeat violation. The best time to win a civil-money-penalty proceeding is before an assessment is issued. While you have a right to a hearing, the procedures do not promise a fair chance of success.
Before responding to the 15-day letter, evaluate the level of possible conflict among the targets thereof.
The response to the 15-day letter should be prepared as carefully and comprehensively as a trial brief Three tactics work well in response to the 15-day letter.
First, carefully analyze the statute, regulations, and facts applicable to the alleged violations. In many cases, the act or omission alleged, as a matter of law, does not actually constitute a legal violation.
Apply the same level of analysis to similar violations alleged in prior examinations. The likelihood and severity of any penalty is increased where the regulator believes that there are repeat violations. Successful rebuttal of alleged past violations decreases this risk.
Even if you cannot convince the regulator that no violation occurred, you can create doubt as to the existence of the violation. This tactic also allows you to show that reasonable minds can differ on the matter, and demonstrates the good faith of the respondents.
Second, analyze the alleged violations using the civil money penalties matrix adopted by several of the regulatory agencies. Even though the FDIC has not formally adopted the matrix, its representatives have advised that they use it as a guideline.
Third, do not automatically furnish financial statements for the affected officers and directors. At a later date, if necessary, you can show that the respondent's financial condition is such that small penalties, if any. are the only ones appropriate.
Be prepared to accept a small penalty if it is impossible to convince the regulator that no penalty whatsoever is appropriate. A cost-benefit analysis, taking into account cost, the risk of loss at a hearing, and the difficulty of obtaining a full review on appeal, must be rigorously and objectively applied.