Originally published in American Banker on July 1, 1982

Penn Square Bank NA of Oklahoma City, which has been criticized in some circles for its highly aggressive energy-lending practices, has stripped the head of its oil and gas division of his lending authority. And it is seeking to shore up its capital base by soliciting additional stock purchases from its shareholders, according to local banking sources.

In another development, the American Banker has learned that several groups of investors in two oil and gas drilling funds promoted by the Longhorn Oil and Gas Co. of Oklahoma City, a major Penn Square customer, have obtained court orders in at least five states enjoining banks there from paying on standby letters of credit about to be called by Penn Square.

The programs — Longhorn Private Drilling Program 1980-I and Longhorn & Associates Ltd. Drilling Program 1980-II — involve 25% initial cash investments, with the remainder secured by letters of credit.

A hearing on three related California lawsuits, in which Penn Square and Longhorn are accused of fraud and misrepresentation in promoting these funds, is scheduled for today in California Superior Court, San Francisco.

All of these developments appear to be associated with the recent weakening in the energy market. With more than 80% of its loan portfolio in oil and gas loans — mostly to small, independent producers — Penn Square is said to be particularly vulnerable to the softening in energy prices.

The bank grew from $30 million in assets in 1976 to almost $400 million by yearend 1981, in large part because of its willingness to lend to relatively new oil and gas operators. It has also been criticized for inadaquate loan documentation and for lending on new properties. Penn Square currently has more than $2.2 billion in outstanding participations, most of which have been purchased by Continental Illinois, Seattle First National Bank, Chase Manhattan, and Northern Trust.

Sources in Oklahoma said that the Dallas regional office of the Comptroller of the Currency, which has been conducting what was termed a "routine examination" of Penn Square, had demanded that the bank terminate the lending authority of its 35-year-old senior executive vice president, Bill G. Patterson.

Welcomed the Outcome

Although Penn Square's chairman Bill P. Jennings said in a telephone interview that it "would be unfair to say the examiners ordered it," he did acknowledge that they "certainly welcomed" this outcome. Mr. Patterson's lending activities, he said, will be "much less" than they had been, adding that Mr. Patterson will be "spending more time with loan syndications and supervision."

Mr. Patterson could not be reached for comment. While he apparently retains his title, he will be replaced as head of the energy division by senior vice president Gregory A. Odean, according to a bank official.

Clifton A. Poole, the regional administrator of the Comptroller of the Currency in Dallas, refused to confirm or deny that his office ordered the change, saying that it is against agency policy to comment on an individual bank.

However, while stressing that he was speaking abstractly, he did say that any recommendation concerning a change in personnel would normally be made in the formal examination report. But he did not rule out the possibility that such action could arise out of informal discussions between senior management and the on-site examiners.

Mr. Jennings also confirmed reports that Penn Square was seeking to sell additional stock, primarily to its existing shareholders. At yearend 1981, shareholders' equity totalled $30.4 million, yielding an equity-to-assets ratio of 7.7%.

According to briefs filed on May 20 in California Superior Court on behalf of three groups of investors, courts in Nebraska, Nevada, Missouri, Colorado, and New Mexico have blocked issuing banks from paying on the Penn Square letters of credit. In one case, a preliminary injunction was granted by a judge in San Juan County, N.M., stating that "Penn Square is not a holder in due course," and the "underlying transactions giving rise to the issuance of the letters of credit were induced by fraud."

The plaintiffs are seeking to enjoin Penn Square from demanding payment from the issuing banks, which include Security Pacific, Bank of America, Commonwealth Bank, Wells Fargo, Crocker National, Valley Bank of Nevada, and the Bank of Hawaii. Each of the three groups of plaintiffs are also asking for general and punitive damages totaling $2 million. Their attorney is Raymond N. Erlach of the San Francisco law firm of Hunt, Gram, and Epstein.

Longhorn allegedly instructed Penn Square to call the letters as they came due when it became apparent the oil reserves would not be sufficient to replace them as collateral on production loans made by Penn Square to the energy firm. Longhorn's chairman, Carl Swan, a prominent figure in the Oklahoma energy business, is also a Penn Square director.

Interlocking Directorates

This tie is the basis for the allegation that Penn Square had an "identity of interest" with Longhorn Gas Programs by virtue of their "interlocking directorates." The plaintiffs contend that the bank was aware that the "projected reserves were reported 400% higher than was the case." Penn Square was "not acting so much as a bank but rather as an oil and gas prospector and investment promoter" the briefs asserted.

The plaintiffs charge that Longhorn and Penn Square "conspired" to induce the investors to purchase shares in the funds by assuring them that the reserves were "more than sufficient to secure the loans" and that there was virtually "no danger" that the letters of credit would have to be called.

Neither Mr. Jennings nor John D. Lang, a Longhorn vice president who was named as a defendant in the California actions, would comment on the matter.

However, several lawyers and bankers familiar with letters of credit pointed out that litigation concerning this instrument has risen dramatically in the last three years in the aftermath of disputes over standby letters issued in favor of the Iranian government.

They said that temporary restraining orders or preliminary injunctions were often easy to obtain, but permanent injunctions would be more difficult to get. Charges of fraud, they continued, are typically the grounds used in seeking injunctions on a letter of credit. While they indicated no awareness of specific litigation involving standby letters of credit backing oil and gas funds, they said they expected such litigation to increase with the weakening of the energy sector.

Trying to Make a Quick Buck

While carefully avoiding making any judgment on the Penn Square cases, a few said that such lawsuits would be expected from "unsophisticated" investors who had expectations of making a "quick buck."

Moreover, these attorneys and bankers expressed fears that a surge in injunctions would destroy the standby letter of credit as a financing vehicle.

Harold Reichwald, a senior vice president and deputy general counsel at Crocker National Bank in San Francisco, which issued letters of credit in favor of Penn Square, said in a prepared statement, "It is Crocker's policy to honor all of our obligations. We hold this duty in the highest degree of importance and expect to continue to do so unless presented with a court order. Further, we hope that commercial disputes such as this are resolved so that the letter-of-credit process is not interrupted."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.