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Subject: The extension of credit to insiders without full disclosure and in amounts in excess of the borrower's ability to repay, violations of Section 22(g) of the Federal Reserve Act and Regulation 0, insider self-dealing.

Order: Required the repayment of insider borrowings, limitations on the further extension of credit to insiders, precluded further self-dealing, terminated self-dealing contracts then in existence.

2. Bank—total deposits: $900 million. Subject: Large loan losses and unusually high depreciation in securities portfolio resulted in severe capital depletion.

Order: Precluded further dividend payments, precluded the redemption of preferred shares by the bank, precluded the payment of interest or principal on its capital notes without the prior permission of the Board.

3. Bank-total deposits: $900 million.

Subject: Modified a prior order concerning the repayment of capital notes of a bank to exclude a trustee and capital note-holders, in the event of default, from being limited in their remedies by the conditions of the prior Order.

4. Bank—total deposits: $250 million.

Order that sought the removal of a bank director for personal dishonesty: was eventually settled by agreement between the parties.

The CHAIRMAN. Before I proceed, unfortunately, I'm going to have to recess the hearing. There's a rollcall going on. I will be back in about 10 minutes. Recess.]

The CHAIRMAN. I take it, Governor Holland, that you had finished? Mr. HOLLAND. Yes, I have.

The CHAIRMAN. Our next witness is Chairman Barnett of the Federal Deposit Insurance Corporation.

STATEMENT OF ROBERT E. BARNETT, CHAIRMAN, FEDERAL

DEPOSIT INSURANCE CORPORATION

Mr. BARNETT. Thank you, Mr. Chairman.

I appreciate the opportunity to testify for the FDIC in support of S. 2304, I will not read my testimony but request that my full statement be placed in the record.

I would like to emphasize two or three things that we at the Corporation consider most important about S. 2304.

First of all, with respect to cease and desist orders, these are relatively new at the Corporation. FDIC, along with the other financial regulatory agencies, received the authority to issue cease and desist orders in 1966. Late in 1971 we issued our first cease and desist order. Until that time we had never issued a cease and desist order, and I think the belief had been at the Corporation that section 8(a) was as useful as section 8(b) and that we would tend to rely on section 8(a) rather than (b).

So cease and desist orders are relatively new at the Corporation. They have weaknesses that our examiners feel must be corrected before they are totally useful pieces of administrative enforcement power.

From our standpoint, then, at the FDIC; we feel that the section 8(b) portions of S. 2304 are the most important parts of the bill

. The possibility of having a $10,000 a day fine for violating a final section 8(b) order, when combined with the extended coverage of the cease and desist power to include not just banks but officers, directors and other persons who are participating in conducting the affairs of the bank, make the cease and desist order much more meaningful, much more dynamic, and much more powerful.

From our standpoint, therefore, sections 6(a) of the bill and 6(e) of the bill are extremely important parts of the bill. We think that they make section 8(b) of our act a very effective tool, one which in conjunction with our already existing section 8(a) powers for removing insurance from banks that are operating in an unsafe and unsound condition, will provide the Corporation with an arsenal of weapons that will be very useful in administering the laws.

In our list of priorities at the FDIC, the amendments in this ill relating to the cease and desist powers, therefore, are most important.

Of second priority, I would think, would be the provisions that permits the removal of bank officers, directors and persons participating in the conduct of its affairs under certain circumstances when they have been grossly negligent in conducting the affairs of the bank or when they willfully disregard the safety and soundness of the bank. We have faced the same questions that other agencies have in trying to prove personal dishonesty in our removal section and have found it extremely difficult to do. We think that someone can be honest but simply very negligent and very careless and very cavalier about conducting the affairs of the bank. That being the case, we feel w ought to have the authority to remove him.

One other provision in the bill that I'd like to comment on is the insider loans provision, which would aggregate loans to any one officer, director or substantial shareholder in a bank and make that aggregation subject to the single borrower lending limit under applicable Federal or State law.

As you know, we have recently enacted an insider training regulation that's based on a little bit different philosophy. Our philosophy on the insider trading regulation is not to prohibit any particular loan to an officer or director or other insider, but, rather, to make sure the board of directors sees it, considers it, reviews it, votes on it, and expresses any comments in the record, a record which then is available to the bank examiner for his review. That's a different approach than prohibiting certain kinds of loans as S. 2304 would do.

If section 22(h) of the Federal Reserve Act is amended as provided in S. 2304, we think it will be useful. We don't oppose it. We support it, but I just want to point out that our approach under our insider trading regulation is based on a somewhat different philosophy, in part, because of our review of this matter between the time that then Chairman Wille testified last July before the House Committee on this matter and the time that the insider trading regulation was issued.

Those would be the parts of the bill that I would want to emphasize, Mr. Chairman, from the standpoint of the FDIC. We support the bill as outlined in my statement. From our standpoint, these are the high priority items.

The CHAIRMAN. Thank you very much. [Complete statement follows:]

STATEMENT OF ROBERT E. BARNETT, CHAIRMAN, FEDERAL DEPOSIT INSURANCE

CORPORATION I appreciate this opportunity to testify in support of S. 2304, 94th Congress, a bill “To strengthen the supervisory authority of the Federal banking agencies over financial institutions and their affiliates”. As you know, the bill was proposed jointly by the FDIC, the Comptroller of the Currency and the Federal Reserve. Its enactment would provide much needed assistance for preventing certain types of abuses that in the past have led some banks to fail and would better enable the regulatory agencies in the future to attempt to correct such "problem bank” situations before they reach the terminal stage. The need for this type of legislation was underscored by former FDIC Chairman Frank Wille in his July 21, 1975 statement before the House Committee on Financial Institutions Supervision, Regulation and Insurance, a copy of which is attached hereto as Appendix A.

In his September 5, 1975 letter to Senator Proxmire forwarding this proposed legislation to the Congress, Federal Reserve Chairman Arthur Burns discussed in some detail the background circumstances giving rise to this proposal. I will briefly summarize these circumstances to refresh the Committee's memory in this regard.

CIVIL PENALTIES

In a number of areas of bank regulation there is no totally effective deterrent to violation of various limitations and restrictions imposed by Federal statute. Although such violations can severely affect a bank's safety and soundness, the only sanction a bank faces in some cases is the possible issuance of a cease and desist order requiring it to reverse a particular transaction or to refrain from committing similar future violations. One example is section 23A of the Federal Reserve Act which in conjunction with section 18(j) of the Federal Deposit Insurance Act) imposes stringent limitations on loans and other dealings between insured banks and their affiliates. Ho er, since there are no specific penalties for violation thereof, a bank holding company or other person experiencing financial pressure may cause a subsidiary bank to violate such restrictions knowing that, if such violations are discovered, the only sanction would be the possible issuance of cease and desist order designed to rectify the violation and prevent further such transgressions.

While the cease and desist order is quite useful for some purposes, it is not as significant a deterrent to violations of restrictions on inter-affiliate or insider lending as a daily money penalty would be. Accordingly, sections 1 and 7 of the bill would authorize the Federal Reserve and the FDIČ to impose up to $1,000 per day civil penalties for violations of section 23A of the Federal Reserve Act relating to inter-affiliate dealings or section 22 of the Federal Reserve Act covering bank loans to their own executive officers. Similarly, section 2 of the bill would authorize the imposition of up to $100 per day civil penalties for violations of Regulation Q type restrictions relating to the payment of interest on deposits (§ 19 of the Federal Reserve Act).

In addition, section 6(e) of the bill would authorize the imposition of a civil penalty against any bank or any officer, director, employee, agent or other person participating in the bank's affairs for violation of a cease and desist order or consent agreement which has become final under section 8 (b) or (c) of the Federal Deposit Insurance Act. Section 6(e) would provide for a civil penalty of up to $10,000 for each day the offending bank or individual willfully refuses to obey the order. The authority to impose such a fine for violating a final cease and desist order would serve to emphasize the gravity of such an order.

Under section 8(k) of the FDI Act, a cease and desist order does not become final unless entered into by consent or until the time has run for filing a petition for review with the appropriate U.S. Court of Appeals and no petition has been filed or perfected, or the petition so filed is not subject to further review by the Supreme Court. In either event, the party must have exhausted the administrative and judicial remedies afforded to him under the Act. If the party then continues to disobey an order, the appropriate agency can apply to the proper U.S. District Court to secure its enforcement. However, the threat of a court enforcement and possible contempt proceedings should not be the only deterrent at this point. The party has been given every opportunity to have his day in court. He should not be allowed to further impede the effect of the order simply to secure another delay and should be subject to a substantial monetary penalty for each day that he does so, as provided in the bill.

In imposing civil money penalties under the bill's provisions, the appropriate bank regulatory agency would be required to take into account the financial resources and the good faith of the bank or person charged with the violation, as well as the history of previous violations. Hopefully, the utility of such penalties would be primarily in their deterrent effect, and the actual imposition of fines could be used sparingly.

INSIDER LOANS Our experience has indicated the need for more vigorous supervision by bank boards of directors and bank supervisory agencies of transactions between an insured nonmember bank and "insiders” of the bank. Abusive self-dealing has been a significant contribution factor in more than half of all bank failures since 1960, including the failure of 30 nonmember insured banks. Losses to the deposit insurance fund as a result of these failures are likely to exceed $175 million. A review of existing and past “problem” bank cases also reveals abusive self-dealing as a significant source difficulty. Even where the immediate result is not the bank's failure or its designation as a bank requiring close supervision, an insider transaction that is not effected on an "arm's length" basis may lead to a diminution of the bank's earnings and an erosion of its capital—thereby increasing the risk of loss to depositors and minority shareholders and ultimately to the deposit insurance fund. Also, insider transactions whose terms and conditions cannot be justified constitute a diversion to insiders of resources that properly belong to all shareholders on a pro rata basis, as well as a misallocation of a community's deposited funds.

For these reasons the FDIC on February 25, 1976 adopted a new regulation dealing with insider transactions. The regulation seeks to minimize abusive selfdealing through the establishment of procedures which insure that bank boards of directors supervise such transactions effectively and which better enable FDIC examiners to identify and analyze such transactions. The board of directors of each insured nonmember bank will be required, effective May 1, 1976, to review and approve each insider transaction involving assets of services having a fair market value greater than $20,000 for a bank having assets under $100 million, $50,000 for bank between $100 and $500 million in assets, or $100,000 for a bank with assets over $500 million. In addition, certain recordkeeping requirements, including a record of dissenting votes cast by members of bank boards of directors, will be imposed in order to foster effective internal controls over such transactions by the bank itself and to facilitate examiner review.

A more complete explanation of the FDIC's new “insider” regulation will be found in our February 25, 1976 press release issued in this connection, which is attached as Appendix B hereto.

In addition to these new regulatory requirements, it is our opinion that more explicit statutory lending limitations on the amount of a bank's loans to its insiders would be helpful in preventing banks from incurring undue risks by lending excessive amounts to insiders and their related business enterprises. Such limits are necessitated by the fact that a bank may be less subject to the restraints imposed by prudence and sound judgment when making loans to its insiders and their related interest than it would be in making loans to unrelated individuals or business enterprises.

Accordingly, we believe further substantive restrictions should be placed on transactions between banks and insiders. Specifically, it would be desirable to amend section 22 of the Federal Reserve Act to impose additional restrictions on loans by a bank to its own officers and directors and to major stockholders and corporations affiliated with such individuals. Accordingly, sections 3 and 7 of the bill would provide that the existing limits under applicable Federal or State law on loans to one borrower would apply with respect to loans by any member or non member insured bank to any one of its officers and directors and to any other individual holding more than five percent of its voting securities, including loans to companies controlled by such officer, director, or five percent shareholder. These provisions would require that loans or extensions of credit to any one of its officers, directors or five percent shareholders and to all companies controlled by such person be aggregated and that the aggregate of such credit not exceed applicable Federal or State one-borrower limits.

ADMINISTRATIVE ENFORCEMENT

While the provisions of the bill discussed above are designed in large part to prevent problem bank situations from developing, the bill also contains several provisions intended to assist in dealing with problem bank situations once they arise. Presently under $ 8(e) of the Federal Deposit Insurance Act the appropriate Federal bank regulatory agency is authorized to remove a bank director or officer who has engaged in a violation of a law, rule or regulation, participated in an unsafe or unsound practice, violated a final cease and desist order, or breached his fiduciary duty—but only if such violation involves personal dishonesty and where substantial financial loss to the bank or other damage to its depositors can be demonstrated. Because of the difficulty of proving circumstances amounting to personal dishonesty, the present law effectively bars removal of individuals even if they have repeatedly demonstrated gross negligence in the operation or management of the bank or willful disregard for its safety and soundness. While we realize that the congressional objective underlying the “personal dishonesty' requirement was to protect bank officers and directors from arbitrary or capricious administrative action, we believe that in light of recent experience it is necessary to balance the interests of the individual bank officer or director against those of the bank's depositors and shareholders, and ultimately against the public interest in maintaining the integrity of the Federal deposit insurance fund. To strike this balance, we strongly recommend enacting the provisions to section 6(d) of the bill, which add to the standard of personal dishonesty an alternative standard which would recognize the need to remove those officers and directors whose gross negligence in the operation or management of a bank or whose willful disregard of its safety and soundness threatens the financial safety of the institution. We believe that the present hearing and judicial review requirements are sufficient to shield bank officers and directors from arbitrary or capricious administrative action.

69-710 O. 76 - 5

Recent experience also indicates that a bank may be harmed not only by the misconduct of its own officers and directors but also by the misconduct of others who are in a position to influence its affairs. However, it is often difficult or impossible to reach such persons through removal proceedings or through cease and desist action brought against the bank itself. Accordingly, we also recommend the amendments contained in section 6 (a) and (c) of the bill, which would amend paragraphs (b) and (c) of section 8 of the Federal Deposit Insurance Act to provide that the appropriate regulatory agency may bring cease and desist proceedings against directors, officers, employees, agents and other persons participating in the conduct of the affairs of a bank, as well as against the bank itself as permitted under present law. We believe that the ability to reach such officers, directors and other persons participating in a bank's affairs through cease and desist orders would result in a greater ability to correct situations which might otherwise result in serious detriment to the bank.

There are other provisions in the bill which relate to bank holding companies or to other matters within the special cognizance of the Comptroller of the Currency or the Federal Reserve. While we support bill the in toto, we defer to these other agencies for detailed discussions of such visions. Also, in response to the request contained in your March 15, 1976 letter, there is attached hereto as Appendix C a resume of administrative enforcement proceedings conducted by the FDIC during the past five years. Finally, we would recommend that the Committee also act favorably with respect to a related bill (S. 2233) which contains various noncontroversial, "housekeeping” amendments to the Federal Deposit Insurance Act.

APPENDIX A.-LEGISLATIVE PROPOSALS UNDER FDIC CONSIDERATION AS A

RESULT OF THE FAILURE OF U.S. NATIONAL BANK AND RELATED ENFORCEMENT PROBLEMS

By Frank Wille, Chairman Federal Deposit Insurance Corporation This statement outlines a number of legislative proposals the FDIC is considering which might curb some of the abuses that led to the downfall of United States National Bank and have or could lead to the failure of similarly operated banks.

I. AFFILIATE:

A BROADER DEFINITION

OF

AFFILIATE FOR LENDING PURPOSES

USNB, which was in fact controlled by C. Arnholt Smith, extended massive credit to other enterprises controlled by Smith, yet these credit extensions apparently did not violate the provisions of g 23A of the Federal Reserve Act limiting loans to "affiliates” of member banks (made applicable to nonmember banks by $ 18(j) of the Federal Deposit Insurance Act). Section 23A incorporates the definition of "affilite” found in Section 2a of the Banking Act of 1933 (12 U.S.C. § 22la). As presently written, Section 2a limits the term "affiliate" to those entities which are controlled by shareholders who control more than 50 percent of the shares of a bank's voting stock, and Smith himself did not directly control a majority of the voting shares of UŚNB. We believe that this definition should be changed to encompass shareholders who have actual control over the mangement or policies of a bank even though they own less than a majority of its voting shares. 1

This change was previously suggested by the Comptroller of the Currency in his prepared statement before this Subcommittee on December 11, 1974.

1 The term “affiliate”, as defined in Section 2a, is used in other sections of the Federal Reserve Act as well as Section 23A. Each of those sections will be separately examined to determine whether the recommended broadening of the definition of “affiliate" is similarly desirable.

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