II. CONGLOMERATES: TIGHTER LIMITS ON LENDING TO ENTITIES UNDER COMMON CONTROL

Although there are federal and state laws which limit loans to a single borrower, many corporate borrowers have been able to avoid such limits through the simple expedient of having each of their subsidiaries borrow separately from the same bank, with the parent company refraining from any direct borrowing from that bank. The danger is that laws or regulations which treat corporate subsidiaries as separate entities for bank lending limit purposes will result in aggregate excessive loans to ostensibly separate entities which are in reality part of a single enterprise. When that enterprise fails, normally the loans to all of the entities go "sour".

For example, USNB extended credit to the Westgage-California conglomerate in amounts far in excess of the legal limit imposed on loans by a national bank to any one borrower (12 U.S.C. § 84). It was able to do so because the parent company (now in Chapter 10 proceedings) didn't borrow directly. In construing § 84, the Comptroller of the Currency has ruled that obligations of subsidiary corporations are generally not considered obligations of the parent if the parent corporation is not itself borrowing from the same bank (12 C.F.R. § 7.1310), and this construction in the view of most lawyers is supported by the language of the statute.

To counter this problem, the FDIC favors changes in both federal and state lending limits, where necessary, which would allow the supervisory authorities to treat loans to entities under common control as loans to a single borrower.

III. INSIDERS: TIGHTER LIMITS ON LENDING TO INSIDERS AND THEIR RELATED BUSINESS INTERESTS

Lending limits should prevent banks from incurring undue risks by lending excessive amounts to insiders and their related business enterprises. A bank may be less subject to the restraints imposed by prudence and sound judgment when making loans to these insiders and their related interests than it would be in making loans to unrelated individuals or business enterprises.

In line with Governor Holland's testimony last Wednesday, we recommend that § 22 of the Federal Reserve Act (12 U.S.C. § 375a) be amended so as to cover directors and controlling shareholders of a member bank in addition to its executive officers, and to business enterprises which such directors, controlling shareholders and executive officers control. We also agree that loans to these individuals should be aggregated with loans to companies controlled by them for the purpose of applying state and federal lending limits. Since many states impose no legal restraints on loans to a bank's own executive officers, directors or controlling shareholders, we recommend that Section 22 of the Federal Reserve Act be extended to encompass those State-chartered banks which are insured by the FDIC but do not belong to the Federal Reserve System.

Parenthetically, I might add that the FDIC is considering regulations which would impose on banks tighter internal controls and recordkeeping requirements for transactions with insiders. We plan to publish these proposed regulations for public comment within the next few weeks.

IV. FINES: ADMINISTRATIVE FINES FOR MAJOR BANKING LAW VIOLATIONS

A special problem has to do with the absence of penalties for violations of major federal banking laws, such as §§ 22 and 23A of the Federal Reserve Act. I previously recommended that § 22 be extended to cover insured nonmember as well as member banks. Section 23A already applies to insured nonmember banks by virtue of § 18(j) of the Federal Deposit Insurance Act. Neither section includes any provision for a fine in the event of its violation, yet both sections are important in preventing the kinds of abuses often found in problem banks. We recommend that Congress authorize the appropriate bank regulatory agency to assess a fine against any bank or individual willfully violating § 22 or § 23A, or willfully refusing to obey any lawful regulation issued pursuant thereto. Such fine would be in the nature of a civil rather than a criminal penalty and would vary in amount, within the maximum set by law, at the discretion of the agency.

We recognize the severity of this remedy but feel that it often constitutes the only effective method of deterring harmful violations. Termination of a bank's insurance has long been recognized as too severe to be used in any but extreme

situations. Cease and desist proceedings are useful but the threat of a cease and desist order, standing alone, has not always proved to be a sufficient deterrent to those who would willfully violate laws or regulations. Hopefully, the threat of a fine would deter conduct that could cause irreparable injury to a bank.

We also recommend the imposition of a fine for the willful violation of any effective and outstanding cease and desist order issued by an agency under § 8(b) or § 8(c) (12 U.S. C. §§ 1818 (b) and (c)) of the Federal Deposit Insurance Act where the order has become final. In this case, the fine would be imposed for each day that the offending bank or individual willfully refuses to obey the order. The imposition of a fine for violating a cease and desist order which has become final would serve to emphasize the gravity of such an order. Under § 8(k) (12 U.S.C. § 1818(k)), 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. Id either event, the party must have exhausted the administrative and judicial remedies afforded 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 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.

V. REMOVAL: INDIVIDUALS WHO WILLFULLY DISREGARD THE SAFETY AND SOUNDNESS OF AN INSTITUTION

As you know, § 8(e) (12 U.S.C. § 1818(e)) of the Federal Deposit Insurance Act authorizes the removal of 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 where his actions also involve personal dishonesty and are seen as causing substantial financial loss to the bank or damage to its depositors. This effectively bars the removal of an officer or director who has repeatedly demonstrated gross negligence or willful disregard for the safety and soundness of his bank, thereby causing it substantial financial injury, but who has not been shown to have engaged in any act amounting to personal dishonesty.

Although we recognize the effort on the part of Congress to shield those who are innocent of any personal wrongdoing from arbitrary or capricious administrative action, we feel that some effort should be made to balance the interests of the individual bank officer or director against those of its depositors and shareholders, and ultimately the Federal deposit insurance fund. This can be done by adding to the Act as an alternative to the standard of personal dishonesty, a new standard which would recognize the need to remove those whose reckless conduct threatens the financial safety of their institutions. Since removal under § 8(e) is an administrative remedy which may not be put into effect until a hearing has been afforded the party in question, providing him with an opportunity to put on his defense, he is adequately protected against arbitrary and capricious administrative action. In addition, he has the right to petition a court of appeals to modify or set aside the removal order.

VI. CEASE AND DESIST: EXTENSION OF ORDER TO CERTAIN PERSONS

Our experience suggests that a bank may be harmed not only by the misconduct of its own management but also by the misconduct of others who are in a position to influence its affairs. However, it is often difficult to reach such persons through a cease and desist proceeding brought against the bank itself.

Section 8(b) (12 U.S.C. § 1818(b)) of the Federal Deposit Insurance Act empowers the appropriate federal banking agency to bring a cease and desist proceeding against a bank that is engaged in a violation of a law, rule or regulation, or an unsafe or unsound practice. We recommend that § 8(b) be amended to expressly include persons such as directors, officers, controlling shareholders and others participating in the conduct of the affairs of the bank. This would enable the appropriate agency to control the participation in the affairs of a bank of those persons who have either violated a law, rule or regulation, or engaged in an unsafe or unsound practice, or participated with others in such violations or practices.

APPENDIX B-FDIC ADOPTS FINAL REGULATION ON INSIDER TRANSACTIONS OF NONMEMBER COMMERCIAL BANKS

Chairman Frank Wille announced today that the Board of Directors of the Federal Deposit Insurance Corporation has adopted in final form a regulation aimed at curbing abuses which may occur in the context of transactions between an insured State nonmember commercial bank and "insiders" of the bank. The regulation becomes effective May 1, 1976, and is similar to but not identical with the proposed regulation on the same subject issued by the FDIC for comment on September 4, 1975.

According to Chairman Wille, the experience of the Corporation has indicated the need for more vigorous supervision of such transactions by bank boards of directors and bank supervisory agencies. Abusive self-dealing has been a significant contributing factor in more than half of all bank failures since 1960, including the failure of 30 nonmember insured commercial 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 of 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.

The regulation seeks to minimize abusive self-dealing through the establishment of procedures which insure that bank boards of directors supervise such transactions effectively and which better enable Corporation examiners to identify and analyze such transactions. The board of directors of each insured nonmember commercial bank will be required to review and approve each insider transaction involving assets or services having a fair market value greater than a specified amount which varies with the size of the bank. In addition, certain record keeping 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.

The term "insider" is defined in the regulation as any director; any officer or employee who participates or has authority to participate in major policy-making functions of a bank; and any other person who has direct or indirect control over the voting rights of more than ten percent of the shares of any class of voting stock of a bank, or who otherwise controls the management or policies of a bank. An "insider transaction" would include, with limited exceptions, any business transaction between an insured nonmember bank or a majority-owned subsidiary of such a bank and an insider or certain persons related to such an insider. Included in the scope of this coverage are transactions between a State nonmember bank and a holding company parent or other entities within a holding company system. An insider transaction would also encompass transactions between the bank and a noninsider where the transaction ultimately inures to the tangible economic benefit of an insider or persons related to an insider.

The regulation makes it clear that formal compliance with the board of directors review and approval requirements it imposes neither relieves the bank of its duty to conduct its operations in a safe and sound manner nor prevents the Corporation from taking whatever supervisory action it deems necessary and appropriate with respect to any insider transaction or group of insider transactions. Such supervisory action could include cease and desist proceedings, removal proceedings, and the termination of deposit insurance under section 8 of the Federal Deposit Insurance Act. Finally, the regulation sets forth factors which will be considered by the Corporation's Board of Directors in determining whether such insider transaction or transactions indicate the presence of unsafe or unsound banking practices. These factors include: whether, because of preferential terms and conditions, such transactions are likely to result in significant loan losses, excessive costs, or other significant economic detriment to the bank which would not occur in a comparable arm's length transaction with a person of comparable creditworthiness or otherwise similarly situated; whether transactions with an insider and all persons related to that insider are excessive in amount, either in relation to the bank's capital and reserves or in relation to the total of all transactions of the same type; or whether from the nature and extent of the

bank's insider transactions it appears that certain insiders are abusing their positions with the bank.

As adopted, the regulation would not apply to the 329 FDIC-insured mutual savings banks. The Corporation will at an early date publish for comment its intention to amend the newly adopted regulation so that it will apply to these mutual savings banks.

Chairman Wille emphasized that although the Corporation has determined that insider transactions require special supervision by bank boards of directors and close scrutiny by the Corporation's examiners, this determination does not mean that all transactions with insiders or their interests are detrimental to the bank in question or that such transactions should be automatically rejected. Accordingly, the Corporation has neither prohibited nor significantly restricted a bank's ability to enter into such transactions. Similarly, an effort has been made to avoid the imposition of costly and unduly burdensome record keeping or reporting requirements. In short, according to Chairman Wille, the regulation represents an attempt on the part of the Corporation to deal with a problem of serious concern in a manner which is both effective and equitable, taking into account the diverse interests of the bank, its customers and shareholders, and the FDIC itself. TITLE 12-BANKS AND BANKING

CHAPTER III-FEDERAL DEPOSIT INSURANCE CORPORATION

SUBCHAPTER B-REGULATIONS AND STATEMENTS OF GENERAL POLICY

PART 337-UNSAFE AND UNSOUND BANKING PRACTICES

(Approval and Record Keeping Requirements Pertaining to Insider Transactions) 1. On September 3, 1975 the Federal Deposit Insurance Corporation (the "FDIC)" published for comment a notice of proposed rulemaking pursuant to the authority in sections 7(a), 8(a), 8(b), 8(e), 9 Tenth, 10(b) and 10(c) of the Federal Deposit Insurance Act [12 U.S.C. sections 1817(a), 1818(a), 1818(b), 1818(e), 1819 Tenth, 1820(b) and 1820(c)]. [40 Fed. Reg. 40548.] The notice indicated that the Board of Directors (the "Board") of the FDIC was considering addition of a new section 337.3 to Part 337 of Title 12 of the Code of Federal Regulations for the purpose of curbing abuses which arise out of the dealings of insiders with insured nonmember banks. The period for public comment ended October 31, 1975. After careful review and consideration of the views and arguments of those who commented on the proposed regulation, the Board has determined that the proposed section 337.3 should be adopted with certain modifications. Accordingly, the regulation was adopted as modified by resolution of the Board on February 25, 1976. Its requirements will become effective on May 1, 1976.

This action is based on the experience of the Corporation which indicates that many banks have suffered loan losses, loss of revenue, excessive costs and other substantial economic detriment as a result of ill-considered transactions with insiders. The need for more rigorous supervision of such transactions by boards of directors and bank supervisory agencies is indicated by the fact that abusive self-dealing has been the primary cause or a significant contributing cause in more than half of all bank failures since 1960, including the failure of 30 nonmember insured banks. The most dramatic example of the harm which can result from abusive self-dealing is the 1973 failure of the United States National Bank, San Diego, California, for which the Corporation has had to establish a reserve of $150 million for loss to the deposit insurance fund. Review of existing and past "problem" bank cases also reveals insider overreaching aw a significant source of serious difficulty. Moreover, an insider transaction that is not effected on an "arm's length" basis will lead to a diminution of earnings and an erosion of capital, even where the immediate result is not the bank's failure or its designation as a "problem" institution. It follows, therefore, that insider transactions whose terms and conditions cannot be justified when viewed in light of all the circumstances surrounding the transaction, increase the risk of loss to depositors and ultimately to the deposit insurance fund. In addition, 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.

The regulation seeks to minimize the risk of such abuse in insured nonmember banks by requiring meaningful board of director review of significant insider transactions and by requiring the maintenance of certain records designed to facilitate internal control and examiner analysis of these transactions and to document the fairness of these transactions to the bank. In order to provide guidance to bank boards, the regulation lists some of the factors which the Corporation would consider in determining whether an insider transaction or group of insider transactions indicates the presence of an "unsafe or unsound" banking practice and what kind of corrective supervisory action is warranted.

Although the Corporation has determined that insider transactions require special supervision by bank boards of directors and close scrutiny by the Corporation's examiners, this determination does not mean that all transactions with insiders or their interests are detrimental to the bank in question, or that they should be discouraged. Accordingly, the Corporation has chosen not to prohibit or restrict such transactions. Similarly, the Corporation has chosen not to impose costly and burdensome record keeping or reporting requirements. Rather, the focus of the proposed regulation is the establishment of internal bank procedures which will minimize the potential for abuse that is inherent in a conflict of interest situation. In short, the Corporation has sought to strengthen existing institutional mechanisms-the bank's board of directors and the examination process to deal with the problem of insider abuse.

SCOPE OF THE REGULATION

The regulation applies to all insured State nonmember commercial banks and to any majority-owned subsidiary of such a bank. It defines an "insider" as any director; any officer or employee who participates or has authority to participate in major policy-making functions or any other person who has direct or indirect control over the voting rights of more than ten percent of the shares of any class of voting stock of a bank or otherwise controls the management or policies of the bank. An insider transaction is considered to be any business transaction or series of related business transactions between an insured State nonmember bank or a majority-owned subsidiary of such a bank and an insider, certain close relatives of an insider, or business interests of an insider. Any transaction between the bank and a non-insider where the transaction is made in contemplation of the person becoming an insider or where the transaction ultimately inures to the tangible economic benefit of an insider, or persons related to an insider, is also considered to be an insider transaction.

3

1 Several comments reflected the misconception that the regulation seeks to prohibit or discourage insider transactions. The Corporation recognizes that in many instances such transactions are not only appropriate but highly desirable and that in certain smaller banking markets they may be inevitable and essential to the provision of adequate banking services. It must be emphasized, therefore, that the regulation is aimed at insuring that insider transactions are effected on terms which are fair to the bank and its shareholders and do not involve overreaching and abuse by insiders.

The phrase "or otherwise controls the management or policies of a bank" was added to the definition of "insider" because the experience of the Corporation indicates that significant influence and even effective control over the affairs of a bank can be exerted by one who is neither an employee, officer, director, nor significant shareholder. For example, a management contract may give one not otherwise connected with a bank substantial influence over the affairs of the institution.

3 In an explanatory footnote to subsection (a) (6), the regulation states:

4

The phrase "series of related business transactions" includes transactions which are in substance part of an integrated business arrangement or relationship such as borrowings on a line of credit, law firm billings, or recurring transactions of a similar nature within a holding company system.

The regulation states that the definition of insider transaction includes "any business transaction or series of related business transactions" between a bank and an "insider" or a "person related to an insider." The term "insider" includes "any other person who has direct or indirect control over the voting rights of ten percent of the shares of any class of voting stock of a bank or otherwise controls the management or policies of a bank," and the term "person related to an insider" includes, in addition to certain close relatives, "any person controlling, controlled by or under common control with an insider." It should be noted that this definitional framework results in application of the regulation to many intra-holding company transactions. A number of comments objected to the regulation on the ground that, in the holding company context, it would cover a great many routine transactions, rendeirng compliance impractical and burdensome. The Corporation has sought to lessen this burden through the addition of the provision in section (b) which allows the bank to approve "a series cf related transactions involving the same insider" as if they were a single transaction. In the holding company context this would allow the bank's board to approve and review similar transactions of a recurring nature, with the parent or another affiliate, as a group rather than singly. Secondly, in the event that the regulation does have unduly burdensome effects that the Corporation has not anticipated, the bank may resort to the waiver provision contained in Part 337 of FDIC regulations, which states:

An insured State nonmember bank has the right to petition the Board of Directors of the Corporation for a waiver of this Part or any subpart thereof with respect to any particular transaction or series of similar transactions. A waiver may be granted at the discretion of the Board upon a showing of good cause. All such petitions should be filed with the Office of the Executive Secretary, Federal Deposit Insurance Corporation, 550-17th Street, N.W., Washington, D.C. 20422.