The good news is that most bankers and bank boards have never had to deal with the myriad of serious issues that accompany enforcement proceedings by banking regulators. The bad news is that, unfortunately, the number of institutions faced with the effects of ratings downgrades is rising rapidly and those downgrades, if significant, are often accompanied by some form of formal or informal agency enforcement proceedings. Institutions, and their boards, must be in a position to understand and anticipate some of the more significant business and related operating challenges that arise in that environment.
The operating environment created by agency enforcement actions presents probably the most challenging environment that the institution will face, particularly if and when the actions become public through disclosure by the institution (when appropriate under applicable securities laws and regulations) and/or by the agencies (as required by law for “formal” actions), or by virtue of a leak through the industry, employee or community “grapevine.”
Even the actions that remain nonpublic can and do impact the institution and its constituencies in profound ways, and heighten the challenges of an already challenging business environment.
The effect on most institutions and their constituencies tends to follow a somewhat common and predictable pattern. Institutions, their management and boards operate under a microscope in this environment, and the reactions of the institution and its constituencies tend to likewise be somewhat common and predictable. Understanding some of the major challenges which the institution and related parties face in this environment, and preparing in advance to at least anticipate, recognize and understand the issues, can help to mitigate the impact on the institution and its constituencies and avoid the action becoming a self-fulfilling prophecy for the future of the institution.
So, like the Boy Scouts, it’s always best to “be prepared,” to understand what can (and typically does) happen in this environment, and to have a plan in place to recognize, address and manage the issues as they arise. That preparedness will pay big dividends in helping the institution minimize the impact of the actions, regain critical regulatory and market credibility, and recover more quickly should the unfortunate situation arise.
One of the first issues typically encountered involves whether the institution can, should, may, or must publicly disclose the actual or pending existence of an “informal” enforcement action (ranging from examination findings and directives to MOUs) or certain of the components, conditions and/or requirements of those actions. Formal actions are publicly disclosed by the agencies, and both informal and formal actions can result in disclosure issues for public and non-public companies. While the general rule is that informal actions may not be disclosed as part of the overall confidentiality surrounding agency examination proceedings, and violations of that confidentiality requirement can result in civil and criminal penalties, practical conflicting issues arise in the context of whether the action (or proposed action) triggers market and shareholder disclosure obligations, insurance underwriter or claims disclosures, potential M&A disclosures, debt holder disclosures, rating agency disclosures, customer disclosures and a myriad of other practical considerations. Confidentiality agreements by themselves unfortunately do not resolve the disclosure prohibition issues. Formal enforcement actions are publicly disclosed by the agencies, and institutions should take care to coordinate their own disclosures (in many of the same instances as previously cited) with agency disclosures (or in advance thereof, depending on the circumstances). This is an important trap for the unwary, and can create significant regulatory, shareholder, customer and contract liability for the institution and related parties if mishandled. Legal counsel should be consulted early to provide advice as to when, and if, disclosures are necessary or appropriate.
Operating expenses increase quickly and significantly in a “problem” institution environment, from increased professional fees to increased FDIC premiums, special supervisory “surcharges” (in the case of Ohio-chartered institutions a 50% surcharge for 3-rated banks and 100% for 4- and 5-rated banks), increased cost of borrowed funds, increased bond and D&O premiums (and limited availability), to increased deposit costs, to name a few. Watch for covenants in bank debt instruments and perhaps requests for additional collateral for FHLB lines (combined with reduced availability).
Capital may be eroded by loan quality and earnings issues, and the saying “capital is king” is still true. If capital drops below certain established standards, agencies lose flexibility and some enforcement discretion and, under the “prompt corrective action” requirements of FDICIA, the regulators may be legally required to institute certain very significant capital restoration (and other) proceedings against the institution. Capital concerns can quickly drive the institution into a very serious tailspin if not addressed expeditiously and effectively.
Employee Retention, Morale and Confidentiality
Attracting and retaining key employees in this environment can become a challenge, and institutions may want to consider special retention and “combat pay” incentive programs to address key employee issues. Employee morale can also become problematic, and in the same fashion institutions should contemplate special initiatives to address the impact of increased pressure and uncertainty on employee morale. Competitors may attempt to recruit key employees, the loss of which may further weaken the institution and result in additional regulatory concern (including further management rating downgrades). Employees must be encouraged to avoid being caught up in rumors and gossip regarding the institution and its constituencies, and be reminded of their obligations of confidentiality with respect to the business of the organization and pending regulatory actions.
Depositor confidence concerns resulting in deposit run-off and non-renewals (long-time depositors, as well as “hot money”), including withdrawal and non-renewal of large public fund deposits (mandatory for political subdivisions in Ohio with regard to state-chartered institutions which are the subject of ODFI C&D enforcement actions), can quickly have a profound impact on institutional liquidity. The ability to participate in CDARS may be adversely impacted. Other liquidity funding sources such as FHLB lines can also suffer with reduced availability and requirements of additional collateral. Agencies can limit or terminate the ability of the institution to accept brokered and out-of-market deposits when concerns arise, and to incur debt. Institutions should analyze the potential impact of such funding issues to determine what, if anything, can be done to provide a standby source and to fill the gap without resorting to further “hot money” or inappropriate (and potentially self-destructive) deposit pricing techniques.
While capital remains “king,” in troubled settings liquidity is a very close second.
Concerned depositors who may consider safety concerns, as well as loan customers who may perceive a weakened and potentially vulnerable creditor, can combine to cause significant customer challenges for the institution. Problem loan customers may perceive that they are dealing with a distracted and weakened institution, and may attempt to take advantage of those perceptions in dealing with loan issues. Maintaining customer confidence and control will be a key to surviving the enforcement action intact.
Shareholder issues run the gamut from disclosure issues to insider trading concerns for institutional “insiders,” restrictions on buyback programs and stock compensation plans, reduced share value, threatened dividends (at the bank and holding company levels), and unwanted takeover solicitations. Institutions subject to informal enforcement proceedings may find themselves in the difficult position of entering into a “material contract” or being involved in a material event that may suggest disclosure under securities laws, while regulators are anxious for the institution to maintain the action as confidential. Nervous shareholders will require additional hand-holding through the process, and may raise very difficult board and management concerns. Careful and thoughtful communication is the key. Plans should be in place to address these kinds of issues well in advance of their actual occurrence to avoid making strategic blunders on these very important issues. Problems in this area can lead to significant legal exposure from both shareholders and regulators.
Board and Management Issues
Board and management credibility is unquestionably at stake in enforcement actions, and care must be taken to protect, maintain and reinforce institutional and individual credibility with regulatory agency representatives, customers, shareholders and the bank’s community throughout the enforcement process. Except as otherwise dictated by extreme situations, boards and management should endeavor to avoid factions and divisiveness in order to attack and address the issues facing the institution in a cohesive fashion. An open and ongoing dialogue with agency personnel is critical in maintaining institutional and individual credibility, and “surprises” for regulatory agencies must be zealously avoided.
Fiduciary obligations of loyalty, care and candor remain the guiding light for board responsibilities, and regulatory agencies will make it clear that they look to the board to resolve the issues. The board must work to ensure a top-down environment of cooperation and compliance, and must take the lead with management in addressing the issues head-on, making certain that management and the entire organization is behind the efforts to aggressively identify, address and resolve problems facing the institution. It must also be prepared to scrutinize management (as well as its own ranks) and be prepared to undertake difficult changes if required.
Outside forces may seek to divide and factionalize the board in order to achieve any of a variety of desired results, and the board must take care to maintain a unified front to resolve the issues facing the institution and retain control of the situation. Board and management distraction arising from the challenges of dealing with an enforcement action can divert attention from important business considerations. Care must be taken to continue to provide an appropriate focus on the business of the institution as it works its’ way through, and out of, the enforcement process.
In addition, a variety of potential board-conflict issues may arise in enforcement actions, not the least of which may entail potentially conflicting board fiduciary obligations between bank boards and holding company boards with respect to bank dividends, regulatory vs. shareholder obligations and other practical considerations. “Special committees” may be recommended (or required) by the regulators, and/or considered by the board, to take the lead in addressing enforcement action issues to report, as with other board committees, to the full board. Boards must take care to obtain appropriate professional advice and document their consideration, actions and resolution of enforcement issues and the business issues that impact the institution.
Competitors and Potential Acquirers
Once the enforcement action and related issues become public, formally or informally (including sometimes as a result of industry and community “grapevines”), the sharks often begin to circle. Competitors, as well as potential acquirers, may well attempt to take advantage of the situation to put further pressure on the institution, its board and its constituencies in a perceived weakened state. Again, a knowledgeable and prepared board and management will be in a better position to continue to control their own destiny as they address the challenges presented by the enforcement action. A cohesive board must be ready to face the issues as a whole and present a united front to any challenges, while providing credible reassurance to customers, shareholders and employees with regard to the ongoing stability of the organization. If the board ultimately decides that it is in the best interests of the organization and its constituencies to pursue “strategic alternatives,” including a potential sale or other transaction, it must create a strong, comprehensive and defensible record of the deliberations and considerations, including receipt of objective outside guidance and professional advice, leading it to that conclusion.
Institutional and individual credibility with agency personnel is paramount in addressing the issues of a “problem” institution, and an open and direct dialogue between the board, management and agency representatives must be established, fostered and maintained. The institution must keep appropriate agency personnel abreast of events within the institution, including new and unanticipated issues, management issues, board issues and steps being taken to resolve the problems identified by the enforcement action. Less significant compliance issues for the institution, previously overlooked by the examiners, may suddenly become more pronounced as examiners place the institution under a microscope. The institution and its board and management must not be perceived as being reluctant to address the issues in an open, independent, objective and direct fashion. Utilizing a “head-on” approach to resolving the issues may well make a very real difference in the level of remedial action directed by the agencies. A sense of cooperation in identifying and resolving issues cited by the agencies will be critical to keeping the regulatory relationship from spinning out of control.
While daunting, the challenges encountered in dealing with regulatory enforcement actions do not by any means have to signal the end of the line for the institution. Regulatory and market credibility is a key concern. While the individual facts and circumstances leading to enforcement actions vary by institution, the more prepared the organization is to understand and deal with the issues and challenges presented by such enforcement actions the more likely it is to continue to control its own destiny. And the faster the issues are confronted and addressed, the faster the regulatory pressures are likely to abate. While a sale may in fact ultimately be determined to provide the best alternative for the institution, it may or may not be the best time to take that action, and care must be taken to carefully review and document consideration of the various available alternatives before choosing any single route. A “home alone” strategy may not be the preferred option when the challenges of enforcement actions continue, but in certain instances it may in fact be the only viable alternative available, and cannot be ruled out until the institution reviews its various potential alternatives and undertakes a comprehensive cost/benefit analysis of each.
Sometimes the analogy of deciding whether to sell the car right after the wreck, or fix it up first, comes into play in the consideration of options facing “troubled” institutions. There are many direct and indirect risk, time and cost considerations that relate to whether it is best to fix the car before deciding whether to keep it or sell it, including whether there are, in fact, any likely buyers. Institutions and their boards must be in a position to identify, analyze and document their consideration of the relative risks, costs and benefits inherent in each alternative.