LAW AND REGULATION IN BANKING

“Bank Director and Officer Fiduciary Duty – Conflicts That Can Derail Even the Best”

Terri D. Thomas SVP - Legal Department Director

Kansas Bankers Association Topeka, KS

tthomas@ksbankers.com 785-232-3444

August 7, 2018

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BANK DIRECTOR AND OFFICER FIDUCIARY DUTY- CONFLICTS THAT CAN DERAIL EVEN THE BEST PLANS

Presented by: Terri D. Thomas, JDSVP-Legal Department DirectorKansas Bankers Association

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REGULATIONS WHICH IMPACT FIDUCIARY DUTY Sarbanes Oxley Act (SOX)- publicly traded banks and banks with over $500 million (audit

standards, but not corporate governance, although compliance is “highly recommended);

Unique regulations governing conflicts of interest for federal savings associations;

Bank Bribery Act;

Regulation 0- Loans to Executive Officers, Directors, and Principal Shareholders;

Regulation W- Transactions between Affiliates;

RESPA anti-kickback rules;

Bank Secrecy Act- Suspicious Transaction Reporting. 2

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LEGAL AND REGULATORY RESPONSIBILITIES OF BANK OFFICERS DIRECTORS Director’s and Officer’s Common Law Duties -

Fiduciary to the shareholders;

Duties of loyalty and care to the shareholders;

Acts must be in the best interest of the financial institution;

Failure to exercise duties can result in personal liability.

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Duty of Loyalty- Loyal to the shareholders and the financial institution, placing

their interests above those of the individual director. Avoid any appearance of impropriety, including engaging in

activity that is, or might appear to be, in competition with the bank.

Duty stops when the financial institution is participating in actions that are illegal or violate regulations.

Duty of loyalty includes: Diligently and honestly administering the bank’s affairs; Placing the bank’s interests above the director or officer’s own

interests; and Transactions between the bank and the director/officer must be

on terms that are fair to the bank (“arms-length” transactions).

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Duty of Care –

Required to take reasonable steps in fulfilling job responsibilities;

The use of diligence, investigating potential problems in the bank’s management;

Maintaining an adequate level of expertise of the banking industry; and

Performing/authorizing only transactions that are legally permitted to be taken by the bank.

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REGULATORY RESPONSIBILITY OF DIRECTOR & THE SARBANES-OXLEY ACT (SOX)

Prior to SOX- Since the late 1980’s, financial institution directors and officers have been required to exercise a higher standard of care than directors/officers of other industries? Why?

FDIC Insurance

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Bank’s board and management have a number of duties relating to insider activities. Board’s primary responsibilities are to provide strategic leadership and oversight of management, and board should ensure that management performs each of the following duties:

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Establishing insider policies, including a code of ethics;

Fulfilling fiduciary obligations;

Complying with insider-related laws and regulations;

Establishing independent processes to monitor and ensure compliance with insider policies, laws, and regulations;

Setting appropriate compensation and fees paid to insiders;

Following prudent dividend policies;

Implementing sound management information systems; and

Submitting accurate financial reports and other disclosures. 8

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Life After SOX –

SOX did result in certain regulatory standards being applied to publicly traded and/or large (over $500 million in assets) financial institutions. The changes are primarily in the areas of accounting, audit, and internal fraud controls. Smaller institutions are being held to similar standards by bank regulators.

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What is Fraud Under SOX –

Fraudulent financial reporting;

Misappropriation of assets;

Fraudulently obtained revenue/assets;

Expenditures and liabilities for improper purposes.10

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WHAT WILL REGULATORS LOOK FOR IN DETERMINING “ANTI-FRAUD” COMPLIANCE?

Control Environment-

Intangibles (employee ethics, the role of the board and audit committees, management philosophy and operating style);

Not static- influenced by the history and culture of the employees and directors/officers in the day-to-day handling of financial institution affairs;

Part of determining the environment will be the examination of:

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Code of Ethics;

Whistleblower Program;

Hiring/Promotion/Compensation Procedures;

Oversight by Audit Committee/Board; and

Investigation/Remediation.

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Risk Assessment- Has the organization considered where fraud is likely to occur in each of its lines of business? Measuring the organization’s vulnerability is key;

Lax policy enforcement, inadequate policy development, or a complete lack of policy may create vulnerability;

Risk assessments should be formalized and on-going, not informal and haphazard;

Additional risk assessments should be used any time the financial institution introduces new products or lines of business and during any restructuring on a company-wide basis, as well as at the line-of-business level. 13

Control Activities- Actions taken by management to prevent and mitigate fraudulent financial reporting or misuse of an organization’s assets. These activities include:

Diversification of: Approval processes; Authorizations; Verifications; Reconciliations;

Segregation of duties;

Reviews of operating performance; and

Security of assets. 14

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Information and Communication-

Employee responsibilities under the financial institution’s antifraud program must be communicated to employees in a timely and clear manner;

Information must flow down, up, and across the organization;

The bank must let the employees know that it is serious about preventing fraud and that it encourages employees to identify problem areas. 15

Monitoring-

The bank must have procedures in place that permit it to monitor the success or deficiencies of the antifraud program;

Techniques should be technology-based, as well as having a human component.

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WHISTLE-BLOWER PROGRAMS

SOX requires covered organizations to establish procedures for information to be reported by employees about potential internal fraud;

But, all institutions should consider implementing.

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UNIQUE REGULATIONS GOVERNING FEDERAL SAVINGS ASSOCIATIONS

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BANK BRIBERY ACT & BANK DIRECTORS, OFFICERS AND EMPLOYEES-

The basic rules pertaining to bank directors and employees are:

It is a violation of federal law for a director/employee to solicit, demand, or accept anything of value intending to be influenced or rewarded in connection with any business or transaction of the Bank. The exceptions are:

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Gifts based on obvious family or personal relationships;

Meals, travel arrangements, or entertainment of reasonable value which have to do with bona fide business;

Ordinary loans;

Advertising and promotional rebates which are provided to other customers;

Gifts of reasonable value related to commonly recognized events or occasions;

Civic, charitable, educational, or religious organizational awards for recognition of service and accomplishments.

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OTHER PERTINENT REGULATIONS DEALING WITH CONFLICTS OF INTEREST AND FRAUD

Regulation O- Loans to Insiders- This regulation governs lending activities between a bank and its directors, principal shareholders, executive offers and their related interest (insiders). It covers:

1) restrictions on loans to insiders, with additional restrictions on loans to Executive Officers; and

2) restrictions on the aggregate total of loans by a bank to all of the bank’s insiders. 23

Loans with terms and conditions that are no more favorable than loans made to non-insiders (looking at rates, collateral and credit standards);

Loans greater than $25,000 or 5 percent of the bank’s capital and surplus (whichever is greater) or greater than $500,000, must be approved in advance by the bank’s board of directors;

Loans to an insider and a related interest cannot, in the aggregate, exceed the statutory lending limit of the bank for loans to one borrower. 24

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Overdrafts of insiders- The bank can not pay an overdraft of an executive officer or director unless there is a written, preauthorized, interest-bearing repayment plan (like an overdraft line of credit), a preauthorized transfer of funds agreement from another account or the overdraft is inadvertent;

The overdraft will not be considered inadvertent if it exceeds $1000 or is outstanding more than 5 days. The standard overdraft fees must be charged.

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ADDITIONAL RESTRICTIONS ON EXECUTIVE OFFICERS-

Restrictions are more rigid than loans to other insiders under the regulation.

Unlimited amount for loans to finance the education of the Executive Officer’s children or if the loan is to finance or refinance the purchase, construction or improvement of the Executive Officer’s residence (secured by a first lien on the property);

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For any other purpose, the loan is limited to $25,000 or 2.5% of the bank’s capital and surplus, but in no event can it exceed $100,000 (unless the loan is secured by U.S. government securities or segregated deposit accounts at the bank or have an unconditional guarantee from a federal agency/federally-owned corporation);

An Executive Officer must have promptly reported a current detailed financial statement to the board of directors and the loan must be payable on demand.

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Preferential Deposit Interest Rates for Directors-

The Federal Reserve Act [Section 22(e)] prohibits a member bank from paying any director, officer, attorney or employee a greater rate of interest than the rate paid to other depositors with similar accounts at the bank.

For state, non-member banks, if a director/executive officer had a loan and a deposit account at the bank, the receipt of a preferential rate on the deposit account would essentially have the same effect as providing a preferential rate on the loan, and therefore would be prohibited.

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SECTIONS 23A AND 23B (REGULATION W); RESTRICTIONS ON BANK’S TRANSACTIONS WITH AFFILIATES- WHY DOES IT MATTER?

FDIC Insurance provides unique “security” for a financial institution;

Passing the “risk” of doing business on to a bank affiliate is a tempting business strategy;

Federal gov’t (through the FDIC) has a strong interest in protecting taxpayers from financial institutions exercising unsafe and unsound business practices.

Rule 1- Totaled covered transactions with any one affiliate (not including operating subsidiaries) can not exceed 10% of total capital stock and surplus;

Rule 2- The bank’s total covered transactions with all affiliates combined cannot exceed 20% of the bank’s capital stock and surplus.

Rule 3- Extensions of credit, letters of credit, and guarantees must be fully secured with qualifying collateral, which must be worth 100%-130% of the amount of the covered transaction, with the percentage depending upon the type of collateral;

Section 23A Rules

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Rule 4- A bank can not purchase a low-quality asset from an affiliate, except when the bank, pursuant to an independent credit evaluation, committed itself to purchase the asset before the affiliate acquired the asset.

EXEMPTIONS FROM 23A RULES

1) Sister-bank exemption- exempts transactions between FDIC-insured depository institutions that are at least 80% common controlled. Will exempt from the capital limitations and collateral requirement, but not the prohibition against purchasing low-quality assets. Will apply if the same company owns at least 80% of two or more institutions or where one institution owns at least 80% of the other institution’s voting shares.

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2) Transactions secured by US gov’t securities or a segregated, earmarked deposit account;

3) Purchasing assets having readily identifiable, publicly available market price;

4) Purchasing loans, without recourse, from affiliated banks (subject to the low-quality asset prohibition);

5) Repurchasing a loan originated by a bank and sold to the affiliate under a recourse or repurchase agreement; 33

6) Giving immediate credit for items submitted for collection in the ordinary course of business;

7) Making deposits in an affiliated bank in the ordinary course of correspondent banking business;

8) Investing in bank service corporations which engage only in such activities as holding title to bank premises, conducting safe deposit business, and providing services to the holding company and its banks. 34

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SECTION 23B RULES

Rule 1- A bank must deal with an affiliate, or in certain transactions involving affiliates, with third persons, on market terms (i.e. at arm’s length). Bank must deal “on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to such bank. . ., as those prevailing at the time for comparable transactions with or involving other non-affiliated companies.

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Rule 2- Bank cannot, as fiduciary, purchase securities or other assets from an affiliate, except as permitted: Under the instrument creating the fiduciary

relationship; By court order; By the law of the jurisdiction governing the

fiduciary relationship.

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Rule 3- Bank cannot, as principal or fiduciary, purchase particular securities while an affiliate is a principal underwriter for those securities (can’t prop up the price of securities for which market demand is lacking by buying the securities for trust accounts or its own portfolio). The only exception is if a majority of bank’s directors approved the purchase BEFORE the securities were initially offered to the public.

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Rule 4- Neither the bank, nor its affiliates, can publish any advertisement, or make any agreement “stating or suggesting that the bank shall in any way be liable for the obligations of its affiliates.”

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Regulation W (23A and 23B) Restrictions on Purchases and Sales of Securities or Property

The Federal Reserve Act also prohibits a bank from selling or purchasing, from its directors, securities or other assets on preferential terms unless the transaction has received prior approval from a majority of the bank’s disinterested directors. The board must determine that such a transaction is consistent with safe and sound banking practices and with the directors’ fiduciary duties. Furthermore, the terms of the transaction can be no more favorable to the director (or less favorable to the bank) than those involving unrelated parties to the bank. 39

RESPA AND CFPB REGULATION X

The Real Estate Settlement Procedures Act prohibits the giving or receiving of unearned fees or kickbacks or any other thing of value unless the fee paid (or the party receiving it) meets specifically listed exceptions on loans involving first or subordinate liens on residential real property.

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No referral fees-No person shall give and no person shall

accept any fee, kickback, or other thing of value pursuant to any agreement or understanding, oral or otherwise, that business incident to or part of a settlement service involving a federally related mortgage loan shall be referred to any person.

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No split of charges except for actual services performed-No person shall give and no person shall

accept any portion, split, or percentage of any charge made or received for the rendering of a settlement service in connection with a transaction involving a federally related mortgage loan, other than for services actually performed.

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Exemptions for fees, salaries, compensation, or other payments- The following are permissible:

A payment to an attorney for services actually rendered;

A payment by a title company to its duly appointed agent for services actually performed;

A payment by a lender to its duly appointed agent or contractor for services actually performed;

A payment to any person of a bona fide salary or compensation or other payment for goods or facilities actually furnished or for services actually performed; 43

A payment pursuant to cooperative brokerage and referral arrangements between real estate agents and real estate brokers;

Normal promotional and educational activities that are not conditioned on the referral of business;

A payment by an employer to its own bona fide employee for generating business for that employer;

In a controlled business arrangement, a payment by an employer of a bonus to a managerial employee based on criteria relating to performance. However, the amount of such bonus may not be calculated as a multiple of the number or value of referrals of settlement service business to a business entity in a controlled business arrangement; and

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Payment by an employer to its bona fide employee for the referral of settlement service business to a settlement service provider that has an affiliate relationship with the employer or in which the employer has a direct or beneficial ownership interest of more than 1 percent, if the following conditions are met: The employee does not perform settlement services;

and The employee provides to the person being referred a

written disclosure in the format of the Controlled Business Arrangement Disclosure Statement;

The marketing of a settlement service or product of an affiliated entity, including the collection and conveyance of information or the taking of an application or order for an affiliated entity, does not constitute the performance of a settlement service. 45

BANK SECRECY ACT – SUSPICIOUS ACTIVITY REPORTING AND BANK EMPLOYEES

Summary of requirements: A bank must report suspicious activity which takes place at the bank. When an employee or director is involved, a SAR is required, no matter what the amount.

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WHEN TO FILE:

Must file within 30 days of the initial detection of suspicious activity;

Have 60 days when no suspect is identified;

Must continue to file every 90 days thereafter for on-going activity.

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SAR FILING THRESHOLDS:

$5,000 or above when suspect is identified;

$25,000 or above when no suspect is identified;

$0 when an insider to the bank.

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What is reportable: Different types of suspicious activity related to insiders:

Bribery/Gratuity Commercial Loan Fraud Computer Intrusion Consumer Loan Fraud Defalcation/Embezzlement False Statement Misuse of Position or Self Dealing Mortgage Loan Fraud Mysterious Disappearance Wire Transfer Fraud Other (type of activity) 49

Areas of greatest risk to financial institutions-Financial institutions have been assessed fines for failure to create adequate programs, including:

Riggs Bank, N.A.- $25 million penalty AmSouth Bank- $50 million in penalties and

forfeiture

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BSA PENALTIES

Civil Penalties:$1,000 to $100,000

Criminal Penalties: $1,000 to $500,000; and Imprisonment of one to five years Fine can be assessed against the person, not just the

bank.

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CONFIDENTIALITY?

CTRs are not subject to confidentiality rules;

SARs are subject to confidentiality rules. A customer (or employees who do not have a need to know) should not be informed of the filing. Board members may be informed of a filing (redact information regarding the suspect’s identity), however if a filing involves a board member, then the existence of the filing would have to be kept from the subject board member. 52

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The End

Any Questions?

Thank you!

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