As Regulators Move in, the Board Acts too Late: The Inside Story of the Franklin Bank Failure
Aug 30, 2009 | See More in: Enforcement, Regulation & Compliance
There was only one item on the agenda for the hastily-called special meeting of Franklin Bank SSB's Audit Committee on Feb. 25, 2008: What to do about the allegations in a letter from the bank's vice president for loss mitigation?
The six-page letter alleged numerous accounting problems. It said the Houston-based bank's latest SEC filing constituted fraud. And it had detailed anecdotal evidence to back up the claims.
Nine months after bank executives received Craig Wolfe's letter, state regulators and the FDIC would close down the $5.1 billion bank. This is Part Two of the inside story of what went wrong, based on interviews, an examination of hundreds of pages of court filings, confidential regulator reports, minutes of bank board meetings and SEC filings. Along with the economy, the failure of Franklin Bank can be blamed in part on deficient regulation, poor board oversight and lax management. As more and more banks fail across the U.S., the demise of Franklin Bank offers a textbook lesson for all.
Wolfe's letter grabbed the board's attention. Bank Chairman Lewis S. Ranieri, the Wall Street icon who founded the bank, and bank director Robert A. Perro, an accountant who had worked with Ranieri for years, attended the Feb. 25th meeting by phone. The group decided to hire special counsel to investigate the allegations, settling on the Houston-based international law firm of Baker Botts LLP.
Baker Botts partner Joseph A. Cialone II would head up the probe. An expert in corporate governance who was awarded both a Bronze Star and a Purple Heart in Vietnam, Cialone was no stranger to high-profile investigations. He had represented former president George W. Bush before the SEC in an insider trading probe involving Harken Energy Corp. in 1991. The SEC closed the investigation without filing any charges.
On March 5, after Baker Botts had begun its investigation and after the accounting firm Ernst & Young was hired to help, the audit committee met again. This time it decided it might be time to send the letter to state and federal regulators, including the FDIC and SEC. The regulators were very interested in the contents of the letter and asked to be included in all future bank meetings about the investigation.
Bank Alerts Public to Potential Accounting Problems
The first public clue that anything was amiss came less than two weeks later. The bank announced on March 14 that it would delay its Form 10-K report because the board of directors "learned of possible accounting, disclosure and other issues related to single-family residential mortgages and residential real estate owned that could affect Franklin's 2007 financial statements."
The law firm and accounting investigation - which would cost the bank more than $2.3 million in fees - involved a review of four bank computer hard drives, an examination of approximately 250,000 e-mails and interviews with 23 Franklin Bank executives, officers and employees. Investigators spoke to Wolfe for more than 20 hours. By mid-April, the internal investigation was essentially complete.
Meanwhile, the bank realized it had to amend its Call Reports for the quarters ending March 31, 2008, Sept. 30, 2007, and Dec. 31, 2007. It submitted those new Call Reports to the FDIC on April 30, 2008. It also announced that "the information contained in the Jan. 31, 2008 press release should no longer be relied upon." Regulators would later ask the bank to amend its June 30, 2008 Call Report, as well.
On May 7, Baker Botts and Ernst & Young presented the final investigative findings to the audit committee. The PowerPoint presentation, which stretched to 85 pages, took 4 ½ hours. The investigation revealed "significant accounting errors, inappropriate accounting entries, lack of internal controls and also raised significant questions about the competency of the management," FDIC examiners later wrote. When the PowerPoint ended, the audit committee held a special meeting with the full board. Conspicuously absent: CEO Anthony Nocella.
Bank Hires More Counsel, Worries about D&O Insurance
The bank and the holding company also had hired the Houston law firm of Bracewell & Giuliani as special counsel. (The boards of the bank and its holding company were identical except for one member.) The bank board later would ask the Bracewell & Giuliani attorneys to review its directors and officers insurance policies.
When a bank fails, the FDIC often goes after a bank's officers and directors. "This is because the FDIC - as the receiver of the failed bank or thrift - views as one of its primary fiduciary duties the obligation to seek provable damages from officers and directors," notes Venable law partner Joseph T. Lynyak III of Washington D.C. and Los Angeles. Such investigations can last years, he says, exposing the officers and directors to possible forfeiture of personal assets if their insurance coverage isn't adequate.
Franklin's directors worried about the impact the whistleblower investigation would have on the bank's reputation. They also were concerned about reaction from regulators. The outside attorneys were planning to present the report to the FDIC, the Texas Department of Savings and Mortgage Lending, the Fort Worth SEC's enforcement division and to the accounting firm of Deloitte & Touche within days of the board presentation.
"The general consensus of the board was that strong action was required," the board minutes state. "Changes in top management must be made in a decisive manner, to be followed by clear corrective actions."
At the time, FDIC regulators from the Dallas Regional Office were already "a continual on-site presence" at Franklin and "were actively investigating accounting issues" uncovered during the bank's October 2007 examination, the FDIC Office of Inspector General later revealed.
The directors discussed the organization's "corporate culture and whether certain members of management had the subjective qualities required for service in a public company," board minutes state.
Board member Lawrence Chimerine, an economist and consultant, suggested that Nocella would probably agree to retire early. The board then discussed the need for a new managing director of mortgage finance as well as a new CFO but worried that it needed continuity to get through the crisis. Any changes to those jobs, they said, could threaten the bank's plans to raise sorely needed additional capital. The directors wondered whether some of the more experienced board members should become directly involved with the bank's operations.
The board met again on May 16th. Ranieri said he had discussed with individual directors a response to the internal investigation. Instead of firing the CFO, the bank instead would hire a special accounting master to oversee internal controls. Nocella had agreed to step down but would remain on the board as a bank director. The board agreed to pay him severance equal to his $434,700 base salary in 12 monthly payments beginning Jan. 21, 2009. Ranieri would become CEO until a new one could be named. Bank director Alan E. Master, a longtime Ranieri business associate and a former bank CEO and CFO, would become president.
Both Master and director Perro would receive $15,000 monthly executive committee retainers for their extra work with the bank from June through September.
"A consensus appeared to exist to take actions to beef up the compliance and internal audit functions, improve the tone at the top of the organization, and increase openness and communication within the organization and with regulatory authorities," the minutes of the meeting state. The board also agreed to establish an executive committee of the bank board to provide greater oversight of the bank's operations, and a disclosure committee to be made up of management to formalize the release of public statements and filings.
Regulators Swoop In, Downgrade the Bank, Chastise Management
Even as the board was trying to rectify the problems, examiners were deciding that their efforts were too little, too late.
"Management and board performance is critically deficient as accounting and financial reporting problems persist and reserves are substantially underfunded," FDIC examiners wrote after a July 14 examination of the bank, which led to the forced resignation of the EVP and managing director of mortgage banking. "Severe asset quality problems have eroded capital protection to a critically deficient level. Operating losses are substantial. Absent a recapitalization that returns the bank to a ‘well-capitalized status,' a near term liquidity failure is inevitable," the examiners wrote in the report, which the FDIC filed earlier this month in federal court. (The FDIC later sought and won a court order sealing the document, saying it should never have been made public.)
Overall, the examination found the bank's overall condition "unsatisfactory."
The bank needed to make a $165 million adjustment for required provisions for loan losses, plus an additional $130 million loan loss provision based on examination findings. Adversely classified items totaled $887 million, "which represents an extremely high 223% of Tier one capital and reserves." The bank's Tier 1 leverage capital was 2.81%, its Tier 1 risk-based capital 4% and its total risk-based capital 5.67%.
Although the board had adopted a resolution calling for a 7.5% Tier 1 leverage capital ratio, Ranieri told examiners that 8% would "more reasonably allow the bank to work through its problem." That would require a capital injection of $281 million.
Examiners said that the "pipeline of delinquent loans" had been constant since year-end 2007, with $60 million in 30-day delinquencies identified monthly. They also noted that the bank's asset acquisition policies and procedures failed to include proper due diligence before acquiring loan packages. Managers said they relied solely on compliance regulation warranties and representations included in the purchase agreements. Managers also told examiners that they never performed any compliance-related reviews of any of their loan servicers.
Regulators Question ‘Depth of Information' Covered at Board Meetings
Examiners blamed management and the board for the bank's problems. "Failure to appropriately measure, monitor and control risk in the ADC concentration and weaknesses in the underwriting of residential mortgage loans have led to the substantial asset quality problems that jeopardize the institution's survival," the report concluded. Accounting and financial controls were unsatisfactory and Call Reports inaccurate, the examiners noted, adding that the reporting errors "were either identified by external consultants or examiners, not by internal audit."
What's more, the examiners said, the audit committee oversight was ineffective. The committee rarely documented what it discussed, regularly adjourning into executive session without leaving an adequate paper trail for regulators to follow. Documentation for board meetings was poor, as well. "The lack of documented, in-depth discussions regarding the bank's financial condition, accounting problems and management deficiencies raises questions about depth of information covered at board meetings," the examiners wrote.
Attorney Lynyak says that any FDIC claims against the bank directors would probably focus on "the lack of identifying those problems" that led to the bank's failure. He says investigators will want to know whether the board properly relied on outside accountants and internal reports and if members asked the right questions during board meetings. They will want to know whether anything came before the board that should have required additional verification.
Lynyak says bank board members all too often are reluctant to challenge dominant executives. "If you look at the corporate culture in America, a great deal of courtesy and deference is shown to leading figures. That may work in corporate America, but it certainly doesn't work in a bank environment where bank regulators expect board members to be questioning management."
FDIC Could Have Done a Better Job, OIG Reveals
Regulators conducted six exams of the bank from 2003 until 2008, making recommendations that the bank establish liquidity limits, enhance its internal audit function and better monitor its risk. But the FDIC OIG concluded that FDIC "did not always ensure that bank management effectively responded to such recommendations."
Indeed, had the FDIC encouraged Franklin "to adequately identify, measure, monitor and control its nontraditional and subprime loan portfolio, the level of loss incurred by the bank due to the economic decline could have potentially been reduced," the OIG reported.
The OIG said a "significant factor" that led to the bank's failure was a reliance on wholesale funding sources. From 2003 through 2008, the OIG noted, the bank was in the 97th to 98th percentile ranking of its peer group for net non-core funding.
Shortly before Wolfe's letter, regulators had downgraded the bank's CAMELS rating from a 2 to a 3. After the July examination, regulators gave the bank a rating of 5.
Throughout the summer, the bank continued to reassess its financial condition as the board scrambled to raise more capital. Meanwhile, the bank spent more than $1 million in fees to consultants to help straighten out the accounting problems. In August, it disclosed that it was restating its financial results for all of 2006 and 2007.
Scrambling for Capital, but Unable to Satisfy Regulators
Franklin Bank Corp., the bank's holding company, hired RBC Capital Markets Corp. to help it develop strategic capital alternatives. The board approved a capital maintenance plan on July 31, which included selling targeted assets in the third and fourth quarters of 2008 to give the bank more time to raise money. It approved a liquidity crisis plan the same day.
On Sept. 24, after failing to find investors for a recapitalization, Ranieri gave regulators four non-binding proposals that would have involved selling off the community bank deposits of about $2 billion, plus other Texas-based assets. Management would have liquidated the rest of the bank. Regulators rejected the plan. Examiners held an exit meeting with the bank on Oct. 21. Their responses "were generally limited and brief," the regulators wrote.
Then on Oct. 24, Ranieri met with regulators again. He had lined up a third party to buy the bank. But the plan involved "substantial loss protection on most of the bank's assets by the FDIC," examiners wrote. That plan, too, was rejected.
Nocella resigned from his bank director position effective July 31 and from the bank holding company on Oct. 28.
The bank applied for emergency funding with the Federal Reserve on Oct. 29, but only had "nominal acceptable collateral," the exam report notes. Other financial institutions had rescinded their borrowing lines with Franklin. That day, the board met with regulators at the Hilton-Westchase Hotel in Houston. The room was packed with board members, senior executives from the bank, two Bracewell & Giuliani attorneys, auditors, six FDIC examiners, three Texas state regulators and two OTS examiners.
When the meeting ended, the FDIC assistant regional director said the bank would soon get a Cease & Desist order, as well as a PCA letter noting their "significantly undercapitalized designation." The order was issued on Nov. 4th.
End Game: FDIC Closes the Bank
The FDIC closed the bank three days later. Prosperity Bank ($8.85 billion) of El Campo, Texas, assumed all deposits.
Franklin's holding company filed for Chapter 7 bankruptcy on Nov. 12 in Delaware, registering debts of more than $273.4 million, the bulk related to the issuance of trust preferred securities. Among the debtors: The law firm of Bracewell & Giuliani, owed $149,323 for legal services from July 1st through Sept. 30, 2008.
On March 13, 2009, the FDIC launched a formal investigation into "former officers, directors, accountants, attorneys, and others who provided services to Franklin Bank" to see whether they could be held liable for the bank's failure. Directors reached by FinCri Advisor said their attorneys had advised them not to comment, citing pending litigation. Each director received an annual retainer of $18,000 plus $1,000 per meeting attended. The chairman of the audit committee received a $30,000 annual retainer.
Former chairman Ranieri, CEO Nocella and CFO McCann got permission from the bankruptcy court in April to allow them to tap into their D&O insurance policy to defend themselves in the pending securities litigation. The aggregate amount of coverage that is available under the policy: $10 million.
In August, the FDIC sued Baker Botts and Ernst & Young when the firms refused to turn over the results of the whistleblower investigation, citing attorney-client privilege. The FDIC contends it has a right to the records as the bank's receiver.
Next month, the FDIC is auctioning off some of Franklin's loans to sealed bidders. It is also selling the servicing rights to more than $1 billion in mortgage loans.
Litigation connected to the failure is expected to last for years.
Read Part One of the Franklin Bank series.
http://www.fincriadvisor.com/2009-08-30/franklinbankfailureparttwo
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