Federal Deposit Insurance Corporation
Office of Audits
Office of Inspector General
Washington, D.C. 20434

DATE: March 10, 2003

MEMORANDUM TO: Michael J. Zamorski, Director, Division of Supervision and Consumer Protection

FROM: Russell A. Rau [Electronically produced version; original signed by Russell A. Rau], Assistant Inspector General for Audits

SUBJECT: Material Loss Review of the Failure of the Connecticut Bank of Commerce, Stamford, Connecticut (Audit Report No. 03-017)

In accordance with section 38(k) of the Federal Deposit Insurance Act (FDI Act), 12 U.S.C. 1831o, the Office of Inspector General (OIG) conducted a review of the failure of the Connecticut Bank of Commerce (CBC), Stamford, Connecticut. On June 26, 2002, the Banking Commissioner of the State of Connecticut declared CBC insolvent, ordered it closed, and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. At the time of failure, CBC reported total assets of approximately $379 million. As of December 31, 2002, the FDIC estimates that the failure of CBC may ultimately cost the Bank Insurance Fund (BIF) $63 million.

As mandated by the FDI Act, the audit objectives were to: (1) ascertain why the bank’s problems resulted in a material loss to the insurance fund and (2) assess the FDIC’s supervision of the bank, including implementation of the Prompt Corrective Action (PCA) requirements of section 38 of the FDI Act. (Note: A material loss is generally defined by section 38 of the FDI Act as a loss that exceeds $25 million and 2 percent of the institution’s total assets at the time the FDIC was appointed receiver. See the glossary at the end of this report for an explanation of PCA and other terms and acronyms used throughout this report.) In this report, we address each of these objectives and discuss our findings as part of our analysis of the bank’s failure and the FDIC and State of Connecticut regulators’ efforts to require CBC’s management to operate the bank in a safe and sound manner. Appendix I contains additional information on our objectives, scope, and methodology.

BACKGROUND

CBC, formerly known as The Woodbridge Bank and Trust Company, was established in 1964 and renamed Amity Bank in 1978. During the 1970s and 1980s, Amity Bank emphasized commercial real estate lending. When the Connecticut economy, specifically the real estate sector, began experiencing a severe downturn in the late 1980s, the bank suffered large operating losses and capital depletion. The FDIC imposed a Cease and Desist (C&D) order in July 1991, that required, among other things, increased capital, revisions to the loan policy, and a policy addressing the sufficiency of the loan loss reserve. In August 1992, with the bank on the verge of failure, a private investor recapitalized the bank and acquired over 80 percent ownership interest by purchasing common stock in exchange for $5 million in cash. The private investor also became the Chairman of the Board of Directors (Chairman) of the bank. On January 11, 1993, the bank’s name was changed from Amity Bank to Connecticut Bank of Commerce.

After the acquisition, the bank continued to experience significant operating losses and capital depletion due to its deteriorating loan portfolio. The bank received a CAMELS "5" rating, the worst level, at a September 1993 examination and was subsequently placed under a second C&D by the FDIC in December 1993 because of managerial weaknesses. (Note: CAMELS (capital, asset quality, management, earnings, liquidity, and sensitivity to market risk) are factors assessed by regulators during examinations.) During 1994, the bank continued to struggle financially, and the Chairman injected additional capital, almost $9 million, averting failure once again. At examinations performed in 1994, 1995, and April 1996, the bank continued to be rated a Composite "5." During that time the Chairman continued to inject capital into the bank as needed and by the end of 1996, his total capital investment in the bank was over $17 million, according to FDIC records. The bank was upgraded to a composite "4" rating at the December 1996 examination, in part, due to the additional capital from the Chairman. Apparent improvement in the bank’s condition noted in the October 1998 examination resulted in an upgrade in the composite rating to a "3," the termination of the two outstanding C&D orders, and the adoption of an informal Memorandum of Understanding (MOU) between the bank, the FDIC, and the Banking Commissioner of the State of Connecticut. As part of the MOU, bank management agreed to, among other things, establish prudent lending limits, devise plans to reduce problem assets, maintain minimum capital levels, and notify the FDIC’s Regional Director and the Connecticut Banking Commissioner of any new lines of business under consideration by the bank.

On April 23, 1999, just one month after termination of the C&D orders, the bank entered into a Purchase and Assumption agreement (subject to regulator approval) with MTB Bank, a New York state-chartered commercial bank with total assets of approximately $278 million. Under the terms of the agreement, CBC would purchase all of the traditional banking assets and assume all of the deposits and certain liabilities of MTB Bank for a purchase price of $20 million. MTB Bank was headquartered in New York City and specialized in lending to small and mid-sized businesses domestically and to companies abroad. According to the Purchase and Assumption application, MTB Bank had banking services that were complementary to CBC in accounts receivable and asset-based lending. The Purchase and Assumption application noted that "The melding of these complementary businesses into a single institution will result in a bank with the financial and managerial resources and capabilities to compete with the large regional and money center banks in these core banking lines of business."

Before the Purchase and Assumption transaction, MTB Bank was experiencing problems and was operating under an MOU entered into on September 16, 1998 with the FDIC. A November 1998 joint (FDIC and State of New York) examination report had rated the bank a CAMELS "3," and criticized the bank’s risk management process, asset/liability management, and internal controls. A subsequent joint examination report dated November 1999 noted "the overall condition of the bank was satisfactory; however, management performance remains fair." (Note: According to DSC officials, this report was completed but never issued to the bank because CBC’s proposed acquisition of MTB Bank had already been approved and therefore MTB Bank was about to go out of existence.) The bank’s condition had improved since the November 1998 examination, and it was upgraded to a CAMELS "2" rating, although its management component rating remained a "3." The report also noted that "[t]he assessment of management reflects the increase in asset classifications, weaknesses in credit administration, audit, and funds transfer…Weaknesses in audit include lack of a written risk assessment for areas that are audited and not completing the annual audit plan." The 1999 report also noted that adversely classified assets as a percentage of Tier 1 Capital and loan loss reserves increased from 10.4 percent in September 1998 to 27.7 percent in September 1999. Examiners were concerned that "although the level is generally considered manageable, the overall trend in volume and severity warrants a moderate level of concern." At a meeting with officials from CBC and MTB Bank in May 1999, Division of Supervision and Consumer Protection (DSC) officials in the Boston Regional Office explained that it would be difficult to approve the Purchase and Assumption of two "troubled banks;" however, that would not preclude CBC from submitting an application. (Note: Effective July 1, 2002, the FDIC’s Division of Supervision and Division of Compliance and Consumer Affairs were merged to form the new Division of Supervision and Consumer Protection (DSC). The DSC promotes the safety and soundness of FDIC-supervised institutions, protects consumers’ rights, and promotes community investment initiatives by FDIC-supervised institutions.) On August 4, 1999, CBC filed an application with the FDIC and the State of Connecticut Department of Banking to acquire MTB Bank. According to the application, the Chairman had agreed to enter into a subscription agreement with CBC whereby he would purchase $10 million of common stock and $10 million of preferred stock, the proceeds of which would be used to consummate the sale agreement. As shown in Table 1, MTB Bank had almost three times the assets of CBC.

Table 1: Comparison of CBC and MTB Information as of December 31, 1999 ($ in thousands)

Source: Call Reports

Before approving CBC’s application to acquire MTB Bank, the FDIC and the State of Connecticut conducted a joint examination of CBC beginning in December 1999. That examination showed continued improvements in capital and asset quality; however, the composite rating remained a "3" and the MOU remained in place. Because of the improvement in the condition of the bank and the Chairman’s perceived financial strength, the FDIC and the Connecticut Banking Commissioner approved CBC’s application to purchase MTB Bank in February 2000. On March 31, 2000, the bank acquired substantially all of the assets and assumed all of the deposits and certain liabilities pertaining to the banking operations of MTB Bank. The transaction specifically excluded the acquisition of assets and assumption of liabilities relating to MTB’s precious metals business. CBC acquired net assets of $20,989,000 that consisted of $247,389,000 in assets, $214,200,000 in deposits, and $12,200,000 in other liabilities. The purchase price was $20 million, which represented a $989,000 discount from book value. In connection with the transaction, the Chairman of the Board of Directors of CBC purchased $10 million of CBC common stock, and a company he controlled purchased $10 million of CBC preferred stock. The proceeds from the issuance of the common and preferred stock were used by CBC to fulfill its contractual obligations under the Purchase and Assumption agreement with MTB Bank.

Regulators performed a limited on-site "visitation" (limited-scope examination) at the bank during September 2000, after the acquisition of MTB Bank. During an examination in March 2001, FDIC and State of Connecticut examiners became suspicious of an unusually high volume of loan activity that had occurred at the bank in March 2000. After they began investigating the matter, they discovered that over $20 million of loans funded in the latter part of March 2000 were ultimately channeled to the bank’s Chairman and used to fund the acquisition of MTB Bank. The irregularities surrounding these loans coupled with other asset quality problems led to the bank’s closure on June 26, 2002, less than 27 months after it acquired MTB Bank.

On November 22, 2002, the FDIC issued a Notice of Charges seeking to impose civil money penalties (CMPs) totaling $5.25 million against a group of former officers and directors of CBC. The Notice of Charges, among other things, alleges that the Chairman of the Board and the bank president orchestrated certain nominee loan schemes, the proceeds of which were used to make the capital injection through the purchase of common and preferred stock into CBC that ultimately paid for the acquisition of MTB Bank; refinance nonperforming loans in a nominee borrower's name; keep nominee loans current or pay them off; and improperly provide funds to the Chairman and related entities. (Note: According to the Department of Justice Criminal Resource Manual, a third-party or "nominee" loan is a loan in the name of one party that is intended for use by another. A misapplication occurs when a financial institution insider uses his position to secure a nominee loan, either for himself or for another person, and the insider conceals his own interest in the loan from the financial institution.) According to the Notice of Charges, the bank’s directors approved most of the nominee loans and failed to fulfill their fiduciary responsibilities to CBC. The FDIC viewed the nominee loan scheme as having had the effect of misleading bank regulators and CBC depositors as to the true financial condition of CBC, ultimately leading to CBC's closure.

In addition to the CMPs, the FDIC is seeking Orders prohibiting the Chairman and president from further participation in the banking industry and requiring restitution in the amount of $34 million. The Connecticut Department of Banking is also pursuing CMPs against the same parties.

The CBC failed and resulted in a material loss to the Bank Insurance Fund because of ineffective corporate governance. The Board of Directors and senior bank management:

• Disregarded sound underwriting practices by making highly speculative and insider loans;
• Used complex transactions and questionable asset valuations to mask the true financial condition of CBC;
• Circumvented or disregarded various laws and banking regulations related to safety and soundness;
• Failed to ensure that the bank’s internal audit function was independent, effective, and complied with applicable regulations; and
• Ignored or did not fully implement examiner recommendations and enforcement actions.

Additionally, CBC’s external auditors issued unqualified or "clean" opinions on the bank’s financial statements that briefly described but did not challenge the presentation of certain questionable transactions and asset valuations. External auditors rendered unqualified opinions on CBC’s financial statements every year from 1996 through 2001. However, the auditors did not always follow up on questionable asset valuations reported in CBC’s financial statements and Call Reports to regulators that represented a significant portion of CBC’s capital. As a result, CBC’s capital was overstated every year in its financial statements and regulatory Call Reports from at least 1997 until the bank failed.

The Chairman of the Board orchestrated loan schemes that were key to the material loss to the Bank Insurance Fund. A major component of the estimated $63 million loss to the insurance fund resulted from the Chairman of the Board orchestrating a scheme where the bank made $20 million in nominee loans to various companies controlled by the Chairman, his family members, and associates in order to fund the acquisition of MTB Bank. The Chairman later devised other loan schemes involving poorly underwritten loans that were used to make payments on the nominee loans and to pay off other non-performing loans. The FDIC estimates that the $34 million in outstanding balances of loans originated as part of these schemes have little monetary value.

• risky lending and weak management practices,
• failure to fully resolve examination findings and comply with enforcement actions, and
• questionable "satisfactory" CRA rating when the application was pending approval.

FDIC and state examiners conducted annual examinations and/or targeted examinations of CBC from 1993 until its closure. The examiners repeatedly identified and reported on significant, yet uncorrected, problems at the bank in resulting examination reports. Examiners also required the bank to operate under two C&D Orders from 1993 to 1999, an MOU from 1999 until 2001, and another C&D Order from December 2001 until CBC failed. In February 2000, the FDIC approved CBC’s application to purchase MTB Bank notwithstanding CBC’s long history of uncorrected management deficiencies identified in examination findings and enforcement actions and absent validation of the Chairman’s source of funds for acquiring MTB Bank. Finally, the 1999 Community Reinvestment Act performance evaluation for CBC did not reflect the bank's actual performance, rather the evaluation was largely based on future projections of the bank’s performance and the bank’s performance in the context of factors not clearly applicable to the institution. As a result, the rating may not have been an appropriate one on which to base approval of the bank's application to acquire MTB Bank.

Finally, the FDIC implemented PCA in accordance with the requirements of section 38 of the FDI Act; however, PCA was not fully effective due to improper asset valuations that overstated CBC’s capital for several years. Because CBC masked the true nature of certain financial transactions, examiners did not determine the actual financial condition of CBC until a full investigation was performed subsequent to the March 2001 examination. Once the loan schemes were uncovered, the examiners concluded that bank was critically undercapitalized. As a result, enforcement actions, including those available under PCA, were not fully effective at minimizing the loss to the insurance fund.

This report contains five recommendations designed to help improve the bank supervision process and to promote the safety and soundness of FDIC-regulated institutions.

The bank’s Board of Directors (or Board) and senior management exhibited a pattern of mismanagement of the bank and failed to provide an adequate system of corporate governance. (Note: The FDIC and state examination reports for 1996 through 2002 listed as few as five and as many as eight directors including the Chairman at CBC. The examinations also noted that the directors other than the Chairman were independent of the bank. The Institute of Internal Auditors identifies the board of directors, senior management, internal auditors, and external auditors as the cornerstones of the foundation on which effective corporate governance must be built (see Institute of Internal Auditors "Recommendations for Improving Corporate Governance." Position paper to the Special Committee of the Board of Directors of the New York Stock Exchange, March 28, 2002).) The Board of Directors’ lack of adequate oversight was a principal cause of the bank’s failure, and happened in large part because the Chairman dominated the bank’s Board. Mismanagement of the bank included failing to diversify the risk of the bank’s loan portfolio, engaging in high-risk activities without proper risk management processes, circumventing or disregarding various laws and banking regulations, and frequently ignoring examiner recommendations. Adding to these problems were a weak internal audit function and external audits that did not always follow up on certain questionable asset valuations that were material to CBC’s financial statements. To achieve an effective corporate governance environment, all four areas – the Board, senior management, internal audit, and external audit –must be in place and working cohesively. As discussed below, this did not occur at CBC.

The Board failed to establish an adequate control environment at CBC and to implement corrective actions that examiners recommended. The FDIC and state examination reports from 1996 through 2001 cited CBC's Board and management for ignoring recommendations regarding asset quality, credit administration, and risk management. Also, minutes of both the Board and Board Credit Committee meetings did not detail discussions of the views expressed by each member in attendance on any item or the record of any vote, even when loans presented for approval lacked sufficient documentation, were contrary to lending policies, or were affiliated with the Chairman of the Board. Board minutes indicated that Board members did not actively question or request details on assets, credit administration, and risks. Because the Board did not adequately perform its duties, CBC operated in an unsafe and unsound manner that eventually led to its collapse.

According to the DSC's Manual of Examination Policies, the quality of management is probably the single most important element in the successful operation of a bank. "Management" includes both the Directors on the Board, who are elected by the shareholders, and the executive officers, who are appointed to their positions by the Board.

Examiner guidance contained in DSC Examination Modules addresses various control and performance standards in evaluating a bank's management. These standards include whether the bank's Board has established policies to maintain a system that effectively measures and monitors risk and to implement corrective actions recommended by auditors and supervisory authorities. To determine whether a bank's risks are adequately identified, measured, monitored, and controlled, the examiners evaluate whether the Board has:

• Identified and assessed major risks that influence the success or failure of the bank,
• Established adequate policies and procedures given the size and complexity of the bank,
• Implemented adequate controls to ensure adherence to bank policies as well as legal and regulatory requirements, and
• Implemented appropriate systems to monitor the bank's activities.

The Board’s failure to provide adequate oversight of the bank resulted in concentrations of credit risk, high-risk lending, and a disregard for banking laws and regulations and for examiner recommendations. (Each area is discussed in detail later in this report.) FDIC and State of Connecticut examination reports from 1996 through 2001 identified numerous matters requiring Board attention pertaining to the lending function. These areas included basic tenets of banking such as risk management, asset quality, loan policies, and loan administration. For example, the 1997 examination report disclosed that the bank had entered into a new lending area, accounts receivable purchases, "without a formal or informal [loan] policy, or procedure guidelines." As of October 1997, without any requisite policies or procedures, the bank’s lending in accounts receivable purchases had grown to $21.6 million and equaled 259 percent of Tier 1 Capital and reserves. (Note: Regulators often use a percentage of Tier 1 Capital to identify possible absence of risk diversification within an institution. At the FDIC, the percentage of Tier 1 Capital used to identify potential absence of risk diversification is 25 percent or more for loans to individuals and 100 percent or more for loans by industry or product line.) Moreover, examiners found these loans to be "riddled with documentation and administrative deficiencies, including the lack of financial information on the individual obligors." Subsequent examination reports show that CBC’s Board of Directors did not adequately address these matters. Further, the Board did not address the fact that typically 45 percent of CBC's loans were to borrowers outside the state of Connecticut, including borrowers in Central and South America and Canada. The bank did not demonstrate the expertise to monitor these international loans.

Also, with respect to the Board of Directors, examiners repeatedly criticized bank management regarding the lack of detail contained in the minutes of Board of Directors’ meetings. These minutes did not adequately document management’s activities or reflect discussion and the decision-making process. Board minutes were devoid of pertinent details regarding discussions and information about the bank’s activities. These deficiencies existed even though the bank had been under a Cease and Desist order that required detailed written minutes of all Board meetings to be maintained and recorded on a timely basis.

Section 4.1 of DSC's Manual of Examination Policies discusses the importance of detailed Board minutes. "A director's attendance should be an informed and intelligent one, and the record should show it. If directors dissent from the majority, they should, for their own protection, insist upon their negative vote being recorded along with the reasons for their action. …Results of board deliberations on any matter involving a potential conflict of interest should be noted clearly in the minutes."

FDIC and state examination reports from 1997 through 2001 consistently recommended that Board minutes include details as to discussion items and the concerns any director expressed. For example, examiners wrote in the October 1998 exam, "minutes lack sufficient detail as to discussions. There were no specifics as to who had concerns and what they were. It is again recommended [referring to the September 1997 examination report] that the Board minutes be enhanced to include more details as to discussions on all areas of importance." In the FDIC Report of Examination of March 2001, the examiners cited CBC’s Board minutes as not timely and noted that they "did not adequately reflect the substance or content of Board concerns or oversight actions."

We also noted problems in recording the Board’s Credit Committee minutes. At the April 2002 examination, examiners noted, "Reasons for voting against a credit, or for abstaining, recusing, or exiting the room were not always explained or identified in the minutes... In most cases, substantive and lengthy discussions regarding the credit proposals were not sufficiently detailed." The examiners also stated that minutes should document related interests, affiliates, business associations, interrelated borrowing relationships, and potential conflicts of interest.

An egregious example of Board deficiencies was evidenced by the March 2000 Board meeting where loans totaling over $20 million were approved by the Board, well above the typical monthly volume and very substantial in relation to the size of the bank. Most of the loans approved at this meeting lacked adequate financial analysis and contained inaccurate or incomplete information about the borrowers. Further, information about the purpose of the loans was vague, typically describing the purpose as working capital or investments. Also, many of the loans were in contravention of CBC's loan policy (lacked personal guarantees) and safe and sound banking practice due to their weak underwriting. Nevertheless, it appears none of the directors questioned any of these loans or probed deep enough to learn the details or offer any objections. Examiners later discovered that the proceeds from these loans were used by the Chairman to fund the acquisition of MTB Bank through his purchase of CBC common and preferred stock with the proceeds.

Senior management also did not fulfill its responsibilities to operate the bank in a safe and sound manner, in part, because the Chairman dominated them. (Note: Senior management refers to executive officers and excludes directors.) Specifically, senior management continually engaged in hazardous lending, did not ensure proper loan administration procedures, and did not provide a sufficient Allowance for Loan and Lease Losses (ALLL). These failures of the bank’s senior management contributed to the collapse of CBC.

According to Section 4.1 of DSC's Manual of Examination Policies, the primary responsibility of executive management is implementation of the Board's policies and objectives in the bank's day-to-day operations. A bank's performance with respect to asset quality and diversification, capital adequacy, earnings capacity and trends, and liquidity and funds management is, to a very significant extent, a result of decisions made by the bank's directors and officers. When significant problems exist in a bank's overall condition, consideration must be given to management's degree of responsibility. At a minimum, the assessment of management by bank examiners should include the following considerations:

1. Whether or not insider abuse is in evidence;
2. Existing management's past record of performance in guiding the bank;
3. Whether loan losses and other weaknesses are recognized in a timely manner;
4. Past compliance with supervisory agreements, commitments, orders, etc.; and
5. Capability of management to develop and implement acceptable plans for problem resolution.

According to FDIC and state examination reports from 1996 through 2001, senior management did not comply with existing policies regarding insider transactions, continually violated laws and regulations, and disregarded some of the regulators’ concerns. Senior management's failure to address these concerns led to an increase in the volume of adversely classified loans. Numerous loans, including insider loans, contained severe underwriting, credit, and collateral deficiencies. Some of the problems identified by examiners included:

• Underwriting decisions made based on stale, incomplete, or nonexistent financial statements.
• High reliance placed on borrower-provided financial projections, some of which had never been achieved.
• Audited or reviewed financial statements not obtained despite Credit Policy requirements.
• Personal guarantees not obtained.
• Lack of an analysis and/or appraisal of collateral securing loans.
• Assignment of leases not obtained.
• Ownership not well documented in the credit files.
• Updated personal and corporate financial statements and tax returns not regularly obtained as required. For those obtained, the tax returns or personal financial statements were not signed or did not include supporting schedules (lack of statement of cash flow and footnotes).
• Over advances on factoring lines, accounts receivable purchase facilities, or inventory lines allowed without appropriate control or monitoring.
• Violations of laws and regulations pertaining to insider lending and affiliate transactions.

Management also failed to adequately identify and recognize credit risk associated with loans, leases, and other commitments for the ALLL. According to the FDIC 2002 draft Examination Summary Report, "the integrity of the ALLL calculation is heavily predicated upon the accuracy of the internal loan grading system. The examination revealed significant discrepancies between internal loan risk ratings and examiner-assigned classifications. Of the $98 million in loans adversely classified at this examination, approximately 40% were not internally criticized by management. These inaccuracies resulted in the underfunded ALLL as of March 31, 2002." (Note: The 2002 FDIC draft Examination Summary Report was never processed or issued due to the bank’s failure before the examination was completed.) Many of these loans originated in prior periods.

Finally, examiners expressed concerns over the Chairman’s apparent domination and control of the bank starting in the FDIC Report of Examination as of December 1996. That report stated "The management of the institution is dominated and controlled by the principal shareholder and Chairman of the Board." The report further noted concerns regarding risk tolerance; the underwriting, approval, monitoring, and collecting of loans to entities that have an affiliation to the Chairman and/or one of his related interests; and the appropriate role for a principal shareholder in the day-to-day operation of the institution.

CBC’s internal audit function was inadequate. According to FDIC and state examination reports from 1997 through 2001, the internal audit function lacked independence and effectiveness, and did not comply with regulations. A strong internal audit function helps to ensure that proper internal controls, policies, and procedures are continuously practiced.

According to Section 4.2 of the DSC Manual of Examination Policies, a strong internal auditing function establishes the proper control environment and promotes accuracy and efficiency in the bank's operations. The basic purpose of internal auditing is the safeguarding of assets and the prevention and detection of problems before they result in losses. The auditor's role is to help safeguard the bank's assets by performing tests and procedures establishing the validity and reliability of operating systems, procedural controls, and resulting records. Auditors must have complete independence in carrying out the audit program and should report their findings directly to the bank's board of directors or a designated directors’ audit committee.

CBC’s internal auditors lacked independence: In July 1996, CBC contracted the internal audit function to its external auditors. According to the FDIC's October 1997 examination report, the external auditor's independence was impaired because the same audit team conducted both the external and internal audits. In 1998, the FDIC considered independence between the internal and external auditing functions restored because separate audit teams within the same firm were performing the audits. (Note: Although not if effect at the time, the Sarbanes-Oxley Act of 2002, Title II--Auditor Independence, Section 201 (g) prohibits a public accounting firm that performs for any issuer any audit to also provide internal audit outsourcing services to that issuer.)

According to documentation we reviewed in CBC's files and the March 2001 examination report, CBC in 1998 appointed an employee who was serving as the Risk Manager as internal auditor. As an auditor, he audited areas for which he had a role or responsibility in approving procedures or making management decisions as the risk manager. Again, FDIC examiners noted the internal audit function lacked independence.

The internal audit function was not effective: The internal audit function was not effective because it delayed in addressing external audit findings and correcting internal control weaknesses, took excessive time to develop an internal audit structure, and formulated inadequate audit plans.

• According to the March 2001 examination report, several stale and repeat internal audit report findings dating back to July 1999 had not been resolved because CBC’s Risk Management Policy did not assign responsibility for managing and monitoring risk.
  
  
• The examiner's evaluation of CBC's internal audit function in March 2001 noted several deficiencies in the audit risk assessment process, audit report process, and the audit manual.
  
  
• The October 1998 FDIC examination report stated that the scope and coverage of the audit plan were inadequate because the scope missed critical internal control checks on insider transactions, Regulation O compliance, and compliance with the CBC Conflicts of Interest Policy.
  
  
• According to DSC's April 2002 draft Examination Summary Report, "internal audit work completed since the previous examination does not adequately address examination criticisms with respect to commercial lending, as well as insider and affiliate relationships."

The internal audit function did not comply with regulations: According to the FDIC October 1997 examination report, CBC was not complying with 12 C.F.R. Part 364, App.A, section IIB, regarding minimum standards for an internal audit program. These standards require, among other things, adequate monitoring of the institution's internal control system and verification and review of management's actions to address material weaknesses. CBC had also violated 12 C.F.R. section 326.8(c)(2) regulations for establishing an internal audit program to ascertain compliance with the Bank Secrecy Act (BSA), which requires banks to report each cash transaction that exceeds $10,000 in one day.

CBC’s oversight of the internal audit function did not adequately ensure that management continuously implemented and practiced sound internal controls, policies, and procedures. The FDIC and state examination reports from 1997 through 2001 cited several significant internal audit program deficiencies that required the attention and corrective action of the Audit Committee and the Board. However, the Board’s oversight of the internal auditing function, through the Audit Committee, failed to establish the proper control environment, or to promote accuracy and efficiency in the bank's operations. This was a contributing factor to CBC’s collapse.

External auditors rendered unqualified opinions on CBC’s financial statements every year from 1996 through 2001. However, we found that the external auditors did not always follow up on questionable asset valuations. For example, questionable valuations regarding CBC's interest in four cargo planes were not adequately addressed in financial statements from 1997 until CBC failed. As a result, CBC's capital was overstated every year in its financial statements and regulatory Call Reports from at least 1997 until CBC failed. The differences in asset valuations led to inaccurate financial reporting to CBC’s stockholders and to the public.

The Interagency Policy Statement on External Auditing Programs of Banks and Savings Associations states that accurate financial reporting is essential to an institution's safety and soundness for numerous reasons. First, accurate financial information enables management to effectively manage the institution's risks and make sound business decisions. Management provides data to stockholders, depositors and other funds providers, borrowers, and potential investors on the company's financial position and results of operations. Such information is critical to effective market discipline of the institution. (Note: Interagency Policy Statement on External Auditing Programs of Banks and Savings Associations, The Federal Financial Institutions Examination Council, September 1999, page 1.)

We reviewed the external auditors' workpapers for the financial statement audits for 2000 and 2001. (Note: The bank’s external auditor for the 2000 and 2001 financial statement audit was Arthur Andersen, LLP. Prior to 2000 it was BDO Seidman, LLP.) The workpapers contained evidence that the external auditors questioned management about certain asset valuations and supporting documentation, especially for those loans pertaining to the Chairman and his associates. However, the workpapers did not indicate whether or not bank management provided an adequate response to the questions. Also, the external auditors did not adequately address the valuation of cargo planes carried on CBC’s books from 1997 until it failed. Based on our review of the external auditors' workpapers, they questioned certain asset valuations, yet according to their workpapers, they did not pursue the matters to closure. For example, during the 2000 and 2001 audits, auditors raised a number of questions to bank management about their ownership interest in, and valuation of, four cargo planes. (The bank’s interest in these cargo planes is further discussed in the "Following Up on Red Flags" section of this report.) File documentation at the bank was lacking and the terms of this transaction were vague. CBC’s ownership interest in these planes was unclear, as apparently no perfected lien was on file. No onsite appraisal had been performed and the bank obtained only "desktop" appraisals for these planes. As a result, critical information such as the condition of the planes, engine age, flight hours, and maintenance records was not considered in the planes' valuation. Because these planes represented 68 percent of the bank’s equity capital in 1997, external auditors should have pursued this matter further. DRR officials informed us that these planes were apparently sold in 2001, and the bank received nothing from the sale. The external auditors did not discover this sale during their year-end 2001 audit.

The bank valued these planes from $4 million to $5.2 million from 1997 until CBC failed in June 2002. From 1997 through 2001, external auditors attested to the accuracy of the valuation of the planes. However, the bank’s financial statements did not fairly present the financial condition of CBC, and regulatory Call Reports were not accurate due to these and other valuations being overstated. These unreliable financial reports misrepresented CBC's financial position to regulators, depositors, shareholders and the public.

Analysis of CBC’s loan portfolio from 1996 until it failed in 2002 indicates that management did not give adequate attention to diversifying risk and, as a result, concentrations of credit risk occurred in its loan portfolio. The failure to diversify risk, coupled with poor underwriting and poor loan administration, contributed to the material loss that resulted from the failure of CBC.

Greater regulatory attention is required when asset concentrations exceed 25 percent of Tier 1 Capital. According to section 3.1 of the DSC Manual of Examination Policies, concentrations are a significantly large volume of economically related assets that an institution has advanced or committed to one person, entity, or affiliated group. These assets may in the aggregate present a substantial risk to the safety and soundness of the institution. Adequate diversification allows the institution to avoid the excessive risks imposed by credit concentrations. It should also be recognized, however, that factors such as the location of the institution and the economic environment of its lending area can limit an institution's ability to diversify. Where reasonable diversification cannot be achieved, the resultant concentration calls for capital levels higher than the regulatory minimums.

The DSC Manual of Examination Policies further states that concentrations generally are not inherently bad but do add a dimension of risk, which the management of the institution should consider when formulating plans and policies. In formulating these policies, management should, at a minimum, address goals for the institution's portfolio mix and set limits within the loan and other asset categories. All concentrations should be monitored closely by management and receive a more in-depth review than the diversified portions of the institution's assets. Recognizing that concentrations may indicate an absence of risk diversification within the institution's asset structure, the DSC Manual of Examination Policies requires examiners to detail in the report concentrations aggregating 25 percent or more of Tier 1 Capital by:

• individual borrower;
• small, interrelated group of individuals;
• single repayment source with normal credit risk or greater; and
• individual project.

A review of FDIC and State of Connecticut examination reports from 1996 through 2001 revealed the following:

• The December 30, 1996 FDIC examination report criticized the bank "for having a significant concentration of credit, 253.5% of Tier 1 capital" with one borrower. The $13 million in loans to this one borrower represented over 21 percent of the loan portfolio as of the examination date. Noting that risk diversification is a tenet of sound banking, the examiner stated that the Board needed to review this relationship and establish prudent limits.
  
  
• In the October 20, 1997 FDIC examination report, concentrations of credit were identified again and examiners recommended that the bank’s directors review the concentrations and adopt a diversification policy. Also, the examiners noted these concentrations posed additional types of risk. Three concentrations of credit totaling $27.3 million were identified, which represented 433 percent of Tier 1 Capital and over 45 percent of the book value of the bank’s loan portfolio.
  
  
• The October 26, 1998 State of Connecticut examination report noted "Risk diversification remains a concern as five relationships ranging from 30% to 138% of Tier 1 Capital are listed in the Concentrations page. The level of concentrations [has] increased from three cited at the prior examination." The report further noted that "Given the weaknesses identified in these relationships as well as the increasing number of overall concentrations, the need for appropriate guidelines and adequate staffing becomes increasingly important. At a minimum, policies should address goals for portfolio mix and limits within the loan and other asset categories."
  
  
• The December 27, 1999 examination report, jointly prepared by the FDIC and State of Connecticut, noted "Eight relationships, which in the aggregate, represent 491% of Tier 1 Capital are listed…within this report." The report further noted " The number of concentrations has increased from the five noted at the last examination."
  
  
• The March 5, 2001 examination report jointly prepared by the FDIC and State of Connecticut states: "Management is again reminded that risk diversification is a basic tenet of sound banking. Seven groupings of loan/asset concentrations, each representing greater than 25% of Tier 1 Capital are detailed on the concentrations page. Of concern is that the majority of these credits are adversely classified or contain loan administration deficiencies. Given these increased risk factors, it is imperative that management monitors these credits closely."

Despite numerous warnings by FDIC and State of Connecticut examiners, CBC’s management repeatedly failed to diversify the risk of the bank’s loan portfolio. Of particular concern was the number of loans to one borrower that exceeded 100 percent of Tier 1 Capital. From 1996 though to 2001, examiners identified at least three separate instances where loans to one borrower exceeded over 100 percent of Tier 1 Capital. Moreover, all of these concentrations contained underwriting and/or other credit deficiencies. Through this concentration of risk, CBC had positioned itself to possibly fail if just one of these loans had to be charged off. Based on our review of DRR loan sales and discussions with DRR account officers, the FDIC, as receiver, will likely realize significantly less than book value when these loans are eventually sold.

A review of examination reports and related records shows that the bank had a history of engaging in high-risk activities without proper risk management policies and procedures in place. Also, the bank routinely engaged in out-of-territory lending. In 1999, more than 45 percent of CBC’s loan portfolio involved companies operating outside of the State of Connecticut and sometimes outside of the United States. According to examiners, some of the lending by the bank appeared to be more representative of lending by venture capital companies as opposed to an FDIC-insured bank. This type of lending without a proper risk identification system is a direct result of the bank’s directors and management failing to fulfill their responsibilities to run the bank in a safe and sound manner.

In guidance to examiners, the DSC Examination Documentation Modules state that Boards of Directors should establish adequate lending policies, procedures, and operating strategies. Inadequate lending policies and procedures may expose banks to greater risk. Bank management should conduct risk assessments to identify key business risks and should adhere to reasonable risk-taking practices.

CBC’s Chairman directed the bank to engage in risky out-of-area lending without the benefit of proper guidelines or documented support for the transactions. Aggressive and uncontrolled risk-taking by the bank led to an increase in the bank's exposure to risk. Our review of examination reports indicates that the bank continually assumed high levels of risk in its loan portfolio without adequate processes to identify, measure, monitor, and control these risks. The December 1996 FDIC examination report noted that much of the bank’s new commercial lending was in leases or purchases of receivables, and was out of state. Examiners were concerned that this type of lending requires "special technical expertise, close monitoring, and hands-on management." The report also indicated that the bank was already understaffed in its commercial loan department. Also, the examination report noted that the loan review process was almost nonexistent, documentation required as part of loan agreements was not being received or requested, and financial information to monitor credits was not being obtained.

Subsequent examination reports noted similar deficiencies. The 1999 examination report found that more than 45 percent of the bank’s loan portfolio was made to companies doing business outside the state of Connecticut, including in Central and South America and Canada. The bank did not have policies in place for controlling risk in foreign countries. Also, the examination report identified that the bank was modifying and restructuring loans without current financial information. The 2001 examination report, under Matters Requiring Board Attention, noted that "risk management practices are severely deficient relative to the institution's size, complexity, and risk profile." The report further noted that "Sound underwriting standards need to be adopted and enforced." Based on examination reports, loan underwriting improved prior to, and deteriorated soon after, the acquisition of MTB Bank.

Weaknesses in risk management were exacerbated after the Purchase and Assumption of MTB Bank. With over $214 million of additional deposits acquired from MTB Bank, CBC funded tens of millions of dollars in high-risk lending and speculative ventures dealing with accounts receivable purchase financing, coal mining and oil exploration, and casino gambling. Many of these loans were to borrowers out of state and/or out of the country.

To illustrate:

• In November 2000, CBC lent money to a start-up company that operated a gaming facility, sports bar, and racetrack in Panama. The company was seeking to expand gambling operations in Central and South America. The original loan of $250,000 was amended 11 times, and by April 2002, the loan amount was in excess of $2.6 million. In addition, the company received a second loan from CBC in December 2001 for over $1.1 million. The purpose of this loan was related to the acquisition of slot machines for the gambling operations. Both loans were based on projected earnings of $23 million and $24 million for years 2001 and 2002 respectively, even though the company had lost over $300,000 in both 1999 and 2000. The guarantor for these loans was also experiencing net losses and collateral coverage was lacking. Repayment was solely dependent on the successful operation of an unproven company engaged in gambling operations in foreign countries. When the loans related to the gambling operation were sold by DRR, the total outstanding book value was over $5 million. Due to the poor underwriting and lack of collateral coverage, these loans were sold at an FDIC auction for less than $668,000, approximately 13 percent of their book value.

Prior to the acquisition of MTB Bank, CBC purchased $1.7 million in foreign currency options without fully understanding the risks assumed. The 1999 examination report stated that the volatility of these instruments made them more difficult to value than other more traditional investments. The uncertainty underlying these investments made them riskier than many other types of securities. Sound risk management principles would require risk management systems in place to evaluate the possible impact to earnings from adverse changes in market conditions. Such risk management systems were not in place at CBC.

The bank was cited a number of times for apparent violations of banking laws and regulations at examinations performed from 1996 through 2001. The most significant one that contributed to the bank’s failure and material loss pertained to legal lending limits of the State of Connecticut. CBC had several relationships on its books that appeared to violate legal lending limits.

CBC circumvented Connecticut statutes pertaining to legal lending limits to one borrower by concentrating a portion of its loan portfolio in accounts receivable purchase agreements. Legal lending limits are a means to diversify risk by limiting the dollar amount of loans to individual borrowers. However, CBC interpreted Connecticut banking law pertaining to liabilities to one obligor in a manner that permitted the financing of poor quality accounts receivable of a single obligor. Below we discuss how the bank was able to lend money oftentimes far in excess of its legal lending limit.

Legal lending limits help to protect the safety and soundness of banks by preventing excessive loans to one person, or to related persons that are financially dependent, and help to promote diversification of risk. As a state-chartered bank, CBC was subject to legal lending limits under Connecticut General Statutes Sec. 36a-262, which provides the following:

Except as otherwise provided in this section, the total direct or indirect liabilities of any one obligor that are not fully secured, however incurred, to any Connecticut bank, exclusive of such bank’s investment in the investment securities of such obligor, shall not exceed at the time incurred fifteen per cent of the equity capital and reserves for loan and lease losses of such bank.

Based on Call Report information, CBC’s approximate legal lending limit (15 percent of equity capital plus the loan loss reserve) for the years 1996 through 2002 would have been as follows:

Table 2: CBC’s Approximate Legal Lending Limit, 1997-2002 ($ in thousands)

Source: OIG analysis of Call Reports

Starting in 1997, the bank made a number of loans that appeared to exceed the legal lending limits of the State of Connecticut. The bank lent millions of dollars for what it termed "accounts receivable purchase facilities." The bank asserted that the accounts receivable purchase facilities were not loans but rather the outright purchase of the borrower’s accounts receivable. By structuring the deals as purchases, the bank contended that each underlying account receivable was the de facto borrower and thus only the individual account receivable amount would be covered by the legal lending limits of the State of Connecticut. From 1997 through 1999, when its legal lending limit would have been somewhere between $1.24 million and $1.53 million, the bank lent money to several borrowers for accounts receivable purchases in excess of that amount, ranging as high as $10 million to one borrower.

We reviewed records that indicated the bank was of the view that the purchase of receivables was not subject to the limitations contained in section 36a-262 based on a number of factors including "the documentation and corporate approvals evidence the parties intent, to engage in a sale of the eligible receivables from the Seller to the Purchaser and not a financing secured by the receivables."

Examiners reviewing these transactions determined that these transactions were in-substance direct loans to the companies rather than accounts receivable purchases. This was based on a number of factors identified by examiners. Particularly, examiners noted that the initial accounts receivable as well as monthly individual accounts receivable were not in the bank's files; therefore, the obligors were not known. Also, there were no documented on-site reviews of the obligors, or documented reviews of the obligors’ creditworthiness by the bank.

By December 31, 1999, accounts receivable purchases represented approximately 28 percent of the bank’s total loan and lease portfolio. Several of these transactions were in excess of the bank’s legal lending limit. According to DRR officials, one of these transactions with a book value over $6.5 million was sold in October 2002 for approximately $1.75 million, less than 27 percent of its book value.

Another way the bank was able to take advantage of legal lending limits was due to an apparent loophole in Connecticut banking law pertaining to legal lending limits. Relevant language in the Connecticut law provides limits on "the total direct or indirect liabilities of any one obligor." According to the FDIC and Connecticut banking officials we interviewed, as long as loans are made to separate legal entities and neither guarantees the obligation of the other, there would be no violation even though the companies could be interlocked and be using the proceeds for a common enterprise.

An example we noted at CBC occurred during 2001 and 2002, when CBC lent money to four different entities related to a coal-mining venture in Montana. These companies appeared to be interlocked, and there are various transactions between the four all related to reopening a coal mine in Montana. CBC’s total exposure on this transaction was about $22 million. Its legal lending limit would have been between $6.1 and $6.6 million (2000 - 2001) at the time these deals were made. According to FDIC and State of Connecticut banking officials, there is apparently no requirement under Connecticut law to aggregate or combine loans to different obligors even though the loans directly benefited one another and the expected source of repayment was the same for each loan.

We discussed this issue with Connecticut banking officials, and they agreed that there are loopholes in the law that need to be addressed. According to the Connecticut banking officials, they are in the early stages of drafting proposed changes to the law.

The Bank’s Board of Directors and senior management frequently disregarded or did not fully address examiner concerns. These concerns included some basic tenets of banking such as risk diversification, risk management, loan underwriting, and loan administration. Examination reports from 1996 through 2001 identified recurring problems at the bank that required attention. The 1996 examination report disclosed CBC’s overall condition as unsatisfactory due to the Board and senior management’s slow progress in addressing and resolving long standing asset quality problems and the resultant drain on earnings. Our review of FDIC and State of Connecticut examination reports indicates that while bank management took action on some recommendations, most were not sufficiently addressed, which contributed to the bank’s failure.

Onsite examinations are a significant part of the FDIC's supervisory function. The DSC Manual of Examination Policies in section 1.1 states that the "examination process can help prevent problem situations from remaining uncorrected and deteriorating to the point where costly financial assistance by the FDIC, or even a payoff of depositors, becomes unavoidable." Further the manual notes "the examination supplies the supervisor with an understanding of the nature, relative seriousness and ultimate cause of a bank's problems, and thus provides a factual foundation to soundly base corrective measures, recommendations and instructions. The examination thus plays a very key role in the supervisory process itself."

Also, the Manual of Examination Policies notes that "[t]he capability of the board of directors and management, in their respective roles, to identify, measure, monitor, and control the risks of an institution’s activities and to ensure a financial institution’s safe, sound, and efficient operation in compliance with applicable laws and regulations should be reflected in the management rating." One of the factors related to the capability and performance of management and the board of directors is its "Responsiveness to recommendations from auditors and supervisory authorities."

Examination reports from 1996 through 2002 cited the following matters for CBC management's attention:

FDIC Report of Examination - December 30, 1996:

• Credit Administration--on-going review, monitoring, and management of the commercial loan portfolio needed improvement. The loan review process was almost nonexistent; documentation required as part of loan agreements was not being received or requested; financial information needed to monitor credits was not being obtained.
  
  
• Management--Principal shareholder and Chairman of the Board dominated and controlled CBC’s management. This raised issues regarding risk tolerance; loans to entities affiliated with the Chairman or one of his related interests; and the appropriate role for the principal shareholder in the daily operations of CBC.

FDIC Report of Examination - October 20, 1997:

• Asset Quality--the volume of adversely classified assets remained excessive and the past due ratio escalated to an alarming level.
  
  
• Asset Administration--documentation, analysis support, and monitoring of assets in the Accounts Receivable Purchase Facility program was inadequate. Two assets were cited for Special Mention. The volume of technical deficiencies in credit files remained high.
  
  
• Management--although management and the Board had taken appropriate steps to correct prior deficiencies, substantial weaknesses in other areas were noted. The new deficiencies reflected poorly on management's ability to prevent further problems. In addition, the lack of a strategic plan and budget for 1998 raised questions regarding management's ability to plan and provide critical direction to CBC.

FDIC Report of Examination - October 26, 1998:

• Asset Quality--volume of adversely classified items remained excessive. Efforts to reduce this level were hampered by new classifications. The return of CBC to a satisfactory condition was dependent on efforts to improve overall asset quality.
  
  
• Concentrations of Credit--constituted over 400 percent of capital, exposing CBC to a high degree of diversification risk. Management should have implemented a process to adequately identify, measure, and monitor the risks inherent in these types of relationships.
  
  
• Management--CBC was operating without a President. Despite this vacancy, senior management took steps toward improving the condition of the institution. However, additional efforts were needed to stabilize earnings performance, reduce problem assets, monitor and administer credit concentrations, and improve internal routine and controls. Also, two directors were noted for having poor attendance at Board meetings.

FDIC and State of Connecticut Department of Banking Report of Examination - December 27, 1999:

• Asset Quality--while improved, remained a concern. Management implemented procedures to strengthen loan administration; however, additional efforts to correct deficiencies were necessary.
  
  
• Concentrations of Credit--continued to represent over 400 percent of capital, exposing CBC to a high degree of diversification risk.
  
  
• Management--took several appropriate steps to address regulatory concerns. Additional efforts to correct deficiencies in the administration of the loan and lease portfolio and Accounts Receivable Purchase Facility program were necessary.

FDIC and State of Connecticut Department of Banking Report of Examination - March 5, 2001:

The report noted that recommendations from prior examinations had not been satisfactorily addressed. The report stated: "loan administration weaknesses that were noted at the past several examinations still remain outstanding." Also, the report noted deficiencies from the prior two examinations pertaining to the loan loss reserve methodology, internal audit function, and review of the interest rate risk model that had not been fully addressed by management. Further, examiners had concerns in the following areas:

• Asset Quality--the volume and severity of items adversely classified increased substantially since the previous examination. Adversely classified items were an unacceptable 90 percent of Tier 1 Capital and reserves. There was $35 million in assets listed for Special Mention.
  
  
• Credit Administration--numerous loans reviewed during the examination contained severe underwriting, credit, and collateral deficiencies. In addition, a substantial number of loan policy exceptions were noted. Numerous imprudent lending practices were identified in loans associated with insiders. There were numerous discrepancies between management’s internal risk ratings and the examiners’ classifications. Also, there were increases in concentrations of credit.
  
  
• Management--the Board’s oversight of management was deficient in the loan and compliance areas as well as risk management practices.

FDIC draft Examination Summary Report - April 1, 2002:

• Asset Quality--management and the Board had not appropriately overseen the loan portfolio and loan administration. Loan relationships were not properly monitored, warning signs were not appropriately researched, and loan officers had not been held accountable for their actions. Since the previous examination, management still could not provide meaningful information on many of the numerous credit relationships and had not rectified many of the noted deficiencies.
  
  
• Credit Administration and Loan Underwriting--weaknesses remained problematic due to a lack of management oversight, lack of an effective credit policy, and lack of an effective risk assessment.
  
  
• Management--the Board and management took action on some previous recommendations; however, the majority of deficiencies were not addressed. The volume of deficiencies identified in the loan portfolio was overwhelming. Loans were not appropriately risk rated, over-advances on factoring lines were prevalent, and appropriate ongoing analysis and monitoring of many credits was not performed.

It is clear from the above examination comments that CBC’s Board of Directors showed a pattern of disregard for examiners’ reported concerns and recommendations aimed at ensuring that CBC operated in a safe and sound manner. The examiners repeatedly reported oversight deficiencies in loan concentrations, affiliate and insider transactions, asset quality, and credit administration. Management and the Board’s failure to address the continued deficiencies in asset quality, problems in credit administration and loan underwriting, year after year, led to massive loan losses and the depletion of CBC’s capital.

In addition to the above, several key events leading to the failure were associated with the March 31, 2000 acquisition of MTB Bank. As a condition of the Purchase and Assumption of MTB Bank, CBC was required by the FDIC to increase capital by at least $20 million. In the application submitted to the FDIC to acquire MTB Bank and in subsequent meetings with the FDIC, the Chairman of the Board of Directors of CBC represented to the FDIC that he would personally inject $20 million into CBC to meet a condition for purchasing MTB Bank. In actuality, the Chairman orchestrated a scheme where he caused the bank to make approximately $20 million in nominee loans to various companies he and family members controlled, and associates during the last week of March 2000 (see Appendix II). The proceeds of these loans were eventually turned over to the Chairman and then used to fund the injection of capital into the bank, deceiving regulators into thinking that the capital injection was provided from the Chairman’s own funds. The Chairman did not disclose to regulators that the proceeds of these loans would be transferred to him or for his benefit. Most of these loans had severe underwriting deficiencies, and according to DSC examiners, would not have been approved at a bank with prudent credit underwriting procedures and risk standards.

In furtherance of the scheme, during June 2000, the Chairman again caused the bank to approve over $11 million in loans to entities controlled by himself, his children, and/or business associates. Approximately $5.5 million of these loans were channeled to an entity called Peachtree Group (Peachtree). The FDIC’s investigation into this matter disclosed that an apparent business associate of the bank’s Chairman created Peachtree in June 2000 with a total capital contribution of $10. FDIC examiners discovered that Peachtree ultimately used the money to purchase various non-performing loans from the bank, giving the appearance that a third party was buying the loans without financing from the bank. By selling the non-performing loans to Peachtree prior to June 30, 2000, the bank’s condition appeared materially better on its June 30, 2000 Call Report than it actually was. FDIC examiners also identified other loans made between April 2000 and May 2001, the proceeds of which were used to make payments on the various nominee loans made during March and June 2000. As of November 2002, the FDIC estimated that the aggregated outstanding balance of these nominee loans is at least $34 million.

By using funds obtained from the bank through nominee loans, the Chairman was able to circumvent a regulatory requirement to provide a capital injection and misled regulators into thinking that he used his own funds to ultimately purchase MTB Bank. As a result, the March 31, 2000 Call Report did not reflect the actual condition of the bank because capital was in reality overstated by approximately $20 million, given that these nominee loans were generally not made to creditworthy borrowers. In Table 3, we compare bank information as reported by CBC in its Call Reports from the calendar quarter preceding the acquisition to bank information reported in Call Reports after the acquisition on March 31, 2000. In addition, we show what the bank information would have been without reflecting the $20 million injected as part of the nominee loan scheme.

Source: Call Reports

As shown in Table 3 above, when the $20 million "capital infusion" is discounted, the bank was actually operating with equity capital of only 2.8 percent of assets–well below regulatory guidelines and woefully insufficient given the risks in CBC’s loan portfolio. Once examiners determined the effects of the nominee loan scheme and the losses associated with it, the bank was deemed insolvent and closed by the Connecticut Banking Commissioner.

The FDIC concluded that unsafe and unsound practices by CBC’s Board of Directors continued right up until the bank failed. On June 23, 2002, in a special Sunday night meeting of the Board of Directors, the Board approved over $16.8 million of loan extensions, modifications, and new loans. The following day, the bank made over $12.6 million in wire transfers pertaining to these loans. These loans lacked supporting documentation and financial analysis, and one extension was for a nominee loan made during March 2000. The Board breached its responsibilities in approving these loan activities under circumstances that should have caused the Board to question the propriety of the extensions and loans.

The FDIC and State of Connecticut Department of Banking had commenced a joint examination of the bank in April 2002. During the examination, FDIC and state examiners informed the bank that they planned to meet with the Board of Directors on June 25, 2002. According to the FDIC Notice of Charges issued on November 22, 2002, the Chairman and president were concerned that the examination results would show a severe deterioration in the bank's condition since the March 2001 examination. They also feared examiners would take additional regulatory actions. One of these actions would be restricting the bank's ability to extend credit. Accordingly, the Board convened a special Sunday night meeting on June 23, 2002 during which it approved over $16.8 million in loans and extensions of loans. The Board was given no more than 2 days' prior notice of the meeting. The Chairman, president, and other five directors conducted the meeting by telephone and approved the funding of the loans as presented.

The FDIC asserts that the Board approved most of these loans based solely upon oral presentations. Status Reports and other written loan presentations, when prepared, lacked information necessary to make an informed credit decision. The loans involved close business associates of the Chairman and entities he owned or controlled. The most egregious of these transactions were two new loans totaling $11.5 million to companies with no financial history and no apparent capacity to repay the loans. The Connecticut Banking Commissioner ordered the bank closed after being notified of these loans. The FDIC, as receiver, was able to secure the return of the $11.5 million of funds.

FDIC and State of Connecticut examiners conducted annual examinations of CBC from 1993 until its closure (see Table 4). Examiners repeatedly identified and reported on significant, yet uncorrected, problems at the bank during that time period. As also shown in Table 4, from 1991 until it failed, CBC operated under various supervisory actions. During the March 2001 examination, the first examination conducted after CBC’s acquisition of MTB Bank, examiners discovered what appeared to be to be inordinately high loan activity in March 2000. Examiners conducted follow-up work and in June 2001 began a formal investigation under section 10(c) of the FDI Act that eventually uncovered the loan scheme used by the Chairman to fund the purchase of MTB Bank.

Although the FDIC’s supervision of the institution generally identified and assessed the risks identified at the bank, we identified three areas where supervision could have been more effective. These areas pertain to: (1) enforcement actions, (2) the approval process for applications, and (3) following up on red flags.

We also determined that the PCA requirements of section 38 of the FDI Act were not fully effective due to the nominee loan activity, other questionable practices, and the improper valuation of bank assets. These problems, once identified, resulted in a precipitous decline in capital and, therefore, PCA’s effectiveness at minimizing losses to the insurance fund was limited. Detailed in the pages that follow is our assessment of the FDIC’s supervision of the institution, including implementation of the PCA provisions of the FDI Act.

From 1993 until the bank closed, safety and soundness examinations of CBC were conducted every year. Supervisory and enforcement actions were issued to address the deficiencies noted at examinations. The table below summarizes CBC’s examination history and supervisory actions from 1991 until it failed.

Table 4: FDIC and Connecticut Department of Banking Examinations and
Supervisory Actions for CBC, 1991-2002

Source: FDIC and State of Connecticut Examination Reports and related correspondence.

At the start of the March 2001 examination, FDIC and State of Connecticut examiners became aware of what appeared to be unusual and irregular activity concerning the volume of loans approved by the bank in the month of March 2000. As discussed earlier in this report, in March 2000, the bank’s Board of Directors approved over $20 million in loans when in the prior 2 months, Board-approved loans averaged less than $5 million per month, as shown below in Figure 1.

[This image appears in the non-508-compliant version of the audit report.]

Text description of Figure 1: In January 2000, there were $3.7 million in loan approvals. In February 2000, there were $4.8 million in loan approvals. In March 2000, there were $21.8 million in loan approvals. In April 2000, there were $6.7 million in loan approvals.

The $20 million in loans were funded between March 22, 2000 and March 29, 2000–the week before the MTB acquisition was consummated. These loans appeared suspicious to examiners due to the unusually high volume, lack of information available, and poor underwriting. Also, many of the loans appeared to be connected to the Chairman of the Board. Additionally, the timing of these loans, just days before the Purchase and Assumption occurred, raised concerns with examiners. The stated purposes for most of these loans were for permanent working capital, revolving lines of credit, or unspecified investments. There was no mention in the loan files as to what examiners later learned: the proceeds from these loans would be used to finance CBC’s acquisition of MTB Bank. After an extensive investigation, which included substantial tracing of funds, examiners uncovered the loan scheme used by the Chairman of the Board to fund the purchase of MTB Bank.

In addition, examiners discovered as a part of their investigation that during June 2000, the bank approved over $11 million in additional loans to entities controlled by the Chairman, his children, and/or business associates. Approximately $5.5 million of these loans was ultimately channeled to an entity called Peachtree Group (Peachtree). The FDIC’s investigation into this matter disclosed that an apparent business associate of the bank’s Chairman created Peachtree in June 2000 with a total capital contribution of $10. Examiners discovered that Peachtree used most of the proceeds to purchase various non-performing loans from the bank, giving the appearance that a third party was buying the loans without financing from the bank. By selling the non-performing loans to Peachtree prior to June 30, 2000, the bank’s condition appeared materially better on its June 30, 2000 Call Report than it actually was. FDIC examiners also identified other loans made between April 2000 and May 2001, the proceeds of which were used to make payments on the various nominee loans made during March and June 2000. As of November 2002, the FDIC estimated that the aggregated outstanding balance of the nominee loans was at least $34 million. As of December 31, 2002, most of these loans were non-performing, most were lacking in collateral coverage, and according to DRR officials, offered little in potential recoveries.

The bank was under a C&D Order beginning in 1991 and a second C&D Order took effect in 1993. The C&D Orders were removed by the FDIC in March 1999 and simultaneously replaced with an MOU as the bank’s condition had apparently improved. The October 1998 FDIC examination upgraded the bank’s CAMELS rating from a "4" to "3" largely due to gains in earnings and increased capital. Also, its Tier 1 Capital was 7.86 percent, which was well above the minimum 6 percent requirement per the C&D.

The Regional Office comments from the October 1998 examination stated, "the effectiveness of both the 1991 and 1993 Cease and Desist Orders is considered outdated and unnecessary in view of compliance to date, as well as the basic soundness now evident." An MOU was recommended to address the October 1998 examination findings and require the bank to place specific limits on concentrations of credit, establish targeted reduction levels of total adversely classified assets, maintain continuity of management, maintain a minimum 7.5 percent Tier 1 capital level to offset its higher risk profile, maintain adequate reserves for loan losses, curtail and control consultant costs, maintain tight conflicts of interest policy, and continue to provide quarterly reports.

The FDIC agreed to remove two C&D enforcement actions in March 1999 even though the bank was not in full compliance with the actions. The C&D orders were replaced with an informal MOU despite the fact that the bank remained deficient in its risk management and risk diversification practices, loan administration, and asset quality. Other specific areas of the C&D where the bank did not appear to us to be in compliance included:

• Detailed written Board of Directors meeting minutes with supporting documentation.
• Sufficient level of reserve for loan losses and sufficient methodology for adequacy of reserve for loan losses.
• Correction of loan technical exceptions such as restructuring loan credits or advancing new funds without current financial information.
• Correction of violations of laws and regulations related to internal audit programs and compliance with Bank Secrecy Act requirements.

The DSC Manual of Examination Policy states,

Banks with composite ratings of "4" or "5" will, by definition, have problems of sufficient severity to warrant formal action. Therefore, the policy of the Division of Supervision is that it shall take formal action pursuant to Section 8 of the FDI Act against all insured State nonmember banks rated "4" or "5," where evidence of unsafe or unsound practices is present. Such formal action will normally consist of either a Cease and Desist Order under either Section 8(b) or 8(c) or initiation of insurance termination proceedings under Section 8(a). Exceptions to the policy may be considered when the condition of the bank clearly reflects significant improvement resulting from an effective corrective program or where individual circumstances strongly mitigate the appropriateness or feasibility of this supervisory tool. For example, acceptable action by the State authority might preempt the need for FDIC action, or qualified new management might allow the use of an informal memorandum of understanding instead of a Cease and Desist Order. Mere belief that bank management has recognized the problems and will implement corrective action is not a sufficient basis to preclude action if the bank is still deemed to warrant a composite rating of "3," "4" or "5."

Regarding MOUs, the DSC manual additionally states, as a general rule, and as a minimum, a Memorandum of Understanding is to be considered for all institutions rated a composite "3." Use of an MOU, as opposed to more formal action, is particularly appropriate where the Regional Office believes the problems discussed with management and the board of directors of the institution have been adequately detailed and the institution, in good faith, will move to eliminate the problems.

The DSC chose to replace the C&Ds with an MOU even though it had concerns with asset quality, credit concentrations, and staffing levels. Asset quality was weak. The volume of adversely classified assets had increased since the previous examination and represented 95 percent of Tier 1 Capital and reserves. Credit concentrations were also higher at 429 percent of Tier 1 Capital, representing poor risk diversification, and 31 percent of concentrations were classified as either Substandard or Special Mention. The MOU remained in effect after the acquisition of MTB Bank.

Moreover, regarding enforcement actions, the March 2001examination resulted in the bank being downgraded from a CAMELS "3" rating to a CAMELS "4" rating. In December 2001, the FDIC imposed a new C&D order containing 31 provisions addressing, among other things, credit underwriting and loan administration weaknesses, inappropriate risk rating of loans, insufficient capital, and several repeat apparent violations. While the C&D order contained numerous provisions, it did not necessarily prevent the bank from continuing to make high-risk out-of-territory loans nor did it place a dollar limit on loans to be extended. As a result, the bank continued to make risky loans, funding over $17 million of such loans from January through June 2002, including $13 million just days before CBC failed. While the FDIC was able to recover $11.5 million of the funded loans in its capacity of receiver, almost $6 million was not recovered, and the FDIC estimates that most of this money will not be repaid because the borrowers are not creditworthy and there is a lack of collateral.

While we have concerns about the lifting of the C&D orders in 1999, we are not making any formal recommendations at this time related to that issue. The OIG plans on doing future audit work on a national level that will address the process used by DSC to determine when enforcement actions are implemented and removed.

Regarding the 2001 C&D, with respect to troubled institutions DSC may want to be more proactive in the future and include a provision in the enforcement action that the FDIC receive prior notice of material transactions, out-of-territory lending, or new business activities and be afforded the opportunity to review and comment on same before the institution concludes such transactions or engages in such activities. Such a provision may be appropriate in those cases where an institution’s primary business focus is experiencing a downturn or where earnings are deteriorating and a "quick fix" such as investing in highly speculative financial endeavors may be tempting.

We recommend that the Director, DSC:

1. Include a provision in enforcement actions for certain troubled institutions that the FDIC receive prior notice of material transactions, out-of-territory lending, or proposed new business activities and be afforded the opportunity to review and comment on same before the institution conducts such transactions or engages in such activities.

The FDIC did not fully consider the past performance of bank management before approving the application to acquire MTB Bank. This happened, in part, because FDIC guidance addressing the review of management in conjunction with a merger or acquisition is vague and as such, there was no requirement to assess certain specific attributes of management’s past performance. The bank had a history of poor management, risky lending, insufficient loan administration, concentrations of credit risk, and questionable compliance with banking laws. These deficiencies were not addressed in the analysis of the application. In total, these management deficiencies raise doubts regarding the FDIC’s decision to approve CBC’s application to acquire MTB Bank.

Section 18(c) of the FDI Act, 12 U.S.C. 1828, commonly known as the "Bank Merger Act," and the FDIC Statement of Policy on Bank Merger Transactions require the prior written approval of the FDIC before any insured depository institution may merge or consolidate with, purchase or otherwise acquire the assets of, or assume any deposit liabilities of, another insured depository institution if the resulting institution is to be a state nonmember bank. Institutions that undertake a merger transaction as described above must file an application with the FDIC. The Bank Merger Act requires, among other things, that the FDIC consider the financial and managerial resources and future prospects of the existing and proposed institutions. The Bank Merger Act also states that the FDIC normally will not approve a proposed merger transaction where the resulting institution would fail to meet existing capital standards, continue with weak or unsatisfactory management, or whose earnings prospects, both in terms of quantity and quality, are weak, suspect, or doubtful. In evaluating management, the FDIC will rely to a great extent on the supervisory histories of the institutions involved and of the executive officers and directors proposed for the resultant institution. The FDIC, as required by the Community Reinvestment Act (CRA), 12 U.S.C. section 2901 et. seq., will also note and consider each institution's Community Reinvestment Act performance evaluation record. An unsatisfactory record may form the basis for denial or conditional approval of an application. Accordingly, each merger application should be evaluated in light of the FDIC's intent and purpose to foster and maintain a safe, efficient, and competitive banking system that meets the needs of the communities served.

The DSC Case Managers Procedures Manual provides limited guidance to case managers when assessing management in conjunction with a prospective merger. The guidance states: "Discussion of the general character of management should address ownership and active management of each institution as well as the combined institution. Insider benefits should be fully discussed."

In accordance with its policy, DSC prepared an analysis of the application that evaluated, among other things, the financial and managerial resources of both CBC and MTB Bank. The analysis of CBC management indicated that "Management of CBC has been rated either a component ‘4’ or ‘3’ since the 1990 examination." The management rating at the December 1999 examination remained a "3." The analysis also discussed each person who would be part of the senior management team and noted that the stability of the current management team was viewed as a positive sign.

Our review of the FDIC’s analysis of the application found no mention of the fact that the bank had a history of poor management as evidenced by risky lending, insufficient loan administration, concentrations of credit risk, questionable compliance with banking laws, and insufficient responsiveness to examiner recommendations. It appears that the analysis was focused more on the condition of the bank and the Chairman’s reported wealth and prior willingness to inject substantial capital into the institution. In our opinion, the history of management deficiencies at the bank raises doubts about the FDIC’s decision to approve CBC’s acquisition of MTB Bank.

Further, related to the application review, the FDIC did not adequately validate and review the financial status of the Chairman of the Board–the source of the capital injection required for the Purchase and Assumption. While the FDIC’s Statement of Policy on Bank Merger Transactions and the Case Managers Procedures Manual require the assessment of the financial resources of the existing and proposed institutions, there is no requirement to validate the financial capability of a would-be investor. As a result, the FDIC did not verify the financial information submitted regarding the source of the capital injection and, accordingly, had no assurance that the principal shareholder was, in fact, injecting the required amount of capital from his personal assets as agreed to with the regulators.

In its application, CBC represented that its majority shareholder would inject $20 million into the bank to purchase $10 million in common stock and $10 million in preferred stock, the proceeds of which would be used to fund the acquisition transaction. According to DSC officials in Boston, the majority shareholder represented that the $20 million would come from his own personal assets. In order to assess his ability to provide the $20 million, the FDIC requested and received a financial statement from the majority shareholder. DSC officials at the Boston Area Office told us that they did not verify the information contained in the financial statement. Our review showed that the financial statement was self-prepared, unaudited, lacked details, and contained no supporting documentation. As a result, the financial statement was not sufficient to determine the financial condition of the Chairman and provided little support or explanation for the source of the $20 million capital injection.

Lastly, regarding the application review process, the CRA performance evaluation (CRA PE) for CBC performed in late 1999, prior to the acquisition of MTB Bank, did not reflect the bank's actual performance. (Note: The CRA was enacted as Title VIII of the Housing and Community Development Act of 1977 and applies to all federally insured financial institutions, excluding credit unions. CRA requires that financial regulatory agencies evaluate institutions' CRA performance and requires that these evaluations be disclosed to the public. In 1995, the regulation was revised to emphasize performance rather than process, to promote consistency in evaluations, and to eliminate unnecessary burden. The new rules require banks to meet the lending, service, and investment needs of the communities where they accept deposits, and require that examinations focus on tangible performance-based results rather than on procedures.) Instead the rating was based on the bank's performance context and future projections of performance. (Note: A bank's performance context takes into account its financial capacity and size, legal impediments, and local economic conditions and demographics, including the competitive environment in which it operates.) Because the majority of the bank's lending was outside of its assessment areas by design, in the OIG’s view, the lending appeared not to meet the conditions of a "Satisfactory" CRA rating. (Note: CRA performance is rated according to a four-tiered system: Outstanding, Satisfactory, Needs to Improve, and Substantial Noncompliance. Banks given Satisfactory ratings are considered to have a satisfactory record of helping meet the credit needs of their assessment areas, including low- and moderate-income neighborhoods, in a manner consistent with their resources and capabilities.) As a result, the rating may not have been an appropriate one on which to base approval of the bank's application to acquire MTB Bank.

According to 12 C.F.R. 303.5, CRA ratings are to be taken into consideration as part of the merger application review process, and an unsatisfactory record may form the basis for denial or conditional approval of an application. In August 1999, the former FDIC Division of Compliance and Consumer Affairs initiated a full scope CRA PE for CBC. The Examiner-in-Charge (EIC) initially rated the bank a "Needs to Improve" due to its huge volume of out-of-territory lending, low lending in low- and moderate-income areas, and the lack of small business loans. The CRA PE reported the following:

• Although the bank's loan-to-deposit ratio averaged 77 percent, much of the lending included in the ratio benefited areas outside of the bank's assessment areas and beyond the state of Connecticut.
  
  
• Based on the bank's data, it appears that 70 percent of the loans originated by the bank were inside its assessment areas; however, the ratio is misleading as the lease finance receivables were originated to one local company but did not primarily benefit businesses or individuals inside the bank's assessment areas. The financial benefits of these leases were to companies located throughout the United States, with several benefiting foreign and offshore companies.
  
  
• A majority of the bank’s mortgage loans by both number (63 percent) and dollar amount (66 percent) were made outside the bank’s assessment areas. For those loans made inside the bank's assessment areas, the geographic distribution of the mortgage loans appeared favorable; however, only 24 percent of the census tracts were penetrated, and none of the loans were made in any of the area's low-income census tracts.
  
  
• The percentage of consumer loans originated inside the assessment areas was 69 percent; however, the percentage measured by dollar showed that a majority had been lent outside the assessment areas. The bank’s consumer loan portfolio accounted for 11.5 percent of the bank's total loan originations by dollar amount.
  
  
• The bank's level of small business lending within the community, both by number of loans and dollar amount, was considered inadequate. Less than a majority of small business loans (22 percent in total) were made within the assessment areas during the evaluation period; however, census data showed that 95 percent of the business establishments in the bank's assessment areas were small businesses.
  
  
• Only 10 percent of all census tracts inside the assessment areas were penetrated in the small business loan portfolio, indicating a lack of geographic dispersion. The small business lending data for other banks in the area showed that loans were, in fact, made by other banks in each of the census tracts in the bank's assessment areas, which demonstrated that lending opportunities existed.

After being informed of the preliminary rating, the bank’s president wrote a letter to the FDIC EIC to document the constraints posed by the bank's performance context. The bank argued that it had experienced several lending constraints during the period under review that included a large portfolio of non-performing loans, poor earnings, and regulatory enforcement. Also, in an effort to return the bank to profitability, bank management had focused its lending efforts on two profitable market niches: lease finance receivables and accounts receivable lending. The EIC noted that the benefit realized by the communities in which the bank operated was minimal. The EIC also reviewed the other performance context issues raised by the bank and found that the bank's assessment areas were booming and there was no reason why the bank could not make loans. He looked at other banks in the area and their data showed that lending opportunities were good, no major employer had closed down in the area, and the bank was returning to profitability.

Despite these findings, the EIC said that DCA management decided to change the rating from a "Needs to Improve" to "Satisfactory." The transmittal letter sent to the bank noted, "CBC's CRA performance is assigned a rating of ‘Satisfactory’ based largely on performance context and less so on actual performance." In addition, according to the CRA report, "The satisfactory CRA rating assigned is largely based on the performance context, given that the actual penetration and dispersion of lending within the bank's assessment areas during the past two and one-half years warrants significant improvement."

According to the Community Reinvestment Act, a bank should be evaluated based on actual performance and not on future projections of performance. Based on our review of the PE, CRA examination workpaper files, and related correspondence, the "Satisfactory" rating assigned did not reflect the actual CRA performance of the bank. Although the EIC's initial rating was "Needs to Improve," after several meetings with bank management, the rating was upgraded to "Satisfactory." However, we found no support justifying the change in rating based on performance context issues.

Although CRA regulations, 12 C.F.R. section 345.21, allow examiners to consider the institution’s performance context when assigning CRA ratings, it appears that the performance context factors were not applicable in the case of CBC. There was lack of evidence to support the bank’s contention that operating under formal and informal enforcement actions forced it to lend outside its assessment areas. Also, there was no evidence in the examination workpapers documenting economic issues or unusual demographics related to the bank's lending area, such as: (1) high unemployment in the area; (2) a major business or employer closing down; or (3) a prison, reservation, or military installation in the area. These types of performance context issues could cause the demographics of the community to appear to reflect more potential borrowers than actually exist, or they could have adverse effects on a bank's lending levels. We also found that although the bank was returning to profitability, it continued a pattern of extensive lending outside of its assessment areas. The strategy to lend outside of the bank's assessment areas was the bank's decision and showed a lack of commitment to the community in which it was operating.

Based on our review of CRA workpapers and follow-up discussions with the EIC and the Review Examiner, we did not find convincing evidence to support the "Satisfactory" CRA rating assigned. The rating appears to be based solely on the bank's projected performance and not on its actual performance during the time period under review. As a result, the rating may not have been an appropriate one on which to base the approval of the bank's merger application to acquire MTB Bank.

We recommend that the Director, DSC:

2. Revise the Case Managers Procedures Manual to ensure that bank management is fully assessed before approving applications for mergers and acquisitions. This should include analyzing all aspects of corporate governance and examining management’s past responsiveness to recommendations made in examination reports.
   
   
3. Regarding capital injections in conjunction with an acquisition, merger, or change of control application, require: (a) acquirers to specify the source of funding in the application package and provide proof the funds are available (this could include requesting tax returns, bank and broker statements, audited financial statements, and any other information deemed necessary to validate the source of funding) and (b) DSC to review and validate the information submitted by acquirers prior to executing the transaction, and document resulting determinations.
   
   
4. Require field office examiners and regional office staff to fully document the rationale behind the decision-making process related to assigning CRA ratings that are based on special circumstances and not on a bank's actual CRA performance during the period under review. At a minimum, the documentation should include the rationale for assigning the CRA rating, a summary of DSC senior management's discussions with bank management, an explanation of the special circumstances considered, and a planned approach for periodic follow-up visits, offsite monitoring, or periodic reporting by the bank.

Finding C: Following Up on Red Flags

Examiners did not always follow up on red flags discovered during examinations prior to the acquisition of MTB Bank. In particular, weak corporate governance and a poor internal control structure, both of which were identified by examiners (and discussed previously in this report), should have heightened the attention given by examiners to some questionable transactions. Red flags that warranted more in-depth review included: (1) the bank booking approximately $4.5 million for a residual interest in four 727 cargo planes; (2) instances at the bank where adversely classified loans were modified or paid off between examinations; and (3) the bank effectively circumventing legal lending limits by structuring transactions as purchases rather than loans. A more in-depth review by examiners might have revealed that the cargo planes were not properly valued, some loans may have been renewed or restructured rather than paid off, and the purchase transactions were in-substance loans and in violation of Connecticut legal lending limits.

Guidance provided by DSC to examiners states that it is essential for examiners to be alert for irregular or unusual activity and to fully investigate the circumstances surrounding the activity. Red flags should be reviewed thoroughly to determine whether there is any substance to them. As necessary, field personnel should perform additional work as necessary to ensure that the matters are resolved promptly. Our review of examination reports and related records shows that questionabl