What exactly is an “unsafe or unsound banking practice”?

As every banker knows, a bank and its officers and directors can face an enforcement action for engaging in “unsafe or unsound banking practices.” This is true for financial institutions of all types and sizes, whether regulated by the OCC, FDIC, or Federal Reserve. The consequences of a finding that a bank has engaged in unsafe or unsound practices can be disastrous, ranging from a supervisory consent order to a cease and desist order and a civil money penalty. Despite these serious consequences, the phrase “unsafe and unsound banking practice” is not defined in the federal regulations. So what exactly is an “unsafe or unsound banking practice”?

The authoritative historical definition comes from a memorandum submitted to Congress by John Horne, then the Chairman of the Bank Board:

“Generally speaking, an ‘unsafe or unsound practice’ embraces any action, or lack of action, which is contrary to generally accepted standards of prudent operation, the possible consequences of which, if continued, would be abnormal risk or loss or damage to an institution, its shareholders, or the agencies administering the insurance funds.”

The regulators have consistently used the Horne definition in enforcement proceedings, but federal courts have expressed disagreement. For example, the Fifth Circuit Court of Appeals rejected the Federal Home Loan Bank Board’s attempt to base a finding of unsafe and unsound practices on actions that might lead to a “loss of public confidence” in the bank, explaining that the Board was required to show that the challenged actions threatened the financial condition of the bank. Gulf Federal Savings & Loan Association v. Federal Home Loan Bank Board, 651 F.2d 259 (5th Cir. 1981). Other courts have reached similar conclusions.

The conflict between the regulators and the courts came to a head a few years ago in an OCC enforcement action against Patrick Adams. The OCC accused Mr. Adams, then the President and CEO of Dallas-based T-Bank, of unsafe and unsound practices stemming from his management of the bank’s relationship with a processor of remotely created checks. After a five-day trial, the OCC’s Administrative Law Judge (ALJ) dismissed the OCC’s claims and completely exonerated Mr. Adams. The ALJ rejected the OCC’s definition of unsafe and unsound practices (the Horne definition), relying on Gulf Federal to define an unsafe or unsound practice as “conduct that, at the time it was engaged in, was contrary to generally accepted standards of prudent operation (that is, it constituted an imprudent act), the possible consequences of which, if continued, created an abnormal risk or loss or damage to the financial stability of the Bank.” The ALJ also took issue with the OCC’s aggressive enforcement action in the absence of guidance surrounding remotely created checks. The OCC appealed to the Comptroller, who rejected the ALJ’s definition of unsafe and unsound practices as well as the Fifth Circuit’s reasoning in Gulf Federal. Instead, the Comptroller reiterated the Horne definition, explaining that “the OCC and other Federal banking agencies consistently have relied on this definition in bringing enforcement actions.” The Comptroller, however, upheld the dismissal of charges against Mr. Adams on equitable grounds, preventing the court of appeals from reviewing the case.

The Adams case provides the most recent comprehensive guidance from a regulator as to what constitutes an unsafe and unsound practice. Unfortunately, the OCC’s definition allows the regulators to determine after-the-fact and with little advanced guidance whether a given practice is unsafe or unsound. Making matters worse, the OCC’s definition of unsafe and unsound practices includes any conduct that exposes a bank or its shareholders to risk of loss, without regard to whether the conduct threatens the financial stability of a bank.

The recent controversy surrounding the FDIC’s enforcement activity in connection with tax refund anticipation loans illustrates the problem with the regulators’ approach. Although no regulations or formal guidance prohibited refund anticipation loans, the FDIC took action against banks that offered such loans, believing them to be unsafe and unsound. The FDIC was even accused of manipulating bank exams to support a pre-determined conclusion that refund anticipation loans were unsafe and unsound. The FDIC Inspector General criticized the FDIC for creating “rules by enforcement” instead of issuing formal guidance. In a related congressional hearing, Rep. Sean Duffy explained the problem with the FDIC’s approach:

“It is hard enough to comply with rules that are put out that people are trying to read and try to comply with but it is even harder when you have a regulatory body of our financial industry that tries to enforce first and give guidance later. We should know what the rules are, the rules of the game should be clear.”

Source: Bank Lawyer’s Blog

Like the Adams case, this situation demonstrates that allowing the regulators to make after-the-fact judgments about what constitutes an unsafe or unsound practice—in the absence of any formal guidance—makes compliance very difficult for banks. However, this appears to be the approach the regulators intend to take, regardless of whether a given practice threatens the financial stability of a bank. Given the regulators’ approach, prudent bankers should avoid loans, products, and practices that are new or unique and not already approved by the regulators. Although this may inhibit banks that wish to expand into new offerings, it is a best practice that will help banks avoid an enforcement action.

[Disclosure: I was on the trial team that defended Patrick Adams in the OCC’s enforcement action.]