Federal court calls into question the constitutionality of bank enforcement actions

In a major blow to the bank regulators’ enforcement powers, the Fifth Circuit Court of Appeals has stayed an FDIC order of removal, finding a strong likelihood that the FDIC’s use of administrative law judges (ALJs) violates the Constitution. The case is Burgess v. FDIC and arises from the FDIC’s allegation that Cornelius Campbell Burgess, a director and former officer of Herring Bank, violated bank laws and regulations by charging personal expenses to the Bank. The FDIC sought a civil money penalty and order of removal and prohibition against Burgess. An FDIC ALJ recommended granting the civil money penalty and the order of removal (a decision I wrote about here), and the FDIC Board accepted the recommendation. Burgess appealed the FDIC’s decision to the Fifth Circuit and asked the court to stay the implementation of the order of removal until deciding the merits of the case. On September 7, the Fifth Circuit granted Burgess’s motion to stay.

The Administrative Action

Burgess currently serves as a director of Herring Bank and previously served as the Bank’s president. During his tenure as president, FDIC examiners took issue with the Bank’s expense management practices, including the absence of proper records to substantiate expenses and the fact that Burgess was permitted to approve his own expenses. In 2011, these issues culminated in a Memorandum of Understanding with the Bank. According to the FDIC, the Bank’s and Burgess’s expenses management practices did not improve after that time. Burgess ultimately resigned as president of the Bank, and in 2014, the FDIC charged him with engaging in unsafe and unsound practices, breaching his fiduciary duties, and violating Regulation O because of his expenses management practices at the Bank.

On January 11, 2017, an ALJ recommended sustaining the FDIC’s charges and issuing a $200,000 civil money penalty and an order of removal and prohibition against Burgess. Burgess objected to the recommendation, but the FDIC Board rejected his arguments and accepted the ALJ’s recommendations. The Board found that Burgess used Bank credit cards for personal expenses in violation of Bank policy, made cash withdrawals from bank funds to cover expenses without documentation, and violated other policies in connection with the management and reimbursement of expenses.

In addition to these factual findings, the Board also made several notable legal conclusions. First, the Board rejected the Gulf Federal standard for defining unsafe and unsound practices. As I have written previously (herehere, and here), several courts follow the Gulf Federal standard, which requires a showing that the challenged actions threatened the Bank with failure. The Horne definition, on the other hand, is the more lenient standard preferred by the regulators and defines unsafe and unsound practices to include “conduct deemed contrary to accepted standards of banking operations which might result in abnormal risk or loss to a banking institution or shareholder.” The Board concluded that it “is not bound by Gulf Federal, and it declines to apply the Gulf Federal standard here.” Second, the Board rejected Burgess’s argument that he should not be penalized for his alleged misconduct when there was no written standard or published guidance defining what the FDIC considers a personal expense versus a business one. The Board noted that “a published definition might be helpful for ambiguous expenses, [but] no definition is needed for the common sense judgment” that more obvious expenses are personal in nature. Finally, the Board rejected Burgess’s constitutional challenge to the administrative procedure employed by the FDIC in enforcement actions.

The Fifth Circuit Decision

Burgess appealed the FDIC Board’s final decision to the Fifth Circuit Court of Appeals. He challenged virtually all of the Board’s legal conclusions and also requested a stay of the removal order since it would require the Bank to immediately remove him from his position as a director. On September 7, 2017, the Fifth Circuit granted Burgess’s motion for a stay. Although Burgess raised several arguments in his filings, the court focused on his constitutional challenge to the FDIC’s administrative process. The argument centers on the Appointments Clause of the Constitution, which sets forth the manner in which different categories of government employees and officers may be appointed. One of the categories is an “Inferior Officer,” which is someone who exercises “significant authority pursuant to the laws of the United States.” These Inferior Officers may only be appointed by the President, a court of law, or the head of a department.

The Fifth Circuit concluded that Burgess made a strong showing that he would likely succeed in proving that the FDIC ALJ is an Inferior Officer, serving in violation of the Appointments Clause because he was not appointed by the President, a court, or a department head. The court reasoned that the ALJ position is established and defined by a statute, carries out important functions, and exercises significant discretion. As the court recognized, the ALJ is closely akin to a judge and wields significant power over bank officers and directors in enforcement actions. Based on these findings, the Fifth Circuit stayed the FDIC’s order of removal until the court can fully consider the merits of the case.

Conclusion

The Fifth Circuit’s ruling is significant because it calls into question the enforcement process that all of the bank regulators use. There is now uncertainty regarding whether the FDIC, OCC, and Federal Reserve (not to mention the SEC and other agencies that use ALJs) can continue to bring enforcement actions in the administrative setting rather than in federal courts, where defendants have more procedural rights and protections. Although this is only an interim ruling until the Fifth Circuit considers the merits, the decision signals the direction the court is leaning. In addition, Burgess will have the opportunity to litigate his other arguments in front of the Fifth Circuit, including the FDIC’s rejection of the Gulf Federal standard and the apparent lack of notice and due process. Bank directors and officers should follow this case closely, as it could provide guidance and clarity on appropriate expense management practices and also could change the way bank regulators file enforcement actions going forward.

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