In this issue:

• From One Big House to Another - Lessons Learned from the Community Bank Prosecutions
  
• Trends in 2009 Public Stock Offerings by Financial Institutions
  

From One Big House to Another - Lessons Learned from the Community Bank Prosecutions¹

Each day, on the way to and from the Guntersville, Ala. post office, Mike Alred passed a nondescript construction site. For a period of several months in the spring of 2000, Alred rarely, if ever, saw any workers at the site and its progress reflected that fact. Months after the project began, only a small amount of demolition and excavation work had been performed. In a vacuum, these facts were not particularly significant; construction projects often vary in scope and speed. The lack of measurable development at a given site might result from any number of causes, including permitting issues, financing difficulties, or priorities at other locations.

But this site was not just any construction project - it was the proposed new home of the Guntersville branch of Community Bank, Alred’s employer. As an Area Vice President, Alred oversaw numerous branches and served as an inside director on the bank’s board. In that capacity, he had access to information that transformed the lack of progress on the Guntersville site from a minor curiosity into a major concern.

In the same months that Alred noted the cessation of activity on the Guntersville site, Community Bank’s fixed asset reports reflected that the institution was paying contractors hundreds of thousands of dollars for work supposedly performed there. Alred’s concerns were elevated when he learned that the companies receiving these substantial sums were also the primary contractors working on the construction of a 17,000 square foot mansion owned by Kennon Patterson, Community Bank’s CEO. After further investigation conducted with a select few individuals (including Mike Bean, then the bank’s CFO, and George Barnett, an outside director), it became clear that Alred was witness to a massive fraud on Community Bank, orchestrated by Patterson and carried out by Larry Bishop, the Bank’s Executive Vice President, and two contractors, Morgan City Construction, Inc. and J&M Materials, Inc. Voicing his suspicions made Alred a pariah at Community Bank and ultimately cost him his job. After years of hard-fought civil litigation and criminal prosecution, the courageous actions of Alred, Bean, and Barnett—while others stayed silent—played a major role in the government’s efforts to obtain five criminal convictions and terms of imprisonment for Patterson, Bishop, and each of Morgan City and J&M’s principals.

Telling the full story of the Community Bank prosecutions requires more time and space than this forum allows. But even a cursory review of that history provides important lessons about directors’ and officers’ ability to detect and obligations to report insider fraud, the importance of meaningful internal controls to protect financial institutions from such activity, and the need to foster a culture that encourages those charged with guarding the institution’s interests to ask difficult questions. In the end, the legacy of Community Bank is to provide a cautionary tale to directors and officers, and in fact all employees, at insured institutions.

At its core, the Community Bank scheme involved Patterson and Bishop abusing the trust placed in them by Community Bank by causing bank funds to be paid for the construction of Patterson’s mansion instead of for the construction of new branch locations. In essence, it worked as follows. Bishop, acting in his capacity as the de facto general contractor on bank projects and on Patterson’s mansion, selected certain contractors to provide construction services at both locations. Those contactors who were complicit in the scheme simply performed construction services on Patterson’s mansion and then submitted invoices to Community Bank for payment. Other contractors were unknowingly and unwittingly made participants in the fraudulent scheme, in that they were directed by Bishop to perform work at both locations but to submit either generic or combined bills for payment. Bishop would then approve payment by the bank for work done at other locations.

In both situations, Bishop’s signature alone was sufficient for the bank’s accounts payable department to process the invoices. These purposely lax internal controls allowed Bishop to function as the sole individual empowered not only to select which companies were awarded bank construction work, but also to authorize payment of bank funds to those companies. Millions of dollars flowed out of the bank’s coffers with nothing more than the notation “Larry” handwritten on invoices indicating that the payment was proper.

While Community Bank and its holding company, Community Bancshares, each maintained boards of directors, the overwhelming majority of those boards’ members were nominated by, friendly with, and ultimately beholden to Patterson. For whatever reason – loyalty to Patterson personally, a desire to maintain the beneficial financial relationship they enjoyed as the result of their status as directors, or a failure to appreciate the scope of their obligations – directors never challenged Patterson. Numerous long serving directors acknowledged that they could not recall a single vote by anyone against Patterson’s proposed actions, much less an outright denial by the board.

Several important lessons emerge from the Community Bank prosecutions. First and foremost is the need to encourage individuals associated in all aspects with insured institutions—whether they are employees, officers, or directors—to ask difficult questions and demand complete answers about how the institution’s funds are being spent. Far too often, individuals either knowingly turn a blind eye toward potential red flags or simply settle for unsupported or incomplete answers to questions about these issues. Although the scope of the moral duty owed by bank insiders can be debated, there is no question that officers and directors owe a legal duty to protect the interests of the institutions they serve. While it is without question that those who elevate their own personal financial interests over the interests of the institution fail to fulfill these duties, it should also be equally clear that those who fail to conduct a reasonable inquiry into apparent wrongdoing are also blameworthy. Ultimately all bank employees, officers and directors fulfill their obligations to the institution the same way—by maintaining a vigilant watch for red flags and asking tough questions when they appear.

The Community Bank prosecutions also highlight the need for meaningful internal controls in order to detect and deter fraudulent activity. Larry Bishop operated in an accounts payable system constructed for the sole purpose of allowing him to defraud Community Bank. His abuse of the trust that system placed in him was essential to the scheme’s success. Not only was construction work on Community Bank projects not bid—meaning that nothing prevented Bishop from choosing whoever he wanted—but Bishop, acting in his sole and absolute discretion, was the only person empowered to decide not only who got paid, but also when and how much. Concentrating this much authority—effectively allowing one individual to control the disbursement of millions of dollars in bank funds without any oversight—was a recipe for disaster. That is exactly what resulted. The Community Bank case should make clear not just that measures such as dual controls are necessary but also that the scope of the risk should serve to define the nature and extent of the necessary internal controls.

In the end, no amount of precautionary measures can serve as an absolute deterrent to insider fraud and abuse. In the words often attributed to noted bank robber Willie Sutton, banks have been and will continued to be targets for fraud—from both external and internal sources—because “that’s where the money is.” Nevertheless, those familiar with history can avoid repeating it. If nothing else, Community Bank provides an important lesson in the annals of the history of insider financial institution fraud.

Contributor: William C. Athanas

[1] The facts reviewed herein are drawn from publicly available sources, including evidence offered during court proceedings, decisions issued by the Eleventh Circuit Court of Appeals, and information recounted in media coverage.


Trends in 2009 Public Stock Offerings by Financial Institutions

To assist clients in staying in front of the issues that affect their businesses, Waller Lansden monitors events and activities in selected industries and reports on emerging trends, opportunities, and challenges. In the banking and financial services industry, one positive trend is the improving market response to underwritten public stock offerings.

At the beginning of 2009, there was virtually no market for underwritten public stock offerings by financial institutions. In fact, none were conducted in January or February. By mid-year, however, the financial upheaval that marked the end of 2008 and the start of 2009 had begun to settle with respect to capital raising opportunities. In May 2009, 15 offerings were completed for an aggregate amount of more than $18 billion. Most of the May offerings were by larger banks, such as Wells Fargo, Bank of New York Mellon, and U.S. Bancorp, many for the purpose of paying back funds received through the TARP Capital Purchase Program. As of the end of October, the busiest month in 2009 in terms of the number of underwritten public stock offerings was September, with 17 offerings priced for an aggregate amount of over $3 billion. The average offering size had dropped significantly since May, primarily because markets have become receptive for offerings by smaller financial institutions and the larger banks planning on repaying TARP CPP funds had completed their offerings in the first half of the year. Although the number of underwritten public stock offerings and the size of such offerings tapered off somewhat in October (11 offerings for an aggregate amount of approximately $1.5 billion), markets still appear to be somewhat receptive to these offerings, which is good news particularly for community banks in need of capital.

Underwriters
The two firms that have served as underwriters for the most public stock offerings by financial institutions through October 2009 are Sandler O’Neill + Partners (31 offerings total, 17 as lead underwriter) and Keefe, Bruyette & Woods (26 offerings total, 16 as lead underwriter). Focusing on the middle of the spectrum with respect to size, the average size of these offerings for which Sandler O’Neill and KBW served as lead underwriter through October 2009 was $207 million and $111 million, respectively. By contrast, Goldman Sachs & Co., J.P. Morgan and Morgan Stanley served as lead underwriter for fewer offerings through October 2009 (10, 12 and 11, respectively), but these firms tend to underwrite the larger financial institution offerings. The average offering sizes for deals in which Goldman, J.P. Morgan and Morgan Stanley served as lead underwriter was $1.2 billion, $1.5 billion and $993 million, respectively. For banks looking to raise smaller amounts in offerings (less than $100 million), in addition to Sandler O’Neill and KBW, Fox-Pitt Kelton Cochran Caronia Waller, Raymond James and Stifel Nicolaus have each served as lead underwriter for multiple successful offerings through October 2009.

Underwriters’ Discounts
Through October 2009, the discounts that underwriters received on public stock offerings by financial institutions have ranged from 2.35% to 6.00%. These discounts reflect the percentage of the aggregate offering proceeds that the underwriters retain in exchange for their services. In general, as the offering amount increases, the underwriter discount decreases. For example, the underwriters’ discounts for all offerings in excess of $1 billion was between 3.75% and 2.35% through October 2009. Therefore, the larger banks that raise comparatively large amounts of capital have paid lower percentage commissions to the larger Wall Street firms. On the other hand, the underwriter’s discounts for all offerings under $300 million was between 4.5% and 6.00% through October 2009 (excluding the first offering of 2009 in March). Smaller banks looking to raise capital on the lower end of the scale have paid the higher commissions and should expect this trend to continue.

Underwriters’ Expenses
Typically, in the 20009 underwritten stock offerings of financial institutions, the underwriters received only a discount in exchange for services, although in some cases the issuer might also have to reimburse the underwriter for certain typical expenses, such as for FINRA filings or blue sky surveys. For some of the underwritten public stock offerings in 2009 where the financial institution issuer had a market capitalization under $300 million, however, the Underwriting Agreement also required the issuer to reimburse the underwriter for reasonable expenses it incurs. This reimbursement liability was typically capped at an amount between $100,000 and $225,000. Not all underwriters that conducted offerings for issuers in this market cap range, however, required such reimbursement. Those who did include such reimbursement provisions in the Underwriting Agreement were Fox-Pitt, Sandler O’Neill and Stifel Nicolaus. Whereas Fox-Pitt and Stifel Nicolaus have each only conducted one offering in this range, Sandler O’Neill required reimbursement for its reasonable expenses in nine out of 10 offerings in this range. Smaller community banks with a market cap under $300 million should be aware of such provisions when negotiating Underwriting Agreements.

Registration Statements
With any public stock offering, a registration statement must be filed with the SEC. Of the financial institutions that conducted underwritten public offerings through October 2009, almost half (49%) conducted the offering pursuant to an automatic shelf registration statement on Form S-3, which is generally only available to issuers with a public float above $700 million. A slightly smaller number (43%) used a standard shelf registration statement on Form S-3, and the remainder (9%) used a dedicated registration statement on Form S-1. Eligible public financial institutions that may need to raise capital at some point in the future would be well served to file a shelf registration statement on Form S-3 to minimize the time necessary to conduct an offering when the need arises and markets permit.

Contributor: David G. Wilson

The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.