The Collapse of Keystone

KEYSTONE, W. Va.u00e2u20ac”The regulators, packed in vans and cars, poured into this small Appalachian coal-mining town on Sept. 1, 1999, swelling its population by 10%. As stunned local residents looked on, they shuttered the financial institution that had become, quite literally, the lifeblood of their community. Throughout the 1990s, the First National Bank of Keystone was hailed as one of the top-performing banks in the nation. With a strategy focused on buying, packaging, and selling subprime loans on a national basis, it grew from a small community bank with $102 million in assets in 1992 to a $1.1 billion-asset behemoth seven years later. For Keystone, an impoverished Appalachian coal-mining town of 600, the growth of the local bank was a boon. Over two-thirds of the town`s tax base came from the bank, and many of its residents were both employees and shareholders. The bank`s leaders invested heavily in the community, owning the hardware store, gas station, and hotel, among other businesses. In the end, however, regulators concluded that First National`s apparent success was a house of cards. In August 1999, after years of suspicion, officials from the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. discovered that $515 million in assets claimed on the bank`s balance sheet had been sold to investors. The bank was subsequently shut down. What has emerged in the 20 months since is evidence that a fraud of epic proportions occurred here. In court filings, investigators allege, among other things, that top executives embezzled millions from bank coffers, forging documents and board minutes at will to support their scheme to both regulators and auditors.

They also have concluded that First National was insolvent nearly three years prior to its shutdown. The story of the First National Bank of Keystone`s spectacular rise and fall reads like a happy fairy tale gone terribly awry. Interviews, court filings, news accounts, congressional testimony, and a critical report on First National`s failure by the Treasury Department`s Office of the Inspector General (OIG) all paint a picture of a bank that pursued a high-risk strategy and grew rapidly, while brazenly battling regulators who long suspected something was amiss. Along the way, observers say, directors missed numerous red flags that, had they acted appropriately, could have averted the trouble they now face.

Founded in 1904, First National spent its first 70 years playing the role of traditional community bank. Both town and bank survived the Depression, lending credence to the motto emblazoned on the side of First National`s building: “Time Triedu00e2u20ac”Panic Tested.” During coal mining`s heyday in the 1930s and 1940s, the town`s “Cinder Bottom” area was a beehive of brothels and taverns catering to the miners` thirsts, and the bank apparently thrived. But as its backbone industry declined, so, too, did the community`s fortunes. By the mid-1970s, Keystone was a town with double-digit unemployment, crumbling sidewalks, and boarded storefronts. First Nationalu00e2u20ac”then with $17 million in assets, and only $5 million in loansu00e2u20ac”was teetering. In 1977, J. Knox McConnell, a Pittsburgh native with banking in his blood, arrived. McConnell, who worked for eight financial institutions over his career, had returned from a two-year stint as head of a U.S. Department of Interior development bank on the island of Saipan in Micronesia, and wanted to run a small bank in need of inspiration. He agreed to become First National`s chief operating officer on the condition that he could run things his way. The directors concededu00e2u20ac”but told him not to surprise them. In short order, he began butting heads with the board. In a 1992 interview with Bank Management magazine, he recalled instructing directors to aggressively solicit deposits. “One board member said, `We`re here to make policy.` And I said, `What`s the loan policy?` They didn`t know,” he said. Three years later, McConnell was promoted to chairman and president. Almost immediately, he invoked a clause in the bank`s bylaws which made the president responsible for director nominations, reducing the 14-member board to six members. The group included two insider friends from Pittsburgh, Billie Cherry and Terry Churchu00e2u20ac”a duo that formed the cornerstone for one of bachelor McConnell`s more infamous quirks: an all-woman workforce, known locally as “Knox`s Foxes,” which he claimed was meant to avoid disruptive office romances. Under his leadership, the bank showed dramatic improvement through the 1980s, as it reached beyond West Virginia in pursuit of growth.

McConnell began marketing discount mortgages to Pittsburgh doctors, eventually establishing an origination office in a Pittsburgh suburb. The move made sense. Even today, a three-bedroom home can be bought in Keystone for $12,000, while some of those doctors` homes were valued at more than $500,000. By 1987, the bank`s assets had grown to $65 million, even as the local economy registered an unemployment rate of 33%. Five years later, the bank, which had moved into the subprime mortgage arena, had assets of $102 million. The growth made First National the place where everyone wanted to work. It also attracted the attention of the OCC. Concerned about the bank`s securitization activities, the agency in 1992 began conducting annual onsite examinations of the bank. That first year, examiners concluded that First National lacked effective internal and external audit functions needed to verify account balances.

Bank officials signed an informal commitment letter, agreeing to take corrective actions prescribed by regulators.

McConnell contested examination findings early and often, trying to discredit examiners` work, while continuing to expand. In 1992, the same year the onsite examinations began, First National moved into a new line of business: purchasing subprime home-improvement loans, insured by the FHA`s Title One program, from other lenders, again bundling them into securities and reselling them. This intensified the regulators` oversight. In 1993, the OCC found, among other things, that First National`s audit functions hadn`t improved and that it lacked proper policies and procedures for handling the Title One loans. A revised commitment letter was signed in October of that year, with pledges from bank officials to address its deficiencies. A year later, however, the OCC issued a supervisory letter to the board, for repeated filings of inaccurate quarterly call reports. Regulators also became concerned about the accounting treatment of gains on the sales of loan-backed securities. The first signs of what could be called fraud were detected in May 1995, when the OCC issued criminal referrals to the local U.S. Attorney against two bank executives for falsifying bank records and misapplying bank funds. It also contacted the Internal Revenue Service about First National`s failure to file tax forms for two officials who performed appraisal services. The referrals made the bank`s insular management more surly toward examiners. The following year, basic documents, including trial balances and general ledgers, weren`t made available to examiners. “Bank management responses were so untimely that examiners did not have time to review them before having to move onto the next scheduled bank examination,” the OIG`s report states. It was a plan, the report adds: “By stalling the examination process long enough, examiners would eventually leave the bank with issues unresolved.” The one significant finding during the 1995 reviewu00e2u20ac”that the bank`s $130 million Title One loan portfolio was out of balance by as much as $12 millionu00e2u20ac”was attributed to the absence of basic accounting controls and poor computer systems. Based on the OCC`s findings, the FDIC lowered the bank`s CAMEL rating to “3”u00e2u20ac”a move that was upheld by an ombudsman on appeal. The Title One and subprime mortgage businesses both were growing rapidlyu00e2u20ac”so much so that McConnell had formed a subsidiary, Keystone Mortgage Corp., to manage it. In 1996, the bank bought and sold $725 million worth of Title One loansu00e2u20ac”about half of the national totalu00e2u20ac”and had its only clean examination of the 1990s. In hindsight, the mortgage unit would become the focal point for much of the fraud. But regulators didn`t know it at the time, and neither, the outside directors claim, did they. What was clear was that First National had become a powerful asset machine that needed deposits to thrive. To get them, McConnell offered rates as high as 200 basis points over market rate, attracting deposit brokers. Meanwhile, First National`s performance made it a darling among community banks. In 1995, the then-$235 million bank reported a return on equity of 81.35% and a return on assets of 7.44%. Capital levels stood at 16%u00e2u20ac”a tip of the hat to regulators` interest-rate risk concerns on securitizations. Three times in the mid-1990s, the American Banker named First National the top-performing small bank in the nation. But the regulators continued to tell a different story. In its 1997 examination, the OCC found numerous violations, including poor controls in the Title One program, poor internal audits, and more call report violations. The bank`s database was riddled with errors, and procedures for reconciling general ledger accounts were unacceptable. To examiners, it looked like First National officials might have been “sanitizing” information before providing it to them. Things were complicated by McConnell`s death in October 1997. Not wanting to issue a sharp enforcement action during a management transition, the OCC held off on its actions. Finally, in mid-1998, the OCC entered into a formal agreement with the bank`s board, with a list of stringent requirements for First National to follow. Unlike the earlier agreements, a formal agreement is legally binding. The agency also assessed each director with $10,000 in civil money penalties for submitting inaccurate call reportsu00e2u20ac”a figure that was later reduced to $2,000 each. But, as the OIG report states, “the dollar amounts assessed did not deter Keystone management from continuing to violate banking laws and regulations.” Indeed, the board reached full and timely compliance on just three of the 13 requirements set forth in the formal agreement and did not comply at all with some of the most serious requirements, including ensuring the accuracy of books and call reports, correcting violations of law, and implementing a strategic plan. Among the OCC-mandated steps it did take was to hire a national auditing firm, Grant Thornton, in July 1998 to go over its books. Grant Thornton gave the bank a clean bill of health late that year. It, now too, has been sued. But the OCC`s exams in 1998 found more of the same: inaccurate call reports, illegal acceptance of brokered deposits, and an unsafe concentration of mortgage loans on the books.

Additional civil money penalities, in the amount of $25,000, were initiated against six directors, while the board was directed to hire a new president. In February 1999, it hired a former OCC capital markets expert and consultant, Owen Carney, to run the bank. Carney, however, lasted less than two months in the job, after suggesting ways to simplify the bank`s paperwork and improve its accounting practicesu00e2u20ac”moves that might have uncovered the embezzlement. Just before the company`s annual meeting, according to an affidavit, Carney was told that the board wouldn`t make him a director and that he could no longer be president. Meanwhile, First National officials became more hostile toward OCC examiners. In 1999, regulators said their conversations were taped and their movements monitored by bank personnel. Bank officials went to court, obtaining a temporary restraining order against the OCC after allegedly discovering agency e-mails that disparaged the bank. OCC officials charged a forgery, saying the e-mail headings weren`t authentic. But the examination was halted for more than a week. A few days later, suspicious examiners sought permission to talk with First National`s loan servicers. In response, the bank ratcheted up its attempts at intimidation, bringing in security guards to “protect” bank employees.

Examiners “were subject to villification by bank officers, to really unprecendented obstruction, to attempts at intimidation, to surveillance by video cameras,” said then-Comptroller John Hawke, in testimony before Congress. Indeed, the examiners were so unnerved that they asked for, and received, U.S. Marshal escorts for their visits.

Regulators soon learned from two loan servicers that the bank only owned $38 million of $553 million in assets that were claimed on its balance sheet. First National officials contended that the discrepancy was the result of reporting errors by those servicers. But when OCC and FDIC officials visited the servicers the following week, they confirmed the discrepancy. Days later they declared the bank insolvent. At a fateful Aug. 30 board meeting, regulators confronted directors with their findings. When the board couldn`t come up with an explanation, they closed the bank. Today, the bank`s dingy brown stucco headquarters building stands vacant, plywood covering the spaces where windows once provided panoramic mountain views. While the well-kept houses built into that mountain bear testament to the bank-generated wealth that once made Keystone the envy of the region, the business closings and layoffs that have followed the bank`s collapse reflect a harsher reality. Shareholdersu00e2u20ac”many of them locals (employees owned more than half the shares) who bought into the stock when it was trading above $300 per shareu00e2u20ac”have watched $132 million in market capitalization evaporate. Meanwhile, some 500 depositors, most of them from the Keystone area, lost approximately $15 million in deposits that exceeded the FDIC`s $100,000 insurance limit. The FDIC estimates that the bailout will cost the Bank Insurance Fund between $750 million and $850 million, making it one of the 10 most costly failures in history. In the flurry of ensuing finger-pointing, the FDIC and the OCC, the primary regulator for national banks, have been criticized in Congress and elsewhere for not pursuing the red flags it found in examinations more aggressively. The OCC conducted onsite examinations of First National for eight straight years, citing it for numerous violations along the way, yet didn`t discover the fraud until just before closing the bank. As a result, examiners have stepped up their own fraud-detection effortsu00e2u20ac”something many banks will experience in the form of longer, more intrusive examinations (see sidebar). In the closure`s aftermath, two inside directorsu00e2u20ac”Terry Church, an executive vice president, and Michael Graham, president of the bank`s mortgage subsidiaryu00e2u20ac”are serving federal prison terms for obstructing bank regulators after burying bank records on Church`s ranch outside of Keystone during the bank`s final months. Billie Cherry, the bank`s chairwoman, faces federal fraud charges for allegedly forging documents related to the estate of the former chairman, J. Knox McConnell. Meanwhile, First National`s four outside directors have been sued in shareholder lawsuits for breaching fiduciary responsibilities and stand accused by the FDIC of “gross negligence” for failing to properly oversee the bank`s activities and catch the fraud. Those directors have rebutted the charges, saying thatu00e2u20ac”like the regulatorsu00e2u20ac”they were duped by management into believing the bank`s activities were safe and legitimate. They also claim to have been unaware of illicit payments made to First National executives, or of the broader fraud that occurred. But none of that has eased the embarrassment of being connected with the failure. “The turmoil this has caused for the directors is very significant,” says Michael Carey, a Charleston, West Virginia attorney who is representing the four outside directors. “To discover that the bank failed due to the fraudulent activities of its officers is quite troubling. And then, from a personal standpoint, to have had their lives upended with all of the ongoing litigation… It has caused them a great deal of personal anxiety.” For outside directors of banks everywhere, the rise and fall of First National should serve as a cautionary tale about the roles they must play in helping safeguard against fraudulent activities in their own institutions and the personal liability they ultimately might be forced to shoulder if they fail to maintain proper vigilence. First National`s directors declined to be interviewed for this story, and much remains unknown about the specific details of the case or how everything will sort out. In an October 2000 U.S. District Court filing, however, the four outside directors asserted their innocence, arguing that federal investigators “simply do not have facts showing wrongful conduct on the part of any of the individual outside director defendants.” In its own court filings charging former managers with wrongdoing, the FDIC has essentially said the same thing, noting that key bank documents, and even copies of board minutes, were forged by director-level managers. “The FDIC has affirmatively stated that the actions of [the inside directors] were done intentionally to keep what was happening from the outside directors,” Carey says. “And on top of that, neither the internal and external auditorsu00e2u20ac”nor the OCC, which had been examining the bank in much greater detail than most any other bank in the countryu00e2u20ac”never discovered fraud. So clearly, I don`t think the outside directors have any liability here.” But experts say that ignoranceu00e2u20ac”or even regulator misstepsu00e2u20ac”are poor defenses for outside directors of a bank found to be engaging in fraudulent activities. “Being duped is not a defense,” says John Douglas, chairman of the financial services group for Alston & Bird in Atlanta, and a former FDIC general counsel. “The defense for a director in proceedings like this has to be, `I gathered the facts that a reasonable person would have gathered; I examined the facts the way a reasonable person would have examined them; and I made the kinds of decisions that a reasonable person would make based on those facts,`” Douglas says.

Yet bank fraud is a complicated business, and when it comes to directors` responsibilities and liability, nothing is clear cut. Dan Bailey, a partner specializing in director and officer liability for Arter & Hadden in Columbus, Ohio, says the law doesn`t specifically require directors to ferret out all wrongdoing that might occur in a company. Directors, Douglas adds, are not “guarantors” of the behavior of officers. If a board establishes the proper policies and procedures, and has strong and independent audit functions, “then the fact that you miss something is not considered the directors` fault,” Douglas says. “When you see a car wrapped around a phone pole with the directors standing beside it, it might be that those directors should have prevented the wreck. But it also may be that they had no ability to stop it. Distinguishing between the two is important, and regulators are supposed to analyze that before bringing charges.” If, on the other hand, it can be shown that the board lacked the appropriate procedures and independence to ensure safety and soundness, look out. “You can get into trouble if there were events or circumstances in which a reasonable person would have said, `Let`s look into this some more,`” Douglas says. The stakes in all this can be incredibly high. While all corporate directors have duties of loyalty and care, bank directors must sign an FDIC oath that allows the agency to seize their personal and business assets in the event of a failure. Most director and officer liability insurance policies won`t cover gross negligence charges brought by regulators, and banks are not allowed to indemnify against such charges. Perhaps most daunting, bank director defendants face the prospect of having the federal government for a plaintiff. This is more than mere theory. Bert Ely, an Alexandria, Virgina banking consultant, provided expert testimony in gross negligence cases brought against thrift directors in the late-1980s and early-1990s. “There were hundreds of S&L directors who were bled dry by legal fees and awards because they allowed fraud to occur,” he recalls. The good times of the past decade have dulled some of those memories, but the potential penalties against directors under FIRREA and FDICIA are even tougher today, thanks in large part to the thrift bailout. To protect their institutions and investors from being victimized by insider fraudu00e2u20ac”and themselves from lawsuitsu00e2u20ac”directors are expected to monitor the operations of the company and its officers closely, set policies and procedures, ask pointed questions, and “act reasonably under the circumstances,” Bailey says. Writing in the February issue of RMA Journal, FDIC Review Examiner Karen Jones Currie said bank boards must ensure that all significant activities are covered by written policies that are communicated clearly to employees. These should include procedures (including a system of internal controls) designed to foster sound practices, comply with laws and regulations, and protect the institution against crimes, and allow for independent third-party reviews of those policies. (See box on page 18 for more risk-reduction steps.) Bank boards also are well-advised to heed the time-honored fraud-prevention practice of requiring all employeesu00e2u20ac”including top executivesu00e2u20ac”to take uninterrupted vacations of at least two weeks a year. As Jones Currie notes, “Any substantial embezzlement usually requires the constant presence of the embezzler … to prevent detection.” At the board level, independence is the crucial building block to fraud-prevention efforts, says Charles Elson, director of the corporate governance center at the University of Delaware. The primary role of any board is to “independently monitor the performance of management for the benefit of shareholders,” he explains. That means carrying “a healthy skepticism” of management and challenging at least some of its proposals. Douglas recommends that directors periodically vote “no” on management proposals, simply to “establish an atmosphere where people feel free to challenge things.” Achieving independence can be a largely structural and procedural effort. Bob Calvert, a Roswell, Georgia bank-board consultant, argues that all boards should have a majority of outside directors and that the chairman should not be a bank official. And Elson says that modern corporate governance practice dictates that directors be nominated by a committee of outside board members. “If the president or CEO picks the board directly, it becomes very difficult to oversee that individual`s performance.” Perhaps above all, knowledge and information is the key to attaining independence. “You have to trust management, but verify that what they`re telling you is accurate,” Ely says. A board must ensure that both internal and external audits are done properly and that the reports go straight to directors, without management interference. “The auditing function is where fraud and embezzlement are caught,” Calvert says.

“It`s where an independent board verifies that what management is saying is true.” For many boards, attaining this kind of independence can be difficult. Despite repeated warnings, it`s still common practice for an auditor to simply turn over his findings to the CEO, without providing uncensored copies to all directors. Worse, directors may be loathe to challenge officers on bank-related matters, and they can even find themselves relying on management for guidance in the same areas where a fraud might occur. Calvert says he`s attended board meetings “where management will say, `Well, this is the way it`s done in banking.` And the directors will say, `Well, I`m not a banker, so I guess he`s right.`”

These are the actions that ultimately may leave directors open to penalties and lawsuits. “The law is clear: the buck stops with directors. They have absolute liability, and they`ve given the FDIC permission to attach their assets if there`s a judgment against them,” Calvert adds. “When you have everything at stake like that, you can`t just sit back and let things happen. That`s gross negligence, and if a board allows it to occur, it ought to be liable and prosecuted to the full extent of the law.” A review of the First National board`s efforts and structure, and of the evidence that has emerged since the closing, presents a mixed picture. The board had a bare majority of outsiders, but they were nominated by the chairman and most had served long terms. While they claim to have been unaware of the fraud that was occurring within the institution, observers say numerous red flags generated by the regulatorsu00e2u20ac”and the bank`s own fast growthu00e2u20ac”should have piqued directors` interest and oversight. From 1992 through 1999, OCC officials, concerned about the bank`s rapid growth and loan securitization activities, conducted onsite examinations in Keystoneu00e2u20ac”an unprecendented level of scrutiny, according to Calvert. During that time, the bank and its directors were fined for lacking effective audit functions, falsifying bank records and numerous call report discrepancies. Yet the OCC didn`t move to close the bank, and instituted penalties that were far below the guidelines for a bank as seemingly troubled as First National. Meanwhile, top executives portrayed the OCC`s increased scrutiny as a vendetta by regulators bitter over the success of a small, rural bank. They were often belligerent, challenging and threatening OCC officials. This “us-against-them” mentality reportedly played well in Keystone, and the OCC`s reticience to take harsher actions against the bank is cited by directors as part of their defense. Ely, who has studied First National`s failure in detail, says that the OCC should have taken a tougher stand with the bank. But the actions it did take should have been more than enough to spur directors to get aggressive in their monitoring of the institution. “This bank was so completely out-of-character for a community banku00e2u20ac”not only in the way it was trying to make money, but also in the shape of its balance sheet and the questionable assets on itu00e2u20ac”and the OCC was in there constantly,” Ely says. “The directors might have been in over their heads and bought management`s story. But I don`t know how they could not have known what was happening, or at least had suspicions.” In the nearly two years since the closing, FDIC forensic examiners have concluded, among other things, that at the end of 1996 First National overstated its loan holdings by at least $288 million, leaving it technically insolvent three years before the shutdown. The FDIC also has alleged that top executives embezzled at least $25 million by charging the bank bogus “due diligence fees” in connection with its subprime lending program, funneling the proceeds into an insider-owned shell corporation. It was an apparently lucrative business. According to an FDIC court filing, McConnell`s net worth soared from $708,275 at the end of 1989 to $17.9 million six years later, “almost entirely due to the receipt of embezzled funds and the fraudulent inflation of the value of his Keystone stock.” The money executives made from this ruse, in turn, fueled the bank`s drive to buy and bundle more risky loans. Top insiders “continually recommended the program to the board,” an FDIC filing statesu00e2u20ac”not to benefit the bank, “but to provide themselves with the opportunity to embezzle millions of dollars.” Eventually, First National collapsed under the weight of the risks it bore. Under pressure from prosecutors, Graham, the mortgage company president, admitted last November that he and other officials laundered embezzled funds through dummy accounts, while doctoring bank ledgers, balance statements, and board minutes to conceal the thefts. Such deception is at the core of the outside directors` defense. In a deposition, First National director and local attorney Michael Gibson testified that he consistently believed Church and Graham when they said the regulators` charges were baseless. The two “had been consistently and persistently representing … that the income was coming in from those loans,” Gibson testified. “And that`s how we, as the directors, were saying, … `We`ve got income coming in, it`s bound to be a computer error.`” When he learned of the fraud from auditors in late August, Gibson testified, he moved to fire Church and Graham. “I knew that we now had two people in the bank who had misrepresented things to … us as directors,” Gibson testified. He said four directors discussed the matter. “We voted to put them on administrative suspension.” But the suspensions never became official, and the next day the bank was closed. In a separate affidavit, Gibson also said the directors didn`t know about the “due diligence” fee payments that executives skimmed from the loan program. Rather, he and the FDIC contend, phony board minutes and documents approving the fees, allegedly signed by the directors, were filed by the insiders. Attorney Carey says the lesson for other directors is clear: “Always be cognizant of the fact that somewhere down the road, due to the intentional acts of wrongdoing by others, you could find yourself caught up in litigation that can be disruptive for you and your community.” That, no doubt, is true, and First National`s directors may very well have been lied to during their tenures. But that may prove a poor defense against the gross negligence charges the directors now face. Ultimately, a court will be forced to decide whether those directors acted in a reasonable and independent manner and provided the proper oversight. It`s a tough call, at best. But for directors of other institutions, the real lesson of First National`s failure is that serving on the board of a bank isn`t as simple or risk-free as it might appear to be on the surface. “If red flags are identified, and the board is put on notice by regulators, then directors could have a serious problem if they don`t react,” Douglas says. The best advice is to be vigilent and think for yourself. “Ask a lot of questions, don`t be afraid to vote against something that doesn`t feel right, and make sure your audit and compliance functions work,” Alston & Bird`s Douglas says. Otherwise, you could find yourself claiming ignorance in depositions while your shareholders and community suffer.