SEC, Bank Settle Action Tied to Loan Loss Reserves

Since the market crisis the Commission has brought a series of enforcement actions centered on the failure of financial institutions to properly evaluate their loan loss reserves. Those issues are not solely the result of that time period however. To the contrary, they continue as a recent case illustrates. In the Matter of Orrstown Financial Services, Inc., Adm. Proc. File No. 3-17583 (Sept. 27, 2016).

Orrstown is the holding company of Orrstown Bank, a Pennsylvania chartered bank. Respondents Thomas Quinn, Bradley Everly, Jeffrey Embly and Douglas Barton were, respectively, the CEO, CFO, Chief Credit/Risk Officer and CAO of the bank.

In 2010 the firm had a loan policy which governed its review process. Loan reviews were to be performed by a Loan Review Officer, supervised by Mr. Embly and the firm’s Credit Administration Committee. The policy required a risk review of 45% to 60% of the bank’s total outstanding loan portfolio annually. A risk rating was to be assigned to each loan. As a practical matter all commercial loans with a balance of $750,000 or more were reviewed each year. The policy also required that quarterly the Loan Review Officer review the bank’s allowance for loan and lease losses to ensure the reserve was adequate. Here the bank did not properly follow those policies.

The key issue centers on three significant commercial lending relationships which involved the bank’s largest customers. Meetings were held with each customer. Messrs. Quinn, Everly and Embly attended the meetings. One customer had a total outstanding balance of about $28.8 million; a second had a balance of $12.2 million; the third had a balance of about $7.7 million. Each of the loans was impaired. The bank did not, however, disclose any of the loans as impaired.

In addition, Orrstown did not disclose the value of other impaired loans in its quarterly filings for the periods ended June 30, 2010 and September 30, 2010. During that period, the firm conducted an impairment analysis under its policy. GAAP requires that loans with an impairment loss be disclosed. The bank’s policy required that where the loan’s carrying value exceeded the estimate of the collateral’s net realizable value, an impairment loss be recorded in the amount of the difference. Although the analysis was conducted, in certain instances the bank failed to include the impairment on the schedule of impaired loans. This caused the quarterly filings to be incorrect. The bank also failed conduct its loan loss calculation in accord with GAAP and to maintain the proper books and records. In this regard its internal controls were not adequate. As a result there were violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B).

To resolve the action each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order except, the order as to Mr. Barton was only based on the cited Exchange Act Sections. In addition, the bank will pay a penalty of $1 million; Messrs. Quin, Everly and Embly, will each pay $100,000 and Mr. Barton $25,000.

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