==========================================START OF PAGE 1====== INITIAL DECISION RELEASE NO. 81 ADMINISTRATIVE PROCEEDING FILE NO. 3-8270 UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION ______________________ ) In the Matter of ) ) INITIAL DECISION BANK OF BOSTON CORP. ) December 22, 1995 ______________________ ) APPEARANCES: William H. Kuehnle and John J. Carney for the Division of Enforcement, Securities and Exchange Commission Bruce A. Baird and Jeffrey O. Cooper for Respondent, Bank of Boston Corporation BEFORE: Brenda P. Murray, Chief Administrative Law Judge ==========================================START OF PAGE 2====== CONTENTS FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . 2 Respondent . . . . . . . . . . . . . . . . . . . . . . . 2 CONCLUSIONS OF LAW . . . . . . . . . . . . . . . . . . . . . 6 BOB's internal reports: . . . . . . . . . . . . . . . . 12 OCC reviews and targeted exams: . . . . . . . . . . . . 15 Highly leveraged transactions (HLT): . . . . . . . . . 21 The New England real estate market . . . . . . . . . . . 22 ORDER . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 The Securities and Exchange Commission (Commission) instituted this proceeding pursuant to Section 21C of the Securities Exchange Act of 1934 (Exchange Act) on January 11, 1994. As pertinent to this proceeding, Section 21C provides: If the Commission finds, after notice and opportunity for hearing, that any person ... has violated ... any provision of this title, or any rule or regulation thereunder, the Commission may publish its findings and enter an order requiring such person, and any other person that is, was, or would be a cause of the violation, due to an act or omission the person knew or should have known would contribute to such violation, to cease and desist from committing or causing such violation and any future violation of the same provision, rule, or regulation. The issue is whether the Bank of Boston Corporation (BOB) violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 by misstating or failing to disclose in its Form 10-Q for the period April 1, 1989 through June 30, 1989, second quarter, material facts and known trends and uncertainties concerning the deterioration of its loan portfolio which BOB reasonably could expect would have a material unfavorable impact on its financial condition and results from operation. Order Instituting Public Proceedings. The Division introduced a great deal of evidence to show that sources inside and outside BOB had informed it that its commercial real estate portfolio had serious problems prior to August 10, 1989, the date on which it filed its second quarter Form 10-Q. BOB appears now to accept that fact. The issue has shifted to whether BOB's disclosure of these problems was sufficient. ==========================================START OF PAGE 2====== The record consists of 1,768 transcript pages of testimony from seven witnesses, including one expert, sponsored by the Division of Enforcement (Division) and two expert witnesses called by BOB, approximately 225 Division exhibits, and approximately 144 BOB exhibits. -[1]- The ten day hearing took place in May 1994. I granted requests that certain exhibits be treated as confidential and those materials should not be disclosed. Protective Orders issued February 15, 1994 and May 5, 1994. The arguments and proposed findings consist of six volumes. The Division filed a Post-trial Brief and its Proposed Findings of Fact and Conclusions of Law on July 22, 1994. BOB filed its Post-trial Brief and its Proposed Findings of Fact and Conclusions of Law on September 2, 1994, and the Division filed a Post-trial Brief and a Counter Statement to Respondent's Proposed Findings of Fact and Conclusions of Law on September 30, 1994. FINDINGS OF FACT My findings and conclusions are based on the record and my observations of the witnesses' demeanor. -[2]- I applied the ---------FOOTNOTES---------- -[1]- I know of only one pending evidentiary matter and that is BOB's objections to the receipt in evidence of Div. Ex. 10. I deny admissibility to Div. Ex. 10 but allow into evidence what was identified as BOB Ex. 404, the same report with the cover page. The exhibit is relevant because it shows when BOB received the formal written report that is discussed in the decision. -[2]- I have considered all proposed findings and conclusions and all contentions, and I accept those that are consistent with this decision. ==========================================START OF PAGE 3====== preponderance of the evidence as the applicable standard of proof. Respondent BOB is a bank holding company whose common stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act. BOB's principal subsidiary is the First National Bank of Boston and it is the actions of the bank that are at issue. I use the terms BOB and the bank interchangeably. In 1988 and 1989, BOB was one of about ten or eleven of this country's largest national banks whose primary regulator was the Office of the Comptroller of the Currency (OCC). OCC considered BOB a major multinational bank. Tr. 546-47. In 1988-89, Ira Stepanian was BOB's chairman of the Board of Directors and chief executive officer (CEO). -[3]- Mr. Stepanian started working for BOB in 1963, and he spent almost his entire career in commercial lending. He oversaw BOB's commercial lending portfolio in 1980-81 as executive vice president and chief lending officer. He became BOB president in 1983, CEO in March 1987, and chair and CEO in 1989. As CEO, Mr. Stepanian was responsible for BOB's public disclosures which included the 10-Q filing at issue here. Tr. 610. Mr. Stepanian personally decided the amount BOB should ---------FOOTNOTES---------- -[3]- Mr. Stepanian signed BOB's Form 10-K on February 28, 1989 as President, CEO, Executive Officer and Director. He signed the Form 10-Q on August 9, 1989 as Chairman and CEO. From this information I conclude that Mr. Charles K. Gifford, who signed the Form 10-K as Vice Chairman of the Board and Director, became BOB's President after February 28 but before August 9, 1989. ==========================================START OF PAGE 4====== include in its quarterly Income Statement as the Provision for Credit Losses (Provision Expense). Tr. 645. The Provision Expense impacts the company's profit or loss for the reporting period because it is a direct charge against earnings which is added to a balance sheet account called Allowance for Loan and Lease Losses (ALLL or reserve ). Tr. 50, 636-37. The purpose of the reserve is to cushion the bank's capital against losses in the loan portfolio. More specifically, the reserve is used to cover any losses that the company incurs from operations so that when a bank determines that a loan is no longer of bankable quality, it takes a "charge-off" which reduces the reserve and assets on the balance sheet. Tr. 48-51, 339-40. As a general rule, lower quality or higher risk credits/loans dictate higher reserves. Tr. 49, 166, 232, 1098. It was OCC policy that banks should determine that their reserves were appropriate each quarter. Tr. 241. In advance of making his decision each quarter on the adequacy of reserves, Mr. Stepanian received an internally generated report, Quarterly Adequacy Memo for Reserve for Credit Losses, that compared the amount that resulted from the average of two formulae - a non-accrual formula and a classified assets ==========================================START OF PAGE 5====== formula - with the amount that was in the reserve. -[4]- Div. Ex. 25, 26, 28; Tr. 319-20, 324-25. According to Kenneth H. Burt (Mr. Burt), BOB's director of financial analysis, the "formulae estimated the required Reserve for Credit Losses, excluding the Reserve for Transfer Risk." Div. Ex. 25, Sch. 1. BOB developed the formulae in 1984 in an attempt to predict what BOB's loan loss would be for the next twelve months. BOB Ex. 463; Tr. 369. The formulae used actual figures from a prior quarter. For example, to determine the adequacy of the reserve at the end of the first quarter of 1989, March 31, 1989, the formulae used actual figures as of December 31, 1988. -[5]- Tr. 394-95. The results of each formula and the ---------FOOTNOTES---------- -[4]- The non-accrual formula took 30 percent of total loans on non-accrual minus the non-accrual loans in Less Developed Countries (LDC) and adjusted that amount to a two year equivalent. The classified assets formula took a different percentage of each category of loans that BOB risk-rated according to its own rating system as W, 4, 5 , or 6. The formula reduced these amounts by the LDC loans, and adjusted the result to a two year equivalent. BOB made the two year adjustment in 1988 because OCC found that "benchmark" result of the formulae did not approximate the amount in the reserve. By increasing the percentage, the formulae produced a higher number which more closely approximated the reserve amount. Tr. 370-80. According to BOB's Director of Financial Analysis, "we souped it [the formulae] up for the benefit of the OCC." Tr. 374. BOB considered a credit with a risk-rating of 4 or higher to be a troubled credit. By BOB's definition a non-accrual loan was probably rated 4 or worse. Tr. 346-49. -[5]- This was the best (most recent) data BOB had on credits risk-rated as 4, 5, or 6 to use in the classified assets formula. It had more current data on non-accruals but used the last quarter's figures for comparability. Tr. 395-96. ==========================================START OF PAGE 6====== average of the two formulae were compared to the reserve on the Balance Sheet and the difference was referred to as the cushion, i.e., the difference between what was in the reserve and what the formulae indicated BOB should have in the reserve. OCC's Banking Circular 21 did not prescribe a method or methods for a bank to use to establish its reserve for loan losses, but required that the method used support the reserve amount, and that it provide reserves sufficient for one year's charge offs. Tr. 641. The OCC considered that the formulae were the documentation supporting BOB's determination that its reserve level was adequate. Mr. Stepanian's took a different position. To him the formulae satisfied regulatory requirements, but he placed little, if any, value on the formulae results. In his view, discrepancies between the results of the formulae and level of the reserve indicated problems with the formulae, not that the risk in BOB's real estate loan portfolio required a higher level of reserves. Tr. 720. Mr. Stepanian considered the formulae results just one piece of information or factor he used to judge whether or not BOB's reserves were adequate. Tr. 648-50, 887-89. Mr. Stepanian acknowledged that increased risk-ratings and levels of non-accruals, the key factors used in the formulae, were not positive occurrences. Tr. 722-23. Mr. Stepanian did not document how he decided whether or not the loan loss reserve was at an appropriate level to deal with problems in the loan portfolio. Tr. 634-36, 683. BOB's expert ==========================================START OF PAGE 7====== witness understood that Mr. Stepanian made the judgement on whether the loan loss reserve was adequate, but he could find nothing in the record that explained Mr. Stepanian's thought process. He could not understand from his review of the record what BOB did to judge the adequacy of the reserve. Tr. 1578-80. Events have demonstrated that Mr. Stepanian's personal judgment was not the best way to determine whether BOB's reserves were accurate, and that OCC was correct that accurate documentation and good risk identification remove much of the subjectivity. Tr. 306-07, 633-48, 671, 674-77, 680-83. Mr. Stepanian testified that: I think I started out saying that the level of reserves, the adequacy of reserves in my view translates - there's one item that is paramount in the establishment or determination of the adequacy of reserves, and that's judgment. There is no quantitative factor and there is no single qualitative factor that, taken by itself, will give me the right number. I don't know what the right number is. Tr. 656. I might sit down at a table like this one day at the end of a quarter and try to come up with what's the reserve. The reserve is a state of mind. It's what I think the economy looks like today and in the future, it's what I think our portfolio looks like, it's what I hear from our people, and it's my own perspective from 25 - 30 years of credit experience. Tr. 1002. BOB's Form 10-Q for the second quarter of 1989, filed August 10, 1989, showed a $36 million Provision Expense and net income of $97.8 million. BOB's Provision Expense had been $36 million in each quarter of 1988 and the first quarter of 1989. Div. Ex. 104; Tr. 398-99. ==========================================START OF PAGE 8====== In the third quarter of 1989, BOB had a Provision Expense of $370 million, an increase of nearly 1000% over the prior quarter, and an after-tax net loss of $125 million for the quarter. BOB Answer at 2. CONCLUSIONS OF LAW Section 13(a) of the Exchange Act requires that issuers of registered securities file periodic and other reports containing the information prescribed in the Commission's rules. Two rules and one regulation promulgated under this statutory provision are relevant here. Commission Rule 13a-13 requires an issuer to file quarterly reports on Form 10-Q, and Rule 12b-20 requires that an issuer supply "such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading." Item 303 of Regulation S-K requires Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) as part of quarterly reports filed pursuant to Section 13(a). Item 303 specifies that MD&A identify known trends, demands, commitments, events or uncertainties which are reasonably likely to result in the registrant's liquidity decreasing or which the registrant expects to have a material unfavorable impact on its revenues or income from continuing operations. Regulation S-K, Item 303(a). -[6]- ---------FOOTNOTES---------- -[6]- Item 303(a) provides: (1) Liquidity. Identify any known trends or any known demands, commitments, events or uncertainties that will (continued...) ==========================================START OF PAGE 9====== The Commission has required some type of MD&A since 1968. The purpose of the MD&A is to provide material historical and prospective textual disclosure enabling investors and other users to assess the financial condition and results of operations, with ---------FOOTNOTES---------- -[6]-(...continued) result in or are reasonably likely to result in the registrant's liquidity increasing or decreasing in any material way. ... (3) Results of operations. ... (ii) Describe any known trends or uncertainties that ... the registrant reasonably expects will have a material ... unfavorable impact on ... revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed. Instructions to Paragraph 303(a). 1. The registrant's discussion and analysis shall be of the financial statements and of other statistical data that the registrant believes will enhance a reader's understanding of its financial condition, changes in financial condition and results of operation. ... 2. The purpose of the discussion and analysis shall be to provide investors and other users information relevant to an assessment of the financial condition and results of operations of the registrant as determined by evaluating the amounts and certainty of cash flows from operations. ... 3. The discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. ... 7. Registrants are encouraged, but not required, to supply forward-looking information. This is to be distinguished from presently known data which will impact upon future operating results, such as known future increases in costs of labor or materials. ... ==========================================START OF PAGE 10====== particular emphasis on the registrant's prospects for the future. Exchange Act Release No. 34-26831 (1989 Interpretative Release), 43 SEC Docket 1577 (May 18, 1989). Issuance of a cease and desist order is appropriate because BOB, acting through Mr. Stepanian, violated the Exchange Act and rules thereunder because it knew or should have known when it filed its Form 10-Q on August 10, 1989, that its financials without explanation were misleading, and that known trends -[7]- and uncertainties in its real estate portfolio would reasonably be expected to have a material unfavorable impact on BOB's financial condition. Disclosure in the MD&A section of the Form 10-Q is required in situations such as this because BOB knew, or should have known, that (1) without explanation its financials were misleading, and (2) BOB's financial statements and accompanying footnotes were insufficient, without a narrative explanation, for an investor to judge the quality of earnings and the likelihood that reported financial information is not indicative of material changes in future operating results. Section 13(a) and Rules 13a-13 and 12b-20; Regulation S-K, Item 303(a); 1989 Interpretative Release, 43 SEC Docket at 1578. -[8]- No one who read BOB's second quarter financials in its Form 10-Q would have anticipated what management knew was highly ---------FOOTNOTES---------- -[7]- A general inclination or tendency; a direction of movement. Webster's II New Riverside University Dictionary, at 1231 (1984). -[8]- Required filings with the Commisssion must be timely, accurate, and complete. SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). ==========================================START OF PAGE 11====== likely to happen, and did happen, to BOB's earnings in the third quarter 1989. The 1989 Interpretative Release requires that management assess whether a known trend, demand, commitment, event or uncertainty is reasonably likely to occur. If it cannot make this determination, it must evaluate the consequences of the known trend, demand, commitment, event or uncertainty on the assumption that it will occur and make disclosure unless it determines that a material effect on its financial operations or results is not reasonably likely. -[9]- Applying that standard to this situation, BOB was required to disclose additional information because (1) its real estate portfolio had deteriorated significantly in value in 1988 and the first six months of 1989, and the evidence was that the deterioration was reasonably likely to continue, and (2) even if BOB could not make this determination, but assumed that the deterioration would continue, the record indicates that it was reasonable to expect that the impact on earnings would be material. BOB relies on the Commission's general rules and regulations issued pursuant to the Securities Act of 1933 (1933 Act), 17 C.F.R. 230.175(c), and VeriFone Sec. Litig., 784 F. Supp. 1471 (N.D. Cal. 1992), aff'd, 11 F.3d 865 (9th Cir. 1993), where the court found that the allegations amounted to no more than failure to disclose forecasts, to support its claim that the information at issue here is forward-looking information or projections that ---------FOOTNOTES---------- -[9]- 43 SEC Docket at 1580. ==========================================START OF PAGE 12====== BOB was not required to disclose. -[10]- VeriFone is distinguishable from this situation in several respects. It was a private litigation arising out of an initial public offering where the plaintiffs alleged violations of Sections 11 and 12(2) of the 1933 Act, Sections 10(b) and 20A of the Exchange Act, and Rule 10b-5 thereunder, Section 1507 of the California Corporation Code and the state law torts of fraud and negligent misrepresentation. 748 F.Supp. at 1475. The court did not focus on Section 13(a) of the Exchange Act or the Commission's rules that are at issue here so its statements are more akin to dicta than binding precedent. -[11]- Even if the court's legal analysis were applicable, the facts in this situation are quite different from VeriFone. Contrary to BOB's assertion, the projections which were the basis of the complaint in VeriFone are not "just the kinds of disclosure" that are at issue here. BOB Brief at 67. The undisclosed material differs both in its nature and magnitude. In VeriFone, the information concerned such items as slowing sales growth, revenue growth projections, projected unit sales declines, little growth in potential revenue, no ability to sell in new markets, etc., which the court characterized as forecasts of future events. 11 F.3d at 868 (emphasis added). This is not ---------FOOTNOTES---------- -[10]- For purposes of this discussion I have assumed that the definition of "forward-looking information" used in a different context in a different statute is relevant. -[11]- According to the Division, this proceeding appears to be the first litigated case involving the requirements of the MD&A. Div. Reply Brief at 52-53, n.52. ==========================================START OF PAGE 13====== the type of information that is at issue here. Behind BOB's use of the terms estimates, forecasts, and projections are facts. BOB knew that its real estate loans, which were a major part of its portfolio, had deteriorated significantly and were continuing to deteriorate, and it made filings which misrepresented this fact. -[12]- The reliable, "hard" information that BOB had is what the court in Verifone referred to. Absent allegations that Verifone withheld financial data or other existing facts from which forecasts are typically derived, the alleged omissions are not material, actual facts. 11 F.3d 865 at 869. -[13]- In addition, in VeriFone the undisclosed happenings were speculative and therefore unquantifiable. The fact that BOB's ---------FOOTNOTES---------- -[12]- All the evidence supporting this finding is detailed later. Some of this evidence is from Mr. Burt who used the terms estimates or projections in his memoranda. Mr. Stepanian seemed to rely on Mr. Burt's use of these terms as a basis for not acting on the information. Tr. 887. Mr. Burt's use of these terms did not make his memoranda "forecasts" within the meaning of VeriFone. Calculating the adequacy of the reserve was Mr. Burt's area of expertise. His participation at monthly meetings of two key BOB committees (Asset Liability and Charge-Off), and his communications with top BOB officials gave Mr. Burt the latest information. For example, his estimate of classified assets in Div. Ex. 29 is based on "mandated downgrades shown in DKM's [David McKown] list" which he received from Mr.Stepanian. Tr. 454. He had the actual figures on non-accruals. My observation of Mr. Burt and his testimony persuade me that he had reliable, fact based support for the figures that he used. -[13]- Mr. Burt informed Mr. Stepanian before August 10 that using the latest figures from June 30, 1989, in the formulae resulted in a $29 million preliminary deficiency in the reserve. At Mr. Stepanian's request, Mr. Burt quantified ways to "adjust" the reserve to eliminate the deficit. None of these adjustments included increasing the Provision Expense from what it had been in the last five quarters. Div. Ex. 29; Tr. 453-63. ==========================================START OF PAGE 14====== Provision Expense increased in the third quarter from $36 million to $370 million demonstrates that the amounts involved here were quantifiable and considerable. Finally, BOB is attempting to use a regulation, 17 C.F.R. 230.175(c), which shields issuers from fraud charges when they make projections with a reasonable basis or in good faith. This record shows that BOB did not act with a reasonable basis or in good faith when it filed its Form 10-Q for the second quarter 1989. -[14]- Next BOB erroneously relies on Bell Atlantic Corporation Securities Litigation, Nos. CIV.A. 91-0514, 91-0518, 91-0673, 91- 0737 and 91-0748, 1991 U.S. Dist. WL 234236 (E.D.Pa. Oct. 30, 1991), citing the 1989 Interpretive Release, 43 SEC Docket at 1582, to support its position. Like Verifone, the decision in Bell is distinguishable because the litigation was a private action, and the alleged violations did not include Section 13(a) of the Exchange Act, but Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5. In Bell, the court found that the company's Form 10-Q filing showed a decreasing rate of growth in operating revenues contrary to the plaintiffs' allegation that the company failed to disclose that its rates of revenue and expense growth would result in declines in revenue and return on equity. Thus, the court reasoned, there was no violation of Item 303(a). The court noted that "[i]f the companies knew of the events which ---------FOOTNOTES---------- -[14]- The record strongly suggests that BOB was able to report second quarter profits of $97.8 million by keeping its Provision Expense at $36 million even though it knew its reserves were inadequate. ==========================================START OF PAGE 15====== would likely impact material changes, failure to disclose them in a Form 10-Q would violate Item 303(b)." 1991 WL 234236 at 8. -[15]- That is exactly what happened here. The evidence is overwhelming that before August 10, 1989, Mr. Stepanian and others in top management positions at BOB, whose knowledge is imputed to BOB, knew or should have known that the future risk of loss in BOB's commercial real estate portfolio was considerably higher than was reflected from the financials for the second quarter, and that its loan loss reserve would not be sufficient to cover those losses. These persons knew, or should have known, in early August 1989 that BOB most likely would have to increase its Provision Expense substantially to add funds to its reserve and that the impact on its income statement would be material. -[16]- I find that on August 10, 1989, Mr. Stepanian and BOB knew or should have known with a reasonable degree of certainty, from ---------FOOTNOTES---------- -[15]- The court found that plaintiffs did not allege facts indicating that defendants "possessed concrete, reliable forecasts within their exclusive control which would require their disclosure." 1991 WL 234236 at 5. -[16]- BOB had 100 percent coverage of its LDC loans. Prior to June 1989, the reserve had substantial amounts which BOB designated for domestic (non-LDC) loans as they were no longer needed for its LDC loans. Mr. Burt's June 22, 1989, memorandum estimated that only $12 million would be transferred from the LDC reserve to the general reserve in the second half of 1989, as compared with $52 million in the first half of the year, because the major sales of the LDC portfolio had been completed. Div. Ex. 27. As noted previously, in July Mr. Burt quantified for Mr. Stepanian some ways to increase the reserve without increasing Provision Expense. Div. Ex. 29. ==========================================START OF PAGE 16====== information supplied by four independent sources - BOB's internal reports, information from OCC and other regulators, the highly leveraged transactions in its portfolio, and New England real estate values which had declined and continued to decline substantially - that its commercial loan portfolio had deteriorated significantly in value, that deterioration was continuing, that BOB's loan loss reserve was inadequate, and that adding to it would have a material impact on earnings. I find further that BOB was required to disclose this information in the MD&A section of its Form 10-Q for the second quarter 1989, and it did not do so. Information is often characterized as being of the type that should have raised red warning flags that something was awry. The following information went beyond red flags. Even a person who was color blind would have known with reasonable certainty, or should have known, based on the following information, that BOB had serious problems in its real estate portfolio that it did not disclose; these problems were not discernable from its second quarter financials; these problems would, or could reasonably be expected to, have a material impact on earnings and the results of operations. BOB's internal reports: A. On July 26, 1989, two weeks before BOB submitted its Form 10-Q, Mr. Burt informed Mr. Stepanian that application of the formulae methodology using estimated figures from June 30, 1989, resulted in a "preliminary deficit of $29 million" in the reserve ==========================================START OF PAGE 17====== as compared with a $33 million cushion using figures from March 31, 1989. Div. Ex. 29. This result using the most recent information revealed that the reserves would be inadequate. Mr. Stepanian also learned from the memorandum that from March 31 to June 30, BOB's loans on non-accrual had increased by over $200 million. -[17]- By any objective standard, this information was alarming and confirmed that the deterioration in BOB's real estate portfolio had continued into the second quarter. As noted, in this memorandum, Mr. Burt at Mr. Stepanian's request, quantified ways of "adjusting" the reserve without increasing the Provision Expense which would have had a negative impact on earnings. Tr. 453-63. Even accepting Mr. Stepanian's position that the formulae was only one indicator of the adequacy of the reserve, the substantial increase in non-accruals should have alerted him to serious problems since BOB considered non-performing assets (non- accruals and Other Real Estate Owned (OREO) as the key measure of the health of its real estate portfolio. BOB's Brief at 4 citing Tr. 1584. Mr. Burt's analysis should have been given considerable weight because he had a long career with BOB, he had helped develop the formulae which were the basis of the Quarterly Adequacy Memo for Reserve for Credit Losses which he prepared, and it was obvious from his testimony and demeanor that he was ---------FOOTNOTES---------- -[17]- The non-accruals, which were not estimates but actuals, went from $738.4 million to $953.4 million. Div. Ex. 29. ==========================================START OF PAGE 18====== knowledgeable and candid. -[18]- Mr. Stepanian called on Mr. Burt directly for this information. Tr. 463. B. On July 27, 1989, at a meeting of BOB's Board of Directors: Mr. Stepanian reminded the Directors that the estimate of the Reserve was based on published quarterly data as of the end of the preceding quarter. He then reviewed with the Directors an analysis of the Reserve assuming that June 30 non-accrual and charge-off figures had been used. He reviewed with the Directors the estimated computations as of June 30. He said that management believed that the proper level of the reserve would require close attention during the third and fourth quarters in view of the relatively high level of non- accrual loans and general economic conditions. Div. Ex. 128 at 2. This presentation demonstrates that Mr. Stepanian had real concerns about BOB's future earnings on August 10, 1989, which he should have disclosed in its public filing, and that absent this information the filing was misleading. It is impossible to tell from the minutes how candid Mr. Stepanian was with the Board, but it is clear that he came a lot closer to telling them what he knew about BOB's finances than he did in BOB's Form 10-Q filed two weeks later. C. On August 2, 1989, Mr. Burt in a memorandum titled "Adequacy of Reserve for Credit Losses" reported that OCC's Examiner in Charge at BOB was disturbed about the adequacy of the ---------FOOTNOTES---------- -[18]- Mr. Burt addressed his quarterly adequacy reports to BOB's Chief Financial Officer. Mr. Stepanian received copies and reviewed them. Mr. Burt served as secretary of the Asset Liability Committee, and he attended monthly meetings of the committee that dealt with troubled credits (Charge-Off Committee) with Mr. Stepanian and Mr. Gifford, BOB's president. ==========================================START OF PAGE 19====== reserve because BOB's internal Risk Review personnel reported that classified assets had increased by $2 billion. Div. Ex. 32. -[19]- Mr. Burt's preliminary figures showed that classified assets increased by $653.9 million between March 31, 1989 and June 30, 1989. Id. D. On August 8, 1989, Mr. Burt informed Mr. Stepanian that: ... the formulae are predicting one year's net loan losses to be around $230 million, which is well above last year's $134 million or the last 12 months' $146 million, so the formulae may be calling for a reserve level well in excess of that needed to cover two years of losses. Div. Ex. 33 at 2. E. On June 22, 1989, well before BOB filed its second quarter Form 10-Q, Mr. Burt expressed the following concerns about the adequacy of BOB's loan loss reserve in 1989. Div. Ex. 27. -[20]- 1. "Thus, the reserve appears to be adequate; but the cushion is going in the wrong direction in light of what appears to be on the horizon. ... In short, a good argument can be made that the present level of the reserve is barely adequate." Div. ---------FOOTNOTES---------- -[19]- According to Mr. Burt, Mr. Griswold, the head of Risk Review, a BOB department that did an independent rating of loans, used the term classified assets to include items beyond what Mr. Burt included in his definition, such as off balance sheet items. Tr. 466, 933. -[20]- Mr. Burt wrote this memorandum titled "Charge-Offs and Non-Accrual" because he was going on vacation and would miss the Charge-Off Committee meeting. Tr. 402-03. ==========================================START OF PAGE 20====== Ex. 27 at 2, 3. -[21]- It appeared to Mr. Burt that BOB's charge-offs in the second half of 1989 would be higher than they were in the first half of the year. Tr. 406-07. 2. Mr. Burt noted that the 1989 annual estimate of domestic, non-LDC, net loan losses had been $135 million, but that they could be $162.5 million ($62.5 million in the first half and $100 million in the second half). Div. Ex. 27 at 2; Tr. 405, 418. -[22]- 3. Mr. Burt noted that BOB's net charge-offs in the last half of the year could be $100 million, $25 million more than the present forecast, and that just to keep the reserve at the same level would require increasing the Provision Expense to $100 million in the second half of the year. Div. Ex. 27 at 2; Tr. 419. 4. Mr. Burt detailed scenarios which, assuming that the Provision Expense remained at $36 million in the second quarter of 1989, made it very likely that it would have to be increased substantially in the second half of 1989. Div. Ex. 27 at 3-4. Mr. Burt believed it was "quite unlikely" that additional ---------FOOTNOTES---------- -[21]- He meant that the cushion [difference or excess in the reserve over what the formulae project will be needed] is declining [from $48 million in the first quarter to $44 million in the second quarter] when the possibility was that net charge- offs would be greater in the second half of 1989 than they were in the first half of the year. Tr. 406-07. -[22]- BOB had one reserve, but it represented that its LDC loans were fully reserved. The parties differed on whether the LDC reserves were available for the entire portfolio. They agreed that recoveries on LDC loans in excess of the one hundred percent reserve were available for domestic loans. ==========================================START OF PAGE 21====== reserves would not be needed for troubled loans in the second half of 1989. Div. Ex. 27 at 4; Tr. 427. Mr. Burt recommended: Since the increase [believe reference is to non- accruals] in Real Estate seems more likely based on the past performance, I would propose that the second quarter's provision be increased from $36 million to at least $56 million. ... If there is a high probability that Heileman will go on non-accrual by year-end, then the quarterly provision should be increased to $70 million. Div. Ex. 27 at 4. OCC reviews and targeted exams: In addition to its twice a year Reports of Supervisory Activities (ROSA), OCC made several reviews or targeted examinations of BOB's real estate portfolio in 1988 and 1989. -[23]- The results of all these exams were alarming. OCC was highly critical of BOB's deteriorating real estate portfolio and the accuracy of the risk on the loans in its portfolio (risk ---------FOOTNOTES---------- -[23]- The three reviews or targeted exams detailed here were done by OCC personnel headed by a senior bank examiner, Joe Michael Hooks, in response to concerns of the OCC Examiner In Charge (EIC) at BOB. In addition to these exams, the OCC conducted an additional target exam of BOB's OREO, in March 1988 which revealed rising levels of OREO a usual indicator of a deteriorating real estate portfolio. Tr. 1050. Assets are put into OREO when a bank takes title to the collateral in lieu of repayment because the borrower was unable to repay the credit. Tr. 1051. Also, BOB's 1988 Shared National Credit (SNC) exam, a review of multi-bank loans of over $20 million, revealed the same concerns that had surfaced in the OREO exam. Tr. 1058-61. In the SNC exam the OCC, the Federal Reserve, and the Federal Deposit Insurance Corporation arrived at the classification jointly. The quality of BOB's real estate loans was an issue in the 1988 SNC exam. Tr. 1063. ==========================================START OF PAGE 22====== assessment). This assessment refers to categorizing the loan's quality and is crucial to how it is valued and whether, and at what level, reserves should be provided for these credits. OCC found that BOB was rating loans as Pass/good loans which it rated as special mention or substandard loans, i.e., indicating presence of more than normal risk. Tr. 111, 117-18. It follows that if BOB was failing to accurately identify risk, it was not putting enough into reserves. Tr. 231. OCC used the following generally accepted definitions for rating risk loans. Pass - no problem, credit is performing as agreed. Criticized Other Assets Especially Mentioned (OAEM) or special mention - potential or undefined weakness Substandard - well defined weakness, distinct possibility of some loss Doubtful - high potential for loss, full collection improbable Loss - loan should not be considered a bankable asset Div. Ex. 208; Tr. 56-59, 1058-59. All criticized loans are negatively rated loans. Tr. 59. Classified assets are all criticized assets except OAEM. OCC did not require banks to use its definitions. While BOB had used OCC's system earlier, BOB used its own classification system to assess risk during this period. -[24]- Mr. Hooks, the OCC senior examiner who conducted the three exams, and Mr. John Lewis Mastromarino, OCC's EIC at BOB at the time, informed BOB personnel of OCC's findings during the exams, ---------FOOTNOTES---------- -[24]- OCC allowed BOB to use its own system with the proviso that BOB would convert its ratings to OCC's ratings at OCC's request. Tr. 1090. ==========================================START OF PAGE 23====== and in exit interviews. Tr. 79-80, 140, 168-69, 1068, 1079-83, 1085, 1088, 1120-26. -[25]- Also, Mr. Hooks and other OCC personnel communicated with BOB's loan officers and other personnel all through the engagements. Mr. Mastromarino generally met with Mr. Gifford monthly, but did so more frequently in the period May through September 1989. Tr. 110, 1068, 1071, 1079-80. A. OCC targeted BOB's real estate operations in an exam conducted between June 6 and July 25, 1989. Based on its examination of 42 percent of BOB's real estate credits totaling $1,394,000,000, OCC found: -[26]- 1. BOB had not accurately identified credit risk within the portfolio, and the problem was pervasive. OCC downgraded or changed the rating on 76 of 108 loans reviewed amounting to $1,074,000,000. The majority of these were from pass to substandard, a drop of two levels which "absolutely amazed" OCC's EIC at BOB who had never seen such a large number of downgrades in his banking career. Tr. 288, 1120. OCC recommended loans totalling $163 million for non-accrual. The extremely high number of exceptions was a major concern, and raised questions about the accuracy and integrity of BOB's earnings and the ALLL because "if you don't identify the risk, there's a good likelihood that you're not going to have sufficient reserve to protect those problem credits." Tr. 148, 241-42. OCC saw the risk as actual and significant; this many loans moving from pass to special mention or substandard will impact on the amount of reserves that should be assigned to these credits. Mr. Hooks expected that moving this many loans from pass to criticized or classified would mean ---------FOOTNOTES---------- -[25]- When Mr. Mastromarino discovered in early 1988 that management in BOB's real estate group had not informed Mr. Stepanian of OCC criticism, he began sending copies of his memoranda to executives at the highest levels of BOB to make sure they were informed. Tr. 1055-57. -[26]- OCC found it necessary to limit the scope of the exam because of the poor quality of BOB's credit files. Tr. 141. ==========================================START OF PAGE 24====== a "real good likelihood that the reserve was going to have to be increased, and that, of course, impacts the bank's earnings." Tr. 180-81. 2. Asset quality was poor and continued to deteriorate rapidly. The fact that some 60 percent of the portfolio is in either the classified or criticized category indicates a well-defined weakness and a poor quality portfolio. Tr. 145, 179-80. The trend on increasing non-accruals continued; they are $492 million or 14.9 percent of the portfolio. Tr. 143, 150. -[27]- Factors causing credit problems include aggressive underwriting, the lack of comprehensive lending policies, weak credit administration, an inadequate internal appraisal process and deterioration in various real estate markets. 3. Credit administration was weak. 4. Management was ineffective and lacked leadership and direction. Div. Ex. 9. Claims that BOB's non-disclosure was justified because it did not receive the final copy of OCC's "harsh, harsh" written final report until August 28, 1989, and that OCC never ordered it to take remedial action are disingenuous. Tr. 158, 190-96, 224- 25. Mr. Hooks and Mr. Mastromarino gave unrefuted testimony that they informed Mr. Stepanian, Mr. Gifford, and other top BOB personnel in frank, blunt terms of all their findings while the work was underway in June and July, and that Mr. Stepanian and Mr. Gifford were aware of the bank's deteriorating real estate portfolio and the major findings of the final report before August 10, 1989. ---------FOOTNOTES---------- -[27]- Non-accruals have been mentioned previously, but it is significant to note here that they represent assets which are not earning interest so the impact on earnings is negative. Tr. 149-50. ==========================================START OF PAGE 25====== At a breakfast meeting at the end of June or first week of July, Mr. Hooks and Mr. Mastromarino informed Mr. Gifford that BOB was not identifying the risks in its real estate portfolio properly, that there was a lot of significant deterioration in loan quality and portfolio quality, and that OCC viewed BOB's portfolio risks significantly different than BOB did. Tr. 127-28, 198-200, 1123-24. -[28]- The tone of the meeting was "real serious," and Mr. Gifford was very concerned. Tr. 125-29. At Mr. Gifford's suggestion, Mr. Mastromarino discussed the same issues the next day with Mr. Stepanian. Tr. 1125. OCC held a "wrap up" session with bank officials on July 27, 1989. Tr. 200. On July 31, 1989, OCC's Director of Multinational Banks traveled to Boston and met with Mr. Stepanian and Mr. Gifford. Mr. Hooks and Mr. Mastromarino attended the meeting and reviewed the major issues - inaccurate risk ratings in that risks were not being properly identified, deteriorating quality of assets in the portfolio, and overall lack of supervision and poor credit administration. Tr. Tr. 174-81. 1137-44. -[29]- I reject Mr. Stepanian's claim that he was justified not to disclose more than he did in the Form 10-Q until he received a ---------FOOTNOTES---------- -[28]- Mr. Hooks told Mr. Gifford: You really have to take these criticisms very seriously. It is critical that the bank acts quickly to correct this. There is not a lot of time to waste. You are just going to have to be very aggressive in your pursuit of correcting this problem. Tr. 1124. -[29]- OCC only met with a bank chairman when it found "real serious problems." Tr. 178. It was unusual for the OCC's Director of Multinational Banks to attend an exit meeting. Tr. 1143. ==========================================START OF PAGE 26====== written response from BOB personnel to OCC's findings on September 5, 1989. Tr. 977-80; Div. Ex. 71. Mr. Stepanian's position that he did not know whether OCC's findings were valid until BOB personnel responded to them in writing is inconsistent with BOB's action in July 1989 of initiating an effort to re-rate its entire real estate portfolio because OCC found that BOB had misidentified risk in the portfolio. This finding and others were communicated to BOB before OCC concluded its work. -[30]- In addition, it is unreasonable for someone with Mr. Stepanian's expertise to characterize OCC's shocking findings delivered at the exit meeting as "fairly negative." Tr. 976-77. B. The SNC exam, released in June 1989, covered 205 of BOB's large loans and represented the majority view of the regulatory authorities: * Found 36 credits, or 17.6%, to be criticized or classified; * Found 21 variances from BOB's internal loan identification system for an overall exception rate of 10.2%; * Downgraded 19, or 47%, of BOB's internally "4" rated credits to substandard; * Downgraded approximately 40% of BOB's internally rated highly leveraged transactions (HLT); and ---------FOOTNOTES---------- -[30]- In early July, Mr. Hooks requested Mr. Gifford's assistance in achieving corrective action to the problems OCC was finding, and the latter acted quickly and ordered a complete re- rating of the risks in the portfolio using OCC's definitions. Tr. 126-29. Mr. Gifford would not have replaced BOB's definitions without Mr. Stepanian's approval. ==========================================START OF PAGE 27====== * Concluded that the high exception rate in problem loan identification raised serious questions as to the accuracy of the bank's internal risk-rating system and the adequacy of the reserve for loan losses. Div. Ex. 45 at 2. Among other recommendations, the review found "[b]ased on apparent risk rating weaknesses, the adequacy of the reserve for loan losses should be reassessed. Div. Ex. 45 at 3. C. OCC's review of BOB's loan production office/real estate division in Dallas, TX, in January - February 1989, found poor asset quality and a lot of deterioration going on in portfolio. Div. Ex. 4; Tr. 78-79. OCC placed 61 percent of the loans in the "classified" category, i.e., problem credits that normally need a certain level of reserve and which present certain present risk. In the view of the senior bank examiner, this indicated "real severe problems in that portfolio." Tr. 81. -[31]- His report noted that: Doubtful classifications of 137 million are indicative of the potential for additional near term loss. Non- performing loans represent an inordinate 141 million or 45% of the RE portfolio. Although OREO [other real estate owned] totals approximately 22MM as of 12-31-88 the volume is expected to increase drastically. The bank has identified an additional 139MM in real estate loans as "in substance foreclosure." The bank's concentration in land loans of $113MM or 35% of the RE portfolio is another cause for concern. Adequate collateral margins have not been maintained ---------FOOTNOTES---------- -[31]- In the summer of 1988, OCC reviewed a loan production office in Florida which revealed problems similar to what it found in Texas. OCC also did a review at a BOB affiliate in Rhode Island that revealed emerging real estate problems. Tr. 1070-72. Mr. Mastromarino could not say for certain that BOB received copies of these written reports, but it was his practice to discuss all issues with BOB. Tr. 1071. ==========================================START OF PAGE 28====== and land values continue to erode. Loss potential on these loans is extremely high. Div. Ex. 4. D. Following a spread sheet review or exam conducted in December 1988, Mr. Hooks confirmed that Mr. Mastromarino's concerns that BOB had problems in its real estate portfolio were appropriate. Tr. 66, 1075. Mr. Mastromarino discussed Mr. Hook's findings with the BOB person in charge of a team that BOB put in place in the third quarter of 1988 to handle problem real estate loans. Tr. 1075-76. Highly leveraged transactions (HLT): BOB engaged in aggressive underwriting, and was one of a few banks that specialized in HLTs. Tr. 1095. On many real estate loans, BOB provided all of the financing and the loans had little, if any, collateral support. The borrower had little equity in the project, and the high risks called for high returns. Tr. 1362. A lot of loans were limited or non-recourse credits where the bank looked primarily to the project for reimbursement. Tr. 151-52. On June 30, 1989, BOB had 91 HLT loans which amounted to $2.3 billion. Div. Ex. 104 at 18. One HLT was BOB's $165 million loan to the G. Heileman Brewing Company, Inc. (Heileman) which represented its share of a highly leveraged $600 million multi-bank loan. BOB was the lead bank on the loan. Tr. 1037, 1362. Heileman was a high risk asset and one of BOB's largest loans. Tr. 1103. Events occurred prior to August 10, 1989, which made it very doubtful that BOB would recover the principal and interest on the loan. ==========================================START OF PAGE 29====== In April 1989, BOB downgraded the Heileman loan from pass to a 4E or Other Real Estate Specially Mentioned. Div. Findings of Fact at 64; BOB Findings of Fact at 17. In the second quarter, BOB downgraded the loan to 5 or substandard which is how the 1989 SNC treated the loan in the report BOB received on June 19, 1989. BOB Findings of Fact at 15. In May and July 1989, Heileman failed to refinance some subordinate short term debt which was required by the loan agreement so that it was in default. Tr. 1361-62; Div. Ex. 145. Heileman's interest payments were current, but BOB understood its parent, Bond Corporation Holdings Limited of Australia (Bond Corp.), had been providing funds to Heileman. Tr. 1363. BOB considered it a serious problem or "troubled credit" in June 1989, but it did not place the loan on non-accrual. Tr. 429- 30, 1592. -[32]- At the end of June 1989, BOB's Senior Credit Policy Officer traveled to Australia and failed to get the Bond Corp. to assume legal responsibility for the loan. Tr. 1363- 64. This is yet another area where BOB's second quarter financials and MD&A failed to give the required notice because BOB had serous concerns about a significant matter which it knew, or should have expected, would impact on its earnings or results of operations in a material degree. The New England real estate market: ---------FOOTNOTES---------- -[32]- The other banks who participated in the loan placed their Heileman loans in non-accrual in September 1989, as did BOB. Bank Ex. 508 at 79-80. BOB's actions were in line with the recommendations of its Senior Credit Policy Officer. Tr. 1592; Bank Ex. 508 at 85. ==========================================START OF PAGE 30====== At the end of 1988, BOB's commercial real estate portfolio, including OREO, was $6.5 billion. Approximately 56 percent of the loans were located in New England. Div. Ex. 101 at 463. BOB knew in 1988 that the weakening market in New England was affecting its real estate portfolio, and it knew in the spring of 1989 that the real estate market had weakened further. Tr. 697, 728-29. OCC's findings confirmed that there was "a lot of deterioration" in the commercial real estate market in New England in June and July 1989. Tr. 92, 94-96. BOB stopped making commercial real estate loans in 1988 because it recognized a weakening market. Tr. 682, 695-98. It is especially necessary for banks to carefully monitor reserves in a declining economy. Tr. 249. BOB's non-public actions prior to August 10 show it was aware of the serious deteriorating condition of its loan portfolio. In late June/early July 1989, in response to OCC criticism, BOB had begun reassessing the risk in its entire real estate portfolio (re-rating) using OCC's definitions. Div. Ex. 46; Tr. 149. BOB completed the project by July 31, 1989. Div. Ex. 71 at 2. Because OCC only reviewed 42 percent of BOB's commercial real estate portfolio, it expected BOB's re-rating using OCC's definitions to result in substantial increase in BOB's criticized/classified assets (problem loans) and increase the amount of needed reserves. -[33]- Div. Ex. 9; Tr. 149. Also ---------FOOTNOTES---------- -[33]- OCC's exam found that 60 percent of BOB's real estate portfolio to be in a criticized posture. Tr. 145, 149. It expected that BOB would find that approximately 60 - 70 percent of the portfolio was criticized. Div. Ex. 9 at 2. ==========================================START OF PAGE 31====== in late 1988, BOB completed a Net Operating Income (NOI) analysis of its real estate loans which resulted in additional non- accruals and large charge-offs at year end. Div. Ex 71. It did a second NOI analysis in May/June 1989, and in July began a discounted cash flow valuation of loans in the portfolio. Id. The information detailed above, all of which BOB had prior to August 10, 1989, considered together, and some portions considered individually, required that BOB provide information in the MD&A section of its Form 10-Q filing which it did not do. BOB's claim that "a reader of the Bank's Form 10-Q for the second quarter of 1989, together with its prior public filings, had all the information necessary to see the Bank's strengths and weaknesses as management itself saw them" is false. Post Trial Brief at 3. The issue here is the disclosure in the Form 10-Q for the second quarter. The existence of information in other filings, unless it was incorporated by reference, is irrelevant to whether disclosure in a particular 10-Q was sufficient. Second, the message of BOB's other filings is overall very optimistic and upbeat about past and future earnings, and gives no indication that management was aware of serious problems that could reasonably be expected to impact earnings to a material degree. For example, the MD&A in BOB's 10-K for 1988, which reported earned record net income and excellent performance, contained the ==========================================START OF PAGE 32====== following language: -[34]- The performance of the domestic commercial real estate portfolio was a major disappointment in 1988. This portfolio represents 25 percent of our total loans, but contains 50 percent of our nonperforming assets. To handle these problem assets, we have created a specialized unit within the Real Estate Group. While we do not foresee an early turnaround in this industry, we know from long experience that the real estate business can, and will once again, make a positive and significant contribution to earnings. Clearly, 1988 was both gratifying and challenging. While we take pride in the Corporation's performance, we also realize that the accelerating pace of change and competition in the financial services industry requires strategic preparation if we are to sustain - and enhance - our results. Consequently, we are adhering to a strategy that combines basic strengths in relationship banking with strict business discipline to: ... Build on our position as the region's leading commercial lender, ... Manage our current real estate exposure, and expertly minimize the impact of this down phase of the industry's cycle... Div. Ex. 101 at 412-13. Third, BOB's actions signaled that it knew of nothing that would materially impact on the optimistic financial information contained in the Form 10-Q. For example, BOB's continuation of its Provision Expense in the second quarter of 1989 at the same level that it had for the previous five quarters which indicated its concern about the adequacy of its reserve had not increased. It did this despite the fact that on June 30, 1989, its reserves ---------FOOTNOTES---------- -[34]- For the MD&A section of its Form 10-K, BOB incorporated by reference a section from its annual report to shareholders. That report was one of 28 exhibits to the Form 10-K which in total numbered over 500 pages. ==========================================START OF PAGE 33====== of $645 million were lower than they had been in prior periods and the deterioration in its real estate portfolio indicated that it would need greater reserves. BOB's reserves had been $690 million on December 31, 1988, and $697 on March 31, 1989. Div. Ex. 104 at 17. BOB's first quarter MD&A stated: The Corporation continues to monitor its real estate portfolio closely in light of the current weakness in the real estate market. Div. Ex. 103 at 16. -[35]- BOB's MD&A for the second quarter stated: With the further weakening of the real estate market during the second quarter, the Corporation continues to closely evaluate and manage its real estate portfolio. Div. Ex. 104 at 17. I find based on the information detailed in this decision that BOB knew, or should have known, that its real estate portfolio had deteriorated significantly between May 12, 1989, when it filed its Form 10-Q for the first quarter, and when it made its second quarter filing on August 10, 1989; and that the MD&A statement in its Form 10-Q for the second quarter 1989 misstated and failed to disclose facts, known trends, events, and uncertainties known to BOB which were reasonably certain to impact materially its earnings and results of operation. BOB's failure to provide further information made the information contained in the Form 10-Q misleading. ---------FOOTNOTES---------- -[35]- The Division is correct that BOB's disclosures were meaningless to investors because it used more or less the same language to describe its real estate portfolio in a six month period - its 10-K for 1988, its first and second quarter 10-Qs, and a press release on issued January 19, 1989. ==========================================START OF PAGE 34====== The definition of non-accrual loans is important to my finding that BOB misrepresented information in the filing. During the period at issue BOB put loans on non-accrual where payments were overdue 90 days, and, within this time period where it believed that the principal or interest would not be fully paid. Tr. 632-33. BOB maintained that it acted in a conservative fashion when it implemented the second part of the definition which it called discretionary non-accrual. In its second quarter MD&A, BOB stated that $130 million of the real estate loans placed on non-accrual in the quarter when "discretionary, that is, they were not 90 days past due." Div. Ex. 104 at 17. And when discussing HLT it noted that about "half of the nonaccrual loans are discretionary." Div. Ex. 104 at 18. The term discretionary non-accrual has no generally accepted meaning in accounting, and a loan should be put on non-accrual even if the payments are current when the bank does not expect that principal and interest will be paid in full. Tr. 1154-55, 1257. I take official notice of OCC's definition. Nonaccrual - For purposes of this schedule, loans ... are to be reported as being in nonaccrual status if: (a) they are maintained on a cash basis because of deterioration in the financial position of the borrower, (b) payment in full of interest or principal is not expected, or (c) principal or interest has been in default for a period of 90 days or more unless the obligation is both well secured and in the process of collection. OCC Instructions to Consolidated Reports of Condition and Income - Reporting form FFIEC at 034, Schedule RC-N. I find that BOB used the term "discretionary non-accrual" in its financials misrepresent BOB's true financial condition, and ==========================================START OF PAGE 35====== mislead readers of its financial statements that it was pursuing conservative risk assessment policies, which was false. Tr. 52- 53, 1256-57, 1622-23. Mr. Stepanian's defense that BOB knew no more than it disclosed on August 10, 1989, and BOB's argument that to have said more than it said in its 10-Q filing would have amounted to a forecast of the future are unpersuasive. BOB Post-Trial Brief at 63. Furthermore, I reject Mr. Stepanian's defense that in 1988 and 1989 the OCC, the Federal Reserve, and the bank's auditors did not find BOB's reserves inadequate, and that regulators rated the bank highly or favorably. BOB, not the regulators, was responsible for deciding the adequacy of the reserve and what should be said in MD&A; none of the regulators had all the information BOB had; and events were so volatile that opinions in 1988 were not relevant in the second half of 1989. Finally, this decision does not require national banks to disclose confidential information received from regulators. It does hold that banks, like any other entity whose securities are registered with the Commission, must make honest disclosures and not mislead public investors. ORDER I ORDER, pursuant to Section 21C of the Securities Exchange Act of 1934, that Bank of Boston Corporation cease and desist from committing or causing any violations and any future violations of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder. ==========================================START OF PAGE 36====== This order shall become effective in accordance with and subject to the provisions of Rule 17(f) of the Commission's Rules of Practice (17 C.F.R. 201.17(f)). Pursuant to that rule, this initial decision shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 17(b) within 15 days after service of the initial decision upon him, unless the Commission, pursuant to Rule 17(c), determines on its own initiative to review this initial decision as to a party. If a party timely files a petition for review, or the Commission acts to review as to a party, the initial decision shall not become final as to that party. ______________________________ . Brenda P. Murray Chief Administrative Law Judge Washington, D.C. December 22, 1995