What the Wells order means for bank directors

WASHINGTON — The Federal Reserve’s enforcement action against Wells Fargo on Friday laid the blame for the bank’s various scandals at the feet of its board, but the agency’s order and additional recent actions may make it easier for other banks’ boards to avoid a similar fate.

The order, which restricts Wells from growing beyond its size as of yearend, was issued alongside uncommonly pointed letters to the bank's board, former CEO John Stumpf and former independent board member Stephen Sanger highlighting their ultimate responsibility for Wells' management failures. When the order was announced, Wells said it had ousted four board members, three to be replaced in April and one in December, without detailing who would be rotated off the board.

Taken together, the actions by the Fed and bank were seen as a warning for board members of other institutions, according to interviews with several industry observers, many of whom declined to speak on the record.

"That's a question for bank board members — are they more vulnerable now than they were before?” said David Baris, president of the American Association of Bank Directors.

At the same time, however, the Wells order helps provide clarity as to what the Fed expects of board members. The Fed has also taken steps in recent months to streamline boards’ activities, reducing the volume of supervisory matters that a bank board must sign off on directly. Those moves have been criticized as enabling boards to turn a blind eye to malfeasance. But in remarks delivered in August, then-Fed Gov. Jerome Powell, who was sworn in as Fed chair on Monday, said that those changes, rather than easing the reins on bank boards, would give them even less of an excuse for not knowing what was going on at their institutions.

“The intent is to enable directors to spend less board time on routine matters and more on core board responsibilities: overseeing management as they devise a clear and coherent direction for the firm, holding management accountable for the execution of that strategy, and ensuring the independence and stature of the risk management and internal audit functions,” Powell said. “These were all areas that were found wanting in the financial crisis, and it is essential that boards get these fundamentals right.”

One particular area the Fed focused on in its Wells order, for example, was communication between the bank and its board. An independent report published last April by the law firm Shearman & Sterling, acting at Wells' behest, concluded that management had concealed the extent of problems from the board.

“Throughout 2015 and 2016, the board was regularly engaged on the issue; however, management reports did not accurately convey the scope of the problem,” the report said. “The Board only learned that approximately 5,300 employees had been terminated for sales practices violations through the September 2016 settlements with the Los Angeles City Attorney, the OCC and the CFPB.”

The Fed's order requires the board to fix any communication problems, including reaching out to multiple sources within the bank, applying acute pressure on the firm’s growth in order to ensure that they comply.

“While most orders focus to some extent on a board of directors ... there's a sense of focus on having sufficient information in which to reach decisions and judgments at the board level, and that should be coming from a variety of sources — from management, the chief risk officers, the chief [auditor]," Baris said. "I think their view is that the board needs the information and to act on that information.”

The Fed is also not sending the signal that this task is simply too difficult, said Dennis Kelleher, president and CEO of consumer advocacy group Better Markets. While Wells' size is being restricted by the order, the deficiencies listed in the order don't relate to the bank's size, but rather management practices and the ability for the bank to keep tabs on activities and identify bad actors.

“I don’t think the Fed thinks that Wells is too big to manage, just like I don’t think it thinks that JPMorgan Chase is too big to manage,” Kelleher said. “I think it is a message not just to Wells Fargo but to all financial institutions that, if you fail, you can expect that the Fed is going to bring the hammer down on you.”

Did they jump or were they pushed?

One unresolved question that the order raises is the extent to which the Fed was involved in Wells’ decision to bring on new members to its board. The Fed highlighted the action in its press release as “concurrent” with the order, but the order itself says nothing about removing or replacing individual members.

The Fed was under political pressure to remove individual directors at Wells by Senate Democrats, including Sen. Elizabeth Warren, who said in a letter to former Fed Chair Janet Yellen that the Fed should remove all members of the Wells board who were active at the time of the scandal. Yellen would not commit to such action, but after the order was publicized on Friday, Warren credited Yellen with forcing the directors out, praising her “courage” for sending a “strong message.”

The Fed has the power to remove individual board members, but that authority is somewhat constrained by legal standards. The Fed would have to demonstrate that a director was engaged in a “violation of law, breach of fiduciary duty, or unsafe or unsound practice,” that their actions precipitated “financial loss or other damage” to the institution or acted in a “culpable mental state.” Directors are also afforded the ability to appeal such an order, and all of those standards require that the Fed demonstrate that the director or directors knew what they were doing was wrong.

There is a diversity of opinion about whether the Fed would have been able to make that case given the circumstances in Wells’ case. But Baris said the mere suggestion that the Fed might have nudged Wells to show some board members to the door recalls a scandal from several decades ago when lawmakers exerted influence on bank regulators.

In that episode, known as the Keating Five, five federal lawmakers — including Sen. John McCain, R-Ariz. — pressured regulators not to look too closely at the potential misdeeds of Lincoln Savings and Loan director Charles Keating, who later pleaded guilty to fraud in the midst of the Savings and Loan scandal of the 1980s and 1990s. Warren may be muddying the waters of the Wells order in a way that suggests the Fed is bowing to political pressure, Baris said.

“They're an independent agency and have a long history of independence and not being susceptible to political pressure," Baris said. "At the same time, there's a perception there that's being emphasized, in fact, by Elizabeth Warren that she used political influence to affect a bank regulatory decision. That reminds me of going back to ... the Keating Five."”

But another industry attorney said that the Fed’s stock and trade is its independence, which it values above all else. Politicians can be expected to make hay out of their actions regardless of what those actions are, and it is most likely that they simply make their best judgments regardless of the political implications.

“You’re damned if you do and you’re damned if you don’t,” the attorney said. “You have that problem again and again, so you call it straight, and the chips are going to fall where they may. If you try to manipulate the political aspect of it, you just get in worse trouble.”