Silvergate Enforcement Actions
Looking at the Fed, California DFPI and SEC orders
The March 2023 announcement by Silvergate Bank that it would commence a voluntary liquidation process has been cited in banking agency postmortems on the Spring 2023 banking turmoil as a factor contributing to the loss of depositor confidence in Silicon Valley Bank and Signature Bank.1
The broad strokes of what happened at Silvergate Bank are at this point fairly well known, but some details remain obscured. A Federal Reserve OIG report last year, for example, was restricted from public distribution because it contained confidential supervisory and trade secret information. Only a five page executive summary was released.
Last week, the Federal Reserve Board, California Department of Financial Protection and Innovation and Securities and Exchange Commission each brought enforcement actions against Silvergate Capital Corporation and Silvergate Bank. The enforcement actions do not answer every open question about events at Silvergate Bank,2 but they do provide a few more details on what was going on in the months leading up to the bank’s decision to voluntarily liquidate.
Board and CA DFPI Enforcement Actions
The actions brought by the Federal Reserve Board and the California DFPI focus on anti-money laundering deficiencies at Silvergate Capital Corporation and Silvergate Bank. The orders are light on specific details, particularly compared to the SEC complaint discussed below, but according to the Board’s order the deficiencies at issue relate to Silvergate’s “monitoring of internal transactions” through its Silvergate Exchange Network — “an internal payments platform that permitted Bank customers participating in the SEN to make and receive, in near real time, internal Bank transfers of U.S. dollars to and from other Bank customers participating in the SEN.” The CA DFPI order includes substantially identical language to that quoted above.
Silvergate agreed to pay $43 million to the Board and a further $20 million to the CA DFPI to settle the charges.
SEC Enforcement Action
Concurrently with the Board and CA DFPI announcements, the SEC announced that it had brought charges against (1) Silvergate Capital Corporation, (2) its former CEO, (3) its former CRO and (4) its former CFO. All but the former CFO have agreed to settle the charges.3
The SEC’s complaint may be of interest to readers of this blog for at least two reasons. First, the complaint is suggestive of the Commission’s views on the disclosures that should be made (or, maybe better put, that should not be made) when a bank is dealing with BSA/AML compliance issues. Second, in the context of alleged accounting missteps, the complaint offers a few more details on bank regulatory developments at Silvergate in its final months as the bank desperately searched for liquidity.
AML Deficiencies and Disclosure Obligations
The first part of the SEC’s complaint takes issue with allegedly misleading statements by Silvergate, its former CEO, and its former CRO as to the effectiveness of Silvergate’s BSA/AML program.4
Factual Background
The SEC characterizes the facts as follows.
Until April 2021, Silvergate monitored transactions through the SEN using a third-party tool called ATMS-A, which the SEC describes as a “rules-based system” with “no intelligence-based capabilities.”
While using ATMS-A, Silvergate’s transaction monitoring approach used both automated and manual monitoring. If ATMS-A triggered an alert, Silvergate’s “BSA staff would review and track transactions on a spreadsheet.”
In April 2021, Silvergate implemented a new automated transaction monitoring system called ATMS-B.
ATMS-B in theory “employed intelligence-based surveillance and had behavioral analytics capabilities” but Silvergate struggled “for many months” to “devise a solution to apply ATMS-B’s automatic transaction monitoring to SEN transactions.”
Here, the SEC cites various emails and other communications between Silvergate’s BSA Officer and the firm’s CRO, from which the SEC alleges that the former CRO “knew or should have known that such monitoring was not occurring.”5
Meanwhile, the Federal Reserve Bank of San Francisco and California DFPI were examining Silvergate’s BSA/AML programs and coming away concerned by what they found.
A January 2022 full-scope exam resulted in an April 2022 exam report that “identified material internal control weaknesses over BSA/AML compliance.”
A September 2022 target exam focused on Silvergate Bank’s identification of suspicious activity found that “the Bank’s transaction monitoring system (i.e., ATMS-B) was not configured commensurately to the Bank’s risk profile, and that Silvergate’s BSA compliance program continued to inadequately dispose of suspicious activity alerts.”
The September 2022 target exam produced a final report delivered to Silvergate in November 2022 which “required the Bank to immediately improve its suspicious activity monitoring.”
These developments led Silvergate’s board to discuss the possibility that Silvergate would become subject to an enforcement action or other sanctions for its BSA/AML deficiencies.
They also led Silvergate to, among other things:
transition its BSA Officer to a new role;
write a letter to the FRBSF acknowledging that “the Bank was working with ATMS-B to customize its transaction monitoring software to better fit its risk profile, but the Bank had not yet achieved that goal”; and
establish a special committee to monitor the bank’s remediation efforts in relation to the findings.
Allegedly False or Misleading Disclosures
While all this was going on, Silvergate was operating as a public company and making periodic disclosures to investors. The SEC alleges that in SEC filings and other public statements Silvergate falsely or misleadingly stated that its BSA/AML compliance program was effective and tailored to the heightened risks posed by its crypto customers, when in fact the BSA/AML program was inadequate.
In particular, the SEC takes issue with the following statements in Silvergate’s 2021 10-K, which were incorporated by reference into the company’s Q3 2022 10-Q.6
We believe that our risk management and compliance framework, which includes thorough reviews we conduct as part of our due diligence process (either in connection with onboarding new customers or monitoring existing customers), is reasonably designed to detect any such illicit activities conducted by our potential or existing customers…
We have developed enhanced procedures to screen and monitor these customers, which include, but are not limited to, system monitoring rules tailored to digital currency activities, [and] a system of “red flags” specific to various customer types and activities … We believe these enhanced procedures adequately screen and monitor our customers associated with the digital currency initiative for their compliance with anti-money laundering laws…
We have developed our proprietary compliance capabilities, which include ongoing monitoring of customer activities and evaluating a market participant’s ability to actively monitor the flow of funds of their own customers. We believe these capabilities are a distinct competitive advantage for us, and provide a meaningful barrier to entry against our potential competitors…
The SEC argues these disclosures were false or misleading because:
the critical weaknesses identified by the FRBSF demonstrated that Silvergate’s BSA compliance program had not used “thorough … due diligence … in connection with onboarding new customers or monitoring existing customers”; nor had it used “enhanced procedures to screen and monitor these customers … for their compliance with [AML] laws.”
more than $1 trillion dollars of SEN transactions were not subjected to automated monitoring for suspicious activity for a period of at least 15 months prior to the filing of the 10-Q, [therefore] Silvergate was essentially not conducting adequate “on-going monitoring of customer activities,” nor did it employ “system monitoring rules tailored to digital currency activities” that could “adequately screen and monitor [its] customers associated with the digital currency initiative for their compliance with anti-money laundering laws.”
the 2021 Form 10-K’s statement … that the Bank’s “risk management and compliance framework … [was] reasonably designed to detect … illicit activities” was misleading in light of: (1) Silvergate’s decision to remove its BSA Officer as unsuited to manage the risks posed by the Bank’s customer activity; and (2) the serious deficiencies in Silvergate’s BSA program.
FTX Collapse and Further Allegedly Misleading Statements
Silvergate’s allegedly misleading 10-Q was filed on November 7, 2022. Sam Bankman-Fried’s FTX filed for bankruptcy a few days later, leading to what the SEC’s complaint describes as “speculation on social media and other fora” surrounding the relationship between Silvergate and FTX.
The SEC’s complaint states that, around this same time, Silvergate’s CRO directed the company’s BSA staff to conduct a forensic review of FTX entities’ transaction activity through Silvergate Bank. Silvergate’s CRO made the CEO aware that this staff review would be conducted.
The staff review ultimately:
“identified as suspicious over 300 transactions by FTX-related entities in Silvergate accounts from January 2022 until November 2022”;
“showed that FTX-related entities had engaged in roughly $9 billion in suspicious transfers—some of which occurred over the SEN—during that period';" and
“[m]ost troubling to the BSA staff,” flagged a “trend of funds that flowed from FTX’s custodial accounts—which held FTX customer funds—to a series of non-custodial FTX-related entities’ accounts, followed by transfers of these funds to other third parties—either through the SEC or to accounts external” to Silvergate Bank.
The staff review was completed on November 17. The results were shared with the CRO on November 18 and on November 23 the CRO informed the CEO that the staff review had been completed and was ready for audit.
It is in this context that the SEC takes issue with additional statements by Silvergate’s CEO that were allegedly false or misleading, or contained material omissions.7 For instance:8
November 21 Letter
In a November 21 letter published on LinkedIn and on Twitter, Silvergate’s CEO wrote:
Our business starts by knowing our customers, their business and the activity they plan to conduct at our institution. Once we approve a new customer, if the activity in their account does not match the activity that we expect based on our initial approval, we take immediate action up to and including terminating that relationship. No exceptions. The U.S. Bank Secrecy Act requires us to develop a robust compliance and risk management program. It’s a responsibility we take very seriously.
The SEC first alleges this was false or misleading for similar reasons as the 10-K disclosures were allegedly false or misleading — the statement implies that Silvergate conducted appropriate due diligence and appropriately monitored transactions, when in fact it was failing to do so.
The SEC also faults Silvergate’s CEO for making this statement at a time when he knew or should have known that Silvergate’s BSA staff were conducting their forensic review of FTX activity, and yet the CEO “failed to inquire about the results of that review.”
Furthermore, and maybe more of a stretch by the SEC, the complaint also alleges that the statement in the CEO’s letter that the Bank Secrecy Act requires a “robust compliance and risk management program” was misleading in that it suggested that Silvergate actually had a robust compliance and risk management program, when in fact the CEO and CRO “knew or should have known of the deficiencies” in the bank’s programs.
CNBC Interview
On November 30, Silvergate’s CEO went on CNBC. During the interview, he said:
The next step is we also then have to be monitoring on an ongoing basis the activity that is moving across the SEN … We monitor for activity that would be inconsistent with the purported use of the account. But as long as the activity is consistent, then there … is nothing else that we would do.
Again, we built this business compliance first. We satisfy all the regulatory requirements. And we have also, in the past, we have offboarded customers if we see activity that is inconsistent and if they can’t correct it or can’t explain it, then we offboard those customers.
The SEC alleges these statements were false or misleading because, among other things, the BSA staff’s FTX review had identified billions of dollars of suspicious transfers that had gone undetected, and the CEO had “failed to inquire about these results” before appearing on CNBC and making these statements.
The complaint also states the CEO knew or should have known that, contrary to what he said on CNBC, Silvergate did not in fact “satisfy all regulatory requirements.”
January 2023 Earnings Call
As a final example, the SEC also alleges that Silvergate’s CEO made false or misleading statements and omitted material facts on an earnings call with investors in January 2023.
For instance, the SEC takes issue with a statement made by the CEO on the earnings call that Silvergate “follow[s] the Bank Secrecy Act, the USA PATRIOT Act for every account that we open and we conduct ongoing monitoring.” This was false, the SEC alleges, because Silvergate did not adequately monitor transactions on the SEN from April 2021 to September 2022.
Settled Charges
As noted in the introduction, Silvergate, its former CEO and its former CRO have agreed to settle the SEC’s charges in relation to the allegedly misleading disclosures described above, without admitting or denying them. As a result, the allegations in this part of the SEC’s complaint will not be tested in court.
Allegedly Misleading Statements Regarding the Bank’s Financial Condition
The second half of the SEC’s complaint is a little different. Drawing in part on certain regulatory details that have not previously been reported, it alleges that Silvergate’s former CFO made “false or misleading statements to the public” and engaged in “deception of regulators” regarding Silvergate Bank’s financial position and leverage ratio.
Searching for Cash
The collapse of FTX “sparked a devastating run on the Bank’s customer deposits,” with deposits falling from approximately $12 billion to approximately $3.9 billion over the space of a single quarter.
Facing this massive run, Silvergate “at its regulators’ urging” in or around December 2022 “decided to maintain cash balances sufficient to cover all its crypto asset customers’ deposits (at a one-to-one ratio).” This “further increased pressure on the Bank’s liquidity.”
The complaint then tells a story about Silvergate’s attempts to source liquidity sufficient to withstand this pressure, without needing to resort to securities sales.
FHLB Borrowings
By mid-December 2022, the Federal Home Loan Bank of San Francisco had “restricted the Bank’s future borrowing” and notified Silvergate that it would be required to “pay down its FHLB debts during the First Quarter of 2023 to a cap of 25% of the Bank’s total assets.”
On December 21, the former CFO informed his staff that Silvergate Bank had agreed with the FHLB to pay down borrowings to the 25% cap by March 31, 2023. The next day, however, the former CFO wrote to Silvergate Bank’s Treasurer to say that the FHLB was now requiring Silvergate to bring its FHLB borrowings down to 25% of total assets by mid-January.
Ultimately, Silvergate Bank agreed to repay $1.475 billion of FHLB borrowings by January 13, 2023, which would bring the bank below the 25% of assets cap on FHLB borrowing, at least as measured against the bank’s assets as of year-end 2022.
Brokered CDs
As of the end of 2022, Silvergate had $2.4 billion in brokered certificates of deposit. The SEC’s complaint alleges the Silvergate’s CFO knew or recklessly disregarded that further funding through brokered CDs was not an option for the first quarter of 2023 “because the Bank’s regulators would disapprove of additional such funding.” In support of this allegation, the SEC’s complaint quotes an email from Silvergate’s CRO to its CEO and CFO saying that “increasing brokered CDs was not an option [regulators] would respond favorably to.”
Repo
In December 2022 and January 2023, Silvergate “approached major financial institutions” to attempt to set up a repo line. One financial institution responded, but offered terms that were “so costly” that it “would not have made economic sense for the Bank to enter into the agreement.” A second financial institution “ultimately never sent” an offer to Silvergate in response to its request.
Without Adequate Alternative Sources of Liquidity, Silvergate Turns to Securities Sales
Silvergate’s pressing liquidity needs, combined with its failure to find other sources of liquidity, meant that Silvergate was left with no better option than to try to sell significant portions of its securities portfolio.
The substance of the SEC’s complaint is that, though Silvergate and its CFO recognized that some sales of securities would be necessary, Silvergate and its CFO either knowingly or recklessly failed to properly acknowledge the likely amount of such sales.
Accounting Rules
As described by the SEC in the complaint, under U.S. GAAP Silvergate was required to assess each security in its available-for-sale portfolio that was in an unrealized loss position and determine whether the security suffered from an other-than-temporary impairment (OTTI).
Again as described by the SEC, under U.S. GAAP OTTI needs to be recognized for a security in a company’s AFS portfolio if either (i) the company intends to sell the security or (ii) the company is “more likely than not” to need to sell the security before recovery of its amortized cost basis.
If OTTI must be recognized, the amount of OTTI recognized would be equal to the difference between Silvergate’s amortized cost basis and the fair market value of the security as of the date of the financial statements in question. And, crucially for bank capital purposes, any OTTI that was recognized would reduce Silvergate’s Tier 1 Capital, and thus in turn (holding all else equal) reduce Silvergate’s regulatory capital ratios.
Taking all this together, and oversimplifying a little, the upshot is that Silvergate’s future intentions to sell securities from its portfolio, or Silvergate’s assessment that future sales were more likely than not to occur, would under accounting rules result in changes to the capital ratios that Silvergate’s was required to report for the just completed quarter.
Alleged False or Misleading Statements
With those accounting rules in the background, the SEC alleges that Silvergate and its CFO either knowingly or recklessly misapplied them, such that Silvergate wound up undercounting the amount it should have recognized as OTTI.
Here, the SEC’s complaint makes much of two allegedly contrasting internal presentations.
First, on January 4, the CFO received a presentation from the Bank’s Treasurer that the SEC says appropriately “accounted for the OTTI impact of securities that the Bank both intended to sell and more likely than not would be required to sell” in the first quarter. This presentation highlighted a need for $2.6 billion in liquidity and, taking into account the securities sales intended to occur or more likely than not to occur in order to meet these needs, estimated an OTTI charge of $176.5 million.
Second, on January 5 the CFO received a presentation from the Bank’s treasury department. This presentation, the SEC alleges, “did not evaluate all securities sales that the Bank would more likely than not be required to make” in the first quarter, and instead only accounted for securities sales needed to pay off certain brokered CDs and repay certain FHLB borrowings. The presentation categorized “[a]ny incremental sales” as “unknown.” Based on these assumptions, the January 5 presentation assumed a lower amount of necessary securities sales ($1.7 billion) and thus a lower amount of OTTI ($134 million).
In the end, the SEC alleges that the earnings Silvergate released on January 17 relied on the OTTI methodology in the January 5 presentation, and so reflected a $134.5 million impairment charge based on $1.7 billion in expected securities sales. These and related statements made in the earnings release were false or omitted material information, the SEC alleges, because “they materially underestimated the Bank’s estimated securities sales in the First Quarter of 2023.”9
In addition to this alleged material underestimation of future securities sales that were more likely than not to occur, the SEC further alleges that Silvergate’s OTTI amount was also false because it, first, failed to take into account approximately $81 million of securities Silvergate had already sold in the first week of January and, second, “failed to account for the iterative effects of the Bank’s shrinking balance sheet caused by $1.7 billion in securities sales.”
For similar reasons, the SEC alleges that the earnings release “falsely and misleadingly” reported the Tier 1 leverage ratios for Silvergate Capital Corporation and Silvergate Bank because those leverage ratios failed to take into account the appropriate amount of OTTI. The alleged misreporting of the holding company and bank leverage ratios was material in this context, the SEC argues, because Silvergate and its CFO knew that the leverage ratio was close to falling below the 5% well capitalized threshold, and this “crucial metric” was closely tracked by investors, analysts and the bank itself.
An Allegedly “Deceptive” Letter to the FRBSF
On January 19, 2023, a couple of days after earnings had been released, Silvergate’s CFO wrote a non-public letter to the FRBSF, seeking permission to pay a dividend.10 The SEC characterizes the letter as “deceptive” because it allegedly:
included, “in both written and graph form,” the “false” leverage ratios Silvergate had reported to investors;
“misleadingly represented … that the Bank ‘remained well-capitalized’”; and
“misleadingly included … a balance sheet item of $868 million for a repo line to limit the securities that needed to be sold, despite the Bank having made no progress towards reaching an economically viable agreement for such repo line.”
The SEC further alleges that the letter to the FRBSF “contained a number of contradictions” as compared to the earnings release from a few days before. For example, the letter “assumed securities sales of $1.86 billion” in the first quarter and assumed “an additional $1.656 billion in expected sales” in the second quarter, “resulting in additional losses that were not accounted for as OTTI.”
No Settlement
At the moment we have only the SEC’s complaint and therefore only its side of the story and, in many cases, only its characterization of the documents in question, without seeing them in their full context. This is not to say that the SEC’s allegations are necessarily wrong or that the Commission would lose if forced to defend its positions in an adversarial setting. But this matters here because, unlike his former colleagues, Silvergate’s former CFO has chosen not to settle the SEC’s charges and instead intends to challenge them in court.11
For those interested in following along, the docket for the case is available here.
For example, Vice Chair for Supervision Barr’s report on the supervision of Silicon Valley Bank cites Silvergate’s decision to voluntarily liquidate as an event that “further affected depositor sentiment.” Similarly, the FDIC Chief Risk Officer’s report on the supervision of Signature Bank says that “[t]he primary cause of SBNY’s failure was illiquidity precipitated by contagion effects in the wake of the announced self-liquidation of Silvergate and the failure of SVB, after both experienced deposit runs”
For example, the executive summary of the OIG report from last year noted that “nepotism, evidenced in the several familial relationships among members of the bank’s senior leadership team, undermined the effectiveness of the bank’s risk management function.” Last week’s enforcement actions do not include anything on this point.
Silvergate, without admitting or denying the charges, agreed to pay a $50 million civil money penalty, but the payment “may be offset by penalties paid” to the Board and CA DFPI. The former CEO and CRO, each without admitting or denying the charges, agreed to $1 million and $250,000 fines, respectively, and each will be barred from serving as an officer or director of a public company for the next five years.
Unless otherwise noted, all quotes in this section come from the SEC’s complaint.
For example:
70. On January 27, 2022, the BSA Officer emailed [the CRO]: “[ATMS-B] can’t take SEN transactions [into] consideration for risk rating purposes. Internal transfers are not a transaction type that can be utilized in building a risk model.” [The CRO] responded: “We have known of this issue and either we have established other controls to account for it or we haven’t and we have to take our lumps.”
71. Similarly, on February 18, 2022, the BSA Officer texted [the CRO]: “I think I found a way to monitor the SEN.” [The CRO] responded: “Oh good!”
72. On June 1, 2022, the BSA Officer texted [the CRO]: “I think I finally got [ATMS-B] to build some monitoring rules for SEN,” to which [the CRO] responded by “emphasizing” the BSA Officer’s message with the Apple iPhone iMessage expression feature (“!!”).
The quotes here come from the 2021 10-K. The SEC cites these quotes, with minor alterations to their first few words, in paragraph 97 of the complaint.
The SEC also seeks to hold the former CRO responsible for certain of these statements, as she allegedly participated in reviewing and approving them.
In addition to what is discussed in the main text above, the SEC’s complaint alleges that false or misleading statements were also included in (1) a letter that Silvergate filed as an 8-K on December 5, 2022 and (2) a December 19 letter Silvergate sent to Senators Kennedy, Marshall and Warren.
Obviously this is easier to say in hindsight, but to be fair to the SEC its complaint also includes facts that, if proven to be true, could support a conclusion that Silvergate’s position was unreasonable even at the time. See for instance paragraph 296: “After the Earnings Release, [the CFO] and others at the Bank were repeatedly informed by the Bank’s auditor that its OTTI statements in the Earnings Release were incorrect and should be corrected.”
According to the SEC’s characterization of the letter, Silvergate argued that it should be permitted to pay dividends, despite the financial pressure it was under, because not doing so would damage Silvergate’s “going concern status.” See paragraph 303 of the complaint.
A statement given to the American Banker by a lawyer representing the former CFO argues that “The SEC is inappropriately seeking, with the benefit of hindsight, to substitute its business judgment with decisions that [the former CFO] — a career finance professional — made in real time."
A similar statement given to Reuters says that the former CFO “will vigorously defend himself in court where he is confident the SEC’s over-reach and mischaracterization of the facts will be clear.”