Friction on Board Brought Kevin Lewis to First Southern Bank

At least seven banks were defrauded by Little Rock lawyer Kevin Lewis and his rural improvement district bond scam, but one of those banks is not like the others.

Unlike the rest, First State Bank of Lonoke didn't buy Lewis' bonds or accept them as collateral without first confirming that the improvement districts were even legitimate. Instead, the two loans totaling $7.6 million that First State made to Lewis and his PA Alliance Trust were secured with collateral that First State Chairman Neil Bennett Jr. and CEO David Estes knew very well: their own stock in First Southern Bank of Batesville, which First State lent Lewis the money to buy.

(Click here for a related story on the banks who made loans to Kevin Lewis.)

In fact, the lawsuit that First State filed against Lewis and the trust last month suggests that the loans were exceedingly well collateralized, with Lewis borrowing only a little more than half the assigned value of the stock that he pledged.

Less than three months after First State made the second loan, $3 million on Sept. 28, all of the collateral was as worthless as the bonds other banks had accepted. State bank regulators shut down First Southern on Dec. 17 after a routine exam by the Federal Deposit Insurance Corp. red-flagged its highly concentrated investment in rural improvement district bonds, bonds that, of course, turned out to be fraudulent.

News reports, public documents and interviews with various people involved in the still-developing scandal, most of whom would not agree to speak on the record, provide a sketchy picture of how a 5-year-old bank founded by experienced bankers came to spend $22.7 million on worthless pieces of paper.

In November 2004, Woody Castleberry resigned as chairman, president and CEO of Citizens Bank of Batesville and announced plans to found a competing bank in town, First Southern. He took EVP David Hidy with him, and in January 2005 the two opened a loan production office of First State Bank of Lonoke, which was an original investor in First Southern.

(Click here for a timeline of First Southern Bank's history.)

The new bank was chartered in August 2005 with a little more than $9 million in capital, significantly less than the $15 million its founders had hoped to raise.

During the next three years, First Southern grew at a rapid clip. By the end of 2008, its assets were more than $100 million, its equity was up to $12.9 million, and the bank had been profitable for two years. But the board of directors was at war over management philosophy with one faction led by Castleberry and director John Gregg and the other, with the advantage of 53 percent majority of the stock, led by Estes and Bennett.

Although the specific source of the board friction couldn't be determined, it wasn't the first time that Estes had been involved in a dispute over bank management. Estes' group of investors had a similar falling out with the management of the bank they helped start in Little Rock in 2007, Central Bank. In that case, Estes' faction forced out twin brothers Troy and Tracy Duke.

(Sources told Arkansas Business that about $2.5 million of First State's loan to Kevin Lewis had been sold to Central Bank, but its CEO, Wade Ruckle, declined comment.)

Rather than face the same fate as the Dukes, Castleberry was actively seeking an investor to buy out the block of stock owned by Estes and his associates, and at least one prospect had already taken a pass.

Estes, in one of the few statements he has made to Arkansas Business since the Lewis bond scam was discovered, denied a rumor that he had recruited Kevin Lewis to buy the controlling interest in First Southern Bank. Instead, he said, he was introduced to Kevin Lewis by Castleberry and Gregg in the fall of 2008.

Negotiations began for the sale of the stock held by Estes; Bennett; First State's holding company, Lonoke Bancshares Inc.; and others. In January 2009, according to a document filed by Gregg in answer to First State's lawsuit, Estes committed to lending Lewis' PA Alliance Trust almost $4.63 million. That figure represents half the price that the trust would pay for 71,200 shares of First Southern stock at $130 per share, with the trust putting up the other half in cash when the deal closed in May 2009.

Where the other $4.63 million came from is not known, although Lewis is known to have borrowed at least $9.7 million from other banks in 2008. While Lewis' father and mother, Harold and Ada Lewis of Searcy, were originally listed as trustees of the PA Alliance Trust, their lawyer, Blake Hendrix of Little Rock, said they didn't even know the trust existed. 

The $9.26 million sale price represented a 30 percent return on the $7.12 million that Estes and the other investors had paid for the stock.

In the Meantime
After Estes began negotiating the stock sale to Lewis, which he said was about September 2008, First Southern acquired its first interest in Lewis' improvement district bonds. The nature of that interest is the subject of fundamental disagreement.

Gregg, the last chairman of the First Southern board and who served as a trustee of Lewis' PA Alliance Trust, said in a court filing that First Southern's credit committee approved the purchase of six bonds valued at nearly $6 million from Lewis between Dec. 31, 2008, and May 6, 2009 - two weeks before Lewis' trust became the bank's largest shareholder.

Gregg alleges that, as members of the credit committee, Bennett voted for five of those bond purchases and Estes voted for three. But Estes, who was planning to file a response to Gregg's allegations late last week, told Arkansas Business that he and Bennett voted to approve loans to Lewis secured by bonds, not to directly invest in the bonds. It was the job of the bank's managers, including Castleberry, to confirm that the collateral presented to the committee was legitimate, Estes said.

Estes said he didn't know when the bonds ceased to be considered collateral and became investments owned by the bank itself.

First Southern's call reports filed with the FDIC lend some support to Estes' version of events. Other than low-risk securities issued or guaranteed by the federal government, no securities were listed in First Southern's investment portfolio until a $1.6 million entry in the third quarter of 2009 - by which time Gregg said the bank had bought at least $6 million worth of bonds from Lewis.

Non-government securities in the portfolio grew rapidly after Sept. 30, 2009 - to $12.12 million at the end of 2009, to $15.1 million on March 31, to $17.75 million on June 30. Although the call reports don't identify the securities as those purchased from Lewis, Gregg's court filing removes any doubt as to what was included in the "other domestic debt securities" line item. It says accounting firm BKD LLP issued an "independent accountant's report stating that the $12,119,867 of private placement (Kevin Lewis) bonds purchased by First Southern Bank were fairly valued as of December 31, 2009."

It wasn't until the final call report filed with the FDIC last fall that First Southern showed that it held "securities issued by states and political subdivisions," the correct category for improvement district bonds. By then the investment total was $22.7 million.

Gregg has reserved the right to file his own claim against BKD. Ryan Underwood, managing partner of BKD in Little Rock, declined to comment.

New Stock
After Estes and his associates sold their stock to Kevin Lewis, First Southern continued its rapid growth. As bankers across the country complained about stagnant loan demand, First Southern's assets grew by more than 70 percent, from $111 million to $191 million, between June 30, 2009, and Sept. 30, 2010.

Asset growth that greatly outstrips growth in the general market can be a warning sign that a bank is making risky loans, but that doesn't seem to be the case with First Southern. When the FDIC sold First Southern to Southern Bank of Poplar Bluff, Mo., the agreement didn't include the kind of loss-share arrangement that has become typical when a bank takes on a risky loan portfolio, although the FDIC did retain $39 million of First Southern's assets "for later disposition."

"This instance was not the result of poor quality loans, but the result of an imprudent business relationship between First Southern Bank and one individual," Arkansas State Bank Commissioner Candace Franks said in a press release when she shut down First Southern.

There were, however, irregularities in the First Southern operation. Although Lewis was never a member of the bank's board of directors, First State has alleged that Lewis "acted as a de facto board member and trustee in many First Southern Bank decisions," and Gregg admitted in his response that Lewis attended "some" board meetings both before and after he purchased the controlling interest.

First Southern's rapid growth did strain its capital, which dropped to 8.66 percent of assets as of June 30 of last year. Just in time for the third-quarter report to the FDIC, Lewis' PA Alliance Trust invested another $5.5 million in First Southern, pumping its equity capital to $19.25 million as of Sept. 30. Three million of those new capital dollars came from the second loan from First State Bank, which Lewis secured with 42,561 newly issued shares of stock. Where the trust got the other $2.5 million is unknown, although it is notable that the value of non-government securities that First Southern held in its investment portfolio increased by almost $5 million during the quarter that ended Sept. 30. It is possible, then, that Lewis got the cash he used to help recapitalize First Southern by selling First Southern more worthless bonds.