The fall of Farmington State Bank warns of the potential consequences of a bank pivoting its business model without prior regulatory permission.

For over 100 years, the Farmington, Wash.-based bank operated as a traditional community bank, making loans and taking deposits, until it was acquired by the newly formed FBH Corp. After that, the bank pivoted its business plan, diving headfirst into the cryptocurrency space and going against regulators' demands that the bank not change its business model after the acquisition. That pivot placed Farmington State Bank in the crosshairs of the collapse and bankruptcy of FTX Trading Ltd.

Now, Farmington State Bank is no longer operating after the Federal Reserve Board and the Washington State Department of Financial Institutions unveiled an enforcement action against the bank and its holding company on Aug. 17, which revealed the bank chose to voluntarily liquidate and cease operations by agreeing to sell its loans and deposits to Heppner, Ore.-based Bank of Eastern Oregon, a subsidiary of BEO Bancorp. The acquisition closed Aug. 31, Executive Vice President and COO Becky Kindle confirmed to S&P Global Market Intelligence.

"The lesson for other banks from this, regardless of their size or situation, is that going to the regulator early is always the better course of action," Matthew Bisanz, a partner in Mayer Brown's Financial Services Regulatory and Enforcement practice, said in an interview. "It may not lead to a good result, but it will avoid this problem."

The journey away from a community bank business model

Farmington State Bank was acquired by FBH, which was led by Jean Chalopin, in 2020. As part of the Washington state financial regulator's order approving FBH's application to become a bank holding company in order to acquire Farmington State Bank, the agency demanded that FBH not change the bank's business model for three years. The San Francisco Fed also included a similar provision when it approved the bank's application to become a member of the Federal Reserve System in 2021.

However, that promise was not upheld, and Farmington State Bank began operating under a new name, playing in the digital asset space, and found itself caught in the crosshairs of the collapse and bankruptcy of FTX.

In the aftermath of the cryptocurrency exchange's collapse, it came to light that Farmington State Bank, which was doing business under the name Moonstone Bank, had received an $11.5 million investment from FTX sister company Alameda Research Ventures LLC in exchange for a noncontrolling minority common share interest, or an interest less than 10%. It was a sizeable investment for a bank that had just $18 million in assets at the end of 2021, prior to the investment.

Then, at the beginning of 2023, the federal government seized just under $50 million in deposits from Farmington that were related to FTX founder and former CEO Sam Bankman-Fried as part of the criminal case against him. Those deposits made up more than three-quarters of the bank's $64.6 million in total deposits at Dec. 31, 2022.

The ties to FTX concerned regulators and prompted them to begin probing the bank. Less than a year later, regulators issued a cease and desist order against Farmington and FBH, alleging the bank engaged in activities that changed its business plan without the Fed Board's prior written approval, such as committing to "work with" a third party "to design the necessary IT infrastructure" to facilitate the third party's issuance of stablecoins to the public in exchange for receipt of 50% of mint and burn fees on certain stablecoins.

Pivoting without permission

One of the main issues that led to the bank's demise was changing its business plan without regulators' permission, according to the cease and desist order.

"[A] basic premise in a regulated business is you don't surprise your regulator," Chip MacDonald, managing director of MacDonald & Partners LLP, said in an interview. "You've got to work with your regulators. You can't just do things and then ask for forgiveness. That approach went out a long time ago."

However, not asking for permission to engage in new activities is typically not enough to shut down a bank entirely, experts said.

"The whole intent is for those orders one day to be rescinded," Michael Bell, partner and chair of the Financial Institutions Practice Group at Honigman LLP, said in an interview. "This one doesn't seem that way at all to me."

Typically, regulators use enforcement actions to force banks to clean up and change whatever it is they are doing wrong, but in Farmington State Bank's case, it was not given that option. According to the order, the bank submitted a plan for ceasing its activity with digital assets and pivoting back to its community bank business model on Jan. 25, but five months later in May, opted to voluntarily cease operations and struck an agreement to be acquired by Bank of Eastern Oregon.

James Stevens, partner and co-leader of Troutman Pepper Hamilton Sanders LLP's Financial Services Industry Group, believes the bank's concentration in the crypto industry was the regulator's main qualm.

"It is extraordinary for a violation of a commitment to the regulators to lead to a winding down of the bank," he said in an interview. "You're not going to be forced to wind down your bank because you failed to get approval. But I think that the fact that they got so concentrated in this business, and this business ... now is not what it was expected to be back when they got into it — this crypto business — that's what's really leading to this extraordinary winddown commitment that they have entered into with the regulators."

Charter stripping

The Farmington State Bank saga has also raised concerns about the idea of "charter stripping," in which an acquirer sidesteps the de novo process by acquiring a bank, but then changes its business model. The lengthy and costly process for establishing a de novo bank makes "charter stripping" attractive for investors looking to start a bank with a new business model, and they typically target very small banks with less than $100 million in assets, industry experts said.

Regulators have provisions to avoid charter stripping, such as not allowing the acquirer to change the bank's business model, Honigman's Bell said. But in Farmington State Bank's case, "the person running the bank did not abide by those restrictions," Bell said.

Now, as investor acquisitions of banks are on the rise, regulators could be on higher alert for such deals in order to avoid a situation similar to Farmington State Bank's.

At a conference in April, Fed Governor Michelle Bowman expressed concerns about charter stripping, saying these deals "have an adverse effect on local banking markets." She suggested that simplifying the de novo formation process could help lessen the demand for charter stripping.

"The ongoing demand for charter strip formations, however, reveals a disparity in treatment between de novo formations and charter strips, a disparity attributable to the difference in expectations and regulatory burden between these two paths," she said.