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FRB San Francisco complied with examination frequency guidelines for the time frame we reviewed, 2005 through 2011, and conducted regular offsite monitoring. During the period covered by our review, FRB San Francisco and the State conducted seven full-scope examinations and three target examinations; executed three enforcement actions, specifically a commitment letter, a written agreement, and a consent order; and implemented applicable PCA provisions. FRB San Francisco responded to situations involving suspicious activity in accordance with the expectations outlined in CBEM 5020.1 and filed the appropriate notification forms.
Our analysis of FRB San Francisco's supervision of Whitman from 2005 through 2011 revealed that FRB San Francisco identified corporate governance weaknesses and other significant deficiencies during its first examination in 2005 but did not take sufficient supervisory action to address these weaknesses until September 2009. In our opinion, Whitman's inability to resolve internal control weaknesses, risk management issues, and federal regulatory and state legal lending limit violations constituted early warning signs regarding the effectiveness of management, the board of directors, and the internal audit function. We acknowledge that the CBEM notes the need for subjective judgment in examinations. However, we believe that FRB San Francisco had multiple opportunities from 2005 through 2009 to take alternative supervisory action by (1) implementing more aggressive enforcement actions, (2) validating the effectiveness of recent control enhancements before upgrading the management component rating in January 2007, and (3) downgrading Whitman's CAMELS composite or component ratings to address the bank's persistent deficiencies prior to the September 2009 examination. The bank's supervisory history is outlined in table 1.
FRB San Francisco complied with premembership supervisory requirements outlined in SR Letter 98-28, Examinations of Insured Depository Institutions Prior to Membership or Mergers into State Member Banks, by verifying that Whitman satisfied the eligible bank criteria detailed in section 208.2(e) of Regulation H, Membership of State Banking Institutions in the Federal Reserve System, before being allowed to become a state member bank.15 These criteria are used to evaluate whether an institution seeking to convert to state member status should be examined before being allowed to convert. To meet these criteria, an institution must (1) be well capitalized under subpart D of Regulation H, (2) have a composite CAMELS rating of 1 or 2, (3) have a Community Reinvestment Act rating of outstanding or satisfactory, (4) have a compliance rating of 1 or 2, and (5) have no major unresolved supervisory issues outstanding as determined by the Federal Reserve Board or the applicable Federal Reserve Bank. In 2004, FRB San Francisco appropriately confirmed that Whitman satisfied these criteria and therefore did not require a premembership examination. SR Letter 98-28 has since been superseded by SR Letter 11-2, Examinations of Insured Depository Institutions Prior to Membership or Mergers into State Member Banks. SR Letter 11-2 contains technical clarifications to SR Letter 98-28 but maintains the eligible bank criteria found in SR Letter 98-28.
|Examination||CAMELS Composite Rating||CAMELS Component and Risk Examination Management Ratings||Supervisory Actions|
|Start Date||Report Issue Date||Scope||Agency Conducting Examination||Capital||Asset Quality||Management||Earnings||Liquidity||Sensitivity||Risk Management|
|01/24/2005||05/02/2005||Full||FRB San Francisco||2||2||2||3||2||3||2||3||Commitment letter issued 05/05/2005|
|01/22/2007||04/19/2007||Full||FRB San Francisco||2||2||2||2||3||2||2||3||Commitment letter released 04/19/2007|
|11/05/2007||12/17/2007||Target||FRB San Francisco||-||-||-||-||-||-||-||-|
|02/17/2009||05/01/2009||Full||FRB San Francisco||2||2||3||2||2||3||2||2|
|09/14/2009||11/24/2009||Target||FRB San Francisco||4||4||4||4||5||4||3||4||Written agreement executed 07/08/2010|
|03/29/2010||06/29/2010||Full||FRB San Francisco & State (Joint)||5||5||5||5||5||4||3||-||Consent order issued 10/22/10a|
|09/27/2010||12/09/2010||Target||FRB San Francisco & State (Joint)||5||5||5||5||5||5||5||5||PCA directive issued 02/09/2011|
|05/23/2011||07/25/2011||Full||FRB San Francisco & State (Joint)||5||5||5||5||5||5||5||5|
a The consent order was issued by the State.
In January 2005, FRB San Francisco began its first full-scope examination of Whitman. FRB San Francisco's examination resulted in a CAMELS composite 2 (satisfactory) rating. Whitman received 3 (fair) ratings for the liquidity and management CAMELS components and received 2 ratings for capital, asset quality, earnings, and sensitivity to market risk. The bank's asset quality component rating declined from 1 (strong) to 2 due to an increase in classified assets from $321,000 during the prior examination to $8.9 million. FRB San Francisco noted that the increased volume of classifications was largely the result of one relationship in the commercial and industrial portfolio. In our opinion, this was an early indicator of Whitman's propensity to develop large lending relationships. The May 2005 examination report stated that Whitman's overall financial condition was satisfactory but noted that management and risk management needed improvement. Whitman's management component rating declined from 2 to 3.
FRB San Francisco commented on the dominance of the CEO, CFO, and CLO over the direction of the institution. Additionally, FRB San Francisco noted the CEO's plans to hire relatives of senior management to serve as department heads. According to FRB San Francisco examiners, the CFO admitted that "it was always the hope of senior management that their children would come to work for the bank to provide continuity of management." In our opinion, senior management's dominance and plans to hire relatives for key functions were an early indicator of management weaknesses.
FRB San Francisco's criticisms of Whitman included deficient credit administration practices, weak internal audit function, inappropriate and outdated ALLL methodology, noncompliance with federal regulations, and weak internal controls. In particular, examiners noted credit administration weaknesses relating to (1) controls for construction lending that were inconsistent with safe and sound banking practices, (2) inadequacies in appraisal policies, (3) the lack of an independent credit review, and (4) underwriting deficiencies. FRB San Francisco commented that several of the deficiencies noted during this examination had been identified in prior examination reports. In the examination report, FRB San Francisco examiners urged Whitman to strengthen credit risk management given the bank's portfolio size, strategic plans for loan growth, and classified assets. Additionally, examiners warned Whitman that its risk management practices could adversely affect long-term capital preservation if not adequately addressed.
FRB San Francisco noted that Whitman's legal risk was increasing due to lax credit administration practices. Examiners also noted several regulatory violations,16 including
In our opinion, the fact that these violations occurred within multiple divisions of the institution were also an early indication of the ineffectiveness of management's oversight.18
As a result of the examination, FRB San Francisco and Whitman entered into a commitment letter to address the bank's audit and risk management weaknesses. According to CBEM section 5040.1, commitment letters are informal supervisory actions that (1) are generally used to correct minor problems or to request periodic reports addressing certain aspects of a bank's operations and (2) may be used when there are no significant violations of law or unsafe or unsound practices and when the bank and its officers are expected to cooperate and comply. As noted above, FRB San Francisco's 2005 examination of Whitman identified controls that were inconsistent with safe and sound banking practices, several regulatory violations, and several recurring deficiencies from prior regulatory examination reports. In our opinion, Whitman's extensive deficiencies and regulatory violations warranted a supervisory response stronger than a commitment letter, such as a memorandum of understanding, to better convey the severity of the issues and the urgent need to resolve them, especially since this examination was FRB San Francisco's initial review of the bank. According to CBEM section 5040.1, a memorandum of understanding is generally used when a bank has multiple deficiencies and must be signed by the bank's board of directors.
We believe that the deficiencies identified during this examination remained at Whitman as its risk profile increased and contributed to Whitman's failure. In our opinion, the deficiencies identified during this examination, several of which existed prior to Whitman's conversion to state member bank status, also evidenced the ineffectiveness of the eligible bank criteria for determining when to conduct a premembership examination.
As a result of a March 2006 examination, the State maintained Whitman's 2 CAMELS composite rating and upgraded the bank's liquidity component rating from 3 to 2. FRB San Francisco participated in this State examination to review management's compliance with the commitment letter. The State concluded that Whitman's overall condition was satisfactory but that the bank's risk management practices needed improvement. Examiners labeled Whitman's earnings and capital satisfactory but noted that the bank's capital ratios had declined since the prior examination due to strong asset growth outpacing earnings retention.
State examiners expressed concerns about the independence of the internal audit function because the CLO's son served as the chief internal auditor. Examiners also noted the chief operating officer's involvement in overseeing some of the internal audit activities. Accordingly, the State instructed the board of directors to address the lack of independence in the internal audit function and to enhance the audit tracking process, among other areas.
State examiners also noted the need for policy and procedure enhancements, responsiveness to recommendations from auditors and supervisory authorities, and compliance with laws and regulations. Among other items, examiners recommended that Whitman (1) strengthen lending policies and credit administration procedures, (2) establish an insider loan policy and improve documentation for insider loans, and (3) establish loan portfolio concentration limits. The State determined that Whitman's response to the independent credit review criticisms from the previous examination was less than satisfactory. Additionally, examiners notified Whitman of new violations of Regulation O, Loans to Executive Officers, Directors, and Principal Shareholders of Member Banks, 19 and Regulation Y, as well as noncompliance with the Interagency Guidelines for Real Estate Lending Policies. 20 The commitment letter remained in effect as a result of the examination.
In January 2007, FRB San Francisco conducted a full-scope examination that maintained the CAMELS composite 2 rating and terminated the 2005 commitment letter. Examiners upgraded the management component rating from 3 to 2. Examiners also downgraded the earnings component rating from 2 to 3 primarily due to a large loan loss in the fourth quarter of 2006.
The Matters Requiring Board Attention section of the examination report noted issues with credit underwriting, ALLL methodology and levels, and measurement and monitoring of credit risk. In addition, FRB San Francisco examiners identified concentrations of credit to borrowers that either individually, or through related entities, exceeded 25 percent of tier 1 capital and reserves. FRB San Francisco again commented on the CEO's dominance over Whitman's affairs.
FRB San Francisco upgraded the bank's management component rating due to its sound financial performance and the responsiveness of management to examination feedback. Additionally, examiners concluded that Whitman was in full compliance with the commitment letter and terminated the action. Examiners noted that Whitman's management had (1) strengthened construction lending policies and procedures, (2) improved the appraisal process and implemented an effective appraisal policy, (3) improved the independent credit review process, and (4) taken actions indicating a stronger internal audit function. However, FRB San Francisco stated that the recently implemented risk management processes related to audit, credit, liquidity, the Bank Secrecy Act, and information technology required validation by management and auditors to ensure their overall effectiveness. Furthermore, FRB San Francisco examiners noted that the overall risk management remained fair and needed further enhancement. In our opinion, FRB San Francisco should not have upgraded the management rating without having the opportunity to validate the effectiveness of recent control enhancements.
In November 2007, FRB San Francisco conducted a target examination to assess Whitman's progress toward strengthening its risk management. Examiners concluded that Whitman had made measurable progress toward strengthening its overall risk management and addressing concerns from the prior examination; however, FRB San Francisco encouraged management and the board of directors to continue strengthening underwriting and credit monitoring. FRB San Francisco noted that Whitman's management and board of directors had not addressed several risk management concerns identified in prior examinations. FRB San Francisco noted that (1) internal loan grade definitions did not match regulatory definitions, (2) the Regulation O policy and procedures needed further enhancement, and (3) the ALLL policy needed refinement.
As a result of a March 2008 examination, the State maintained Whitman's CAMELS composite 2 rating. Examiners upgraded the earnings component rating from 3 to 2 and maintained 2 ratings for all other components. The State deemed Whitman's overall condition satisfactory and its risk management practices appropriate for the size and complexity of the institution.
State examiners noted that credit administration had improved and underwriting was adequate. The State concluded that Whitman's ALLL methodology was generally adequate and that the allowance level was appropriate. Examiners noted several areas of concern, however, including (1) high CRE concentrations, (2) high noncore funding, and (3) federal regulatory and state legal lending limit violations. In particular, the State notified Whitman of several violations, including violations of Regulation Y and Revised Code of Washington 30.04.111, Limit on Loans and Extensions of Credit to One Person. Examiners also notified Whitman of a contravention of Interagency Guidelines for Real Estate Lending Policies for a loan that exceeded supervisory loan-to-value guidelines.
State examiners noted that Whitman's concentration risk was elevated due to a high volume of loans made to a relatively small group of borrowers. According to the State, Whitman's management exceeded limitations on loans to a single borrower with eight separate individuals. Loans to one borrower totaled approximately $60 million and accounted for 118 percent of the bank's capital. In aggregate, Whitman exceeded the lending limit for the eight borrowers by $196 million as of March 2008. The concentrated lending to individual borrowers increased the risk that a single borrower experiencing financial difficulties could significantly affect the bank's capital position, which ultimately contributed to Whitman's failure.
FRB San Francisco began a full-scope examination of Whitman in February 2009. The previous examination noted significant findings regarding legal lending limit violations. FRB San Francisco examiners determined that Whitman remained in satisfactory condition but noted that its overall risk profile was moderate with an increasing trend even though the bank's legal lending limit violations remained unresolved. The bank's CAMELS composite rating remained a 2, but examiners downgraded the bank's asset quality and liquidity component ratings from 2 to 3.
FRB San Francisco examiners noted an increase in Whitman's classified assets and the need for improved credit risk management practices. Furthermore, FRB San Francisco identified management's lack of oversight on large unsecured lines of credit and urged management to improve its monitoring of them. Examiners did not find any new legal violations during this examination and deemed the internal audit program and internal controls adequate for Whitman's size and complexity.
Examiners noted that Whitman's credit risk was increasing due to its high CRE concentrations and a softening real estate market. FRB San Francisco concluded, however, that the CRE levels remained manageable. The volume of CRE loans had increased by $41.2 million since the prior year. Examiners concluded that Whitman's CRE concentration risk management was adequate but noted the need for enhanced underwriting of CRE loans.
During this examination, FRB San Francisco again commented on the CEO's dominance in controlling the institution. Additionally, examiners noted that three outside directors expressed concerns regarding the number of inside directors and the difficulties of implementing change. FRB San Francisco stated that the inside directors were part of the executive management team and that strong bonds appeared to exist.
FRB San Francisco examiners notified Whitman that asset quality problems were evident, economic conditions were weakening, and continued deterioration in the loan portfolio could seriously impact Whitman's capital position. An FRB San Francisco interviewee noted that he did not feel comfortable with the combination of the management team, the deteriorating economy, and the composition of the bank's portfolio. Nevertheless, Whitman's composite rating remained a 2. In our opinion, the bank's increasing risk profile and weak credit risk management practices warranted a stronger supervisory response, such as downgrades to the composite and component ratings.
FRB San Francisco recognized several significant issues in the February 2009 examination and appropriately accelerated the next examination to September 2009. In September 2009, FRB San Francisco began a target examination to review the accuracy of Whitman's internal loan rating system and the overall effectiveness of its credit risk management. The target examination revealed that the bank had serious financial and ongoing managerial deficiencies and exhibited unsafe and unsound conditions or practices. FRB San Francisco examiners noted deficient board oversight and risk management activities as well as an increased level and severity of problem assets and critically deficient earnings. Based on the results of the target examination, FRB San Francisco expanded the examination scope to include all of Whitman's CAMELS components. The examination resulted in a double downgrade to the CAMELS composite rating from 2 to 4 (deficient). Additionally, the examination resulted in a triple downgrade to the earnings component rating from 2 to 5 (critically deficient) and double downgrades to the risk management rating and the capital and management component ratings from 2 to 4. FRB San Francisco examiners also downgraded the asset quality and liquidity component ratings from 3 to 4 and the sensitivity to market risk component rating from 2 to 3.
FRB San Francisco noted deficient board of directors' oversight and risk management and inadequate capital for Whitman's heightened risk profile. Examiners criticized the board of directors and management for implementing a strategy that allowed high borrower and CRE concentrations and questionable underwriting practices. FRB San Francisco also notified Whitman of its need to improve credit risk management after identifying weaknesses in risk identification, underwriting standards, appraisal practices, and concentrations of credit. In addition, examiners informed Whitman that its ALLL methodology was unacceptable.
Whitman's classified assets increased by approximately 228 percent since the February 2009 examination. FRB San Francisco examiners noted that OREO had increased from approximately $270,000 at the prior examination to nearly $8 million at the target examination. Examiners attributed the bank's asset quality deterioration to the economic downturn, liberal underwriting, borrower concentrations, and poor risk selection. FRB San Francisco issued Matters Requiring Immediate Attention directing the board of directors to, among other things, (1) establish a plan to reduce classified assets, (2) improve the monitoring of unsecured lines of credit, (3) establish portfolio limits for unsecured lending, (4) reduce CRE concentrations, and (5) strengthen credit administration and underwriting.
As previously noted, FRB San Francisco downgraded the earnings component rating from 2 to 5. Examiners noted that the distressed asset quality coupled with weak credit risk management, high ALLL provisions, and a contracting net interest margin elevated the risk to the bank's earnings. Furthermore, examiners concluded that Whitman's capital levels were deficient given the bank's risk profile. In our opinion, this significant downgrade further evidences that stronger supervisory action should have been taken during the prior examination, especially given the short time frame between these examinations.
As a result of this examination, FRB San Francisco directed management to develop a comprehensive capital plan and warned that the bank's capital position was under pressure. FRB San Francisco also deemed Whitman to be in "troubled condition." 21 Furthermore, as a result of this examination, examiners initiated a formal enforcement action and implemented the action, a written agreement, in July 2010. We acknowledge that this was the appropriate supervisory response. However, by the time examiners initiated the action, the severity of Whitman's asset quality deterioration had already negatively impacted the bank's capital and earnings.
As a result of a March 2010 full-scope examination of Whitman, FRB San Francisco and State examiners downgraded the CAMELS composite rating to 5, noting that the bank's overall condition continued to deteriorate and threaten its viability. In addition, examiners downgraded the capital, asset quality, and management component ratings to 5. The earnings, liquidity, and sensitivity to market risk ratings remained unchanged.
In the Matters Requiring Board Attention section of the examination report, FRB San Francisco and State examiners instructed the board of directors to, among other things, (1) reduce the level of adversely classified items, (2) develop a formal capital plan that will increase capital ratios to a level commensurate with the bank's risk profile, (3) strengthen board of directors and management oversight, (4) establish specific underwriting criteria for all unsecured lending, and (5) correct apparent violations of law and contraventions of regulatory guidance and ensure future compliance.
FRB San Francisco and State examiners labeled asset quality critically deficient and noted an increase of more than $90 million in adversely classified items since the February 2009 examination and appropriately downgraded Whitman's asset quality component rating to 5. Additionally, examiners determined that concentrations of CRE and credit to individual borrowers remained excessive and instructed Whitman to reduce the concentrations. Examiners noted that Whitman's historically liberal underwriting practices and concentrations of credit to single borrowers had resulted in the high volume of problem loans. Furthermore, FRB San Francisco and State examiners noted numerous credit administration weaknesses and an unreliable credit grading process. Examiners also noted management's strategy to replace secured problem loans with unsecured loans to new borrowers and concluded that the strategy demonstrated imprudent credit underwriting and appropriately downgraded Whitman's management component rating to 5.
FRB San Francisco and the State notified management that this strategy of liberally underwriting unsecured loans to work through problem loans exposed the bank to additional risk. Furthermore, during the examination, a whistleblower alleged to FRB San Francisco that Whitman was intentionally misrepresenting nonperforming assets. The whistleblower also alleged that a bank-approved appraiser's son obtained a loan from Whitman for "business purposes or business investments," but instead used the proceeds to make outstanding interest payments on a loan that his father had obtained from the bank. Examiners directed management to notify the appropriate authorities regarding this transaction. Examiners also criticized another transaction involving the same appraiser, noting that the transaction had the appearance of self-dealing and a potential conflict of interest. FRB San Francisco filed the appropriate notification forms regarding this transaction.
FRB San Francisco and State examiners also noted that Whitman's severe asset quality deterioration continued to result in net losses and capital depletion. According to examiners, Whitman's ALLL methodology continued to be inappropriate, and the ALLL remained underfunded. Whitman's asset quality deterioration resulted in significant provision expenses. Examiners concluded that capital was critically deficient and that immediate financial support was required. According to examiners, Whitman's holding company was not able to provide capital support at that time due to its own financial strain. In March 2010, a member of senior management in credit administration resigned, claiming he was expected to engage in schemes to deflect regulators' attention from Whitman's capital issues and that he was terminated for choosing not to assist in the efforts.
FRB San Francisco and State examiners concluded that management's and the board of director's oversight was critically deficient and noted that management had not appropriately identified risks. Examiners also noted that management had not addressed key recommendations and criticisms from prior examinations. Additionally, examiners noted several violations and contraventions of federal regulatory guidance, including violations of Regulation Y and contraventions of Regulation H. Furthermore, examiners recommended that Whitman strengthen its management by adding qualified individuals from outside the bank to change the credit culture because of the dominating influence of the senior executive team. As a result of the September 2009 and March 2010 examinations, FRB San Francisco executed a written agreement in July 2010, and the State issued a consent order in October 2010.
FRB San Francisco and the State conducted a joint target examination and maintained the bank's CAMELS composite 5 rating, as the overall condition of the bank continued to deteriorate. Examiners downgraded the liquidity and sensitivity to market risk component ratings to 5 and maintained 5 ratings for all other components.
The joint examination report noted that liberal underwriting, concentrations of credit to single borrowers, large unsecured loans, and a high volume of problem loans posed a distinct threat to Whitman's viability. FRB San Francisco and State examiners stated that, since the prior examination, adversely classified assets had increased by more than $23 million and represented approximately 253 percent of tier 1 capital plus ALLL. Furthermore, examiners identified weaknesses in the bank's management of problem loans, credit concentrations, and the ALLL methodology. Examiners expressed doubt regarding the integrity of Whitman's loan workout program and noted management's propensity to manipulate problem loans.
Additionally, FRB San Francisco and State examiners concluded that Whitman had not complied with the written agreement and had not adequately addressed eight of the provisions relating to, among other things, board of directors' oversight of the institution, enhancements to the ALLL methodology, and the capital plan. The examination report deemed Whitman's ALLL methodology to be unacceptable and inappropriate and the ALLL to be underfunded. Furthermore, examiners noted that Whitman still had not submitted an acceptable capital plan; subsequently, the Federal Reserve Board issued a PCA directive to Whitman on February 9, 2011.
As a result of a May 2011 joint examination, FRB San Francisco and State examiners determined that Whitman exhibited extremely unsafe and unsound practices and conditions and that its financial performance was critically deficient. Examiners maintained Whitman's CAMELS composite and component ratings at 5. According to examiners, Whitman's ineffective board of directors and senior management oversight and deficient risk management practices were the catalyst to the bank's declining and unsatisfactory condition.
The joint examination report noted that Whitman's risk management practices were inadequate and noted that the ALLL methodology was materially flawed and that the ALLL was significantly underfunded. FRB San Francisco and State examiners noted that this was the fourth consecutive examination with criticisms to management's oversight of the ALLL methodology. Examiners required a provision of approximately $10.6 million to the ALLL, which resulted in Whitman falling to critically undercapitalized upon conclusion of the May 2011 examination.
Furthermore, FRB San Francisco and State examiners noted that Whitman had not complied with the written agreement and still had not adequately addressed eight provisions relating to, among other things, the board of directors' oversight of the institution, credit risk management, lending and credit administration, the ALLL, and the capital plan. In addition, examiners concluded that an immediate capital injection was necessary for Whitman to avoid failure and noted that Whitman still had not submitted an acceptable capital plan at the time of the examination.
FRB San Francisco and the State expressed concern regarding Whitman's CRE exposure due to high levels of classified loans and management's inability to identify asset quality problems in a timely manner. At the time of this examination, adversely classified loans accounted for approximately 22 percent of total assets and approximately 340 percent of tier 1 capital and ALLL. In addition, examiners criticized Whitman's credit risk practices and noted the need to improve areas such as management of concentrations and the lack of an ongoing loan review function.
The examination report noted that Whitman had circumvented or disabled its risk management processes altogether, which led to an environment in which questionable accounting practices and unethical business practices went unchallenged. During the examination, FRB San Francisco and the State also noted that the board of directors chose to ignore or neglected to act on information regarding suspicious activities. According to the report, senior management allegedly coerced several employees to obtain loans in an effort to increase the bank's capital. For example, a member of management alleged that he was coerced into purchasing Whitman stock as a condition of his employment. Examiners noted that the board of directors failed to follow established policies and procedures for notifying appropriate authorities in this and other instances. FRB San Francisco responded to these situations in accordance with the expectations outlined in CBEM 5020.1 and filed the appropriate notification forms.
As a result of the examination, FRB San Francisco and State examiners concluded that Whitman's high level of problem loans, failure to raise additional capital, and overall lack of compliance with the written agreement and the consent order demonstrated management's inability to return Whitman to a satisfactory condition. Whitman fell to critically undercapitalized upon conclusion of the May 2011 examination. The State closed Whitman and appointed the FDIC as receiver on August 5, 2011.