8.COMMITMENTS AND CONTINGENT LIABILITIES

Off-Balance-Sheet Financing and Concentrations of Credit

The Company is a party to certain financial instruments with off-balance-sheet risk to meet the financing needs of its customers. These financial instruments include the Company’s commitments to extend credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated statement of condition. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the commitments to extend credit is represented by the contractual notional amounts of those instruments which are presented in the tables below (dollars in thousands). The Company uses the same credit policies in making commitments as it does for on-balance-sheet instruments.


	March 31, 2020
	Fixed Rate		Variable Rate		Total
Financial instruments whose contract amounts represent credit risk (including unused lines of credit and unadvanced loan funds):
Commitments to extend credit	$	32,859	$	205,008	$	237,867
Standby letters of credit		—		30,483		30,483
	$	32,859	$	235,491	$	268,350


	June 30, 2019
	Fixed Rate		Variable Rate		Total
Financial instruments whose contract amounts represent credit risk (including unused lines of credit and unadvanced loan funds):
Commitments to extend credit	$	23,892	$	357,223	$	381,115
Standby letters of credit		—		33,385		33,385
	$	23,892	$	390,608	$	414,500

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and require payment of a fee. Since certain commitments are expected to expire without being fully drawn, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral, if any, required by the Company for the extension of credit is based on management’s credit evaluation of the customer.

Commitments to extend credit may be written on a fixed rate basis thus exposing the Company to interest rate risk, given the possibility that market rates may change between commitment and actual extension of credit.

Standby letters of credit are conditional commitments issued by the Company to guarantee payment on behalf of a customer or to guarantee the performance of a customer to a third party. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Since a portion of these instruments will expire unused, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance-sheet instruments. Bank policies governing loan collateral apply to standby letters of credit at the time of credit extension.

Certain residential mortgage loans are written on an adjustable basis and include interest rate caps which limit annual and lifetime increases in interest rates. Generally, adjustable rate mortgages have an annual rate increase cap of 2% and lifetime rate increase cap of 5% to 6% above the initial loan rate. These caps expose the Company to interest rate risk should market rates increase above these limits. At March 31, 2020, approximately $46.4 million of adjustable rate residential mortgage loans had interest rate caps. In addition, certain adjustable rate residential mortgage loans have a conversion option whereby the borrower may elect to convert the loan to a fixed rate during a designated time period. At March 31, 2020, approximately $3.6 million of the adjustable rate mortgage loans had conversion options.

The Company periodically sells residential mortgage loans to FNMA and to the State of New York Mortgage Agency. At March 31, 2020 and June 30, 2019, the Bank had no loans held for sale. In addition, the Bank has no loan commitments with borrowers at March 31, 2020 and June 30, 2019 with rate lock agreements which are intended to be held for sale, if closed. The Company generally determines whether or not a loan is held for sale at the time that loan commitments are entered into or at the time a convertible adjustable rate mortgage loan converts to a fixed interest rate. In order to reduce the interest rate risk associated with the portfolio of loans held for sale, as well as loan commitments with locked interest rates which are intended to be held for sale if closed, the Company enters into agreements to sell loans in the secondary market. At March 31, 2020 and June 30, 2019, the Company had no commitments to sell loans to unrelated investors.

Concentrations of Credit

The Company primarily grants loans to customers located in the New York State counties of Albany, Greene, Rensselaer, Schenectady, Saratoga, and Warren. Although the Company has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon the real estate and construction-related sectors of the economy.

Legal Proceeding and Other Contingent Liabilities

The Company is involved in various pending and threatened claims and other legal proceedings in the ordinary course of business. The Company evaluates the possible impact of these matters, taking into consideration the most recent information available. A loss reserve is established for those matters for which the Company believes a loss is both probable and reasonably estimable. Once established, the reserve is adjusted as appropriate to reflect any new developments. Actual losses with respect to any such matter could be significantly more or less than the amount estimated by the Company. For matters where a loss is not probable, or the amount of loss cannot be reasonably estimated by the Company, no loss reserve is established.

As of March 31, 2020, the Company believes that any liabilities individually or in the aggregate, which may result from the final outcomes of legal proceedings, is unlikely to have a material adverse effect on the Company’s consolidated financial statements. However, legal proceedings are often unpredictable, and it is possible that the ultimate resolution of any such matters, if unfavorable, may be material to the Company’s results of operations in any future period, depending, in part, upon the size of the loss or liability imposed and the operating results for the period, and could have a material adverse effect on the Company’s business, results of operations and financial condition. In addition, regardless of the ultimate outcome of any such legal or bankruptcy proceeding, inquiry or investigation, any such matter could cause the Company to incur additional expenses, which could be significant, and possibly material, to the Company’s results of operations in any future period.

Potentially Fraudulent Activity

As previously disclosed, during the first fiscal quarter of 2020 (the quarter ending September 30, 2019), the Company became aware of potentially fraudulent activity associated with transactions conducted in the Company’s first fiscal quarter of 2020 by an established business customer of the Bank. The customer and various affiliated entities (collectively, the “Mann Entities”) had numerous accounts with the Bank. The transactions in question relate both to deposit and lending activity with the Mann Entities. Several other parties are asserting claims against the Company and the Bank related to the series of transactions between the Company or the Bank, on the one hand, and the Mann Entities, on the other. The Company and the Bank continue to investigate these matters and it is possible that the Company and the Bank will be subject to additional liabilities which may have a material adverse effect on our financial condition, results of operations or cash flows. The Company is pursuing all available sources of recovery and other means of mitigating the potential loss and the Company and the Bank are vigorously defending all claims asserted against them arising out of or otherwise related to the fraudulent activity of the Mann Entities. See “Legal Proceedings,” below.

For the fraudulent activity related to the Mann Entities, the Bank’s potential exposure with respect to its deposit activity is expected to be approximately $19.0 million and with respect to its lending activity with the Mann Entities, the Bank’s potential exposure is expected to be approximately $16.0 million (which represents the Bank’s participation interest in the approximately $36.0 million commercial loan relationships for which the Bank is the originating lender). In the first fiscal quarter of 2020, the Bank exercised its legal right of setoffs on the deposit accounts held by the Mann Entities at the Bank. The Bank recognized a charge to non-interest expense in the amount of $2.5 million, in the first fiscal quarter of 2020, based on the net negative deposit balance of the various Mann Entities’ accounts after the setoffs. In the first fiscal quarter of 2020, the Bank concluded that due to the impact of the potential fraudulent activity, it is more likely than not that the Bank will not be able to recover the loan balances. The Bank recorded a provision for loan losses in the amount of $15.8 million, in the first fiscal quarter of 2020, related to the charge-off of the entire principal balance owed to the Bank related to the customer’s commercial loan relationships. During the third fiscal quarter of 2020 (the quarter ended March 31, 2020), the Bank recognized a partial recovery in the amount of $1.7 million related to the charge-off of the Mann Entities commercial loan relationships. No additional charges to non-interest expense or the provision for loan losses were recognized in the third fiscal quarter of 2020 related to the transactions with the Mann Entities.

For the other parties asserting claims against the Company and the Bank, in the second fiscal quarter of 2020, Southwestern Payroll Services, Inc. (“Southwestern”), a payroll company, and National Payment Corp. (“NatPay”), a third-party automated clearing house service provider, filed lawsuits against the Bank seeking recovery of allegedly wrongful seizure and retention of funds related to the Mann Entities. In February 2020, Berkshire Bank and Chemung Canal Trust Company, the participating lenders with the Bank in the Mann Entities commercial loan relationships, filed lawsuits against the Bank seeking recovery of their respective aggregate participation interest and additional damages. See “Legal Proceedings” below for additional information regarding these lawsuits.

Legal Proceedings

On October 31, 2019, Southwestern filed a complaint against the Company and the Bank (“Pioneer Parties”), Michael T. Mann, Valuewise Corporation, MyPayrollHR, LLC and Cloud Payroll, LLC (collectively, the “Mann Parties”) in the United States District Court for the Northern District of New York. The complaint alleges that the Pioneer Parties (i) wrongfully converted certain funds belonging to Southwestern, (ii) engaged in fraudulent and wrongful collection and retention of funds belonging to Southwestern, and (iii) committed gross negligence and that Southwestern is entitled to a constructive trust limiting how the Pioneer Parties distribute the funds in question, which are about $9.8 million. On November 26, 2019, the Pioneer Parties moved to dismiss Southwestern’s fraud claim, which also postponed the Pioneer Parties’ deadline to file an answer until 14 days after the court decides the motion to dismiss. On December 10, 2019, Southwestern filed both a response to the Pioneer Parties’ motion to dismiss and an amended complaint, which rendered the Pioneer Parties’ motion to dismiss moot. The amended complaint names several corporate entities affiliated with the Mann Parties as co-defendants and asserts claims against the Pioneer Parties for declaratory judgment, conversion, actual and constructive fraud, gross negligence, unjust enrichment and constructive trust, and an accounting. The amended complaint seeks a monetary judgment of at least $9.8 million. Each party has filed numerous motions in the proceedings. On January 10, 2020, the Pioneer Parties moved again to dismiss Southwestern’s fraud claim, which also postponed the Pioneer Parties’ deadline to file an answer until 14 days after the court decided the motion to dismiss. On April 16, 2020, the court granted the Pioneer Parties’ motion to dismiss Southwestern’s fraud claim. On April 30, 2020, Southwestern filed a motion to reconsider the court’s motion to dismiss, along with a second amended complaint. On May 1, 2020, the Pioneer Parties filed their answer. The Pioneer Parties asserted numerous affirmative defenses, and the Bank asserted counterclaims against Southwestern and cross-claims against certain of the Mann Parties based on common law fraud under New York law and violations of the federal Racketeer Influenced and Corrupt Organization Act (“RICO”). The Bank’s fraud counterclaim/cross-claim seeks damages of at least $15.6 million, plus pre-judgment interest, jointly and severally against Southwestern and the named Mann Parties. The Bank’s RICO counterclaim/cross-claim seeks treble damages of at least $46.5 million, plus pre-judgment interest and attorneys’ fees, jointly and severally against Southwestern and the named Mann Parties.

On December 10, 2019, NatPay filed a motion to intervene as a plaintiff in Southwestern’s lawsuit against the Pioneer Parties and the Mann Parties as described above. Attached to NatPay’s motion to intervene is a proposed complaint, which includes, among other matters, a prayer for relief seeking “compensatory damages in an amount of no less than $4 million” (the complaint also seeks punitive damages and interest in unspecified amounts). On January 10, 2020, the Pioneer Parties filed their response opposing NatPay’s motion to intervene. NatPay’s motion to intervene remains pending.

On February 4, 2020, Berkshire Hills Bancorp Inc.’s wholly owned subsidiary Berkshire Bank (“Berkshire Bank”), filed a complaint against the Bank in the Supreme Court of the State of New York, in the County of Albany, New York resulting from its participation interest in the commercial loan relationship to the Mann Entities. The complaint alleges that the Bank (1) breached the amended and restated loan participation agreement between the Bank and Berkshire Bank dated as of June 27, 2018, (2) breached the amended and restated loan participation agreement between the Bank and Berkshire Bank dated as of August 12, 2019, (3) engaged in constructive fraud, (4) engaged in fraudulent inducement, (5) engaged in fraudulent concealment, and (6) negligently misrepresented certain material information. The complaint seeks to recover $15.6 million and additional damages. The timeframe within which the Bank’s response is due has been extended.

On February 4, 2020, Chemung Financial Corporation’s wholly owned subsidiary, Chemung Canal Trust Company (“Chemung”), filed a complaint against the Bank in the Supreme Court of the State of New York, in the County of Albany, New York resulting from its participation interest in the commercial loan relationship to the Mann Entities. The complaint alleges that the Bank (1) breached the participation agreement between the Bank and Chemung dated as of August 12, 2019, (2) engaged in fraudulent activities, (3) engaged in constructive fraud, and (4) negligently misrepresented and omitted certain material information. The complaint seeks to recover $4.2 million and additional damages. The timeframe within which the Bank’s response is due has been extended.

During the quarter ended March 31, 2020, Cachet Financial Services (“Cachet”), a third-party automated clearing house service provider, filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code in the Central District of California, Los Angeles Division. Cachet is currently involved in legal proceedings against certain Mann Parties and other related parties. The Bank is not listed as a creditor in the bankruptcy proceedings. However, in the filings with the bankruptcy court, Cachet asserts that the Bank is holding $7.0 million of its funds. The Company and the Bank dispute this assertion and, if necessary, intend to defend themselves vigorously.

On April 30, 2020, the U.S. Department of Justice, with the authorization of a delegate of the Secretary of the Treasury, filed a civil complaint against the Company and the Bank (and Cloud Payroll, LLC) in the United States District Court, Northern District of New York (the “DOJ Complaint”). The complaint alleges, among other things, that the Company and the Bank wrongfully seized approximately $7.3 million from an account held by Cloud Payroll to apply towards debts allegedly owed to the Bank by Cloud Payroll and other affiliates of Michael Mann. The complaint alleges that the funds in question were comprised of payroll taxes withheld by Southwestern and thus subject to a statutory trust under 26 U.S.C. § 7501 that prohibited the Bank from seizing those funds to apply towards debts owed to the Bank. The complaint seeks return of any payroll taxes, plus interest. The Bank and the Company have not yet answered or otherwise responded to the government’s complaint. The DOJ Complaint relates to the same set of facts described above in– “Potentially Fraudulent Activity,” and the alleged payroll taxes, plus interest, sought in this proceeding may be part of the recovery sought in the Southwestern complaint described above.

The Company and the Bank are defending each of these lawsuits vigorously, and management believes that the Company and the Bank have substantial defenses, including affirmative defenses, counterclaims and cross-claims to the various allegations that have been asserted. The Company and the Bank continue to investigate these matters and it is possible that the Company and the Bank will be subject to additional liabilities. The ultimate outcome of these lawsuits, or any other litigation or other similar proceedings, involving the Company, the Bank or the Pioneer Parties, cannot be predicted with certainty. It also remains possible that other parties will pursue additional claims against the Bank as a result of the Bank’s dealings with certain of the Mann Entities or as a result of the actions taken by the Pioneer Parties. The Company’s and the Bank’s legal fees and expenses related to these actions are expected to be significant. In addition, costs associated with potentially prosecuting, litigating or settling any litigation, satisfying any adverse judgments, if any, or other proceedings, could be significant. These costs, settlements, judgments or other expenses could have a material adverse effect on the Company’s financial condition, results of operations or cash flows.