Lightning on the Horizon

Lawrence Seidman has been investing in small banks and thrifts for 22 years, often using the leverage afforded by those shares to pressure boards and managements to change strategic direction or sell. So how does he assess the present state of board/shareholder relations in the industry? “Worse than it’s ever been. Directors seem much more willing to do whatever they can to limit the voice of the shareholder,” says the Parsippany, New Jersey-based activist. “With the really good companies, the relationship has gotten better. But you still see a lot of boards that circle the wagons and won’t communicate when they’re performing poorly.”

The observations of Seidman, who essentially goes out looking for trouble by targeting underperforming institutions, tell one side of the storyu00e2u20ac”but there’s another viewpoint as well. Many astute observers say that, generally speaking, relationships between bank boards and their investors are more orderly and less combative than they’ve been in some time. “Things are as peaceful as I’ve ever seen them,” says Robert Clarke, who served as comptroller of the currency in the late 1980s and early 1990s and is now a senior partner at the law firm of Bracewell & Giuliani in Houston.

There’s plenty to support such good feelings. A constant drumbeat of shareholder scrutiny has made boards more accountable and more professional than ever. Most now boast independent audit and compensation committees. New legislationu00e2u20ac”most notably the Sarbanes-Oxley Actu00e2u20ac”and tougher regulations have codified those good governance notions into law.

Perhaps most important, banks as a group have never done better financially. In the first quarter of 2006, the industry posted profits of $37.3 billionu00e2u20ac”smashing the previous record of $34.6 billion in last year’s third quarteru00e2u20ac”with returns on equity and assets of 13.07% and 1.35% respectively, according to the Federal Deposit Insurance Corp. And when returns are good, investors are more willing to cut board members slack.

Consider McLean, Virginia-based Capital One Financial Corp., where Chairman and CEO Richard Fairbank cashed in some $249 million in options last year. While the figure made for some juicy headlines and predictable outrage from governance watchdogs, it barely raised an eyebrow among shareholders. That was partly because Fairbank has collected no salary or bonus since 2002 and faced an expiration date that required he either use the options or lose them. But what really seemed to mute shareholder criticisms was the credit card and banking giant’s 800% return over the past 10 years. “If you’re performing well, most investors will give boards the benefit of the doubt,” says Robert McCormick, vice president of proxy research for Glass Lewis & Co., a proxy advisory firm in San Francisco.

Watching the radar

For all the positives, the past year hasn’t been short on combativeness and strife at the intersection of investor interests and board oversight. Shareholder resolutions on proxies are on the rise, proxy fights are still occurring, and the courts are asked to intervene in disputes far more than seems reasonable. So what does the future hold? All quiet on the shareholder front, or all-out war? While it’s tricky trying to predict the future, there are some ominous signs.

For starters, rising rates and flat yield curves are compressing margins. According to the FDIC, two of every three banks and thrifts saw spreads decrease in the first quarter; for big banks, they’ve fallen to their lowest level in more than 15 years. Investors are much more assertive now than they were the last time the industry hit a rough patch. So if profits start to fall, expect shareholders to begin pressing boards to pursue new strategies or even sell out.

The hottest flashpoint is expected to be executive compensation. New Securities and Exchange Commission rulesu00e2u20ac”widely expected to be approved this fall, in plenty of time for the 2007 proxy seasonu00e2u20ac”will require that proxies disclose the current values of all elements of compensationu00e2u20ac”including salary, bonus, equity grants, pension, and severance benefits, even perksu00e2u20ac”in one easily digested table. (The old method effectively hid the values of key parts of comp packages, such as pension and severance benefits, or perks, in complicated formulas.) The SEC also plans to require a “compensation discussion and analysis” narrative in the proxy statement, loaded with such details as the role of peer benchmarking in setting the CEO’s pay, what sort of performance the package is intended to reward, and why it’s important that top executives have personal access to the corporate jet.

The rules are an effort by regulators to rein in runaway CEO pay packages with more shareholder scrutiny, and to force boards to think hard about how various pieces of these often-convoluted packages fit together. While it might eventually pan out that way, a more-probable short-term scenario is shareholder outrageu00e2u20ac”especially for boards signing off on big paychecks that aren’t justified by performance. “With greater disclosure comes a greater likelihood that shareholders will actually read the numbers and revolt,” says Patrick McGurn, executive vice president of Institutional Investor Services, a Rockville, Maryland, proxy adviser. “We’ll wind up with more confrontation when the complete numbers see the light of day for the first time.”

Smart board members must navigate these dynamics with one eye set on doing right by shareholders and the other on protecting their own backs. “You have to pay attention to, and take into account, the climate of the times. But you also have to recognize that there are fads and waves in shareholder sentiments, and ultimately those recede and change,” says H. Rodgin Cohen, chairman of the law firm Sullivan & Cromwell in New York. Put another way, “You have to try and understand what you can do to deal with certain situations at a specific point in time, but not fundamentally undermine your own basic principles.”

When those principles go against the populist grainu00e2u20ac”or even if they don’tu00e2u20ac”a combination of knowledge and proactive communications are the most crucial tools in the board’s arsenal. Perception can be as important among today’s investors as the facts, and many more assertive shareholders aren’t afraid to try and pressure boards into action by going public with their beefs and demands. If a board isn’t prepared to counter those argumentsu00e2u20ac”strongly and with reasoned communications that show it has all the bases coveredu00e2u20ac”things can get nasty.

Defense measures

On the compensation front, lawyers say boards with highly paid CEOs will ultimately live or die on how well the discussion and analysis part of the comp committee’s report is able to justify and explain various parts of the pay package. “You have to be able to tell a story, not only that yes, we espouse pay for performance, but also the type of performance we’re [aiming] at and how each element of our pay gets us there,” says Laura Thatcher, a partner and head of the executive compensation practice at Alston & Bird in Atlanta.

Don’t be surprised if some of the more egregious comp packages somehow find their way to courtu00e2u20ac”with board members as defendants. Some boards have spent the summer going through dry-run mockups of what their disclosures would look like, and a handful have actually altered parts of their CEO’s pay before the story goes public. “It’s all about the final number,” says Michael Melbinger, partner and global head of employee benefits and executive compensation at Winston & Strawn in Chicago. “To protect yourself, you need to know, review, and discuss every component of the compensation package to make sure you’re comfortable with it.”

Getting a good grasp of the issues and communicating those views effectively to shareholders is important in other areas, as well. Take shareholder proposals. Boards tend to oppose most of them, and that’s fine: For most issues, there are at least two arguments to be made, and often many more nuanced ones. The key is making the argument well.

At both San Francisco-based Wells Fargo & Co. and Wachovia Corp. in Charlotte, for instance, shareholders introduced resolutions this year to require a majority of shares represented be cast for a candidate to join the board, instead of simply giving the seat to the person who gets the most votes. It’s a subtle, but important, difference. And it makes some intuitive sense on the surface. But the companies argueu00e2u20ac”and most experts agreeu00e2u20ac”that down the road, such rules would likely boost proxy solicitation costs significantly, and could even spark legal problems if an election failed to produce a result. “Taken to its logical conclusion, it could lead to almost political-style campaigns for board seats,” says Ralph Davis, chairman of Waller Lansden Dortch & Davis, a Nashville, Tennessee law firm. “It’s not a good model. But on the face of it, how can you be against majority rule?”

By and large, banks are in the same boat as other segments of corporate America, with investors taking their ownership roles more seriously and challenging boards’ governance methods through proposed shareholder resolutions. In the past proxy season, several, including Wachovia and Minneapolis-based U.S. Bancorp, had proposals on the ballot aimed at making director elections annual. And a group of shareholders at New York-based Citigroup proposed that the company reimburse “reasonable expenses” incurred by shareholders in contested director elections.

Sometimes, the subject matter has little to do with banking. Proxies at Citi, Wachovia, and Seattle-based Washington Mutual Inc. in Seattle all had proposed resolutions demanding that the boards prepare semi-annual reports on the amounts of corporate political contributions and the policies that govern them. Citi shareholders also requested a similar report on charitable contributions. At Wells Fargo, one resolution would have required the board to prepare a report explaining the “racial and ethnic disparities in the cost of loans” in its lending practices, and to opine on such areas as whether “some of these disparities are explained by the racial wealth divide prevalent in the United States.”

On rare occasions, poor performance can push boards themselves into adopting more progressive, shareholder-friendly postures. For years, Fifth Third Bancorp in Cincinnati was one of the industry’s highfliers. But since early 2004, share prices have fallen 40%u00e2u20ac”fueled by rising interest rates, accounting issues, and the departures of some key executives. With investors getting anxious, the board this year recommended that shareholders approve resolutions to declassify board elections and eliminate supermajority voting requirements on issues related to director elections and removals. “A lot of these situations have to be evaluated on a case-by-case basis,” Cohen says. “Sometimes conditions suggest that you need to placate unhappy shareholders by taking steps you might otherwise not have taken.”

The boards of smaller banks don’t face as many resolutions; when they do arise, however, the subject matter is typically more serious. “When we see activity like that, almost always the resolution is demanding that the board hire a financial adviser and give serious consideration to its strategic alternatives,” says Walter Moeling, chairman of the financial institutions practice at Powell Goldstein, an Atlanta law firm with 350 community bank clients across the country. “There’s a natural skepticism that the bank is being run to give the CEO a job, and that even if there were an attractive offer, it wouldn’t be considered.”

Holding the board accountable

As a handful of high-profile cases during the past year illustrate, the tit-for-tat between investors and boards can get nasty when poor performance melds with communications problems. At Pittsburgh-based Mellon Financial Corp.u00e2u20ac”a chronic underperformer compared to its more highly valued bank rivals in the transaction processing and asset management spaceu00e2u20ac”the board came under attack in December from a shareholder group that publicly denigrated its strategy and demanded the board either sell the company or spin off one of its key business units.

“Shareholders have had a long, hard wait of over seven years to see Mellon create value,” stated a letter sent by Richard Grubman, a managing director at Boston-based Highfields Capital Management, to then-Chairman and CEO Martin McGuinn. “It’s time to do something other than hunker down and blame inaction on the limitations of the marketplace.”

One Pittsburgh newspaper, the Tribune-Review, ostensibly fearful that the company’s weakness could imperil local jobs, took the bait, going so far as to publish the names and day jobs of the company’s outside directors on its editorial page. “Will the board of directors take definitive action now to ensure that a large segment of this beleaguered region’s economic foundation is preserved?” the paper asked in an editorial urging directors to fire McGuinn. “Lest they look forward to a personal black eye, we call on them to grow a spine and do their civic duty in aiding a city that can afford to lose nothing more.”

Directors say the tactic resulted in few phone calls from the public. Nevertheless, a month later, the board fired McGuinn, its CEO of seven years (with a $19 million severance package), replacing him with Robert Kelly, a former chief financial officer at Wachovia who earned plaudits for making the nation’s fourth-biggest banking company more open and shareholder-friendly.

Mellon’s share prices have risen by nearly 20% since then. But the board is not out of the woods yet. While Highfields has backed off, another big investoru00e2u20ac”the California Public Retirement System, or CalPERS, owner of 2.5 million Mellon shares worth about $87 millionu00e2u20ac”has been demanding a meeting with Mellon’s independent directors to press them to remove a requirement that a 75% supermajority vote is necessary to amend the company’s bylaws. “We still see stock performance as a problem,” says a CalPERS spokesman. “We’re not walking away from the table while we still have a stake in what happens.”

Another investor, a union, has been making noise about replacing the board’s staggered terms with annual elections. Kelly says he has “committed to put into writing that we’ll review all of our antitakeover provisions” during the next year. “We’ll look at everything in detail and make appropriate changes in due course,” he adds. “But I want to understand everything we’re doing first.”

Across the Keystone state, the board of Sovereign Bancorp Inc. in Wyomissing was put on the hot seat by a group of activist shareholders, led by San Diego investment firm Relational Investors. Relational, owner of a 7.3% stake in Sovereign, had threatened a proxy battle last summer, charging that the board lacked independence. When Sovereign Chairman and CEO Jay Sidhu announced plans to simultaneously sell a 19.8% stake to Spain’s Banco Santander Central Hispano and acquire Independence Community Bank Corp., a $19 billion thrift in New York, the stage was set for an intense skirmish.

Relational argued that the deals were merely part of an effort to dilute shareholders’ power and demanded they be put to a shareholder vote because the transactions amounted to a change in control. Sovereign countered that a vote wasn’t necessary because Santander’s proposed stake was below 20%u00e2u20ac”and the New York Stock Exchange signed off on the arrangement. Relational, which won support from several key shareholders, including CalPERS and Franklin Mutual Advisers LLC, appealed to the SEC, and over the course of five months both sides jockeyed for position in the courts, the press, and even the Pennsylvania legislature, which passed a law that supported Sovereign’s stance.

The two sides eventually struck an uneasy compromise: In exchange for dropping its opposition to the deals, Relational got one board seat itself and the ability to recommend the person who will hold another. It was the kind of face-saving agreement that allowed both sides to claim victory, though neither side appears to be very satisfied with the outcome.

“Sovereign’s board was doing everything it was supposed to do, but you had an investor who wanted to make waves,” says Clarke, who compiled a lengthy report on the transaction for Sovereign. Counters an attorney who represented Relational: “The board was rife with conflict, and Sovereign decided to pick a fight with an investor that was very determined and smart. … [Relational] could have won, but it concluded that it would have hurt the value of its investment in Sovereign itself.”

Sovereign hasn’t been the only bank fighting in court with a shareholder. Overall, the industry’s tight regulatory environment is a plus when it comes to dealing with shareholders. Having an extra set of eyes scrutinizing things tends to keep bankers on their toes and gives investors some reassurance. But sometimes that notion works in reverse. Sullivan and Cromwell’s Cohen notes that several large banks, including Citigroup, New York-based JP Morgan Chase & Co., and AmSouth Bancorp in Birmingham, Alabama, have been the targets of class-action shareholder suits for minor regulatory missteps. “Sometimes, there are no fines, no big share-price drop. Just the fact that there was a regulatory issue leads to a lawsuit being filed,” he explains. Plaintiffs will “claim that the company’s reputation has been damaged in some way.” The Delaware courts, Cohen adds, have thrown out several such cases before they reach the discovery phase. Even so, the banks are forced to mount defenses.

Smaller skirmishes just as testy

Smaller bank boards aren’t immune to such shareholder conflicts. Activist Seidman, known for his willingness to strong-arm inexperienced boards of recently converted mutual thrifts with proxy battles and lawsuits, rightly strikes fear into many directors. According to a 2005 report by analyst Joseph Fenech at Sandler O’Neill & Partners in New York, 13 of the 18 banking companies targeted by Seidman between 1995 and early 2005 wound up selling. And this past April, another oneu00e2u20ac”$1.5 billion Interchange Financial Services Corp. in Saddle Brook, New Jerseyu00e2u20ac”agreed to be bought by Portland, Maine-based TD Banknorth Inc. for $481 million in cash, a 21% premium to its price the day before the deal was announced. “We notified them that we were going to have a proxy contest, and they decided to sell the bank,” Seidman says matter-of-factly.

His latest battle involves Yardville National Bancorp, a $3 billion thrift in Hamilton, New Jersey. Owner of an 8.5% stake in the company, Seidman nominated his own slate of candidates for three board seats last May, only to see them beaten soundly by incumbents. In response, he’s taken the company to court, challenging the results. The case was in discovery at press time, and Seidman declined to talk about details, except to say he has “a simple philosophy: If you own 5% of a company, you have a right to representation on the board.” Yardville representatives did not respond to interview requests.

Activist investors like Seidman, who target smaller institutions that are underperforming, could be dismissed as relative aberrations. Sure, they grab headlines. But there are nearly 8,800 banks and thrifts in the country, so certainly their impact is limited. Or is it?

Walter Moeling believes that the mindsets of local shareholders in community banks have changed markedly as the industry’s consolidation plays out. Not long ago, most viewed their bank holdings “as an abstraction that was good for the community and nice to own, but not as a manageable financial asset,” the attorney explains. Over the past decade, however, many have seen institutions they know get sold for big premiums, and they want in on the action. “There’s a growing awareness among shareholders that this is a real investment. They’re talking about it at their coffee clubs and beauty parlors, and are feeling like owners,” Moeling says. “And they’re much more interested in valuations and how the company is performing. That’s bringing more pressure to bear on the boardroom.”

The ramifications of this shift can have a profound influence in smaller towns where everybody knows everybody else. In such cases, the pressure might not be as well organized as with an activist. But many boards are now seen as keepers of a key financial asset in the communityu00e2u20ac”something that the shareholders expect to produce regular dividends, and perhaps a jackpot down the road. And sometimes, disputes centered on those feelings wind up in court.

Moeling tells of a pending shareholder lawsuit against the directors of an Alabama bank. “You have the CEO and chairman going around town telling shareholders every year that the bank is wonderful, but it’s never performed, and the stock is worth less now than it was five years ago,” he says. “The real problem is, the board hasn’t been responsive to shareholders, and now some shareholders are trying to do something about it” by forcing a sale.

Similarly, former shareholders of Napa Community Bank in Napa, California filed a lawsuit in November, charging that the company’s acquireru00e2u20ac”Capitol Bancorp Ltd. of Lansing, Michiganu00e2u20ac”misrepresented the value of the company and underpaid for their shares in a 2005 acquisition. And the board of Independence Federal Savings Bank in Washington, D.C. has been embroiled in a battle for control with its biggest shareholder, Morton Bender, who also owns Colombo Bank in nearby Rockville, Maryland.

The ownership mentality plays out in other ways that can require effective communications. The SEC requires community banks that have between 500 and 1,000 shareholders to be registered, meaning they need to comply with Sarbanes-Oxley accounting and reporting rules. For a bank that makes, say, $2 million a year, the compliance price tagu00e2u20ac”he estimates it at more than $200,000u00e2u20ac”is borderline ridiculous. So some banks are choosing to deregisteru00e2u20ac”a move that requires bringing the shareholder count below 300.

There are two ways to accomplish this, Moeling says: reacquire minority shares or reclassify some shares into a special nonvoting class. The catch is both approaches require a persuasive argument to get shareholders to voluntarily give up shares. “You need to go to them and say, ‘We hate to do this. We don’t want to send you home. But the costs are killing us. … We’ve got to buy your stock back for the sake of remaining shareholders and the health of the institution.’” Moeling says shareholders are surprisingly receptive to such pleas, provided they get a little something in returnu00e2u20ac”a premium on those shares, for instance, or special dividends and rights if they give up voting power.

“Smart bank boards are realizing they have an obligation to know their shareholder base, and to make their case to investors effectively and in a fair light,” Moeling adds. Keeping on top of the bank’s performance and coming up with well-crafted messages to address shareholder concerns are the best ways to keep the board out of harm’s way.