Investor Pressure Points for the 2018 Proxy Season

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proxy-2-9-18.pngInvestors need to stay focused on long-term performance and strategy in 2018. So says Larry Fink, the chief executive of BlackRock, the world’s largest asset manager with $6.3 trillion in assets under management, in a recent and well-circulated letter. “Companies must be able to describe their strategy for long-term growth,” says Fink. “A central reason for the risk of activism—and wasteful proxy fights—is that companies have not been explicit enough about their long-term strategies.”

Focusing on long-term success isn’t controversial, but Fink’s letter underlines the fact that proxy advisors and investment management firms are more frequently looking at broader issues—gender diversity and equality, and other cultural and environment risks—that can serve as indicators of long-term performance.

Board composition will continue to be a growing issue. BlackRock, along with State Street Global Advisors, the asset management subsidiary of State Street Corp., both actively vote against directors where boards lack a female member. “[Institutional investors] are tired of excuses,” says Rusty O’Kelley, global leader of the board consulting and effectiveness practice at Russell Reynolds Associates. “Regional banks [in particular] need to take a very close look at board quality and composition.” Fink, in his letter, said that diverse boards are more attuned to identifying opportunities for growth, and less likely to overlook threats to the business as they’re less prone to groupthink.

The use of board matrices, which help boards examine director expertise, and disclosure within the proxy statement about the use of these matrices, are increasingly common, according to O’Kelley. The varied skill sets found on the board should link to the bank’s overall strategy, and that should be communicated to shareholders. Expertise in cybersecurity is increasingly desired, but that doesn’t necessarily mean the board should seek to add a dedicated cybersecurity expert. “Institutional investors view cybersecurity as a risk the entire board should be paying attention to,” says O’Kelley. “They want all directors to be knowledgeable.”

Some investors are pursuing gender equality outside of the boardroom. On February 5, 2018, Bank of New York Mellon Corp. disclosed the pay gap between men and women—the fourth bank to do so in less than a month, following Citigroup, Bank of America Corp. and Wells Fargo & Co. “Investors are demanding gender pay equity on Wall Street, and we have no intention of easing up,” said Natasha Lamb, managing partner at the investment firm Arjuna Capital, in a release commenting on BNY Mellon’s gender pay disclosure. These banks, along with JPMorgan Chase & Co., Mastercard and American Express, rejected Arjuna’s proposals last year to disclose the pay gap between male and female employees, along with policies and goals to address any gap in compensation.

A domino effect can occur with these types of issues. “[Activist investors will] move on to the next bank,” says Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware.

Shareholders are aware that cultural risks can damage an organization. This includes bad behavior by employees—Wells Fargo’s account opening scandal, for example—as well as an organization’s approach to sexual harassment and assault, an issue that has received considerable attention recently due to the “Me Too” movement. “Shareholders are very focused on whether or not boards and management teams are doing a sufficient job in trying to understand what the tone is throughout the organization, understand what the corporate culture is,” says Paul DeNicola, managing director at PwC’s Governance Insights Center. Metrics such as employee turnover or the level of internal complaints can be used to analyze the organization’s culture, and companies should have a crisis management plan and employee training program in place. Boards are more frequently engaging with employees also, adds DeNicola.

Investors are keenly aware of environmental risks following a year that witnessed a record-setting loss estimate of $306 billion due to natural disasters, according to the National Oceanic and Atmospheric Administration. Institutional investors expect boards to consider the business risk related to environmental change, says O’Kelley, particularly if the bank is at greater risk due to, for example, a high level of real estate loans in coastal areas.

Finally, investors will be looking at how organizations use the expected windfall from tax reform. “What will you do with the increased after-tax cash flow, and how will you use it to create long-term value?” said Fink in his letter. It’s an opportunity for companies to communicate with shareholders regarding how additional earnings will be distributed to shareholders and employees, and investments made to improve the business.

In an appearance on CNBC’s “Squawk Box,” Fink explained that BlackRock votes with the companies it invests in 91 percent of the time due to the engagement that occurs before the proxy statement is released. Fink’s preference is that engagement occurs throughout the year—not just during proxy season—to produce better long-term results for the company’s investors.

Engaging with shareholders—and listening to their concerns—can help companies succeed in a serious proxy battle. “If you have good relations with your investors, you’re apt to, in a contest, fair a bit better,” says Elson.

Preparing Your Bank to Fight Shareholder Activists

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activism-9-25-17.pngThe financial sector has not been immune to the growth in shareholder activism seen in recent years, and certain trends have emerged that make “bank activism” distinct from other parts of the economy. Understanding these trends, the statistics underlying them and their ramifications can help determine the steps banks should take in advance to ensure the best possible outcome should a contentious engagement with an activist ever occur.

First, financial companies, particularly banks, are among the firms most frequently targeted by activists. In recent years, 21 percent of activist targets have been in the financial sector, second only to technology companies. This focus on the financial services industry has stayed relatively consistent post-financial crisis, with banks comprising the majority of these financial targets, although that may fluctuate some from year to year. Thus, as activism continues to grow, the frequency at which banks are targeted can likely be expected to grow as well.

Campaign Breakdown by Sector, January 16 – July 17

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Banks as Percentage of Activist Targets

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However, bank targets are significantly smaller than targets in other sectors. Due in part to the complex regulatory regime for banks versus other industries, the main driver for bank activism is to pursue a sale, a strategy usually easier to deploy at smaller companies due to the larger universe of viable buyers. Therefore, banks targeted by activists from January 2016 through July 2017 had a mean market capitalization that was 47 percent smaller than nonbank targets over the same period.

Smaller banks may have fewer resources to respond to an activist. For example, their finance, legal and IR/PR functions may be managed by just a handful of employees, meaning the time and attention required of staff, management and the board can be much bigger. In that case, distraction from the day-to-day duties of running the business can be disproportionately larger.

While activists outside of the banking sector are usually industry generalists, bank activists are normally sector-specialist investors. The majority of bank campaigns are currently undertaken by a few hedge funds that invest nearly all of their portfolios in financial companies—primarily banks—and practically all of their previous campaigns have been against banks.

Prominent Activist Investors in Banks

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Therefore, these activists have extensive knowledge of the industry, the individual banks and their management teams, and most importantly the decision-makers at other institutional investors that invest in this sector. They also have a successful track record of forcing bank targets to initiate a sale, a marked difference from other sectors where an activist typically is a relatively new fund with little activism or proxy fight experience.

A bank activist may have a generally benign relationship with management and the board, and be a significant shareholder of a small-cap bank for quite some time before agitating. However, when market conditions evolve to support a possible sale, the dynamic can change quite dramatically, potentially leading to transformative change—for better or worse—within a short time. For example, Basswood Capital had been a key shareholder at Astoria Financial Corp. for more than 15 years before filing its 13D and demanding a sale of the company. Astoria capitulated just a few months later, and its acquisition by Sterling Bancorp is expected to close in the fourth quarter 2017.

These factors underscore how bank activists are both experienced and sophisticated, while their targets may be relatively less prepared to effectively respond and, if need be, protect the long-term interests of their shareholders in a public battle. As a result, bank activists are more successful than activists in other sectors at winning board seats, where they can aggressively push forward their agenda. From January 2016 through July 2017, activists were successful in getting board representation at bank targets 32 percent of the time, versus only 26 percent in other sectors.

In this environment, mid- and small-cap banks must be proactive in preparing for, and hopefully avoiding, a confrontation with an activist. First, banks must periodically assess their strategy versus alternatives an activist may demand, and effectively articulate and execute on that strategy. Although not a guarantee, the strongest defense is performance, knowing where you may be vulnerable to criticism by an activist and preemptively trying to mitigate that. Second, banks should develop an activism response plan and team, including members of management and the board, and a ‘go-to’ team of outside advisors with experience in bank activism. Finally, banks should regularly seek feedback from their shareholder constituencies, and be aware of their views on certain issues and how to resolve them. Given how suddenly an activist situation can occur, it is critical to be ready in advance.

The Proactive Approach to Managing Shareholder Relations

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shareholder-relations-7-13-16.png“You either die the hero or you live long enough to see yourself become the villain.” While it is safe to assume that filmmaker Christopher Nolan did not have a board of directors in mind when he wrote that line about Batman in The Dark Knight, the words are fitting nonetheless. In this day and age, if you sit on a board of directors of a bank long enough, you will eventually be confronted by a shareholder that no longer appreciates how the board is managing the bank. Knowing a confrontation with an activist shareholder will inevitably arise, a board of directors has two options: be proactive or reactive.

Being proactive means taking steps now to engage with all shareholders and prepare to address the concerns of a hard-charging shareholder. Being reactive means ignoring the inevitable in hopes that the board can react quickly under pressure about the board’s stewardship of the bank. Historically, the reactive approach was safe due to the infrequency of shareholder activism in banking. However, in today’s “what have you done for me lately” culture, people believe they are entitled to immediate recognition of their complaints, substantive responsiveness from the board and, ultimately, satisfaction of their demands.

Boards should consider implementing a number of actions to avoid being caught flat-footed. A board can adopt a shareholder engagement policy and/or create a shareholder relations committee. A good shareholder engagement policy will delineate the board’s process regarding shareholder communications and guidance on what is and is not permissible for directors to discuss with shareholders. A shareholder engagement policy typically includes:

  • the purpose of the policy;
  • the responsibilities of the board with regard to shareholder communications;
  • the procedures for interactions between the board and shareholders, including details about how and when such interactions should be conducted, documented and reported to the board;
  • acknowledge the legal and regulatory concerns inherent in engaging with shareholders; and
  • the general topics that are appropriate for the board to address, any limitations on those topics and any topics that the board and management are expressly prevented from discussing.

A detailed shareholder engagement policy also allows the board to set forth a clear shareholder communication strategy prior to confronting an activist shareholder.

A board can also implement a shareholder relations committee. The shareholder relations committee can:

  • review, update and implement a shareholder engagement policy or other procedures governing interactions with shareholders;
  • oversee and document all communications from the board to shareholders;
  • establish avenues or forums for shareholders to communicate with the board and vice versa;
  • appoint a specific individual to supervise and be responsible for speaking directly with shareholders;
  • communicate with management regarding investor relationships; and
  • set the procedures and oversee the purchase of stock by insiders.

The committee would oversee shareholder communications. During difficult stretches, a shareholder relations committee facilitates the board’s understanding of the issues concerning shareholders. This will simplify the process of conveying the bank’s strategy to shareholders. This is particularly important when the board feels it is necessary to calm any shareholder anxieties. During prosperous times, a board can ensure that shareholders fully understand the exemplary results the bank is producing and what it means for the shareholders’ investments.

Should the board have to deal with an activist shareholder, the foundation built and maintained by the committee can prove invaluable. Banking is about relationships. That is just as true for shareholders as it is for customers. If an activist shareholder arrives, the shareholder relations committee can utilize the goodwill generated with the majority of shareholders to gauge where the shareholder base stands on certain issues. Having relationships with all of the shareholders can help the board craft an appropriately measured response and ensure its message is disseminated properly to all shareholders.

A proactive board should not be viewed the same as a board taking defensive measures in the face of a proxy contest or hostile takeover. Some boards may be hesitant to take proactive actions for fear that the board will appear as though they are trying to entrench themselves. Communicating with shareholders is vastly different than implementing defensive measures that can (rightly or wrongly) be painted by activist shareholders as self-serving. By taking these actions the board shows shareholders that it cares about transparency and meaningful communication with the owners of the bank. The proactive approach conveys the message that the board welcomes and will be responsive to constructive interactions with shareholders.

Preparing for the New Reality of Bank Activism

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activism-4-8-16.pngFrom 2000 to 2014, activist hedge fund assets under management are reported to have swelled from less than $5 billion to nearly $140 billion. This sharp rise in assets under management is reflected in a 57 percent increase in activist campaign activity over the last five years. And while performance can vary greatly by fund, reports are that activist hedge funds have generally outperformed other alternative investment strategies in recent years. The upshot for the banking industry is clear: as more activist investors with more dry powder are looking for investment opportunities, activists have moved beyond the “low-hanging fruit” into regulated industries, including financial services, which had previously been considered too complex.

Banks historically were viewed as unlikely targets for activist investors. The burdens are significant on an investor deemed to “control” the bank (from a bank regulatory perspective). The investor must be concerned with an intrusive Change in Bank Control Act filing and fundamental changes may be mandated by the Bank Holding Company Act if the investor’s voting, director and activist activities result in it crossing often less than well-defined “control” thresholds. However, today’s activists have learned that even small holdings of a bank’s stock—for example less than 5 percent of voting stock—often suffice to generate the desired change and provide the desired return. Many activists thus have successfully achieved their objectives without triggering bank regulatory consequences.

As activist investors sharpen their focus on the banking sector, their criteria for which entities to target remain the same. Target companies generally share several key characteristics: underperforming (on a relative basis), broadly held ownership structures and/or easily exercisable shareholder rights. An underperforming business presents the potential for economic upside, while a dispersed ownership structure and easily exercisable shareholder rights provide access to the boardroom, or at least the ability to make demands. Activist stakes are often small as a percentage of overall capital and many activist campaigns rely on winning over institutional and other investors on measures to improve the performance of the business and, ultimately, the stock price. These measures can range from those intended to result in a sale of the bank, such as changing directors, to less disruptive, but nonetheless material changes, such as enhancing clawback features in executive compensation plans.

While no two activist campaigns are alike, activist engagement generally begins with a private approach to the board of directors or management. If the activist does not succeed in private conversations, more public disclosure of the activist’s campaign can take the form of public letters to the board of directors or management, public letters to stockholders, white papers laying out the activist proposal, or filings with the Securities and Exchange Commission related to ownership of the target’s stock. Finally, and at greater cost to the activist and target alike, activists can commence a proxy contest or litigation.

So how is a bank to know whether an activist has taken a position in its stock? For smaller, privately held banks, it is more important than ever to maintain close oversight of investor rolls. Publicly traded banks need to monitor Schedule 13D and Form 13F filings. An investor that accumulates beneficial ownership of more than 5 percent of a voting class of a company’s equity securities must file a Schedule 13D within 10 days. In an activist campaign, however, 10 days can represent a very long time and an activist can build up meaningful economic exposure through derivatives without triggering a Schedule 13D filing obligation. 13F filings are made quarterly by institutional investment managers. On the antitrust front, and likely more relevant to midsize and larger banks, an investor that intends to accumulate more than $78.2 million of a company’s equity securities must generally make a Hart-Scott-Rodino (HSR) filing with the Federal Trade Commission and notify the issuer of the securities. As with Schedule 13D filings, an activist can use derivative investments to avoid triggering an HSR filing. Given the limits of these regulatory filings, many publicly traded companies turn to proxy solicitors and other advisors who offer additional data analytics services to track a company’s shareholder base.

Boards must proactively prepare for such events. Any activist response plan will address a handful of key issues, including an assessment of the bank’s vulnerabilities, an analysis of the bank’s shareholder rights profile, engagement with shareholders on strategic priorities generally, identification of the proper team to respond to an activist approach, and ongoing analysis and monitoring of the shareholder base. No plan will address all potential activist approaches, but the planning exercise alone, done well in advance without pressures of an activist campaign, can position a bank to minimize exposure to activist pressures and to respond quickly, proactively and effectively to activist approaches.

Could You Be a Target of Shareholder Activism?

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shareholder-activism-2-2-16.pngShareholder activism appears to be on the rise again, after subsiding somewhat during the financial crisis, and hedge funds are driving most of it, according to speakers Monday at Bank Director’s Acquire or Be Acquired Conference in Phoenix.

“They want to create public discussion and increase value through an increase in stock price or sale,’’ said Bill Hickey, co-head of investment banking for the investment bank Sandler O’Neill + Partners.

Activist hedge funds’ assets have risen 11-fold from 2003 to the third quarter of 2015, to $131 billion, according to Hedge Fund Research reports.  Banks are hardly immune. In fact, Sandler O’Neil analyzed acquisitions above $50 million in value for banks and thrifts traded on a major exchange since January 1, 2014, and found 61 percent of the sellers had activist shareholders involved. Recent targets have included New York-based Astoria Financial Corp., which announced a sale to New York Community Bancorp late last year shortly after Basswood Capital Management filed what’s known as a 13-D letter with the Securities and Exchange Commission, announcing the hedge fund had acquired a significant stake in the bank. Some activists have even ganged up on banks together, which was the case with Harrisburg, Pennsylvania-based Metro Bancorp; Cincinnati, Ohio-based Cheviot Financial Corp.; and Alliance Bancorp, Inc. of Pennsylvania, the speakers said.

Underperforming community banks are most likely the targets but bigger banks such as CIT and Bank of New York Mellon also have been subject to activist attacks. “In the last couple of weeks, we’ve heard more and more noise about the potential for larger organizations to be targets,’’ Hickey said. But really, almost any bank can qualify as a target. According to Hickey, traits that often attract activist investors include having a stock that trades at a discount to intrinsic value, having substantial cash or liquid assets, underperforming a peer group of banks, having inefficient operations, or even just having the potential to sell for a premium. Even private banks are subject to shareholder activism. Peter Weinstock, an attorney with Hunton & Williams LLP, said he has represented banks as small as $100 million in assets with proxy battles and family-owned banks whose shareholders do battle with the board.

While bank CEOs and boards generally despise them, activist shareholders argue that the pressure they apply to boards and management teams can lead to an increase in shareholder value and propel sluggish management teams to make improvements. Share prices often increase substantially after an activist hedge fund gets involved. Most often, activist hedge funds are looking for a sale of the bank, and if no suitable buyers appear, they go away, Hickey said. Sandler and Covington identified the major activist shareholders targeting banks right now, and they include PL Capital, Stilwell Value, Basswood Capital Management, Veteri Place Corp., Jacobs Asset Management, Clover Partners and Ancora Advisors.

Defenses against shareholder activists include tracking the bank’s performance to peers, as well as the bank’s shareholder rights practices and compensation in relation to peers, because that’s what the activists do, said Rusty Conner, an attorney with Covington & Burling. Boards should also pay close attention to shareholder advisory firms’ recommendations, especially if the bank has a significant institutional shareholder ownership. Also, Conner said it pays to beef up your communication with shareholders, and make sure you have a media relations and investor relations team ready to spring into action if your bank is targeted.

In general, banks are bit tougher for activist investors to crack, as they are heavily regulated and even gaining two seats on the board may constitute taking a controlling interest in the bank’s board, said John Dugan, an attorney with Covington. Investors who take a controlling interest potentially become subject to regulation as a bank holding company. Also, regulators have to approve a bank’s capital plan, including the payment of dividends and share buybacks, so struggling banks often are restricted in what they can do for shareholders.

Still, it pays to get your bank ready if you might be vulnerable to an attack.

Four Predictions for Bank M&A in 2016

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M&A pricing and shareholder activism are both on the rise as 2015 comes to a close. In this video, Peter Weinstock, a partner at Hunton & Williams LLP, outlines his predictions for bank M&A in 2016.

  • Will sellers command a higher price in 2016?
  • How will deals be structured?
  • Will there be more shareholder activism?
  • Where will community banks find growth opportunities?

How to Avoid Minefields in a Merger or Acquisition

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With hundreds of bank failures since the financial crisis began and many mergers and acquisitions taking place in an environment of financial and regulatory stress, Commerce Street Capital Managing Director Tom Lykos responds to written questions related to M&A in the face of shareholder activism and heightened judicial scrutiny.

Can you say a little about the regulatory and financial environment and how that is impacting banks?

The increased regulatory scrutiny that began with the crisis of 2008 has only been heightened by the increased regulatory burdens of the Dodd-Frank Act. However, there is a tension between the fiduciary duties owed to shareholders and the obligations directors owe to the FDIC and their primary regulator. At times, the director is caught between the need to accede to the “requests” and directives of regulators while vigorously advocating and advancing the interests of shareholders where the burdens of compliance seem excessive and adversely affect profitability. In such situations, engaging qualified and independent financial and legal advisors is justified given the nature, complexity and immediacy of the issues confronting management and directors. Reliance upon their advice is advisable given that the FDIC alleged, in its demand for payment of civil damages sought from certain officers and directors of BankUnited FSB in Florida, that they failed to heed the warnings and/or recommendations of bank consultants prior to the bank’s 2009 failure. 

How should bank directors approach M&A in the current environment?

In general, it is fair to state that the old standards still apply. However, the application of these standards has been more rigorous with regard to corporate governance in the context of both evaluating a bank’s strategic direction in general and especially in M&A transactions.  Officers and directors do not necessarily have to prove they received the “highest” or “best” price. Rather, they are charged with the duty of following a course or a process that leads to a reasonable decision, not a perfect decision.  In the context of a merger, an independent fairness opinion increases the probability that a board’s decisions will be protected by the business judgment rule and may also help facilitate shareholder approval of a proposed transaction.

If the old standards still apply, then how have the burdens on directors changed?

Although the standards have not changed, there is a higher level of scrutiny on directors now than at any time in the recent past. Increased regulatory oversight combined with increased shareholder activism has resulted in a corresponding increase in judicial scrutiny of the reasonableness of directors’ actions. The level of scrutiny is heightened in situations where an institution is not adequately capitalized, financial performance has lagged and shareholders have concerns about the bank’s strategic direction and the strategic options proposed by management. With regards to situations where subpar performance has led to shareholder activism, the creation of a special committee of the board and retention of an advisor to present strategic options are appropriate responses to address shareholder concerns. Without sounding alarmist, it may be that it is no longer enough for directors to satisfy their obligations to shareholders by negotiating a premium, hiring a financial advisor and obtaining a fairness opinion for a sale or acquisition. The courts have demonstrated an increased willingness to look behind the conclusions of a fairness opinion and board deliberations to determine if a transaction is fair from a financial point of view.

Can you give me an example?

Directors can look to recent court decisions to discern the inquiries relevant to appropriate director conduct. These include: Were the conflicts of interest adequately addressed and disclosed to shareholders, including those that may have unduly influenced directors, management and the financial advisor in the exercise of their judgment and discretion? Who took the lead in negotiating the transaction and what were their financial incentives for doing so? Was the process designed and implemented in a way intended to maximize shareholder value? Were there terms in the merger agreement and “deal protection devices” that were excessive or coercive in the context of the specific transaction? Was there adequate input from disinterested and independent directors? Was the fairness opinion truly independent or was the advisor’s fee contingent on a successful transaction, creating conflicts or “perverse incentives?” In short, both the courts and shareholders are focusing on the events and circumstances that lead to a transaction; the board process in evaluating a transaction (whether accepted or rejected); deal protection devices that may discourage or preclude the consideration of other offers; and the existence and disclosure of apparent or actual conflicts of interest among officers, directors and advisors that might impair their independent judgment.