In Blocking Activists, the Fed Protects Poorly Performing Banks

An activist shareholder sought to shake up a money-losing company. It was shaping up to be a typical corporate dogfight — until the Federal Reserve stepped in.

That’s what happened recently in the case of First Financial Northwest when a major shareholder, the Stilwell Group, sought to elect two nominees to the board of the savings and loan.

It was not the first time the Federal Reserve had opposed shareholder activism, preferring not to shake things up at badly performing banks.

First Financial Northwest is a struggling community bank based in Renton, Wash., with more than $1.1 billion in assets. Like many small banks, it did not fare well during the financial crisis, losing about $90 million over the last few years.

In 2010, First Financial was put under special supervision by the federal government and was required to increase its capital, reduce its commercial real estate loan portfolio and enhance its corporate governance. First Financial is now supervised by the Federal Reserve and is required to obtain approval from the government for any change in directors or officers.

In October, First Financial was approached by the Stilwell Group, a New York-based money management firm that had acquired a 7.9 percent stake. First Financial and Stilwell agreed to appoint Spencer L. Schneider, the general counsel of Stilwell, as a director of the bank.

He obtained Federal Reserve clearance to serve, but his tenure was short.

At a Feb. 15 meeting, Mr. Schneider made three demands on the First Financial board. He proposed to “terminate the director emeritus program,” which Mr. Schneider claimed paid directors as much as $150,000 a year even after their death for doing “nothing.” He also proposed to “remove the directors’ photographs from the executive suite walls” since the photos rewarded poor past performance and the bank was “not a country club or an English manor.”

Finally, as a symbol of First Financial’s newfound austerity, Mr. Schneider wanted to “serve only hard candy at the upcoming annual meeting.” He also protested the board’s policy of free iPads for directors.

When the First Financial board refused to accede immediately to his demands, Mr. Schneider resigned, claiming that the board was unwilling to make necessary changes.

Stilwell promptly renominated Mr. Schneider and a second director to the nine-member First Financial board, setting off a proxy fight.

At this point, the Federal Reserve stepped in to block Stilwell.

Under government regulations, an acquisition of “25 percent of the voting shares” or “control” of a savings and loan holding company is subject to Federal Reserve approval.

Although Stilwell was seeking only two of nine board seats, or 22 percent of the board — and those two were unlikely to have any kind control over it — the regulator forced Stilwell to reduce the number of its nominees to one.

The Fed has also recently injected itself into a shareholder activist campaign against Cardinal Bankshares, a Virginia-based bank with about $250 million in assets. Schaller Equity Partners owns 9.8 percent of the bank and initially proposed to fill five of six director seats at the company’s May 22 annual meeting.

Cardinal Bankshares is regulated as a bank holding company. The Fed claimed that if Schaller elected a majority of Cardinal Bankshare’s directors, then Schaller would also become subject to regulation as a bank holding company, a death knell for the operation of the firm. The regulator was acting under a 2008 policy that states that any shareholder having more than one board seat on a bank potentially has a controlling interest, making it subject to this regulation.

Schaller has subsequently dropped the number of its nominees to three to placate the Fed. Even so, the regulator has taken more steps to ensure that Schaller does not have control over these nominees, claiming that even this number of directors could still make Schaller a bank holding company. The directors are now executing passivity agreements that will limit their ability to coordinate activity with Schaller.

The Fed’s position here is bound to raise questions not just among those who favor shareholder activism as an instrument of good corporate governance. The regulator is acting directly to limit shareholder efforts to oust entrenched bank directors intended to improve the operation of banks.

The proxy advisory service Institutional Shareholder Services first raised an alarm about the Fed’s conduct. In a note to its clients, I.S.S. argued that “by limiting a dissident slate through regulatory fiat, rather than allowing shareholders to do the winnowing, regulators hobble one of the more powerful corrective mechanisms of capital markets, and insist instead that bank shareholders stick with the devil they know.”

In other words, the Fed appears to prefer the management of poorly performing banks over those who want to run the banks’ operations better. To accomplish this, it is taking a bureaucratic view of its regulations, claiming in the case of First Financial that two of nine directors constitute control of the bank when it obviously doesn’t. Under Fed policies, even trying to start a proxy contest to force management change can subject a shareholder to bank holding company regulations.

The Fed’s position is surprising. You might think that after the financial crisis, it would want to move quickly to oust bad bank managers and shape up the banks. Shareholder activists do just this for a living.

Instead, the Fed is blocking shareholders from monitoring and changing banks, leaving only regulators with the ability to effect change. That hasn’t worked out well in the past.

A Fed spokeswoman declined to comment.

But the central bank has previously stated that these policies were established to ensure those shareholders who reap the benefits of bank ownership also share in the responsibilities of oversight and support.

This is all a matter of balance, however. I understand the argument that shareholder activists can force banks to take short-term actions that are not in the best interests of the company, but regulators will still be there to act in such a case. This should be weighed against the benefits of shareholder activism.

Most unsettling is that the Fed’s actions send a message to all banks that they are safe from the activists, and a warning to shareholder activists not to press banks too much. It relieves all banks from the fear of having to answer fully to shareholders.

The Fed is quite busy these days, but perhaps it should take the time to reconsider its policies on shareholder activism. After all we’ve gone through during the financial crisis, perhaps protecting poorly performing banks against change isn’t the best idea.