Hardline Stance Can Backfire on a Bank Board

Fighting the rancor of activist investors can exhaust bank directors and management.

Directors at Cardinal Bankshares Inc. may learn this lesson the hard way. The Floyd, Va., company's board has decided to take a hard-line stance against Douglas Schaller, who is likely to initiate a proxy fight next spring.

Should Cardinal win and stay independent, other beleaguered banks may opt for a similarly uncompromising position. But if Schaller succeeds in forcing the company's sale, the door may be blown open for opportunistic investors to infiltrate other banks.

Cardinal's board responded late Thursday to repeated attacks from its largest outside investor, claiming in a letter to shareholders that Schaller's only objective is to force Cardinal's sale.

"We urge you to support us in maintaining the independence of our bank," the letter said. "While community banking is challenging, what business isn't these days? We know we are up to the challenge and can continue to provide our shareholders and the community we serve, with safe and sound banking; locally run and managed."

Industry observers questioned whether a dug-in defense was appropriate, suggesting other tactics to help a bank fight off an activist investor such as Schaller.

Several moves would involve corporate governance, said Frank Bonaventure, a principal at Ober, Kaler, Grimes & Shriver who would not specifically discuss the face-off at Cardinal.

A company can better defend itself if it has staggered boards instead of having all directors stand for re-election annually. That way an activist "doesn't change the entire board," Bonaventure said.

Leon Moore, Cardinal's chairman and CEO, said in an interview Friday that the board has a growth plan that includes branch and bank acquisitions.

"Regardless of what Schaller says, we have not been hoarding cash," Moore said. "At this point in time, we want to make sure we're safe and strong."

Schaller has expressed an interest in launching a proxy fight to get several people elected to Cardinal's board. Cardinal, meanwhile, is set up where all seven directors are elected annually.

Another of Schaller's goals is getting Moore to step down. In an interview last month with American Banker, he suggested Howard Cunduff, another big investor, take over the post.

Bonaventure said it may bode well to split the chairman and CEO roles, perhaps rotating the chairman's post "so there are different points of view as a leader of the board."

Other defensive measures are available, said David Baris, a partner at the BuckleySandler law office in Washington who is also executive director of the American Association of Bank Directors.

Baris said some boards have a charter provision to create blank-check preferred stock. Often referred to as a poison pill, the terms of such shares may be determined by the board and used to ward off takeovers.

Cardinal's board seems intent to assert that the independence of the $238 million-asset company is critical to shareholders and the community. "If Mr. Schaller doesn't share this vision, he and his group are welcome to sell their shares to somebody that does," the letter said.

Moore said his strategy with Schaller for now is to "just fight it when it comes."

Schaller has contacted some Cardinal investors while creating a website to support his cause. "I've been talking to other investors, and I believe I have the votes necessary to make changes to the board," he told American Banker last month.

Schaller is upset with Cardinal's plan to have Michael Larrowe succeed Moore. Though Larrowe has more than 30 years of accounting experience, Schaller questions his banking experience and his role as Cardinal's external auditor when the company faced the first whistle-blower case filed under the Sarbanes-Oxley Act of 2002.

Cardinal's board pointed to Larrowe's accounting record and knowledge of southwest Virginia. "In this capacity, he has worked with over 100 community banks," the letter said. "He worked closely with us … for years while he was our outside auditor. We were personally familiar with his work, his expertise and his knowledge of the way banks work."

The board's letter touted Cardinal's strength in recent years, calling the bank's capital position "the envy of many banks today" and noting that it did not report a loss during the financial crisis. Cardinal cut its dividend to shore up capital and did not participate in the Troubled Asset Relief Program, the letter stated.

"We are entirely self-funded," the board said. "This makes us the safe and strong financial institution that can continue to support the credit needs of our community when other banks cannot and are struggling to raise their own capital."

The letter tried to quantify the economic impact that Cardinal's sale would have on Floyd County. (Schaller has suggested in the past that Cardinal should try to sell itself to the $1.03 billion-asset National Bankshares Inc. in nearby Blacksburg, Va.)

James Rakes, the chairman, president and CEO at National Bankshares, said in an August interview that he was flattered by such statements, but he would not discuss any possible targets.

The board wrote that Cardinal's 40 employees "would almost certainly lose their jobs" if the company sells, stripping $1.7 million of direct economic benefit from Floyd. "This doesn't take into account the loss of community activities the bank currently supports, which would be reduced or lost in any sale," the letter said.

Industry observers said a community-oriented argument is flawed due to a board's fiduciary duty to investors. "Directors in today's world should look at all options, and they can't have a closed mind," Bonaventure said.

"There must be reasonable tests for why they are taking a course of action," said Bonaventure, who suggested hiring an outside firm to validate a growth strategy. "The best defense is to be prepared."