Shareholder Activism and the Bank Holding Company Act

Victor Lewkow is a partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by John McGill.

The ongoing battle between Floyd, Virginia-based Cardinal Bankshares Corporation (Cardinal) and activist investor Douglas Schaller raises interesting questions with respect to whether an activist shareholder entity can wage a proxy contest to replace a majority of directors on the board of a bank holding company (BHC) without the activist entity being considered a BHC under the Bank Holding Company Act (BHCA).


Cardinal is the holding company of the Bank of Floyd, which provides banking services in five counties of Virginia. Cardinal is publicly-traded and has a market capitalization of approximately $22 million.

In a February 7, 2011 Schedule 13D filing with the Securities and Exchange Commission (SEC), entities associated with Douglas Schaller (Schaller Equity Partners, Schaller Equity Management, Inc. and Schaller Investment Group Incorporated) disclosed an 8.3% ownership stake in Cardinal. Over the following 12-month period the Schaller entities filed several amended Schedule 13Ds, reflecting an ownership stake in Cardinal that eventually increased to 9.8%. Beginning in June 2011, Schaller and Cardinal engaged in a war of words, largely carried on in open letters and in the press. Schaller first pushed for Cardinal to explore a sale and later appeared to back off that position, instead arguing for management changes. Cardinal resisted Schaller and has maintained that Schaller is only interested in selling Cardinal. While the letters between Schaller and Cardinal are not the focus of this article, they make for interesting reading and can be found in SEC filings by Schaller and Cardinal.

At Cardinal’s next annual shareholders meeting, which is scheduled to occur on May 22, 2012, all six of Cardinal’s directors are to be elected. In a proxy statement filed in March 2012, the Coalition to Improve the Bank of Floyd (Coalition) filed preliminary proxy materials to solicit proxies in favor of five of its board nominees, all whom are described as independent of Schaller and associated entities. The Coalition consists of Schaller and associated entities, together with several individual Cardinal shareholders and a special purpose vehicle formed to hold and vote proxies.

In April 2012, the Coalition amended its proxy statement to decrease the number of its nominees from five to three. In the amended filing, the Coalition explained that it was reducing the number of nominees because the staff of the Federal Reserve Board (FRB) had taken the position that the leadership role of Schaller Equity Partners (SEP) in soliciting proxies to elect a majority of Cardinal directors could cause SEP to be considered a BHC under the BHCA. The FRB staff reportedly based its position on Section 2(a)(2)(B) of the BHCA, which is triggered by the ability of a “company” to “control in any manner” the election of a majority of the board of a BHC. According to the Coalition, the FRB staff held the view that because SEP was an entity rather than an individual, its leadership role in the proxy solicitation would trigger Section 2(a)(2)(B). The Coalition noted that the FRB staff took this position even though the proxies are revocable until Cardinal’s annual meeting and expire at the end of the annual meeting. [1] The FRB staff did not provide written confirmation of its position to the Coalition. The FRB staff reportedly indicated that SEP’s participation in a solicitation to elect less than a majority of Cardinal’s board would not be a problem under FRB staff interpretations of Section 2(a)(2)(B).

Despite the Coalition’s decision to reduce the number of its Cardinal board nominees from five to three (i.e., 50% of Cardinal’s board) in response to concerns raised by the FRB staff under Section 2(a)(2)(B), a May 4, 2012 proxy filing by the Coalition reported that, in subsequent discussions with the FRB, the FRB staff expressed concern that SEP’s involvement in soliciting proxies for the election of three directors might constitute SEP’s exercise of a “controlling influence” over the management or policies of Cardinal. Under Section 2(a)(2)(C) of the BHCA, if such a controlling influence were found to exist, SEP could be considered a BHC. While SEP disagreed with the FRB staff’s position, it and the Coalition nominees proposed entering into the FRB’s standard passivity commitments, which are designed to alleviate any FRB concerns that SEP will have a controlling influence over Cardinal. [2] The Coalition nominees (all of whom are independent of Schaller and associated entities) committed not to take any action to cause (or otherwise do anything that assists or facilitates) SEP to take the actions specified in SEP’s passivity commitments. In the filing, the Coalition indicated that the FRB staff had not yet responded to the proposed passivity commitments.

In its proxy filings, the Coalition indicated its suspicion that Cardinal’s public statements about Schaller and the Coalition may have contributed to questions from the FRB staff relating to the intentions of SEP if the Coalition’s proxy solicitation is successful. However, there is no indication in public materials that Cardinal raised BHCA issues with the FRB staff as a means to defeat the Coalition’s proxy challenge. Nonetheless, it is not uncommon, particularly in the hostile takeover context, for the target of a proxy contest to use BHCA control concerns as a defensive tactic (e.g., by arguing to the FRB that the potential acquirer cannot solicit proxies without prior FRB approval).

Cardinal Proxy Contest and BHCA Issues

Section 2(a)(1) of the BHCA defines a BHC as “any company which has control over any bank or over any company that is or becomes a bank holding company . . .” An investment fund such as SEP would typically not want to be regulated as a BHC because of, among other things, the restrictions imposed on a BHC’s non-banking and investment activities, limitations on leverage, the requirement to serve as a “source of strength” to any controlled banks, and FRB and other regulatory examination and reporting requirements.

Under Section 2(a)(2)(B) of the BHCA, a company has control over a bank or any BHC if “the company controls in any manner the election of a majority of the directors . . . of the . . . company.” As indicated above, the FRB staff initially expressed concern that SEP’s involvement in soliciting proxies for a majority of Cardinal directors might cause SEP to be considered a BHC under the BHCA. As reported by the Coalition, the FRB staff took the view that SEP was potentially subject to Section 2(a)(2)(B) because it is an entity but would not be subject to Section 2(a)(2)(B) if it were an individual. This result, while consistent with the language of Section 2(a)(2)(B), which specifically refers to “companies” having control, creates a potential impediment to the participation in proxy solicitations of any shareholders that, like SEP, are entities. Shareholders that are entities could participate in a proxy solicitation in the sense of granting proxies to others who are soliciting them, but the FRB staff’s reported position in the Cardinal matter appears to caution against such shareholders taking a leadership role. [3]

It should be noted that there is a relevant statutory exception in Section 2(a) of the BHCA to the definition of a BHC. Recognizing that the definition of a BHC in Section 2(a) would not allow the formation of a bona fide stockholders’ committee or similar organization for the purpose of soliciting proxies in order to gain control of voting rights of shares (until the proxy contest is terminated), Section 2(a)(5)(C) of the BHCA was adopted to provide for an exception to the BHC definition in the context of a proxy solicitation. Section 2(a)(5)(C) provides that “[n]o company formed for the sole purpose of participating in a proxy solicitation is a bank holding company by virtue of its control of voting rights of shares acquired in the course of such solicitation.” Absent such an exception, a company formed to solicit and hold proxies that acquires temporary control over the voting rights of 25% or more of a banking organization could find itself within the definition of a BHC. However, since the Section 2(a)(5)(C) proxy exception is focused on the entity formed for the purpose of holding and voting proxies (in the case of the Coalition’s proxy solicitation, Coalition Proxy Holding and Voting SPV, Inc.) and not other proxy solicitation participants, the FRB staff likely viewed this exemption as unavailable to SEP.

Under Section 2(a)(2)(C) of the BHCA, a company has control if the FRB “determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies” of the banking organization. As indicated in the Coalition’s May 4 proxy filing, despite previously decreasing the number of its board nominees from five to three in response to the position taken by the FRB staff under Section 2(a)(2)(B), the FRB staff apparently expressed concern that SEP’s involvement in the solicitation of proxies to elect three directors might be seen as the exercise of a controlling influence over the management and policies of Cardinal, causing SEP to be considered a BHC. The Coalition’s nominees are local businessmen in the Floyd, Virginia area and are independent of Schaller. Nonetheless, there appeared to be concern on the FRB staff’s part that Schaller and associated entities would exercise influence over the nominees and thereby over Cardinal if the nominees were elected to the Cardinal board. This same concern was expressed by Cardinal in public statements made in opposition to the Coalition’s proxy solicitation.

In its proxy filings, the Coalition indicated that SEP does not believe the Coalition’s solicitation of proxies should cause SEP to be considered a BHC on any basis under the BHCA. The Coalition reasoned that proxy solicitation and trying to influence the voting of other shareholders through reasoned argument is not the exercise of a controlling influence, but is instead participation in shareholder democracy. The Coalition argued that even if the Coalition is successful in securing votes to effect a one-time change in the board, that success does not give SEP the ability to exercise a controlling influence over Cardinal. Instead, according to the Coalition, Cardinal would have several new board members who are not controlled by or committed to SEP.

Schaller and his associated entities own a minority 9.8% interest in Cardinal, which is greater than the 5% threshold below which a company is presumed not to control a BHC. In the FRB’s 2008 policy statement on equity investments in banks and BHCs, the FRB provided guidance on questions under Section 2(a)(2)(C) that are raised by minority investments in banking organizations. In particular, the FRB provided guidance in the policy statement on the extent to which a minority investor’s communications with a banking organization’s management would be consistent with a noncontrol determination. The policy statement notes that in previous cases, minority investors have committed to the FRB not to solicit proxies on any matter from other shareholders of the banking organization. While the policy statement indicates that a minority shareholder is permitted to advocate for changes in a banking organization’s policies, operations and management (including recommending alternative management), the FRB did not indicate any acceptable participation in proxy solicitations, other than allowing its shares to be voted by proxy in connection with another shareholder’s proxy solicitation. The FRB cautioned minority investors not to accompany its management communications with explicit or implicit threats to sponsor a proxy solicitation as a condition of action or non-action by the banking organization or its management. While the policy statement does not explicitly state that leading a proxy solicitation is inconsistent with a noncontrol determination, one is left with that impression.

The policy statement provides useful guidance with respect to the extent of board representation and communications with management that a minority investor may have, but this guidance is better suited to negotiated transactions in which an investor acquires a stake in a banking organization and negotiates for board representation and other rights. What remains less clear is how an activist investor can effect change at a banking organization through a proxy contest. In light of the Cardinal matter, the involvement in a BHC proxy contest of an activist investor in the form of an investment fund or other entity (even if the activist forms a special purpose vehicle like Coalition Proxy Holding and Voting SPV, Inc. to hold and vote proxies) may raise issues for the activist fund under Section 2(a)(2)(B) of the BHCA, or other provisions of Section 2(a)(2), since the fund would not be an entity formed solely for the purpose of participation in a proxy solicitation, and seems to be unable, based on the FRB’s reported views, to take advantage of the exception to the definition of a BHC provided by Section 2(a)(5)(C) of the BHCA.

From what has been reported about the Cardinal matter, it is not clear whether or how the size of SEP’s stake in Cardinal affected the positions taken by the FRB staff under Sections 2(a)(2)(B) and 2(a)(2)(C). Although the size of Schaller’s stake is above the 4.9% level where a presumption of non-control exists, it is below thresholds that, when considering only the investment amount, typically raise control concerns under the BHCA and related regulations and guidance. The FRB’s concerns could have been affected by the existence of the minority stake. However, based on the reported concerns, a potential conclusion as a regulatory matter could be that, whether an activist investment fund holds 0.1%, 5% or, like Schaller, 9.8% of a BHC, the fund could risk potential classification as a BHC under Sections 2(a)(2)(B) and 2(a)(2)(C) if it had a leading role in the BHC proxy contest to elect a majority (or less) to the board of the BHC. [4]

If the Coalition is successful in obtaining the election of its reduced three-person slate of nominees to Cardinal’s board, the Coalition nominees will have “negative control” over board decisions because they constitute 50% of the board seats (assuming Cardinal’s three continuing directors do not resign, as they have threatened to do if any of the Coalition’s nominees are elected). However, the Coalition nominees would not have “positive control” to effect changes to policies, operations or management at the board level because they would not be able to carry a vote by themselves.


[1] The Coalition may have highlighted the nature of the proxies due to an exemption (found in the FRB’s rules) from the notice requirement under the Change in Bank Control Act (CBCA) for the “acquisition of the power to vote securities of a . . . bank holding company through the receipt of a revocable proxy in connection with a proxy solicitation . . . if the proxy terminates within a reasonable period after” the shareholders meeting. However, the Coalition’s proxy statement described concerns over SEP becoming a BHC rather than having to file a notice under the CBCA. This may be because the CBCA provisions are generally triggered by an acquisition of voting securities rather than acquiring other forms of control.
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[2] SEP agreed not to: (1) exercise or attempt to exercise a controlling influence over the management or policies of the Company or any of its subsidiaries; (2) have or seek a representative on the Cardinal board; (3) have or seek any employee or representative of SEP to serve as an officer, agent or employee of Cardinal; (4) take any action that would cause Cardinal to become a subsidiary of SEP; (5) allow SEP to own or control 25% of Cardinal stock; (6) following the Cardinal annual meeting in 2012, propose a director or slate of director in opposition to Cardinal’s management or otherwise solicit or participate in a solicitation of proxies with respect to any matter presented to Cardinal shareholders; (7) enter into any agreement with Cardinal that substantially limits the discretion of its management over major policies and decisions; (8) dispose or threaten to dispose of shares of Cardinal in any manner as a condition or inducement of specific action or non-action; and (9) enter into certain business relationships with Cardinal.
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[3] In a current proxy contest relating to First Financial Northwest, a savings and loan holding company, concerns raised by the FRB staff caused Stilwell Group, an activist shareholder, to reduce the number of its nominees from two out of nine directors to one. However, the Cardinal matter is distinguishable from First Financial Northwest because Stilwell’s nominees were Stilwell Group employees rather than individuals who are independent of the activist shareholder, as the Coalition’s nominees are. FRB guidance provides that a minority shareholder’s board representation should be proportional to the shareholder’s ownership stake. Having one out of nine representatives on First Financial Northwest’s board is more proportional to Stilwell Group’s 7.9% stake than two representatives.
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[4] An activist could pursue the election of new directors if it is an individual rather than a “company” and presumably not trigger Section 2(a)(2)(B) or Section 2(a)(2(C) of the BHCA, but shareholder activism is often an investing strategy pursued by funds that acquire stakes in a target companies and then try to effect changes or a sale to increase the value of the investments.
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