Community Banks Breaching Fiduciary Responsibility To Shareholders

by: Phil Timyan

Surveying the current community bank stock landscape, I have to ask, what are some of these bank officers and directors thinking?

When you've proven unable, for whatever reason, to deliver on your promise to produce a decent return for your shareholders, don't you have an obligation to sell for real money now, or better yet, for stock in a company whose management is producing acceptable returns? In what world does it make fiscal or ethical sense to dilute shareholders by raising additional equity well below book value or the price for which they could reasonably expect to sell their companies?

True, if you stick around chasing your fantasy figure of what you think the bank under your leadership is worth, you can keep your job with its prestige and fancy salary. Grant yourself some options at the new cheaper, diluted price, maybe even get yourself a pay raise. But don't pretend it's not at the expense of the bank's owners, who have supported you thus far under the explicit understanding that you would produce a minimum level of return on a consistent basis.

Consider Heartland Bancshares (OTC:HRTB) of Franklin, Indiana. With their stock trading in the $3 range, they agreed to sell to Horizon Bancorp (NASDAQ:HBNC) of Michigan City, IN, for about HRTB's $10 stated book value. Heartland was limping along, barely able to make their TARP interest payments. They realized the bank couldn't pay TARP back without serious dilution to current shareholders. (The bank was capitalized in 1998 at $10 per share so shareholders were already on a 14-year ride that had dissipated 70% of their initial investment.) Instead, HRTB sold for a cheap currency in an under-followed powerhouse, Horizon. Since the deal was announced on February 10 this year, HBNC has delivered stellar performance and their stock has appreciated an additional 50 %, yielding an almost four-fold gain to Heartland shareholders from the day prior to the merger announcement. Well-deserved kudos to founder and President Steve Bechman for making the right decision.

In sad contrast, Community West Bancshares (NASDAQ:CWBC) of Goleta, CA, apparently faced a similar choice late last Summer. With their stock in the same $3 range, CWBC appears uninterested in entertaining selling opportunities, and is said to have rebuffed overtures from PacWest (NASDAQ:PACW) of Los Angeles, CA. Now CWBC's stock is in the low $2's after reaching the low $1's on miserable Q-4 numbers. Shareholders are reeling instead of enjoying PacWest's strong performance.

From what I can see, there's no shortage of community banks facing this issue. Take Blackhawk Bancorp (OTCQX:BHWB) of Beloit, WI, for instance. While I've heard of no current suitors, I'm sure BHWB would have no trouble attracting interested buyers. But instead, on May 2nd, President and CEO R. Richard Bastion III has hired investment banker River Branch Capital to explore strategic capital-raising initiatives. With a book value of $15.48 as of today, wouldn't a sale at even 80 % or so of book be better than whatever diluted (or is it "deluded"?) plan Blackhawk is contemplating?

Before you answer for our friends at Blackhawk, consider the ride they've taken their poor shareholders on: BHWB's shares reached a 1998 high of $16, declining to a low of $8 in 2001.They recovered to $14 in 2005 only to drop to $5 in 2010. BHWB shares are now trading sporadically between $7 and $9. True, their last 5 years have been profitable. On the other hand, Blackhawk's nonaccrual loans have been creeping up from 1.7 % in 2010's 4th quarter to a current 4.2 % of total loans. Return on equity has averaged around 6 %. I see no way BHWB can repay TARP without seriously diluting the long-suffering shareholders.

Seems to me, in cases like Community West and Blackhawk, management has not earned the right to dilute its owners, and should do the right thing by selling to someone capable of earning a decent return on equity. When a bank's own Borrowers aren't able to earn a decent return to make their loan payments, the bank forecloses on them. Isn't what's good for the goose also good for the gander?

Disclosure: I am long OTCQX:BHWB, CWBC, HBNC, OTC:HRTB.