At the end of every Issue of the Oddball Stocks Newsletter is our "General Commentary," which has our thoughts on topics of interest to Oddball investors. Some recurring topics are "Academic Corner," where we review interesting economics or finance journal articles; "Delaware Chancery Corner," where we look at new court opinions out of Delaware that may be relevant for Oddball investors, and often we write small notes on the banking industry.
We thought we'd share the General Commentary section from our most recent Issue (#31) in August, which was heavy on small bank coverage. (Issue 31 is available à la carte).
Academic Corner
A 2019 research paper by Stanford University GSB professor Charles Lee titled “ELPR: A New Approach to Measuring the Riskiness of Commercial Banks” addresses some failures of the current “risk weighted
assets” framework. This new approach focuses on the covariance of the default rates of the 14
classifications of bank loans (e.g. construction, residential, farmland, agricultural). It suggests that
banks with loans concentrated in categories that have a high covariance with each other, even if they
appear diversified, are more likely to fail than the traditional metrics based on capitalization suggest.
As one example, they show a Nevada bank called Silver State Bank that was closed in September 2008
at a cost to the FDIC of $500 million. It was regarded as well-capitalized up to a year before its failure,
even though its loan composition was 60% construction and 23% nonfarm/nonresidential real estate.
Essentially, Silver State was all-in on loans to land developers and housing developers, and a metric
that considered the high covariance of default rate of those two categories would have flagged the risk,
while the traditional, primitive capitalization ratio metric did not.
The pairwise correlation in the default ratio of Silver State's two primary loan categories was 0.86.
Other pairs of the fourteen loan classifications have weaker, or even negative, pairwise correlations.
Table Two from this paper, “Correlations of Aggregate Delinquency Rates across Loan Categories”
might be something to pin above your desk whilst analyzing the bank stocks from this Issue.
Delaware Chancery Corner
We have a few notable cases at the Delaware Court of Chancery to mention since our last update in Issue 28. First, there is In Re HomeFed Corporation Stockholder Litigation, concerning a squeeze-out merger and acquisition of HomeFed by Jefferies Financial Group.
The issue before the court was whether this complied with the framework set forth in
Kahn v. M & F
Worldwide Corp. (“MFW”) for subjecting a squeeze-out merger by a controlling stockholder to
business judgment review rather than the entire fairness standard. Company managers will always want
to benefit from a presumption that their decisions were correct – business judgment deference by courts
– and unhappy minority shareholders will always want them to be judged without such deference or
presumption. In the MFW case, the court established six conditions that must be satisfied to invoke
business judgment review of a squeeze-out merger by a controlling stockholder:
“[T]he business judgment standard of review will be applied if and only if: (i) the controller conditions
the procession of the transaction on the approval of both a Special Committee and a majority of the
minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is
empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets
its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no
coercion of the minority.”
This means that if a minority shareholder plaintiff can plead a set of facts showing that any or all of
those conditions did not exist for a transaction, then their pleading states a claim for relief and they are entitled to conduct discovery. And if, after discovery, triable issues of fact remain about whether either
or both of the two procedural protections (special committee and informed vote) worked, then a case
can proceed to trial. In this HomeFed case, the court concluded that Jefferies, which was the controlling
shareholder, may not have met the conditions and so rejected the defendants' motion to dismiss.
Another recent case further clarifies the MFW framework: In Re Dell Technologies Inc. Class V
Stockholders Litigation, disputing the redemption of a tracking stock that was issued when Dell
acquired EMC Corporation. The court emphasized that to have the business judgment protection of the
decision, “the controller [must] irrevocably and publicly disable itself from using its control to dictate
the outcome of the negotiations and the shareholder vote.” And again, “if a plaintiff... can plead a
reasonably conceivable set of facts showing that any or all of those enumerated conditions did not
exist, the complaint states a claim for relief that entitles the plaintiff to proceed and conduct discovery.”
Then there is a fantastic Section 220 demand case, Sahara Enterprises, Inc., between a privately held
investment fund and a shareholder who “became concerned that the Company was paying its officers
and directors, paying highly compensated fund managers, and paying professional consultants to help
select the fund managers, yet achieving subpar results.” When the shareholder made a books and
records demand, the company gave a list of stockholders and a copy of the bylaws, but otherwise
refused on the grounds that she lacked a proper purpose and/or the scope of the demand was too broad.
The company eventually provided a summary of director's fees being paid, but otherwise stonewalled.
This particular Section 220 case was decided impressively quickly. She sent the demand on August 8,
2019, did not file suit until March 2, 2020, and even with the pandemic taking place the court had a
trial (on the paper record) on May 21st and decided in her favor on July 22nd. One of the company's
futile arguments was that the shareholder's purpose for the inspection of records of “valuing her shares”
was insufficient and that she needed to demonstrate why she needed to value them. That was slapped
down by the court: “Delaware law does not require that a stockholder establish both a purpose for
seeking an inspection and an end to which the fruits of the inspection will be put.”
More interesting was the court's reasoning regarding the second stated purpose of her inspection, which
was to investigate wrongdoing or mismanagement. He ruled that while the company's recent poor
performance “has not been sufficiently protracted or extreme to draw an inference of wrongdoing,” the
company's litigation posture itself bolstered her investigative purpose:
It is, of course, permissible for a board of directors to delegate management responsibilities to officers,
employees, and outside advisors. What the board invariably retains—and must fulfill—is the obligation
of oversight. It would be an exceptional board of directors that could satisfy its duty of oversight
without creating any books and records—no minutes, no resolutions, no actions by written consent, no
reports, no policies, no nothing. Yet that is what the Company claimed by arguing that this action was
“moot” because the Company did not have any responsive books and records. The Company’s own
arguments thus established a credible basis to suspect corporate wrongdoing. Woods has therefore
established a proper purpose for an inspection.
The opinion goes on to outline Delaware law as it pertains to determining the scope of a shareholder
books and records inspection, once it has been established that it is for a proper purpose.
Importantly, as pertaining to minority investments in micro-cap, OTC-listed companies, the holding is:
“[H]ow directors and senior officers are compensated and whether they are the beneficiaries of any
related-party transactions are basic facts that stockholders are entitled to know. Section 220(b) defines
a proper purpose as any purpose reasonably related to the stockholder’s interest as a stockholder.
Some information is so foundational that a desire to have that information is itself a proper purpose. A
stockholder should be entitled to obtain a general description of the company’s business, the identities
of its directors and senior officers, and basic information about how they are compensated. Directors
and officers are fiduciaries who have a duty to act loyally, in good faith, with due care to maximize the
long-term value of the corporation for the benefit of its residual claimants. The residual claimants are
entitled to know how their fiduciaries are taking money out of the corporation. A stockholder should
not have to point to a valuation purpose or assert suspicions about corporate wrongdoing to be able to
learn how much money the directors and senior officers are receiving.”
We have never seen that stated so explicitly in a books and records case, and
it seems eminently true
and necessary. Think of all the Oddballs that refuse to disclose management compensation or the
existence of related-party transactions. This is a Delaware chancellor flatly stating that shareholders are
entitled to at least upper management and director compensation information, and related-party
transaction information, period, without having to state any “purpose.”
One last shareholder victory for this Issue. In a case between an individual investor (Robert Elburn)
and Investors Bancorp, Inc. where he alleges that the company's board approved excessive
compensation awards in breach of their fiduciary duties, the Chancery Court refused to certify an
interlocutory appeal of the Court's denial of the bank's motion to dismiss. The motion to dismiss turned
on the issue of whether a demand on the board by the investor for it to pursue the breach of fiduciary
claim would have been futile (which the Court ruled it was). In the application for certification of
interlocutory review, the bank argued that the case involved an issue of first impression. This was
smacked down beautifully: “There was absolutely nothing unusual about the demand futility
allegations addressed by the Opinion, or the means by which the Opinion addressed them. Determining
the sufficiency of demand futility allegations is steady grist for the Chancery mill.”
The Narrow Bank USA Inc.
Historically, banks have tried to do two incompatible jobs: safely store the medium of exchange, and
also make long-term investments in productive enterprise. Because of the incompatibility, they have
done both imperfectly, with “imperfectly” meaning manias followed by panics and human misery. Past
attempts to solve this have consisted of deposit insurance, with attendant moral hazard, or regulation,
which tends to force everyone to make the same mistake at once, like treating a no-interest long-term
government bond as completely risk-less.
A real solution to this would be to separate those two incompatible functions. Where society's long-term
investments were being financed by loans, these would be originated and assembled into
something akin to closed end funds. The investments would not be redeemable on demand but there
would be a secondary market for the portfolios of loans. There would not be maturity transformation “alchemy” that makes promises it can't keep, which has historically required bailouts and government
subsidized deposit insurance. But the price would not be that volatile. (Think how little price volatility conservatively underwritten home loans have, for example.)
For storing the medium of exchange, you need something like what a group of bank entrepreneurs
actually proposed a few years ago: a “narrow bank”. Their startup, The Narrow Bank USA (TNBU)
wanted to take deposits and invest 100% of the money in interest-paying reserves at the Federal
Reserve. Their plan was not to offer accounts to the public at large, but only to mutual funds and megacap
companies with cash balances to invest that are far beyond the limits of deposit insurance. They
would have held 100 percent of their assets derived from customer deposits as Federal Reserve Bank
balances, earning interest at the interest on excess reserves rate (IOER), and paying interest to
depositors at a slightly lower rate, thereby earning a modest profit.
In order to get in business, TNBU needed a master account at the Federal Reserve Bank of New York,
but the Fed was not excited about his business because it would have been a huge “disruption” to
everyone else in the industry, closing the gap between IOER and what banks pay depositors. The Fed
refused to accept or deny the master account application and so TNBU sued. In March, a federal court
dismissed the TNBU suit on the grounds that TNBU “lacks standing to pursue its stated claim and its
claim is both constitutionally and prudentially unripe.” The court decided that the “delay” in approving
the application for a master account has not been long enough to constitute a “denial”: “If TNB had
been waiting 30 years for a decision, I would have no trouble finding that the FRBNY had
constructively denied TNB’s application, and thus that TNB had an injury in fact sufficient for
standing.”
Small Banks
In our essay “What is an Oddball Stock?” in Issue 25, we quoted something from the book Panic, by
hedge fund manager Andy Redleaf, pertinent to the dearth of information that the minority shareholders
of Oddball companies have about their investments. (We think that his book is so worthwhile that we
handed out copies of Panic to everyone who attended the Oddball Meetup in February 2019.) So it is
with great interest that we have watched Redleaf sell his stake in his hedge fund management company
(Whitebox) and buy a small bank in Minnesota: Park State Bank. From a Forbes interview with him:
Another pocket of safety can be found, counterintuitively, in regional U.S. banks. “Small banks have
privileged access to capital too,” and Redleaf himself bought one of these institutions in 2015. “Even
as a very small bank I think we’ll continue to have privileged access to capital.” The business
opportunity comes from the large number of potential borrowers “that really are bankable but don’t
have access to cheap capital.”
His thesis is that certain players (the largest mega cap companies, and all banks, since they can offer
depositors the mispriced, government subsidized deposit insurance) have access to incredibly cheap
capital that has a tight spread to the government's nearly zero Treasury yield curve. And then there is a
divide between them and smaller companies that pay much more for capital, whether equity or debt.
The opportunity that he sees is to get paid a big spread to bridge that gap. Just like earlier in his career,
as a hedge fund manager, when distressed debt and equity markets were less connected than today, and
it was possible to arbitrage distressed companies' capital structures.
