This is annual report season for many companies, especially banks. Since I own 25+ banks in my portfolio I've been inundated with bank annual reports. I rarely read the entire report because in most cases I've already seen the bank's financials on CompleteBankData.com by the time I receive the report in the mail. Even though I've seen the financials I like to receive the reports for a few reasons. The first is I like to read the President's letter if there is one. Secondly I like to evaluate the quality of the report, by this I mean the material it was printed on. Some annual reports appear like they were Xeroxed off in the back room, stapled by the tellers and mailed third-class. Others are heavy card stock and fully of colorful glossy pictures and inspirational quotes. But what I really enjoy looking at are the profiles for the directors of the banks.
After thumbing through some of the proxies send with the reports this week I have to ask:
Who are the empty suits filling bank board rooms?
The board of directors at a company are supposed to represent shareholders' interest in the company. Shareholders elect them to hire and fire the management team and run the company for the benefit of the shareholders. That's the theory at least.
The reality is often very different. A bank's board of directors are usually friends and acquaintances of the CEO or Chairman. They are often somehow involved in the community which in the community banking world somehow qualifies them for directorship. A friend of mine jokes that being a funeral director is a qualification to being a community bank director.
If the board is tasked with managing the managers it would make sense for them to know about banking. Good managers should have an idea of what their subordinates are doing. Bad managers are clueless and often have their head in the sand. The problem is most bank directors have zero banking experience meaning they are ineffective at managing a bank's executives. At these banks the board is reduced to agreeing with management because they don't know better. If the CEO says the lending environment is difficult they agree nodding their heads in unison.
When I page through proxies for some of the banks I own I see directors that run HVAC companies, a golf course, an organic vegetable farm, a seafood company, and a lot of real estate and construction related businesses. In most cases the bank states that the individual's experience in running some small company in their community qualifies them because of their experience with the local market.
A former bank regulator told me a story about a bank he worked with in the 1990s. He said that as he was evaluating the board he discovered that all of the directors had ties to the local auto industry with most being car dealers. When the regulator began to examine the bank's loan book he found that most of the bank's loans were auto loans. Guess what dealerships were doing significant business with that bank? The regulators forced the bank to reduce their auto lending and change the composition of their board. Unfortunately management abuse isn't always that obvious.
I sometimes wish for radical and honest transparency. It would be refreshing to see the truth in a proxy. What if a director nominee's blurb stated something like this: "The CEO and the nominee's sons play on the same soccer team. The nominee and other directors have been in the same fantasy football league for 13 years." or "This nominee's business does significant business with the bank. The bank CEO informally agreed to put the nominee on the board in exchange for continued business."
Another axe I have to grind are with directors who make a career out of being directors. You know the type, their bio talks about a job they held in "business development" in the early 1980s. Since then their only experience seems to be serving on boards. Some directors serve on a number of different boards, enough that they can string together quite a salary.
There are always exceptions to the rule, but not many. One bank I own seems to have the type of board I'd like to see everywhere. FS Bancorp's board consists of individuals who have prior banking experience, or worked in finance and investing. Another exception is in the bio of one director at Sound Financial. This director works in the food industry but states that he has taken extensive training courses and seminars on banking during his term as a director. Even though his professional experience isn't in banking he's made a significant effort to learn the industry something that should be applauded.
There are two solutions to this problem, a regulatory solution and a market solution. The regulatory solution would be a set of rules that force director independence. These rules already exist and they don't seem to be working. The market solution is for investors in these sleepy and mismanaged institutions to fire the directors and to nominate new ones with satisfactory backgrounds. Some of this is accomplished through activist investors, but the majority of the work needs to come from non-activist bank shareholders. I vote against almost all director nominees at banks I own. If someone owns a Vitamin Shoppe that doesn't qualify them to be a director, I let the bank know that with a no vote.
Disclosure: Long Sound Financial, Long FS Bancorp