First Financial Northwest's ongoing battle with a tenacious activist investor could serve as a warning to mutual thrifts that are considering going public.

The Renton, Wash., company is locked in legal proceedings with Stilwell Group over a contested proxy battle. Earlier this month, the $1 billion-asset company disclosed a succession plan for Victor Karpiak, the chairman and chief executive that Stilwell has been trying to oust.

First Financial (FFNW) is far from alone. Since May 2007, firms such as Stilwell, Seidman & Associates and PL Capital have targeted more than 20 thrifts. Stilwell has been very active, reporting stakes in at least 18 thrifts since early 2011.

These investors are taking advantage of lax regulatory oversight that developed during the past decade, says Doug Faucette, a lawyer at Locke Lord. "A lot of people out there are exploiting the rules," he says.

Conversions make thrifts especially vulnerable, observers say. A first-step conversion for a mutual holding company involves selling some common stock to depositors, often discounted, while most of the shares stay with the parent. A second-step involves selling holding company shares.

Mutuals without a holding company can convert in one step.

"It's a good play for dissident investors to invest in recently converted thrifts," says Gary Bronstein, a lawyer at Kilpatrick Townsend & Stockton. Activists "come in early at that kind of pricing and there is a nice return for them if they can push for a sale."

Converted thrifts are vulnerable because they are overcapitalized and have widely held shares. Regulators crafted rules to protect those thrifts, but they have been lax enforcing them, Faucette says. "Regulators haven't been faithful to the original implied covenant to converted institutions" to watch out for them, he says.

The Federal Home Loan Bank Board, a predecessor to the Office of Thrift Supervision, developed rules in the 1970s that included a provision barring anyone from making takeover offers for thrifts for five years after a conversion.

Thrift regulation has since evolved. The five-year ban was cut to three years, and regulatory oversight of thrift holding companies fell to the Federal Reserve Board. The Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. now regulate the institutions. (The OTS was eliminated last year by the Dodd-Frank Act.)

Such changes created a "gap of expertise," highlighted by last week's news that Julie Willliams, the longtime No. 2 at the OCC, is leaving, Faucette says. She "truly understood these rules," he says. "Now she's gone."

Conversions involve selling stock in the holding company, making it the Fed's domain, says OCC spokesman Bryan Hubbard. The Fed did not respond.

Spencer Schneider, general counsel to Stilwell Group and the firm's nominee to replace Karpiak on First Financial's board, declined to comment.

Activists were a consideration for First Financial when it started looking into a second-step conversion in 2007, Karpiak says. The company decided to proceed.

"It's the risk you take when you go public," Karpiak says. "We felt it was best for us to do the conversion … because we felt like we had a lot of investments in construction lending and we needed the capital. No one could have predicted what happened in 2008 and 2009."

Karpiak says his plans to retire in 2014 do not reflect issues with Stilwell Group, which filed a lawsuit alleging that First Financial rigged a shareholder vote to let Karpiak, and not Schneider, serve on the board. Retirement planning "was in the works well before" Stilwell bought a stake in the company, he says.

Many thrifts have few capital-raising options if they want to grow. Mutual holding companies in particular are a dying breed. It can be also be difficult to have a voice in Washington. "The only way to maximize value is" a second step, Bronstein says.

Several thrifts have recently completed conversions.

Northeast Community Bancorp (NECB) in White Plains, N.Y., converted in June. Stilwell first reported a stake in the thrift in 2007, demanding a second step three years later and claiming in a lawsuit that directors were protected by nepotism. A call to Kenneth Martinek, Northeast's chairman, president and CEO, was not returned.

Polonia Bancorp (PBCP) in Huntingdon Valley, Pa., plans to convert later this year. PL Capital reported a stake in the thrift in 2007 and began pushing last year for a second step. Anthony Szuszczewicz, Polonia's president and CEO, did not return a call seeking comment.

Georgetown Bancorp (GTWN) in Massachusetts is the latest thrift to draw activist attention. Georgetown completed its second step on July 11. Just 12 days later Stilwell disclosed a 7.2% stake and vowed to "encourage management and the board to pay dividends to shareholders and repurchase" stock with excess capital.

Georgetown's chief financial officer, Joseph Kennedy, did not return a call seeking comment.

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