First Federal Bank in Kansas City, Mo., is at the center of litigation that threatens to undermine what it means to be a mutual.

Two former account holders of Inter-State Federal Savings and Loan Association of Kansas City, which merged into First Federal last year, filed a lawsuit in February in U.S. District Court for the Western District of Missouri, claiming they were shortchanged by the merger.

The lawsuit, which was filed against First Federal and former Inter-State directors and is seeking class-action status, claims that Inter-State failed to make mandatory capital distributions to its account holders. The plaintiffs also allege that First Federal never compensated Inter-State account holders after their holdings were “significantly diluted” by the merger.

The unusual case is drawing national attention, with the Office of the Comptroller of the Currency, the American Bankers Association and the Missouri Bankers Association filing briefs in support of First Federal.

The concern is that a ruling in favor of Inter-State account holders could give more rights to mutual members which would, by extension, redefine what it means to be a mutual. For now, the rights for mutual members largely involve issues tied to electing directors, subscribing for shares and liquidation.

“The theme … is just what is mutuality,” said Kip Weissman, a lawyer at Luse Gorman in Washington. “If you try to expand [rights more] … it’s really opening a Pandora’s box that really threatens mutuality in a big way and opens them up to activism.”

Activist investors often open deposit accounts at mutuals in hopes of building large stakes when an institution converts. After a conversion, those investors typically pressure management to improve shareholder value, often by selling to another bank.

A ruling for the Inter-State group could allow activists to exert more pressure on mutuals well before a conversion takes place.

First Federal did not respond to requests for comment. A lawyer for the Inter-State account holders declined to comment.

The Inter-State account holders want the court to award more than $5 million in damages, claiming they did not receive any compensation or "any corresponding benefit" for the excess capital First Federal and its members gained from the merger.

“When the banks combined, each bank and its members gained an ownership interest in the other bank’s capital,” the lawsuit claims. First Federal and its members “were unjustly enriched and received a windfall — ownership in the additional $25 million in capital that Inter-State and its members brought to the table.”

The lawsuit also claims that an Inter-State member vote, required under the mutual’s charter, never took place and that the board failed to hire an experienced consultant to evaluate the merger.

The American Bankers Association and the Missouri Bankers Association called the lawsuit’s capital claims a “grave threat” to mutuals, noting in a filing supporting First Federal that such institutions are unable to turn to outside investors if challenges arise.

“Capital is critical to a banking institution’s safety and soundness and is the first measure of soundness that state and federal bank examiners evaluate in their regular examinations,” the group’s states in their document backing First Federal. “Retained earnings provide the primary means to grow and thrive and to survive economic hard times.”

The OCC, for its part, questioned the logic behind the lawsuit, particularly claims that Inter-State’s account holders own the mutual’s capital.

“The plaintiffs demonstrate that they fundamentally misunderstand the nature of depositors’ interests in a mutual,” the agency said in its brief. “While depositors of a mutual [federal savings association] do have the right to perceive a pro rata distribution of capital … in the unlikely event that a solvent institution dissolves, they do not have the ability to compel distributions of capital in other contexts.”

The Inter-State account holders, as a result, may have difficulty making a compelling case, industry observers said.

“What’s the right here that’s been infringed upon by this transaction?” said Doug Faucette, a Washington banking lawyer who also serves as counsel to the trade group America's Mutual Banks. He added that former Inter-State members should benefit from having “improved” access to services.

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Allison Prang

Allison Prang

Allison Prang is a reporter for American Banker, where she writes about community banks.