When a shareholder becomes aggressive, will your bank be ready?

Under securities law, shareholders must report an ownership stake that exceeds 5% of the company and include their stated intentions, which may range from peaceful coexistence with management and other shareholders to a sale of the company. But more times than not, the intent may not be clear. Whether or not it is revealed, activist investors are often focused on making something happen that will increase the value of their stock, such as a takeover.

Here are six tips to get your bank prepared:

Be Suspicious

It is a mistake to ignore the potential that a shareholder will be unfriendly. A bank’s management that is unprepared for a hostile investor may get caught flatfooted. The institution’s bylaws and certificate of incorporation may lack state-of-the-art corporate protections. Similarly, director-and-officer indemnification provisions and errors-and-omission insurance may provide inadequate comfort to the board of directors in a stressful situation. Employment and severance agreements also may not have been crafted to anticipate the triggering events that unfold in a contest for control of the bank.

Shareholders are owners of the company, and treating them like second-story burglars out of the gate will usually result in the relationship getting off to a rocky start. On the other hand, an activist may not have the long term interests of the company and its other shareholders at heart.

Know Your Investor

A legal and communications strategy should be formulated with a view to garnering the support of long-term shareholders and discouraging the formation of a short-term “wolf pack” of activists. Understanding whom you are dealing with and where you want to end up is critical. Call it the “know-your-investor” rule.

Study the personalities of shareholders, their records with other companies, past litigation and any history of regulatory or criminal problems. That will normally reveal an investor’s true intentions, as well as whether regulators will approve the shareholder’s control stake. If a shareholder’s last three investments resulted in a sale of the company, that is pretty good evidence of his or her intentions. Similarly, a history of parallel activities by other activists may indicate concerted shareholder activity in violation of bank control rules.

Know Where You’re Vulnerable

Management should always be attuned to business situations that may make the company more vulnerable to attack. Activist investors often emerge when a company is highly liquid, particularly after a sale of a business or secondary stock offering. Alternatively, a shareholder may become antagonistic when the company fails to reach profit expectations, and it becomes clear that changes will be required to right the ship.

Institutions that end up with regulatory issues also often experience financial problems that may attract activist investors, as do institutions with no apparent management succession plan. While it may seem obvious, sound performance can be the best tool to repel an activist, related bear hug, tender offer or proxy contest, since the majority of shareholders often vote their pocket books in these cases.

Regulators May Be on Your Side

Institutions should use the corporate and regulatory tools available to deal with an activist shareholder, particularly when the shareholder will be required to make disclosures under the securities laws and receive prior approvals from bank regulators. While the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. are inclined to allow business disputes to play out without interference, or leave them to the courts, they will not stand by if there are violations of the Change in Bank Control Act or Bank Holding Company Act.

If an activist investor wants to acquire at least 10% of the voting securities, he or she may need regulatory approval under federal bank control rules. That approval will require the investor to detail his or her plans for the company, present a complete picture of the shareholder’s finances, attest to having integrity and satisfy a long list of regulatory conditions accompanying approval in order to acquire control. The more regulatory issues that arise, the more likely it is that that approval will be delayed. Banks can play a key role in exposing those issues to regulatory scrutiny. A shareholder passivity commitment with the regulators, or a “standstill agreement” with the company, may become a compromise that neutralizes the activist.

There’s Always Court

Institutions should consider the pros and cons of a lawsuit against an activist shareholder when corporate, securities or bank control laws have been violated. The initiation of legal process can temporarily enjoin an activist, supplement what regulators are doing and delay necessary regulatory approvals. Although litigation involving disclosure violations has fallen out of favor because such victories may be pyrrhic and temporary, there are serious regulatory implications for activists when a court finds that they have violated the law. On the other hand, for smaller companies, such expenditures may themselves affect financial returns.

Stay Strong

Lastly, institutions will only be as strong and resolute as their boards of directors. Having a board comprised of tough, experienced business people who will not run for the door at the first sight of an unfriendly shareholder is a fundamental part of any strong defense. In any confrontation with an activist shareholder, the human elements will always play an important role. Board preparation and effective communication among the directors is critical before and during any action by an activist shareholder.

Thomas P. Vartanian is the chairman of the financial institutions practice at Dechert LLP and a former regulatory official at two different federal banking agencies. Martin Nussbaum is a partner at Dechert LLP who specializes in mergers and acquisitions, corporate governance and securities matters.