Lineage Blindsided By Activists' Board Coup
CFPB's Comment Letter Is A Warning For EWA, Q3 Quarterly Banking Profile
Hey all, Jason here.
I ended up hosting Thanksgiving last Sunday solo, but somehow pulled it off — eight friends (none American!) joined me for turkey, sweet potatoes, dressing, green bean casserole, and pecan pie. I managed to get dinner on the table a mere 90 minutes late!
Looking forward to spending more time with friends and family over the remainder of the holiday season.
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Lineage, Bank Partner to Synapse and Synctera, Blindsided By Activist Shareholders’ Board Coup
Lineage Bank, previously known as Citizens Bank and Trust Company, was the smallest bank in Tennessee until just a few years ago.
Since being acquired by a group led by the Herringtons, a Tennessee family with a long, if mixed, history of running banks in the state, Lineage has grown rapidly.
The bank’s assets ballooned by some 790% in just two years — from $27.25 million at the end of 2020 to $242 million just two years later.
A major lever driving that growth: cheap deposits sourced through Lineage’s banking-as-a-service relationships with Synctera and Synapse.
This August, Fintech Business Weekly reported that Synapse, whose troubles have intensified since then, attempted to use its control over a material share of Lineage’s deposits to pressure the bank into approving new Synapse client programs with little to no due diligence review.
Activist Shareholders Seek To Oust Current Board
Now, Lineage seems to have its own problems: a group of activist shareholders is seeking to remove the entire board of the bank’s holding company, Lineage Financial Network, and its officers.
According to shareholder communications and legal filings obtained exclusively by Fintech Business Weekly, two activist shareholders, Robert Sparks and Mark Marshall, are leading the effort on behalf of “similarly situated” shareholders.
Sparks and Marshall allege that, over the past 18 months, the financial condition of the bank has deteriorated, and it is the current board and officers that are responsible.
The two further allege that there is credible evidence of misstatements to the board and shareholders about the bank’s concentration risk, health, and financial condition.
The activist shareholders argue that the very “survival” of Lineage depends on shareholders taking immediate action to replace the entire board and company officers — including the CEO Richard Herrington and his son, Lineage President and COO Kevin Herrington.
Sparks and Marshall say the newly appointed board would work to bring the bank into compliance with FDIC and Tennessee Department of Financial Institutions regulations.
This would be achieved, they say, by improving AML/CFT programs to reduce exposure to significant regulatory and legal risk, as well as by revamping the bank’s approach to banking-as-a-service and implementing third-party risk management processes.
Lineage Pushes Back on Activists’ Claims
The activist shareholders’ efforts to unseat the current board haven’t been without drama.
Sparks and Marshall gathered the support of nearly 20% of Lineage shareholders — in excess of the 15% threshold necessary to call a special shareholder meeting.
Shareholders supporting the measure to call a special meeting included Sparks and entities controlled by his family, a trust controlled by Marshall, Michael Dewey, who would be nominated to the new board, and former Tennessee Titans offensive tackle and inspiration for the movie “The Blindside” Michael Oher:
On October 27th, once they had secured the support they needed, the activists asked Lineage Financial Network’s corporate secretary, Brandon Hedge, to send a notice that the special meeting would take place on November 15th at the office of the activists’ law firm.
Only, before sending out the notice, Hedge didn’t inform or seek the approval of the Lineage board or any officers of the company, according to legal filings by Lineage.
Once the existing board became aware that the meeting had been scheduled and notice mailed out, they fired back, in a letter emailed to Lineage shareholders on October 31st:
The letter, signed by board members and company officers Richard and Kevin Herrington, describes the notice of the scheduled shareholder meeting as a housekeeping “error,” clarifying that no such meeting had yet been scheduled.
The Herringtons’ letter also rebuts allegations made by Sparks and Marshall as “inflammatory, inaccurate, and misleading” and argued that “the volatile economy and rising interest rates have created a tough and challenging environment for financial institutions throughout the U.S., including community banks like Lineage Bank.”
The existing board also defended its fintech strategy, presumably including its relationships with Synapse and Synctera, by writing in part (emphasis added):
“Among other things, [the activist shareholders’] letter refers to our efforts this year to manage the innovative relationships that the bank has developed with financial technology customers (commonly called “fintech” customers). As with any new frontier in financial services, opportunity comes with challenges, and we have worked closely with consultants and our regulatory agencies to carefully manage these relationships.
We continue to believe that the fintech sector is an important new business line that future-focused community banks should embrace, and we are one of the leading community banks adopting the technology necessary to grow this line of business.”
In addition to defending the direction of the bank and the current board’s record, the letter urged the recipients to reject the activists’ proxy solicitation.
Court Sets Special Shareholder Meeting Date For Friday, December 8th
With battle lines drawn, Sparks and Marshall filed suit in early November to seek a declaration that the meeting was properly called in order to keep the original November 15th meeting date.
In the suit, Sparks and Marshall allege that, upon learning of the scheduled shareholder meeting, Lineage and its board “immediately sprang into action and began working to nullify, invalidate, delay and stop the meeting from occurring altogether.”
In addition to seeking the restoration of the original November 15th meeting date, the activists allege that Lineage and its board’s attempt to interfere constitutes breach of contract, as their actions violate the company’s bylaws, and a breach of fiduciary duty.
In an affidavit in support of their filing, Sparks writes in part (spacing adjusted and emphasis added):
“Mr. Marshall and I, along with the other shareholders, made the Request because the Bank’s condition has deteriorated significantly over the past eighteen months, and the actions and decisions that have placed the Bank in this position have occurred under the Bank’s current leadership.
We believed (and still believe) that we had to act because the Bank’s condition threatens its continued existence and the value of all our investments is in jeopardy because of the poor management decisions ofthe current leadership.”
In Lineage and the board’s response to the initial complaint, they argue that, while the activist shareholders have the right to call for a special meeting, they do not have the right to schedule it. Their response further argues that Mr. Hedge, the corporate secretary, “did not have the authority to unilaterally schedule a specially called shareholders’ meeting.”
Prior to filing its response, the Lineage board scheduled its preferred date for the special meeting: January 17th, 2024.
Their response argued this later date, which was within the timeframe permitted by the company’s bylaws, was appropriate and necessary because:
the activist shareholders would not suffer irreparable harm and failed to articulate any specific harm
that granting the November 15th date would harm Lineage’s compliance with regulators, specifically the 60 day notice period for a change in control required by the Bank Control Act
that granting the November 15th date would harm Lineage by depriving it of adequate time to prepare for the special meeting
and that when the corporate secretary sent the meeting notice, he did not include proxy materials, ballots, or voting instruments, thus depriving shareholders of meaningful access to a proxy other than the activists’ proxy
The affidavit of Lineage COO and President Kevin Herrington, submitted with the response, also disputes the activists’ characterizations of a bank in trouble.
Herrington wrote in part (spacing adjusted):
“I disagree with their contentions that LFN’s bank subsidiary is being mismanaged. In fact, as confirmed by publicly available data recently filed with the FDIC, the Bank is profitable for the year and is performing well in light of the present financial situation in a difficult year for the banking industry and community banks in the U.S.
Any challenges faced by the Bank in the current banking environment are being managed carefully and effectively by the officers and directors of the bank, and LFN continues to be a source of strength for its bank subsidiary.”
In support of his statement, Herrington specified that, per recent FDIC data, Lineage’s tier one capital ratio is in the 50th percentile for its peer group, its return on assets is in the 68th percentile, and its return on equity is in the 68th percentile.
Since acquiring the bank, Lineage (Citizens at the time) swung from a very modest net income of of $6,000 in 2020 to posting losses in 2021 and most of 2022, as the bank made investments and ramped up operations. But, since Q4’22, the bank has posted positive quarterly net income.
As of Lineage’s Q3’23 call report, the bank held just shy of $20 million in equity against total risk-weighted assets of $174.6 million — giving it a capitalization ratio of about 11.5%, which is considered well capitalized.
What’s Next For Lineage?
After hearing arguments from both sides, the judge in the case, Williamson County Chancery Court Judge Woody Woodruff, ordered Lineage to hold the special shareholder meeting later this week, on December 8th, at 10:00am.
In a letter sent to shareholders after the judge’s decision, the existing Lineage board reiterated its position that the activists’ claims about the bank’s financial position and regulatory risk are “inflammatory and misleading” and that their tactics are “unreasonable and very unfair to [Lineage] shareholders.”
The letter, signed by both Herringtons, describes the activists’ position as “a nuclear approach” that “makes no sense at all.”
Reached for comment, Lineage board chair and CEO Richard Herrington wrote in an email (spacing adjusted and emphasis added):
“We believe that Lineage Bank’s leadership team and the Board of Directors has the support and confidence of its shareholder as well as the business community. The majority of our investors are pleased with the bank’s profitability and direction.
It is unfortunate that during a difficult time for community banking nationally, a handful of investors have taken an opportunistic stance. As your reporting has correctly identified, there is much regulatory uncertainty around “banking as a service” (BaaS) and the fintech line of business.
We are working through that with our partners and regulators and believe it will play a significant role in the future of banking. Our Board of Directors and management team look forward to leading the bank in 2024 and in the many years that follow.”
Yet, in a communication from the activist shareholders sent to Fintech Business Weekly in error, Sparks and Marshall reveal they already have votes equal to 51% of the outstanding shares of Lineage — meaning they are likely to succeed in ousting the Herringtons and the rest of the board (emphasis in the original):
“Despite the incumbent leadership’s efforts to prevent shareholders’ voices from being heard, LFN’s shareholders have overwhelmingly agreed with our vision for LFN and actions. To date, we have received proxy agreements in support of our motion to replace the incumbent leadership that total more than 51% of the outstanding shares of the Bank.”
Robert Sparks, representing the activist shareholders, declined to comment on the situation.
Representatives for Synapse and Synctera didn’t respond to questions about what impact, if any, the change of leadership could have on their relationship with the bank.
Five Takeaways From FDIC Q3 Quarterly Banking Profile; Service Fees On Consumer Accounts Continue To Decline
The FDIC recently released its Q3 Quarterly Banking Profile, which contains a wealth of data on the overall health of the US banking sector. While there are a handful of areas worth watching, overall, trends in Q3 were fairly steady.
Net income was down slightly quarter over quarter, dropping 3.4% to $68.4 billion in Q3. Q1 and Q2 2023 benefited from the accounting treatment of the acquisitions of failed banks in those quarters; excluding those one-time items, net income would have been roughly flat over the past year.
However, unrealized losses on banks’ securities portfolios remain elevated, as they have been since the beginning of the rate hiking cycle. Total unrealized losses on held-to-maturity and available-for-sale were $683.9 billion in Q3, up 22% vs. the prior quarter.
Banks’ net interest margin has been fairly stable quarter over quarter, though there are differences by size of institution. Overall, net interest margin increased by 3bps quarter over quarter, reaching 5bps above the pre-pandemic average. Deposit costs increased faster than loan yields in Q3, but costs of non-deposit liabilities helped offset the industry’s overall cost of funds.
On the lending side, there are signs that credit quality continues to normalize, as non-current and net charge-off rates crept up slightly in the quarter. The increase in non-current loans was driven by commercial real estate (CRE), while the increase in net charge-offs was driven primarily by consumer credit card balances.
Community banks continue to outperform on credit quality, with a non-current rate of 0.51% and a net charge-off rate of 0.11% — both of which are significantly better than pre-pandemic averages.
Perhaps the greatest cause for concern is emerging signs of stress in the commercial real estate sector. There was a 36.4% jump in the volume of non-owner-occupied CRE loans that are non-current, driven primarily by office building loans. This is the highest non-current rate for this type of lending since 2014.
S&P Global also recently published an analysis, based on banks’ Q3 call report data, that shows service fees and charges on consumer deposit accounts continued to decline quarter over quarter:
Total service fee income dropped by about 2% quarter over quarter to $2.85 billion. This was largely driven by a decrease in overdraft fees, which have dropped a significant 22.7% vs. Q3’22.
Total deposit account service fees and especially overdraft fees have been on the decline since late 2021 amid the CFPB and wider Biden administration’s war on so-called “junk fees.”
Still, per S&P Global’s analysis, some banks — mostly smaller ones — derive a double-digit share of their operating revenue from such fees:
CFPB’s Comment On California’s “Income-Based Advance” Rule Is A Stark Warning For EWA Providers
Early last week, the Consumer Financial Protection Bureau filed a somewhat unusual comment letter regarding California’s proposed rule clarifying regulations around “income-based” advances, including earned wage access products.
The CFPB comment letter, penned by Bureau General Counsel and senior advisor to Director Chopra Seth Frotman, notes that “income-based” products have a long history across various product structures, including as wage “sales” or “assignments,” payday lending, which is typically legally structured as a “deferred presentment transaction,” and “deposit advance” products tied to checking accounts.
While the exact mechanism, legal treatment, and level of risk to the lender vary, the consumer purpose and experience is largely similar: a borrower receives funds that are typically repaid in full on their next pay date.
The comment letter argues that equivalent products that meet similar needs should receive the same regulatory treatment, regardless of label, saying (emphasis added):
“Rigorous supervision of all income-based advance products helps to ensure that the label of a product does not determine how providers are held accountable, or the extent to which consumers are protected, under the law.”
The comment letter approvingly notes that California’s proposed rule would define income-advance products, including both “employer-integrated” and “direct-to-consumer” EWA as “loans” and that associated fees, including expedited funding fees and “gratuities” would be considered “charges” (spacing adjusted and emphasis added):
“The CFPB notes that DFPI’s proposal would clarify that income-based advances are “loans” under the California Financing Law and that “charges” under that law include “gratuities” as well as “expedite fees.”
By treating these products as loans and including a variety of charges that accompany the advance, DFPI’s proposal takes a similar approach as the Truth in Lending Act and its implementing Regulation Z…”
Finally, the letter notes that the CFPB intends to issue further guidance about how TILA and Reg Z apply to these products — which suggests the Bureau is likely to push for EWA-type products in all states to be treated as “credit” with costs treated as “finance charges” and, presumably, disclosed as an APR.
How this would interact with the laws passed in numerous states that take the opposite tact, explicitly defining such products as not being loans, and state usury caps is unclear, but any CFPB guidance along these lines seems likely to generate significant confusion and challenges for EWA providers.
Other Good Reads
A Divorce With Apple, Internal Strife: How Goldman’s Main Street Bet Failed (Wall Street Journal)
The Inside Story Of Microsoft’s Partnership With OpenAI (The New Yorker)
Fintech Grab Bag (Fintech Takes)
The Token Layer Cake (Fintech Brainfood)
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