To repeat the news reported last quarter, one of our holdings (OSHC) is being acquired by another of our holdings (OCFC, the shares of which we acquired when it bought CBNJ). The deal is expected to close late this year or in early 2017, and I believe the prospects for the combined company are bright. CEO Chris Maher is an impressive banker and he has a clear, rational plan for the company. Depending on the prevailing market prices we may sell some of our holding in OCFC, but unless conditions change or the price increases dramatically I expect to retain a large investment in OCFC following its acquisition of OSHC. It is also worth noting that our research regarding CBNJ and the other banks in the area lead directly to our investment in OSHC. Its acquisition by OCFC was never a given and our outcome would have been satisfactory either way, but this deal made plenty of sense to both sides.

The following table updates our holdings in community banks. Bank A is undergoing an exploratory process that we hope results in a sale of the company. Bank F is a new holding that we’ve been buying slowly over the past few months; we hope to buy much more in the near future.

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On September 8th Wells Fargo announced its settlement of charges that it had fraudulently opened accounts that its customers did not authorize. The company paid a total of $185 million in fines and penalties to various agencies, with an additional $5 million set aside for customer remediation. Despite breathless media coverage, I have yet to see a single story that gets all of the numbers correct.[1] And the numbers do matter, both in terms of assessing the impact of this problem and in terms of diagnosing the likelihood of more problems yet to come.

Over a period of several years, Wells Fargo opened many sham accounts in attempt by branch-level employees to meet their daily sales quotas. These quotas were a focus at the company, from the top of the company down, but they were inherently arbitrary and not even grounded in a rational expectation of making money. Wells Fargo, it should be noted, made no money by opening these accounts. The total fee revenue of $2.6 over several years is the definition of immaterial for a company of this size. Even the fines of $190 million and any business disruptions or added compliance costs are unlikely to matter financially. If a second or third edition of the PwC audit finds more problem accounts and even if more regulatory agencies pile on (both of which I’d consider likely) I still do not believe the damage in purely financial terms will be meaningful to Wells Fargo’s business. Customers value the convenience of having multiple accounts at one institution that can handle all of their banking needs, and Wells Fargo still has many thousands of excellent people providing products and services their customers really can’t do without.

Likewise, I think the hallowed Wells Fargo “cross-selling” approach drove a lot of its success in the past, Wells Fargo is a gigantic, entrenched bank that has saturated many of its markets. I do not believe the fallout or changes from this scandal will alter the future course of the business model to a material degree. It is unclear whether customers would be best served by four, six or eight products, but that customer relationship was already profitable and unlikely to benefit from a perpetual drive to add more products. This management tactic to push more and products clearly strained the boundary of logic and reason and it should have been a non-starter.

At its core I view this as a management failure. The managers and employees responsible for this problem were, in my opinion, rebelling against unreasonable expectations set by top-level management in a bid to preserve their own jobs. Management at all levels is to blame for fostering this environment, even if it only materialized into a problem in a tiny minority of its employees. And senior management proved even more inept in its handling of the investigation, settlement, and public response. The Board has also proven to be ineffective throughout this episode. Then-CEO John Stumpf appeared to be caught off guard despite having several years to prepare for just this situation. I don’t think anyone held Stumpf in the same regard as his legendary predecessors, and not every CEO has to be an industry-shaping legend, but every CEO should be held to a higher standard than this.[2]

Now that Stumpf has resigned, apparently without any push from the Board, will his replacement Tim Sloan be able to chart a new course? And what does this episode say about the vaunted Wells Fargo culture? It’s clearly not good. This is definitive evidence of some degree of rot inside the company. I have not yet reached the conclusion that the entire organization has gone off the rails, but I am concerned. Barring any revelations of further misconduct – a big if – this still appears to be a manageable situation with very minor financial consequences. But Wells Fargo has clearly lost – and deserved to lose – some of the all-important trust it has built with its customers over the years. Will the public and regulator backlash lead to further erosion of trust? What other problems are lurking beneath the surface? How much weight should this mistake carry in evaluating the company’s ability to make intelligent decisions in the future?

As the answers to those questions become clearer I will continue to evaluate our investment.

[1] According to work done by PwC, an independent investigator hired by the company in 2013, from 2011 to 2015 Wells Fargo opened a total of 82 million deposit accounts and 11 million credit card accounts. Of the 82 million deposit accounts, PwC found 1.5 million accounts that could not be verified. Some were fraudulent but many were found to be lacking proper documentation and did not generate fees; in other words, many of these accounts were the result of employees “stuffing the file” with no fees to a customer and no benefit to Wells Fargo. Only 100,000 accounts were found to be unauthorized and the source of fees (which totaled $2.2 million in revenue for Wells Fargo). For the credit card accounts, PwC considered all credit cards that were never activated by the customer, a total of 565,000, even though the vast majority of the cards were authorized by the customers. Of that number, 14,000 incurred a fee (totaling $400,000), but PwC did not find that these cards were unauthorized. So across all products there were a confirmed 114,000 accounts that were truly damaging to customers, and they generated a total of $2.6 million in revenue for Wells Fargo. That is a big problem and it is a horrible failure of management on multiple levels, but the reality is far different than claiming there were “millions” of fraudulent accounts in a “massive fraud” that “[drove up] the value of [Wells Fargo] stock.” At the least, it should be clarified that the full 2,165,000 accounts were poorly documented and possibly fraudulent, but only a fraction of that number were confirmed to be fraudulent and harmful to customers. I would also argue that at enormous companies, there are often small subsets of the managerial and employee ranks that go off course into unethical and/or illegal territory. The disappointing aspect of this issue is not just that the problem happened in the first place, but that management so badly botched the response to it. Sources: http://www.banking.senate.gov/public/index.cfm/2016/9/an-examination-of-wells-fargo-s-unauthorized-accounts-and-the-regulatory-response ; https://www.wellsfargo.com/commitment

[2] My first draft of this letter was written before Stumpf resigned on October 12th. I had written that clawing back some of his pay but keeping him as CEO seemed like another “too little, too late” response. A firm response by Stumpf and the Board once the results of the PwC investigation became clear could have negated the need for most or all of this hang-wringing. I also noted that the company’s largest shareholder and longtime cheerleader, Warren Buffett, had been notably silent despite his often vocal support for other CEOs facing business turbulence.

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The above commentary is excerpted from the quarterly letter of Anabatic Investment Partners LLC. The fund’s Managing Principal and Portfolio Manager is Philip C. Ordway. Please note that the complete text of the disclaimer included with the fund’s quarterly letter is also reproduced below.

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