IKB Deutsche Industriebank, the German bank that suffered the most significant losses as a result of the subprime mortgage crisis, will hold its second annual meeting of the year on Aug. 28 amidst growing uncertainty about its liquidity and future ownership situation. The bank, which specializes in financing small to midsize companies and is 45 percent owned by the German government, received a EUR 8.5 billion ($12.5 billion) bailout from the German government and a consortium of German banks in 2007 to cover subprime-related losses.

The losses were incurred in off-balance sheet transactions undertaken by the bank’s structured credit conduit Rheinland Holding, and the scope of the damage initially came to light in July 2007 after the release of the bank’s preliminary annual results. The timing of the discovery forced the bank to restate its earnings and delay its 2007 annual meeting until March 2008. An independent assessment of the damages by PricewaterhouseCoopers blamed IKB management for failing to implement effective risk analysis and risk management controls, and for giving its IKB Credit Asset Management subsidiary, which ran Rheinland Holding, a disproportionately high degree of responsibility over the company’s risk position.

Notably, for the second consecutive annual meeting, management is recommending that shareholders postpone liability discharges for members of the bank’s management and supervisory boards who were in office during the lead up to the subprime crisis. The vote of discharge, which is a routine agenda item at German annual meetings, is generally considered to be a symbolic vote of confidence in the actions of the management and supervisory boards during the previous fiscal year. Also, because supervisory board directors in Germany generally are elected once every five years, the vote to discharge represents one of the few opportunities that shareholders have to express their dissatisfaction with a company’s leadership. Although a vote to discharge does not necessarily preclude a company and investors from taking legal action against its directors, a management recommendation to postpone or refuse discharge is a good indicator that a company is considering such action.

In this case, IKB management has recommended postponing discharge because former IKB management and supervisory board members are currently being investigated for breach of duty under the authority of a special audit proposed by the Dusseldorf-based shareholder organization DSW and approved at the March 2008 annual meeting. DSW was able to successfully reverse IKB management’s original recommendation for discharging the supervisory board and pass its special audit proposal with 82 percent approval. DSW managing director Carsten Heise told RiskMetrics Group that the strong showing was attributable to the German government’s willingness to going along with the proposal. According to Heise, IKB is cooperating fully with the investigation, and that the results are expected to be published this fall.

Although IKB suffered more significant subprime-related losses than most other European banks, the bank’s concentrated ownership structure, combined with political support from Berlin, were clearly the decisive factors that enabled DSW to pass its special audit proposal. For the sake of comparison, the German government’s ownership percentage at IKB (45 percent) was actually greater than the total share capital participation at two shareholder meetings for large European banks with subprime-related shareholder proposals: UBS (37 percent) -- where a similar special audit proposal narrowly failed – and Deutsche Bank (33 percent) – where several more extreme shareholder proposals failed to receive significant support. Both of those banks have large free floats, whereas the German government’s dominant ownership position at IKB effectively allowed it to control the proceedings with a two-thirds voting majority. Thus the success of DSW’s proposal at IKB doe not reflect a groundswell of investor support in Europe so much as it reflects political pressure within Germany to get to the bottom of what has been a significant financial hit for the German government (this pressure was further illustrated last month when the opposition Free Democrat party pushed for a special government committee to investigate IKB’s managerial transgressions). In this respect, IKB appears to be an exceptional case, rather than the signal of changing investor sentiment in Europe.

In the lead up to next week’s annual meeting, the bank remains in a precarious financial position, and there is widespread concern in the German financial community that IKB’s collapse could trigger a more wide-ranging banking crisis there. Because the bank’s current liquidity is not expected to last beyond the end of the year, IKB management proposed a EUR 1.5 billion ($2.2 billion) recapitalization passed at the March annual meeting, but the recapitalization was blocked until last month by a number of shareholder lawsuits that were seen by some in the industry as opportunistic. By the time the shareholder lawsuits had been settled, the German government had stepped in to guarantee a subscription of at least EUR 1.25 billion ($1.84 billion) under the proposed rights issue, although this guarantee is currently being reviewed by the European Commission to determine whether it constitutes state aid (the subscription would take the government’s ownership stake in IKB to over 90 percent). This appears to be a formality however, since the government has resolved to sell its stake as soon as possible, preferably for a price of approximately EUR 800 million ($1.18 billion). According to news reports, private equity investors Ripplewood and Lone Star Funds have submitted final bids after Swedish Bank SEB – thought by many to be the preferred candidate – dropped out of the bidding. This creates an interesting scenario in which the German government would end up selling an important midsize domestic bank to a foreign private equity fund only three years after the Social Democratic Party (the junior partner in Germany’s ruling grand coalition) tried to swing national parliamentary elections through populist rhetoric that included branding foreign private equity and hedge funds as “locusts.” An announcement on the winning bid is expected soon, possibly by the end of the week.