With hundreds of bank failures since the financial crisis began and many mergers and acquisitions taking place in an environment of financial and regulatory stress, Commerce Street Capital Managing Director Tom Lykos responds to written questions related to M&A in the face of shareholder activism and heightened judicial scrutiny.
Can you say a little about the regulatory and financial environment and how that is impacting banks?
The increased regulatory scrutiny that began with the crisis of 2008 has only been heightened by the increased regulatory burdens of the Dodd-Frank Act. However, there is a tension between the fiduciary duties owed to shareholders and the obligations directors owe to the FDIC and their primary regulator. At times, the director is caught between the need to accede to the “requests” and directives of regulators while vigorously advocating and advancing the interests of shareholders where the burdens of compliance seem excessive and adversely affect profitability. In such situations, engaging qualified and independent financial and legal advisors is justified given the nature, complexity and immediacy of the issues confronting management and directors. Reliance upon their advice is advisable given that the FDIC alleged, in its demand for payment of civil damages sought from certain officers and directors of BankUnited FSB in Florida, that they failed to heed the warnings and/or recommendations of bank consultants prior to the bank’s 2009 failure.
How should bank directors approach M&A in the current environment?
In general, it is fair to state that the old standards still apply. However, the application of these standards has been more rigorous with regard to corporate governance in the context of both evaluating a bank’s strategic direction in general and especially in M&A transactions. Officers and directors do not necessarily have to prove they received the “highest” or “best” price. Rather, they are charged with the duty of following a course or a process that leads to a reasonable decision, not a perfect decision. In the context of a merger, an independent fairness opinion increases the probability that a board’s decisions will be protected by the business judgment rule and may also help facilitate shareholder approval of a proposed transaction.
If the old standards still apply, then how have the burdens on directors changed?
Although the standards have not changed, there is a higher level of scrutiny on directors now than at any time in the recent past. Increased regulatory oversight combined with increased shareholder activism has resulted in a corresponding increase in judicial scrutiny of the reasonableness of directors’ actions. The level of scrutiny is heightened in situations where an institution is not adequately capitalized, financial performance has lagged and shareholders have concerns about the bank’s strategic direction and the strategic options proposed by management. With regards to situations where subpar performance has led to shareholder activism, the creation of a special committee of the board and retention of an advisor to present strategic options are appropriate responses to address shareholder concerns. Without sounding alarmist, it may be that it is no longer enough for directors to satisfy their obligations to shareholders by negotiating a premium, hiring a financial advisor and obtaining a fairness opinion for a sale or acquisition. The courts have demonstrated an increased willingness to look behind the conclusions of a fairness opinion and board deliberations to determine if a transaction is fair from a financial point of view.
Can you give me an example?
Directors can look to recent court decisions to discern the inquiries relevant to appropriate director conduct. These include: Were the conflicts of interest adequately addressed and disclosed to shareholders, including those that may have unduly influenced directors, management and the financial advisor in the exercise of their judgment and discretion? Who took the lead in negotiating the transaction and what were their financial incentives for doing so? Was the process designed and implemented in a way intended to maximize shareholder value? Were there terms in the merger agreement and “deal protection devices” that were excessive or coercive in the context of the specific transaction? Was there adequate input from disinterested and independent directors? Was the fairness opinion truly independent or was the advisor’s fee contingent on a successful transaction, creating conflicts or “perverse incentives?” In short, both the courts and shareholders are focusing on the events and circumstances that lead to a transaction; the board process in evaluating a transaction (whether accepted or rejected); deal protection devices that may discourage or preclude the consideration of other offers; and the existence and disclosure of apparent or actual conflicts of interest among officers, directors and advisors that might impair their independent judgment.