Due Diligence and Decision Making throughout the Transaction Process

Boards contemplating acquisitions have much to consider in light of heightened awareness about corporate governance, financial accountability, and the importance of due diligence. Our second roundtable panel debates the impact of Sarbanes-Oxley on M&A, the changing role of the auditing firm, and new and creative ways to structure transactions.

BANK DIRECTOR: In the post-Sarbanes-Oxley environment, what effect has increased scrutiny on best practices had on the M&A culture and the transaction process?

Jim Rockett: Two years after Sarbanes-Oxley, we are observing real defensiveness on the part of boards. The lines of governance between management and the board have become blurred by Sarbanes-Oxley such that boards and management are becoming mutually suspicious of each other. And while boards are doing many things they weren’t doing in the past, they are not doing them for the right reasons, so it’s not productive.

Ben Plotkin: This year we saw some of the negative implications of Sarbanes-Oxley. But after a couple of years, boards and managements will adjust. Today, many boards and management teams at small-cap banks are not equipped to deal with all the new responsibilities–perhaps they don’t have the right personnel, the right directors, or the right management. So there’s going to be some reverberations, especially in terms of restaffing. At this point, we haven’t seen the benefits of Sarbanes-Oxley, but over the long term, I think it will be healthy because it will lead to better practices.

Michael Mayes: I think the word “reverberations” is a good one. Managements and boards are both feeling their way a bit. Managements believe boards are becoming a little too intrusive in the day-to-day management of the bank, and boards, rightly so, are very concerned about their role and their liability. On the other hand, I’ve been pleased to see boards taking a more active, constructive role in the M&A process. We see boards developing M&A committees and strategic advisory committees, and those committees are working much more closely with counsel and bankers to review the landscape, understand their options, monitor valuations, and communicate back to the board on a regular basis. So boards are creating a better process for making decisions.

Ron Janis: I agree with Marty Lipton who says there are too many checklists for boards. For one thing, boards need to operate, psychologically, like a team, rather than having everyone attend to their own checklist. I’ve tried to help boards break down into smaller groups, where one person is the team leader. This helps them realize what they need to do and it helps them maintain a proper perspective on reality. As an example, last year Krispy Kreme said its earnings declined because everyone was on a low-carb diet. That comment didn’t make sense. But the board was slow to say, “That’s not an accurate perception of reality.” It took them longer than it should have to recognize the underlying problem.

Kerrie MacPherson: I think the best boards today are careful not to step over the line and to make sure they monitor–not manage– the process. That’s a tough balancing act, and boards and management are working hard to figure it out. But companies are also trying to make sure there’s benefit in all this oversight. Having an involvement and an understanding of the landscape early on makes a big difference. It allows directors to consider potential deals even before they know the details, so that when an opportunity arises and requires a decision, they’ve had a chance to think about it and ask questions ahead of time. I believe decisions are actually being made in a more thoughtful way than they were before, when the board was too often a rubber stamp. For companies that have dedicated themselves to making Sarbanes-Oxley work in their favor, the result has been better decisions.

Gene Weil: I have two quick observations. First, the far-reaching implications of Sarbanes-Oxley really have not had much impact on the thinking of those associated with smaller banks. It appears that many in this sector of banking do not yet fully understand what this legislation could mean to them. Second, from an M&A perspective, board involvement on the buy side has escalated incredibly in the last two years. We are having more meetings that cover many more details than in the past.

Janis: Another issue that is going to cause trouble is the WorldCom/ Enron personal settlements with the directors. I am on the corporate governance committee of the American Bar Association, and one banker wrote in and said he was worried about whether plaintiffs’ lawyers are now focusing on best practices where “best practice” is defined as getting a pound of flesh from the directors. If that’s what’s happening, plaintiffs aren’t going to settle unless they get some money from the directors personally. I thought that was a very disturbing concept and probably not far off the mark.

Rockett: I question whether Sarbanes-Oxley has had that kind of impact. In my experience, good boards of directors remain good boards of directors, although Sarbanes-Oxley can make even a good board jumpy, nervous, and somewhat paranoid. A bad board of directors remains a bad board of directors, and yet Sarbanes-Oxley really doesn’t address how to go through the process of weeding those people out and changing the culture and character of the board.

Plotkin: Over the next couple of years, good chairmen and lead directors on the nominating committees are going to look much more carefully at the composition of the board, and I do think we’ll see more turnover. One of the biggest problems in community banking is the quality of the board. So while Sarbanes-Oxley may not have been as necessary in banking because financial institutions are already a closely regulated industry, with regard to internal controls, the law is actually going to be helpful in encouraging a better-quality set of directors, which will lead to a better industry for the long term.

Weil: Frankly, I am a little surprised that Sarbanes-Oxley has not had more of a chilling effect on interest in becoming a director, particularly for some of the small community banks. We continue to see strong interest among local business leaders in serving on a bank board.

Plotkin: It’s for the same reason we’ve had almost 700 de novo banks since 1999–people like to be involved in their local banks. And banks that work on improving their board composition are going to be more effective, and they are going to have a competitive edge in doing deals. So I think the turnover is going to have a direct impact on M&A. Managers who get it right and go through some clinics with their directors will probably be more effective as acquirers.

Mayes: I agree there will be a weeding-out process over the next five years. Directors today who are not actively involved and are not sure what’s happening with their bank should think long and hard about whether they should be on the board at all. Getting new, qualified, capable people on boards will be a challenge, but banks will find them. And, as we’ve all pointed out, because banking has been a regulated industry for so many years, banks are actually going to be further along than the corporate sector in terms of improved governance because of that regulation. Furthermore, banks are in an industry that is consolidating, so if they can’t create a smooth, efficient process, they are going to miss out on opportunities. A lot of banking companies are still getting their feet wet in the deal process and finding that it sometimes takes bids on two or three transactions to actually get one done.

Janis: One area that’s been a plus so far that’s come from the new stock exchange rules is the emphasis on identifying conflicts and standards of independence. CEOs naturally want some control over the people on the board and the guidance for the identification of conflicts helps balance that.

Rockett: I’d like to pose a question regarding independent auditors to Kerrie. I have found the relationship between the bank and its auditor has gone from consultative and collaborative to being rather taciturn. How are we going to get back to a point where there is more trust between clients and auditors?

MacPherson: It’s a great question. We’ve gone through a huge shift in the last two years. While the client is and always has been the shareholder (via the auditor’s relationship with the board and the audit committee) for the last 20 years, important working relationships were built with management. Some would suggest that having such close relationships probably meant that, from time to time, auditors gave people whom they had worked with for many years the benefit of the doubt, when perhaps that wasn’t the best choice. But the rules of the road have shifted dramatically. Today, for example, when a client is looking at making a change in audit firms, it is not uncommon for us to talk to only a handful of people in management–the access we have is more to the members of the board, because it’s the board that makes the decision. So there’s no question that the pendulum has swung very far in one direction right now.

Janis: But also, the rules are just too complex. Even the best CFO doesn’t always get it right and there is so much room for divergence. Even the SEC is beginning to realize that the rules are far too complicated for people to deal with, and the uncertainty and the liability involved is so great that people are nervous about getting something on an application wrong.

Weil: Kerrie, given this new paradigm and the fact that there are functions that auditors used to perform from a diligence standpoint that are now being done either internally or by other third-party consultants, how has the auditor’s role changed?

MacPherson: There have been cases where we used to perform due diligence for SEC audit clients and these boards have now said we can’t do such work anymore. And while companies want to be purer than pure, frankly, there may be benefits to having your auditors involved in the diligence process. The auditors are aware of information that no one else knows, and you can also make sure that, as part of that process, the auditors are getting up to speed on the target company.

The flip side is that there are many situations where we’ve had the opportunity to work with clients for whom we are not their auditors. The trick is to make sure we appropriately involve the auditors to ensure they are getting that transfer of knowledge. I honestly don’t think there’s one right answer. It depends on the board’s willingness to say either, “I’m absolutely going to cover my tail and am not going to take any chances” versus the board that says, “Wait a minute, it just makes good sense to me that the people who have audited our bank for years need to be involved.” But however you do it, it is really important to make sure that before the board makes its final decision on a transaction, there has been some sharing of knowledge between the audit team and the diligence team.

Plotkin: Checks and balances– that’s what it’s all about in this environment. Sometimes a separate diligence team seems unnecessary since the existing audit team can do the work. Yet the audit partner is there to be an objective party representing the board and the shareholders. I know in some recent transactions we’ve been involved in, the board wanted someone else doing the diligence. And in the spirit of the new regulatory scheme, I think that’s to be expected.

MacPherson: Let me clarify one thing. Even in the case where one of our audit clients is making an acquisition and we are doing the diligence, the audit partner is not the lead partner on diligence. That’s been our model for 15 years.

BANK DIRECTOR: So has this translated to a higher comfort level on the part of directors?

Plotkin: No, they are terribly agitated and anxious. For that reason, it’s becoming increasingly important to have clinics with boards before they ever do a live deal. This helps them understand the parameters of a good deal. It also helps them learn when the audit committee needs to get involved. Otherwise, when you have time pressures, especially in a good deal situation, it’s like everything else–if you haven’t practiced and prepared for it, you won’t be effective.

BANK DIRECTOR: Can you discuss how current financing options and changes in accounting rules have allowed deal structure to become more flexible?

Plotkin: First, we’ve enjoyed a wonderful period of time for acquirers where capital has been very cheap, whether you look at it in terms of the low cost of cash financing or in terms of stock with currency multiples at historic highs. So that’s created a lot of different ways to structure deals efficiently. As rates go up and as currency values start to decline, deals will become less affordable.

Mayes: Selling boards are spending a lot more time evaluating the stock and the currency of the buyer when they have multiple bids. There is more flexibility and openness in terms of what a board is willing to do, even if one stock, on a nominal basis, appears to be more valuable than another stock. Their analyses are much more detailed, and there’s more discussion about the future prospects of the potential buyer. That is very refreshing.

Second, sometimes we forget how little flexibility we had in restructurings, divestitures, or financing options with poolings. Historically, everybody was trying not to spoil the pooling; now we don’t even think about that. So the landscape is wide open, which is good. Furthermore, with the significant amounts of goodwill being created, banks are much more careful and disciplined about how they are going to spend their money.

Weil: Because we have moved away from pooling and have this flexibility, we often see transactions that might not otherwise have closed. For example, we worked on the Staten Island Bancorp/Independence Community Bank Corp. deal last year, in which Staten Island had a mortgage company that had grown to be a very large percentage of the bank’s earnings. Because most of the buyers interested in the bank franchise were not interested in the mortgage company, the entity needed to be broken apart and sold to separate buyers to achieve maximum value for the bank. Obviously that could not have happened under the pooling rules.

Rockett: Because of low capital gains rates, more people are willing to take cash, whereas in the past, that was just not the case. So now transactions tend to be either all-cash or cash-as-stock–usually with the stock at a level where a tax opinion can be issued that the stock component is tax-free, even if it is still up to 55% to 60% cash. Also, because of the availability of proceeds of trust-preferred offerings and because bank stocks are so readily salable right now, there is more willingness to accept a transaction that has a financing contingency in it. Last year, we did two transactions that each had a contingency of a trust-preferred offering to fund the transaction. We also had one transaction where, because of unique regulatory circumstances, the seller wanted all cash while the buyer wanted to structure it as cash and stock, so we included in the definitive agreement an underwritten offering of the stock portion to be closed immediately upon closing. We also have a deal pending where there was a need to sell common stock in order to fund an all-cash transaction. Basically, we signed the agreement–took a time-out while we sold the stock– and now that the stock sale is oversubscribed, we are going back to close the deal. These are contingencies that simply wouldn’t have been acceptable in the past.

Weil: As some of the banks on the acquiring side get filled up with trust-preferred securities and can’t issue any more trust preferred without jeopardizing their Tier 1 capital treatment, they are looking for other ways to finance their transactions. Are any of you seeing transactions in which acquirers are attempting to issue preferred or convertible debentures to the selling shareholders as a means of capital treatment?

Mayes: We’ve seen buyers trying to come up with some creative securities, which is, again, another advantage of purchase accounting. We typically recommend to buyers that when you have stocks trading at these levels, the best currency to use is your own common stock. There are many analyses that show that using common stock is actually cheaper than issuing trust preferred, for example, depending upon the valuations.

Also, Jim made a good point with respect to the lower capital gains tax and the willingness of some sellers to take cash. I’ve always had a slight bias, particularly when dealing with community banks, toward encouraging boards to look at taking stock, particularly when it’s the stock of a bank that is actively traded. In fact, we are now seeing people with the same investment who are on their fourth and fifth rounds of transactions just by trading up. And the benefits you can see in terms of value when you’ve traded up three or four times on the same stock are enormous. While we tend to get creative when the stocks are trading at depressed levels, at today’s levels, I think it’s a good time to use stock.

Weil: Just one note on that–on the buy side, while currencies are at tremendous levels, so are transaction values. It has been tough in all-stock deals because the transaction levels are so high that we have to seek ways to issue less stock and be more creative on the financing side.

Plotkin: The wheel will turn. I’m sure we’ll be using more creativity a year from now.

BANK DIRECTOR: Could you each describe missteps commonly made during the deal process and advise boards how to avoid them?

MacPherson: Two mistakes are underestimating the cost to integrate the people, the technology, the real estate–everything, as well as not having realistic timelines. These are almost never done to the extent they should be. Peter Verrill, COO from Banknorth, mentioned at this [Acquire or Be Acquired] conference that his bank’s model does not include revenue synergies. There would be a lot of deals that boards would never approve if the models had no revenue synergies in them. So having realistic modeling and then using those models to form year-one budgets to track against would be a huge change in behavior.

Rockett: The failure to understand the culture of the target in order to determine how best to retain customers and employees and to take into consideration the impact of business runoff can be a major misstep. Acquirers must look at both sides of the balance sheet: On the asset side, can you accommodate the types of products the target is offering and integrate those quickly and smoothly into your asset base and make those customers feel good? And on the liability side, can you quickly assimilate those customer relationships into your culture? If not, the acquirer will grossly underestimate the potential runoff, and the deal can become pretty ugly from the standpoint of a going-forward earnings stream.

Weil: This concept does not just apply to customer relationships; it applies to the management at the target bank as well. The management of the acquiring entity generally will have strong opinions on how it wants to structure and staff the combined company. Whenever possible, we encourage boards of acquiring banks to work with the target bank’s management team and to determine what resources can be integrated. Developing positive relationships with the target bank’s management can be invaluable in this regard. The last thing an acquiring bank needs is to have the best personnel of the acquired company leave and become part of the competition.

Plotkin: There is also risk created because the period of time between the announcement and the closing is very long in the banking world–longer than in most other corporate situations. This is a dynamic, living, breathing bank that’s been acquired and, during that period of time, you can lose line personnel–the relationship people that you count on–because your competitors–banks that bid on the company and didn’t get it– would love to hire those key people. Also, your financial assumptions can be altered dramatically, either by the movement of interest rates or by yield curve changes; thus, the accounting assumptions may be very different by the time you close. The mistake is in not planning for contingencies during that executory period in terms of customers, people, and financial assumptions.

Mayes: Some missteps occur prior to signing an agreement. On the buy side, one of the most common things is that people just aren’t prepared. One analogy we use is having your gun fully loaded and knowing when to pull the trigger– a lot of prep work needs to be done to get to that point. We tell buyers who are serious about acquiring, particularly if they already have a list of their most important targets, to be prepared to pay more than they think they are going to have to pay. Another analogy is remembering when you bought your first home. You sat down and figured out how much you could afford, and then you came up with a magical number to spend for the house–but everybody ends up spending more. It’s the same thing when you buy a bank.

On the sell side, these transactions create a certain amount of momentum, and boards need to be prepared to meet regularly and make decisions very quickly. You often spend a lot of time slowly going through the process, and then, as you get to the end of that process, a lot of things happen very quickly. So again, being prepared, being experienced, and doing all the prep work is crucial. It’s very important not to lose that momentum on either the buy side or the sell side.

Janis: On a very specific topic that I’ve seen recently, I think especially in the Northeast, in Florida, and in California, AML (anti-money-laundering) is a big problem. So the first question I always ask is, “Do you have any grand jury subpoenas? Are there any investigations occurring?" Interestingly, when the Patriot Act rules were adopted, the Treasury wisely said it was not going to treat customers acquired in a branch or whole-bank acquisition as new customers. On the other hand, you also have to have an effective AML program. But these two positions create a contradiction. You do have to know the customers you are acquiring regardless of what Treasury rules say. AML is now at the level that it can cause banks serious problems, so you have to be very aware of what’s going on and how you are going to account for the institution you are acquiring, even though, theoretically, you don’t have any “new” customers.

Rockett: I believe Bank Secrecy Act/USA Patriot Act/AML issues are going to have a dramatic, negative impact on the level of M&A activity in the near future. We are already seeing the impact in California, where several acquirers are under various forms of AML regulatory enforcement action. Unless the regulators become more balanced in their approach toward anti-money-laundering, we’re going to experience a period of time where banks are going to be effectively sidelined from M&A.

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