Good Governance during the Transaction

Good communication between the board and the CEO, the legal and investment banking advisers,and the deal partners is central to ensuring a smooth transaction process.Board independence is often tested during deal negotiations,and our panel discusses when and how to use a special committee,the uses of fairness opinions,and how to align interests on both sides of the table.

BANK DIRECTOR: Let’s begin by talking about how the roles of the board and management intersect during the M&A process, and how you resolve conflicts when their interests diverge.

Ron Janis: From a legal point of view, the courts have said the board should control the sale process, yet the issue that comes up all the time is who should initiate the process? Sometimes it’s the CEO, who may not have a clear succession plan and thus is interested in selling the bank. Sometimes you have board members who are interested in selling and who may persuade the CEO it is time to sell the bank. The best process I was ever involved in was a discussion among the board members that lasted about six months, where they presented a scenario of what would happen if the bank stayed independent and what would happen if the bank was sold. That was a great presentation, because in the end, the board understood what it would have to do independently to equal the sale value.

Dory Wiley: From an investment banker’s perspective, if there is a lot of communication in the beginning between management and the board, it goes much smoother.That’s the right way to do a deal, and it takes care of the board’s fiduciary responsibility. But so often, the process is initiated by senior management, and you’re not sure whether their interests are aligned with the board’s, and, on top of that, whether they’re aligned with shareholder interests. I’ve always felt the best situations are where the board is involved from the beginning.The board can set up a separate committee if directors want to be more actively involved in the process.

Steve Klein: You should start with the concept of the board’s fiduciary duties.Then you must deal with any conflicts of interest, and one way of doing so is to have an M&A committee, as Dory mentioned. This committee is usually composed of outside directors, with the CEO as an ad hoc member.You certainly cannot or should not exclude the CEO from the process. Foremost, however, as a director, you should be thinking about how to avoid putting yourself in a position where conflicts exist. If board members are educated and understand the process better, it won’t be as much of a fire drill when an event such as an overture, a large shareholder putting pressure to sell, or an illness or death of a senior manager or director occurs.Those things put pressure on the board to act quickly. Ultimately boards must focus on what’s the best for shareholders. Sarbanes-Oxley does not address these issues directly, and yet whatever the board does now is scrutinized more heavily than ever before. Outside directors, I would argue, have even greater potential exposure. Last, in my experience, the best thing you can do is have senior management in place in whom you have confidence.You should also provide appropriate incentives and rewards for them, in terms of stock options, so their ownership is aligned with that of shareholders. On top of that, set up appropriate severance packages, whether they’re change-of-control, severance, or salary continuation agreements. Buyers will pay a reasonable cost for these arrangements, and you don’t want to disincent management from doing the right thing for shareholders. If you take care of these things up-front, it can minimize the conflicts.

Art Loomis: The permutations of how M&A discussions get started are endless, though it’s usually segmented into two categories: seller-initiated or buyer-initiated. Typically, when a buyer initiates the discussion, advisers tend to be involved more rapidly, and consequently, the board’s involvement is also more immediate. In these instances, there are fewer opportunities for conflicts to arise. When the seller initiates the discussion, it becomes more problematic in the sense that you may never know who among the sellers truly did the initiating.You may find out the CEO floated the idea, or you may discover there are board members who were responsible. At that point, it becomes more difficult to understand the common denominator, or source, which broadens the opportunity for conflicts and puts more pressure on professionals to help control or augment the process.

Klein: What we haven’t yet talked about, though, and yet it is critical, has to do with the relationship between the board and management–there has to be a good line of communication. These types of discussions are very sensitive and serious and should be communicated up-front.

Janis: You often run into problems with a large board because the communication can be much more difficult.

Klein: I agree. Even though Sarbanes-Oxley mandates more independent directors, it is preferable to have a board that’s under 10 members, because otherwise it splits into subgroups.

Wiley: And large boards are political and prone to leaks.

Janis: Harvard Professor Richard Hackman, who started out as a mathematician, wrote a book about leading great teams. He says if you have a team of more than six people, you are unlikely to reach an understanding with each other because there are too many diverse conversations going on. That’s where you run into the politics of larger boards.The smaller the board, the easier it is to develop a successful team approach. Dr. Hackman states that his analysis does not apply to boards of directors because he did no research on that, but I believe those inside the boardroom can see its application.

Wiley: Aligning interests is key. Many times the board’s interest and management’s interests aren’t aligned–sometimes management doesn’t have enough ownership, or doesn’t have enough stock options, or is not going to get anything out of the sale, or it may be insecure about its role in the new organization. All these things factor in, and all of a sudden, the deal can go awry.To counter this, we encourage “stay-put” plans. A buyer often wants to retain the customer contact personnel, for example, so having a stay-put plan makes for a smoother process.

Klein: When we sold Pioneer Citizens Bank, which was about $1 billion, in Las Vegas to Zions several years ago, we put in 70 different types of change-ofcontrol, severance, and salary continuation plans, and in doing so, we broke them into three different levels.The first level was senior management, the second involved next-level-down managers, and below that were VPs. Senior-level personnel got up to three years, and those at the second level received one year plus a month for every year they’d been with the bank up to two years, and the last level got six months to a year. It didn’t cost Pioneer a nickel because Zions wanted all those people. In fact, this ensured Pioneer was in a better position to deliver everything Zions wanted. Many times, boards have a misconception these agreements are going to come out of shareholders’ pockets. But done correctly, a severance plan becomes a positive factor and allows the board and management to focus on one thing: the best interests of the shareholders.

Loomis: Our experience has been that any benefits flowing to management or the board from the standpoint of the transaction itself get factored into the overall purchase price by the buyer. Of late, however, we are also starting to see what are referred to as “cramdowns”– where some entitlements, which are considered particularly excessive, are actually being voluntarily reduced by the seller in exchange for higher values to shareholders.

Janis: Personally, I haven’t seen any cramdowns. However, I have seen buyers create problems for themselves by asking, “Do we really have to pay that?” or “Could we use that money to retain the person as opposed to creating an entitlement?” Bad blood can develop right away for those reasons.

Klein: There are a couple of interesting things that come into play.The most subtle thing we haven’t talked about–and the most powerful, potentially–is what happens if you don’t have the right benefits or incentives in place.

Wiley: The board absolutely needs to be proactive because, let’s face it, management can be insecure about these kinds of things.

BANK DIRECTOR: When you refer to management incentives, are you speaking about just the executive level or those below the C-suite as well?

Klein: It depends on the size of the organization. But in a typical community bank with assets under $1 billion, you’re probably only talking about three people.

Wiley: I remember one instance where we had three senior lenders practically hijack a deal because they felt they were underpaid to begin with.They had no contract going forward, and the buyer had done its assumptions based on their current salaries.The buyer had to pay them up-front money and increase their salaries, which had the effect of slowing down negotiations for about a month. In fact, the buyer almost walked away.

Klein: Likewise, we had a deal where the night before the signing, the guy with the biggest book of business walked away and wouldn’t sign the contract.That’s a case where, had a salary continuation agreement been put in place, things would have been so much easier because of the security it gives to the second-tier management. Buyers want to keep those income producers.

Loomis: Then there are “stay bonuses,” which also can become contentious from the standpoint of who’s paying for them. A stay bonus is meant to encourage someone stick around, and it usually goes further down into the ranks of the employee base.

Klein: Stay bonuses are often paid to people who will be terminated shortly after the merger, but are critical in the four to six months preceding the deal and are necessary to deliver what’s been promised in the deal.

Wiley: One thing that really hits a nerve with me is the notion of credibility. All these issues need to be addressed beforehand. People tend to look at issues as chits on a negotiating table. I try to be straightforward with managements and boards in the beginning and tell them this is not a game of Texas Hold ‘Em. It’s not poker. It’s an exercise in credibility, and you can get away with playing the game once in a while, but it will catch up with you. If you make it an exercise in credibility, it gets you dollars.That’s really important.

BANK DIRECTOR: I’d like to follow up on the use of special committees. What flags lead you to suggest that the board ought to create a special M&A committee?

Wiley: I usually determine it very quickly. Does management have ownership in the bank? Do executives have compensation plans set up for them? Are they protected? Are their interests aligned? If it’s a family-owned bank and the interests are aligned, it’s not a big deal. But if the interests are divergent or run the risk of being divergent, then I want a committee.

Klein: What you’re trying to do is create a vehicle to look after shareholders’ interests. But I also think you find conflicts inside a boardroom, especially with larger boards, as Ron said. If you have a board that’s either not functioning at a high level or there are different schools of thought among the members, it’s useful to have a committee made up of people who are accessible. A lot of board members aren’t accessible, and let’s face it, this process can move rather quickly.That’s not to say the board won’t be fully reported to and have the final say.The committee is not designed to disempower the board, rather, it creates a functional vehicle.

BANK DIRECTOR: Let’s get into the topic of fairness opinions, which have been the subject of some debate lately regarding whether they involve an inherent conflict of interest. When is a fairness opinion needed, and when might a board consider using a third party?

Janis: This is a fascinating issue involving a perception of conflict since the investment banker’s fee is dependant on the price of the deal and it is providing the fairness opinion.

Klein: In other words, the issue is whether the investment banker is compromised because a large part of the fee paid is based on the success of the transaction.

Janis: Of course there are those firms that do second fairness opinions on a fixed-fee basis. Boards have often asked me, “Do we need a second opinion?” My view is, if you understand the conflict and you sign somebody up and pay them a contingency fee, you don’t necessarily need a second opinion.

Klein: But the bottom line is boards should reasonably be able to rely on experts, whether it’s counsel or investment bankers. My feeling is, whenever you’re selling your company, get a fairness opinion.That’s the conventional view. I don’t think I’ve seen a deal of any consequence that did not have an investment banker working for the selling company. From a buyer’s standpoint, the exchanges have a rule that if you issue more than 20% of your existing stock as consideration, you must take it to your shareholders. So if you have to take it to your shareholders, you should probably seek a fairness opinion from an investment banker.

BANK DIRECTOR: Are there other proper procedural steps boards ought to be aware of to avoid liability?

Wiley: As far as process, the mistake is made in bringing people in at the last minute for a fairness opinion. It happens to us quite a bit, and that’s unfortunate, because in doing so, they’re trying to steamroll the deal, and they just want a stamp of approval. And how would that look to a jury? A plaintiff’s counsel is going to ask, “When did you ask for this fairness opinion from an expert?” And you’ll have to say, “Oh, the day before we signed the definitive agreement.”To me, that would look bad in court.

Klein: It creates a Smith vs. Van Gorkum liability issue, where the court found the board didn’t undergo adequate preparation.

Janis: Rather than forcing a second opinion, I think the NASD is proposing that you have to disclose all the conflicts in the opinion you are relying on.You could resolve this by bringing in two investment bankers–one to do the negotiating and one to give the fairness opinion, although you should hire both at the beginning. Of course, the board’s going to ask how much that will cost and whether that cost is justified. I’m not sure it is justified, because what is a fairness opinion other than a prediction of future events?

Klein: It’s not an appraisal. All the investment banker is doing is looking at the selling company’s projections. It looks at what’s been paid in the market to see if the offer is reasonable in relation to that. It’s doesn’t mean it’s the highest and best price you could get.

Janis: Furthermore, there’s a committee that helps make this judgment, and it’s a rational process. I don’t think it makes sense to think you’re going to get anything more by getting a second opinion.

Loomis: The elements that support the concept of third-party fairness opinions pretty much entail the construct of raising new equity and are oriented toward the fairness opinion being provided to the buyer, largely when the buyer is doing external separate financing. In my mind, in such cases, there’s a basis for having a third-party fairness opinion. Now, eventually, pro forma, it becomes one entity, but there are two separate groups with an interest in connection with that type of transaction. Another occurrence, though it is somewhat limited, is when you have a mutual savings bank that is going through a full conversion and exchanging stock to purchase another bank. In that case, there is an opportunity, I believe, for a conflict to arise with the investment banker rendering the opinion, because the interests of the depositors purchasing the shares may not be aligned with the target bank’s shareholders who are exchanging shares for newly issued shares from the acquirer.

Janis: Should a third-party fairness opinion be contingent on anything?

Klein: From a practical standpoint, I’m still of the view that if you’re a seller, it’s good and common practice for the board to be protected by getting a fairness opinion on behalf of shareholders. The rule of thumb about taking it to your shareholders probably also makes it prudent for you, unless you have your own in-house M&A group advising to also get a fairness opinion to protect the buyer. In that case, your shareholders have something to rely on, independent of the board. If nothing else, it provides for an outside party testing management’s assumptions, which is a healthy practice.

© Board Member Inc. All Rights Reserved