Joseph Silvia
Partner

We all know that the numbers have to work on a pro forma basis before any merger agreement is executed and also before any deal is closed, but what role do the numbers play in the interim? Of course, financials are monitored consistently between signing and closing, but the next critical role they serve relates to the regulatory application process.

The financials are ultimately the core of the regulatory application, assuming there are no clear barriers to approval, such as a poor Community Reinvestment Act ratings, outstanding enforcement actions or other ratings or compliance challenges. Regulatory agencies are keen to focus on the financial and managerial factors set out in statute as well as a few specific components of the financials. Here are four suggestions to approach pro forma financials in the regulatory application phase.

First, pro forma financials need to be clear and comprehensive. All of the customary financial statements — balance sheet, income statement, etc. — should be included in the application submission and should project results out at least three years, and more if possible.

One component of the more recent regulatory focus has been on concentrations, particularly with respect to commercial real estate and deposit concentrations. Where concentration thresholds are exceeded or close thereto, expect questions about the management of that concentration risk. We typically see applicants get ahead of some questions by including a narrative acknowledging the concentration risk and outlining current or future risk mitigation plans.

If financials need to be revised for any reason during the regulatory application phase, it is critical that the modifications are highlighted in the revised submission and a discussion regarding the modifications is included for context. It is especially important to be honest and concise. Regulators really don’t like surprises, especially when they are the ones to uncover them.

Secondly, pro forma financials also need to include current and pro forma regulatory capital ratios. Since the March 2023 stresses in the banking environment, the regulatory agencies have enhanced their scrutiny of capital levels and projections. Regardless of the ratios, questions consistently arise related to the resulting organization’s ability to raise capital if needed. In most cases, regulatory agencies request a capital plan from the applicant to address how it would raise capital in case of unforeseen stress or a shortfall, i.e., issuing new shares to existing shareholders, drawing on a holding company line of credit, issuing subordinated debt or otherwise.

Thirdly, if any dividends will be issued by the target as part of the transaction, such dividends must be outlined in the financials. Application analysts will expect to understand how the dividend is calculated if, for example, the target institution is permitted under the definitive agreement to pay out a dividend at closing in an amount above a set purchase price. Also, note that the payment of certain dividends will require additional applications and approvals depending on the regulatory agencies involved.

Finally, summaries of the financials, notes to the financials or similar narratives should discuss the accounting methodology used, assumptions made and details around any unique attributes — such as material expenses or adjustments included in the financials. Using these notes and similar narratives, especially when embedded in the financial worksheets, will only make the application analysts life easier when reviewing, which is always helpful.

Financials are always a critical piece of any proposed transaction, but they play an especially important role in the application context. The key is to be clear and comprehensive, while anticipating areas that may receive enhanced scrutiny.

 

WRITTEN BY

Joseph Silvia

Partner

Joseph E. Silvia is a Partner at Duane Morris LLP in Chicago. Mr. Silvia represents financial institutions in corporate, regulatory, and operational matters. He previously served as counsel to the Federal Reserve Bank of Chicago.