Since the financial crisis, banking M&A has been on the rise, as more and more buyers and sellers are getting off the sidelines and into the game. Over the past decade, our firm has seen a dramatic shift in certain provisions of transaction agreements. This is a constantly evolving area, and it has never been more important to engage transaction advisors experienced in this industry. Below, we provide our take on a couple of the agreement provisions that have shifted in recent years.
Interim Covenants: How Can Buyers Navigate the Regulatory Crackdown?
Interim covenants are extremely important for a buyer to ensure that the seller is in substantially the same condition at closing as it was when the buyer priced the deal. In general, these covenants require the seller to operate in the ordinary course of business and not to take certain extraordinary actions. Common examples include limitations on new loans, purchases of securities and payment of dividends. Recently, the Federal Reserve has started to crack down on interim covenants on the basis that they allow the buyer to “control” the seller prior to closing. Federal banking law prohibits a buyer from obtaining “control” of a depository institution prior to receiving regulatory approval.
The Fed’s primary focus is on whether contractual constraints are being placed on the seller’s customary activities. While one of our firm’s former Fed lawyers has commented that this policy is nothing new, based on our interactions with the Fed, we have definitely seen a renewed emphasis over the past few years in reigning in these buyer restrictions. If the Fed finds that the covenants are too “controlling,” it will insist that the parties amend the agreement (which can present significant difficulties), or in some instances, will agree to accept a commitment that the buyer will not enforce certain restrictions. This can have a number of unexpected impacts on the terms of a negotiated deal. For example, a fixed price acquisition would typically limit dividends prior to closing. However, a Fed pronouncement negating that restriction obviously does real harm to the buyer’s economic assumptions. There are a number of possible workarounds or negotiation positions that the Fed has found acceptable with respect to board observation rights, dividends, lending restrictions and securities purchases, but the parties and their counsel need to be knowledgeable enough to plan for this result.
On the one hand, we understand the Fed’s position, especially when we are on the sell-side of a transaction. Sellers must remember that the deal may not receive regulatory approval and may not close, so they need to continue to operate as a stand-alone entity. On the flipside, this position strips buyers of a key tool they have historically used to protect their interests. Notably, other regulatory agencies have not yet adopted this approach, which in some instances has allowed buyers to creatively structure transactions to “forum shop” for a more accommodating regulator.
Can Selecting the Right Regulatory Forum Help?
Structuring an agreement for tax, accounting and various corporate reasons has always been crucial. Recent regulatory stances and considerations also factor into deal structures. An example is the variability of regulatory positions on interim covenants noted above. More deals are also being structured at the bank level to avoid what has often become a time-consuming and sometimes curious Fed review process.
Post-Closing Seller Indemnification: What Should Sellers Expect?
Prior to the financial crisis, post-closing seller indemnification provisions were rare and primarily limited to discrete tax, environmental or litigation issues in transactions involving closely held sellers. Today, seller indemnification is much more commonplace in private M&A banking transactions, and potential sellers should expect this to be a heavily negotiated item in any deal. This differs from transactions involving two publicly traded companies, where the market standard is no post-closing indemnification. The scope is generally broad, covering all losses that can be tied to a breach of any of the seller’s representations and warranties in the transaction agreement. Although sellers may not be able to avoid indemnification, they can negotiate limitations on the scope, duration and amount of the indemnification obligation.
Enforcement mechanisms for these provisions are also changing. Generally, sellers seem more willing to agree to a purchase price holdback or third-party escrow. Without such an enforcement mechanism, we caution our buy-side clients that the indemnification may not be worth the paper it is written on. Regardless, buyers need to keep in mind that they likely will have a fight on their hands if they pursue an indemnification claim post-closing, so it is always best if buyers control the pot of money.