Two of the biggest obstacles to merger activity are mismatched pricing expectations and regulatory impediments. With the dramatic increase in banking stock prices and trading multiples, buyers now have much better stock currency and thus, the capacity to pay more. The driver of this improvement has been better earnings and improved credit quality resulting in lower credit marks.
With these improving conditions, one might expect a wave of merger activity that advisors dream about. However, we have to keep in mind that equity markets are pricing in the expected future results while banking regulators are focused on past exam results and potential future market stresses. Therefore, regulators are not caught up in the current market euphoria. Regulatory issues can materially delay deals as evidenced by the pending M&T Bank and Hudson City transaction.
Limitations of Joint Meetings with Regulators
Regulatory factors will continue as impediments to deals. One common approach in addressing regulatory factors is a pre-filing meeting with regulators prior to announcement. This pre-filing meeting serves multiple purposes. It provides a courtesy to regulators and helps strengthen the relationship and trust between banker and regulator. Bankers and their advisors also view the meeting as a due diligence tool. Managers report to their boards of directors that they meet with the regulators on the transaction and did not hear any objections. However, it is important to realize that the usefulness of this meeting from a due diligence perspective will depend upon the attendees of the meeting. Regulators are prohibited by law from discussing examination findings with anyone other than the management of the regulated institution and their regulatory advisors, so regulators must limit what is said in a joint meeting with both management teams and advisors. As a solution, the pre-filing meeting should be a two-part meeting. One part should allow for an open dialog on examination matters between the regulator and regulated institution. The second part will allow the buyer, target and their advisors to discuss the application and processing matters with the regulator.
From my experience, regulatory impediments toward mergers revolve around three areas: 1. safety and soundness, 2. compliance and 3. golden parachute restrictions. From a safety and soundness perspective, regulators require that the combined entity be at least pro forma CAMELS rated 2. The key to addressing regulatory concerns from a safety and soundness standpoint is compiling a pro forma enterprise risk management (ERM) analysis. The ERM analysis will provide a framework for management to discuss the resulting entity’s risk profile in a CAMELS format. Regulators will be interested in discussing the impact of any new lines of business, concentrations and new staffing models of the combined entity.
Material buyer compliance issues will usually delay or prevent a transaction. Management teams of buyers have to be vigilant with regulatory compliance and resolve issues pre-announcement, even if the delay is weeks or months. Compliance issues at sellers are easier to resolve. Regulators will be evaluating whether the buyer’s management and policies and procedures are sufficient to provide a sound compliance framework going forward. However, correcting compliance going forward does not absolve buyers from the target’s past issues as JPMorgan Chase & Co. and Bank of America have found in their purchases of Washington Mutual Inc. and Countrywide Financial Corp. Therefore, due diligence remains key in identifying these issues while deal structure helps manage liability. For example, we recently advised two different acquirers that were purchasing banks with significant Bank Secrecy Act/anti-money laundering violations. In the first case, the acquirer built in a walk-away provision in the merger agreement which allowed the acquirer to terminate the deal if fines exceeded a threshold. In the second case, the buyer could not determine the potential liability and elected to structure the transaction as a purchase of assets and assumption of certain liabilities. In this second case, the regulatory fines amounted to almost the entire deal consideration. The buyer was immune from the fines, but the sellers received almost nothing.
Golden Parachutes as a Problem
One factor used to induce the management teams of sellers to go along with (and sometimes promote) the sale of their institution are golden parachute agreements. However, a renewed focus by regulators on Section 359 of the Federal Deposit Insurance Corp.’s rules and regulations has led to deal hurdles. Section 359 limits the payment of golden parachutes to the management team of institutions in troubled condition. Historically, payments were structured so the acquirer made the payment, not the troubled institution, as a means of sidestepping the issue. But now, the FDIC has strictly limited payments to no more than twelve months salary, regardless of which entity pays it. Therefore, sellers either have to improve their risk profile to remove the regulatory troubled condition or management teams have to accept the severance limitations.
While the market is improving and conditions are ripe for deal making, addressing and evaluating regulatory position needs to be a continued focus.