The family dynamic in closely held banks is a powerful driver in bank mergers and acquisitions today, and deals involving closely held financial institutions often take a very different tack than transactions by their publicly traded brethren.
Whether it is the ability to move expeditiously to execute a transaction or to pursue structures that would be impossible in a publicly held bank holding company, closely held financial institutions get deals done differently.
“Family-owned or closely held buyers have the ability to take the long view when they make an acquisition,” says John Zeilinger, a senior banking attorney at Baird Holm LLP. “The flipside has been the case for a number of recent sellers—when pressured to raise capital, family held banks may not have attractive sources from which to raise new investment, which can lead to shotgun marriages and deal structures that are creative by necessity.”
Transaction structure is probably the most salient distinction in such deals. Whereas a purchase-and-assumption transaction typically is used only in FDIC-assisted transactions involving larger financial institutions, closely held banks make use of such structures on a fairly regular basis to exclude toxic assets and obtain stepped-up tax basis when acquiring assets. For example, toxic assets may be held in a liquidating trust, to facilitate the sale of assets post-closing.
While representations and warranties are common across all transactions, buyers of closely held financial institutions enjoy greater opportunities for recourse. Personal indemnities are common in the family banking context, whether or not such indemnities are subject to escrows or holdbacks. It is common to set aside dollar amounts that are tied to assets subject to valuation disputes. For example, other real estate owned (OREO) assets, which often include foreclosed properties, can be subject to specific indemnities and holdbacks to bridge the valuation gap between buyer and seller on such balance sheet items.
Baird Holm LLP attorneys have assisted with recent deals that included creative methodologies for valuations of disputed assets and, in one case, even personal guarantees of loans for a specified period. This kind of cherry picking is impossible in deals involving publicly held financial institutions, but has become very common with closely held banks during the downturn.
Perhaps one of the most striking examples of such deal-making that made the headlines was the so-called good bank-bad bank transaction last March involving First Independent Bank. In that deal, the Firstenberg family, which owned the institution, sold its main banking operations to Sterling Financial of Spokane, Washington According to public reports, the deal required the shareholders to retain $83 million in toxic assets in exchange for a $7 million down payment with a potential $17 million earn-out depending on the ultimate value of those assets.
But transaction structure is not the only consideration to keep in mind when doing deals with closely held banks. Because the owners of family banks often maintain strong ties to the local community, strong non-compete contracts are essential to ensure the premium paid for an institution is justified. Failure to obtain a strong non-compete may result in an owner using proceeds from a transaction to set up shop “across the street” from the sold institution and to begin rebuilding the franchise by poaching key employees and customers.
Furthermore, tax planning opportunities also may exist in connection with transactions involving family held financial institutions. Because many family held banks have elected subchapter S tax status, an S corporation election that has been in force for more than 10 years may enable a buyer to purchase shares from their holders while obtaining a stepped-up tax basis in acquired assets.
However, there are potential roadblocks to doing deals with closely held banks. The internecine deals struck among the shareholder base of closely held banks can be complex. For example, shareholder buy-sell agreements may contain complicated rights of first refusal, drag-along rights and tag-along rights (contract terms that force minority shareholders to go along with a deal or give minority shareholders the right to sell on the same terms as the majority shareholders). Navigating such agreements when dissident shareholders refuse to participate in a transaction can be key to executing a deal. In addition, finding ways to address preemptive rights provisions, which grant certain shareholders the right to purchase shares before the general public, may be essential to facilitating an influx of new capital.
“Preemptive rights provisions were the bane of many banks seeking to bring on TARP investments several years ago, and they frequently forced struggling institutions to incur additional expense in connection with capital raises required by regulators,” said Amber Preston, a banking and securities lawyer at Baird Holm LLP. “Our advice to the shareholders of closely held banks today is definitely colored by the many challenges banks faced in the recent downturn.”