Reverse due diligence in the context of bank mergers and acquisitions has become more relevant in the current regulatory environment. Bank regulators are more closely scrutinizing transactions and taking a stricter approach to supervisory and regulatory matters. This may generally extend processing timeframes and increase risk to not only the buyer, but also the seller. Therefore, a seller should develop a fairly comprehensive understanding of the regulatory condition of a proposed suitor as early as possible, even in an all-cash deal.
Reasons for Reverse Due Diligence
The purpose of a seller’s due diligence investigation of a buyer is to obtain sufficient data to allow the board of directors to make well-informed strategic decisions in accordance with its fiduciary duties. Such an investigation is important not only in transactions in which seller’s shareholders receive the buyer’s securities, but also in transactions in which the consideration is paid entirely in cash. A regulatory issue affecting the buyer can delay processing and lead to adverse consequences regardless of the form of consideration.
Recently, several transactions have been halted indefinitely as a result of regulatory concerns regarding the buyer, including fair lending practices, Bank Secrecy Act compliance and anti-money laundering protections. Under these circumstances, regulators may require remediation of the issues before resuming their review, which further extends the transaction timeframe. There are also recent examples of regulators staying review until satisfactory remediation is confirmed by the institution’s next full-scope examination. Furthermore, publication of regulatory delays may prompt public comments on the application, which could further delay approval.
A material delay in a pending transaction presents potential risks to a seller. If a definitive agreement provides a stand-still covenant, the seller is generally unable to pursue other transactions until a termination right becomes available (which may be several months down the road). A seller runs the risk of having to forego other strategic opportunities during any extended immobilization. Moreover, unanticipated delays may expose a seller to instability and disruption in its operations as a result of diverting personnel from ordinary banking duties, additional transaction costs and professional fees, criticism from investors and reputational risk.
Scope of Reverse Due Diligence
While the scope of the investigation will depend on the nature and size of the institutions involved, a seller should at a minimum evaluate the following items:
- the two or three most recent year-end financial statements (audited, if available) of the buyer;
- sources of the buyer’s funding for the proposed transaction;
- the status of any capital raising transactions or incurrence of indebtedness of the buyer;
- anticipated capital requirements necessary for the buyer to fund the proposed transaction and execute its strategic plan;
- buyer’s shareholder composition, including outstanding capital commitments; and
- material pending or threatened litigation involving the buyer or its affiliates.
Ideally, a seller also should be satisfied with the buyer’s regulatory condition and should be aware of any regulatory enforcement actions. A seller should also be aware of the timing of the buyer’s next examination and whether it will occur during the anticipated application period.
However, reverse due diligence is challenged by legal restrictions on disclosing confidential supervisory information, including examination reports, to third parties, which could prevent a seller from obtaining reasonable comfort in the buyer’s ability to obtain regulatory approval. In such case, a seller may consult its legal advisor regarding alternative methods for completing its review of the buyer. Furthermore, there may be conditions affecting the buyer that do not become material until after the definitive agreement is signed and applications are filed.
Depending on the results of reverse due diligence, a seller may consider negotiating contractual protections, including representations and warranties related to the buyer’s compliance with laws and regulatory condition, limitations on the buyer’s ability to terminate for burdensome regulatory conditions, and acceleration of seller’s termination right in the event of delays in obtaining regulatory approval. In addition, a seller may consider negotiating reverse break-up fee arrangements or purchase price adjustments related to delays in obtaining regulatory approval.
Bank regulators are taking a more authoritative approach to supervisory and regulatory matters in the context of bank mergers and acquisitions. Accordingly, sellers should plan fairly comprehensive reverse due diligence in all potential transactions. While reverse due diligence will not eliminate all of seller’s transaction risk, it can better the position seller in making strategic decisions and negotiating contractual safeguards that are commensurate with the anticipated risk.