View From The Front Row

Over the past 15 years, H. Rodgin Cohen has just about seen it all. As one of the nation’s leading bank merger and acquisition attorneys, Cohen has helped midwife some of the industry’s largest deals, including two of the most recent onesu00e2u20ac”the union between Wachovia Corp. and First Union Corp., and Norwest Corp.’s acquisition of Wells Fargo & Co.

Cohen, the managing partner at New York-based Sullivan & Cromwell, is also a first-rate regulatory attorney who has guided his bank clients through the legal thickets of the FDIC Improvement Act of 1991, the Gramm-Leach-Bliley Act of 1999, and the Sarbanes-Oxley Act of 2002. When you consider that banking is a highly regulated industry that has undergone tremendous consolidation since the early 1990s, Cohen has had a front-row seat for just about every important thing that has happened since then.

While he believes that banks are better prepared than other types of corporations for the new accounting and corporate governance requirements imposed by Sarbanes-Oxley, Cohen worries that the law’s rigidity and the inability of the Securities and Exchange Commission to interpret its provisions will fall particularly hard on commercial banks and thrifts, which are heavily regulated to begin with. He says that boards of directorsu00e2u20ac”and particularly audit committeesu00e2u20ac”will have to play more of a watchdog role because of Sarbanes-Oxley, and bank chief executives must learn to live with it. And he thinks the consolidation of the public accounting industry, which now has just four large firms, will complicate life for all public companies in the post-Sarbanes world.

Regarding the bank M&A market, Cohen cites a number of reasons why he expects deal-making activity to resume within the next 12 months, including the important psychological factor that a change-in-control premium would now exceed the 52-week-high stock price at most banks and thrifts.

Cohen is a native of Charleston, West Virginia whose father, the late Louis Cohen, was a successful pharmacist and businessman who teamed with two brothers to build a large drugstore chain. Rodgin Cohen graduated from Harvard College in 1965 and received his law degree from Harvard Law School three years later. In 2000, and somewhat against his wishes, he became the managing partner at Sullivan & Cromwell. There was one proviso: He still wanted to be able to spend most of his time practicing law. Cohen says he has no trouble jumping back and forth between the two, somewhat different, functions. “At the end of the day, so much of this is a question of dealing with people, whether it’s clients or the firm.” Bank Director Senior Editor Jack Milligan recently interviewed Cohen about corporate governance accountability, directors’ liability, and the changing nature of the market for mergers and acquisitions.

What are the major aspects of Sarbanes-Oxley that you think will impact banks the most?

There are some positives in Sarbanes, actually. It clearly raises everybody’s consciousness about the importance of accuracy in financial statements, the importance of proper dealing, the importance of good corporate governance. As SEC Chairman Donaldson said recently, it’s really the spirit of Sarbanes-Oxley that is a positive.

But there are negatives as well. Although I agree with the spirit, it’s the letter of Sarbanes-Oxley that is terribly troublesome, because it is very rigid. Arguably, the Securities and Exchange Commission has little discretion [to interpret the law]. One example would be the potential for a violation of the auditor independence rule, irrespective of materiality. The prohibition on loans probably covers activities that no one intended it to cover. It’s the absence of rule-making authority for the commission that I find troublesome, and the absence of some sort of materiality standard in the statute. I fear that banks will be caught in inadvertent violations, and there will be no way out of the box. This is a problem for all corporations, but I think it’s particularly intense for banks because of their extraordinary array of general rules and regulations. It’s obviously consuming a tremendous amount of time for managements, boards, counsel. It’s expensive, but I think that’s probably a price that the environment requires.

Could you explain more fully your concerns about the prohibitions against insider loans?

Because of the breadth of the language, such items as split-dollar insurance programs can be considered to be loans; “any advance” is the way it literally reads. If you give a senior executive an advance to go on a business trip, that could be [considered] a loan. A number of law firms have gotten together and said we’ve got to apply a rule of reason, but that’s the type of issue. Sarbanes-Oxley was very hastily enacted in response to what was perceived as a crisis; there wasn’t a lot of careful deliberation.

Because the provisions in Sarbanes-Oxley that deal with internal auditing and control procedures were modeled on the FDIC Improvement Act (FDICIA), which has been in force for 11 years, are large banks and thrifts better prepared for these changes than nonfinancial companies?

For insured depository institutions, a lot of the internal control aspects were already present. There were some obvious tweaking and additions, but in that respect, the environment really didn’t change.

How has the audit committee changed under Sarbanes-Oxley, both in its complexion and responsibilities?

The [SEC] took a very progressive but absolutely necessary position when it modified the original proposal on the financial expert [requirement]. Because of New York Stock Exchange rules, most audit committees were already fully independent, so when the financial expert [requirement] was changedu00e2u20ac”the original proposal would have required most audit committees to go out and find somebody, because so few [existing board members] would have qualifiedu00e2u20ac”the new proposal now permits qualification of someone on most audit committees. So I don’t think you’re going to see any significant changes in the composition of the audit committee at many institutions, although there may be some modest changes because there are slight differences in the definition of independence.

But the work of the audit committee has changed radically, and it’s not just considerably more meetings and considerably more information and considerably longer meetings; there is very substantial responsibility assigned to the audit committee. If there is one key theme in Sarbanes-Oxley, it is that there has to be very substantial responsibility for the accuracy of financial statements. And that responsibility is at two levels. It’s at the CEO and CFO level with their certification requirements, and at the audit committee level with its review [of management’s certification] and with the [committee’s] responsibility for the audit. So it’s becoming a much more intensive set of responsibilities.

Those responsibilities also include retaining the external auditor. Is that a significant change from how things were done in the past?

For some time at a number of our clients, the audit committee had had the responsibility for retaining the audit firm. But what probably is happening today is that auditors the audit committee is spending more time reviewing the qualifications of the auditors. For example, it now has to review all the nonaudit services and approve them. That in itself is a major undertaking.

You mean nonaudit services provided by the external auditing firm?

Correct. It’s easy to sit back and say you should never use your own auditor [for nonauditing services]. Why not have a flat rule [that everything] other than audit services goes elsewhere? But that’s a theory that’s not grounded in reality, because you’ve got only four audit firms left, and it’s not necessarily the case that all four of them have expertise in each of these other areas. Some may have more than others, or you may not want to use the auditor who is auditing your major competitor. If that’s the case, it brings it down to only two options other than your own [auditor], and [the other firms] may not be as well qualified in a particular area. It will be a continuing problem.

So the narrowing of the public accounting field in recent years is a more significant factor than people might perceive?

I think it is. And from what I hear from both banks and regulators, this is also an international issue. Let’s say somebody has made an allegation that there is something wrong at the company, and you don’t want to use your own auditor to investigate. And because of the restrictions on nonaudit services, you’ve been using a couple of the other audit firms and paying them very large amounts of money. So now you’re really concerned about using them because they may be seen as having a conflict of interest, and there’s basically nobody left. If you have to change auditors, it also raises the question of whether there’s going to be somebody who can do it.

Has the relationship between the board of directors and management changed under Sarbanes-Oxley, in the sense that the board is now required to play more of a watchdog role?

The premise is absolutely correct as you stated it. The [board’s] watchdog role is considerably heightened, because if you look at some of the worst scandals in corporate America, those experiences sustained the view that when you had a so-called imperial CEO, the board was either unwilling or incapable of providing any type of check and balance. Because so much of the focus is financial, the audit committee is sort of on the leading edge of all of this. But the conclusion that this will create friction between the board and the CEO remains to be seen. Certainly, when the board questions what a CEO has done as opposed to accepting it without questioning it, there is the opportunity for friction. But the CEOs I know understand the environment and have accommodated themselves to itu00e2u20ac”and are prepared to accept a somewhat different relationship, a more proactive questioning and checking by the audit committee and the boardu00e2u20ac”and also [understand] that the audit committee will have responsibility for certain aspects of the financial arrangements for the company.

I would think that in its entirety, Sarbanes-Oxley will be especially challenging for small institutions, particularly those publicly traded banks with less than $500 million in assets, since they were not required to comply with FDICIA.

When you’re a very large bank with very large legal and compliance departments and very sophisticated advisers, the incremental costs are thereu00e2u20ac”but they are incremental. It’s lost in the rounding of a penny in a per-share number. A smaller bank has to meet the same [regulations] as a large bank, but it has to do it off a smaller asset and revenue base. The relative expenses are potentially much higher, and in fairness, there’s just not the level of sophistication because they haven’t dealt with these problems in the past. So it really is a burden for smaller banks. They did provide an exemption for smaller institutions in FDICIA [because they] understood the problem, but Sarbanes-Oxley took a very different approach and there are virtually no exceptions.

Would you expect to see an acceleration in the number of small publicly traded banks that decide to go private just to escape the requirements of Sarbanes-Oxley?

There’s been some speculation about that and there may be situations where that can occur, but it is not easy to do financially. Who is going to buy out the public shareholders? There would be very, very few institutions that are sufficiently well capitalized that could use their own funds to do any substantial part of that. So there may be cases where you’ve got a family that owns 50%, 60% of the bank and decides it would be cheaper to go and buy out the remaining 40%, but even that would have to be a pretty small bank or a very rich family.

Is the board’s D&O liability exposure affected by Sarbanes-Oxley?

I’ll be careful here to protect either the innocent or the guilty, I’m not sure which. I was on a panel a few months ago talking about Sarbanes-Oxley, and it included a prominent member of the plaintiffs’ bar, a very good lawyer. A similar question was asked: “Is Sarbanes-Oxley a great opportunity for the plaintiffs’ bar?” He tried to say with a straight face that it really didn’t make that much difference, but he couldn’t do it and sort of laughed a bit. I think it does create [more] liability. There are various provisions in Sarbanes-Oxley, particularly the whistle-blower [provisions] and the up-ladder reporting by attorneys, which are going to create opportunities for the plaintiffs’ bar. Actually, as far as I’m concerned, the biggest single issue as far as potential liability relates to whether a financial institution has responsibility for its counterparties. That comes out of Sarbanes-Oxley, although it’s not part of it.

Could you explain that a bit more fully?

This comes out of the allegations made in Enron and strongly supported by the SEC that a bank or other financial institution that enters into a transaction with another party has responsibility for the counterparty’s accounting, its financial disclosure, its taxes, its regulatory position, and so forth. That’s a very worrisome issue, because it’s hard enough in this environment to mind your own house; it’s extraordinarily difficult to mind someone else’s.

How would you even make that determination?

That’s a very key part of the question. Do you ask every time on every transaction for something signed in blood by the accountant on the other side? Do you have your own accountants review all of these? Do you have to make an analysis, even if you find that it’s being correctly accounted for as a matter of GAAP? Do you have to say that that is not accurate financial disclosure?

What’s your assessment of the bank M&A market? Is the slowdown in activity that we’ve seen in recent years the result of temporary market forces that affect valuations and currency, or is there something bigger going on?

This has been the deepest and longest period of inactivity in the bank merger market I can think of in the roughly 27, 28 years of the consolidation phase. There are a number of reasons that explain that. I may be going so far out on a limb that I can’t even see the tree, but I do not believe this is a secular change. We should see a substantial pickup in M&A activity over the next 12 months, although it’s hard to pinpoint exactly when. The reasons for this are multiple. In my mind, the basic factor behind this huge wave of consolidation was economic, and all those economic factors remain in place: intense competition, the need to cut costs because of limits on top-line revenue growth, the scalability of certain banking businesses and whether banking as a whole is scalable. Another important factor is the increasing costs of technology and compliance. If you can spread these costs over a larger base, you’re ahead of the game.

Beyond these economic drivers, the pickup in the stock market is a real positive. People feel better about themselves. When markets are down, buyers look inwardu00e2u20ac”they really don’t want to buy. Sellers look at their [stock price] and say, “Gee, even with a [change-of-]control premium, I’m not getting to my 52-week high.” Today, for most banks, a control premium would take them well over their 52-week high. A third factor is that there have now been two large mergers that have followed the same model, and both appear to have been very successful. That model is a relatively low premium and a very conservative approach to integration, both in terms of expected costs and the time period in which those savings will be realized. The two deals, of course, are Wachovia/First Union and Wells Fargo/Norwest. I think the market would receive similar transactions positively if investors have confidence in the management of the combined company. Again, you saw a whole slew of deals that didn’t work well for a long period of time, but now two deals following the same model have worked well, and I think that’s a positive.

Another positive factor for the merger market is that the Europeans and Canadians will tend to look to the United States more and more. There are several reasons for that. [Regulatory] authorities in many countries have restricted additional in-country mergers; Pan-European mergers also seem to be very difficult to consummate; and with all our regulations and laws, it is still easier to do transactions and obtain the efficiencies here than in most, if not all, other countries. There is also a lot of pent-up demandu00e2u20ac”people have been on the sidelines for a long time. A number of acquirers have been on the sidelines because of regulatory or digestion issues; the digestion issues are about finished, although I’m a little worried that every day you see a new regulatory issue, but hopefully those are being resolved. So net-net, absent a new wave of regulatory problems, I think we will see a pickup in the bank M&A market across [the full spectrum] of large, medium, and small deals.

Will Sarbanes-Oxley affect how a board goes about the decision-making process when considering a deal?

Sarbanes doesn’t really focus on that, but I suspect that you will see, in some cases, a more active board. In particular, there have been a number of transactions where the board found out about the deal relatively late. I don’t think that will happen anymore, or it will be rare. I think boards, or at least executive committees of boards, will be informed much earlier. I also think that boards will be more active in their questioning at an earlier stage. We always advise boardsu00e2u20ac”and I’m sure others do toou00e2u20ac”that their obligations as directors are to make inquiries. You can rely on outside experts, but you can’t abdicate your responsibility to make an independent judgment. For most transactions that I’ve worked on for some years, the boards have been very, very active, with lots and lots of questions. So I think the impact of Sarbanes-Oxley on board performance [in an M&A situation] is only marginal. Where Sarbanes-Oxley may have some modest impact is that lots of banks have issuesu00e2u20ac”whether it’s revenue growth or something elseu00e2u20ac”and Sarbanes-Oxley adds one more. So maybe it’s just one more factor that would encourage a sale. I don’t think you’re going to see a bank that had no intention of selling say, “Gee, because of Sarbanes-Oxley, we’ve got to sell.” But if a bank is on the fence, that will tip it toward a sale.

Give us a short list of questions that a board should be asking when management brings a proposed transaction, whether it’s a sale or an acquisition, for its consideration.

The questions should be quite similar, irrespective of which side you’re on, assuming that it is a stock deal. I think the first set of questions relates to the due diligence that has been performed; [the board should] insist upon a full discussion of that due diligence. How deep has it been? Who has been doing it from your institution? What subjects have been discovered, addressed? What problems have been found? What issues do you have? Obviously a very critical focus today should be on any regulatory issues that the acquirer may have, or the seller may have. It’s not just that if something blows up you won’t get approval for the deal; you also don’t want to acquire somebody and then have a regulatory problem blow up in your face after the deal closes.

On the buyer’s side, a board needs to know what the compensation arrangements are for the seller’s key executives. The seller’s board sure as heck needs to know that as well. Sometimes it’s not so easy to tell who’s the buyer and who’s the seller. In one of these so-called mergers of equals, do change-in-control agreements [thereby requiring large severance payments to certain executives] get triggered on both sides, and so forth? Obviously there are questions on pricing. There are questions on the process. This one is a sell-side question: Why did you go to this particular buyer? Why did you not go to other potential buyers? I think the board will want to spend some time discussing not only how the bank’s investment banker reached its conclusionu00e2u20ac”because you would be very foolish not to have a fairness opinion, at least on the sell sideu00e2u20ac”but also what other relationships exist between the investment banker and the client, because there have been allegations of conflicts of interest. That is perhaps a short list.

You’ve been the managing partner at your firm for three years now. How much time do you spend running the firm, and how much time do you spend practicing law?

I’m not going to disagree or agree with the premise that I’m running the firm. I’m not sure what the subject and object are, whether the firm runs me as opposed to I run the firm. But, all kidding aside, when I took this, I said I really enjoy the practice of law, I love working with clients, so I don’t want to do this unless I can spend somewhere around two-thirds to three-quarters of my time practicing and the remaining time managing the firm. And I’ve been able to stick to that. Now, that’s not every week and every month, because it will vary depending on what client needs are and what the firm’s needs are, and it’s certainly not true day-to-day. I am very fortunate in that the way we operate here, there are a number of partners who take on very significant administrative and management responsibilities, so I don’t have to.

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