Small business investment companies have been growing in popularity since the financial crisis, as these can help banks comply with the Community Reinvestment Act and manage interest rate risk, as Dory Wiley, CEO at Commerce Street Capital, explains in this video.
Bankers are in the business of managing risk, which is critical, not only in an institution’s day-to-day oversight, but also in its evaluation of strategic acquisitions. While obvious acquisition-related risks, such as credit or operational risks, may be appropriately addressed through careful due diligence, banks often overlook the more indeterminate risk that its acquisition application will draw adverse public comments.
The application review process for each of the federal bank regulatory agencies involves a notice and comment procedure through which the agencies may receive adverse comments or “protests” to an application from individuals or interested community groups. These comments are typically based upon the applicant’s Community Reinvestment Act (CRA) or fair lending records, and regardless of their merit, are increasingly employed with an apparent intent to gain leverage over the applicant.
Although the percentage of protested applications is small, the cost of a single public comment can be significant. For example, during the first half of 2016, the average Federal Reserve processing time for an application that received adverse public comments was 213 days, versus 54 days for an application not receiving comments. Even though nearly all protested applications are ultimately approved, the extended review process creates a significant amount of deal uncertainty; enhances the risk of employee and customer loss, which may diminish the value of the target; and generally results in higher professional fees. A history of protested applications may also affect the attractiveness of an acquirer’s offer to a potential target.
Fortunately, the risk of adverse application comments is not completely unmanageable. Although a bank cannot eliminate the risk of a protest, it may employ certain best practices to reduce that likelihood and minimize any related processing delays. As part of its regular CRA program, an acquisitive institution should proactively work to establish and preserve productive, two-way relationships with activist community groups, with a particular focus on groups with a history or growing reputation for application protests. Community participants who feel that an institution is listening and responsive to their needs are less likely to damage that growing goodwill through a formal application protest. These relationships should have the added benefit of enhancing the long-term effectiveness of the institution’s CRA program.
An acquisitive institution should also project a consistent, positive image in its community and be mindful about how all of the information that it provides to the public may be used. For example, a bank touting that it is “ranked first in deposit market share” should ensure that it also maintains a similar rank for meeting credit needs in its assessment area with products such as mortgages and small business loans. An acquisitive bank should also emphasize its CRA and other community service initiatives as a part of its marketing strategy.
In summary, bankers cannot avoid the risk or effects of adverse public comments in the context of regulatory applications. However, proactive and engaging institutions with strong, well documented CRA and compliance management systems are much less likely to attract public protests and will be better positioned to address those received.
There are a million reasons for leveraging fintech to enhance a financial institution’s small business lending experience. To name a few, there’s better efficiency, customer convenience, profitability, speed to decision, speed to capital, cost reductions and a much-improved overall customer experience. However, one that often gets lost in the fray is the impact technology will have on the day- to-day productivity, motivation and morale of the bankers who work so hard to source and sell small business loans. This “banker experience” as it is known, plays a huge role in sales performance, retention, revenue generation and employee satisfaction.
The reality of a day in the life of a small business lender is that a surprisingly small amount of time is spent on sourcing new opportunities or even cross-solving to sell deeper into an existing relationship. Because they are shackled with the responsibility of shepherding deals through the multiple steps in the lending process, the more loan deals a banker has, the less time he or she is able to spend growing the book of business. So how are they spending their time?
I ran small business sales for a $150 billion asset institution, and our data proved that whenever a banker had as little as two loan deals in the workflow process, their new business acquisition productivity was reduced by 50 percent. Bankers with five deals in the process had their acquisition productivity diminished by 75 to 80 percent. That’s because they expend all their time and energy shepherding deals through the various stages of the process, gathering additional documentation, or monitoring the progress of each deal.
All of this is challenging for one person to do… but simple for technology to handle automatically, accurately and consistently. Technology can ensure an application is complete before it is submitted. It can ping the client for any-and-all documentation or data required. It can communicate progress and monitor a deal at every step in the lending process. Technology can also facilitate the collection of more and better data and translate that data into information that enables the banker to add value by asking great questions that help solve more problems for the customer.
When technology is used end-to-end, from application to closing, bankers are able to focus on the important things like:
Technology makes the banker’s life simpler. When bankers are able to do what they do best, which is sell, job satisfaction, performance, job retention and morale go through the roof. And that positivity translates into improvements in the customer experience, and increases in revenues for the institution.
Fund administrators, the independent service providers that verify the assets and valuation of investment funds, are not currently as big a presence with private equity and real estate funds as they are with hedge funds. But private equity and real estate funds should take note, because fund administrators are becoming increasingly critical to how they go to market.
Fund administrator penetration of the hedge fund market is above 80 percent, and having a fund administrator has become a requirement for hedge funds of any size.
Private equity assets have risen from $30 billion in 1995 to $4 trillion in 2015. All indications are that growth will continue to be steep, as 64 percent of limited partners (LPs) plan to increase their allocation to private equity funds, which increased from 26 percent just five years ago.
Despite this dynamic in hedge funds, fund administrators have not penetrated private equity and real estate funds in the same way. Estimates are that penetration by fund administrators of private equity and real estate fund assets under management (AUM) is only 30 percent today, and projected to increase to 45 percent by 2018.
I think this growth projection is understated, however, because many of the reasons that compelled hedge funds to begin using fund administrators also apply to private equity and real estate funds.
Here are three key reasons why hedge funds had to begin working with fund administrators and why these also apply to private equity and real estate funds:
Investor Demands for Greater Transparency
I think that this is going to be the biggest driver that will force private equity and real estate funds to use fund administrators. Investors are increasingly demanding third-party validation of AUM and Net Asset Values, as well as greater transparency in reporting.
Also, operational due diligence of a fund is occurring earlier in the request for proposal process, particularly when institutional investors are factored in. Institutional investors want to have confidence in the middle and back office capabilities of the fund, which generally means a strong accounting and reporting practice.
If these investors don’t have confidence in the management company, then they will increasingly pass on the opportunity. One recent private equity study shows that 65 percent of limited partners are increasing the level of operational due diligence that they are performing on general partners.
Increasing Regulatory and Compliance Pressures
This started to materialize in the aftermath of the Bernie Madoff scandal, with acronyms like KYC/AML, FATCA and others fast becoming part of the lexicon. Conventional wisdom holds that regulatory and compliance pressures aren’t the same for private equity and real estate funds because the level of activity is less frequent. I find this argument to be short-sighted because some of these regulations already apply to fund types beyond just hedge funds.
Technology as a Requirement
Technology is already a means of differentiation among progressive private equity and real estate fund managers. My feeling is that technology should be a requirement for all of these fund managers.
Technology can provide an effective means to address the first two points, but how to best employ technology can be tricky. When it comes to technology, there are two typical approaches. The first is often for the management company to try handling it on its own, including attempting to build out the required technology itself. The second approach (often after having been unsuccessful in the first step) is for the management company to retain an external technology vendor to handle it. Either way, the experience often ends up with the same result: Managing technology on their own takes more time, personnel, and money than the fund expects.
Private equity and real estate fund managers should instead look to fund administrators to implement and manage technology that they need. Fund administrators are better suited to adopt and manage technology given that it is required by all of their fund manager clients. This is also a more cost effective solution for fund managers, because fund administrators are better suited to spread the cost of technology across their clients.
Private equity and real estate fund managers that still think they can go it alone without the help of fund administrators are going to quickly fall behind, and lose out on opportunities.
What aspect of a deal is critical to the success of an acquisition? While many in the banking industry may point to features like pricing and culture, which are certainly important, the devil is in the details. How do you protect your institution if the other party walks away from the deal? Will you have the personnel in place to ensure a successful transition? These six areas indicate where boards and management teams of buyers and sellers will want to focus their initial attention.
1. A detailed letter of intent really helps.
Putting the time in on the front-end to negotiate a detailed letter of intent (LOI) is in the best interest of buyers and sellers. The LOI is a preliminary document, and it is best to resolve any important issues at this stage. If a seller insists on a term that a buyer cannot accept, it is far better to know that before time is wasted and significant expenses are incurred while negotiating a definitive agreement. If the only substantive term in an LOI is the purchase price, then all of the other issues must be resolved among lawyers negotiating the definitive agreement.
2. Do not overlook the importance of due diligence.
The representations made in a definitive agreement supplement—but do not replace—each party’s due diligence investigation. Some important facts about a seller will fall outside the scope of the representations made in the definitive agreement. For example, the seller will disclose any actual and potential litigation against itself, but is not required to reveal litigation against its customers. If the seller’s biggest customer is facing a sizable judgment that could negatively affect its ability to repay its loans, a buyer will have to conduct detailed due diligence to uncover this fact. Further, due diligence is not just for buyers. The seller needs to critically examine the buyer if shareholders are taking the buyer’s stock in the transaction.
3. Be thoughtful about drop dead dates.
A drop dead date is the date on which a deal must close before either party can terminate the definitive agreement without incurring a penalty. Calculating the correct drop dead date is more art than science when balancing the number of actions that must be taken pre-closing—especially regulatory and shareholder approval—with the parties’ desire to get the deal closed as soon as possible. At the same time, an agreement with a short time period between signing and the drop dead date encourages the parties to take the necessary pre-closing actions expeditiously. Striking the proper balance between these two competing factors is key. In the event of a contested application, the time required to receive regulatory approval will be at least twice as long as expected.
4. Be prepared to negotiate termination and related fees.
Termination fees, which are paid by a seller to the buyer if the seller accepts an unsolicited superior proposal from a third party, are common, but the amount of the fee, and the triggers for paying it, are frequently negotiated. Expense reimbursement provisions payable to the nonterminating party are perhaps equally common, in terms of prevalence and contention of the amount. Far less common are termination fees to be paid by the buyer to the seller if the buyer terminates the transaction. These reverse termination fees are generally resisted but can be appropriate in certain circumstances, such as situations where the buyer must obtain shareholder approval for the transaction.
5. Consider the treatment of critical employees.
Buying a bank is obviously more than buying loans and deposits. Integrating the seller’s employees is critical to a successful transaction. Buyers should consider establishing a retention bonus pool to ensure that critical employees remain with the combined enterprise after the transaction (and at least through conversion). A critical employee may not be obvious—frequently they are the unsung backroom employees who keep things running smoothly—and doing right by them will help ensure a successful integration.
6. Be aware of board dynamics.
It’s relatively common for the CEO and CFO to negotiate the sale of their bank and for the deal to include a meaningful pay package for the two of them. The deal is presented to the board and, right or wrong, the board is highly skeptical of the agreement that the executives cut. In this instance, the board’s advisers can help the directors clearly assess the merits of the transaction without the distraction of potentially questionable motivations.
Why should banks and credit unions consider consolidating their vendor relationships? Here are three top reasons why:
1. Save Time And Money
Banks and credit unions that reduce the number of their vendor partnerships can increase their operational efficiency and productivity. When an institution partners with multiple vendors, typically that means staff has to deal with multiple back-end systems, often accessing each system numerous times a day and struggling to keep abreast of all of the updates for every system. Sometimes, staff is even unnecessarily bogged down with having to deal with duplicative systems from multiple vendors.
Consolidating vendor relationships also can significantly reduce the amount of training for staff as well as for customers. Bank and credit union staff typically has to train customers on how to use vendors’ private-labeled portals, and that can be time-consuming, particularly if a financial institution uses multiple vendors with multiple portals. But if an institution uses the same vendor for multiple solutions that all have the same look and feel and the same technology, then training of both staff and customers is significantly reduced.
When banks and credit unions are able to negotiate fewer contracts, they can conduct less due diligence on potential vendors, as well as get more for their money by reducing the amount of monitoring and reporting required for risk and assessment compliance. On the other hand, having multiple contracts with multiple vendors adds even more burden to staff because they will also have to monitor different contract term dates for renewal, and then they’ll have to determine how one expiring contract could impact solutions from other vendors.
Furthermore, when a bank or credit union uses fewer vendors, the institution has more negotiating power because it frees up more dollars with the remaining vendors. The higher the volume provided to a vendor, the more likely they will offer their best pricing resulting in lower cost.
2. Save On Vendor Due Diligence
Financial institutions are increasingly responsible for keeping up with the third-party vendor management requirements of the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the National Credit Union Administration, the Federal Reserve, and for state-chartered institutions, the requirements of state regulators.
For example, the FDIC’s Guidance for Managing Third-Party Risk (FIL-44-2008), provides four main elements of an effective third-party risk management process: risk assessment, due diligence in selecting a third party, contract structuring and review and oversight. But today, there’s even more heightened scrutiny, as a number of high-profile security breaches of major vendors has caused regulators to make sure that financial institutions are actually taking all the necessary steps spelled out in the regulations, such as the IT handbook of the Federal Financial Institutions Examination Council (FFIEC).
Banks and credit unions can find it very time consuming to conduct the proper due diligence and ongoing monitoring on each vendor. By partnering with a one vendor, financial institutions can significantly reduce their compliance burden.
3. Help Customers
Consolidating vendors can enable banks to greatly elevate the experience for their customers, by providing a single platform that is easy to navigate. Banks may also have access to additional monitoring and reporting of customer activity to help prevent and detect fraud.
Vendor consolidation can provide substantial return on investment by saving time and achieving cost savings, as well as reduce regulatory burdens by providing the right monitoring and reporting to meet compliance requirements. Partnering with a one vendor can not only save time and money and boost return on investment, but also enhance customer loyalty by elevating the user experiences on the platform.
A “lift-out” is often used to describe the hiring of a group of individuals from the same company who have worked well with each other and can make an immediate and long-term contribution. A successful lift-out can create financial gain or provide competitive advantage such as replacing or crowding out a competitor. It can help expand the bank’s geographic markets or solidify its existing footprint.
Lift-outs, however, are not without risk. Management that becomes too enamored with a team can overlook essential steps required to determine whether it would be accretive. Inadequate due diligence or simply “paying up” on compensation without having a reasonable understanding of the expected results can cause a myriad of issues. In order to mitigate the risk, bankers should follow a standardized process, as outlined below:
Stages of a Successful Lift-Out
| Initial Conversation | Due Diligence | Team Transfer | Cultural Integration |
| Bank and team leader discuss potential market opportunities and competitive advantages. | Team leader gauges interest of other members, develops market projections and business plan for the bank’s review. Both sides investigate reputation, culture, resources and viability of a union. | Team joins bank and transfers client relationships in accordance with any contractual agreements. The bank plans for and announces the acquisition of the team internally and externally. | The team, which is now on the bank’s operational platform, becomes fully integrated and establishes relationships with other groups within the bank. |
The compensation structure for the lift-out team should also support the four stages:
During the Initial Conversation stage, discuss high-level compensation expectations. Often, these conversations provide insight into the team’s current compensation levels and programs. It can help the bank determine whether the team can easily fit into the current compensation structure or whether additional compensation is required to entice the team to come onboard. If additional compensation is required, it is important to determine (i) how much?, (ii) in what form?, (iii) for how long?, and (iv) whether it will create any internal equity or pay compression issues for existing talent.
During the Due Diligence stage, the bank must determine compensation levels that are commensurate with the economic value of the lift-out. Understanding the amount and the timing of each team member’s individual production is essential. It can also help the bank make the determination about which team members are essential and truly accretive. Determining the expected production streams can help determine who needs a compensation package outside of the current structure and who within the team could readily be integrated into the current structure.
It may be helpful to create a program where the additional pay phases out over a period of time or is only paid if the individual (or team) meets the production expectations agreed on at the time of the lift-out. For example:
During the Team Transfer stage, care should be taken to address any internal equity concerns and ensure that non-competition/non-solicitation commitments are upheld.
Possible rationales for accepting differing levels of compensation among like positions could include the limited nature or timing of the differences or the financial impact of the additional revenue stream.
Revenue producing roles are increasingly subject to non-competition and non-solicitation agreements. To avoid litigation, it is extremely important to ask lift out team members for any documents that involve their interaction with clients or the solicitation of former employees. The bank should review these and seek the advice of legal counsel.
During the Cultural Integration Stage, the Bank should assess whether pay differences should (a) remain given the structure and/or economics of the team or (b) be discontinued.
Maintaining pay differences makes sense if the team continues to outperform or if the group is highly-sought after by other institutions. However, if the results are commensurate with those in similar roles, it may become increasingly divisive to maintain special programs. Integration into the existing pay programs is a more natural choice.
In summary, team lift-outs provide a way for banks to accelerate growth by acquiring, rather than developing, proven revenue producers. Thoughtful management of compensation during the stages of a lift-out ensures that individuals are enticed to move and are motivated to produce for the bank.
Through many merger cycles, the basic template for M&A deals in the banking sector hasn’t changed very much. Provisions governing the regulatory process included fairly conventional cooperation undertakings, including rights to review. Time periods and drop-dead dates were matched to the regulatory requirements and expectations. The level of effort required on the part of the buyer and the target to obtain regulatory approvals was limited: Neither party would be required to take steps that would have a material adverse effect, typically measured relative to the size of the target. Reverse termination fees, payable by buyers if regulatory approvals were not forthcoming, were rare. Covenants governing the target’s operations between signing and closing were conventional and not unduly controversial.
Deals continue to get done on this basis but in the post-Dodd-Frank era, the regulatory climate is creating new forces that could reshape some of these basic M&A terms. These changes arise for several reasons. First, regulators increasingly see mergers as an occasion to scrutinize the buyer—its compliance record, systems, capacity to integrate and general good standing. In its September 2015 approval of M&T Corp.’s acquisition of Hudson City Bancorp, the Federal Reserve starkly warned that if an examiner identifies a material weakness in an acquiring bank, it will expect the bank to withdraw its application and resolve the issue before proceeding with the transaction.
The specter that the buyer’s challenges or standing can cause the target to be left at the altar has not yet fully worked its way through our M&A contract provisions. This is quite a different sort of regulatory risk, from the target’s point of view, than concerns about potential liabilities of the target or concerns about the competitive effects of the combination, which both parties can evaluate. Already, this regulatory focus has led targets to perform regulatory diligence on buyers, even in cash deals. As the M&A process continues to evolve, targets may try to distinguish between different kinds of regulatory risk and seek explicit protection where the sins of a buyer spoil the ceremony. Alternatively, it may prove too difficult to determine with certainty the cause of a regulatory obstacle, which could lead targets to seek greater protection for any regulatory failure. In either event, the result could be more requests for regulatory break-up fees—targeted or broad-based.
A number of other M&A provisions could be affected as well. For example, as the pendency of agreements becomes longer to allow time for an uncertain regulatory process, the market and intervening events that could change the value of the target or the buyer’s currency become more important, which in turn will increase the importance of material adverse effect conditions, interim covenants, the structure of “fiduciary outs” enabling a target board no longer to recommend an agreed deal, the size of break-up fees, the timing of shareholder votes, and the consequences of a no vote. In stock-for-stock deals between companies of comparable size, there is often a helpful symmetry to the parties’ situations and incentives, which could result in both parties wanting to limit the conditions under which they can back out of a deal—or, conceivably, the reverse. In cash deals or other true acquisitions, that symmetry is absent and each side can be expected to push for protection from the other’s problems. For the buyer, this may mean seeking greater conditionality in the event of adverse developments as well as tougher interim covenants. For the target, it may mean more regulatory protection and greater flexibility to respond to intervening events.
Longer delays and greater volatility also impact techniques for determining the merger consideration in stock deals. A fixed exchange ratio in which the buyer offers an agreed number of its shares in exchange for each share of the target, long a staple, implicitly presumes that the value of the two companies will likely move in sync. As the prospect of asymmetrical changes in value increases—which can be a result of an increasingly vigorous regulatory environment—there is some urge to fix the value of the buyer’s consideration, rather than the number of buyer shares. More fixed value deals will lead to negotiation over “collars” that create minimum and maximum numbers of shares the buyer is obligated to issue in the transaction, and, perhaps, walk-away rights that enable one party or the other to terminate the deal if the buyer’s stock price becomes too high or too low.
It’s too early to assess the impact of the changing regulatory climate on the M&A craft, but there are many reasons to think the current template will evolve, perhaps quite rapidly. That, of course, will put a premium on thoughtful lawyering and creative, practical solutions.
In today’s competitive environment, some bank directors may view an acquisition offer from another financial institution as a relief. With directors facing questions of how to gain scale in the face of heightened regulatory scrutiny, increased investor expectations, and general concerns about the future prospects of community banks, a bona fide offer to purchase the bank can change even the most entrenched positions around the board table.
So, how should directors evaluate an offer to sell the bank? A good starting place is to consider the institution’s strategic plan to identify the most meaningful aspects of the offer to the bank’s shareholders. The board can also use the strategic plan to provide a baseline for the institution’s future prospects on an independent basis. With the help of a financial advisor, the board can evaluate the institution’s projected performance should it remain independent and determine what premium to shareholders the purchase offer presents. Not all offers present either the premium or liquidity sought by shareholders, and the board may conclude that continued independent operation will present better opportunities to shareholders.
Once the board has a framework for evaluating the offer, it should consider the financial aspects of the offer. The form of the merger consideration—be it all stock, all cash, or a mix of stock and cash—can dictate the level of due diligence into the business of the buyer that should be conducted by the selling institution.
If the proposed offer consists of primarily cash consideration, the selling institution’s board should focus on the buyer’s ability to fund the transaction at closing. Review of the buyer’s liquidity and capital levels can signal whether regulators may require the buyer to raise additional capital to complete the transaction. Sellers bear considerable risk once a merger agreement is signed and the proposed transaction becomes public. The seller’s customers often think of the announcement as a done deal and the merger also naturally shifts the seller’s attention to integration rather than its business plan, which can benefit the combined company, but affect the seller’s independent results. It is difficult for the seller to mitigate these risks in negotiations, so factoring them into the board’s valuation of a sale offer is the best approach.
When considering a transaction in which a significant portion of the merger consideration is the buyer’s stock, the board has additional diligence responsibilities. First, the board should consider whether the buyer’s stock is publicly traded on a significant exchange or lightly traded on a lesser exchange. As the liquidity of the buyer’s stock decreases, the burden on the seller to understand the buyer’s business and future plans increase, as its shareholders will be “investing” in the combined company, perhaps for a lengthy period of time. The board should also consider if and when there will be opportunities for future shareholder liquidity.
On the other hand, when the seller’s shareholders are receiving an easily-traded stock, both parties will have an interest in mitigating the effects of market fluctuations on the pricing of the transaction. In most cases, a pricing collar, fixing the minimum and maximum amounts of shares to be issued, can allocate market risk between the parties. Such a structure can ensure that a market fluctuation does not cause the seller to lose its premium on sale or make the transaction so costly that it could affect the prospects of the buyer.
In addition to the financial terms of the proposed transaction, the seller’s organizational documents may include language allowing the board to consider a broad range of non-financial matters as part of the evaluation of a proposal. Certain matters, particularly with respect to how the seller’s executives and employees are integrated into the resulting institution and how the buyer’s business plan fits into the seller’s market, can have a significant impact on the success of the transaction. Just as community banking is largely a relationship-based model, the most successful mergers are those that make not only economic sense, but also address the “human element” to maintain key employee and customer relationships. The board can add value by raising these issues with management as part of its discussion of the merger proposal and definitive agreement.
In evaluating an offer to sell, the board is responsible for determining whether the bank’s financial advisors and management have considered a range of relevant items in evaluating an offer, including the offer’s financial terms, execution risks associated with the buyer, and social issues relating to the integration of the transaction. Using the bank’s strategic plan to determine which issues require closer scrutiny can focus the board’s attention on truly meaningful issues that will provide additional value to the institution’s shareholders.
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:
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.
Conclusion
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.