How the New Regulatory Environment Could Change Bank Mergers and Acquisitions


mergers-7-25-16.pngThrough 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.

Considering a Sale of the Bank? Don’t Forget the Board’s Due Diligence


due-diligence-5-16-16.pngIn 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.

How to Protect Your Bank in a Sale: Reverse Due Diligence


due-diligence-4-22-16.pngReverse 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.

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.

It’s Time to Add Legal Analysis to the Due Diligence Process


due-diligence-2-22-16.pngFinancial institution regulators have increased their scrutiny of bank compliance systems and controls following the financial crisis. The number and severity of enforcement actions has accordingly increased. At the same time, the pace of community bank M&A has also increased, leaving bank directors and investors with an essential dilemma: How much is a bank worth as compliance costs continue to rise in the post-financial crisis world? This article adds clarity to that question by exploring the relationship between regulatory risks and firm value. A well designed legal due diligence process can uncover regulatory issues that can, when analyzed through a valuation-oriented lens, assist management and financial professionals in adjusting a firm’s value, up or down, as appropriate.

Due diligence consists of evaluating both business and legal work streams, with the former tending to focus on business risks and valuation and the later tending to focus on legal risks and deal structure. While legal due diligence might occasionally inform firm valuation, such as purchase price adjustments due to litigation or insurance claims, it does not generally, by design, prioritize valuation.

Take, for instance, the following example of a hypothetical medium-sized bank with $15 billion in assets that offers a variety of traditional banking products, including consumer financial products. Given its size and product offerings, this mid-sized bank is subject to regulation by the Consumer Financial Protection Bureau (CFPB) in addition to its prudential banking regulators.

In our hypothetical example, legal due diligence uncovers that the mid-sized bank previously marketed and sold a debt protection credit card product for several years through an aggressive telemarketing campaign. The product was advertised as permitting customers the ability to cancel credit card payments in the event of certain hardships such as job loss, disability and hospitalization. Consumers who enrolled in the product were charged a fee. Legal due diligence finds that the telemarketers did not disclose the product fee and that promotional materials contained material inaccuracies concerning the product’s scope of coverage and exclusions. Legal due diligence further reveals that the CFPB is pursuing an ongoing campaign of enforcement actions against banks that sold similar products.

Legal counsel conducts an analysis of prior enforcement cases, studying time frames between banks’ underlying offending activities and resultant enforcement actions; sizes and types of penalties in relation to the offending banks’ conduct; mitigating effects of remediation, self-reporting, and cooperation; and other pertinent factors. Legal counsel also reviews the underlying customer contracts, the dollar volume of fees collected by the mid-sized bank on the product, the number of customers who applied for coverage versus the number who successfully obtained debt protection, the volume of customer complaints received on the product, and the pattern of private class action suits based on similar underlying facts in other cases.

Based on this legal due diligence, mid-sized bank’s financial advisors determine that it is appropriate to adjust the financial forecast of the bank such that two years after an acquisition, forecasted pre-tax earnings are decreased by $15 million as a result of a possible CFPB-ordered restitution and civil money penalty payments, as well as related compliance, consulting, and legal fees. Year four pre-tax earnings are decreased by $10 million, as a result of an expected settlement of private class action litigation. These adjustments then flow through the valuation model. In assessing a potential acquisition of a mid-sized bank, a prospective buyer might now be able to better adjust the purchase price of mid-sized bank in a more disciplined and analytical fashion, and negotiate certain other purchase price adjustments based on these enforcement contingencies.

We are aware of at least one serial acquirer of smaller community banks that builds into its typical merger agreement a purchase price adjustment for declines in capital resulting from compliance deficiencies (among other specified items). Such provisions are rare in the bank M&A market as they are not attractive to a seller, unless the acquirer’s bid is clearly higher than the next closest in value. This further points to the importance of the due diligence process.

The example of the mid-sized bank presents a case in which valuation and deal structure can benefit from valuation-oriented legal due diligence. Buyers can avoid the risk of overpaying and sellers can avoid the risk of underselling a bank. Whether valuation is adjusted up or down in light of legal due diligence, in the post-financial crisis world, bank directors can add significant value to an M&A transaction through the addition of such a process.

Preparing Your Bank for Sale


bank-sale-2-18-16.pngIf your board is considering a sale of the institution, you’re not ready to sell if you’re not prepared to sell. There are a variety of issues that your board will need to consider if it wants to maximize the value of the bank’s franchise in a sale. Many, although not all of these considerations, involve the bank’s balance sheet. Other important issues include cutting overhead costs and dealing with regulatory compliance issues. Sal Inserra, an Atlanta-based partner for the accounting and consulting firm Crowe Horwath LLP, offered the following advice to Bank Director Editor in Chief Jack Milligan.

Take a hard look at impaired loans on your balance sheet.
When bank executives consider a sale and analyze the loan portfolio, they are not always looking at it from the perspective of a potential buyer. If there’s a problem customer, they have a sense of the potential collection on that impaired loan. When buyers come in cold, they don’t have that history. They are doing an antiseptic review. It is numbers on a page that lead to a conclusion. They’re not going to accept the backstory as a reason why they should pay more for the loan than they think they should. If you have another appraisal in hand that shows the value higher, they may give credence to that, but not as it relates to the sob story. From the buyer’s perspective, if a loan is leveraged with 100 percent loan-to-value with a five-year life, the prospective buyer will require accretion yield of 9 percent to be attractive given the risk. If the coupon on that loan is only 5 percent, the buyer is only going to pay 75 cents on the dollar to achieve their yield. You have to get past the subjective analysis and get more objective detail about that impaired loan. You need to get the most current financial information possible about that impaired loan and the borrower.

Avoid bad leverage transactions as much as possible.
A bad leverage transaction sometimes occurs when the bank has excess deposits and invests in securities of different durations in an attempt to leverage the capital in the financial institution. Depending on how far out into the future the bank is leveraged, it could end up in a bad position where the assets are at a fixed rate, and the liabilities are at a variable rate. And because the bank is maximizing yield, as liabilities start creeping up, net interest margin can erode rather quickly. In the current market, unless the bank wants to go out four or five years or more on a bond and take some credit risk in something other than a U.S. Treasury security, the bank is going to have a pretty narrow net interest margin. Rather than buy low-earning securities, you might benefit your bank’s value by waiting for a buyer with a high loan-to-deposit ratio that needs additional funding. If the seller has excess funding that hasn’t been tied up, that could be a very lucrative purchase to a bank that needs the funding. But once the seller has tied that funding up in something with a narrow net interest margin, the buyer will have to unwind that in order to get value. And if the buyer has to take a hit to unwind that investment, it’s going to impact the seller’s value.

Manage excess capital on the balance sheet.
This is really about how you spin the story of selling the bank. Let’s say you have $50 million in capital. So if you sell for two times book value, you would get $100 million. But of that $50 million, let’s say that $10 million has not been deployed, so you’re not going to get two times $50 million. You’re going to get 1.60 times $50 million, which is $80 million. However, if the bank gets rid of that $10 million in excess capital by paying it out in dividends, it will receive $70 million, but because it is now working off a $40 million base, the bank reports a higher premium. Net cash is still $80 million when you consider the dividend.

Another approach would be to try to leverage up that excess capital. Where you may have turned down a loan before because the pricing wasn’t good, but it was still going to create a good margin and a decent return on investment, the bank may want to invest in the loan because at least it becomes an earning asset. This strategy will depend on what is available in the market.

Shed costly assets or debt before attempting to sell the bank.
Since the value of the bank is based on future earnings, if the bank is carrying some high cost debt, it’s going to impact future margins. Or if the bank has low yielding assets, that’s going to affect future margins. When buyers come in to price those assets and liabilities, they’re going to knock down the value of the bank. Most high cost debt has a prepayment penalty associated with it, so there’s a net cost to get out of that debt. But when it comes to low yielding assets, the bank can maximize net interest margin by getting rid of assets that are going to cause issues for future earnings.

Focus on cost control prior to a sale.
When it comes to cost control, the first thing to look at is the branch network. It’s no secret that branch activity continues to decrease as folks get more and more comfortable with digital banking. I love [author Brett King’s motto], “Banking is no longer somewhere you go, it’s something you do.” And the value of a seller’s branch network may be going down because the cost of maintaining those branches is still significant, not only from a hard cost standpoint but also with training staff, marketing and all the other costs of operating a branch. So take a hard look at those branches that buyers are going to consider exiting. If the bank can start narrowing those costs by closing some of those marginal branches, so that the buyer can see what the run rate is going forward, that will help improve value because the value is going to be driven on the multiple of future earnings.

The other thing I would focus on is staffing. A lot of banks have made big strides in technology, but they haven’t reevaluated their head counts. And they need to do a review of what is necessary to operate and deliver service. A phrase I hear a lot is, “We’re not going to change our head count, we’re going to grow into it.” And that doesn’t necessarily work because as you grow, it doesn’t mean the resources are going to be able to continue to help you get to the next level. So doing a critical analysis of head count is key. Those are the two major variables—branches and people—that when addressed can help you improve your efficiency.

Avoid entering into long-term contracts if you’re considering a sale.
The thing that just makes me scratch my head is when a board is thinking about selling the bank and a year before it pulls the trigger, it enters into a four- or five-year core processing contract. The cost associated with exiting a core processing contract, unless it happens to be the same company that they buyer uses, is incredible. I’ve seen millions of dollars spent to exit a core processing contract.

Factor regulatory compliance issues in a potential sale.
If the bank knows its potential acquirers, it knows its potential new regulators. The key issue is making sure that regulator knows the seller has its compliance house in order. The seller can put together an in-house review or use external resources to address the issues of that potential regulator. If I’m a $2 billion asset bank and it’s likely that I’m going to become part of an institution that’s over $10 billion in assets, I need to be focused on issues that the Consumer Financial Protection Bureau is focused on, because I know that my portfolio is going to be subject to a CFPB review. If I’m a $200 million asset bank and I’m going to merge into bank that’s in the $2 billion to $3 billion range, that may present a higher level of scrutiny. So knowing my potential acquirer allows for adequate preparation.

Mastering the Art of Unsolicited Takeovers


takeover-11-25-15.pngAssume you sit on the board of a bank that has no present interest in being acquired. Without warning, you receive an unsolicited takeover offer. Much as you may find this an annoying distraction, you cannot dismiss the offer out-of-hand. Rather, you must ensure that the board respects the foundational principle that, as a body, it must make decisions that enhance shareholder value. It must accept its decision-making responsibility, and promptly undertake a financial analysis to determine whether the offer is one that could put the shareholders in a better position than maintaining the status quo. If the board concludes that the offer is legitimate and that, once accepted and consummated after negotiations, it could put the shareholders into a more favorable position than retaining their existing bank shares, then a decision is virtually unavoidable.

If You Are the Target
In most states, following their version of the business judgment rule will protect the board’s decision and courts are reluctant to second-guess that decision as long as:

  1. The board has adhered to the bank’s documented governance processes and recusal mechanisms that are consistent with peer institutions and designed to eliminate board member self-interest influences.
  2. The board relied in good faith upon non-conflicted expert advice.
  3. The board minutes establish that it conducted a thoughtful decision-making process. If the financial analysis makes the ultimate decision too close to call, thereby giving good reason to consider non-economic issues, and the bank’s by-laws permit the board to weigh non-economic factors, it is imperative that negotiations over non-economic concerns be carefully documented to mitigate litigation risk regardless of whether a transaction receives a green or red light.

If You Are the Acquirer
Now assume you are a board member of the acquiring bank. Knowing that your unsolicited offer will gain traction only if the target’s board finds the offer to be legitimate, your first concern should be to make certain that you have assembled a team with the necessary expertise willing to devote the resources to due diligence. The better the acquirer understands the target’s governance and attitude, as well as its customer demographics, competitive position and the potential for regulatory concern over market concentration, the more tailored the offer will be to the interests of the target and the more likely the offer will receive favorable consideration. If later challenged, the board’s due diligence will be judged by the investigative standard of reasonableness, where management decisions were ratified by the board only after independent inquiry. The board must uphold its duty of care, and that obligation will have been met if it has made reasonable examination of the totality of available information, including strategic, operational, management, timing and legal considerations.

Using Advisors
Whether you are on the board of the target or the acquirer, you will need to have a level of market, industry and technical expertise that requires engagement of outside advisors, with investment bankers often being the most prominent. The board will need to understand every advisor’s motive. It is essential that the advisors challenge your assumptions, and if their financial incentives depend on closing the deal, you must remain alert to that natural bias. The board must resist investment banker pressure to get a deal done, making sure that board agendas provide adequate time to study implementation progress, to anticipate and mitigate risks and to identify additional and alternative opportunities.

Clarity and open communication among members of the key leadership team and their advisors is imperative, especially with regard to keeping the transaction true to the board’s primary business goals.  These factors will drive contract negotiations, elevate the quality of the due diligence effort and ensure that the initiatives and business elements that create value are prioritized in the integration process.

For both acquirer and target, investment bankers in collaboration with legal counsel can be invaluable in guiding the boards towards successful completion of the transaction. Seasoned investment bankers can help set appropriate price terms and conditions and establish critical protocols for communicating with employees, the media, the market and investors. Experienced legal counsel can negotiate a transition services agreement governing consolidation and systems conversion and provide early, active and competent interaction with regulators to ensure unimpeded processing of all necessary filings and approvals.

Above all, it is vital to remember that failing to close the deal may ultimately be in the best interests of the enterprise. Ego, incentive compensation and deal momentum can all too easily distract the board from its paramount responsibility, namely, to constantly vet all pro forma assumptions of the deal.

Buyer Beware: How Banks Can Avoid a Transaction Disaster


acquisition-10-26-15.pngMergers and acquisitions are exciting: they make the news, they show a position of strength to competitors, and most deals promise benefits for customers, employees and shareholders. Transactions have the same kind of excitement one might experience when buying a car. And like buying the car, that new car smell, or in this case, the allure of growth and synergies, can wear off quickly once you realize all of the work required to successfully integrate two institutions. Worse still is the feeling you have bought a lemon. There are, however, strategies that banks can employ before an integration to make sure they are getting a good deal.

Ensure You Have the Right, Experienced Resources
There is a reason that most professional services firms have an M&A practice: mergers and acquisitions are hard. In the middle market, it is even more important to look at current staff or partners that can support integration and bring the much needed experience to the table. No other industry is as complex as banking in terms of converting systems and processes. Banks require a unique set of skills to navigate the complexities of core systems, online banking, debit/credit cards, treasury management and lending.

Conduct an Operational and Technical Assessment of Your Target
Looking at the operational and technical complexities before a deal is made will improve the chances of a successful integration. Assess the scalability and interoperability of your technology and process landscape (as well as the target’s landscape) so that you can identify risks to the integration early and put together a mitigation plan quickly. All too often, middle market transactions focus only on diligence conducted by bankers, lawyers and accountants. Operational and technology diligence are de-prioritized.

Knowing how much car you can afford before even thinking about a deal puts you ahead of other bidders in terms of understanding how a target will fit into your garage. An operational and technical assessment provides the opportunity to understand and potentially implement systems, processes and products that will create a scalable and flexible operating model.

Evaluate Third Party Relationships
Understanding how your service providers can flex (or not) is critical to understanding the level of effort and cost of integration, along with the risks that need to be mitigated. Do your vendors have dedicated conversion teams? Are you the largest client of your core provider? Is there information available from your peers on the pros and cons of particular solutions in terms of integration? What are the service areas that could be improved through an acquisition?

Know Your Customer
Don’t forget the customer. Most transactions are driven by the desire to grow an institution’s customer base. But, in the frenzy of bringing two institutions together, customers often take a backseat to other integration priorities. Reacting to problems once customers start to leave is too late—the damage is already done. You will continue to hemorrhage customers while you course correct. Consider how well you know your customers before a deal is on the table. Do you have a way to make sure the customer’s voice is heard? Mapping the customer impact during diligence will prepare you to monitor (and hopefully improve) customer experience through the integration.

During integration, avoid focusing solely on cost synergies at the expense of customer experiences that could undermine revenue objectives. Whatever the changes, make sure communications to customers are clear, regular and transparent. You can never over communicate change to customers. Lastly, don’t assume that postponing changes is always best for customers. In many cases, making changes early and communicating them effectively will offer the most seamless customer experience across all channels (branches, digital, etc.).

Never Underestimate the Importance of Culture
It’s easy to sweep culture under the rug and consider it too soft and fuzzy for due diligence and integration. Many find it hard to put concrete metrics and plans around culture. Generational changes continue to change the way companies recruit, retain and operate—and that’s forcing companies to rethink their priorities in order to avoid costly turnover.

Having tools in place to implement change management is a best practice. This starts with knowing what your own cultural identity and management style is and what that means in terms of potential deals. If you’re into sports cars, don’t look at SUVs. By having your own cultural assessment up front, you can start analyzing cultural differences earlier in the process.

Assess Your M&A Readiness Before You Buy
If you want to successfully retain customers and key employees while achieving financial synergies, take the time to kick your own tires before looking at a new deal. An internal M&A readiness assessment is not only valuable if you are a buyer, but as a potential seller as well. An assessment will identify both deficiencies and differentiators in your operating model that a potential buyer will notice during due diligence. This knowledge gives you better negotiating power and can put you in the driver’s seat.

Stick to the Basics as Bank M&A Heats Up


Anyone paying close attention is seeing that the number of bank deals in the United States is increasing.

There was a 25 percent increase in bank deals in the U.S. in 2014, compared to 2013, and there is a good possibility that the number of deals in 2015 will exceed that of 2014.mergers-chart.PNG

While good news for the deal makers, investors and regulators are ratcheting up the pressure on buyers and sellers to get things right. But, if history has taught us anything in mergers and acquisitions (M&A), it is that they often are fickle undertakings, where many of them simply don’t work out as planned.

Costly and sometimes fatal mistakes are made in the planning, due diligence, and execution stages, just to name a few steps along the way. Those and other critical factors make it vital to issue a common reminder: Stick to the basics.

Fundamental Questions Can Help Form the Foundation
The top question management should ask themselves before the start of a M&A transaction is, “does this deal fit our current business model, both culturally and strategically?”

There must be a recognition that people sometimes get so wrapped up in trying to get the best deal possible that they lose sight of whether the deal makes sense on its merits.

A message we often deliver is that there will be times that participants might not get the best deal from a price perspective, but when deep considerations are made about the other matters that are involved—long-term strategic objectives, the people you will acquire, the level of technological sophistication, the seller’s culture of connecting with customers—the deal could be a very good one.

In short, it sometimes comes down to having to pay a bit of a premium on the price in order to get the best deal, given the circumstances and strategic plan.

We often counsel board members and top management—whether the buyer or the seller—to ask this question: Does the deal put me in a better place tomorrow than I am today? Beyond that baseline question, there always are considerations about fundamentals: Does this make sense as it relates to the strategy that is already laid out?

Four other key questions include:

  • What are the quality of earnings? Just a few years ago, many prospective buyers looking at the balance sheet of the target actually didn’t believe the financials. Now, in more than a few cases, we are seeing the main issue being some skepticism about earnings. Although we see fewer concerns about the balance sheet, it remains a prime area for deep review. When the issue of quality of earnings is raised, it is prudent to investigate whether there has been a flurry of reserve releases. Have costs been squeezed down so much that, from an operational perspective, there are some key processes that are untenable for a long-term period?  Has the bank gone too far out the rate curve in seeking yield on the bond portfolio so that when rates finally start going up, the bank is going to get whipsawed and take a bunch of mark-to-market hits on those bonds?
  • What is the current asset / liability management profile of the bank? It would be useful to discover whether the target bank has been focused too much on short-term products. Another question: After rates rise, will the customers who are happy to be in a transaction product today (because they are not making much on CDs or money markets) walk out the door if another bank has a better product?
  • Is the target bank up to date on their regulatory compliance efforts? Beyond the numbers, there should be ample evidence that the target’s regulatory profile is rock solid. Is there clear evidence that the bank has had professional assistance in determining any liability relating to anti-money-laundering or Bank Secrecy Act issues? If it has not engaged professional assistance, ask the bank board and senior management how it gained comfort that it has done the proper level of diligence regarding these critical challenges?
  • What are the data practices of the target bank? Where and how is data stored? What security protocols have been instituted and followed? How often are those protocols reviewed and updated? Does the board and top management believe the data it receives after it orders a report?

In a rapidly evolving M&A landscape, our message is simple: When the time comes to do a deal, rely on the basics.

Regulatory Scrutiny Focuses on Inadequate Strategic and Capital Planning


capital-planning-9-24-15.pngOnce again, regulators are zeroing in on inadequate strategic and capital planning processes at many community banks.

The Office of the Comptroller of the Currency (OCC) listed “strategic planning and execution” as its first supervisory priority for the second half of 2015 in its mid-cycle status report released in June. That echoes concerns from the latest OCC semiannual risk perspective, which found that strategic planning was “a challenge for many community banks.”

FDIC Chairman Martin J. Gruenberg said in May that regulators expect banks “to have a strategic planning process to guide the direction and decisions of management and the board. I want to stress the word ‘process’ because we don’t just mean a piece of paper.”

He said that effective strategic planning “should be a dynamic process that is driven by the bank’s core mission, vision and values. It should be based on a solid understanding of your current business model and risks and should involve proper due diligence and the allocation of sufficient resources before expanding into a new business line. Further, there should be frequent, objective follow-up on actual versus planned results.”

In writing about strategic risk, the Atlanta Federal Reserve’s supervision and regulation division said that “a sound strategic planning process is important for institutions of all sizes, although the nature of the process will vary by size and complexity.” The article noted that the process “should not result in a rigid, never-changing plan but should be nimble, regularly updated (at least annually) and capable of responding to risks and changing market conditions.”

Given economic changes and increased market competition, community banks must understand how to conduct effective strategic planning. This is more important now than ever, says Invictus Consulting Group Chairman Kamal Mustafa.

The smartest banks are using new analytics to develop their strategic plans— not because of regulatory pressure, but because it gives them an edge in the marketplace and a view of their banks they cannot otherwise see, Mustafa said.

Strategic planning is useless without incorporating capital planning. The most effective capital planning is built from the results of stress testing. These critical functions—strategic planning, capital planning and stress testing—must be integrated if a bank truly wants to understand its future,” he said.

He advises banks to use the same fundamental methodology for both capital planning and strategic planning, or else they will run the risk of getting misleading results. This strategy is also crucial in analyzing mergers and acquisitions.

OCC Deputy Comptroller for Supervision Risk Management Darrin Benhart also advises community banks to use stress testing to determine if the bank has enough capital. “Boards also need to make sure the institution has adequate capital relative to all of its risks, and stress testing can help,” he said in a February speech. “We also talk about the need to conduct stress testing to assess and inform those limits as bank management and the board make strategic decisions.”

Avoiding Pitfalls in Your Bank’s Data Processing Agreement


vendor-management-9-23-15.pngA bank’s core processing agreement is often, by far, its most significant vendor agreement. These lengthy and complex agreements are commonly weighted heavily in favor of the vendor and can be rife with traps, such as steep change-in-control and early termination penalties. Nonetheless, many banks enter into core processing agreements without prior review by counsel, or even reading the agreement themselves. In the current regulatory environment, which stresses and scrutinizes vendor risk management and diligence, a bank’s failure to review and negotiate its core processing agreement could easily result in regulatory criticism, as well as unanticipated costs and potential liability.

In the past few years, the bank regulatory agencies have issued new or updated guidance related to vendor diligence and risk management. In those issuances, the regulators express concern that banks’ vendor risk management practices may be inadequate, citing instances in which management has failed to properly assess and understand the risks and costs of their vendor relationships. Regulators are concerned that banks may enter into agreements that are detrimental to the bank’s employees, customers or other stakeholders. Banks are expected to have risk management processes that correspond with the level of risk and complexity of their vendor relationships. Those processes include due diligence, careful vendor selection, contract negotiation, proper termination mechanisms and ensuring proper oversight. Regulators further expect banks to have more comprehensive and rigorous oversight of management of third-party relationships that involve critical activities, which may include significant bank functions, such as payments, clearing, settlements and custody, or significant shared services, such as information technology.

Regulators conducting bank examinations expect to see adequate risk management policies and procedures in place. Proper due diligence, negotiation, and oversight for data processing contracts should be integral to those procedures. Contrary to what many may think, the terms of data processing agreements are negotiable. Some of the most unfavorable terms may be eliminated simply by emphasizing the regulatory or business necessity for those changes during negotiations. Key terms to address in the negotiation process include termination provisions, regulatory provisions, audit rights and performance standards, among others.

A less obvious concern with core processing agreements arises in the context of a bank merger or acquisition. Steep termination fees in a data processing contract can change the economics of a bank acquisition transaction, making the selling bank a less attractive target and negatively impacting shareholder returns on the sale. It is typical for the initial proposal of a data processing agreement to include contract termination fees equal to roughly 80 percent of the remaining fees payable during the term of the contract. In most cases, these termination fees are negotiable, and data processing providers may be receptive to a graduated termination fee schedule, such that termination fees are less severe later in the term of the contract. In addition, termination fee calculations in core processing agreements are often complex. As such, it will be important for bank management to understand the practical implications of those calculations. Data processing providers will often attempt to recoup any past credits or rebates through the termination fee formula. Understanding and negotiating these termination provisions on the front end can save millions of dollars for the acquiring bank, and ultimately increase returns for the bank’s shareholders.

If your bank is considering a new data processing vendor, or reaching the expiration of your current term and considering renewing with your old vendor, you should work through your regulatory vendor risk management and due diligence checklists before entering into a new contract. We further encourage you to identify a dedicated team, with access to bank counsel, to review and negotiate any proposed agreement. If your institution is considering a future sale or other business combination transaction, then negotiating your data processing contract is of paramount concern. Ultimately, an ignored termination provision in your core processing agreement has the potential to undermine a potential merger or materially impair shareholder returns.