Pent-up deal demand will define 2022, continuing this year’s momentum as pandemic-related credit concerns recede. Stinson LLP Partner Adam Maier believes banks can expect to see a high volume of deals in the space but anticipate approval slowdowns from regulatory scrutiny. He also shares his top advice for directors as their banks prepare for growth next year. Topics include:
Will deal volume pick up pace in 2021? Despite credit concerns and negotiation hurdles, Stinson LLP Partner Adam Maier predicts a stronger appetite for deals — but adds that potential acquirers will have to be aggressive in pursuing targets that align with their strategic goals.
Financial institutions increasingly seek to use technology to efficiently and effectively mitigate risk and comply with regulations. Bank leaders will need the right solutions to meet these objectives, given the amount of data to make sense of as organizations include risk as part of their decision-making process. Microsoft’s Sandeep Mangaraj explains how banks should explore these issues with Emily McCormick, Bank Director’s vice president of research. They discuss:
Bank directors may want to revisit how and what corporate meeting minutes they keep, following the crucial role that meeting minutes played in a recent court case.
Corporate minutes played an important part in determining the allegations created a “reasonable inference” that a company’s directors failed to fulfill their fiduciary obligations. Bank directors may want to revisit the structure and contents of their meeting minutes, particularly as they relate to risk oversight and board-level reporting and monitoring systems.
There has always been a tension in corporate governance when it comes to the amount of detail in the minutes for a board of directors or a board committee meeting. Generally, most governance experts agree that minutes should contain details on the meeting’s date and time, who attended and whether there was a quorum, summaries of each discussed agenda item and a record of actions taken, at a minimum.
Where experts differ is around questions of how much discussion detail should be in the minutes, based in part on their discoverability under most state corporation codes. A recent Delaware Supreme Court case may shed some light on this debate.
The 2019 decision, Marchand v. Barnhill, centered around the listeria outbreak in Blue Bell Creameries’ ice cream that resulted in the illness and, in some cases, death of several consumers. Blue Bell recalled all of its products, laid off a significant number of its employees and shut down production at its plants.
In the fallout, a stockholder derivative suit was filed against Blue Bell’s key executives and directors, claiming breaches of their fiduciary duties. The Chancery Court dismissed the claims, partly on the basis that the pleadings were not sufficient to support a reasonable inference that the directors acted with bad faith. The Delaware Supreme Court reversed that decision on appeal, finding that the facts sufficiently supported a reasonable inference that the board “failed to implement any system to monitor Blue Bell’s food safety performance or compliance.”
The Supreme Court concluded that it was reasonably conceivable that the directors breached their duty of loyalty. They relied on a prior Delaware case that established the standard for claims involving the breach of the duty of loyalty, and that the failure of a board to make a good faith effort to oversee a company’s operations and have a board-level system to monitor and mitigate risks is an act of bad faith. This is commonly referred to as the Caremark duties.
In Marchand, the plaintiff used the company’s books and records to allege that the board lacked a committee that addressed food safety, had no regular process requiring management to inform the board on food safety matters and compliance, and no schedule to regularly consider food safety risks prior to the listeria incident. The plaintiff also alleged there was no evidence that management reports containing certain red flags were reported to the board and no record showing any regular discussion of food safety issues at board meetings.
In finding that the facts were sufficient to support a claim that Blue Bell’s board breached its duty of loyalty, the Supreme Court stated that bad faith is established when a board fails to implement a reporting or monitoring system, or implements one and fails to monitor or oversee its operations. A key factor was the lack of any discussion of food safety risks in board minutes or other board materials.
The court also noted that being in a highly regulated industry and compliance with applicable regulations did not “foreclose an inference that the directors’ lack of attentiveness rose to the level of bad faith indifference” — a concept that can apply to regulated industries like banking.
Marchand reminds boards of directors what is required to fulfill their duty of loyalty and their oversight responsibilities. Key takeaways from the decision include:
Identify, in consultation with management, a company’s critical risks, and regularly consider the risk management efforts and appropriateness of board-level procedures in board and/or committee meetings.
Implement appropriate board-level reporting systems for monitoring critical risks, including regular reports to the board or a board committee on those risks.
Document contemporaneously, carefully and with some specificity, an accurate, precise and complete record of decision-making by the board in board minutes and other documents. This includes board-level procedures and compliance efforts for monitoring critical risks, and that the board is monitoring such risks.
What might the second half of 2019 bring for bank mergers and acquisitions (M&A)?
The favorable drivers in the first half of 2019 — the regulatory landscape, enhanced earnings as a result of tax reform, desire for scale and efficiency, and the search for digital capabilities — will likely continue to be the catalysts for bank M&A activity in the second half of 2019. While the market has not seen a spike in the bank M&A deal volume, overall deal values continue to rise because of a few large transactions, including mergers with price tags of a $28 billion and a $3.6 billion. The following trends and drivers are expected to continue to have an impact on banking M&A activity in the second half of 2019 and beyond.
Intensifying Battle for Secured Customer Deposit Bases U.S. banks’ deposit costs rose far more quickly than loan yields in the first quarter of 2019; further increases in deposit costs may prevent net interest margins from expanding in 2019. As the competition for deposits intensifies, buyers are increasingly looking for banks with a secured deposit base, especially those with a significant percentage. Moreover, as deposit betas accelerate — even as the Federal Open Market Committee slows rate hikes — it becomes more difficult for banks to grow deposits.
With the largest banks attempting to grow their deposit market share via organic customer growth, the regional and super regional banks are trying to develop similar presences through acquisitions. Banks that can navigate this rate environment ably should emerge as better-positioned acquirers via their stock currency, or sellers through the attractiveness of their funding base.
Favorable Regulatory Environment Dodd-Frank regulations have eased over the past 12 months, increasing the threshold for added oversight and scrutiny from $50 billion in assets to $250 billion. Easing bank regulations and tax reforms that create surplus capital could continue driving regional and super regional consolidation. Moreover, banks with $250 billion to $700 billion in assets may continue to benefit in the second half of 2019 from a more-favorable regulatory landscape.
MOE’s Potential Change on the Competitive Landscape There were a couple of mergers of equals (MOE) in the first half of 2019 that were welcomed by investors — an indication that the industry could be likely to see a rise in the volume of larger transactions in 2019. Regional banks that miss the MOE wave in the near term may soon find themselves without a “partner” after the initial wave of acquisitions occurs.
As the banks pressure-test their MOE strategy, the key may be to find a partner with strategic overlap to drive the synergies and justify the purchase price premium yet also provide an opportunity for growth and geographic footprint. Furthermore, unlike smaller tuck-ins, MOE requires additional strategic diligence and capabilities. This includes the ability to successfully integrate and scale capabilities, the ability to cross-sell to newly acquired segments, the ability to consolidate branches in overlapping markets and integrating divergent management processes and culture.
The Hunt for Digital Capabilities Evolving consumer wants and the table stake needed to provide an integrated digital ecosystem are compelling many bank executives to differentiate themselves via technology and digital channels growth. Investors typically place a premium on digital-forward banks, driving up multiples for banks with efficient ecosystems of digital capabilities. The hunt for digital capabilities may provide an opportunity to not only add scale, but also transform legacy banks into agile, digital-first banks of the future.
Bank boards and executives should remain cognizant of above trends as they progress through their strategic M&A planning. Their resulting decisions — to be buyer, seller or an observer on the sidelines — may shape bank M&A activity in the second half of 2019 and into 2020.
Moreover, while the banks continue to assess the potential impact of the current expected credit loss (CECL) standard, the general market consensus is CECL may require a capital charge. As such, M&A credit due diligence should be treated as an investment in reducing future losses, even though the loan quality is currently viewed as benign. Successfully driving value from acquisitions while mitigating risks requires a focused lens on M&A strategy with the right set of tools, teams and processes to perform due diligence, execute and integrate as needed.
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Like laws and regulations applicable to financial institutions, corporate governance best practices are not static concepts. Instead, they are constantly evolving based on changes in the law, the regulatory framework and investor relations, among other matters. When was the last time the governing documents of your financial institution were reviewed and updated? The governing documents of many financial institutions were prepared decades ago, and have not evolved to reflect or comply with current laws, regulations, and corporate governance best practices. In fact, in the course of advising financial institutions, we have come across numerous governing documents that were prepared prior to the Great Depression. Although such documents may still be legally effective, operating under them may subject your financial institution and its board of directors to certain legal, regulatory and business risks associated with antiquated governance practices. As such, reviewing and, if necessary, updating your financial institution’s corporate governance documents is not just a matter of good corporate governance but also an exercise in risk mitigation.
Certain common—yet often alarming—issues may arise from the use of outdated governing documents. These include:
Indemnification provisions may be inconsistent with and unenforceable under applicable law. Likewise, most governing documents also contain provisions providing for the advancement of expenses to directors and officers in connection with legal actions relating to their service to the financial institution. In addition to legal compliance concerns, these provisions should be carefully drafted to ensure that the financial institution is not required to advance expenses to such officer or director with respect to a lawsuit between such person and the financial institution.
Voting procedures may be inconsistent with applicable law and/or best practices. These practices may also be inconsistently defined and conflict with relevant governing documents of a single financial institution.
Procedures to prevent or discourage shareholder activism or a hostile takeover of your financial institution could be inadequate.
Rights of first refusal or equity purchase rights contained in different, but operative, agreements among shareholders and the financial institution could be inconsistent.
Provisions limiting the liability of directors and officers of your financial institution may be inconsistent with and unenforceable under applicable law, or such provisions inadvertently may be more restrictive than permitted under applicable law.
Non-competition and non-solicitation provisions contained in various agreements applicable to the same director or executive officer could compete with one another.
Shareholder agreements for financial institutions could be structured in a fashion such that the Federal Reserve deems the agreements themselves to qualify as a bank holding company under the Bank Holding Company Act of 1956. For instance, based on guidance previously issued by the Federal Reserve, this unexpected outcome could occur if your financial institution’s shareholder agreement contains a buy-sell provision and is perpetual in term. These are common terms of shareholder agreements designed to protect a financial institution’s Subchapter S election, so bank holding companies that are Subchapter S corporations are being required by the Federal Reserve to amend their shareholder agreements to limit the terms to 25 years. Without such an amendment, the Federal Reserve takes the position that a Subchapter S shareholder agreement, in and of itself, can be deemed a bank holding company.
The board of directors and management team can protect the financial institution from these risks by following a few simple steps to update its governing documents.
Locate your governing documents. These could include the financial institution’s articles or certificate of incorporation, bylaws, committee charters, shareholder agreements, buy-sell agreements, corporate governance guidelines or policies, intercompany agreements, and tax sharing agreements.
Review and analyze the financial institution’s governing documents to identify any risks or areas for improvement, or areas that could be updated to reflect current laws and to incorporate current best practices.
Revise the financial institution’s governing documents to mitigate identified risks, address legal deficiencies and reflect current best practices.
Develop a procedure for monitoring changes in applicable laws and best practices that affect the institution, and implement an ongoing process for addressing any such changes in a timely manner.
Finally, designate a committee of the board of directors (e.g. the governance committee) or a member of the management team to manage the monitoring procedure established for this purpose.
Although simple, following these steps will help to prevent or mitigate many of the legal, regulatory and business risks that may arise as a result of operating under outdated governing documents and, more importantly, strengthen your financial institution’s corporate governance practices in a manner that better positions the board of directors and management to effectively oversee your financial institution and protect against unwanted shareholder activism.
The economy has recovered significantly since the financial crisis in 2008. The stock market continues to thrive. The unemployment rate is the lowest it’s been in almost two decades, and there’s more demand for housing than ever before. Consumer lending has substantially increased in the past year, and now that the U.S. has returned to more prosperous times, it only makes sense for community banks to open their doors again to welcome consumer lending—and make a sizeable profit while they are at it.
The Great Recession brought a more restrictive regulatory environment and calls from legislators for revision and change in the banking industry. Facing heightened regulatory concerns, many community bankers abandoned potential revenue from consumer lending in the face of mounting costs. For example, total costs for originating a $30,000 unsecured consumer loan in a bank branch could be over $3,000, making the overhead and costs unattractive to many bankers. With an improving economy and a need for higher yielding assets, community banks are looking for ways to lower these costs and make consumer lending profitable again.
The consumer lending landscape has changed drastically in the past decade. The space has gone through a digital transformation led by marketplace lenders focused on disrupting traditional brick and mortar banks. These marketplace lenders are not yet as highly regulated as banks, enabling their online lending platforms to thrive in the current economy with little to no legislation working against them.
Many community banks lack the internal expertise, infrastructure and resources to quickly build their own digital lending platforms. Those that do build their own platforms face the challenge of keeping the platform current and fully compliant while still delivering an exceptional experience that meets the needs of today’s digital banking customer. This creates significant costs in capital expenditures for the platform’s infrastructure, and lofty operating expenses for the institution to continue to competitively offer these products and maintain regulatory compliance.
Banks can dramatically decrease both the cost and time-to-market for a digital lending platform by partnering with technology providers. Implementing and launching a digital lending platform can take as little as six weeks by partnering with an outside provider, and these partnerships provide the necessary infrastructure banks are looking for without having to build and staff internally. In contrast to the high costs of originating loans in a traditional branch, the digital platforms provided through technology partnerships can lower total costs to originate that same $30,000 unsecured consumer loan down to roughly $750, making it significantly more profitable for the bank. The reduced costs and reduced risks in creating these platforms is resulting in an increase in technology partnerships.
Choosing a digital lending platform provider that understands the regulatory and compliance complexities facing the banking industry, and focuses on a higher standard of customer service, should be a top priority for community bankers in 2018. The boards and management teams of these institutions should seek partnerships with endorsed technology providers that demonstrate a keen eye for ever-evolving regulations, exceptional customer experiences and lucrative lending opportunities for the future.
Shareholder lawsuits are relatively common for the banking industry, but the reverse—a bank suing one of its shareholders—is fairly unique. On October 31, 2017, Nashville, Tennessee-based CapStar Financial Holdings, with $1.3 billion in assets, sued its second-largest shareholder, Gaylon Lawrence Jr. The bank alleges that the investor and his holding company, The Lawrence Group, violated the Change in Bank Control Act, which requires written notice and approval from the Federal Reserve before owning more than 10 percent of a financial institution, as well as a related Tennessee law. CapStar also maintains that Lawrence violated the Securities Exchange Act of 1934 by failing to disclose plans to acquire additional CapStar stock.
Passing the 10 percent ownership mark without the proper approvals is more common than one might think, according to Jonathan Hightower, a partner at the law firm Bryan Cave LLP. And often the violators of these rules are directors who are simply enthusiastic about their bank’s stock and want more of it. “They’re interested in the bank. They may know of shares that are available in the community and buy them up without realizing they’ve crossed the threshold where they need regulatory approval,” says Hightower.
How the Fed interprets these regulations and the steps required of shareholders is a specialized area, adds Hightower. “Given that, the Fed’s approach, assuming there’s not an intentional violation, is more permissive than might be expected.” The Fed is unlikely to levy penalties against a shareholder acting in good faith.
Lawrence filed a motion to dismiss the lawsuit on November 13, 2017, and maintains that he has complied where necessary and that, as an individual investor, the Tennessee code requiring a bank holding company to acquire control of the bank isn’t relevant.
What’s unique in the CapStar case is that it’s the bank taking action against the investor, rather than the regulator. In a letter dated November 20, 2017, CapStar asked the Fed to reject Mr. Lawrence’s stake in the bank and require that Lawrence divest “all illegally acquired CapStar shares,” in addition to a request for a cease-and-desist order and the levying of civil money penalties against Lawrence.
Requiring Lawrence to divest will likely harm what is, in CapStar’s own words, a “thinly traded” stock, according to Stephen Scouten, a managing director at Sandler O’Neill + Partners. Without Lawrence’s acquisitions of large amounts of stock, “the stock would be appreciably lower than it is today,” says Scouten. The stock price rose 6.95 percent year-over-year as of November 27, 2017, and 17 percent in the three months in which Lawrence has been accumulating a sizeable number of shares.
Filings by CapStar indicate that Lawrence attempted to acquire the bank in the summer of 2016. When that attempt was unsuccessful, CapStar alleges that Lawrence approached two of the bank’s largest stockholders to buy their combined 30 percent stake. That attempt also failed, and Lawrence began acquiring CapStar stock on the open market after the bank’s initial public offering last year. From August through October 2017, Lawrence rapidly increased his stake in CapStar from 6.2 to 10.2 percent, paying a total of $82.7 million for 4.6 million shares. CapStar alleges that Lawrence has “coveted control” of CapStar, and it’s easy to see how the bank arrived at that conclusion.
Lawrence is a long-term investor who appears to like what he sees in the Nashville market. He even recently purchased a home there. He’s certainly an experienced bank investor. He owns seven community banks, including two in the Nashville area: F&M Bank, with $1 billion in assets, and Tennessee Bank & Trust, formerly a division of $510 million asset Farmers Bank & Trust in Blytheville, Arkansas, which is also owned by Lawrence. “He’s got a lot of money to put to work, [and] he thinks banks are a good investment for his capital,” says Scouten. Right now, that looks to be as much as 15 percent of CapStar. Whether that turns into a full-fledged bid for the bank, as he sought in 2016, is anyone’s guess. Bank Director was unable to reach a representative of Gaylon Lawrence Jr., and CapStar CEO Claire Tucker declined to comment.
Bank boards frequently deal with active investors, and in most cases, Hightower recommends focusing on shareholder engagement and ensuring that large investors understand the broad strokes of the bank’s strategic plan. “More often than not, it’s people not understanding what they’ve invested in, and where it’s going,” he says.
A new front has developed in the ongoing battle between banks and credit unions. While relatively unheard of in prior years, credit unions have been aggressively pursuing bank acquisitions over the last three years, winning over sellers with large cash premiums and frustrating potential bank buyers that cannot bid competitively. Given the competitive advantage that credit unions have in the bidding process, this trend is expected to continue for the foreseeable future.
Since 2011 there have been 16 acquisitions of banks by credit unions nationally, including several transactions that are currently pending. Initially starting as a trickle, the pace has been picking up steam in recent years. There were a handful of deals between 2011 and 2014, three deals announced in 2015, four in 2016, and four in 2017—and the year is not over. Many industry experts believe that several additional transactions will be announced before year-end. Much of this activity has been in the Midwest and Southeast, which traditionally have been large markets for credit unions.
Credit unions are cash buyers and have two big advantages over banks during the bidding process. First, because they have no shareholders looking over their shoulders, credit unions can more aggressively price a transaction without fear of shareholder retribution. Second, credit unions can offer a far higher premium than bank suitors since credit unions are exempt from federal and most state taxes.
What does this mean? On one hand, banks that want to cash out are able to obtain a higher premium for the institution, which ultimately is good for shareholders. However, banks that want to grow through acquisition could miss out on attractive acquisition opportunities that only a few years ago would have been within their grasp. The tax advantage enjoyed by credit unions poses a significant hurdle for traditional bank bidders. Even banks sitting on the sidelines will be affected by this trend, as local competitors are acquired by credit unions.
If the banking industry determines that bank acquisitions by credit unions are, on balance, a net negative, one solution is to advocate for an “acquisition tax” to be paid by credit unions at the state and/or federal level at the time of acquisition. Such a tax could help level the playing field and protect taxpayers (at least in part) from the loss of tax revenue generated on income of the bank going forward.
Another strategy is for banks, either individually or together with other institutions, to explore the possibility of turning the tables and acquiring a credit union. Such a transaction would eliminate a credit union competitor and also give credit union members a one-time payment, compensating them for the loss of any perceived benefits that a credit union may have with regard to more favorable customer interest rates and fees. Challenges abound with this strategy, including finding a suitably motivated credit union, navigating a very complex structuring and regulatory approval process, and retaining the credit union’s members as customers.
Regardless of the industry response to this issue, selling banks need to understand and appreciate the complexity posed by a credit union acquisition. Since a credit union cannot acquire a bank charter, the transaction needs to be structured as a purchase and assumption transaction, in which assets and liabilities need to be individually transferred and assigned. This is a costly and burdensome process and requires, among other things, consents from vendors and service providers, the preparation of mortgage assignments and allonges, and the filing of deeds and other documents related to the transfer of real estate.
Since the transaction must be structured as a cash asset sale, the transaction is taxable to the bank and shareholders. Additionally, the selling bank and, if applicable, its bank holding company, has to go through a liquidation and dissolution process, which is further complicated if there is outstanding debt at either the bank or holding company level. All of these costs need to be considered in determining the adequacy of the final bid. Finally, in our experience, the regulatory approval process is much longer than a traditional bank acquisition.
Whatever your bank’s situation, it is important to understand that credit unions and their investment bankers are actively and aggressively searching for banks to acquire, adding a new and rapidly expanding dimension to credit union competition.
Private fund managers are showing an increasing penchant for firing their fund administrators. A new report by the alternative investments data and research firm Preqin shows that 21 percent of fund managers changed a service provider in 2016, and of those, 36 percent changed fund administrators.
While that figure is alarming in and of itself, the trend for fund administrators is unfortunately heading in the wrong direction, as this is a 29 percent increase from 2015. All indications are that this will continue in 2017, as the report shows that 72 percent of private fund managers review their fund administrators at least annually, with 30 percent doing so every single time they bring a new fund to market.
Have fund administrators lost their way, or are they being scapegoated by their own private fund manager clients? The study lists the primary drivers given by fund managers for this level of firing as:
Dissatisfaction with quality of service provided (27 percent)
Cost (23 percent)
Increased portfolio complexity (23 percent)
To cope with regulation (23 percent)
The inability to help clients deal with more complex portfolios and cope with regulation would both contribute to a dissatisfaction with the quality of service being provided. These factors are interconnected.
As such, I would argue that the overwhelming reason that fund administrators were fired in 2016 is because of the lack of service they are providing to their private fund manager clients.
Going one level deeper, I also feel that a lot of this discontent is driven by a lack of modernization. The alternative investment industry is overwhelmingly document-based and manual in nature. The wave of technology-driven automation and efficiency that has swept through other areas of financial services has only recently started to impact alternative investments.
A peek under the hood of how a private fund is managed and administered would reveal an industry seemingly stuck in the 1990s, with manpower typically being the biggest determinant of the speed and quality with which the industry operates.
Private fund managers are tiring of the difficulty they are experiencing with their fund administrators over critical and repetitive actions. Things like getting monthly financial packages completed, formalizing agreements and sharing validated information with stakeholders is too difficult in an age that values simplicity and convenience.
The other factor that is at play here is that fund managers themselves are under increasing pressure from their investors. Many fund administrators and private fund managers alike forget that the same person that is invested in a private equity fund has banking and brokerage accounts at a bank or credit union.
These people are used to being able to see and interact with their information digitally on a laptop or a mobile device, be able to take certain actions in a self-service manner, and access their information at any time. Customers are frustrated about dealing with a fund manager who only delivers performance metrics in a document via email. To make matters worse, the volume of documents increases the more investments that investor has.
So why does it seem like fund administrators are bearing the brunt of the industry’s lack of modernization? The fund administrator is the backbone of it all. They have not only become the conduit for interactions between the investor and the fund manager, but also that for interactions between the fund manager and the fund administrator themselves.
Private fund managers are increasingly looking for their fund administrators to provide them the tools to better manage their funds and service their investors. As evidenced by the Preqin study, private fund managers are showing an easy willingness to change to a fund administrator that they feel gives them what they need.
Fund administrators that are absorbing this message are starting to take the right steps to address the quality of service that they provide to their clients. They are taking actions like creating investor relations teams that can better handle communications with clients and investors. They are adopting technology that will automate manual processes between themselves and their clients, as well as make the needed transition to be able to present investment metrics in dynamic and interactive digital dashboards rather than in static documents.
These are the types of actions that fund administrators will need to take to ensure they are on the right side of the firing line.