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.

A Look Ahead to 2020: How Bank Directors Can Guard Against Risk

risk-12-11-15.pngAs banks look to the year 2020, we’ve identified five key risks that need to be actively assessed and monitored as the industry changes and adapts to consumer demands and competition. When it comes to data security and technology, regulatory risk, finding qualified personnel, profitability, and bank survival, bank directors need to ask:

  • How do we as an organization identify these risks on an ongoing basis?
  • How do they affect our organization?
  • How can we work with management to manage future risks?

Here’s a snapshot of the risk areas, what’s anticipated as we look to the future, and steps you can take to stay competitive and mitigate risk.

Data Security & Technology
It’s important to keep up with your peers and provide services as your clients demand them. More sophisticated payment platforms that make it easier to access and transfer funds will continue to gain popularity, particularly mobile platforms.

Being competitive requires innovation, which means software, bank integration, and sophisticated marketing and delivery. Third-party service providers may be the answer to help cut expenses and improve competition, but they also present their own unique risks.

With innovation comes opportunity: attacks on data security will increase, making the safeguarding of data a high priority for banks. While technology is an important element to this issue, the primary cause of breaches is human error. To this end, it’s essential for management to set the example from the top while promoting security awareness and training.

Regulatory Risk
Expectations from the Consumer Financial Protection Bureau regarding consumer protection will intensify. Anticipate some added expenditure to hire and retain technical experts to manage these expectations. Regulations are on the way for small business and minority lending reporting, as well as the structure of overdraft protection and deposit product add-ons, among others. Directors and management need to evaluate:

  • Compliance management infrastructure
  • Staffing needs and costs
  • Impact of proposed regulatory change to the bottom line

Qualified Personnel
For instance, baby boomers are retiring at a rate faster than Generation X can replenish, making it more difficult and costly to attract and retain skilled people. Meanwhile, the shrinking availability of skilled labor in this country is costing organizations throughout the United States billions of dollars a year in lost productivity, increased training and longer integration times.

A bank’s succession plan for its people should:

  • Identify key roles and technical abilities in your organization
  • Assess projected employee tenure
  • Develop a comprehensive employee replacement strategy
  • Prioritize training and apprentice programs

The bottom line at traditional banks will continue to be stressed as momentum builds for institutions to reduce product and service-related fees. Overhead expenses also will continue to increase as banks boost spending for IT infrastructure to support demands by customers for mobile technology and technical innovation and finding and retaining qualified personnel to manage complex regulatory requirements. Responses to these trends are already underway. Some institutions are:

  • Divesting of consumer-related products laden with heavy regulatory requirements
  • Sharpening strategic focus on holistic customer relationships with professional and small business customers to increase relationship-driven revenue
  • Exploring new or more complex commercial lending products and partnerships designed to increase interest income to attract customers in new markets

Banks will need to closely monitor the impact of regulatory initiatives on future earnings from fees and alternative revenue sources.

Bank Survival
Here are some proactive steps to consider as your bank prepares for 2020:

  • Develop an ongoing strategy for mergers and acquisitions to expand capital
  • Consider charter conversions to lend flexibility in expanded product and service offerings or a change in regulatory expectations or intensity
  • Evaluate the impact of higher regulatory expectations

To help identify and manage risk, management should plan regular discussions in the form of annual strategic planning meetings, regular board meeting agendas, and targeted meetings for specific events. The focus should extend beyond known institutional risks, such as credit, interest rate and operational, but should also look at key strategic risks.

If your institution can innovate with the times to stay ahead of risk and competition with a systematic approach, then the path to 2020 will be less fraught with difficulties.

Year in Review: Big Profits, but Big Regulatory Fines, Too

1-9-15-Naomi.pngThe banking industry has never seen it so good. Or has it? Bank earnings have returned to record levels, and average return on equity (ROE) is about what is has been historically. At the same time, regulatory fines are huge and banks are contending with increased regulation like never before. Digitization is providing new opportunities for some banks to cut costs and please customers, and yet the surge in technology startup companies poses special challenges for banks. Because of this, management consulting firm McKinsey & Co. concludes in its 2014 annual review that “those banks that have articulated and executed a regulation-savvy, customer-centric strategy are collecting all the surplus value in the industry.”

Improved Profitability
One of the most impressive trends has been the industry’s return to profitability following the financial crisis six years ago. In 2013, U.S. banks above $10 billion in assets made $114 billion in profits, second only to the record year that was 2007, according to McKinsey.Year-end earnings for the largest banks will be released in the next few weeks, but 2014 is shaping up to top $100 billion in earnings again, says Fritz Nauck, senior partner at McKinsey. Improved credit quality and cost cutting were major drivers of the increased profits. Where is this cost cutting coming from? Many banks are cutting branches. Since 2011, U.S. banks have downsized the industry’s branch network by nearly 5 percent. In 2013 alone, that amounted to 1,300 branches, according to McKinsey.“Should that continue, that will drive future earnings and ROE,’’ Nauck says.

Banks now are close to an historical average ROE of 10 percent, calculated since 1980.

U.S. and Canadian banks are doing better than their European counterparts. The ROE for U.S. and Canadian banks went from 8.4 percent in 2012 to 9.3 percent in 2013 and 9.9 percent in the first half of 2014. For comparison’s sake, Western European banks had an ROE in 2013 of only 2 percent. Credit quality is better in the U.S. than in Europe, plus banks trimmed operating expenses and added capital earlier in the financial crisis than European banks, Nauck says.

Increased Regulation
Fines and settlements, however, have put a damper on the banking world’s profitability, both in Europe and North America, with many of those settlements relating to the financial crisis. The top 15 European banks and top 25 U.S. banks paid $60 billion in fines and settlements combined in the first half of 2014, according to McKinsey. From 2010 to 2014, those banks have paid about $165 billion in fines and settlements, and some of that involves regulators stepping up enforcement in areas not relating to the crisis, including money laundering rules, McKinsey says. Without those fines, the banking industry would have been significantly more profitable. In addition, increased regulation is taking more staff time and more hours out of the executive management team. McKinsey estimates that senior executives spend about 20 to 25 percent of their time on regulatory matters.

Driven to Digitization
The trend toward digitization—connecting with customers through apps and websites as well as automation of transactions and personalization of products and services—is transforming banking. McKinsey estimates that there are now more than 12,000 financial technology startups in existence. Fintech companies such as PayPal were first interested in transactions but many of them are now moving into new areas, including lending.

Interestingly, McKinsey sees fintech companies as more of an opportunity than a threat, because banks can set up joint ventures and sometimes acquire them to deepen and broaden their offerings for customers, just like Spanish bank BBVA did when it acquired the innovative online banking startup Simple in 2014.

Banks that have well defined strategies and execute them effectively are outperforming others, McKinsey says. But as the past year has made clear, banks must respond well to enhanced regulation and have a digital strategy in place to be successful.

Selling Your Bank? How to Manage the Regulatory Headaches

11-19-14-ArnoldPorter.jpgIn considering a merger or sale transaction, the board of directors of a bank or bank holding company must consider a variety of factors in order to fulfill its fiduciary duties, but lately, the potential for regulatory hang-ups has to be part of that mix. Over the years, price has traditionally been the primary factor in a board’s consideration of a deal, however, most state corporate laws contain statutory provisions that allow a board to take into account a variety of other factors when evaluating a sale transaction, including impact on consumers, employees and local communities. Boards are also well advised to take into account the ability of the buyer to complete a transaction in a timely fashion, including whether the buyer may face any regulatory delays. In recent years, a number of transactions have experienced significant regulatory delays, and, in a few instances, transactions have been terminated due to buyer regulatory issues. This phenomenon has raised the stakes for boards that have not properly evaluated the regulatory risks of a transaction.

Identify Existing or Potential Regulatory Issues
For the seller, a protracted regulatory approval process can make it extremely difficult to continue business in the ordinary course and can damage employee relationships and morale.  Moreover, a failed transaction can result in a decrease in the value of the seller’s stock and damage to its ongoing business and reputation.

The seller’s board needs to be aware of any existing or potential regulatory issues facing the acquiring institution. While a few years ago regulatory scrutiny was generally limited to financial stability, capital and liquidity levels and Community Reinvestment Act compliance, today there is an increasing focus on the scope and depth of the acquiring bank’s compliance risk management. Material deficiencies identified in any area of regulatory compliance can derail an M&A transaction. Therefore, before approving a transaction, it is important that the board ensure that management has conducted adequate due diligence on the buyer, focusing on a number of key regulatory areas, including:

  • supervisory history of the buyer and the status and effectiveness of any corrective actions that remain outstanding; 
  • buyer’s record of compliance and the adequacy of its programs, policies and procedures, including “hot button” issues such as Bank Secrecy Act/anti-money laundering laws and fair lending;
  • capital levels and stress test results;
  • potential asset quality issues;
  • buyer’s Community Reinvestment Act record and history of consumer activism; and
  • for larger institutions, the absence of systemic risk resulting from the proposed transaction.

The seller must also be aware of its own problems and not rely on the historical rule of thumb that a strong buyer can assuage regulatory concerns about the seller. Sell-side due diligence enables the seller to proactively identify potential issues and resolve them before they escalate, thereby minimizing uncertainty in the sale process. Buyers will be focused on these issues in the diligence phase as well, with significant regulatory issues being factored into pricing and potentially narrowing the field of potential buyers.

Scrutinize Transaction Documents
The seller’s board should review the key terms of the transaction to ensure that the seller has the flexibility to address regulatory deficiencies that are identified in advance of signing the agreement as well as during the pendency of the transaction. Provisions that limit or restrict the seller’s ability to adequately address these issues can be damaging to the institution, particularly if the transaction cannot be completed. These restrictive provisions could include overly broad negative covenants that require the seller to seek the buyer’s approval before taking an action. The board must also be familiar with any termination and no-shop provisions as they may be overly restrictive if a buyer’s regulatory compliance issues delay a transaction. Any provisions that serve to restrict the flexibility of the seller when the transaction may be in regulatory jeopardy could be viewed as inconsistent with the selling board’s fiduciary obligations.

Engage Independent Counsel
It is axiomatic that when negotiating a merger transaction, the seller should engage its own counsel and not share legal counsel with the buyer.  However, a recent trend has emerged with a seller and buyer jointly engaging counsel for the regulatory application process. While sharing regulatory counsel may decrease a portion of the transaction costs, sharing counsel can create risk of conflicts when the buyer is faced with regulatory delay due to compliance issues.  If the regulatory delay causes a drop-dead date to approach, a seller is well advised to rely on independent counsel for advice on the status of the relevant regulatory issues and on the considerations involved in deciding whether to terminate or extend the transaction.