Good Corporate Governance Starts With the Articles and Bylaws


governance-11-14-16.pngJust as a good diet and regular exercise contribute to a healthy lifestyle, good corporate governance and board oversight often serve as the foundation for the health and stability of any corporate organization. Corporate governance is often a difficult concept to nail down. In the highly regulated banking industry, the importance of good corporate governance practices is significantly amplified due to the additional layer of regulatory risk that may not affect businesses in other industries.

Although good corporate governance is often associated with maintaining certain policies and procedures, such as guidelines, codes of conduct, committee charters, shareholder agreements and intercompany and tax sharing agreements, we routinely encounter financial institutions that ignore or overlook one of the most fundamental aspects of corporate governance: the articles of incorporation and bylaws. In fact, we experience many situations in which financial institutions have articles and bylaws that are significantly outdated and have not been revised to comply with current laws, regulations and other corporate best practices. Failure to keep these governing documents current can not only raises legal and regulatory concerns, but oftentimes compromises the ability of the management team to protect and preserve the interests of its shareholders.

A comprehensive review of the articles and bylaws is recommended, particularly if you have not conducted such a review in the past. Set forth below is a summary of certain terms and provisions that may be of particular interest to your management and board of directors.

Compliance With State Corporate Laws
State corporate laws provide the basic foundation for the conduct of business of most banks and bank holding companies. Over time, these state corporate laws are revised or replaced with more modern corporate statutes. Although the corporate laws may evolve over time, many financial institutions fail to adapt their articles and bylaws to conform to these changes. In many cases, we encounter articles and bylaws that reference outdated and repealed laws and statutes that could lead to questionable legal interpretations and uncertainty in many critical situations.

Limitation of Personal Liability and Indemnification of Directors and Officers
Most state corporate laws have provisions that permit a corporation to limit the personal liability of, and/or provide indemnification to, directors and officers pursuant to provisions in its articles or bylaws. Typically, the ability to limit liability and provide indemnification to directors and officers is eliminated in certain situations such as a breach of fiduciary duty or intentional misconduct. However, we routinely experience situations in which the limitation of liability and indemnification are either not addressed by the articles or bylaws or contain provisions that may not fully protect the interests of the management team.

Electronic Communications
As technology continues to evolve, many state corporate statutes have been revised to permit certain shareholder and director communications, such as notices of shareholder and director meetings, to be delivered in electronic format. Despite these statutory revisions, if your institution’s articles and bylaws require physical delivery of these notices, you might not be able to take advantage of these newer and less costly forms of communication.

Uncertificated Shares
As financial institutions continue to consolidate and increase their shareholder base, the use of third-party transfer agents is becoming more prevalent for the management of stock transfer records. Most transfer agents have implemented uncertificated book-entry systems as a means of recording stock ownership, which eliminates the need for physical stock certificates. However, it is not uncommon for the articles and bylaws to specifically require the issuance of physical stock certificates to their shareholders. Obviously, these provisions must be revised before implementing an uncertificated stock program.

In addition to the specific matters addressed above, some other important areas to consider when reviewing your articles and bylaws include the shareholders’ ability to call special meetings, the process for including shareholder proposals at annual or special meetings, the implementation of a classified board of directors, the process for the removal of directors, mandatory retirement age for directors, shareholder vote by written consent and a supermajority vote standard for certain article and bylaw amendments, such as limitation of liability and indemnification.

A review of your institution’s articles and bylaws is only one component of the broader corporate governance umbrella, but it is one of the more important and fundamental aspects of your board’s corporate governance responsibilities. Routine maintenance of these fundamental corporate documents will be a good start towards enhancing your institution’s overall corporate governance structure.

Six Tips for Negotiating a Successful M&A Transaction


merger-transaction-11-11-16.pngWhat aspect of a deal is critical to the success of an acquisition? While many in the banking industry may point to features like pricing and culture, which are certainly important, the devil is in the details. How do you protect your institution if the other party walks away from the deal? Will you have the personnel in place to ensure a successful transition? These six areas indicate where boards and management teams of buyers and sellers will want to focus their initial attention.

1. A detailed letter of intent really helps.
Putting the time in on the front-end to negotiate a detailed letter of intent (LOI) is in the best interest of buyers and sellers. The LOI is a preliminary document, and it is best to resolve any important issues at this stage. If a seller insists on a term that a buyer cannot accept, it is far better to know that before time is wasted and significant expenses are incurred while negotiating a definitive agreement. If the only substantive term in an LOI is the purchase price, then all of the other issues must be resolved among lawyers negotiating the definitive agreement.

2. Do not overlook the importance of due diligence.
The representations made in a definitive agreement supplement—but do not replace—each party’s due diligence investigation. Some important facts about a seller will fall outside the scope of the representations made in the definitive agreement. For example, the seller will disclose any actual and potential litigation against itself, but is not required to reveal litigation against its customers. If the seller’s biggest customer is facing a sizable judgment that could negatively affect its ability to repay its loans, a buyer will have to conduct detailed due diligence to uncover this fact. Further, due diligence is not just for buyers. The seller needs to critically examine the buyer if shareholders are taking the buyer’s stock in the transaction.

3. Be thoughtful about drop dead dates.
A drop dead date is the date on which a deal must close before either party can terminate the definitive agreement without incurring a penalty. Calculating the correct drop dead date is more art than science when balancing the number of actions that must be taken pre-closing—especially regulatory and shareholder approval—with the parties’ desire to get the deal closed as soon as possible. At the same time, an agreement with a short time period between signing and the drop dead date encourages the parties to take the necessary pre-closing actions expeditiously. Striking the proper balance between these two competing factors is key. In the event of a contested application, the time required to receive regulatory approval will be at least twice as long as expected.

4. Be prepared to negotiate termination and related fees.
Termination fees, which are paid by a seller to the buyer if the seller accepts an unsolicited superior proposal from a third party, are common, but the amount of the fee, and the triggers for paying it, are frequently negotiated. Expense reimbursement provisions payable to the nonterminating party are perhaps equally common, in terms of prevalence and contention of the amount. Far less common are termination fees to be paid by the buyer to the seller if the buyer terminates the transaction. These reverse termination fees are generally resisted but can be appropriate in certain circumstances, such as situations where the buyer must obtain shareholder approval for the transaction.

5. Consider the treatment of critical employees.
Buying a bank is obviously more than buying loans and deposits. Integrating the seller’s employees is critical to a successful transaction. Buyers should consider establishing a retention bonus pool to ensure that critical employees remain with the combined enterprise after the transaction (and at least through conversion). A critical employee may not be obvious—frequently they are the unsung backroom employees who keep things running smoothly—and doing right by them will help ensure a successful integration.

6. Be aware of board dynamics.
It’s relatively common for the CEO and CFO to negotiate the sale of their bank and for the deal to include a meaningful pay package for the two of them. The deal is presented to the board and, right or wrong, the board is highly skeptical of the agreement that the executives cut. In this instance, the board’s advisers can help the directors clearly assess the merits of the transaction without the distraction of potentially questionable motivations.  

Are Your Owners Violating the Change in Bank Control Act?


Change-in-Control-10-18-16.pngMore people probably violate the Change in Bank Control Act (CBCA) than any other banking statute, as it is complicated and easy to do. But knowing the law and helping your shareholders keep up with their ownership filings is important. The law requires regulatory approvals before a person or group of persons “acting in concert” may take actions to directly or indirectly “control” a bank or savings association. Consequently, the CBCA impacts both bank and thrift holding companies and, with minor variations, all of the federal regulators have implementing regulations for the CBCA. Although the focus of this article is the Federal Reserve Board regulations regarding changes in control of bank holding companies, it is fair to say that given the intricacy of control determinations, the CBCA is likely one of the most inadvertently violated banking statutes currently on the books. The inadvertent CBCA violations often occur because of the presumption that certain groups are “acting in concert,” and the application of the CBCA requirements to these groups.

The CBCA requires that any person or groups of persons “acting in concert” must file change in bank control notices with the applicable federal regulator if the individual or group reaches an ownership level of 25 percent or more of any class of voting securities of an institution. The definition of “person” under the CBCA is very broad and includes individuals, corporations, partnerships, trusts, associations and other forms of business entities. Acting in concert is defined as knowing participation in a joint activity or parallel action towards a common goal of acquiring control of a bank or bank holding company, whether or not pursuant to an express agreement.

There is a rebuttable presumption that an acquisition of voting securities of a bank holding company is the acquisition of control under the CBCA, requiring a notice filing, if, immediately after the transaction, the acquiring person or persons acting in concert will control 10 percent or more of any class of voting securities of the institution, and if the institution has registered securities under the Securities Exchange Act of 1934 or if no other person will own, control, or hold the power to vote a greater percentage of that class of voting securities immediately after the transaction.

In determining whether persons are engaging in concerted action, there is a rebuttable presumption that the following groups are acting in concert:

  • A company and any controlling shareholder, partner, trustee, or management official of the company, if both the company and the person own voting securities of the institution;
  • An individual and the individual’s immediate family, which includes a person’s father, mother, stepfather, stepmother, brother, sister, stepbrother, stepsister, son, daughter, stepson, stepdaughter, grandparent, grandson, granddaughter, father-in-law, mother-in-law, brother-in-law, sister-in-law, son-in-law, daughter-in-law, the spouse of any of the foregoing, and the person’s spouse;
  • Companies under common control;
  • Persons that are parties to any agreement, contract, understanding, relationship, or other arrangement, whether written or otherwise, regarding the acquisition, voting, or transfer of control of voting securities of an institution, other than through certain types of a revocable proxy;
  • Persons that have made, or propose to make, a joint filing under certain sections of the Securities Exchange Act of 1934; and
  • A person and any trust for which the person serves as trustee.

With respect to inadvertent CBCA violations, the most likely “acting in concert” scenario is the consolidation of voting securities held by an individual and the individual’s “immediate family” members. To the extent a family group owns at least 10 percent of a bank holding company, a new notice filing may be required any time the family group or ownership mix changes. Violations of the CBCA are inadvertently committed literally all the time by family groups as ownership is realigned at death, through estate planning or gifting, as minors age into formal ownership stakes and by birth or marriage.

Although the burden of obtaining regulatory approval is on the person or group of persons acquiring control, not the institution, the issue has recently been arising with great frequency when bank holding companies seek to acquire other institutions. As part of the review process, the Federal Reserve has requested current shareholder lists to compare them to prior control determinations made by the Federal Reserve. If a review of the shareholder list indicates changes, even intra-family changes, in the control group, the Federal Reserve may require that a new notice be filed.

Although at least in the family context, CBCA issues are generally easily resolved by filing an after-the-fact corrective notice, reviewing your bank holding company shareholder lists for technical changes in family group ownership may prevent a holdup down the line as you seek approval for future expansion.

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.

Four Ideas to Engage Millennials as Bank Customers and Investors


millennials-5-11-16.pngIn my work advising community banks on capital and liquidity issues, one of the more common concerns I encounter is how to deal with a changing shareholder base. As existing shareholders age or pass away, they are bequeathing their stock to children and grandchildren, many of whom have no connection to the bank or no longer live in the same community.

Engaging and retaining these younger shareholders has become a challenge—they might sell the shares at a discounted price or fail to support the bank or subsequent capital raises. After all, as all community banks know: A bank’s best shareholders are its customers. Fortunately, there are a number of things community banks can do now to foster better relationships with the younger generation, including millennials.

1. Embrace the Crowd

The recent adoption of Regulation A+, a provision under the Jumpstart Our Business Startups (JOBS) Act, allows small companies to raise up to $50 million in crowdfunded offerings from non-accredited investors in any 12-month period. Millennials are natural crowdfunding investors. In fact, millennials’ craving for connection and desire to give back to their communities makes them more likely to participate in crowdfunding than more traditional capital raises.

That’s a benefit to community banks that are looking to raise capital under Reg A+. Already, several community banks have filed Reg A+ offerings to either issue shares in connection with a merger/acquisition or to redeem preferred stock issued from the Small Business Lending Fund, or SBLF, program. We’ll be keeping an eye on these offerings to see how they progress.

2. Get Tech Savvy

While most bank directors will remember a time before the Internet and mobile phones, today’s youth were weaned on smartphones. Millennials have seen technology transform and disrupt almost every aspect of their lives, from how they communicate, to how they consume entertainment, to how they bank.

In fact, according to a Viacom Media Networks’ survey, The Millennial Disruption Index, 68 percent of millennials believe that in five years, the way we access money will be totally different. Seventy percent believe that the way we pay for things will be completely different and 33 percent believe they won’t need a bank at all. Eek!

For community banks, that means investing in technology is critical. Online and mobile banking services are no longer optional, they are essential. Also, young and old alike are relying on web sites and electronic delivery of company reports and financial information so they can make investment decisions. To meet that demand, banks on our OTCQX market are providing news, quarterly and annual financial reports, which can be easily accessed via Yahoo! Finance and other financial portals.

Banks that don’t invest in their web presence to ensure their news travels risk being overlooked by millennials researching them online.

3. Invest in Education

Millennials grew up during the recession and are more frugal than the generation before. At the same time, they are more skeptical of traditional authority figures when it comes to managing their finances. All this has a resulted in a certain anxiety around finances. A recent study by Bank of America Corp. and USA Today found 41 percent of millennials are “chronically stressed” about money. Only one-third (34 percent) of millennials feel content about their finances, while many are anxious (2 percent) and overwhelmed (22 percent).

For community banks, that presents a tremendous opportunity for education. Chicago-area Liberty Bank for Savings has held free workshops on reducing student debt, even bringing in a debt specialist. Virginia Beach, Virginia’s Bank @tlantic holds regular “lunch and learn” sessions with guest speakers on everything from first-time home buying to cybersecurity for small businesses.

4. Think Outside the Box

Heads buried in their smartphones and tablets, millennials have gained a reputation that they care only about themselves. But that’s just not true. In truth, millennials care deeply about their local communities and the world around them. They want to know that what they do makes a difference. That presents a significant opportunity for community banks which are already deeply embedded in the communities they serve.

But it also means thinking about your community involvement differently. Instead of simply donating to local organizations, organize events where millennials can get involved. Liberty Bank for Savings partnered with a local news site to sponsor a Saturday night “taco crawl” to five local taco restaurants. Other banks have had success inviting their millennial customers to exclusive events they might not otherwise be able to attend like high-profile fashion shows and sporting events.

Think outside the box and you’ll find other ways to engage today’s youth as customers and shareholders.

Four Reasons Why Waiting to Sell May Be a Bad Idea


bank-strategy-2-5-16.pngMost community banks have a timeframe for liquidity in mind. Strategic plans for these institutions are often developed with this timeframe as a key consideration, driven by the timing of when the leader of the bank is ready to retire.

We meet with a lot of bank CEOs, and we regularly hear some version of the following: “I’m in my early 60s and will retire by 70, so I’m looking to buy not sell.” When we ask these CEOs to describe their ideal acquisition target, the answer often involves size, market served, operating characteristics and, most importantly, talent. After all, banking is a relationship business and great bankers are needed to build those relationships with customers. Buyers will undoubtedly pay a higher premium for a bank with great talent that still has “fire in the belly.” It is hard to recall a time when a buyer was looking for a tired management team ready to retire. So, it seems ironic that a buyer cites talent as the key component to a desirable acquisition candidate, but that same buyer is planning to wait until retirement to sell. Put differently, they’re planning to sell at the point their bank will become less desirable.

We have highlighted four key items for boards and management teams to consider when evaluating the timing of a liquidity event as part of the strategic planning process: the timing of management succession, likely buyers or merger partners, shareholders and the overall economy and market for community banks.

Management Succession
Timing of management succession is critical to maximize price for shareholders. As referenced above, if the leadership of an organization would like to retire within the next five years, and there isn’t a logical successor as part of senior management, the board should begin evaluating its options. Waiting until the CEO wants to retire may not be the best way to maximize shareholder value.

Likely Buyers/Merger Partners
The banking industry is consolidating, which means fewer sellers and buyers will exist in the future. While there may be a dozen or more banks that would be interested in a good community bank, once price is considered, there may only be one or two banks that are both willing and able to pay the seller’s desired price. These buyers are often looking at multiple targets. Will a buyer be ready to act at the exact time your management is ready to sell? In fact, there are a number of logical reasons that your best buyer may disappear in the future. For example, they could be tied up with other deals or they may have outgrown the target so it no longer “moves the needle” in terms of economic benefit.

Shareholder Pressure
Shareholders of most banks require liquidity at some point. While the timing of liquidity can range from years to decades, it is worthwhile for a bank to understand its shareholders’ liquidity expectations. And liquidity can be provided in many ways, including from other investors, buybacks, listing on a public exchange, or a sale of the whole organization. As time stretches on, pressure for a liquidity event begins to mount on management and, in some cases, a passive investor will become an activist.

Overall Economy and Markets
With the Great Recession fresh in mind, virtually every bank investor is aware the market for bank stocks can go up or down. Before the Great Recession, managers who were typically in their mid-50s to early 60s  raised capital with a strategic plan to provide liquidity through a sale in approximately 10 years, which would correspond with management’s planned retirement age. We visited with a number of bankers in their early 60s from 2005 to 2007 and indicated that the markets and bank valuations were robust and it was an opportune time to pursue a sale. Many of these bankers decided to wait, as they were not quite ready to retire. We all know what happened in the years to follow, and many found themselves working several years beyond their desired retirement age once the market fell out from under them.

Over the past two years, we had very similar conversations with a lot of bankers and once again we see some who are holding out. While bankers and their boards generally can control the timing of when they would like to pursue a deal, the timing of their best buyer(s), the overall market and shareholder concerns are beyond their control. Thorough strategic planning takes all of these issues into account and will produce the best results for all stakeholders.

Five Key Steps to Integration Success


When it comes to the completion of a merger or acquisition, whether you view the glass as half full or half empty will likely depend on your planned approach to integration. After all, there’s no shortage of statistics on the failure rate of mergers and acquisitions due to post-deal integration issues. And it’s easy to see why. The challenge of integrating the people, processes and technology of two organizations into one is a daunting exercise whose success depends on a variety of factors, many of which can be subtle, yet complex.

Still, such challenges are not deterring bankers from the pursuit. Through November of 2015, there were 306 M&A banking deals. With the December numbers not yet available, we would expect the total for 2015 to be about the same as the total for 2014. And, according to recent KPMG community banking survey, nearly two-thirds of the 100 bank executives surveyed anticipate being involved in a merger or acquisition as either buyer or seller during the next year. Moreover, one out of three of those community bank executives foresee integrating information technology systems as the most difficult integration challenge, followed closely by talent management.

While such challenges are undeniable, directors must play a key role in helping management achieve positive results. These five key steps can help directors guide management in driving a successful integration.

Step 1: Set the Tone at the Top
Prior to signing the deal, establish a set of goals that cascade a vision of the deal into high-level, practical operating objectives for the combined organization. Directors should review and provide input in these operating objectives to ensure they align with the bank’s overall strategy, risk appetite and the strategic rationale for the deal. With a strong set of operating objectives in place, executives can develop guiding principles which clearly define the key fundamentals that stakeholders should follow as they begin the planning phase of the integration.

Step 2: Assess the Integration Plan and Roadmap
An integration plan and roadmap needs to be established early in the deal lifecycle. Anchor the plan with a well-understood methodology and a clear, high-level and continuously monitored timeline that identifies key activities and milestones throughout the course of the integration. Develop an integration playbook that details the governance structure, scope of the work streams and activities in addition to well defined roles and responsibilities. Directors must fully understand the integration plan so they can provide valuable feedback, effectively challenge timelines, and have the requisite knowledge to determine if there is a prudent methodology for each phase of the integration. Key disclosures about the transaction should be reviewed to ensure communications to regulators and shareholders set realistic expectations for closing the deal, converting customers, and capturing synergies.

Step 3: Effectively Challenge and Monitor Synergy Targets
Operating cost and revenue efficiencies are identified as part of the deal model, factored into the valuation, and play a critical role in determining the potential success of a merger. Executive management should establish synergy targets at the line-of-business level to promote accountability. Directors should foster effective challenge of expected synergies and provide oversight of the process for establishing the baseline and tracking performance against targets over the course of the integration.

Step 4: Promote Senior Leadership Involvement and Strong Governance Oversight
The program structure and governance oversight is established during the initial planning phase to control the integration program and drive effective decision making. Executive management should identify an “integration leadership team’’ with sufficient decision-making authority and a combination of merger and operating experience to effectively identify risks, resolve issues and integrate the business. Directors should examine the team’s experience, track progress against goals, and closely monitor key risks to assess management’s ability to execute the integration activities.

Step 5: Evaluate Customer and Employee Impacts and Communication Plans
The objective of customer and employee experience programs is to take a proactive approach to help ensure that significant impacts are identified, analyzed and managed with the goal of minimizing attrition. Integrated and effective communication plans are established to address concerns of customer and employee groups to reduce uncertainty, rumors and resistance to change. Directors should scrutinize customer and employee impacts in an attempt to ensure management has an effective mitigation plan for negative impacts through communication, training and target operating model design. Planning for employee retention should include the identification of critical talent to mitigate risks to the integration while ensuring business continuity.

By taking these five steps, directors can provide management with the guidance and support needed for a successful integration.

Policing Your S Corporation Status: Six Simple Steps


s-corporation-12-30-15.pngS corporations have an obligation to police their shareholder base to see that all shareholders remain eligible. A common problem S corporations face is making sure that after the subchapter S election is made, it stays effective. When a bank is gearing up to make its S election, attorneys and accountants are typically reviewing shareholder documentation to confirm eligibility. But, after the S election is effective, most banks do not regularly review their shareholders’ list to confirm eligibility. Actions beyond the bankers’ control, such as the death or divorce of a shareholder, can result in an inadvertent termination of the S election. The tax consequences for the company and its shareholders can be disastrous.

Here is a common scenario.  A bank has a shareholder who passes away. The executor, who is much more concerned with administering the estate than protecting the bank’s S election, either transfers the bank shares to an ineligible shareholder, such as a corporation, or does nothing and leaves the shares in the estate. While an estate is an eligible shareholder, an estate does terminate for tax purposes at some point, so as a general rule, shares cannot be held in an estate indefinitely. The executor fails to notify the bank that the shareholder has passed away for several years. Dividend checks continue to be cashed in the name of the deceased shareholder. All the while, the bank is not aware of what has happened

Then, sometimes years later, something raises the issue. For example, the executor may finally contact the bank to effect the transfer of the shares, or a new review of the bank’s shareholder list may raise questions about why an estate is still a shareholder. Only then does the bank realize that the shareholder’s will transferred the shares to a corporation or that the shares have been sitting in the estate for many years. As a result, the S election has been compromised.

The good news is that the IRS has a program in place for S corporations to request relief for inadvertent terminations. However, consent of 100 percent of the S corporation shareholders is required, along with a filing to the IRS and a substantial filing fee.

It can be time consuming to obtain the requested relief from the IRS, but going through the process is essential if there has been an inadvertent termination. However, through the suggestions below, bankers may be able to avoid the inadvertent termination in the first place, which is obviously preferable:

  1. Review shareholders’ list: The bank should conduct a detailed review of the list of shareholders at least annually to confirm all shareholders are eligible. In addition, every two years, the bank’s accountants or attorneys should conduct a detailed review of the list.
  2. Review the shareholders’ agreement: Most S corporations have a shareholders’ agreement in place to protect the S election. If the shareholders’ agreement was drafted several years ago, an attorney should review it to confirm that the agreement is up to date with current law. In addition, the agreement should contain protections in the event the S election is inadvertently terminated, such as shareholder indemnification of the expenses incurred in connection with obtaining relief for the inadvertent termination and a covenant by the shareholders to take all steps necessary to remedy the inadvertent termination. There are other provisions that are useful as well.
  3. Shareholder communication: On an annual basis, banks should send a certification to each shareholder to confirm the shareholder still qualifies as an eligible shareholder. This annual certification requirement can be built into the shareholders’ agreement or something that the bank just sends out on its own each year.
  4. Remind shareholders of estate planning issues: Either in conjunction with the annual certification or separately, remind shareholders about the consequences upon the shareholder’s death. For example, a shareholder should talk with the attorney who drafted his or her will to confirm that the shares pass to an eligible shareholder.
  5. Train the bank’s corporate secretary: The corporate secretary should be mindful of S corporation qualifications and eligibility issues as well as common issues that could impact the S election. The corporate secretary can possibly help avoid an inadvertent termination by being proactive and asking the right questions.
  6. Road map memos: Banks should consider requiring shareholders, for example, as part of the shareholders’ agreement, to have their estate planning attorneys provide the bankers with a letter or memorandum detailing what happens to the shares upon the death of a shareholder, especially if the shares are already held in a trust.

By taking the steps above, a potential inadvertent termination of a bank’s subchapter S election can be avoided. An ounce of prevention is worth a pound of cure.

A New Delaware M&A Case Is a Warning to Investment Bankers: Take Care That You Don’t Mislead the Board


investment-bankers-12-21-15.pngMerger and acquisition activity appears to be accelerating among community banks large and small. Despite the nearly ubiquitous shareholder lawsuit that follows a merger announcement from a publicly traded target company, the corporate law relating to the obligations of a board of directors in a merger transaction is well developed and favorable. There is a high bar for board culpability in an M&A transaction, and an even higher bar for board liability. However, recent Delaware court cases have highlighted potential liability for investment bankers that is not shared by directors. This is quite an alarming development, which is of obvious concern to investment bankers, but also should impact boards of directors as they consider deals.

Under Delaware law, which is followed by most states, the primary obligations of the board in a merger transaction relate to good faith, a component of the duty of loyalty, and making an informed decision, duty of care. Fortunately, most companies have a charter provision eliminating director personal liability for monetary damages for breaches of the duty of care, which is not allowed for breaches of the duty of loyalty. And, according to the Delaware Supreme Court in the Lyondell case, director personal liability for “bad faith” requires a knowing violation of fiduciary duties. For example, in a sale transaction, shareholders aren’t supposed to act on a goal other than maximizing value, or in a non-sale merger, act for reasons unrelated to the best interests of the stockholders generally.

Another important hallmark of Delaware M&A case law is the extreme reluctance of judges to enjoin a stockholder vote on a merger transaction when there is no competing offer. And once a transaction closes, and the challenged target company directors were independent and disinterested, and did not act with the intent to violate their duties, judges typically dismiss the lawsuits against directors.

However, in a recent case, which involved the sale of a company called Rural/Metro Corporation, the Delaware Supreme Court ruled that third parties, such as investment bankers, can be liable for damages if their actions caused a board to breach its duty of care, even if directors are not liable for the breach. Moreover, simple negligence by the board, rather than gross negligence, can serve as the basis for third party liability.

In Rural/Metro, the investment bankers were found to have had numerous conflicts of interest, most of which were not discussed with the board. They sought to participate in the buyer’s financing of the acquisition and they sought to leverage their involvement with the seller, Rural/Metro, to obtain a financing role in another merger transaction. They were also found to have manipulated the fairness analysis to serve their conflicted interest in having a particular party win the bid for Rural/Metro. The court held the behavior of the investment bankers caused the board to be uninformed as to the value of the company and caused misleading disclosure. They were held liable to stockholders for $76 million in damages.

The Delaware Supreme Court stated that a board needs to be active and reasonably informed in its oversight of a sale process and must identify and respond to actual or potential conflicts of interest as to its advisers. Importantly, the Delaware Supreme Court rejected the lower court’s characterization of the role and obligations of an investment banker as a quasi fiduciary “gate keeper,” and stated that the obligations of an investment banker are primarily contractual in nature. It further held that liability of an investment banker will not be based on its failure to take steps to prevent a director breach but on its intentional actions causing a breach.

The case is a warning for both boards and investment bankers: Take care when there is a conflict of interest. Investment bankers should avoid conflicts where possible, disclose all conflicts to the board and the board and the investment bankers need to work diligently to address conflicts adequately. In order to do their job well, board members must make sure their advisors are telling them what they need to know.

Assessing Your Say-on-Pay Vote


As banks prepare for their annual shareholder meetings, most will have a say-on-pay vote where shareholders indicate whether they support the executive compensation program. This process has pressured companies to improve their compensation disclosures and clearly explain their pay practices and decisions. Today’s bank boards should engage with shareholders to understand their evolving perspectives on compensation and governance practices.

Meridian Compensation Partners’ Susan O’Donnell and Daniel Rodda discuss how to interpret your say-on-pay results and how to prepare for next year’s vote.

What do directors need to understand about the results of their 2015 say-on-pay vote?
Directors should know what percentage of their shareholders voted in favor of their executive compensation programs, and how that level of support compared to prior years. Receiving majority support isn’t enough. Over 70 percent of banks last proxy season received a favorable shareholder vote on their programs of 90 percent or more, so any result below that level suggests potential concerns. If your bank receives less than 70 percent support, shareholders and advisory firms such as Institutional Shareholder Services (ISS) will expect to hear specific details on how the company responded to feedback, and they will conduct a more rigorous assessment the following year. Strong shareholder support one year does not guarantee future success. We have seen the result change swiftly when not monitored.

How can directors understand what drove the results of their say-on-pay vote?
Directors should understand the makeup of their shareholder base, as there are differences in what drives the voting patterns of retail and institutional investors. Many institutional shareholders are influenced by ISS and another prominent shareholder advisory firm, Glass Lewis, so it is valuable to review their vote reports. Other institutional shareholders, like Blackrock and Vanguard, follow their own voting guidelines. While pay outcomes are more easily controlled, say-on-pay also reflects how shareholders view performance, primarily based on total shareholder return (both relative to peers and on an absolute basis). Directors need to take an objective look at how shareholders will view the relationship between executive pay and the bank’s performance.

How can banks improve the results of their say-on-pay vote?
Ensuring a significant portion of your total pay program is variable and that actual pay outcomes vary based on performance are the best ways to gain shareholder support. It is also important to maintain and disclose policies and practices that reinforce sound governance, such as stock ownership requirements, clawback policies, minimal perquisites and elimination of any tax gross-ups. The Compensation Discussion and Analysis (CD&A) section of your company’s annual proxy must effectively communicate the context and rationale for pay decisions, as well as how the programs ensure alignment between pay and performance. Investors want to understand the “how and why” of compensation decisions, including why performance measures were chosen, how pay decisions were made, and how the compensation program is aligned with shareholder value. If the say-on-pay vote receives less than 90 percent support, banks should consider reaching out to large shareholders to understand any concerns they may have. Additionally, banks that received negative recommendations from ISS and Glass Lewis should reach out to these advisory firms to discuss what led to their recommendation and what might address their concerns.

When should banks begin preparing for the following year’s say-on-pay vote?
Directors should already be thinking ahead to next year’s vote. The board has likely already made pay decisions in 2015 that will be evaluated as part of the 2016 say-on-pay vote. Typically, salary increases and equity awards are made in the first quarter of the year, but shareholders will be evaluating those decisions through the lens of performance through the end of the year. This can at times lead to an unfortunate disconnect. As a result, it is never too early to consider decisions in light of shareholder perspectives and the potential impact on the say-on-pay vote. In addition, ongoing shareholder outreach is viewed positively by investors and can proactively surface potential issues while there is still time to make changes. Being proactive and considering pay in the broader context of bank performance and shareholder perspectives should be an ongoing process.