How A New Court Decision Could Change Bank M&A

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merger-3-11-19.pngA recent decision by the Delaware Supreme Court relating to a merger between two pharmaceutical companies that was terminated before closing could have implications on bank mergers and acquisitions.

On Dec. 7, 2018, the Delaware Supreme Court affirmed the lower court’s ruling in Akorn v. Fresenius Kabi that a Material Adverse Effect (“MAE”) had occurred with respect to Akorn under the terms of its merger agreement with Fresenius.

The Supreme Court upheld the lower court’s determination that (1) Akorn had suffered an MAE under the terms of the agreement that excused Fresenius from its obligation to close the transaction, and (2) Fresenius properly terminated the merger agreement because of Akorn’s breach of its regulatory representations and warranties under the merger agreement, which gave rise to an MAE, and Fresenius had not materially breached the merger agreement (which would have prevented it from exercising its termination rights).

Why the Akorn Case Is Important

  • This is the first ruling in Delaware that an MAE had occurred in a merger transaction, allowing the buyer to walk away from a signed merger agreement.
  • The lower court’s opinion provides unprecedented guidance for future negotiation and litigation of MAE clauses.
  • The decision is applicable to all industries, including the banking industry, and makes it clear that, first, the heavy burden to establish an MAE with respect to the target remains with the buyer.

How The Case Impacts Bank M&A

  • Merger partners should carefully consider the categories of events or changes, as well as any specific events, that should be excluded from the MAE definition, ensuring that the definition accurately reflects the agreed upon allocation of risk between the parties.
  • Sellers should exclude industry-wide changes impacting the seller, while buyers should be mindful to provide that broad industry changes that disproportionately affect the seller are not carved out from the definition.
  • Typical carve-outs from the MAE definition in a bank merger agreement include: changes in laws and regulations affecting banks or thrift institutions, changes in GAAP, changes in the value of securities or loan portfolio or value of deposits or borrowings resulting from a change in interest rates, and changes relating to securities markets in general.
  • Buyers who are uncomfortable with the broad definition of an MAE, even following Akorn, and are significantly larger than the seller may wish to consider inclusion of a few specific financial closing conditions to supplement the broad MAE clause.
  • Buyers in the bank M&A context should in good faith continue the regulatory approval process even while contemplating terminating the deal over a possible MAE — having “clean hands” matters.

How the Court Found an MAE
Fresenius, a German pharmaceutical company, and a U.S. generic drug manufacturer, Akorn, formally agreed in April 2017 to merge.

Shortly after, Akorn’s financial performance “fell off a cliff;” its revenues declined the next four quarters by 29 percent, 29 percent, 34 percent and 27 percent, respectively. Its operating income plummeted 84 percent, 89 percent, 292 percent and 134 percent, respectively, during the same period.

Fresenius terminated the merger agreement in April 2018, asserting that Akorn had suffered a general MAE. Fresenius further asserted it had an explicit right to terminate the merger agreement because Akorn breached its regulatory compliance representations and warranties. Akorn’s lawsuit followed, seeking for the court to force Fresenius to close the transaction.

The Court of Chancery determined Akorn suffered a general MAE, which resulted from issues that disproportionately affected Akorn compared to similar companies in its industry. Focusing on the plain text of the merger agreement, the court determined that Akorn bore the general risk of the MAE and through several carve-outs to the provision, Fresenius bore the “systemic” risks related to Akorn’s industry. However, through specific exclusions from these carve-outs, the risk was shifted back to Akorn in the event that the risks disproportionately affected Akorn’s business as compared to other participants in its industry. In analyzing whether the effect was “material,” the court stated the effect should “substantially threaten the overall earnings potential of the target in a durationally-significant manner.”

In other words, the court determined that Akorn’s dramatic downturn in performance was significant because it had persisted for a year and had no sign of abating, rejecting Akorn’s argument that any assessment of the decline in its value should be measured not against its performance as a standalone entity but against its value to Fresenius as a buyer.

Conclusion
This case is directly applicable to the banking industry. Many banks suffered dramatic declines in earnings during the financial crisis that would be considered durationally significant within the framework reinforced by Akorn. Causes included massive credit losses, drastic margin compression and the regulatory reaction to the crisis. Banks need to take into account their risk profile and that of their merger partner when negotiating the MAE definition and consider how it would work under a variety of adverse economic environments.

Can We Say Goodbye to Fair Lending Cases?

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lawsuit-6-2-17.pngOne of the potential impacts of a new administration in Washington, D.C., is a lot less fair lending enforcement. For a number of banks, that would be a very good thing. Banks have been hit with fines, bad press and enforcement actions in the last few years, as the Justice Department and the Consumer Financial Protection Bureau have brought cases alleging everything from indirect auto loan discrimination to redlining, the practice of carving out minority neighborhoods to exclude from loans.

Institutions such as Fifth Third Bank and Ally Bank have been hit with the auto finance accusations, and Tupelo, Mississippi-based BancorpSouth Bank last year paid $10.58 million in fines and restitution to settle a case accusing it of redlining in Memphis. The $13.9 billion asset bank said it had taken several steps to improve its commitment to affordable lending products in low and moderate income and minority areas.

Many of the accusations have relied on the disparate impact theory, which has been upheld by the Supreme Court. The idea behind it is that no intentional discrimination has to occur for a violation of the law. Bank managers, as a result, must stay vigilant not only on their own lending policies and staff training, but they have to research lending patterns and loan terms to make sure that a disproportionate number of minorities aren’t stuck with loans on worse terms than non-Hispanic whites. If they are, there has to be a justifiable reason why this was so. Marketing efforts can’t exclude minority neighborhoods.

The most recent case was when the U.S. Department of Justice sued KleinBank, a small community bank in the suburbs of Minneapolis, accusing it of redlining. The bank’s CEO said the lawsuit had no basis in fact, and challenged the idea that the $1.9 billion asset bank has a duty to serve the urban areas of Minneapolis and St. Paul.

One of the odd aspects of the case is that it was filed on Jan. 13, 2017, right before President Donald Trump was inaugurated. Now, the new attorney general, Jeff Sessions, is in an excellent position to influence the case and whether it moves forward at all.

“I would expect fair lending cases to be less a priority under Jeff Sessions,’’ says Christopher Willis, a fair lending attorney and partner at Ballad Spahr. “And the cases that would be brought would be less eager to explore new ground.”

John Geiringer, a partner at the law firm Barack Ferrazzano in Chicago, agreed. “Presumably, under the Trump administration, fair lending is not going to be on the front burner as much as it was in the Obama administration.”

But that’s not a pass-go card, not quite yet. The Consumer Financial Protection Bureau (CFPB) is moving ahead with plans to implement an expansion of the requirements for mortgage data under the Dodd-Frank Act. Basically, there are 25 new data points banks must send to the bureau, starting January 2018, on everything from the borrower’s credit score, to the parcel number of the property, to a unique identifier for the loan originator who originated the loan, according to the American Bankers Association, which has argued the rule should be repealed because of increased cost to banks and data security concerns. The Home Mortgage Disclosure Act already mandates 23 data points, the association says.

The fear is that the data will be used to initiate even more fair lending cases against banks, although regulators have said the data could be used to weed out unnecessary fair lending reviews. The CFPB and the Justice Department did not respond to a request to comment.

So far, it’s not clear that the rule will be thrown out, despite the change at the White House. The CFPB is led by Director Richard Cordray, whose term doesn’t end until 2018.

For now, bankers must assume that regulations due to go into effect will indeed do so. Fair lending enforcement won’t go away under the Trump Administration. It’s not just that the CFPB’s leadership is still in place. The agency’s goal from the Fair Lending Report for 2016, published in April, 2017, is to increase “our focus on markets or products where we see significant or emerging fair lending risk to consumers, including redlining, mortgage loan servicing, student loan servicing, and small business lending.” The banking agencies also can continue to pursue enforcement actions, even if the Justice Department doesn’t.

But the tone has changed. The former head of the Justice Department’s civil right division, Vanita Gupta, told The New York Times in January 2017 that “the project of civil rights has always demanded creativity… It requires being bold. Often that means going against the grain of current-day popular thinking. Or it requires going to the more expansive reading of the law to ensure we are actually ensuring equal protection for everyone.”

There’s a good chance that the creativity Gupta described is gone.

Supreme Court Ruling Could Impact Your Bank

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disparate-impact-10-16-15.pngOn June 25, 2015, nearly four years after first agreeing to consider the question, the Supreme Court issued a decision in the case Texas Dept. of Housing and Community Affairs v. Inclusive Communities Project, Inc., holding that disparate impact claims may be brought under the Fair Housing Act (FHA). The Court’s decision confirms that, irrespective of intent, an institution engaged in residential real estate-related transactions such as mortgage lending may be held liable for a practice that has an adverse impact on members of a particular racial, religious, or other statutorily protected class.

However, the Court pointed out the following important limitations on the ability of plaintiffs to raise claims:

  • It is not sufficient to point out statistical disparities alone. Instead, plaintiffs must show that a defendant’s policy or policies caused that disparity.
  • Policies may only be challenged under disparate impact analysis if they are “artificial, arbitrary and unnecessary barriers.”
  • A defendant’s valid business justification may not be rejected unless a plaintiff identifies an alternative practice that has less disparate impact while still serving the entity’s legitimate needs.

To receive the benefit of any heightened standard resulting from the Court’s opinion, however, financial institutions must be willing to litigate. To avoid litigation in the first place, experience has shown that proactive steps taken by financial institutions can protect against possible disparate impact claims. Those steps include, for example:

Internal Audits and Fair Lending Risk Analysis
Financial institutions should be proactive in identifying and analyzing lending portfolios to identify areas susceptible to statistical challenge. One of the most reliable methods of doing so is to conduct routine statistical self-assessments on a portfolio-wide basis, appropriately structured to ensure attorney-client privilege will apply. Institutions should conduct periodic assessments, analyze the results (including file reviews of any outliers), and tailor policies and procedures to address the results, thus ensuring the institution is alert to potential disparities and can address any fair-lending related issues before they become supervisory concerns.

Policies and Procedures
Institutions should carefully review their policies and procedures to identify instances in which discretion is permitted in any aspect of underwriting or other credit processes, as discretion may give rise to discriminatory results. To the extent policies and procedures allow for discretion or exceptions, institutions should craft corporate governance mechanisms to approve such exceptions or departures from common practice as well as record keeping procedures to ensure proper documentation. In effect, the financial institution is creating a record of why it departed from its normal business practices. To the extent that the institution considers any changes to its policies and procedures as a result of its review, senior management should articulate the business- or risk-related reasons why such changes were or were not made.

Corporate Governance and Documentation
With increased scrutiny from regulators on fair lending issues, any business decisions that may involve practices that could have a disparate impact on a protected class, such as changing or discontinuing a particular product or service, should be carefully considered and the justifications for them should be clearly documented. Institutions should establish corporate governance procedures that provide for review of material changes to product and services offerings by senior management and fair lending/risk committees. The results of the review, including assessments of the reasons for the business decisions at issue, should be documented through meeting minutes and other records.

The Inclusive Communities decision almost certainly will embolden private plaintiffs and government agencies to assert claims of disparate impact discrimination. Proactive steps taken now can head off years of litigation and costly settlements by preventing statistical disparities from ripening into claims of discrimination. Financial institutions should aggressively review and enhance their compliance efforts to ensure the compliance of their business policies and practices.