Significant Activity in All Sectors as Financial Institutions Innovate and Evolve

Edward D. Herlihy is a partner and co-chairman of the Executive Committee, and Richard K. Kim is a partner in the corporate department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton publication.

2016 began with a flurry of bank M&A activity that decelerated somewhat as fears of Brexit and an overall slowdown in global growth overtook the financial markets and dampened expectations of a near-term interest rate increase. While commodity and stock prices have gradually recovered, the yield curve is now flatter than when the year began. It remains unclear whether the Federal Reserve will increase interest rates this year, but it will likely take several rate hikes to meaningfully alleviate NIM compression. At the same time, the regulatory environment for financial institutions continues to prove very challenging and volatile, with higher capital requirements and increased compliance expenses weighing heavily on profitability. The lack of a discernible economic tailwind is gradually motivating a number of financial institutions to seize the day and find ways to adapt and thrive.

Execution and innovation are at the core of what leads financial services firms to success. But in challenging conditions, when scaling up matters or when attractive opportunities arise, mergers and acquisitions, thoughtfully and reasonably deployed, continue to be effective tools to create value. Savvy boards of directors and executives should examine recent deals in all sectors of the financial services industry to find lessons in how, and how not, to execute and capitalize on strategic transactions. To gain an accurate picture of the deal landscape, it is also important to consider developments in the key areas of bank regulation and executive compensation rules and practices.

Shareholder activism is also a more important factor than ever. There is no doubt that short-term activism leads to increased discussion of deals. What is very much in question is whether these deals executed, so to speak, at the point of a gun create long-term shareholder value, especially in financial services where people, relationships and community involvement are essential to the long-term success of an enterprise. As a corollary, institutions entering into strategic deals must increasingly gauge the likelihood of activist response as an organic part of their deal diligence.

Lessons Learned from Recent Strategic Deals

Now with over a year of combined post-closing operations, both Royal Bank of Canada’s acquisition of City National Corporation and ACE Limited’s acquisition of The Chubb Corporation stand out as prime examples of well-conceived, well-executed, value-studies in the right way to do strategic mergers.

City National—widely considered to be among the strongest regional banking franchises in the U.S.—presented RBC with a unique opportunity to reenter the U.S. retail and commercial banking market. Unlike RBC’s prior acquisition of Centura, a retail bank (subsequently sold to PNC), City National was a franchise with complementary high-net-worth clients and expertise in wealth and asset management. City National’s shareholders received a significant premium in the transaction and the opportunity to participate in the benefits of the combination through a significant stock merger consideration component. City National CEO Russell Goldsmith and his family supported the deal not only by committing to vote their 13 percent ownership in favor of the transaction, but also by agreeing to receive their merger consideration entirely in RBC stock and hold at least half of that stock through the third anniversary of closing. Perhaps most importantly, RBC and City National appear to have found the right balance of oversight and autonomy that has eluded many domestic acquisitions by foreign banks. Goldsmith and his management team continue to run City National while at the same time gradually integrating City National into the RBC franchise. RBC’s 2016 results to date reflect a significant contribution by City National.

The ACE/Chubb merger had a transformational impact on both companies. The deal created a global leader in commercial and personal property and casualty insurance, and significantly enhanced the growth and earning power potential of both companies. ACE projected immediate earnings per share and book value accretion, with double-digit EPS accretion by year three. After announcement of the deal, ACE’s stock significantly outperformed, providing an immediate value benefit to ACE’s own shareholders in addition the Chubb shareholders.

While reflecting different strategic goals, each transaction was characterized by sound deal strategy and process from the start. The RBC/City National transaction was notable for months of pre-announcement engagement and commitment to meticulous diligence and integration planning. RBC/City National also stood out on the regulatory approval front. The transaction attracted significant attention from community groups, some of whom filed protests. However, City National was able to win the support of these groups and persuade them to withdraw their protests and the parties were able to obtain timely regulatory approval.

The ACE/Chubb transaction was likewise the product of careful preparation, an encompassing strategic vision, negotiations notable for the decisive but thoughtful decision making of both parties, and—again—detailed attention to the regulatory approval process. Despite creating a global P&C leader with significant positions across a range of products, the parties and their advisor were able to quickly and seamlessly cooperate in a joint effort to obtain the numerous foreign and U.S. state insurance approvals, and the expiration of the HSR and other antitrust review waiting periods, all accomplished in just over six months.

Both deals demonstrated key characteristics that are common to nearly all successful strategic mergers:

  • well-considered strategic case for combining;
  • keen advance focus on integration;
  • well-planned and prompt approach to obtaining regulatory approvals;
  • careful attention to social and governance issues, to help ensure that cultural friction did not impede strong projected strategic and financial benefits;
  • diligent but non-confrontational price and deal term negotiations; and
  • an appreciation by all parties involved of the time, effort and focus necessary to successfully implement large M&A transactions.

In contrast to these two examples, the Anthem/CIGNA transaction—announced a mere three weeks following the ACE/Chubb transaction but still pending—started on a hostile footing and at every point thereafter has remained a cautionary tale to potential dealmakers. While the deal, which has been challenged by the federal government, may ultimately be successful, its history as recounted by news reports and proxy filings is replete with warning signs: reluctance to engage by both parties; strategy that appears driven more by defense than offense—primarily the fear of being left behind rather than a firm belief in value creation; difficulty negotiating terms cooperatively and resort to airing negotiating differences in public; clashing cultures and personalities; failure to quickly resolve outstanding social issues; and evident difficulty in planning for and executing crisply on complicated regulatory approvals. With a protracted termination date in the merger agreement and no end in sight, this deal demonstrates the many issues that can arise when the parties to a strategic merger are not fully aligned from the outset.

Bank Mergers Continue to Present Opportunities to Banks with Sound Regulatory Positions

The noteworthy success of the RBC/City National transaction provided a roadmap for CIBC’s merger with PrivateBancorp announced earlier this year. CIBC, a strong, well-run Canadian bank, moved decisively to establish a major U.S. platform centered in the highly desirable Chicago market. Just as with City National, the deal is fundamentally premised upon the continued involvement of PrivateBancorp CEO Larry Richman and his team in managing the U.S. businesses of CIBC going forward. PrivateBancorp had, through the years, established an extraordinarily valuable franchise through personal effort and connection with its clients, team members and communities, and CIBC validated this through extensive research, discussion and diligence. When culturally compatible banks are able to pursue merger discussions carefully and confidentially from mutual positions of strength, value creation for shareholders and all constituencies is likely to follow.

KeyCorp’s acquisition of First Niagara and Huntington Bancshares’s acquisition of FirstMerit, both multi-billion dollar stock/cash transactions, were announced a mere three months apart in late 2015 and early 2016. The deals were notable in that both acquirers are CCAR banks based in Ohio and both targets had total assets well in excess of $20 billion. The Federal Reserve approved KeyCorp’s application in seven and a half months, a relatively short timeframe for a transaction of that size and degree of market overlap. Huntington’s application was approved in four and a half months—an unusually short period for transactions involving a CCAR bank and antirust-driven divestitures.

The success of the Huntington/FirstMerit merger will be written over the next several years, but Huntington’s careful approach to negotiating and announcing the deal, the regulatory approval process and integration efforts have the hallmarks of past successful transactions. Huntington CEO Steve Steinour thoughtfully addressed FirstMerit board concerns about the local Akron area (where FirstMerit was headquartered), and made strong commitments to charitable giving and employment in Akron. Huntington worked constructively with FirstMerit on other social issues from an early stage in the deal discussions, and ultimately agreed to add four FirstMerit directors to the Huntington board. Huntington also proactively reached out to government officials and community groups to win their support, a strategy that has become key to obtaining regulatory approval.

The California market has been, and should continue to be, fertile ground for M&A among community banks. A clear indicator of this last year was the acquisition of a majority stake in Mechanics Bank by Ford Financial Fund II—a private equity fund that is also a bank holding company and is controlled by renowned bank investor Gerald Ford. Equipped with extensive in-market experience and a track record of building strong franchises through acquisitions, Ford led Mechanics in the transformative acquisition of a complementary institution in California Republic Bancorp. The two institutions share a similar culture and management style, and the deal, which also received prompt regulatory approval, brings together a strong asset generator with an efficient funding source: California Republic’s strong indirect auto lending business and Mechanics’ capital strength and attractive Bay Area deposit franchise.

Other notable examples of continued value creation through thoughtful strategic mergers include South State’s merger with Southeastern Bank Financial and Cathay’s acquisition of Far East National Bank. Both South State and Cathay have exceptional track records of pursuing manageable, immediately accretive acquisitions that logically expand their footprint and create value for shareholders. Their ability to execute and integrate transactions smoothly while maintaining credibility with regulators to responsibly pursue additional initiatives is a sign of a board and management culture that embraces thoughtful advance strategic planning.

A significant driver of deals among mid-size and larger community banks has been the need for private equity investors to exit their investments. Many of the selling banks were recapitalized in the 2010-2013 period and have reached the originally anticipated exit point for these investors. Limited float, coupled with very substantial positions held by the private equity firms, means that secondary sales are not usually feasible, or would be tantamount to an initial public offering for some institutions. Due to relatively healthy M&A premia and a desire in some cases to reduce exposure to a banking industry burdened by rising costs and prolonged earnings challenges, whole institution sales have typically been the preferred exit option. This is a well-established phenomenon, with many banks (e.g. West Coast Bancorp, Sterling Financial, Square One) selling for this reason over the last couple years. Several additional examples have been announced or completed in recent months: American Chartered Bancorp’s sale to MB Financial; Yadkin Financial’s sale to F.N.B. Corporation; and most recently Everbank’s sale to TIAA.

The Everbank transaction was notable as an outlier, involving a non-traditional acquisition by a large asset manager, with a small thrift subsidiary, of another thrift holding company that operates largely through internet and other mobile channels. The particular mix of Everbank’s non-localized operating structure and product offerings apparently drew interest earlier in their process from other unconventional acquirers, including private equity firms.

Another notable development in bank deals, at least in our anecdotal experience, was a modest uptick in auctions versus transactions negotiated with a single buyer. Astoria Financial and Suffolk were two prominent examples of banks in the greater New York market whose auction results were informed not only by price, but by acquirer regulatory status and preparedness to address execution risks, including capital, asset concentration and other key regulatory matters.

Asset Management Industry M&A Remains Active

The asset management industry remains an active source of FIG M&A and witnessed a number of deal announcements in 2016. Notable transactions included: a three-way merger-of-equals involving NorthStar Asset Management, NSAM’s former parent NorthStar Realty Finance and Colony Capital (although consummation remains uncertain in light of significant shareholder pushback to date); Legg Mason’s acquisition of stakes in two new affiliates; Old Mutual Asset Management’s announcement of its first acquisition in several years; and State Street’s acquisition of GE Asset Management. Affiliated Managers Group continued to execute on its long and successful acquisition strategy by announcing new deals to add minority positions in six firms, including a five-for-one transaction in which it acquired minority positions in multiple alternative investment firms from a Goldman Sachs-affiliated private equity fund. Bank of America also announced the completion of the sale of its money-market funds business to BlackRock, notable in part due to the business’s position as the last remaining public fund advisory business at Bank of America following prior dispositions including Columbia Management and Marsico Capital.

A range of forces, including overcapacity, margin pressures, competition, active fund product performance issues, growth in exchange traded funds, the desire to build out product offerings, and significant regulatory developments such as the Labor Department’s fiduciary rule, will all help keep asset management M&A active in the future. Indeed, leading asset management CEOs, including BlackRock’s Larry Fink, AllianceBernstein’s Peter Kraus and Franklin Resources’ Greg Johnson have all commented publicly this year that they see the industry as ripe for consolidation.

Despite the factors favoring consolidation, asset management M&A is hard to do successfully, given the importance of firm culture, the need to obtain client (including fund board and fund holder) consents and the vital importance of compensating and incentivizing the employees who are the true assets at most investment advisory firms.

As a result, transactions are more likely to be incremental rather than transformative and to predominantly involve targets outside of the largest advisors. That said, just this morning Janus Capital and U.K.-based Hender Group announced a “mergers of equals” transaction, featuring co-CEOs, an evenly split board and a U.K. headquarters address, that is expected to result in combined AUM of just over $320 million.

Fintech Firms Evolve and Consolidate

Financial institutions of all kinds continue to position themselves to deal with the opportunities and threats presented by financial technology innovators. Fintech companies and digital financial ecosystem ventures have seen a substantial increase in interest and investment dollars in the last several years.

Fintech is not a precise term. The financial services space has long been a high tech environment, particularly on the capital markets and trading side where financial infrastructure, back office providers, computerized trading platforms and digital exchanges are familiar participants. Indeed, Intercontinental Exchange’s acquisition of Interactive Data was one of last year’s largest deals, and BM&F Bovespa’s acquisition of electronic depository Cetip is, to date, one of this year’s largest. As to the new breed of fintech companies, the early emphasis for many has been on the individual consumer. Increasingly, fintech is now being aimed at facilitating transactions and providing solutions in the commercial and wholesale market.

Likewise, the new fintech wave has made perhaps its largest early impact in the payments, ecommerce and money transfer spaces. Payments has seen a number of significant recent transactions among both traditional and newer companies, including the acquisition of Heartland Payment Systems by Global Payments, the consolidation of Visa and Visa Europe, the IPO of WorldPay and PayPal’s acquisition (among several others) of merchant payment platform provider Paydiant.

Fintech’s app culture is spreading to retirement planning and asset management on the individual side, and treasury and cash management on the commercial side. Fintech startups are trying to disrupt the investing and asset management space by providing a much simpler, more transparent and highly automated customer experience, including “robo-advisers” aimed at newer investors and the mass affluent.

Indeed, asset management acquisitions have contributed strongly to fintech M&A. Notable deals include SS&C’s purchase of portfolio management software maker Advent, BlackRock’s acquisition of FutureAdvisor, a retail-focused robo-adviser, and multiple acquisitions by Envestnet of startups engaged in data aggregation, analytics, robo-advising and online financial planning. Fidelity Investments and Northwestern Mutual also acquired financial planning startups.

On both the payments and wealth management side, fintech startups are largely relying on mobile and the promise of simplicity and transparency to acquire customers. They are marketing apps to millennials and others who are comfortable communicating, being informed and transacting on their phones. With access to customers’ phones and the ability to collect large amounts of detailed personal and transactional data, these companies are working to establish close relationships that include not only 24/7 access for customers via messaging and email but offers, data-driven recommendations, notifications and analysis pushed to customers on their handsets. In this way they are aiming to build their own version of the close relationships that community banks have enjoyed with customers, but on a larger scale and more cost-effectively.

Similar tech-driven changes are taking place elsewhere in the financial ecosystem. Customer expectations regarding the speed, ease and security of payments are being driven by the new technology, and banks understand that older and more time-consuming approaches will come increasingly under attack. The distributed ledger technology of the blockchain has attracted significant interest; many believe it could vastly simplify back-office tasks such as validation and recordkeeping, ultimately handling more complex transactions with substantially lower transactional costs and fewer intermediaries. There has been significant investment in blockchain-related startups, including by banks and other established financial services companies. A notable recent transaction was the investment by a group including JPMorganChase, Citigroup and Santander in Digital Asset Holdings, focused on application of the distributed ledger to capital markets transactions. The blockchain-bitcoin space has contributed a remarkable number of recent “unicorns” at a $1 billion or higher valuation. Widespread application of the technology is yet to come.

While fintech represents a real challenge to established banks, brokers, asset managers, custodians and payment companies, the incumbents retain strong competitive advantages. Many startups are taking a collaborative approach rather than a disruptive one. J.P. Morgan’s program with On Deck Capital for underwriting small business loans and Regions’ program with Avant for consumer loans both illustrate partnerships marrying emerging technologies with traditional bank underwriting activities. For all the changes, banks’ insured deposit accounts remain at the core of both individual and commercial financial lives. Banks have strong reputations for being safe and secure, providing robust data systems, strong physical and cyber security and leading protections for customer data privacy.

Capital One has long been a leader in expanding its asset portfolio and product offerings through thoughtful acquisitions in the fintech space. Its special expertise and data-driven approach to the credit card business has repeatedly placed Capital One in a position of seizing valuable strategic opportunities, most recently with their announcement today of the acquisition of the Cabela’s card portfolio and long-term issuing partnership covering Cabela’s going forward. Capital One’s strategic focus has not been limited to major card partnerships, though, as they continually innovate through acquisitions of early stage fintech firms whose offerings, or people, can help enhance the Capital One customer experience and improve their competitive position.

It may be difficult for fintech companies ultimately to displace community banks as lenders or service providers to individuals, professionals and small business. While many have sophisticated data collection and analytic capabilities, community banks are likely to retain for some time the advantage of intimate personal familiarity with their customers and local markets. This underwriting advantage may become critical as the credit cycle turns and the limits of internet-based loan decisioning are better understood.

Banks also have an important lead in adapting to the vast array of regulatory requirements, from capital adequacy to consumer protection to anti-money laundering. Many fintech companies today are set up to minimize their exposure to traditional financial regulation. But as the aspirations of fintech companies broaden, they will increasingly find themselves needing to build systems to assure compliance with a comprehensive regulatory structure. The OCC’s recent notice of proposed rulemaking addressing receivership of non-insured national banks may turn out to be a first step on a path to a potential federal charter for fintech companies. However, while tantalizing, the ultimate goal of a specialized charter that allows firms to comply with federal rules rather than state-by-state licensing requirements does not appear likely in the near-term.

Capital investment in fintech is accelerating strongly. There is little doubt that banks will need to move aggressively to thrive in the coming changed environment. But with a few exceptions it remains challenging to predict which particular companies, strategies and technologies will set the future agenda. Fintech investments continue to largely be spread among multiple venture capital firms, sometimes with the participation of traditional banks. The number of venture capital funds focused on fintech is increasing, reflecting not only the perceived opportunity but the need to have a focused and deep understanding of the risks and barriers to entry and growth in this special and unique area. Recent stumbles by marketplace lenders and other fintech newcomers illustrate that we are still at an early stage of this transformation.

Activists Look to Extend Disruption into the FIG Arena

“Activist” is a label applied to a wide variety of investors and market participants by the media and market observers. In years past it usually meant corporate or governance “gadflies,” whether individuals or labor unions or similar entities pursuing political or social objectives. More recently its usage expanded to capture hedge funds pursuing financial objectives. This group runs the gamut from long-term holders with firmly held views about business strategies, to short-term traders (whether long or short) focused on nothing more than pushing an event that allows an exit with a quick gain. Financially motivated activism also includes funds whose actions, when examined closely, appear to be motivated by nothing more than marketing their fund to potential limited partners. Broad discussions about “activists” have a tendency to gloss over the complex and divergent motives of those bearing the moniker. The only clear, common thread uniting activists is outsized and increasing influence, bestowed by proxy advisors and a fawning press.

Regulated financial institutions historically have seen less activism than unregulated industries. Legal restrictions on control and limitations on ownership stakes have discouraged more established activist investors from entering the space in earnest. Post-crisis, tighter regulation affecting both M&A, and dividends to and repurchases from shareholders, have limited access to the usually preferred endgames for an activist. It is probably no accident that financial institutions have attracted an inordinate share of would-be activists with no discernible agendas other than “sell yourself immediately at all costs” or “cover my campaign in the media so I can raise AUM and make more management fees.”

The sheer variety of motivations of activists approaching a financial institution stands in stark contrast to the clear fiduciary and legal duties of the directors sitting on its board. Banks and other regulated financial institutions are required by law to focus on the safety and soundness of their companies, their duties to their communities and customers, and the interests of their long-term shareholders. Any activist action or approach that threatens the Board’s ability to comply with these duties must be examined closely and skeptically.

The Board is not the only check on potentially wrongful behavior. As an example, there are important legal restrictions attaching to acquisitions of more than 4.9% or 9.9% of bank holding companies. Investors crossing the 9.9% threshold are usually required to execute passivity commitments to the bank regulators ensuring they cannot influence or control the company’s key governance functions. Such investors may also become subject to complex regulations that may implicate banking transactions and relationships between the target bank and the investors’ affiliates. Investors seeking to control a bank or its holding company must file applications in advance and be subject to extensive review by bank regulators, and the ultimate approval is far from certain. These restrictions are grounded in the same fundamental concerns that gave rise to the directors’ duties—effective governance of a financial institution requires independence, awareness of all material facts and a careful and deliberate decision-making process free from manipulation or undue pressure.

Boards of financial services companies that remain true to these basic principles, and resist attempts to subvert their governance role, avoid potentially disastrous outcomes for all of the company’s constituencies. Arlington Asset Management was targeted earlier this year by a proxy contest launched by a short-term, de minimis shareholder, Clinton Group, and Imation to replace a majority of the Board. Clinton had won a proxy contest at Imation in 2015, and promptly caused Imation to enter into a series of self-dealing transactions (including an investment in Clinton Group’s fund) while also presiding over the loss of much of the stock market value of Imation. Strenuous resistance by the Arlington Board convinced even the proxy advisors of the risks of Clinton’s proxy contest, and averted a potential disaster when the shareholders overwhelmingly rejected Clinton’s nominees. FBR & Co.’s successful effort to turn back a proxy contest from short-term holder Voce Capital featured direct, professional communication of FBR’s long term strategy to shareholders. This approach neutralized Voce’s vitriolic campaign and ended with Voce selling its position at a significant loss.

Add to this list the numerous banks that have resisted efforts to co-opt the careful strategic planning of their board and management teams, in close communication with regulators. Some short-term holders or event-based traders care nothing about the timing of a sale, whether conditions will produce an optimal outcome for long-term shareholders and other constituencies or whether there even exists a merger partner that is capable or interested. It is enough for these traders to foster rumors and speculation about a process or potential sale, which in turn produces short term gains and volume increases and provides an exit opportunity for all or part of the activist’s position. Boards that perceive this agenda for what it is can immediately recognize how dramatically it departs from their legal and regulatory obligations and respond accordingly.

In the current environment, financial institution directors must strive to remain focused on their primary role as stewards of their institutions, their important legal mandates under regulatory regimes and their special responsibility to protect the interests of their institution’s communities, customers and other constituencies. As has always been the case with financial institutions, attending to regulatory obligations, operating responsibly and actively engaging in long-term strategic planning will redound to the benefit of the long-term shareholders. In the end, companies led by management teams and boards of directors who are well prepared, who speak with one voice and are able to remain unified and resolute in the face of attack, will control their own destinies. Those who fail to live up to this standard—those who are too quick to settle or whose boards and management teams are driven apart by the public pressure of an activist and the commentary of proxy advisors—may find themselves quickly losing control of the governance of their institution.

Regulatory Environment Continues to Impact M&A—Both Positively and Negatively

The regulatory environment for financial institutions has continued to have a schizophrenic impact on bank M&A, both fostering and impeding it. On the one hand, the increasing compliance burden combined with higher capital and liquidity targets impede profitability and incent consolidation, particularly in a low-rate, low-growth environment. These factors, combined with generally strong credit quality across the industry, make today an opportune time to engage in M&A. Post-crisis regulatory requirements previously thought to be obstacles to M&A, such as crossing the $10 billion asset threshold or passing CCAR, are now being almost routinely navigated by banks.

Yet, at the same time, a growing number of potential bank buyers are sidelined from M&A activity as a result of enforcement and other regulatory actions. For the past several years, BSA/AML has been the most heavily targeted area for regulatory enforcement. However, enforcement actions focused on consumer compliance and, more recently, unsatisfactory ratings under the Community Reinvestment Act are becoming increasingly common. The current administration has long had a heightened focus on consumer protection, and the CFPB has been a powerful influence, actively pursuing enforcement actions and, more importantly, profoundly shaping the thinking and priorities of the Federal Reserve, FDIC and OCC.

The recent actions by the CFPB, OCC and Los Angeles City Attorney against Wells Fargo are not notable so much for the size of the fine imposed, but rather the massive and continuing backlash that has followed, from elected officials, regulators, market observers and even fellow industry participants. The impact to the stock price, the Senate and House hearings, the relentless negative media coverage and unprecedented, substantial compensation clawbacks from CEO John Stumpf and former head of community banking Carrie Tolstedt, present a stark reminder to all regulated financial institutions of the criticality of effective crisis management in the current volatile regulatory environment. The Wells Fargo board continues to deal with an independent probe, reputational damage and ongoing legal and regulatory investigations and issues. Other large banks with diverse product offerings are already receiving inquiries from their regulators relating to their cross-selling practices.

While the sidelines have become increasingly crowded with banks unable to engage in M&A, we do not believe that the regulators are philosophically opposed to consolidation as some have speculated—with the exception of the largest banks, it is more a function of unintended consequences. The regulatory approval process has become longer and more difficult to navigate. However, as demonstrated by the Huntington/FirstMerit and Key/First Niagara transactions this year and others, such as BB&T’s acquisitions of Susquehanna and National Penn last year, large complex transactions can still obtain regulatory approval in timeframes comparable to pre-crisis transactions. Delays in the regulatory approval process are generally attributable to two broader themes—an almost zero tolerance attitude by the regulators to compliance mishaps, and a heightened focus on CRA that has empowered community groups. Potential acquirers are well-served by investing heavily in processes, people and systems that can mitigate the risk of these issues arising.

Compensatory Matters Remain Essential to M&A

An essential part of the value and sustainability of any financial services firm is the talent and personal relationships of the firm’s management and employees. In many financial mergers, the primary assets to preserve are the people, and thus issues surrounding compensation—such as treatment of equity awards, severance protection and retention—are often of critical importance to the deal.

Developments over the past decade have chipped away at the flexibility of companies to design and implement compensation arrangements in the ordinary course, including because of the influence of proxy advisors and, in the bank space in particular, increased regulatory focus. The elimination of “golden parachute” excise tax gross-ups and single-trigger vesting, the increasing prevalence of equity awards that are performance-based and deferred and mandatory “say on golden parachute” votes in merger proxy statements can result in a range of potential consequences and tax implications that deal makers must think through and plan for in advance of signing. To comply with Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the several federal bank regulatory bodies and the SEC this year re-proposed rules to prohibit incentive-based compensation arrangements that encourage inappropriate risks at covered financial institutions.

The proposed rules would apply to a range of companies, including bank holding companies, banks, investment advisers and registered broker-dealers, once the covered institution (or, in some cases, its parent company) has average total consolidated assets of $1 billion. The rule has three tiers, with the second and third tiers commencing at average total consolidated assets of $50 billion and $250 billion. The proposed rules, among other things, prohibit all tiers from establishing incentive-based compensation arrangements that encourage inappropriate risk by providing covered persons with excessive compensation, fees or benefits that could lead to material financial loss, while the two largest tiers would also be subject to annual reporting requirements, policy and procedure requirements, and specific (and increasingly prescriptive) requirements relating to compensation deferrals, forfeitures, downward adjustments and clawbacks. While it is likely to be some time before the rules are finalized, just as bank acquirers must consider the impact of crossing asset thresholds into enhanced regulatory regimes, so too must organizations that would be covered by the new compensation rules take into consideration and plan for future compliance with the Dodd-Frank incentive compensation rules once they are finalized.

Regardless of these hurdles, in businesses where individuals are the key assets being acquired, transaction parties must still work to ensure the delivery of those assets with the deal by negotiating employment and retention arrangements. These frequently take the form of individual employment or consulting arrangements for executives and key producers, and retention pools to be allocated among a broader group of critical employees. Well-tailored retention programs can mitigate the disruptive potential of a deal on needed personnel by incorporating both “upside” incentives (retention awards) and “downside” protections (severance benefits and vesting). Retention programs provide key employees critical to the success of the combined company with a tailored financial incentive to remain focused on the company’s best interests and mitigate personal uncertainty relating to the deal. Severance and termination protections also seek to reduce unwanted defections by providing key individuals with greater security against the risk of an involuntary termination (including reassignment, relocation or another “constructive discharge”) associated with combining of two companies. In certain situations, it may even be desirable to provide target employees with ongoing equity interests in the acquired business or earn-out arrangements. When carefully structured, deal-related compensation programs can play a critical role in guaranteeing the successful completion and integration of the transaction and the future strength of the acquired business.

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We remain optimistic about the overall financial institutions M&A environment. Both the markets and regulators have shown positive receptivity to thoughtful transactions, and over time we expect to see companies continue to draw upon M&A as a source of innovation and evolution. Those firms that are able to do so in a careful and thoughtful manner can create meaningful value notwithstanding the ups and downs of business and economic cycles.

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