Financial Institutions Developments

Edward HerlihyRichard K. Kim, and Nicholas G. Demmo are partners at Wachtell, Lipton, Rosen & Katz. The following post is based on a Wachtell Lipton memorandum by Mr. Herlihy, Mr. Kim, Mr. Demmo, and Matthew M. Guest.

The opening trading days of 2019 mostly continued the whipsaw pattern of late 2018, with large declines followed by large gains, each seemingly prompted by a bit of news and viewed as overreactions with the benefit of hindsight. In markets dominated by algorithmic trading, the fundamentals of individual companies have very little to do with the vast majority of trades. To bank holding companies that have performed well but nonetheless been buffeted by volatile markets and disproportionate declines, this disconnect between value and trading prices may be cold comfort. But it is a stark reminder of how boards and management must as fiduciaries look through volatile markets and negative short-term trading moves and develop strategic plans that maximize long-term value regardless of extrinsic forces.

The current environment requires parties to give even greater focus to fundamental principles of deal execution, including thoughtful pricing, developing a shared strategic vision and minimal conditionality. A recent deal was marred by flaws and demonstrates the risks to both parties of forgetting these basics, and provides valuable lessons for companies considering deals.

Principles for Boards and Management Considering Mergers

Deals are a partnership from announcement, and should only be entered with mutual certainty and commitment.

Boards must evaluate the merits of a stock merger before announcement and be committed to the partnership. Banks, by their very nature, are comprised of many different constituencies that are directly impacted by a merger announcement. Customers will see the nature of their services and relationships changed, and many employees will have their roles and daily lives affected and some may be in a position of wanting or needing to seek alternate employment. Associates and dependents of customers and employees, and those doing business with them, will be indirectly impacted.

Communities and regulators will also see the nature of their relationship with one or both parties to a merger change dramatically. All of these parties start reacting to these anticipated changes immediately upon announcement, and it is impossible to return the parties to their status quo ex ante if the deal is abandoned. Common sense dictates that only in the rarest situations, due to completely unforeseen events, should a merger not close. No party should enter into a bank merger unless it is completely committed. Recognizing this, the law has given the board the authority to enter into a firm and binding stock merger, contingent only upon the vote of stockholders and any governmental approvals required by law.

Excessive conditionality is legally questionable and to the benefit of neither party.

Unfortunately, the best planned deals at the principal level can still be jeopardized post-announcement by poorly thought-out deal terms or a failure by advisors to steer the parties away from unintended consequences. A target company in a failed deal process suffers significant and unavoidable value destruction. The same holds true for acquirers, due to waste of resources and regulatory credibility on the terminated deal, lost opportunities for alternative capital employment, the inevitable departure/poaching of valued employees and damaged reputation in the deal marketplace. Recognizing this, bank M&A has for many years been typified by limited condition merger agreements that are designed to create a high likelihood of closing. Legally unnecessary or inappropriate provisions, such as fiduciary termination rights in stock deals, have long been absent from bank mergers, even as they crept into other deals.

“Walkaways” undermine deals and create major risks.

The use of the acquirer stock price-based, so-called “walkaways” that have shown up in some recent deals is highly problematic. These provisions are not utilized in other industries and are of dubious legality. There is no case law supporting so-called “walkaways,” they have not been tested by any court and they present serious regulatory and SEC issues. Acquirer and target boards should be aware of the following:

  • Price-based termination rights, by providing a downside trigger based on short-term trading moves, are fundamentally inconsistent with a fixed exchange ratio partnership;
  • A key part of negotiating the exchange ratio, and assessing the fairness of a merger, is the contribution analysis. Short-term market fluctuations have little impact on current and forecasted earnings and balance sheet contributions of each party, and which provide a solid sense of long-term value grounded in audited results and good faith estimates;
  • Walkaway provisions place a target’s board into a very difficult position of having their earlier, fully protected fiduciary decision to enter into the deal questioned, or being at risk of losing a game of chicken by providing a notice of termination to the acquirer only to find that the acquirer refuses to increase the merger consideration in order to avoid termination;
  • Walkaways, by design, promote deal uncertainty and generate friction between merger partner Merging banks is not akin to selling a widget company. Bank mergers require significant, advance integration planning, synergies, management compatibility and customer focus and communication;
  • If there is a fundamental change in either party, it will be adequately covered by a well-constructed MAE provision;
  • Target shareholders have usually approved the merger before the board is placed in the position of considering the provision; the board is therefore being asked to overturn an informed vote of the shareholders, and subject itself to second-guessing and fiduciary litigation;
  • In many jurisdictions, additional shareholder meetings and approvals of both target and (if applicable) acquirer shareholders may need to be obtained before increases in consideration or other changes in terms that are deemed to amend the merger agreement. This would require another filing of the proxy statement with the SEC, another solicitation and months of delay;
  • The issuance of additional consideration may require amendment of regulatory applications and supplemental SEC disclosure and submission of revised pro formas, and could under some circumstances put the continued validity of regulatory approvals at risk;
  • The provisions require several different measurements and are susceptible to error and varying interpretations;
  • They create the possibility of activist or arbitrageur manipulation of acquirer stocks; and
  • They can greatly complicate primary or secondary capital market activities by an acquirer or its affiliates while the deal is pending, and may present issues for stock repurchases under Regulation M and Rule 10b-18.

In sum, these provisions create unintended and unnecessary deal risk for a long-term strategic partnership.

Shareholder approval is always at risk; failure to adequately plan for it can lead to disaster.

In the past, it was virtually unheard of for a bank merger not to receive shareholder approval. Yet it happened recently with a poorly structured deal that cratered.

Hanmi’s failed merger with Southwestern National Bank is a lesson in how not to structure a merger, and was mistake-laden from the outset. Hanmi and Southwestern terminated their merger in August 2018 after Southwestern’s shareholders failed to meet a 2/3 vote requirement to approve the merger, even following a meeting adjournment to solicit more votes. Hanmi stock traded down fairly significantly after announcement of the merger, which initially was struck as 80% stock and 20% cash. The Southwestern board then withdrew its recommendation of the deal to shareholders until the parties amended the deal to 70% stock and 30% cash. Notwithstanding this amendment, the Southwestern shareholder still failed to approve the deal, and the parties subsequently terminated their agreement. In and of itself, such an occurrence is extremely rare. Incredibly, Hanmi received no termination fee under the contract, and despite its gaffes sued Southwestern’s board in an attempt to get damages.

The currently litigation reveals an embarrassing series of blunders by Hanmi that doomed the deal from the start. 47% of the voting shares were controlled by Southwestern insiders and already locked up at signing; so to meet a 2/3 vote requirement only an additional 19% of the outstanding Southwestern shares needed to vote in favor. Southwestern was a closely held bank, giving Hanmi great opportunity to get a voting commitment from other large community shareholders outside of the boardroom. Hanmi could also have structured the deal as a tender offer to get a lower, simple majority, threshold for taking control. Finally, Hanmi could have included a termination fee or expense reimbursement for the failure to get the vote, considering the closely held nature of Southwestern and the ability of the board and close associates to control the voting outcome. Inexplicably, none of these things were done.

Another major blunder in the merger agreement also left Hanmi without any recourse after the Southwestern board initially changed its recommendation and apparently communicated this to certain shareholders. Every public company merger agreement routinely provides the ability for an acquirer to terminate the agreement, and receive a termination fee, if the target board changes its recommendation to shareholders to vote in favor of the deal. Hanmi’s agreement, on its face, appears to only give them this protection for a change in recommendation arising from a competing offer. Southwestern’s board was otherwise free to withdraw its recommendation for any other reason if it thought its fiduciary duties required it, without any contractual consequence. In reality, Hanmi had not entered into a binding merger agreement, it had given Southwestern a free one-way put option. The Southwestern board obviously treated it as such, and reversed direction on the deal, leaving Hanmi at the altar when Hanmi’s stock traded down.

Diligence misses can jeopardize value creation.

Most acquirers devote significant resources to combing through corporate records and loan portfolios, assessing human capital and understanding contingent liabilities. It is equally important to consider the impact of a deal’s announcement on a target’s key constituents. In branch deals, one of the most significant deal considerations is largely outside the purchase agreement, and that is the estimate of potential deposit run-off. The economics of any given transaction often depend heavily on these estimates, particularly in transactions where the acquirer is taking on significant real estate and employee costs that need to be supported by branch banking activity. Many factors can impact deposit run-off, including factors intrinsic to the parties (e.g., comparative deposit pricing, conversion efficacy), factors intrinsic to the geography (e.g., are there aggressive competitors looking to pick off depositors?), and the manner in which customers are allocated to the branches being sold (i.e., in a world of mobile banking, are the branch customers truly within the branch footprint or are they inaccurately allocated to the branch based on “householding” factors?). While appropriately measuring deposits for premium purposes is a helpful step, it is far from a cure-all, and Flagstar’s recent announcement regarding the relatively large and unexpected run-off from its Wells Fargo branch deal and related impact to tangible book value counsels caution.

Pricing discipline is mutually beneficial.

Common to all stock mergers is agreement on an exchange ratio. Reaching agreement becomes exceedingly difficult in a volatile market, as the parties may see their stocks trade apart on a daily basis and metrics of precedent deals may become less pertinent. Under these conditions, it is important for the parties to develop a common understanding of the benefits of price restraint. A target holding out for the last penny in a stock transaction can hurt its own stockholders, and jeopardize the closing of their deal, if its efforts push the deal price beyond the range that the market will accept. A stock merger where the acquirer stock remains reasonably steady—and the implied value of the exchange ratio holds up—following announcement is best for everyone. Focusing on that long-term value creation, and not just maximizing announcement price, is entirely consistent with the fiduciary duties of a target company’s board.

Bank M&A Looking Forward

Notwithstanding challenging equity markets, 2018 marked a steady year for bank M&A and 2019 should be similar. The first three quarters of 2018 witnessed six very significant mergers, including Fifth Third’s acquisition of MB Financial, Synovus’ acquisition of FCB and Cadence Bancorporation’s acquisition of State Bank. Deals continued to be reached through the end of the year, including two large community bank deals announced in December in CenterState/National Commerce and Ameris/Fidelity Southern.

Market participants who remain faithful to the time-tested principles of careful planning and committed mergers with limited conditionality, and have the vision to see through short-term markets, will continue to create long-term value. As always, planning for the successful execution of a merger will require consideration of all other terms and characteristics of the combined company, from lending concentrations to the capital levels and regulatory status of the combined organization, to understand the potential for post-merger value creation. It is also essential to plan out in great detail operational and cultural matters including management roles, board composition, branding, headquarters and other facility locations, and community commitments. And before announcement, the principals must see eye-to-eye on culture, communication and anticipated synergies. In the current environment, deal savvy remains more important than ever.

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