Risk management pitfalls in bank M&A

Kris St. Martin

Expectations for modest growth in the U.S. economy, regulatory burdens, customer demands and new technologies will continue to encourage smaller community and regional banks to consolidate in response to this shifting landscape. Almost half of the bank executives and directors participating in Bank Director’s 2018 M&A Survey believed the current environment for bank M&A was more favorable for deals. Additionally, 54 percent said their institution was likely to purchase another bank by the close of 2018.

In spite of due diligence and best intentions, merger and acquisition activity invariably heightens the risk of liability and the threat of shareholder lawsuits that claim some degree of economic harm due to a merger. It is important to note that board members can be sued for actions they took on behalf of the bank even before it was acquired.

In such lawsuits, attorneys representing shareholders or other stakeholders will list any number of issues or conflicts to support plaintiff positions. Why was only one valuation made when determining the share price of the company being acquired? Why didn’t the board market the bank to a wider array of potential suitors? Why did no one realize that a board member’s brother was selected to conduct the valuation? Why did the company being acquired choose not to disclose hidden liabilities on the balance sheet?

Using its proprietary data, the insurance giant Chubb reports a dramatic increase in the cost of insurance claims for merger-objection litigation in recent years.The average cost of settled merger-objection claims grew 63 percent to $4.5 million in 2016 from $2.8 million in 2012. That’s an average settlement of $3.6 million. The portion of total claims payments going to shareholders (39 percent) was far less than the 61 percent that flowed to plaintiffs and defense attorneys for fees and expenses. For dismissed merger-objection claims, the average total cost increased 162 percent to $2.3 million in 2016 from $880,000 in 2012. The average total direct cost was approximately $912,000.

Risk mitigation

To minimize deal-related risks and maximize deal value, sellers and buyers need to develop a comprehensive and organized plan and an agreed-upon approach that includes aggressive due diligence around previous, current and potential future risks. Potential liabilities are often overlooked in the due diligence phase, particularly when speed is a factor in closing the deal. Best practices that ensure the process is successful include proper and consistent communication with board members and company officers and shareholders — and inclusion of risk consultants on the advisory team managing the deal.

Keeping everything transparent throughout the merger process goes a long way toward lowering the risk of incurring post-deal liability. No one wants to be accused of being sold a bill of goods. It is critically important for each member of the due diligence team to share findings with the full group, and all decision-makers in the acquiring company need to be fully aware of the liabilities that might exist. In most cases where misrepresentation is alleged, sellers have not placed themselves in that position intentionally.

Often transmission of inaccurate information through poor communication channels is the culprit. Acquirers will want to determine what legal and financial exposures will accompany the acquisition and which exposures are covered by the acquirers’ insurance. Director and officer liability generally has a six-year statute of limitations. The acquiring bank typically takes responsibility for actions from the closing date going forward. Therefore, the acquired bank will often purchase a “tail” or “run-off” policy to protect its directors and officers for their actions occurring prior to the closing date. These tail policies will allow the sellers to have protection for up to six years after the sale.

Adding subject-matter expertise

Enlisting the assistance of experienced risk advisors during a merger or acquisition seems an obvious best practice. Yet for many smaller banks, especially those outside of major metropolitan areas, the temptation is to rely on long-standing legal, accounting and risk consulting relationships. Mergers are complicated affairs. Compared with a decade ago there is greater potential today for unseen risks that could hinder an otherwise sound merger or acquisition.

Having the right insurance policies in place to mitigate risk is an important complement to aggressive due diligence. D&O liability insurance has proven its handiness for bank mergers. It provides coverage for officers and board members for damages arising from settlements and defense costs in lawsuits alleging various wrongful acts frequently charged in shareholders’ suits.

A key to addressing D&O liabilities in an M&A context is to leave no ambiguities on the table. Bank officials should review their existing insurance coverages prior to the start of any serious M&A discussions held at the board level. If a merger ends up in litigation, board decisions that were made early on in the process may be cited in a lawsuit. It isn’t just a matter of obtaining coverage that will start when a merger is finalized. It is also important to understand existing policies for both the buyer and seller in case any issues from a company’s past are unearthed during or after the merger process. Also, the post-transaction risk profile of the combined entity may be different from that of the separate organizations prior to the transaction.

Getting the right types of insurance in place is a critical step a company can take to limit exposure during the merger process. Partnering with an experienced insurance provider minimizes the possibility that unexpected and uninsured post-transaction liabilities will emerge.

 

Kris St. Martin is vice president and bank program director with CBIZ Insurance Services. He has more than 23 years of direct bank experience in audit, procedures, IT security, lending and board training and has held many positions in the banking industry including senior lending officer, president, CEO and board chair. St. Martin has been providing risk mitigation services, including cyber, directors & officers and crime bond insurance, to the financial industry since 2009. Contact him at  [email protected] or 763-549-2267.