Financial institution regulators have increased their scrutiny of bank compliance systems and controls following the financial crisis. The number and severity of enforcement actions has accordingly increased. At the same time, the pace of community bank M&A has also increased, leaving bank directors and investors with an essential dilemma: How much is a bank worth as compliance costs continue to rise in the post-financial crisis world? This article adds clarity to that question by exploring the relationship between regulatory risks and firm value. A well designed legal due diligence process can uncover regulatory issues that can, when analyzed through a valuation-oriented lens, assist management and financial professionals in adjusting a firm’s value, up or down, as appropriate.
Due diligence consists of evaluating both business and legal work streams, with the former tending to focus on business risks and valuation and the later tending to focus on legal risks and deal structure. While legal due diligence might occasionally inform firm valuation, such as purchase price adjustments due to litigation or insurance claims, it does not generally, by design, prioritize valuation.
Take, for instance, the following example of a hypothetical medium-sized bank with $15 billion in assets that offers a variety of traditional banking products, including consumer financial products. Given its size and product offerings, this mid-sized bank is subject to regulation by the Consumer Financial Protection Bureau (CFPB) in addition to its prudential banking regulators.
In our hypothetical example, legal due diligence uncovers that the mid-sized bank previously marketed and sold a debt protection credit card product for several years through an aggressive telemarketing campaign. The product was advertised as permitting customers the ability to cancel credit card payments in the event of certain hardships such as job loss, disability and hospitalization. Consumers who enrolled in the product were charged a fee. Legal due diligence finds that the telemarketers did not disclose the product fee and that promotional materials contained material inaccuracies concerning the product’s scope of coverage and exclusions. Legal due diligence further reveals that the CFPB is pursuing an ongoing campaign of enforcement actions against banks that sold similar products.
Legal counsel conducts an analysis of prior enforcement cases, studying time frames between banks’ underlying offending activities and resultant enforcement actions; sizes and types of penalties in relation to the offending banks’ conduct; mitigating effects of remediation, self-reporting, and cooperation; and other pertinent factors. Legal counsel also reviews the underlying customer contracts, the dollar volume of fees collected by the mid-sized bank on the product, the number of customers who applied for coverage versus the number who successfully obtained debt protection, the volume of customer complaints received on the product, and the pattern of private class action suits based on similar underlying facts in other cases.
Based on this legal due diligence, mid-sized bank’s financial advisors determine that it is appropriate to adjust the financial forecast of the bank such that two years after an acquisition, forecasted pre-tax earnings are decreased by $15 million as a result of a possible CFPB-ordered restitution and civil money penalty payments, as well as related compliance, consulting, and legal fees. Year four pre-tax earnings are decreased by $10 million, as a result of an expected settlement of private class action litigation. These adjustments then flow through the valuation model. In assessing a potential acquisition of a mid-sized bank, a prospective buyer might now be able to better adjust the purchase price of mid-sized bank in a more disciplined and analytical fashion, and negotiate certain other purchase price adjustments based on these enforcement contingencies.
We are aware of at least one serial acquirer of smaller community banks that builds into its typical merger agreement a purchase price adjustment for declines in capital resulting from compliance deficiencies (among other specified items). Such provisions are rare in the bank M&A market as they are not attractive to a seller, unless the acquirer’s bid is clearly higher than the next closest in value. This further points to the importance of the due diligence process.
The example of the mid-sized bank presents a case in which valuation and deal structure can benefit from valuation-oriented legal due diligence. Buyers can avoid the risk of overpaying and sellers can avoid the risk of underselling a bank. Whether valuation is adjusted up or down in light of legal due diligence, in the post-financial crisis world, bank directors can add significant value to an M&A transaction through the addition of such a process.