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Considering a Sale of the Bank? Don’t Forget the Board’s Due Diligence

July 12, 2016

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In today’s competitive environment, some bank directors may view an acquisition offer from another financial institution as a relief. With directors facing questions of how to gain scale in the face of heightened regulatory scrutiny, increased investor expectations, and general concerns about the future prospects of community banks, a bona fide offer to purchase the bank can change even the most entrenched positions around the board table.

So, how should directors evaluate an offer to sell the bank? A good starting place is to consider the institution’s strategic plan to identify the most meaningful aspects of the offer to the bank’s shareholders. The board can also use the strategic plan to provide a baseline for the institution’s future prospects on an independent basis. With the help of a financial advisor, the board can evaluate the institution’s projected performance should it remain independent and determine what premium to shareholders the purchase offer presents. Not all offers present either the premium or liquidity sought by shareholders, and the board may conclude that continued independent operation will present better opportunities to shareholders.

Once the board has a framework for evaluating the offer, it should consider the financial aspects of the offer. The form of the merger consideration—be it all stock, all cash, or a mix of stock and cash—can dictate the level of due diligence into the business of the buyer that should be conducted by the selling institution.

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How to Get the Most out of Annual Board Reviews

There has never been a more challenging time to be a bank director. The combination of today’s hugely competitive banking market, increased regulatory burden and rapid technological developments have raised the bar for director oversight and performance. In response, an increasing number of community banks have begun to assess the performance of directors on an annual basis.

Evaluation of board performance is done in many ways, and ranges from an assessment by the board of its performance as a whole to peer-to-peer evaluation of individual directors. Public company boards are increasingly being encouraged by institutional investors and proxy advisory firms to conduct meaningful assessments of individual director performance. The pace of turnover and change on most bank boards is slow, and more often the result of mandatory retirement age limits than focus by the board on individual director performance. This may be untenable, however, as the pace of external change affecting financial institutions often greatly exceeds the pace of changes on the bank’s board.

While some institutions prefer a more ad hoc approach to assessing the strengths and weaknesses of the board and its directors, we suggest that a more formal approach, perhaps in advance of your board’s annual strategic planning sessions, can be a powerful tool. These assessments can improve communication between management and the board, identify new skills that may not be possessed by the current directors, and encourage engagement by all directors. If used correctly, these assessments often provide valuable information that can focus the board’s strategic plan and help shape future conversations on board and management succession.

So what are the key considerations in designing an effective board evaluation process? Let’s look at some points of emphasis:

  • Think big picture. Ask the board as a whole to consider the skill sets needed for the board to be effective in today’s environment. For example, does the board have a director with a solid understanding of technology and its impact on the financial services industry? Are there any board members with compliance experience in a regulated industry? Does the board have depth in any areas such as financial literacy, in order to provide successors to committee chairs when needed? Do you have any directors who graduated from high school after 1985?
  • Develop a matrix. Determine the gaps in your board’s needs by first writing down all of the skill sets required for an effective board, and then chart which of those needs are filled by current directors. Then discuss which of the missing attributes are most important to fill first. In particular, consider whether demographic changes in your market will make recruiting a diverse and/or female candidate a priority.
  • Determine the best approach to assessment. Engaging in an exercise of skills assessment will often focus a board on which gaps must be filled. It can also focus a board on the need to assess individual board member performance. Many boards are not prepared to launch into a full peer evaluation process, and a self-assessment approach can be a good initial step. Prepare a self-assessment form that touches upon the aspects of being an effective director, such as engagement, preparedness, level of contribution and knowledge of the bank’s business and industry. Then, have each director complete the self-assessment, with a follow-up meeting scheduled with the chair of the governance committee and lead independent director for a conversation about board performance. These conversations are often the most impactful part of the assessment process.
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Employee Stock Ownership Plans: Another Tool for Family-Owned Banks

October 7, 2015

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Today’s economy presents numerous challenges to community bank profitability—compressed net interest margins, increased regulation, and management teams fatigued by the crisis. In response to these obstacles, many boards of directors are exploring new ways to reduce expenses, retain qualified management teams, and offer opportunities for liquidity to current shareholders short of a sale or merger of the institution.

For many family-owned banks, their deep roots in the community and a desire to see their banks thrive under continued family ownership into future generations can cause these challenges to be felt even more acutely. In particular, recruiting and retaining the “next generation” of management can be difficult. Cash compensation is often not competitive with the compensatory packages offered by publicly-traded institutions, and equity awards for management officials are unattractive given the limited liquidity of the underlying stock. All the while, these institutions should ensure that their owners have reasonable assurances of liquidity as needs arise or as investment preferences change. In combination, these challenges can often overwhelm a family-owned bank’s desire to remain independent.

Depending on the condition of the institution, implementing an employee stock ownership plan, or ESOP, may help a board address many of these challenges. While the ESOP is first a means of extending stock ownership to the institution’s employees, an ESOP can have other applications for family-owned banks.

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How the New FDIC Assessment Proposal Will Impact Your Bank

September 9, 2015

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In June, the Federal Deposit Insurance Corp. (FDIC) issued a rulemaking that proposes to revise how it calculates deposit insurance assessments for banks with $10 billion in assets or less. Scheduled to become effective upon the FDIC’s reserve ratio for the deposit insurance fund (DIF) reaching a targeted level of 1.15 percent, these proposed rules provide an interesting perspective on the underwriting practices and risk forecasting of the FDIC.

The new rules broadly reflect the lessons of the recent community bank crisis and, in response, attempt to more finely tune deposit insurance assessments to reflect a bank’s risk of future failure. Unlike the current assessment rules, which reflect only the bank’s CAMELS ratings and certain simple financial ratios, the proposed assessment rates reflect the bank’s net income, non-performing loan ratios, OREO ratios, core deposit ratios, one-year asset growth, and a loan mix index. The new assessment rates are subject to caps for CAMELS 1- and 2-rated institutions and subject to floors for those institutions that are not in solid regulatory standing.

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The Link Between Board Diversity and Smart Business

August 19, 2015

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Our time is one of rapid technological and social change. The baby boom generation is giving way to a more diverse, technology-focused population of bank customers. In conjunction with the lingering effects of the Great Recession, these changes have worked to disrupt what had been a relatively stable formula for a successful community bank.

Corporate America has looked to improve diversity in the boardroom as a step towards bringing companies closer to their customers. However, even among the largest corporations, diversity in the boardroom is still aspirational. As of 2014, men still compose nearly 82 percent of all directors of S&P 500 companies, and approximately 80 percent of all S&P 500 directors are white. By point of comparison, these figures roughly correspond to the percentages of women and minorities currently serving in Congress. Large financial institutions tend to do a bit better, with Wells Fargo, Bank of America and Citigroup all exceeding 20 percent female board membership as of 2014.

However, among community banks, studies indicate that female board participation continues to lag. Although women currently hold 52 percent of all U.S. professional-level jobs and make 89 percent of all consumer decisions, they composed only 9 percent of all bank directors in 2014. Also of interest, studies by several prominent consulting groups indicate that companies with significant female representation on boards and in senior management positions tend to have stronger financial performance.

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Ownership Succession for Family-Owned Banks: Building the Right Estate Plan

April 28, 2015

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For a number of community banks, the management and ownership of the institution is truly a family affair. For banks that are primarily controlled by a single investor or family, these concentrated ownership structures can also bring about significant bank regulatory issues upon a transfer of shares to the next generation.

Unfortunately, these regulatory issues do not just apply to families or individuals that own more than 50 percent of a financial institution or its parent holding company. Due to certain presumptions under the Bank Holding Company Act and the Change in Bank Control Act, estate plans relating to the ownership of as little as 5 percent of the voting stock of a financial institution may be subject to regulatory scrutiny under certain circumstances. Under these statutes, “control” of a financial institution is deemed to occur if an individual or family group owns or votes 25 percent or more of the institution’s outstanding shares. These statutes also provide that a “presumption of control” may arise from the ownership of as little as 5 percent to 10 percent of the outstanding shares of a financial institution, which could also give rise to regulatory filings and approvals.

Upon a transfer of shares, regulators can require a number of actions, depending on the facts and circumstances surrounding the transfer. For transfers between individuals, regulatory notice of the change in ownership is typically required, and, depending on the size of the ownership position, the regulators may also conduct a thorough background check and vetting process for those receiving shares. In circumstances where trusts or other entities are used, regulators will consider whether the entities will be considered bank holding companies, which can involve a review of related entities that also own the institution’s stock. For some family-owned institutions, not considering these regulatory matters as part of the estate plan has forced survivors to pursue a rapid sale of a portion of their controlling interest or the bank as a whole following the death of a significant shareholder.

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Integrating a New Product Line: Asking the Right Questions in the Boardroom

April 16, 2015

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As year-end results are finalized, many financial institutions are now budgeting for the coming year. With many banks struggling to find new revenue sources, these conversations are often focused on operational matters, including diversifying into new loan products and electronic payment applications designed to attract and retain new and existing customers. And while some boards of directors have a productive conversation regarding new products, these detail-rich discussions can result in the board overlooking the impact of the new product line on the bank’s strategic direction.

Directors, as part of their duty to maximize shareholder value, are responsible for charting the strategic course of the bank.  Too strong of a focus on operational matters may have the effect of muddling the important distinction between the roles of directors and officers going forward, leaving management feeling micro-managed and directors overwhelmed by reports and data in their “second” job. Instead, a higher-level discussion may be necessary in order to ensure that the board is focused on overseeing the institution’s strategic plan, while management is charged with safely and profitably executing the new business line.

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Negotiating Complexity: Executive Compensation Issues in M&A

April 8, 2015

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Upon reaching a letter of intent to acquire or sell a financial institution, many bank directors will breathe a sigh of relief. Following the economic challenges of the past several years, the directors of each institution have charted a course for their banks that will likely result in their respective shareholders realizing the benefits of a strategic combination. Although directors should be focused on “big picture” issues during the negotiation of a definitive agreement, they should not overlook the resolution of the many issues that can arise from executive compensation arrangements in a potential transaction. While often seemingly minor, compensation matters can raise unexpected issues that can delay or de-rail a transaction.

Procedural Issues

In addition to considering the economic features of a proposed merger, directors should also consider their individual interests in the transaction, including the potential payout of supplemental retirement plans, deferred fee arrangements, stock options, and organizer warrants that are not available to the “rank and file” of the company’s shareholder base. These arrangements may pose conflicts of interest for members of the board and are subject to different types of disclosure:

Disclosure of potential conflicts:  Early in the negotiation of a potential sale, individual directors should identify deal features that may create the appearance of a conflict of interest or an actual conflict of interest. With help from legal counsel, these personal interests should be disclosed and documented in the board resolutions approving the transaction. Appropriate disclosure and documentation of these actual or potential conflicts usually resolves these issues, but if significant conflicts exist, counsel may advise the use of a special committee or special voting thresholds for the transaction.

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Don’t Forget to Consider Deposits in an Acquisition

February 17, 2015

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With many U.S. markets experiencing slow loan growth, some boards of directors looking to increase the size of their institutions have turned to acquisitions to capture greater scale and efficiencies. While asset growth is important, directors should also consider the deposits acquired as part of a merger. Many banks have found that a careful evaluation of the deposits of the selling bank can spot unexpected issues and also drive earnings for the combined institution. The issues and opportunities raised by the liability side of the balance sheet have implications for both buyers and sellers going forward, particularly as they seek to maximize the scope and franchise value of their institutions.

Gaining Deposit Share and Margin

 With many growth opportunities centered in more densely-populated areas, some financial institutions plan to use an acquisition to establish a “beachhead” in a growing market. Unfortunately, many have found that a beachhead may not be enough, particularly with ferocious competition for quality loans in many metro markets. Other banks have taken a different approach by either consolidating market share in their home or adjacent markets, or by acquiring banks in rural areas that have solid earnings performance. For these banks, acquiring lower-cost deposits in slower-growth markets may help generate earnings that can fund loan growth in more competitive markets. What’s more, some banks have been able to diversify their CRE-heavy loan portfolio by picking up agricultural and other types of lending products through these acquisitions.

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Is The Time Right for De Novo Banks?

January 28, 2015

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Ten years ago, business was booming for community banks—profitability driven by a hot real estate market, a wave of de novo banks receiving charters, and significant premiums paid to sellers in merger transactions. Once the community bank crisis took root in 2008, however, the same construction loans that once drove earnings caused significant losses, merger activity slowed to a trickle, and only one new bank charter has been granted since 2008. But as market conditions improve and with Federal Deposit Insurance Corporation’s (FDIC) release of a new FAQ that clarifies its guidance on charter applications, there are some indications that an increase in de novo bank activity may not be far away.

To understand the absence of new bank charters in the last six years, one must look to the wave of bank failures that took place between 2009 and 2011, which involved many de novo banks. Many of these banks grew rapidly, riding the wave of construction and commercial real estate loans, absorbing risk to find a foothold in markets saturated with smaller banks. This rapid growth also stretched thin capital and tested management teams that often lacked significant credit or loan work-out experience. When the economy turned, these banks were not prepared for a historic decline in real estate values, leading to a wave of FDIC enforcement actions and bank failures.

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