Community banks rely on a number of partners and vendors to ensure the bank operates properly—from the lawn service to core data processors. A bank will often have a number of contracts governing its relationships with vendors. Vendor contracts are of great interest to a bank’s regulators. In addition, a potential buyer will conduct a thorough review of a bank’s third party contracts and vendor relationships. Therefore, proper vendor management and investment of resources on the front end can produce tremendous benefits not only with respect to examinations, but also in the context of a potential merger or sale.
When negotiating their vendor contracts, bankers should be aware that the FDIC, Federal Reserve and OCC all issued guidance regarding third party vendor management and outsourcing risks. The guidance is very useful and contains examples of the contractual provisions each agency will expect to see in vendor contracts. In our experience, it is difficult for a bank vendor to refuse terms referenced by the guidance even though such terms generally favor the bank.
Although existing regulatory guidance sets forth a number of contract terms to consider, the terms most important to a potential buyer govern (i) the term of the agreement, (ii) changes in control of the bank, and (iii) early termination penalties. A buyer will want the flexibility to terminate redundant contracts at or shortly following the acquisition. Accordingly, a seller may be able to demand a higher premium, or at least have additional leverage, if the buyer has the desired flexibility to terminate contracts without penalty.
On the other hand, vendors may be willing to offer lower rates if a bank agrees to a long contract term, high early termination penalty and strict prohibitions on changes in control of the bank. Therefore, when negotiating such terms with third party vendors, bankers should carefully consider whether they might want to engage in a potential merger or sale in the future. Although vendor discounts may sound very appealing on the front end, a bank’s circumstances can change greatly within a few years. Generally, avoiding contracts that are effective for longer than three years is the safest practice, although longer terms are appropriate under some circumstances.
M&A DEFINITIVE AGREEMENT
A buyer and seller will devote a fair amount of resources to ensuring matters regarding vendor contracts are addressed in the definitive agreement governing the sale of the bank. At a minimum, the seller will generally have to create a schedule to the definitive agreement containing all of its material vendor contracts. If the seller devoted appropriate resources in negotiating its vendor contracts as described above, this schedule and a few basic representations regarding the effectiveness of the contracts might be the end of the matter with respect to the definitive agreement.
However, depending on the circumstances, the definitive agreement may need to address certain additional details regarding the vendor contracts such as (i) which party is responsible for obtaining vendor consents regarding the change in control, (ii) what happens if a vendor refuses to consent, and (iii) who pays early termination fees. Again, not all contracts will contain restrictions on changes in control or early termination fees, but the buyer and seller will want to address such items in the definitive agreement in case they may become an issue. Typically the definitive agreement requires each party to obtain all required vendor consents. If a vendor will not consent, the party seeking such consent (typically the seller) is responsible to use reasonable efforts to provide the other party (typically the buyer) the benefit of such contract following closing. The party seeking consent will also often be responsible for paying early termination fees. However, a seller might argue buyer should pay the early termination fees since seller is delivering the bank in its historically operated condition and buyer should pay if buyer wants to change historical operations going forward. The ultimate terms of the definitive agreement governing vendor contracts will vary depending on the leverage of the parties and the definitive agreement as a whole.
M&A TRANSACTION STRUCTURE
Parties to a bank sale generally have the following choices when structuring the transaction: stock sale, merger, or purchase and assumption of assets and liabilities. Each of these transaction structures have unique advantages and disadvantages, applicable under different circumstances. Regulatory, liability, and tax considerations generally drive the parties’ decision about which transaction structure to use. However, vendor contracts potentially influence transaction structure, which may be detrimental to the overall acquisition process.
Take the following example: A buyer proposes to structure the transaction as a purchase and assumption of assets and liabilities based on regulatory, liability and tax considerations. Further, the buyer is willing to pay a larger premium if the seller agrees to this structure. The seller is not initially aware of any negative consequences to the structure. However, after completing additional diligence regarding vendor contracts, the buyer determines that too many of the seller’s vendor contracts require the vendor’s written consent prior to assignment of the contract to buyer and impose early termination fees if the vendor refuses to consent. The parties might now consider revising the transaction structure to a stock purchase or merger to avoid the additional time, effort and expense associated with obtaining vendor consents. Since the regulatory, liability and tax consequences of a stock purchase or merger are less advantageous to the buyer, the buyer will also likely lower its bid accordingly.
M&A ADDITIONAL CONSIDERATIONS
In many cases, the buyer and seller will use different core data processors (or even different products of the same processor), causing the buyer to terminate the contract with seller’s core data processor at closing. Unfortunately, data processor contracts are often the most sophisticated when it comes to restricting changes in control, long terms and early termination fees. Therefore, the parties are frequently in a position of having to deal with at least one early termination fee. Data processor contracts often contain complex formulas with respect to the amount of the termination fee depending on how many months remain on the contract and the average payments paid in prior months. Due to the complexity of the formula, the data processor may be willing to negotiate with respect to the ultimate termination fee. Data processors may be even more likely to negotiate the termination fee where the buyer and seller use different products from the same processor. However, data processors cannot be expected to leave too much on the table with respect to the early termination penalty, so a bank should not assume that its data processor will simply waive the fee if the bank is later put on the market.
Further, the buyer will often need to contact seller’s core data processor to schedule a conversion that will occur simultaneously with the closing. However, depending on transaction structure and the buyer’s situation, a conversion will not always be necessary. Buyers should consider the necessity of a conversion early in the acquisition process and make arrangements to consummate any required conversions as soon as possible. This early action is essential to minimizing delay as it is not uncommon for core data processors to require six months or more advance notice of a conversion. Often, the timing of the closing is more dependent on the conversion schedule than the regulatory approval process.
Proper negotiations with third party vendors and early strategic planning can generate good will, leverage and possibly a premium for sellers in the M&A process.