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In this second part of a two-part series, we will continue to provide a brief overview of the current issues that remain at the forefront of recent activity in the financial institutions industry, as it continues to be in the midst of a major transformation. LOCKUPS AND FIDUCIARY TERMINATION RIGHTS In previous years, a merger agreement between two banking institutions was unlikely to draw fire from other bidders. These days, though, the strategic importance of banks’ expansion plans often means that a single company may be the target of great interest by numerous potential acquirers — a trend that may be encouraged by Gramm-Leach-Bliley, which has opened up the game to a range of new players. For this reason, the practice has become nearly universal of “locking up” a merger agreement with strong contractual protections, and relatively few bank merger agreements (even in the context of a cash merger) contain fiduciary termination rights which are more prevalent in non-bank merger transactions. Lock-up protections generally include a stock option granted to the acquirer by the target, as well as prohibitions in the merger agreement against the target soliciting or encouraging a competitor to bid. In an MOE, cross stock options are generally granted. The lockup provisions give the acquirer additional assurance that its proposal will be consummated or, at the least, that if a competing bidder is successful the acquirer will be compensated for its efforts. The terms of these lockups are heavily negotiated, and their structure is dictated by regulatory concerns about capital and control issues and by legal considerations about directors’ duties and “fiduciary outs,” as well as by business considerations. The form of lock-up option that is most prevalent in bank merger transactions is a 19.9 percent option on the target’s shares, including a put right that enables the holder to receive the cash value of its option shares upon the consummation of a competing acquisition. The put feature, if not the mere grant of the option itself, will prevent a competing acquirer to account for its competing transaction on a pooling-of-interests basis. Where potential raiders may not need pooling treatment, stock option agreements are sometimes replaced or supplemented with cash bust-up fees. In all situations, it is important that a proper record and foundation be made for the grant of lock-up protections, especially in light of cases outside of the banking context in which lock-up options have been challenged. It has long been accepted that lock-ups are necessary and appropriate in bank mergers and other transactions that have lengthy regulatory approval processes or other special attributes. Notably, courts have shown particularly great deference to director determinations in the bank merger context. MERGERS OF EQUALS Merger of equals (MOE) activity has risen dramatically in recent years, with transactions coming in all shapes and sizes. MOEs differ in many important respects from a straightforward acquisition of a smaller company by a larger one. In a merger of equals in which governance and management roles are truly shared, neither company will be able simply to eliminate the culture and traditions of the other and to impose a new order from above. Rather, the parties must cooperate to make the merger work. This cooperation must begin at the management level, where painful decisions frequently must be made. The partners must find ways to combine operating systems, integrate businesses, cut costs and coordinate activities without harming employee morale, disrupting customer relationships or disrupting important ongoing projects. In some cases, conforming one company’s practices to the other’s is necessary; in other cases, maintaining different practices may achieve the best results. No easy formula for success exists. Each situation must be judged on the basis of individual facts and circumstances, with sensitivity to the personalities involved and their talents and weaknesses. To avoid nonproductive turf battles that can undermine performance, companies should carefully consider the need to clarify lines of authority early when necessary to accomplish the tasks required to close the transaction. In a number of recent MOE transactions, moves by companies to jointly appoint a transition team of senior executive officers to provide accountability in the integration process have been well received by the investor community. Successful implementation of a merger of equals requires careful advanced planning. As recent experience has shown, it is critical that a positive market reaction to the transaction be obtained in order to reduce both parties’ vulnerability to a competing offer following the announcement of the deal. While lock-up options can provide some economic and structural protection against competing offers, the protection is often incomplete, especially for smaller transactions. Strong market support and a strong business rationale for the merger are needed to provide added protection and deterrence. The line between MOE transactions and true “purchase” or “acquisition” transactions is often blurred. Over the past several years we have seen a number of significant transactions in which one merger partner, received significant social concessions in the context of a modest or even high premium-to-market transaction. Each such transaction involved a delicate balancing of agreements on name, headquarters, board composition, management and management succession. With these transactions structured as stock-for-stock pooling transactions, each party remained on firm legal ground in seeking out its preferred merger partner without conducting any specific market check or broader auction. LOW PREMIUM MERGERS Generalizations about merger pricing are difficult to make, and there is likely less predictability today than in the past. Premiums to market price in bank acquisitions in the range of 25 percent to 40 percent are not uncommon. The largest transactions, however, often are lower-premium “merger of equals” transactions. Many mid-cap banks and thrifts in particular have found it increasingly difficult to attract large cap acquirers in this current market environment. And, indeed a number of institutions that have quietly tested the waters in recent periods have found a “buyer’s market” with limited interest at price levels they would find attractive at the current time. This suggests that lower premium mergers among mid and smaller cap institutions may prove to be the most attractive strategy available to some. It is also important to recognize that premiums to market reflect a wide variety of factors, and the trading range of a target’s shares often fluctuates significantly relative to the target’s underlying intrinsic value. Certain rumored target bank stock prices have run up on deal speculation. Thus, the market price of these companies may be fully priced from an acquirer’s perspective and a further large premium to market may not be realizable. The Huntington/First Michigan transaction in 1997 and MONY/Advest transaction from earlier last year are examples of deals priced slightly below market, underscoring what may happen when a takeover target has been bid up to full premium levels. Such takeover speculation can make premium to market a less reliable indicator of the value target stockholders are receiving in a merger. MOE pricing is obviously different, often being done at a market exchange shortly before announcement of the merger agreement, reflecting an apportionment of relative contributions of earnings, equity, assets, deposits and the like. Because MOE pricing is often at market, speed and absolutely confidentiality prior to execution of a definitive agreement is even more critical, as speculation of an impending deal may raise unrealistic expectations about the probable premium to market, pushing up the target’s stock price. From a legal perspective, there is no per se requirement that transactions be priced at a premium to market. A decision to proceed with a given transaction need not be abandoned solely because speculation or rumor pushes a target’s market price above the deal price. Numerous transactions both inside and outside of the banking industry have been struck at below announcement date market prices. While directors should of course consider the relationship between deal and market prices, both current and historic, especially in the context of an all-stock, or even a part-stock part-cash merger transaction, directors have substantial flexibility in evaluating the potential benefits of a transaction based on a broad range of financial factors. HOSTILE ACQUISITIONS Hostile acquisitions of financial institutions have been relatively rare in the U.S. The challenges faced by Wells Fargo in its hostile acquisition of First Interstate and the relatively ample supply of white knight alternatives to a hostile bidder in the U.S. context suggest that such tactics will only be used rarely, at least in the nearer term, in a U.S. context. Target institutions are typically well fortified against an all-out hostile attack, and given the high regulatory hurdles and availability of white knights, the successful implementation of a hostile raid is extremely difficult. Even where a would-be acquirer succeeds in putting a target company “into play,” the acquirer faces a substantial risk that it will not ultimately be the successful acquirer (as was the case in Ahmanson/Great Western). All that said, for every general rule there are exceptions, as witnessed in North Fork’s unsolicited offer for Dime Bancorp in March 2000 which derailed Dime’s then pending merger with Hudson United. North Fork’s bid was ultimately defeated when Dime entered into a white squire transaction with Warburg Pincus. More widely, with a dwindling universe of willing targets, bear hug letters and other pressure tactics remain common. The best initial takeover approach is almost always a friendly approach on a CEO to CEO basis, although other contact points, including key directors or significant shareholders may also be productive. Bear hug letters constitute a more aggressive approach, especially if the letter is made, or becomes, public, and run the risk of scaring away a potential target or forcing the target into the arms of another suitor. A well crafted bear hug letter may, in some circumstances, be a useful means of keeping your toe under the tent. Even if the bear hug letter does not trigger an immediate result, it can be useful in increasing the pressure on the target to consider a possible sale and to include the sender on the list of parties that are contacted if and when a sales process is commenced. Both the making of a bear hug or hostile offer and the response to such overtures require a careful balancing of legal, financial and business concerns. The combined demands of securities and banking laws, and the fiduciary duties of directors under state laws, must be considered. STRATEGIES FOR SELLERS While there is generally no duty for the board of directors of a public company to seek an acquisition partner or to negotiate with a potential acquirer that approaches the company, the realities of the marketplace and the competitive pressures faced by many institutions may make it difficult for target boards to ignore actual or potential overtures unless they have established an independent strategy designed to achieve greater long-term value for shareholders. In light of the recent high level of takeover activity, it is extremely important for potential takeover candidates to proceed carefully in exploring their strategic options. Extreme care must be exercised in commencing merger discussions, even on a preliminary basis, if a company is not firmly committed to pursuing a sale. When meaningful discussions are held, appropriate confidentiality and standstill arrangements should be implemented. Even where the company has committed to the sale process, careful thought must go into structuring the process and in determining whether a controlled auction or limited negotiations with one or more parties is the best means of obtaining the optimal merger proposal. While the assistance of expert outside advisors is important to help ensure a successful result, management and the board should remain in control of the process and make sure that it is one of their choosing as opposed to one dictated by their advisors. A company can pursue a friendly negotiated transaction, including a so-called merger-of-equals transaction, without putting itself up for auction. It is extremely important, however, for institutions pursuing such strategies to manage the process carefully to avoid attracting competing bidders before their transaction can be signed up. In advance of any exploratory process, it is important for an institution to carefully review its takeover defenses to ensure that the institution is prepared to respond to an unfriendly takeover overture. ALTERNATIVE ACQUISITION STRUCTURES The structures available for financial institution acquisitions are as numerous as the considerations influencing the choice of structure. Not surprisingly, recent mergers have used a variety of structures. Depending on the circumstances, structure can be determined by regulatory capital requirements, desired accounting treatment, tax considerations, preserving certain “grand-fathered” activities no longer permitted under federal banking law, shareholder or debtholder approval requirements, timing considerations or shareholder-, public- or employee-relations concerns. The ultimate choice can only be made after careful analysis, and, because the analysis will be shaped by emerging economic, legal, accounting and market developments, will of necessity be the subject of an ongoing, up-to-the-minute review. While stock-for-stock pooling transactions have remained a prevalent form of bank merger transactions, there have been recent incidences of part-cash, part-stock transactions and 100 percent stock purchase transactions as capital conditions in the industry have improved and stock buybacks have become an important tool in managing equity returns. Indeed, cash and part cash acquisitions can be one of the most effective means of deploying excess capital. Cash election mergers present a host of complex structural issues, including issues relating to the allocation of the cash and stock components through an election or proration procedure, as well as special tax considerations. All-cash transactions, which though less common are used in the context of assisted transactions, sales of subsidiaries or assets, smaller acquisitions and acquisitions by foreign-owned banks, raise their own set of legal and regulatory issues. Acquisition structures for non-bank financial institution transactions run the full gamut of possibilities With the end of poolings, cash acquisition structures and more complex structures involving hybrid securities (including possible letter or tracking stock structures) may become more prevalent. Stock will remain an important component of most transactions, however, at least in the case of regulated entities that need to satisfy capital requirements. Once a structure is chosen, the format of the merger or acquisition agreement for a large public company transaction will largely follow as a matter of course. However, recent transactions have demonstrated that certain contract issues can become critical. Pricing provisions, in particular, present a number of important choices: whether to use a fixed exchange ratio or a pricing formula and, if the latter, whether to “collar” the formula, or to add a “walkaway” provision. Post-signing due diligence termination rights and post-signing financial conditions have also been utilized in rare circumstances and can raise complex and delicate negotiating issues. The treatment of special provisions for loan losses and other merger-related charges and potential divestiture issues can also raise delicate concerns which must be handled with extreme care to avoid deal-threatening complications. Acquirers should not lose sight of the fundamentals that have led to the recent state of health in the financial institutions industry. Unlike the conditions that faced the industry in the late 1980s and early 1990s, today the U.S. financial institutions industry still remains largely sound with a solid capital base and good long-term earnings prospects. Nonetheless, in the context of planned acquisitions, especially in the current market environment, careful and considered due diligence is a must. Like other aspects of reaching agreement on a deal, it is worthwhile to think about the due diligence process that will be best for a particular transaction, and in particular the number and seniority of people that should be involved. ANTITRUST ISSUES Antitrust analysis of in-market transactions has become increasingly important in view of the recent actions of the Antitrust Division of the Department of Justice with respect to bank mergers. In 1999 cross-town rivals in Boston and Salt Lake City proposed mergers with very significant in-market overlaps. While the latter transaction, Zions/First Security, was terminated for reasons unrelated to antitrust concerns, the New England merger between Fleet and BankBoston was successfully completed and illustrates the considerations that parties in such transactions must take into account. In proposing their merger, Fleet and BankBoston were aware that the prior history of acquisitions and mandated divestitures in the New England region, as well as the operation of various state deposit cap statutes, would require a preemptive divestiture proposal. The parties, accordingly, worked with the Department of Justice and the Federal Reserve Board — even prior to entering into the merger agreement — to develop a comprehensive divestiture proposal that met regulatory concerns while preserving the economic rationale for the transaction. With the basic outlines of the $13 billion divestiture plan in pace as of the public announcement of the merger, the remainder of the regulatory review process focused primarily on addressing competing federal and state political concerns with respect to the structure of the divestiture package and the identity of the divestiture buyers. In addition, novel issues were presented with respect to excluding from the divestiture certain lines of middle-market business conducted in the parties’ headquarters locations. The Fleet/BankBoston transaction demonstrated that the impact of antitrust considerations must be evaluated before entering into negotiations, and discussions between the two parties should include the formulation of a strategy for minimizing the required divestitures. Because of the technical and legal nature of these issues, the entire process should be guided by competent counsel experienced in banking and antitrust matters. In 2000, banks also faced a new antitrust regulator, since under the Gramm-Leach-Bliley Act, the non-bank portions of financial holding company acquisitions and mergers are now subject to the Hart-Scott-Rodino Act, and the jurisdiction of the Federal Trade. So far this process has run smoothly in most major transactions. Craig M. Wasserman is a partner at New York’s Wachtell, Lipton, Rosen & Katz. Larry S. Makow is an associate at the firm.

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