The community bank mergers and acquisitions market is currently very active. While this has been the case for the past few years, the industry as a whole is in a much different place today than it was five years ago. During and coming out of the recession, much of the industry’s consolidation was born out of necessity—i.e., survival—and many of the “traditional” reasons for mergers and acquisitions, such as lack of succession or a price too good to refuse, were not predominant factors driving deals. In today’s environment, an increasing number of community banks that are looking to get into the game are there, at least in general, because they believe an acquisition transaction is a good strategic move for the long term benefit of the shareholders. This shift in motivation has not only impacted the tenor of the negotiation process, but it has had a positive impact on overall preparedness for a transaction, particularly as it relates to due diligence.

The due diligence component of an acquisition is an irreplaceable factor in the overall success of the transaction. From the buyer’s perspective, conducting a proper due diligence review will, at a minimum, either confirm the legitimacy of a safe and sound target or allow a buyer to avoid what would otherwise be a very unwelcome surprise after closing. When a target limps out of the recession and comes to the negotiation table bleeding, it is clear—at least it should be clear—to the acquirer that there is a problem in need of addressing. For the most part, though, today’s banks are healthier, more profitable, and more compliant. This only underscores the importance of taking time to confirm the shape of the target.

From the seller’s perspective, if the transaction is funded entirely with cash, the seller’s due diligence is limited essentially to whether the buyer can receive regulatory approval of the acquisition and fund the cash consideration at closing. If the seller is accepting the buyer’s stock as all or a portion of the total consideration, however, the seller is practically in the same position as the buyer. In that situation, the seller is, in essence, using their company to acquire stock in the purchaser, so it is prudent for the seller to complete a thorough due diligence review of the buyer prior to making the investment.

In light of what is at stake, the due diligence review should always take place prior to entering into the acquisition agreement. Although there are often “outs” that allow either party to walk away from a transaction after the agreement is signed, there are often monetary penalties imposed on the party that walks away, not to mention the wasted time and emotional energy. It is in everyone’s best interest, then, to coordinate and prepare for each aspect of due diligence as soon as possible. In this respect, there are essentially three major components of a thorough due diligence review that need to be taken into account by the buyer, each with multiple “sub-components” of importance. (As noted above, due diligence is of significance to sellers as well, but this article will focus on the perspective of the buyer.)

Asset Quality Review

The first major component, and the one given the most focus in recent memory, is asset quality. The asset quality review is similar to a safety and soundness examination in that the acquirer should thoroughly review the quality of each of target’s primary classes of assets. The scope in this regard will vary depending on the makeup of the specific target. With that said, for most community bank acquirers, the majority of their efforts will focus on the target’s loan and investment securities portfolio, since this typically represents the vast majority of assets in most community banks. However, the value and investment quality of the other assets should not be taken for granted.

To properly complete the asset quality review, an acquirer needs to have the right people involved. For example, to thoroughly review the target’s loan files, the acquirer should at minimum use its loan officers, outside professional assistance, or both. Due to confidentiality and the sheer volume of documents, this review is typically done on-site, which requires the buyer to ensure all the necessary individuals are present and have access to the necessary documents. While this requires an increased level of coordination, having the right individuals involved affords the buyer three benefits:

  1. The acquirer gains a first-hand understanding of the target’s credit culture, underwriting standards, documentation standards, and similar aspects of credit administration;
  2. The acquiring loan officers familiarize themselves with the target’s credits and fully understand the combined credit portfolio following the acquisition; and
  3. Specific credit or documentation deficiencies are noted, considered, and possibly resolved prior to entering into the definitive agreement.

The acquirer’s review of the target’s investment portfolio is similar to its loan review. The acquirer identifies the appropriate individuals, and those individuals review the target’s investment portfolio so the acquirer thoroughly understands the types of investments held in the portfolio and the associated risks, particularly interest rate and credit risk. The most notable difference is that the investment portfolio review is often much easier to conduct off-site. An off-site review may also be appropriate for other sub-categories of assets, but the overall process should be similar in form and function to the loan portfolio review.

Which individuals are appropriate for a specific area of review is a matter of discretion, but it is certainly better to over prepare than under prepare. As previously noted, some asset quality reviews are completed solely by the acquirer’s loan officers. Others involve outside professionals, such as consultants or external loan review providers. The involvement of outsiders will depend on the size of the loan portfolio, the cost, and other similar factors, which is a good reason to begin communicating and coordinating the due diligence process as soon as possible.

Regulatory Compliance Review

The second major component of an appropriate due diligence review is a thorough review of the target’s regulatory compliance. It should be no surprise that compliance has been a “hot button” issue since the recession. A compliance violation can result in a quick and heavy hammer on the institution, and resolving a compliance issue can be a long road. Under no circumstances does an acquirer want to purchase an unidentified compliance nightmare, so the importance of this review cannot be overstated.

In regard to personnel, a compliance review is most often completed by the acquirer’s compliance officer or internal or external auditor. The form or process of this review is similar to an asset quality review, though it is most often conducted off-site, at least initially. It is typically only if the off-site review of policies, SARs, board minutes, and the like reveals any issues or matters of question that a team may be sent on-site for a more detailed review. However, in most situations, requesting provision of additional documentation or information is sufficient. Again, what is appropriate should be determined in light of the specific target and specific matter at hand.

It should go without saying that this portion of the due diligence review is intended to identify any and all areas of deficiency or risk with regulatory compliance. This, of course, results in an extensive list of areas to be reviewed, so prioritization based on the environment and specific target is critical. The “hot topics” in today’s environment relate to Unfair, Deceptive or Abusive Acts or Practices, BSA/AML, Fair Lending, Truth in Lending, RESPA, and similar regulations. The important aspect of a regulatory compliance review is to identify areas of potential liability in the target’s operations, any prior regulatory criticisms, and any material weaknesses that must be corrected in order to ensure the acquirer does not have any surprise regulatory compliance issues following closing.

Legal Review

The third important component of a thorough due diligence review is the legal review, which analyzes the legal risks associated with target’s governance and operations. Typically, the legal due diligence is completed by the acquirer’s outside or in-house counsel and is intended to fully understand the target’s corporate structure, potential corporate liabilities, and corporate operating policies and procedures. Examples of documents that should be reviewed in this area are the target’s governing documents, such as the Articles of Incorporation and Bylaws, Board Minutes for typically the prior two years, shareholder proxy materials and meeting minutes for typically the past two years, statements from counsel regarding any recently completed, pending, or forthcoming litigation, any documents associated with recent merger transactions or stock offerings, and similar documentation.

Of the three areas discussed in this article, the legal review is the most ambiguous on the front end. Whereas asset quality and compliance are issues commonly critiqued in the banking world, it is much less common for an outside party to conduct a detailed review of the target’s governing documents and shareholder materials. Often, the potential issues that arise in this review are ones that the buyer may not know to look for because they frankly have very little to do with the target’s operations. That does not, however, mitigate their significance.

As an example, our firm recently conducted a due diligence review in which the number of target shares issued and outstanding exceeded the number of shares authorized by the target’s governing documents. While we were able to resolve the issue with the appropriate board resolutions and amendments, this could have been a significant problem if it had gone unnoticed. For one, the target attested to the validity of all issued and outstanding shares as a representation and warranty in the definitive agreement. Failure to remedy the error would have at minimum resulted in a technical breach of the representation and warranty, and it could have ultimately invalidated the transaction on the basis that shareholder approval was ineffective since some of the shares were not validly issued.

An appropriate due diligence review includes an asset quality, regulatory compliance, and legal review. If you find yourself in a situation where due diligence of another party is appropriate, be certain not to omit any of these important components or fail to have the appropriate individuals participate in the review. Doing so significantly increases the chances of unwelcome surprises at some point in the future.


by Greyson Tuck, Attorney, Gerrish Smith Tuck