- Credit Union Mergers vs. Compliance Considerations: An Oxymoron
- March 7, 2012 | Authors: Aaron J. Ambrose; E. Andrew Keeney
- Law Firm: Kaufman & Canoles A Professional Corporation - Norfolk Office
In today’s economic climate, all credit unions are well advised to stay flexible and seek every opportunity to achieve success in these difficult financial times. With ever increasing operating and compliance costs, coupled with significantly decreased member fee income, credit unions considering a merger must be on the alert for the short-term, as well as long-term, impact of the ever-changing world of consumer compliance rules and regulations.
Unfortunately, many credit unions tend to view a potential merger opportunity as a sign of weakness or an indication that the credit union has given up on its mission and its members. To the contrary, quite often a credit union merger, and even the initial discussions with a potential merger partner, represent a well-intended forward thinking and long-term strategic plan and approach. Often a struggling credit union will face a tough reality - if the struggling credit union stays on its present course without any remedial action, member service will ultimately suffer. When member service begins to suffer, the members begin to migrate away from the credit union, seeking more stability and better customer service. No credit union wants to lose members, and in the current economic climate, very few credit unions can afford to lose members.
Credit union mergers generally fall into one of two categories. The first is a forced merger that is regulatory in nature and is driven by the credit union’s regulatory agency.
The second type of merger, and the type of merger that will be the focus of the remainder of this article, is a voluntary, strategic merger between two willing credit unions. They desire to pool and merge resources to achieve certain efficiencies with the goal of achieving the ability to provide optimal member service to the collective membership base of the two merging credit unions.
The benefits of a merger are well documented and include the ability of the surviving entity to take advantage of economies of scale, administrative and management consolidation, regulatory compliance efficiencies, and other advantages that come along with a larger membership base. If a credit union is struggling financially, finding a larger, more stable merger partner in which to merge the credit union can be an attractive methodology for achieving the goal of long-term health of the credit union and its members. This should not be viewed as a failure or a disappointment to the members. Instead, it can and should be presented to the existing membership base in a positive light, as a strategic business decision to reposition the credit union and its members for long-term viability and sustainable success over the long term.
Credit union mergers can also provide for a valuable succession planning tool. For a credit union led by a Chief Executive Officer with plans to retire in the near future, but without a clear succession plan in place in terms of the credit union’s next-in-line to become CEO, a potential merger with another credit union that has strong leadership and a well-positioned CEO may be the best option.
Regardless of the reason for a merger, it is worth noting that the merger process is something that takes planning, forethought and a good bit of courting between the two potential merger partner credit unions. Typically, the discussions and preliminary negotiations take place between the CEOs of the potential merger partner credit unions or the CEOs and respective Chairmen of their Boards. At this preliminary stage, the two potential merger partners need to get a sense of each other’s philosophies, core and fundamental beliefs, and strategy for success going forward. There are no rules or regulations that would specify how long the courtship period between two potentially interested credit union merger partners should last. These courtships can last for six months or even two years (or more) depending on the situation and the process, and either is perfectly normal.
Once the CEOs of the potential credit union partners have agreed in principal that they would be willing to merge the entities, the next major step is taking the concept and preliminary details of the proposed merger plan to the respective credit unions’ Boards of Directors. This process can also be time consuming. It will require education of each Board such that each is fully apprised of the motives and objectives behind the potential merger and the expected benefits and efficiencies that will result. A thorough presentation to the Board by the credit union’s senior management team is a must.
Once each respective credit union has "kicked the tires" of the other potential merger partner credit union and each are satisfied with the results of such due diligence inquiries, the parties then must adhere to and obtain preliminary regulatory approval from the applicable regulatory agency or agencies. Depending on the structure of the two merging credit unions (i.e. whether they are both federally-chartered credit unions or if one is a federally-chartered credit union and the other a state-chartered credit union), the rules are slightly different. Preliminary regulatory approval is the precursor to taking the potential merger to a vote of the members. Often a major undertaking based on the size of the merging credit unions, the member vote is essential. Much like the initial presentation to the Board, the presentation to the members must be strategic and centered on the positive and beneficial nature of the intended and expected results of the merger. Without the requisite member approval vote, the merger is dead in the water. Finally, once the members have voted to approve the merger, the respective Boards of the merging credit unions may begin to integrate and initiate strategic long-term plans and decisions, and must also obtain final regulatory approval.
The NCUA (for federally-chartered credit unions) publishes a Credit Union Merger and Conversion Manual that walks a credit union through the regulatory process and requirements for consummation of a credit union merger. The document is available by clicking here. It provides a valuable resource to credit unions that are exploring a potential merger and/or moving forward with merger discussions and negotiations. The guide provides useful forms for credit unions to utilize as they navigate the merger landscape. Of course, the involvement of experienced advisors, including attorneys, accountants, and other business advisors, who understand and have worked with credit unions, but that also have experience in mergers and acquisitions, is a must. The guide is a useful tool and the forms provided by NCUA are helpful. Nothing replaces the expertise and insight of professional advisors who understand both the credit union industry and who also understand the complexities associate with mergers and the post-merger consummation.
As noted above, due diligence is key. A comprehensive due diligence phase will include a look at every aspect of the other potential merger candidate, from contracts to personnel, from management philosophy to dividend policies, from branch locations to electronic member service lines. Each credit union will want to obtain as clear a picture as possible with respect to the health, status and direction of its potential merger partner.
As one of the major due diligence items, the surviving credit union will want to complete a thorough analysis of the potential merging credit union’s open-end lending portfolio. This would include all open-end loans, including without limitation credit card portfolios, home equity line portfolios, and the status of the other credit union's open-end lending program, if any.
The credit union must be sure, prior to assuming them pursuant to the merger, that such open-end loans and lines of credit in its merger partner’s portfolio are acceptable to the acquiring or surviving credit union. Once the merger plan is executed and finalized, the surviving credit union inherits and assumes the assets and liabilities of the non-surviving credit union. Thus, it is imperative to note the health, past performance, and future prospects for such open-end lending platforms.
To focus on the credit card portfolio, the surviving credit union needs to get itself comfortable with the existing credit card portfolio. This includes the rates, the credit tiers used to establish risk-based rates, etc., with respect to the non-surviving credit union’s portfolio that would be assumed pursuant to the merger. In merging with another credit union, should the surviving credit union determine that it desires to increase the annual percentage rates on the credit cards assumed from the non-surviving credit union pursuant to the merger, the change in annual percentage rate would be considered a significant change in terms. The surviving credit union would be required to send a change in terms notice to each member affected by the increase in APR. Regulation Z requires forty-five days’ advance notice to the member of an increase in the annual percentage rate. In addition, the member would then have the option to reject the "significant change in terms" to their credit card and opt instead of accepting the increase to reject the change, close their credit card account, and repay it on its then current terms.
Clearly, the surviving credit union would face a difficult business decision if it were to assume an underperforming credit card portfolio. One the one hand, the credit union can always decide to increase rates on its credit card products in accordance with the procedures set forth in Regulation Z, but any such decision would have to be tempered by and weighed against the potential loss of credit card business and volume due to member backlash and outcry against such increases in rates from the "new" credit union.
Another important area for the due diligence inquiry will be third-party vendor contracts. All third-party vendor contracts will need to be reviewed thoroughly to determine which vendors will be retained by the surviving credit union. In many instances, where the two merging credit unions have contracts with two separate vendors for the same service (for example, a check printing service), the surviving entity will need to make a determination as to which vendor to retain and which to part ways with. Typically, the surviving credit union will want to maintain its current vendor relationship, but this is not always the case. If, during the due diligence process, the surviving credit union determines that the non-surviving credit union has a better third-party vendor arrangement, this may give the surviving credit union additional motivation to consummate the merger. The focus would then turn to a review of the surviving credit union’s vendor contract to determine how it may be terminated. In calculating the costs and expenses involved in the overall merger process, the due diligence review of vendor contracts will be critical, as some contracts will require early termination fees, while others will contain provisions that set pricing terms on the number of members of the credit union.
Similarly, the surviving credit union, prior to assuming and taking on a mortgage loan portfolio of its merger partner, must perform a thorough analysis of the target credit union’s existing mortgage loan portfolio. If mortgage lending is something that the surviving credit union is actively engaged in and relies on as a revenue-producing segment of the credit union, then the surviving credit union needs to ensure that it will be assuming a healthy and profitable, well-performing mortgage portfolio. Relevant to the inquiry is whether the target credit union originates, funds and services its own mortgage loans in its own portfolio or whether the target credit union outsources these functions or sells its mortgage loans on the secondary market. If a third party services the mortgage loans, does the target credit union have a right to buy back those servicing rights such that the surviving credit union may be able to purchase the right to add such loans back into the credit union’s portfolio in order to realize profits from the same? Regardless of the status of the mortgage lending portfolio, the surviving credit union during the due diligence process needs to become familiar with the target credit union’s mortgage lending practices, and the overall "fit" of the target credit union’s mortgage loan portfolio into the surviving credit union’s existing mortgage loan program and portfolio. With the bevy of recent regulatory changes to the requirements for loan modifications, the costs, time and resources involved in modifying mortgage loans has increased to heightened levels. For all intents and purposes, after a merger the surviving credit union cannot, from a practical perspective, assume an underperforming mortgage loan portfolio with the intent to go in and modify the terms of the existing mortgage loans to align with the surviving credit union’s mortgage loans.
Often overlooked, but vitally important to a financial impact analysis of a potential merger, is the existence of such springing clauses that would operate to increase the fees due to a third-party vendor based on membership size. Take a core processor vendor contract that is priced based on membership size. The surviving credit union may be paying, by way of example only, $2,000 a month for the third-party service, but that pricing may be based on a membership base of 25,000 members. Once that credit union merges with another credit union comprised of 20,000 members, the credit union could conceivably see a marked increase in the fees charged by the third-party vendor based on the new membership total of 45,000 members. These types of inquiries are essential during the due diligence process and should be completed by, or at minimum should involve, professional advisors with experience in these matters, who can identify the issues and provide sound advice with respect to potential pitfalls in the merger process as it relates to integrating third-party vendor services for the surviving, merged credit union.
As mentioned above, this article cannot possibly cover all aspects of pre- or post-mergers. For the reasons discussed above, credit unions considering a merger should always consult qualified advisors and an attorney who can walk the credit union through the process, including the regulatory framework and the logistics of a full-blown due diligence review of the potential merger partner.