Risks of contract separation in financial services M&A

WORDS: James Cunningham, principal, and Adam Forgacs, manager, at Efficio

When thinking of banks, there is a picture of monolithic institutions built to stand for a thousand years. Yet since the financial crisis in 2008, financial institutions have faced unprecedented pressure to reorganize their operations and refocus their business models. This has led to the sale or separation of business units into standalone operations.

Any bank faces a significant risk to its day-to-day operations if the supply chain is not proactively managed. This risk is significantly increased during a commercial separation as the supply chain will need to agree to new terms and conditions required by the bank. The disposing bank may have to buy back services from the recently sold business unit or source them from other external providers, and this all needs to be formally contracted.

The role of procurement is to manage risks from early on during the strategic discussions around separation. The potential acquirer needs the confidence that the existing supply chain and related third-party contracts ensure continuation of services to the sold entity, at least in the short to medium term while the businesses split.

The process of contract separation

Procurement first has to collect the ‘as-is’ contractual information, then engage with Legal and other business functions to determine a contractual design following separation that will ensure service continuity. Finally, it must lead – often complex – negotiations with suppliers to enable the future contractual landscape and service provision.

1. Preparation starts with identifying and documenting all the contracts that are impacted by the separation. Contract discovery is often made more difficult if Purchasing’s contract database is out-of-date or missing information. It is not uncommon for contracts to have expired with no extensions put in place, hard copies are often filed in the buyer’s filing cabinet and, in some instances, the contract is not held by Procurement at all but by the end user in the business. 

2. Following contract discovery, contracts should be categorized by criticality. The treatment of some suppliers is more risky than others. IT is the most problematic as it needs to be working 24/7 without interruption and it is difficult and costly to replace core IT platforms, often containing valuable client data. HR contracts, at the other end, can be replaced more easily.

3. Once categorization is complete, contract treatments can be identified in co-operation with the business and Legal to determine future requirements. Contract treatments may include the novation or termination of an agreement, or a contract can simply be left in place at the seller’s organization with no action required. 

4. Once the contract treatment strategies are set up, suppliers can be briefed about the bank’s transformation process how this will affect their contracts. Many suppliers respond positively from the start; however, some will request the payment of fees to enable contract treatments or decline the proposed treatment, in which case negotiations have to be held. 

5. Negotiations are especially likely if additional complexities are present as part of the transformation. For example, if mortgage books are also being sold then third-party servicing rights are needed to ensure that the new asset owner has the correct rights and permissions to access the accounts and deliver the services. In case of selling the actual mortgage operations, bureau rights have to be set up to enable the continuous servicing of a portfolio of mortgages.

Key risks

Separation is complex for any institution, and significant focus is required from a number of different teams working together during a particularly strained period. Finance teams, IT, Treasury and Procurement are often under additional pressure from external stakeholders to either manage the separation while continuing business as usual, or to facilitate a commercial sale while maximising the bank’s return. No mean feat.

The biggest mistake is to hold off starting the separation process until all the contracts have first been analyzed. Put deadlines in place and be very clear with the business that, after this point, no more contracts will be reviewed or accepted. 

Transparency of the process is another key ingredient to success. Regular updates on progress ensure that both the acquirer of the business and the business itself are confident that separation is progressing and can help to avoid many future warranty issues.