As bank mergers continue apace, financial institutions are taking a harder look at early-termination penalties in outsourcing contracts.
In the customary outsourcing deal, banks give vendors control of their computer operations for seven to 10 years. The term must be long so the vendor can recover the conversion expenses.
But mergers can throw a monkey wrench into the machinery by forcing banks to end the contracts early. The two parties may then find it difficult to agree on early-termination penalties
"People get divorced at the drop of a hat," said bank technology consultant M. Arthur Gillis of Computer Based Solutions, New Orleans. "But this is worse, and tougher. If you can't make an outsourcing deal last 10 years, you should never go into it."
The issue was thrown into the spotlight on July 30 when Integra Financial Corp. announced plans to buy Equimark Corp. in an exchange of stock valued at $282.5 million. Both banks are based in Pittsburgh.
Equimark agreed recently to have M&I Data Services run Equimark's computers, but Integra plans to scrap this agreement. Instead, Systematics Information Services Inc., which runs Integra's computers, will handle data processing for the combined entity, said Integra's chairman and, chief executive, William R. Roemer.
Equimark is one of M&I's largest customers, paying the vendor more than $4 million a year to run its computers, Mr. Roemer said. Integra will have to pay M&I $4.5 million to end the contract early, he said.
Future Revenue Lost
"M&I will be made whole" on the conversion costs, said Lawrence A. Willis, managing vice president of First Manhattan Consulting Group, New York. "But what they are giving up is future revenue and profits expected from the contract."
But even though Integra and the unit of Milwaukee-based Marshall & Ilsley Corp. appear likely to end their contract amicably, other terminations may not be so easy. Mr. Gillis said that four of his bank clients, which he declined to name, had gone to court with outsourcers over early-termination penalties.
The potential for new problems continues to increase as about five dozen institutions each year sign their first outsourcing contract. Some of the biggest outsourcing contracts in recent years have been signed by financially troubled banks that are acquisition candidates, including International Business Machines Corp.'s deals with Hibernia National Bank, New Orleans, and Riggs National Bank, Washington.
In fact, the biggest users of outsourcing services, midsize banks with assets of $2 billion to $5 billion, are also among the industry's biggest acquisition candidates, Mr. Gillis said.
Earlier Penalties Tougher
The key to successful early termination of an outsourcing contract is agreement on a fair exit penalty. And as recently as the late 1980s, the cards were stacked against banks, Mr. Willis said.
Back then, outsourcers commonly insisted on penalties that, in essence, forced a bank to pay a vendor all the profits expected from the full term of the contract.
Mr. Willis called these penalties poison pills since they make it much more expensive for an acquiring bank to streamline systems of an acquired bank. Operational savings from the merger would be greater if the acquired bank ran its computers in-house.
Michael Zucchini, chief information officer of Fleet Financial Group, Providence, R.I., said in a keynote speech at the American Bankers Association's operations conference in May, that banks could, in theory at least, make exit provisions in outsourcing contracts so onerous that they become a "shark repellent" that wards off potential suitors.
Mr. Zucchini added after the speech that he had never seen a bank try this strategy. But the prospect is there.
Mr. Willis said that over the past two years, large banks have successfully pressured outsourcers to drop excessive early-termination penalities. Instead, large banks usually compensate outsourcers only for the cost of handing computer operations back to the bank. Such is the case with M&I's deal with Equimark.
But Mr. Willis said that many smaller institutions continue to agree to pay excessively large early-termination penalties.
As large banks reduce their penalties, outsourcers have more incentive to avoid doing business with takeover candidates. On the other side of the coin, signing up an acquiring bank can be like hitting the jackpot.
Systematics is a case in point. It has provided outsourcing services to Integra for more than 10 years. During that period, Integra has grown from a modest institution to a regional powerhouse that will have $13.4 billion in assets after its Equimark purchase.