Financial due diligence: the scrutiny the most regulated sector demands

Financial due diligence: the most demanding in the Spanish market

The acquisition of a financial institution is the most complex M&A transaction in the Spanish market, and the due diligence that precedes it reflects that complexity. To the standard due diligence reviews — legal, tax, employment — sector-specific layers are added: the regulatory review of licences and compliance, analysis of capital and liquidity ratios, review of asset portfolio quality, and quantification of contingent liabilities arising from litigation over distributed financial products.

At BMC we carry out financial institution due diligences with the specialisation the sector requires. We know the banking, insurance, and securities regulatory framework, the criteria of the Bank of Spain, the CNMV, and the DGS in their supervisory processes, and the case law on the most frequent sector disputes.

Regulatory due diligence: the heart of the review

The licence and regulatory position of a financial institution are its most critical assets: without them, it cannot operate. We verify that licences are current and unconditional, that there are no ongoing sanction proceedings, that supervisory requirements are being met, and that capital and liquidity ratios comply with the regulatory minimums. Institutions with pending capital requirements or with significant sanction histories may be higher-risk acquisitions than the balance sheet suggests.

Contingent liabilities from litigation: the most difficult chapter

Litigation arising from the distribution of financial products to retail clients is one of the most difficult contingencies to quantify in a Spanish bank’s due diligence. Claims over floor rate clauses, IRPH, preference shares, swaps, and other products whose terms the Supreme Court has declared unfair extend over years and generate uncertainty that balance sheet provisions may not cover fully.

We analyse the status of pending litigation, the current case law on the most frequent types of claim, and estimate the probable contingent liability in different scenarios.

Regulatory approval process: managing it from the outset

Regulatory approval in a financial institution acquisition is not a formality: it is a process that can take months, requires extensive documentation about the buyer, and can condition or delay the closing of the transaction. We manage the process from the first informal interactions with the regulator through to the formal submission of the application and follow-up during the review period.

Tax due diligence on financial institutions: the specialist dimension

The tax due diligence of a financial institution adds specific layers that are not present in other sector acquisitions. Open tax periods under Article 66 of the General Tax Act (LGT) extend to the standard four years, but this extends to ten years where the institution has carry-forward losses or applied deductions — a material risk in financial groups that experienced losses during the 2008-2014 financial crisis and accumulated significant deferred tax assets (DTAs).

The acquirer must assess whether the target’s DTA position is recoverable. Spanish credit institutions have special DTA arrangements under which certain deferred tax assets are convertible into direct tax credits against future tax liabilities under Real Decreto-Ley 14/2013 and Law 27/2014, but the conversion triggers are subject to regulatory capital treatment requirements. DTAs that are not protected by this mechanism may not be recoverable if the business plan post-acquisition changes significantly.

Transfer pricing within the financial group — intra-group loans, management service fees, shared services, technology licences — must be reviewed for compliance with Article 18 LIS documentation requirements. The AEAT’s Large Taxpayers Delegation scrutinises transfer pricing in financial groups intensively, and undocumented or poorly documented intercompany transactions represent a significant contingent liability in a tax due diligence.

VAT on financial services is the most litigated area of taxation in the sector. The acquirer must review the target’s VAT recovery pro-rata calculations for the open periods, assess whether any ancillary services have been incorrectly classified as VAT-exempt, and evaluate whether there is exposure from back-office outsourcing arrangements where the AEAT has sought to tax the service rather than treat it as part of the exempt financial service supply. CJEU case law on the exemption boundary is the key analytical framework here.

AML compliance: a mandatory due diligence chapter

Anti-money laundering compliance must be treated as a separate due diligence chapter in any financial institution acquisition. The AML/CFT obligations for Spanish credit institutions, payment institutions, and investment services firms are governed by Law 10/2010 on the Prevention of Money Laundering and Terrorist Financing and the Reglamento RD 304/2014.

The SEPBLAC (Servicio Ejecutivo de la Comisión de Prevención del Blanqueo de Capitales e Infracciones Monetarias) supervises AML compliance and has imposed increasingly significant sanctions — both fines and, in serious cases, licence conditions — for deficient AML programmes. Acquiring an institution with AML deficiencies means inheriting the regulatory relationship with SEPBLAC and potentially the in-progress sanction proceedings.

Key AML due diligence questions include: whether the institution’s customer due diligence (CDD) policies meet the risk-based approach requirements; whether enhanced due diligence (EDD) has been applied to Politically Exposed Persons (PEPs) and high-risk jurisdictions; whether the Suspicious Activity Reporting (SAR) programme is operational and the internal reporting chain documented; and whether any SAR filing decisions have been reviewed by the compliance function and signed off by the senior responsible officer.

For fund managers and investment services firms, additional MiFID II conduct requirements layer on top of the AML obligations. The due diligence must assess whether client categorisation, suitability assessment records, and product governance documentation meet current CNMV standards.

Credit portfolio review: quality of earnings and provisioning adequacy

For bank acquisitions, the credit portfolio review is the most time-intensive component of the due diligence. The objectives are to assess whether the Bank of Spain provisioning circulars have been correctly applied, whether non-performing loan (NPL) coverage ratios are adequate, and whether the collateral valuations supporting secured exposures are current and realistic.

The Spanish NPL framework is governed by Bank of Spain Circular 4/2017 (accounting standards for credit institutions), which establishes criteria for staging loans between Stage 1, Stage 2, and Stage 3 under IFRS 9, and for calculating expected credit loss provisions. Acquisitions of bank loan portfolios (rather than the entire institution) typically involve a price negotiation based on the actual versus expected loss calculations, which requires specialist credit assessment skills.

A buyer that relies solely on the target’s published provision levels without commissioning an independent portfolio review sample is taking material risk. Standard practice is to sample 70-80% of the portfolio by value, focusing on Stage 2 and Stage 3 loans, and to commission external property valuations on a subset of the real estate collateral. The findings feed directly into the purchase price adjustment mechanism in the SPA — a well-designed earnout or price adjustment clause is worth significantly more than the due diligence cost if provisioning deficiencies are found.

Derivatives and securities portfolio: mark-to-market and accounting risk

Financial institutions with significant derivatives portfolios introduce valuation complexity into the due diligence. OTC derivatives are carried at fair value on the balance sheet, and the valuation models used must be reviewed for reasonableness — particularly for illiquid or complex instruments where the model assumptions are material.

The credit valuation adjustment (CVA) and debit valuation adjustment (DVA) applied to OTC derivative portfolios can be significant and may have changed materially since the balance sheet date. An acquirer that does not review the CVA/DVA calculations as part of due diligence may find that the derivatives portfolio fair value is different from the published figures, with a direct impact on net asset value.

For securities portfolios classified at amortised cost (held-to-maturity or business model 2 under IFRS 9), the due diligence must assess whether any reclassification events have occurred that could trigger IFRS 9 penalties, and whether the duration risk embedded in the portfolio is consistent with the ALCO framework.

Insurer due diligence: technical provisions and reinsurance

Insurer acquisitions have a specific due diligence dimension that does not arise in other financial sector transactions: the adequacy of technical provisions. Technical provisions — premium reserves, claim reserves, and IBNR — are the most material item on an insurer’s balance sheet and their calculation involves actuarial assumptions that must be independently validated.

Under Solvency II (Directive 2009/138/EC, implemented in Spain by Law 20/2015 on Insurance Organisation), technical provisions must represent the best estimate of the insurer’s obligations plus a risk margin. Actuarial review of the best estimate — including the claims development factors, discount rates, and the tail assumptions for long-tail lines of business — is an essential part of insurer due diligence.

Reinsurance arrangements are the second major due diligence focus. Intra-group reinsurance (captive arrangements) must be reviewed for arm’s length pricing and transfer pricing compliance. External reinsurance must be reviewed for credit risk of the reinsurer and for the enforceability of the recoveries — including whether any excluded or disputed claims could reduce the recoveries below the balance sheet carrying value.

The change-of-control provisions in reinsurance treaties must be reviewed carefully: some treaties include notification and consent requirements that, if not met, could trigger early termination, leaving the acquired entity without its expected reinsurance protection post-closing.