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* FirstMerit terms not seen before in bank deals -banker
* Reverse breakup fees on the rise
* Firms add clauses to protect themselves if deal nixed
By Jessica Toonkel
NEW YORK, Feb 11 (Reuters) - When FirstMerit Corp struck a $912 million stock deal to buy Citizens Republic Bancorp last September, it offered unusually generous terms to secure $250 million in subordinated debt financing that was critical to the acquisition.
FirstMerit needed the funds to repay the U.S. government for bailing out Citizens in 2008, so the Akron, Ohio-based financial services company promised bond investors that it would buy back their subordinated debt at $1.01 for every dollar if the acquisition received no regulatory approval within nine months.
"While we fully expect regulatory approval, this was our way of mitigating the risks of not getting approval and being left with the capital," said Jerry Wiant, co-head of the financial services group at RBC Capital Markets, which advised FirstMerit. Wiant said it was the first time he had seen a U.S. bank use this kind of financing clause.
With regulators placing the financial industry under the microscope in the wake of the financial crisis, firms have to become more creative to seal deals, according to bankers and lawyers who specialize in mergers and acquisitions for banks, insurers and other financial service providers.
They cite long delays caused by regulatory scrutiny of recent high-profile deals, such as Capital One's $9 billion bid for ING Direct USA, and General Electric Co's bid for MetLife Inc's deposit-taking business.
To hedge against regulatory risk, bankers expect more financial institutions to follow FirstMerit in looking for creative ways to protect themselves against deal failure.
For instance, some financial services firms are discussing inserting "holdback clauses" into M&A contracts seeking to keep a portion of the amount they will pay for a company to cover potential regulatory issues that might plague the target post-closing.
Other institutions are asking for reverse breakup fees, whereby the buyer agrees to pay the seller some compensation if the deal falters.
The number of financial services deals with reverse breakup fees jumped to 24 in 2012, from 13 in 2009, Thomson Reuters data shows.
The size of these fees has also increased from the traditional 3 to 5 percent of deal value, lawyers said. There were 10 financial services deals with reverse breakup fees above 5 percent over the past two years, up from six in 2009 and 2010.
"The increase in reverse breakup fees in financial services is directly related to greater concern about the regulatory environment," said Rodgin Cohen, senior chairman of law firm Sullivan & Cromwell.
The most notable example of this is IntercontinentalExchange Inc's $8.2 billion bid for NYSE Euronext. ICE agreed to pay NYSE a $750 million termination fee, representing more than 9 percent of the deal value, if regulators do not approve the merger.
Just months before, NYSE's proposed merger with Deutsche Boerse had been derailed by regulators so the exchange wanted to make sure it was covered if that were to happen again, people familiar with the deal said. An NYSE spokesman declined to comment.
Regulators are under immense pressure to reduce systemic risk in financial markets so they are looking beyond the usual antitrust issues, such as market concentration, when reviewing financial services deals.
Regulators are scrutinizing systems, looking for compliance violations, and examining the soundness of combined institutions, bankers and attorneys said.
"If the buyer has a pending significant compliance issue at the time of announcement, or one arises before close, and the regulators are unwilling to approve the deal because of the issue, then the seller can be out in the cold," Cohen said.
The increased scrutiny has led to fewer deals as some firms decide it is easier to avoid buying anything in this environment. Financial services M&A volume in 2012 was down nearly 20 percent from 2007, Thomson Reuters data shows.
But faced with a weak economy, high regulatory compliance costs and low interest rates, banks are finding that doing deals may be the only way to expand profits. Bankers and lawyers said deal terms that are historically rare in financial services M&A are likely to become more common in the months ahead.
One banker said he recently worked on a transaction for which the regulators required that the buyer and seller integrate their systems at close of deal. "The whole way you deal with closing and regulatory risk has changed," the banker said.
Reverse breakup fees had been rare in finance industry deals until recently, bankers say. Such high fees were more common in non-finance M&A deals for which antitrust issues are major concerns.
In 2011, for instance, Google Inc's $12.5 billion acquisition of Motorola Mobility Holdings had a 20 percent reverse breakup fee, and AT&T Inc's failed $39 billion bid for T-Mobile USA had a 10.8 percent fee.
But now, it's not just the big financial services deals that require reverse breakup fees. BankUnited Inc agreed to a $5 million reverse breakup fee, or 7 percent, when it struck a $72 million agreement in 2011 to buy Herald National Bank.
"Everyone is just nervous about everything because they don't know what the regulators are going to do or what new legislation might come down," a person familiar with that deal said.