Delaware courts have been warning banks, boards of directors, and those who provide advisory services to proceed with caution when the sale of a company involves conflicts of interest. A recent Delaware Chancery Court ruling hammers that message home.
In the case of In Re Rural Metro Corp., the Chancery Court found a financial advisory firm liable for aiding and abetting a fiduciary breach by a company's board of directors, even though the directors themselves are shielded from financial liability in certain circumstances under Section 102(b)(7) of Delaware corporate law.
This case marked the first time that a financial adviser sough coverage by the protections of Section 102(b)(7), arguing that, since directors can't be held financially liable for breaching their fiduciary duties, such a provision should equally apply to third parties charged with aiding and abetting such a breach.
In a 91-page post-trial decision, authored by Vice Chancellor Travis Laster, the court held that the plain language of Section 102(b)(7) does not extend to aiders and abettors. “The threat of liability helps incentivize gatekeepers [such as financial advisers] to provide sound advice, monitor clients, and deter client wrongs,” Laster wrote.
To many financial advisers, the decision may come as a rude awakening. “I don't think financial advisers have ever viewed themselves as gatekeepers,” says Steven Haas, a partner with the law firm Hunton & Williams.
The decision serves as a reminder to all financial advisers, particularly on the sell side, that they have an obligation to actively assist the board or special committee that they are advising in carrying out the sale of a company to ensure the board is fully informed throughout the process. “In this decision, Vice Chancellor Laster, in repeatedly referring to financial advisers as ‘gatekeepers,' is saying in effect ‘you have a responsibility here, and you better honor it, or you bear a significant risk of liability,'” says Jason Halper, a partner with law firm Cadwalader.
The ruling is likely to lead to more litigation against third-party advisers, including due care claims for which directors themselves often can't be held financially liable if shareholders have voted to adopt a Section 102(b)(7) charter provision. “I think you're going to see financial advisers being named as defendants in these lawsuits far more often,” says Halper.
Financial advisers will likely not be the only targets. Haas says the wider implications of the decision “could also extend to law firms and other consultants,” in cases where third parties knowingly participated in a breach of fiduciary duty.
In addition, the Rural Metro decision will have a “significant influence on other courts and to some extent on how financial advisers view their obligations and risk of liability given the Delaware Chancery Court's prominence in this area,” says Halper.
Other states often look to Delaware for guidance on cutting-edge issues of corporate law. The issues surrounding Rural Metro are so “unique,” Haas says, that “other states are more likely to look to Delaware in dealing with these kinds of unusual M&A issues.”
Conflicts of Interest
The Rural Metro case arose from allegations that directors of ambulance services company Rural Metro breached their fiduciary duties, by failing to obtain the best possible price in connection with the company's 2011 $438 million sale to an affiliate of private equity firm Warburg Pincus. Rural's financial advisers also were named as defendants.
Prior to trial, the defendant directors settled for $6.6 million, and Rural's secondary advisory firm, Moelis & Co., settled for $5 million. This left Rural's primary financial advisor, RBC Capital Markets, as the lone defendant.
The facts of the case date back to August 2010, when Rural received word that Emergency Medical Services, the parent company of Rural Metro's biggest competitor, American Medical Response, was up for auction. During that time, Rural was weighing its long-term strategy—whether to acquire its competitor, or be acquired itself.
To reach a decision, Rural Metro formed a special committee to assess strategic alternatives available to the company, and then report back to the full board. Instead, the committee moved forward with the sale process without the board's knowledge. Ultimately, the sale was later approved by the full board.
“I think you're going to see financial advisers being named as defendants in these lawsuits far more often.”
—Jason Halper,
Partner,
Cadwalader
Following the acquisition, angered shareholders filed lawsuits objecting to the transaction. In siding with the shareholders, the court cited several factors supporting the finding that “RBC designed a process that favored its own interest,” Laster wrote.
The court especially took issue with RBC's recommendation, for example, that Rural Metro put itself up for sale in parallel with the sale of EMS, reasoning that it would encourage potential bidders to acquire both companies, because of the synergies they shared. RBC never disclosed, however, that it planned to use its position as Rural's sell-side adviser to secure financing work with bidders of EMS, creating a conflict of interest.
The plan did not turn out as RBC had hoped. Most of the bidders did not feel comfortable participating in the purchase of both Rural Metro and EMS at the same time, greatly reducing Rural Metro's pool of potential buyers. In the end, Warburg was the only firm to submit a final bid.
“Laster questioned whether selling another company in the same industry at the same time is necessarily the best option, when you have potential bidders focused primarily on buying the other company,” says Gary Kubek, a partner with law firm Debevoise & Plimpton.
Specifically, the court ruled that it was “readily foreseeable” from the outset that “financial sponsors who participated in the EMS process would be limited in their ability to consider Rural simultaneously because they would be constrained by confidentiality agreements they signed as part of the EMS process and because EMS would fear that any participants in both processes would share EMS's confidential information with its closest competitor.”
Clouded Decisions
A well-informed board might still decide to sell the company under similar circumstances, but the board wasn't well-informed in this case, which clouded the board's decision from the get-go, according to the court's opinion.
CASE DETAILS
Below is an excerpt from In Re Rural Metro Corp., which provides a case summary & background.
Case Summary
On June 30, 2011, Rural/Metro Corp. merged with an affiliate of Warburg Pincus. Each publicly held share of Rural common stock was converted into the right to receive $17.25 in cash. The plaintiffs contend that the members of the Rural board of directors breached their fiduciary duties by approving the merger and by failing to disclose material information in the company's definitive proxy statement. The plaintiffs further contend that defendant RBC Capital Markets aided and abetted the directors' breaches of fiduciary duty. The directors settled before trial. So did Moelis & Company, a financial advisor that played a secondary role in advising the board. The case proceeded to trial against RBC.
This post-trial decision holds RBC liable for aiding and abetting breaches of fiduciary duty by the Board. It does not specify a damages award against RBC or address the plaintiffs' application for fee shifting. The parties will submit further briefing on those issues in accordance with this opinion.
Factual Background
Trial took place over four days. The plaintiffs proved the following facts by a preponderance of the evidence. In resolving factual disputes and drawing inferences, this decision has placed the greatest weight on the contemporaneous documents. This decision has placed the least weight on the testimony of the two RBC managing directors who appeared at trial. Their accounts at times strained credulity, and the plaintiffs successfully impeached their testimony on multiple occasions.
Source: In Re Rural Metro Corp.
Providing financing to bidders while also advising the sell-side of a transaction doesn't automatically represent a breach of fiduciary duty in the eyes of the Delaware courts, says Kubek. Nevertheless, a “board needs to consider whether it's in the best interest of stockholders to allow its financial adviser to do so,” he says.
The reason is simple: from the perspective of courts and shareholders, if the financial adviser gets paid not only by the seller, but also has the potential to gain even higher financing fees—as in the Rural Metro case—from the bidder, “it has a real incentive to ensure a deal gets done, and may be viewed as not in a good position to be giving the best advice to the company as to whether it's being given a fair price, or the best deal,” says Kubek.
The court further took issue with the fact that RBC did not provide the board with any valuation materials to enable Rural Metro to evaluate the bids until “less than twelve hours before the expiration of Warburg's bid,” despite having several prior meetings with directors to discuss the sale process, Laster wrote.
The omission of such disclosures together led to the board's breach of fiduciary duty. “Lacking any earlier valuation information, the Rural directors did not have a reasonably adequate understanding of the alternatives available to Rural, including the value of not engaging in a transaction at all,” the court stated.
Overseeing the Advisers
A broader lesson for financial advisers is that “they need to ensure that there is regular, ongoing interaction with the board throughout a sale process so that they facilitate the board meeting its due care obligations," says Halper.
Haas says that same lesson also applies to boards of directors in their communication with their third-party advisers. “Delaware courts are really imposing an obligation on boards to actively manage and oversee their advisers,” he says.
The ruling further highlights how important it is for boards to identify and address any potential conflicts of interest early on in the sale of a company and to actively oversee the role of the financial adviser to ensure that new conflicts don't arise. “Corporate boards will want to insist that their financial advisers cannot offer any financing to a buyer without getting the board's consent,” says Haas.
The ruling also serves as a warning to directors that they can still face liability for the conduct of their advisers, even if that conduct is done without their knowledge. “From the directors' point of view, this ruling is concerning because you can't stop what you don't know is happening,” says Haas. So boards need to carefully vet conflicts of interest with their financial advisers before engaging with them.
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