A heads up to directors considering whether to sell the company: recent Delaware court decisions have demonstrated the potential perils of passively following the advice of financial advisers, particularly where the adviser may have conflicted interests. Here are some key take aways.

Don’t delegate your supervisory role

One of the most important and difficult situations facing a board of directors is considering whether to sell a corporation, and a board of directors is encouraged to seek the advice and guidance of professional experts. Given a financial adviser’s expertise in conducting the sales process, and evaluating multiple bidders and their bids, the advice of a financial adviser in change-of-control situations can be indispensable to a board of directors. However, a board of directors must ensure that it does not delegate its role as supervisor to a financial adviser by following the adviser’s advice without meaningful scrutiny or analysis. At all times during the sales process, a board must keep in mind that the corporation is the principal and the adviser is the agent—not the other way around.

Get—and understand—a fairness opinion

While not required to demonstrate that a board of directors fulfilled its fiduciary duties, including its duty of care in a takeover situation (at least since the 1985 seminal Delaware Supreme Court decision Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985)), it has been standard operating procedure for boards of directors of public company targets to obtain a financial adviser’s “fairness opinion” stating whether a proposed sale is fair to the company’s stockholders from a financial perspective. There are rules governing this opinion. For example, Financial Industry Regulatory Authority (“FINRA”) Rule 5150 requires a financial adviser to make certain disclosures in a fairness opinion and to follow certain procedures in rendering a fairness opinion. Among the disclosures required to be included in a fairness opinion are:

a. whether the financial adviser will receive a fee contingent upon whether the transaction is completed (a “success fee”);
b. whether, within the past two years, a material relationship has existed between the financial adviser and any of the parties involved in the transaction and whether the financial adviser anticipates developing any material relationship; and
c. whether or not the fairness opinion expresses a view about the fairness of the compensation to any officers, directors or employees relative to the compensation to the stockholders.

These disclosures are focused on shining a light on the interests of the financial adviser in rendering its advice to a board. Note, however, that there is no prohibition on a financial adviser participating on both sides of a transaction. In such a situation, in theory, the conflict must be fully disclosed to, and approved by, the board of directors and steps must be taken to ensure that the conflict does not infect the adviser’s advice or the sales process. In a number of recent decisions, the Delaware courts have found that theory does not always follow the real-world practice.

Stapled Financing—the Pros and Cons

Delaware courts are extremely skeptical of "stapled financing." Stapled financing comes in many forms but typically involves the seller’s financial adviser offering acquisition financing to potential buyers in the sales process. The financial adviser stands to collect a fee from both sides of the deal: an advisory fee from the seller and a financing fee from the successful bidder. Among the advantages cited for a stapled financing are:

1. increasing the likelihood of completion because of the financial adviser’s commitment to finance the transaction; 
2. accelerating the timetable for closing since the acquisition financing is readily available;
3. eliminating the need for multiple potential lenders to perform due diligence and examine the target’s confidential books and records;
4. reducing the risk that buyers will use financing considerations to seek to lower the acquisition price or otherwise condition the completion of the transaction; and
5. increasing the number of potential buyers because there already exists one source of funding.

Among the disadvantages of stapled financing are:

1. the inherent conflict of interest because the financial adviser acts on both sides of the transaction (the financial adviser has financial incentive to favor a buyer that will use the stapled financing even if there are higher bidders);
2. bidders may drop out of the sales process because they perceive that to prevail they must accept the stapled financing package; and
3. other potential financing sources may not participate because they perceive the sales process as “rigged.”

When the Sales Process Gets Infected

In the 2011 $5 billion leveraged buyout of Del Monte, the Delaware Court of Chancery enjoined the stockholder vote on the transaction and the enforcement of certain deal protections due to the financial adviser’s conflicts of interests infecting the sales process. In Del Monte, the court noted, among other things:

1. after the board terminated the sales process, the financial adviser continued to meet with several bidders without the knowledge of Del Monte board;
2. the financial adviser obtained the board’s permission to provide stapled financing before an acquisition price had been determined;
3. the financial adviser was to be paid $20 million for its role as the seller’s adviser and an additional $20 million for its role in providing one-third of the financing for the buyout; and
4. the same financial adviser was put in charge of running the post-signing “go shop” process designed to obtain a higher bid even though the financial adviser’s fee would be reduced by half should a topping bid materialize. The leveraged buyout transaction was subsequently approved by shareholders and consummated. The related stockholder lawsuits were ultimately settled for over $85 million, of which Del Monte paid over $65 million and the financial adviser paid over $20 million.

Last month, in the case of In re Rural Metro Corporation Stockholders Litigation, the Delaware Chancery Court held the lead financial adviser liable for aiding and abetting breaches of the board’s fiduciary duty of care in the sale of the company. Key factors in the court’s decision were numerous conflicts of interest concerning the lead financial adviser, including its attempt to secure buy-side financing for the acquisition of the parent of the company’s principal competitor, and seeking to provide stapled financing to the successful bidder – assignments that would have generated fees many times greater than the fee the financial adviser would have received for advising the target company. The financial adviser was not selected to participate in either financing. Nevertheless, the court found that these conflicts were not fully disclosed to the board and factored in a number of questionable decisions taken by the board, including:

1. commencing the sales process after the sales process of the parent of the company’s primary competitor had already been underway, which resulted in few bidders participating in the company’s process because they were already participating in the competing sales process and were subject to confidentiality obligations thereunder;
2. commencing of the sales process by the special committee of the board without the approval of the full board; and
3. refusing to extend the sales process to allow the winning bidder of its competitor to participate in the sales process.

In addition, the court criticized certain changes made by the financial adviser to its fairness opinion and the board for passively accepting the fairness opinion without critical question or analysis.

In analyzing these decisions, one is tempted to conclude that the very fact a financial adviser seeks to participate on both sides of a sales transaction—as a financial adviser to the target and also as a provider of financing to the buyer—may irretrievably infect the sales process.

Key Takeaways

1. A board of directors must take an active role in the sales process and oversee the work of its financial adviser and other professionals, and must resist the temptation to “defer to the experts.” A board must always keep in mind that the corporation is the principal and the adviser is the agent.
2. A board’s monitoring of its advisers and potential conflicts of interest is dynamic and must continue throughout the entire sales process.
3. Boilerplate language that waives potential conflicts of interest will not suffice to negate the failure to disclose existing specific conflicts of interest.
4. The retention of a second financial adviser to render a fairness opinion will not cleanse the conflicts of the lead financial adviser where those conflicts infect the entire sales process.
5. Financial advisers must faithfully serve as a “gatekeeper” for the board and must carefully scrutinize the contents of its fairness opinion and the process employed in rendering its fairness opinion.
6. Courts are extremely skeptical of situations where a trusted adviser participates on more than one side of a transaction.
7. In takeover situations, a target company should seriously consider employing independent boutique advisers to advise on acquisition assignment or otherwise forbid its financial adviser from providing stapled financing.