What you need to know:
A recent Delaware Chancery Court decision reinforced the premise that directors of Delaware corporations will be held culpable if they conduct an M&A process based on inadequate information and/or conflicted advice from management or third party advisers such as investment bankers. In addition, advisers who aid and abet directors in the breach of their fiduciary duties in this manner may also be held directly accountable.
What you need to do:
Take steps to ensure that the board is in the driver's seat in an M&A process and not being pulled along by advisers and management. Directors should understand that an actual conflict of interest of an adviser may color the entire process and create exposure to fiduciary breach. Consequently, directors should question their advisers early and often about potential conflicts of interest and assess whether and how those advisers may be coloring the information and advice the board receives.
The Delaware Court of Chancery has issued another forceful critique of conflicted investment banks that seek to advise target company boards while simultaneously seeking to provide funding to the acquirer. The case, In re Rural Metro Corp. Stockholders Litigation, resulted in a finding at trial that the investment bank, RBC Capital Markets, LLC, aided and abetted breaches of fiduciary duty by directors of Rural Metro in connection with its sale in 2011 to an affiliate of private equity firm Warburg Pincus LLC. At issue was RBC’s failure to disclose to the Rural Metro Board its efforts to provide staple financing to the buyer and its revisions to its fairness opinion during the course of such efforts that made the Warburg deal look more appealing than it was.
For directors, the decision is a cautionary tale about what happens when directors fail to exercise oversight over outside advisers, especially investment bankers, in an M&A transaction; and for bankers, the decision is further evidence that the Delaware courts are highly skeptical of sell-side bankers who take a piece of the buy-side financing, even if the practice might qualify as business as usual.
Vice Chancellor Laster, who also authored the In re Del Monte Foods Co. Shareholders Litigation decision in 2011 enjoining Del Monte’s acquisition by a private equity consortium in part because of similar conduct by Del Monte’s banker, suggests that upping the ante in terms of potential liability for investment banks will have a salutary effect on the thoroughness with which corporate boards conduct M&A activity. He wrote in the Rural Metro decision:
The prospect of aiding and abetting liability for investment banks who induce boards of directors to breach their duty of care creates a powerful financial reason for the banks to provide meaningful fairness opinions and to advise boards in a manner that helps ensure that the directors carry out their fiduciary duties when exploring strategic alternatives and conducting a sale process.
Case Details and Background
On June 30, 2011, Rural was acquired by an affiliate of Warburg in exchange for $17.25 per share in cash. The plaintiff stockholders contended that members of the Rural Board breached their fiduciary duties by approving the merger and failing to disclose material information in the proxy statement sent to shareholders for approval of the merger. The plaintiffs also alleged that RBC aided and abetted the directors’ breaches of fiduciary duty.
Rural was a national provider of ambulance and fire protection services. Its seven-member Board consisted of six outside directors and President and CEO Michael DiMino. In August 2010, the Board established a special committee of three outside directors to consider M&A alternatives, with Christopher Shackleton as chair.
RBC Advises Rural on M&A Activity Involving EMS
Weeks prior to the formation of the Special Committee, RBC pitched Shackleton and DiMino on the possibility of Rural acquiring AMR, Rural’s only national competitor in the ambulance business. AMR was a subsidiary of Emergency Medical Services Corporation, a publicly traded corporation. However, EMS indicated it was not interested in selling AMR at Rural’s price when contacted by Shackleton.
In early December 2010, rumors circulated that EMS itself was in play. RBC gave Shackleton and DiMino an overview of the EMS process, reporting that potential private equity buyers believed AMR should be separated from EMS and that several firms interested in EMS believed Rural could be a partner.
In their discussions with Rural, RBC acknowledged that if they were engaged as a sell-side advisor to Rural, RBC could use that position to secure buy-side roles with the firms bidding for EMS because those firms would perceive RBC as giving them an inside track on Rural if they included RBC among their “financing trees.”
Rural Special Committee Hires Advisers
On December 23, 2010, the Special Committee interviewed three financial advisers, including RBC. RBC devoted the bulk of its presentation to a sale (as opposed to other alternatives) and recommended coordinating such an effort with the EMS process. RBC noted that credit markets were open for acquisition financing, but acknowledged that it hoped to offer staple financing to the potential buyers in any transaction. Importantly, according to Vice Chancellor Laster, RBC did not disclose that it planned to use the Rural engagement to capture financing work from the bidders for EMS.
At this time, the Rural Board had not authorized the Special Committee to start a sale process. Instead, the Board authorized the Special Committee to retain an advisor to analyze the range of strategic alternatives available and to make a recommendation to the Board. Nonetheless, internal RBC emails made it clear that the investment bank believed it had been hired as a sell-side advisor and that it would be able to assist on the overall financing of a Rural/EMS deal.
RBC Initiates a Sale Process
RBC then set in motion a sale process that favored potential buyers of Rural who were also involved in the EMS sale process so that they would include RBC in their financing trees. However, Shackleton and RBC ran into “readily foreseeable problems” when RBC prioritized potential buyers who were involved in the EMS process and whose confidentiality agreements with EMS limited their ability to participate simultaneously in the Rural process. Nonetheless, RBC elicited six bidders for Rural, including CD&R, the eventual acquirer of EMS.
Plaintiff Brings Sale Process and Disclosure Claims
Plaintiffs alleged the Rural directors breached their duties in two ways: by running a defective sale process and through disclosure violations. Plaintiffs also sought damages directly from RBC for aiding and abetting alleged breaches of fiduciary duty by the Rural directors.
Chancery Court Finds Sale Process Unreasonable
On the merits of the breach of fiduciary duty claims, Vice Chancellor Laster found that the conduct of the sale process was unreasonable insofar as it tilted the process in favor of bidders who were mostly likely to generate fees for RBC.
The Chancery Court next concluded that the Board’s decision to approve Warburg’s bid lacked a reasonable informational basis because during the final negotiations with Warburg, the Board failed to provide active and direct oversight of RBC. When it approved the merger, the Board was unaware of last-minute efforts by RBC to solicit a buy-side financing role from Warburg, it received valuation information only within three hours before the meeting to approve the deal, and it did not know that RBC had been manipulating its valuation metrics to make the Warburg bid look more appealing.
RBC’s Participation in Sale Process Breach Was Knowing
Having concluded that the process was unreasonable and, therefore, a breach of fiduciary duty, the Chancery Court then turned to the question of whether RBC’s participation in the Board’s breaches was knowing. “If the third party knows that the board is breaching its duty of care and participates in the breach by misleading the board or creating the informational vacuum, then the third party can be liable for aiding and abetting,” Vice Chancellor Laster wrote.
Here, RBC knew that it did not disclose its interest in obtaining a role financing the acquisition of EMS or how it intended to use the Rural process to capture the EMS financing business. RBC also knew that the Rural directors were uninformed about Rural’s value when making critical decisions. “Most egregiously,” Vice Chancellor Laster wrote, RBC never disclosed its continued interest in buy-side financing and plans to engage in last-minute lobbying of Warburg. According to the Chancery Court, under those circumstances, it was natural that the Board assumed Warburg’s fully financed bid did not include RBC and, thus, it was appropriate to have RBC negotiate with Warburg—but RBC was at the same time continuing to seek financing business from Warburg and simultaneously revising its valuation of Rural downward.
The Chancery Court dismissed RBC’s argument that it should be immune from the aiding and abetting claim because it ultimately did not provide staple financing or receive the buy-side fees it sought. The fact that it was unsuccessful does not mean that it did not act consciously to obtain them, Vice Chancellor Laster reasoned.
The Chancery Court also was unmoved by RBC’s claim that language in its engagement letter acknowledging that it might extend acquisition financing to other firms precluded any claim against it. That language did not amount to a waiver of claims that RBC failed to inform the Rural Board about specific conflicts of interest.
Chancery Court Finds Disclosure Breach
With respect to plaintiffs’ disclosure claims, the Chancery Court concluded that Rural’s proxy statement contained materially false information, including that RBC had used “Wall Street research analyst consensus projections” in its valuation exercise when, in fact, the valuation was based on Rural’s actual reported results, without adjusting for one-time expenses as analysts did. The proxy statement was also misleading insofar as it said that RBC received the right from Rural to offer staple financing because it could provide financing on terms that might not otherwise be available. However, the Board never concluded that RBC could provide financing that might otherwise not be available.
The Chancery Court also faulted the proxy statement for failing to describe how RBC used the initiation of the Rural sale process to seek a role in the EMS acquisition financing; RBC’s receipt of more than $10 million for its part in financing the acquisition of EMS; and RBC’s lobbying of Warburg after Warburg delivered its bid and while RBC was developing a fairness opinion.
The Chancery Court saved for another day the amount of damages, whether and the extent to which damages against RBC would be subject to contribution, and whether plaintiffs’ attorney’s fees should be paid by RBC.
The Rural Metro decision makes it clear that directors cannot rely blindly on outside advisers in discharging their fiduciary duties in an M&A process. Directors must be vigilant in overseeing their investment bankers in order to detect and address conflicts that might affect the sale process and test the information that they receive, including most particularly the fairness opinion, to assure that it is complete and will stand up to scrutiny after the deal closes. As a threshold question, directors should consider prohibiting their investment bankers from providing staple financing from the outset to avoid setting in motion activities by their bankers that may invariably be difficult to supervise and to disclose accurately in seeking deal approval from stockholders.
Meanwhile, bankers that continue to want to play on both sides of deals – as many are likely to – will have to assess their disclosures to sell-side clients both up-front and as the deal progresses to ensure that they do not cripple the effectiveness of the board’s process and leave the deal, and themselves, open to attack.