In a much-anticipated, 91-page post-trial opinion issued on March 7, 2014, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery held in In re Rural Metro Corporation Stockholders Litigation that the lead financial advisor to Rural/Metro Corporation (Rural) in connection with its June 2011 sale to Warburg Pincus LLC (Warburg) was liable for aiding and abetting breaches of fiduciary duty by Rural’s board of directors.1 The directors (as well as Rural’s secondary financial advisor) settled the claims against them before trial.2
The decision covers a number of critical issues for boards and their advisors. First, the court held that bankers advising a company may be liable for aiding and abetting a breach of the fiduciary duty of care by the directors of the company even where the directors themselves are exculpated from such liability under Section 102(b)(7) of the Delaware General Corporation Law (DGCL). Second, the opinion contains another extensive discussion by the court of the risks to boards and their advisors when dealing with potential conflicts of interest, especially when financial advisors are seeking to obtain business from multiple parties in a sale process, even if the bank is ultimately not successful in obtaining such business. Third, the opinion is yet another reminder that boards must play an active role in overseeing the sale process, including carefully overseeing and appropriately addressing any potential conflicts of interest among any of the advisors or directors involved in the sale process. Fourth, the court’s ruling reaffirms the importance of independent directors and advisors in the M&A process under Delaware law, as it notes that the same decision, which may be considered “reasonable” if made by an independent board using independent advisors, may be found to be beyond the bounds of reasonableness if the directors or advisors are conflicted.
In late 2010, Rural formed a special committee to consider strategic alternatives and make recommendations to the board of directors. Around the same time, Emergency Medical Services Corporation (EMS), the parent company of Rural’s only national competitor, American Medical Response (AMR), publicly announced that it was exploring strategic alternatives. After interviewing three banks, Rural’s special committee hired RBC Capital Markets LLC (RBC) as its financial advisor. Although the special committee was not explicitly authorized to pursue a sale of the company, the financial advisor’s presentation to the special committee focused upon the benefits of a sale process. The financial advisor also “noted that it hoped to offer staple financing to the potential buyers in any transaction” but did not inform the committee that it hoped to use its engagement as Rural’s advisor to obtain financing work in a possible competing transaction from the bidders for EMS.3
The EMS announcement fueled speculation that Rural could also be in play, and Rural’s own stock price climbed. The chairman of Rural’s special committee (at the financial advisor’s suggestion) determined that selling Rural in parallel to EMS’s process was appealing because it could “give the winner of the EMS auction the opportunity to make a bid [for Rural] that included synergies.”4
The court found, however, that the private equity firms involved in the EMS process ultimately were limited in their ability to pursue a possible acquisition of Rural on a parallel timeline, in part because they had signed confidentiality agreements and received non-public information in connection with the EMS process. As a result, some of the bidders for Rural—including KKR, Bain Capital, and Clayton, Dubelier & Rice (which ultimately acquired EMS)—suggested staggering the two deals, but no change to the process was made.
The court found that Rural’s financial advisor pushed for a parallel process because of its own interest in leveraging its role in the Rural process to gain financing work from the bidders for EMS. The financial advisor hoped to generate more than $60 million in aggregate fees from the Rural and EMS deals, including through providing financing to the buyer in both deals, an aggregate amount considerably higher than the advisory fee it might obtain from Rural. Although the financial advisor was largely unsuccessful in these efforts, the court found that it continued to “lobby” Warburg until the final moments of the deal, sharing information about the internal deliberations of the Rural directors with Warburg and offering to fund a $65 million revolver for another Warburg portfolio company. The court found that the financial advisor did not disclose to Rural’s board or special committee the information it was providing to Warburg about the board’s deliberations or the extent of its efforts to convince Warburg to use it as the source of Warburg’s financing.
Certain other facts relating to the Rural sale process were also important to the court’s decision. The court found that aside from valuation figures in the financial advisor’s initial pitch to the special committee, the financial advisor did not prepare, and the special committee and board did not consider, valuation analyses until the final meeting at which they approved the sale to Warburg. In addition, the court was critical of the financial advisor’s opinion-committee processes and determined that the financial advisor had “manipulated” its valuation analyses to lower its valuation ranges, including by using EBITDA numbers for Rural that did not add back one-time expenses and noting that “Wall Street research analysts covering [Rural] do not make pro forma adjustments,” which the court found to be false, as well as excluding the contribution of a recent Rural acquisition and a significant new customer contract. The court also noted that the precedent transactions used as comparables that were presented in the final board meeting to approve the deal were different and resulted in lower multiples than those used in the financial advisor’s initial pitch valuation analysis.
Ultimately, Rural’s stockholders approved the merger by a 72 percent vote, and the deal involved a significant premium to Rural’s pre-announcement stock price. As is typical, stockholders filed suit challenging the deal. Before trial, the Rural directors settled for $6.6 million, and the secondary financial advisor settled for $5 million. The case proceeded to trial against the lead financial advisor on the aiding and abetting claims.
The Court of Chancery’s Decision
The decision focused on whether there was an underlying breach of the board’s duties (and, relatedly, which types of breaches bankers can be liable for aiding and abetting), and whether the financial advisor knowingly participated in a breach, each of which are required showings in an aiding and abetting claim.
The Inapplicability of 102(b)(7)
Section 102(b)(7) of the DGCL allows a Delaware corporation to include in its charter a provision exculpating directors for personal liability relating to breaches of the duty of care. Rural’s charter included such a provision (which are common in the charters of most Delaware corporations). Based upon this provision, the financial advisor argued that exculpation “should apply equally to a party charged with aiding and abetting a breach of fiduciary duty” and thus a claim for aiding and abetting liability could only be maintained if Rural’s directors breached their duty of loyalty.5
Vice Chancellor Laster rejected that contention, determining that financial advisors can still be liable for aiding and abetting directors’ breach of their duty of care, even where the directors are exculpated pursuant to Section 102(b)(7) from liability for the underlying breach of duty, because Section 102(b)(7) only addresses the liability of directors, not the existence of a breach, and does not address anyone other than directors. The court further noted that:
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, rather than in a manner that falls short of established fiduciary norms.6
The Directors Breached Their Fiduciary Duties
Given the court’s conclusions on the above points, the court noted that it need not parse whether the Rural directors breached their duty of care or loyalty. But the court did determine that the directors had, one way or another, breached their fiduciary duties in connection with the sale, based on two interrelated sets of problems:
The poor timing of the sale process and the lack of clear authorization by the Rural board for the process, at least when paired with the financial advisor’s conflicts and ulterior motives for pushing the sale at that time, and
The Rural board’s approval of Warburg’s bid lacked a reasonable informational basis because of the following key factors: (1) the special committee’s “failure to place meaningful restrictions” on the financial advisor given the advisor’s disclosed desire to provide buy-side financing and the special committee’s counsel’s admonition that the committee would need to be “especially active and vigilant” as a result;7 (2) the financial advisor’s last-minute lobbying of Warburg and its desire to provide financing in the EMS deal, which it had not disclosed to the committee or full board; and (3) the problems relating to the valuation analyses (both the failure to consider analyses throughout the process, as well as the court’s conclusion that the financial advisor manipulated the valuation metrics, of which the Rural directors were unaware).
In addition, while the court did not make an explicit finding that the directors were not independent, it did find that the special committee members had “personal circumstances” that “inclined them towards a near-term sale” when such a sale may not have been in the best interests of the company’s stockholders. Of particular note is the court’s suggestion that Rural’s special committee chair, who became a director of the company as part of a settlement after a threatened proxy contest against the company, may have been conflicted because his fund was the largest stockholder in the company and the “unrealized capital gain” from the fund’s investment in Rural was the fund’s “most successful investment” and “twice the size” of the fund’s target core investment.8
Given these issues, the court again emphasized the importance of having an independent financial advisor. “Because of the central role played by investment banks in the evaluation, exploration, selection, and implementation of strategic alternatives, directors must act reasonably to identify and consider the implications of the investment banker‘s compensation structure, relationships, and potential conflicts."9
The Financial Advisor Knowingly Participated in the Breaches
Once the court established that the Rural board had breached its fiduciary duties, the next question was whether the financial advisor knowingly participated in those breaches. The court defined “knowing participation” as follows: “It is not the fiduciary that must act with scienter, but rather the aider and abettor. If [the financial advisor] 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 financial advisor] can be liable for aiding and abetting."10 The court noted that the Delaware Supreme Court “has not formally ruled on this issue,” and also recognized the special role of a banker or other advisor to the board as a “gatekeeper” because directors do not normally “have the time or ability to design and carry out a sale process.”11 Given the importance of this function, the court concluded that it was immaterial that the financial advisor did not ultimately succeed in providing buy-side financing in the Rural sale. The court stated that “this decision need hold only that a claim for aiding and abetting a breach of the duty of care can be maintained . . . [when an advisor], for improper motives of its own, misleads the directors into breaching their duty of care."12
The Breaches Caused Damages
The court found that the financial advisor’s aiding and abetting of the board’s breaches of fiduciary duty harmed the Rural stockholders because, as a result of the financial advisor’s actions, the company was sold at a price below its fair value at the time of the sale, and the sale process unfolded differently than it otherwise would have.13
The decision has several important takeaways for directors and their advisors. First, the decision is another stark reminder from the Delaware Court of Chancery that financial advisors face the risk of potentially significant liability in the sale process when (1) the advisor has a conflict and (2) the full extent of that conflict is not disclosed to the board, including the implications that may arise from such conflict.14 This should not be read that all advisors must be “conflict-free,” but when negotiating its engagement by a board, an advisor with a conflict (or potential conflict) should fully disclose the conflict to the board at the time of engagement or, if the conflict develops later, as soon as it arises. The conflict and its implications should also be fully explained and documented in the minutes of the board meetings, and the board should consider how best to address the conflict, including taking appropriate measures to manage any potential issues arising out of the conflict.15
Second, the opinion again makes clear the need for directors to take an active and engaged role in any sale process, and this role includes making sure that the board is fully informed and their advisors take the necessary affirmative steps to ensure that all conflicts are known, disclosed, and addressed. This includes having directors (and their counsel) ask questions about any potential conflicts that may exist, as well as explaining the potential implications of such conflicts and taking actions that may be necessary to address such conflicts.
Finally, we expect that this opinion will lead to more detailed negotiations between a company and its financial advisor(s) on indemnification and related issues. The court’s holding that exculpatory provisions under 102(b)(7) protect only the directors of a corporation—not other actors, including third parties or the board’s advisors, leaves open potential risks for financial (and other) advisors.