In a 91-page post-trial decision, Chancellor Travis Laster found RBC Capital Markets LLC (“RBC”) liable for aiding and abetting breaches of fiduciary duty in connection with RBC’s role as a financial advisor in the 2011 $438 million buyout of Rural/Metro Corporation (“Rural”). RBC is the investment banking arm of the Royal Bank of Canada and acted for Rural, the target company.
The ruling turned in part on findings that RBC had multiple conflicts of interest and had sought to participate in providing buy-side financing. The court did not set a damages award at this time, but left that open to further submissions by the parties. However, the court did state as follows with respect to the testimony of two RBC managing directors who testified at trial: “Their accounts at times strained credulity, and the plaintiffs successfully impeached their testimony on multiple occasions.” Decision at 1.
Key Practice Points
The decision highlights a number of key practice points:
When a board is considering strategic alternatives, and constitutes a Special Committee for that purpose, the board’s mandate and the scope of the Special Committee’s authority must be made very clear.
When relying on a Special Committee, a board must ensure it is adequately informed of the Special Committee’s process. Board members and Special Committee members should take their roles seriously and should not be mere passive observers. They should be actively engaged in the process. As well-established in other recent cases, such as In re El Paso Corp. S’holder Litig., 41 A.3d 432, 439 (Del. Ch. 2012) and In re Del Monte Foods Co. S’holders Litig., 25 A.3d 813, 830-31 (Del. Ch. 2011), directors must provide active and direct oversight by acting reasonably to learn about actual and potential conflicts faced by directors, management, and their advisors.
A board and a Special Committee must insist on full disclosure of possible conflicts of interest on the part of its respective financial advisors, and must monitor the services performed by the financial advisor(s). As the court recognized, “such information is material to stockholders when deciding to vote on a merger and whether to seek appraisal.” Decision at 81.
For financial advisors, care must be taken in issuing fairness opinions and the way fairness opinion committees are constituted (including ensuring appropriate care is taken with internal drafts of valuation materials). Also, conflict waiver language in engagement letters needs to be explicit and conflicts must be adequately disclosed.
Staple financing, while not prohibited, will get increasing scrutiny in the Delaware courts. Hiring a second financial advisor to provide a second fairness opinion, who is not offering staple financing, is not enough to avoid this scrutiny.
With respect to shareholder litigation and disclosure-only settlements, Delaware courts are increasingly pushing back on such quick settlements for attorneys’ fees. Here, the court rejected such a settlement and replaced plaintiffs' counsel after first counsel sought such a settlement.
RBC served as Rural’s primary financial adviser in the merger of Rural with a subsidiary of Warburg Pincus LLC (“Warburg”). Rural was a public company, and the merger resulted in Rural’s shareholders receiving $17.25 in cash per share.
The plaintiffs initially asserted claims that the directors of Rural breached their fiduciary duty in approving the merger for an inadequate price, and in failing to disclose material information in the company’s proxy statement, and also named as defendants Rural’s financial advisors. Prior to the trial, the defendant Directors settled for $6.6 million, and a secondary advisory firm (Moelis & Company) settled the claims asserted against them for $5 million. As a result, RBC remained the lone defendant at trial.
In August 2010, RBC first approached Rural’s CEO, Michael DeMino, and an outside director, Christopher Shackelton (who soon became Chairman of the Board), about the possibility of Rural acquiring a competitor, AMR. In response, Rural created a Special Committee with Shackelton as chair and two other outside directors to oversee an approach to AMR. While that transaction did not proceed, the Special Committee was reformed in response to an unsolicited acquisition offer that Rural had received.
In December 2010, RBC again approached Shackelton and DeMino about rumors that EMS, AMR’s parent, was also in play. RBC told them that a number of private equity firms were looking for an industry partner and had mentioned Rural as one. The Board ultimately authorized the Special Committee to retain advisors and generate a recommendation on the best course of action.
The Special Committee interviewed financial advisors and hired RBC in December 2010. RBC’s presentation focused on a sale of Rural and a recommendation to coordinate the sale effort with a parallel process to sell AMR’s parent company, EMS. RBC proposed to offer staple financing to the potential buyers in any transaction. However, the court noted, “RBC did not disclose that it planned to use its engagement as Rural’s advisor to capture financing work from the bidders for EMS.” Decision at 10.
Notably, the Board had not authorized the Special Committee to hire a sell-side advisor or to start a sale process. Rather, the Board had only authorized the Special Committee to retain an advisor to analyze the range of strategies available to the company. In its decision, the court noted that certain of the Rural directors had strong personal motivations to see the company sold, and those factors “helped shape the boardroom environment,” but that the plaintiffs had stopped short of alleging a breach of the duty of loyalty by those directors. Decision at 7.
Minutes from the Special Committee meeting noted that its counsel advised the Special Committee that RBC’s proposal to provide staple financing “would present for it a potential conflict of interest, and potential appearances of conflicts,” and that “if the Committee were to select RBC, the Committee would need to be especially active and vigilant in assuring the integrity of the [process], and that it should consider appointing a second firm” to also deliver a fairness opinion and assure “both the fact and the appearance of an appropriate and robust auction process.” Decision at 11. Consequently, the Special Committee hired RBC as primary advisor, and Moelis as the secondary advisor.
The court cited a host of factors that supported a finding that “RBC designed a process that favored its own interest,” or which the court was otherwise critical of, including the following:
RBC sought to generate maximum financing fees of $55 million from both the Rural and EMS deals that were 10 times the $5.1 million advisory fee, “giving RBC a powerful reason to promote itself as a financing source at the expense of its advisory role.” Decision at 13.
RBC prioritized contacting participants who would include RBC in their financing.
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.” Decision at 14.
Though RBC made presentations at Special Committee meetings after initial bids came in, those presentations did not include any valuation metrics. Decision at 16-17.
During the sale process, the full board and the Special Committee met very infrequently. Decision at 16.
With the bid date approaching, one bidder (who had won the bidding for EMS) indicated to RBC that it could outbid other sponsors for Rural because of synergies with AMR, and wanted to push the bid date to April to formulate a bid. However, Warburg told RBC it did not want the deadline delayed.
RBC delivered a signed financing commitment to Warburg prior to Warburg submitting its bid.
When Warburg’s bid did not use RBC’s commitment, “[r]ather than accepting defeat, RBC re-doubled its efforts to win the business…and continued to try to find a way into the financing.” Decision at 23.
RBC debated internally “whether to provide valuation materials to the Special Committee to enable them to evaluate the bids. RBC had delayed working on a fairness analysis because the firm still hoped to secure a buy-side financing role and did not want to render a fairness opinion under those circumstances.” Decision at 24-25. After bids were received, and the Special Committee asked its advisors to negotiate with Warburg, “RBC did not disclose that it was continuing to seek a buy-side role providing financing to Warburg.” Decision at 26.
RBC “engaged in a full-court press” to convince Warburg to include RBC in the financing and offered to fund a $65 million revolver for a different Warburg portfolio company. Decision at 27.
RBC also worked to lower the analyses in its fairness presentation so Warburg’s bid looked more attractive and coordinated activities between the senior bankers pressing for a financing role and the deal team working on the fairness presentation.
Although many leading investment banks have a standing fairness committee staffed by senior bankers who oversee the opinion process and review opinions to ensure their quality and consistency, RBC had a markedly different practice. The RBC fairness committee was composed of any managing directors who happen to be available and willing at the time a request for review goes out. At least two managing directors must respond and be willing to serve as the ad hoc fairness committee. In the Rural case, one of the two RBC managing directors who approved the fairness opinion had no prior fairness opinion experience. Decision at 27-28.
The Rural Board received RBC and Moelis’ written valuation analyses approximately an hour and fifteen minutes before the 11 p.m. meeting at which the transaction was approved. This was the first valuation information that the Board received as part of the sale process. Decision at 31.
Applying the Revlon Standard of “Enhanced Scrutiny,” the Court Determined the Rural Board Acted “Unreasonably” and Breached Its Fiduciary Duty
In assessing RBC’s liability, the court applied the four elements of aiding and abetting the breach of fiduciary duty under Delaware law: (i) the existence of a fiduciary relationship, (ii) a breach of the fiduciary‘s duty, (iii) knowing participation in the breach by the non-fiduciary defendants, and (iv) damages proximately caused by the breach. Decision at 33 (citing Malpiede v. Townson, 780 A.2d 1075, 1096 (Del. 2001)). Since the Rural Directors clearly have a fiduciary duty to the company and its shareholders, the first element was easily satisfied.
As to the second element (whether there was a breach of fiduciary duty), the court noted the distinction between the standard of conduct (i.e., what directors are expected to do, which is defined by the duties of care and the duties of loyalty) and the standard of review. Decision at 36.
The court determined that because the Rural Board approved a sale of Rural to Warburg for cash, the standard of review intensifies from the business judgment rule analysis to Delaware’s intermediate level of review, “enhanced scrutiny,” which was first applied to the sale of a corporation for cash in the Delaware Supreme Court’s Revlon decision. Decision at 38, 41. To satisfy the enhanced scrutiny standard, defendant directors must establish both (i) the reasonableness of the decision-making process employed by the directors, including the information on which the directors based their decision, and (ii) the reasonableness of the directors’ action in light of the circumstances then existing. Decision at 39. (Although defendants typically have the burden of proving their conduct was reasonable, with respect to an aiding and abetting claim, the burden of proof rests with the plaintiffs.)
The Court Found that the Rural Board’s Process Was Not Reasonable – Directors Must Not Be Passive Observers During Merger Talks
The court’s decision affirms the importance of a board following a proper process and a board and its advisors taking appropriate actions in a sales process. In applying the enhanced scrutiny standard to the Board’s action, the court found that the Directors’ actions were not reasonable and that they had breached their fiduciary duty, thus satisfying the second element of an aiding and abetting claim.
The court determined that although the Directors were required to maintain an active and direct role in a sales process – and in so doing to be reasonably informed about the alternatives available to the company, and take steps to learn about actual and potential conflicts faced by directors, management and their advisors – the Directors failed to do so. Decision at 49-52.
The court found the very initiation of the sales process itself was unreasonable. The Board did not make the decision to launch a sales process nor did it authorize the Special Committee to do so. The Board permitted Shackelton, the Special Committee and RBC to take charge of the process, and relied on advice from RBC that was tainted by RBC’s own financial interests. Decision 52-56.
The court also held the ultimate decision to approve Warburg’s bid was unreasonable because the Board failed to provide active and direct oversight of RBC. When it approved the merger, the Board was unaware of RBC’s last-minute efforts to solicit a buy-side financing role from Warburg, had not received valuation metrics until just hours before the meeting to approve the deal, and did not know about RBC’s manipulation of the valuation metrics. The court found that these factors, and RBC’s undisclosed lobbying of Warburg, illustrated the Board’s failure to place meaningful restrictions on RBC.
Under the circumstances, the Board’s decision to approve Warburg’s bid lacked a reasonable informational basis and fell outside the range of reasonableness under Revlon. Decision at 58 63.
Aiding and Abetting Liability Applies to Third Parties Who Mislead the Board into Breaching the Duty of Care
On the third element of an aiding and abetting claim (“knowing participation in the breach of fiduciary duty”), because the Revlon standard applied, the court held that it need not determine whether the Directors’ breach was a breach of their duty of loyalty or their duty of care, assuming instead that the Directors breached the duty of care. Decision at 64. The court also held that while the Supreme Court of Delaware had not expressly ruled on the issue, a number of Chancery Court decisions had recognized that a third party can be liable for aiding and abetting even if the Board only breached its duty of care. Id. at 64 n. 21, 67-68. Thus, the court found that “knowing participation” is established when, as here, “a third party, for improper motives of its own, misleads the directors into breaching their duty of care.” Id. at 69-70.
RBC’s Conduct Demonstrated “Knowing Participation” Even if it was Unsuccessful in Securing Staple Financing and Buy-Side Fees
With respect to RBC’s knowing participation, the court held that “RBC knowingly participated in the Board’s breach of its duty of care by creating the informational vacuum that misled the Board.” Decision at 71. The court justified this ruling on a host of facts showing that RBC, for its own improper motives, misled the directors into breaching their duty of care. Decision at 69 72. Specifically, the court determined the following:
RBC created an unreasonable process and informational gaps that led to the Board’s breach of duty.
At the outset, RBC knew that it was not disclosing its interest in obtaining a financing role in the acquisition of EMS, or how it intended to use the Rural process to capture the EMS financing business.
RBC had not provided any preliminary valuation analysis since December 23, 2010, and had only provided its December 23 pitch book to the Special Committee. RBC knew that the Board and the Special Committee were uninformed about Rural’s value when making critical decisions.
“Most egregiously,” RBC never disclosed to the Board its continued interest in buy-side financing and its plans to engage in last-minute lobbying of Warburg. Decision at 70.
RBC knew that the Board was uninformed about these critical matters, but failed to disclose the relevant information to further its own opportunity to close a deal, get paid its contingent fee, and receive additional and far greater fees for buy-side financing work. Id. at 70 (citing Del Monte and El Paso cases).
An Engagement Letter Cannot Insulate RBC from Liability Without Adequate Disclosure
The court rejected RBC’s argument that the terms of its engagement letter precluded the claims being asserted. Specifically, the retainer agreement contained a general acknowledgment that RBC and Moelis might extend acquisition financing to other firms. The court held such a provision did not amount to a “non-reliance disclaimer” that would waive or preclude a claim against RBC for failing to inform the Board about specific conflicts of interest. Decision at 72. The court stated that if RBC thought it was obtaining a waiver without first disclosing the conflict and its import, then it was committing “what, in the old days, might have been called constructive fraud.” Id. at 72.
An Exculpatory Charter Amendment is Irrelevant to RBC’s Liability
The court also rejected RBC’s argument that, because Rural’s certificate of incorporation had an exculpatory provision consistent with section 102(b)(7) of the Delaware General Corporation Law (eliminating financial liability to directors who breach their fiduciary duty of care), provision should apply equally to a party charged with aiding and abetting a breach of fiduciary duty. To the contrary, the court held that the presence of an exculpatory provision does not eliminate the underlying duty of care or the potential for fiduciaries to breach that duty. Decision at 44. More importantly, the court held the language of section 102(b)(7) does not extend to aiders and abettors. Id. at 45-48.
RBC’s Liability for Aiding and Abetting Duty of Disclosure Violations is Based in Part On Providing Faulty Valuation Information and Not Fully Disclosing Conflicts
The court found that plaintiffs proved at trial that the Proxy Statement contained materially misleading disclosures in the form of false information that RBC gave to the Board in its financial presentation. The court’s decision thus reaffirms that the duty of disclosure is not an independent duty, but derives from the duties of care and loyalty. Decision at 78 (citing Pfeffer v. Redstone, 965 A.2d 676, 684 (Del. 2009)).
In particular, the court determined that the Proxy Statement contained false and misleading information about RBC’s incentives. “Information that bears on whether an investment bank faces conflicts of interest is material to stockholders when deciding how to vote on a merger and whether to seek appraisal.” Decision at 81. The court determined that the statement in the Proxy Statement that RBC received the right to offer staple financing because it could provide a source for financing on terms that might not otherwise be available to potential buyers of the company was false; the Board had never concluded that RBC could provide financing that might otherwise not be available, and no such evidence was introduced at trial. Id. at 82.
Further, the court noted such partial disclosures imposed on the Rural Directors a duty to speak completely. Id. The Proxy Statement did not disclose, but should have, how RBC used the initiation of the Rural sale process to seek a role in the EMS acquisition financing, and that RBC received more than $10 million for its part in financing the acquisition of EMS. The Proxy Statement also said nothing about RBC’s lobbying of Warburg after the delivery of Warburg’s fully financed bid while RBC was developing its fairness opinion.
The court concluded that RBC knowingly participated in these disclosure violations, since they were either created by RBC’s actions or because only RBC knew the full extent of the conflicts that were undisclosed. RBC’s actions thus resulted in stockholders voting on the merger based on a Proxy Statement that contained materially false disclosures and omissions about RBC’s valuation analyses and conflicts. Decision at 84.
The Case Continues to Determine Damages
As to the final element of aiding and abetting (proof that the aided-and-abetted breach caused damages to the plaintiffs), the court held that plaintiffs proved at trial that RBC’s actions proximately caused the Board’s breach of fiduciary duty and damaged Rural’s stockholders by causing the company to be sold at a price below its fair value. The court found that the evidence at trial “demonstrated persuasively” that the fair value of Rural’s stock at the time of the sale exceeded the $17.25 per share that Warburg was willing to pay. Decision at 72, 72-77. As to the disclosure claim, the court held that RBC denied the stockholders the information necessary to make an informed decision whether to seek appraisal, and they voted on the merger based on a Proxy Statement that contained materially false disclosures and omissions about RBC’s valuation analyses and conflicts. Id. at 84.
The court ordered separate briefing on the issue of damages. The court also indicated that based on the “magnitude” of misrepresentations made in RBC’s pretrial papers versus the evidence at trial, the court found “it possible the facts could support a bad faith fee award” and directed plaintiffs to raise that at a later stage of the case. These developments bear further watching.