On November 30, 2015, the Delaware Supreme Court issued its long-anticipated opinion in the stockholder litigation over the sale of Rural/Metro Corporation (Rural). In a unanimous opinion, the court affirmed the Delaware Court of Chancery's ruling that financial advisors can be liable under Delaware law for aiding and abetting breaches of fiduciary duty by directors. The court further upheld the lower court's damages award of over $75 million against the financial advisor, or 83 percent of the approximately $91 million in damages suffered by the class. The decision is very important for both financial advisors and directors in handling potential financial advisor conflicts.
Background and Pertinent Court of Chancery Decisions
The litigation leading to the Supreme Court's decision centered on Rural's sale to Warburg Pincus LLC (Warburg) in June 2011 and, in particular, the conduct of Rural's lead financial advisor. Earlier in the deal litigation, Warburg was dismissed from the litigation. The Rural directors settled the claims against them for $6.6 million. Rural's second financial advisor settled the claims against it for $5 million. The case then proceeded to trial against the lead financial advisor on the aiding and abetting claims—the core claims left in the litigation.
The factual findings and legal conclusions by the Court of Chancery were critical to the Supreme Court's decision.1 In late 2010, Rural formed a special committee of its board of directors to consider strategic alternatives and to make recommendations to the board as a whole. Around the same time, Emergency Medical Services Corporation (EMS), the parent company of Rural's only national competitor, American Medical Response, publicly announced that it was exploring strategic alternatives. After interviewing three banks, Rural's special committee hired a lead financial advisor and a secondary financial advisor. Although the Rural special committee was not yet explicitly authorized to pursue a sale of the company, the lead financial advisor's presentation to the special committee focused on the benefits of a sale process. The lead financial advisor noted that it hoped to offer staple financing to the potential buyers in any transaction but did not inform the committee that it also privately hoped to use its engagement as Rural's advisor to obtain financing work from the bidders in a possible competing transaction with EMS.
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 lead financial advisor's suggestion, determined that selling Rural in parallel to EMS's process was appealing because doing so could allow the buyer of EMS to a make a bid for Rural that included synergies. The Court of Chancery found, however, that the private equity firms involved in the EMS process—including the ultimate buyer of EMS—were limited in their ability to pursue a possible acquisition of Rural on a parallel timeline for various practical reasons, including restrictions on information sharing in Rural's own confidentiality agreements. As a result, some of the bidders for Rural suggested staggering the two deals, but Rural did not change the timing of its sale process.
The Court of Chancery found that Rural's lead financial advisor pushed for a parallel process because of its own interest in leveraging its role in Rural's process to gain financing work from the bidders for EMS. In particular, the court found that the lead financial advisor hoped to generate more than $60 million in aggregate fees from the Rural and EMS deals, including through providing financing to the buyers in both deals, an aggregate amount considerably higher than the advisory fee it might obtain from Rural in connection with a sale transaction. Although the financial advisor was largely unsuccessful in these efforts, the Court of Chancery found that the financial advisor continued to "lobby" Rural's ultimate buyer, 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 of Chancery 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 of Chancery's decision. The court found that aside from valuation figures in the lead financial advisor's initial pitch to the special committee and informal advice during the process, the financial advisor did not prepare valuation analyses until the final meeting at which the board 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. This included using EBITDA numbers for Rural that did not add back one-time expenses and making adjustments to the financial advisor's comparable companies and precedent transactions analyses.
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. In an interesting twist on the story, approximately two years later, Rural entered bankruptcy.
In a post-trial opinion issued on March 7, 2014, the Court of Chancery held that Rural's lead financial advisor had aided and abetted breaches of fiduciary duty by Rural's directors. The court concluded that the Rural directors breached their fiduciary duties in light of the various interrelated factors at play: the timing of the sale process and the initial lack of clear authorization by the Rural board for the sale process; the lead financial advisor's conflicts and the board's failure to put "meaningful restrictions" on the financial advisor, including after the financial advisor announced a desire to provide staple financing; and the informational problems that existed for the board given the financial advisor's failure to disclose its desire to participate in financing the EMS deal, its lobbying of Warburg, and the lack of valuation analyses. Separately, the court determined that the lead financial advisor's behavior and lack of full disclosure caused the board to breach its fiduciary obligations to provide all material information to stockholders in the proxy statement issued in connection with the deal.
In addition, the court determined that the lead financial advisor had "knowingly participated" in the board's breaches—which requires "scienter" or "improper motives" on the part of the financial advisor. In particular, the court found that the financial advisor had knowingly created an "informational vacuum" that led to many of the flaws in the process. As part of this determination, the court stressed the important role of financial advisors as "gatekeepers" in an M&A transaction.
In reaching these holdings, the Court of Chancery held that it did not matter that the directors had potentially breached their duty of care rather than their duty of loyalty. This was an important ruling because Section 102(b)(7) of the Delaware General Corporation Law allows a Delaware corporation to include in its charter a provision exculpating directors for personal liability relating to breaches of the duty of care, and, as is typical, Rural's charter included such a provision. This meant that the directors themselves potentially would not have faced personal liability for the underlying breaches of duty (assuming the court found that the directors had just breached their duty of care) had they remained in the litigation. Rural's lead financial advisor argued that this 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. The Court of Chancery rejected that contention, determining that the existence of a 102(b)(7) provision only affects directors' liability, not the underlying existence of a breach, and that Section 102(b)(7), by its terms, can only protect directors and no one else.
In a subsequent October 10, 2014, opinion assessing liability, the Court of Chancery determined that the Rural stockholders had suffered over $91 million in damages, representing the difference between the amount stockholders received in the sale to Warburg and Rural's going concern value as determined by the court based on expert testimony. The court held that the lead financial advisor was responsible for 83 percent of the damages, awarding the stockholders over $75 million against the advisor. The court attributed the other 17 percent to two of the Rural directors, but did not award damages against them in light of their prior settlements.
The court's determination about the directors, however, is noteworthy. The court determined that one of the directors, who was the chairman of Rural's board and special committee, pushed for a sale because he was a principal of a fund that took a 12 percent stake in Rural with the intended purpose of seeking a sale of the company and Rural had grown to 20 percent of the fund's portfolio.
The court determined that the other director, who had recently been brought on as CEO and played a significant role in the sale process, pushed for a sale because he was under pressure from some of the directors to sell the company and because of the benefits he would receive in a sale (acceleration of the equity awards he received upon joining the company and potentially new equity and employment with a private equity buyer).2
The Delaware Supreme Court Decision
The Supreme Court upheld the Court of Chancery's decisions, both as to the merits of the aiding and abetting claim and as to the calculation of damages. The decision thus confirms that stockholders can, depending on the facts, maintain aiding and abetting claims against financial advisors under Delaware law. Perhaps not surprisingly, just since the decision of the Court of Chancery, more aiding and abetting claims have been filed against financial advisors in public company deal litigations.3 We believe this trend is likely to continue, particularly if there are meaningful allegations of conflicts.
At the same time, and perhaps recognizing the risks of increasing litigation against investment banks and other advisors, the Supreme Court's decision also provides certain important insights and commentary for going forward. Although the Supreme Court upheld the fundamentals of the Court of Chancery's decisions, the Supreme Court emphasized that its holding is a "narrow" one. The Supreme Court warned that its decision "should not be read expansively to suggest that any failure on the part of a financial advisor to prevent directors from breaching their duty of care gives rise to a claim for aiding and abetting" and that the "requirement that the aider and abettor act with scienter makes an aiding and abetting claim among the most difficult to prove" (emphasis in original). The court specifically noted that "we do not adopt the Court of Chancery's description of the role of a financial advisor in M&A transactions," including as "gatekeepers." This commentary should provide some help to financial advisors in dealing with these claims in the future.
In addition, in reviewing the damages award against Rural's lead financial advisor, the Supreme Court provided interesting commentary about the potential value of a second financial advisor. Specifically, the court rejected an argument by the lead financial advisor that the existence of the secondary financial advisor and its additional financial analysis inherently "cleansed" the defects in the Rural process. The court remarked that the other advisor was "paid on the same contingent basis as the primary bank." The Supreme Court did acknowledge, however, that "obtaining the advice of a second bank is a common practice and that such practice can have a salutary effect on a sale process."
Finally, the Supreme Court applied the Revlon standard of review in assessing whether the board breached its fiduciary duties. This is the heightened reasonableness standard of review that applies to courts' review of directors' decisions in connection with the sale of a company, as compared to the more deferential, director-friendly business judgment rule. In another recent decision, the Supreme Court held that in post-closing litigation against directors following a fully informed vote by stockholders, the heightened Revlon standard no longer applies and a plaintiff must instead rebut the application of the deferential business judgment rule by showing that directors either acted with gross negligence (and thereby violated their duty of care) or acted disloyally.4 In this decision, for purposes of the aiding and abetting claim at hand, the court applied the Revlon standard.
Takeaways for Directors
Although the directors in this case did not share in the ultimate damages award, they paid a significant amount of money to settle the claims against them and were found to have breached their fiduciary duties as a result of the litigation against their financial advisor. Such a conclusion again demonstrates the importance of directors seeking to take reasonable steps to inform themselves about potential conflicts that the board's financial advisor may have. As the Supreme Court noted in its decision: as part of their fiduciary duties, "directors need to be active and reasonably informed when overseeing the sale process, including identifying and responding to actual or potential conflicts of interest." The Supreme Court recognized, however, that this rule has its limits: "at the same time, a board is not required to perform searching and ongoing due diligence on its retained advisors in order to ensure that the advisors are not acting in contravention of the company's interests, thereby undermining the very process for which they have been retained." But directors should ask questions and appropriately handle possible conflicts when they arise. If handling conflicts means bringing on a second financial advisor, the board and its legal advisors should carefully think through the role and incentives of the second advisor.
Takeaways for Financial Advisors
The Supreme Court has confirmed that stockholders can bring aiding and abetting claims against financial advisors under Delaware law, and these claims likely will continue. That said, the Supreme Court set a useful tone that these claims should be difficult to pursue. Financial advisors should be forthright with directors about their possible conflicts to the extent practicable and should carefully discuss with their own advisors the types of conduct that can expose a bank to liability. Target companies may at times ask for disclosures from financial advisors that are not practical (including in the early phases of an auction process) given a bank's size or the information available to the bank. But financial advisors should nonetheless expect an iterative process between the bank and its director clients that will draw out and handle meaningful conflicts.
1 A more detailed discussion of the facts of the case as found by the Court of Chancery are discussed in our prior alert on that case, which can be found here: [https://www.wsgr.com/WSGR/Display.aspx?SectionName=publications/PDFSearch/wsgralert-fiduciary-duty-breach.htm].
2 Interestingly, the Court of Chancery also criticized another director—although it did not attribute damages to that director—for supporting a sale of the company allegedly because he was "over-boarded" as a repeat nominee of a hedge fund serving on 12 boards, was under pressure from proxy advisory firms to resign from at least six of them, and sought to exit his service on Rural's board on a "high note," perhaps with accelerated vesting of $200,000 in equity on a change of control.
3 In re TIBCO Software Inc. S'holders Litig., 2015 WL 6155894 (Del. Ch. Oct. 20, 2015); In re Zale Corp. S'holders Litig., 2015 WL 5853693 (Del. Ch. Oct. 1, 2015); In re PLX Tech. Inc. S'holders Litig., C.A. No. 9880-VCL (Del. Ch. Sept. 3, 2015) (transcript).
4 Corwin v. KKR Fin. Holdings LLC, 2015 WL 5772262 (Del. Oct. 2, 2015).