United States: Financial Advisor Held Liable For Aiding And Abetting Target Board’s Breach Of Fiduciary Duties

Court Focuses on Undisclosed Conflicts of Interest

The Delaware Court of Chancery recently held a financial advisor liable for aiding and abetting breaches of fiduciary duty by the board of directors of Rural/Metro Corporation in agreeing to sell Rural to a private equity firm.1 Damages payable by the financial advisor will be determined in the next phase of the proceedings.

The court focused on the financial advisor's conflicts of interest and its failure to disclose the conflicts to the board. The conflicts related principally to the advisor's desire to participate in the financing of the sale of Rural and in the financing of the sale of a competitor company in a contemporaneous process. The court also noted that, although the interests of the financial advisor and the board initially may have been aligned in seeking a sale of Rural, as the sale process continued the financial advisor may have been interested in simply closing a deal while the board was interested in seeking additional consideration.

The opinion, like many (if not all) fiduciary duty opinions, is highly contextual and fact-specific, but provides lessons for boards and advisors in constructing sale processes.

Background

Rural was a publicly-traded Delaware corporation. In December 2010, the financial advisor approached two Rural directors regarding the sale process for Emergency Medical Services Corporation, the parent of Rural's only national competitor, that was then commencing, and suggested the possibility of some form of combination between Rural and EMS, including through an acquisition by Rural of the competitor in partnership with a private equity firm. The Rural board re-activated a special committee to consider and recommend alternatives for Rural.

The financial advisor, in its initial pitch to the special committee, focused on a potential sale of Rural, in parallel with the EMS process, and said that it might seek to provide staple financing to potential bidders for Rural. However, it did not disclose that it also planned to use an engagement by Rural to seek to provide financing to bidders for EMS as well. The financing fees the financial advisor thus hoped to gain, at up to $55 million, could be more than 10 times the sell-side advisory fee it would earn from a sale of Rural. The special committee engaged the financial advisor and hired another investment bank, that would not provide staple financing, as a "secondary" financial advisor.

As Rural's sale process progressed, however, bidders for EMS indicated that they were precluded by confidentiality and timing constraints from simultaneously bidding for Rural. In March 2011, Warburg Pincus LLC, a private equity firm that had dropped out of the bidding for EMS, submitted a fully-financed bid to acquire Rural. The financial advisor nonetheless continued to seek a role in Warburg's financing for the acquisition of Rural, sharing with Warburg information regarding the board's positions and delaying delivery of any fairness analysis to the board because the advisor did not intend to provide a fairness opinion if the advisor could participate in Warburg's financing.

The Fairness Presentation. The financial advisor provided the board with a valuation analysis for the first time less than two hours before the board met to approve the Warburg bid.

The court reviewed the financial advisor's internal work on the analyses and compared the analyses to the analyses in the financial advisor's initial pitch to Rural. The court found that the fairness presentation "conflicted with the [financial advisor's] earlier advice, contravened the premises underlying the board's business plan for Rural, and contained outright falsehoods." "Most notably," the financial advisor used projections that gave no value to Rural's acquisitions and did not add back one-time expenses, which was inconsistent with the advisor's pitch book and other materials; the financial advisor said that the projections were consistent with those of Wall Street research analysts, but the court found that not to be the case. The court also noted that the advisor used an older, lower multiple transaction to which it had given only limited importance in the pitch. The court concluded that the financial advisor had "worked to lower the analyses" so as to make the Warburg bid "look[] more attractive."

On the day of the presentation, the financial advisor continued to have conversations with Warburg in an attempt to be included in Warburg's financing.

The Litigation. Following the announcement of the merger, stockholders brought litigation. Prior to closing, the parties entered into an MOU, based upon additional disclosures provided by Rural, but after the closing the court rejected the settlement and a new lead plaintiff and counsel took over. The board and the second financial advisor settled for $6.6 million and $5 million, respectively, but the financial advisor continued on to trial.

Court's Analysis

Aiding and Abetting Breach of Fiduciary Duty in the Sale Process. The plaintiffs claimed that the financial advisor aided and abetted breaches by the directors of their fiduciary duties in timing and designing the process for soliciting bids and in providing disclosure of the merger to stockholders.

Enhanced Scrutiny When Selling a Company. Because the board was selling Rural, the court reviewed their actions under the (in)famous Revlon "enhanced scrutiny" standard, which requires directors to show that they "act[ed] reasonably to seek the transaction offering the best value reasonably available," which could include remaining independent. To do so, the directors must show the reasonableness of both their decisionmaking process, including the information on which they based their decision, and their action, "in light of the circumstances then existing."

The court also noted that the board was obligated to provide "active and direct" oversight in the sale process, to become reasonably informed about the company's alternatives, and to "act reasonably to learn about actual and potential conflicts" of its advisors as well as the company's directors and management.

Breach of Fiduciary Duty. The court determined that some of the board's actions fell outside of the range of reasonableness.

  • Running a sales process in parallel with the EMS sales process was unreasonable, since, among other things, the board did not consider the potential disadvantages of such a schedule, including that the EMS bid process would impose confidentiality and other practical restrictions that would limit the ability of bidders for EMS to participate in the Rural bid process. While such a decision might ordinarily be part of reasonable decision-making, given the undisclosed conflicts of interest it had to be viewed more skeptically. The court also noted that the decision to begin the process had not been made by an authorized company decisionmaker, since at that time the special committee's mandate was only to make recommendations.
  • Approving the Warburg bid was unreasonable, primarily because the board lacked a reasonable informational basis. The court noted that the board failed to oversee the financial advisor during the final negotiations, when the financial advisor may have been influenced more by its own interests than by a desire to obtain the best deal for Rural, and was unaware of the financial advisor's continued efforts to solicit buy-side financing; that the board did not receive any valuation information until shortly before the final board meeting to approve the transaction; and that the board was unaware that the fairness analyses it did receive had been "manipulated" by the financial advisor to make Warburg's bid appear more attractive. The court concluded that the financial advisor "took advantage of the informational vacuum it created to prime the directors" to support the proffered deal.

Knowing Participation in Breach. The court found that the financial advisor knowingly participated in the board's breaches of fiduciary duty by inducing those breaches. The financial advisor "created the unreasonable process and informational gaps" that led to the board's breaches. More specifically, the financial advisor knew that the board was uninformed about a number of matters when making critical decisions. The financial advisor never disclosed its intention to use the Rural advisory role to capture a financing role in the acquisition of EMS, and, "[m]ost egregiously," did not disclose its continued interest in pursuing buy-side financing for Warburg and "last minute" lobbying plans. The financial advisor also knew that the board was uninformed about the company's valuation, which was caused by the financial advisor's delay in providing valuation material and its misleading fairness analyses. The fact that the financial advisor was unsuccessful in obtaining the financing mandate did not counteract its actions.

Causally Related Damages. The court found that the financial advisor's self-interested actions proximately caused the board's breach of fiduciary duty and damaged the Rural stockholders by causing the company to be sold below its fair value. The court noted that the premium of the sales price over the pre-transaction market price did not ensure that the merger price was the best value reasonably available.

Aiding and Abetting Breach of Fiduciary Duty of Disclosure. The court determined that the financial advisor's manipulated valuation analysis, which was included in Rural's proxy statement, was materially misleading. Also, the financial advisor's failure to disclose its interest in obtaining a buy-side financing role prevented stockholders from being informed about the advisor's conflict of interest.

Observations

  • Directors Can Violate Their Fiduciary Duties Even When They Are "Misled" by Their Advisors. The court found that the financial advisor's undisclosed conflicts of interest led to breaches by the directors of their fiduciary duties, even though the directors were unaware of the conflicts and in fact were "misled" by the financial advisor. The court emphasized the obligation of directors to actively and directly supervise a sale process, including taking steps to understand and limit the scope and impact of a financial advisor's conflicts.
  • Exculpatory Provisions Are Not Bulletproof. As in most corporations, the directors were protected by a 102(b)(7) exculpatory provision in Rural's charter. The court nonetheless found that the directors faced potential exposure, although the directors settled the litigation so the court did not address their actual liability. In any event, such exculpatory provisions do not benefit financial advisors or other third parties
  • Financial Advisors Are Gatekeepers. The court characterized the financial advisor as "highly compensated" and a "gatekeeper" for the board. The court noted that the prospect of aiding and abetting liability should serve to incentivize financial advisors to advise boards "in a manner that helps ensure that the directors carry out their fiduciary duties when exploring strategic alternatives and conducting a sales process."
  • Boards Should Investigate, and Advisors Should Disclose, Actual and Potential Conflicts. The court repeatedly pointed to the financial advisor's failure to disclose its interest in obtaining buy-side financing fees for the Rural sale and the EMS sale and to the impact of these conflicts and the financial advisor's actions on the board's decisions. Financial advisors should inform the board of potential conflicts during the engagement to allow the board to be adequately informed when making decisions.
  • Scrutiny of the Preparation of Fairness Analyses is Increasing. The court scrutinized the steps taken by the financial advisor in preparing its fairness analyses, including steps taken internally before the analyses were delivered to the board and differences between presentations. Banks should keep in mind that all steps in the development of their analyses may be subject to scrutiny. They may be justified in making changes and judgments, but their actions may be reviewed with hindsight and potentially with the assumption that the changes were made for a self-interested purpose. Boards should consider taking an active approach in obtaining valuation information and other material from their advisors.
  • Fairness Opinion Committee Processes also May be Scrutinized. The court criticized the "ad hoc" nature of the financial advisor's fairness opinion committee, which was comprised of bankers who "happen[ed] to be available" at the time of review rather than "of senior bankers who oversee the opinion process and review opinions to ensure their quality and consistency" as in other investment banks.
  • The Effect of Engagement Letter Language May be Limited. The court found that the general acknowledgement in the financial advisor's engagement letter, to the effect that the advisor might extend acquisition financing and other products to other companies, did not constitute a non-reliance disclaimer that would preclude a claim against the advisor for failure to disclose its specific conflicts of interest. Financial advisors should consider disclosing, and boards should seek to understand and then, if accepted, provide oversight of, actual and potential conflicts more specifically, keeping in mind that such conflicts may change as the process evolves. As noted by the court, it is only by disclosing a conflict that an advisor can obtain a meaningful waiver from the company.
  • Courts Continue to be Skeptical of Staple Financing. The court did not rule out staple financing, but asked why the staple was allowed when the financial advisor also told the board that financing was readily available from other sources. The fact that the financial advisor ultimately did not participate in the financing was irrelevant, given the impact on the bank's incentives and the steps it took to pursue the financing. Boards should consider whether there are benefits to the company and its shareholders prior to allowing a financial advisor to pursue staple and other buy-side financing.
  • A Preliminary Settlement Before Closing Does Not Necessarily End the Matter. The parties may agree to a settlement of litigation, but until approved by a court the settlement may not be effective. Here, the parties agreed to a settlement, but the court found that the disclosures obtained by the plaintiffs were insufficient to support the settlement. The litigation thus continued after the closing.

Footnote

1. In re Rural Metro Corp. Stockholders Lit., Del. Ch. March 7, 2014.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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