On November 30, 2015, the Delaware Supreme Court issued an opinion affirming the Court of Chancery’s decision in In re Rural/Metro Corporation Stockholders Litigation.In the earlier decisions, the Court of Chancery found that Rural/Metro Corporation’s primary financial advisor aided and abetted breaches of fiduciary duty by Rural/Metro’s board in connection with the company’s acquisition by a private equity firm, and held that the primary financial advisor was liable for approximately $76 million in damages, plus interest. Vice Chancellor Laster’s decision sent shockwaves through the financial advisor community, both for the amount of the award and scope of its holding, including for its apparent shifting of responsibility for properly running a sale process from a board of directors to a financial advisor.
The Delaware Supreme Court’s opinion is vital because it affirms both the award and the principal legal holdings, including that the primary financial advisor was liable for aiding and abetting a breach of the directors’ fiduciary duties without finding gross negligence by the directors. The Delaware Supreme Court did break from the Court of Chancery’s decision in a significant way as it pertains to the role of the financial advisor, however; VC Laster’s characterization of financial advisors as “gatekeepers” with a quasi-fiduciary responsibility to monitor a board to ensure it has both adequate information and exercises due care was rejected by the Court. Rather, the Court found that the relationship between a financial advisor and a company or its board “is primarily contractual in nature” and “the parameters of the financial advisor’s relationship and responsibilities with its client” are set forth in the contract between the parties, not through a vague “gatekeeper” function. The Court further narrowed VC Laster’s decision by affirming that scienter is a requisite element of an aiding and abetting claim, and underscored that a financial advisor’s failure to prevent directors from breaching their duty of care did not give rise to such a claim.
Rural/Metro was sold to a private equity firm in June 2011. The year prior, Rural/Metro was considering the acquisition of its primary competitor, American Medical Response, Inc. (AMR), a subsidiary of Emergency Medical Services Corporation (EMS). The board formed a special committee to oversee the process of formulating Rural/Metro’s acquisition strategy as it pertained to AMR. The special committee was re-formed in October 2010 in response to an approach by potential acquirers of Rural/Metro, but the trial court found that the board did not authorize the special committee to pursue a sale of the company; instead, the board authorized the special committee to engage an advisor to review strategic alternatives and report its findings to the board. The special committee engaged the primary financial advisor and a secondary financial advisor in December 2010, and, the trial court found, proceeded to initiate an unauthorized sale process without the knowledge, oversight or approval of the full board and without ever considering strategic alternatives. The trial court found that the primary financial advisor steered the special committee to engage in a sale process designed to run in parallel with the sale of EMS, which had previously announced that it was exploring strategic alternatives, and that the primary financial advisor did not disclose to Rural/Metro that it planned to use its engagement by Rural/Metro to seek financing work from the bidders for EMS.
As we discussed in “Who’s in Charge – Is the Board Responsible to Monitor Its Financial Advisor or Vice Versa?”, VC Laster found that the directors breached their fiduciary duties in initiating the unauthorized sale process, for failing to be adequately informed as to Rural/Metro’s value during the sale process, and for failing to provide proper oversight of the primary financial advisor (particularly as it pertained to the primary financial advisor’s efforts to get on buy-side financing trees for the potential purchase of EMS, its attempts to provide staple financing to the private equity firm in the purchase of Rural/Metro, and its last-minute manipulation of its valuation metrics). The Court of Chancery further found that the board committed a disclosure violation by including materially misleading information in its proxy statement by indicating that the primary financial advisor had used “Wall Street research analyst consensus projections” in its precedent transaction analysis and that the board concluded that the primary financial advisor was given the right to offer staple financing because it could offer such financing on terms that “might not otherwise be available,” neither of which was accurate. The primary financial advisor was found to have aided and abetted those breaches.
Revlon applies to a sale, not the evaluation of strategic alternatives
The parties agreed that Revlon was the correct standard of review, but disagreed as to when it applied. The primary financial advisor argued that the Court of Chancery erred in applying Revlon’s enhanced scrutiny during the period when Rural/Metro was supposedly exploring strategic alternatives, and that Revlon applied only “when the sale of the Company became inevitable.” The Delaware Supreme Court agreed thatRevlon is not triggered by a company “being in play,” but found that the special committee never “genuinely explor[ed] other strategic alternatives” and instead initiated a sale process in December 2010. The board, which subsequently “restated and ratified” the special committee’s activities, rendered them acts of the company. As a result, Revlon applied from the outset of the special committee’s unauthorized sale process. The Court further disagreed that Revlon would apply only at the end of a sale process and not during the course thereof, noting that such an argument “would allow the Board to benefit from a more deferential standard of review during the time when, due to its lack of oversight, the Special Committee and [the primary financial advisor] engaged in a flawed and conflict-ridden sale process.” Further, the Court noted “[s]uch a result would potentially incentivize a board to avoid active engagement until the very end of a sale process by delegating the process to a subset of directors, officers, and/or advisors.” While there is no bright-line test as to when Revlon duties are triggered, Delaware courts will analyze when a sale process was initiated in determining when Revlon applies – even if a special committee has commenced an unauthorized sale.
Aiding and Abetting requires scienter
The Delaware Supreme Court affirmed the Court of Chancery’s holding that the financial advisor was liable for aiding and abetting the breach of the director’s fiduciary duties. In particular, the Court noted that the primary financial advisor “knowingly induced the breach [of the directors’ fiduciary duties] by exploiting its own conflicted interests to the detriment of Rural and by creating an informational vacuum.” The key element is scienter. The Court stated that to be liable for an aiding and abetting claim, “[t]he aider and abettor must act ‘knowingly, intentionally, or with reckless indifference’…with an ‘illicit state of mind.’” The Court affirmed that the primary financial advisor acted with scienter because, as we described in our prior article “From Bad to Worse – Rural/Metro Financial Advisor Hit With $75.8 Million in Damages”, it knowingly failed to (i) disclose its conflicts with respect to seeking buy-side financing for bidders of EMS, (ii) provide the board with information about Rural/Metro’s value (including the manipulation of the valuation analysis) and (iii) inform the board of its repeated attempts to seek a buy-side financing role with the private equity acquirer of the company. “The manifest intentionality of [the primary financial advisor’s] conduct...is demonstrative of the advisor’s knowledge…[and] [p]ropelled by its own improper motives, [the primary financial advisor] misled the Rural directors into breaching their duty of care.” The Court further underscored that its holding should be read narrowly, however, and “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 a breach of the duty of care.” Rather, the Court noted that the scienter standard make such an aiding and abetting claim very difficult to prove, and that its ruling was based on the “unusual facts proven at trial.”
The Delaware Supreme Court’s decision confirms that financial advisors may be held liable for aiding and abetting a breach of directors’ fiduciary duties – even without a finding of gross negligence on the part of the directors. The Court’s opinion further reinforces the trend noted in our earlier article, “ The Importance of Oversight: Recent Trends in Delaware Financial Advisor Liability,” regarding the necessity of financial advisor transparency and disclosure of conflicts of interest, and underscores that financial advisors should proactively monitor and disclose to their client boards potential conflicts throughout a sale process. Additionally, the decision reaffirms that directors must be vigilant and informed during a sale process, including by ongoing inquiry into potential conflicts of interests of its financial advisors.
Another vital takeaway from the Court’s decision from a financial advisor perspective is that the Court found that they are not “gatekeepers.” In its prior decision, the Court of Chancery provided dictum noting that financial advisors “function as ‘gatekeepers’” that provide expert services to “[d]irectors [that] are not expected to have the expertise to determine the corporation’s value for themselves, or to have the time or ability to design and carryout a sale process.” The Court rejected such broad language, noting “the role of a financial advisor is primarily contractual in nature” and that “[a]dhering to the trial court’s amorphous ‘gatekeeper’ language would inappropriately expand our narrow holding here by suggesting that any failure by a financial advisor to prevent directors from breaching their duty of care gives rise to an aiding and abetting claim against the advisor.” In so doing, the Court curtailed the ability of future litigants to make claims based upon the “amorphous ‘gatekeeper’” concept. At the same time, financial advisors should continue to ensure that their client boards are informed of material information, particularly as it pertains to the financial advisor’s conflicts of interest – knowingly creating an “informational vacuum” will still subject a financial advisor to potential aiding and abetting liability.
Finally, the Court rejected the notion that the secondary financial advisor’s independent financial analysis cut the proximate causal link, “in part, because the supposedly conflict-cleansing bank was paid on the same contingent basis as the primary bank.” Similar to the secondary financial advisor in In re El Paso Corporation Shareholder Litigation, where the purportedly conflict-cleansing financial advisor was only paid if El Paso was purchased by Kinder Morgan, in this instance the Court intimated that the secondary financial advisor’s compensation arrangement gave it a reason to share similar incentives with the primary financial advisor and to prefer a sale of the company. As a result, it failed to cleanse the defective sale process and deficient proxy disclosures. The Court noted that a compensation arrangement that pays a percentage of the deal value upon consummation of the transaction would have a “salutary effect of aligning the interests of the advisor with those of its client in attempting to obtain the best value.” We believe that a secondary financial advisor compensated based upon an incentive fee tied to a higher offer coming out of a go-shop period, however, would likely be acceptable to the Court, and that such a fee arrangement, along with the secondary financial advisor performing its own independent financial analysis, would likely lead to the desired “cleansing” effect on a deficient process, in certain circumstances.