On March 7, in a decision following a trial on the merits, the Delaware Court of Chancery held an investment bank liable to a selling company's shareholders for the bank's conduct during the sale process. In re Rural Metro Corp. Stockholders Litig., C.A. No. 6350-VCL (Del. Ch. Mar. 7, 2014). This decision is the latest in a string of post-Financial Crisis cases in which the Chancery Court has closely scrutinized the actions of investment banks in M&A transactions, and there is no reason to think the trend will end any time soon.
Vice Chancellor Laster held the investment bank liable for aiding and abetting fiduciary duty breaches by the Rural/Metro Corp. board of directors in connection with the sale of the company to a financial sponsor. The court found, among other things, that the investment bank took actions that were not authorized by the board (its formal authorization extended only to analyzing the range of available strategic alternatives) and that the sale process was tainted by the investment bank's desire to get the inside track on financing another deal in the same industry. The investment bank also sought to provide buy-side financing to the ultimately successful bidder for Rural/Metro, and the court found that those efforts were not adequately disclosed to the board. The court concluded that the bank's actions created an unreasonable process, caused the target board to act without sufficient information, and ultimately resulted in a lower sale price.
- Rural Metro is the most recent in a growing line of post-Financial Crisis cases, including Del Monte and El Paso, in which investment banks have been criticized for alleged conflicts. In re Del Monte Foods Co. S'holders Litig., 25 A.3d 813 (Del. Ch. 2011); In re El Paso Corp. S'holder Litig., 41 A.3d 432 (Del. Ch. 2012). The underlying theory of these cases is that a bank that advises a selling company can have interests that diverge from those of its client, and that a deal process can be tainted when a selling board does not take steps to police those potential conflicts, or when a bank pursues its diverging interests without making appropriate disclosures to the board.
- In the eyes of the Chancery Court, banker conflicts can arise in multiple ways. The court has perceived conflicts when a sell-side bank also seeks to provide buy-side financing (as in Del Monte and Rural Metro), or when the bank is simultaneously pursuing other deals in the same industry (as in Rural Metro). The Chancery Court is seemingly open to arguments about banker conflicts based on the special circumstances of each deal, which means that directors and bankers need to be alert to potential conflicts before they arise.
- Boilerplate provisions in engagement letters warning of potential conflicts, and other general advance notice about the potential for staple financing, may be viewed by courts as insufficient to protect investment banks from liability for failure to affirmatively disclose conflicts to their clients. Put simply, the cases indicate that an informed waiver may require that the potential conflict be specifically disclosed, and appropriate ethical walls must be set up and observed in the event of any waived conflicts.
- After Rural Metro, investment banks—particularly sell-side advisors—are likely to be increasingly targeted in deal litigation. Aiding and abetting claims against investment bankers may be more likely to survive motions to dismiss given the Rural Metro court's finding that an exculpatory provision in a company's certificate of incorporation does not insulate an advisor from liability. Duty of care breaches that would not give rise to liability for directors because of a 102(b)(7) exculpatory provision can, at least according to Rural Metro, still give rise to aiding and abetting liability for bankers.
- To ensure effective board oversight, directors must do what is necessary to stay informed and place meaningful restrictions on investment banks' behavior. Courts may deem a failure to seek out information about potential conflicts, or to monitor the banker's conduct, to result in breaches of the directors' fiduciary duties, even where information has been hidden from the directors.
- Decisions like Rural Metro may signal the demise of staple financing by sell-side advisors for the foreseeable future. Given the ubiquity of shareholder litigation in the M&A context and the increased focus on investment banks' behavior, banks may conclude that it is not worth the risk, and directors of selling companies may decline to permit their advisors to participate in staple financing arrangements.
As we have previously noted, judicial scrutiny of investment banks in the transactional context has increased significantly since the Financial Crisis. While we believe this scrutiny may in many instances be unnecessary and could distract from the key questions of whether the board itself exercised informed and unbiased decision-making and whether shareholders were harmed, it is clear that isolated aspects of transaction processes will continue to be closely examined.