Almost anyone who reviews an underwriting agreement or engagement letter with a major investment banking firm for the first time stands back in awe. Such agreements are relatively one-sided affairs, in which the investment banking firm outlines its responsibilities conditionally and narrowly (in the case of underwriting agreements) or vaguely and generally (in the case of engagement letters). At the same time, the bank’s compensation and indemnification rights are drafted quite specifically and inclusively.
In the face of these agreements, questions have sometimes arisen as to the full contours of the investment bank’s obligations to its corporate client and to the corporation’s shareholders.
The US Court of Appeals for the Seventh Circuit recently rejected a claim that an investment banker retained by the seller’s board of directors owed a fiduciary duty to the corporation’s shareholders. Joyce v. Morgan Stanley & Co., Inc., No. 07-19992 (7th Cir. Aug. 19, 2008). The case arose from a merger in which 21st Century Telecom Group was being acquired by RCN Corporation, and the shareholders of 21st Century would receive RCN stock. Morgan Stanley advised 21st Century’s board in connection with the stock-for-stock exchange transaction. After the agreement was signed, but before it was effective, the market value of RCN’s stock fell dramatically, and the 21st Century shareholders received worthless RCN stock.
The merger agreement did not include a “collar,” “walk away” right or other pricing protection, although 21st Century and Morgan Stanley had unsuccessfully sought to have such provisions included in the agreement. The plaintiff shareholders alleged that, having unsuccessfully sought to obtain price protection, Morgan Stanley somehow assumed a fiduciary duty to 21st Century’s shareholders to advise them to effect their own hedging arrangements. Morgan Stanley’s fairness opinion did not do so, and no such disclosure or suggestion was made in the proxy statement for the transaction. The plaintiffs argued that Morgan Stanley breached its fiduciary duties to render that advice, and should be liable to the plaintiffs for the drop in RCN’s stock value.
The Seventh Circuit rejected this somewhat novel argument, noting that: “We are not aware of any authority to support the proposition that an attempt to facilitate an outcome that would benefit a party automatically makes the attempter a fiduciary of that party.”
While the Joyce case has been cited by some commentators as reaffirmation of a general principle that investment banks have no extra-contractual duties, such a statement would appear to go too far. Joyce is probably better read as indicating that an investment bank owes no fiduciary duties to shareholders of its client to offer independent investment advice on how to mitigate investment risks associated with the transaction.
Further evidence of the fact that Joyce cannot be read to eliminate all exposure of investment banks to fiduciary duty claims is provided by a now 12-year-old Ninth Circuit decision in In Re Daisy Systems Corporation v. Bear Stearns & Company, Inc., 97 F.3rd 1171 (9th Cir. 1996). There, the Ninth Circuit held that Bear Stearns’ status as “exclusive financial advisor” to a corporation created a fiduciary duty to the corporation that may have been breached as a result of Bear Stearns’ negligent, ill-informed and non-expert advice on the manner in which to execute the acquisition of a high-technology company. The record in Daisy reflected that Bear Stearns had little, if any, experience in high-technology acquisitions, and nevertheless advised the board to undertake an ill-considered hostile acquisition of a company whose primary asset was the intellectual property resident in the minds of the target’s employees. Bear Stearns’ position was further weakened by the fact that it had provided two “highly confident” letters assuring the parties of the availability of financing, without apparently having made any real effort to determine whether the financing would be available.
The Joyce and Daisy cases can perhaps best be understood as bookends. An investment bank that competently executes a transaction should not generally fear extra-contractual liability if the transaction does not turn out well for its clients or its shareholders. On the other hand, having undertaken a duty to serve as a financial adviser, the bank can reasonably be expected to face potential liability if it lacks the necessary experience to give professional and informed advice, fails to do its homework and acts negligently.
The Daisy and Joyce cases also serve to point out that care should be taken by both sides when preparing investment banking engagement letters. Those letters should thoughtfully spell out the scope of the investment bankers’ engagement and avoid the vague characterizations that often appear in those agreements. If the company expects the banker to provide a broad range of advice on how to manage shareholder investment risks associated with the transaction, that expectation is unlikely to be accommodated by the bank and certainly not without special arrangements (and undoubtedly a separate fee).