On March 7, 2014, the Delaware Court of Chancery issued a significant post-trial decision in In re Rural Metro Corp. S’holders Litig., C.A. No. 6350-VCL, mem. op. (Del. Ch. Mar. 7, 2014), holding a financial advisor liable for aiding and abetting a board of directors’ breach of its “Revlon duty” to obtain the best price reasonably available in a merger. Among other things, Vice Chancellor J. Travis Laster held that the board of directors breached its fiduciary duties when it initiated a sale process at an inopportune time and by not adequately informing itself in approving the merger. He also held that the company’s financial advisor knowingly participated in the breach by, among other things, structuring the sale process to maximize their ability to obtain buy-side financing fees and not fully disclosing their conflicts of interest.
• Financial advisors can be held liable for aiding and abetting a board’s breach of the duty of care or loyalty, even if directors are exculpated from liability for due care violations.
• Exculpatory provisions authorized under Section 102(b)(7) of the Delaware General Corporation Law only apply to directors.
• Delaware courts continue to scrutinize financial advisor conflicts of interest and related disclosures on a case-by-case basis.
• Faced with the threat of actual liability, financial advisors will be under additional pressure to disclose actual and potential conflicts of interest.
• In some cases, the actions of advisors could result in a board of directors breaching its fiduciary duties, even if the directors are unaware of those actions.
• Directors must exercise reasonable and active oversight over their advisors, including by taking proactive steps to identify and mitigate actual and potential conflicts of interest.
• Before taking action, directors need to ensure that they have received sufficient information in a timely manner.
Rural/Metro Corporation (“Rural” or the “Company”) was a leading provider of ambulance and fire protection services. In early December 2010, the Company learned that its lone national competitor, Emergency Medical Services Corporation (“EMS”), was exploring a potential sale. The Company’s financial advisor (the “financial advisor”), in an overview to the Company, reported that some of the private equity firms interested in EMS might be interested in partnering with the Company.
© 2014 Hunton & Williams LLP 2
According to the court, the financial advisor thought that a buyer of EMS might also be interested in acquiring the Company. The financial advisor recognized that if the Company engaged in a sale process concurrently with the EMS process, then the financial advisor “could use its position as sell-side advisor to secure buy-side roles with the private equity firms bidding for EMS.” The firms would “think they would have the inside track on Rural if they included [the financial advisor] among the banks financing their bids for EMS.” The financial advisor thus believed that with the Rural “angle,” it could get a place on the EMS bidders’ financing trees. As a result, the financial advisor pitched the Company to initiate a sale process that would run parallel with EMS’s sale process. In the financial advisor’s presentation to the Company, the financial advisor mentioned that it would offer stapled financing to potential buyers of the Company, but it did not disclose its desire to use its engagement as the Company’s sell-side advisor to capture financing work from the bidders for EMS. The financial advisor estimated that its sell-side advisory fee plus the fees earned if it financed both the EMS transaction and the sale of the Company could be $60.1 million. After authorizing the stapled financing to potential buyers of the Company, the Company engaged an additional financial advisor to render a fairness opinion in any transaction.
As the Company’s sale process unfolded, it became apparent that the EMS bidders were unable to pursue the Company simultaneously. Among other things, the confidentiality agreements that the EMS bidders entered into restricted the bidder’s ability to share or evaluate EMS’s confidential information. In addition, the final bidder for EMS requested the Company to push back its bid deadline so that it could complete the EMS acquisition and pursue a proposal for Rural. The Company moved forward with its sale process, however, and announced in March 2011 a definitive agreement to be acquired by a private equity firm.
After the transaction was announced, Rural stockholders brought suit. Before the stockholders’ meeting to approve the merger, the defendants entered into a “disclosure-only” settlement, with the then lead plaintiff, in which the Company supplemented its proxy statement with additional disclosures and agreed not to oppose a fee application. One of the plaintiffs objected to the settlement, however, and the court refused to approve it. Before trial, the Company’s directors and the other financial advisor settled the claims for $6.6 million and $5 million, respectively, leaving the plaintiffs to pursue its remaining claims against the financial advisor at trial.
THE COURT’S OPINION
Following a four-day trial, the court held the financial advisor liable for aiding and abetting the board’s breach of fiduciary duty. The elements of an aiding and abetting claim require (i) the existence of a fiduciary relationship, (ii) a breach of the fiduciary’s duty of loyalty or care, (iii) the non-fiduciary’s knowing participation in that breach, and (iv) damages proximately caused by that breach. According to the court, the plaintiffs’ claims against the financial advisor fell into two categories: (i) misconduct leading to breaches of the board’s fiduciary duty during the sale process and (ii) misconduct leading to disclosure violations.
The court found that the board breached its Revlon duty to obtain the best price reasonably available because its actions fell outside of a “range of reasonableness.” The Revlon breach was based on two findings: (i) that the board initiated the sale process on an uninformed basis at an inopportune time; and (ii) the board acted unreasonably in approving the final merger.
Decision to Run a Sale Process Parallel to Competitor’s Sale Process
The court said that there were “obvious and readily foreseeable” problems associated with running parallel sale processes that were never considered by the Company’s board or special committee or discussed by the financial advisor. Among other things, third parties bidding to acquire the competitor would be bound by confidentiality agreements hindering their ability to simultaneously evaluate and pursue a purchase of the Company. The court also found that the initiation of the Company’s sale process was inconsistent with the Company’s previous view that it needed to continue demonstrating its
© 2014 Hunton & Williams LLP 3
existing strategy was successful in order to maximize its sale price. Additionally, the court found the special committee, which was formed to consider the Company’s strategic alternatives, acted largely outside its authority by hiring the financial advisor and initiating the sale process.
The court said the decision to run the Company’s sale process in parallel to EMS’s process might be a “close call” in other circumstances but that the Company’s board and special committee never considered the foreseeable problems. In addition, the directors’ decision to conduct the sale process was made without disclosure from the financial advisor that “proceeding in parallel with the EMS process served [the financial advisor’s] interest in gaining a role on the financing trees of bidders for EMS.”
Decision to Approve Final Bid
The court also concluded the board of directors breached its Revlon duty in approving the final merger agreement. Although the buyer did not use the financial advisor’s stapled financing, the directors were unaware that the financial advisor engaged in “secret lobbying” and “last minute efforts to solicit a buy-side financing role” from the buyer. The court found these discussions problematic because the financial advisor was not incentivized to negotiate an additional increase in price. “Rather than pushing for the best deal possible for Rural,” the court said, the financial advisor “did everything it could to get a deal, secure its advisory fee, and further its chances for additional compensation from [the buyer].”
The court also found the financial advisor had informed the buyer of “internal dynamics in the Rural boardroom, including the various directors’ competing views on price.” None of this was disclosed to the board as it considered the buyer’s final proposal. Importantly, the court noted that the board failed to “place meaningful restrictions on” the financial advisor. Specifically, the court said that the directors “did not provide any guidance about when staple financing discussions should start or cease, made no inquiries on that subject, and imposed no practical check on [the financial advisor’s] interest in maximizing its fees.”
The court also concluded that the directors did not receive valuation material sufficiently in advance to analyze the final offer and compare it to the Company’s alternatives. The board did not receive the financial advisor’s financial analysis until three hours before it met to approve the transaction. More importantly, this was the first valuation analysis provided by the financial advisor since its pitch materials provided several months earlier. As a result, “the directors did not have an opportunity to examine those materials critically and understand how the value of the merger compared to Rural’s value as a going concern.”
The court also found that the valuation analysis “conflicted with [the financial advisor’s] earlier advice, contravened the premises underlying the Board’s business plan for Rural, and contained outright falsehoods.” Because the board had not previously received any valuation materials, the court said the directors were in an “informational vacuum.” The court further noted that because valuation was not provided prior to “critical meetings,” the financial advisor “took advantage of the informational vacuum it created to prime the directors to support a deal at $17.25.” Consequently, the court concluded that “this is not a case where a Board’s independent sense of the value of the company is sufficient to carry the day.”
The court found that the Company’s proxy statement contained “materially misleading disclosures in the form of false information that [the financial advisor] presented to the board in its financial presentation.” The financial advisor “told the directors that it used ‘Wall Street research analyst consensus projections’ to derive Rural’s EBITDA for 2010”; however, the court found that the “consensus projections” were Rural’s actual results and also not adjusted for one-time expenses.
The court also determined that the Company’s proxy statement contained false and misleading information about the financial advisor’s incentives by not describing how the financial advisor used the
initiation of the Rural sale process to seek a role in the EMS acquisition financing, and not disclosing the financial advisor’s receipt of more than $10 million for its part in financing the EMS acquisition. In addition, the proxy statement falsely said that the financial advisor was authorized to provide stapled financing because such financing terms “might not otherwise be available to potential buyers.” Further, the proxy statement said nothing regarding the financial advisor’s “lobbying” of the buyer after the delivery of the buyer’s fully financed bid, while the financial advisor was simultaneously developing its fairness opinion. In conclusion, the court held that the financial advisor’s actions caused the Company to disseminate a proxy statement “that contained materially false disclosures and omissions” about the financial advisor’s valuation analysis and conflicts.1
The court concluded that the financial advisor knowingly participated in the fiduciary breach and that damages were causally related. It requested supplemental briefing from the litigants on the amount of damages to be awarded. The court also requested supplemental briefing on the financial advisor’s defense of contribution from the other defendants, which could become a significant issue.
Breach of Revlon Duty Because Actions were Outside a “Range of Reasonableness”
Rural Metro is significant because the court held that the directors breached their Revlon duty by taking actions that fell “outside the range of reasonableness.” Under Revlon, courts apply enhanced scrutiny to examine (i) the reasonableness of the directors’ decision-making process and (ii) the reasonableness of the directors’ action in light of the circumstances.
Importantly, the plaintiffs-stockholders did not press breach of loyalty claims, and the court said it did not need to “categorize the directors’ conduct under the headings of loyalty or care.” As a result, the court applied Revlon’s reasonableness standard instead of parsing the claims into breaches under the business judgment rule’s test. This means, however, that the aiding and abetting claims in Rural Metro should have to stand solely on a breach of the duty of care. It further means that the court applied Revlon’s “reasonableness” standard rather than the traditional “gross negligence” standard associated with the duty of care. 2
As discussed above, the Revlon breach was based on two findings: (i) the board acted unreasonably in approving the final merger; and (ii) the board initiated the sale process on an uninformed basis at an inopportune time. The court found that when the board approved the final merger, it was:
1 Because the court concluded that stockholders were not fully informed about the merger, it did not address the effect of stockholder ratification on the plaintiffs’ claims. Cf. In re Morton’s Rest. Group, Inc., 74 A.3d 656, 663 n.34 (Del. Ch. 2013) (“Traditionally, our equitable law of corporations has applied the business judgment rule standard of review to sales to arm's-length buyers when an informed, uncoerced vote of the disinterested electorate has approved the transaction.”); In re PNB Hldg. Co. S’holders Litig., 2006 WL 2403999, at *14 (Del. Ch. Aug. 18, 2006) (“[O]utside the Lynch context, proof that an informed, non-coerced majority of the disinterested stockholders approved an interested transaction has the effect of invoking business judgment rule protection for the transaction and, as a practical matter, insulating the transaction from revocation and its proponents from liability.”).
2 Rural Metro is unique because most post-closing claims in M&A litigation have required proof that directors breached their duty of loyalty by acting in bad faith. See, e.g., Lyondell Chem. Co. v. Ryan, 970 A.2d 235 (Del. 2009) (holding, in a post-closing Revlon case, that plaintiff had to show the directors “utterly failed to attempt to obtain the best sale price” to show bad faith); accord In re Morton’s Rest. Group, Inc. S’holders Litig., 74 A.3d 656 (Del. Ch. 2013). This is because most directors (including Rural’s board) are exculpated from liability for due care violations under charter provisions adopted pursuant to Section 102(b)(7) of the Delaware General Corporation Law. In Rural Metro, however, the directors settled before trial, leaving the plaintiffs to pursue claims that the financial advisor aided and abetted breaches of the duty of care and/or loyalty. The court held that Delaware’s exculpation provisions were not applicable to the financial advisor.
unaware of [the financial advisor’s] last minute efforts to solicit a buy-side financing role from [the buyer], had not received any valuation information until three hours before the meeting to approve the deal, and did not know about [the financial advisor’s] manipulation of its valuation metrics [to justify the transaction].3
The court was particularly critical of the board’s receipt of initial valuation materials just hours before it approved the merger. The court stated that “[p]art of providing active and direct oversight is becoming reasonably informed about the alternatives available to the company,” which includes “a reasonably adequate understanding of the value of not engaging in a transaction at all.” It further said that “directors not only must receive the information, but also have adequate time to consider it.”
It bears noting that Delaware courts have repeatedly stated that there is “no single blueprint” for discharging Revlon duties. Given the wide latitude generally conferred on directors, there are few Delaware cases finding that a sale process itself was unreasonable.4 Nevertheless, Rural Metro found that the board’s decision was unreasonable because the board was not adequately informed. For example, the premise of the Company tracking the EMS sale process was that a single buyer of both companies could capture significant synergies, thus maximizing the sale price. But in actuality, potential bidders were unable to execute parallel sale processes and the board never considered the “obvious and readily foreseeable disadvantages” to this strategy. The court also indicated that the Company probably would have been better served by delaying its sale process to show buyers that its existing acquisition strategy was working. Moreover, the board was not aware that the financial advisor thought the parallel sale process would help it obtain a buy-side financing role in the EMS acquisition.5
Ongoing Scrutiny of Financial Advisors
The decision reflects ongoing scrutiny of sell-side financial advisors as illustrated by recent Delaware cases such as Del Monte, El Paso, and Atheros.6
Further Pressure on Financial Advisors to Disclose and Manage Conflicts of Interest
Rural Metro found that the financial advisor did not disclose the full extent of its conflict of interest and that there were numerous discussions between the buyer and the financial advisor of which the board was not made aware. Rural Metro thus demonstrates the potential of actual liability for financial advisors in M&A transactions. As the court observed:
3 See also Rural Metro at 63 (“The combination of [the financial advisor’s] behind the scenes maneuvering, the absence of any disclosure to the Board regarding [the financial advisor’s] activities, and the belated and skewed valuation deck caused the Board decision to approve [the buyer’s final] offer to fall short under the enhanced scrutiny test.”).
4 But see In re Netsmart Techn. S’holders Lit., 924 A.2d 171 (Del. Ch. 2007) (holding that plaintiffs had a reasonable probability of success in proving that a board of directors acted unreasonably in excluding strategic buyers from a sale process).
5 See Rural Metro at 53 (“[T]he decision to initiate a sale process fails the enhanced scrutiny test because [the financial advisor] did not disclose that proceeding in parallel with the [competitor’s sale] process served [the financial advisor’s] interest in gaining a role on the financing trees of bidders for [the competitor].”).
6 See 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); In re Atheros Commc’ns, Inc. S’holder Litig., 2011 WL 864928 (Del. Ch. Mar. 4, 2011); see also In re Coventry Health Care, Inc. S’holders Litig., Consol. C.A. No. 7905-CS, trans. ruling (Del. Ch. Aug. 29, 2013) (awarding $975,000 in attorneys’ fees where supplemental disclosures addressed, among other things, preliminary discussions between the buyer and the seller’s financial advisor); In re Art Techn. Group, Inc. S’holders Litig., C.A. No. 5955-VCL, trans. (Del. Ch. Dec. 20, 2010) (enjoining a merger until the target company provided supplemental disclosures regarding the work that its financial advisor had provided to the buyer).
[T]he prospect of aiding and abetting liability for investment banks who induce boards of directors to breach their duty of care creates a powerful financial reason for the banks to provide meaningful fairness opinions and to advise boards in a manner that helps ensure that the directors carry out their fiduciary duties when exploring strategic alternatives and conducting a sale process, rather than in a manner that falls short of established fiduciary norms.
Rural Metro also puts pressure on financial advisors in connection with the company’s disclosures to stockholders. As noted above, the court found that the Rural board violated its disclosure obligation because the proxy statement included false statements about the financial advisor’s valuation analysis and failed to disclose the financial advisor’s conflicts.7 Rural Metro is thus a reminder that Delaware’s judges will closely scrutinize financial advisors’ valuation analyses and related disclosures.8
Financial Advisors May Start Limiting the Range of Services They are Willing to Provide
In Rural Metro, the board authorized its financial advisor to provide stapled financing. As is customary in such a situation, the board also engaged a second financial advisor to render a fairness opinion. Plus, the ultimate buyer declined to use the stapled financing. Nevertheless, the court said one of the reasons the board acted unreasonably was that it was unaware of the financial advisor’s “secret” and “last minute lobbying” of the buyer to finance the merger when the directors thought the buyer’s offer was fully-financed.9
Stapled financing can provide a “price floor” and expedite a sale process, but it has also drawn judicial scrutiny because the financing fees can significantly exceed the M&A advisory fees paid to the financial advisor.10 Going forward, in the absence of an open credit market, parties may decide that the conflicts of interest associated with stapled financing outweigh the benefits. Nevertheless, there is no per se rule against stapled financing and there may be situations where it is beneficial to a company and its stockholders.11
7 See Atheros, mem. op. at 21-22 (“Financial advisors… serve a critical function by performing a valuation of the enterprise upon which its owners rely in determining whether to support a sale. Before shareholders can have confidence in a fairness opinion or rely upon it to an appropriate extent, the conflicts and arguably perverse incentives that may influence the financial advisor in the exercise of its judgment and discretion must be fully and fairly disclosed.”).
8 See, e.g., Koehler v. NetSpend Holdings Inc., C.A. No. 8373-VCG (Del. Ch. May 21, 2013) (finding that a fairness opinion was “weak” and a “poor substitute for a market check”).
9 See Rural Metro at 59 (“Rather than pushing for the best deal possible for Rural, [the financial advisor] did everything it could to get a deal, secure its advisory fee, and further its chances for additional compensation from [the buyer].”).
10 See, e.g., In re Toys “R” Us, Inc. S’holder Litig., 877 A.2d 975, 1006 n.46 (Del. Ch. 2005) (“In general... it is advisable that investment banks representing sellers not create the appearance that they desire buy-side work, especially when it might be that they are more likely to be selected by some buyers for that lucrative role than by others.”); Ortsman v. Green, 2007 WL 702475 (Del. Ch. Feb. 28, 2007) (finding plaintiffs were entitled to expedited discovery where, among other things, the target’s financial advisor had a conflict of interest due to its buy-side financing role).
11 See, e.g., In re Morton’s Rest. Group, Inc. S’holders Litig., 74 A.3d 656 (Del. Ch. 2013) (upholding the board’s decision to allow its banker to finance the buyer where it appeared buyer was having difficulty obtaining financing); In re Lear Corp. S’holder Litig., 926 A.2d 94, 114 (Del. Ch. 2007) (noting favorably that the target was offering stapled financing to facilitate topping bids where a second financial advisor conducted the go-shop process).
Further Obligations on Boards to Vet Financial Advisor Conflicts of Interest
The court stated that “[b]ecause of the central role played by investment banks in the evaluation, exploration, selection, and implementation of strategic alternatives, directors must act reasonably to identify and consider the implications of the investment banker’s compensation structure, relationships, and potential conflicts.” There has been a significant change in practice on this point since Del Monte and El Paso, particularly in the negotiation of financial advisor engagement letters. Additional change is likely to follow this decision.
This decision may also place an increased burden on boards to actively manage their advisors and continually identify conflicts of interest. For example, the court said the board:
did not provide any guidance about when staple financing discussions should start or cease, made no inquiries on that subject, and imposed no practical check on [the bank’s] interest in maximizing its fees.
More importantly, the board was found to have acted unreasonably by being unaware of certain discussions between the banker and the buyer.
A similar issue arose in Vice Chancellor Laster’s decision in Del Monte. In that decision, the court enjoined a merger and held that a plaintiff had a reasonable probability of success in proving the board of directors breached its fiduciary duties where its financial advisor allegedly put the company into play and paired potential bidders in apparent violation of confidentiality agreements, all without board authority and supposedly in an attempt to provide buy-side financing. The alleged misconduct was never known by the board. The Del Monte court said that, because the directors were exculpated from liability for due care violations, the chance of monetary damages against them was “vanishing small.” Nevertheless, the court still found a likelihood that the board breached its duties. It stated that, “[a]lthough the blame for what took place appears at this preliminary stage to lie with [the company’s financial advisor,] the buck stops with the Board,” which must take “an ‘active and direct role in the sale process’” (emphasis added).
These aspects of Rural Metro and Del Monte are controversial. Arguably, directors should be able to presume that their advisors are acting in good faith unless they have reason to believe otherwise. Under Rural Metro and Del Monte, however, the court seems to be imposing a high degree of accountability on directors to actively oversee their advisors, identify conflicts, and prevent misconduct. A failure to exercise effective oversight creates a risk that an advisors’ misconduct will be imputed to the board of directors.
Claims Against Third-Party Advisors
The decision could incent plaintiffs to pursue more claims against third-party advisors, including with respect to due care claims for which the directors themselves would be exculpated. Whether Rural Metro results in a significant increase in such claims remains to be seen. A challenge to such claims is that plaintiffs must still show that the third party “knowingly participated” in the breach. For example, in Goodwin v. Live Entm’t, Inc., 1999 WL 64265, at *28 (Del. Ch. Jan. 25, 1999), then-Vice Chancellor (now Chief Justice) Leo E. Strine, Jr. said that aiding and abetting liability could be available where the third party “purposely induced the breach.” But even if the prospects for prevailing at trial are small, plaintiffs may increasingly name third-party advisors as defendants to try to seek discovery of undisclosed conflicts of interest or otherwise create leverage in M&A litigation.
Rural Metro also converts what looks like a professional malpractice claim that, if pursued by stockholders as a derivative claim, would have been extinguished at closing, into a fiduciary duty claim that can be pursued by stockholders. Typically, a stockholder’s right to pursue a derivative claim is extinguished in connection with the merger, for failure of standing, leaving the buyer (as the new sole stockholder of the target company) in control of the claim. In this situation, however, the buyer arguably is the beneficiary of the alleged misconduct and would not be expected to pursue the claim.