The recent Rural Metro decision in the Delaware Court of Chancery provides important guidance to boards of directors and financial advisors in change of control situations. Specifically, the decision underscores the need for boards to be actively engaged in the sale process and to be well-informed about the conflicts of interests of key players. For financial advisors in particular, Rural Metro teaches that full disclosure of conflicts of interest is expected, as financial advisors function as gatekeepers when they advise boards in sales processes.
Given the views expressed by Canadian courts and securities regulators on the role of boards and financial advisors, Rural Metro’s teachings are highly relevant from a Canadian perspective.
In December 2010, Rural/Metro Corporation (Rural) considered making a bid for American Medical Response (AMR), a subsidiary of Emergency Medical Services Corporation (EMS) and Rural’s sole competitor in the ambulance business. At the time, there were rumours that EMS was in play and a financial advisor advised Rural that private equity firms could be interested in making a bid for AMR.
According to the Court, a representative of the financial advisor realized that a private equity firm that acquired EMS might decide to buy Rural rather than sell AMR. If Rural engaged in a sale process led by the financial advisor, it could then use its position as sell-side advisor to secure buy-side roles with the private equity firms bidding for EMS. The financial advisor perceived that the private equity 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.
At its December 2010 meeting, Rural’s board reinstated a special committee previously formed to examine M&A alternatives. The committee was chaired by Christopher Shackelton, a managing director of a hedge-fund with a stake of about 12% in Rural’s stock. It was charged with a broad mandate to explore Rural’s strategic alternatives. However, the board did not authorize the special committee to pursue a sale of Rural.
The committee retained the financial advisor as its principal financial advisor. The financial advisor represented to the board that it intended to focus on the sale of Rural, coordinating the efforts with the EMS process, and would involve only private equity firms. While the financial advisor disclosed that it hoped to offer staple financing to the potential buyers in the transaction, it did not disclose that it planned to use its engagement as Rural’s advisor to capture financing work from the bidders for EMS.
In light of the recent Delaware Del Monte case, legal advisors recommended that the committee appoint an additional financial advisor and conduct a robust auction process. It was also decided that both financial advisors should provide a fairness opinion if a transaction were to take place.
According to the Court, the special committee and the financial advisor then put Rural in play without a formal board decision. The concurrent sale process of EMS complicated the search for possible bidders. Ultimately, indications of interest were received from six private equity firms among the 28 that had been contacted and Warburg Pincus was the only suitor to table a formal bid. CD&R, which had just won the bidding for EMS, was denied a deadline extension to make a formal offer.
In March 2011, the special committee decided to go forward with the Warburg Pincus offer at $17.00 without valuation materials and directed the financial advisor and the additional financial advisor to engage in final negotiations with Warburg over price. In parallel and unbeknownst to the special committee and the board, the financial advisor was continuing to seek a buy-side role providing financing to Warburg.
In late March, the board met to approve the best and final offer of Warburg Pincus. Valuation analyses from the financial advisor and the additional financial advisor were provided for the first time to the board as part of the sales process. Both financial advisors submitted favorable fairness opinions and the merger was approved by Rural’s shareholders, with 72% of the shares voted in favor.
The Chancery Court decision
The plaintiff shareholders sued Rural’s directors for breach of fiduciary duties and disclosure violations, ultimately settling with the directors for $6.6M. They also sued the financial advisors for aiding and abetting breaches of fiduciary duties. While the additional financial advisor settled for $5M, the financial advisor contested the plaintiffs’ action.
The Court first addressed the plaintiffs’ contention that Rural’s directors breached their fiduciary duties by approving the merger. With respect to the sale process, the Court analysed the conduct of the directors in light of the Revlon standard of review. Under Revlon, directors of a corporation that is in play are required to maximize shareholder value, and directors’ decisions will be reviewed in light of the enhanced scrutiny test, which requires that they establish: i) the reasonableness of their decisionmaking process including the information on which they based their decision; and ii) the reasonableness of their action in the circumstances then existing.
With respect to the reasonableness of the board’s decisionmaking process, the Court emphasized that directors cannot be passive instrumentalities during merger proceedings. Directors must maintain an active and direct role in the sale process and to do so, they must become reasonably informed about the alternatives available to the company. They must receive information and have adequate time to consider it. Another dimension of providing active and direct oversight is acting reasonably to learn about actual and potential conflicts faced by directors, management, and their advisors.
The Court found that the decision to run a sale process in parallel with the EMS auction was not reasonable. First, the board did not make, nor did it authorize, such a decision. Second, the special committee was influenced by the financial advisor, which was motivated, by a desire to secure its place in the financing trees of the bidders in the EMS auction. Given the context and timeline of the sale process, as well as the fact that the board was not well-informed about the conflicts of interest, the Court concluded that the board’s decision to initiate the sale process fell outside the range of reasonableness.
The Court also held that the board’s decision to approve the merger with Warburg Pincus lacked a reasonable informational basis and fell outside the range of reasonableness. The Court criticized the board’s decision to approve the transaction given that it had not received any valuation information until three hours prior to the meeting. Given the central role of investment banks, the Court stressed that the board had the duty to “act reasonably to identify and consider the implications of the investment banker’s compensation structure, relationships, and potential conflicts”. In particular, the Court found that the board failed to place meaningful restrictions on the financial advisor to ensure the integrity of the process. Thus, the board’s “independent sense of the value of the company [was] insufficient to carry the day”.
As for the aiding and abetting claims, the Court held that the financial advisor knowingly participated in the breaches to fiduciary duties. First, the financial advisor created the unreasonable and informational gaps that led to the board’s breach of duty. Second, the financial advisor knew that the board and the special committee were uninformed about Rural’s value when making critical decisions. Third, the financial advisor never disclosed to the board its continued interest in buy-side financing and plans to engage in last minute lobbying of Warburg. Finally, the financial advisor revised its valuation of Rural downward for the fairness opinion. To summarize, the Court stated that “the financial advisor knowingly participated in the Board’s breach of its duty of care by creating the informational vacuum that misled the Board”.
To conclude, the Court considered that the aided and abetted breach caused damages to the plaintiffs. The faulty process led to a merger that did not generate the best value reasonably attainable for shareholders. However, the Court was not prepared to determine an appropriate remedy. It asked the parties’ experts to prepare revised valuations of Rural to assist it in establishing the monetary liability that the financial advisor should bear.
In Re Rural Metro Corporation Stockholder Litigation, Del. Ch., March 7, 2014.