On November 30, 2015, the Delaware Supreme Court issued its much-anticipated ruling in RBC Capital Markets, LLC v. Jervis, No. 140, 2015, C.A. No. 6350-VCL (Del. Nov. 30, 2015) (Rural Metro). In short, the Court affirmed the principal legal holdings of the Delaware Chancery Court’s earlier rulings that found RBC Capital Markets, LLC liable for $76 million (plus interest since 2011). That judgment was based on the Chancery Court’s determination that RBC aided and abetted breaches of fiduciary duty by former directors of Rural/Metro Corporation in connection with the sale of the company to a private equity firm for $17.25 per share, a price the Chancery Court found inadequate and the result of a flawed sale process. In reaching its decision, the Supreme Court emphasized and cautioned that its ruling should be read narrowly based on the unique and complex facts involved.
The Court’s Opinion runs 105 pages, with the first 50 pages devoted to a detailed recitation of the facts as found by the Chancery Court. Throughout that recitation, the Court makes clear its view that the evidence in the record supported the Chancery Court’s findings. The Court also cites–approvingly–any number of criticisms lodged by the Chancery Court against Rural/Metro’s board of directors and RBC. The Opinion is significant to M&A and litigation practitioners, and to the financial advisor community.
Rural Metro arose from the June 2011 sale of Rural/Metro Corporation to a private equity firm. Stockholder plaintiffs sued Rural/Metro’s directors and its two financial advisors, including RBC. All defendants except RBC settled on the eve of trial. In a number of post-trial rulings, the Chancery Court found that (1) the directors had breached their fiduciary duties by failing to properly monitor the sale process and by including false disclosures in the company’s merger proxy statement; (2) RBC had aided and abetted those breaches; and (3) stockholders had suffered $4.17 per share in resulting damages (based on a “quasi-appraisal” judicial valuation of $21.42 per share). The Chancery Court found RBC liable for 83% of those damages and found two of the settling directors liable for the remaining 17%. The Chancery Court also determined that the Special Committee that Rural/Metro’s Board had formed to hire a financial advisor to begin evaluating strategic alternatives had instead effectively put the company up for sale without the knowledge or approval of the full Board, and without ever considering strategic alternatives (including remaining independent). The Chancery Court reviewed the directors’ conduct under the Revlon–rather than the business judgment–standard of review. The Court also noted, as had the Chancery Court, that three of the directors, including the Chairman and the CEO, had personal incentives that inclined them toward a sale in the short term.
The Court concurred with the Chancery Court in its finding four principal sale process-related deficiencies: (1) the sale process was designed to run in parallel with a bidding process for Rural/Metro’s principal competitor, Emergency Medical Services Corporation, which deterred EMS and the bidders for EMS from participating in bids for Rural/Metro; (2) that faulty sale process design was caused by RBC’s efforts, unbeknownst to the Rural/Metro Board, to get on buy-side financing trees for private equity firms bidding for EMS; (3) RBC provided the Rural/Metro Board with inadequate and misleading valuation information, without affording the Board adequate time to review that material before it approved the private equity firm’s final bid; and (4) RBC actively pursued opportunities to provide staple financing to the private equity buyer, and shared confidential information about the Rural/Metro Board’s “bottom line” on price with the private equity firm, at the same time it was engaged in final price negotiations with the private equity firm on behalf of Rural/Metro.
In its Opinion, the Court analyzed in detail each of RBC’s six arguments on appeal, as well as plaintiff’s cross-appeal on fee shifting. The following summarizes the more significant aspects of the ruling.
Aiding and Abetting Liability is Limited to “Fraud on the Board” with Scienter as a Critical Element
The Court found that RBC, “propelled by its own motives,” misled the Rural/Metro directors into breaching their duty of care, thereby aiding and abetting the Board’s breach. The Court carefully limited a cause of action for aiding and abetting a board’s breach of its duty of care to situations where the financial advisor commits “fraud on the Board” such as the Court and the Chancery Court found had occurred in Rural Metro. Specifically, the Court affirmed the “narrow holding” of the Chancery Court that “[i]f the third party knows that the board is breaching its duty of care and participates in the breach by misleading the board or creating the informational vacuum, then the third party can be liable for aiding and abetting.” The Court upheld the Chancery Court’s finding that RBC “intentionally duped” the Rural/Metro directors “for RBC’s own motives” and “purposely misled the Board so as to proximately cause the Board to breach its duty of care.” The Court cautioned that its ruling was based on the egregious facts at issue and should be read narrowly:
Accordingly, our holding is a narrow one that should 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.
In noting the limited reach of its ruling, the Court reiterated the traditional stringent requirements of an aiding and abetting claim, particularly the scienter requirement:
The aider and abettor must act “knowingly, intentionally, or with reckless indifference” … that is, with an “illicit state of mind.” To establish scienter, the plaintiff must demonstrate that the aider and abettor had “actual or constructive knowledge that their conduct was legally improper.”
These statements should provide comfort to financial advisors who are transparent about actual or potential conflicts of interest with their client boards.
Triggering of Enhanced Scrutiny When Directors Begin Negotiating a Sale
RBC and Rural/Metro disputed on appeal when the directors’ Revlon duties were triggered. RBC argued that the Chancery Court incorrectly applied Revlon’s enhanced scrutiny during the period Rural/Metro was allegedly “merely exploring strategic alternatives,” urging that Revlon should not have applied until “the sale of the Company became inevitable.” The Court disagreed and reaffirmed its 2009 holding in Lyondell Chemical Co. v. Ryan that enhanced scrutiny is warranted when “directors [begin] negotiating the sale of [the company].” Here, the Court found that the Rural/Metro Board and its Special Committee never really considered strategic alternatives as the Special Committee set out on a sale from the start.
Financial Advisors are Not “Gatekeepers”
One focus of industry and press attention in the aftermath of the Chancery Court’s earlier liability ruling in the case was that court’s characterization of financial advisors as “gatekeepers.” The Chancery Court used broad language suggesting financial advisors had a quasi-fiduciary responsibility to monitor their client boards to ensure they were both adequately informed and exercising due care in their deliberations and decisions. In an important footnote, the Court squarely rejected that view of the financial advisor’s role:
In affirming the principal legal holdings of the trial court, we do not adopt the Court of Chancery’s description of the role of a financial advisor in M & A transactions. In particular, the trial court observed that “[d]irectors are not expected to have the expertise to determine a corporation’s value for themselves, or to have the time or ability to design and carryout a sale process. Financial advisors provide these expert services. In doing so, they function as gatekeepers.”. . . Although this language was dictum, it merits mention here. The trial court’s description does not adequately take into account the fact that the role of a financial advisor is primarily contractual in nature, is typically negotiated between sophisticated parties, and can vary based upon a myriad of factors. Rational and sophisticated parties dealing at arm’s-length shape their own contractual arrangements and it is for the board, in managing the business and affairs of the corporation, to determine what services, and on what terms, it will hire a financial advisor to perform in assisting the board in carrying out its oversight function. The engagement letter typically defines the parameters of the financial advisor’s relationship and responsibilities with its client. . . . Adhering 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.
This passage affirmatively recognizes the essentially contractual nature of the financial advisor-board relationship, and effectively eliminates the use of the term “gatekeeper” to describe financial advisor activities. It should also severely limit–if not eliminate–the ability of litigants to claim that financial advisors have diffuse and undefined responsibilities to monitor the conduct of their client boards in seeking to impose potential liability.
Rural Metro contains numerous lessons for participants in an M&A transaction. It echoes many of teachings from the growing list of recent Delaware cases involving flawed sales processes and financial advisor conflicts of interest, including Del Monte in 2011 and El Paso in 2012.1 The following is a non-exhaustive list of key lessons, with guidance taken directly from the Opinion identified in quotations.
Lesson for Target Company Boards
- Directors must maintain an active and direct role in the sale process from beginning to end, which includes acting reasonably to identify and respond to actual and potential conflicts of interest faced by directors, management and advisors.
- The scope of any special committee’s mandate must be clear and fully understood. Boards should monitor special committee processes, including by ensuring that information flow is adequate and decision-making is properly authorized.
- Boards must thoroughly vet potential financial advisors before engagement to ensure that all actual and potential conflicts of interest are uncovered. Boards should ask probing questions about past interactions between financial advisors and potential bidders in a sale process and any other current marketplace dynamics.
- “Because the conflicted advisor may, alone, possess information relating to a conflict, the board should require disclosure of, on an ongoing basis, material information that might impact the board’s process.”
- A board’s efforts to identify and evaluate financial advisor conflicts of interests should be referenced in board meeting minutes and in the Background section of the merger proxy statement.
- The board must “have a reasonably adequate understanding of the alternatives available to [it], including the value of not engaging in a transaction at all.”
- Depending on the facts at hand, the board’s retention of a second financial advisor may not be sufficient to cleanse defects in the sale process, particularly if the board views the second financial advisor’s involvement and advice as “secondary.”
Lessons for Financial Advisors
- Information contained in pitch materials, viewed in hindsight, can have implications and exhibit predisposition pre-decision-making.
- A financial advisor can be subject to a claim of aiding and abetting a breach of fiduciary duty by directors even when the directors who breached that duty are themselves exculpated, although, as the Court noted, the threshold for imposing such liability in the aftermath of Rural Metro will be high.
- Financial advisors should ensure that they have internal reporting systems and mechanisms in place that enable them to adequately disclose actual or potential conflicts at the outset of an engagement and throughout the sale process as events develop.
- Participation (or even only attempted participation) in any buy-side financing should require, among other things, clear disclosure to–and approval of–the company’s board regarding the timing and scope of the financial advisor’s interactions with any bidder.
- If the financial advisor’s intention is to provide buy-side financing to a bidder (either for the transaction in question or another deal), the parameters of any understanding on such matters should be specifically addressed in the engagement letter.
- “The banker is under an obligation not to act in a manner that is contrary to the interests of the board of directors, thereby undermining the very advice that it knows the directors will be relying upon in their decision making processes.”
- The content and internal consistency of valuation-related analytics will continue to be analyzed rigorously in deal litigation.
- Litigation discovery can surface all internal communications and banker chatter, resulting in both monetary and reputational damages.
Sidley Austin LLP represented an amicus in the Rural Metro case.
1 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).
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