A Strong Message to Bankers Playing Both Sides of Sales Processes
Authored by Albert H. Manwaring, IV
This article was originally published in the Delaware Business Court Insider | March 26, 2014
Investment bankers seeking to profit as both adviser to the seller and financier to the buyer in corporate sales processes have faced increased scrutiny by the Delaware Court of Chancery over the last few years. In a highly publicized 2011 decision that changed the landscape for investment bankers, Vice Chancellor J. Travis Laster criticized investment banker Barclays PLC for acting both as adviser to the seller and financier to the buyer in the sale process of Del Monte Foods Co. Laster found that Barclays "secretly and selfishly manipulated the sale process to engineer a transaction that would permit Barclays to obtain lucrative buy-side financing fees." Laster explained that Barclays faced conflicts of interest in the sale process, which were not disclosed to the board of Del Monte Foods, in its role as financial adviser to the board, while at the same time profiting by providing staple financing to the buyer, private equity firm KKR & Co.
In the following year, then-Chancellor Leo E. Strine Jr., now chief justice of the Delaware Supreme Court, issued his decision in a case in which El Paso Corp.'s banker, Goldman Sachs Group, allegedly steered El Paso's $21.1 billion sale to its buyer, Kinder Morgan Inc. Strine criticized both El Paso's alleged self-dealing CEO and Goldman Sachs in the negotiations, referring to the sale process as "tainted," "inadequate" and "disturbing," but denied a request to preliminarily enjoin the merger to allow shareholders the opportunity to choose for themselves whether to approve the merger because no competing bidders had emerged.
In its latest decision criticizing bankers guiding corporate sales processes who are on both sides of a transaction, In re Rural/Metro Stockholders Litigation, C.A. No. 6350-VCL (Del. Ch. March 7, 2014), the Court of Chancery held after a four-day trial that investment banker RBC Capital Markets LLC was liable for aiding and abetting the breach of fiduciary duties of Rural/Metro Corp.'s board in connection with its sale to the buyer, private equity firm Warburg Pincus LLC. Continuing where he left off in Del Monte Foods, Laster criticized Rural/Metro's banker, RBC, for its role in both advising the board of the seller, Rural/Metro, and at the same time seeking a fee to provide financing to the buyer, Warburg. In a strongly worded decision, Laster emphasized that investment bankers function as "gatekeepers" in the sale process, and the "threat of liability helps incentivize gatekeepers to provide sound advice, monitor clients and deter client wrongs." He explained that "the 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 directors carry out their fiduciary duties when exploring strategic alternatives and conducting a sale process."
In Rural/Metro, the court found that the self-dealing conduct of RBC in the sale process to mislead and manipulate Rural/Metro's board set the directors up to breach their fiduciary duties by unknowingly approving a sale that significantly undervalued the company. RBC's conduct in the sale process was motivated by its seemingly singular desire to collect both adviser fees from Rural/Metro and much larger financier fees from Warburg. The court explained that RBC's actions led to an "ill-timed" sale that failed to capture the value attributable to growth from its near-term acquisition strategy. First, instead of following the mandate of Rural/Metro's board to consider various strategic alternatives, the special committee, which was chaired by a director from a hedge-fund investor, Coliseum Capital Management, which was bent on a near-term sale, retained RBC. Then, ignoring fundamental problems arising from selling Rural/Metro at the same time as the sale of Emergency Medical Services (EMS), the parent company of Rural/Metro's primary competitor in the ambulance services industry, was taking place, the special committee and RBC put Rural/Metro up for sale without board authorization. But RBC did not disclose to the board that its motivation to push for a sale of Rural/Metro at the same time as EMS was being sold was to obtain financier fees in the EMS deal. The court pointed out that "RBC correctly perceived that the firms bidding for EMS would think they would have the inside track on Rural if they included RBC" as a financier for their acquisition of EMS.
But the simultaneous timing of the sale impaired the board's ability to obtain a higher price for Rural/Metro. Confidentiality agreements, protecting access to information of two primary competitors in the ambulance services industry, and limited financial resources of potential bidders operating in the same space restricted the ability of potential private equity and strategic bidders to participate in both the sale of Rural/Metro and EMS simultaneously. Participation of other potential acquirers in the sale process would likely have driven up the sale price for Rural/Metro. Indeed, another banker, JPMorgan, had recommended deferring any sale until after Rural/Metro had developed a track record of growth through its acquisition strategy, and potential strategic buyers were not unavailable to participate due to their own change-of-control transactions. JPMorgan's recommendations were, however, only disclosed to Rural/Metro's CEO, RBC and the chair of the special committee, but not the rest of the special committee or board.
The court found that RBC manipulated its fairness opinion and sold out the board's position to Warburg in a fervent attempt to obtain fees from Warburg to finance its acquisition of Rural/Metro. The court explained that because RBC had failed to conduct or present a meaningful valuation analysis and strategic alternatives to the board prior to the board vote set to approve the sale of Rural/Metro to Warburg, the board was not in a position to make an informed decision comparing the Warburg offering price to the going-concern value of the company, or consider other strategic alternatives for Rural/Metro. Then, to convince the Rural/Metro board that the Warburg offering price was fair, while hoping to ingratiate itself to Warburg in a last-ditch effort to attempt to obtain a financing role in Warburg's acquisition of Rural/Metro, RBC manipulated its fairness opinion to the board by falsely claiming that Wall Street analysts do not add back in one-time expense items to pro forma financial statements in their valuation of Rural/Metro, and relying upon purported comparable transactions that were both stale and of questionable relevance. Lastly, RBC betrayed the board by sharing the board's internal competing views regarding Rural/Metro's sale price with Warburg, which gave the buyer the upper hand in the final negotiations over Rural/Metro's sale price.
In sum, based on RBC's double-dealing that motivated its egregious conduct, which undermined the sales process and, in turn, impaired the board's ability to make a knowledgeable, informed decision on the value of Rural/Metro compared to the Warburg offering price, the court had an ample record after trial to conclude that RBC had aided and abetted the board's breach of the fiduciary duty of care to Rural/Metro's stockholders.
In a New York Times article published March 18, professor Steven Davidoff commented that "because of laws that make it virtually impossible to hold directors personally liable," RBC in Rural/Metro will bear the brunt of paying for the shortfall in the undervaluation of the company to Rural/Metro's stockholders. Davidoff's comments miss the mark. To support his point regarding the difficulty to hold directors liable for breaches of their fiduciary duties under Delaware law, he relies on common corporate charter provisions designed to exculpate director liability for fiduciary duty of care violations in precisely these circumstances, where five out of six of the directors approving the Rural/Metro sale were misled and manipulated by their banker, RBC, which was supposed to be their expert, guiding them through the sale process, but instead induced the board to breach its fiduciary duty of care by unknowingly approving a sale that significantly undervalued the company. As explained by Laster, directors "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 carry out a sales process." Laster emphasized that a board retains bankers or financial advisers to provide this expertise, and in "doing so, they function as gatekeepers." The exculpatory provision in Section 102(b)(7) of the Delaware General Corporation Law shields directors from duty of care, in contrast to more culpable duty of loyalty, violations, but does not extend such protection to aiders and abettors. The purposes of the exculpatory provision are to ensure that directors do not become overly risk-adverse, and to encourage the best and brightest people to serve on boards of directors of Delaware companies without fear of liability for breaches of the fiduciary duty of care.
Finally, while the liability of the banker was decided in the much-anticipated saga of Rural/Metro, the court put off for another day the issues of the amount of damages for the shortfall in the undervaluation of the company, and the effect of the directors' settlement on the scope of contribution to reduce the liability of RBC for damages to the stockholders. Stay tuned for the next round.
The key takeaway from Del Monte Foods, El Paso and Rural/Metro is that counsel to boards, special committees and investment bankers, guiding corporate sales processes, must emphasize the requirement for complete banker disclosures, especially their conflicts of interest, to the seller's board. Counsel should caution boards not to permit their bankers to serve as both adviser to a selling constituent company's board and financier to the buyer in a sale process. In imposing liability on bankers for aiding and abetting directors' breach of fiduciary duties, the Court of Chancery expects bankers to be gatekeepers in the sale process, providing sound advice and monitoring boards, to ensure that directors comply with their fiduciary duties to act prudently, loyally and in good faith to maximize a company's value over the long term for the benefit of its stockholders.