Chancery Chides Investment Banker on Both Sides of Deal
This post was prepared by Kevin F. Brady.
In Re Rural Metro Corporation Stockholder Litigation, C.A. No. 6350-VCL (Del. Ch. Mar. 7, 2014).
Why is this Decision Important?
The Court of Chancery found RBC Capital Markets LLC liable for aiding and abetting the breach of fiduciary duties of directors by advising simultaneously Rural/Metro Corp. on the value of the company in connection with a sale to Warburg Pincus LLC, while other bankers at RBC were pitching their services to Warburg in an effort to gain fees by helping Warburg finance the same deal.
This opinion highlights the importance of the Board’s role in scrutinizing the role of financial advisors and identifying potential conflicts of interests at the outset of the engagement consistent with the Court’s prior decisions in Del Monte and El Paso. Moreover, the Court noted that even though Rural’s directors were protected from liability under 8 Del. C. § 102(b)(7) for breaches of a fiduciary duty of care, that statutory provision provided no protection to a financial advisor on an aiding and abetting claim.
Plaintiff shareholders brought an action against the directors of Rural Metro Corporation for breach of fiduciary duty in connection with the merger of Rural and an affiliate of Warburg Pincus LLC. Plaintiffs argued that the directors failed to disclose material information in the Company’s proxy statement. The plaintiffs also sued RBC Capital Markets, LLC, and Moelis & Company, financial advisors to the Board. After the Court consolidated the lawsuits and appointed a lead plaintiff, the parties entered into a Memorandum of Understanding to settle the action for supplemental disclosures and the defendants’ agreement not to oppose a fee application.
The shareholders approved the merger and the Court conducted a hearing on the fairness of the settlement. An objector argued that the post-settlement confirmatory discovery revealed conflicts of interest claims against RBC and Moelis. Shortly before trial, the directors and Moelis settled. The plaintiffs proceeded to trial against RBC for aiding and abetting the directors’ breaches of fiduciary duty. Plaintiffs argued that RBC induced the Board to breach its fiduciary duties during the sale process.
Highlights of the Court’s Decision:
- When determining whether corporate fiduciaries have breached their duties, Delaware corporate law distinguishes between the standard of conduct (which describes what directors are expected to do and is defined by the content of the duties of care and loyalty) and standard of review for director decision-making (business judgment rule, enhanced scrutiny and entire fairness).
- Enhanced scrutiny review adopted by the Delaware Supreme Court in Unocal and Revlon applies to “specific, recurring and readily indemnifiable situations involving potential conflicts of interest where the realities of the decision-making context can subtly undermine the decisions of even independent and disinterested directors.”
- Enhanced scrutiny requires that the fiduciaries “bear the burden of persuasion to show that their motivations were proper and not selfish,” and that “their actions were reasonable in relation to their legitimate objective.”
- To satisfy the enhanced scrutiny test in the M&A context, defendant directors must establish: (i) the reasonableness of “the decision-making process employed by the directors, including the information on which the directors based their decision,” and (ii) “the reasonableness of the directors’ action in light of the circumstances then existing.”
- Here the Board approved the sale of Rural to Warburg for cash which triggers the enhanced scrutiny standard. When a stockholder sues a director alleging breach of fiduciary duty in connection with a decision that is subject to enhanced scrutiny, the burden of proof shifts to the defendant directors to satisfy its requirements. However, when the plaintiffs are alleging an aiding and abetting claim, the burden remains with the plaintiffs.
- The presence of an exculpatory provision does not eliminate the underlying duty of care or the potential for fiduciaries to breach that duty. Directors whose actions fail to pass muster under the applicable standard of review have breached their fiduciary duties, even though they are not liable for damages when exculpation applies under 8 Del. C. §102(b)(7).
- Key quote:
Rural has an exculpatory provision in its certificate of incorporation. If this case involved questions of individual director liability, rather than only the predicate question of a fiduciary breach, then Rural’s exculpatory provision would have a significant role in the analysis. Like the entire fairness test, enhanced scrutiny is a standard of review designed to assess whether a transaction “should be respected or set aside in equity.” Venhill Ltd. P’ship ex. rel. Stallkamp v. Hillman, 2008 WL 2270488, at *22 (Del. Ch. June 3, 2008) (making this observation regarding the entire fairness test). A failure to satisfy the enhanced scrutiny standard, like a failure to satisfy the entire fairness test, establishes the existence of a breach of duty, but that fact “has only a crude and potentially misleading relationship to the liability any particular fiduciary has for involvement in” the challenged decision. Id. (same). Affirmative defenses, most commonly the existence of an exculpatory provision authorized by Section 102(b)(7) of the DGCL, may result in a director not being held liable despite having been found wanting under the applicable standard of review. “[T]he presence of the exculpatory charter provision would require an examination of [each director’s] state of mind, in order to determine whether they breached their duty of loyalty…” Id. at *23 (same). “If those directors acted in the good faith belief that they were pursuing the corporation’s best interests—that is, with a loyal state of mind—their failure” to achieve a result falling within the range of reasonableness does not expose them to liability, “because the charter provision immunized them from liability for mere violations of the duty of care.” Id. (same).
- Directors cannot be passive instrumentalities during merger proceedings; they must maintain an active and direct role in the context of a sale of a company from beginning to end. Another part 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 initiate a sale process fell outside the range of reasonableness because the Board did not launch the sale process and it did not authorize the Special Committee to start one. The Special Committee, which was charged with pursing an analysis of alternatives, hired RBC to sell the company and then RBC put the company in play without Board authorization.
- The Court found that RBC was motivated by a desire to secure its place in financing the bidders in the auction and that negatively impacted the timing and structure of the sale process even though the Board was not aware of the conflict.
- During the final negotiations with Warburg, the Court found that the Board failed to provide active and direct oversight of RBC. When the Board approved the merger, it did not know that RBC had made some last-minute efforts to solicit a buy-side financing role from Warburg and it had not received an valuation information until three hours before the meeting to approve the deal.
- Instead of pushing for the best possible deal for rural, the Court found that RBC did everything it could to get a deal, secure its advisory fee and further its chances for additional compensation from Warburg.
- Lacking any earlier valuation information, the Court found that the Rural directors did not have a reasonably adequate understanding of the alternatives available to Rural, including the value of not engaging in a transaction at all. Because the Board’s financial advisors did not provide the directors with valuation materials until the final board meeting, just hours before the merger was approved, 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. By the time the directors received RBC’s book, there was no time to seek follow-up information or probe inconsistences.
- The Court found that RBC acted with the necessary degree of scienter because it misled the Board into breaching their fiduciary duties when it created an unreasonable sale process with informational gaps. RBC knew from the beginning that: (i) it was not disclosing its interest in obtaining a role financing for the acquisition; (ii) that the Board was uninformed about Rural’s value when making critical decisions; (iii) that it was interested in buy-side financing and planned to engage Warburg in last-minute lobbying; and (iv) at the same time revising its valuation of Rural downward.
- The fact that RBC ultimately did not provide staple financing and received buy-side fees was of no consequence to the Court.
- The Court also found that the directors breached their fiduciary duties regarding disclosures because the Proxy Statement: (i) contained misleading disclosures about false information RBC provided to the Board in connection with its precedent transaction analysis; (ii) contained false and misleading information about RBC’s incentives; and (iii) failed to disclose RBC’s material conflicts of interest.
- In terms of a remedy, the Court stated that it was not in a position to determine an appropriate remedy and it asked the parties for supplemental expert submissions identifying a range of fair value for Rural at the time of the merger.
Liz Hoffman’s Wall Street Journal article today has an excellent overview of the facts and law. The full opinion is must reading for investment bankers and others involved in M & A. One of many notable aspects of this decision, which is the latest of several Delaware opinions finding fault with investment bankers for similar behavior, is that even if directors may be exculpated from liability under DGCL Section 102(b)(7), that protection does not extend to others, such as investment bankers, who may be found to have “aided and abetted” the breach of fiduciary duty.