Getting Engaged: When Hiring an M&A Financial Advisor, It's About the Contract

Two recent opinions by the Seventh U.S. Circuit Court of Appeals serve as a reminder to investment banks and their clients that the time expended up front negotiating the terms of an engagement letter is well spent, as these terms can—and do—have significant consequences if the transaction at issue later encounters problems. These seemingly one-sided, boilerplate-laden documents are frustrating for investment bank clients and their counsel to navigate, but their terms importantly serve to frame the relationship between the parties and deserve the parties' full attention. The Seventh Circuit decisions reinforce the fact that this contract governs the relationship, and courts will respect that contract and be reluctant to impose any extra-contractual liability or obligations, where sophisticated parties did not clearly intend any.

Both HA2003 Liquidating Trust v. Credit Suisse Securities and Joyce v. Morgan Stanley & Co. involved buyers who encountered difficulties following execution of a merger agreement. In HA2003, unhappy creditors of the buyer (the buyer having emerged from bankruptcy following the merger) were the litigants. In Joyce, shareholders of the acquired corporation were the plaintiffs. Both cases involve alleged failures by the investment bank to perform services that plaintiffs believed were consistent with the obligations undertaken by the investment bank. In the end, the appellate court in each case concluded that these were not duties undertaken by the investment bank by contract and that otherwise to impose them would be "to make up a set of duties as if this were tort litigation."

In light of these cases, investment banks and their clients should take a fresh look at engagement letters with a view to capturing the intended services to be performed and the resulting allocation of responsibilities. Some suggestions are detailed more fully below.

HA2003 Liquidating Trust v. Credit Suisse Securities

HA-LO Industries, a publicly traded company, caught dot-com fever in the late 1990s and was determined to convert its promotional products division to an e-commerce platform. The vehicle for this conversion eventually became the acquisition of Starbelly.com, a startup company with an e-commerce platform. After identifying Starbelly as a target, HA-LO hired Credit Suisse to act as its financial advisor. Among other recommendations, Credit Suisse suggested that HA-LO hire Ernst & Young to evaluate Starbelly's technology. Ernst & Young's due diligence revealed significant uncertainties about that technology and also revealed the speculative nature of Starbelly's projections. Credit Suisse provided HA-LO a liquidity analysis of the merged HA-LO/Starbelly entity that indicated potential unmet cash requirements for technology development and other operational needs.

Despite these uncertainties, HA-LO was determined to proceed with the merger. Relying on the Starbelly projections furnished to it and management's assessment of synergies, the validity of Starbelly's technology, and HA-LO's ability to meet the cash needs of the merger and operations, Credit Suisse rendered its opinion in January 2000 that the merger consideration was fair to HA-LO.

While the merger was pending, the market for technology company stocks was beginning to implode. HA-LO renegotiated its credit facility, but apparently with far less borrowing capacity than the Credit Suisse liquidity analysis suggested would be needed post-merger. Nevertheless, the board and management proceeded with the merger without any updating of the Credit Suisse fairness opinion or renegotiation of the terms of the merger. Within months of closing of the cash-and-stock merger, HA-LO was in financial distress. Approximately a year after closing, the company went into Chapter 11 bankruptcy.

The trust representing unpaid creditors of HA-LO brought suit against Credit Suisse claiming gross negligence in the performance of its duties under the engagement letter with HA-LO and failure to fulfill duties that did not expressly reside in the engagement letter but that Credit Suisse was allegedly bound to perform. According to the plaintiff trust, Credit Suisse should not have relied upon the Starbelly projections furnished to it and should have withdrawn its opinion, or prepared a new one, as the market price of dot-com stocks declined.

The court easily brushed these claims aside, pointing to the language of the engagement letter, the fairness opinion and the proxy statement. Each of these said that Credit Suisse would rely and had relied on information (including estimates and projections) furnished by HA-LO and the target and that Credit Suisse had no duty to investigate or verify this information. These documents also contemplated only one opinion to be provided by Credit Suisse and specified no obligation to update it, as the opinion was based on information available as of its date. Because Credit Suisse had "followed the rules in its contract with HA-LO," the court found none of Credit Suisse's conduct to be grossly negligent under New York law (the standard of culpability imposed by the indemnification and exculpation terms of the contract). Refusing to let plaintiffs have Credit Suisse "write an insurance policy against managers' errors of business judgment," the court instead concluded that "intelligent adults can set their own standards of performance, and courts must enforce the deal they have struck."

Joyce v. Morgan Stanley

In Joyce, 21st Century Telecom Group had engaged Morgan Stanley to act as its financial advisor in a proposed acquisition by RCN Corporation in a stock-for-stock merger. Apparently, at the beginning of negotiations, RCN was represented by Morgan Stanley as its advisor, while 21st Century was unrepresented. For reasons that were disputed, Morgan Stanley changed sides and represented 21st Century and RCN engaged a different advisor. The potential conflicts of interest were expressly addressed in the engagement letter between Morgan Stanley and 21st Century by means of an explicit waiver.

In December 1999, Morgan Stanley rendered its opinion that the consideration in the merger was fair to shareholders of 21st Century. The merger received the approval of shareholders and closed in April 2000. During the period between execution of the agreement and closing, the price of RCN stock dropped almost 50 percent, and it continued to drop following the merger, to a point where it was worthless. The merger agreement did not include a collar or other provisions designed to protect 21st Century shareholders against material changes in the price of RCN stock.

The heart of the shareholder claim was that Morgan Stanley had a duty to advise shareholders about how to minimize their exposure to a potential loss in value of RCN stock. As the court notes, "this claim requires the existence of a confidential or fiduciary relationship," as it was not a contractually imposed duty, and therefore the claim must be based on some type of constructive fraud arising out of a duty to make full and fair disclosure to shareholders. The court made short work of this argument by referring, as in HA2003 Liquidating Trust, to the engagement letter, which "explicitly noted that Morgan Stanley was working only for the corporation," and the fairness opinion, which indicated it was "for the information of the Board of Directors" and "expresses no opinion or recommendation as to how the holders of the 21st Century Common Stock should vote at the shareholders' meetings." Even the waiver of conflict of interest, the court noted, was from the corporate client, and made no mention of shareholders. The court was persuaded that these disclaimers refuted any contractual duty to shareholders and, similarly, gave insufficient indication of acceptance by Morgan Stanley of the position of trust necessary to creation of a fiduciary relationship with shareholders and any corresponding extra-contractual duties to them.

Considerations When Drafting Engagement Letters

These appellate court cases reinforce two fundamental contract-drafting truths: If you really want somebody to do something for you…get it in writing addressed to you; and, similarly, if you don't intend to accept responsibility to someone or for something, don't hesitate to make that explicit. Absent special circumstances, among sophisticated commercial parties in the context of an M&A engagement letter, courts are reluctant to impose extra-contractual duties and are willing to give judicial recognition to disclaimers and other contractual provisions that limit liability and responsibility.

In light of these considerations, financial advisors should review their engagement letters with a view toward, and investment bank clients should be alert to, the following, much of which has commonly been found in fairness opinion letters and proxy statement disclosures, but not always engagement letters:

Disclaimer of fiduciary duty. It has become customary for investment banks to expressly disclaim any fiduciary duty to the company or anyone else. Such disclaimers were just coming into vogue when the engagement letters in these two cases were executed, and apparently were not included. The inclusion of such an express disclaimer would facilitate a court's finding that there were no extra-contractual duties, although it is not clear that in every jurisdiction one can contract out of fiduciary duties otherwise created.

Identify services explicitly. Every effort should be made to anticipate and set forth with reasonable specificity the services for which the investment bank is being engaged. This effort should include, in particular, provision for a bring-down fairness opinion if there is any expectation that one may be desirable. Without such an obligation, in general the opinion speaks as of its date based on information available at that time, without any extra-contractual duty to update.

Consistently identify who the client and beneficiary of the services are to be. Take care to identify in the engagement letter the corporation and, typically, its board of directors, as the client and primary beneficiary, respectively, of the financial advisory services. This identification should be carried through to any opinion, for example, by addressing it to the client's board of directors and indicating that it is directed to the board of directors. Where the opinion is not required to be included in a document filed with the SEC, the opinion should indicate that it is directed "solely" to the board of directors and include a disclaimer of authorized reliance by anyone other than the board of directors.

Spell out any potential conflicts of interest. The engagement letter is an appropriate place to set out any significant potential conflicts the investment bank may confront in its representation of a client that are not otherwise embedded in the terms of the engagement (such as the contingent success fee) and to obtain a waiver of the potential conflict. While there is no set of rules to govern this process, lawyers can assist investment banks and their clients by drawing on the lawyer professional responsibility principles with which they are familiar. Both SEC and Financial Industry Regulatory Authority (FINRA) rules will require disclosure in the opinion and proxy statement of certain material relationships between the investment bank and the parties to the transaction.

Add information disclaimers. Investment banks customarily rely on their clients to vet information and, accordingly, the engagement letter and opinion should indicate the absence of any duty to investigate or verify the information furnished. Those documents should similarly state explicitly that the bank has relied on the accuracy of the information it has been furnished. Under FINRA rules, an investment bank must set forth in the opinion whether it verified information furnished by its client.

Take particular care with forward-looking information. Client management is better positioned to assess the merits of most forward-looking information that is relevant to the work of an investment bank, such as stand-alone projections of the target, anticipated synergies, and projected post-merger combined results. As with information generally, this forward-looking information should be the responsibility of client management, and the engagement letter and fairness opinion should clearly reflect this fact.

Set out material assumptions. Not every engagement letter or opinion is routine. Some call for creative, sometimes non-intuitive, analyses, built on a foundation of key assumptions. Like projections and other information, assumptions ultimately are the province of management. Where possible, material assumptions should be set out with reasonable specificity up-front in the engagement letter and, at the very least, identified in any fairness opinion.

Make clear that the opinion is not a valuation or appraisal. While a fairness opinion relies in significant part on valuation techniques, it is not a valuation of shares or companies, either now or in the future, nor is it an appraisal of any asset or liability. The engagement letter and the opinion should set forth this limitation expressly.

Make clear that it's not a solvency opinion. Cash deals like HA-LO may raise significant questions about the acquirer's ability to pay the purchase price and to fund post-merger operations. While those issues are clearly a relevant consideration for either board of directors, the typical financial engagement and fairness opinion are not intended to address them.