Delaware Court Issues Additional Guidance on Financial Advisor Conflicts

The Delaware Court of Chancery recently found Royal Bank of Canada (RBC) liable for aiding and abetting breaches of fiduciary duties in connection with the sale of Rural/Metro Corporation (Rural/Metro) to an affiliate of Warburg Pincus LLC. The opinion, In re Rural Metro Corp. Stockholders Litig., C.A. No. 6350-VCL (Del. Ch. Mar. 7, 2014), authored by Vice Chancellor Laster, continues a trend of recent opinions that focus on financial advisors' conflicts of interests and provides directors of Delaware corporations a reminder of several well-established principles in connection with merger and acquisition transactions.

The Transaction

Rural/Metro provides ambulance and fire protection services. In August 2010, the company's board formed a special committee to evaluate a possible acquisition of American Medical Response (AMR), a subsidiary of Emergency Medical Services Corporation (EMS) and Rural/Metro's lone national competitor in the ambulance business. EMS would not sell AMR at the time, but a combination of Rural/Metro and AMR became of interest later in 2010 when EMS began a process to sell itself.

In December 2010, RBC advised Rural/Metro that several potential EMS buyers were looking for a partner to facilitate a separation of AMR from EMS, and that Rural/Metro could provide an "angle." At a meeting of Rural/Metro's board held shortly thereafter, the head of the special committee formed in August discussed the rumored EMS sale and made a presentation regarding Rural/Metro's strategic alternatives. The board then re-formed the special committee and gave it the authority to retain advisors and recommend a course of action from the company's various strategic alternatives. Notably, the special committee was not authorized to commence a process to sell Rural/Metro, but was only authorized to explore strategic alternatives.

In late December 2010, the special committee interviewed several investment banks, including RBC. RBC communications from early December 2010 noted that if Rural/Metro engaged RBC for a sell-side transaction, then RBC could use the position to secure a buy-side engagement for private equity firms bidding for EMS. RBC also stated in its pitch to the special committee that it hoped to offer "staple financing" to potential Rural/Metro acquirers, even though RBC also stated that "the credit markets were open" when discussing reasons it was a good time to sell. The special committee retained RBC, and communications from Rural/Metro's CEO and among RBC personnel indicate an understanding that RBC was engaged to sell Rural/Metro rather than evaluate strategic alternatives as the special committee was charged to do.

The process of selling Rural/Metro proved difficult. Firms bidding for EMS avoided participating in the Rural/Metro sale process due to difficulties in conducting simultaneous parallel transactions with a competitor and concerns arising from obligations under confidentiality agreements entered into as part of the EMS sale process. Rural/Metro ultimately received one final bid from Warburg for $17 per share, which the special committee sought to increase. During the auction process, the special committee refused a request from the winner of the EMS auction to extend the auction's timeline to allow it to formulate a bid for Rural/Metro, which may have been at a higher price due to synergies with AMR. Warburg eventually raised its bid to $17.25 per share and the parties entered into a merger agreement at that price.

Throughout the sale process, RBC did not present any valuation analysis to the special committee. The initial valuation analysis RBC prepared for purposes of its fairness opinion suggested that the transaction price was not as attractive as RBC thought it should be. The court's opinion details RBC's efforts to lower its fairness analysis to make Warburg's final offer look more attractive. The opinion also describes RBC's efforts to promote a sale to Warburg and assure RBC's participation in Warburg's buy-side financing, where there was the potential to earn substantially higher fees than it would receive as financial advisor to Rural/Metro. RBC provided the board its first valuation analysis approximately one hour before the meeting to approve the sale to Warburg. The board and stockholders holding 72 percent of Rural/Metro's outstanding shares ultimately approved the merger.

Stockholder litigation followed the transaction's announcement. Rural/Metro's directors settled for $6.6 million and Moelis & Company LLC, the special committee's other financial advisor, settled for $5 million. The Chancery Court held a trial relating to RBC's alleged aiding and abetting of the Rural/Metro directors' breaches of fiduciary duties and found RBC liable, determining in the process that the directors breached their fiduciary duties.

Key Takeaways for Directors

Rural/Metro reminds directors of Delaware corporations of several considerations involved in overseeing the sale of a company:

• Directors must understand and actively monitor advisor conflicts of interest.
  Although the Chancery Court continues to avoid declaring staple financing per se problematic, its skepticism of such arrangements—also recently highlighted in In re Del Monte Food Company Shareholders Litigation—is clear. Absent a unique need for staple financing to complete a transaction—which did not exist in this case because the credit markets, by RBC's admission, were "open"—advisor conflicts, including staple financing, will continue to be a focal point in litigation. Although RBC disclosed to the special committee its desire to provide staple financing, and counsel advised the committee of the conflict that creates, the Chancery Court criticized the directors for not monitoring the conflict by asking for or receiving updates from RBC regarding RBC's efforts to secure buy-side financing work. The court similarly criticized the failure of RBC to advise the board, and of the board to inquire of RBC, about RBC's desire for future business from Warburg and buy-side advisory fees from a possible transaction with AMR. The Rural/Metro decision serves as a reminder that directors must actively anticipate, identify and monitor the variety of conflicts of interest financial advisors might have.

• Process is paramount.
  The Chancery Court reiterates the well-established rule that, in an M&A transaction, directors must employ a reasonable decision-making process and take reasonable action in light of the circumstances. The court's opinion also emphasizes the evidentiary value of contemporaneous documents as compared to statements made during litigation. Fundamental breakdowns in Rural/Metro's process highlighted by the court include:
  • The special committee conducted only two formal meetings throughout a three-plus month sale process, and did not create contemporaneous minutes for those meetings.
  • The special committee and the board failed to receive information about the company's valuation either in an M&A transaction or on a stand-alone basis until hours before the meeting convened to approve the sale.
  • The special committee pursued a sale process despite only being authorized to evaluate a variety of strategic alternatives.
  • The special committee failed to consider the potentially negative effects of attempting to sell Rural/Metro during the EMS auction process, which prohibited many bidders, including the most likely acquirers, from participating in the Rural/Metro process. These negative effects were not identified for the special committee by RBC, even though RBC admitted at trial that the effects were "obvious." The court clearly gave less deference to the decision to pursue this flawed tactic in light of RBC's conflicts of interest discussed above.
  • The special committee relied on the flawed work of its financial advisor. Although the flaws were unknown at the time, this nevertheless contributed to Rural/Metro's own breach of the duty of care.

Key Takeaways for Financial Advisors

Rural/Metro provides several important, and potentially alarming, lessons for financial advisors:

• Financial advisors may be liable for monetary damages for aiding and abetting breaches of directors' duties of care or loyalty even when the directors themselves may not be.
  In order to be held liable for aiding and abetting a breach of fiduciary duty, a court first must find that a person breached his or her fiduciary duty. Although directors typically are not liable for monetary damages for breaches of the duty of care due to Section 102(b)(7) of the Delaware General Corporation Law, no similar exculpation exists for financial advisors such as aiders or abettors. The court noted that, unlike directors, financial advisors frequently are highly compensated for the work they perform for corporations, and "the threat of liability helps incentivize gatekeepers [like investment banks] to provide sound advice, monitor clients, and deter client wrongs." That threat is much more real as a result of the Rural/Metro decision. There is a possibility that financial advisors in public company sales will become a party to standard plaintiff's suits challenging M&A transactions on an alleged aiding and abetting claim, especially given that financial advisors provide a deep pocket. RBC's conflicts of interests, its failure to disclose its desire to provide buy-side services to EMS bidders, and its work with a special committee acting outside of its board mandate all contributed to the Chancery Court's finding of liability. Avoiding or addressing these circumstances should make it easier to obtain early dismissal of any aiding and abetting claims that come in the wake of the Rural/Metro decision.

• Standard engagement letter language regarding potential conflicts of interest is ineffective to waive specific conflicts of interest.
  RBC's engagement letter with Rural/Metro contained the following standard language:
  
  "As financial organizations, RBC and Moelis and their affiliates may also provide a broad range of normal course financial products and services to their customers…including companies that may be involved in a Transaction contemplated by this Agreement and…may arrange and extend acquisition financing or other financing to…purchasers that may seek to acquire companies or businesses that offer products and services that may be substantially similar to those offered by the Company."
  
  The court found this generalized language ineffective to waive specific potential conflicts of interest that were known to RBC when the engagement letter was signed. Financial advisors seeking to limit their exposure relating to claims involving alleged conflicts of interest should specifically address those conflicts in their agreements with clients when known at that time and as they arise thereafter. It is enough that a potential conflict of interest could be perceived as infecting the process of the board; it is not necessary to show that that the conflicting interest ultimately produced economic benefit for the advisor.

• Know the scope of engagement.
  RBC, by launching a sales process for the special committee, exceeded the mandate under which the special committee was formed. In the court's view, this contributed to the board's breach of duty and evidenced the self-interest of RBC. Financial advisors should take care to review and understand the scope of their engagement and the authority under which it is provided.

• Fairness analysis often are challenged and should be prepared to be defended.
  Recent Delaware cases such as Rural/Metro and Koehler v. NetSpend Holdings Inc.highlight that fairness analyses frequently are scrutinized in litigation and therefore should be prepared with an eye toward defending them. Changes to final valuation analyses from preliminary analyses should be objectively justifiable, and analyses should not be altered for the primary purpose of making a proposed transaction appear more attractive. In addition, financial advisors should have a robust fairness opinion committee process that challenges valuation analyses. Although these points are obvious, the court in Rural/Metro seized on several communications among the members of the RBC banking team that made clear the team's efforts to lower valuations in its analyses to make Warburg's bid seem more attractive and to revise information previously provided to the board for that purpose.

• Keep clients informed throughout the process.
  Although this is as much business advice as legal advice, the Rural/Metro decision highlights the importance of financial advisors providing regular information to their clients regarding valuation metrics for and conflicts of interest relating to a proposed transaction. The court based its finding of the directors' underlying breach of fiduciary duties in large part on the vacuum of valuation and conflict of interest information that existed throughout process. That vacuum made it impossible for the directors to have a reasonably adequate understanding of alternatives available to the company, including not engaging in a sale transaction at all, and to take reasonable steps to mitigate potential advisor conflicts of interest. Providing timely valuation and potential conflict of interest information to directors facilitates their compliance with their fiduciary duties and mitigates the possibility of financial advisors having aiding and abetting liability.

Conclusion

The Rural/Metro decision provides a cautionary tale to financial advisors regarding conflicts of interest and to boards of directors regarding their duty to monitor those conflicts and police the decision-making process. Ultimately, even the appearance of impropriety by a financial advisor could cause plaintiffs and courts to question the legitimacy of a transaction process and the related fairness opinion, and could lead to liability for directors and financial advisors.