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Conflicts of Interest in M&A Transactions

02.24.17

What’s your board’s role?

When a company is acquired, its board of directors should take an active role in overseeing the sale process — including identifying and responding to actual or potential conflicts of interest on the part of the company’s investment bankers or other financial advisors. This is one of the lessons gleaned from the influential Delaware Supreme Court’s decision in 2015, RBC Capital Markets, LLC v. Jervis (the Rural/Metro case).

Rural/Metro also offers guidelines for financial advisors. In this case, the court affirmed the Delaware Chancery Court’s $75 million verdict against a financial advisor for “aiding and abetting” breaches of fiduciary duty by the company’s directors.

Advisor advancing personal interests

The case involved the sale of Rural/Metro Corporation to a private equity firm. In 2010, after Rural/Metro had been approached by potential buyers, a special committee of independent directors was asked by the board of directors to retain an advisor to explore strategic options. These potential options included buying a subsidiary of the company’s main competitor, Emergency Medical Services Corporation (EMS).

The factual background of the case is fairly complicated, but, in a nutshell, the special committee engaged RBC as its financial advisor and quickly began to pursue a full-fledged sale, exceeding its board mandate to simply evaluate strategic alternatives. Ultimately, however, the full board ratified the committee’s actions.

At the same time, EMS was also marketing itself for sale. Despite the negative impact this had on Rural/Metro’s sale process, RBC advised the committee to proceed. One reason for this, the Chancery Court found, was that RBC hoped to use its position as sell-side advisor to Rural/Metro to secure buy-side roles with the private equity firms bidding for EMS.

In addition, RBC aggressively pursued buy-side financing opportunities with the private equity firm that purchased the company, without first consulting the board. And RBC failed to include any valuation analysis in its presentations to the board until three hours before the board voted to approve the deal. The court found that RBC had manipulated its valuation metrics to make the private equity firm’s bid appear more attractive.

All of these conflicts of interest placed RBC’s interests above those of the company and its shareholders, and none of them were disclosed to the board. And the advisor’s actions misled the board into making false disclosures in its proxy statement regarding the merger.

Higher court’s ruling

The Delaware Supreme Court affirmed the Chancery Court’s finding that the company’s directors had breached their fiduciary duties by failing to properly monitor the sale process and by including misleading disclosures in the company’s proxy statement. As a result, shareholders were damaged in the amount of just over four dollars per share.

According to the Delaware Supreme Court, the lower court properly evaluated the directors’ conduct under the Revlon v. MacAndrews & Forbes Holdings standard rather than the more lenient business judgment rule. Under the business judgment rule, courts generally defer to directors’ decisions. Under Revlon, however, they scrutinize directors’ decisions more closely when a sale of control is involved. The court said that this enhanced scrutiny applied as soon as the committee retained RBC and commenced the sale process, even though the board hadn’t authorized it to do so and didn’t ratify the committee’s actions until months later.

The court also found that RBC was liable for aiding and abetting the board’s breach of its duty of care, even though the directors themselves were exculpated by the company’s corporate charter. (See “Exculpatory clauses protect directors from personal liability.”) The court disagreed, however, with the Chancery Court’s suggestion that financial advisors serve as “gatekeepers” and are responsible for monitoring their clients’ boards. Advisors don’t become liable merely by failing to prevent directors from breaching their duty of care. Rather, they must induce a breach knowingly, intentionally or with reckless indifference.

Disclosure is the key

Boards of directors are free to consent to certain conflicts. Nevertheless, they should actively monitor the sale process to identify and respond to any actual or potential conflicts of interest. “Because the conflicted advisor may, alone, possess information relating to a conflict,” the Rural/Metro court said, “the board should require disclosure of, on an ongoing basis, material information that might impact the board’s process.” From the financial advisor’s perspective, ongoing disclosure of potential conflicts of interest is the best way to avoid liability for the board’s failure to fulfill its fiduciary duties.

Exculpatory clauses protect directors from personal liability

Many states have enacted laws that allow shareholders to include a clause in a corporation’s charter that protects directors (and, in some states, officers) against monetary liability for unintentional breaches of their fiduciary duty of care. Typically, these “exculpatory” clauses don’t provide protection for directors who:

  • Breach their duty of loyalty,
  • Act in bad faith,
  • Engage in intentional misconduct,
  • Knowingly violate the law, or
  • Engage in transactions from which they derive improper personal benefits.

Often, directors or officers are able to use exculpatory clauses to support a motion to dismiss a lawsuit against them, allowing them to avoid costly litigation. These clauses aren’t mandatory. Corporations may adopt them, however, if their shareholders believe that liability protection is necessary to attract quality directors or officers.