Lessons for M&A Advisors in Crafting Engagement Letters

A federal court decision interpreting an investment bank’s engagement letter on a motion to dismiss highlights the risk that—absent careful drafting—financial advisors may be held liable to third-party beneficiaries on both contract and fiduciary duty claims. Baker v. Goldman Sachs, Civ. No. 09-10053-PBS (D. Mass. Sept. 15, 2009).

The financial advisor represented a closely held company, founded and controlled by the Bakers, in connection with its review of potential strategic transactions in early 2000. Allegedly relying on the financial advisor’s advice, the company entered into a stock-for-stock merger agreement with a Dutch buyer, and the deal closed in June 2000. Just months later, the Wall Street Journal uncovered a massive accounting fraud at the Dutch buyer, whose shares subsequently lost all value and whose collapse cost the Bakers their investment. Seeking to recoup some of their losses, the Bakers filed suit against the financial advisor for breach of contract and fiduciary duty. The financial advisor moved to dismiss, arguing that its engagement agreement was with the closely held company alone and that it owed neither fiduciary nor contractual duties to the Bakers.

Applying New York contract law, the Court denied the motion to dismiss in principal part. The Court ruled that although the Bakers were not parties to the engagement letter with the financial advisor, one of the Bakers was an intended third-party beneficiary because she was a member of the board of directors and was a named addressee of the engagement letter. The Court emphasized the letter’s use of “the word ‘you’ rather than ‘company’ when discussing [the financial advisor’s] duty to provide ‘financial advice and assistance.’” Because one of the Bakers was an addressee of the letter, the “plain meaning” of “you” meant that she had enforceable rights under the agreement. The Court added that the engagement letter anticipated advice given “for the information of the Board of Directors,” evincing an “express intent” to benefit board members such as Baker.

The Court went on to conclude that the “muddy” relationship between the financial advisor and the Bakers permitted an inference that “special circumstances existed to create a fiduciary relationship” between them. The Court distinguished Joyce v. Morgan Stanley, a 2008 Seventh Circuit decision that held shareholders were unable to allege a fiduciary breach against a corporation’s financial advisor. The Court emphasized that unlike in Joyce, there was in this case “no explicit waiver in the Engagement Letter precluding an extracontractual fiduciary duty,” and that the Bakers themselves had worked closely and communicated extensively with the financial advisor.

The Baker decision makes clear that no bright line insulates corporate financial advisors from third-party liability to frustrated shareholders. Careful drafting can be the key to avoiding costly post-transaction litigation, especially in the context of closely held companies.