2014’s Valuable Lessons For M&A Financial Advisers

The following post comes to us from Jason M. Halper, partner in the Securities Litigation & Regulatory Enforcement Practice Group at Orrick, Herrington & Sutcliffe LLP, and is based on an article by Mr. Halper, Peter J. Rooney, and Colton M. Carothers that that first appeared in Law360. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

During the past year, Delaware and New York courts have issued a number of decisions that have important implications for financial advisers, as well as attorneys advising them, on mergers and acquisitions transactions. From the point of view of financial advisers and their legal counsel, the record is mixed. The two decisions by the Delaware Court of Chancery in In re Rural Metro Corp. Stockholders Litigation demonstrate the perils facing M&A financial advisers (especially financial advisers that are large, multifaceted financial institutions) in today’s litigation environment, where virtually all public deals are subject to shareholder litigation.

New York courts, on the other hand, in the case of S.A. de Obras Y Servicios v. The Bank of Nova Scotia, confirmed the protection that can be accorded to financial advisers by a well-crafted engagement letter governed by New York law and litigated in a New York forum. These and other decisions discussed below also provide useful guidance for counsel charged with protecting financial advisers providing M&A advisory services.

In re Rural Metro Stockholders Litigation

On Oct. 10, 2014, the Delaware Court of Chancery issued a decision awarding nearly $76 million in damages against a seller’s financial adviser, In re Rural Metro Corp. Stockholders Litigation (2014 Del. Ch. LEXIS 202). This damages determination followed an earlier March 7, 2014, opinion in the case, In re Rural Metro Corp. Stockholders Litigation, C.A. No. 6350-VCL (Del. Ch. March 7, 2014), in which Vice Chancellor J. Travis Laster found RBC Capital Markets LLC liable for aiding and abetting the board’s breach of fiduciary duty in connection with Rural Metro’s 2011 sale to private equity firm Warburg Pincus for $17.25 per share, a premium of 37 percent over the pre-announcement market price.

In its damages decision, the court concluded that the actual value of Rural Metro was $21.42 per share (a 70 percent premium to market). The court reached this conclusion despite the fact that Rural Metro was forced to file for bankruptcy less than two years after its acquisition by Warburg Pincus.

The two Rural Metro decisions yield several valuable lessons:

(1) Failing to thoroughly and promptly disclose real or perceived conflicts of interests between a financial adviser and its client creates a significant risk of liability, even in instances, such as this case, in which the board is employing a second financial adviser due to its general awareness that potential conflicts exist with its primary financial adviser. Once such undisclosed conflicts are allowed to persist, all of the financial adviser’s decisions may come under suspicion in subsequent related litigation and lead a court to conclusions it might not otherwise reach.

The court in fact stated that “where undisclosed conflicts of interest exist … choices [of the board] ‘must be viewed more skeptically.’” The court in Rural Metro concluded that, “[v]iewed skeptically,” decisions regarding the timing of the sale process, and even the order in which potential bidders were notified of the pending sales process, were unreasonable and driven by the financial advisers’ interest in using its engagement to obtain financing work for a bidder, thereby tilting the playing field in favor of that bidder. Generalized warnings in an engagement letter that the financial adviser is a large financial institution that is likely to be engaged in activities that create conflicts (or potential conflicts) of interest with the client do not provide protection from liability.

(2) Financial advisers should attempt to keep the board informed and consistently involve the board in important decisions in a deal process. Absent express authorization to the contrary, a financial adviser should not limit its interaction to either the CEO or only certain directors. The court in Rural Metro found that, “[a]s a threshold matter, the decision to initiate a sale process falls short under enhanced scrutiny because it was not made by an authorized corporate decisionmaker.” The court found that the board had merely “charged the Special Committee with pursuing ‘an in-depth analysis of the alternatives discussed during the meeting’ [and] [i]nstead of carrying out that directive, the Special Committee hired RBC to sell the Company, then RBC and Shackelton put Rural in play without Board authorization.”

(3) The Rural Metro decision also serves as a reminder that board decisions with the advice of a financial adviser in the context of a sale of a company may subject financial advisers to the risk of aiding and abetting liability even in the absence of onerous deal protection devices or overtly suspect decision- making. Unlike directors, who in many companies are not at risk for monetary damages for a breach of the duty of care due to charter exculpation provisions authorized by Section 102(b)(7) of the Delaware General Corporation Law, financial advisers now represent the “deep pocket” that can be reached by stockholder plaintiffs alleging “unreasonable” decisions by a board engaged in a sales process.

The “deep pocket” status of investment bankers was also illustrated in another Court of Chancery decision, In Re Tibco Software Inc. Stockholders Litigation, which involved the sale of a company in which both the board of the target company, Tibco, and the acquirer, Vista Equity Partners, were under the mistaken impression that Tibco had roughly 4 million more shares outstanding than was in fact the case. As a result of this misunderstanding, the total merger consideration was only $4.144 billion, rather than the $4.244 billion anticipated by the parties when they agreed to a merger at a price of $24 per share.

In denying the stockholder plaintiffs’ motion for an injunction blocking the merger, the court observed that the damages from the error were readily ascertainable, and capable of being awarded at a future date. The court added that “[a]lthough ‘the one-two punch of exculpation under Section 102(b)(7) and the full protection under Section 141(e)’ may limit (but does not eliminate) the prospects for recovery against the members of the Board, those statutory protections do not apply to aiders and abettors of breaches of fiduciary duties, including the duty of care,” and cited Rural Metro, a clear reference to the possibility of a claim against Tibco’s financial adviser.

Pontiac General Employees Retirement System v. Healthways Inc.

In a recent bench ruling, Pontiac General Employees Retirement System v. Healthways Inc., C.A. No. 9789-VCL (Del. Ch. Oct. 14, 2014) (transcript ruling) , the Court of Chancery appeared to open the door to a further expansion of “aiding and abetting” liability beyond financial advisers to lenders who ostensibly are at arm’s length from the borrower.

In this decision, Vice Chancellor Laster refused to dismiss claims that the directors of Healthways Inc. violated their fiduciary duties by approving a credit facility with SunTrust that provided for an event of default (and with it the lenders’ right to accelerate the debt) if “noncontinuing” directors failed to comprise a majority of the board within a 24-month period. (Noncontinuing directors generally are defined as directors that were not on the board at the time the debt agreement was signed or appointed by such persons.)

The court refused to dismiss claims that such a “dead-hand proxy put,” which could not be waived by the borrower’s board, impermissibly entrenches incumbent directors by deterring potential insurgents considering a proxy fight to replace the board due to concerns that voting for insurgents would trigger an event of default. In addition, the court refused to dismiss a claim that Suntrust “aided and abetted” the alleged breach of fiduciary duty by agreeing to amend the credit facility to include the proxy put not on a “clear day,” but rather at a time when the company was threatened with a proxy fight.

This ruling should be a significant concern for financial institutions and their counsel because it calls into question the ability of financial institutions to negotiate for the ability to exit their debt investments upon a change of control of their debtor. The line of reasoning expounded in Healthways, which takes the view that relatively typical change-of-control creditor protection provisions are in fact “entrenchment devices” (even a “Sword of Damocles” against insurgent stockholders) could impose changes to the debt financing markets that are much more significant than the de facto ban on undisclosed staple financing for public company sellers that the Court of Chancery has imposed with its Del Monte and Rural Metro rulings.

If deprived of the ability to require their debt to be refinanced in the face of a change of control, lenders and bondholders can be expected to seek higher interest rates and other improved terms to compensate for the risks being imposed upon them (or even to refuse to finance companies deemed to be at a high risk of being subject to a change of control) should the approach outlined in Healthways become settled law in Delaware. In any event, lenders and bondholders, and their counsel, should carefully evaluate any change-of-control puts or events of default to determine whether they may in fact be creating a risk of liability to their institution as an “aider and abettor” of a breach of fiduciary duty.

S.A. de Obras Y Servicios v. The Bank of Nova Scotia

While the Delaware Court of Chancery was reminding financial advisers of their potential liabilities, the courts of New York reaffirmed the ability of financial advisers to protect themselves from liability with appropriately drafted engagement letters containing exculpation clauses and indemnities. In S.A. de Obras Y Servicios v. The Bank of Nova Scotia, (N.Y. Supr. 2014), clients of a financial adviser were bidding on rights to develop a toll road in Chile in a process in which the lowest bid would win.

According to the complaint (which, on a motion to dismiss, the court assumed was true), errors in financial modeling conducted by the financial adviser, which were very difficult to detect and caused by junior personnel acting without proper supervision, caused the clients’ bid to be much too low. When the clients won the bidding but could not profitably perform, they were forced to abandon the project and thereby forfeited a $10 million performance bond. The clients sued the financial adviser to recover their loss on the bond and other related damages.

The engagement letter contained two significant clauses limiting the financial advisers’ liability and providing it with indemnification. Section 20 of the engagement letter, titled “Special Damages and Limitation of Liability,” provided that: “The aggregate liability to the [clients] …, in contract or tort or under statue [sic] or otherwise, for any direct loss or damage suffered by such party arising from or in connection with the services provided hereunder, however the direct loss or damage is caused, including negligence or willful misconduct by [the financial adviser], shall be limited to 50% of the amount of the Success Fee actually received to [sic] any one or more of such persons.”

Schedule A of the engagement letter provided that “[T]he [clients] agree to indemnify and hold harmless [the financial adviser] … from and against all losses, claims (including shareholder actions, derivative or otherwise) damages, expenses, actions or liabilities, joint or several, of any nature … to which [the financial adviser] becomes subject or otherwise involved in any capacity insofar as the Claims arise out of … the Engagement.” The indemnity went on to state that it did “not apply to the extent that any losses, … are determined by a final nonappealable judicial determination … to have resulted solely from the gross negligence or willful misconduct of the Indemnified Party.”

In the course of dismissing the clients’ claims, the court discussed the high levels of culpability necessary for a New York court to find that the gross negligence exclusion contained in the engagement letter (and generally in most standard investment banking engagement letters) is applicable. The court, citing numerous New York precedents, stated that:

New York courts demand ‘nothing short of … a compelling demonstration of egregious intentional misbehavior evincing extreme culpability: malice, recklessness, deliberate or callous indifference to the rights of others, or an extensive pattern of wanton acts’ in order to nullify a limitation of liability provision (Net2Globe Int’l, Inc. v Time Warner Telecom of New York, 273 F Supp 2d 436, 454 [SD NY 2003]). ‘Ordinary mistakes or miscalculations in performing a task will not meet this standard’ (Industrial Risk Insurers, 387 F Supp 2d at 307).

The court went on to state that under New York law, “[g]ross negligence, when invoked to pierce an agreed upon limitation of liability in a commercial contract, must smack of intentional wrongdoing …. It is conduct that evinces a reckless indifference to the rights of others” (citing, Abacus Federal Savings Bank v. ADT Security Serv., 18 NY3d 675, 683 [2012]).

Applying these standards to the mistakes alleged in the complaint, the court found the liability limitation capping damages at 50 percent of any success fee received to be applicable and, based on the fact that no success fee was paid due to the failure of the transaction, concluded that the clients’ claims should be dismissed.

The court also reviewed the claim of the financial adviser to receive indemnification from the clients for the legal and other expenses it incurred in connection with defending the clients’ claims. Notwithstanding the very broad language in the indemnity, the court concluded that “a provision that does not clearly imply an intent to provide for intra-party indemnification for attorney’s fees is ‘fatal to defendant’s claim’” and therefore dismissed the financial adviser’s claim for indemnification against the losses arising from the clients’ claims against the financial adviser.

The S.A. de Obras Y Servicios decision reaffirms that New York courts will respect contractual risk allocation by sophisticated parties. Financial advisers and their counsel should consider drafting engagement letters with these principles in mind, and insist upon New York choice of law and New York forum in their engagement letters. However, as Rural Metro illustrates, even the most solid indemnification provisions are little benefit if the client providing the indemnity has gone bankrupt.

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