Investment Bank Liability for M&A Services

Arthur H. Rosenbloom is Managing Director of Consilium ADR LLC, and Gilbert E. Matthews is Senior Managing Director and Chairman of the Board of Sutter Securities, Inc. This post is based on their recent paper and is part of the Delaware law series; links to other posts in the series are available here.

Introduction

To err is human but there is often no divine or other forgiveness for investment banks in Delaware litigation when their misconduct rises to the level of aiding and abetting the board’s breach of fiduciary duty to its shareholders. In this article, we consider recent Delaware case law on investment banker liability that has resulted in judgments against bankers and has caused them to make contributions to shareholders when some of these matters settle even when they deny liability.

Delaware has ruled that investment banks are not in privity with the shareholders, their obligations being limited solely to those who engage them. In the 1990 Shoe-Town decision, the Court of Chancery ruled that the investment bank hired by management “owed no fiduciary duty to the shareholders.” [1] The Court distinguished this case from the Wells decision in New York (which had ruled that the investment banks liable to shareholders) “because the investment advisor in that case was hired by a special committee charged solely with determining the fairness of the transaction for the shareholders.” [2] In 1996, the Delaware Superior Court ruled similarly in Stuchen v. Duty Free Int’l, Inc. [1996 WL 33167249 (Del. Super. Apr. 22, 1996) at *12.]

Moreover, investment banks’ engagement letters customarily contain a provision that indemnifies them for liability unless there is a judicial finding of gross negligence or willful misconduct that is not subject to further appeal. [3] Nonetheless, investment banks have been forced to ante up when they have been found liable for aiding and abetting breaches of directors’ fiduciary duties to shareholders, or simply when their conduct, while less egregious than that required to satisfy Delaware’s tough aider and abettor standards, falls short of the punctilio of honor.

Delaware case law “stand[s] for the proposition that sell-side boards must treat banker contracts in a contractual rather than fiduciary frame.” [4] Investment bankers’ potential liability arises when there are material conflicts or improper activities. “Conflicts may arise because banks engage simultaneously in multifarious nonadvisory activities, often giving them opportunities to extract wealth at their clients’ expense.” [5]

We examine the ground rules for investment banker liability as financial advisor in corporate transactions and enumerate the damages described in recent major cases.

The Ground Rules

Notwithstanding that it is well established in Delaware that investment banks are liable only to those who hire them, investment banks may be held liable for aiding and abetting directors’ breach of their fiduciary duties. Delaware’s standard for breach of fiduciary duty include four elements: (i) the existence of a fiduciary relationship; (ii) a breach of that relationship; (iii) knowing participation by the defendant non-fiduciary in the fiduciary’s breach; and (iv) damages proximately caused by the breach. [6]

Delaware courts have permitted a third-party fiduciary duty claim to proceed against an investment bank for aiding and abetting company’s breach of fiduciary duties [Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1284 n. 33 (Del.1989)]. However the investment bank must have been a knowing participant in the fiduciary’s breach and complaints must allege allegations from which knowing participation can reasonably be inferred [In re Gen. Motors (Hughes) Sh’holder Litig., 2005 WL 1089021, at *24 (Del. Ch. May 4, 2005)]. In analyzing an aiding and abetting claim, Delaware courts look to a number of factors including (i) the nature of the tortious act that the secondary actor participated in or encouraged, including its severity, the clarity of the violation, the extent of the consequences and the secondary actor’s knowledge of these aspects; (ii) the amount, kind and duration of assistance given, including how directly involved the secondary actor was in the primary actor’s conduct; (iii) the nature of the relationship between the secondary and primary actors; and (iv) the secondary actor’s state of mind [In re Good Technology Corp. St’holder Litig., WL 2537347 (Del. Ch. May 12, 2017) at *3].

Consider the RBC Capital Markets’ actions in the Rural Metro case. [7] The Court of Chancery’s found that RBC had aided and abetted Rural Metro’s board in conduct so egregious as to invoke Revlon‘s enhanced scrutiny [8] respecting the board’s breach of its fiduciary duty to Rural Metro’s public shareholders. It found RBC liable for convincing the Rural Metro board to rush into a $438 million leveraged buyout by a private equity firm without ever disclosing that it was also trying (unsuccessfully) to obtain the more lucrative role of providing financing to the buyer. The Court tagged RBC with 83% of the total liability of $91.3 million in this class action, an amount equal to the difference between the fair market value of Rural’s stock (developed by the Court in a quasi-appraisal) and the price received by Rural’s shareholders, and the Supreme Court affirmed the decision.

In affirming, the Delaware Supreme Court noted that RBC had: (i) failed to disclose its desire to offer stapled financing to Rural buyers; (ii) given Warburg, Rural’s ultimate acquiror, preference over another equity investor who was busy putting up bids for both Rural and another company possessing synergies with Rural; (iii) failed to provide adequate valuation data to Rural’s board, its final valuation having been supplied only three hours before the board’s vote on the deal; (iv) contrived to develop valuation figures that supported Warburg’s bid. Such misconduct satisfied the scienter requirement needed to support plaintiffs aiding and abetting claim. However, the Supreme Court noted that its affirmation of RBC’s aiding and abetting liability should not be read expansively to support liability for any failure by an investment bank. It noted that aiding and abetting liability claims should, under ordinary circumstances, be very difficult to prove due to the scienter requirement [RBC Capital Markets at 865-66]. Indeed, whether or not Revlon or only the business judgment standard applies, a fully informed non-affiliated shareholder vote creates no liability for the board and in consequence no liability for the investment bank advising that board [Singh v. Attenborough, 137 A.3d 151 (Del. 2016)].

That said, improper behavior by a bank that falls short of aider and abettor liability, may result in the bank’s willingness to contribute to a settlement. Consider in this respect, Barclays’s improper actions as Del Monte Foods’ investment banker in the company’s sale to a consortium of Kohlberg Kravis Roberts (“KKR”), Vestar Capital Partners (“Vestar”), and Centerview Partners. The Vice Chancellor wrote:

Barclays secretly and selfishly manipulated the sale process to engineer a transaction that would permit Barclays to obtain lucrative buy-side financing fees. On multiple occasions, Barclays protected its own interests by withholding information from the Board that could have led Del Monte to retain a different bank, pursue a different alternative, or deny Barclays a buy-side role. Barclays did not disclose the behind-the-scenes efforts of its Del Monte coverage officer to put Del Monte into play. Barclays did not disclose its explicit goal, harbored from the outset, of providing buy-side financing to the acquirer. Barclays did not disclose that in September 2010, without Del Monte’s authorization or approval, Barclays steered Vestar into a club bid with KKR, the potential bidder with whom Barclays had the strongest relationship, in violation of confidentiality agreements that prohibited Vestar and KKR from discussing a joint bid without written permission from Del Monte.

—In re Del Monte Foods Co. Sh’holders Litig., 25 A.3d 813, 817 (Del. Ch. 2011).

In consequence, given Barclays’ misconduct and a Del Monte board that too readily accepted that misconduct, defendants were preliminarily enjoined for 20 days from proceeding on the merger vote to give a competing bidder an opportunity to come forward. An $89 million settlement was shared equally by Del Monte and Barclays, including the surrender by Barclays of its $21 million fee. [9]

In In re El Paso Corp. Sh’holders Litig. [41 A.3d 432 (Del.Ch. 2012)], plaintiffs sought to enjoin the company’s sale to Kinder Morgan, alleging that El Paso’s CEO had failed to disclose to the company’s board his interest in buying its exploration and production business that Kinder Morgan planned to divest after the acquisition. Goldman Sachs, El Paso’s sell-side advisor, owned 19% of Kinder Morgan and controlled two of its board seats. Further, Goldman’s lead banker failed to disclose his ownership of $340,000 of Kinder Morgan stock. Unlike Del Monte, the Court did not temporarily enjoin the transaction given the absence of another buyer and the market conditions at the time of the deal that resulted in a large merger premium. Since the shenanigans were now fully disclosed, El Paso’s shareholders were informed and could have voted against the deal. Ultimately, given plaintiffs solid damage theory, the case settled with El Paso paying $110 million to its shareholders and Goldman giving up its $21 million advisory fee and the right to be indemnified for its court costs. [10]

In another case involving Goldman Sachs [In re Tibco Software Inc. St’holders Litig., 2015 Del. Ch. LEXIS 265 (Del. Ch. Oct. 20, 2015)], Vista Equity Partners and Goldman paid a total of approximately $30 million to settle a lawsuit by investors alleging an error in the number of shares outstanding that lowered the price they received by around $100 million. [11] Goldman was charged with having aided and abetted the board’s dereliction. Directors were spared liability because the company’s charter provision protected it against shareholders suits absent a finding of gross negligence.

Sometimes the parties to a merger will waive an error by an investment bank and the merger will close without litigation against the investment bank. While the Tesla/Solar City transaction generated a spate of litigation, none was directed to Lazard Freres, Solar City’s banker that double-counted Solar City’s indebtedness. Lazard escaped liability because the transaction price was still within the range of values that Lazard attributed to Solar City. [12] And, of course, even if an investment bank’s conduct was questionable, it can have no liability for aiding and abetting if the board’s conduct was not found to have breached its fiduciary duty [In re Zale Corp. St’holders Litig., 2015 Del. Ch. LEXIS 274 (Del. Ch. Oct. 29, 2015) at *13-*15]. In addition, the absence of detrimental reliance on the advice of an investment bank may result in the dismissal of a fraud complaint against it [Bachman v Bear Stearns & Co. Inc. 57 F. Supp. 2d 556 (N.D. Ill. 1999)].

Conclusion

Despite the absence of privity between investment banks and the shareholders on whose behalf they render services under Delaware law, investment banks that weave tangled webs of deception may find themselves liable to those shareholders, contributing to payments to them or foregoing their fees in settlements.

Endnotes

1In re Shoe-Town. Inc. Stockholders Litig., 1990 WL 13475 (Del. Ch. Feb. 12, 1990) at *7. In accord are several federal cases that ruled that investment banks duties are contractual: e.g., Collins v. Morgan Stanley Dean Witter, 224 F 3d 496 (5th Cir. 2000); HA2003 Liquidation Trust v Credit Suisse Securities (USA) LLC, 517 F.3d 454 (7th Cir. 2008); Joyce v. Morgan Stanley & Co., 538 F.3d 797 (7th Cir. 2008); Baker v. Goldman Sachs & Co., 656 F. Supp. 2d 226 (D. Mass. 2009).(go back)

2Wells v. Shearson Lehman/American Express, Inc., 127 A.D.2d 200, 202 (N.Y. App. Div. 1987); rev’d on other grounds, 72 N.Y. 2d 953, 526 N.E.2d 8, (N.Y. 1988).(go back)

3Investment bank’s engagement letters customarily have, in substance, the following clause in the indemnification section:

The Company agrees that [Investment Bank] shall not have any liability (whether direct or indirect, in contract or tort or otherwise) to the Company for or in connection with the engagement of [Investment Bank], except for any such liability that is found in a final judgment of a court of competent jurisdiction (not subject to further appeal) to have resulted primarily and directly from the gross negligence or willful misconduct of [Investment Bank].

Investment banks almost always insist on a gross negligence standard as a consequence of Hershkowitz v. Nutri-Systems, Inc., 857 F.2d 179 (3rd Cir. 1988), in which the investment bank was deemed negligent (but not grossly negligent) for using the then-current 46% corporate tax rate in its DCF valuation rather than the 33% to 36% tax rate that was then expected to be enacted.(go back)

4William C. Bratton and Michael L. Wachter “Bankers and Chancellors,” 93 Tex L. Rev. 1 (2014).(go back)

5Andrew F. Tuch, “Banker Loyalty in Mergers and Acquisitions,” 94 Tex L. Rev. 1081, 1082-83 (2016) (discussed on the Forum here). This contrarian article argues that investment banks advising on M&A transactions should be deemed to be fiduciaries.(go back)

6Mesirov v Enbridge Energy Co. Inc. 2018 WL 4182204 (Del. Ch. 2018) at *13, citing Malpiede v. Townson, 780 A.2d 1075, 1096 (Del. 2001) and RBC Capital Mkts. LLC v. Jervis, 129 A.3d 816, 861 (Del. 2015).(go back)

7In re Rural/Metro Corp. St’holders Litig., 102 A.3d 205 (Del. Ch. 2014); aff’d, RBC Capital Markets v Jervis, 129 A.3d 816 (Del. 2015).(go back)

8Revlon, Inc. v McAndrews & Forbes Holdings Inc., 506 A.2d 173 (Del. 1986). However, Revlon‘s entire fairness standard will not attach and the business judgment standard will apply in determining post­ closing damages when the court finds that the merger was approved by a fully informed uncoerced majority of disinterested stockholders (Corwin v KKR Financial Holdings LLC, 125 A.3d 304 (2015) and Flood v. Synutra Intl. Inc., __ A.3d __, 2018 WL 4869248 (Del. 2018)).(go back)

9 In re Del Monte Foods Co. Sh’holders Litig., 2011 WL 6008590 (Del. Ch., Dec. 1, 2011).(go back)

10In re El Paso Corp. Sh’holders Litig. [2012 WL 6057331 (Del.Ch., Dec. 3, 2012)].(go back)

11“Goldman Sachs, Vista Equity Agree to Settle Tibco Investor Suit,” Wall St. Journal, Apr. 21, 2016, available at www.wsj.com/articles/goldman-sachs-vista-equity-agree-to-settle-tibco-investor-suit-1461270117.(go back)

12“SolarCity advisor Lazard made mistake in deal with Tesla,” Reuters, Sept. 1, 2016, available at www.reuters.com/article/solarcity-lazard/solarcity-advisor-lazard-made-mistake-in-deal-with-tesla-idUSL1N1BD007.(go back)

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