M&A Advisor Misconduct: A Wrong Without a Remedy?

Rarely have investment banks faced liability in their role as advisors on merger and acquisition (“M&A”) transactions. At first glance, this is puzzling. M&A deals are ubiquitous and frequently attract lawsuits. Moreover, in their other activities, most notably securities underwriting, investment banks are frequent litigation targets, being seen as deep-pocketed defendants. And yet, in advising on often-contentious M&A deals, they have succeeded spectacularly by generally avoiding liability altogether.

In M&A Advisor Misconduct: A Wrong Without a Remedy?, I examine this anomaly, explaining the doctrinal and practical reasons for it. The article puts in context a recently successful shareholder strategy to bring M&A advisors to heel. It shows how this litigation strategy—a direct action by shareholders alleging aiding and abetting liability against the corporation’s M&A advisor based on the underlying wrong of directors—may delicately side-step the traditional obstacles. This strategy has succeeded on occasion, provoking widespread alarm in the investment banking community—but the approach marks only a modest increase in liability risk for M&A advisors. The liability framework for M&A advisors remains piecemeal and unlikely to be effective in deterring M&A advisor misconduct.

The analysis identifies four significant obstacles to liability. First, clients’ rights and remedies are limited by the engagement letters, which include extensive disclaimers. Clauses purporting to disclaim fiduciary and agency relationships may be insufficient to have fiduciary claims dismissed, but engagement letters typically defeat or significantly constrain clients’ other claims against M&A advisors. Second, whatever legal claims may be available to them, clients rarely fight publicly with their M&A advisors, preferring instead to resolve disputes behind closed doors; and, in any case, buyers succeed to the rights of target companies, significantly reducing the possibility of suits by targets. Third, while shareholders have shown themselves considerably more willing than client corporations to claim against M&A advisors, in derivative claims, target shareholders lose standing under the requirement for continuous share ownership. Finally, shareholders have limited prospects in direct claims based on primary liability because both the common law and terms in engagement letters virtually assure that an advisor’s duties run to the client corporation rather than to its shareholders. These obstacles do not prevent M&A advisor liability, but they largely explain its infrequency.

At least since Rural Metro/RBC Capital, the most promising actions for aggrieved shareholders have been based on aiding and abetting liability. Brought by the target shareholders, the action alleges that the advisor aided and abetted fiduciary breaches by the client corporation’s directors. Despite avoiding many of the obstacles facing other causes of action against M&A advisors, aiding and abetting is a limited cause of action. As is well known, the action’s requirements for scienter – or knowing participation – and for a predicate breach of fiduciary duty narrow the range of conduct within reach of liability.

The requirement for knowing participation in a predicate breach has required the advisor to know that the board is breaching its duties and to “participate[] in the breach by misleading the board or creating the informational vacuum.” In Morrison v. Berry, the Chancery Court characterized Rural Metro/RBC Capital as finding that liability attached “if the advisor, with the requisite scienter, caused the board to act in a way that [breached its Revlon duties].” Similarly, aiding and abetting liability can arise “where a conflicted advisor has prevented the board from conducting a reasonable sales process, in violation of [Revlon duties].” These formulations emphasize the extent of participation required: It is insufficient that the advisor takes part in the underlying breach, even knowingly; the board’s breach will arise from, if not be caused by, the M&A advisor’s conduct.

Predicate breach may be established by a board’s failure to satisfy its Revlon duties or breach of its disclosure obligations. In Morrison v. Berry, the Chancery Court observed that because of the difficulty of satisfying this element, a “faithless advisor” may escape liability; there is a risk of “a wrong without a remedy.” The court suggested in obiter that this element may be satisfied in the absence of board culpability: “where a conflicted advisor has prevented the board from conducting a reasonable sales process, in violation of [Revlon duties], the advisor can be liable for aiding and abetting that breach without reference to the culpability of the individual directors.” However, this suggestion is difficult to reconcile with courts’ analysis which has established predicate breach by reference to a board’s failings.

An extreme set of facts may amount to aiding and abetting by an M&A advisor, or at least survive a motion to dismiss. For example, in Morrison v. Berry, a target M&A advisor had provided a conflict disclosure memorandum to the target’s board without fully disclosing its communications with the bidder, including back-channel communications by one of its bankers alleged to have given the bidder “an edge in the bid process.” The court accepted the inference that “the Board’s failure to comprehend its financial advisor’s conflict of interest with the sole bidder conceivably breached duties imposed in the Revlon context.” The board had received the disclosure memorandum but “did not probe further”. As to the requirement of knowing participation, the M&A advisor had “intentionally disguised its communications with [the bidder] and thus knowingly deceived the Board about its ongoing conflicts.” The court denied the M&A advisor’s motion to dismiss, finding it conceivable that the advisor had aided and abetted the target board’s breach of Revlon duties.

Nevertheless, clients of M&A advisors have few avenues for holding M&A advisors liable for wrongdoing and probably will not take the chance even if they have a realistic option to do so; and shareholders usually cannot feasibly hold M&A advisors liable. There is also reason to question the deterrence force of public enforcement: although the SEC and FINRA have the authority to sanction M&A advisors, they rarely do so, focusing their enforcement efforts on broker-dealers’ conduct toward retail clients instead.

The M&A liability regime has provoked a range of responses from commentators. One would allow a target’s shareholders to bring post-closing derivative claims against M&A advisors “where the claims relate to conduct inextricably linked to the transaction whose closing would otherwise extinguish stockholder standing,” overcoming the continuous share ownership requirement. Another would recognize a new tort for “fraud on the board.” This article suggests that self-regulation may offer a more encompassing and durable approach than alternatives to deter wrongdoing by M&A advisors, at least for hard-to-detect misconduct. M&A advisors would benefit from principles of conduct tailored to the M&A setting, principles consistent with the reality that M&A advisors are professionals and are understood by clients to be loyal advisors.

The paper is available here.