In a series of recent decisions, Delaware courts have emphasized the potential risks arising when a board's financial advisor has a conflict of interests.
The board of an acquired entity generally will enjoy the protections of the business judgment rule in suits stemming from the acquisition if the transaction was ratified by a free and informed vote of disinterested shareholders. However, the courts have further held that the protections of the business judgment rule could be overcome if the directors were grossly negligent, and that if so, financial advisors could also be liable on aiding and abetting grounds.
The Rural/Metro Case: RBC Capital Markets, LLC v. Jervis, No. 140, 2015 (Nov. 30, 2015) – Financial Advisors Are Not "Gatekeepers," But They Can Be Held Liable if They Do Not Disclose Conflicts In a lengthy and thorough decision, the Delaware Supreme Court recently affirmed a series of post-trial decisions of the Court of Chancery in this much-discussed litigation. In so doing, the court affirmed the recent emphasis that Delaware courts have placed on the risks of undisclosed conflicts of interests by financial advisors in change-of-control transactions. Although the Supreme Court repeatedly referred to its decision as "narrow," it nevertheless set forth important guidelines for boards in the transactional context, and for their financial advisors who might be conflicted.
Background After a bench trial, the Court of Chancery determined that the financial advisor to the board of Rural/Metro Corp. was liable for more than $75 million in damages to a class of shareholders for aiding and abetting breaches of fiduciary duty by Rural's board. In brief, the trial court concluded that the financial advisor had attempted to leverage its engagement by Rural in order to obtain future business both from Rural's acquirer and from potential acquirers of Rural's chief competitor. The financial advisor misled Rural's board about the valuation of the company, which caused material omissions in disclosures – which, in turn, may have both impeded other bidders for Rural and tainted the shareholder vote that approved the transaction.
Because board members were exculpated pursuant to standard Delaware charter provisions, and because all other defendants had already settled, the financial advisor was the only remaining defendant at trial. The Court of Chancery held that the financial advisor bore most of the responsibility and was 83 percent liable. The Delaware Supreme Court affirmed these findings.
Holding and Analysis In its decision, the Delaware Supreme Court held that "directors need to be active and reasonably informed when overseeing the sale process, including identifying and responding to actual or potential conflicts of interest." Rural/Metro, at 62. The court stated that the board should, "when faced with a conflicted advisor . . . treat the conflicted advisor at arm's-length, and insist on protections to ensure that conflicts that might impact the board's process are disclosed at the outset and throughout the sale process." Id. at 63 n.130. However, the court held, "a board is not required to perform searching and ongoing due diligence on its retained advisors." Id. at 62. "[W]hile a board is entitled to rely upon experts, officers and employees selected with reasonable care . . . it may not avoid its active and direct duty of oversight in a matter as significant as the sale of corporate control." Id. at 58 n.117 (citation omitted).
One notable comment in the Supreme Court's decision is that the court specifically rejected the Chancery Court's dicta that financial advisors "function as gatekeepers" by providing expert services in a transaction that boards are not themselves equipped to handle. This view, the Supreme Court held, fails "to take into account the fact that the role of a financial advisor is primarily contractual in nature, is typically negotiated between sophisticated parties, and can vary based upon a myriad of factors." Id. at 80 n.191. The court nevertheless faulted the advisor for its lack of disclosure, and added that even the "board's consent to a conflict does not give the advisor a 'free pass' to act in its own self-interest and to the detriment of its client." Id. at 62.
Revlon Standard and Other Key Holdings The Supreme Court's opinion included several other important analyses. The parties agreed that the intermediate Revlon level of scrutiny applied, but debated when in time Revlon was triggered. Typically, Revlon is triggered by a decision to sell, not by an earlier decision to explore strategic alternatives. But the Supreme Court held that here, Revlon was applicable during the earlier period, because the advisor erroneously treated its mandate as a sale, even before Rural's board had reached that conclusion.
The court also rejected the argument that it was unfair to hold a financial advisor liable if the board itself had been exculpated and thus could not be held liable. The court affirmed the Chancery Court's ruling that "if the third party knows that the board is breaching its duty of care and participates in the breach by misleading the board or creating the informational vacuum, then the third party can be liable for aiding and abetting." Id. at 74. Otherwise, allowing financial advisors to benefit from any exculpation given to the board would "create a perverse incentive system wherein trusted advisors to directors could, for their own selfish motives, intentionally mislead a board only to hide behind their victim's liability shield when stockholders or the corporation seeks retribution for the wrongdoing." Id. at 97. In addition, the court observed, "the law provides third-party advisors . . . a benefit not available to directors": directors can be liable for acting with gross negligence, but not advisors; "plaintiffs must prove that the advisor acted with scienter." Id. at 98.
Finally, the court affirmed the finding that Rural's financial advisor was responsible "for a disproportionate amount of the fault," id., rejected the advisor's other arguments, and affirmed the Court of Chancery's calculation of damages.
In re Zale Corp. Stockholders Litigation, C.A. No. 9388-VSP – Reconsideration Granted As we reported in our October 21, 2015, client alert, the Delaware Court of Chancery determined, in its October 1, 2015, decision that the board of directors of jeweler Zale Corporation may have breached its fiduciary duty by not uncovering a potential conflict of interests on the part of its financial advisor. As a consequence, claims for aiding and abetting breach of fiduciary duty against the financial advisor were permitted to proceed, even though the claims against Zale's board had been exculpated and were therefore dismissed.
In a letter opinion issued October 29, 2015 ("Zale II"), Vice Chancellor Parsons granted the financial advisor's motion to reconsider and dismissed the claims against it in light of the Delaware Supreme Court's new decision in Corwin v. KKR Financial Holdings LLC, No. 629, 2014 (Oct. 2, 2015). The reconsideration opinion also relied heavily on the Court of Chancery's October 20, 2015, Memorandum Opinion in In re TIBCO Software Inc. Stockholders Litigation, C.A. No. 10319-CB.
Corwin v. KKR – A Free and Informed Vote of Disinterested Shareholders Affords Directors the Protections of the Business Judgment Rule In Corwin, in a concise opinion, the Delaware Supreme Court affirmed a holding that the business judgment rule applies to a "post-closing damages action when a merger that is not subject to the entire fairness standard has been approved by a fully informed, uncoerced majority of the disinterested stockholders." Corwin at 1.
The court first affirmed the Chancery Court determination that KKR was not a controlling shareholder, and therefore that the merger was not subject to an enhanced "entire fairness" standard of review. The question then was the appropriate standard of review of a merger, given that a majority of shareholders voted to approve the transaction.
The plaintiff argued that even if "entire fairness" did not apply, the intermediate Revlon level of scrutiny did. But the Supreme Court rejected this contention, citing substantial "precedent under Delaware law for the proposition that the approval of the disinterested stockholders in a fully informed, uncoerced vote that was required to consummate a transaction has the effect of invoking the business judgment rule." Id. at 7 n.19.
In addition to relying on Delaware precedent, the court noted other reasons for its ruling, including the "long-standing policy . . . to avoid the uncertainties and costs of judicial second-guessing when the disinterested stockholders have had the free and informed chance to decide on the economic merits of a transaction for themselves." Id. at 11-12.
Zale II – Although the Business Judgment Rule Could Be Overcome if the Directors Were Grossly Negligent, They Were Not Grossly Negligent in This Case In its initial opinion in Zale, the Court of Chancery had determined that a fully informed and disinterested majority of Zale's shareholders voted in favor of the merger, but the court there nevertheless applied the Revlon standard in considering whether Zale's board had breached its fiduciary duties. In light of the Delaware Supreme Court's opinion in Corwin, the Zale court granted reargument and applied the business judgment rule instead of Revlon. Zale II, at 6.
The court then considered how the plaintiff might overcome the presumption of the business judgment rule, and held that it could do so "by showing that it is reasonably conceivable that the Director Defendants' actions were grossly negligent." Id. at 7. Thus, the court held, "when reviewing a board of directors' actions during a merger process after the merger has been approved by a majority of disinterested stockholders in a fully informed vote, the standard for finding a breach of the duty of care under [the business judgment rule] is gross negligence" – that is, "the decision has to be so grossly off-the-mark as to amount to reckless indifference or a gross abuse of discretion." Id. at 9-10 (citation omitted).
The court reiterated that it found the financial advisor's conduct "troubling." Id. at 14. It re-emphasized its warning that the advisor should have disclosed its potential conflict of interests to Zale's board at the outset, and that Zale's board should have "take[n] additional steps to obtain information material to the evaluation of their financial advisors' independence." Id. But the court nevertheless held that the conduct of Zale's board, while potentially negligent, was not grossly so, and therefore did not meet the standard required to overcome the business judgment rule. Accordingly, the court held that because no predicate breach of fiduciary duty was sufficiently alleged, the aiding and abetting claim against the financial advisor must be dismissed as well.
In re TIBCO – If the Directors Were Grossly Negligent, and the Financial Advisor Knowingly Participated, the Financial Advisor May Be Liable Even if the Claims Against the Directors Are Dismissed In deciding to apply a gross negligence standard, Zale II was significantly informed by Chancellor Bouchard's recent decision in TIBCO. In TIBCO, Vista, a private equity fund, agreed to acquire TIBCO for $24 per share, which both parties inaccurately believed implied an aggregate equity value of approximately $4.244 billion. However, after the merger agreement was signed, TIBCO learned of an error in the capitalization table, and learned that the actual aggregate valuation was approximately $100 million less – money that Vista expected to pay but would no longer have to, and which the plaintiff therefore sought to recover for TIBCO's shareholders through this action.
The Court of Chancery initially dismissed a claim for reformation of the merger agreement, because such a claim requires proof of an antecedent agreement that was contrary to the written terms of the contract. Here, the court held that there was no allegation of an antecedent agreement to purchase TIBCO for $4.244 billion, but rather to purchase it for $24 per share, which was honored.
The plaintiff also asserted a breach of fiduciary duty claim against TIBCO's board for allegedly failing even to try to recoup the $100 million, and against TIBCO's financial advisor for aiding and abetting that breach. The court first held that because of the exculpatory provision in TIBCO's charter, a claim for breach of fiduciary duty against the board could be pursued only if there was a credible allegation that the board acted in bad faith – and there was no such allegation here. However, consistent with Rural/Metro, the court also held that an allegation that TIBCO's board breached its fiduciary duty could still serve as a predicate for a claim that its financial advisor aided and abetted such a breach.
The court then held – critically, for purposes of the Zale reconsideration opinion – that in this context, a claim of breach would be sufficient only if it credibly alleged that the directors acted with gross negligence. The court determined that a gross negligence claim was sufficiently pleaded. In particular, the court noted, TIBCO's board "never considered or explored a reformation claim and failed to ask [its financial advisor] such basic questions as . . . how the share count error occurred." Id. at 52. "[T]he failure to make such basic inquiries does raise litigable questions over whether the Board acted in a grossly negligent manner." Id. at 54.
Moreover, the court held that the plaintiff had sufficiently alleged that the financial advisor knowingly participated in the breach of fiduciary duty, and thus the court declined to dismiss the claim against the financial advisor for aiding and abetting breach of fiduciary duty.
Conclusion The Chancery Court's opinions in Rural/Metro and the initial Zale opinion both warned boards to be vigilant with respect to financial advisors' potential conflicts of interests, and that timely disclosure of such conflicts is important. They also warned directors to act with care with respect to such conflicts.
The Delaware Supreme Court decision in Rural/Metro, while maintaining these warnings, clarified that financial advisors are not in fact "gatekeepers" for their board-clients, but may still face significant liability if it turns out they contributed to a board's failure to meet its duties. Like Rural/Metro, the Zale reconsideration opinion, while maintaining its warnings over conflicts of interests, took a step back in dismissing the claims against the financial advisor.
Nevertheless, the substance of these judicial admonitions remains intact, and liability in such circumstances is still clearly possible if the board's failure to vet a financial advisor's conflicts rises to the level of gross negligence – or if the conduct is not insulated by a fully informed, uncoerced vote of disinterested shareholders.
The Corwin decision clarifies that under Delaware law, such a fully informed, uncoerced vote will insulate the directors by affording them the protections of the business judgment rule. As Zale II itself demonstrates, this creates even greater incentive to meticulously ensure that such a vote is uncoerced and fully informed. But as Rural/Metro and Zale II both make clear, to avoid potential liability over a financial advisor's potential conflicts of interests, the best inoculation is insistence upon disclosure of, and a full examination of, potential advisor conflicts.
This article is presented for informational purposes only and is not intended to constitute legal advice.
