Contributed by Andrea Saavedra
The recent decision by Vice Chancellor Laster of the Delaware Chancery Court, In re Rural/Metro Corp. Stockholders Litigation has generated substantial interest and discussion within the legal and investment banking communities. In that decision, the court held the principal investment bank advisor to the target company’s board of directors liable for aiding and abetting the directors’ breach of their fiduciary duties in consummating a merger and failing to disclose certain material information in connection therewith. Although not in the restructuring context, the decision, with its focus on the importance of conflicts disclosure and fair process to the integrity of a major corporate transaction, contains lessons with universal application.
Rural is a leading provider of ambulance and fire protection services throughout the United States. Prior to its take-private acquisition in the summer of 2011 (which became the subject of the relevant litigation), Rural was a public company with a clear, but not yet fully borne out, growth strategy. Its board was comprised of seven members, six of whom were facially independent and disinterested outside directors. Beginning in the summer of 2010, Rural’s board formed a special committee to explore acquiring Rural’s lone, national competitor, American Medical Response (AMR), a subsidiary of the publicly-traded Emergency Medical Services Corporation (EMS). EMS rejected Rural’s offer, but by the fall, Rural found itself on the receiving end of purchase offers by various private equity funds.
Rural rejected these offers, but the market’s interest in the emergency medical ambulatory space — and Rural specifically — was not left unnoticed by certain of Rural’s directors. Specifically, a director, who also served as chair of the special committee, had been placed on the board as a result of his hedge fund’s investment. The court characterized this director’s fund’s return strategy as “taking concentrated positions in small-cap companies, obtaining influence, and then facilitating an exit in three to five years.” Accordingly, the court characterized his view of an “M&A event” as the “next logical step” in his fund’s involvement with Rural. Another director faced resignation for being “over-boarded,” or being a director on too many boards, and a Rural sale would relieve him of his role without penalty to his equity interests in Rural. Lastly, even the one director who initially resisted a sale — Rural’s CEO and President — ultimately concluded that a sale would be in his better interests because he hoped that new owners were more likely to support a long-term growth strategy of Rural’s business. Therefore, the court found that at least three of the directors had “personal circumstances that inclined them to a near-term sale” of Rural and that, although there were no allegations of breaches of the duty of loyalty, this was the “boardroom environment” at the time that an investment bank was brought on board to assist the special committee in considering strategic alternatives.
Consequently, in December 2010, the investment bank reached out to the hedge-fund affiliated director (with whom it had a prior relationship) and the CEO and President to inform them that EMS was officially “in play” and that certain private equity funds viewed Rural as a strategic partner in the acquisition. Internally, the investment bank realized that a private equity firm that acquired EMS could either (a) sell AMR to Rural or (b) seek to purchase Rural. It recognized that it could “use its position as sell-side advisor” to Rural to secure buy-side roles (financing) to a bidder for EMS.
In any event, the hedge fund-affiliated director advised the board of what was happening with respect to EMS, and outlined three strategic alternatives for Rural in light of those facts: (i) sticking with Rural’s current standalone business plan; (ii) pursuing a sale of Rural; and (iii) pursuing an acquisition of AMR. Although he professed no preference for any one strategy, he did recommend that Rural’s board approve reconstitution of the special committee and retention of advisors to help its exploration. At that meeting, the director also took over as chairman of the board.
What exactly happened next became the subject matter of a four day trial. In short, the court found that the hedge-fund affiliated director took control of the process, and convinced the special committee – rather than the board – to retain the investment bank as its advisor to explore various strategic alternatives, including the possibility of a Rural sale in which the investment bank could provide staple financing to potential buyers. Generally speaking, staple financing is a pre-arranged financing package offered to potential bidders in an acquisition by the investment bank advising the selling company. In these scenarios, the investment bank has the opportunity to not only make fees in its stead as an advisor, but also in its role as a lender. In the Rural case, the court determined that if the investment bank were able to take a piece of all sides in any EMS/Rural deal, it could have earned up to $60.1 million in fees — rather than simply $5 million in advisory fees for its representation of Rural. The court found this to be a “powerful reason” for the investment bank to “take steps to promote itself as a financing source at the expense of its advisory role” from the very beginning of its engagement. Indeed, the board minutes reflected that Rural’s counsel advised the board that it would have to be “active and vigilant” in ensuring the integrity of the process given the possibility of a conflict of interest for the investment bank. The board, however, did not authorize the special committee to hire a “‘sellside’ advisor or initiate a sale process. It only authorized the special committee to retain the investment banker to analyze the range of strategic alternatives available and make a recommendation to the board.”
Shortly after the investment bank’s retention and without the board’s approval, the hedge-fund affiliated director and the investment bank quickly put Rural “in play.” From the court’s perspective, the investment bank created a “parallel-process” that favored its interest in fee maximization, despite the “readily foreseeable” problem that financial sponsors who participated in the EMS process would be limited in their ability to consider Rural simultaneously because they would be constrained by confidentiality agreements they signed as part of the EMS process. At the same time, another investment bank advisor to Rural provided management with a presentation that concluded it was premature to sell the business and that it should execute on a long term growth strategy that would ultimately ensure that, when and if it was sold, it would obtain the highest price possible. Neither the members of the special committee nor the board were provided with this report.
After receiving six bids of interest, the special committee — not the board — held a meeting to discuss each and relevant next steps. One of the potential bidders had won the EMS process and asked to push back the bid deadline for Rural so that certain of the confidentiality issues could be resolved. However, other bidders refused to agree to such an extended process, as that would result in increased competition (and an increased price) for Rural.
The board was finally called to convene and discuss the offers approximately three months after the investment bank had initiated the sellside process. To the court, it was clear from the evidence presented that counsel to Rural was concerned that the process was not “defensible.” The investment bank did not provide a valuation analysis to the board and the minutes falsely claimed that the special committee had held formal meetings to discuss the various bids. The board considered extending the deadline for bids, but declined same in fear of losing other bidders. At the same time, the investment bank sought internal approval to fully underwrite a deal with the entity it had identified as the likely winner in any auction. It did not disclose this fact to the board.
Ultimately, the board received two bids — one from the bidder for which the investment bank sought to provide staple financing (which the bidder did not include as part of its bid) and the other from the entity that had won the EMS acquisition. The latter bidder, however, asked for additional time as it was unable to fully commit to a Rural transaction until it had closed on the EMS deal. It expressed its continued belief that a merger with it would have resulted in the highest price for Rural shareholders, but, in the court’s view, this was no longer relevant to the investment bank, who “just wanted a deal” to close. It was at this time that the interests of the investment bank and the hedge-fund affiliated director diverged. The director believed that Rural merited a higher sale price per share than what the investment bank’s preferred bidder had offered. The investment bank did not provide a valuation opinion, but rather circulated a one-page transaction summary that compared the metrics implied by the preferred bidder’s offer to the “metrics implied by Rural’s closing market price” of the previous day, which made the offered price look “great in comparison.” The special committee therefore authorized the investment bank to engage in final negotiations over price with the preferred bidder. The investment bank again did not disclose that it was seeking to provide staple financing to the deal if its preferred bidder won.
The preferred bidder increased its offer slightly to get the board of directors to a “quick consensus” on approving the sale, but said its offer would expire within three days. At this time, the investment bank made a “final push” to provide the staple financing, while also providing the fairness opinion (which, it again, did not disclose). It ultimately provided a written (and ultimately found to be defective) valuation analysis to the board less than twelve hours prior to the offer’s expiration. The board approved the merger. Shortly after its public announcement, shareholder litigation challenging the transaction was filed. The deal closed ultimately with 72% of shareholder approval.
The Court’s Legal Analysis
Prior to reaching the merits of the plaintiffs’ allegation that the investment bank aided and abetted a breach of the directors’ fiduciary duties on two grounds (defective process and materially false disclosures), the court faced a factual conundrum — the individual board members had settled with plaintiffs prior to the trial, but a predicate element of finding the investment bank liable was determining that the directors had breached their fiduciary duties in the first instance. Because judicial review of directors’ decisions in the M&A context in cash for stock deals requires “heightened scrutiny” under Delaware law, the burden of persuasion is generally on the director-defendants to show that their “actions were reasonable in relation to their legitimate objectives.” In order to do so, directors generally have to establish the reasonableness of the process employed and the actions taken in light of the particular circumstances at issue. Because, however, the claim was for aiding and abetting, the court explained that the burden of proof rested with the shareholders.
The investment bank argued that the exculpatory provisions in Rural’s certificate of incorporation barred the plaintiffs from proving a breach. Pursuant to section 102(b)(7) of Delaware General Corporation Law, a Delaware corporation may provide for the elimination of a director’s personal liability for monetary damages resulting from his or her breach of the fiduciary duty of care. The court clarified, however, that the existence of such an exculpatory provision does not eliminate the underlying duty of care; rather it places a limitation on liability. Further, the court explained that the exculpatory provisions only protect directors, and not aiders and abettors. Therefore, the investment bank could not rely upon the exculpation provisions to foreclose a determination of the predicate breach.
Given the evidence presented, the court determined that certain decisions by the board fell outside the range of reasonableness. The court explained that, in merger proceedings, a board cannot be passive. Rather, its members must be active, informed, and knowledgeable participants that consider all alternatives, and have a “reasonable understanding” of the value of engaging in the transaction — as well as not engaging in the transaction at all. The court further noted that adequate time to consider the terms of a transaction is essential as “[h]istory has demonstrated [that] boards [that] have failed to exercise due care are frequently boards that have been rushed.” Lastly, the court emphasized that an essential element of being active and engaged includes providing “direct oversight” of advisors and to “learn about actual and potential conflicts faced by directors, management and their advisors.” Because of the “central role” played by investment banks as “gatekeepers” in the M&A process, this oversight requirement is of even greater importance.
The court found that there were a number of errors committed by the board in the sale process, such as (i) the fact that the board had never actually authorized the investment banker or the special committee to pursue a sale (and yet permitted its pursuit); (ii) its deference to the hedge-fund affiliated director in pursuing a sale transaction in the first instance; and (iii) the failure of the board to oversee the investment banker’s actions in conducting the sale. Indeed, the court characterized certain of the investment bank’s ostensibly deceptive actions (such as its “secret lobbying” to provide staple financing to the successful bidder) as being the direct result of the board’s “failure to place meaningful restrictions” on it. The court concluded that it was the combination of the investment bank’s “behind the scenes maneuvering, the absence of any disclosure to the board” of same, and the “belated and skewed valuation deck” provided by the investment bank that caused the board’s decision to approve the successful bid to “fall short” under the heightened scrutiny standard. Because the process was defective, the court reasoned, the directors’ actions were unreasonable.
Turning to whether the investment bank knowingly assisted the board in breaching its fiduciary duties, the court found that it was not essential to establish the investment bank’s fraudulent intent or self-dealing; purposeful inducement was enough. Because the investment bank’s actions were a “substantial factor” in the directors’ breach and the investment bank “created the unreasonable process and informational gaps” that lead to the breach, the court found that the investment bank knowingly participated in the breach. Further, the court determined that the investment bank’s engagement letter — which disclosed its potential interest in providing such staple financing in generic, rather than specific, terms — was not adequate disclosure under the circumstances and could not be used as a general “non-reliance disclaimer.”
Lastly, the court had to determine whether the shareholders were damaged by the aided-and-abetted breach. The court found that the evidence at trial established that the price paid for Rural’s stock at the time of the sale exceeded the successful bidder’s price. The court determined that Rural was taken to a fabricated and uncompetitive market prematurely, and that its going concern value exceeded what stockholders received on the merger, establishing the requisite harm.
As to plaintiffs’ disclosure claims, the court found that the plaintiffs established that the investment bank’s valuation analysis and failure to fully disclose its conflicts of interest were additional grounds for finding aiding-and-abetting breach. As the court noted “a disinterested board with a disinterested advisor” would likely not have reached the same conclusions that the Rural board reached.
In closing, the court determined that it was not yet ready to fashion a remedy, but asked for additional briefing and revised evidence on damages, claims for contribution by the investment banker against the directors, and the plaintiffs’ request for fee shifting.
The Bankruptcy Take-Away
Advisors in bankruptcy are familiar with the disinterestedness provisions of the Bankruptcy Code. Under well-established precedent, the general rule to establish disinterestedness is “disclose, disclose, disclose!” Further, directors of debtors in possession understand that their fiduciary obligations flow to the estate and its stakeholders. Accordingly, per well-established precedent, the best practice is to ensure that both the process and the actions taken are reasonable, based on informed judgment, and consistent with one’s fiduciary and professional responsibilities. Interestingly, in the context of sales or mergers in bankruptcy, the Rural/Metro decision could potentially be used by constituents challenging the debtor’s business judgment to advocate for a more careful review of a board’s decision. Where there are potential conflicts of interest, some may advocate that such additional review is appropriate to ensure that the estate receives the highest and best price. Ultimately, time will tell what the effect, if any, Rural/Metro may be in the context of bankruptcy law. The Weil Bankruptcy Blog will provide updates as additional information on the case unfolds.
Post-Mortem Note: Rural/Metro commenced cases for chapter 11 bankruptcy in the Delaware Bankruptcy Court on August 4, 2013. Its plan of reorganization, which gave equity to creditors in the reorganized business and cancelled existing equity interests, became effective as of December 31, 2013. It continues to operate today.