Boards must be alert for signs of investment advisors’ conflicts of interest

Boards of directors must be vigilant when hiring and using M&A advisors: hidden conflicts of interest can harm shareholders and create liability for board members and their advisors. A recent Delaware case lays bare a worst case example of what can happen.

Vice Chancellor J. Travis Laster’s opinion In re Rural Metro Corporation Shareholders Litigation, No. 3650-VCL, 2014 WL 971718 (Del. Ch. March 7, 2014) is a gripping read, detailing how a transaction that looked completely proper on paper was in fact deeply flawed and shortchanged stockholders. In short, the Board breached its fiduciary duties by hastily approving the sale of the company to Warburg Pincus at an unfairly low price.

That unfair price was reached because both the timing of the sale and the types of buyers solicited by the M&A advisor were driven by the self-interests of the board members on the special committee formed to consider strategic options, and those of the M&A advisor, RBC Capital Markets. One special committee member, whose hedge fund had invested substantially in Rural Metro, desperately wanted to sell it quickly because of the hedge fund’s needs. Another director needed to step down from Rural Metro’s board, but he stood to lose a lot of money by resigning unless Rural Metro was sold first. RBC was conflicted because it was trying to get very lucrative business from Warburg arising from the Rural Metro deal.

The flawed sale process was set in motion when the board designated a special committee to explore strategic options, including selling the company or sticking with its newly implemented growth strategy. Because of the hedge fund director’s focus on selling Rural Metro, however, the special committee simply hired RBC to facilitate the sale.

The sale process was so bad, and RBC’s role so integral to it, that RBC was found liable for aiding and abetting the board’s breaching its duty of care. That liability was particularly striking because the directors themselves were protected by a clause in the company’s certificate of incorporation that excuses board members for breaching their fiduciary duty of care. Whether the clause would have excused the board members’ breach  wasn’t tested because both the board and the secondary financial advisor, Moelis & Company, settled with stockholders before trial, leaving only RBC in the case.

While the misconduct described was extreme, the opportunity for such mischief is not so rare. RBC’s conflict was rooted in its desire to provide ‘staple financing,’ which the sell-side advisor sometimes seeks to provide to help the buyer pay the purchase price.

This conflict, far from being limited to the fact that the advisor has clients on both sides of the deal, extends to the relative sizes of the fees involved: helping with the financing can generate as much as 10 times the fees that advising the seller can. Thus, providing staple financing can give an M&A advisor a powerful motive to serve the buyer’s interests over the seller’s. In this case, RBC created flawed and misleading estimates of Rural Metro’s value to make the price Warburg wanted to pay appear fair. RBC also gave Warburg information about Rural Metro’s board that advantaged Warburg’s bargaining position over the board’s.

Nonetheless, ‘staple financing is not per se impermissible,’ and ‘could be useful in some transactions,’ explains Edward Smith, a partner at Chadbourne & Parke who has advised boards for nearly 50 years.

If the advisor had helped negotiate a good deal for the seller, but the purchaser was having trouble meeting the purchase price, the advisor would be helping the board by providing the financing to close the deal. Given the potential for conflicted interest, however, ‘when an investment advisor’s retainer agreement authorizes it to provide staple financing, the board should view this as a yellow flag,’ Smith says.

The standard response to staple financing ‘is to get a second firm to give a fairness opinion, although in this case it did not inoculate against the disease,’ because the second firm didn’t do its job well, explains Smith. The conflict, and the risk that it won’t be prevented by a second firm’s opinion, argue for standard best practices. ‘Directors have to show that they’re exercising vigorous oversight and are fully informing themselves as to all matters that reasonably appear relevant,’ Smith stresses. In Rural Metro, ‘the board failed to properly examine motivations and potential conflicts of the special committee members and the financial advisor.’

Smith also noted Judge Laster’s critique of the minutes of a key Rural Metro board meeting as not true in parts and appearing to have been created with an eye towards litigation. Smith recommends that minutes of board meetings be prepared in a timely and accurate manner.

Beyond the yellow flag of being authorized to provide staple financing, Smith says a board should ‘be nervous if an investment advisor only pursued one approach, such as a sale, instead of a range of options.’ Another bad sign would be limiting potential buyers to one type, such as financial buyers, and excluding strategic ones. Both instances occurred in Rural Metro; indeed, there was a strategic buyer that would have paid a higher price than Warburg if only Rural Metro had been willing to adjust the timing to allow its bid.

’The board failed to ask a critical question, which was: why sell now?’ Smith notes. Equally bad, ‘the board failed to properly inform itself on the critical question of value, and then it rubber stamped a transaction after only a cursory review of the flawed valuation analysis.’

To avoid such risks, Smith advises boards to conduct ‘an orderly, deliberate and full informed sale process,’ which includes ensuring the special committee is properly authorized and keeps the board fully and timely informed. He further urges boards ‘to explore all alternatives to determine what’s in the best interest of the stockholder, including perhaps not selling the company, or at least not selling now.’