June 01, 2014

For the third time in recent memory, the Delaware Chancery Court has ruled on problems that have occurred pertaining to Board approval of M&A transactions. Recent Delaware court cases such as Del Monte and El Paso weighed in on Boards’ breaches of fiduciary duty on transactions and while the ink is newly dry, another Delaware court case, Rural Metro, has found there were breaches of fiduciary duties involving the Board of Directors as well as aiding and abetting of such breaches by their investment bankers in the sale of the Company.

The spirit of these three Delaware cases highlights the Board’s responsibilities in entering into and approving M&A and recapitalization transactions. These cases have important implications for directors to consider as they contemplate transactions.

Rural Metro Corporation (“Rural Metro” or the “Company”) is a Delaware corporation headquartered in Scottsdale, Arizona and is a national provider of ambulance and fire protection services. In June 2011, Rural Metro merged with an affiliate of Warburg Pincus and each publicly held share of Rural Metro common stock was converted into the right to receive $17.25 in cash. The plaintiffs in the case contended that the Rural Metro Board breached their fiduciary duties by approving the merger and by failing to disclose material information in the Company’s definitive proxy statement. The plaintiffs also contended that the investment bank aided and abetted the directors’ breaches of fiduciary duty.

The Rural Metro case highlighted that, in the Court’s opinion, the Board was not involved adequately in the M&A process. Hiring an investment banker to advise a Board or Special Committee does not mean that a Board’s duties and involvement in the process can be abdicated. In fact, the Court stated that “directors cannot be passive instrumentalities during merger proceedings” and that directors must maintain “an active and direct role in the context of a sale of a company from beginning to end.”

According to the Court, in the case of Rural Metro, the issues began with the investment bank’s engagement. The investment bank was hired to explore three strategic alternatives including steady state, entering into a transaction with a close competitor and the sale of Rural Metro. Interestingly, the engagement of the investment bank morphed into a sale assignment and exploration of the other strategic alternatives appears to have been limited. Apparently no one on the Board challenged moving directly to a sell-side assignment without serious consideration of other strategic alternatives.

Another key issue highlighted by the Court was the investment bank’s failure to disclose its conflicts of interest to the Special Committee. While the investment bank’s engagement letter did contain a provision that it may arrange for stapled financing for a potential buyer of Rural Metro, the investment bank did not subsequently disclose to the Special Committee its ongoing attempts to provide financing during the sale process. In particular, the investment bank made a final push for a role in the winning bidder’s financing consortium all the way up until the Board’s vote to approve the transaction, all the while not disclosing such fact to the Board or the Special Committee. This was a key fact in the case. The investment bank’s main interest in the transaction was to provide financing in the transaction given how lucrative the financing fees would have been. The financing fees the investment bank sought were 10x the M&A advisory fees the bank was to receive in the transaction ($55 million vs. $5.1 million).

The investment bank was also found by the Court to have run a flawed M&A process in a few ways. First, the M&A process focused exclusively on private equity buyers and did not include strategic buyers. Several of the most prominent and likely strategic buyers for Rural Metro, including it’s largest domestic competitor, were waylayed by their own change of control sale processes during the Company’s own M&A process. The decision not to include strategic buyers was not challenged or explored significantly by the Special Committee. Secondly, the timing of the sale process designed by the investment bank ensured that many of the potential private equity players were conflicted. Given that the sale of its closest competitor was underway at the same time, many of the likely buyers were unable to bid on Rural Metro due to their participation in the competitor sale process and their possession of confidential information. Several bidders expressed interest in bidding on Rural Metro and asked whether the timing of Rural Metro’s process could be altered, but the investment bank declined to do so. Some potential bidders even stated that they would pay more than the final bid on the table by Warburg once the competitor process was completed.

Finally, the Delaware Court determined that there were informational gaps that led to the Board’s breach of its duty of care. During its initial pitch meeting for the engagement mandate from the Special Committee, the investment bank did provide the Board with materials regarding its view of the intrinsic value of Rural Metro on a stand-alone basis. Moreover, as the M&A process progressed, there were a few update meetings held with the Special Committee. However, while these meetings included information regarding the bids that had been received, they excluded any additional information about the fundamental underlying value of Rural Metro. While the investment bank did finally provide such information when the Board was set to vote on the sale of Rural Metro, the Board received the package containing this information only 3 hours before the meeting. Moreover, in its opinion on the case, the Court criticized the valuation information that was provided at this late stage as being inherently flawed. Specifically, it claimed that the investment bank changed certain assumptions in its valuation analysis from its prior drafts in order to put the winning bid in a more favorable light. The Court also criticized the investment bank’s process for review and approval of its fairness opinion by its internal fairness committee as being less robust than those employed by other leading investment banks. In this case, the Rural Metro bankers’ procedures did not require that committee members have prior fairness opinion experience (one of the committee members had not previously served on a fairness committee), and the committe did not meet until the day before the valuation package and fairness opinion was sent to the Board, hardly giving it enough time to ensure proper feedback to the deal team. According to the Court, the lack of valuation information that was provided during the process, as well as the flawed valuation analysis that was ultimately produced, put the Special Committee and the Board at an informational disadvantage when it came to understanding the final bid on the table (relative to other alternatives that the Board may have pursued including doing nothing, executing on the Company’s strategic plan, and thereby unlocking its intrinsic value), and, therefore, whether to proceed with the transaction.

In the Court’s eyes, the immediate morphing of the investment bank’s engagement to a sale process at the exclusion of other alternatives, the running of a flawed M&A process, the Board’s lack of understanding of valuation during the process and the flawed valuation information that it finally did receive, and the Board’s lack of awareness of the investment bank’s conflicts of interest all contributed to the Court’s finding that the Board breached its fiduciary duty. Boards of directors should take note of these findings in their next deal. Careful scoping of investment banking engagements, close monitoring of sale processes, including valuation factors and a thorough understanding of potential conflicts of interest in transactions, may help them to exercise their fiduciary duties and reduce the risk of successful litigation in a transaction.