RBC Capital Markets v. Jervis: Delaware Supreme Court Affirms "Rural/Metro" with Narrower View of Financial Advisor Liability; Describes Trigger for Revlon Duties

Practical Law Legal Update w-001-0212 (Approx. 12 pages)

RBC Capital Markets v. Jervis: Delaware Supreme Court Affirms "Rural/Metro" with Narrower View of Financial Advisor Liability; Describes Trigger for Revlon Duties

by Practical Law Corporate & Securities

Background

The Supreme Court's ruling in RBC stems from four Chancery Court opinions, two of which contained the Chancery Court's main findings on matters of corporate law:

On March 7, 2014, the Chancery Court in In re Rural Metro Corp. S'holders Litig., 88 A.3d 54 (Del Ch. 2014) (Rural I), found RBC Capital Markets liable for aiding and abetting breaches of fiduciary duty committed by former directors of Rural/Metro Corporation in connection with the sale of Rural/Metro to an affiliate of private equity firm Warburg Pincus LLC. For a summary of the underlying merger agreement, see What's Market, Warburg Pincus and Rural/Metro Corporation Merger Agreement Summary. In Rural I, the Chancery Court held that the directors had breached their duty of care through their conduct in the sale process, that the company's financial advisor RBC Capital Markets had aided and abetted that breach, and that while the directors were exculpated from monetary damages for the underlying breach, their aiders and abettors were not.
On October 10, 2014, the Chancery Court set the amount of RBC's liability at $75,798,550.33, constituting 83% of the $91,323,554.61 in total damages that the class plaintiffs suffered, which represented the difference between the value the stockholders received in the merger and the company's value as a going concern (102 A.3d 205 (Del. Ch. 2014)) (Rural II). The Chancery Court held in Rural II that RBC could not seek contribution from the directors, the targets of RBC's wrongdoing.

The essence of the factual background of the case is that RBC Capital Markets designed and ran the Rural sale process for the sake of maximizing its chance of winning the opportunity to provide staple financing to the eventual acquirer of the company.

Before the merger, the company had seven directors, three of whom comprised the board's special committee. The committee was first formed in August 2010 after RBC—which had had a relationship with the company in relation to debt-financing transactions and other advisory matters—advanced the idea of Rural acquiring its primary competitor American Medical Response, Inc. (AMR). Director Christopher Shackelton was the committee's chair and played the most significant role on it, with the other two committee members generally deferring to him. RBC was hired by the special committee as the company's primary financial advisor in late 2010 on an engagement to explore strategic alternatives. The company also engaged Moelis & Company as a secondary financial advisor.

At the time, AMR was a subsidiary of a company called Emergency Medical Services Corporation (EMS). In early December 2010, with EMS rumored to be in play, RBC recognized that if Rural engaged in a sale process led by RBC, RBC could use its position as a sell-side advisor to secure buy-side roles with private equity firms bidding for EMS and even get in on EMS's financing trees. The Chancery Court found that RBC did not disclose to the Rural board that it planned to use its engagement as Rural's advisor to capture financing work from the bidders for EMS. The Chancery Court also found that the decision to initiate a sale process at that time was unreasonable because the board did not make the decision to launch a sale process, nor did it authorize the special committee to start one. The Chancery Court further concluded that the initiation of the sale process was unreasonable because RBC did not disclose that proceeding in parallel with the EMS process would serve RBC's interest in gaining a role on the financing trees of bidders for EMS. In essence, RBC treated the Rural engagement as an angle to obtain EMS work, the fees for which were more than ten times the simple advisory fee from Rural.

In December 2010 and January 2011, RBC developed and attempted to manage a two-track bidding process in which bidders could simultaneously diligence and bid for both Rural and its competitor EMS. In this process, there were two main groups of buyers:

One comprised primarily of those participating in the EMS process.
A second grouping generally comprised of those bidders that had dropped out of the EMS process or had interest in Rural as a standalone deal.

RBC sent bid instruction letters to 21 private equity firms that had signed confidentiality agreements. The process created readily foreseeable problems for the protection of confidential information in a process in which bidders were made to engage in parallel investigations of two direct competitors. Yet the board of Rural had had no input into the design of the process, with the full board not having met since December 8, 2010. RBC essentially ran the process with the involvement only of Shackelton and CEO Michael DiMino.

On January 24, 2011, DiMino heard a presentation from a team from J.P. Morgan. The J.P. Morgan team urged DiMino to postpone its sale process until the EMS sale could be completed and until strategic buyers, who had been focused on their own change-of-control transactions at the time, could get more involved. Nevertheless, the sale process proceeded apace. The Chancery Court found that RBC's faulty design prevented the emergence of the type of competitive dynamic among multiple bidders that is necessary for causing the best available price to surface. The company did eventually receive two bids, from Warburg Pincus and private equity firm CD&R, both for $17.00 per share. Warburg had been able to focus on a bid for Rural because it had dropped out of the bidding for EMS, while CD&R, the eventual acquiror of EMS, could explore synergies with Rural that were not available to other private equity firms.

At subsequent presentations to the special committee and full board, RBC presented only the thinnest of presentation materials, with no valuation metrics or preliminary drafts of fairness opinions. At one executive session of a special committee meeting, without the financial advisors present, legal counsel discussed the Chancery Court's holding in Del Monte on the need to monitor financial advisors who seek to provide staple financing. At a March 15, 2011, meeting of the full board, the board adopted a resolution that the Chancery Court described as a confirmation of the authority that Shackelton and RBC had already assumed for themselves.

On receiving offers from Warburg and CD&R, Shackelton's focus changed to seeking a higher price, while RBC just wanted to get a deal done and secure financing work from Warburg. The special committee rejected both offers, again without the benefit of any valuation materials beyond a one-page summary. Warburg increased its bid to $17.25 per share, without staple financing from RBC. Although its engagement letter with Rural authorized it in general terms to provide staple financing, RBC did not disclose to the board that it would continue to seek a buy-side financing role with Warburg.

When the time came for preparing a fairness opinion, RBC worked to lower its valuations so Warburg's bid would look more attractive. The board did not receive any valuation information until three hours before the meeting to approve a deal with Warburg, and did not know about RBC's manipulation of its valuation metrics.

The proxy statement was also found to contain materially misleading disclosures. The proxy statement contained false information about the financial information presented to the board and about RBC's incentives and conflicts of interest. The proxy statement omitted discussion of RBC's staple financing efforts in both the Rural and EMS sales and of RBC's last-minute efforts to reserve a place on Warburg's financing tree.

Outcome

RBC did not refute the principal factual findings underpinning the Chancery Court's decisions. RBC raised various legal issues on appeal, primarily contending that:

The Chancery Court had erred by holding that the board had breached its duty of care under the enhanced scrutiny standard of Revlon.
The Chancery Court had erred by holding that the board had violated its duty of disclosure by making material misstatements and omissions in the proxy statement.
RBC had not aided and abetted any breaches committed by the board.
It was inappropriate as a matter of policy for a financial advisor to be held liable for aiding and abetting a breach for which the directors themselves were exculpated.

The Supreme Court rejected RBC's arguments, in some instances on the same grounds articulated by the Chancery Court, in others on narrower grounds.

Enhanced Scrutiny under Revlon

As discussed in Malpiede v. Townson and many cases since, enhanced scrutiny under Revlon does not change the nature of fiduciary duties owed by directors, despite the shorthand phrases like "Revlon duties" and "heightened duties" that are commonly used to reference enhanced scrutiny (780 A.2d 1075, 1083 (Del. 2001)). Rather, Revlon emphasizes that the board must perform its fiduciary duties in the service of a specific objective, namely, to maximize the sale price of the enterprise. Revlon requires the court to examine whether the board's overall course of action in pursuit of that objective was reasonable under the circumstances. As discussed by the Supreme Court most recently in C&J Energy Services, there is no single blueprint that a board must follow to fulfill its duties, and the court must determine only whether the board made a reasonable decision, not a perfect one (107 A.3d 1049, 1066 (Del. 2014)).

On appeal, the parties in RBC did not contest that Revlon applies. They only differed as to when it was triggered and whether it had been satisfied.

Revlon Retroactively Triggered to when Special Committee Initiated Sale Process

As the Delaware Supreme Court ruled in Lyondell, enhanced scrutiny does not attach simply because the target company is "in play" (970 A.2d 235, 242 (Del. 2009)). Rather, a sale of the enterprise must have become inevitable. RBC therefore contended that Revlon was triggered in this case at the point where the auction was coming to an end and two bids remained, which is when the board was in a position to decide whether to sell the company. Until then, RBC argued, a sale could not have been inevitable, because Shackelton could not have sold the company absent board approval.

Were RBC to succeed on this argument, all of the board's and RBC's questionable conduct from December 2010 to March 2011 would be free from reasonableness review. However, the Chancery Court had held that the initiation of the sale process was in December 2010, when the special committee, without board authorization, hired RBC to sell the company. The Supreme Court agreed, for these reasons:

Ratifying resolution. Without genuinely exploring other strategic alternatives, the special committee initiated an active sale process in December 2010. The board, on March 15, 2011, passed a resolution restating and ratifying the actions of the special committee taken over the past three months. This resolution reflected the board's recognition of, and attempt to fix, the problem of a special committee exceeding its authority. Though this is an imperfect method for initiating a sale process, perfection is not the standard and the court could reasonably deem the sale process to have been initiated in December 2010. While a sale would not necessarily have been inevitable at that point, the Supreme Court has recognized that the initiation of an active sale process triggers Revlon (Arnold v. Soc'y for Sav. Bancorp, Inc., 650 A.2d 1270, 1290 (Del. 1994)).
Process initiated by the company itself. The Supreme Court distinguished the facts of Lyondell for purposes of RBC's proposition that Rural was merely "in play" until March 2011. Lyondell involved a third party putting the target company in play by filing a Schedule 13D, and the target board responded with a decision that it would neither put the company up for sale nor implement defensive measures to fend off a possible hostile bid. In RBC, by contrast, the process was initiated by Shackelton, Rural's own Chairman of the board and of the special committee.
Policy. The Supreme Court expressed a concern that if RBC could postpone application of Revlon to the end stages of the sale process, it would allow the board to benefit from a deferential standard of review precisely when the board and RBC engaged in a flawed and conflict-ridden process.

In point of fact, much of the court's ruling on this issue is difficult to understand and surprising for its lack of analytical rigor. In its discussion of the triggering based on the ratifying resolution, the court relies on the principle that perfection is not required in Revlon claims. But this principle is meant to benefit the board, in the sense that once Revlon applies, the board does not have to conduct a perfect process to satisfy it. The principle that perfection is not required had not previously been understood to stand for the idea that the court can be imperfect about finding a trigger of Revlon duties in the first place.

The policy rationale cited by the court seems to be little more than a confession that Revlon applies because that is what the court wants to apply. The court also adds a concluding statement to its discussion of the difference between Lyondell and RBC that "we confine our holding to these unusual facts and do not view our affirmance of the trial court's holding as a departure from our prior case law." The court then footnotes a rationale that if the court were to apply Revlon at the end of the sale process, directors would be incentivized to avoid active engagement in the sale process until the very end, thereby avoiding enhanced scrutiny of as much of the process as possible. This seems like an important, broadly applicable point to make, except that the footnote comes at the end of the court's narrowing statement of its second rationale, that it is restricting its holding to the narrow facts of the case.

Ultimately, then, the only takeaway that may be available from this section of the court's opinion is that a board that has not otherwise been engaged in the process can potentially activate Revlon retroactively if it ratifies the previous actions taken by the special committee.

Post-Signing Market Check Did Not Suffice

The Supreme Court agreed with the Chancery Court that the board's overall course of conduct failed Revlon scrutiny. The Supreme Court highlighted that:

The solicitation process, running parallel with the sale process being conducted by EMS, was structured and timed in a manner that impeded interested bidders. While in isolation this decision may have fallen within a range of reasonableness, it deserved to be reviewed more skeptically in light of RBC's undisclosed conflicts of interest.
The confidentiality restrictions would have prevented bidders from learning enough information to make an offer.
The board, not knowing of RBC's conflicts of interest, took no steps to mitigate them.

RBC responded that the court's recent decision in C&J Energy Services stands for the proposition that the board's market check does not have to involve an active solicitation, so long as interested parties have a fair opportunity to present a superior offer and the board has the flexibility to accept it. Thus, the post-signing market check in this case—which produced no superior offers—should cleanse the sale process of whatever pre-signing deficiencies it may have suffered from.

The Supreme Court rejected this reading of C&J Energy Services for ignoring that Rural's stockholders did not have enough information to fully evaluate Warburg's offer. The C&J decision had emphasized that the board can only rely on a passive market check when, in evaluating the merits of the transaction for its own satisfaction, it can "take into account that its stockholders would have a fair chance to evaluate the board's decision for themselves." This condition is only satisfied if the stockholders will be fully informed when they vote on the merger. Here, by contrast, the stockholders were unaware of RBC's conflicts and how those conflicts potentially impacted the Warburg offer. The board therefore could not offload its evaluation of the merits of the transaction to a passive market check.

For more on the efficacy of passive market checks, see Legal Update, C&J Energy Services v. City of Miami GESERT: Delaware Supreme Court Reverses Chancery Court, Rules that Passive Market Check Satisfied Revlon.

Post-Closing Liability Without Gross Negligence

The Supreme Court recently held in Corwin that the Revlon standard only applies when reviewing the board's conduct for pre-closing injunctive relief, while review reverts to business judgment once the stockholders have approved the merger (see Legal Update, Delaware Supreme Court Affirms "KKR," Lowers Standard of Review from Enhanced Scrutiny to Business Judgment when Merger Approved by Fully Informed Stockholder Vote). On this basis, RBC argued that the Chancery Court needed to (and did not) find gross negligence on the part of the directors to find a due care violation.

The Supreme Court rejected this argument. As it explained, when disinterested directors themselves face personal liability, the law requires that they be deemed to have acted with gross negligence in order to sustain a monetary judgment against them. That does not mean, however, that if they were subject to Revlon duties, and their conduct was merely unreasonable, that there was not a breach of fiduciary duty. In this case there was such a breach, which was enough to sustain a claim of aiding and abetting against RBC.

The Disclosure Omissions Were Material

RBC made three challenges to the Chancery Court's analysis with respect to the class plaintiffs' disclosure claim:

RBC did not falsely summarize the valuation analysis.
The board and stockholders were aware of RBC's role in the EMS financing as a result of a February 14, 2011, press release that identified RBC among the banks providing financing in that transaction.
RBC did not make materially misleading disclosures about the board's conclusion as to RBC's ability to provide financing to potential buyers.

The Supreme Court explained that for an omission to be considered material, "there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available" (Arnold, 650 A.2d at 1277). Stated another way, "omitted facts are material 'if there is a substantial likelihood that a reasonable stockholder would consider them important in deciding how to vote'" (Skeen v. Jo-Ann Stores, Inc., 750 A.2d 1170, 1172 (Del. 2000)).

The Chancery Court concluded that the board's omissions satisfied the test for materiality, and the Supreme Court did not disagree. In particular, the disclosure that RBC had the right to provide staple financing was only a partial disclosure and did not describe RBC's efforts to provide staple financing to Warburg. The disclosure that RBC could provide financing on terms not otherwise available to Rural buyers was also false.

Aiding and Abetting Liability

In Malpiede, the Supreme Court described the elements of aiding and abetting breaches of fiduciary duty as:

The existence of a fiduciary relationship.
A breach of the fiduciary's duty.
Knowing participation in the breach by the third-party defendants.
Damages proximately caused by the breach.

(780 A.2d at 1096.)

RBC argued that it could not have aided and abetted the board's breach of its duty of care, because a third party cannot "knowingly participate" in a breach that is exculpated and therefore not "inherently wrongful." RBC also argued that it could not have knowingly participated in a breach if the directors were themselves misled into breaching their fiduciary obligations.

The Supreme Court upheld the Chancery Court's "narrow holding" that a third party is liable for aiding and abetting if it knows that the board is breaching its duty of care and participates in the breach by misleading the board or creating an informational vacuum. This knowing participation must be acted on with scienter. Scienter is established when the third party acts knowingly, intentionally, or with reckless indifference. A plaintiff establishes the presence of scienter when it demonstrates that the third party had actual or constructive knowledge that its conduct was legally improper. The Chancery Court found that RBC acted with the necessary degree of scienter, and the Supreme Court affirmed that the evidence supported that finding.

RBC knowingly exploited its own conflicted interests to the detriment of Rural by creating an informational vacuum. Key facts demonstrating RBC's actual knowledge of this exploitation included:

RBC's failure to disclose its interest in obtaining a financing role in the EMS transaction and how it planned to use its engagement as Rural's advisor to capture buy-side financing work from bidders for EMS.
Its knowledge that the board and special committee were uninformed about Rural's value.
Its failure to disclose to the board its interest in providing the winning bidder in the Rural process with buy-side financing.
Its eleventh-hour attempts to secure that role while simultaneously leading the negotiations on price.

The "manifest intentionality of RBC's conduct," as the Supreme Court put it, as evidenced by the bankers' own internal communications, demonstrated RBC's knowledge of the reality that the Rural board was proceeding on the basis of fragmentary and misleading information. The result of having an uninformed board at the helm of a company going through a sale process was a poorly timed sale at a price that was not the product of appropriate efforts to obtain the best value reasonably available. This was the "inherently wrongful" conduct in which RBC knowingly participated.

Knowing Participation when the Board Has Been Misled

As to the metaphysical question of how a "victimized" board could have engaged in wrongdoing in the first place to support a finding of aiding and abetting, the Supreme Court pointed to the Chancery Court's finding that the board had acted wrongfully, in a manner not caused by RBC, when the board failed to oversee the unauthorized initiation of the sale process (see footnote 177).

Implicit in this response, though, is that without wrongful conduct independent of the aider and abettor, the third party cannot in fact be liable for aiding and abetting. Still, in any factual scenario in which the sale process has been conducted poorly, there is likely some hook the court can find for a breach committed by the board without the help of the advisor.

Proximate Cause

To establish proximate cause, a plaintiff must show that the result would not have occurred but for the defendant's action. RBC argued that Moelis's presence in the negotiations cut the causal link between RBC's conduct and the board's breach.

Moelis Involvement Did Not Remedy RBC's Conduct

Under Delaware law, in order to break the causal chain, the intervening cause must also be a superseding cause—a new and independent act that was neither anticipated nor reasonably foreseeable. The court held that the board's receipt of Moelis's financial analysis—which the special committee treated as "secondary" to that of RBC—did not remedy RBC's improper conduct, nor destroy the causal link between RBC's actions, the board's failure to satisfy itself of its fiduciary obligations, and the harm suffered by the stockholders.

RBC's argument that Moelis's involvement cleansed the process failed because Moelis was paid on the same contingent basis as RBC. Although a contingency fee that pays an advisor a percentage of the deal value can have the positive effect of aligning the interests of the advisor with the target company, there exists the potential for misalignment of incentives over whether to take a deal in the first instance. Here, because RBC was motivated to take any deal, Moelis's contingent fee did not act as a counterbalance against RBC's incentive. Moelis's presence also did nothing to correct the misleading disclosures in the proxy statement concerning RBC.

No Imbalance of Responsibilities

The Supreme Court addressed an additional argument that finding liability for aiding and abetting would create an anomalous imbalance of responsibilities in which a non-fiduciary may be held liable for an unintentional violation of a fiduciary duty by a fiduciary. The court considered this concern overstated, since the court had already ruled that RBC had "intentionally duped" the board into pursuing and accepting the deal. Given that RBC had purposely misled the board so as to proximately cause the board to breach its duty of care, the court characterized its decision as "narrow," not to be read as attaching liability to financial advisors whenever they are around for a deal in which the board commits a minor breach.

No Gatekeeper Role

The court emphasized that its opinion in RBC "should not be read expansively to suggest that any failure on the part of a financial advisor to prevent directors from breaching their duty of care gives rise to a claim for aiding and abetting that breach." Here the court parted with the Chancery Court most starkly, emphasizing in a long footnote that it was not adopting the Chancery Court's description of the financial advisor role as that of a "gatekeeper." In the Supreme Court's view, the Chancery Court's gatekeeper description does not adequately take into account the fact that the role of a financial advisor:

Is primarily contractual in nature.
Is typically negotiated between sophisticated parties.
Can vary based upon a myriad of factors.

By contrast, adhering to the Chancery Court's "amorphous 'gatekeeper' language" would inappropriately expand the narrow holding of RBC by suggesting that any failure by a financial advisor to prevent directors from breaching their duty of care gives rise to an aiding and abetting claim against the advisor.

Financial Advisor Liable for Damages in Spite of 102(b)(7) Provisions

The Supreme Court upheld the Chancery Court's detailed damages calculation and agreed that the Section 102(b)(7) exculpatory provision in the company's certificate of incorporation does not shield RBC from liability.

RBC argued that from a policy perspective, it does not make sense to hold a third party liable for monetary damages for a breach for which the directors are exculpated, because the purpose of Section 102(b)(7) is to eliminate monetary liability, not shift it. But in the Supreme Court's judgment, the provision operated exactly as intended.

The statute's purpose in exculpating directors from monetary liability for breaches of the duty of care is to clear directors to take business risks without worrying about negligence lawsuits. This purpose does not extend on any policy grounds to non-fiduciaries. Section 102(b)(7) insulates directors from monetary damages stemming from the breach of the duty of care; it does not insulate third parties. If it did, the statute would create a perverse incentive in which advisors could, for their own motives, intentionally mislead a board only to "hide behind their victim's liability shield" when the corporation seeks retribution for the wrongdoing.

To this view RBC argued that if that is the correct interpretation of Section 102(b)(7), stockholders—who voted to place such exclusions from liability in their corporate charters—would be able to shift damages from the directors, who are primarily liable but who are statutorily immunized from a damages claim, to a non-immunized financial advisor. In effect, then, the court would be turning financial advisors into sureties for grossly negligent directors who can approve M&A transactions with no risk of liability to the directors themselves.

The Supreme Court, however, saw no inequitable treatment. In the financial advisor's benefit, the court reminded, the advisor must act with scienter in order to be found liable for aiding and abetting. Directors, by contrast, are liable on a lower standard of gross negligence.

No Contribution from Directors

RBC argued that the Chancery Court erred by concluding that RBC could not seek contribution from the directors because it (RBC) had unclean hands. The Supreme Court agreed with the Chancery Court that RBC had forfeited its right to contribution, because to allow it here would be to allow RBC to take advantage of the targets of its own misconduct.

Practical Implications

The Supreme Court's decision affirms many of the core legal principles first aired by the Chancery Court in Rural I. The threat of liability for financial advisors exists when they aid and abet a breach committed by the board, even though the directors themselves are exculpated from damages through a 102(b)(7) clause. This principle does not change from the Chancery Court's 2014 decisions.

Aiding and abetting, however, is not established whenever the bankers happen to have been around and failed to prevent a breach committed by the board. The Supreme Court's decision assures that a high degree of culpability is required on the part of the financial advisor to establish liability. That degree is satisfied when the advisor knowingly creates an informational vacuum for the board for its own, conflicted purpose, and does not disclose that conflict to the board or stockholders. In this regard, footnote 191 of the decision will likely be a source of comfort for financial advisors, who had been most irked by the "gatekeeper" description in Rural I.

Although the court acknowledges that engaging a second financial advisor can have a salutary effect, the court cautions that the cleansing effect is not universal. Rather, the compensatory arrangements of the two banks should be structured so that the second bank's incentives are aligned more closely with the company than with the first bank.

The decision is also useful for its discussion of retroactive triggering of Revlon, even though, as discussed above, the analysis is somewhat muddled. At a minimum, boards and their counsel are on notice that if the special committee (or even just the chairperson of the special committee) genuinely initiates a sale process, the board, though unaware at the time, can later insert itself into Revlon mode starting back on that date if it ratifies the actions taken by the runaway committee.

RBC Capital Markets v. Jervis: Delaware Supreme Court Affirms "Rural/Metro" with Narrower View of Financial Advisor Liability; Describes Trigger for Revlon Duties | Practical Law