Merger and acquisition activity appears to be accelerating among community banks large and small. Despite the nearly ubiquitous shareholder lawsuit that follows a merger announcement from a publicly traded target company, the corporate law relating to the obligations of a board of directors in a merger transaction is well developed and favorable. There is a high bar for board culpability in an M&A transaction, and an even higher bar for board liability. However, recent Delaware court cases have highlighted potential liability for investment bankers that is not shared by directors. This is quite an alarming development, which is of obvious concern to investment bankers, but also should impact boards of directors as they consider deals.
Under Delaware law, which is followed by most states, the primary obligations of the board in a merger transaction relate to good faith, a component of the duty of loyalty, and making an informed decision, duty of care. Fortunately, most companies have a charter provision eliminating director personal liability for monetary damages for breaches of the duty of care, which is not allowed for breaches of the duty of loyalty. And, according to the Delaware Supreme Court in the Lyondell case, director personal liability for “bad faith” requires a knowing violation of fiduciary duties. For example, in a sale transaction, shareholders aren’t supposed to act on a goal other than maximizing value, or in a non-sale merger, act for reasons unrelated to the best interests of the stockholders generally.
Another important hallmark of Delaware M&A case law is the extreme reluctance of judges to enjoin a stockholder vote on a merger transaction when there is no competing offer. And once a transaction closes, and the challenged target company directors were independent and disinterested, and did not act with the intent to violate their duties, judges typically dismiss the lawsuits against directors.
However, in a recent case, which involved the sale of a company called Rural/Metro Corporation, the Delaware Supreme Court ruled that third parties, such as investment bankers, can be liable for damages if their actions caused a board to breach its duty of care, even if directors are not liable for the breach. Moreover, simple negligence by the board, rather than gross negligence, can serve as the basis for third party liability.
In Rural/Metro, the investment bankers were found to have had numerous conflicts of interest, most of which were not discussed with the board. They sought to participate in the buyer’s financing of the acquisition and they sought to leverage their involvement with the seller, Rural/Metro, to obtain a financing role in another merger transaction. They were also found to have manipulated the fairness analysis to serve their conflicted interest in having a particular party win the bid for Rural/Metro. The court held the behavior of the investment bankers caused the board to be uninformed as to the value of the company and caused misleading disclosure. They were held liable to stockholders for $76 million in damages.
The Delaware Supreme Court stated that a board needs to be active and reasonably informed in its oversight of a sale process and must identify and respond to actual or potential conflicts of interest as to its advisers. Importantly, the Delaware Supreme Court rejected the lower court’s characterization of the role and obligations of an investment banker as a quasi fiduciary “gate keeper,” and stated that the obligations of an investment banker are primarily contractual in nature. It further held that liability of an investment banker will not be based on its failure to take steps to prevent a director breach but on its intentional actions causing a breach.
The case is a warning for both boards and investment bankers: Take care when there is a conflict of interest. Investment bankers should avoid conflicts where possible, disclose all conflicts to the board and the board and the investment bankers need to work diligently to address conflicts adequately. In order to do their job well, board members must make sure their advisors are telling them what they need to know.