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(Article from Securities Law Alert, December 2015) 

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Financial Advisor Held Liable for Intentionally Aiding and Abetting Board’s Breaches of Fiduciary Duty

On November 30, 2015, the Delaware Supreme Court affirmed post-trial decisions (1) finding financial advisor RBC Capital Markets, LLC ("RBC") liable for aiding and abetting breaches of fiduciary duty by the Board of Rural/Metro Corporation (“Rural”) in connection with Rural’s 2011 acquisition by Warburg Pincus LLC (“Warburg”); and (2) holding RBC responsible for 83% of the total damages that the class suffered. RBC Capital Markets, LLC v. Jervis, 2015 WL 7721882 (Del. 2015) (Valihura, J.) (Rural III).[1]

Background

On June 30, 2011, Warburg acquired Rural at a price of $17.25 per share (the "Merger"). Rural’s shareholders brought suit in connection with the acquisition. Plaintiffs contended that Rural’s directors, including the company’s President and CEO (collectively, the “individual defendants”), had “breached their fiduciary duties in two ways: first, by making decisions that fell outside the range of reasonableness during the process leading up to the Merger and when approving the Merger, and second, by failing to disclose material information in the definitive proxy statement … that [Rural] issued in connection with the Merger.” In re Rural/Metro Corp. S’holdrs. Litig., 102 A.3d 205 (Del. Ch. 2014) (Laster, V.C.) (Rural II). Plaintiffs also asserted aiding and abetting claims against RBC, Rural’s lead financial advisor, as well as Moelis & Company LLC, Rural’s secondary financial advisor.

Prior to trial, plaintiffs reached an agreement in principle to settle their claims against the individual defendants and Moelis. The case proceeded to trial against RBC only.

On March 7, 2014, the Delaware Chancery Court issued a post-trial decision holding RBC liable for aiding and abetting breaches of fiduciary duty by Rural’s directors. In re Rural Metro Corp., 88 A.3d 54 (Del. Ch. 2014) (Laster, V.C.) (Rural I).

On October 10, 2014, the Chancery Court in Rural II issued an opinion addressing RBC’s entitlement to a settlement credit under the Delaware Uniform Contribution Among Tortfeasors Act (“DUCATA”) and holding RBC liable for $75.8 million in damages.

RBC appealed both decisions.

Delaware Supreme Court Finds the Chancery Court Did Not Err in Applying Revlon’s Enhanced Scrutiny Standard to the Special Committee’s Actions in December 2010, Prior to the Rural Board’s Formal Decision to Sell the Company in March 2011

The parties agreed that the enhanced scrutiny standard articulated in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986) applied to plaintiffs’ breach of the duty of care claims against Rural’s directors. However, “they differ[ed] as to when, in the continuum between December 2010 and March 2011, Revlon’s enhanced scrutiny was triggered.” Rural III, 2015 WL 7721882. RBC contended that “the business judgment rule—not Revlon—applie[d] to the Board’s decision to explore strategic alternatives in December 2010.” According to RBC, Revlon did not apply until March 2011, when there were two bids on the table for Rural and the Board was “‘in a position of deciding to sell the [c]ompany—when the sale of the [c]ompany became inevitable.’”

On appeal, the Delaware Supreme Court explained that “enhanced scrutiny under Revlon is triggered . . . ‘when a corporation initiates an active bidding process seeking to sell itself,’” among other scenarios (quoting Revlon, 506 A.2d 173). The court explained that “the Court of Chancery, as a factual matter, found that there was no exploration of strategic alternatives” in December 2010. The Chancery Court instead “found that the Special Committee, acting ‘without Board authorization,’ ‘hired RBC to sell the [c]ompany’” in December 2010. The Delaware Supreme Court determined that there was “sufficient evidence in the record to support [the Chancery Court’s] conclusions.”

The Delaware Supreme Court “reject[ed] RBC’s attempt to delay the triggering of Revlon to late March 2011 for three reasons.” First, the court explained that in March 2011, the Rural Board “purportedly ‘restated and ratified’ the actions of the Special Committee, including the initiation of the sale process that had transpired over the preceding months.” The court found that “the March 15 ‘restatement and ratification,’ which deemed the actions of the Special Committee to be acts of the [c]ompany, undermine[d] RBC’s contention that Revlon should not apply because action by the full Board was required.”

Second, the court found that its earlier decision in Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (Del. 2009) was distinguishable because “that case involved a third party putting the target company in play.” Lyondell’s “directors decided that they would neither put the company up for sale nor institute defensive measures to fend off a possible hostile offer,” but instead “decided to take a ‘wait and see’ approach.” The Lyondell court held that “[t]he time for action under Revlon did not begin until . . . the directors began negotiating the sale of Lyondell.” Here, however, the Delaware Supreme Court found that the Special Committee had “initiated the sale process in December 2010” and the Board subsequently ratified those efforts. Rural III, 2015 WL 7721882. The court held that Revlon’s enhanced scrutiny standard therefore applied in this case beginning in December 2010. Notably, the court expressly “confine[d] [its] holding to these unusual facts” and did not consider its decision to be “a departure from” Lyondell.

Third, the Delaware Supreme Court found that delaying Revlon scrutiny until March 2011 “would allow the Board to benefit from a more deferential standard of review during the time when, due to its lack of oversight, the Special Committee and RBC [had] engaged in a flawed and conflict-ridden sale process.”

Court Finds Rural’s Directors Breached Their Revlon Duties

The Delaware Supreme Court “agree[d] with the Court of Chancery’s principal conclusion that the Board’s overall course of conduct fail[ed] Revlon scrutiny.” Under Revlon, a board may “pursue the transaction it reasonably views as most valuable to the stockholders, provided ‘the transaction is subject to an effective market check under circumstances in which any bidder interested in paying more has a reasonable opportunity to do so.’” The court noted that under its recent decision in C & J Energy Services, Inc. v. City of Miami General Employees’ & Sanitation Employees’ Retirement Trust, 107 A.3d 1049 (Del. 2014), “‘[s]uch a market check does not have to involve an active solicitation, so long as interested bidders have a fair opportunity to present a higher-value alternative, and the board has the flexibility to eschew the original transaction and accept the higher-value deal.’” Here, the Delaware Supreme Court found that “the evidence fully support[ed] the trial court’s findings that the solicitation process was structured and timed in a manner that impeded interested bidders from presenting potentially higher value alternatives.”

Rural’s Directors Did Not Fulfill Their Obligation to Uncover and Address RBC’s Conflicts of Interest

Based on the record, the Delaware Supreme Court found that RBC had designed the sale process for Rural to run in parallel with the sale process for Rural’s competitor, Emergency Medical Services Corporation, but did not disclose that RBC stood to benefit financially from this parallel sales structure. The court recognized that a parallel sales structure might arguably “fall within the range of reasonableness,” but explained that “such decisions must be viewed more skeptically” where, as here, “undisclosed conflicts of interests exist.” The court found that “Rural’s Board was unaware of the implications of the dual-track structure of the bidding process,” and consequently “took no steps to address or mitigate RBC’s conflicts.”

The Delaware Supreme Court underscored that “directors need to be active and reasonably informed when overseeing the sale process, including identifying and responding to actual or potential conflicts of interest.” The court clarified that “a board is not required to perform searching and ongoing due diligence on its retained advisors in order to ensure that the advisors are not acting in contravention of the company’s interests, thereby undermining the very process for which they have been retained.” However, the court explained that “the board should require disclosure of, on an ongoing basis, material information that might impact the board’s process.” The court acknowledged that “a board may be free to consent to certain conflicts,” but cautioned that “[a] board’s consent to a conflict does not give the advisor a ‘free pass’ to act in its own self-interest and to the detriment of its client.”

Rural’s Directors and Stockholders Were Not Adequately Informed of Rural’s Value

The Delaware Supreme Court further found that “Rural’s directors were not adequately informed as to Rural’s value.” Specifically, the court noted that the Board was “unaware of RBC’s conflicts and how they potentially impacted the Warburg offer.” The court explained that “‘[w]hen a board exercises its judgment in good faith, tests the transaction through a viable passive market check, and gives its stockholders a fully informed, uncoerced opportunity to vote to accept the deal,’ a court will have difficulty determining that such board violated its Revlon duties” (quoting C & J Energy, 107 A.3d 1049). Here, however, the court found that “both the Board and the stockholders were operating on the basis of an informational vacuum created by RBC.” The company’s “stockholders were [therefore] not fully informed when they voted to accept the deal.”

Plaintiffs Were Not Required to Plead Gross Negligence to Establish a Breach of the Directors’ Revlon Duties

The Delaware Supreme Court explained that “[w]hen disinterested directors themselves face liability,” plaintiffs must establish that the directors “acted with gross negligence in order to sustain a monetary judgment against them.” However, the court stated that this prerequisite for monetary damages “does not mean . . . that if [directors] were subject to Revlon duties, and their conduct was unreasonable, that there was not a breach of fiduciary duty.” The court agreed with the Chancery Court’s determination that the directors had “breached their fiduciary duties by engaging in conduct that fell outside the range of reasonableness, and that this was a sufficient predicate for its finding of aiding and abetting liability against RBC.”

Court Finds Rural’s Directors Breached Their Disclosure Obligations

The Delaware Supreme Court affirmed the Chancery Court’s finding that “the Proxy Statement incorporated a false valuation analysis” that “did not accurately represent RBC’s analysis.” The court also agreed with the Chancery Court’s determination that “[t]he Proxy Statement’s discussion of RBC’s right to offer staple financing was a partial disclosure.” The court explained that “[w]hen viewed in conjunction with the potential fees RBC was to receive for its financing services, the investment bank’s pursuit of Warburg’s financing business was demonstrative of a conflict that was unquestionably material, and necessitated full and fair disclosure for the benefit of the stockholders.”

Court Holds RBC Knowingly Aided and Abetted the Board’s Breaches

The Delaware Supreme Court explained that “‘[a] third party may be liable for aiding and abetting a breach of a corporate fiduciary’s duty to the stockholders if the third party ‘knowingly participates’ in the breach’” (quoting Malpiede v. Townson, 780 A.2d 1075 (Del. 2001)). The court emphasized that “the aider and abettor . . . must act with scienter.”

Here, the court found that RBC had “knowingly induced” the Rural directors’ duty of care breaches “by exploiting its own conflicted interests to the detriment of Rural and by creating an informational vacuum.” The court further concluded that “RBC’s failure to fully disclose its conflicts and ulterior motives to the Board, in turn, led to a lack of disclosure in the Proxy Statement.” The court determined that “[t]he record evidence amply support[ed] the trial court’s conclusion that RBC [had] purposely misled the Board so as to proximately cause the Board to breach its duty of care.”

Significantly, the Delaware Supreme Court underscored that its “holding is a narrow one that 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 a breach of the duty of care.” The court explained that “the requirement that the aider and abettor act with scienter makes an aiding and abetting claim among the most difficult to prove.”

In a footnote, the Delaware Supreme Court rejected the Rural I court's description of financial advisors as "'gatekeepers'" for directors (quoting Rural I, 88 A.3d 54). The Delaware Supreme Court explained that "[a]dhering to the [Chancery Court's] amorphous 'gatekeeper' language would inappropriately expand [its] narrow holding here."

Court Finds Rural’s Section 102(b)(7) Exculpatory Provision Does Not Shield RBC From Aiding and Abetting Liability

The Delaware Supreme Court explained that “while Section 102(b)(7) insulates directors from monetary damages stemming from a breach of the duty of care, its protection does not apply to third parties such as RBC.” The court reasoned that the Delaware legislature “did not intend for Section 102(b)(7) to safeguard third parties and thereby create a perverse incentive system wherein trusted advisors to directors could, for their own selfish motives, intentionally mislead a board only to hide behind their victim’s liability shield when stockholders or the corporation seeks retribution for the wrongdoing.” Here, the court found that RBC could not “commit a fraud upon the very directors who hired and relied upon it, and subsequently seek to exploit the Board’s exculpatory provision.”

The Delaware Supreme Court rejected the contention that it was inequitable to hold RBC “liable for damages for aiding and abetting the directors’ breach of due care where the directors themselves would not have been liable for damages.” The court found that the Chancery Court had “properly determined that RBC’s conduct accounted for a disproportionate amount of the fault.” Moreover, the Delaware Supreme Court emphasized that third-party advisors can only be held liable for aiding and abetting if they acted with scienter. The court explained that “[i]f an advisor knowingly induces directors to breach their duty to act reasonably under Revlon, the advisor is liable but only under a more stringent standard for imposing liability than a director faces when the director is not protected by a Section 102(b)(7) provision.” The Delaware Supreme Court stated that “[i]n essence, the aider and abettor standard affords the advisor a form of protection by insulating it from liability unless it acts with scienter.”

Delaware Supreme Court Affirms the Chancery Court’s Damages Ruling

Finally, the Delaware Supreme Court held that “the record reflects that the Court of Chancery properly exercised its broad discretionary powers in fashioning a remedy and making its award of damages.”

The applicable settlement agreement provided that the damages recoverable against RBC would be reduced to the extent of the pro rata share of the settling defendants’ liability, in accordance with 10 Del. C. § 6304(b) of DUCATA. RBC contended that “of the eight total defendants, each should have been allocated an equal 12.5% share” and thus “RBC claim[ed] it should have received a settlement credit . . .  equal to 87.5% of the damages.” On appeal, the Delaware Supreme Court found that the Chancery Court had “properly determined” that the term “pro rata” means “proportionate” rather than “equal.” The Chancery Court “assigned 83% of the responsibility for the damages to the Class to RBC.” The Delaware Supreme Court “agree[d] with the trial court’s pro rata allocation of fault.”

On October 2, 2015, the Delaware Supreme Court affirmed dismissal of an action brought by stockholders of KKR Financial Holdings LLC (“Financial Holdings”) who sought post-closing damages in connection with Financial Holdings’ acquisition by KKR & Co. L.P. (“KKR”). Corwin v. KKR Financial Holdings LLC, 2015 WL 5772262 (Del. 2015) (Strine, C.J.) (KKR II). The Court held that “when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.”

The Delaware Supreme Court reasoned that “Delaware corporate law has long been reluctant to second-guess the judgment of a disinterested stockholder majority that determines that a transaction with a party other than a controlling stockholder is in [its] best interests.”

Allegations of Both a Close Friendship and a Business Relationship with an Interested Party May Be Sufficient to Plead That a Director Could Not Act Independently of the Interested Party for Demand Purposes 

On October 2, 2015, the Delaware Supreme Court reversed dismissal of a shareholder derivative action brought against the directors of the Sanchez Energy Corporation alleging a “gross overpayment” in connection with a transaction involving Sanchez Resources, LLC. Del. Cnty. Emps. Ret. Fund v. Sanchez, 2015 WL 5766264 (Del. 2015) (Strine, C.J.). The Delaware Supreme Court found that “plaintiffs had pled particularized facts raising a pleading-stage doubt about the independence of” Alan Jackson, one of the other Sanchez Energy directors, by alleging that (1) Jackson “had a close friendship of over half a century with” the chairman of Sanchez Energy; and (2) Jackson’s “primary employment (and that of his brother) was as an executive of a company over which the [chairman of Sanchez Energy] had substantial influence.”

In the case before it, the Delaware Supreme Court found that plaintiffs had not pled “the kind of thin social-circle friendship . . . which was at issue in” Beam v. Stewart, 845 A.2d 1040 (Del. 2004). The court found that “[w]hen, as here, a plaintiff has pled that a director has been close friends with an interested party for a half century, the plaintiff has pled facts quite different from those at issue in Beam.”

The court also found that the Chancery Court had erred in separately considering allegations concerning Jackson’s personal relationship with Sanchez and allegations of Jackson’s economic ties to Sanchez. The Delaware Supreme Court underscored that the “law requires that all the pled facts regarding a director’s relationship to the interested party be considered in full context in making the, admittedly imprecise, pleading stage determination of independence.”

On May 14, 2015, the Delaware Supreme Court addressed the following question: “in an action for damages against corporate fiduciaries, where the plaintiff challenges an interested transaction that is presumptively subject to entire fairness review, must the plaintiff plead a non-exculpated claim against the disinterested, independent directors to survive a motion to dismiss by those directors?” In re Cornerstone Therapeutics Inc., S’holder Litig., 115 A.3d 1173 (Del. 2015) (Strine, C.J.). The court “answer[ed] that question in the affirmative,” and held that “[a] plaintiff seeking only monetary damages must plead non-exculpated claims against a director who is protected by an exculpatory charter provision to survive a motion to dismiss, regardless of the underlying standard of review for the board’s conduct.”

The Delaware Supreme Court determined that “the mere fact that a plaintiff is able to plead facts supporting the application of the entire fairness standard to the transaction, and can thus state a duty of loyalty claim against the interested fiduciaries, does not relieve the plaintiff of the responsibility to plead a non-exculpated claim against each director who moves for dismissal.” In so holding, the Delaware Supreme Court relied on its earlier decision in Malpiede v. Townson, 780 A.2d 1075 (Del. 2001). There, the court “analyzed the effect of a Section 102(b)(7) provision on a due care claim against directors who [had] approved a transaction which the plaintiffs argued should be subject to review under the Revlon standard.” The court found that “[b]ecause a director will only be liable for monetary damages if she has breached a non-exculpated duty, a plaintiff who pleads only a due care claim against that director has not set forth any grounds for relief” since the Section 102(b)(7) exculpatory provision bars such a claim as a matter of law.

The Delaware Supreme Court found that plaintiffs are not “entitled to an automatic inference that a director facilitating an interested transaction is disloyal because the possibility of conflicted loyalties is heightened in controller transactions.” First, the court explained that “‘independent directors are presumed to be motivated to do their duty with fidelity.’” Second, the court found that such an inference “would likely create more harm than benefit” because “the negotiating efforts of independent directors can help to secure transactions with controlling stockholders that are favorable to the minority.” The court “decline[d] to adopt an approach that would create incentives for independent directors to avoid serving as special committee members, or to reject transactions solely because their role in negotiating on behalf of the stockholders would cause them to remain as defendants until the end of any litigation challenging the transaction.” The court observed that “the fear that directors who faced personal liability for potentially value-maximizing business decisions might be dissuaded from making such decisions is why Section 102(b)(7) was adopted in the first place.”

[1]         Please note that we discuss the Delaware Supreme Court's decision in Rural III at length because we have not previously covered it in a prior Alert.