January 20, 2016

DELAWARE INSIDER: Rural Metro: Gulping Advisers and Practitioner Guidance

John Legaré Williams

For general business practitioners, the Delaware Supreme Court’s November 2015 decision, RBC Capital Markets, LLC v. Jervis (2015 WL 7721882), finding financial advisers in a merger liable for aiding and abetting corporate directors’ breaches of fiduciary duties, provides guidance to attorneys representing clients who may be selling a company. The decision affirmed the Delaware Court of Chancery’s rulings In Re Rural/Metro Corp. Stockholders Litigation (Del. Ch. Mar. 7, 2014) and In Re Rural/Metro Corp. Stockholders Litigation (Del. Ch. Oct. 10, 2014), which together with RBC Capital above, collectively “Rural Metro.” 

Although the holding concerns a publicly traded corporation, undoubtedly, its interpretation of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. 506 A. 2d 173 (Del. 1986), known as the “Revlon doctrine,” can be extended to smaller, private corporations and to alternative entities, including LLCs. For background, the Revlon doctrine subjects certain board action to an “enhanced scrutiny” standard of review more rigorous than the deferential business judgment rule, but less rigorous than “entire fairness,” which requires that directors show challenged acts were entirely fair to stockholders. Delaware judicial interpretation of Delaware fiduciary duty law often starts with cases involving corporations, then extends those precedents to LLCs that have not otherwise waived fiduciary duties by contract. In this article, we focus on the future implications on LLCs of the court’s holding in Rural Metro.

Rural Metro held, in part, that ongoing board decisions to sell a company faced enhanced scrutiny beginning at the time the sale was first contemplated. The court further held that subsequent approval by disinterested directors did not cure earlier conflicts of interest on sale of company transactions recommended by financial advisers who were prejudiced by conflicts of interest. Note this preceding sentence refers to separate conflicts of interest. A special committee of the board was conflicted when it initiated a sale process without approval of the full board, and the financial adviser was separately conflicted because it was attempting to construct a sale process that would maximize its chances of being selected to provide financing for the buyer in the transaction, rather than maximizing the price for stockholders. This enhanced scrutiny resulted in board liability and financial adviser liability. One interesting aspect of this case was that the directors were indemnified for breaches of the duty of care under 8 Del. C. Section 102(b)(7). Simply saying the trial court found the board liable glosses over an important distinction between breach of fiduciary duty and personal financial responsibility. All of the director defendants settled before trial. Their liability was not adjudicated. What the court found was breaches of fiduciary duties of care and disclosure, though no director was actually found liable for breach; the financial adviser was found liable for aiding and abetting those breaches.

Financial Adviser Is Not the Gatekeeper

The Delaware Supreme Court narrowed the liability for financial advisers by making a narrow exception for liability because the advisers in this case were aiding and abetting the breach of fiduciary duty via affirmative misconduct with an illicit state of mind. The Delaware Supreme Court rejected the Court of Chancery’s more general statement that financial advisers equal “gatekeepers.” Gatekeepers were only mentioned by the trail court as part of an analogy discussing why third parties are not entitled to exculpation for aiding and abetting breaches of care under 8 Del C. Section 102(b)(7).

Business lawyers and advisers can breathe a sigh of relief on the one hand not being gatekeepers, but will likely get palpitations with the result regarding financial adviser personal liability for more than $70 million in damages, a majority of the damages. Often, small business lawyers may be de facto advisers to small businesses engaged in sale of business transactions when the company’s numbers do not have the “extra zeros” needed to hire financial advisers. After the trial court ruling and prior to the appellate decision, financial advisers and, by extension, businesses attorneys had some reason to be concerned that the Delaware Supreme Court might affirm a new “gatekeeper” aiding and abetting liability rule for deal maker advisers. However, the Delaware Supreme Court’s ruling narrowed the Court of Chancery’s earlier ruling, declining to define the financial advisers generally as deal gatekeepers. The Delaware Supreme Court affirmed aiding and abetting liability in the absence of directors being found liable for the breaches that their advisers were found to have aided and abetted. This was unprecedented. It also affirmed, at least by implication, that the trial court’s holding that directors’ exculpation under 102(b)(7) does not extend to third parties and does not exculpate them from liability.

Even though the gatekeeper characterization was rejected, the court adopted a more expansive application of Revlon enhanced scrutiny than was previously believed by many to exist. First, the court affirmed its application in a post-closing damages context (some believed that it applied only to requests for injunctive relief in advance of a stockholder vote). Second, the court held that aiding and abetting liability does not require proof of gross negligence. The court, rejected the financial adviser’s contention that the trial court erred by finding a due care violation without finding gross negligence. When disinterested directors themselves face liability, the law, for policy reasons, requires that they be deemed to have acted with gross negligence in order to sustain a monetary judgment against them. The court decided the board violated its situational duty by failing to take reasonable steps to attain the best value reasonably available to the stockholders. Nevertheless, the independent directors breached their fiduciary duties by engaging in conduct that fell outside the range of reasonableness. This was a sufficient predicate for its finding of aiding and abetting liability against the financial adviser.

Therefore, even if there was no imposition of a gatekeeper standard, the court opinion eliminated multiple barriers to third party aiding and abetting liability that had previously been though to exist. The holding rejected the gross negligence standard for aiding and abetting. This has significant consequences for others.

Timing of the Scrutiny

In addition, the Rural Metro decision clarified the time at which the Revlon doctrine is triggered in the process of selling a business. The court held that the financial adviser’s lack of independence in this case should have been discovered by the board at an early stage in the sale process. Interestingly, Revlon was not pled by either party in the trial court. The court decided that enhanced scrutiny of the board’s decision, which was held to be not truly independent due to two different conflicts: (1) in the committee that initiated the sale process, and (2) the financial adviser, for seeking to provide financing to the acquirer. For purposes of when Revlon was triggered, it was the committee’s initiation of a sale process without full board approval that drove the analysis. It was not simply the financial adviser’s conflicts of interest, imputed to the board, which triggered Revlon or drove the court’s analysis. The court’s scrutiny of the board began at the time the board either directly or indirectly began the process of selling a company, and not just with the final sale approval. The board had a duty of care to act on a fully informed basis. The duty of care required the board to confirm that its financial advisers did not have a conflict of interest. There are different ways to insure a transaction is reasonable, even if not subject to the strictest standard, entire fairness. One way the board could have supported that the transaction was reasonable would have been to engage in a more open sale to a broader audience. While it is possible for a board to make an independent reasonable decision based on just one buyer, this is rare. When selling all of the assets or changing of control of a corporation, usually the best deal is the best offer, which is considered to be the offer that results in the highest short term shareholder value.

Third Party Breach of Fiduciary Duty

Additionally, it is worthwhile to examine the aiding and abetting of the breach of fiduciary duty by third parties. The court imposed liability on a financial adviser with a conflict of interest who aided and abetted the breach of fiduciary duty, and ultimately held that most of the damages should be paid by that financial adviser. The financial adviser aided and abetted the Rural Metro board’s breach of its fiduciary duty of care by knowingly creating an informational vacuum to pursue its own conflicted interests to the detriment of the company through a sale process not conceived to maximize stockholder value. Even after a second financial analysis from a second, independent and noninterested financial adviser was obtained, this second analysis did not cure the earlier breach, especially when the second financial adviser provided its analysis compensated under a contingent fee arrangement, contingent on the sale ultimately transpiring. 

Will the Rural Metro ruling be extended to LLCs by analogy?

In Rural Metro, the breaches at issue were arguably tied to the company’s status as a publicly traded corporation. Rural Metro was an ambulance and private fire protection service serving more than 400 communities in 22 states. Apparently, this business can be as competitive as the trash collection business in New York City.

The precedence from publicly traded companies is often extended to private companies and LLCs to fill in gaps in the Delaware LLC Act and gaps in alternative entity operating agreements.

So, how might Rural Metro impact small business and LLCs, in particular? Reliance on freedom of contract and strict contract interpretation is the hallmark of the Delaware limited liability company. Looking to the four corners of the LLC agreement is the starting point to analyze the conduct of management in any LLC internal affairs disputes. When an LLC agreement waives fiduciary duties, the corporate fiduciary analysis largely falls away. Instead, in that limited situation, the court is primarily concerned with the non-waivable contractual covenant of good faith and fair dealing.

This leads back again to the distinction between corporations and alternative entities: What would be the effect not just of statutory exculpation, but contractual waiver of fiduciary duties? Does contractual waiver eliminate management liability, such that breach is still possible and third parties could be liable for aiding and abetting breach? More likely contractual waiver eradicates the duty itself, so that there is nothing to breach other than the implied and un-waivable covenant of good faith and fair dealing.

Regarding the question of translating the effects of 102(b)(7) exculpation, breach, and liability in Rural Metro to the fiduciary duty waiver in the alternative entity context, does the corporate fiduciary analysis fall away as to aiding and abetting liability? This remains an open question which suggests that caution is advisable.

Nevertheless, reviewing the LLC agreement is the starting point in all internal affairs transactions, including, but not limited to: sale, break up, or change of control transactions. The Delaware LLC Act has a statutory provision providing for the maximum flexibility of contract. Yet, that is not where a Delaware court’s analysis ends. For matters not expressly addressed in the limited liability company agreement, the court fills the gaps. In Delaware, the courts can reform contracts to imply terms into the limited liability company agreement.

It is common for LLC agreements to be silent on waiving or modifying fiduciary duties, especially given the prevalence of standard form LLC agreements and LLCs without negotiated LLC agreements. When entering into an LLC, many LLC members do not consider the duties they will owe each other in the event of a breakup or sale, especially when members are not separately represented when negotiating the LLC agreement.

Aside from member agreements, management agreements, correspondence and conduct of parties, the Delaware courts fill gaps using the Delaware LLC Act and Delaware LLC case law. Section 18-1104 of the Delaware LLC Act provides that, unless the limited liability company agreement says otherwise, the managers and controlling members of a limited liability company owe fiduciary duties of care and loyalty to the limited liability company and its minority members. Delaware courts use their gap filling equitable powers with the over layer of fiduciary duties. Corporate fiduciary duties apply to LLCs by analogy, unless waived or reduced by a limited liability company agreement. Since many LLCs are silent on fiduciary duties, it is important to know what the case law says about fiduciary duties in general. Plus, LLC case law is rather thin compared to corporations. A strong tide in the court’s jurisprudence is shifting toward imposing traditional corporate duties and its corporate cases on LLC management as a gap filler. 

Conclusion

Thus, when engaging in sale of company transactions for companies large or small, it is important to be careful of who is giving advice. Although the holding from Rural Metro was limited to a financial adviser, and did not extend to the deal attorney, it is especially important to have a squeaky clean conflict of interest check to be sure any possible financial interest in the outcome of the sale is removed to protect the advisers from scrutiny. Similarly, when advising management of businesses of any size on a sale transaction, it is important to suggest the advantages of using disinterested management, when possible, to make the decisions at every critical step along the way and to advise company management to seek approval by disinterested third parties in order to maintain the protection of the business judgment rule. In addition, this may be a drafting opportunity to look at client LLC agreements in an analogous context to determine whether this Rural Metro scenario should be considered when deciding how the language of the LLC agreement should be updated. For example, if members do not agree to waive fiduciary duties, then, perhaps, a provision can be added to the LLC agreement to name disinterested third parties as independent directors to approve the process and price for sale and change of control transactions. With every fiduciary duty case that comes out of the courts, it gives business attorneys one more opportunity to suggest ways to fill gaps on their own forms through the experience of others to anticipate problems to prevent the courts from having to fill the gaps in the future.

Additional Resources

For other materials on this topic, please refer to the following.

The Business Lawyer

Financial Advisor Engagement Letters: Post-Rural/Metro Thoughts and Observations
By Eric S. Klinger-Wilensky and Nathan P. Emeritz
Vol. 71, No. 1 Winter 2015–2016

Annual Survey of Judicial Developments Pertaining to Mergers and Acquisitions
By the Annual Survey Working Group of the M&A Jurisprudence Subcommittee, Mergers and Acquisitions Committee
Vol. 70, No. 2 Spring 2015

John Legaré Williams

John Legaré Williams is managing director at The Williams Law Firm P.A. in Wilmington, Delaware, where he practices in the areas of alternative entity, corporate and trust law. He is also president of Agents and Corporations, Inc., an online Delaware incorporation service.