Actions of Target’s Financial Advisor Impose Potential Liability for Breach of Fiduciary Duties by Target’s Board and Bidder

In In re Del Monte Foods Company Shareholders Litigation (Feb. 14, 2011), the Delaware Chancery Court temporarily enjoined a stockholder vote and the enforcement of deal protection measures because of actions taken by the target’s financial advisor and conflicts of interest between the financial advisor and the target. The Delaware Chancery Court found that‚ on the preliminary record presented in connection with the plaintiff's injunction application‚ the target’s board of directors may have breached its fiduciary duties even though most of the advisor’s actions were taken without the board’s knowledge. In addition, the Court decided that the bidder may have aided and abetted the board’s breach of fiduciary duty because the bidder knowingly participated in the advisor’s actions.

 

Background

On November 24, 2010, Del Monte agreed to be acquired by a three-member consortium of private equity firms. The acquisition resulted from an on-and-off one year process, which included one round of bidding limited to select private equity firms that did not yield any acceptable bids and, after a six-month hiatus, the resumption of exclusive negotiations with Kohlberg, Kravis, Roberts & Co., which was the lead acquirer, that resulted in a signed acquisition agreement. The Court found that only after shareholder litigation was brought alleging breaches of fiduciary duty did the target discover that throughout the sale process its financial advisor acted without the target’s knowledge and contrary to its instructions.

The target’s financial advisor’s actions ranged from what may be considered as typical but aggressive actions to promote a transaction to‚ what the Court viewed as‚ actions that were at cross-purposes to the target and its stockholders. Among other things, the Court found that the financial advisor put the target “in play” by pitching an acquisition to various private equity firms without the target’s knowledge; the financial advisor planned to provide buy-side financing and secured the buy-side financing mandate from the lead acquirer prior to agreement on the acquisition price; even after the target instructed it to shut down the sale process, the financial advisor continued to pursue a transaction and teamed up the lead acquirer with the former highest bidder in violation of confidentiality agreements, and kept this consortium a secret from the target for two months; and the financial advisor worked with the lead acquirer to preclude another financial advisor from representing the target during the go-shop period by securing a percentage of the buy-side financing for the other financial advisor.

Court’s Analysis

The Court concluded that the plaintiff shareholders had a reasonable probability of success on the merits for their claims of breaches of fiduciary duty against the target’s board and aiding and abetting breaches of fiduciary duty against the lead acquirer. The Court applied enhanced scrutiny, using the Revlon¹ standard of whether the directors sought “to secure the transaction offering the best value reasonably available for the stockholders.”²

The Court concluded that the financial advisor’s actions and conflicts of interest tainted the board’s process. The Court emphasized that the financial advisor had a significant conflict of interest because of its buy-side role in which it would receive more fees than those generated on the sell-side. Moreover, the Court believed the financial advisor crossed the line when it secretly teamed the lead acquirer with the next highest bidder and actively concealed this from the board. The Court found that these conflicts of interests and actions gave the financial advisor an incentive to ensure a deal was reached with the lead acquirer (from which it would receive more compensation for providing financing), and not to negotiate for a higher price with the lead acquirer or another bidder.

Although it appeared to the Court that the financial advisor bore much of the blame, the Court found that the target’s board violated its obligations to take an “active and direct role in the sale process.” In particular, the Court concluded that the board did not act reasonably when it granted the lead acquirer’s request to add the next higher bidder to the bidding consortium; there was no record that the board deliberated the consequences of this action, especially the effect on price competition. The Court also decided that the board unreasonably allowed the financial advisor to provide financing to the acquirer when the acquisition price was still being negotiated and thereby created a direct conflict of interest. However, the Court noted it was unlikely that the directors would face monetary liability in light of Sections 102(b)(7) and 141(e) of the Delaware General Corporation Law because the board sought in good faith to fulfill its fiduciary duties.

The Court acknowledged that typically a third-party bidder negotiating at arm’s length would not be liable for a claim for aiding and abetting fiduciary duty breaches. However, a bidder cannot create or exploit a fiduciary breach. The Court determined that the lead acquirer knowingly participated in the financial advisor’s activities, and thus could be liable for aiding and abetting the breach of fiduciary duties by the target’s board.

Practical Implications

In re Del Monte Foods Company Shareholders Litigation continues various lines of Delaware cases that scrutinize the role of financial advisors and their conflicts of interests in the sale process and emphasize the obligation of the board of directors to supervise and retain control of the sale process. It provides practical lessons for targets, financial advisors and bidders.

• Conflicts of Interests. A financial advisor should clearly disclose all conflicts of interests to its client, and any conflicts of interests should be minimized and addressed. An engagement letter should include a representation by the financial advisor that there are no potential conflicts of interests, or a meaningful description of such conflicts. Where any material conflicts of interest arise, a target should consider engaging an additional financial advisor (including whether to offset the cost of such engagement against the fees of the conflicted advisor). At a minimum, a financial advisor should not be allowed to provide buyer financing to a selected bidder until after an acquisition agreement is signed and the financial advisor should not seek this role, whether internally or otherwise, prior to such time. If a financial advisor is allowed to take a buy-side role, a board should consider whether the financial advisor should be able to take on any significant additional mandates, such as running a go-shop process. Assuming that stapled financing is permissible, this case suggests any decision to allow a financial advisor to provide stapled financing at the start of the sale process should be carefully deliberated by a board and procedures instituted (e.g., retention of an independent investment banker) to help ensure that the sale process is not tainted.
• Board Participation in the Sale Process. A board cannot overly rely on its financial or other advisors, and should actively manage the sale process. Although this case does not go as far as In re Netsmart Technologies, Inc. Shareholder Litigation, which suggested the board should manage minutia such as the due diligence process, the Court does emphasize that the “buck stops with the Board.” A board should also question, as well as review the basis and ramifications of, its advisors’ recommendations, especially the effect on price.
• Client Interests. Financial advisors should follow the letter and spirit of their client’s instructions. The Court's decision in this case appears to be animated by the Court's view that the financial advisor seemed to act more out of its self-interest rather than for the interest of its client.
• Limit to Arm’s Length Negotiations. This case makes clear that there is a limit as to what bidders can do in the name of arm’s-length negotiations. A bidder cannot co-opt a target’s advisors or agree to side deals with an advisor without the target’s knowledge. In particular, a bidder should take its confidentiality agreement obligations seriously and insist on written consent from the target prior to deviating from any of its provisions.
• Club Deals. The process of teaming up bidders or permitting bidders to team up amongst themselves should be undertaken carefully. At each pairing, a board and the financial advisor should consider whether this would enable the target to get a higher acquisition price or increase deal certainty and whether another pairing would better achieve those goals.

 

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¹ Revlon, Inc. v. MacAndrews & Forbes Holdings, 506 A. 2d 173 (Del 1986).

² Paramount Communications Inc. v. QVC Network, Inc., 637 A. 2d 34, 44 (Del. 1994).