Transactions involving financial advisor conflicts of interest and the role of boards of directors in policing these conflicts have occupied much of the news from the Delaware Court of Chancery during the last 18 months. The most notable recent cases in this area are In re Del Monte Food Company Shareholders Litigation and In re El Paso Corporation Shareholder Litigation, both of which involved claims for, among other things, breaches of fiduciary duties by directors.
Although both opinions focused to a large degree on financial advisor malfeasance, the judge in each case concluded that the plaintiffs established a reasonable likelihood that the company's directors breached their fiduciary duties. The Del Monte opinion in particular makes clear that, despite the existence of conflicts of interest and efforts to conceal those conflicts, ultimately "the buck stops with the Board" when it comes to managing a financial advisor's conflicts of interest. This article briefly summarizes the Del Monte and El Paso cases and provides some guidance to boards of directors and their advisors in dealing with conflict situations.
In re Del Monte Food Company Shareholders Litigation
Del Monte Foods Company's merger with a private equity group led by Kohlberg, Kravis, Roberts & Co. (KKR) involved a variety of financial advisor conflicts of interest. Barclays Capital served as Del Monte's financial advisor for the merger. The sale process arose in significant part due to Barclays' efforts to drum up interest by its private equity clients for a leveraged buyout of Del Monte before Barclays discussed the possibility of selling Del Monte with Del Monte's board. From the outset, Barclays contemplated providing financing to Del Monte's buyer, for which it would earn a fee roughly equal to (or even higher than) the fee payable by Del Monte for acting as its sell-side advisor.
This desire to provide financing led Barclays to favor KKR, another Barclays client, in the bidding process. Barclays informed Del Monte's board of this intention well into the course of negotiations with KKR, but before KKR and Del Monte agreed upon a price. Del Monte's board acceded to Barclays' request to provide buy-side financing without any concessions from KKR or Barclays, and despite the fact that Barclays' participation in buy-side financing was not necessary to facilitate the transaction. In an effort to address this conflict, Del Monte engaged Perella Weinberg Partners as a second financial advisor and to provide a fairness opinion, which it did for a $3 million fee.
Barclays also facilitated a pairing of KKR and Vestar Capital Partners, the highest bidder in an earlier round of bidding for Del Monte, in violation of the confidentiality agreements of both KKR and Vestar, which provided that bidders could not team with other bidders without the consent of Del Monte. Barclays matched these potential buyers at a time when Barclays had been instructed by Del Monte's board not to pursue a sale of the company, and this pairing weakened the competitive bidding process for Del Monte as Vestar could have partnered with another private equity firm to create a competitive second bid. Barclays then worked with KKR and Vestar to conceal their pairing from Del Monte's board for approximately one month. When requested, Del Monte's board approved Vestar's pairing with KKR rather than exploring the possibility of Vestar teaming with another private equity firm to obtain a higher bid for the company.
In re El Paso Corporation Shareholder Litigation
In May 2011, El Paso Corporation announced that it planned to spin off its exploration and production (E&P) business from its pipeline business. In the wake of this announcement, Kinder Morgan, Inc. approached El Paso about the possibility of acquiring El Paso in its entirety. The parties ultimately agreed to an acquisition of El Paso involving cash, stock and warrants.
El Paso engaged Goldman Sachs, who was El Paso's longtime financial advisor and its advisor in connection with the proposed spinoff transaction, as its financial advisor in connection with the sale to Kinder Morgan. Private equity funds affiliated with Goldman Sachs owned approximately 19 percent of Kinder Morgan, representing a $4 billion investment, and had two representatives on Kinder Morgan's board of directors. The El Paso board was aware of these facts and had taken several corrective actions to mitigate the conflict. The El Paso board later learned, during post-transaction announcement litigation, that the lead Goldman advisor working with El Paso also personally owned approximately $340,000 of Kinder Morgan stock.
The actions taken by the El Paso board of directors included hiring Morgan Stanley as a second financial advisor to advise in connection with the Kinder Morgan transaction. The El Paso board and management did not, however, negotiate an amendment to Goldman Sachs' exclusive engagement to advise El Paso on the initially proposed spinoff of El Paso's E&P business. As a result, Morgan Stanley would receive compensation from El Paso only if the proposed merger with Kinder Morgan proceeded and not if El Paso decided to pursue the spinoff transaction.
Both Del Monte and El Paso involved shareholder suits for, among claims, breaches of directors' fiduciary duties, with the Del Monte transaction resulting in an $89.4 million settlement by Del Monte and Barclays. What key points can be gleaned by boards of directors and their advisors from these deal-specific situations?
Boards Need to Understand and Assess the Incentives and Conflicts of Their Advisors
Engaging a financial advisor involves understanding the variety of activities and relationships of the advisor that can lead to actual or apparent conflicts of interest. Boards of directors should carefully weigh a financial advisor's knowledge of an industry and ties to participants in that industry, including prospective buyers, with the possibility of conflicts of interest that might cause the advisor to take actions that may be detrimental to the company's shareholders. There is no requirement that a company's financial advisor be free of conflicts, and boards of directors should keep in mind that not all conflicts, including equity interests in or loans to bidders, are of a sufficient size and nature to prevent the advisor from effectively representing the company. Boards also should know that due to institutional information barriers, certain information about holdings and thresholds by a financial advisor and its affiliates may not be known by the transaction team. Ultimately, boards should actively identify what its advisors' conflicts are and address the adverse incentives any material conflicts create.
In the wake of Del Monte, there was some speculation that, to ferret out conflicts of interest, companies might seek representations in engagement letters with investment banks regarding banks' prior activities with potential buyers. That approach has not become customary and is not necessary, but active questioning by boards of investment bankers regarding their relationship and activities with potential buyers should be part of evaluating any investment bank at the engagement stage in today's environment, and boards should instruct financial advisors to keep boards apprised of conflicts that arise later in the transaction process. El Paso introduces the added wrinkle of boards potentially desiring information on individual members of the banking team in addition to information about potential conflicts at a firm level.
Incentives Created by Financial Arrangements Should Be Considered
Boards should be cognizant of, and give careful consideration to, the incentives created by the financial advisor's fee arrangements. In El Paso, although the court took issue with the company's engagement of Goldman Sachs given Goldman's unusually significant conflicts (noting that the company had prior relationships with several similarly qualified but substantially less conflicted investment banks), the court also criticized the board's failure to negotiate arrangements that would allow the company and its second financial advisor to explore, and be compensated for, an alternative transaction — the sale of its E&P business — which might have maximized El Paso's value for its shareholders. The Chancery Court has repeatedly recognized that structuring financial advisor engagements with a significant success-based fee is acceptable, but boards should be aware of the impact of those fees on the advice the board may receive, especially if a second advisor is engaged. By structuring Morgan Stanley's engagement so that Morgan Stanley would not receive a fee if El Paso sold its E&P business rather than pursuing the Kinder Morgan transaction, the board created an economic incentive for Morgan Stanley to prefer one transaction over another.
Boards Should Address Advisor Conflicts as They Arise
In addition to simply identifying conflicts, Del Monte and El Paso emphasize the need for boards to understand and address those conflicts. In Del Monte, the court did not rule that the conflict created by Barclays "staple financing" for the company's buyer was impermissible per se; rather, the court faulted the board for allowing the conflict to arise when the company obtained nothing in return and because the conflict was not necessary to consummate the transaction.
In light of Goldman Sachs' conflicts in the El Paso transaction, El Paso's board took the appropriate step of engaging a second financial advisor in connection with the Kinder Morgan transaction. However, simply bringing a second advisor into a conflict situation does not adequately address the conflict if the second bank is not given sufficient authority to take actions that address the conflict that led to their engagement in the first place. Simply identifying a conflict of interest is of little value if boards do not understand and mitigate the adverse incentives created by the conflict, obtain some value for shareholders for permitting the conflict or otherwise have a strong explanation why the conflict is necessary to facilitate a transaction that benefits shareholders.
Disclosure of Conflicts to Shareholders Will Be Carefully Scrutinized
El Paso and Del Monte reminded directors that their management of financial advisor conflicts will be carefully scrutinized by litigators. Directors and their advisors similarly should take note that disclosure of conflicts to shareholders is subject to increasing scrutiny. Both cases emphasize the critical role financial advisors play in the sale process and, given their critical role, any conflicts of interest they have may be material to shareholders' evaluation of a transaction. Although appropriate disclosure is determined on a case-by-case basis, companies, investment banks and their advisors should carefully consider prior buy-side engagements, contemplated future transactions, investments in potential acquirers and other relationships that could be seen to compromise a bank's objectivity and therefore potentially need to be discussed in shareholder disclosure documents. The time when it was sufficient to include general disclosure about financial advisors receiving a "customary" fee contingent upon closing of transaction has passed.
Disinterested Directors and Negotiated Transactions Have Significant Protections From Issues With Advisor Conflicts
In both Del Monte and El Paso, despite the issues with the sale processes outlined above, the court noted that the disinterested directors of each company likely could not be held personally liable for breaches of their fiduciary duties in connection with the transactions due to typical exculpatory provisions in the companies' certificates of incorporation. Although directors of Delaware corporations would be wise to follow the advice discussed above, they should take comfort in knowing they likely will not have personal liability for mishandling a conflict of interest if they gain no personal benefit from the conflicted advisor's conduct.
Both cases also demonstrate Delaware courts' reluctance to scuttle a transaction when the acquirer offers a premium and shareholders have an opportunity — after being provided adequate disclosure — to vote against a merger or not tender their shares in a tender offer. Both transactions closed, but there is the risk of liability for the company and its financial advisors (as reflected in the substantial settlement agreed to by Barclays and Del Monte). Parties that believe they have negotiated a good deal for shareholders, regardless of the existence of banker conflicts or the manner in which the conflict is handled, should consider agreeing upon a short window between signing and the date on which either party may terminate the definitive agreement, which may limit a court's ability to interfere with the transaction without depriving shareholders of a potentially attractive deal.
Financial advisor conflicts of interest are not new, but the degree of scrutiny they are receiving is increasing. Boards of directors and their advisors need to understand and address any conflicts of interest, manage their financial advisors and make sure any material conflicts are fully disclosed to shareholders.