In Stewart v. Wilmington Trust (March 26, 2015), the Delaware Chancery Court characterized the outside auditor and the administrative management company for certain captive insurance companies as having a “gatekeeping role” for the companies. On that basis, the court refused to dismiss claims against them for aiding and abetting the alleged breaches of fiduciary duties of the companies’ directors. The decision expands the Chancery Court’s recent focus on the gatekeeper concept, underscoring the potential for aiding and abetting liability for advisors.
Focus on advisors who have a “gatekeeper” role. An advisor to a board may have aiding and abetting liability if the advisor “knowingly participated” in a directors’ breach of fiduciary duties—even if the director herself is exculpated under the company’s charter against liability for breach of the duty of care. Recent Chancery Court decisions have focused on aiding and abetting liability of advisors who the court views as having a gatekeeper role with respect to a corporation’s sale or other process. As articulated in Wilmington Trust, the court’s view is that, while “gatekeepers” are engaged by companies to provide services and are not fiduciaries with the same duties as directors have, they “are different from other third parties with whom the corporation may conduct business,” in that they “occupy a position of trust and materially participate in the traditional insiders’ discharge of their fiduciary duties.” This view reflects a heightened risk of aiding and abetting liability for directors’ breaches. Importantly, however, in the two cases in which the court has found (or, at the pleading stage, has inferred) the requisite “knowing participation” by an advisor, the court viewed the advisor’s conduct as egregious, involving an unusual degree of negligence and conflict of interest.
- Rural Metro. Last year, in In re Rural Metro Stockholders Litigation, the Chancery Court characterized an investment banker as a gatekeeper in a company’s sale process and held the banker liable for aiding and abetting the directors’ breach of fiduciary duties (with damages of $76 million). According to Vice Chancellor Laster, the board had breached its fiduciary duties by not supervising the sale process and by making decisions without sufficient information. The court found that the investment banker, in negotiating a sale on behalf of the company, had been subject to multiple conflicts of interest (including efforts to secure lucrative buy-side financing work without adequately informing the board) and had not provided the board in timely fashion with valuation materials that would be sufficient to permit them to be informed—and, when furnished, the materials made the acquiror’s offer appear more favorable than it actually was. The court, emphasizing the investment bankers’ gatekeeper role in the sale process, stated that the potential for aiding and abetting liability for investment bankers would “create a powerful financial reason for the banks to provide meaningful fairness opinions and to advise boards in a manner that helps ensure that the directors carry out their fiduciary duties when exploring strategic alternatives and conducting a sale process, rather than in a manner that falls short of established fiduciary norms.”
- Tibco. Also last year, in In re Tibco Software Stockholders Litigation, the Chancery Court, citing Rural Metro, noted that plaintiffs can recover damages from aiders and abettors even when the liability of the directors who breached their fiduciary duties are exculpated under the company’s charter. Vice Chancellor Parsons denied the stockholder plaintiffs’ motion for an injunction blocking a merger in which, allegedly, a mistake in calculating the consideration resulted in an understated per share merger price. The court noted that damages would be readily ascertainable and recoverable, even though the directors who made the mistake would be exculpated from liability for a breach of their duty of care.
Wilmington Trust. In Wilmington Trust:
- “Gatekeeper” characterization for auditor and management company. Vice Chancellor Parsons characterized the independent auditor and the management company for four special purpose captive insurance companies as having a gatekeeping role for the companies.
- New exception to an affirmative defense so that aiding and abetting claims can be made against “gatekeepers”. The Vice Chancellor found that, in the factual context presented, the legal doctrine of in pari delicto (discussed below) would have supported aiding and abetting claims only against insider fiduciaries and would have barred such claims against non-fiduciary third parties (such as an auditor or management company) engaged to provide services to the company. However, the court reasoned that “non-fiduciaries like auditors, who occupy a position of trust and materially participate in the traditional insiders’ discharge of their fiduciary duties, are different from other third parties with whom the corporation may conduct business.” Based on that view, the Vice Chancellor created a new exception to the in pari delicto doctrine so that aiding and abetting claims would not be barred against third parties acting in a gatekeeper role.
- Gatekeepers’ aiding and abetting conduct. Based on the allegations in the plaintiff’s complaint, the court found it reasonably conceivable, at the pleading stage, that the management company and the auditor had “knowingly participated” in a fraudulent scheme by the CEO (who was also a director and the sole stockholder) involving theft from the companies’ policyholders and misleading the regulatory authorities, as well as the breach of fiduciary duties by the other directors involving their not discovering and preventing the fraud. The auditor and the management company had together prepared the companies’ 2007 and 2008 audited financial statements. Noting that the processes relating to the 2007 statements were “replete with alleged irregularities”, the court found it was “reasonably conceivable” that both the management company and the auditor “knew something was significantly wrong within the [companies’] operations” and “knew that the directors were not informing themselves and not exercising their oversight responsibility”.
The court noted that the management company and the auditor were present when the audited financial statements for 2008 were approved by the board with little or no discussion. Most importantly, the management company and the auditor, in connection with the 2008 financial statements, presented certain items that had been identified in the 2007 “significant matters letter” as being “less of a problem than they really were”, and then “allowed the directors to ignore the letter and the suggestions in it”. Adopting the phraseology used in Rural Metro, the court stated: “This knowing lack of follow-up directly created the ‘unreasonable process’ and ‘informational gaps’ that are alleged to have led to the Board’s breaches of fiduciary duties.”
The court distinguished the situation involving another auditor that had been engaged only for the 2008 financial statements. This firm may well have been negligent in its work, according to the court; but it had “not been around long enough” to have engaged in the dereliction of its responsibilities that the court ascribed to the management company and the auditor—namely, the “knowing failure to follow up on the original warnings they provided to the Board in connection with the first audit, despite experiencing very similar irregularities the next year.”
The in pari delicto doctrine and exceptions. In Wilmington Trust, the court held that the doctrine of in pari delicto barred breach of contract and negligence claims against the management company and the auditor, and also would have barred aiding and abetting claims against any person other than an insider fiduciary of the companies. To avoid aiding and abetting claims being barred against non-fiduciary third parties who are gatekeepers, the court created a new exception to the doctrine. Applying this new exception for gatekeepers, the court refused to dismiss the aiding and abetting claims against the auditor and the management company.
In pari delicto is an affirmative defense that, unless an exception applies, bars courts from adjudicating the claims between parties that both suffered their losses substantially as a result of their illegal conduct. The doctrine requires that the courts not waste resources in adjudicating these claims and “leave [the wrongdoers] where their own acts have placed them.” Since the actions of corporate directors and officers, acting within the scope of their authority, are imputed to the corporation itself, when corporate officers or directors engage in illegal conduct, the corporation itself is generally considered a wrongdoer, and is barred from stating a claim against a third party that participated in the scheme of wrongdoing. In this case, the plaintiff’s own complaint alleged that the director (J) and the corporation itself bore “substantially equal responsibility”—J for the alleged fraud and the corporation for the other directors’ failure to detect and prevent the fraud. Thus, in this case, the corporation (and, accordingly, the plaintiff) would be barred from stating a claim against the management company and the auditor for having participated in the wrongdoing (i.e., aiding and abetting), unless an exception to the in pari delicto doctrine were applicable.
The “adverse interest exception” to the doctrine eliminates the bar against claims, in the corporate context, when the officer or director acts solely for his or her own benefit and not the corporation’s benefit (as when an officer or director steals money from the corporation, for example). This exception did not apply in Wilmington Trust because J’s fraud in part benefited the companies. The “fiduciary duty exception” to the doctrine eliminates the bar against claims in a suit by a corporation against its own fiduciaries for breaches of their fiduciary duties. The rationale for the exception is that parties (like receivers or stockholder derivative plaintiffs) must be able to act on the corporation’s behalf to hold faithless directors and officers accountable. This exception did not apply in Wilmington Trust because the management company and the auditor were not corporate fiduciaries but outside third parties engaged to perform services.
The court concluded that the fiduciary duty exception “should extend to cover well-pled aiding and abetting claims against defendants like auditors”—because of their gatekeeper role.
The new exception to the in pari delicto doctrine—and, more generally, the courts expanded view of advisors as “gatekeepers”—increases the potential for aiding and abetting liability for advisors. The following should be kept in mind, however:
- Egregious conduct. The factual context of both Rural Metro and Wilmington Trust involved allegations of egregious conduct by the advisors. Thus, at least to date, the court has focused on aiding and abetting liability for gatekeepers only in what the court has regarded as “extreme” circumstances.
- Uncertainty as to future developments. While investment bankers, auditors, and an administrative management company have now been characterized by the court as gatekeepers in the context of aiding and abetting claims, it is uncertain whether the characterization will be extended to other types of advisors and, if so, which ones. It also remains to be seen whether the Delaware Supreme Court will endorse the Chancery Court’s approach to aiding and abetting liability for gatekeepers.
- Financial consequences. The financial consequences of aiding and abetting liability for advisors will depend on a number of factors, including whether or not the liability is indemnifiable under the advisor’s terms of engagement with the company. Indemnity provisions should be drafted so that it is clear whether aiding and abetting liability is covered or excluded. Of course, even if the liability is covered, the advisor will face reputational risk, as well as the risk of not being indemnified if (as was the case in Wilmington Trust) the company becomes bankrupt or if the activities involve a violation of federal securities laws which the SEC asserts cannot be indemnified.
- Engagement letter. In addition to the indemnity provision concerns noted above, advisors should consider expressly disclaiming a gatekeeper role in the engagement letter. The disclaimer, and a list of activities to be performed that does not include gatekeeper-type responsibilities, may mitigate the risk, although the court may view the gatekeeper role as inherent in the advisor’s duties and therefore not disclaimable.
The preceding post comes to us from Fried, Frank, Harris, Shriver & Jacobson LLP. It is excerpted from their recent publication “Fried Frank M&A Quarterly April 2015”, which was published on April 23, 2015 and is available here.