Using Financial Advisor Engagement Letters to Vet Potential Conflicts of Interest

Financial advisors often are selected by a board of directors (or committee thereof) to advise on a strategic review process because of their role as brokers in the market and their ability to generate transactional activity.  Of course, that role and ability is dependent upon relationships with potential counterparties to a transaction.  Because financial advisors are hired in part to exploit their relationships with potential counterparties, inevitably conflicts of interest will arise.  Delaware law clearly permits directors to make a decision that the benefits of engaging a particular financial advisor (including, in many cases, that financial advisor’s contacts in the market or particular industry) outweigh any potential detriments arising from potential conflicts of interest.  That decision, however, must be fully informed.

In a series of cases since the beginning of this decade, financial advisors and the boards they represent have run into difficulty because information about the financial advisors (including their relationships with potential counterparties) that created potential conflicts was not surfaced.  We believe that financial advisor engagement letters are an efficient (although admittedly not the only) tool to vet such potential conflicts at the beginning of a strategic review process, and that the use of financial advisor engagement letters in this respect will be beneficial not only to boards of directors, but also to financial advisors whose liability for aiding and abetting a breach of the directors’ fiduciary duty may be premised on the failure of the directors to “identify and consider the implications of the investment banker’s compensation, structure, relationships, and potential conflicts.”[1]

Consider the importance of disclosure in the following cases involving different types of conflicts:

  • In In re Del Monte Foods Co. Shareholders Litigation, a transaction was enjoined in part because the board of Del Monte was not aware of its financial advisor’s “efforts to stir up the initial LBO bid until discovery” in the litigation.
  • In In re El Paso Corp. Shareholder Litigation, then-Chancellor Strine found it “at best[] doubtful” that Goldman Sachs would be found liable for damages because “Goldman’s largest conflict was surfaced fully and addressed”; at the same time, the then-Chancellor described as “troubling” the lead banker’s failure to disclose his own potential conflicts.
  • RBC’s liability in Rural/Metro arose in part out of the board being unaware of RBC’s “last minute efforts to solicit a buy-side financing role from” the acquiror.
  • In the recent litigation over the transaction between Zale Corporation and Signet Jewelers, the Court found troubling the fact that the Zale board was unaware at the time it hired its financial advisor that that advisor had previously pitched to Signet a transaction with Zale and at the pitch had discussed specific valuations for Zale. The Court found, however, that once the Zale board was informed it “took reasonable steps to investigate whether it presented a problem as to BofA’s ability to deliver independent and disinterested advice.”
  • Finally, in a little-discussed but important case, Houseman v. Sagerman, the Court distinguished Rural/Metro and did not take issue with a board’s use of the company’s largest creditor as its financial advisor because the board was aware of the financial advisor’s status as such.

Given the above, Justice Brandeis’ timeless observation seems at the heart of much of the Delaware court’s financial advisor-related jurisprudence:  “Sunlight is said to be the best of disinfectants.”[2]

In our experience, cases like Del Monte, El Paso, and Rural/Metro are moving the needle when it comes to disclosure of potential conflicts of interest of financial advisors; however, the scope and method of those disclosures continues to develop.  In our view, financial advisor engagement letters are an appropriate and helpful tool to vet those conflicts of interest and in a forthcoming article in the Business Lawyer, we set out contractual provisions to help do so.[3]

The provisions we discuss in our article include representations from a financial advisor that it has disclosed certain relationships with, holdings in, and prior pitches regarding the target company to, certain potential bidders and a covenant that additional disclosures will be made if another potential bidder comes on the scene.  In addition, our proposed provisions would allow the board to terminate the banker for cause (and thus not be on the hook for a tail termination fee and free to bring in a new financial advisor) if any of the conflicts-related representations or covenants were breached.

We have heard objections to our recommendation in favor of a financial advisor engagement letter (as opposed to an extra-contractual disclosure memorandum or slide in a bankers’ book) as a tool to vet conflicts.  Among other things, certain commentators to our article suggest that addressing financial advisor conflicts through a contract – in those commentators’ view, a tool to allocate risk that most directors do not even read – is inappropriate.  We respectfully disagree for several reasons.

First, as James Freund wrote forty years ago,[4] representations in a contract do not solely serve as a tool for allocating risk.  Rather, they are a tool to ensure that both the bank and the client are on the same page with respect to the basis upon which the bank is being engaged.  As the cases cited above make clear, the understanding of all potential conflicts is a fundamental aspect of the bank’s retention.  Such understanding serves to head off situations where a financial advisor purports to surface conflicts at the beginning of an engagement only to “find more” conflicts in preparing to deliver a fairness opinion letter or draft a proxy disclosure – a point when the target board can no longer “carefully select” its advisors or make an “informed decision” with respect to that conflict.

Moreover, we do not believe including such provisions necessitates directors’ reading an engagement letter front-to-back.  Like many other contracts, the actual drafting and diligence of the relevant provisions should surface issues, and then legal counsel can take those issues back to the board.

Next, we think it would be the rare case where a financial advisor engagement letter leads to a damages action:  if a transaction fails, it is hard to envision damages and if it succeeds it is hard to envision the buyer (i.e., the successor counterparty to the engagement letter) suing the financial advisor for breach of contract.  However, a contractually-created remedy (feasible only if the representations are in themselves contractual provisions) of allowing a target board to terminate the engagement with its initial financial advisor and hire a new financial advisor without having to pay a tail fee if a contractual conflicts representation proved inaccurate could, in some instances, provide a more feasible remedy than suing the original financial advisor for damages.

In addition, even if potential conflicts are vetted at the outset of the engagement, absent a contractual covenant to disclose additional information about relationships that may create conflicts in light of developments in the strategic review process, a financial advisor is under no obligation to disclose future potential conflicts. Drafting such a covenant at the outset of the engagement will maintain the board’s authority to oversee its advisors and will mitigate any questions regarding the “what’s” and “when’s” of conflicts-related disclosure in the heat of a review process.

There is legitimate debate whether financial advisor conflicts-related disclosures are best addressed in an engagement letter or some other form of writing. For the reasons discussed above, as well as others discussed in our article, we believe engagement letters are an effective route for addressing these issues. Whether they become “market”, only time will tell.

ENDNOTES

[1] In re Rural Metro Corp., 88 A.3d 54, 90 (Del. Ch. 2014)

[2] L. Brandeis, Other People’s Money 62 (National Home Library Foundation ed. 1933).

[3] Klinger-Wilensky, Eric S. and Emeritz, Nathan P., Financial Advisor Engagement Letters: Post-Rural/Metro Thoughts and Observations (April 24, 2015). Business Lawyer, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2604250.  Although our Article discusses potential contractual provisions, we believe that the potential conflicts addressed by those provisions are important for a target board to consider, even if they are considered on an extra-contractual basis.

[4] James C. Freund, ANATOMY OF A MERGER:  STRATEGIES AND TECHNIQUES FOR NEGOTIATING CORPORATE ACQUISITIONS (1975).

The preceding post comes to us from Eric S. Klinger-Wilensky and Nathan P. Emeritz, who are respectively a partner and an associate at Morris, Nichols, Arsht & Tunnell LLP in Wilmington, Delaware.  The views expressed in the post are those of the authors only, and do not necessarily reflect the views of the firm or its clients.  The post is based on their recent article, which is entitled “Financial Advisor Engagement Letters: Post-Rural/Metro Thoughts and Observations” and is available here.