Financial Advice Under More Scrutiny in M&A

Financial advice is a growing area of focus for target boards in M&A transactions and is increasingly in the spotlight in deal litigation.

Disputes implicating financial advisers are arising in connection with adviser conflicts of interest and the scope and disclosure of fairness opinions. Expert financial advice assists boards in fulfilling their responsibilities in overseeing the negotiation of M&A transactions and, when disclosed, that advice also assists shareholders in evaluating those transactions. However, recent developments are a reminder to directors to scrutinize carefully the advice they receive and the adequacy of the disclosure of that advice to shareholders.

Adviser Conflicts of Interest

A series of decisions from the Delaware courts has highlighted potential conflicts of interest which financial advisers may face. Conflicts of interest have arisen where financial advisers seek to advise on both sides of a transaction, where they have financial interests in a particular form of transaction or the outcome of a sales process, and where no disclosure of these conflicts has been made to the advisers’ clients. Conflicts may negatively affect a target board’s sales process and the board’s ability to rely on financial advice tainted by conflict in connection with fulfilling their fiduciary duties.

Target boards should require that their financial advisers identify and disclose potential conflicts, not merely in the engagement letter but throughout the mandate.

These Delaware cases give some examples of the kinds of conflicts of interest that can arise:

• Sell-side advisers soliciting potential buyers. The target’s financial adviser solicited proposals from buyers after being instructed not to, paired up buyers in breach of “no teaming” restrictions, and approached buyers to provide financing, without disclosure to the board.¹
• Sell-side advisers holding an interest in the bidder. The target's longtime financial adviser, who was advising the target on pursuing a spin-off, was also a significant shareholder of the bidder and held two board seats. Its lead banker also had a significant undisclosed personal investment in the target. These financial interests gave rise to a conflict of interest. A second financial adviser was hired to advise the target on the proposed merger but it would only get paid if that deal was consummated, creating a conflict for the second adviser without curing the concerns regarding its primary conflicted advisers. All of this resulted in what the Delaware court called a deal "tainted by disloyalty."²
• Sell-side advisers doing financing work for buyer. The target conducted a sale process with the assistance of a financial adviser who intended to capture financing work from potential bidders for the target and also financing work for the acquisition of a competitor that was running a concurrent sales process. While the target’s special committee was aware of the adviser’s intentions, it did not make enquiries or impose any practical check on the adviser’s activities. The Delaware court found that the board had breached its fiduciary duty and was aided and abetted in the breach by the financial adviser. Significantly, the court decided that the adviser’s sell-side engagement letter, which stipulated that it could extend acquisition financing to purchasers, did not preclude a claim against the adviser for failing to inform the target board about a specific conflict of interest.³
• Lack of independence. The independence of financial advisers has also been highlighted by the courts. In a recent decision, the Delaware court criticized a sell-side financial advisers’ valuation report prepared in support of an M&A transaction, which produced a favourable tax result for the seller, but adversely affected the option holders who were cashed out pursuant to the terms of the stock option plan. The sell-side advisers, who had been retained to provide an “independent” valuation, were found to have produced a report to achieve the valuation outcome targeted by the target’s principal shareholder, and were found to have lacked independence.⁴

Identifying and managing potential financial adviser conflicts of the kind described above is one of the board’s responsibilities in M&A transactions. Target boards should require that their financial advisers identify and disclose potential conflicts, not merely in the engagement letter but throughout the mandate. Standard disclosures in their engagement letters may not be adequate to address this risk. In certain cases, a target board’s engagement of a second, unconflicted adviser may also not be enough to cure pervasive conflict of interest concerns in an M&A transaction. The conflict of interest decisions from Delaware deliver a clear message: a target board must ensure that conflicts of interest are identified and addressed during an M&A process, requiring that financial advisers make full disclosure of both potential and actual conflicts of interest. Failure to do so can taint a sale process.

Fairness Opinions

In its decision in the 2009 HudBay proceedings, the Ontario Securities Commission noted that an adviser’s success-based compensation may adversely affect the ability of a board to rely on financial advice: “a fairness opinion prepared by a financial adviser who is being paid a signing fee or a success fee does not assist directors comprising a special committee of independent directors in demonstrating the due care they have taken in complying with their fiduciary duties in approving a transaction.”⁵ Recent decisions from Canadian courts have again put fairness opinions in the spotlight.

Where a transaction may be challenged in court, the rationale for a more detailed fairness opinion and enhanced disclosure will likely be stronger.

The current Canadian practice of financial advisers providing a fairness opinion in the context of an M&A transaction (other than mandatory valuations provided in connection with related-party transactions), without public disclosure of the underlying financial analysis supporting the opinion, was called into question by the Yukon Court of Appeal’s decision in InterOil v. Mulacek, and the subsequent decision of the Yukon Supreme Court approving an amended version of the arrangement of InterOil. Like HudBay, the InterOil decisions also questioned a board’s ability to rely on a fairness opinion where the financial adviser providing the opinion received a success fee (and whether the amount of the success fee needed to be disclosed to shareholders).

In the amended version of the InterOil arrangement, the target not only provided additional disclosure on the financial advice it had received, but it also included in its circular a fairness opinion from its financial advisers which included more detail than current Canadian market practice. Post-InterOil, target boards will have to consider whether the circumstances of the transaction require a more detailed fairness opinion or enhanced disclosure that highlights information provided by financial advisers and the conclusions reached by the board based on financial advice. Where a transaction may be challenged in court, the rationale for a more detailed fairness opinion and enhanced disclosure will likely be stronger. For a detailed analysis of the InterOil decisions, see our bulletin “Deal Litigation Puts Growing Pressure on Financial Advice.”

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¹ Del Monte Foods Company Shareholders Litigation, Delaware Court of Chancery, 2011.

² In re El Paso Corp. Shareholder Litigation, Delaware Court of Chancery, 2012.

³ In re Rural/Metro Corp. Stockholders Litigation, Delaware Court of Chancery, 2014.

⁴ Fox v. CDX Holdings, Inc., Delaware Court of Chancery, 2015.

⁵ Ontario Securities Commission, 2009.