US judges clamp down on M&A farce
Litigation ritual that accompanies mergers benefits lawyers rather than shareholders
Apeculiar ritual occurs after almost every merger or acquisition is announced in the US. Even if the acquirer is paying a 20, 30 or 40 per cent premium above the undisturbed share price, several lawsuits will immediately be filed that breathlessly allege the target company’s board of directors breached its duties by selling up too cheaply.
Yet for virtually all transactions, this litigation is more charade than threat. The post-deal litigation kabuki has a specific choreography: all the lawsuits are consolidated into a single-class action claim. There may be a perfunctory discovery period when depositions are taken. But quickly a settlement is reached: a few lines of prose are added to the proxy document that describe the deal circumstances. (These additional disclosures are derisively referred to in the industry as “peppercorn” for their weightlessness.)
Shareholders rarely receive a nickel, but the plaintiffs’ lawyers typically get several hundred thousands of dollars in fees. This game has long been accepted as a “tax” on doing deals. But now the farce has proceeded long enough that judges in the Delaware Court of Chancery, which must typically approve these “disclosure-only” settlements, are embarrassed.
In several recent cases, the Delaware chancellors have expressed deep unease about the practice. Last Friday, the court rejected a disclosure-only settlement related to Hewlett-Packard’s $3bn acquisition of Aruba Networks.
The dilemma is as follows: plaintiffs’ lawyers get a sizeable fee for little work, companies pay a few hundred thousand dollars and, crucially, as the irreverent judge Leo Strine has put it, the board gets in exchange an “intergalactic” waiver that prevents any other misconduct claims against them from being litigated anywhere else. The arrangement benefits lawyers and companies but discourages the investigation of genuine bad behaviour.
The growing resistance in Delaware is not about discouraging all shareholder lawsuits. Rather, the judges want lawyers to focus their efforts on genuine failures in the M&A process. To make that happen, the court has made clear that in cases of bad behaviour, deep-pocketed investment banks can be held to account.
In a sensational Delaware case decided last year by Chancellor Travis Laster, the investment bank Royal Bank of Canada was found to have “aided and abetted” a breach of duty by its clients, the directors of Rural/Metro Corp. Rural/Metro was an ambulance company that was acquired by Warburg Pincus for $728m in 2011. The trial uncovered evidence that RBC had slanted its analysis and advice to secure lucrative financing assignments. The judge ordered the bank pay $76m in damages.
RBC is appealing, and its defence hinges on multiple technical legal arguments. But language in last year’s trial decision has bankers across Wall Street on edge: “The threat of liability helps incentivise gatekeepers [bankers] to provide sound advice, monitor clients and deter client wrongs,” says one.
Bankers, in an effort to limit their legal exposure, usually try to describe their duties as narrowly as possible in carefully drafted client engagement letters. The new Delaware ruling would shoot huge holes in that strategy. “In effect, the Court of Chancery’s new rule of law would require financial advisers to assume a de facto duty to supervise the board — essentially to act as the board’s overseer,” industry group the Securities Industry and Financial Markets Association warned in a brief to the Supreme Court.
The RBC case is not one-off. Goldman Sachs, Barclays, Bank of America and Credit Suisse have also taken heat from the court for their advice in prominent transactions. Those cases, importantly, have forced bankers and boards to think more consciously about conflicts of interests. Today, the practice of bundling deal financing with deal advice has effectively ended. Companies also increasingly hire multiple financial advisers so they have several points of view before selling themselves.
But the worry is that zealous plaintiffs’ lawyers, enabled by aggressive judges, will swing the pendulum too far. For banks, it is not just about losing in court but losing the pitch. One prominent litigator said: “Bankers don’t like this regime. They don’t want to invent conflicts where they don’t exist . . . The more your disclose the hell out of stuff, the more directors take their deal somewhere else”.