Keeping Your M&A Bankers Honest

It's up to a target firm's board to keep a financial adviser's conflicts of interest from tainting a deal, says the Delaware Court of Chancery.

While regulators continue to probe investment banks’ role in matching up buyers and sellers of structured-finance products, two high-profile Delaware Chancery Court cases highlight merger and acquisition engagements as another area of potential conflicts of interest by banks.

In the two cases, In re Del Monte Foods Co. and In re Atheros Communications Inc., the Delaware court showed it “is prepared to raise the bar” regarding investment bankers’ actual or potential conflicts of interest that could threaten to compromise the integrity and fairness of an M&A transaction, according to a new paper by Gardner Davis and Tyler Parramore, attorneys at law firm Foley & Lardner. (The paper appeared in a recent issue of Securities Regulation & Law Report.)

Significantly, though, the Delaware court put the onus on boards of directors, not bankers, to prevent such situations. Failure to do so can result in breaches of fiduciary duty under the Revlon standard, which says directors must focus on securing a deal “that is the best value reasonably available for the shareholder” and “must exercise their fiduciary duties to further that end.”

The Del Monte case concerned the relationship between Kohlberg Kravis Roberts and Barclays Capital during the recent $5.3 billion acquisition of Del Monte Foods by a
KKR-led private-equity group. While Barclays came to advise the Del Monte board on the deal, it failed to disclose pre-engagement discussions with KKR on a Del Monte takeover and the fact that it was pursuing a role in the lucrative buy-side, or “staple,” financing that KKR would need to purchase Del Monte. According to the Delaware court decision, the Del Monte directors did not act reasonably “because they relied upon, and were deceived by, a conflicted financial advisor,” write Davis and Parramore.

The Del Monte ruling sends a strong message that CFOs and other board members need to have an honest, open conversation with their prospective bankers about conflicts of interest. If a board wants to avoid breaches of fiduciary duty, the “beauty contest” for selecting an investment banker or financial adviser now needs to include “blunt questions about [the bank’s] potential conflicts of interest,” say Davis and Parramore.

That may require negotiation, because the first draft of engagement letters from investment-banking firms typically says the banker can and may represent other parties involved in the transaction and may in fact at the time of the auction sale be engaged by them, says Libby Kitslaar, a partner in the corporate practice at law firm Jones Day. Says Kitslaar: “As a client you need to go back and say, ‘Look, that’s really not acceptable. If you’re working for us as our banker in the sale, you cannot be compensated or be engaged by another party in this transaction. On this deal you’re our banker.’”

If a conflict arises in the middle of a sale, Kitslaar says the seller should engage a second investment banker to “do the backstop work on a fairness opinion” and perhaps evaluate competing bids. The selling company’s board could demand that the first bank split its fee with the second.

The good news is that Wall Street is very aware of the Del Monte case, says Kitslaar. “I think [investment banks’] insistence on having a role other than representing the target is going to be diminished — although they may continue to ask for it,” she says.

The other circumstance of the Del Monte case — sell-side bankers representing buyers in staple financing — has come under scrutiny before, says Kitslaar. But now as a result of Del Monte, boards of directors will be loath to let their bankers do staple financing for buyers, unless there are very special circumstances, she says.

In Atheros, the issue was the “success fees” that sellers pay their bankers. The Delaware court took issue with the success fee of Qatalyst Partners, an adviser to chipmaker Atheros Communications in its sale to Qualcomm. Qatalyst negotiated a fee that was 98% contingent on the closing of the transaction. Structured this way, the court said, the financial adviser’s compensation created substantial incentives for it to close the sale. Because Qatalyst’s fee was overwhelmingly contingent on the deal’s closing, the court said it was “material to the stockholders’ decision to support or oppose the transaction,” write Davis and Parramore. But Atheros failed to disclose the fee details in its proxy statement.

While it is long-standing market practice for investment bankers to get some of their pay via a retainer and some via a success fee, the Securities and Exchange Commission has always required detailed information about the extent to which a banker’s fee is contingent on the deal’s success, says Kitslaar. “We see more deals where the bankers are representing a special committee [of the board] and the fee is not contingent, because the special committee wants advice from the bank that is not affected by whether the transaction goes through or not,” she says. “The case law focuses on this — financial advisers to special committees should not have contingent-fee arrangements.”

While there may be no bright-line standard in deals where management is part of the team evaluating an offer, “smart clients understand that bankers have incentives to close the sale because they get a fee, and they keep an eye on that factor,” says Kitslaar.

Regarding disclosure, target companies should fully disclose the fees their investment bankers would earn from a successful transaction, if they want to avoid giving plaintiff shareholders “potential ammunition to attack the ultimate deal,” say Davis and Parramore.