Financial Advisor Contingent Fee and Investment Conflicts in M&A Transactions
By Richard B. Kapnick, Courtney A. Rosen, and Arsen R. Ablaev, Sidley Austin LLP
Courts evaluating board of director decisions concerning strategic transactions, including the proposed sale of public companies, frequently are asked to determine whether a financial advisor had any improper incentives that may have tainted the transaction process. This article briefly surveys how various courts have evaluated allegations of financial advisor conflicts of interest arising from contingent fees and investments.
As the decisions of state and federal courts demonstrate, sell-side advisor investments and advisor fee structures may become the basis for stockholder lawsuits, especially where they occur simultaneously in the context of other potential conflicts. These lawsuits can create substantial exposure and potentially impact the merger and acquisition approval process and the timing and certainty of closing. In order to minimize the likelihood of such risks, directors and corporate counsel should investigate and consider these potential investment- and fee-based conflicts, as well as any related disclosure implications.
I. Financial Advisor Contingent Fees
Some portion of the financial advisor’s compensation often is contingent upon closing the transaction for which the advisor is asked to deliver a fairness opinion. In some cases, this has caused plaintiffs to allege that the financial advisor has a conflict arising from an incentive to favor the transaction. The Delaware courts “routinely” have upheld such contingent fees,1 as have the courts of other states.2
Most contingent fee cases turn on whether the fact of contingency and, in some cases, the amount of the contingency, must be disclosed. For example, where the contingent portion of the advisor’s fee makes up a sufficiently large part of the fee, Delaware courts have typically required a quantified disclosure of the amount of, or the contingent proportion of, the contingent fee, rather than a simple disclosure that a “substantial” portion of the fee is contingent. In one case, the Delaware Chancery Court required quantified disclosure of a contingent fee that comprised approximately 98 percent of the total amount and was nearly 50 times the non-contingent fee. The court stated:
Although the Proxy Statement reports that a “substantial portion” of the fee is contingent, the percentage of the fee that is contingent exceeds both common practice and common understanding of what constitutes “substantial.” Contingent fees are undoubtedly routine … . Here, however, the differential between compensation scenarios may fairly raise questions about the financial advisor’s objectivity and self- interest.3
In another case, the Delaware Chancery Court preliminarily enjoined a merger to require more complete disclosure of a $17.5 million contingent fee, which made up 92.11 percent of the financial advisor’s total fee; that court stated the general rule that, “where a significant portion of bankers’ fees rests upon initial approval of a particular transaction, that condition must be specifically disclosed to the shareholder.”4
Courts in other states have followed a similar approach. For example, a Maryland trial court denied a preliminary injunction in a stockholder class action where a conflict was alleged based on the contingent fee of the seller’s advisor.5 The court held that “Plaintiff presents no credible basis for this court to conclude that the size of the fee and its contingent nature are out of normal bounds and a ground for finding that Defendants breached their duty of care.”6 Moreover, the proxy statement in that proposed transaction had fully disclosed that each of the seller’s two financial advisors would receive fully contingent $12.6 million fees.7 Similarly, a Massachusetts state appellate court held that contingent financial advisor fees are not improper provided that the fact of contingency is disclosed to the stockholders.8
The disclosure of contingent fees may also be required under federal law. A few federal cases have set parameters on when Section 14(a) of the Securities Exchange Act requires contingent financial advisor fees to be disclosed in a proxy statement soliciting a stockholder vote for a proposed transaction. For example, inAnderson v. Boothe, a U.S. District Court declined to dismiss stockholder plaintiffs’ Section 14(a) claim that a sell-side advisor’s fee, which was contingent on it delivering a fairness opinion in favor of the merger, was inadequately disclosed.9 The proxy disclosed that the advisor was to receive a $250,000 non-contingent fee and an additional $150,000 fee payable only if the fairness opinion “has been made publicly available.”10 The advisor’s senior partner testified that the advisor would receive the second fee only if its opinion found the merger proposal fair and was thus disclosed in a proxy statement. The court held that the plaintiffs alleged sufficient facts to survive a motion to dismiss on the claim that the outcome-contingent nature of the second fee was not disclosed. In other words, the court interpreted the disclosure as not indicating clearly enough the outcome-contingent nature of the fee. In so holding, the court observed that “[b]ecause a contingent fee arrangement between a target company and its investment banker could have the potential to taint the fairness opinion of the investment banker, we conclude that the reasonable shareholder would consider information regarding a contingent fee arrangement of obvious importance in deciding how to vote on a merger proposal.”11
On the other hand, in Radol v. Thomas, a U.S. District Court held that a clear disclosure of a contingent fee was sufficient to defeat a Section 14(a) disclosure claim.12 The financial advisor initially had been hired by the target, Marathon Oil Company, to seek out and negotiate alternatives to a hostile $85 per share cash tender offer by Mobil, Inc. During the course of the hostile offer, the target negotiated a two-step transaction with a “white knight,” United States Steel Corporation. The advisor was entitled to a base fee of $1 million, as well as $4 million plus 1 percent of the aggregate consideration stockholders would receive in excess of $85 per share.13 Plaintiffs contended that the proxy’s characterization of the advisor as “independent” was misleading in part because of the contingent fee structure. The court denied a preliminary injunction, holding that the proxy statement “fully disclosed” the nature of the fee arrangement.
II. Seller Financial Advisor Investments in the Acquiror
Recently, in In re El Paso Corporation Shareholder Litigation, the Delaware Chancery Court evaluated an alleged financial conflict arising from an investment in the acquiror by the seller’s financial advisor.14 El Paso is a unique case where multiple conflicts and severe defects in the transaction process raised serious questions about the financial advisor’s incentives in recommending a course of action. In El Paso, Goldman Sachs was retained to act as a financial advisor for a Texas oil and gas company, El Paso Corporation. After a spinoff of El Paso’s exploration and production business (“E&P”) was announced, another Texas oil company, Kinder Morgan, in which Goldman held investments, made a non-public offer for all of El Paso, which ultimately resulted in a $21 billion sale of the whole company. El Paso stockholders filed an action seeking to enjoin the merger, in part due to Goldman’s alleged conflict of interest. The court held that Goldman’s $4 billion investment in Kinder Morgan (19 percent of that company), a $340,000 personal investment by the lead Goldman banker in Kinder Morgan, and Goldman control of two Kinder Morgan board seats so misaligned Goldman’s incentives in advising El Paso that it tainted the sale process.15
In an effort to cleanse any alleged advisor conflict, El Paso brought in another financial advisor, Morgan Stanley, to advise it on the merits of the sale to Kinder Morgan and established an ethical screen that purported to limit Goldman’s advisory role to evaluating the E&P spin-off.16 However, the court held that these measures were insufficient, in part because the spin-off, as the strategic alternative to the merger, was integral to the El Paso board’s decision whether to sell to Kinder Morgan. The court concluded that “because Goldman stayed involved as the lead advisor on the spin off, it was in a position to continue to exact influence over the Merger.”17Although the court held that the plaintiff stockholders had shown a likelihood of success at trial on their claims that the acquisition process was flawed, it declined to grant a preliminary injunction because no rival bidders had emerged and El Paso stockholders should have the opportunity to vote on a transaction they might find “desirable in current market conditions, despite the disturbing behavior that led to its final terms.”18 Ultimately, the El Paso stockholders approved the transaction.19
Provided that sufficient disclosure is made, however, an investment by the seller’s financial advisor in a potential acquiror does not automatically create a disabling conflict of interest. Under Delaware law, the magnitude of an advisor’s investment in a target company must be disclosed where plaintiff stockholders allege and prove circumstances establishing that the investment substantially misaligns the advisor’s incentives. For example, inDavid P. Simonetti Rollover IRA v. Margolis, the court ordered quantified disclosure of the value of certain notes and warrants in the target’s stock owned by the seller’s financial advisor: “[It] is imperative for the stockholders to be able to understand what factors might influence the financial advisor’s analytical efforts. In this instance, if the merger occurs, [the seller's financial advisor] not only would receive a substantial fee … but also it would receive certain benefits as the holder of various [seller] obligations.”20
The advisor’s actual incentives may be analyzed by reference to its total holdings. Applying that principle in In re Micromet, Inc. Shareholders Litigation, the Delaware Chancery Court held that the disclosure that the seller’s financial advisor may “actively trade” in the buyer’s securities was sufficient, despite the advisor’s $336 million investment in the buyer, because the advisor’s position constituted only 0.16 percent of its overall investment portfolio and was substantially smaller than the advisor’s holdings in other potential buyers.21
Courts outside Delaware have applied similar principles in dismissing alleged financial advisor conflict claims. For example, in Dixon v. Ladish Co., Inc., the Eastern District of Wisconsin, applying Wisconsin law, dismissed a stockholder claim arising out of the proposed sale of Ladish Company to Allegheny Technologies, Inc.22 The dismissed complaint alleged that the seller’s financial advisor owned shares of the buyer, Allegheny, and that this created a conflict of interest and breach of fiduciary duty for the Ladish board members. Although the Ladish opinion does not discuss the amount or nature of the advisor’s holdings in the buyer, the proxy statement in the transaction clearly disclosed that the advisor, as a full-service investment firm, may from time to time trade in securities of the buyer for its own account or for accounts of its customers.23 In dismissing the Ladish complaint, the court strongly suggested that the advisor’s investment in the buyer for its own account or accounts of its customers did not constitute a meaningful conflict of interest. This was especially true because the alleged conflict was “actively disclosed” in the proxy soliciting votes on the transaction and because the Ladish complaint failed “to connect the advisor’s alleged conflict to imputation of the conflict on the board.”24The Ladish shareholders ultimately approved the merger and the transaction closed a little over a month after the complaint was dismissed.25
Similarly, a Connecticut state court applying Delaware law dismissed a disclosure claim brought by a tender offer target’s stockholder based on the target advisor’s alleged holdings of the buyer’s securities.26 Relying on Delaware precedent, the court dismissed the disclosure claim, holding that, to survive a motion to dismiss, the plaintiff had to allege “the probable magnitude” of the advisor’s holdings in the buyer or a “special or unique benefit” that the advisor’s holdings would confer if the tender offer were accepted.27 Two Massachusetts state courts reached the same conclusion.28
On the other hand, in at least two cases, courts have found financial advisor conflicts to be material in situations like El Paso that involved multiple allegations of conflicts of interest and severe defects in the transaction process.
In Berkman v. Rust Craft Greeting Cards, Inc., the Southern District of New York granted a preliminary injunction on a federal disclosure claim after finding that a meaningful conflict existed where the advisor in a $6.6 million friendly takeover purchased $750,000 of the target’s convertible debentures one day before its retention as the target’s financial advisor.29 Four of the target’s directors were aware of the financial advisor’s investment but did not disclose it to the other five members of the target board until the draft proxy statement was circulated.30 At that point, in an effort to cleanse the potential advisor conflict, the board sought a fairness opinion from an additional financial advisor and subsequently circulated a proxy statement that omitted any mention of the first advisor’s potential conflict arising from the investment. Plaintiff stockholders filed a motion for a preliminary injunction, which the court granted, holding that the first advisor’s potential conflict of interest “affected [its] credibility and was highly relevant in assessing the firm’s per share price recommendation” and that the four directors’ failure to communicate the advisor’s conflict to the other board members “borders upon a breach of fiduciary duty.”31 Following an amended proxy solicitation, the company’s stockholders approved the sale at a higher price and the transaction was closed.32
In re New York Stock Exchange/Archipelago Merger Litigation involved a merger transaction between the New York Stock Exchange, Inc. and Archipelago Holdings, Inc.33 In negotiating the transaction, the parties provided that Goldman Sachs “would act as facilitator to the deal.”34 Another investment banker, Lazard, acted as the NYSE’s financial advisor in the proposed transaction. Following announcement of the transaction, NYSE seatholders filed a complaint alleging that Goldman and Lazard were conflicted due to Goldman’s 15.6 percent ownership interest in Archipelago and Lazard having been hand-picked by the NYSE’s Chief Executive Officer who, as a former Goldman partner, also had an indirect ownership interest in Archipelago.35
Following its denial of defendants’ motion to dismiss, the court heard two days of testimony concerning the alleged advisor conflicts before the matter was settled. In evaluating the parties’ settlement, the court held that “plaintiffs established a prima facie case of Goldman’s conflict of interest.”36 Although the parties had retained Goldman only as a deal “facilitator” and not as a financial advisor to either side, the court found Goldman’s involvement in the valuation and negotiations to be so pervasive as to effectively make it a “financial advisor to both parties.”37 Specifically as to Goldman’s services to the NYSE, the court stated that Goldman, along with other banks, “first ‘pitched’ or otherwise suggested a deal with Archipelago to the NYSE” and subsequently presented to the NYSE board a preliminary financial analysis of the merger vis-à-vis other strategic alternatives.38 The court found that given “the circumstances of Goldman’s extensive role and the conflicts of the participants to this transaction, … plaintiffs’ claims seeking further disclosure were likely to be meritorious.”39Despite these defects in the transaction process, the court found the independent fairness opinion and additional disclosures provided in the settlement to be fair, and thereafter the NYSE seatholders voted overwhelmingly in favor of the transaction and the merger closed.40
As these decisions of state and federal courts demonstrate, sell-side advisor investments and advisor fee structures may become the basis for stockholder lawsuits, especially where they occur simultaneously in the context of other potential conflicts. These lawsuits can create substantial exposure and potentially impact the merger and acquisition approval process and the timing and certainty of closing. In order to minimize the likelihood of such risks, directors and corporate counsel should investigate and consider these potential investment- and fee-based conflicts, as well as any related disclosure implications.
Cases involving allegations of financial advisor conflict of interest are intensely factual. Adding or subtracting critical facts alters the outcome. This is especially true of the cases where the courts have found substantial financial advisor conflicts, such as El Paso, Rust Craft and NYSE. In each of these cases, the presence of a potential advisor conflict magnified other potential conflicts and defects in process. The ultimate question in each of these cases is what is the appropriate remedy? As the El Paso court stated: “No one can tell what would have happened had unconflicted parties negotiated the Merger. That is beyond the capacity of humans.”41 In each of the cases, the courts embraced full disclosure as the appropriate remedy, leaving the stockholders “to decide for themselves about the Merger, despite the disturbing nature of some of the behavior leading to its terms.”42
Richard B. Kapnick and Courtney A. Rosen are partners and Arsen R. Ablaev is an associate at Sidley Austin LLP in Chicago, where their practices include litigation involving mergers and acquisitions, breaches of fiduciary duties, securities fraud and complex commercial litigation. The views expressed in this article are exclusively those of the authors and do not necessarily reflect those of Sidley Austin LLP. This article has been prepared for informational purposes only and does not constitute legal advice. Copyright for this article is retained by the authors.
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