Ruling Highlights Unequal Treatment in Penalizing Corporate Wrongdoers

Bankers are not exactly popular these days, but is it right to let directors escape scot-free when they do wrong and an investment bank pays the bill?

A Delaware judge recently found the Royal Bank of Canada’s investment bank liable for up to $250 million based on a claim that the investment bank, RBC Capital Markets, “aided and abetted” wrongdoing by the board of the ambulance services company Rural/Metro Corporation — namely, selling the company on the cheap. Yet, because of laws that make it virtually impossible to hold directors personally liable, Rural/Metro’s board was able to settle a shareholders’ lawsuit over the sale for just $6.6 million, most of which was paid by insurance, according to a source with knowledge of the lawsuit. The case shows just how greedy investment bankers can be, but is it right for the bank to be paying so much money and not the directors, particularly when it is the directors’ misconduct that the bank’s liability is based on?

The road to the Delaware courtroom began in 2010, when Rural/Metro formed a special committee to examine a possible combination with its biggest competitor, American Medical Response, and subsequently other strategic alternatives. At this point, two directors on the Rural/Metro board began to favor their own interests, according to the opinion by Delaware judge overseeing the case, Vice Chancellor J. Travis Laster.

One director, Christopher Shackelton, appeared to prefer a buyout. He runs a hedge fund, Coliseum Capital Management, which owned 22 percent of Rural/Metro and was looking to sell this stake, according to the judge’s opinion. A second director, Eugene Davis, was going to resign from the board if a sale was not announced soon. Mr. Davis sat on a dozen boards at the time, and his resignation was in response to criticism by Institutional Shareholder Services, the shareholder proxy adviser, that he was “over-boarded,” or unable to devote enough attention to all the company boards he sat on. If a sale occurred, Mr. Davis would keep $200,000 in incentive compensation, an amount he would forfeit if he resigned.

Even with these personal interests, the two men were picked for the special committee of three directors that would consider Rural/Metro’s future.

The judge found evidence that, at the behest of Mr. Shackelton and Mr. Davis, the special committee set up a process to auction the company despite directions from the board to consider other options.

The apparent goal to sell came into conflict with the interests of the company’s new chief executive, Michael DeMino, who wanted to execute a growth plan that he thought would make the company “more valuable.” But Mr. Shackelton thought a growth stock was too risky for his fund and favored an exit, according to the opinion.

Relations between the two directors and the chief executive subsequently soured. Mr. Shackelton and Mr. Davis then provided a “scathing” review of Mr. DeMino’s performance for his first six months on the job. Afterward, Mr. Davis testified that a “light bulb” went off over the chief executive’s head and he became an advocate for a sale.

With a special committee stacked in favor of a sale and the chief executive now on board, RBC entered the stage.

The investment bank was hired by the special committee to provide financial advice, but it seemed more interested in arranging a quick sale of Rural/Metro. The reason was that not only would RBC be paid a fee only if there was a sale, but RBC was also angling to provide the debt financing for a bidder in the auction, the private equity firm Warburg Pincus, which was the eventual winner.

The fee for the sale of Rural/Metro was only $5.1 million, but the financing fees paid by Warburg could be as much as $20 million. With these incentives, the judge found, RBC was bent on selling Rural/Metro at a lower price than might otherwise be obtained, in order to get the financing engagement.

The Delaware judge found that RBC’s lust for those extra millions in financing fees led it to do some other bad things. The parent company of American Medical Response, Emergency Medical Services, also put itself up for sale during this time, and RBC also wanted an inside track for the financing there to earn another $35 million in fees.

Any bidder for Emergency Medical Services was also most likely a bidder for Rural/Metro, so RBC pushed for a sale of Rural/Metro at the same time to get more fees because “RBC correctly perceived that the firms bidding for Emergency Medical Services would think they would have the inside track on Rural if they included RBC” as part of the financing team for an Emergency Medical Services acquisition, according to the opinion.

This ended up hurting Rural/Metro, however, as bidders for Emergency Medical were effectively prevented from participating in auctions for Rural/Metro.

Not only that, but RBC did scant financial analysis for the Rural/Metro board. In its limited financial valuation, RBC massaged the numbers to justify Warburg’s final offer price of $17.25 a share, when the investment bank had determined a valuation $21.27 a share for the company just three months earlier.

Given these facts, it was no surprise that Vice Chancellor Laster found RBC liable.

To find the investment bank liable, however, the judge also had to find misdeeds committed by the Rural/Metro board. Vice Chancellor Laster held that the Rural/Metro Board had breached its fiduciary duties because Mr. Shackelton and RBC effectively put the company up for sale without full board authorization and that the board had failed to properly supervise RBC. He also concluded that the Rural Metro board did not have an “adequate understanding of the alternatives available to Rural” and that its decision to accept the Warburg offer was not reasonable because of a lack of sufficient information.

The judge has yet to calculate damages, but they could be as much as $250 million, despite the fact that RBC was never retained to do the financing and earned only its $5 million fee. If the opinion is correct, there is no doubt that RBC deserves to be found liable for these and other claims made. But the opinion most likely focuses on RBC’s misdeeds because of the earlier settlement with the directors.

Do we think that the directors here were duped? These were sophisticated directors on the special committee. And even if some or most directors were fooled, the judge found that Mr. Shackelton and RBC “unilaterally put Rural into play,” that Mr. Shackelton and Mr. Davis pushed a sale and that RBC and Mr. Shackelton drove a strategy that “prevented Rural from generating the higher values” of Mr. DeMino’s growth strategy. Because of the settlement with the directors, RBC cannot even pursue them for their contribution as wrongdoers, a common legal claim. Instead, to the extent that RBC can show that the directors, including Mr. Shackelton, were at fault, RBC’s liability will be reduced. This means Rural Metro’s shareholders will receive less money, not that the directors will pay up.

So why was there such a puny settlement, you may ask? Well, it goes back to Delaware laws, which allow companies to limit the liability of directors, rules that Rural/Metro adopted. But these laws don’t apply to investment bankers, so you have the strange situation where the RBC bankers who did wrong pay for their liability but the directors move on without any real penalty.

Lawyers for Mr. Davis, Mr. Shackleton and the other directors did not respond to a request for comment.

So far, the commentary on this case has focused on RBC’s conduct and saying “don’t act like a clown,” “be careful” and “don’t blindly pursue fees.” But we knew that already.

Instead, perhaps we should rethink how companies are sold and who is held liable when things go wrong. The Rural/Metro case shows how skewed the incentives can be, and how the checks and balances can too easily go wrong. Next time, there may not be a bank that can be put on the hook so easily. In other words, the directors may once again get away with wrongdoing, and shareholders will be left with nothing.