A New Delaware M&A Case Is a Warning to Investment Bankers: Take Care That You Don’t Mislead the Board

investment-bankers-12-21-15.pngMerger and acquisition activity appears to be accelerating among community banks large and small. Despite the nearly ubiquitous shareholder lawsuit that follows a merger announcement from a publicly traded target company, the corporate law relating to the obligations of a board of directors in a merger transaction is well developed and favorable. There is a high bar for board culpability in an M&A transaction, and an even higher bar for board liability. However, recent Delaware court cases have highlighted potential liability for investment bankers that is not shared by directors. This is quite an alarming development, which is of obvious concern to investment bankers, but also should impact boards of directors as they consider deals.

Under Delaware law, which is followed by most states, the primary obligations of the board in a merger transaction relate to good faith, a component of the duty of loyalty, and making an informed decision, duty of care. Fortunately, most companies have a charter provision eliminating director personal liability for monetary damages for breaches of the duty of care, which is not allowed for breaches of the duty of loyalty. And, according to the Delaware Supreme Court in the Lyondell case, director personal liability for “bad faith” requires a knowing violation of fiduciary duties. For example, in a sale transaction, shareholders aren’t supposed to act on a goal other than maximizing value, or in a non-sale merger, act for reasons unrelated to the best interests of the stockholders generally.

Another important hallmark of Delaware M&A case law is the extreme reluctance of judges to enjoin a stockholder vote on a merger transaction when there is no competing offer. And once a transaction closes, and the challenged target company directors were independent and disinterested, and did not act with the intent to violate their duties, judges typically dismiss the lawsuits against directors.

However, in a recent case, which involved the sale of a company called Rural/Metro Corporation, the Delaware Supreme Court ruled that third parties, such as investment bankers, can be liable for damages if their actions caused a board to breach its duty of care, even if directors are not liable for the breach. Moreover, simple negligence by the board, rather than gross negligence, can serve as the basis for third party liability.

In Rural/Metro, the investment bankers were found to have had numerous conflicts of interest, most of which were not discussed with the board. They sought to participate in the buyer’s financing of the acquisition and they sought to leverage their involvement with the seller, Rural/Metro, to obtain a financing role in another merger transaction. They were also found to have manipulated the fairness analysis to serve their conflicted interest in having a particular party win the bid for Rural/Metro. The court held the behavior of the investment bankers caused the board to be uninformed as to the value of the company and caused misleading disclosure. They were held liable to stockholders for $76 million in damages.

The Delaware Supreme Court stated that a board needs to be active and reasonably informed in its oversight of a sale process and must identify and respond to actual or potential conflicts of interest as to its advisers. Importantly, the Delaware Supreme Court rejected the lower court’s characterization of the role and obligations of an investment banker as a quasi fiduciary “gate keeper,” and stated that the obligations of an investment banker are primarily contractual in nature. It further held that liability of an investment banker will not be based on its failure to take steps to prevent a director breach but on its intentional actions causing a breach.

The case is a warning for both boards and investment bankers: Take care when there is a conflict of interest. Investment bankers should avoid conflicts where possible, disclose all conflicts to the board and the board and the investment bankers need to work diligently to address conflicts adequately. In order to do their job well, board members must make sure their advisors are telling them what they need to know.

Stock Analyst: Own Bank Stocks Now

Anthony Polini is a managing director at Raymond James & Associates in New York and covers big and regional banks, such as JPMorgan Chase & Co., Citigroup Inc. and Hudson City Bancorp. This is a longer version of an interview that appeared in the fourth quarter issue of Bank Director magazine, where Polini talks about the cyclical nature of bank stocks and why they are a good investment right now given the country’s slow recovery.

What is your outlook for bank stocks?

You tell me the results of the presidential election, what interest rates are going to be by the end of the year and I’ll tell you what will happen with bank stocks. I personally think a Republican victory [in the presidential election] would be better for bank stocks and the stock market in general. The one caveat is interest rates. There is a point where you keep rates so low for so long, even if you have growth, the incremental yield comes down, which is a headwind for earnings growth.

One thing you have to realize is that bank stocks are cyclical. For many years, bank stocks were viewed as interest rate plays but in reality, they are very cyclical. A positive comment from the Federal Reserve [chairman Ben Bernanke] could send stocks up 5 percent. Increased concern about Spanish debt could mean Citigroup, JPMorgan and Bank of America lead the market lower. If the news is generating a negative outlook, the banks are going to move down.

Given the fact the bank stocks are cyclical, is this a good time for investors to buy them?

You want to load up on bank stocks in the middle of a recession. Sometimes you are in a recession for several quarters before you [determine] when the recession began. You want to overweight banks from the latter stages of a recession to the mid-stages of a recovery. One of the problems with this recovery is we are in the early stages of a recovery. It is slow. The economy is on two or three cylinders, not eight cylinders.

So you think investors should be sure to have bank stocks in their portfolio? What are your favorite picks?

Yes. You have some that are super, high-quality names and have high dividends. Those banks tend to lag [the rest of bank stocks] on positive days. A top pick in that category has been [the $43.5-billion asset] New York Community Bancorp. NYB is the ticker symbol. We have it rated a strong buy. It has a dividend yield of 7.5 percent and trades slightly above book value. It’s at a relatively safe valuation to play the sector and pick up a high dividend yield.

The mega-cap banks clearly have the most attractive valuations. They also have more risk related to the global economic outlook. They probably have more volatility than the small- to mid-cap banks. In general, the more defensive names tend to be the smaller banks with less global exposure.

We’ve had very few M&A deals lately. But two of the banks you cover are merging in one of the biggest deals all year. M&T Bank Corp. is buying Hudson City Bancorp. What’s your take on that deal?

I think Hudson City was on everybody’s list as a likely seller this year. The chief executive officer recently had some health issues. It is a quality franchise but the business model—leveraging up debt, sticking to residential mortgages—[isn’t] as good as it used to be. I think they were under pressure to redefine themselves, which they started to do, and I think the decision to sell was probably a wise one. What M&T paid didn’t look exorbitant. [The deal value was $3.8 billion, or 85 percent price to tangible book value.] Another way to look at it is, it’s a very good deal for M&T. It’s not a huge deal but it’s a good deal for them. It was a good price. The only thing that didn’t make sense to me was the high cash component, [60 percent was stock and 40 percent was cash]. Both stocks have done well since the announcement. But if you are going to sell cheap without a bidding process, one would think you would take all stock.

Bank acquisitions rise in first quarter, but not by much

Top dealmakers include Sandler O’Neill & Partners, Raymond James & Associates and Keefe, Bruyette & Woods 

Top dealmakers by volume

Top dealmakers by number of deals

There weren’t a lot of fish to be had, but Sandler O’Neill & Partners took the bigger fish. With 34 total bank and thrift acquisitions worth just $2.3 billion in the first quarter, the firm’s investment bankers were the top dealmakers by volume in the first quarter, after handling the $1 billion Comerica Inc. acquisition of Sterling Bancshares, Inc., according to SNL Financial.

race-track.jpgSenior Managing Director Jimmy Dunne III of Sandler O’Neill was ranked number one with two deals worth a total $1.5 billion: He handled Comerica as well as People’s United Financial’s $489 million acquisition of Danvers Bancorp., both announced in January.

He was quickly followed by John Ziegler and Liz Jacobs, both of Sandler O’Neill & Partners, who both worked on the Comerica deal as well.

Tom Mecredy of Raymond James & Associates, Inc., and Jeff Brand and Steve Kent with Keefe, Bruyette & Woods, Inc., were the top bank deal makers by number of deals, with three deals each.

Deal volume improved in the first quarter compared to last year, with 34 deals done compared to 26 during the same quarter last year. But pricing remains lower than historic levels, with the average deal price to book value at 103.2 percent in the first quarter, down from 123.7 percent a year ago.

Last year, there were more than 170 bank mergers and acquisitions announced worth about $12 billion, compared to 296 in 2006 worth $109 billion, according to SNL.