Articles Banker Loyalty in Mergers and Acquisitions

TUCH.TOPRINTER (DO NOT DELETE) 5/24/2016 6:07 PM Articles Banker Loyalty in Mergers and Acquisitions Andrew F. Tuch* When investment banks advise on merger and acquisition (M&A) transactions, are they fiduciaries of their clients, gatekeepers for investors, or simply arm’s-length counterparties with no other-regarding duties? Scholars have generally treated M&A advisors as arm’s-length counterparties, putting faith in the power of contract law and market constraints to discipline errant bank behavior. This Article counters that view, arguing that investment banks are rightly characterized as fiduciaries of their M&A clients and thus required to loyally serve client interests. This Article also develops an analytical framework for assessing the liability rules that will most effectively deter disloyalty on the part of investment banks toward their M&A clients. Applying optimal deterrence theory, the framework shows why holding only banks liable for disloyalty is unlikely to effectively deter such disloyalty. Instead, it suggests the need for fault-based liability rules to be applied to corporate directors (of M&A clients) for their oversight of the banks they engage as well as the potential need for public enforcement of certain hard-to-detect conflicts. Applying this framework, this Article assesses existing law, focusing on recent Delaware decisions, generally supporting that law but arguing that it is unlikely to effectively deter advisor disloyalty. It suggests changes to address the regulatory gap. * Associate Professor, Washington University School of Law. For helpful comments and discussions, I thank Adam Badawi, Scott Baker, Stephen Bainbridge, Randall Baron, Richard Brooks, John Coates, Matthew Conaglen, Steven Davidoff Solomon, Gerrit De Geest, Deborah DeMott, Jesse Fried, Stephen Galoob, Donna Hitscherich, Hon. Randy Holland, Rebecca Hollander-Blumoff, Howell Jackson, Peter Joy, Dan Keating, Dan Kelly, Reinier Kraakman, Arthur Laby, Don Langevoort, Hon. J. Travis Laster, David Law, Alan Morrison, Russell Osgood, Hon. Donald Parsons, Jr., Teddy Rave, Laura Rosenbury, Hillary Sale, Steve Shavell, Holger Spamann, Brian Tamanaha, William Wilhelm, and participants at the American Law and Economics Association 2015 Annual Meeting and at workshops hosted by Boston University, Brigham Young University, Indiana University Bloomington, Seton Hall University, University of Delaware, University of Notre Dame, University of Toronto, and Washington University. For help in understanding market practices, I thank Eric Klinger-Wilensky, Jason Tyler, Bob Wigley, and Michael Zaoui. For research assistance, I thank Galen Spielman, Mark Stern, John Torrenti, and Hancen Yu. All errors and opinions are my own. TUCH.TOPRINTER (DO NOT DELETE) 5/24/2016 6:07 PM 1080 Texas Law Review [Vol. 94:1079 INTRODUCTION ................................................................................ 1080 I. THE M&A ADVISOR AS FIDUCIARY ......................................... 1085 A. Transactional Context ................................................... 1086 B. Organizational Structure and Risk of Conflict .............. 1089 C. Client Relations............................................................. 1093 D. Characterization ............................................................ 1098 E. Countervailing Considerations ..................................... 1105 1. Clients’ Capacity to “Fend for Themselves” ............ 1105 2. Pervasiveness of Disloyalty ...................................... 1108 3. Market Practices ....................................................... 1109 4. Firm Structure........................................................... 1110 II. STRUCTURING LIABILITY RULES .............................................. 1112 A. Framework for Analysis ............................................... 1112 B. Liability of M&A Advisors: A Simple Regime ............ 1116 C. Liability of Corporate Directors.................................... 1124 D. Caveats and Extensions ................................................ 1129 III. EVALUATING EXISTING LAW ................................................... 1133 A. How Delaware Law Conforms ..................................... 1134 B. How Delaware Law Fails to Conform .......................... 1143 C. How Delaware Law Should Develop ........................... 1146 IV. OTHER IMPLICATIONS .............................................................. 1151 CONCLUSION ................................................................................... 1154 Introduction As advisors to corporations, governments, and other institutions, investment banks often face conflicts of interest.1 The risk of conflict is especially pronounced in their core role as advisors on merger and acquisition (M&A) transactions. The most significant of corporate events,2 M&A transactions are a major component of economic activity: in 2015, over 10,000 such transactions, collectively valued at $2.3 trillion, were announced in the United States.3 In these important transactions, conflicts may arise because 1. In accord with its usage in the legal context, the term conflict of interest is understood here to refer to circumstances giving rise to a substantial risk that the advisor’s own interests, or a duty it owes to another person, will materially and adversely affect its representation of a merger and acquisition client. See RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS § 121 (AM. LAW INST. 2000) (“A conflict of interest is involved if there is a substantial risk that the lawyer’s representation of the client would be materially and adversely affected by the lawyer’s own interests or by the lawyer’s duties to another current client, a former client, or a third person.”). For further discussion, see infra notes 63–77 and accompanying text. 2. See BEVIS LONGSTRETH, MODERN INVESTMENT MANAGEMENT AND THE PRUDENT MAN RULE 71 (1986) (“[T]he takeover phenomenon . is the dominant corporate event of recent years . .”). 3. See THOMSON REUTERS, MERGERS & ACQUISITIONS REVIEW: FINANCIAL ADVISORS 2 (2015), http://dmi.thomsonreuters.com/Content/Files/4Q2015_Global_MandA_Financial _Advisory_Review.pdf [http://perma.cc/9BCU-V6Q5]. The figures are for announced M&A transactions in the United States. TUCH.TOPRINTER (DO NOT DELETE) 5/24/2016 6:07 PM 2016] Banker Loyalty in Mergers and Acquisitions 1081 banks engage simultaneously in multifarious nonadvisory activities, often giving them opportunities to extract wealth at their clients’ expense. Consider recent examples of the phenomenon under inquiry. In the acquisition of El Paso Corporation by Kinder Morgan, Goldman Sachs advised the seller despite owning 19% of the buyer—a stake valued at $4 billion—and controlling two seats on its board.4 While advising Del Monte Food Company on its possible sale, Barclays surreptitiously worked with the buyers, even offering to fund their acquisition of Del Monte.5 When Citigroup advised Toll Holdings on its acquisition of Patrick Corporation, the bank purchased over one million shares in the seller (on the bank’s own account) the business day before its client publicly announced its premium- priced offer.6 Though firm conclusions are hard to draw, M&A advisors’ conflicts systematically and adversely harm their clients, according to empirical evidence.7 By distorting advisors’ advice, conflicts may lead buyers to pay more than they otherwise would or to enter into wealth-destroying deals they otherwise would avoid.8 Conflicts may lead sellers to sell for less than they otherwise would or to choose one prospective deal over more favorable deals.9 They may increase bonding and monitoring costs for clients.10 When conflicts involve the misuse of nonpublic client information, they may reduce market liquidity, increase trading costs, increase the cost of equity capital and volatility, and reduce the accuracy of stock prices.11 4. In re El Paso Corp. S’holder Litig., 41 A.3d 432, 435 (Del. Ch. 2012). 5. In re Del Monte Foods Co. S’holders Litig., 25 A.3d 813, 833 (Del. Ch. 2011). 6. See Australian Sec & Invs Comm’n v Citigroup Glob Mkts Austl Pty Ltd [No. 4] (2007) 160 FCR 35 (Austl.). 7. For a discussion of the costs of disloyalty and other misconduct by investment banks and bankers, see Andrew F. Tuch, The Self-Regulation of Investment Bankers, 83 GEO. WASH. L. REV. 101, 123–33 (2014). Of course, not every conflict of interest will impose net harm on the client. See infra notes 72–74 and accompanying text. 8. See, e.g., Andriy Bodnaruk et al., Investment Banks as Insiders and the Market for Corporate Control, 22 REV. FIN. STUD. 4989, 4992 (2009) (suggesting that investment banks “induce bidders to enter wealth-destructive deals for their own interests”); id. at 5016–24 (finding that clients pay higher premiums and overpay for target companies in which their investment banking advisors have a stake). But see John M. Griffin et al., Examining the Dark Side of Financial Markets: Do Institutions Trade on Information from Investment Bank Connections?, 25 REV. FIN. STUD. 2155, 2163, 2185 (2012) (finding limited exploitation of nonpublic information by investment banks during the period from 1997 to 2002, based on NASDAQ trading records). For further discussion of the harm caused by conflicts, see infra notes 67–71 and accompanying text. 9. The potential for such conduct underlaid the court’s cautionary statement in In re Toys “R” Us, Inc. Shareholder Litigation, 877 A.2d 975, 1006 n.46 (Del. Ch. 2005), that M&A advisors not “create the

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