Warburg deal highlights hidden liability risk

Private equity firms need to understand and thoroughly diligence a target’s sale-side process if they want to remove certain liabilities after purchase, advise industry lawyers reacting to a recent Delaware court case.

In Re Rural Metro Corporation Stockholders Litigation, a Delaware judge found that in its capacity as a financial advisor, RBC Capital Markets was partly liable for a breach of fiduciary duty committed by Rural/Metro Corporation’s board of directors. Warburg Pincus later acquired the company, a provider of emergency vehicles, unaware that the RBS liabilities could become its own.

The case underscores the risk that GPs can inherit certain litigation liabilities once a company is under their control, warn legal experts.

“As a private equity firm, you may end up holding the bag for any breaches of fiduciary duty or aiding and abetting breaches of fiduciary duty committed by the target, the targets board or financial advisor,” said Robert Myers, senior counsel at Clifford Chance.

The details of the case are that RBC was hired to conduct a sales process on Rural/Metro’s behalf. RBC recommended running a parallel sales process with Emergency Medical Services Corporation (EMS), one of Rural/Metro’s competitors. But bidders for EMS, including many large private equity funds that would have been potential bidders for Rural/Metro, were reluctant to bid on the Rural/Metro sale to avoid breaking any confidentiality agreements signed as part of the EMS auction. Moreover bidding for Rural/Metro could have meant diverting resources away from the EMS process, which was much further along. In the end, that created an uncompetitive sales process for RBC, which Warburg was able to take advantage of, according to the ruling. 

The court also took issue with how RBC developed its valuation opinion of the company, highlighting the fact that its quest to provide buy-side financing in connection with the deal, known as staple financing, opened potential conflicts of interest issues. Staple financing is commonly used by banks advising private equity firms but legal sources say it is a practice that must be managed carefully.

The case highlights the need for buyout firms to understand why a company is engaging in the sale process at a certain time and perform due diligence on whoever is managing the sale, meaning both the target’s board of directors and its financial advisor, as a way of rooting out potential conflicts of interest, said Jason Freedman, corporate partner at Ropes & Gray.

“It’s difficult because until the merger agreement is signed and you have an obligation to buy the target you are not privy to a lot of things that are happening with the target, its board or its financial advisors. But they ought to do what they can,” added Myers.