On October 17, 2007, the Securities and Exchange Commission (SEC) published its approval of amended Rule 2290 in the Federal Register. The new rule 2290 involves disclosures and procedures related to the issuance of “independent” fairness opinions included in proxy statements. Specifically, any proxy statement that includes a fairness opinion will soon need to disclose:
1. Whether the issuer of the fairness opinion will receive any compensation that is contingent upon the successful completion of the transaction;
2. Any material relationship that existed in the past two years, or that is contemplated in the future between the issuer of the opinion and the companies involved in the transaction at issue;
3. Information that formed a substantial basis for the fairness opinion, and whether such information was independently verified – This is a change from current predominant practice in which the opinion simply states, “We have not independently verified the accuracy and completeness of the information supplied to us with respect to [client name], and do not assume any responsibility with respect to it.” Although the new rule does not require verification, the opinion will need to provide additional detail regarding the opinion’s foundation;
4. Whether the fairness opinion was approved by a committee of the firm issuing the opinion that followed procedures designed to provide a balanced view of the transaction. Such procedures would normally include the process used for selecting the committee, the qualifications of persons serving on the committee, and the nature of the review by persons who are not on the “deal team” to the transaction.
By default, most companies hire the deal’s investment banker to provide the fairness opinion regarding the transaction. Although the fee earned for rendering a fairness opinion is typically separate and not contingent on the transaction closing, the same investment bank usually has a separate significant fee that is completely contingent on the transaction closing. The fairness opinion is needed to complete the deal, so the much larger contingent fee will not happen unless the fairness opinion reaches the desired conclusion. The conflict of interest is obvious. The National Association of Securities Dealers (NASD), and now the SEC, acknowledge this conflict of interest, and are issuing the rule because they are:
“… concerned that the disclosures provided in fairness opinions may not sufficiently inform investor-shareholders about the potential conflicts of interest that exist between the firm rendering the fairness opinion and the issuer. Among these conflicts are fees that the firm rendering the fairness opinion will receive upon the successful completion of the transaction (either from advisory fees or fees for the fairness opinion itself), as well as other material relationships between the firm and the issuer …”
The NASD introduced the possibility of a rule change in 2004. Wall Street’s major investment bankers successfully lobbied against the change, thus accounting for the long delay that has already occurred. However, others (primarily investor groups) proposed stronger measures than what will now be required. The stricter guidelines (that are NOT part of the current rule) include (i) requiring independent fairness opinions from someone other than the investment banker on the deal, and/or (ii) prohibiting investment banks from receiving success fees for transactions in which they issue fairness opinions. The NASD’s milder rule for disclosure only is a victory for the large investment bankers that have these conflicts of interest. The large investment banking firms should be particularly happy with their lobbying accomplishments since the NASD concluded that, “Arguments that independent fairness opinions or those without a success fee component offer advantages may be well-founded.”
What is a Fairness Opinion?
Board members have a fiduciary duty of care that requires them to be reasonably informed when making specific decisions that affect public or minority investors who are not actively participating in the decision. Since most Boards of Directors are not made up of merger & acquisition and valuation experts, they often seek financial advice to assist with their decision making. A formal opinion, most often referred to as a “fairness opinion”, serves as evidence that the board members conducted a process that was sufficient for meeting its fiduciary obligations.
A fairness opinion addresses, from a financial point of view, the consideration involved in a transaction. However, the opinion does not indicate whether the price of a proposed transaction is the best that could be obtained. Instead, the opinion addresses whether the price is “fair”, usually within an acceptable value range. Because fairness opinions are not required, the board of directors determines whether to request a fairness opinion, the scope of the opinion, and who should be engaged.
Although there are many court decisions on fairness opinions, the following are landmark Delaware court decisions:
1. In Weinberger vs. UOP in 1983, the company obtained a fairness opinion, but the opinion was found to be less than necessary because too little attention was paid by the investment banker in the transaction, and the same investment banker was getting a large success fee. The Court focused on the haste of the decision as well as the lack of independence by the investment banker. Because of this, the bulk of the post-Weinberger case law focuses on the question of what constitutes a fair procedure.
2. In Smith vs. Van Gorkom in 1985, the Court imposed personal liability on outside directors because of gross negligence for failing to determining a company’s value before selling it. This occurred despite the fact that the price being paid was an all-cash bid at an almost 50 percent premium over the prior price of the acquired company’s stock. The Court implied that the liability could have been avoided by getting the advice of anyone in a position of knowing the company’s value.
3. The Revlon decision in 1986 established that board members of publicly held companies have a duty to get the highest price for its shareholders once it puts itself up for sale. While it is easy to determine the highest price in an all-cash transaction, complications arise in comparing prices when the consideration includes stock or notes.
Best Practices in Fairness Opinions
1. A Special Committee should be appointed to supervise the evaluation process. Members of the Special Committee must be truly independent. Cases involving Special Committees focused on close relationships with management, even if not strictly a conflict based on ownership or direct compensation.
2. In light of the obvious conflict (which soon must be disclosed), companies should not use their investment banker for their fairness opinion, even if allowed to do so. The fact that “everyone else is doing it” is not a justification. If a conflict is allowed to persist, the resulting process leaves the board members relying on a biased fairness opinion, and thus exposed to lawsuits.
3. Some Wall Street firms are requesting second opinions because of the obvious conflict of interest when the first firm is also getting a success fee for the transaction. However, a second opinion from another investment banker (vs. an entity that does not engage in investment banking) may have a bias to upset the transaction. If the second firm decides the deal is unfair, this may be an opportunity to replace the incumbent. If the first banker interprets the need for a second opinion as a sign of mistrust, this may also discourage the incumbent from introducing future investment opportunities. Boards can solve each of these potential challenges by using a valuation firm that does not compete with the investment banker. A fee-based valuation firm has no interest in the transaction, has strict conduct requirements, and follows procedures/standards that ensure independence.
4. Most problems with fairness opinions occur because of unsubstantiated use of management projections. Even though not typical, the scope of the fairness opinion should include verifying important documents independently. The results of such investigation should be included in the report, which necessarily means that the report should be more than one of two pages long.
5. The fairness evaluation process should consider any compensation packages put in place after the deal begins, such as ‘stay bonuses’ and other deal-related compensation. Compensation arrangements that predate the deal are to be honored, but new arrangements may indicate a reallocation of sales proceeds between management and shareholders.
6. The fairness opinion expert must be given sufficient time to perform a thorough analysis. Deals usually are done with extreme time pressure, but too much time pressure will be an automatic means of attack by dissidents.
7. The fairness opinion expert should have a detailed analysis that is discussed at length with the Special Committee. While summary-level formal reports may be acceptable, the fairness opinion process should include detailed calculations and work paper analyses. The Special Committee should insist that the fairness opinion expert retain these analyses and supporting records for as long as a claim may occur, even if the professional claims that this is not their normal practice.
8. Ensure that the fairness opinion expert(s) have complete access to records and management. Court cases have consistently been critical of opinions that were not backed by relevant information. The fairness opinion report should list those records upon which the provider of the opinion is relying.
Fulcrum Inquiry is a valuation firm with significant experience in litigation matters. We regularly evaluate the appropriateness of fairness opinions and the related valuation process used by board of director Special Committees.