November 2007

The Delaware Chancery Court issued an opinion (Tele-Communications, Inc. Shareholders Litigation, C.A. No. 16470, December 21, 2005) that questions a number of widely-established procedures used when addressing the fairness of merger transactions.  Wise corporate directors and lawyers will need to more closely scrutinize (i) conflicts of interest issues involving investment bankers and (ii) fairness opinion contents.

What Went Wrong With TCI

In 1999, ATT acquired Tele-Communications, Inc. (TCI). TCI had a complex capital structure including six classes of stock. This occurred because TCI issued its own shares plus two tracking stocks. Each of these three “companies” had high-vote and low-vote shares. John Malone (TCI’s Chairman and CEO) and the other TCI directors owned the majority of the high-vote stock. At the outset of negotiations, Malone insisted that the high-vote stock receive a 10 percent premium over the low-vote stock. This 10 percent premium equaled over $130 million for Malone personally, and $220 million for the Board of Directors as a group. The underlying litigation involves the manner in which the TCI sales proceeds were allocated among the six classes of stock.

TCI engaged Donaldson, Lufkin & Jenrette (DLJ) as its financial advisor. Recognizing the conflict of interest that most Board members had because of the 10 percent premium, a special committee was appointed. However, the Special Committee used TCI’s advisors (DLJ) instead of retaining its own separate legal and financial advisors. Currently, this is a common practice.

DLJ opined that that the exchange ratio offered to holders of each class of TCI stock was fair to the holders of such class, but did not opine as to the fairness of the exchange ratio between the high-vote and low-vote shares. This additional conclusion is commonly referred to as a “relative fairness” opinion. Although such relative fairness opinions are uncommon, the Court concluded that


[Alternative Fund Ltd. vs. Readers Digest Association – a precedent case] appears to mandate exactly such an analysis: that the relative impact of the preference to one class be fair to the other … in other words, the [Special Committee in Levco] should have sought an opinion as to whether the transaction was fair to the disadvantaged class of shareholders …”

The Court further determined that the Special Committee’s actions were subject to the “entire fairness standard” of review, instead of the more lenient business judgment rule. This hardly seems controversial in light of the premium being paid to the high-vote shareholders (who were concentrated in the Board of Directors). Obviously, TCI and DLJ thought otherwise.

Because of the ruling as to the entire fairness standard of review, the Court concluded that:

“The initial burden of proof rests with the director defendants to demonstrate the fairness of a particular transaction. Ratification of the transaction by disinterested directors of shareholders can have a powerful legal effect. Ratification by a majority of disinterested directors, generally serving on a special committee, can have the effect of shifting the burden onto the plaintiff shareholders to demonstrate that the transaction in question was unfair. In order to shift the burden, the defendants must establish that the special committee was truly independent, fully informed, and had the freedom to negotiate at arm’s length.”

With this standard in mind, the Court found process flaws in the Special Committee’s work. Putting aside obvious problems that are particular to the TCI case (i.e., DLJ glossed over relevant data, and the Special Committee was not truly disinterested), here are lessons to be learned:

  1. A special committee should have separate legal and financial advisors. According to the Court:

    “The Special committee chose to use the legal and financial advisors already advising TCI. This alone raises questions regarding the quality and independence of the counsel and advice received. Further, the contingent compensation of the financial advisor, DLJ, of roughly $40 million creates a serious issue of material fact, as to whether DLJ (and DLJ’s legal counsel) could provide advice to the Special Committee. … A contingently paid and possibly interested financial advisor might be more convenient and cheaper absent a deal, but its potentially misguided recommendations could result in even higher costs to the special committee’s shareholder constituency…”

  2. A special committee’s mandate should be clearly written. In TCI’s case, the Special Committee members described differently what they were supposed to be doing, thus raising the concerns about the standards that the Special Committee should use, and did use, in evaluating the admittedly complex transaction. This could have been avoided by having legal counsel and/or the financial advisor provide additional direction and advice.
  3. A special committee’s compensation arrangements should be determined in advance, and therefore not contingent upon the result achieved. Although the TCI Board concluded that the Special Committee should receive reasonable compensation for their additional work, the specifics of this compensation were not decided until after the transaction was approved. For this reason, the TCI proxy statement did not disclose the specifics of the yet undecided compensation. After the transaction was approved, the Board provided each of the two members of the Special Committee with $1 million of additional compensation.  While reserving for a later time a ruling on the reasonableness of this large payment, the Court commented that this had the appearance of being contingent compensation that impairs the independence of the Special Committee members, as follows:

    “I pass over, for the moment, how one might rationally consider a $1 million payment for four meetings over a one-week period to be ‘reasonable’ compensation. I also pass over for the moment, the rather obvious question of how a Special committee member might act when he suspected that potential compensation might hinge on the answer he were to give.”

Disclosure of Contingent Compensation

The issue of financial advisor contingent compensation is also getting pressure from an NASD Rule 2290 approved by the Securities and Exchange Commission (SEC). See Additional Disclosure regarding fairness opinions now required in Proxy Statements for additional information and background.

Interestingly, even investment bankers that are not involved in a specific transaction could be perceived to have a conflict of interest. Fairness opinion work is a low-margin business compared to deal making. Investment bankers are understandably motivated by the deal (and contingent compensation) portion of their business. They might be seen as accepting fairness opinion work solely as an entrée to investment banking for future transactions.

The potential impact of these events could be substantial. Lawyers and financial advisors need to question longstanding merger-approval processes, including the manner of employing and compensating financial advisors.

Fulcrum Inquiry is a valuation and financial advisory firm. We do not perform investment banking services, nor accept contingent fee compensation.