The Current State of the Fairness Opinion
Many years ago, during my first formal presentation to a board of directors and after listening to legal counsel review the board's fiduciary obligation, my attempt to paraphrase the "good" business judgment rule was met with a chortle and an admonition from the senior banker, who correctly stated that "just plain business judgment" was an acceptable standard.
However, given the unprecedented challenges facing directors of publicly traded companies in the post-Sarbanes-Oxley (SOX) world, perhaps the good business judgment rule is emerging as a new theoretical benchmark for exercising due care. More and more this standard is being applied, even to privately held companies.
There is a school of thought held by some states attorney general offices and members of the plaintiff bar that a board member must be de facto omnipotent or else face direct attack for decisions often made under difficult circumstances with incomplete information and limited time. Thus, that "plain ol' business judgment" is thinly stretched, and boards are rightly turning to external experts along the way to fulfill their fiduciary obligations and use due care in deliberations, particularly as it applies to fairness opinions.
The whole issue of who, what, when and how to rely on the fairness opinion in certain types of material transactions has garnered a great deal of press lately. Likewise, investment banking firms that are called upon to issue these fairness opinions are also under increased scrutiny. Below are some practical guidelines on how to use fairness opinions that will help boards fulfill fiduciary obligations, provide maximum benefit and demonstrate due care.
The Tangled SOX Board
Boards are increasingly turning to committees, special committees and outside legal and financial professionals to build the case for due care while enhancing the integrity of the decision-making process on behalf of stakeholders. In the case of mostly healthy companies, that effort is focused primarily on the common shareholders. However, as a practical matter, other parties—employees, customers, banks, bondholders, vendors and plaintiff attorneys—can often feature more prominently in the decision-making process, especially if the company is experiencing even the remotest kind of challenge.
As the company inches closer toward "issues," discussions can arise around theoretical and legitimately expanding "zone of insolvency" responsibilities. Conflicted stakeholders often spur boards to seek an external perspective to manage this complicated calculus. See Revlon Inc. v. MacAndrews & Forbes Holdings Inc., 506 A.2d 173 (Del. 1985); Smith v. Van Gorkum, 488 A.2d 858 (Del. 1985); Weinberger v. UOP, 457 A.2d 701 (Del. 1983); Joseph v. Shell Oil, 482 A.2d 335 (Del. Ch. 1984); and Cavalier Oil Corp. v. Harnett, 564 A.2d 1137 (Del. 1989).
From the perspective of the investment banker, the fairness opinion is a comprehensive valuation exercise within a specific situation analysis, and it is a product that features substantially higher litigation risk. In fact, litigation risk may grow as many bankers are under pressure to expand the conclusion beyond whether a proposed transaction is "fair from a financial point of view" to include a multitude of other issues, such as, "was the process appropriate and fair?"
Fairness opinion content should provide a complete description of the contemplated transaction, including a point-in-time situation analysis of the company, the counterparty and the market as a backdrop for the contemplated transaction. The banker should review due diligence steps and procedures that provide the foundation for the opinion, outline interviews with senior management, disclose limitations to the analysis and review certain assumptions that underpin the all-important valuation ranges and methodologies. It's important to note that the assumptions are almost always built on projections created by the management team that potentially has much to gain from a contemplated transaction. Bankers are typically pressured to outline and detail specific alternatives to the contemplated transaction, or to at least consider other possible pathways to pursue.
At the end of several pages, the classic fairness opinion will note that the "transaction is fair, from a financial point of view." The investment banker does not advocate or recommend whether the transaction should be consummated, as such recommendation is presented in the proxy solicitation. Likewise, it is increasingly rare to see the entire text of the fairness opinion in the proxy; rather, the standard of disclosure is usually a detailed summary of the contents.
The use of fairness opinions—while not required by statute—is expanding to include a variety of material transactions. These include:
- virtually all mergers or acquisitions;
- "going private" transaction under SEC Rule 13(e)-3;
material transactions under certain state regulations;
- many material financings (especially if there is any kind of equity kicker);
- some contemplated transactions that may change the underlying risk profile of the company (e.g., ESOP structures or recapitalizations that increase financial leverage);
- restructurings when stakeholders are asked to compromise claims; and
- asset sales that trigger bond indentures.
From the investment banker's point of view, the objective is usually to provide sufficient evidence demonstrating due care. However, the fairness opinion procedure is occasionally used by special committees as the "bad cop" for further negotiation, whereby sophisticated special committees use the fairness opinion process to improve the terms and conditions of a proposed transaction.
The Whirlwind of Inherent Conflicts
Recently, a good deal of financial press has addressed the regrettable perception of a certain "wink wink, nudge nudge" that surrounds the inherent conflicts involved in providing fairness opinions. Below is a modest primer from one investment banker's perspective.
1. It is tough to issue the opinion if you have advised both sides of the contemplated transaction. In perhaps the best known recent example, Goldman Sachs helped both the New York Stock Exchange and Archipelago Holdings (a situation that entailed what The New York Times called "conflicts so blatant that they are almost laughable"). While the parties relied on Lazard and Greenhill to issue the opinions to the respective boards, it was noted that Goldman Sachs led the pending Lazard IPO and that it underwrote the Greenhill IPO. Despite the princely fees paid to all three investment banks, the respective boards may not have gained the protection they desired.
2. It is tough to issue the opinion if your parent is involved. When JP Morgan Chase acquired BankOne Corp., the in-house bankers at JP Morgan Chase issued the fairness opinion, which hardly advanced the cause of restoring the luster of investment banking with the general public.
3. It is tough to issue the opinion if you have a long-standing relationship with management. Management is almost always the primary driver of value creation for the enterprise, and it is exceedingly challenging to balance the interests of management with the goals of other stakeholders. Board members need independent advice for all. As Oscar Wilde noted, "one should always play fairly when one has the winning cards." Likewise, senior management should be exceedingly cautious about participating in the selection process for the investment bank asked to provide the fairness opinion.
4. It is tough to issue the opinion if you are in line to receive significant compensation that is contingent upon completion of the contemplated transaction. While arguably the most controversial point, this inherent conflict needs to be put into perspective. The classic investment banker is drawn to this career with a risk appetite that will put an emphasis on large transaction fees—fees that dwarf typical fairness opinion work. It is precisely because of the motivation and risk appetite of investment bankers that U.S. capital markets were created, which remain the greatest capital markets in the world. The imagination of the men and women in this profession, who work with entrepreneurs and business leaders, creates unprecedented return for investors from the strongest economy the world has ever known.
Therefore, in the case of this fourth inherent conflict, please note some equivocation. Depending on the degree of market exposure, it may be possible and entirely appropriate to mitigate this inherent conflict.
Degree of Market Exposure Test
Issuing an opinion in this last circumstance depends on the degree of capital market exposure underlying the contemplated transaction. There are instances where the existing investment bank can provide a cheaper and faster fairness opinion through an in-house peer review process that is genuinely independent, depending on the facts surrounding the creation of the contemplated transaction.
In fact, the market is the best test of "fairness," so if the contemplated transaction passes the Market Exposure Test (i.e., it MET the market), the downside risk to the board and to the issuing investment bank is substantially eliminated. In one recent example, a company decided to test the merger market. Of the universe of 14 competitors, 13 were discretely informed of the opportunity, eight held face-to-face meetings with management, four issued letters of interest, two issued letters of intent and one finally emerged as the appropriate party to engage in exclusive negotiations on terms and conditions. We confidently issued the fairness opinion in this matter, with the disclosure of the transaction fee that we earned upon the closing of the contemplated transaction. We enjoyed a profoundly accurate understanding of the current market for our client and its alternatives.
While a high degree of MET may be achieved in a particularly hot space (i.e., one with many good, comparable transactions and companies with recent market stats, relevant situation analysis matches and tons of public operating data), special committees and boards need to exercise caution when using the existing bank on a narrowly negotiated transaction. In general, the more academic the valuation exercise, the more merit there will be from using a quality independent perspective.
Proposed NASD Rule 2290
The National Association of Securities Dealers (NASD), like the New York Stock Exchange, is a self-regulated enterprise. Last year, a new rule was proposed to guide members issuing fairness opinions that are referred to in proxy statements. The proposed rule requires members to:
- disclose whether the member acted as the financial advisor,
- outline potential conflicts of interest, including:
- compensation, especially fees contingent upon the completion of a transaction
- any material relationships over the past two years (mirroring NASD Rule 1015(b)(4) of Reg. M-D)
- review whether information has been independently verified, and
- state whether the opinion was reviewed, approved or issued by an independent fairness opinion committee.
Before the NASD issues new rules, it invites comments from members and other interested parties, and several groups provided interesting points. For example, CalPERS and the AFL-CIO desire further disclosure on payments to senior management that may be triggered by the contemplated transaction. CalPERS goes further, recommending an absolute prohibition on fairness opinions from those in line for success fees. Others in this camp have asked whether a "materially better price could have been obtained"—i.e., was the process "fair and appropriate," and did the management team and the investment banker do a good job?
As Mark Twain remarked in his 1907 "Wearing White Clothes" speech, "I am not one of those who in expressing opinions confine themselves to facts."
There is the related matter of solvency opinions. In general, the practical view is that restrictions and qualifications accompanying the solvency-opinion work virtually guarantee that the solvency opinion will provide little protection, comfort and benefit to the board or special committee that asked for the solvency opinion in the first place.
By virtue of making the request, opposing legal counsel will inevitably find a lucid argument that the company was, in fact, insolvent at the time in question, especially given the benefit of 20/20 hindsight.
Selecting the Investment Banker
The number-one criteria for a board or a special committee in selecting a party to issue a fairness opinion is that the investment bank is an NASD member firm, and this criteria becomes absolutely necessary if the proposed transaction features any form of equity involved with the contemplated transaction. The NASD enforces rigorous licensing procedures, completes comprehensive background investigations and regulates never-ending education and training. The board may increase their exposure if an opinion emanates from an unlicensed enterprise (ask whether you fly with an unlicensed pilot!).
It is difficult to imagine how a board can select a professional for this critical task without interviewing several candidates, and parties should seek to match the professionals with the specific situation—i.e., type of transaction, industry knowledge, degree of difficulty and reputation in the capital markets. Pay for quality, and look to the financial strength of the issuer of the fairness opinion to back the opinion and analysis. Ask how many times the investment bank has been sued after issuing a fairness opinion or valuation report. If the investment bank does bankruptcy work, ask whether a judge has ever slashed fees ex post facto. It may be prudent to insulate senior management from the selection of the fairness-opinion provider, although it will be necessary for senior management and those professionals to interact effectively once the special committee has made its selection.
Depending on the materiality of the contemplated transaction, the work project generally deserves a face-to-face presentation. As Friedrich Nietzsche wrote, "It is hard enough to remember my opinions, without also remembering my reasons for them!" The special committee and the board need sufficient time to review the materials beforehand in order to prepare tough questions and participate in lively debate. The interaction between senior management, the special committee and the rest of the board should be vigorous and frank to build a case for adequate due care and some emerging consensus.
Fees will obviously depend on the size and complexity of the contemplated transaction. According to research, for public transactions more than $50 million in value, since January 2003 fees ranged widely from a minimum of $100,000 to more than 2.25 percent of aggregate transaction value.
Overall, there are many reasons why the fairness opinion is a hot topic swirling in controversy. In light of SOX, boards must proactively manage the process to limit future criticism and lower financial exposure. The approach to fairness opinions has evolved considerably over recent years, and there are several important considerations for companies and their advisors to prudently consider.
1 Jeffrey R. Manning, senior managing director, leads FTI Capital Advisors LLC, the wholly-owned investment banking subsidiary of FTI Consulting, and works out of Washington, D.C. He has more than two decades of transaction-related experience. Return to article