An Expanded View of DEAL FAIRNESS: NASD adds management rewards to possible conflicts of interest

The NASD has stepped into the long-running controversy over possible conflicts of interest by bankers rendering fairness opinions in M&A transactions. If a process launched by the association results in a proposed rule, fairness opinions that are aimed at determining whether a purchase is fair to selling shareholders may, for the first time, come under formal regulation. The results may extend the concept of fairness by going beyond whether an adviser is in conflict because it has two or more roles in a single deal or an unacceptably close relationship with management of the company requesting the fairness opinion. While the NASD did not propose a specific rule, it called for comment on whether it should issue a two-part regulation dealing with conflicts among its member firms. One part would require an NASD member providing a fairness opinion in an acquisition to disclose any possible conflicts it might have, such as providing financial advice or raising funds for either side in the same transaction. The second would outline procedures for identifying possible conflicts and controlling them. However, the most controversial aspect of the proposal is the suggestion that the firm proffering the fairness opinion assess whether management compensation triggered by a change in control impacts the fairness of the deal. In other words, the fairness opinion would be expanded to determine whether the selling management’s take relative to the shareholders’ take influenced the fairness opinion. That idea has been sharply criticized by comments submitted to date, with many opponents saying that financial advisers would have trouble reaching that determination. Because of the controversy and the apparent extension of the fairness opinion into new territory, we will focus on the management compensation issue. Possible regulation is being put forth at a time when many commentators have not only attacked fairness opinions as an inherently conflict-ridden system but have proposed that they be eliminated altogether. Fairness opinions do not have a long history. Their use as a protective mechanism surged in the mid-1980s after the landmark Smith v. Van Gorkom decision, also known as the TransUnion case, in Delaware. The Chancery Court ruled in that decision, later upheld by the state Supreme Court, that TransUnion Corp. directors did not do a proper market check for an alternative bid even though they accepted a purchase offer with a 50% premium over the stock price. The market’s response was to obtain an opinion from a reputable financial adviser that an offered price was fair to selling shareholders. Third-party advice is intended to demonstrate that the board performed due diligence and did not blindly rely on a proposal from its management. Although best known for its oversight of the Nasdaq securities trading market, the NASD has broader regulatory powers over its members as the only national securities association recognized by the SEC. The organization counts among its members all major banking and trading firms that provide M&A advice. NASD rules have to be vetted by the SEC prior to adoption. The NASD letter seeking comment contains only a general policy statement relating to management compensation: “When the transaction will result in one group of shareholders, a board member, or employee receiving a benefit or payout that is materially different than that received by the unaffiliated shareholders, this result may create biases in favor of the transaction if the people receiving the benefit were involved in hiring the investment bank or are in the position to direct future business to the investment bank.” In managing this conflict of interest, the NASD suggests that members rendering fairness opinions should implement a procedure “to evaluate the degree to which the amount and nature of the compensation from the transaction underlying the fairness opinion benefits any individual officers, directors or employees, or class of such persons, relative to the benefits to shareholders of the company.” The policy concern and the proposed process address different issues. The policy concern is that management will have undue influence over the adviser rendering the fairness opinion because that firm is beholden to management for engagements. The proposed process focuses on how change-in-control payments affect the fairness of the transaction. All the NASD proposal requires is that the members “evaluate” whether management compensation affected its fairness determination, and does not prevent any member from rendering the fairness opinion because of a conflict of interest. Without the benefit of a stated policy reason, we can only speculate on the precise motivation for the proposal. While couched as procedural, the import of the NASD statement is that the member should consider how management compensation affects fairness, a substantive determination. It is also implicit that the organization considers management compensation to be an aspect of the financial fairness of the deal. Because a control premium over the current market capitalization of the target is paid, the acquirer looks at the cost of the deal not from the perspective of what the target shareholders receive but its own cost in closing the deal. This cost includes taxes, professional fees, advisory fees, financing costs, printing costs, etc., as well as management compensation resulting from change-in-control or employment agreements and stock options that are accelerated when a company is sold. The larger the payments to management, the smaller the premium that’s available to the target’s shareholders. Management’s interests may not be aligned with those of shareholders if managers are not motivated to maximize value for shareholders, such as when its compensation does not depend on the size of the control premium. Management also may receive new benefits that are not shared with shareholders, e.g., a job with the acquirer or a rollover of equity interests. The NASD’s procedural proposal calls for the member rendering the opinion to assess whether the control premium is being fairly allocated between management and shareholders. Since management compensation is usually fixed in advance of any takeover, the implication is that if the payout to management is disproportionately high, the adviser should be asking management to moderate its compensation. Obviously, this is a very unpopular role to play. The comment letters received by the NASD indicate a fairly uniform opposition to the proposal. The letters supporting the proposal encouraged the adoption of a rule but did not evaluate the specifics. A letter from CalPERS did call for shareholders to be informed whether management benefits were “excessively disproportionate.” The letter states that a fairness opinion can be silent on compensation arrangements but that it may be perceived as biased if the opinion does not disclose the arrangements. Three main arguments were submitted for opposing the proposal: Pre-Existing Liabilities The acquirer assesses a transaction by calculating the full takeover cost (or enterprise value), not the value of the equity interest. An adviser that prepares a fairness opinion will use a variety of financial measures, many of which involve determining a range of takeover values. To determine the value of the equity interest, all liabilities due at closing that have priority over the equity interest must be subtracted from the takeover cost, such as debt of the target that must be refinanced at closing, preferred stock, severance costs, and management compensation. Other financial measures do not require calculating the cost of management compensation. For instance, price multiples based on earnings or historic share price analysis involve a direct comparison of equity values, and other costs are assumed to be factored in by the market. In those cases, the amount of management compensation is not relevant. Pre-existing obligations are relevant in a number of ways. First, at the time management compensation was established, it is probable that the board of directors used its compensation committee to recommend awards to executives and consider the terms of employment and severance agreements. The committee was composed of persons who were knowledgeable on compensation matters or who sought advice from consultants who probably conducted a peer group review to determine whether the compensation arrangements were reasonable. The compensation committee or the adviser may not have known of the specifics of the takeover transaction but should have carefully considered a broad range of possibilities and recommended compensation payments that were merited in various circumstances. The board would have approved the arrangements based on the work of the compensation committee and other considerations it deemed material. The adviser delivering the fairness opinion is asked to determine a reasonable range of takeover values and will work back to the equity value. Pre-existing liabilities such as debt and management compensation do not affect this takeover value since they are often fixed values and, thus, transaction-neutral. However, if most of management compensation consists of options that accelerate on a change in control, these liabilities will differ in size depending on the takeover proposal. Second, when a deal is announced, management compensation arrangements are enforceable obligations of the target company to third parties, that is, members of management. The obligations of the target to repay its debt or to respect a non-assignment clause in a services agreement also are pre-existing contractual obligations of the target. For the same reasons that a financial adviser should not be called on to second-guess the board’s decision to incur debt, the adviser should not have to assess whether it was a good idea to enter into a severance agreement with management. In addition, while the board may have the ability to accept or reject the proposed transaction, its pre-existing contractual obligations cannot be set aside without paying counter parties for terminating these agreements. The board’s decision to grant management compensation was a permissible exercise of its powers and by requesting a fairness opinion, directors are not asking their adviser to revisit all relevant corporate actions or omissions. Third, the adviser has no means of determining the value of management compensation arrangements. Any analysis of pre-existing liabilities necessarily will rely on information provided by the board, which tends to undermine the independence of the fairness opinion exercise. The weakness of the pre-existing liability argument is that it adheres to a blinkered vision of fairness opinions. A board would be poorly served if an adviser ignored existing liabilities, such as products liability, environmental liabilities, or regulatory risk that threatened the future of the company even if these liabilities did not play into post-closing projections. If management compensation is predetermined or derived from management data, it does no harm to state that fact and use the data for a comparative analysis of how the control premium was divided on other deals. After all, management projections are widely used for conventional valuation analysis. Lack of Expertise Another argument is that an adviser is not an expert in management compensation and is not in as good a position as the board and their comp advisers to evaluate executive pay. The typical investment bank that renders fairness opinions does not necessarily have a staff of employment consultants or legal experts who can evaluate severance packages. An adviser would need to engage compensation consultants, possibly delaying the deal and adding to deal costs. If the board is concerned about management compensation arrangements, it can take a number of different actions, such as: * Establish a committee of independent directors who will not receive any benefits from the deal and allow that unit to evaluate the proposed transaction, or * Hire consultants that were not involved in the original adoption of management compensation plans to review the arrangements and recommend whether they should be modified because of the deal. Since hiring an adviser for a fairness opinion is principally to obtain protections from Smith v. Van Gorkom, the board probably would be best served by selecting a compensation expert to advise it on compensation matters. Disclosure Many of the comment letters state that the procedural compensation issue could be dealt with through enhanced disclosure. Disclosure of management compensation is addressed comprehensively by SEC regulations applicable to takeover transactions. There is no suggestion that the existing disclosure regimen is inadequate for a shareholder to discover whether a large part of the control premium is being siphoned off by management or to assess on his or her own whether that payoff is justified. The comment letters propose that the fairness opinion should state that it does not address the fairness of management compensation or that the adviser has not considered compensation as an element of financial fairness. This approach is imperfect because it ignores why the NASD might think it appropriate for an adviser to comment on the allocation of the control premium. It is not correct to say that management compensation is not a financial consideration because it boils down to cash payments that will be made at or shortly after the closing and are not a contingent liability that has been triggered. Additionally, there is obviously concern that boards are not addressing this topic in a forthright manner in disclosure and a third party is needed for the proper focus on the issue. While fairness opinions are not prepared for the benefit of shareholders, they provide shareholders with a degree of comfort that an apparently neutral and knowledgeable third party agrees that the transaction is fair. Perhaps the NASD believes that its members that serve as advisers should be filling this gap in corporate practice? Variations on Payoffs Fairness opinions are intended to evaluate the fairness of transactions to shareholders as a whole, from a financial perspective. The opinion does not purport to account for the differences among shareholders. For example, a member of management who receives a $10 million bonus when the deal is consummated is likely to accept a much lower price per share than a shareholder holding an interest through a mutual fund. The adviser is not expected to investigate the interests of each shareholder constituency – an issue that again relates pre-existing contractual obligations and the division of the control premium. Arguably, the benefits of the management compensation arrangements cannot be weighed through the kind of financial measures applied in fairness opinions. For example, the takeover premium allocated to management may be a reward for favorable past performance, serve as compensation for salary or even job loss suffered in the takeover, help recruit and retain future executives, or be calculated through peer group influence. None of the foregoing reasons is usually considered as a part of a financial valuation analysis. The basic idea behind the NASD’s procedural suggestion is sound – that is, management should not be allowed disproportionate change-in-control payments to the detriment of selling shareholders. But by thrusting the responsibility on NASD members to act as neutral opinion-givers, the NASD is treading outside of its area of responsibility. Board members are solely responsible to shareholders as a matter of corporation law for implementing management compensation arrangements. The board may, for the same reason that it seeks a fairness opinion, decide to protect itself by analyzing whether the allocation of the control premium between management and shareholders is fair. The board also could hire an outside adviser, which could be the banker, to evaluate the compensation arrangements both at the time of adoption and at the time of the takeover. If one consultant advised the compensation committee on the initial adoption of the management plan, then a different consultant should advise the special committee of the board in connection with the takeover. In addition, if a consultant believes that change-in-control payments are too high, the board will have greater flexibility if the terms of management compensation agreements are short and can be reviewed from time to time. The NASD has called on its members to evaluate compensation plans largely because they are the only presumably visible neutral experts routinely employed in takeover transactions, rather than they enjoy expertise to perform that role. Perhaps the issue would be better addressed if the SEC mandates that fairness of management compensation be disclosed. Ultimately, the proposal is a reaction to shareholder mistrust and the inadequacies of corporation law. To that extent, it is within the power of boards to satisfy the expectations of shareholders without causing the NASD to tread further outside of its area of responsibility. Bruce Rader is a Partner, and Shane de Burca is an Associate, at Chadbourne & Parke in New York. (c) 2005 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com