Avoiding the “L” Word: Deal advisers face unprecedented threats of liability and litigation in an era marred by corporate and capital markets scandals.

The procession of corporate scandals that began with Enron Corp., continued with WorldCom Inc. and HealthSouth Corp., and has now leaped across the Atlantic with Italy’s Parmalat Finanziaria SpA should serve as a clarion call for dealmakers, and corporate warriors generally, to make sure they protect themselves if a transaction goes sour. Experts contacted by Mergers & Acquisitions say the finger pointing has ratcheted up to a new level, rippling beyond the usual suspects to include, conceivably, everyone short of the guys in the mailroom when a deal or other corporate maneuver blows up. No longer do you have to be the primary accountant, lawyer, or investment banker on a deal to be called before regulators, face prosecution, or be targeted for damages. “Since Enron and Sarbanes-Oxley, you have more people saying that any professionals that help in crafting transactions will face increased scrutiny and potential liability for their work,” says William Nordman, a partner at Akerman Senterfitt, a Fort Lauderdale, Fla.-based, law firm. Maybe in more innocent times, plaintiffs and regulators went after the accountants and left it at that, satisfied that they had identified the parties that were easiest to attack and had deep pockets. Now, vulnerability for liability has spread to nearly any professional who has worked on a deal or other corporate transaction. “Third-party opinion providers are being scrutinized as never before. It’s clear that they will be increasingly susceptible to claims being made by shareholders and creditors,” says Chuck Baker, a partner at the law firm of Paul, Hastings, Janofsky & Walker. Some examples of the widening ring of liability are: * In September 2003, the SEC fined insurer American International Group Inc. in a case arising from accounting fraud at Brightpoint Inc. The fraud charges against AIG resulted from its role in selling a purported “insurance product” to Brightpoint. The agency says Brightpoint used the policies to report false and misleading financial information to the public. * Last December, the IRS issued administrative guidance aimed at ending abusive tax avoidance transactions. The rules set requirements for tax opinions provided by attorneys and accountants. The guidance included an outline of the agency’s expectations for those with supervisory responsibility for a professional service firm’s tax practice. The issue of whether tax shelters were abused is at issue in the bankruptcy proceedings of the former WorldCom. The telecom firm’s bankruptcy examiner found that auditor KPMG recommended a tax avoidance policy that “was highly aggressive and seriously vulnerable to state challenge.” * Also last year, a California jury levied damages against Lehman Brothers for securitization work with subprime mortgage lender First Alliance Corp. Lehman was ordered to pay $5 million by a jury in a federal court in California which found that First Alliance committed fraud in its lending practices, that Lehman had knowledge of this fraud, and that Lehman “substantially assisted” First Alliance in perpetuating fraud. * An investment group led by Retirement Systems of Alabama filed suit in January against HealthSouth accountant Ernst & Young and onetime investment banker UBS Warburg, charging the ignored signs of wrongful acts and that fraud could not have been committed without them. It’s not unusual for accountants to be sued in these types of cases but the suit against UBS marks something of a turn. UBS is not accused of doing anything illegal itself but the plaintiffs suggested that the firm supplied cover through normal work such as investment advice and fund raising. The issues then are not dissimilar to the determination of Lehman’s position in the First Alliance case. * HealthSouth also was criticized last year by the House Committee on Energy and Commerce for the lack of independence and oversight by board members and outside advisers. In addition to critiquing UBS Warburg, the panel questioned the actions of the board’s compensation committee. Board members say they relied on outside compensation experts to help set CEO pay levels. The Changing Playing Field Ben Howe, a principal at Americas Growth Capital, says, “The change in rules and climate are so new, it’s hard to determine how much of an increased burden dealmakers will have to bear. But the risks of litigation are higher now than they have been at any time in my 20-year career.” And while the risk of litigation for the dealmaking professions has progressed past the auditors to other primary deal professionals, it also extends now to professionals who give third-party opinions. “Any third-party professional who is instrumental to a deal’s process now has a responsibility to say that a transaction or other corporate maneuver isn’t a good idea, if that’s the case,” says Charles Elson, head of the John L. Weinberg Center for Corporate Governance at the University of Delaware. Of course, the increased responsibility of third-party advisers isn’t happening in a vacuum. It’s influenced by other corporate governance initiatives such as the emphasis on director independence. “The closer scrutiny of third-party advisers is consistent with an increased focus on the role of gatekeepers, those outsiders who are called in to help corporate leaders make decisions,” says Jill Fisch, a Fordham University law professor. Fisch says she sees pressure on board members and deal professionals coming from two sources. The first is the requirement from Sarbanes-Oxley and elsewhere that board members do a more rigorous analysis of opinions and options presented to them by management. A second push is coming from law firms specializing in shareholder suits, regulators, and bankruptcy examiners for the third-party advisers themselves to do a more thorough job and to vet conflicts without whitewashing them. Third-party advisers who either are already being placed under the microscope, or who can expect increased liability as the drive for greater accountability washes through the corporate arena, include those who provide the following services and opinions: * Fairness opinions * Valuations * Solvency opinions * Commercial lending * Investment bankers who consult rather than initiate a deal * Tax expertise * Insurance advice * Public relations counseling * Bankers who determine compliance with issues arising from the switch in accounting rules, which eliminated pooling of interest (FASB statements 141 and 142) * Compensation advice 20/20 Hindsight Warnings Dealmakers say that in the post-Enron, Sarbanes-Oxley world, all deal personnel must be aware that all their actions will be judged with the benefit of 20/20 hindsight. Baker says that everyone should be conscious that what might seem innocent at the time of the transaction could be viewed differently after the fact. From her perspective, Sheryl Cefali, a managing director at Duff & Phelps, says client companies should realize that a critical player in any transaction is the attorney. She adds that if counsel doesn’t know how to guide the board in this era of heightened scrutiny, it makes life more difficult for everyone. She also notes there has been a huge increase in “strike suits,” or shareholder derivative suits filed against corporate directors and executives soon after deals are announced. Nordman says that in his experience, securities lawyers don’t always look at the transaction from the point of view of a litigator. “You need somebody’s who’s two steps away, who can look at the transaction the way the SEC might,” he states, adding that dealmakers must construct the deal as if the government will soon be looking over their shoulder. Nordman says consultants and principals alike need to be able to prove that whatever they say is true and correct, even if other parties involved in the deal turn out to be crooks. If you are a professional or a public company and any of your activities make the front page of the local or national newspapers, he adds, you can expect permanent damage even if you are exonerated eventually. One reason for this is that corrections are run inside the paper in small type, while the indictment will be a headline on the front page. Fairness opinions are the most researched and discussed type of third-party relationship that is being challenged, but experts say that the kind of conflict-of-interest alerts being sounded will spread. They note that concerns will spread to other types of third-party opinion deliverers. Ted Goth, a partner at Goth Christopher, says that there will be more suits that focus specifically on m&a advisers as time goes on. “So far, most of the attention has been driven by political concerns and regulators. Eventually, we’ll see court cases attacking the role of merger advisers in areas beyond fairness opinions.” He also expects compensation issues to become an area that will drive more legal and regulatory challenges to advice by third-party professionals. And while this discussion will focus on third-party advisers, the same emphasis on transparency and a need to make sure the work product can withstand close scrutiny after the fact applies to the primary deal professionals, such as the initiating investment banker, the accountants, and the lawyers. In any case, these categories are not mutually exclusive; professionals who give third-party opinions on some deals may well be principal advisers on other transactions. Changed State of Fairness Opinions In the pre-Enron world, the investment bank that was structuring a deal often issued a fairness opinion. It was a minor detail – often thrown in by the bank for a small fee – whose purpose was to give directors a layer of protection if shareholders or regulators later questioned aspects of the deal. “The fairness opinion was often a loss leader because the primary bank on a transaction was willing to let the client negotiate a below-market rate,” Howe says. The conflict-of-interest was clear because the same bank that issued the fairness ruling stood to clear millions of dollars in fees contingent upon the deal closing. “I’d like to see an investment bank that had a $5 million contingency fee riding on a deal come back with an opinion that the deal was unfair,” Howe says. Last year, New York State Attorney General Elliot Spitzer said he was studying the problems with these opinions and might take action. Presumably, the mutual fund scandal is occupying his time now, but he may revisit fairness opinions. In the current climate, with its emphasis on transparency and avoidance of conflicts of interest, it seems that the days of the in-house fairness opinion are numbered. “There’s a good chance that in two years, you won’t see any more fairness opinions done by the primary bank. But for now, if there’s no conflict on the transaction, people may think it’s not worth the extra $200,000 or $300,000,” Guth says. Even beyond the conflict issue, experts say there are other problems with these letters. Elson says that fairness opinions are inherently flawed because they can be easily changed by tinkering with any number of the structures the opinion is built on. “These are subjective opinions. It’s hard to come up with real values. If you change something like interest rates in the formula, the whole model can be thrown off.” In a perfect world, the Delaware professor would end the use of the opinions. He says he would prefer to let the market pass judgment on whether a deal makes sense. Cottage Industry in Fairness Opinions At a minimum, it seems safe to say that fairness opinions, at least in high profile deals, will be farmed out to independent bankers. “The buzz out there is that a lot of people want these opinions to be done by secondary sources with a fee structure that isn’t contingent upon the deal closing,” says Sam Clark, a managing director at Houlihan Lokey Howard & Zukin. He adds that the wrong answer when a company is considering a fairness opinion is that the primary investment banker on the deal might as well do it because it will be cheaper. But the pressure to bless deals, even by independent, third-party opinion providers, can be significant. Cefali says that on fairness opinion assignments, or on solvency opinions, which she says can also make or break a deal, firms come under a lot of pressure if the referral source is a major collaborator or customer. “A firm has to have the backbone to say no if it’s asked to bless a questionable deal,” she states. Cefali has been asked to approve going-private transactions in which all the cash was going to be withdrawn from the company. At Duff & Phelps, she says the culture that exists made turning down this sort of assignment less difficult that it might be at another firm. It is also no longer enough just to get an independent fairness opinion, she adds. If there is a lawsuit challenging a deal, the defendant will have to face questions that go beyond the independence of the opinion. This could include considerations such as whether the board read the fairness letter, whether it was merely a document or whether a board presentation was involved, and whether the board voted on the presentation immediately or allowed time for closer consideration. Although she is using fairness opinions as an example, there’s no reason to believe that the defense of the results from a shift in accounting methods or a senior management compensation agreement wouldn’t be stronger if the attorneys were able to make the same kind of points. Cefali notes that while some of these approaches are subjective, they provide useful protection for boards that get sued. One class of professional worker on the deal scene and elsewhere that might represent the furthest afield that post-Enron and post-Sarbanes-Oxley scrutiny has gone so far is the public relations professional who writes, in conjunction with corporate counsel and others, news releases. Drew Chapman, an associate in the New York-based law firm Fox Horan & Camerini, says that a public relations firm that knowingly misrepresented the facts about a transaction might find itself the target of shareholders’ suits and regulatory attention Changing the Referral Process Chris Kramer, a managing director at Strategic Equity Group, says that one change his firm has seen in response to the increased scrutiny advisers are coming under is that it’s making more of an effort to get to know referral sources. “Whether it’s a CPA or a lawyer on the deal, we now want to get a better understanding and have a higher comfort level with the referral source,” he says. He adds that the third-party adviser has to check whatever due diligence was done and sometimes increase the amount of investigation before he or she recommends or facilitates a transaction. The way advisers get hired is by relationships with management and boards, Baker points out. While this might have been all right traditionally, it’s now imperative that securities lawyers counsel their clients that there should be no financial or personal relationship between any financial advisers and management or board members. In order to enforce this approach, Baker says it’s important for professional service firms to rethink their client intake procedure generally. He recommends that one approach that could be used would be to build internal ethics walls between different departments of firms. Protect Yourself “Financial and other deal professionals must be increasingly careful and aware of these new risks as they advise clients,” Baker says. In light of this and other developments, financial advisers and others would do well to make sure that all their deal work be able to withstand the closest scrutiny. Third-Party Deal Adviser Protective Devices * Increase insurance * Get to know referral sources * Learn as much as possible about business practices of parties * At a minimum, check for felonies * Increase due diligence * Save documents, prepare files for hostile scrutiny * Use e-mail judiciously (the Quattrone proviso) * Find out the motivation of the other side for deal initiation * Determine how the deal will be reflected on the other side’s books * Find out how it will show up in final reports * Rethink the client intake process Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com