The Growing Storm Over Fairness Opinions

“Shed the blinders of industry practice’ that may have made it possible for you to not see the conflicts that surround you daily. Just because the industry has always done something that way,’ don’t assume it’s acceptable. It won’t be acceptable to your customers when they come to understand the conflicts involved.” Stephen M. Cutler, Director of the SEC’s Division of Enforcement, calling on Wall Street firms to do “top-to-bottom” reviews of their business. “Shed the blinders of industry practice’ that may have made it possible for you to not see the conflicts that surround you daily. Just because the industry has always done something that way,’ don’t assume it’s acceptable. It won’t be acceptable to your customers when they come to understand the conflicts involved.” Stephen M. Cutler, Director of the SEC’s Division of Enforcement, calling on Wall Street firms to do “top-to-bottom” reviews of their business. Since the collapse of Enron Corp., business practices once thought to be standard, such as the use of special purpose entities and enlisting auditors for significant non-audit services, have come under intense scrutiny from regulators, courts, and commentators. As a result, many of these standard practices have been changed significantly, or even prohibited. In light of this new environment, boards and their advisers should reevaluate practices they previously considered to be “business as usual” to make sure their actions will withstand future regulatory and judicial scrutiny. Fairness opinions are among the practices that are being challenged. They have been subjected to criticism from some commentators for decades. In the past, this criticism has had little impact on how and from whom companies involved in m&a obtain the opinions. Recently, however, attacks have been ratcheted up and the spectrum of critics has been broadened to include, among others, high-profile regulators, increasing the likelihood that changes will be made in current practices. Intensification of the controversy suggests that prudent directors of both acquirers and targets take steps to protect themselves, including: * Assignment of the opinion to an expert third-party firm that is not advising either company in the deal and can be regarded as truly independent. * Asking for a “second opinion” from another independent expert to support the primary opinion. * Keeping copious records of how the consultant was selected in case a court challenge is mounted. The scope of the criticism and concern suggests how much is at stake. In the spring of 2003, New York Atty. Gen. Eliot Spitzer, fresh off his successful inquiries into suspect practices involving security analysts and mutual funds, called for an inquiry into fairness opinion practices. Spitzer’s office never initiated the inquiry, citing resource constraints, but his call placed a regulatory spotlight on fairness opinions. In published comments, a number of lawyers dismissed the need for regulators to investigate fairness opinion practices. However, in June 2004, the NASD initiated what The Wall Street Journal called a “potentially far-reaching inquiry into the fees, methods, and possible conflicts of interest connected with [fairness] opinions.” In November, the association asked for comments on whether to propose rules, and the comment period expired January 10. In addition, it was reported recently that Wall Street firms have been conducting internal “conflict reviews” at the request of the SEC to identify conflicts of interest that affect their businesses. One of the areas identified in the press report was fairness opinions, where investment banks “face pressure to bless as fair’ deals that enrich clients.” The fallout from these conflict reviews is not yet clear. Finally, based on a number of recent decisions, there is increasing concern among directors and their advisers that the Delaware courts are taking a more critical look at director conduct, particularly in conflict-of-interest situations. The Delaware courts historically have been deferential to the judgment of directors regarding fairness opinions, including the selection of the investment banks providing them. But that position may be changing, more recent opinions suggest. Based on the foregoing, it seems clear that the new, more demanding environment has increased the risk of relying on “business as usual” practices. Consequently, now is the right time for directors to re-evaluate fairness opinion practices. Although Cutler’s admonition was directed at Wall Street firms, it is obvious that boards and their advisers should take notice as well. Fairness Opinion Practice Origins Fairness opinions have been issued in change-of-control transactions for decades. To understand the role played by fairness opinions, it is important to understand the board’s duties regarding these transactions. Under the corporate laws in Delaware and most other states, boards of directors are responsible for managing the business and affairs of the corporation. This means that certain fundamental decisions affecting the corporation, including a change of control transaction, are the responsibility of the board. In fulfilling this responsibility, directors owe certain fiduciary duties to the shareholders, including the duty of care. The duty of care has been interpreted by the courts to mean that, prior to making a business decision, the directors must have informed themselves of all information reasonably available to them. Once the directors have been so informed, they must act with “requisite care” in discharging their duties. The established standard of “requisite care” under Delaware law is gross negligence. Absent fraud, bad faith, or self-dealing, directors who act on an informed basis are entitled to the protections of the business judgment rule, which ordinarily prevents a court from second-guessing directors’ actions. In fulfilling their duty of care, directors may rely on information and analyses provided by outside experts, such as fairness opinions. Specifically, Section 141(e) of the Delaware law provides in relevant part: (e) A member of the board of directors…shall, in the performance of such member’s duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation’s officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person’s professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation. In its famous 1985 Smith v. Van Gorkum decision, the Delaware Supreme Court, affirming the Chancery Court, held directors of Trans Union Corp. personally liable for approving a sale of the company without, in the view of the court, adequately informing themselves about all material information reasonably available. This failure was found by the court to constitute gross negligence in violation of the directors’ duty of care. One of the primary bases for the decision was, in the courts’ opinion, the board’s failure to obtain valuation information sufficiently adequate to reach an informed judgment on the fairness of the price. The board argued that its decision was an informed one in large part because of the large spread between the bid price of $55 per share and Trans Union’s market price of $38 per share. An unpersuaded court responded that: “A substantial premium may provide one reason to recommend a merger, but in the absence of other sound valuation information, the fact of a premium alone does not provide an adequate basis upon which to assess the fairness of an offering price.” The court further stated that “the adequacy of a premium is indeterminate unless it is assessed in terms of other competent and sound valuation information that reflects the value of the particular business.” The court expressly stated that an outside valuation study was not essential to support an informed business judgment and that a fairness opinion issued by an “independent investment bank” was not required as a matter of law. Yet it became standard practice for a target board (and in certain large deals, the acquirer’s board) to obtain a fairness opinion, often from the investment bank advising the target board on the transaction. It should be noted that the Van Gorkum decision gave rise to the “market check” as a standard practice in which a publicly traded target and some privately owned sellers contact potential competing bidders to determine whether a higher bid is available. “Problems” With Fairness Opinions Over the years, critical commentators have raised numerous concerns over fairness opinions with the primary concern in recent years related to conflicts of interest. Critics are vexed over at least three potential conflicts of interest: “Success Fee” Frequently, an investment bank providing financial advice on a deal also provides the fairness opinion. The bank usually receives a fixed fee for the opinion and a variable fee for the advisory services based on the value received by the target shareholders if a deal goes through – a so-called “success fee.” The fixed fee for the fairness opinion typically ranges from $250,000 for mid-sized deals to $1 million or more for larger ones. The success fee usually is much larger, or more than $10 million in some larger deals. As a result, critics allege that the success fee provides an adviser with an incentive to deem a transaction “fair” to shareholders, regardless of its merits, in order to “make the deal happen.” “Beholden to Management” If the bank providing the fairness opinion is recommended and/or hired by the target’s management, there is concern that the bank’s relationship with management may provide an incentive to find the deal fair, regardless of its merits, in order to make the deal happen. This conflict may arise particularly if management receives big payouts under golden parachutes and other compensation arrangements when the deal is completed. “Future Business” Even if the consultant providing the fairness opinion is hired by the target board or, better yet, a special committee of independent directors, there is concern that the bank has a desire to please the directors to obtain future business. That, critics say, may provide an incentive to find the transaction fair, regardless of its merits, in order to make the deal happen. Commentators also have criticized fairness opinions based on the methodologies used, and the types and number of assumptions made, by banks to determine fair value, as well as the lack of consensus on industry standards for valuation methodologies. There also has been concern that shareholders do not understand that fairness opinions, even though disclosed to them in SEC filings, are not directed to shareholders and are not intended to be relied on by them. It is unclear what, if any, changes to fairness opinion practices will be proposed by the NASD. But press reports and the request for comment indicate that at a minimum the securities regulatory association is expected to require enhanced disclosure regarding an investment bank’s relationships with the target, its management, and its board, as well as the fee for the opinion. The NASD also may require enhanced disclosure on the potential payouts to management in the transaction. These requirements are not likely to cause any significant change in current practices because management payouts, bank relationships, and fee arrangements already are required under SEC rules to be disclosed in the proxy materials for the deal that are distributed to shareholders. However, there has been speculation on more substantive changes, such as a requirement that fairness opinions be issued only by banks or other consultants that do not provide advisory services on the transaction. That requirement could address the success fee conflict. Congress took a similar approach in Sarbanes-Oxley in dealing with purported conflicts of interest involving auditing firms’ performance of lucrative non-audit services, such as strategic consulting. Although it seems unlikely that the NASD would order enlistment of a totally independent expert, the political and regulatory pressure to eliminate, or significantly minimize, the appearance of conflicts of interest in fairness opinion practices is strong. Court Challenges to Fairness Opinions As stated earlier, in order for directors to receive the protections of the Delaware corporate law, the adviser providing a fairness opinion must be selected with reasonable care and the directors’ reliance on the fairness opinion must be in good faith. To date, directors’ ability to rely on a fairness opinion and receive the protection of Delaware law has not been directly challenged in the Delaware courts on a “reasonable selection” or good faith basis. However, in the two Delaware cases involving the most direct challenge to directors’ ability to rely on a fairness opinion because of conflicts of interest among the target, its board, and the bank rendering the opinion, the courts found for the directors. In Crescent/Mach I Partners LP v. Turner, decided by the Chancery Court in 2000, minority shareholders challenged a merger alleging, among other things, that the target board breached its duty of care. They claimed the duty was breached because Donaldson, Lufkin & Jenrette (DLJ), which issued the fairness opinion for the target board, was improperly influenced because it had a financial interest in the completion of the transaction, and because a DLJ managing director was a director of the target. The court rejected these bases, finding that: * With regard to DLJ’s financial interest (presumably a success fee), the bank was entitled to compensation for its efforts in completing the transaction, there was nothing in the record to suggest that the compensation was excessive or extraordinary, and the plaintiff failed to plead any allegations that DLJ’s or the managing director’s interest in the transaction was not completely aligned with the shareholders in attempting to maximize value. * Fairness opinions prepared by independent investment bankers are generally not essential, as a matter of law, to support an informed business judgment. Similarly, in a 1989 case, In re Formica Shareholder Litigation, shareholders unsuccessfully challenged a special board committee’s reliance on a fairness opinion from Shearson Lehman Hutton, which also was the financial adviser to the special committee and owned approximately 13% of the target’s stock. The plaintiff claimed, among other things, that the special committee breached its duty of care by appointing Shearson, rather than a firm totally independent of management, as the committee’s financial adviser. Despite Shearson’s alleged ties to target management, the Chancery Court found that the committee was entitled to rely on Shearson’s fairness opinion, in part because the bank’s ownership interest and advisory compensation (a success fee) offered “economic, structural incentive” to provide independent, accurate valuation advice. While on the surface these cases should give target directors some comfort in relying on fairness opinions issued by investment banks receiving success fees and with significant ties to the target company and its management, there are some concerns lurking beneath the surface. First, the Turner and Formica decisions preceded the corporate scandals of the early 2000s and the resulting increased focus on conflicts of interests in the boardroom and in hiring professional advisers. Second, in Turner, the court specifically noted that the plaintiff’s complaint failed to include allegations that DLJ’s interests in the deal were not completely aligned with the target’s shareholders. If the complaint had included such allegations, it is possible the case would have been decided differently. Third, in Formica, even though the court found for the directors, the opinion acknowledged in a footnote that: “The goal or model being strived for is to assure that the board, in negotiating and deliberating on behalf of the public shareholders, is able to function as independently and in as conflict-free a manner as possible. Given that objective, there is some merit to the criticism it would have been preferable…for the board to have selected a financial adviser having no previous business relationship with management.” Fourth, a “reasonable selection” challenge was successfully asserted in another context in Boyer v. Wilmington Materials Inc., a 1999 Chancery Court decision. The court stated that Delaware law was not available to protect directors who relied on the advice of outside legal counsel not selected with reasonable care. The counsel testified that it represented the principal shareholders in the challenged transaction, not the corporation, its board, or the minority shareholders. Because of this conflict of interest, the court found the directors were unreasonable in selecting that firm to provide advice on the fairness of the transaction to the minority shareholders. Finally, commentators have noted that the Delaware courts have recently issued a number of decisions critical of director conduct, indicating a possible ratcheting up of the scrutiny with which the courts will review such conduct. Consequently, it seems unlikely that the Delaware courts will review a future challenge to a board’s reliance on a fairness opinion with the same deference found in the Turner and Formica decisions. Under Delaware law it is clear that boards need valuation data in order to properly evaluate a premium offered in a change-of-control transaction. It is also clear that the valuation data can come from internal or external sources. However, because target management typically has substantial financial interests triggered by the transaction, e.g., golden parachute payments, valuation data provided from internal sources may be more suspect than valuation data and fairness opinions provided by investment banks, even if they are entitled to success fees. Therefore, although fairness opinions are not required as a matter of law, target boards will, in most circumstances, continue to obtain fairness opinions from investment banks in order to become fully informed on valuations to satisfy their duty of care requirements. Given the current regulatory and judicial environment, boards and their advisers should, at minimum, carefully consider the qualifications and independence of the adviser selected to provide a fairness opinion. This means not blindly following the “business as usual” approach of receiving a fairness opinion from an adviser directly involved in the transaction. Investment banks with significant prior relationships with the target’s board and management should be considered suspect even if they possess the most institutional knowledge of the target. To further enhance the position that they are acting in good faith and with reasonable care, boards should consider obtaining the fairness opinion from an adviser other than the investment bank providing deal advice. In fact, some buyers now are requesting, as part of the offers, that the target’s fairness opinion be obtained from an independent financial adviser. On the basis of the Turner and Formica decisions, it is possible to argue that the success fee promised to an adviser is an incentive to maximize value, and that separating the two functions is unnecessary. However, it is also possible to argue that the investment bank simply wants to get the transaction closed and receive its fee, even if the transaction does not produce the highest fee and is not in the best interests of shareholders. Accordingly, even when separating the two functions is not mandated and may be more costly and less efficient, assigning the opinion to an adviser with no other role in the deal should increase the likelihood that the document will provide the protection that directors want. In most circumstances, fairness opinions and valuation data provided by investment banks and other recognized valuation experts will continue to be the best information reasonably available to directors trying to evaluate the adequacy of a purchase price. And while it is not required in all circumstances, a board should consider obtaining a second opinion as part of its “reasonable selection” analysis. A second opinion recognizes that great variations in valuations are possible, given the lack of a fully accepted system for calculating business values, and can help directors meet the requirements for Delaware law protection. In all events, a board should thoroughly review its financial adviser’s interests, compensation, and other relationships and keep a careful record of the results. n Patrick Leddy is an M&A Partner in Cleveland, and Randall Walters is an M&A and Corporate Finance Partner in Columbus, at the law firm of Jones Day. Copyright 2005 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com