Conflict of Interest: Fairness Opinions
May 10, 2006
By Erik Sherman – Corporate Secretary Magazine
The fit between the New York Stock Exchange and Archipelago, an electronic exchange, seemed natural. Not only did each have capabilities the other lacked, but in April 2005 Nasdaq announced it was going to buy Instinet, the NYSE's other leading acquisition candidate in that area. By the summer there was a merger agreement, but by the fall a lawsuit from a group of NYSE seat holders sought to postpone a vote on the deal.
What set them off? A number of factors came into play, including Goldman Sachs facilitating the deal when it had existing relationships with both organizations; Lazard, financial advisor to the NYSE, having its IPO underwritten by Goldman Sachs; NYSE CEO John Thain, former chairman and CEO of Goldman Sachs, still owning 2.2 million shares of that company's stock; and Lazard preparing a fairness opinion without, as it admitted, verifying the underlying financial information provided by the NYSE, Archipelago and Goldman Sachs.
Since the 1980s fairness opinions have become de rigueur in M&A activities as a succinct way of, well, covering corporate posteriors. But this `proof' of board due diligence has taken a heavy beating in recent court cases, as the current investment and business climate has seen the spotlight of scrutiny focus on fairness opinions.
Companies often have valid economic reasons for wanting the investment bank involved in a potential deal to provide the fairness opinion. Boards also have good reason to control their expenditures, wanting to pay significant banker fees only if a transaction actually takes place. However, obtaining a fairness opinion from an entity with a vested interest in seeing a deal get done raises serious questions about just how fair most fairness opinions can really be. And many boards don't acknowledge how a process they honestly think is fair can appear far different to outsiders.
The wide use of fairness opinions is only about 20 years old, stemming from a court case called Smith v Van Gorkom. The chairman and CEO of the Trans Union Corporation, Jerome Van Gorkom, proposed a sale of the company to Jay Pritzker, a corporate takeover specialist. Ultimately, the board signed the merger agreement without reading it, recommended that share-holders approve the deal and voted not to consider other bids, discouraging two other suitors. A group of stockholders sued after the deal went through. Eventually the Delaware Supreme Court ruled that the directors had breached their duty of care for not having acted in an informed and deliberate manner.' Among the reasons was that the board 'lacked valuation information' as to whether the selling price was fair.
Thus the heyday of fairness opinions began. 'They were not unknown before then, but after that they became quite common,' says Howard Steinberg, co-head of the M&A practice at McDermott Will & Emery and former general counsel at Prudential Equity. Shareholders in the acquiring company wanted some indication that the amount being paid Was reasonable; shareholders in the acquired company didn't want to leave significant value on the table.
It may come as a surprise that fairness opinions are still a legal nice-to-have, not must-have. 'There's no requirement for a fairness opinion in an M&A transaction,' says John Utzschneider, a partner and co-chair of the M&A practice at Bingham McCutchen. But they have become a way for a board to satisfy its 'duty of due care.'
Spawning an industry
The prevalence of fairness opinions has spawned an industry to assemble the data, marshal the analysts, choose the financial models, crunch the numbers and produce the results. And they are being used for more than just M&A deals. For example, boards at companies issuing an IPO often want a fairness opinion on the initial offering price.
But creating a fairness opinion — at least on the M8zA front — takes extensive work, and fees 'often run to seven figures,' says Bruce Bingham, senior managing director of Trenwith Valuation. Understandably, as the expenses of a deal mount, a board typically wants to rein in costs.
In fact, cost pressures are a major reason why investment banks that broker and finance M&A deals have divisions that prepare fairness opinions. They like the extra business and can argue that most of the data and analysis necessary for developing an opinion is already in their hands, so the fairness opinion can cost less because a corporation doesn't pay for work being done twice. It is apparently no contradiction that banks promise a Chinese wall between the groups brokering and evaluating the deal. Indeed, Bingham recalls that when he was the national valuation practice director at BDO Seidman, he never felt any pressure to have an opinion come out one way or the other.
But there is at least a problem of perception in the outside world. When a bank is slated to receive a percentage of the selling price as a contingency fee if a deal goes through, the bank could have a vested interest in ensuring a successful conclusion.
'Is there any evidence of clear collusion?' asks Bingham. 'Probably not. But the word I use is perception. When you're trying to attract investors and maintain confidence in both the company and the bank as institutions, it seems to be a risk that both are taking.' In other words, investors and the public could begin to wonder whether the separation between the valuation and M&A groups in the bank is a Chinese wall, or more like a moveable room divider.
Contingency fees aren't the only potential sore points. In the NYSE-Archipelago deal, it was the tangle of relationships among the banks, companies and certain individuals that caused a furor. 'That doesn't necessarily mean at the end of the day that any particular relationship results in a finding that a particular financial advisor or bank had a conflict in a particular setting,' says Tom Skelton, a partner at Lowey Dannenberg Bemporad & Selinger and co-lead plaintiff counsel in the class action, 'but the more interwoven relationships there are, the more challenges you'd expect.'
Those interrelationships extend to other financial undertakings as well. Look at IPOs, where an underwriter tradition-ally sets the opening stock price based on what it thinks the market can bear. A presumption is that the underwriter will be selling to long-term investors, like institutions, to help make a stable market for the company's stock. However, some studies have come to the conclusion that IPOs are, on average, under-priced. One study undertaken in 2000 by a visiting scholar at the SEC came to the conclusion that underwriters quote a price below what could reasonably be expected. This creates an opportunity to 'flip' a stock, generating an immediate aftermarket.
'In many instances, these allocations of scarce pre-pop stock were given away as rewards for business directed to the underwriting company,' says Walter Zweifler of Zweifler Financial Research. 'The company coming to market often gets short-changed significantly.'
It may be that the actions of the underwriter are perfectly legal. 'Because IPOs are relatively risky in the first place, you can expect a defense argument that an underwriter has great latitude in pricing,' says Mitch Bryan, a senior partner at Chicago law firm Levenfeld Pearlstein.
Yet even if the action is defensible, the results can still be 'ridiculously outrageous,' Bingham says. 'I've seen fairness opinions in the offering documents … which, with the passing of history, would make case studies in business schools. Say the offering document says a price of $6 per share is appropriate. If it goes to $60 a share, I don't think valuation was properly done because the fairness opinion is sup-posed to foreshadow it.'
Fairness opinions have been subject to scrutiny not just by the public, but by the courts as well. As part of the decision on the class action over the NYSE-Archipelago deal, Judge Charles Edward Ramos wrote, 'Fairness opinions have become watered down and useless. While financial experts are not expected to repeat their own due diligence, some analysis of the validity of management's assumptions would be a breath of fresh air…. It is worth noting, though not probative, that when asked by this court if any of the assembled counsel were aware of any fairness opinion that opined that a proposed transaction was in fact unfair, the response was a resounding never.'
This case is hardly an anomaly. In Delaware, a suit over the merger between TCI and AT&T erupted over issues ranging from sudden preferential treatment of a particular class of stock to huge bonuses paid to board members after merger approval.
'There's nothing startling or new about the TCI decision other than it's a cookbook if you want to make every conceivable mistake,' says William McGuinness, partner and chair of the litigation department at Fried, Frank, Harris, Shriver & Jacobson. 'The court was very critical, and that's caused the practicing bar to have a lot of discussion on fairness opinions. This whole issue of fairness opinions – what they are, what they aren't, what they're supposed to be, and disclosures, literally who they're for in the first place – is white hot in the investment banking and M&A world right now.'
No longer unassailable
What makes these cases of such concern to boards is that for years the fairness opinion was prepared just for directors and thus it was unassailable by investors. Yet boards have often attached the opinions to proxy statements sent to shareholders, and the result has been increased pressure on fairness opinions.
'I think the SEC is clearly pushing in that direction,' McGuiness says. 'If you're going to put the fairness opinion out there, they don't want you to be walking away from it.'
Indeed, investors have not put much faith in fairness opinions, particularly as they are not judgments on whether a given deal is good or not. 'Shareholders probably view fairness opinions with some degree of skepticism,' says Shirley Westcott, managing director of policy staff at Proxy Governance.
The National Association of Securities Dealers (NASD) has filed with the SEC proposed rule 2290, which would require a number of disclosures along with a fairness opinion. However, the rule would not likely be enough to avert shareholder distrust. Ironically, the disclosures could actually increase skepticism, because they discuss situations that could be perceived as conflicts of interest. Furthermore, fairness opinion is really a subjective call, resting on a string of assumptions and decisions.
A growing number of boards are beginning to bite the bullet and order a second fairness opinion from a disinterested party. 'I think that will grow over time,' says Michel Feldman, partner at Seyfarth Shaw. 'We're in an evolutionary process of corporate governance, and little by little … you're going to see more things done by the board that will ultimately lead to more independence and ultimately avoid any appearance of conflict.'
Directors, corporate secretaries and legal teams may groan at the need for yet another layer of expensive due diligence, but it doesn't look like the problem is going away anytime soon.