THE FAIRNESS OPINION: OLD DOG, NEW TRICKS
By: Nevin Sanli
It’s time to re-think the fairness opinion. You can debate whether the typical fairness opinion does or does not enlighten shareholder deliberations, or even whether it will shield directors and officers against shareholders should a deal go south. What you cannot debate is that, given the NASD’s current efforts to flush out possible conflicts of interest among those who prepare fairness opinions, this is a good time to breathe new life into the idea.
How? The first step is to broaden the scope of the fairness opinion to assess not only the financial terms of the deal but also the process by which it came about. The second is to ensure that whoever issues a fairness opinion takes a truly independent look at the deal. Taken together, these steps could make fairness opinions worth something more than the paper they are written on. They may also help to assure shareholders that directors really do have their interests in mind.
It is not hard to say who benefits from fairness opinions now. When recommending a particular transaction to shareholders, directors commission a fairness opinion, take it to shareholders and say: “We believe this is a good deal, and we have this fairness opinion to back us up, so we think you ought to vote for it.”
In reality, the fairness opinion is nothing more than an insurance policy offering directors a first line of defense against the plaintiff’s bar with angry shareholders in tow. Interestingly, although the law does not require that directors obtain fairness opinions, they have become so routine in recent decades that, in any major transaction, it is rare for companies not to commission one and sometimes two or more fairness opinions. Even so, fairness opinions remain a defensive tool, and for good reason. These days, given the aggressiveness of shareholders and the impetus toward disclosure in Sarbanes Oxley, directors had better commission at least one fairness opinion in any major deal lest they have nothing to say to shareholders except: “We like this deal, but we have no information on it to offer you besides our own testimony.”
The better idea is for directors to expand the fairness opinion, reshaping it to give shareholders enough information about a given transaction so that they can vote rationally.
How? At present, fairness opinions ask only one question: “Are the terms of this deal fair to the parties, given the circumstances?” They do not ask: “Did the parties to this deal exercise prudence in negotiating it? Did they keep shareholders’ interests in mind? Did they negotiate at arm’s length? Did the selling party seek other offers? Did any individuals with potential conflicts of interest reveal same and recuse themselves from the negotiations?”
Put another way, fairness opinions now look at results, not processes. They should do both. Indeed, the firm issuing a fairness opinion should:
· Conduct a “blind” market test of the deal, taking care to preserve the confidentiality of the deal. This could include contacting other companies that have done similar deals in the same or related industries and asking what impact certain hypothetical numbers might have had on their deal – the hypothetical numbers being something like those of the deal at hand. This, of course, would require great caution, but the results could shed valuable light on the deal at hand.
· Construct a narrative of the negotiations leading up to the signing of the letter of intent. This should include inspecting the paper trail and interviewing all parties to the deal on both sides, including directors, officers, lawyers, accountants, investment bankers, etc., to determine how the deal came about and whether the parties negotiated at arm’s length. Depending on the circumstances, the fairness opinion might only note the firm’s satisfaction as to the above-board nature of the negotiations or, in the alternative, it could lay out the full narrative so that shareholders could come to their own conclusions.
· Probe carefully for conflicts of interest among all of the parties to the deal. This would include checking stock holdings among directors and others, formal or informal side deals, severance agreements, deferred payments, golden parachutes, employment agreements, and the like, and possibly seeking signed statements from all parties affirming for the record that they have no conflicts of interest.
· Check for hidden value on the asset side of the balance sheets of the parties to the deal – and for possibly hidden danger on the liability side. This could include appreciated assets such as real estate purchased in the past or trademarks or other intellectual property carried on the books at nominal value.
Some of the work outlined here would duplicate the due-diligence efforts on both sides of the deal, but the difference is that the goal here would be to inform shareholders, not directors, of the wisdom of the deal.
Note, however, that these questions do not seek to determine whether the deal in question is the best one possible. In commerce, the perfect is the enemy of the good, so the law requires only that in driving a transaction, directors negotiate a good deal, not the best deal possible. Thus, firms preparing fairness opinions need not troll the marketplace looking for a better deal than the one on the table. But they should inquire whether, in driving their bargain, directors themselves followed procedures designed to meet their duty to protect shareholders.
But there is more to the story. Fairness opinions also ought not to come from firms doing other business with the parties to a particular transaction – for example, investment banking firms advising on a deal. In research published last year, finance academics Darren Kisgen and Jun Qian of Boston College and Weihong Song (CQ ALL NAMES) of the University of Cincinnati touched on the source of trouble – the high fees investment banks earn for advising on deals. Among acquiring firms in 906 deals between 1994 and 2003, 75 percent commissioned fairness opinions from an investment bank advising on the same deal, even though the advisors stood to earn fees only if the deal closed successfully; among target firms, 53 percent did the same. The median fees paid for fairness opinions in these deals came to $312,000, according to the researchers, but that was small change compared to the success fees earned by investment bankers – $2.24 million at the median.
Clearly, the potential exists for an investment bank’s deal advisors to lean on those who prepare a fairness opinion to bless a given deal so that the firm can book the success fee. Investment banks insist they have a Chinese wall between their deal advisory and fairness opinion groups, but even if you grant this is true, the potential for conflicting interests is huge, as a number of recent deals suggest.
In acquiring FleetBoston Financial Corp. in 2003, for example, Bank of America agreed to pay Goldman Sachs $5 million to prepare a fairness opinion plus another $17 million to advise on the deal, contingent on a successful close, according to the Wall Street Journal. For its part, FleetBoston agreed to pay Morgan Stanley up to $25 million for a fairness opinion and advisory services in the same deal, most of it contingent. Also in 2003, when Royal Bank of Scotland bought Charter One Financial, the latter agreed to pay Lehman Brothers more than $23 million for a fairness opinion and advisory services, all but $2 million of it a success fee.
Is the implication that investment banks ought not to issue fairness opinions? Not necessarily. But the potential for trouble is real, as J.P. Morgan Chase & Co. discovered in acquiring Bank One Corp. in 2003. Morgan Chase told its shareholders that it had a fairness opinion on the transaction from one of “the top five financial advisors in the world” – itself. Unsatisfied, shareholders of both Morgan Chase and Bank One sued after the deal closed, claiming a conflict of interest.
Lo, the NASD, breathing hard.
But no matter what the NASD ends up bringing to the table, surely the better idea is for directors to obtain fairness opinions from firms with nothing to gain from the success of the deal at hand. It is not enough, that is, for a firm preparing a fairness opinion and also serving as investment banker to disclose a possible conflict of interest, since to disclose any such conflict is not to eliminate it. Instead, directors should require the firm issuing a fairness opinion to affirm, in a statement comprising part of its report, that it:
· Acknowledges that it has an affirmative duty to help shareholders assess the entirety of the deal at hand;
· Has no conflicting financial or other interests, actual or potential, with any of the parties to the transaction at hand;
· Will not earn fees contingent on the close of the transaction, and
· Bases its opinion solely on the facts and circumstances of the transaction, uninfluenced by other considerations of any kind.
Companies should also require fairness opinion firms to specify the methodology and due diligence they use in analyzing deals and to make explicit any circumstances inhibiting their ability to carry out the task at hand – for example, unexplained refusals by any parties to a transaction to supply them with information necessary to reach a judgment.
At the very least, directors who engage investment bankers to prepare fairness opinions should insist that the firm warrant the independence of its fairness opinion people and wait a very discreet time – say, at least one year – before its investment bankers come knocking on the door again to work on some new deal.
Clearly, shareholders are better served when there is no potential whatever for a conflict of interest in any firm preparing a fairness opinion, and since it lies within the power of directors to see that this comes about, they should see to it, and soon.
Nevin Sanli is president of Sanli Pastore & Hill,Inc., Los Angeles, a specialist business valuation firm (www.sphvalue.com). He may be reached at (310) 571-3400 or email@example.com.