Contrary to popular belief, fairness opinions are not required by law when companies are involved in deals. In fact, they are not really valuation opinions, or even a determination of the best price. Nor do fairness opinions serve as validation that a specific transaction is the best possible deal from the shareholders’ point of view.

Yet board members are increasingly giving them greater credence in deal deliberations. That’s because they can provide important legal cover for the board that it is acting in a fair manner and using sound business judgment. Although a fairness opinion is, by its nature, of limited scope and purpose, its usefulness as an additional level of due diligence can be enhanced if board members actively engage with financial advisors to understand the scope of the fairness opinion, challenge its conclusions, and appreciate its inherent limitations.

Fairness opinions can help directors gain clarity into the soundness of a deal and underscore their duty of care to shareholders. However, they should not be seen as a good governance panacea and do not absolve directors from considering other factors in their deal deliberations. Nor are they a substitute for independent business judgment and scrutiny. The more involved the board is with its advisors throughout the process, the more insight it will glean to help it make the right business decision.

Getting At What’s Fair

Two recent developments affecting fairness opinions are worthy of closer attention by board members: a decision by the U.S. 7th Circuit Court of Appeals involving Credit Suisse and the recent adoption of the new rule (FINRA 2290) by the Financial Industry Regulatory Authority, a non-governmental regulator of securities firms.

The first sheds light on financial advisors obligations and responsibilities, and the advisors terms of engagement when they rely on the management of the advisor’s client (the seller in the Credit Suisse case) for financial information. In the Credit Suisse case, the court found that the bank acting as financial advisor to the buyer (a trust known as HA 2003 Liquidating Trust) was not grossly negligent and had fulfilled its responsibilities under the terms of its engagement when it delivered a fairness opinion based on financial projections provided by manage-ment of the seller. Subsequent to closing, the target company failed to achieve those expected results. The court found that Credit Suisse acted appropriately and in accordance with the terms of its engagement even though management had access to conflicting financial projections provided by another outside advisor that stood in stark contrast to the information management provided to Credit Suisse. The court ruled that Credit Suisse “did not write an insurance policy against managers’ errors of business judgment” and had acted appropriately in relying on the financial information provided by management without independently verifying that information and in accordance with its terms of engagement.

Additionally, because the Credit Suisse engagement agreement did not provide for updates, the court found that Credit Suisse had no obligation to update its fairness opinion between the time the fairness opinion was delivered and the deal closed, even though market conditions had deteriorated dramatically during that intervening period.

This decision highlights the importance of understanding the potential limitations of a fairness opinion created by the specific scope of work carried out by the financial advisor and the quality of information underpinning its analysis. When engaging financial advisors, boards should consider the context of the fairness opinion analysis and the potential limitations of that analysis.

Increased Disclosure

FINRA Rule 2290, adopted late last year, was the outcome of a process initiated a few years ago to review the role of fairness opinions in corporate control transactions. The basic question FINRA aimed to address was whether existing proxy disclosure requirements mandated by the Securities and Exchange Commission (SEC) are sufficient to inform investors about the subjectivity that goes into rendering fairness opinions as well as the potential for insider or advisor biases.

Rule 2290 does not actually prescribe methodology or the type of transactions requiring a fairness opinion. It does, however, prescribe additional disclosure requirements and procedures that FINRA member firms must follow when issuing fairness opinions.

FINRA maintains, as evidenced by Rule 2290, that shareholders are best served through further disclosure of conflicts and enhancement of advisor procedures. The rule requires all FINRA member firms that issue fairness opinions to disclose whether they have material relationships with any party to the transaction. They are also required to disclose whether their fee is contingent on the success of the transaction. Procedurally, FINRA member firms are required to have written procedures outlining processes and to disclose whether a fairness committee was involved in approving opinions issued. They must also disclose whether they have independently verified information relied upon in coming to a conclusion on fairness and whether they expressed any opinion on the fairness of compensation to be received by insiders as a result of the transaction relative to shareholders.

Although Rule 2290 formalizes some of the procedures and disclosures commonly provided by financial advisors, there are several potential implications that directors should understand. For example, the requirement that financial advisors disclose whether they have verified information used as a basis for issuing the opinion may cause more robust processes around record-keeping and information management, and may extend reasonable time-frames required for financial advisors to provide fairness opinions.

In addition, increased disclosure of conflicts and advisory relationships may open debate about the objectivity of fairness-opinion providers and could extend deliberations over business decisions. The board can take steps to minimize conflicts by forming a special committee of independent directors and hiring an advisor to provide a fairness opinion that is otherwise independent of the transaction and whose fee is not dependent on the success of the deal.

Board Practices to Consider

The primary responsibility for determining whether a fairness opinion will be obtained will continue to reside with the company’s board of directors. In turn, directors must be more vigilant than ever in demonstrating they have fulfilled their fiduciary obligation to shareholders. What follows are some items that should be on the to-do list when directors obtain a fairness opinion.

1. Assess Risk

Assessing risk is the starting point for determining whether a fairness opinion would be useful to directors in evaluating the fairness of the consideration to be paid or received in a transaction. Directors should consider the nature of the contemplated transaction and consider the following characteristics that may signal the need for a heightened level of board oversight, which is closely correlated with the need for a fairness opinion:

• Terms and conditions that depart from comparable transactions
• Non-competitive sale process
• Materiality of the transaction
• Multiple classes of equity with different rights
• Substantial executive severance in the event of a change of control
• Related party transactions
• Apparent investor conflicts
• A deal that is far afield from the company’s normal business or operations
• A deal driven by expected synergies
• The amount and type of consideration to be received/paid in the transaction

2. Manage Conflicts

Litigation risk may be heightened in situations in which there are perceived conflicts among parties involved in a transaction, such as a transaction between related parties or if a financial advisor acts in multiple capacities on the same transaction.

Although this does not necessarily indicate a real conflict, directors should have a heightened awareness of the perception of conflict and take action to demonstrate that they have considered such perceived conflicts. This may include forming an independent committee of directors to make key decisions regarding the pending transaction. In cases where a financial advisor is providing a fairness opinion as well as other services on the same transaction, the board may want to consider requiring the financial advisor to use separate teams for different activities and to have those teams observe ethical walls so information is not shared between teams. Or the board may opt to satisfy this need more directly, by engaging an altogether independent financial advisor.

3. Define Scope

Directors should be involved with financial advisors in establishing the scope of the fairness opinion analysis. It can make a big difference whether the scope of the analysis includes a specific consideration of the compensation arising from the transaction to a particular class of shareholders, or just considers transaction compensation as a whole. In addition, transaction compensation structure and the premium over market offered by the proposed counter-party, if any, that diverge from industry norms deserve a deeper dive since they are likely to attract a high level of investor scrutiny. Directors are well advised to engage in detailed discussions with financial advisors at the outset of the fairness opinion analysis to ensure that the scope of the analysis is commensurate with the needs of the transaction.

4. Consider Methodology

Financial advisors will determine methodology largely based on the specifics of the transaction and the nature of the business. This will be influenced by, among other things, any of the basic transactional business factors, including the type of transaction (merger of equals, acquisition, etc.), key risks and value drivers, the nature of the business and stage of development, expected growth and profitability, availability of information, and market capitalization. Financial advisors have wide latitude in applying methodologies, and directors are well advised to not only understand the methodologies, but also why the financial advisors applied them or chose not to use particular approaches. For example, were synergies explicitly considered? If so, how were they analyzed? How will a company engaged in several unique businesses be analyzed? Will those businesses be separately evaluated or will the advisor look at the company as a whole?

5. Understand Limitations

Directors must interpret fairness opinions subject to the limitations of the analysis conducted by the financial advisor. For example, although Rule 2290 requires financial advisors to disclose whether they have independently verified financial information underpinning their analysis, it is not common practice for financial advisors to do so. Directors will, therefore, typically need to conduct additional diligence to get comfortable with the quality of certain information.

6. Review Results

Boards hire financial advisors and pay them a fee for rendering fairness opinions. The value of a fairness opinion is not just in the physical letter delivered by a financial advisor but also the insight that the financial advisor can provide to help shed light on the business decisions boards must make. For this reason, directors are well advised to spend time with their financial advisors to understand the rationale behind their conclusions. Remember, a fairness opinion is the culmination of an extensive analysis and the synthesis of a variety of information that attempts to portray an accurate picture of a company and its intended transaction. What it may not be is objective in the most comprehensive sense of the word.