It is the responsibility of the members of a corporation’s board of directors to decide whether or not to proceed with certain major acquisitions, divestitures, and other corporate transactions. While there is no legal requirement that directors seek expert advice as part of the process of coming to a decision, it has become commonplace for them to do so. Thus, in such situations, before proceeding, directors routinely secure a “fairness opinion” from a financial expert assuring them that the proposed consideration involved is fair from a financial point of view to the corporation’s shareholders.
In recent years, there has been increasing criticism from regulators, academics, and others of the practice of directors relying solely on the investment bankers involved in the transaction at issue to provide fairness opinions with respect to that transaction. The reason for this is clear: a potential conflict of interest. As one academic has explained, under the typical investment banking fee arrangement, “compensation is a success fee payable to the bank at transaction milestones such as announcement or completion,” and the “investment bank therefore has a hefty incentive to ensure that the contemplated transaction for which it will issue a fairness opinion progresses to completion.” But, S. Davidoff writes that conflict arises where a bank is asked to opine and advise on a transaction that it stands to benefit from only if the transaction transpires. In fact, under the fee structure explicated above the bank will not be paid if it cannot find fairness.”
The reason directors secure fairness opinions, as BusinessWeek has explained, is to “give directors a shield in court when unhappy shareholders sue. The opinions are evidence that the directors checked with outside experts to make sure that the deal is fair to shareholders whom they represent.” As FINRA put it in November, 2007, fairness opinions “are routinely used by directors . . . to satisfy their fiduciary duties to act with due care and in an informed manner.”
While fairness opinions are regularly published in proxy materials relating to major transactions, the primary intended beneficiaries of fairness opinions are not shareholders, but rather directors. The principle purpose of the fairness opinion is to provide directors with expert assurance that the consideration in the transaction is fair from a financial point of view so that the directors can better defend against any later charge that they failed to discharge their fiduciary obligations in this regard.
Four developments have served to heighten the focus on the conflicts present when the same investment bank that is at the center of a transaction also provides the fairness opinion. First, in a December, 2005 opinion, the Delaware Chancery Court denied a motion by the directors of TCI for summary judgment dismissal of a complaint challenging their approval of TCI’s acquisition by AT&T. The opinion stated that hiring the same financial advisors for both deal-making and fairness opinions “raises questions regarding the quality and independence of the counsel and advice received,” noting that “the contingent compensation of the financial advisor, DLJ, of roughly $40 million creates a serious issue of material fact” as to whether the directors could rely on DLJ’s fairness opinion. In light of this development, Valuation Research advises that corporations “obtain fairness opinions from independent providers,” and that using the same bankers that are doing the deal to provide a fairness opinion may leave “the board members relying on a biased fairness opinion, and thus exposed to lawsuits.”
Second, in the wake of the TCI-AT&T decision, an increasing number of articles began to appear in scholarly journals, legal periodicals, and director-oriented publications highly critical of the practice of relying solely upon a fairness opinion from an investment bank that stands to receive a large fee if, but only if, the transaction is found to be fair and closes. As one such article in the Los Angeles Business Journal, harshly asserted, “the investment bankers stand to make s lot of money on this deal, but only if it closes. How, then can they be objective in determining whether the transaction is fair to . . . public shareholders? The simple, inescapable answer is that they can’t and won’t.”
Third, under FINRA Rule 2290, effective December 8, 2007, fairness opinions must specifically disclose not only contingent-fee conflicts but also past and future business relationships that might lead to a potential conflict of interest when providing a fairness opinion.
Fourth, there has been an ongoing shift in the views of company executives and board members about independent fairness opinions. This was confirmed in a 2006 survey conducted by Mergermarket at the behest of Houlihan Lokey Howard & Zukin, which reported that a “new fairness opinion paradigm” is emerging. Specifically, the survey found that, while “24 months ago it was relatively uncommon for companies to actively seek independent (i.e., separate from their M&A advisor) fairness opinions,” now more than half of the executives and directors surveyed said they “were not comfortable having their M&A advisor also act as their fairness opinion provider.” In fact, the survey “respondents felt that the greatest impact of [FINRA Rule 2290] would be an increase in the number of corporations that require a second fairness opinion.”
While fairness opinions are regularly published in proxy materials relating to major transactions, the primary intended beneficiaries of fairness opinions are not shareholders, but rather directors. The principle purpose of the fairness opinion is to provide directors with expert assurance that the consideration in the transaction is fair from a financial point of view so that the directors can better defend against any later charge that they failed to discharge their fiduciary obligations in this regard. Under new FINRA Rule 2290, however, the directors will be put on specific notice of conflicts, if there are any, that may call into question the reliability of the fairness opinion. The disclosure of such conflicts, in turn, will raise questions as to whether the directors receive any benefit from relying on the fairness opinion. Indeed, plaintiffs’ lawyers will likely argue that, because of the newly-mandated disclosures, the directors were on notice that the fairness opinion was not reliable and thus acted improperly in purporting to rely on it. In such circumstances, directors will likely increasingly conclude that, to better protect themselves, they would be well served to secure an independent fairness opinion.
Donald G. Kempf Jr. is a senior advisor at Broadpoint Gleacher Securities Group. He has previously been general counsel at Morgan Stanley and a partner at Kirkland & Ellis.