Leading / Thinking / Performing®
Fairness Opinions
and Advisor Independence
Background
The financial meltdown that began in 2008 has resulted in consolidation in the
transaction advisory arena. Bear Stearns merged with JP Morgan, Merrill Lynch
merged with Bank of America, Lehman Brothers filed for bankruptcy and sold its
businesses, and Wachovia merged with Wells Fargo. All of the principal parties
in these transactions had been providers of fairness opinions, as were many of
the acquirers. As a result, there are fewer financial advisors and independent
providers of fairness opinions than in 2008, and, of those that remain, some have
become even larger with a broader array of services. These changes make the
issue of independence that much more important to boards of directors – and that
much more difficult to assess.
As a quick primer, the courts have generally supported the notion that boards of
directors are protected, under the business judgment rule, in most types of transactions.
Under the business judgment rule, a plaintiff must prove that the board of directors:
Did not make an informed judgment, that is, did not inform themselves of all reasonably available and relevant information;
•
Failed to act in good faith; or
•
Had a conflict of interest in connection with the subject transaction.
•
Although not legally required, the courts have viewed the receipt of a fairness opinion as
an important piece of evidence; it is one of several measures that board members can
take to prove that they fulfilled their fiduciary duties and, as such, are protected under
the business judgment rule. Many types of transactions lend themselves to fairness
opinions; however, the most common fairness opinions relate to the consideration to be
received or paid in connection with a transaction.
Fairness opinions rose to the mainstream as a result of the 1985 landmark case Smith
v. Van Gorkom (488 A. 2d 858). The Delaware Supreme Court held that, despite
consideration to the selling shareholders representing a 50% premium over the trading
price, the target’s board of directors had violated its duty of care by approving the
sale. In fact, the individual directors were found to have been grossly negligent and
were subject to personal liability. According to the Delaware Supreme Court, one of the
procedural mistakes made by the board of directors was the board’s failure to obtain a
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fairness opinion. After the Delaware Supreme Court’s opinion, boards began routinely requesting fairness
opinions as one element of proving that the directors had met their fiduciary obligations.
Interestingly enough, the supreme court’s opinion in Smith v. Van Gorkom actually references “independent”
fairness opinions. How far have we come since then?
Muddy Waters: Financial Advisor Conflicts of Interest
Financial advisor conflicts of interest arise from several different arrangements - some more obvious than
others. An investment bank may own some form of equity in its client, particularly if the investment bank
was providing services for the company before the initial purchase offer. Another clear conflict may occur
when the investment bank (or one of its affiliates) that ran the auction process for the subject company also
agrees to provide financing to one of the potential buyers (“staple financing”) – thereby providing services to
the seller and the buyer in connection with the same transaction. Generally, the involved parties recognize
such situations as conflicts, and a financial advisor other than, or in addition to, the conflicted party provides
a fairness opinion.
Another common yet more debated conflict can arise when the financial advisor to a company also provides
the fairness opinion in connection with a potential transaction. It is customary for the investment banker’s
fees, other than those for the fairness opinion, to be contingent on the successful close of the transaction.
The magnitude of the contingent fees usually dwarves the fee to be collected for providing the fairness
opinion – hence, the inherent conflict. Nevertheless, supporters of this arrangement argue that the most
qualified group to provide the opinion should be the financial advisor that helped initiate, negotiate, and
structure the transaction and that a financial advisor brought in only to render the fairness opinion would
not be as familiar with the company nor the transaction and therefore would not be useful to the board of
directors.
Financial advisors may have other relationships that create potential conflicts for boards of directors. Today’s
financial institutions are providing underwriting, financing, cash management, and investment research
services, among others, to companies all over the globe. The expansion of services makes it difficult for a
board of directors to identify a qualified financial advisor that is not already providing some service to the
subject company (or its subsidiaries) or other parties to the transaction (or their subsidiaries). Compounding
this issue is the prospective business that the financial advisor (or its affiliates) may be seeking from one
or more parties to the transaction – an issue that could also extend to a financial advisor retained solely to
render the fairness opinion.
Political and Regulatory Environment
Over the years, criticism of the potential conflicts between financial advisors and their clients has come from
many sources including shareholder activists, politicians, and industry groups. The AFL-CIO (American
Federation of Labor - Congress of Industrial Organizations) recommended that boards receive fairness
opinions only from financial advisors who have no other relationship with the company or other participants
in the transaction.1
"Investors and Regulators Question Reliability of ‘Non-Independent’ Fairness Opinions." The Hempstead Letter: Fairness Opinion
Edition, Vol. XXIII, No. 3. http://www.hempsteadco.com/vol23no3.shtml#fairness, n.d. Web.
1
The downfall of Enron and other corporate scandals eventually led to Congress’s
approval of the Sarbanes-Oxley Act (“SOX”) in 2002. Although SOX puts board
members on notice that they need to work harder to protect the interests of
shareholders, including the use of independent advisors, SOX only specifically prevents
auditors from providing certain services, including fairness opinions, to audit clients.
Several politicians have made efforts to draw attention to the independence issue.
Massachusetts Secretary of the Commonwealth William F. Galvin was very critical of
the fairness opinions issued to the board of directors of Gillette in connection with
the company’s merger with Proctor & Gamble. In addition to claiming that Gillette
shareholders were not receiving adequate consideration for the considerable synergies
expected from the transaction, Mr. Galvin criticized the conflict between the roles the
investment banks, Goldman Sachs and UBS, played in initiating, negotiating, and
structuring the transaction and the $30 million in fees the banks would receive upon
successful completion of the transaction.2
The Financial Industry Regulatory Authority (“FINRA,” formerly known as the National
Association of Securities Dealers) spent a few years polling its members and eventually
proposed Regulation 5150, which, after much commentary from members and several
amendments, the U.S. Securities and Exchange Commission (“SEC”) approved,
effective December 8, 2007.3 This regulation was the industry’s response to growing
skepticism about certain aspects of fairness opinions including independence. Relative
to the conflict issue, Regulation 5150 requires the following:
•
Disclosure of whether any fees to be received by the financial advisor are contingent on the successful close of the transaction
•
Disclosure of any material relationships existing in the past two years, or contemplated for the future, between the financial advisor and any other party to the transaction
The above disclosures were already common practice and required by the SEC in
materials sent to shareholders, such as proxies. Regulation 5150 moves some of the
disclosure from the general narrative in the proxy into the opinion itself. One difference
between the SEC’s requirements and Regulation 5150 relates to material relationships.
Regulation 5150 requires disclosure of material relationships between the financial
advisor and any other party to the transaction; however, it only pertains to direct
relationships, not arrangements between affiliates of the financial advisor and affiliates
of other parties to the transaction. The SEC only requires disclosure of relationships
between the financial advisor and its affiliates and the client and its affiliates – there is no
such disclosure requirement regarding other parties to the transaction.
Conclusion
Over the last few years, numerous court opinions have had an impact on the procedures
of boards of directors, for example, in determining when to form an independent
committee and providing it with authority to act.
2
Gretchen Morgenson, "Mirror, Mirror, Who is the Unfairness?" The New York Times. nytimes.com, 29 May 2005. Web.
Regulation 5150 was originally known as Regulation 2290; the change to Regulation 5150 was effective December 15, 2008.
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However, virtually no changes have been made to the procedure of selecting the
financial advisor who will provide the fairness opinion; specifically, the degree of conflict
at which point a board should consider selecting an alternative or additional provider of
the opinion has not been clarified. Regulation 5150 attempts to add transparency to
the procedures and disclosures of the fairness opinion; it too, however, stops well short
of developing any kind of bright line. While SOX implementation was specific, it only
applies to accounting firms and does not address other financial advisors.
As evidenced 25 years ago in Smith v. Van Gorkom, if the court finds that the directors
did not exercise their duty of care, then they could be held to be grossly negligent and
be subject to personal liability. It is obvious that no member of a board of directors
facing the above conflicts would want to be the test case that determines the location
of the line in the sand, setting the “independence” threshold – that is, the next Van
Gorkom.
About American Appraisal:
American Appraisal is a leading valuation and related advisory services firm that provides
expertise in areas such as fairness and solvency opinions and all classifications of tangible and
intangible assets. It comprises 900 employees, operating from major financial cities throughout
Asia-Pacific, Europe, the Middle East, North America, and South America. Our portfolio of
services focuses on four key competencies: valuation, transaction consulting, real estate advisory,
and fixed asset management.
Since its founding in 1896, American Appraisal has played a key role in creating and shaping
the valuation profession - while forming long-term client relationships based on integrity and
performance. Our commitment is reflected by our passion to lead our profession from the
podium, in print, and through significant participation in many of our profession’s governing
bodies and associations including the American Society of Appraisers, Appraisal Issues Task
Force, Financial Accounting Standards Board’s Valuation Resource Group, The Appraisal
Foundation, China Appraisal Society, and International Valuation Standards Committee.
American Appraisal focuses exclusively on valuation and related advisory services. That
independence guarantees our greater objectivity.
Valuation
Nancy M. Czaplinski
National Director
Fairness and Solvency Services
tel: 414 225 1035
email: nczaplinski@american-appraisal.com
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