Fairness Opinion Practice Comes Under Scrutiny as NASD Considers New Rules
by Stephen Glover and David Harris

Over the past two years, the SEC, the NASD, state attorneys general, and plaintiffs’ lawyers have focused an intense spotlight on investment banking practices, but for the most part, the banks’ mergers and acquisitions advisory business has escaped close scrutiny. That will soon change, as the NASD has announced a plan to review the practice of issuing fairness opinions. Notice to Members 04-83, issued in November, requests comment on whether the NASD should propose a new rule that “would address conflicts of interest when members provide fairness opinions in corporate control transactions.”¹ At this stage, the NASD is only gathering information on the desirability of a new rule and has not committed to adopting anything.²

The NASD explained that investment bank fairness opinions address the fairness, from a financial point of view, of the consideration in mergers and acquisitions, asset sales, securities buybacks, and other transactions. It expressed concern that fairness opinions may be influenced by whether management of the company that retained the bank supports the transaction. According to the NASD, a bank may be inclined to opine that a transaction is fair if management supports the transaction, and opine that it is not fair if management opposes the transaction. The NASD said these concerns may be particularly serious when the investment bank is also acting as financial advisor to the company in the transaction, or will receive advisory fees when (if) the transaction is completed.

The NASD is considering whether to propose a new rule that would deal with these concerns. For purposes of seeking comment and gathering information, the NASD described two general features of a proposed new rule. First, the proposed rule would require NASD members to “disclose in any fairness opinion appearing in any proxy statement any significant conflict of interest, including if applicable that the member has served as an advisor on the transaction in question, and the nature of compensation that the member will receive upon the successful completion of the transaction.”³ Second, the proposal would require members to establish “specific procedures . . . to identify and disclose potential conflicts of interest in rendering fairness opinions.”⁴

The NASD’s Discussion of Why Rules May be Necessary

The NASD notice observes that fairness opinions “have become a regular feature of corporate control transactions since 1985,”⁵ when the Delaware Supreme Court issued its decision in Smith v. Van Gorkum.⁶ The Van Gorkum court stated that a corporate board breached its fiduciary duty of due care when it approved a merger without adequate information. In determining that the board had not exercised due care, the court gave significant weight to the fact that the board failed to obtain a fairness opinion from investment bankers.

The NASD acknowledges that the SEC’s proxy rules already provide that when a proxy statement refers to a fairness opinion, the proxy statement must fairly summarize the opinion, and describe:

• The procedures followed in preparing the opinion;
• The findings and recommendations set forth in the opinion;
• The bases for and methods of arriving at such findings and recommendations;
• Any instruction received from the subject company concerning the investigation conducted by the investment bank before delivering the opinion; and
• Any limitation imposed by the subject company on the scope of the bank’s investigation.

The NASD suggested that the SEC proxy rules may not go far enough because they may not inform investors about the subjective nature of some fairness opinions and their “potential biases.”⁷ Bankers may use a “multiplicity of valuation technologies,”⁸ and the results may be sensitive to small changes in underlying assumptions.

The NASD expressed concern that bankers may be inclined to support the outcome preferred by the members of management who hired them, or who have the power to send them business in the future. The incentives to favor management may be particularly troublesome when members of the management team are receiving benefits in a transaction that differ from those other shareholders will receive.

The NASD discussed the conflict of interest disclosure it might require, including a clear and complete description of any significant conflict of interest that might affect the banker’s fairness analysis. If applicable, this disclosure would discuss the compensation the banker will receive upon completion of the transaction. The NASD suggested that variable or contingent fee arrangements deserve special attention.

The NASD also indicated that any new rule might include a requirement that the banker disclose the extent to which it relied on information supplied by the company or management, rather than independently verified information. The NASD suggested that reliance on company information might be problematic when management is receiving special benefits in the transaction or when the bankers already are predisposed to reach conclusions that favor management.

The NASD said that the new rule might set forth specific procedures that members must follow to guard against conflicts of interest. The procedures might address:

• The process by which the bank reviews and approves fairness opinions, including whether the firm uses a fairness opinion committee, the reviewing persons’ experience, the procedures used to ensure balanced review, and whether the compensation of the reviewing persons is directly affected by the delivery of the fairness opinion;
• The process used to determine whether the valuation analyses underlying the opinion are appropriate for the type of transaction and the participants in the transaction; and
• The process used to evaluate the question of whether the transaction will result in special benefits to officers, directors, or employees of the subject company.⁹

Purposes of Fairness Opinions

The NASD’s decision about whether to develop specific rules should be guided by the purposes of the fairness opinion. First, the fairness opinion is an aid to sound decisionmaking by the board of directors. When the board reviews a proposed transaction, it turns to investment bankers, who have significant dealmaking expertise, and asks them whether the transaction is sensible from a financial point of view. Obtaining a favorable opinion—and knowing that the bankers have done considerable work to develop the underpinnings for their opinion—gives the directors comfort that a decision to approve a transaction is reasonable.

Second, the fairness opinion helps the directors fulfill their fiduciary duty of due care and reduces the risk of personal liability for a bad decision. This purpose is closely related to the first. Under Delaware law, directors have a fiduciary duty of due care when they review a proposed transaction. If they fail to fulfill this duty, they may be held responsible for damages suffered by the shareholders. As the NASD observed in its Notice to Members, the Smith v. Van Gorkum decision suggests that the failure to obtain a fairness opinion may evidence a breach of the duty to exercise due care.¹⁰ Subsequent judicial decisions have also considered this factor.¹¹

Third, in transactions that require a stockholder vote or a stockholder decision to tender shares in response to a tender offer, the company may want to refer to a fairness opinion to help persuade the shareholders that they should vote in favor of the transaction or make the tender. A shareholder trying to determine whether a transaction is sensible may take guidance from a reputable investment bank’s opinion that the transaction is fair from a financial point of view to the unaffiliated shareholders.¹²

Negative fairness opinions also have value. Boards deciding whether to oppose a deal proposed by management or whether to reject a hostile bid will find support in a bankers’ opinion concluding that the proposed transaction is not fair. Shareholders deciding how to vote or whether to tender shares also may take guidance from a negative opinion.

Opinions can be particularly helpful to boards of directors and shareholders when some participants in the proposed transaction are being treated differently than others. For example, in a going-private transaction engineered by a management buy-out group, the independent directors and the public shareholders are likely to take comfort from an opinion that finds the buy-out price is fair, notwithstanding the fact that management shareholders are increasing their stake in the company and have an incentive to pay a low price.

Given these important purposes, the NASD’s desire to ensure that potential conflicts are properly managed and fully disclosed seems sensible. It is difficult to argue with the general notion that opinions on which decision-makers will rely should not be tainted by bias, or that material bias risks should be disclosed. But the need for additional regulation should turn on the severity of the bias risk and the effectiveness of the protections now in place.

Problems in Fairness Opinion Practice

The NASD’s observations about investment banks’ fairness opinion practice parallel those made by commentators who view fairness opinion practice as inherently problematic. These commentators argue that investment banks have substantial discretion in determining whether a price is fair; in their view, fairness is a highly subjective concept. The commentators reason that this discretion, when coupled with an investment bank’s conflicts of interest, makes it likely that bankers will issue opinions that favor management of the company that hired them.¹³

To explain their discretion argument, commentators observe that bankers can use a variety of definitions for fair price, including:

• The company’s value if it remains independent;
• The company’s value if it is sold in an auction process to the highest bidder;
• The company’s value as determined in an arm’s-length negotiation between a willing buyer and a willing seller; and
• The company’s value in a liquidation.¹⁴

Depending on which definition is used, the fairness analysis may produce different results. The independent company and liquidation value definitions would probably yield the lowest range of fair prices, and the auction definition would probably yield the highest.

The commentators further observe that discretion does not end with the choice of fair price definition.¹⁵ The bankers also must make a range of choices when they apply the definition. Suppose, for example, the bankers are seeking to determine what range of prices would be fair if the subject company were to be sold through an arms’-length negotiation. Should arm’s-length value be estimated by reviewing the value of the company’s assets and earnings stream, by analyzing the prices at which other comparable companies were sold, by reviewing the trading value of other comparable companies, by developing a discounted cash flow model, or by combining these approaches?

Whichever approach is chosen, the bankers must make a number of estimates and assumptions. Results may be very sensitive to their choices. For example, if the bankers use a discounted cash flow approach, they must make assumptions about future cash flows, termination values, and appropriate discount rates. If the bankers decide to review the sales prices of other companies, they must decide which companies are truly comparable.

The commentators argue that this discretion makes fairness analysis easy to manipulate because bankers have incentives to frame the analysis to favor the management teams that hire them.¹⁶ Possible conflicts include:

• If the banker is receiving a fee contingent upon completion of the proposed transaction, there is an incentive to bless the transaction; ¹⁷
• The banker may have an incentive to deliver the opinion desired by management if a decision to go forward with the transaction will generate additional work for the banker (for example, work on a related financing or work in future transactions);
• The banker may have an incentive to deliver the opinion desired by management if the banker believes that other managers will hire the banker based on the bank’s approach to fairness opinions; and
• The banker may have an ongoing professional or personal relationship with members of the management team that would make it difficult to deliver an opinion adverse to management’s wishes.

Countervailing Considerations

The discretion and conflict of interest arguments are not trivial, but there are countervailing considerations. Investment banks have strong incentives to maintain their professional reputation for producing high quality work. Over the long term, manipulating the results of fairness analysis will undermine this reputation and injure their business.

Investment banks may have liability risk if they issue a flawed opinion. If the opinion is delivered for the benefit of a target board and described in a proxy or other disclosure document, and the bases for and conclusions of the opinion are misleading, the bank may have exposure under current securities laws. And although the law in this area is very unclear, there are even cases suggesting that investment bankers may be held liable to stockholders on a negligence theory.¹⁸

The banks themselves are very aware of fairness opinion problems. They will frequently say that fairness analysis is not science but art. Their opinions and the supporting materials delivered to the board take pains to highlight definitions, assumptions, estimates, and sensitivities. They do not attempt to specify a particular fair price, but instead provide a range of prices. They will disclose potential material conflicts. Many banks have fairness opinion review procedures that are designed to reduce the risk that biases and personal loyalties will influence the outcome.

In addition, as the NASD acknowledged, the SEC already enforces a set of demanding rules regarding fairness opinion disclosure. These rules contemplate a lengthy discussion in proxy materials distributed to shareholders in a transaction that requires a shareholder vote. Similar disclosure is required in registration statements on Form S-4. The going-private rules require the proponents of the going-private transaction to state whether the transaction is fair to public stockholders, and if a fairness opinion was obtained, to describe the opinion.¹⁹

The SEC staff subjects fairness opinion disclosure to very careful examination. It comments aggressively, asking for disclosure about fee arrangements, potential conflicts, and other bias risks about which the NASD has expressed concern. The SEC staff also asks to review on a supplemental basis any other materials the W bankers provided to the board of directors. Thus, as a practical matter, much of the disclosure the NASD seeks is already provided in SEC filings.

Whether the NASD will decide to propose specific rules, and the precise content of these rules, remains to be seen. Comments provided by investment banks and other industry participants are likely to play an important role in shaping the outcome.

Notes

1. NASD Notice to Members No. 04-83 (Nov. 2004), available at <www.nasd.com/stellent/groups/rules_regs/documents/notice_to_members/nasdw_012248.pdf>.

2. The comment period expired on January 10, 2005.

3. Notice to Members No. 04-83, supra note 1, at 1010.

4. Id.

5. Id. at 1011.

6. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).

7. Notice to Members No. 04-83, supra note 1, at 1011.

8. Id.

9. Id. at 1012.

10. Id. at 1011.

11. See, e.g., In re Pennaco Energy, Inc., 787 A.2d 691 (Del. Ch. 2001); Crescent/Mach 1 Partners, L.P. v. Turner, 846 A.2d 963 (Del Ch. 2000); Cottle v. Storer Communication, Inc., 849 F.2d 570, 578 (11th Cir. 1988).

12. See Robert J. Giuffra, Jr., “Investment Bankers’ Fairness Opinions in Corporate Control Transactions,” 96 YALE L.J. 119, 123 (1986).

13. See, e.g., Lucian Arey Bebchuk and Marcel Kahan, Symposium “Fundamental Corporate Changes; Causes, Effects, and Legal Responses: Fairness Opinions: How Fair are they and what can be done about it?,” 1989 DUKE L.J. 27, 30 (1989); Bill Shaw, “Resolving The Conflict of Interest in Management Buyouts,” 19 HOFSTRA L. REV. 143 (1990).

14. Bebchuk and Kahan, supra note 13, at 31.

15. Id. at 34.

16. Id. at 40.

17 In many cases, bankers receive a flat fee for their fairness opinion work, but a contingent or variable fee for other advisory work provided in connection with a proposed transaction. Variable fees that increase as the size of the transaction increases may actually work in favor of shareholders’ interests since they give the bank incentive to seek out the highest obtainable price.

18. See, eg., Dowling v. Narragansett Capital Corp., 735 F. Supp. 1105 (D.R.I. 1990); Herskowitz v. Nutri/System, 857 F.2d 179 (3rd Cir. 1988); Wells v. Shearson Lehman/American Express, Inc., 127 A.D.2d 200 (N.Y. App. Div. 1987), rev’d on other grounds, 72 N.Y.2d 11 (N.Y. 1988).

19 Notice to Members No. 04-83, supra note 1, at n.5.

About the Authors

Stephen Glover (siglover@gibsondunn.com) is a partner, and David Harris (dharris@gibsondunn.com) is an associate, in the Washington, D.C. office of Gibson, Dunn & Crutcher LLP.