It’s Time To Make Fairness Opinions A Lot Fairer
from
January/February 2006
by John R. Engen
You’ve
probably had doubts about the credibility of most corporate fairness
opinions. And lately critics have been speaking up: In just the past
two years, deals involving Bank of America, JPMorgan Chase & Co.,
and Procter & Gamble, among others, have been challenged or
criticized on the ground that the valuations issued by investment banks
were tainted by conflicts of interest.
Things kicked up a notch when William Higgins, a New York Stock Exchange seatholder, opposed the NYSE’s plan to merge with the online trading service Archipelago Holdings. Higgins sued to block the deal, arguing that the fairness opinion offered by Goldman Sachs, an Archipelago shareholder, and written by Lazard significantly undervalues the seats. The scuffle took some strange twists—one seatholder even phoned Higgins with a death threat and was later arrested—and was settled in mid-November only after the NYSE agreed to an independent review. The incident highlights the growing animosity between those who benefit from these opinions and those they are intended to mollify.
It may be just a matter of time before a fairness opinion, meant to provide legal cover for directors, might actually get them into trouble—or at least help kill a deal. In early 2005 Massachusetts secretary of State William Galvin, a prospective candidate for governor, attacked Procter & Gamble’s $57 billion merger with Gillette Co. by going after the fairness opinions issued by Goldman Sachs and UBS Securities, the advisers on both sides.
The numbers offered in those opinions pegged the synergies to be produced by the merger at roughly $22 billion, versus the two companies’ public declarations of $14 billion to $16 billion. That made the deal worse for Massachusetts-based Gillette than investors had been led to believe, says Rajesh Aggarwal, a finance professor at the University of Minnesota who was hired by Galvin’s office to examine the deal.
The merger went through anyway, but fairness opinions took another hit in the process. “The big problem is, fairness opinions are not really independent,” Aggarwal says. “At some point, a high-profile deal will blow up because an independent fairness opinion wasn’t rendered.”
Fairness opinions came into vogue after the Delaware Supreme Court ruled in a landmark 1985 case, Smith v. Van Gorkom, that the board of Trans Union LLC breached its fiduciary duty by rushing through a sale of the company to a private buyer without first determining its fair value.
The ruling didn’t mandate fairness opinions but did note the board’s lack of diligence in not getting one. Soon after, investment banks began pitching fairness opinions as legal safeguards, and boards bit.
The concept of getting an opinion on a deal’s fairness makes intuitive sense. The problem—and this is a whale of a problem—is that the opinion-provider is usually the same bank that has advised the board on the deal, and is due a much heftier “success fee” if it sees the transaction through to completion. Indeed, it’s not unusual for payment of the fairness-opinion fee to be contingent on the deal’s going through.
“There is a very large incentive for an investment bank to find that a transaction is fair regardless of the circumstances, when the bank will receive the bulk of its fee only if the transaction is successful,” wrote Mark Anson, chief investment officer at the big pension fund Calpers, in a recent comment letter to the National Association of Securities Dealers.
Today getting fairness opinions is simply part of the dealmaking dance. Typically provided by investment banks, they’re akin to an appraisal but less exacting. Most offer a “range of fairness” for the pricing of a transaction, and not surprisingly, the deal’s value always seems to fall within that range. Shareholders rarely get to see much more than the opinion’s high points in the proxy. For boards, however, opinions are an integral part of the legal-defense package—proof that, yes, directors were diligent enough to seek out an expert opinion on the value of whatever was being bought or sold.
Even critics concede their worth as a legal shield. Jay Eisenhofer, a managing partner with Grant & Eisenhofer, a Delaware law firm that represents institutional investors in lawsuits against boards, calls fairness opinions a “joke and a scam being put over on shareholders.” But he acknowledges that directors need the opinions “as a legal fig leaf to protect them from liability. You’d be dumb not to have one.”
And not only for mergers-and-acquisitions deals. Increasingly, fairness opinions are being used for large debt or secondary-stock offerings, or any other transaction that might affect the standing of existing shareholders. When the board of NRG Energy Inc., a New Jersey company, decided in 2004 to issue preferred stock to buy out its largest shareholder, directors first asked the Los Angeles investment bank Houlihan Lokey Howard & Zukin to assess the fairness. “It involved an insider, and the transaction wasn’t being offered to all shareholders, so they got a fairness opinion first,” explains Marjorie Bowen, head of Houlihan Lokey’s fairness-opinion practice.
According to the Securities and Exchange Commission, 1,375 transactions required the writers of their fairness opinions to disclose potential conflicts of interest in fiscal years 2003 and 2004, and another 390 through the first eight months of 2005. Some of those certainly smell fishy. The AFL-CIO, whose pension fund has $400 billion in assets, complained loudly about conflicts in AXA Financial’s proposed acquisition of Mony Group. Mony got a fairness opinion from Credit Suisse First Boston, which is set to collect $15 million in success fees, even though the price per share was just 6% over Mony’s price the day before the merger was announced.
The sense that fairness opinions can be, and sometimes are, manipulated behind the scenes riles investor groups and inspires skepticism even among some executives. Most opinions are based on assumptions and projections provided by management, not derived independently. As the CFO of one acquisitive midsize oil and gas company confides, “You can get a fairness opinion that says pretty much whatever you want it to say,” because “all the investment bank cares about is getting paid.”
In 2001 the board of office-supplies retailer Staples sought to repurchase shares of its Staples.com tracking stock for $7, after selling them two years earlier to venture capitalists, executives, and directors, among others, for $3.25. Court documents from a subsequent lawsuit showed that the two investment banks writing the fairness opinions on the deal—one for each side—were uncomfortable with the price but eventually signed on after management cajoling.
It doesn’t help that the fine print in fairness opinions almost always includes language that indemnifies the opinion-provider against liability and goes to great lengths to make clear that the opinions are not recommendations. Most opinions are limited to price solely, not strategic or legal considerations, and state only that the price falls within a “range of fairness” that often is so wide you could fly a jet through it. In the Staples case, for instance, an analysis of comparable company sales put the range between $4.77 and $9.53 per share.
Considering the headaches and costs—a fee can be nominal but typically runs $1 million to $3 million—some academics think fairness opinions should be abolished altogether. Charles M. Elson, head of the University of Delaware’s corporate governance center and a director of several companies, including AutoZone Inc., argues that fairness opinions should be scrapped because their sole purpose is to protect directors. “You have to ask what value comes out of these opinions other than to protect boards by providing evidence of good faith,” he says.
At the very least, it’s a situation crying out for reform. But as with any reform that riles vested interests, the gears turn slowly. The SEC’s powers are limited mostly to disclosure—it requires that conflicts of interest be divulged in proxy filings. And it hasn’t taken a position on whether those conflicts should keep an investment bank from providing a fairness opinion, according to Alan Beller, director of the SEC’s division of corporation finance.
The NASD has proposed a rule requiring broker-dealers to report if a fairness opinion’s author has a financial stake in the transaction. It also wants to set stiffer standards for the process investment banks use to come up with opinions. For example, an investment bank’s fairness-opinion team would have to include at least one person who wasn’t involved in putting the deal together.
Congress is conflicted. In 1993 Congressman Edward Markey, a Massachusetts Democrat, sponsored a bill that would have required that fairness opinions be issued by parties without a financial stake in the deal. It passed the House but died in the Senate. Markey made additional noise last summer during the Gillette-P&G debate, comparing a fairness opinion from a deal’s financial adviser to a baseball game in which the manager of a team also serves as the umpire. “You can’t be a disinterested observer when you have a vested interest in the outcome,” he said.
The real power to change things may lie beyond legislators or regulators. The well-founded perception that a board actually needs to have a fairness opinion came from the courts, Charles Elson says, and only the courts can really reverse that. The Delaware Supreme Court is “well aware of the problem,” he adds, and wants to do something about it. The hitch: This would probably require a challenge by a board that was sued and didn’t have a fairness opinion—an unlikely scenario in an environment where directors seek out every legal safeguard.
You’d be hard-pressed to find a director who doesn’t want the additional evidence of care and good faith that a fairness opinion provides. “I wouldn’t want to do a deal without one,” says Jack Henry, a director of several companies, including White Electronic Designs, a microelectronics manufacturer, and phonemaker Vodavi Technology Inc., both in Phoenix, Arizona.
Eugene Davis, CEO of Pirinate Consulting Group, was a director of Metrocall Holdings, an Alexandria, Virginia, pager distributor that merged in 2004 with Arch Wireless. Metrocall was sued by a shareholder who thought the deal was unfair. The plaintiff dropped the case, but had it gone to court, “the fairness opinion would have been one of our defenses,” says Davis, who’s a member of five boards, including Atlas Air Worldwide Holdings, where he is chairman.
To avoid the appearance of conflict, many boards are seeking second or independent fairness opinions. A cottage industry of appraisers that specialize in them has emerged in recent years to provide ostensibly unbiased views. “The idea is to create a scenario where if there’s any litigation you can say, ‘We hired someone who was totally independent,’” says Robert Pirie, an M&A veteran who has worked at Skadden Arps, Rothschild Inc., and Bear Stearns. He now heads Pirie Goldsmith Associates, a New York City firm that does nothing but fairness opinions—paid for in advance.
When Tickets.com was sold to an arm of Major League Baseball earlier this year, board members feared that some shareholders would be irked. The company’s common stock was trading in penny-stock territory, and holders of preferred shares—including most of the board members—stood to benefit most from the sale, although the board negotiated a “giveback” of about $1 per share for common shareholders.
The investment bank handling the deal, Perseus Group, came up with a fairness opinion, but directors demanded a second opinion too, from Houlihan Lokey, which has written more independent fairness opinions than anyone else over the past five years. Perseus “was already getting a commission for closing the transaction, so we felt it was necessary to get a fairness opinion from another banker that didn’t have skin in the game,” explains Jack Henry, who is on the Tickets.com board. The transaction closed fine, and no lawsuits resulted.
Independent opinions carry their own risks and hassles, however. Educating a new party on a deal’s particulars at the end of long negotiations can be arduous. And what if the outside opinion-provider decides that the deal’s no good or requires substantial revision? “Sometimes when we get involved, the terms need to be altered,” explains Marjorie Bowen of Houlihan Lokey. “The price isn’t right, or there’s a clause in the agreement that doesn’t work right. So there’s a renegotiation required to get a positive fairness opinion.”
This might sound good to shareholders. But as the CFO of one midsize oil and gas company says, “When the deal train leaves the station, no one involved wants to see it get derailed.” Cynics, meanwhile, assert that achieving total independence is next to impossible. “You can remove some of the conflict,” Chris Young, director and co-head of M&A research at Institutional Shareholder Services, says about second opinions. “But if a firm shot down a lot of deals, they wouldn’t get hired.” So a strong incentive to render positive opinions exists even for independent firms.
Removing some of the conflict, as Young says, may be the most that happens in the near future. Meantime, boards can protect themselves by asking a lot of questions to find out how the investment bank came up with its opinion. “It’s important to understand the mechanics, methodology, and analytics that went into it,” says Bowen. Frank Placenti, a securities partner in the Phoenix law office of Bryan Cave, adds that jittery boards should go even further, documenting steps to “create a road map that makes it very clear that the board acted with due care” in reviewing the opinion.
In the end, fairness opinions, as the name implies, should be about ensuring that shareholders are getting a fair deal. Boards that make efforts toward that end will be protecting not only their shareholders, but themselves.
