In the midst of a boom in merger activity, the debate over fairness opinion practices has begun to heat up. At the center of the controversy is whether investment banking firms should be allowed to provide fairness opinions on deals from which they stand to collect a material success fee. Last November, the NASD issued a notice to its members seeking comments on whether it should propose a new rule that would address procedures, disclosure requirements, and conflicts of interest when members provide fairness opinions in corporate control transactions.

The comment period ended February 1 and the NASD has begun to disclose some of the comments it has received. Representatives from large pension funds, including The California Public Employees' Retirement System (CALPERS), and the AFL-CIO, have submitted comment letters. Calpers Chief Investment Officer Mark Anson wrote, "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."

AFL-CIO representative Michael Garland called for an "outright ban on the most egregious conflicts, notably arrangements in which part of an investment bank's fee for rendering its opinion is contingent upon the transaction closing."

Others weighing in on the matter include attorney Michel J. Feldman, of Seyfarth Shaw LLP, in Chicago. Feldman advises boards of their responsibilities in mergers and acquisitions and he is also the director of an NYSE company. "It troubles me that investment bankers routinely give fairness opinions on transactions where they have large success fees riding on the outcome. In this era of transparency, obtaining a fairness opinion from an independent valuation firm with no stake in the outcome of their work seems to provide a better measure of protection for boards of directors," said Feldman.

Fairness opinions have become commonplace on most material transactions since the Supreme Court of Delaware's Smith v. Van Gorkum decision in 1985. In that case, the Delaware court essentially said the board of Trans Union Corporation had breached its fiduciary duty to the company and its shareholders by failing to become informed as to the fair value of the company before voting in favor of a transaction with Jay A. Pritzker. The court went on to say that they "did not imply that an outside valuation study is essential to support an informed business judgment; nor do we state that fairness opinions by independent investment bankers are required as a matter of law." Regardless of the court's qualification of its opinion, the financial community adopted the practice of providing fairness opinions on most material transactions. The only aspect of the court's qualification they ignored, the reference to the investment banker being independent, has surfaced again. 

AXA Financial's bid to purchase the MONY Group appears to have been one of the catalysts for the NASD's investigation. In this transaction, certain shareholders attempted to block the deal claiming the offer was too low, citing in their complaint to the court that senior officers stood to reap tens of millions of dollars in golden parachute payments if the transaction were completed. Since payments to executives upon a change of control are negotiated in an arms-length environment upon hire, they are a reality in the marketplace.

The NASD is considering a new rule which would regulate the disclosure of conflicts by members that provide fairness opinions in corporate control transactions. The rule may require the proxy statement to include a description of any significant conflict of interest including, if relevant, that the investment bank has served as an advisor on the deal and the nature of compensation that the bank will receive upon the successful completion of the transaction. The rule might also require disclosure of the extent to which the member relied on key information supplied by the company, or whether the information was independently verified.

In addition, the NASD may establish procedures for determining whether the valuation analyses used are appropriate for the transaction. Currently, issuers of fairness opinions usually state that the price received is within a range of value indications and therefore fair. Value indications are developed using several valuation methods including, but not limited to, historical stock prices, a premium analysis, a comparable public company analysis, a transaction analysis, a discounted cash flow analysis, an LBO analysis, and a break-up analysis. Presently, no rules exist that specify which methods must be applied, in which circumstances, and how the value indications must be considered and weighted in the conclusion.

To protect themselves from future accusations of conflicts of interest, some investment banks are considering changing their policies to require a second opinion on fairness opinions in situations where they are acting on both sides of the transaction - providing financing to the buyer and advising the seller.

Boards of directors would be well advised to consider all the qualifications of a fairness opinion provider, including fairness opinion expertise and the independence of the provider. A lesser course of due diligence leaves directors susceptible to lawsuits that question their business decisions because they relied on the opinion of advisors that were conflicted. Valuation Research Corporation has provided fairness opinions for a variety of transactions. For more information on fairness opinions, contact your Valuation Research representative or Stuart Gruskin at (212) 983-3370. VR