Independent Analysis Critical to Opinions
Since the issuance of Rule 2290 by the Financial Industry Regulatory Authority (FINRA) in 2007, more scrutiny has been placed on fairness opinions. FINRA issued Rule 2290 in response to concerns over conflicts of interest with respect to fairness opinions. At the heart of the controversy was whether investment banks should be allowed to provide fairness opinions on deals from which they stand to collect a material success fee. Under Rule 2290, an investment bank that provides a fairness opinion is required to disclose whether it is serving as an advisor on the deal and whether it will receive compensation contingent upon the successful completion of the transaction.
In addition, any FINRA member issuing a fairness opinion must have adopted written procedures for approval of fairness opinions, including the process to determine whether the valuation analyses used in the fairness opinion are appropriate.
The independence of an opinion provider is a critical issue and one that will not be overlooked by regulators or minority shareholders. In this issue of the Valuation Researcher Alert, we focus on fairness, solvency, and capital adequacy opinions.
FAIRNESS OPINIONS
A fairness opinion is a letter stating whether the consideration offered in a transaction, either by insiders or third parties, is fair to the nonaffiliated shareholders of the company from a financial perspective. Obtaining a fairness opinion helps boards of directors fulfill their fiduciary duties of loyalty and care by acting on an informed basis and also provides liability protection under the Business Judgment Rule.
Fairness opinions are typically prepared for independent directors and fiduciaries, buyers and sellers, limited partners, institutional investors, and trustees. Typical transactions which trigger fairness opinions are tender offers (LBO, MBO, and going private), large block stock purchases, mergers, reorganizations, and hostile takeovers. Fairness opinions may also be required by related party transactions and bond indentures. When a transaction involves related parties, such as a director or company, a fairness opinion is needed to protect the director or company from being accused of unfair insider dealings. In the case of a bond indenture, a fairness opinion is required in order to protect the lenders from any fraudulent conveyance (an instance whereby a borrower transfers assets which may undermine the position of lenders).
Fairness opinions should be based on objective, independent analyses that include not only a valuation, but also a review of the relevant transaction’s financial structure and terms, the type and timing of consideration, and the transaction’s financial and tax consequences.
SOLVENCY OPINIONS
The risks surrounding leveraged deals stem from the potential use of fraudulent conveyance claims by unsecured creditors in a bankruptcy proceeding to contest a leveraged transaction. If the deal is determined to be a fraudulent transfer, a lender’s security interest in the company’s assets can be voided and the lender risks subordination of its claims to the company’s other creditors. Directors and controlling shareholders risk a breach of fiduciary duty to lenders, and thus may face personal liability for the insolvency of the company. In a worst case scenario, the entire deal can be reversed affecting all parties including deal advisors who could be required to return their fees.
A solvency opinion addresses potential attacks under the constructive fraud theories of the fraudulent conveyance laws. Constructive fraud is not concerned with the intent of the parties to the transactions, but the result of the transaction. In general, under the constructive fraud theories, a transfer may be avoided where the leveraged company does not receive reasonably equivalent value for the transfer and if either of the following circumstances exist: (i) the company is insolvent at the time of the transfer, or is rendered insolvent by the transfer; or (ii) the target is left with unreasonably small assets (capital) for its business. All that is left for unsecured creditors to demonstrate is that one of the two preceding circumstances is not true. Given the risks, obtaining a thorough analysis of the proposed transaction on the financial health of the company by an independent third party at the time of the transaction is critical.
CAPITAL ADEQUACY OPINIONS
As an adjunct to a solvency opinion, VRC will often provide a capital adequacy opinion (also referred to as a capital surplus opinion). In many states, when a company contemplates a repurchase of stock or payment of a special dividend to shareholders, statutes require that the enterprise demonstrate that it would not be left with impaired capital. We are frequently asked to determine and document whether the fair value of a company’s assets exceeds the company’s liabilities by an amount in excess of a proposed repurchase or special dividend payment and the par value of the stock.
CASE STUDY
A private equity-owned portfolio company was seeking to acquire another portfolio company that was owned by the same private equity sponsor. Since there were potential conflicts of interest, we were retained by the board of directors of the acquiring portfolio company to determine if the acquisition was fair to the acquiring company. Working closely with the management teams of both the acquirer and target, we reviewed the expected financial performances of each company on both standalone and pro forma bases. In addition, we reviewed the anticipated synergies and their expected impacts on the acquirer’s value. After a thorough due diligence process, we concluded that the acquisition would be fair to the acquiring company.
VRC has issued more than 1,000 fairness, solvency and capital adequacy opinions in connection with transactions of all sizes covering all major industry groups. For more information, contact your VRC representative. VR
