The Current State of the Fairness Opinion

<p>Many years ago, during my first formal
presentation to a board of directors and after listening to legal
counsel review the board's fiduciary obligation, my attempt to
paraphrase the "good" business judgment rule was met with a chortle and
an admonition from the senior banker, who correctly stated that "just
plain business judgment" was an acceptable standard.

</p><p>However, given the unprecedented challenges facing directors of
publicly traded companies in the post-Sarbanes-Oxley (SOX) world,
perhaps the good business judgment rule is emerging as a new theoretical
benchmark for exercising due care. More and more this standard is being
applied, even to privately held companies.

</p><p>There is a school of thought held by some states attorney general
offices and members of the plaintiff bar that a board member must be
<i>de facto</i> omnipotent or else face direct attack for decisions
often made under difficult circumstances with incomplete information and
limited time. Thus, that "plain ol' business judgment" is thinly
stretched, and boards are rightly turning to external experts along the
way to fulfill their fiduciary obligations and use due care in
deliberations, particularly as it applies to fairness opinions.

</p><p>The whole issue of who, what, when and how to rely on the fairness
opinion in certain types of material transactions has garnered a great
deal of press lately. Likewise, investment banking firms that are called
upon to issue these fairness opinions are also under increased scrutiny.
Below are some practical guidelines on how to use fairness opinions that
will help boards fulfill fiduciary obligations, provide maximum benefit
and demonstrate due care.

</p><h4>The Tangled SOX Board</h4>

<p>Boards are increasingly turning to committees, special committees and
outside legal and financial professionals to build the case for due care
while enhancing the integrity of the decision-making process on behalf
of stakeholders. In the case of mostly healthy companies, that effort is
focused primarily on the common shareholders. However, as a practical
matter, other parties—employees, customers, banks, bondholders,
vendors and plaintiff attorneys—can often feature more prominently
in the decision-making process, especially if the company is
experiencing even the remotest kind of challenge.

</p><p>As the company inches closer toward "issues," discussions can arise
around theoretical and legitimately expanding "zone of insolvency"
responsibilities. Conflicted stakeholders often spur boards to seek an
external perspective to manage this complicated calculus. <i>See Revlon
Inc. v. MacAndrews &amp; Forbes Holdings Inc.,</i> 506 A.2d 173 (Del.
1985); <i>Smith v. Van Gorkum,</i> 488 A.2d 858 (Del. 1985);

<i>Weinberger v. UOP,</i> 457 A.2d 701 (Del. 1983); <i>Joseph v. Shell
Oil,</i> 482 A.2d 335 (Del. Ch. 1984); and <i>Cavalier Oil Corp. v.
Harnett,</i> 564 A.2d 1137 (Del. 1989).

</p><p>From the perspective of the investment banker, the fairness opinion
is a comprehensive valuation exercise within a specific situation
analysis, and it is a product that features substantially higher
litigation risk. In fact, litigation risk may grow as many bankers are
under pressure to expand the conclusion beyond whether a proposed
transaction is "fair from a financial point of view" to include a
multitude of other issues, such as, "was the <i>process</i> appropriate
and fair?"

</p><p>Fairness opinion content should provide a complete description of the
contemplated transaction, including a point-in-time situation analysis
of the company, the counterparty and the market as a backdrop for the
contemplated transaction. The banker should review due diligence steps
and procedures that provide the foundation for the opinion, outline
interviews with senior management, disclose limitations to the analysis
and review certain assumptions that underpin the all-important valuation
ranges and methodologies. It's important to note that the assumptions
are almost always built on projections created by the management team
that potentially has much to gain from a contemplated transaction.
Bankers are typically pressured to outline and detail specific
alternatives to the contemplated transaction, or to at least consider
other possible pathways to pursue.

</p><p>At the end of several pages, the classic fairness opinion will note
that the "transaction is fair, from a financial point of view." The
investment banker does not advocate or recommend whether the transaction
should be consummated, as such recommendation is presented in the proxy
solicitation. Likewise, it is increasingly rare to see the entire text
of the fairness opinion in the proxy; rather, the standard of disclosure
is usually a detailed summary of the contents.

</p><p>The use of fairness opinions—while not required by
statute—is expanding to include a variety of material transactions.
These include:

</p><ol>

<li>virtually all mergers or acquisitions;
</li><li>"going private" transaction under SEC Rule 13(e)-3;
<lil>material transactions under certain state regulations;
</lil></li><li>many material financings (especially if there is any kind of equity
kicker);
</li><li>some contemplated transactions that may change the underlying risk
profile of the company (<i>e.g.,</i> ESOP structures or
recapitalizations that increase financial leverage);
</li><li>restructurings when stakeholders are asked to compromise claims; and
</li><li>asset sales that trigger bond indentures.
</li></ol>

<p>From the investment banker's point of view, the objective is usually
to provide sufficient evidence demonstrating due care. However, the
fairness opinion procedure is occasionally used by special committees as
the "bad cop" for further negotiation, whereby sophisticated special
committees use the fairness opinion process to improve the terms and
conditions of a proposed transaction.

</p><h4>The Whirlwind of Inherent Conflicts</h4>

<p>Recently, a good deal of financial press has addressed the
regrettable perception of a certain "wink wink, nudge nudge" that
surrounds the inherent conflicts involved in providing fairness
opinions. Below is a modest primer from one investment banker's
perspective.

</p><p><i>1. It is tough to issue the opinion if you have advised both sides
of the contemplated transaction.</i> In perhaps the best known recent
example, Goldman Sachs helped both the New York Stock Exchange and
Archipelago Holdings (a situation that entailed what <i>The New York
Times</i> called "conflicts so blatant that they are almost laughable").
While the parties relied on Lazard and Greenhill to issue the opinions
to the respective boards, it was noted that Goldman Sachs led the
pending Lazard IPO and that it underwrote the Greenhill IPO. Despite the
princely fees paid to all three investment banks, the respective boards
may not have gained the protection they desired.

</p><p><i>2. It is tough to issue the opinion if your parent is
involved.</i> When JP Morgan Chase acquired BankOne Corp., the in-house
bankers at JP Morgan Chase issued the fairness opinion, which hardly
advanced the cause of restoring the luster of investment banking with
the general public.

</p><p><i>3. It is tough to issue the opinion if you have a long-standing
relationship with management.</i> Management is almost always the
primary driver of value creation for the enterprise, and it is
exceedingly challenging to balance the interests of management with the
goals of other stakeholders. Board members need independent advice for
all. As Oscar Wilde noted, "one should always play fairly when one has
the winning cards." Likewise, senior management should be exceedingly
cautious about participating in the selection process for the investment
bank asked to provide the fairness opinion.

</p><p><i>4. It is tough to issue the opinion if you are in line to receive
significant compensation that is contingent upon completion of the
contemplated transaction.</i> While arguably the most controversial
point, this inherent conflict needs to be put into perspective. The
classic investment banker is drawn to this career with a risk appetite
that will put an emphasis on large transaction fees—fees that dwarf
typical fairness opinion work. It is precisely because of the motivation
and risk appetite of investment bankers that U.S. capital markets were
created, which remain the greatest capital markets in the world. The
imagination of the men and women in this profession, who work with
entrepreneurs and business leaders, creates unprecedented return for
investors from the strongest economy the world has ever known.

</p><p>Therefore, in the case of this fourth inherent conflict, please note
some equivocation. Depending on the degree of market exposure, it may be
possible and entirely appropriate to mitigate this inherent conflict.

</p><h4>Degree of Market Exposure Test</h4>

<p>Issuing an opinion in this last circumstance depends on the degree of
capital market exposure underlying the contemplated transaction. There
are instances where the existing investment bank can provide a cheaper
and faster fairness opinion through an in-house peer review process that
is genuinely independent, depending on the facts surrounding the
creation of the contemplated transaction.

</p><p>In fact, the market is the best test of "fairness," so if the
contemplated transaction passes the Market Exposure Test (<i>i.e.,</i>
it MET the market), the downside risk to the board and to the issuing
investment bank is substantially eliminated. In one recent example, a
company decided to test the merger market. Of the universe of 14
competitors, 13 were discretely informed of the opportunity, eight held
face-to-face meetings with management, four issued letters of interest,
two issued letters of intent and one finally emerged as the appropriate
party to engage in exclusive negotiations on terms and conditions. We
confidently issued the fairness opinion in this matter, with the
disclosure of the transaction fee that we earned upon the closing of the
contemplated transaction. We enjoyed a profoundly accurate understanding
of the current market for our client and its alternatives.

</p><p>While a high degree of MET may be achieved in a particularly hot
space (<i>i.e.,</i> one with many good, comparable transactions and
companies with recent market stats, relevant situation analysis matches
and tons of public operating data), special committees and boards need
to exercise caution when using the existing bank on a narrowly
negotiated transaction. In general, the more academic the valuation
exercise, the more merit there will be from using a quality independent
perspective.

</p><h4>Proposed NASD Rule 2290</h4>

<p>The National Association of Securities Dealers (NASD), like the New
York Stock Exchange, is a self-regulated enterprise. Last year, a new
rule was proposed to guide members issuing fairness opinions that are
referred to in proxy statements. The proposed rule requires members to:

</p><ul>
<li>disclose whether the member acted as the financial advisor,
</li><li>outline potential conflicts of interest, including:

<ul>
<li>compensation, especially fees contingent upon the completion of a
transaction
</li><li>any material relationships over the past two years (mirroring NASD
Rule 1015(b)(4) of Reg. M-D)
</li></ul>
</li><li>review whether information has been independently verified, and
</li><li>state whether the opinion was reviewed, approved or issued by an
independent fairness opinion committee.
</li></ul>

<p>Before the NASD issues new rules, it invites comments from members
and other interested parties, and several groups provided interesting
points. For example, CalPERS and the AFL-CIO desire further disclosure
on payments to senior management that may be triggered by the
contemplated transaction. CalPERS goes further, recommending an absolute
prohibition on fairness opinions from those in line for success fees.
Others in this camp have asked whether a "materially better price could
have been obtained"—<i>i.e.,</i> was the process "fair and
appropriate," and did the management team and the investment banker do a
good job?

</p><p>As Mark Twain remarked in his 1907 "Wearing White Clothes" speech, "I
am not one of those who in expressing opinions confine themselves to
facts."

</p><h4>Solvency Opinions</h4>

<p>There is the related matter of solvency opinions. In general, the
practical view is that restrictions and qualifications accompanying the
solvency-opinion work virtually guarantee that the solvency opinion will
provide little protection, comfort and benefit to the board or special
committee that asked for the solvency opinion in the first place.

</p><p>By virtue of making the request, opposing legal counsel will
inevitably find a lucid argument that the company was, in fact,
insolvent at the time in question, especially given the benefit of 20/20
hindsight.

</p><h4>Selecting the Investment Banker</h4>

<p>The number-one criteria for a board or a special committee in
selecting a party to issue a fairness opinion is that the investment
bank is an NASD member firm, and this criteria becomes absolutely
necessary if the proposed transaction features any form of equity
involved with the contemplated transaction. The NASD enforces rigorous
licensing procedures, completes comprehensive background investigations
and regulates never-ending education and training. The board may
increase their exposure if an opinion emanates from an unlicensed
enterprise (ask whether you fly with an unlicensed pilot!).

</p><p>It is difficult to imagine how a board can select a professional for
this critical task without interviewing several candidates, and parties
should seek to match the professionals with the specific
situation—<i>i.e.,</i> type of transaction, industry knowledge,
degree of difficulty and reputation in the capital markets. Pay for
quality, and look to the financial strength of the issuer of the
fairness opinion to back the opinion and analysis. Ask how many times
the investment bank has been sued after issuing a fairness opinion or
valuation report. If the investment bank does bankruptcy work, ask
whether a judge has ever slashed fees <i>ex post facto.</i> It may be
prudent to insulate senior management from the selection of the
fairness-opinion provider, although it will be necessary for senior
management and those professionals to interact effectively once the
special committee has made its selection.

</p><p>Depending on the materiality of the contemplated transaction, the
work project generally deserves a face-to-face presentation. As
Friedrich Nietzsche wrote, "It is hard enough to remember my opinions,
without also remembering my reasons for them!" The special committee and
the board need sufficient time to review the materials beforehand in
order to prepare tough questions and participate in lively debate. The
interaction between senior management, the special committee and the
rest of the board should be vigorous and frank to build a case for
adequate due care and some emerging consensus.

</p><p>Fees will obviously depend on the size and complexity of the
contemplated transaction. According to research, for public transactions
more than $50 million in value, since January 2003 fees ranged widely
from a minimum of $100,000 to more than 2.25 percent of aggregate
transaction value.

</p><p>Overall, there are many reasons why the fairness opinion is a hot
topic swirling in controversy. In light of SOX, boards must proactively
manage the process to limit future criticism and lower financial
exposure. The approach to fairness opinions has evolved considerably
over recent years, and there are several important considerations for
companies and their advisors to prudently consider.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} Jeffrey R. Manning,
senior managing director, leads FTI Capital Advisors LLC, the
wholly-owned investment banking subsidiary of FTI Consulting, and works
out of Washington, D.C. He has more than two decades of
transaction-related experience. <a href="#1a">Return to article</a>