A Guide to Fairness Opinions
A fairness opinion provides important information in a variety of financial transactions, such as: mergers, buyouts, business privatization, or employee stock options transactions. They offer protection for shareholders and can be imperative in hostile takeovers and distress sales.
Fairness opinions address the fairness of the purchase price in an anticipated transaction. They are not generally required by the SEC or by statute or law, but have been considered best practice since the case of Smith v. Van Gorkom (488 A. 2d 858 – 1985), where a corporation’s board of directors was subject to liability for breaching the fiduciary duty owed to shareholders. Fairness opinions may also be included in proxy material provided to shareholders in charge of control transactions.
The purpose of a fairness opinion is to provide an assessment of whether an offered price is fair. However, the best definition may be in what it does, not provide. A fairness opinion:
- Does not give advice on whether the company should enter into a transaction;
- Does not provide detailed business valuation information;
- Does not take into account the strategic purposes of a transaction or the political and social implications of a transaction;
- Does not report of solvency or a company’s capital structure;
- Does not indicate a company’s credit rating;
- Does not tell a company whether to enter into a transaction; and
- Does not inform a company as to whether the transaction is the best possible option.
Further, because reports are made after negotiations are underway or completed, the report is not necessarily a tool in negotiating a price to be paid: it simply reports on the fairness of a transaction and nothing more.
While fairness opinions are part of due diligence and should be recommended to clients, a fairness opinion cannot be the only tool of investigation used when examining a potential transaction. In addition, the case, HA 2003 Liquidating Trust v. Credit Suisse Securities LLC, made clear that without a prior agreement, the reporting analyst has no obligation to update the report when or if changes occur in market conditions or valuation following the reporting.
A fairness opinion should be recommended prior to voting on a sale offer to avoid having to declare a transaction unfair that the board has already approved. More than 74% of respondents to 2009 Fairness Opinion Insight Survey indicated that the report should be commissioned no less than one month prior to entering into an agreement, although it is also suggested that it be during the initial due diligence process. Contingency fees are also generally discouraged.
The analyst(s) preparing the report should be independent and not previously involved in the valuation or the merger/transaction. According to the National Association of Securities Dealers (NASD) Rule 2290(a), analysts issuing a fairness opinion must disclose any material relationship with parties to the transaction in the two years prior to issuing the fairness opinion.
(NASD) Rule 2290(b) also requires that any firm responsible for the creation of fairness opinions have written procedures in place regarding the method of preparing the fairness opinion and a written policy for when a fairness committee will be used. The use of a committee must also be disclosed as part of the report.
Fairness opinions are prepared by assessing the market valuation of a company and the valuation multiple. A market valuation is made based on the assumption that:
- The property is offered for sale on an open market for a reasonable time period and the transaction is an arms-length transaction;
- The purpose of the acquisition is to continue the operation of the business, rather than to liquidate the business;
- Both buyer and seller enter into the transaction after performing due diligence and with full knowledge of any material information;
- Neither the buyer nor seller are acting under duress; and
- The hypothetical buyer is paying cash or the equivalent, is reasonably cautious, and the purpose of the acquisition is to make a profitable investment.
A fairness opinion is typically not prepared based on audits or actuarial opinions. The 2003 Liquidating Trust case, indicated that analysts preparing the report may rely on management projections, even if there are indications that those figures are overstated. There is also no requirement that projections given be independently verified and (NASD) Rule 2290(a) states that the report should contain a disclosure making clear that the information was not independently confirmed. When independent confirmation of financial figures and projections does occur, a description of what information was verified and the methods of verification should be included in the report.
Attorneys advising board members or companies entering into mergers or other financial transactions should consider recommending a fairness opinion to protect corporate officers and board members from lawsuits. A threat of shareholder suits exists in these transactions because corporate officers and boards of directors have a fiduciary duty to act in the best interests of shareholders. Although a legal doctrine called the business judgment rule protects shareholders/officers from liability, this rule applies only if the officials act in good faith. Failure to do appropriate due diligence can subject corporate officials to liability to shareholders; fairness opinions can be cited by corporate officials as an indication that due care was exhibited in voting to approve or enter into a transaction.
Like corporations, attorneys have a fiduciary duty to their clients. The ABA Model Rules of Professional Conduct also impose a duty upon attorneys to provide competent representation. Part of fulfilling the duty is informing clients of the benefits of fairness opinions and helping clients to commission certified forensic financial analysts. Again, while such reports alone are not alone sufficient, they can go a long way toward providing proof that all appropriate steps were taken to fulfill the fiduciary duty owed by the corporate officers.