New Demands on Fairness Opinions

Mergers and acquisitions are beginning to pick up, and deals in 2010 will be under intense scrutiny. This stepped-up scrutiny will include fairness opinions: investment banker valuations used by corporate directors to review and approve M&A transactions.

Fairness opinions tend to come under fire at two points in M&A market cycles: First during recessions, when questionable acquisitions turn glaringly bad. Second during rebounds in deal activity, when minority shareholders feel coerced or underpaid. Some early cycle M&A deals are driven by circumstances of opportunity or need. These can create minority shareholder disagreements, and higher levels of deal-related litigation and appraisal actions. Fairness opinions are open to criticism for any number of reasons, including valuation methodologies, opinion process, shareholder disclosure and fee-related conflicts of interest.

Fairness opinions serve competing and conflicting masters. Fairness opinions are originally a construct of the Delaware Courts, which gave them weight evidencing corporate directors’ efforts to make informed decisions around M&A transactions. Their second constituency is the SEC, which sees them as a tool to maximize disclosure in public company shareholder proxies. Going beyond the Delaware courts, the SEC has tried to consistently push past whether a deal is “fair”, to the question whether a deal is a "good" one for shareholders. This policy disagreement is fuel for transaction litigation.

Between 2003 and 2007 following some spectacularly bad dot-com deals there was significant discussion about what fairness opinions were and weren’t, involving a wide range of constituencies (led in part by Eliot Spitzer, the then-AG of New York). At the end of this period, the NASD/FINRA published Rule 2290, which articulated disclosures & best-practice procedures now required in fairness opinions issued by member firms.

FINRA’s new rules have not calmed critics. In late 2009 The Journal of Applied Finance published a detailed analysis of fairness opinions: A Review of Fairness Opinions and Proxy Statements: 2005-2006, Shaked and Kempainen. The research was a thorough comparison of fairness opinion valuation methodologies, and is a useful document for anyone looking to understand how opinions are structured. But the article's abstract also stated: “Our study of 105 fairness opinions supports the criticism placed on fairness opinions. We find that financial advisors provide partial information to shareholders as to the inputs used in their valuation models and similar to academic scholars, they varied greatly in their application of valuation methodologies. Shareholders are provided little information as to the inherent value of the company.”

The courts are also demanding higher quality standards. We noted the Jan-2010 Delaware appraisal action involving the cash-out of a 15% owner in Sunbelt Beverage Corp, a one-time private equity-backed distribution company. In that case, the court held the controlling shareholders liable for breach of fiduciary duty, regarding both fair price and fair process, tripling the amount of money to be paid to the minority shareholder plaintiff. Sunbelt's investment banker also drew a rebuke for issuing a shoddy opinion lacking in both substance and process (completing its work in less than a week’s time, while traveling coast-to-coast on another client project).

Setting aside the bad actors in that deal, our attention was drawn to the court’s dismissal of the experts’ valuation methodologies other than discounted cash flow analysis, and the judge’s scrutiny of the DCF inputs. The court was critical of the logic and quantitative research in choosing size and company-risk premiums, wholly dismissing the latter as unsubstantiated. Stepping back from Sunbelt, we believe this is consistent with a trend towards increased demands on analytic rigor, and with respect to DCFs, more heavy-duty statistical scrutiny in the calculation of equity risk premiums and terminal values. Management projections also need to become more scenario-based, capturing the potential impact of concentrated risks or growth opportunities.

Benning Associates’ investment bankers have been involved in preparing public and private company fairness opinions since 1985. We believe our valuation and project management skills in preparing and delivering fairness opinions benchmark favorably with the best known investment banking firms.