Put the 'fair' in fairness opinions: avoiding conflicts of interest will increase the likelihood that a fairness opinion provides adequate protection for directors.

• Author: Leddy, Patrick J.
• Position: MERGERS & ACQUISITIONS

COMMENTATORS HAVE criticized fairness opinions--letters from investment banks opining that the value of the consideration to be received by shareholders in a transaction is fair from a financial point of view--for decades. But such criticism has not had much impact on fairness opinion practices. Recently, however, fairness opinions have caught the attention of regulators, including New York attorney general Eliot Spitzer and the National Association of Securities Dealers, the main regulatory body for brokerage firms. In the spring of 2003, Spitzer, fresh off his successful inquiries into suspect practices involving security analysts and mutual funds, called for an inquiry into fairness opinion practices. Although Spitzer's office did not initiate such an inquiry, his call placed a regulatory spotlight on fairness opinion practices.

In published comments, a number of lawyers dismissed the need for regulators to investigate fairness opinion practices. But in June 2004, the NASD initiated what the Wall Street Journal called a "potentially far-reaching inquiry into the fees, methods and possible conflicts of interest connected with [fairness] opinions." In November 2004, the NASD sought comments on whether to propose rules regarding fairness opinion practices. The comment period expired on Feb. 1, 2005, after an extension.

In addition, it was recently reported that Wall Street firms have been conducting internal "conflict reviews" at the request of the Securities and Exchange Commission to identify conflicts of interest that affect their businesses. One of the areas identified in the press report was fairness opinions, whereby investment banks "face pressure to bless as 'fair' deals that enrich clients." The fallout from these conflict reviews is not clear yet.

'Shed the blinders'

Based on a number of recent decisions, there is increasing concern among directors and their advisers that Delaware courts are taking a more critical look at director conduct, particularly in conflict of interest situations. The Delaware courts have historically been deferential to directors' judgment regarding fairness opinion practices, including selection of the investment banks providing fairness opinions, but that may be changing.

"Shed the blinders of 'industry practice' that may have made it possible for you to not see the conflicts that surround you daily," Stephen M. Cutler, director of the SEC's Division of Enforcement, said when calling on Wall Street firms to do "top to bottom" reviews of their business. "Just because the industry has always done something 'that way,' don't assume it's acceptable. It won't be acceptable to your customers when they come to understand the conflicts involved." Although Cutler's admonition, reported in the Wall Street Journal, was directed at Wall Street firms, it is obvious that boards and their advisers should take notice as well.

It seems clear that the new, more demanding environment has increased the risk of relying on "business as usual" practices. Consequently, now is the right time to reevaluate fairness opinion practices.

The problems with the opinions

To understand the role played by fairness opinions, it is important to understand the board's duties regarding these transactions (see sidebar, "Origin of Fairness Opinion Practices"). The primary concern in recent years has been related to conflicts of interest. There are at least three potential conflicts of interest involving fairness opinions:

* "Success Fee" Conflict of Interest. It's common for an investment bank that provides financial advisory services on a transaction to also provide a fairness opinion. The investment bank usually receives a fixed fee for the fairness opinion and a variable fee for the advisory services, based on the value received by the target shareholders if and when the transaction is completed (a "success fee"). The fixed fee for the fairness opinion typically ranges from $250,000 to $1 million or more for larger transactions. The success fee is typically considerably more. In some large transactions, the success fee can be well over $10 million. As a result, there is concern that the success fee provides an...