Jill R. Goodman is a managing director at Rothschild, where leads the firm's practice representing special committees of independent directors in M.&A. transactions.
There is a trend emerging in corporate boardrooms to request fairness opinions, which are used in merger deals to provide a gauge of a company's worth.
The trend to use them in nontraditional situations may be a result of a confluence of factors, including a significant increase in deal-related litigation. Presumably, a board's rationale is that if a fairness opinion provides comfort to the directors in mergers, it should provide comfort in other situations as well.
This trend merits scrutiny. Directors should understand what “fairness†conveys outside of a change of control or mergers-and-acquisitions context. Moreover, courts have increasingly shown a willingness to parse through the analyses undertaken to support fairness opinions in conventional situations; it is possible that the y may start to consider, particularly in unconventional situations, the actual language of such opinions and the reliance that directors place on them.
Fairness opinions have typically been limited to transactions involving a change of control. The practice was established after a Delaware Chancery Court decision in 1985, when a target company's directors were found to have breached their duty of care, based in part on their failure to obtain a fairness opinion. Although fairness opinions are not legally required, the courts have generally noted with approval when a fairness opinion has been obtained in a merger.
The substance of a fairness opinion is the valuation work conducted by a financial adviser. The financial analyses set forth a value range â€" estimates of intrinsic value, trading value and takeover value â€" against which the proposed consideration is compared. The value range creates guideposts for determining how much a company might be worth.
“Fairness†is not actually defined. From a financial adviser's perspective, it is a determination that, at a particular point in time, the consideration proposed falls within a range of values. If the proposed price does not fall within that range, the price is inappropriate.
The wording of a fairness opinion describes its scope, the work that was completed and the assumptions made. The opinion makes clear that a conclusion about financial fairness is not a recommendation regarding whether to enter into a transaction and is not an affirmation that the proposed consideration is the best achievable. Most of the wording is standard if the opinion is rendered in a traditional M.&A. context.
But tension can arise when the situation is outside that context. The conventional value range â€" the relevant set of estimates for valuing a company â€" may not be applicable.
Consider a transaction where a company exchanges debt for equity. Before a deal, the c ompany's indebtedness exceeded its enterprise value â€" in other words, its equity is worthless; but afterward, the company's enterprise value would exceed its debt. An investment banker can prepare a set of analyses illustrating that the company's equity will be more valuable after the proposed transaction.
Such a conclusion does not, however, require citation to a reference range or guideposts. The conclusion is that positive equity value is greater than zero equity value.
Or consider a transaction where a controlling stockholder asks a company to provide consideration to induce the stockholder to sell stock into the open market. All other things being equal, the float and liquidity of the stock will increase, which may create a benefit for all stockholders. Given that the proposed transaction will be with a controlling stockholder, the board (or special committee) may ask an investment banker for a fairness opinion. While an investment banker can provide evidence of the benefits of greater float and liquidity, there is not a reference range of values that can be determined for the transaction.
In these and other unconventional situations, where the usual reference range is not applicable, it is unclear what “fairness†means. As in a conventional situation, financial analyses will form the basis for the written opinion. But if a conventional value range does not apply, the opinion may say so. The opinion may also go on to set forth a nonstandard list of assumptions and qualifications. Read in its entirety, the opinion could, in essence, circumvent the question of fairness.
How the courts will think about such opinions remains to be seen. In the meantime, an analogy to “second opinions†may be instructive. Boards obtain second fairness opinions for a variety of reasons, but most frequently when there is a perceived or actual conflict of interest on the part of the primary financial adviser. The courts are clear that obtaining a second opinion at the end of an M.&A. process does not negate the conflicts of the primary adviser nor does it retroactively fix a troubled process. A fairness opinion has never been, and continues not to be, an essential condition for a change of control transaction.
That is also the case in a unconventional situation. Directors exercise their business judgment by evaluating all the information available. If an opinion is rendered in a nontraditional context, the board should be made aware of the substance of the opinion, so reliance is not misplaced.
And a financial adviser may determine that a conventional value range does not apply in particular situation and that a fairness opinion cannot be rendered. This characterization is different from a conclusion that a fairness opinion cannot be rendered because the consideration is not fair. Directors who understand why the conventional value range does not apply can make a fully info rmed decision about whether “fairness†is applicable to a nontraditional situation and exercise their judgment accordingly.
