by Brent McDade, ASA, CBA/BVAL
“A fairness opinion addresses, from a ﬁnancial point of view, the fairness of the consideration in a transaction. Fairness opinions are routinely used by directors of companies in connection with a change of control transaction, such as a merger or sale or purchase of assets, to satisfy their ﬁduciary duties to act with due care and in an informed manner.” –FINRA Regulatory Notice 07-54, November, 2007, page 2.
In 1980, Trans Union, a publicly traded lessor of railcars, found itself in a diﬃcult tax situation. Trans Union had accumulated a signiﬁcant dollar value of investment tax credits, but the depreciation expense related to its rolling stock prevented their use.
Trans Union Chairman and Chief Executive Oﬃcer J.W. Van Gorkom decided that the way to unlock the value of the investment tax credits was to sell the company to an acquirer with signiﬁcant taxable income against which the investment tax credits could be applied. Van Gorkom located a potential buyer, Jay Pritzker, with whom he struck a deal at $55 per share—a 45% premium to the $38 per share trading price. The board approved the merger at a special meeting, and a ﬁve-year legal battle over the fairness of the transaction began.
In 1985, the Delaware Supreme Court determined that the individual members of the board failed to adequately inform themselves of how the purchase price was determined, failed to inform themselves of Trans Union’s value, and, as a result, were grossly negligent in approving the merger. The Court’s ﬁnding undermined the protection aﬀorded individual board members by the business judgment rule, and the defendant directors were found to have breached the duty of care owed to the Trans Union shareholders.
The lack of a fairness opinion was speciﬁcally noted by the Court. While the ruling points out that the law does not speciﬁcally require a fairness opinion by independent investment bankers, the fact that the lack of one may have played a role in the Court’s decision to shift liability to the individual directors fueled a spectacular increase in the number of fairness opinions issued in transactions of all kinds.
Almost all fairness opinions address the deal’s absolute fairness – whether the deal price represents adequate ﬁnancial consideration for the asset to be transferred. Typically, opinions of absolute fairness compare an opinion of the value of the underlying business enterprise with the deal price. If the deal price is greater than or reasonably close to the opinion of the value of the underlying enterprise, the analyst issues an opinion that the deal is fair.
In some instances, issues of relative fairness arise. This refers to whether the total deal consideration paid is shared fairly among the stakeholders. Opinions of relative fairness might address noncompete or other employment agreements given to certain stakeholders, or the allocation of deal proceeds between classes of stock.
Procedural fairness refers to whether the process by which the transaction was approved is likely to result in a fair deal. Not all transactions result from a well-planned auction process that allows for adequate market exposure; some deals involve family members, management buyouts or unexpected offers. In these situations, the lack of procedural fairness might result in questions regarding the transaction’s absolute fairness.
In response to concerns that many fairness opinions were issued by investment bankers who stood to collect only if the deal was consummated, the Financial Industry Regulatory Authority issued new disclosure rules in 2007 to allow board members and shareholders to assess the independence of those who issue fairness opinions. Under the new rules, FINRA member firms who issue fairness opinions are required to disclose:
- If the firm acted as a financial advisor to either party to the transaction and if its fees are contingent on the successful completion of the deal and whether the firm stands to receive significant fees for other work related to the transaction (such as financing).
- Whether the firm had a material relationship with either party to the transaction in the two years prior to the deal.
- If the information relied on in the fairness opinion was independently verified by the firm providing the opinion.
- Whether a “Fairness Committee” of the issuing firm approved the opinion, and, if so, a description of the committee.
- If the opinion considers compensation paid to the subject company’s officers, directors, and employees relative to the compensation paid to shareholders.
- The process used to determine the appropriateness of any valuation analyses performed.
We Can Help
In the current market and regulatory environment, we anticipate increased scrutiny of individual directors’ actions and of the fairness opinions on which they rely. If you are the general counsel, special counsel, or a member of the Board of Directors for a company considering a transaction, we may be able to assist. You are welcome to call us in confidence at 800.782.8382.