The Importance of Fairness Opinions in Transactions

The final aspect of many merger/sale transactions is the fairness opinion. A fairness opinion is provided by an independent financial advisor to the board of directors of selling companies in many transactions today, especially those with a significant number of minority shareholders. In cases where the transaction is considered to be “material” for the acquiring company, a fairness opinion from another financial advisor is sometimes retained on its behalf.

A fairness opinion involves a total review of a transaction from a financial point of view. The financial advisor must look at pricing, terms and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of minority shareholders.

Why is a fairness opinion important? While there are no specific guidelines as to when to obtain a fairness opinion, it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.

The facts of any particular transaction can lead reasonable (or unreasonable) people to conclude that a number of perhaps preferable alternatives are present. A fairness opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal, as well as litigation than can kill transactions.

Although the following is not a complete list, consideration should be given to obtaining a fairness opinion if one or more of these situations are present:

1. Competing bids have been received that are different in price or structure, thereby leading to an interpretation as to the exact terms being offered, and which offer is “best.”
2. Insiders or other affiliated parties are involved in the transaction.
3. The company has experienced a recent history of poor financial performance.
4. The offer is hostile or unsolicited.
5. There is lack of agreement among the directors as to the adequacy of the offer.
6. There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties.
7. The board desires additional information about the investment characteristics of the acquiring company.
8. Varying offers are made to different classes of shareholders.
9. There is only one bid for the company, and competing bids have not been solicited.
10. There is a significant transaction between a significant insider and the company.

Directors have a fiduciary responsibility to the shareholders known as the business judgment rule. In general, directors and management are given broad discretion in directing the affairs of a business. Directors are expected to act in good faith based upon the care that an ordinary person would take in supervising the affairs of the business. Inherent in this rule is the requirement that the board of directors be informed about the basis for major decisions prior to reaching a conclusion. In essence, there is an expectation that reasonable decisions will be made in a proper way.

In the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court expanded the concept of the business judgment rule to encompass a requirement for informed decisions. The process by which a board goes about reaching a decision can be just as important as the decision itself. While the Delaware court decision is applicable only to Delaware, the wide influence of Delaware law on business law in general makes the case very important. There have, of course, been other cases relating to fairness opinions since Smith v. Van Gorkom, but a case review is beyond our scope in this short article.

The fairness opinion is a short document, typically a letter. The supporting work behind the fairness opinion letter is substantial, however. A well-developed fairness opinion will be based upon at least the following five considerations:

1. Financial performance and factors impacting earnings.
2. Dividend-paying history and capacity.
3. Pricing of similar transactions.
4. A review of the investment characteristics of the consideration to be received.
5.  A review of the merger agreement and its terms.

Due diligence work is crucial to the development of the fairness opinion. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling for stock). We believe that it is prudent to visit the selling company, conduct extensive reviews of documentation, and interview management.

A similar process should be performed with respect to the buying company, especially if the consideration is its stock. If the purchaser is a public company, it is imperative that all recent public financial disclosure documents be reviewed. It is also helpful to talk with financial analysts who routinely follow the purchasing company in the public markets.

Fairness opinions are often memorialized in the form of fairness memoranda. A fairness memorandum examines the major factors of the fairness opinion in some detail, and summarize the considerations of each factor for discussion by the board of directors. In many cases, the financial advisor will participate in these discussions and answer questions addressed by the board.

Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 1, 1997.