Following a series of large bank acquisitions in the late 1990s that did not live up to expectations, one institutional investor was quoted over a decade ago as saying fairness opinions were not worth the three dollar stationery they are written on. The portfolio manager was expressing disappointment with a bank that was in his fund that had announced a large transaction. Institutional investors are sophisticated investors. For those that do not like a major corporate decision, the “Wall Street Rule” can be exercised: sell the position.
Boards of directors on the other hand rely upon fairness opinions as one element of a decision process that creates a safe harbor related to significant decisions. Fairness opinions are issued by a financial advisor at the request of a board that is contemplating a significant corporate event such as selling, acquiring, going private, raising dilutive capital, and/or repurchasing a large block of shares. Under U.S. case law, the concept of the “business judgment rule” presumes directors will make informed decisions that reflect good faith, care and loyalty to shareholders. Directors are to make informed decisions that are in the best interest of shareholders. Boards that obtain fairness opinions are doing so as part of their broader mandate to make an informed decision.
The fairness opinion states that a transaction is fair from a financial point of view of the subject company’s shareholders. The opinion does not express a view about where a security may trade in the future; nor does it offer a view as to why a board elected to take a certain action. Valuation is at the heart of a fairness opinion, though valuation typically is a range concept that may (or may not) encompass the contemplated transaction value.
In addition, process can be an important factor in assessing fairness. This is especially true when a company is contemplating selling. Our lay-person view of case law is that boards have some flexibility around marketing a company when entering into a merger that is structured as a stock swap because shareholders will swap common shares; however, when the predominant consideration to be received is cash there is a presumption that an auction was conducted to obtain the best value. Other factors that may be considered include financial interests of insiders, the ability of an acquirer to obtain financing to close, the investment attributes of the buyer’s shares after giving effect to the merger for such factors as relative valuation compared to peers, dividend paying capacity, trading volume, and dilution or accretion to earnings per share and book value per share.
Fairness opinions are typically issued by investment bankers who arranged a transaction; however, because most of their fee is contingent upon the successful closing of a transaction, the lead banker’s opinion has always had some taint even if the consensus is that a transaction is a good deal. In 2007, the Financial Industry Regulatory Authority (“FINRA”) issued Rule 2290, which requires the issuer of a fairness opinion to disclose such conflicts.
It is probably not a coincident that transparency that is promulgated by Rule 2290 has led to more litigation. The New York Times noted on March 8, 2013, that “once you’ve announced a deal, you are likely to get sued.” Academics Matt Cain of the University of Notre Dame and Steven Davidoff of Ohio State University published research in February 2013, that 59% of all takeovers announced during 2005-2012, over $100 million with an offer price of at least $5 per share, involved litigation.
Pre-crisis, approximately 40% of the announced mergers entailed litigation; since 2008 the litigation rate has exceeded 84% each year. The average complaints per transaction were five, and 50% involved multi-jurisdictions. The median attorney fees to settle when disclosed were $595 thousand in 2012, which was within the $528 thousand to $638 thousand median band since 2006. “Disclosure-only” settlements (i.e., adding disclosures about the transaction to the proxy statement) accounted for 88% of the settlements in 2012 vs. 12% for settlements that increased the consideration or reduced the termination fee. In 2005 and 2006, “disclosure-only” settlements were only 64% and 58%, respectively.
The current poster-child for financial advisor conflict is a March 7, 2014, opinion by Vice Chancellor Travis Laster of the Delaware Court of Chancery regarding the acquisition of Rural/Metro Corporation by an affiliate of Warburg Pincus LLC on June 30, 2011, for $17.25 per share in cash. The Court’s decision walks through a minefield of a poorly structured sales process, a skewed valuation, inadequate oversight of the fairness opinion process, and advisor and director conflicts.
Although the acquisition price represented a 37% premium, the Court found that RBC Capital Markets as financial advisor to Rural/Metro allowed its interest in pursuing (unsuccessful) financing roles to the buyer of Rural/Metro and a competitor that was on the block to negatively impact the sales process to the detriment of the shareholders. RBC stood to make upwards of $55 million in financing fees, which were 11x its advisory fee. The board was not informed of the conflicts, and some members of the board were viewed as conflicted and disinterested. Further, the valuation was found to be “belated and skewed” such that the valuation was pushed lower to conform to the proposed acquisition price. The directors settled before the trial for $6.6 million, while secondary advisor Moelis & Company settled for $5 million. In October, the Court found RBC Capital Markets liable for $76 million in damages based upon his finding that the company’s value was $21.42 per share.
In the case of Rural/Metro, the second fairness opinion from a financial advisor that was not conflicted did not negate the factors that resulted in the Court’s view that shareholder value was not maximized; rather, the Court focused on the how the conflicts and faulty board oversight harmed shareholders. That said the competing interests in Rural/Metro point to why corporate transactions increasingly include a second (or third) fairness opinion from a financial advisor that does not stand to benefit from a success fee or fee from arranging financing. Boards that recognize conflicts and which actively manage the transaction process may strengthen their position of having made an informed decision to thereby ensure their actions meet the standards of care, loyalty and good faith.
Mercer Capital is an independent valuation and financial advisory firm. We render hundreds of valuation opinions each year and are regularly engaged by boards to evaluate significant transactions. As part of our financial advisory practice, we regularly issue fairness opinions on behalf of boards that are involved in transactions that span a range of purposes, though M&A is the most common. If your firm is contemplating or has initiated a significant transaction, we would be glad to discuss the matter in confidence.
- Fairness Opinions: Evaluating a Buyer’s Shares from the Seller’s Perspective
- Transaction Advisory Services: Fairness Opinions