FAIRNESS OPINIONS: A Brief Primer UNDERSTANDING THE CHANGING TRANSACTION LANDSCAPE For more than 30 years, fairness opinions have played an integral role in merger and acquisition (M&A) and related corporate transactions. While fairness opinions were issued for deals prior to the mid-80s, the 1985 ruling in the Smith v. Van Gorkom 1 case earned fairness opinions a much more prominent place in the deal process. Yet, the marketplace continues to struggle with a lack of consistent standards and methods, as well as perceived conflicts of interest where fairness opinions are concerned. This paper, the first in a series on this topic, looks at the evolution of fairness opinions, the critical role they continue to play in supporting transaction value and decision-making, and why it s important for stakeholders to solicit opinions from highly experienced, independent, and sophisticated providers. WHAT IS A FAIRNESS OPINION? A fairness opinion is a letter summarizing an analysis prepared by an investment bank or independent third party, which indicates whether certain financial elements in a transaction, such as price, are fair to a specific constituent, from a financial point of view. While not required by law, 2 fairness opinions are commonly used in M&A transactions to assist the board, a special committee of the board, or other fiduciaries in assessing the fairness of the financial terms of a transaction, as of a specific date and based on a given set of assumptions. Fairness opinions do not constitute legal, regulatory, accounting, insurance, tax or other similar advice; are not intended to constitute a recommendation as to how shareholders should vote on any action; and do not represent a judgment of the merits of a company s securities. However, a fairness opinion helps to provide boards with a safe haven in which 1 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). 2 A notable exception being Section 1203 of the California Corporations Code (CA Corp Code 1203 (2016)) covering tender offers made by certain insiders. FAIRNESS OPINIONS: A Brief Primer 1
What types of deals use fairness opinions? Fairness opinions are generally issued to support transactions involving the purchase or sale of publicly traded companies, but may also be issued for transactions involving a: Management buyout Recapitalization Bankruptcy, liquidation, or restructuring scenario Employee Stock Ownership Plan (ESOP) Private company with diverse ownership Related party transfer transactions are generally viewed under the more forgiving legal standard of the business judgment rule. In short, as a result of receiving a fairness opinion as part of an otherwise well-structured (and well-executed) transaction process, boards are generally not second-guessed on their decisions to proceed (or not proceed) with a transaction. While the fairness opinion itself is generally a twoto four-page letter, the process used to arrive at the conclusion is substantial and often quite complex. Fairness opinions are based on objective, independent analyses performed by experienced financial experts that include not only a valuation (including full financial due diligence on the underlying business), but a review of the transaction s financial structure, the type and timing of the deal, and the financial and tax consequences of the transaction. While fairness opinions are only one input used by board members and other stakeholders in the process of analyzing a transaction, they are considered an essential part of the transaction process. Their purpose is twofold: 1) to provide an objective standard against which certain financial elements of a transaction can be measured, and 2) to insulate board members from a subsequent breach of fiduciary duty claim a direct outcome of the 1985 ruling in the Smith v. Van Gorkom case. IMPORTANCE OF FAIRNESS OPINIONS The Delaware Supreme Court ( the court ) ruling in the Smith v. Van Gorkom case stands out as an inflection point for the enduring legacy of fairness opinions as a core element in M&A transactions. The case involved a proposed leveraged buyout of TransUnion by Marmon Group. Defendant Jerome Van Gorkom, TransUnion s chairman and CEO, chose a proposed price of $55 without consulting outside financial experts. Instead, he only consulted with the company s CFO to determine a per share price that would work for a leveraged buyout. However, Van Gorkom and the CFO did not determine an actual total value of the company. The court was highly critical of this decision, writing that the record is devoid of any competent evidence that $55 represented the per share intrinsic value of the Company. While the proposed transaction was subject to board approval, a number of items were not disclosed at the board meeting, including the problematic methodology that Van Gorkom used to arrive at the proposed price. Ultimately, the board moved forward in approving the proposal. At issue in this landmark case was whether the business judgment used by the board of directors of TransUnion to approve the deal was an informed decision. The court ruled against the board, who FAIRNESS OPINIONS: A Brief Primer 2
voted for a leveraged buyout, based on the absence of a fairness opinion from an independent financial advisor. The Delaware Court found the board liable for breach of its fiduciary duty of care to the corporation and hence liable for damages to the plaintiff shareholders. The court believed the liability could have been avoided had the directors elicited a fairness opinion from anyone in a position to know the firm s value. In Smith v. Van Gorkom, the court ruled against the board of directors of TransUnion Corporation, who voted for a leveraged buyout, based in part on the absence of a fairness opinion from an independent financial advisor. The court believed the liability could have been avoided had the directors elicited a fairness opinion from anyone in a position to know the firm s value. Prior to the decision in Smith v. Van Gorkom, courts were reluctant to hold boards liable for a breach of their fiduciary duty of care if the directors acted in good faith, in the best interest of the corporation, and its decisions were not tainted by fraud, illegality, or loyalty violations. Cases such as Dodge v. Ford Motor Co., Shlensky v. Wrigley, and Joy v. North evidence this precedent. 3 In many ways, Smith v. Van Gorkom was a turning point for stakeholders in M&A transactions and corporate board members in particular. Despite the fact that the board s decision in Smith v. Van Gorkom was never tainted by even a hint of selfdealing or conflict of interest, 4 because the board did not disclose a lack of valuation information to shareholders, the court found that the board had breached its fiduciary duty to disclose all germane facts to the shareholders. This was widely interpreted as a warning shot to corporate board members vis-àvis their exposure to personal financial liability in the course of conducting M&A transactions. THE EVOLUTION OF FAIRNESS OPINIONS As a direct result of the Smith v. Van Gorkom decision, fairness opinions are routinely used in M&A and similar financial transactions, serving as a form of defense and legal protection for the board of directors on both sides of these transactions. However, fairness opinions are not without controversy. A number of issues have surfaced over the last 30+ years regarding the quality and consistency of fairness opinions, as well as who s providing the opinion. Specifically, fairness opinions are often: Considered a check-the-box activity with little attention paid to (or analytical support surrounding) how the opinion was formed. Conducted by the same party that is advising the target company (or the buyer) on the transaction and for a fee that is contingent on the successful completion of the deal, which represents a clear conflict of interest. Subjective; developed using a wide variety of methods and assumptions that can lead to equally varying values to support fairness or value ranges so broad that they re essentially meaningless. 3 DePaul University Business and Commercial Law Journal; Vol. 3., Issue 1: Fall 2004, Article 3. 4 Northwestern University Law Review; Vol. 96, No. 2. FAIRNESS OPINIONS: A Brief Primer 3
It s important to place these concerns in proper context. While fairness opinions are solicited for virtually all M&A and related corporate control transactions, they re typically obtained at the tail end of the transaction, usually when the deal closing is pending. That puts additional pressure on the parties managing the transaction to choose a fairness opinion provider who can execute under intense deadline pressure and without inordinately driving up costs. As a result, it s not uncommon for companies to devote an inadequate amount of time searching for a qualified independent advisor, and instead rely on the investment bank that structured the transaction. The downside of this approach is the potential for conflicts of interest and/or opinions that fail to hold up in court if challenged. There s little question that an inherent conflict of interest exists in situations where the investment bank conducting the deal also receives a separate fee for issuing a fairness opinion for that deal. Many critics have objected to this perceived lack of objectivity as well as the practice of front-loading a portion of the bank s fee. This is often viewed as a way for banks conducting deals to insure a portion of their fee should a deal fall through. Another concern that s played out over the past three decades is the lack of consistency in the practices and procedures used to assess and demonstrate the financial fairness of a transaction. This is due in large part to the fact that no formal standards or guidelines exist governing the methodologies and analyses used to perform fairness opinions. Instead, the rigor of the analyses performed is only tested in the event that the opinion is challenged in court. Both opinions and their underlying analyses have been subject to increased litigation and scrutiny by the courts in recent years due in part to heightened concerns about transparency and objectivity in the wake of the financial crisis. 5 In fact, more than half of all M&A deals valued over $100 million are challenged. 6 That s why it s more important than ever for stakeholders to select an independent financial advisor whose opinions and analyses can withstand scrutiny. 5 Financier Worldwide; Forum: Valuations and Fairness Opinions in M&A, June 2014. 6 Thomson Reuters SDC; SEC filings.
EXPERIENCE COUNTS As a leading fairness opinion advisor, 7 Stout leverages its considerable investment banking and valuation experience to assist clients in making sound business decisions and completing their critical transactions. We understand the complexity and uncertainty inherent in completing a deal and are committed to navigating through the noise to provide timely, sophisticated and reliable advice. Our analytical approach incorporates: Comprehensive empirical research Real-world deal knowledge Deep valuation experience Guidance from recent court decisions and findings In addition, we follow best practices and regulatory guidance for every opinion, regardless of size. Not only do we have quality control procedures in place regarding the issuance of our opinions, but we include disclosure if any potential conflicts of interest exist between the firm issuing the opinion and the parties involved in the transaction. These steps ensure the quality and independence of the opinions we provide. Furthermore, every opinion is reviewed and approved by Stout s Transaction Opinion Committee. This committee, which is composed of senior firm leaders, plays an integral role in making certain that every opinion we issue is analytically sound, well supported, and meets best practices for ensuring an independent review process. The members of Stout s Transaction Opinion Committee have: Testified in approximately 100 cases Authored more than 150 articles in various publications and text books Spoken at more than 270 industry events Our experts have advised corporate boards, special transaction committees, independent trustees, management, and other fiduciaries of public and private companies on the financial aspects of a transaction. Moreover, we stay current on the transaction environment and incorporate our knowledge of court decisions and findings into our opinions so you can feel confident that our opinions reflect recent developments in the industry. Finally, our independent perspective ensures that our opinions come with no contingencies, conflicts, or success fees. As a result, our clients can trust that our independent advice will withstand scrutiny from shareholders, bondholders, the SEC, IRS, or counterparties to a transaction. Our transaction opinion services include: Fairness opinions Solvency opinions Capital adequacy opinions ESOP transactions Typical engagements involve: Going-private transactions Recapitalizations Related party transfers Special dividends Clients include: Corporate boards Special committees Trustees Other fiduciaries 7 Thomson Reuters Mergers & Acquisitions Review (2011 2016). FAIRNESS OPINIONS: A Brief Primer 5
CONTRIBUTING AUTHORS Jeff Phillips Managing Director TYSON S CORNER +1.703.848.4955 jphillips@ T.J. Hope, CFA Director NEW YORK +1.646.807.4223 thope@ Jeff Phillips is a Managing Director in the Valuation Advisory group. He has extensive experience in providing transaction and valuation opinions involving Fortune 500 and middle market companies. Jeff has more than 20 years of experience across many industries resulting in a comprehensive understanding of the specific issues and challenges that need to be considered in each industry. Jeff is head of the firm s Tyson s Corner office and leads Stout s Transaction Opinions practice. Prior to joining Stout, Jeff was a Director with Houlihan Lokey, Howard & Zukin, and served as an audit manager of a major public accounting firm. T.J. Hope is a Director in the Valuation Advisory group. He has more than 15 years of experience providing a broad range of valuation advice spanning a range of industries and for numerous purposes. In addition, T.J. has completed numerous transaction opinions, including fairness opinions and solvency opinions for mergers and acquisitions, recapitalizations, relatedparty transactions, and other types of transactions. T.J. s professional experience also includes time he spent at Blue Point Capital Partners, a middle market private equity fund, where he gained significant principal investing experience. His responsibilities included financial modeling; capital raising for acquisitions; legal documentation of transactions; business, market and industry due diligence on target companies; and the support of portfolio company executive management in acquisitions, refinancings, and strategic planning. FAIRNESS OPINIONS: A Brief Primer 6
ABOUT STOUT Stout is a leading independent advisory firm specializing in Investment Banking, Valuation Advisory, Dispute Consulting, and Management Consulting services. We leverage synergies across these practices to deliver a unique perspective to our clients. INVESTMENT BANKING Our industry-focused bankers specialize in mergers and acquisitions, private capital raising, and other financial advisory services for privately held businesses, portfolio companies of private equity firms, and divisions of large corporations. Our depth of experience in recapitalizations, management buyouts, and sales or mergers provides our clients with the full range of liquidity alternatives. DISPUTE CONSULTING Our deep bench of experts has decades of experience working on complex and highprofile controversies. Private sector clients, government agencies, and outside counsel engage our experts to assist with investigations, analyze financial, statistical and economic issues, evaluate damages, and offer expert testimony in arbitrations, state courts, federal courts, and other venues across the U.S. VALUATION ADVISORY As one of the largest independent valuation practices in the country, we bring deep and specialized experience across a broad spectrum of industries in the valuation of businesses, complex securities, intellectual property, real estate, and personal property. Our opinions are fully supported and are prepared to withstand scrutiny whether that be from the SEC, IRS, Department of Labor, a trier of fact, an auditor review, or a counterparty. MANAGEMENT CONSULTING We work collaboratively with companies to transform their businesses. Our consultants work side by side with organizations to manage risk through industry-leading analysis; make informed decisions from machine and deep learning; contain costs through process improvement; and stabilize finances and operations through restructuring. Stout is a trade name for Stout Risius Ross, LLC and Stout Risius Ross Advisors, LLC, a FINRA registered broker-dealer and SIPC member firm. Investment Banking Valuation Advisory Dispute Consulting Management Consulting FAIRNESS OPINIONS: A Brief Primer 7