Copyright Euromoney Institutional Investor PLC Aug 2004Fairness opinions given by investment banks on mergers and acquisitions deals are the most recent focus of regulators' concerns over potential conflicts of interest.
Fairness opinions, in which investment banks say whether a proposed deal is a good one for their client, may be vulnerable to conflicts of interest similar to those identified in other parts of the financial industry. The National Association of Securities Dealers (NASD) has launched an inquiry into the matter, and is paying special attention to how banks are paid for these opinions and who pays them. Already, directors should be cautious about counting on opinions to protect them from liability to shareholders for agreeing to a deal that turns out to be bad. Banks, also, are rethinking their potential liability to shareholders in a company, lest they be accused of writing opinions that are tainted by interests other than the fairness they claim to uphold.
The potential for conflicts arises because the firms that provide fairness opinions often provide other services as well, such as underwriting and financial advising. Indeed, it is common for one firm to provide both a fairness opinion and advisory services for the same transaction. For example, in 
AXA's recent stock-for-cash acquisition of MONY, Credit Suisse First Boston provided a fairness opinion for MONY, and advised MONY's board.
Yet, what a bank says about the fairness of a deal might be influenced if compensation for its efforts turns on whether a transaction is consummated (which is typical for fees paid for advisory work). A bank might opine that a cheap price is fair for a company rather than jeopardize its prospects of a pay off when the deal is done.
These conflicts can also run deeper.
If the bank is engaged by members of management who stand to gain if a proposed transaction occurs, the bank's work may be influenced in ways it would not be were the engagement made by directors who were not members of management. If the bank's work includes advising the company's management and its directors on how to structure the transaction, or negotiating terms of the transaction, the bank might bring less dispassion to its assessment of the financial merits of the transaction than would a bank engaged solely to provide a fairness opinion. When the bank does not have any connection to a transaction apart from providing a fairness opinion, the bank's interest in nurturing future business for other services it would wish to provide could be jeopardized if the bank believes that withholding a fairness opinion will lead to the perception that it is a deal breaker rather than a dealmaker.
The fees associated with different services provided to the same client serve to magnify these potential conflicts. For example, in connection with its acquisition of Fleet Boston Financial Corp, Bank of America agreed to pay Goldman Sachs Group Inc $3 million as a retainer, $5 million for furnishing a fairness opinion, and $17 million upon completion of the $40 billion-plus merger. The recognition that professional work may be biased when a lower-paid service is compromised by the desire to protect a higher-paid service underlies the prohibitions in Sarbanes-Oxley Title II. These prohibit an auditor's provision of specified consulting and other financial services to an audit client.
Bank liability
In view of this, corporate directors should reconsider the likelihood of being held to account by shareholders for making a bad deal, and of how useful a fairness opinion might or might not be as a defence in those circumstances (see box). It is hard to determine how far current evolution in practices surrounding fairness opinions is also driven by bankers' assessment of their risk of liability to shareholders. Although an investment bank might be subject to liability to shareholders on the basis of a flawed fairness opinion under a variety of theories, the body of relevant cases is not as extensive as one might suppose, and the approach could differ based on jurisdiction.
In general, a bank's exposure to liability is limited by the content of a fairness opinion. That is, fairness opinions conventionally state the materials the bank worked with in preparing the opinion and disclose whether the bank relied on representations made by the company's management and whether the work done was subject to limitations. These statements and disclosures limit the bank's exposure to liability by explicitly informing the reader that a fairness opinion is subject to limitations.
Losing faith
Changing practices surrounding fairness opinions include the disclosure of more information on the structure of bank's fees in many M&A deals, while many companies now seek second or confirmatory fairness opinions from banks not otherwise associated with a particular transaction. Pressure for change also stems from the boards of companies that are the audiences for fairness opinions. More boards now form committees comprised of independent directors to assess whether a transaction has been influenced by conflicts of interest.
Moreover, a director's right to rely on a fairness opinion is not absolute. General standards of corporate law protect directors who rely on a report or an opinion only if the reliance is in good faith. It's arguable that a director's reliance on a fairness opinion furnished by a bank known to have conflicts of interest might not be in good faith because the director would have reason to doubt whether the opinion reflects an honest statement of the bank's expert judgment. This possibility is heightened when the bank is known to have had interactions with members of the company's senior management who stand to gain if a merger transaction occurs, for example through a payment required by a change-in-control provision in an employment contract. Directors who want to minimize their risk of liability have incentives to minimize the conflicts that cloud fairness opinions on which the directors wish to rely.
Beyond this basic point, whether a fairness opinion was addressed to a company's shareholders is also relevant to the outcomes reached in cases. If a bank addressed a fairness opinion to shareholders, the bank can assume a duty to shareholders to use reasonable care in preparing the opinion because it is known to the bank that shareholders are likely to rely on the opinion, for example in determining whether to approve a transaction. If a fairness opinion is not directly addressed to shareholders, but could come to their attention to comply with the SEC's disclosure requirements, it is arguable that the bank preparing a fairness opinion has enough notice that shareholders might rely on the opinion to create a duty of care to shareholders. The circumstances that justify imposing such a duty will vary among jurisdictions. Likewise, if a bank preparing a fairness opinion has reason to know that statements in the opinion are false, the circumstances in which it will be subject to liability to shareholders for fraudulent misstatement also vary among jurisdictions.
If a fairness opinion is not addressed to a company's shareholders and does not otherwise come to their attention, the bases on which the bank that authored the opinion might be subject to liability are different. To begin with, the bank might be subject to liability to the company itself for breach of contract if the bank did not fulfil the terms of its engagement, for example by failing to perform valuation analyses as promised. The company's shareholders, in contrast, are not themselves parties to the bank's contract with the company and will confront obstacles in persuading the court that they acquired direct rights under the contract on the basis that it was made for their benefit. If the company's shareholders were not given the fairness opinion, they cannot show they relied on it, a requisite to establishing the bank's liability for negligent or fraudulent misrepresentation.
A bank may nonetheless be subject to liability, based on two different theories. In Schneider v Lazard Freres, the bank was retained to opine on the relative merits of bids submitted in the auction of RJR-Nabisco to assist a special committee of the board. New York's Appellate Division held that the bank's alleged negligence in determining two bids to be substantially equivalent breached a fiduciary duty the bank owed to RJR-Nabisco's shareholders. In the court's analysis, the bank owed a fiduciary duty directly to the company's shareholders because it was retained by a special committee of the board, which was created to act as the shareholders' agent in auctioning off the company. Schneider is unique in recognizing the existence of a direct fiduciary duty between a bank providing a fairness opinion and the company's shareholders when the bank is not retained to advise the shareholders.
A bank may also be subject to liability for breach of fiduciary duty through a more indirect route. If the bank knowingly participates in breaches of fiduciary duty owed by others to the corporation and its shareholders, the bank could be subject to liability on the basis that it aided and abetted (knowingly participated) in the fiduciaries' breach. Delaware's Court of Chancery recognized this theory in 1990 in In re Shoetown Inc, in which shareholders sued Shearson Lehman, retained by the company's management in connection with a management buyout transaction. Shearson was retained to provide advice to the management group and to render a fairness opinion. Although the court held its retention did not automatically impose a fiduciary duty to shareholders on the bank, the court also held that the facts alleged in the complaint were enough for a claim of knowing participation in the management group's alleged breaches of fiduciary duty because the bank had early involvement with the management group and with the special committee of the board created to handle the transaction, and was present when management decided to concentrate on one particular bidder to the exclusion of others.
Lastly, undisclosed conflicts of interest on the part of the bank providing a fairness opinion can only augment the bank's risk of liability to shareholders. To the extent the shareholders' claim turns on reliance on the bank's opinion, the undisclosed fact that the bank's relationship with the company created strong incentives that may have biased its opinion enhances the argument that material information was withheld from shareholders. If the shareholders' claim turns on the existence of fiduciary duties owed by the bank, the bank's failure to disclose a material conflict itself constitutes a breach of fiduciary duty.
Reform
Eliminating the possibility of conflicts of interest from fairness opinion practices would require the segregation of fairness opinion work from the advisory, and other, work that investment banks provide to their clients. Mandatory segregation is, of course, the route followed to some extent in Sarbanes-Oxley to insulate auditing from various consulting services. Still, the provider of a fairness opinion might be tempted to shape its opinion to meet the hopes of a company's management, who may select the opinion provider. It is hard to design a vehicle that enables shareholders as a group to select their own expert adviser.
Short of mandatory segregation of fairness opinion work, it will be helpful if company directors consider carefully when reliance on a fairness opinion is warranted. Justifying reliance against a standard of good faith should focus the attention of directors and their counsel on the structure of a bank's compensation and its relationships with the company, including its senior management.
A fair view
Fairness opinions are often addressed solely to a corporation's board, but shareholders asked to approve a transaction typically have access to the opinion as well. In a management buyout or other going-private transaction subject to SEC rule 13e-3, compliance with Schedule 13E requires that the company disclose whether it believes the terms of the transaction to be fair to minority shareholders and, if so, the factors on which that belief is based. If the company has received any opinion or report on the transaction from an outside party, Schedule 13E requires disclosure of that fact, as well as the outside party's identity, qualifications, and material relationships with the company during the two preceding years, plus a summary of the opinion. The SEC's staff also requires equivalent disclosure through the proxy statements that accompany a solicitation of a shareholder vote to approve other merger transactions, including arm's length negotiated mergers.
A company's directors might also obtain a fairness opinion to help establish that they have discharged duties they owe the company and its shareholders. This is so in two circumstances relevant to the NASD inquiry. First, Delaware law (applicable to many large public companies) imposes a so-called Revlon duty on directors when they contemplate selling control. The selling company's directors must act reasonably to seek the transaction that offers the best value reasonably available to the company's shareholders. A fairness opinion might help assure directors that a particular transaction satisfies the Revlon standard. Second, Delaware law also requires that directors exercise reasonable care and good faith when they decide to support any proposed merger transaction, including a negotiated transaction. The Delaware Supreme Court held in the well-known Trans Union case (Smith v VanGorkom) in 1985 that, to discharge their duties, directors must avail themselves of all information reasonably available to assess the merits of a proposed merger, including whether the consideration is enough in light of the company's intrinsic value. Although the court emphasized that directors could discharge this duty without receiving a fairness opinion from an investment bank or other external expert, it is conventionally believed that such an opinion is helpful in establishing that the directors acted in an appropriately informed manner.
Determining whether or not a proposed transaction is financially fair is often characterized as an art, not a science, and financial fairness is best conceived as a range rather than a single number. Many discretionary choices influence valuations, whatever techniques or models are used. Moreover, the analysis required to prepare a typical fairness opinion is not comparable to an audit. Bankers customarily rely on a company's publicly filed financial statements, plus non-public information and projections furnished by management
Deborah A DeMott is David F Cavers Professor of Law at Duke University School of Law
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