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Fairness Opinions in Affiliated Party Transactions

  • Sutter Securities Financial Services, San Francisco


This article discusses fairness opinions in affiliated party transactions and focuses on the following topics: what fairness opinions address, what “fairness” means, criticism of fairness opinions, Delaware law’s impact on their content and use, FINRA and SEC requirements, and valuation methods employed.
by Gilbert E. Matthews, CFA
Sutter Securities Inc., San Fransisco
by Michelle Patterson, JD, PhD
Sutter Securities Inc., San Fransisco
This article discusses fairness opinions in af liated party transactions and focuses on the following
topics: what fairness opinions address, what “fairness” means, criticism of fairness opinions,
Delaware law’s impact on their content and use, FINRA and SEC requirements, and valuation
methods employed.
Our recommendations and comments are italicized and placed in a paragraph under the
relevant text.
Af liated party transactions, also known as related party transactions and non-arm’s-length
transactions, include the following:
going-private transactions through a negotiated merger (one-step freezeouts),
going-private transactions through a two-step transaction (two-step freezeouts – a tender
offer followed by a short-form merger),
going private through a reverse stock split,
leveraged buyouts with management participation,
• recapitalizations,
material sales of particular parts of a business to insiders,
transactions in which high-vote shares receive greater consideration than low-vote shares,
transactions in which insiders receive different consideration from other shareholders.
A. What Do Fairness Opinions Address?
A fairness opinion is a letter report that states whether or not a transaction, or the consideration
paid in a transaction, is fair from a nancial point of view to a group of constituents as of a speci c
date. It is addressed to the duciaries responsible for determining whether the proposed trans-
action should be recommended on behalf of these constituents. Fairness opinions are normally
prepared by a knowledgeable nancial advisory rm, generally an investing banking rm or a
valuation rm. An opinion of fairness from a nancial point of view expresses the nancial advisor’s
conclusion, supported by its analyses that the nancial terms of a proposed transaction fall within
a range to which the parties might reasonably agree. The opinion letter sets forth the assumptions,
limitations and procedures relevant to the conclusion.
B. What is Financial “Fairness?”
A determination of nancial fairness weighs what is being given up against what is being received
in a particular transaction. The nancial advisor determines a range of values based on various
valuation approaches, giving consideration to current nancial data and expected future results.
Unlike a valuation, a fairness opinion does not determine a speci c dollar value of a company, but
instead determines whether the proposed transaction is nancially fair based on the terms of the
transaction and on market conditions at the date of the opinion.
It is important to note that even if a proposed transaction is deemed fair, it does not mean
that the proposal must be accepted. Directors may exercise their business judgment to reject a
proposed transaction even if the consideration offered is fair. Furthermore, a fairness opinion is not
a recommendation that the parties enter into a transaction; it merely provides a basis for decision-
making and is only one of the factors the decision-makers should consider.
C. The Widespread Criticism of Fairness Opinions
There have been extensive criticisms of fairness opinions in af liated party transactions in the
nancial press,1 in academic articles,2 and in the courts. The fact that fairness opinions are neces-
sarily subjective can lead to different views, and the quality of the analyses has often been ques-
tioned. The criticisms, however, go deeper. The principal criticisms address:
opinions that are con icted because a major portion of the fee is contingent on closing,
perceived bias because of past and potential future relations between the opinion-giver
and the acquiror,
an appearance that analyses are manipulated to achieve a pre-determined result, and
the extensive use of disclaimers in the opinion letter.
D. Fairness Opinions in Af liated Party Transactions
By their nature, going-private and other af liated party transactions may be subject to controller
opportunism. In these transactions, a public company’s board of directors usually appoints an inde-
pendent committee that engages an independent rm to render a fairness opinion.3 The opinion
report with its nancial analyses evidences that the duciaries’ approval is based on consideration
of the transaction’s bene t for the minority shareholders. A fairness opinion provides decision-
makers with information which may affect their decision, and it con rms in litigation that they used
reasonable business judgment in approving the transaction. In addition, summaries of the nancial
analyses underlying the opinion are provided to minority shareholders in the proxy statement or
tender offer to assist in their decisions.
1 See, e.g., Andrew R. Sorkin, “Mergers: Fair Should Be Fair,” N.Y. Times, Mar. 25, 2005.
2 See, e.g., Steven M. Davidoff, “Fairness Opinions,” 55 Am. U. L. Rev. 1557 (2006).
3 There is one exception: Delaware exempts short-form mergers from a fairness requirement (Glassman v. Unocal Exploration
Corp., 777 A.2d 242 (Del. 2000)). Under Delaware law, a controller who owns at least 90% of each class of stock may consum-
mate a “short-form” merger without a shareholder vote. The shareholder’s only remedy is appraisal.
The Delaware courts have effectively set the standards for reviewing fairness of corporate af liated
party disputes. Delaware corporate law is widely accepted and a majority of listed companies are
incorporated in Delaware.
A. Delaware Requires Financial Advisors for Freezeouts
Delaware requires that when a freezeout is proposed, the independent committee must be given
the ability to hire their own independent nancial and legal advisors and be given suf cient time to
react. Moreover, the shareholders must be given adequate summaries of the advisor’s analyses to
enable the shareholders to make an informed judgment.4 Although a 2000 Delaware decision held
that “fairness opinions … are not generally essential as a matter of law, to support an informed
business judgment,”5 later decisions began to call for them.6 A 2010 decision on this issue, CNX
Gas, not only effectively mandated fairness opinions in freezeouts but spelled out as well that
unless the independent committee af rmatively recommends the transaction based on its nancial
advisor’s opinion, the Court will subject the transaction to a strict standard of scrutiny (“entire
fairness” review) rather than the more lenient “business judgment” review.7
The fairness opinion requirement, along with the necessity of the independent committee’s
positive recommendation to the minority shareholders based on it, arose from freezeout transac-
tions. Although these decisions address freezeouts, we believe that the reasoning which requires
an independent nancial valuation as well as a positive recommendation could be expanded in the
future to other types of af liated party transactions.
B. Delaware Disclosure Requirements
The general rule in Delaware today is based on the Court’s insistence that shareholders receive
information that enables them to understand the basis of the independent committee’s recommen-
dation so that they can decide on their course of action. Directors have “a duciary duty to disclose
fully and fairly all material information within the board’s control.”8
The key determinant as to information that must be disclosed is whether that information
is material to the minority shareholder. If the Court has decided that a certain type of informa-
tion, such as nancial analyses, is material in the subject case, disclosure is required. The U.S.
Supreme Court in 1976 set forth the “materiality” standard that is still in force:
An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote. Put another way, there must be a substantial likeli-
hood that the disclosure of the omitted fact would have been viewed by the reasonable investor as
having signi cantly altered the “total mix” of information made available.9
4 In re Pure Resources, Inc. Shareholder Litigation, 808 A.2d 421, 445 (Del. Ch. 2002).
5 Crescent/Mach I Partners v. Turner, 846 A.2d 963, 984 (Del. Ch. 2000), citing Smith v. Van Gorkom, 488 A.2d 858, 876
(Del. 1985).
6 See Pure Resources at 445, In re Cox Communications, Inc. Shareholder Litigation, 879 A.2d 604, 624 (Del. Ch. 2005).
7 In re CNX Gas Corporation Shareholder Litigation, 4 A.3d 397, 412-3 (Del. Ch. 2010). The Court also ruled that the committee
be empowered to elect to take appropriate defensive measures, such as a “poison pill.” Id. at 414-5.
8 Gantler v. Stevens, 965 A.2d 695, 710 (Del. 2009), citing Stroud v. Grace, 606 A.2d 75, 84 (Del. 1992).
9 TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
Vice Chancellor Leo Strine stated in Pure Resources (2002) that the general legal standards that
govern plaintiffs’ claims for disclosure of nancial information are settled:
[S]tockholders are entitled to disclosure of all material [emphasis added] facts pertinent to the
decisions they are being asked to make. . . . [They] rely on those documents to provide the sub-
stantive information on which stockholders will be asked to base their decision whether to accept
the merger consideration or to seek appraisal.
As a result, it is the information that is material [emphasis added] to these various choices that
must be disclosed. In other words, the S-4 and the 14D-9 must contain the information that “a
reasonable investor would consider important in tendering his stock,” including the information
necessary to make a reasoned decision whether to seek appraisal.10
1. Delaware Does Not Require Disclosure of Data Suf cient for Independent Determination of
Fair Value
Although the Courts agree that minority shareholders must have a basis for understanding how
the Board came to its decision, Delaware does not require disclosure of all the extensive and
detailed information necessary for minority shareholders or their advisors to conduct an indepen-
dent valuation. Indeed, “Delaware law does not require stockholders be ‘given all the nancial data
they would need if they were making an independent determination of fair value’.”11 The Court
has said, “A disclosure that does not include all nancial data needed to make an independent
determination of fair value is not, however, per se misleading or omitting a material fact. The fact
that the nancial advisors may have considered certain non-disclosed information does not alter
this analysis.”12 It observes that a minority shareholder who believes the transaction is unfair and
wishes to conduct an independent valuation can undertake an appraisal action.13
2. Delaware Does Requires Summaries of Advisor’s Financial Analyses
The Delaware Courts recognize the materiality of substantiated valuations and the necessity of dis-
closure to minority shareholders of the important information in the nancial advisor’s analyses.14
Delaware requires that a detailed summary of the analyses underlying a fairness opinion be
included in the documents sent to shareholders. The Pure Resources decision stated:
[C]ourts must be candid in acknowledging that the disclosure of the banker’s “fairness opinion”
alone and without more, provides stockholders with nothing other than a conclusion, quali ed by
a gauze of protective language designed to insulate the banker from liability.
The real informative value of the banker’s work is not in its bottom-line conclusion, but in the
valuation analysis that buttresses that result. . . . [A] minority stockholder engaging in the before-
the-fact decision whether to tender would nd it material to know the basic valuation exercises that
[the investment banker] undertook, the key assumptions that they used in performing them, and
the range of values that were thereby generated.15
10 Pure Resources at 448-9, citing Zirn v. VLI Corp., 621 A.2d 773, 779 (Del. 1993).
11 Globis Partners, L.P. v. Plumtree Software, Inc., 2007 Del. Ch. LEXIS 169 (Nov. 30, 2007) at *45, citing Skeen v. Jo-Ann Stores,
Inc., 750 A.2d 1170, 1174 (Del. 2000).
12 In re General Motors (Hughes) Shareholder Litigation, 2005 Del. Ch. LEXIS 65 (May 4, 2005) at *65.
13 Recent cases in which the Court deemed the disclosures adequate and pointed out the appraisal option are In re 3Com
Shareholders Litigation, 2009 Del. Ch. LEXIS 215 (Dec. 19, 2009) at *21 and In re Cogent, Inc., Shareholder Litigation, 7 A.3d
487, 516 (Del. Ch. 2010).
14 As discussed below, the SEC also requires a summary of the fairness opinion analyses in going-private transactions.
15 Pure Resources at 449.
A 2010 decision similarly held, “[S]tockholders are entitled to a fair summary of the substantive
work performed by the investment bankers upon whose advice their board relied in reaching their
Although the summary must cover the various methods used by the nancial advisor, it does
not have to disclose whether or why the advisor’s analyses deviated from accepted practices or
from the Delaware standards for determining fair value.17 In addition, if the nancial advisor has
performed its DCF analysis based on its own projections, there is no requirement to disclose these
In practice, these summaries of investment banker analyses are often of limited value to
shareholders. The summaries give limited data such as ranges of value and the names of selected
guideline companies and guideline transactions without presenting data for these companies. The
summaries of DCF analyses give a range of value, discount rates, and the method of calculating
terminal value but often give no other data. It is our belief that these summaries are therefore of
limited value to shareholders. The Court should consider requiring that the valuation section of
the advisor’s presentation to the independent committee (which has to be led with the SEC) be
attached as an exhibit to the document sent to shareholders.
3. Summary of Management Projections Provided to Advisor Is Required
Delaware has ruled that a proxy statement should “give the stockholders the best estimate of the
company’s future cash ows as of the time the board approved the [transaction].”19 The Court said:
[S]tockholders must measure the relative attractiveness of retaining their shares versus receiving
a cash payment, a calculus heavily dependent on the stockholders’ assessment of the company’s
future cash ows. . . .
It would therefore seem to be a genuinely foolish . . . inconsistency to hold that the best estimate of
the company’s future returns, as generated by management and the Special Committee’s invest-
ment bank, need not be disclosed when stockholders are being advised to cash out. . . . Indeed,
projections of this sort are probably among the most highly-prized disclosures by investors. What
[investors] cannot hope to do is replicate management’s inside view of the company’s prospects.20
Nonetheless, even though a valuation analysis is heavily dependent upon the projections
utilized, the Delaware Courts permit summaries and do not require detailed management projec-
tions to be disclosed.
When the disclosed management projections included no more than revenues, gross margin,
operating pro t, and EPS, the Court determined that “full disclosure of the projections would [not]
alter the total mix of available information.”21 More recently, however, the Court in Maric Capital
ordered that projected free cash ow be included in the summarized projections,22 ruling that “man-
agement’s best estimate of the future cash ow . . . is clearly material information.”23 In a situation
16 Cogent at 511; see Pure Resources at 450.
17 3Com at *21.
18 Id. at *23.
19 David P. Simonetti Rollover IRA v. Margolis, 2008 Del. Ch. LEXIS 78 (June 27, 2008) at *30, citing In re Netsmart Technologies,
Inc. Shareholders Litigation, 924 A.2d 171, 203 (Del. Ch. 2007).
20 Netsmart at 203.
21 3Com at *7, fn. 11 and *10.
22 Maric Capital Master Fund, Ltd. v. Plato Learning, Inc., 2010 Del. Ch. LEXIS 115 (May 13, 2010) at *9.
23 Id. at *11.
where a company disclosed projections that the nancial advisor had not used, the Court required
that the projections relied on by the advisor also be disclosed.24
When projections were stale, the Court understandably ruled that no disclosure was required.25
Similarly, the Court also did not require disclosure of projections that it deemed incomplete because
they did not re ect known risks.26
In practice, the determination of what is material to the investor and important to the “total mix
of information” varies within the Court of Chancery. The recent Maric Capital decision (discussed
above) requiring the disclosure of projected free cash ow is a positive step for investors.
In our view, given the emphasis that the Delaware Courts have placed on DCF analyses in
valuation cases,27 more detailed management projections should be disclosed.
C. Delaware Requires that Financial Advisor’s Con icts Be Disclosed
“[C]on icts of interest must be disclosed [whether or not] there is evidence that the nancial
advisor’s opinion was actually affected by the con ict.”28 When an advisor had previously worked
for the buyer, the Court criticized a proxy statement because it did not disclose “how much [the
investment bank] was paid, whether it would have received the same payment even if it was unable
to render a fairness opinion . . . or how much [it] has earned in recent periods from . . . members of
the buyer group.”29 In a situation where the investment bank rendering a fairness opinion bene ted
from its ownership of securities, the Court ruled that the bank’s entire bene t, including bene ts as
a debtholder and warrantholder, must be disclosed.30
The Court recognizes the con ict raised by contingent fees, stating that “the contingent nature
of an investment banker’s fee can be material and have actual signi cance to a shareholder relying
on the banker’s stated opinion.”31
The Court also recognizes that projections prepared by a party with an interest in the transac-
tion may be biased. It rejected a valuation based on projections prepared by an of cer who bought
a business from a company.32
24 Netsmart at 200.
25 In Re PNB Holding Co. Shareholders Litigation, 2006 Del. Ch. LEXIS 158 (Aug. 18, 2006) at *69-70. “[O]ur law has refused to
deem projections material unless the circumstances of their preparation support the conclusion that they are reliable enough to
aid the stockholders in making an informed judgment.” Id. at *60.
26 In re CheckFree Corporation Shareholders Litigation, 2007 Del. Ch. LEXIS 148 (Nov. 1, 2007) at *10-11.
27 See, e.g., Grimes v. Vitalink Comm. Corp., 1997 Del. Ch. LEXIS 124 (Aug. 26, 1997) at *3 (“[The] discounted cash ow model
[is] increasingly the model of choice for valuations in this Court.”); Gholl v. eMachines, Inc., 2004 Del. Ch. LEXIS 171 (July 7,
2004) at *20 (“This [DCF] method is widely accepted in the nancial community and has frequently been relied upon by this
Court in appraisal actions.”).
28 In re John Q. Hammons Hotels Inc. Shareholder Litigation, 2009 Del. Ch. LEXIS 174 (Oct. 2, 2009) at *56.
29 Ortsman v. Green, 2007 Del. Ch. LEXIS 29 (Feb. 28, 2007) at *4-5.
30 Simonetti at *26.
31 Louisiana Municipal Police Employees Retirement System v. Crawford, 918 A.2d 1172, 1191 (Del. Ch. 2007).
32 McPadden v. Sidhu, 964 A.2d 1262,1272 (Del. Ch. 2008).
D. Delaware Requires Independent Opinions in Af liated Party Transactions
Recent Delaware decisions have been critical of independent directors who engaged rms that
had recently advised the control shareholder or were otherwise con icted.33 The Court has stated
that independent committees should hire their own advisors, holding that where an independent
committee employed an advisor who had previously worked for the control party, the “con ict of
interest robs [the] fairness opinion of its value as an indicator of fairness.”34
Since the committee is responsible for negotiations with the control party, and the opinion-
giver may function as the committee’s de facto nancial advisor in connection with these negotia-
tions, the independence of the nancial advisor is particularly vital.
1. Advisor Should Structure Its Fee to Maintain Independence
Fairness opinion fees are often about 25% of the customary M&A advisory fee for a transaction of
the same size; however, most rms have a minimum fairness opinion fee. Assignments for inde-
pendent committees sometimes include advisory work and assistance in negotiations.
Furthermore, the committee may contract to pay an incremental fee contingent on the advisor
negotiating a higher price. This fee structure rewards the advisor for increasing the consideration
paid to minority shareholders. This structure is unlikely to be judicially criticized.
The credibility of an opinion is harmed if the advisor’s fee is substantially contingent on closing.
Moreover, the fee structure should not give the appearance of favoring a positive opinion. The
advisor’s engagement letter should provide that the fee is payable whether or not its opinion favors
the proposed transaction.35
E. Additional Criticisms by the Delaware Courts
The Court criticized opinions that are hastily rendered. In Weinberger, the seminal Delaware
valuation case, the Delaware Supreme Court discussed the “cursory preparation of the [investment
bank’s] fairness opinion” in ve days, but attributed the problem to the defendants, stating that “the
rush imposed on Lehman Brothers by Signal’s timetable contributed to the dif culties under which
this investment banking rm attempted to perform its responsibilities.”36 More recently, when a
fairness opinion was produced in a week, the Court derided the opinion as “pure window dressing
intended by defendants to justify the preordained result.”37
Also, the Court has faulted some opinions that considered what shareholders were receiving
but did not weigh what insiders were getting. When high-vote shares received a substantial premium
over low-vote shares, the advisor was faulted for failing to opine upon the relative consideration
to be received by shareholders in each class.38 In another case, the Court criticized the directors’
33 Finkelstein v. Liberty Digital, Inc., 2005 Del. Ch. LEXIS 53 (Apr. 25, 2005) at *64, fn. 39; Gesoff v. IIC Industries Inc., 902 A.
2d. 1130, 1150-1 (Del. Ch. 2006); In re Tele-Communications, Inc. Shareholders Litigation, 2005 Del. Ch LEXIS 2006 (Oct. 11,
2006) at *41.
34 Gesoff at 1150.
35 To demonstrate that the fee is not contingent on a favorable opinion, the engagement letter should contain language such as
“The fee for our opinion is $XXX,000, of which 50% shall be paid upon execution of this letter and 50% shall be paid at the time
we inform you that we are prepared to render our opinion.”
36 Weinberger v. UOP, Inc., 457 A.2d 701, 712 (Del. 1983).
37 In re Sunbelt Beverage Corp. Shareholder Litigation, 2010 Del Ch. LEXIS 1 (Jan. 5, 2010) at *19.
38 Tele-Communications at *55. See also Levco Alternative Fund Ltd. v. Reader’s Digest Association, Inc., 803 A.2d 428 (Del.
reliance on a fairness opinion regarding sale of a company that did not consider the concurrent sale
of a subsidiary to a major shareholder.39
Opinions normally address only the fairness of the consideration to be paid in a given transac-
tion. A transaction can be structurally unfair if certain inside shareholders are receiving materially
different consideration than the outside shareholders40 or if a class of securities is receiving unjus-
ti ably disproportionate consideration.41 An opinion that the consideration is fair is misleading if the
advisor has reason to believe that the transaction taken as a whole is not fair.
A. FINRA Rule 5150
The Financial Industry Regulatory Authority, Inc. (“FINRA”), the successor to the National
Association of Securities Dealers, Inc. (“NASD”), is a non-governmental self-regulatory organi-
zation that has regulatory oversight over all securities rms that do business with the public. It
regulates its members through the adoption and enforcement of rules and regulations governing
business conduct of member rms.
FINRA Rule 5150 (formerly Rule 2290) became effective in 2007. It set forth disclosure and
procedure standards applicable to all FINRA members who render fairness opinions. Although
these standards are not explicitly applicable to non-member rms, all practitioners would be well
advised to conform to them.
Rule 5150 requires that FINRA member rms have written procedures for approval of a
fairness opinion, as well as procedures for internal approval of a fairness opinion. When an internal
committee is used, the rm must have written procedures as to the process for selecting committee
members, the quali cations for persons on the internal committee, and provisions for review and
approval by persons not on the deal team. The committee can include someone on the deal team,
but the committee must have a “balanced review.”
Rule 5150 also sets forth speci c required disclosures that must be made when fairness
opinions are included in documents sent to public shareholders. The chart below shows the
required disclosures and the customary responses to these requirements.
Disclosures required by Rule 5150 Customary disclosures in practice
1. Whether the member has acted as advisor to
any party to the transaction.
1. Past engagements disclosed; hedged as to
future engagements.
2. Whether compensation is contingent upon
closing. (Amount does not necessarily have to
be disclosed.)
2. Whether compensation is contingent is
disclosed; compensation amount is often (but
not always) disclosed.
39 Alidina v. Corp., 2002 Del Ch. LEXIS 156 (Nov. 6, 2002) at *25.
40 Hammons at *55-56.
41 See Tele-Communications and Levco.
3. Any material relationships between the
member and any party to the transaction
(i) during the preceding two years or
(ii) mutually understood to be contemplated
3. Past relationships are disclosed; no disclosure
as to future relationships.
4. Whether an internal committee approved
fairness opinion.
4. Disclosed.
5. Whether the member has independently
veri ed any company-supplied information
that formed substantial basis for its opinion.
If so, describe the information veri ed. (When
no information is veri ed, a blanket statement
is suf cient.)
5. Blanket statement that no company-supplied
information has been veri ed by the advisor.
6. Whether the opinion expresses a view as to
the fairness of any compensation to of cers
and directors relative to the payment to public
6. No opinion is expressed as to the fairness of
compensation to any of cers or directors.
B. SEC Rule 13e-3 Fairness Opinion Disclosure Requirements
The SEC has established rules with respect to disclosure in going-private transactions.42 The
actual opinion letter and a summary of the fairness opinion analyses must be included in the
proxy statement or tender offer document (Form 14D-9) for the transaction. A description of the
substance of written and oral reports and opinions by the advisor must be included as well.
The summary of the analyses must include a discussion of each methodology used. Data
such as multiples used in guideline company and guideline transaction analyses and discount
rates used in DCF analyses are included. Any limitation imposed on the scope of the investigation
must be disclosed. In its comment letters to the company, the SEC often requests supplemental
information and may ask for additional disclosure.
Written reports supporting the opinion must be led as exhibits and must made available at the
company’s principal of ce for inspection or copying by a shareholder’s designated representative.
Companies sometimes make the advisor’s nal report publicly available.
Any material relationship between the advisor and the company and/or its af liates must be
disclosed. The SEC’s requirements are limited to disclosure; it does not require that the advisor be
42 For purposes of Rule 13e-3, going private transactions include any transaction which would cause a class of equity securities
to be delisted or to become eligible for termination of registration, or would cause the reporting obligations with respect to such
class to become eligible for termination. Other types of af liated party transactions are not subject to Rule 13e-3.
A. Methods for Determining Fairness
As any valuation professional would expect, most fairness opinions are based on three methods:
discounted cash ow, guideline companies, and guideline transactions (including control premiums).
These approaches are normally used unless relevant information, such as reasonable projections
or relevant guideline transactions, is not available.
Other approaches occasionally used include asset value, liquidation value, present value of a
projected future price, a leveraged buyout model, value available in a recapitalization, target prices
published by security analysts, a regression model, and industry-accepted rules of thumb (such as
value per ton of steel or per cable subscriber).
The frequently stated Delaware preference for discounted cash ow as a valuation meth-
odology makes the use of DCF mandatory whenever adequate projections are available. But
DCF should not be used as the sole approach; other methods should be used to corroborate the
About half of the published fairness opinions use a “premiums paid” analysis, which compares
the premium over market to be paid in the subject transaction to average premiums paid in other
The use of average premiums as a standard of fairness is conceptually wrong and statistically
awed. Historical premiums are a biased sample: they include only acquisitions of companies that
buyers view as undervalued and exclude companies viewed as overpriced. The premium paid is a
result, not a cause: each premium depends on speci c facts. Depending on a company’s value, a
small premium could be fair or a large premium could be unfair.
1. Price Less Than the Highest Bid Can Be Fair
Directors may choose, in their business judgment, to accept an offer whose value is certain rather
than a facially higher offer whose value is uncertain or conditional. For example, they may choose
to accept (i) a cash bid rather than a higher bid that is subject to anti-trust or other regulatory
approval and therefore has a risk of not closing; (ii) a cash bid rather than a bid in stock or debt
with a greater current market value; or (iii) a lower bid because of a perceived risk in the higher
bid’s nancing.
The nancial advisor is justi ed in providing a fairness opinion that the selected proposal is fair
after giving consideration to the facts and circumstances of the transaction.
2. The Need for Heightened Due Diligence in Af liated Party Transactions
The due diligence for preparing a fairness opinion in an af liated party transaction has to be
conducted with skepticism. The valuator should recognize that management may have an incentive
to prepare overly conservative projections. It is essential to review forecasts that had been made
43 In re Hanover Direct, Inc. Shareholders Litigation, 2010 Del. Ch. LEXIS 201 (Sept. 24, 2010) at *5-6. (“[T]here are commonly
accepted methodologies that a prudent expert should use in coordination with one another to demonstrate the reliability of its
valuation. If a discounted cash ow analysis reveals a valuation similar to a comparable companies or comparable transactions
analysis, I have more con dence that both analyses are accurately valuing a company.”)
prior to the gestation of the proposal. The valuator should also review information provided to
parties asked to assist in nancing, since projections given to nancing sources are less likely to
be low-balled.
B. Appraisal Standards Set a Floor for Fairness
In Delaware, all frozen-out shareholders are entitled to receive at least the “fair value” of their stock,
whether or not the structure of the transaction permits shareholders to use the appraisal remedy.44
In Delaware and in a majority of other states, minority discounts, discounts for lack of marketability,
and control premiums may not be considered when valuing shares in appraisal actions.
In arriving at a fairness opinion, the opinion-giver should consider the value of the minority
shares under the appraisal standard, because appraisal value in the relevant jurisdiction repre-
sents a oor value for fairness. A cash or cash-equivalent transaction should not be considered fair
if the consideration is below the price which the opinion-giver believes would likely be awarded in
an appraisal action.
C. The Lack of Industry Standards for Fairness Opinions
No professional investment banking or valuation organization has yet proposed standards for
fairness opinions. The SEC and FINRA rules do not address any standard that should be consid-
ered in determining the fairness of a transaction.
In practice, it is highly unlikely that any investment banking group would propose standards
without prodding from the SEC. Members of the academic community have made “ivory tower”
proposals involving such concepts as setting the methodology for determining discount rates and
prescribing the weighting to be given to different valuation methods. These proposals appear to be
As the courts review and critique fairness opinions, they contribute toward the evolution of
standards. Areas that the courts might conceivably address in the future include, among others,
the impact of disclaimers on the credibility of an opinion, improved descriptions of the nancial
advisor’s analyses, nancial advisors’ liability for questionable opinions, the impact on fairness of
factors in addition to the consideration paid, and whether opinions need to be updated.
About the Authors
Mr. Matthews is Chairman of Sutter Securities Incorporated in San Francisco and can be reached
at He previously was a Senior Managing Director of Bear Stearns in New York,
where, among other things, he was in charge of all fairness opinions for 25 years. He has super-
vised more than 200 fairness opinions in af liated party transactions. This article is an expanded
version of his presentation by at the ASA/CICBV Joint Advanced Business Valuation Conference in
Miami Beach on October 5, 2010. The italicized recommendations and comments are his.
Dr. Patterson is a consultant to Sutter Securities. She was an associate in litigation with Gibson,
Dunn & Crutcher, taught law-related courses at Brandeis University, University of California at
Santa Barbara, Mills College, and is a retired professor at San Francisco State University.
44 Metropolitan Life Insurance Co. v. Aramark Corp., 1998 Del. Ch. LEXIS 70 (Feb. 5, 1998) at *6.
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