Fairness Opinions in
Affiliated Party Transactions
Gilbert E. Matthews, CFA
2010 ASA/CICBV Joint Advanced
Business Valuation Conference
October 5, 2010
SUTTER SECURITIES GIL@SUTTERSF.COM
I. OVERVIEW: AFFILIATED PARTY
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What we will discuss (1)
•Affiliated party transactions (related party
transactions, non-arms' length transactions, etc.)
two-step freeze-outs (a tender offer followed by a
sale of certain parts of a business to insiders,
high-vote shares receiving greater consideration
than low-vote shares, and
insiders receiving different consideration than
What we will discuss (2)
•Affiliated party fairness opinion considerations:
Valuation methods used in fairness opinions.
•Same for affiliated and non-affiliated.
•FINRA Rule 5150 (formerly Rule 2290).
•SEC Rule 13e-3.
Lack of industry standards.
Fairness opinions routinely used
since Van Gorkom
•Delaware Supreme Court in Smith v. Van Gorkom, 488 A.2d 858
(Del. 1985) ruled that directors were grossly negligent in not
seeking a valuation study of company’s value.
•Although transaction price was substantially over market,
directors were held liable to plaintiffs for damages.
•The Court did not hold that directors must always obtain
outside valuation study.
•However, fairness opinion would have helped the directors
demonstrate that they had made an informed business
•In practice, since Van Gorkom, Boards have routinely requested
Affiliated party transactions
should have fairness opinions
•Although there is no regulatory or legal requirement
that directors must obtain a fairness opinion, in
practice, fairness opinions are almost always obtained
in affiliated party transactions.
Special Committees must explain why they support
an affiliated party transaction and whether they
obtained a fairness opinion.
Well-supported fairness opinions often assist
Judges are critical of opinions that are conflicted or
Purpose of fairness opinions
•Committees of independent directors usually request
fairness opinions to show they are acting for target
provide decision-makers with information
supporting their decisions, and
serve as evidence in litigation demonstrating that
decision-makers used reasonable business
What does “fairness” mean in a
•No court has yet defined it.
•Neither the SEC nor FINRA has defined it.
•The investment banking industry has established no
•Neither the ASA nor any other valuation industry
group has established “fairness” standards.
Minimum requirements for fairness
•My two minimum requirements :
the investor should be at least as well off after the
transaction as before it; and
if there is a valid superior alternative, the
transaction is not fair.
Fairness opinions have been
•Financial press, academia and courts have frequently criticized
•Principal criticisms of opinion-givers:
conflicted because a major portion of their fee is
predominantly contingent on closing,
biased because of past and potential future relations with
their analyses are manipulated to achieve a pre-determined
extensive use of disclaimers.
•Valuation analysis is subjective.
•Even in non-conflicted opinions, the quality of the analyses has
often been questioned.
II. INDEPENDENCE OF
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Affiliated party transactions should
have independent opinions
•Based on recent cases, Special Committees are
effectively required to engage independent opinion-
givers in public company transactions.
An exception: Delaware exempts short-form
mergers from a fairness requirement.
•Delaware courts are critical of independent directors
who engage firms that have recently advised the
The independent advisor’s role
•Affiliated party transactions may be subject to controller
opportunism or other conflicts.
•Thus, Special Committee should engage independent firm to
render fairness opinion.
conduct due diligence with skepticism,
beware of overly conservative management projections,
review forecasts prior to proposal, and
review any information provided to lenders.
•Opinion-giver also may be asked to:
act as Special Committee’s advisor for its negotiations with
consider possible alternatives.
Advisor should structure fee
to maintain independence
•Fairness opinion’s credibility is harmed if advisor's fee is
substantially contingent on closing.
Engagement letter should provide that fee is payable
whether or not opinion is positive.
•Fairness opinion fees are often about 25% of customary M&A
advisory fee for same-size transaction; however, most firms
have minimum fairness opinion fee.
•When advisory services are provided, a higher fee may be paid.
A Special Committee may contract to pay incremental fee
contingent on increased price.
Since this incremental fee structure rewards advisor for
increased price, it is unlikely to be judicially criticized.
III. VALUATION METHODS
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Principal valuation methods for
•Predictably, most fairness opinions for affiliated and
non-affiliated transactions are based on:
discounted cash flow,
guideline companies, and
•These methods are widely accepted.
•DCF is the method of choice for the Delaware Courts.
Methods occasionally used
Present value of projected future price
Leveraged buyout model
Value available in recapitalization
Target prices of security analysts
Rule of thumb (e.g., value per ton of steel)
Average premiums: a flawed method
•“Premiums paid” analysis compares premium over market
offered in subject transaction to average premiums paid in
Used in about half of published fairness opinions.
•Method is conceptually wrong and statistically flawed.
Historical premiums are biased sample: they include
only acquisitions of companies that buyers view as
undervalued and exclude companies viewed as
The premium paid in any transaction is a result, not a
cause: each premium depends on specific facts.
•In some cases, a small premium could be fair; in
others, a large premium could be unfair.
IV. AGENCY REGULATORY
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New procedure and disclosure
standards: FINRA Rule 5150
•FINRA Rule 2290 became effective in 2007 and was
renamed Rule 5150 in 2008.
•Applicable to all fairness opinions for public
companies issued by FINRA members.
•Not explicitly applicable to non-member firms, but
all practitioners should endeavor to conform to
Rule 5150: required procedures
•Written procedures for approval of a fairness opinion.
•Procedures as to when internal committee must
approve fairness opinion.
•When internal committee is used:
process for selecting committee members,
qualifications for persons on committee, and
review and approval by persons not on deal team.
•committee can include someone on deal team,
but committee must have “balanced review.”
Rule 5150: required disclosure
to public shareholders (1)
What is required
1. Whether member has acted as
financial advisor to any party to
2. Whether compensation is contingent
Amount does not necessarily have to
3. Any material relationships between
member and any party to the
transaction (i) during preceding two
years or (ii) mutually understood to
1. Past relations disclosed;
indefinite on future
2. Disclosed; amount of
compensation is often
3. Past relations disclosed;
indefinite on future
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Rule 5150: required disclosure
to public shareholders (2)
What is required
4. Whether internal committee approved
5. Whether member has independently
verified any company-supplied
information that formed substantial
basis for its opinion.
If so, describe information verified.
When no information verified,
blanket statement sufficient.
6. Whether opinion expresses view as to
fairness of any compensation to officers
and directors relative to payment to
5. No company-supplied
information verified by
6. No opinion as to the
fairness of compensation
to any officers or directors.
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SEC Rule 13e-3: affiliated party transaction
fairness opinion disclosure requirements
•Opinion letter and summary must be in proxy statement or tender offer
document (Form 14D9).
•Disclosure of advisor’s written and oral reports and opinions.
•Detailed description of the methods used:
discussion of each methodology used, and
data such as multiples, discount rates, etc.
•Any limitation on the scope of the investigation.
•SEC comment letters often request additional disclosure.
Underlying written report given to directors made available at
company's principal office for inspection or copying by a shareholder.
Report sometimes filed as exhibit to SEC filing.
•No SEC requirement that advisor be independent.
Any material relationship between advisor and issuer and/or its
affiliates must be disclosed.
V. JUDICIAL REQUIREMENTS
AND GUIDANCE – DELAWARE
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The Delaware Courts recognize the
importance of substantiated valuations
“The financial advisor’s opinion of financial fairness for a
proposed transaction is one of the most important process-based
underpinnings of a board's recommendation of a transaction to its
stockholders and, in turn, for the stockholders' decisions on the
appropriateness of the transaction. Thus, it is imperative for the
stockholders to be able to understand what factors might
influence the financial advisor’s analytical efforts."1
"The real informative value of the banker's work is not in its
bottom-line conclusion [of fairness], but in the valuation analysis
that buttresses that result.“2
"Shareholders are entitled to a fair summary of the substantive
work performed by the investment banks.“3
The Delaware Courts:
conflicts must be disclosed
"[C]onflicts of interest must be disclosed" whether or not "there is evidence that
the financial advisor’s opinion was actually affected by the conflict ."4
Conflicts concerning benefits and fees must be disclosed:
Investment banker’s entire benefit, including benefits as a debtholder and
warrantholder, must be disclosed.5
"The contingent nature of an investment banker's fee can be material and
have actual significance to a shareholder relying on the banker's stated
The Court has stated that Special Committees must hire their own advisors,
holding that, in a case where a Special Committee employed an advisor who had
worked for the control party, the "conflict of interest robs [the] fairness opinion
of its value as an indicator of fairness."7
The court rejected a valuation based on projections prepared by an officer who
bought a business from a company.8
The Delaware Courts: no requirement
of full disclosure of financial data
"Delaware law does not require stockholders be given
all the financial data they would need if they were
making an independent determination of fair value."9
"A disclosure that does not include all financial data
needed to make an independent determination of fair
value is not per se misleading or omitting a material
fact," even if the financial advisor had "considered
certain non-disclosed information."10
The Delaware Courts: decisions
requiring inclusion of projections
"[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 flows" and it would be wrong “to hold that
the best estimate of the company's future returns, as generated by management and
the Special Committee's investment bank, need not be disclosed when stockholders
are being advised to cash out. . . . What [investors] cannot hope to do is replicate
management's inside view of the company's prospects."11
The key assumptions made by a banker in formulating his opinion are of paramount
importance to the stockholders because any valuation analysis is heavily dependent
upon the projections utilized. A proxy statement should "give the stockholders the
best estimate of the company's future cash flows as of the time the board approved
The court has required the inclusion of projections relied on by the financial advisor
when other projections have been disclosed.13
The Delaware Courts:
decision holding the inclusion of
projections not to be required
The Court has declined to require the disclosure of projections
that it did not deem to be material information.14
•It is difficult to understand why management projections
should not be a required disclosure, given the emphasis that
the Delaware courts have placed on DCF analyses in valuation
cases, and their belief that a “fair summary of the substantive
work performed by the investment banks” be made available
to shareholders so that they may make an informed view.
The Delaware courts:
some other criticisms of opinions
•The court derided a fairness opinion produced in a week
as "pure window dressing intended by defendants to
justify the preordained result." 15
•When high-vote shares received a substantial premium
over low-vote shares, the advisor was faulted for
providing only separate analyses of the fairness of the
respective exchange ratios to each class, and failing to
opine upon the relative consideration.16
Impact of appraisal standards
•In Delaware, cashed-out shareholders are entitled to receive
at least the “fair value” of their stock, whether or not the
structure of the transaction permits use of the appraisal
Thus, a cash or cash-equivalent transaction should not be
considered fair if the consideration is below the price
which likely would be awarded in an appraisal action.
•In Delaware (and in a majority of other states), minority
discounts, and discounts for lack of marketability may not be
considered when valuing shares in appraisal actions.
•Control premiums are generally not applicable in appraisals,
but they are relevant in determining fairness.
Appraisal value is a floor for fairness.
VI. THE LACK OF STANDARDS
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Lack of industry standards
for fairness opinions
•Neither the SEC nor FINRA has proposed standards for fairness opinions.
•No professional investment banking or valuation organization has proposed
standards for fairness opinions.
It is unlikely that any investment banking group would propose standards
without prodding from the SEC.
•Members of the academic community have made "ivory tower" proposals
including such concepts as setting the methodology for determining discount
rates and prescribing the weighting to be given to different valuation methods.
•As the courts review and critique fairness opinions, they contribute toward the
evolution of standards.
•Areas that the courts might address in the future include, among others:
the impact of disclaimers on the credibility of an opinion,
improved descriptions of the financial advisor's analyses,
financial advisor's liability for questionable opinions,
the impact on fairness of factors other than consideration paid, and
the need to update opinions.
Impact on fairness of factors other
than consideration paid
•Opinions normally address the fairness of the
consideration to be paid in a given transaction.
•There are instances in which the consideration itself is fair
to non-control shareholders, but the transaction is
structurally unfair for other financial reasons, e.g., when
certain inside shareholders are receiving materially
different consideration than the outside shareholders.
•For example, Delaware courts have been critical of
transactions in which holders of high-vote shares received
greater consideration than holders of low-vote shares.17
•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.
Opinions in affiliated party
transactions should be updated
•No regulation or judicial decision has yet directly addressed the issue of
a fairness opinion that has become unfair due to subsequent events
prior to closing.
•Special Committees would be better protected, and shareholders would
be better informed, if a fairness opinion was updated shortly prior to
mailing of a proxy statement.
•The Delaware court has stated:
The financial advisor's opinion of financial fairness for a proposed
transaction is one of the most important process-based underpinnings of a
board's recommendation of a transaction to its stockholders and, in turn,
for the stockholders' decisions on the appropriateness of the transaction.18
•If a fairness opinion is no longer valid, the proxy statement becomes
•If a material change in market conditions or in factors intrinsic to the
target company take place after a fairness opinion has been rendered,
the issuer of the opinion should consider whether or not its opinion is
still valid and, if appropriate, withdraw its opinion.
1David P Simonetti Rollover IRA v. Margolis, 2008 Del. Ch. LEXIS 78 (June 27, 2008) at *25.
2Id. at *30, citing In re Pure Resources, Inc. Shareholders Litigation, 808 A.2d 421, 449 (Del. Ch. 2002).
3In re CheckFree Corporation Shareholders Litigation, 2007 Del. Ch. LEXIS 148 (Nov. 1, 2007) at *29-30, citing In re
Pure Resources at 449.
4In re John Q. Hammons Hotels Inc. Shareholder Litigation, 2009 Del. Ch. LEXIS 174 (Oct. 2, 2009) at *56.
5Simonetti at *26.
6 Louisiana Municipal Police Employees Retirement System v. Crawford, 918 A.2d 1172, 1191 (Del. Ch. 2007).
7Gesoff v. IIC Industries Inc., 902 A. 2d. 1130, 1150 (Del. Ch. 2006).
8McPadden v. Sidhu, 964 A.2d 1262,1272 (Del. Ch. 2008).
9 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).
10 CheckFree at *8, citing In re General Motors (Hughes) Shareholder Litigation, 2005 Del. Ch. LEXIS 65 (May 4, 2005) at
11 E.g., In re Netsmart Technologies, Inc. Shareholders Litigation, 924 A.2d 171, 203 (Del. Ch. 2007).
12 Simonetti at *30, citing Netsmart at 203.
13 Netsmart at 200.
14 E.g., Checkfree at *11.
15 In re Sunbelt Beverage Corp. Shareholder Litigation, 2010 Del Ch. LEXIS 1 (Jan. 5, 2010) at *19.
16 In re Tele-Communications, Inc. Shareholders Litigation, 2005 Del. Ch LEXIS 2006 (Oct. 11, 2006) at *55. See also
Levco Alternative Fund Ltd. v. Reader's Digest Association, Inc., 803 A.2d 428 (Del. 2002).
17 See Hammons, Tele-Communications and Levco.
18 Simonetti at *25.