ArticlePDF Available

Fairness Opinions in Affiliated Party Transactions

Authors:
  • Sutter Securities Financial Services, San Francisco

Abstract

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.
BVResources.com
From the developers of Pratt’s Stats®
Timely news, analysis, and resources for defensible valuations Vol. 17, Nos. 3-4 , March-April 2011
Business
Va
luation
update
Reprinted with permissions from Business Valuation Resources, LLC
•transactionsinwhichhigh-voteshares
receivegreaterconsiderationthanlow-vote
shares;and
•transactionsinwhichinsidersreceivediffer-
entconsiderationfromothershareholders.
A. What Do Fairness Opinions Address?
Afairnessopinionisa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responsi-
blefordeterminingwhethertheproposedtransac-
tionshouldberecommendedonbehalfofthese
constituents.Fairnessopinionsarenormallypre-
pared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conclu-
sion,supported byitsanalyses that the nan-
cial terms ofaproposedtransactionfallwithin
arangeto whichthe parties might reasonably
agree.Theopinionlettersetsforththeassump-
tions,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 considerationto
currentnancialdataandexpectedfutureresults.
Unlikeavaluation, afairnessopiniondoesnot
Gilbert E. Matthews, CFA, and
Michelle Patterson, J.D., Ph.D.
I. Introduction
Thisarticlediscussesfairnessopinionsinafli-
atedpartytransactionsandfocusesonthefollow-
ingtopics:whatfairnessopinionsaddress,what
“fairness”means,criticismoffairnessopinions,
Delawarelaw’simpactontheircontentanduse,
FINR A and SEC requirements, and valuation
methodsemployed.
Ourrecommendations and comments are itali-
cized and placed in a paragraph under the rel-
evant text.
Affiliated par ty transactions, also known as
relatedpartytransactionsandnon-arms’-length
transactions,includethefollowing:
•going-privatetransactionsthroughanegoti-
atedmerger(one-stepfreeze-outs);
•going-privatetransactionsthroughatwo-step
transaction(two-stepfreeze-outs—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busi-
nesstoinsiders;
Fairness Opinions in Afliated Party Transactions
2 BusinessValuationUpdate March-April2011
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from
Business Valuation Resources, LLC
ExecutiveEditor: JanDavis
LegalEditor: SherryeHenryJr.
CEO,Publisher: DavidFoster
ManagingEditor: JanicePrescott
ContributingEditors: AdamManson,
VanessaPancic,DougTwitchell
Graphic&TechnicalDesigner: PaulErdman
CustomerService: StephanieCrader
SalesandSiteLicenses: LindaMendenhall
President: LucretiaLyons
EditorialAdvisoryBoard
Business Valuation Update (ISSN1088-4882)ispublishedmonthly byBusiness
ValuationResources,LLC,1000 SWBroadway,Suite1200,Portland,OR,97205-
3035.PeriodicalsPostagePaidatPortland,OR,andatadditionalmailingofces.
Postmaster:SendaddresschangestoBusiness Valuation Update™,Business
ValuationResources,LLC,1000SWBroadway,Suite1200,Portland,OR,97205-3035.
TheannualsubscriptionpricefortheBusiness Valuation Update™is$359.Low
cost sitelicensesareavailableforthosewishingtodistributetheBVUtotheircol-
leaguesatthesameaddress.Contactoursalesdepartmentfordetails.Pleasefeel
free tocontactusviaemailatcustomerservice@BVResources.com,viaphoneat
503-291-7963,viafaxat503-291-7955orvisitourwebsiteatBVResources.com.
Editorialandsubscriptionrequestsmaybemadeviaemail,mail,faxorphone.
PleasenotethatbysubmittingmaterialtoBVU,youaregrantingpermissionforthe
newslettertorepublishyourmaterialinelectronicform.
Althoughtheinformationinthisnewsletterhasbeenobtainedfromsourcesthat
BVRbelievestobereliable,wedonotguaranteeitsaccuracy,andsuchinformation
maybecondensedorincomplete.Thisnewsletterisintendedforinformationpur-
posesonly,anditisnotintendedasnancial,investment,legal,orconsultingadvice.
Copyright 2010, Business Valuation Resources, LLC (BVR).Allrightsreserved.No
partofthisnewslettermaybereproducedwithoutexpresswrittenconsentfromBVR.
Business Valuation update
JAMES S. RIGBY, ASA, CPA/ABV
IN MEMORIAM (1946 – 2009)
NEIL J. BEATON
CPA/ABV, CFA, ASA
GRANT THORNTON
SEATTLE, WASH.
JOHN A. BOGDANSKI, ESQ.
LEWIS & CLARK
LAW SCHOOL
PORTLAND, ORE.
NANCY J. FANNON
ASA, CPA/ABV, MCBA
FANNON VALUATION GROUP
PORTLAND, ME.
JAY E. FISHMAN
FASA, CBA
FINANCIAL RESEARCH
ASSOCIATES
BALA CYNWYD, PA.
LYNNE Z. GOLD-BIKIN, ESQ.
WOLF, BLOCK, SCHORR
& SOLIS-COHEN
NORRISTOWN, PA.
LANCE S. HALL, ASA
FMV OPINIONS
IRVINE, CALIF.
JAMES R. HITCHNER
CPA/ABV, ASA
THE FINANCIAL
VALUATION GROUP
ATLANTA, GA.
JARED KAPLAN, ESQ.
MCDERMOTT, WILL & EMERY
CHICAGO, ILL.
GILBERT E. MATTHEWS CFA
SUTTER SECURITIES
INCORPORATED
SAN FRANCISCO, CALIF.
Z. CHRISTOPHER MERCER
ASA, CFA
MERCER CAPITAL
MEMPHIS, TENN.
JOHN W. PORTER
BAKER & BOTTS
HOUSTON, TX.
RONALD L. SEIGNEUR
MBA CPA/ABV CVA
SEIGNEUR GUSTAFSON
LAKEWOOD, COLO.
BRUCE SILVERSTEIN, ESQ.
YOUNG, CONAWAY, STARGATT
& TAYLOR
WILMINGTON, DEL.
JEFFREY S. TARBELL
ASA, CFA
HOULIHAN LOKEY
SAN FRANCISCO, CALIF.
GARY R. TRUGMAN
ASA, CPA/ABV, MCBA, MVS
TRUGMAN VALUATION
ASSOCIATES
PLANTATION, FLA.
KEVIN R. YEANOPLOS
CPA/ABV/CFF, ASA
BRUEGGEMAN & JOHNSON
YEANOPLOS, P.C.
TUCSON, ARIZ.
determineaspecicdollarvalueofacompany,
but instead determines whether theproposed
transactionisnanciallyfairbasedontheterms
ofthetransactionandonmarketconditionsatthe
dateoftheopinion.
Itis importanttonotethatevenifa proposed
tra nsact ion is  deeme d fair, it  does n ot mea n
thattheproposal mustbeaccepted.Directors
mayexercisetheirbusinessjudgmenttoreject
a proposed transaction even if the consid-
eration offered is fair.  Furthermore, a fair-
nessopinionisnotarecommendationthatthe
parties enter into a transaction; it merely pro-
vides abasisfor decision-making and is only
one ofthefactors 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 inthe
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acquirer;
•anappearancethatanalysesaremanipu-
latedtoachieveapredeterminedresult;and
•theextensiveuseofdisclaimersinthe
opinionletter.
1 See,e.g.,AndrewR.Sorkin,“Mergers:FairShouldBe
Fair,”New York Times,March25,2005.
2 See,e.g.,StevenM.Davidoff,“FairnessOpinions,”55
Am.U.L.Rev.1557(2006).
March-April2011 BusinessValuationUpdate 3
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
D. Fairness Opinions in Afliated
Party Transactions
Bytheirnature,goingprivateandotherafliated
party transactionsmay be subject to control-
leropportunism.Inthesetransactions,apublic
company’sboard ofdirectors usuallyappoints
an independent commit tee that engages an
independentrmtorenderafairnessopinion.3
Theopinionreport,withitsnancialanalyses,is
deemedtoprovideevidencethattheduciaries’
approvalisbasedonconsiderationofthetrans-
action’sbenetfortheminorityshareholders.A
fairnessopinionprovidesdecision-makerswith
informationthatmayaffecttheirdecision,andit
conrmsinlitigationthatthey usedreasonable
businessjudgmentinapprovingthetransaction.
Also,summariesofthenancialanalysesunder-
lyingtheopinionareprovidedtominorityshare-
holdersintheproxystatementortenderoffer.
II. Delaware’s Inuence on Fairness
Opinions in Afliated Party Transactions
TheDelawarecourtshaveeffectivelysetthestan-
dards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 Freeze-outs
Del aware r equires that when  a free ze-out  is
proposed,theindependentcommittee mustbe
giventheabilitytohireitsownindependentnan-
cialand legaladvisorsand begivensufcient
timetoreact. Moreover,theshareholdersmust
begivenadequatesummariesoftheadvisor’s
analysestoenabletheshareholderstomakean
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consummatea
“short-form”mergerwithoutashareholdervote.The
shareholders’onlyremedyisappraisal.
informedjudgment4.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freeze-outsbut spelledout
aswellthatunlesstheindependentcommittee
afrmativelyrecommendsthetransactionbased
onitsnancialadvisor’sopinion,thecourtwill
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posi-
tiverecommendationtotheminorityshareholders
basedonit,arosefromfreeze-outtransactions.
Althoughthesedecisionsaddressfreeze-outs,we
believethatthereasoningthatrequiresaninde-
pendent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
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)2010Del.Ch.LEXIS
119(May25,2010)at*39-41.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*46-50.
4 BusinessValuationUpdate March-April2011
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
fullyandfairlyallmaterialinformationwithinthe
board’scontrol.8
Thekeydeterminantastoinformationthatmust
bedisclosediswhetherthatinformationismate-
rialtotheminorityshareholder.Ifthecourthas
decidedthatacertaintypeofinformation,such
asnancialanalyses, ismaterial 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substan-
tial likelihood that areasonable shareholder
wouldconsideritimportantindecidinghowto
vote.Putanotherway,theremustbeasubstan-
tiallikelihood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
Vice Chancellor Leo Str ine stated in Pure
Resources(2002)that the general legalstan-
dardsthatgovernplaintiffs’claimsfordisclosure
ofnancialinformationaresettled:
[S]tockholdersareentitledtodisclosureofall
material [emphasisadded]factspertinent to
thedecisionstheyarebeingaskedtomake....
[They]relyon those documentstoprovidethe
substantiveinformationonwhichstockholders
willbeasked 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
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).
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thecourts agreethatminorityshare-
hol ders m ust have  a basi s for un derst andin g
howtheboard came toitsdecision,Delaware
doesnotrequiredisclosureofalltheextensive
anddetailedinformationnecessaryforminority
shareholdersortheiradvisorstoconductaninde-
pendentvaluation.Indeed,“Delawarelawdoes
notrequirestockholdersbe‘givenallthenan-
cial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
misleadingor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share-
holder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
disclosuretominorityshareholdersoftheimpor-
tantinformationinthenancialadvisor’sanaly-
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disclo-
sures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),2010Del.Ch.LEXIS203(Oct.52010)at*73.
March-April2011 BusinessValuationUpdate 5
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
ses.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-lineconclusion,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
tha t [the  invest ment  banker ] unde rto ok, th e
keyassumptionsthat theyusedinperforming
them,andtherangeofvaluesthatwerethereby
generated.”15
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
recommendation.”16
Although thesummarymust coverthevarious
methodsusedby the nancialadvisor,itdoes
not havetodisclosewhetheror why the advi-
sor’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pro-
jections,thereisnorequirementtodisclosethese
projections.18
Inpractice,thesesummariesofinvestmentbanker
analysesareoftenoflimitedvaluetosharehold-
14 Asdiscussedbelow,theSECalsorequiresa
summaryofthefairnessopinionanalysesingoing-
privatetransactions.
15 Pure Resourcesat449.
16 Cogentat511*56;seePure Resourcesat450.
17 3Comat*21.
18 Id.at*23.
ers.Thesummaries give limiteddata such as
rangesofvalueandthenamesofselectedguide-
linecompaniesandguidelinetransactionswithout
presentingdataforthesecompanies.Thesum-
maries ofDCFanalysesgivearange of value,
discount rates, and themethod 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com-
mittee(whichhas tobeledwiththeSEC)be
attachedasanexhibitto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bestestimateofthe
company’sfuturecashows asofthetimethe
boardapprovedthe [transaction].”19 The court
said:
[S]tockhol der s 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
investmentbank,neednotbedisclosedwhen
stockholdersarebeingadvisedtocashout....
Indeed,projections of this sor tare probably
amongthe most highly-prizeddisclosures by
investors.What[investors]cannothopetodois
replicatemanagement’sinsideviewofthecom-
pany’sprospects.20
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.
6 BusinessValuationUpdate March-April2011
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
Nonetheless,eventhoughavaluationanalysisis
heavilydependentupontheprojectionsutilized,
theDelawarecourts permit summariesanddo
notrequiredetailedmanagementprojectionsto
bedisclosed.
When thedisclosed 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
rec ently, h owever, the cour t 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
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
Whenprojections were stale,the court under-
standably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.
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.
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stock-
holders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.
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]onfli cts of interest must be disc losed
[whetherornot]thereisevidencethatthenan-
cialadvisor’sopinionwas actually affectedby
theconict,”28 When anadvisorhad previously
workedforthebuyer,thecourtcriticizedaproxy
statementthat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invest-
ment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 warrant holde r,  must be
disclosed.30
Thecourtrecognizestheconictraisedbycon-
tingent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
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).
March-April2011 BusinessValuationUpdate 7
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
Thecourtalsorecognizesthatprojectionspre-
paredbyapartywithaninterestinthetransaction
maybebiased.Itrejectedavaluationbasedon
projectionspreparedbyanofcerwhoboughta
businessfromacompany.32
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.33Thecourthasstated
that independentcommitteesshould hire their
ownadvisors,holdingthatwhereanindependent
committeeemployedanadvisorwhohadprevi-
ously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 negotia-
tions with the control party, and the opinion-giver
may function as the committee’s de facto nancial
advisor in connection with these negotiations, the
independence of the nancial advisor is particu-
larly vital.
Advisor Should Structure Its Fee
to Maintain Independence
Fairnessopinion feesareoftenabout25%of
thecustomaryM&Aadvisoryfeeforatransac-
tionofthesamesize;however,mostrmshave
aminimumfairnessopinionfee.Assignmentsfor
independentcommitteessometimesincludeadvi-
soryworkandassistanceinnegotiations.
Furthermore,thecommitteemaycontracttopay
an incremental fee contingent on the advisor
32 McPadden v. Sidhu,964A.2d1262,1272(Del.Ch.
2008).
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.
neg otiati ng a hi gher p rice.  This f ee str uctur e
rewardstheadvisorforincreasingtheconsider-
ationpaidtominorityshareholders.Thisstructure
isunlikelytobejudiciallycriticized.
The credibility of an opinion is harmed if the advi-
sor’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  cour t cri ticiz ed opi nions that are h astily
rendered.InWeinberger,theseminalDelaware
valuationcase,theDelawareSupremeCourtdis-
cussedthe “cursory preparation ofthe[invest-
mentbank’s]fairnessopinion”invedays,but
attributedtheproblemtothedefendants,stating
that“therushimposedon LehmanBrothersby
Sig nal’s timetable  contributed t o the d ifficul-
ties underwhich thisinvestment bankingrm
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
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execu-
tion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.
8 BusinessValuationUpdate March-April2011
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
bereceivedbyshareholdersineachclass.38 In
another case,thecourtcriticizedthedirectors’
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 transaction.
A transaction can be structurally unfair if certain
inside shareholders are receiving materially differ-
ent consideration than the outside shareholders40
or if a class of securities is receiving unjusti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.
III. Governmental and Professional
Requirements for Fairness Opinions
A. FINRA Rule 5150
The  Financial I ndustry Regulator y Author ity,
Inc. (FINR A), the successor to the National
AssociationofSecuritiesDealersInc.(NASD),is
anon-governmentalself-regulatoryorganization
thathasregulatoryoversightoverallsecurities
rmsthatdobusinesswiththepublic.Itregulates
itsmembersthroughtheadoptionandenforce-
ment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proce-
durestandardsapplicabletoallFINRAmembers
who render fairness opinions.Althoughthese
standardsarenotexplicitly applicable to non-
member firms, all practitioners would be well
advisedtoconformtothem.
38 Tele-Communicationsat*55.SeealsoLevco
Alternative Fund Ltd. v. Reader’s Digest Association,
Inc.,803A.2d428(Del.2002).
39 Alidina v. Internet.com Corp.,2002DelCh.LEXIS156
(Nov.6,2002)at*25.
40 Hammonsat*55-56.
41 SeeTele-CommunicationsandLevco.
Rule 5150requires that FINRAmemberfirms
havewrittenprocedures for approvalof afair-
nessopinion,aswellasproceduresforinternal
approvalofafairnessopinion.Whenaninternal
committeeisused,thermmusthavewrittenpro-
ceduresastotheprocessforselectingcommit-
tee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.”
Disclosures required
by Rule 5150
Customar y disclosures
in practice
1.Whetherthemember
hasactedasadvisortoany
partytothetransaction.
1.Pastengagementsdis-
closed;hedgedastofuture
engagements.
2.Whethercompensation
iscontingentuponclosing.
(Amountdoesnotnecessar-
ilyhavetobedisclosed.)
2.Whethercompensation
iscontingentisdisclosed;
compensationamount
isoften(butnotalways)
disclosed.
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com-
mitteeapprovedfairness
opinion.
4.Disclosed.
5.Whetherthememberhas
independentlyveriedany
company-suppliedinforma-
tionthatformedsubstantial
basisforitsopinion.Ifso,
describetheinformation
veried.(Whennoinforma-
tionisveried,ablanket
statementissufcient.)
5.Blanketstatementthatno
company-suppliedinforma-
tionhasbeenveriedbythe
advisor.
6.Whethertheopinion
expressesaviewastothe
fairnessofanycompensa-
tiontoofcersanddirectors
relativetothepaymentto
publicshareholders.
6.Noopinionisexpressed
astothefairnessofcom-
pensationtoanyofcersor
directors.
March-April2011 BusinessValuationUpdate 9
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
Rule5150alsosetsforthspecicrequireddisclo-
suresthatmustbemadewhenfairnessopinions
areincludedindocumentssenttopublicshare-
holders.Thechartbelowshowstherequireddis-
closuresandthecustomaryresponsestothese
requirements.
B. SEC Rule 13e-3 Fairness Opinion
Disclosure Requirements
TheSEChas establishedruleswithrespectto
disclosureingoing-private transactions.42The
actualopinionletterandasummaryofthefair-
nessopinion analyses mustbeincluded inthe
proxy statement or tenderoffer document 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inDCF analysesareincluded. Any
limitation imposedon thescope ofthe investi-
gationmustbedisclosed.Initscommentletters
tothecompany,theSECoftenrequestssupple-
mentalinformationandmay ask foradditional
disclosure.
Writtenreportssupportingtheopinionmust be
fi led as exhi bits a nd must ma de avail able a t
thecompany’sprincipalofceforinspection or
copyingbyashareholder’sdesignatedrepresen-
tative.Companiessometimesmaketheadvisor’s
nalreportpubliclyavailable.
Any material relationship between the advisor
and thecompany and/or its afliates mustbe
disclosed.TheSEC’srequirementsarelimitedto
42 ForpurposesofRule13e-3,going-privatetransac-
tions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li-
atedpartytransactionsarenotsubjecttoRule13e-3.
disclosure;itdoesnotrequirethattheadvisorbe
independent.
IV. Fairness Opinions in Practice
A. Methods for Determining Fairness
Asanyvaluationprofessionalwouldexpect,most
fairnessopinionsarebased onthreemethods:
discountedcashow,guidelinecompanies,and
gui deline  trans actions  (includi ng con trol p re-
miums).These approachesarenormallyused
unlessrelevantinformation,suchasreasonable
projectionsorrelevantguidelinetransactions,is
notavailable.
Other  appro aches  occa sionally  used incl ude
asset value,liquidationvalue, presentvalueof
a pr oject ed fut ure pr ice, a  leveraged bu yout
model, value available in a rec apitalization,
targetpricespublishedbysecurity analysts,a
regressionmodel,and industry-acceptedrules
ofthumb(suchasvaluepertonofsteelorper
cablesubscriber).
The frequently stated Delaware preference for
discounted cash ow as a valuation methodol-
ogy makes the use of DCF mandatory when-
ever adequate projections are available. But
DCF should not be used as the sole approach;
other methods should be used to corroborate the
conclusion.43
Abouthalfofthepublishedfairnessopinionsuse
a“premiumspaid”analysis,whichcomparesthe
premiumovermarkettobepaid inthe subject
transactionto average premiumspaidinother
transactions.
43 In re Hanover Direct, Inc. Shareholders Litigation,
2010Del.Ch.LEXIS201(Sept.24,2020)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.”).
10 BusinessValuationUpdate March-April2011
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
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 compa-
nies 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.
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uncer-
tainorconditional.Forexample,theymaychoose
toaccept(i)acashbidratherthanahighercash
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.
Aftergivingconsiderationtothefactsandcircum-
stancesofthetransaction,thenancialadvisor
isjustiedinprovidingafairnessopinionthatthe
selectedproposalisfair.
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con-
ductedwithskepticism.Thevaluatorshouldrec-
ognizethatmanagementmayhaveanincentive
toprepareoverlyconservativeprojections.Itis
essentialtoreviewforecaststhathadbeenmade
priortothegestationoftheproposal.Thevalu-
atorshouldalso reviewinformationprovidedto
partiesaskedtoassistinnancing,sinceprojec-
tionsgiventonancingsourcesarelesslikelyto
below-balled.
B. Appraisal Standards Set a Floor for Fairness
In D elawar e, all fro zen- out share holde rs are
entitledtoreceiveatleastthe“fairvalue”oftheir
stock,whetheror notthestructureofthetrans-
action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
co nsider ed whe n valui ng sha res in a pprai sal
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 represents a
oorvaluefor fairness.Acashorcash-equiv-
alenttransactionshouldnotbeconsideredfair
iftheconsiderationisbelowthepricethat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fair-
nessopinions.TheSECandFINRArulesdonot
addressanystandardthatshouldbeconsidered
indeterminingthefairnessofatransaction.
Inpractice,it ishighlyunlikelythatanyinvest-
ment bankinggroup wouldproposestandards
withoutproddingfromtheSEC.Membersofthe
academiccommunityhavemadeivorytower”
proposalsinvolvingsuchconceptsassettingthe
methodologyfordeterminingdiscountratesand
prescribingtheweightingtobegiventodifferent
valuationmethods.These proposalsappearto
beimpractical.
Asthecourtsreviewandcritiquefairnessopin-
ions,theycontributetowardtheevolutionofstan-
dards.Areasthatthe courtsmightconceivably
add ress i n the f uture i nclud e, amo ng othe rs,
theimpactofdisclaimersonthecredibilityofan
opinion, improveddescriptionsofthenancial
advisor’sanalyses,nancialadvisors’liabilityfor
44 Reis v. Hazelett Strip-Casting Corp.,Del.Ch.LEXIS
11(Jan.21,2011)at*33,citingMetropolitan Life
Insurance Co. v. Aramark Corp.,1998Del.Ch.LEXIS
70(Feb.5,1998)at*6.
March-April2011 BusinessValuationUpdate 11
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
questionableopinions,theimpactonfairnessof
factorsinadditiontotheconsiderationpaid,and
whetheropinionsneedtobeupdated.
Gil Matthews, chairman of Sutter Securities Inc.,
San Francisco, can be reached at gil@suttersf.
com. As a senior managing director of Bear
Stearns, New York, he was in charge of fairness
opinions for 25 years. This article is an expanded
version of his presentation at the ASA/CICBV
Joint Advanced Business Valuation Conference,
Miami Beach, Oct. 5, 2010.
Michelle Patterson, J.D., Ph.D., is a consul-
tant to Sutter Securities. She was an associate
in litigation with Gibson, Dunn & Crutcher, and
has taught at Brandeis, UC Santa Barbara, Mills
College, and San Francisco State University.
ResearchGate has not been able to resolve any citations for this publication.
ResearchGate has not been able to resolve any references for this publication.