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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
•transactionsinwhichhigh-voteshares
receivegreaterconsiderationthanlow-vote
shares;and
•transactionsinwhichinsidersreceivediffer-
entconsiderationfromothershareholders.
A. What Do Fairness Opinions Address?
Afairnessopinionisaletter reportthatstates
whetherornotatransaction,ortheconsideration
paidinatransaction,isfairfromanancialpoint
ofviewtoagroupofconstituentsasofaspecic
date.Itisaddressedtotheduciariesresponsi-
blefordeterminingwhethertheproposedtransac-
tionshouldberecommendedonbehalfofthese
constituents.Fairnessopinionsarenormallypre-
paredbyaknowledgeablenancialadvisoryrm,
generallyaninvestingbankingrmoravaluation
rm.Anopinionoffairness fromanancialpoint
ofviewexpressesthenancialadvisor’sconclu-
sion,supported byitsanalyses that the nan-
cial terms ofaproposedtransactionfallwithin
arangeto whichthe parties might reasonably
agree.Theopinionlettersetsforththeassump-
tions,limitationsandproceduresrelevanttothe
conclusion.
B. What is Financial ‘Fairness’?
Adeterminationofnancialfairnessweighswhat
isbeinggivenupagainstwhatisbeingreceived
inaparticulartransaction.Thenancialadvisor
determinesarangeofvaluesbasedonvarious
valuation approaches,giving considerationto
currentnancialdataandexpectedfutureresults.
Unlikeavaluation, afairnessopiniondoesnot
Gilbert E. Matthews, CFA, and
Michelle Patterson, J.D., Ph.D.
I. Introduction
Thisarticlediscussesfairnessopinionsinafli-
atedpartytransactionsandfocusesonthefollow-
ingtopics:whatfairnessopinionsaddress,what
“fairness”means,criticismoffairnessopinions,
Delawarelaw’simpactontheircontentanduse,
FINR A and SEC requirements, and valuation
methodsemployed.
Ourrecommendations and comments are itali-
cized and placed in a paragraph under the rel-
evant text.
Affiliated par ty transactions, also known as
relatedpartytransactionsandnon-arms’-length
transactions,includethefollowing:
•going-privatetransactionsthroughanegoti-
atedmerger(one-stepfreeze-outs);
•going-privatetransactionsthroughatwo-step
transaction(two-stepfreeze-outs—atender
offerfollowedbyashort-formmerger);
•goingprivatethroughareversestocksplit;
•leveragedbuyoutswithmanagement
participation;
•recapitalizations;
•materialsalesofparticularpartsofabusi-
nesstoinsiders;
Fairness Opinions in Afliated Party Transactions
2 BusinessValuationUpdate March-April2011
FairnessOpinionsInAfliatedPartyTransactions
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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.
determineaspecicdollarvalueofacompany,
but instead determines whether theproposed
transactionisnanciallyfairbasedontheterms
ofthetransactionandonmarketconditionsatthe
dateoftheopinion.
Itis importanttonotethatevenifa proposed
tra nsact ion is deeme d fair, it does n ot mea n
thattheproposal mustbeaccepted.Directors
mayexercisetheirbusinessjudgmenttoreject
a proposed transaction even if the consid-
eration offered is fair. Furthermore, a fair-
nessopinionisnotarecommendationthatthe
parties enter into a transaction; it merely pro-
vides abasisfor decision-making and is only
one ofthefactors the decision-makersshould
consider.
C. The Widespread Criticism of Fairness Opinions
Therehavebeenextensivecriticismsoffairness
opinions in afliated party transactions inthe
nancialpress,1inacademicarticles,2andinthe
courts.Thefactthatfairnessopinionsareneces-
sarilysubjectivecanleadtodifferentviews,and
thequalityoftheanalyseshasoftenbeenques-
tioned.Thecriticisms,however,godeeper.The
principalcriticismsaddress:
•opinionsthatareconictedbecauseamajor
portionofthefeeiscontingentonclosing;
•perceivedbiasbecauseofpastandpotential
futurerelationsbetweentheopinion-giver
andtheacquirer;
•anappearancethatanalysesaremanipu-
latedtoachieveapredeterminedresult;and
•theextensiveuseofdisclaimersinthe
opinionletter.
1 See,e.g.,AndrewR.Sorkin,“Mergers:FairShouldBe
Fair,”New York Times,March25,2005.
2 See,e.g.,StevenM.Davidoff,“FairnessOpinions,”55
Am.U.L.Rev.1557(2006).
March-April2011 BusinessValuationUpdate 3
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
D. Fairness Opinions in Afliated
Party Transactions
Bytheirnature,goingprivateandotherafliated
party transactionsmay be subject to control-
leropportunism.Inthesetransactions,apublic
company’sboard ofdirectors usuallyappoints
an independent commit tee that engages an
independentrmtorenderafairnessopinion.3
Theopinionreport,withitsnancialanalyses,is
deemedtoprovideevidencethattheduciaries’
approvalisbasedonconsiderationofthetrans-
action’sbenetfortheminorityshareholders.A
fairnessopinionprovidesdecision-makerswith
informationthatmayaffecttheirdecision,andit
conrmsinlitigationthatthey usedreasonable
businessjudgmentinapprovingthetransaction.
Also,summariesofthenancialanalysesunder-
lyingtheopinionareprovidedtominorityshare-
holdersintheproxystatementortenderoffer.
II. Delaware’s Inuence on Fairness
Opinions in Afliated Party Transactions
TheDelawarecourtshaveeffectivelysetthestan-
dardsforreviewingfairnessofcorporateafliated
partydisputes.Delawarecorporatelawiswidely
accepted,andamajorityoflistedcompaniesare
incorporatedinDelaware.
A. Delaware Requires Financial
Advisors for Freeze-outs
Del aware r equires that when a free ze-out is
proposed,theindependentcommittee mustbe
giventheabilitytohireitsownindependentnan-
cialand legaladvisorsand begivensufcient
timetoreact. Moreover,theshareholdersmust
begivenadequatesummariesoftheadvisor’s
analysestoenabletheshareholderstomakean
3 Thereisoneexception:Delawareexemptsshort-form
mergersfromafairnessrequirement(Glassman v.
Unocal Exploration Corp.,777A.2d242(Del.2000)).
UnderDelawarelaw,acontrollerwhoownsatleast
90%ofeachclassofstockmayconsummatea
“short-form”mergerwithoutashareholdervote.The
shareholders’onlyremedyisappraisal.
informedjudgment4.Althougha2000Delaware
decisionheldthat“fairnessopinions...arenot
generallyessentialasamatteroflaw,tosupport
aninformedbusinessjudgment,”5laterdecisions
begantocallforthem.6A2010decisiononthis
issue,CNX Gas,notonlyeffectively mandated
fairnessopinionsinfreeze-outsbut spelledout
aswellthatunlesstheindependentcommittee
afrmativelyrecommendsthetransactionbased
onitsnancialadvisor’sopinion,thecourtwill
subject the transaction to a strict standard of
scrutiny(“entirefairness”review)ratherthanthe
morelenient“businessjudgment”review.7
Thefairnessopinionrequirement,alongwiththe
necessityoftheindependentcommittee’sposi-
tiverecommendationtotheminorityshareholders
basedonit,arosefromfreeze-outtransactions.
Althoughthesedecisionsaddressfreeze-outs,we
believethatthereasoningthatrequiresaninde-
pendentnancialvaluationaswellasapositive
recommendationcouldbeexpandedinthefuture
toothertypesofafliatedpartytransactions.
B. Delaware Disclosure Requirements
ThegeneralruleinDelawaretodayisbasedon
thecourt’sinsistencethatshareholdersreceive
informationthatenablesthemtounderstandthe
basisoftheindependentcommittee’srecommen-
dationsothattheycandecideontheircourseof
action.Directorshave“aduciarydutytodisclose
4 In re Pure Resources, Inc. Shareholder Litigation,
808A.2d421,445(Del.Ch.2002).
5 Crescent/Mach I Partners v. Turner,846A.2d963,
984(DelCh.2000),citing Smith v. Van Gorkom,488
A.2d858,876(Del.1985).
6 SeePure Resourcesat445,In re Cox
Communications, Inc. Shareholder Litigation,879
A.2d604,624(Del.Ch.2005).
7 In re CNX Gas Corporation Shareholder Litigation,4
A.3d397,412-3(Del.Ch.2010)2010Del.Ch.LEXIS
119(May25,2010)at*39-41.TheCourtalsoruled
thatthecommitteebeempoweredtoelecttotake
appropriatedefensivemeasures,suchasa“poison
pill.”Id.at414-5*46-50.
4 BusinessValuationUpdate March-April2011
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
fullyandfairlyallmaterialinformationwithinthe
board’scontrol.”8
Thekeydeterminantastoinformationthatmust
bedisclosediswhetherthatinformationismate-
rialtotheminorityshareholder.Ifthecourthas
decidedthatacertaintypeofinformation,such
asnancialanalyses, ismaterial inthesubject
case,disclosureisrequired.TheU.S.Supreme
Courtin1976setforththe“materiality”standard
thatisstillinforce:
Anomittedfactismaterialifthereisasubstan-
tial likelihood that areasonable shareholder
wouldconsideritimportantindecidinghowto
vote.Putanotherway,theremustbeasubstan-
tiallikelihoodthatthedisclosureoftheomitted
factwouldhavebeenviewedbythereasonable
investorashavingsignicantlyalteredthe“total
mix”ofinformationmadeavailable.9
Vice Chancellor Leo Str ine stated in Pure
Resources(2002)that the general legalstan-
dardsthatgovernplaintiffs’claimsfordisclosure
ofnancialinformationaresettled:
[S]tockholdersareentitledtodisclosureofall
material [emphasisadded]factspertinent to
thedecisionstheyarebeingaskedtomake....
[They]relyon those documentstoprovidethe
substantiveinformationonwhichstockholders
willbeasked to base their decision whether
toacceptthemergerconsiderationortoseek
appraisal.
Asaresult,itistheinformationthatismaterial
[emphasisadded]tothesevariouschoicesthat
mustbedisclosed.Inotherwords,theS-4and
the14D-9mustcontaintheinformationthat“a
reasonableinvestor wouldconsiderimportant
intenderinghisstock,”includingtheinformation
8 Gantler v. Stevens,965A.2d695,710(Del.2009),
citingStroud v. Grace,606A.2d75,84(Del.1992).
9 TSC Industries, Inc. v. Northway, Inc.,426U.S.438,
449(1976).
necessarytomakeareasoneddecisionwhether
toseekappraisal.10
1. Delaware Does Not Require Disclosure
of Data Sufcient for Independent
Determination of Fair Value
Althoughthecourts agreethatminorityshare-
hol ders m ust have a basi s for un derst andin g
howtheboard came toitsdecision,Delaware
doesnotrequiredisclosureofalltheextensive
anddetailedinformationnecessaryforminority
shareholdersortheiradvisorstoconductaninde-
pendentvaluation.Indeed,“Delawarelawdoes
notrequirestockholdersbe‘givenallthenan-
cialdatatheywouldneediftheyweremakingan
independentdeterminationoffair value.’”11The
courthassaid,“Adisclosurethatdoesnotinclude
allnancialdataneededtomakeanindependent
determinationoffairvalueisnot,however,perse
misleadingoromittingamaterialfact.Thefact
thatthenancialadvisorsmayhaveconsidered
certainnon-disclosedinformationdoesnotalter
thisanalysis.”12Itobservesthataminorityshare-
holderwhobelievesthetransactionisunfairand
wishestoconductanindependentvaluationcan
undertakeanappraisalaction.13
2. Delaware Does Requires Summaries
of Advisor’s Financial Analyses
TheDelaware courts recognizethemateriality
ofsubstantiatedvaluationsandthenecessityof
disclosuretominorityshareholdersoftheimpor-
tantinformationinthenancialadvisor’sanaly-
10 Pure Resources at 448-9,citingZirn v. VLI Corp.,621
A.2d773,779(Del.1993).
11 Globis Partners, L.P. v. Plumtree Software, Inc.,2007
Del.Ch.LEXIS169(Nov.30,2007)at*45,citing
Skeen v. Jo-Ann Stores, Inc.,750A.2d1170,1174
(Del.2000).
12 In re General Motors (Hughes) Shareholder Litigation,
2005Del.Ch.LEXIS65(May4,2005)at*65.
13 RecentcasesinwhichtheCourtdeemedthedisclo-
suresadequateandpointedouttheappraisaloption
areIn re 3Com Shareholders Litigation,2009Del.Ch.
LEXIS215(Dec.19,2009)at*21andIn re Cogent,
Inc., Shareholder Litigation,7A.3d487,516(Del.Ch.
2010),2010Del.Ch.LEXIS203(Oct.52010)at*73.
March-April2011 BusinessValuationUpdate 5
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
ses.14Delawarerequiresthatadetailedsummary
oftheanalysesunderlyingafairnessopinionbe
includedinthedocumentssenttoshareholders.
ThePure Resources decisionstated:
[C]ourtsmustbecandidinacknowledgingthat
thedisclosureofthebanker’s“fairnessopinion”
aloneandwithoutmore,providesstockholders
withnothingotherthanaconclusion,qualied
byagauzeofprotectivelanguagedesignedto
insulatethebankerfromliability.
Therealinformativevalueofthebanker’swork
isnot in itsbottom-lineconclusion,but inthe
valuationanalysisthatbuttressesthatresult....
[A]minoritystockholderengaginginthebefore-
the-factdecisionwhethertotenderwouldndit
materialtoknowthebasicvaluationexercises
tha t [the invest ment banker ] unde rto ok, th e
keyassumptionsthat theyusedinperforming
them,andtherangeofvaluesthatwerethereby
generated.”15
A2010decision similarlyheld,“[S]tockholders
areentitledtoafairsummaryofthesubstantive
workperformedbytheinvestmentbankersupon
whoseadvicetheirboardreliedinreachingtheir
recommendation.”16
Although thesummarymust coverthevarious
methodsusedby the nancialadvisor,itdoes
not havetodisclosewhetheror why the advi-
sor’sanalysesdeviatedfromacceptedpractices
orfromtheDelawarestandardsfordetermining
fairvalue.17Inaddition,ifthenancialadvisorhas
performeditsDCFanalysisbasedonitsownpro-
jections,thereisnorequirementtodisclosethese
projections.18
Inpractice,thesesummariesofinvestmentbanker
analysesareoftenoflimitedvaluetosharehold-
14 Asdiscussedbelow,theSECalsorequiresa
summaryofthefairnessopinionanalysesingoing-
privatetransactions.
15 Pure Resourcesat449.
16 Cogentat511*56;seePure Resourcesat450.
17 3Comat*21.
18 Id.at*23.
ers.Thesummaries give limiteddata such as
rangesofvalueandthenamesofselectedguide-
linecompaniesandguidelinetransactionswithout
presentingdataforthesecompanies.Thesum-
maries ofDCFanalysesgivearange of value,
discount rates, and themethod of calculating
terminalvaluebutoftengivenootherdata.Itis
ourbeliefthatthesesummariesarethereforeof
limitedvaluetoshareholders.Thecourtshould
considerrequiringthatthevaluationsectionofthe
advisor’spresentation totheindependentcom-
mittee(whichhas tobeledwiththeSEC)be
attachedasanexhibittothedocumentsentto
shareholders.
3. Summary of Management Projections
Provided to Advisor Is Required
Delawarehasruledthataproxystatementshould
“givethe stockholdersthebestestimateofthe
company’sfuturecashows asofthetimethe
boardapprovedthe [transaction].”19 The court
said:
[S]tockhol der s must measure the relative
attractivenessof retainingtheirsharesversus
receivingacashpayment, a calculus heavily
dependentonthestockholders’assessmentof
thecompany’sfuturecashows....
Itwouldthereforeseemtobeagenuinelyfoolish
...inconsistencytoholdthatthebestestimate
ofthecompany’sfuturereturns,asgenerated
bymanagementandtheSpecialCommittee’s
investmentbank,neednotbedisclosedwhen
stockholdersarebeingadvisedtocashout....
Indeed,projections of this sor tare probably
amongthe most highly-prizeddisclosures by
investors.What[investors]cannothopetodois
replicatemanagement’sinsideviewofthecom-
pany’sprospects.20
19 David P. Simonetti Rollover IRA v. Margolis,2008
Del.Ch.LEXIS78(June27,2008)at*30,citingIn re
Netsmart Technologies, Inc. Shareholders Litigation,
924A.2d171,203(Del.Ch.2007).
20 Netsmartat203.
6 BusinessValuationUpdate March-April2011
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
Nonetheless,eventhoughavaluationanalysisis
heavilydependentupontheprojectionsutilized,
theDelawarecourts permit summariesanddo
notrequiredetailedmanagementprojectionsto
bedisclosed.
When thedisclosed management projections
includednomorethanrevenues,grossmargin,
operatingprot,andEPS,thecourtdetermined
that“fulldisclosureoftheprojectionswould[not]
alterthetotalmixofavailableinformation.”21More
rec ently, h owever, the cour t in Maric Capital
orderedthatprojectedfreecashowbeincluded
inthesummarizedprojections,22rulingthat“man-
agement’sbestestimateofthefuturecashow
...isclearlymaterialinformation.”23Inasituation
whereacompanydisclosedprojectionsthatthe
nancialadvisorhadnotused,thecourtrequired
thattheprojectionsreliedonbytheadvisoralso
bedisclosed.24
Whenprojections were stale,the court under-
standablyruledthatnodisclosurewasrequired.25
Similarly,thecourtalsodidnotrequiredisclosure
ofprojectionsthatitdeemedincompletebecause
theydidnotreectknownrisks.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 3Comat*7,fn.11and*10.
22 Maric Capital Master Fund, Ltd. v. Plato Learning,
Inc.,2010Del.Ch.LEXIS115(May13,2010)at*9.
23 Id.at*11.
24 Netsmartat200.
25 In Re PNB Holding Co. Shareholders Litigation,2006
Del.Ch.LEXIS158(Aug.18,2006)at*69-70.“[O]ur
lawhasrefusedtodeemprojectionsmaterialunless
thecircumstancesoftheirpreparationsupportthe
conclusionthattheyarereliableenoughtoaidthestock-
holdersinmakinganinformedjudgment.”Id.at*60.
26 In re CheckFree Corporation Shareholders Litigation,
2007Del.Ch.LEXIS148(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 Conicts Be Disclosed
“[C]onfli cts of interest must be disc losed
[whetherornot]thereisevidencethatthenan-
cialadvisor’sopinionwas actually affectedby
theconict,”28 When anadvisorhad previously
workedforthebuyer,thecourtcriticizedaproxy
statementthatdidnotdisclose“howmuch[the
investmentbank]waspaid,whetheritwouldhave
receivedthesamepaymentevenifitwasunable
torenderafairnessopinion...orhowmuch[it]
hasearnedinrecentperiodsfrom...membersof
thebuyergroup.”29Inasituationwheretheinvest-
mentbankrenderingafairnessopinionbeneted
fromitsownershipofsecurities,thecourtruled
thatthebank’sentirebenet,including benets
as a debtholder and warrant holde r, must be
disclosed.30
Thecourtrecognizestheconictraisedbycon-
tingentfees,statingthat“thecontingentnatureof
aninvestmentbanker’sfeecanbematerialand
haveactualsignicancetoashareholderrelying
onthebanker’sstatedopinion.”31
27 See,e.g.,Grimes v. Vitalink Comm. Corp.,1997
Del.Ch.LEXIS124(Aug.26,1997)at*3(“[The]
discountedcashowmodel[is]increasinglythe
modelofchoiceforvaluationsinthisCourt.”);Gholl
v. eMachines, Inc.,2004Del.Ch.LEXIS171(July7,
2004)at*20(“This[DCF]methodiswidelyaccepted
inthenancialcommunityandhasfrequentlybeen
relieduponbythisCourtinappraisalactions.”).
28 In re John Q. Hammons Hotels Inc. Shareholder
Litigation,2009Del.Ch.LEXIS174(Oct.2,2009)at
*56.
29 Ortsman v. Green,2007Del.Ch.LEXIS29(Feb.28,
2007)at*4-5.
30 Simonettiat*26.
31 Louisiana Municipal Police Employees Retirement
System v. Crawford,918A.2d1172,1191(Del.Ch.
2007).
March-April2011 BusinessValuationUpdate 7
FairnessOpinionsInAfliatedPartyTransactions
Reprinted with permissions from Business Valuation Resources, LLC
Thecourtalsorecognizesthatprojectionspre-
paredbyapartywithaninterestinthetransaction
maybebiased.Itrejectedavaluationbasedon
projectionspreparedbyanofcerwhoboughta
businessfromacompany.32
D. Delaware Requires Independent
Opinions in Afliated Party Transactions
RecentDelawaredecisionshavebeencriticalof
independentdirectorswhoengagedrmsthat
hadrecentlyadvisedthecontrolshareholderor
wereotherwiseconicted.33Thecourthasstated
that independentcommitteesshould hire their
ownadvisors,holdingthatwhereanindependent
committeeemployedanadvisorwhohadprevi-
ouslyworkedforthecontrolparty,the“conictof
interestrobs[the]fairnessopinionofitsvalueas
anindicatoroffairness.”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 feesareoftenabout25%of
thecustomaryM&Aadvisoryfeeforatransac-
tionofthesamesize;however,mostrmshave
aminimumfairnessopinionfee.Assignmentsfor
independentcommitteessometimesincludeadvi-
soryworkandassistanceinnegotiations.
Furthermore,thecommitteemaycontracttopay
an incremental fee contingent on the advisor
32 McPadden v. Sidhu,964A.2d1262,1272(Del.Ch.
2008).
33 Finkelstein v. Liberty Digital, Inc.,2005Del.Ch.
LEXIS53(Apr.25,2005)at*64,fn.39;Gesoff v.
IIC Industries Inc.,902A.2d.1130,1150-1(Del.Ch.
2006);In re Tele-Communications, Inc. Shareholders
Litigation,2005Del.ChLEXIS2006(Oct.11,2006)at
*41.
34 Gesoffat1150.
neg otiati ng a hi gher p rice. This f ee str uctur e
rewardstheadvisorforincreasingtheconsider-
ationpaidtominorityshareholders.Thisstructure
isunlikelytobejudiciallycriticized.
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.InWeinberger,theseminalDelaware
valuationcase,theDelawareSupremeCourtdis-
cussedthe “cursory preparation ofthe[invest-
mentbank’s]fairnessopinion”invedays,but
attributedtheproblemtothedefendants,stating
that“therushimposedon LehmanBrothersby
Sig nal’s timetable contributed t o the d ifficul-
ties underwhich thisinvestment bankingrm
attemptedtoperformitsresponsibilities.”36More
recently,whenafairnessopinionwasproduced
inaweek,thecourtderidedtheopinionas“pure
windowdressingintendedbydefendantstojustify
thepreordainedresult.”37
Also, thecourthas faulted someopinionsthat
consideredwhatshareholderswerereceivingbut
didnotweighwhatinsidersweregetting.When
high-votesharesreceivedasubstantialpremium
overlow-voteshares,theadvisorwasfaultedfor
failingtoopineupontherelativeconsiderationto
35 Todemonstratethatthefeeisnotcontingentona
favorableopinion,theengagementlettershould
containlanguagesuchas“Thefeeforouropinionis
$XXX,000,ofwhich50%shallbepaiduponexecu-
tionofthisletterand50%shallbepaidatthetime
weinformyouthatwearepreparedtorenderour
opinion.”
36 Weinberger v. UOP, Inc.,457A.2d701,712(Del.
1983).
37 In re Sunbelt Beverage Corp. Shareholder Litigation,
2010DelCh.LEXIS1(Jan.5,2010)at*19.
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bereceivedbyshareholdersineachclass.38 In
another case,thecourtcriticizedthedirectors’
relianceonafairnessopinionregardingsaleofa
companythatdidnotconsidertheconcurrentsale
ofasubsidiarytoamajorshareholder.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 unjustiably
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
AssociationofSecuritiesDealersInc.(NASD),is
anon-governmentalself-regulatoryorganization
thathasregulatoryoversightoverallsecurities
rmsthatdobusinesswiththepublic.Itregulates
itsmembersthroughtheadoptionandenforce-
mentofrulesandregulationsgoverningbusiness
conductofmemberrms.
FINRARule5150(formerlyRule2290)became
effectivein2007.Itsetforthdisclosureandproce-
durestandardsapplicabletoallFINRAmembers
who render fairness opinions.Althoughthese
standardsarenotexplicitly applicable to non-
member firms, all practitioners would be well
advisedtoconformtothem.
38 Tele-Communicationsat*55.SeealsoLevco
Alternative Fund Ltd. v. Reader’s Digest Association,
Inc.,803A.2d428(Del.2002).
39 Alidina v. Internet.com Corp.,2002DelCh.LEXIS156
(Nov.6,2002)at*25.
40 Hammonsat*55-56.
41 SeeTele-CommunicationsandLevco.
Rule 5150requires that FINRAmemberfirms
havewrittenprocedures for approvalof afair-
nessopinion,aswellasproceduresforinternal
approvalofafairnessopinion.Whenaninternal
committeeisused,thermmusthavewrittenpro-
ceduresastotheprocessforselectingcommit-
teemembers,thequalicationsforpersonson
theinternalcommittee,andprovisionsforreview
andapprovalbypersonsnoton thedealteam.
Thecommitteecanincludesomeoneonthedeal
team,butthecommitteemusthavea“balanced
review.”
Disclosures required
by Rule 5150
Customar y disclosures
in practice
1.Whetherthemember
hasactedasadvisortoany
partytothetransaction.
1.Pastengagementsdis-
closed;hedgedastofuture
engagements.
2.Whethercompensation
iscontingentuponclosing.
(Amountdoesnotnecessar-
ilyhavetobedisclosed.)
2.Whethercompensation
iscontingentisdisclosed;
compensationamount
isoften(butnotalways)
disclosed.
3.Anymaterialrelationships
betweenthememberand
anypartytothetransaction
(i)duringtheprecedingtwo
yearsor
(ii)mutuallyunderstoodto
becontemplated.
3.Pastrelationshipsare
disclosed;nodisclosureas
tofuturerelationships.
4.Whetheraninternalcom-
mitteeapprovedfairness
opinion.
4.Disclosed.
5.Whetherthememberhas
independentlyveriedany
company-suppliedinforma-
tionthatformedsubstantial
basisforitsopinion.Ifso,
describetheinformation
veried.(Whennoinforma-
tionisveried,ablanket
statementissufcient.)
5.Blanketstatementthatno
company-suppliedinforma-
tionhasbeenveriedbythe
advisor.
6.Whethertheopinion
expressesaviewastothe
fairnessofanycompensa-
tiontoofcersanddirectors
relativetothepaymentto
publicshareholders.
6.Noopinionisexpressed
astothefairnessofcom-
pensationtoanyofcersor
directors.
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Rule5150alsosetsforthspecicrequireddisclo-
suresthatmustbemadewhenfairnessopinions
areincludedindocumentssenttopublicshare-
holders.Thechartbelowshowstherequireddis-
closuresandthecustomaryresponsestothese
requirements.
B. SEC Rule 13e-3 Fairness Opinion
Disclosure Requirements
TheSEChas establishedruleswithrespectto
disclosureingoing-private transactions.42The
actualopinionletterandasummaryofthefair-
nessopinion analyses mustbeincluded inthe
proxy statement or tenderoffer document for
thetransaction. A descriptionofthe substance
ofwrittenandoralreportsandopinionsbythe
advisormustbeincludedaswell.
The summary of the analyses must include a
discussion of each methodology used. Data
such as multiples used in guideline company
andguidelinetransactionanalysesanddiscount
rates usedinDCF analysesareincluded. Any
limitation imposedon thescope ofthe investi-
gationmustbedisclosed.Initscommentletters
tothecompany,theSECoftenrequestssupple-
mentalinformationandmay ask foradditional
disclosure.
Writtenreportssupportingtheopinionmust be
fi led as exhi bits a nd must ma de avail able a t
thecompany’sprincipalofceforinspection or
copyingbyashareholder’sdesignatedrepresen-
tative.Companiessometimesmaketheadvisor’s
nalreportpubliclyavailable.
Any material relationship between the advisor
and thecompany and/or its afliates mustbe
disclosed.TheSEC’srequirementsarelimitedto
42 ForpurposesofRule13e-3,going-privatetransac-
tionsincludeanytransactionwhichwouldcausea
classofequitysecuritiestobedelistedortobecome
eligibleforterminationofregistration,orwouldcause
thereportingobligationswithrespecttosuchclassto
becomeeligiblefortermination.Othertypesofafli-
atedpartytransactionsarenotsubjecttoRule13e-3.
disclosure;itdoesnotrequirethattheadvisorbe
independent.
IV. Fairness Opinions in Practice
A. Methods for Determining Fairness
Asanyvaluationprofessionalwouldexpect,most
fairnessopinionsarebased onthreemethods:
discountedcashow,guidelinecompanies,and
gui deline trans actions (includi ng con trol p re-
miums).These approachesarenormallyused
unlessrelevantinformation,suchasreasonable
projectionsorrelevantguidelinetransactions,is
notavailable.
Other appro aches occa sionally used incl ude
asset value,liquidationvalue, presentvalueof
a pr oject ed fut ure pr ice, a leveraged bu yout
model, value available in a rec apitalization,
targetpricespublishedbysecurity analysts,a
regressionmodel,and industry-acceptedrules
ofthumb(suchasvaluepertonofsteelorper
cablesubscriber).
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
Abouthalfofthepublishedfairnessopinionsuse
a“premiumspaid”analysis,whichcomparesthe
premiumovermarkettobepaid inthe subject
transactionto average premiumspaidinother
transactions.
43 In re Hanover Direct, Inc. Shareholders Litigation,
2010Del.Ch.LEXIS201(Sept.24,2020)at*5-6.
(“[T]herearecommonlyacceptedmethodologiesthat
aprudentexpertshoulduseincoordinationwithone
anothertodemonstratethereliabilityofitsvaluation.
Ifadiscountedcashowanalysisrevealsavaluation
similartoacomparablecompaniesorcomparable
transactionsanalysis,Ihavemorecondencethat
bothanalysesareaccuratelyvaluingacompany.”).
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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
specic 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
Directorsmaychoose,intheirbusinessjudgment,
toacceptanofferwhosevalueiscertainrather
thanafaciallyhigherofferwhosevalueisuncer-
tainorconditional.Forexample,theymaychoose
toaccept(i)acashbidratherthanahighercash
bidthatissubjecttoanti-trustorotherregulatory
approvalandthereforehasariskofnotclosing;
(ii)acashbidratherthanabidinstockordebt
withagreatercurrentmarketvalue;or(iii)alower
bidbecauseofaperceivedriskinthehigherbid’s
nancing.
Aftergivingconsiderationtothefactsandcircum-
stancesofthetransaction,thenancialadvisor
isjustiedinprovidingafairnessopinionthatthe
selectedproposalisfair.
The Need for Heightened Due Diligence
in Afliated Party Transactions
Theduediligenceforpreparingafairnessopinion
inanafliatedpartytransactionhastobecon-
ductedwithskepticism.Thevaluatorshouldrec-
ognizethatmanagementmayhaveanincentive
toprepareoverlyconservativeprojections.Itis
essentialtoreviewforecaststhathadbeenmade
priortothegestationoftheproposal.Thevalu-
atorshouldalso reviewinformationprovidedto
partiesaskedtoassistinnancing,sinceprojec-
tionsgiventonancingsourcesarelesslikelyto
below-balled.
B. Appraisal Standards Set a Floor for Fairness
In D elawar e, all fro zen- out share holde rs are
entitledtoreceiveatleastthe“fairvalue”oftheir
stock,whetheror notthestructureofthetrans-
actionpermitsshareholderstousetheappraisal
remedy.44 InDelawareandinamajorityofother
states,minoritydiscounts,discountsforlackof
marketability,andcontrol premiumsmaynotbe
co nsider ed whe n valui ng sha res in a pprai sal
actions.
Inarrivingatafairnessopinion,theopinion-giver
shouldconsiderthevalueoftheminorityshares
undertheappraisalstandard,becauseappraisal
value in the relevant jurisdiction represents a
oorvaluefor fairness.Acashorcash-equiv-
alenttransactionshouldnotbeconsideredfair
iftheconsiderationisbelowthepricethatthe
opinion-giverbelieveswouldlikelybeawardedin
anappraisalaction.
C. The Lack of Industry Standards
for Fairness Opinions
Noprofessionalinvestmentbankingorvaluation
organizationhasyetproposedstandardsforfair-
nessopinions.TheSECandFINRArulesdonot
addressanystandardthatshouldbeconsidered
indeterminingthefairnessofatransaction.
Inpractice,it ishighlyunlikelythatanyinvest-
ment bankinggroup wouldproposestandards
withoutproddingfromtheSEC.Membersofthe
academiccommunityhavemade“ivorytower”
proposalsinvolvingsuchconceptsassettingthe
methodologyfordeterminingdiscountratesand
prescribingtheweightingtobegiventodifferent
valuationmethods.These proposalsappearto
beimpractical.
Asthecourtsreviewandcritiquefairnessopin-
ions,theycontributetowardtheevolutionofstan-
dards.Areasthatthe courtsmightconceivably
add ress i n the f uture i nclud e, amo ng othe rs,
theimpactofdisclaimersonthecredibilityofan
opinion, improveddescriptionsofthenancial
advisor’sanalyses,nancialadvisors’liabilityfor
44 Reis v. Hazelett Strip-Casting Corp.,Del.Ch.LEXIS
11(Jan.21,2011)at*33,citingMetropolitan Life
Insurance Co. v. Aramark Corp.,1998Del.Ch.LEXIS
70(Feb.5,1998)at*6.
March-April2011 BusinessValuationUpdate 11
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questionableopinions,theimpactonfairnessof
factorsinadditiontotheconsiderationpaid,and
whetheropinionsneedtobeupdated.
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.