Fairness Opinion Neutrality Questioned

A recent court ruling calls into question whether investment banks should issue fairness opinions for clients.
Marie LeoneFebruary 2, 2006

Jeffrey Williams is giving up investment banking. Before the year is out, Williams, a former Morgan Stanley and Greenhill Co. dealmaker, will transform his eponymous boutique investment bank into an independent valuation firm.

Among other financial reviews, the company will issue fairness opinions—the analysis of merger calculations that are used by directors and officers as a guide to gauge whether investors are getting a relatively equitable deal. “We’ll be finished with the investment banking businesses in less than 12 months,” says the founder of Jeffrey Williams and Co. As a result, the fairness opinion provider will be rid of any conflict-of-interest taint that investment bankers currently face.

Williams’ decision to hang out an “independent” shingle was partly driven by proposed regulations from the National Association of Securities Dealers (NASD), the private-sector regulator of the U.S. securities industry. Rule 2290, which is currently being reviewed by the Securities and Exchange Commission, compels NASD members that issue fairness opinions to disclose whether they are involved in the deal making side of a merger. The rule’s aim is to inform investors of any potential conflicts present in a deal.

Williams decision to reinvent his business seems to have been fortuitous. A month after NASD sent Rule 2290 to the SEC for a second look, Delaware’s Chancery Court ruled on a case that is likely to affect the future of the fairness opinion business. The ruling, handed down by Chancellor William Chandler, makes it more likely that corporate directors will scrutinize fairness opinions that they get from investment banks more carefully.

The Delaware ruling concerns a shareholder lawsuit against the former directors of Tele-Communications Inc. (TCI), and brings to light the potential conflict-of-interest that investment banks may have when issuing fairness opinions for their clients’ merger deals.

The lawsuit focused on TCI’s 1998 merger with AT&T. In a memorandum opinion issued on December 21, 2005, Chandler noted that hiring legal and financial advisors for both deal-making and the fairness opinions, “raises questions regarding the quality and independence of the counsel and advice received.” Further, he wrote, contingent compensation for financial advisors creates “a serious issue of material fact” as to whether the advisors can provide independent advice.

Chandler’s remarks were in response to a request for a summary judgment by the TCI defendants. But Chandler denied the motion, sending the case to full trial. The trial date hadn’t been set as of press time. Nevertheless, controversy has recently engulfed these merger valuations.

As the number of corporate scandals rise, and the Sarbanes-Oxley Act focuses more attention on ferreting out conflicts of interest, fairness opinions have been cited in shareholder lawsuits. The suits question, among other things, whether directors breach their fiduciary responsibility by enabling deal advisors—usually investment banks—to also render fairness opinions. Currently, hiring the same advisor to play the dual role is a fairly common practice.

The TCI board was aware of the need to limit perceptions of conflicting interests. The directors set up a special committee to review the AT&T transaction, mainly because five of the seven directors stood to gain an aggregate $220-million premium payment if the deal went through. Those directors held TCI series B stock, which, according to the merger agreement, was provided with a 10 percent premium compared to series A stock.

But the special committee didn’t fully exorcise the deal of conflict issues associated with the advisors the company chose. “Rather than retain separate legal and financial advisors, the Special Committee chose to use,” Chandler wrote, “the advisors already advising TCI.” Those advisor were from the firm of Donaldson, Lufkin & Jenrette. The fact that DLJ was paid a fee of $40 million that was contingent on the merger’s success called into question the firm’s independence as a provider of the fairness opinion, according to the judge.

Theoretically, the judge’s opinion on such a fee structure could cause investment banks to scale back on fairness opinion work, a low-margin business compared to deal making. In that case, it could spawn a cottage industry of independent fairness opinion providers.

Indeed, even investment banks not directly involved in a deal could be perceived to have a conflict of interest. That’s because bankers are always trolling for new business, and even fairness opinion engagements represent new investment banking clients. Hence the possiblity of an emerging call for independent providers.

Still, Bruce Bingham, a senior managing director at Trenwith Valuation, a firm that provides independent fairness opinions, has no illusions that investment banking firms will exit the fairness opinion business. Further, he acknowledges that investment banks have the large-scale resources appropriate to render fairness opinions on large-scale deals.

The dream of the independent firms, then, is that decisions like Judge Chandler’s will move boards to hire them to make extra sure their companies aren’t hit with conflict charges. If that happens, the smaller firms could be used to help companies put together a “belt and suspenders” approach to obtaining fairness opinions, Bingham hopes.

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