New Rules for Fairness Opinions: A Cosmetic Exercise

The SEC recently approved a new rule (NASD Rule 2290,effective Dec. 8) requiring specific disclosures in fairness opinions provided by investment banks in change of control transactions. The objective is to tackle the obvious conflicts of interest that arise when bankers, who have much more to gain by completing the deal and earn large fees, are (notionally) asked to evaluate the valuation of the company from the perspective of the shareholders.

Fairness opinions became commonplace after the decision in Van Gorkom, despite the court stating that “[w]e do not imply that an outside valuation study is essential to support an informed business judgment; nor do we state that fairness opinions by independent investment bankers are required as a matter of law.”

Rule 2290 requires investment banks to disclose if they are advising any party to the transaction; whether any compensation is payable upon consummation of the transaction or any related transactions – (2290(a)(1)); whether it will receive “significant” payment contingent upon the completion of the transaction – (a)(2); material relationships between the firm and any party to the transaction during the two prior years for which compensation was paid – (a)(3); whether it independently verified any information provided by the client and to the extent that it did, what that information is or categories thereof - (a)(4) ; whether or not a fairness committee approved or issued the opinion - (a)(5); and whether or not the opinion expresses an opinion about the fairness of the amount or nature of the compensation payable to the officers, directors, or other insiders relative to the public shareholders - (a)(6).

The Rule also requires investment banks to follow certain procedures with regard to the working of fairness committees – (b). Interestingly, the rule does not seem to mandate a fairness committee comprised entirely of non-deal bankers. All that it requires is a “process to promote a balanced review by the fairness committee, which shall include the review and approval by persons who do not serve on the deal team to the transaction.” (2290(b)(1)(c)). It does not require any qualifications for membership of fairness committees either.

While it is true that fairness committees have access to expertise that helps in making determinations about valuation, the reality is that the skewed incentive structure negates any possibility of the opinion being fair in any meaningful sense. Despite the fact that investment banks staff these committees with non-deal bankers, the pressure to consummate the deal often stands in the way of an adverse opinion, except in the rarest of rare cases. Further, all that is asked of the opinion is that the deal is within a range of values that are considered to be “fair.” Given that these flaws in the process of issuing fairness opinions are common knowledge, it is naïve to assume that seasoned market participants place any value in these opinions. Rule 2290 is a cosmetic exercise to help in conveying the impression that fairness opinions serve shareholder interests.

In their current form, fairness opinions are a waste of shareholder money. If they are to serve any meaningful purpose, they have to be fundamentally transformed into independent assessments on the soundness of the deal from the perspective of shareholders in the light of competing options that the board could consider as alternatives to the current deal. If that cannot be achieved, it is time to consign fairness opinions to the bin and spare the hapless shareholder an unnecessary expense.