The case for a second opinion on certain fairness opinions

Fairness opinions have become matter of course since the 1985 case Smith v Gorkom. In that case, the Delaware Supreme Court ruled that the directors of Trans Union Corporation were grossly negligent for approving a sale without knowing the “intrinsic value” of the company and could have satisfied their duty of care by obtaining a fairness opinion. In transactions where negotiations are between independent third parties on an arms-length basis, there is less risk of a successful challenge. In such cases, these fairness opinions have become standard.

But there are times when a transaction has characteristics that make the fairness opinion more important; in cases where a plaintiff’s attorneys will look for reasons to discredit the opinion provider, the analysis, or the process. Some examples:

• Marquee deals with a potential conflict of interest: These types of transactions could include situations where one party has equity or even controlling interest in both sides of the transaction and therefore may not be exactly aligned with one or both sets of shareholders. One example of this was seen in the 2016 Tesla-SolarCity merger. Elon Musk’s ownership on both sides created a potential conflict. Another example would be a de-SPAC combination transaction. The SPAC sponsor is not exactly aligned with the shareholders, due to effective contingent ownership. In these and other transactions where a potential conflict exists, the purpose of a fairness opinion is not simply an “informed basis,” but it also serves as protection for the independent interest holders vs the potentially conflicted party.

• Smaller private company transactions with conflicts of interest: These transactions tend to be the bread and butter of independent fairness opinion providers. Typically, the risk associated with these transactions is such that bulge-bracket investment banks often are not willing to take on relative to the smaller fees. However, in recent years, especially with the energy market slowdown during the pandemic, many investment banks without a dedicated transaction opinion practice have been dabbling in fairness opinions to supplement declining traditional M&A fees. The following are examples of these types of transactions:

1. Take-private transactions
2. Sales among affiliates
3. Drop-down transactions
4. Portfolio company mergers, acquisitions, or investments between two or more different private equity funds (ie. Fund I and Fund II)

Potential fairness opinion provider considerations

Choosing the right fairness opinion provider can mean a strong defense in the face of potential or actual legal challenges. But in many legal cases, the circumstances around the engagement of a provider have sometimes hurt the defense of the fairness of a transaction. Two of the most common pitfalls that can hurt a defense are success fees and conflicts of interest:

• Success fees: Many successful challenges of fairness opinions stem from the perception that the adviser is conflicted from making an independent valuation assessment due to the nature of their success fees. In a large public-to-public M&A deal, each side’s advisers’ fees are typically heavily success-weighted. If the deal closes, the investment bank often will make tens of millions of dollars. This is a big incentive to show that the negotiated deal is “fair” to their client.

• Perception of conflict of interest for the adviser: Especially with the types of transactions outlined above, where there is an innate conflict of interest in the transaction, the perception that the adviser is beholden or loyal to the conflicted party has led to successful challenges. Imagine if six months after delivering a fairness opinion the adviser is awarded a key role in an equity offering with a multi-million-dollar fee, for example.

Process considerations

The process of obtaining a fairness opinion is critical to avoid potential legal pitfalls. A nicely formatted board presentation accompanying a fairness opinion is useless if it isn’t supported with methodical processes, documentation, internal scrutiny and review. Investment banks that don’t have a dedicated transaction opinion practice typically view the opinion as an add-on to the M&A process.

There have been examples of firms delegating the process and work to junior staff. As was shown in the 2015 El Paso decision, this can have disastrous implications for the client. A good lawyer can help educate all parties, but most work done by fairness opinion advisers is carried out behind the scenes and will never become known until a challenge is brought up.

Obvious process pitfalls such as rogue emails or lack of well documented board meetings are easy to warn against. But things like routine changes to the analysis (in some cases that the board never even knows about) can call objectivity into question. Plaintiff’s attorneys will subpoena all drafts of analysis hoping to find earlier drafts where the analysis looks unfavorable to a transaction, but then adjustments are made that make the result look “fairer.”

The reasons for this can be completely reasonable, but only experienced practitioners will be consciously thinking about this throughout the process and diligently document reasons for changes that can be brought out if needed. In the El Paso decision, Delaware Supreme Court Vice-Chancellor J Travis Laster was extremely critical of the investment bank’s continued answer as to why assumptions were made: “It was our professional judgment.”

Similarly, post-transaction process optics can be problematic in the common event that a fairness opinion adviser is acting as both adviser to the board and fairness opinion provider. The board and their advisers’ role are clear: to get the best deal possible for shareholders (independent of the conflicted party) or even to be willing to walk away from a deal.

In arms-length third-party negotiations, part of an M&A adviser’s job is to look at the analysis and point out reasons why value should be lower (buyer) or higher (seller), depending on which side of the transaction they’re on. Advisers and boards should negotiate as hard as possible to get the best deal.

A potential issue that not a lot of investment banks think about is that putting forth a valuation, set of discount rate assumptions, or growth rate assumptions intended to support the negotiating position can create a pattern that looks bad in hindsight. Often, once a negotiated price is settled, the fairness opinion analysis will go back to less aggressive valuation assumptions (not a negotiating case), giving the impression that the analysis was changed to “make it work.”

Second opinions

We can now see how, in major marquee deals, investment banks may be seen as conflicted when receiving success fees, or when they engage in business with the company or conflicted party. Here, a second opinion provider charges a non-contingent fee, mitigating the appearance of a potential lack of independence.

And in transactions where significant negotiations are needed or expected, it can be useful for legal challengers to make the fairness opinion provider the “bad guy”. Here, it may be better to have a second independent fairness opinion provider that isn’t part of the negotiations. But it might even be better to have separate advisers for each role (negotiations and fairness opinion) instead of a second opinion.

When does a second opinion not make sense?

For big marquee M&A deals that are arms-length third-party, when the opinion is only being sought to satisfy the “informed basis” (due care) standard as highlighted in Smith v. Van Gorkom, it’s not necessary to seek a second opinion. The inherent nature of third-party negotiations (especially as part of a well-run M&A process) mitigates many of the risks associated with legal challenges.

For other kinds of smaller deals with significant conflicts or perceived conflicts, it’s better to just go straight for one adviser that specializes in fairness opinions rather than the company’s traditional investment bank to avoid any pitfalls during a potential legal challenge.

James Hanson is a managing director at Opportune Partners, LLC, specializing in transaction opinions