Who says it's a fair deal?

What people who write fairness opinions have at stake and what that means for investors and financial managers.

Even though almost every SEC filing disclosing a change in corporate control includes a fairness opinion, these documents do very little for investors--the group disclosure is supposed to inform. Fairness opinions developed as legal protection for members of boards of directors against possible shareholder challenges to their decisions. However, the investment bankers typically preparing such opinions often have an inherent bias in favor of ratifying the transactions.

When reviewing a fairness opinion as part of due diligence, investors and financial executives--especially CPAs in business and industry--need to know that these opinions can be highly subjective. Accordingly, they should consider the credentials and motives behind a fairness opinion while weighing its merits and temper the conclusions they draw from it. In the words of Phil Clements, CPA, the New York-based global leader of corporate value consulting at PricewaterhouseCoopers, "A fairness opinion is never a substitute for due diligence."

WHAT IS A FAIRNESS OPINION?

A fairness opinion is a written and signed third-party assertion certifying--some would say rationalizing--the price of a proposed deal involving a tender offer, merger, asset sale or leveraged buyout. It usually discusses the price and terms of the deal in the context of comparable transactions, drawing attention to strategic considerations that might make a particular transaction worth more or less than others. In many ways, it is an explanation of the deal price arrived at by the negotiating parties.

For investors and financial executives, the most useful fairness opinions are detailed, well reasoned and convincing without being too restrictive about what might be fair. Rather than say the exact price of a deal is equitable, a typical fairness opinion outlines a range of fair prices. The actual deal price should fall in that range. Nonetheless, those reading fairness opinions should remain skeptical.

Fairness opinions almost never are required as a matter of law although such avowals became customary after January 1985, when the Delaware Supreme Court ruled against the directors of Trans Union Corp. in Smith v. Van Gorkom. Aggrieved shareholders of that company had accused the company's directors of accepting a paltry sum when the company went private in a leveraged buyout. Justice Horsey's majority opinion on the case concluded that the directors hadn't bothered to inform themselves adequately about the company's value before agreeing to sell it. The court opened a safe harbor by implying that the liability could have been avoided had the directors elicited a fairness opinion from anyone in a position to know the company's value. Instead, they had relied solely on the unwarranted assertions of Trans Union's CEO, Jerome Van Gorkom.

The boards of American corporations got the message. According to John C. Coffee, Jr., a securities expert teaching at Columbia Law School in New York, the fairness opinion became the established standard "as a minimum precaution."

In addition, fairness opinions sometimes are used in contexts outside the SEC's jurisdiction. For example, insurance commissioners in Massachusetts recently called on PWC to assess whether a demutualization plan by an insurance company was fair to policyholders, according to that firm's Clements.

WHO WRITES FAIRNESS OPINIONS?

Van Gorkom emerged as "a full employment act for investment bankers," Columbia's Coffee says, only half-jokingly. Since the law seldom requires fairness opinions, no specific credentials are needed to write them. Traditionally, investment bankers have written most of them, but the high fees and low risks have attracted new competition-consultants and some CPA firms, for example. The new competitors may offer more independence, lower prices and different credentials.

Initially, a company's investment bank would seem to be the obvious place to turn for a fairness opinion. After all, the reason a company hires an investment bank as an M&A adviser is its experience negotiating such deals. As negotiations progress, with both sides jockeying to get a good deal, many of the arguments that could affect the price of each particular deal are brought forward by one side or the other. As a result, it is easy for an investment banker to write up the reasoning by which a deal was struck and call it a fairness opinion.

However, because of the typical fee structure, competitors and shareholder activists see an inherent conflict of interest when a company's merger adviser also writes the fairness opinion. Fairness opinion fees vary (see sidebar, page 47), but they usually are not conditional. In contrast, merger advisory fees--which typically are much bigger than fairness opinion fees--almost always are contingent on the consummation of a deal. If the same investment bank acting in both capacities wrote a truly thorough, independent fairness opinion, the result might scotch the deal or force a renegotiation of the price, eliminating, reducing or postponing a very large cash reward for the investment bank. Sometimes the same investment bank also is underwriting the financing for the deal and stands to lose out on even more.

Dennis Soter, a partner of Stern, Stewart & Co., the economic consulting firm in New York famous for popularizing the economic value-added approach to business valuation, says that because of that conflict, "some Wall Street firms have a cavalier attitude toward fairness opinions and parrot whatever the client proposes to them." To be fair, Stern, Stewart also is active in the fairness opinion business and markets itself as more independent than the investment banks.

Major players in the corporate governance movement--activist investors who advocate more management accountability to the stockholders--often say that fairness opinions are little more than rubber stamps and not worth the handsome fees Wall Street charges for them. Nell Minow, a principal at the Lens Fund, an activist institution in Washington, D.C., calls the fairness opinion an oxymoron, explaining "you can get just about any outcome you want in a fairness opinion. That is hardly fair."

Ralph Whitworth, former president of United Shareholders Association--an advocacy group for improved corporate governance--and now chairman of Apria Healthcare in San Diego, says, "Investment bankers are like good bird dogs." Either will "hunt with anybody who has a gun." In other words, he thinks just about any company wanting to get a deal done can get an investment banker to support its point of view.

While the public rarely gets to see such behavior in a bright light, an incident highlighted in the Wall Street Journal's "Heard on the Street" column last November indicates he may have a point--at least in extreme cases. As described in the Journal, Foamex International's board rejected the first fairness opinion it solicited, which said the price was too low, and hired another firm to issue an opinion more to its liking. It then acted on the second opinion, ignoring the first.

Academics and legal experts tend to agree that a fairness opinion from a company's merger adviser has little value to investors. Charles Elson, a professor at Stetson University College of Law in Saint Petersburg, Florida, notes that, even in less blatant situations, an investment banker has a strong personal incentive to put his or her firm's imprimatur on its client's transactions. Failure to do so could cut into the banker's personal bonus, which usually is contingent on his or her firm's profits. Accordingly, investment bankers have little incentive to second-guess their first analyses. "The process is subjective and the relationships between the banker and the client militate against independence," Elson says.

Even a fairness opinion that manages to be somewhat objective despite the pressures on those preparing it can be so vague as to be nearly meaningless. For example, a price range described as fair may be very broad. In fact, the Lens Fund's Minow recalls that the judge presiding over a shareholder's challenge to the Time-Warner merger ridiculed the fairness opinions endorsing the deal with memorably colorful language, saying they "provided a range of opinions that even a Texan would feel at home on"--very big indeed.

ROOM FOR PRINCIPLED COMPETITION

Not surprisingly, Wall Street has awakened to find a legion of arrivistes trespassing on its turf, including commercial banks, consulting firms and accounting firms. However, these new competitors have conflicts of their own to reconcile.

Commercial banks may be angling for a piece of the loan syndicate financing the deal. Consultants also may be hoping to forge a relationship that will bring in more business. And, as CPAs know, the SEC requires auditors to be independent so discourages accounting firms from doing fairness opinion work for audit clients.

Does that mean the SEC won't allow an accounting firm to do a fairness opinion for an audit client? The commission is not entirely clear on that point. A 1994 Staff Report on Auditor Independence, prepared by the SEC Office of the Chief Accountant, lists the "issuance of fairness opinions and valuation reports" among the management advisory services that, if provided to a client by an auditor, could prove questionable. As a practical matter, most accountants interpret that to mean audit clients are off limits for fairness opinions, especially when the client company has securities regulated by the SEC.

Speaking for his firm, Robert Knoll, until recently national director of accounting and auditing professional practice at Deloitte & Touche, says, "In the United States, we don't do fairness opinions for audit clients or nonaudit clients." Because of the independence considerations, "it's not a business we want to be in."

Nonetheless, many CPA firms that sometimes prepare fairness opinions say their professional standards qualify them as independent experts. CPAs accredited in business valuation (ABV) can offer that as a credential. Terry Allen, CPA, a senior manager at McGladrey & Pullen in Des Moines, Iowa, who serves on the AICPA ABV examination committee, recommends that corporate board members seek out ABV-qualified CPAs. If ever there is a lawsuit, "part of my proof of due diligence is that I relied on an expert who was accredited and independent," she says. Accordingly, "if I were a board member, I'd look very hard at the credentials of the people the board hires to do the fairness opinion."

A GOOD FAIRNESS OPINION CAN PREVENT A BAD DEAL

While a fairness opinion should never be the final word in due diligence, a well-researched one can provide investors and financial managers with another line of defense against getting a raw deal. Proponents, including investment bankers and others that provide this service, say a carefully constructed fairness opinion sometimes can flush out deal-breaking problems that ordinary due diligence somehow might have overlooked.

Martin Wade, a managing director at Prudential Securities in New York who has served as an adviser and has helped to prepare fairness opinions, says, "Our role is to check very deeply what is presented as fact by the seller. Our legal colleagues do the same. So you have three sets of eyes [the company's managers, its attorneys and its investment advisers] looking at the same facts. If there's a problem, at least one of those sets of eyes [should be able to] detect it."

For example, Prudential recently prepared a fairness opinion for the board of a private company in the consumer products industry. Wade says Prudential's thorough analysis for the fairness opinion kept the client from making a big mistake. Prudential's client "was buying a division of a Fortune 50 company, which was represented by one of the finest names in the banking community." The client was "much smaller" than the company selling the business. It would have been a significant acquisition for it. Because of the seller's reputation and the credibility of its well-known investment banker, "we went into it with some degree of confidence that the chance of things not being where they were supposed to be was small."

But the situation turned out to be "a ticking time bomb," Wade says. Just as the deal was about to be consummated, Prudential discovered the patents the client had expected to purchase with the business actually belonged to someone else. That was a severe impediment to the deal--so much so that it fell through. He thinks that Prudential's fairness opinion work encouraged the "heightened skepticism" that spurred discovery of the problem.

SOME INVESTMENT BANKERS STEP DOWN

Rather than say flat out that a deal price is unfair, the more honorable investment bankers and others doing fairness opinion work sometimes turn down an opportunity to earn a fee on a particular fairness opinion or resign from the assignment partway through. Such actions almost always are very discreet, so investors and financial executives making acquisition decisions are not likely to be told of such demurrals. For the same reason that few securities analysts working for brokerage firms ever write a sell report on a stock, investment bankers don't like writing a negative fairness opinion. A well-deserved negative fairness opinion doesn't earn them enough to outweigh the soured business relationships that are likely to result.

On the other hand, a firm writing an unwarranted positive opinion risks its reputation but is unlikely to face much legal liability. But a good name is important. No firm wants the kind of publicity that Bear Stearns and Goldman Sachs got for putting their names on the fairness work on the Cendant debacle (see "The Cendant Deal: Limited Liabilities," page 46, and "The Tropical-Farah Deal: Assertions and Caveats in a Typical Fairness Opinion," page 48). Usually, a firm of that stature will resign from a fairness assignment if it can't affirm the price in good conscience. Neither firm saw the problems with the Cendant deal, because both relied on erroneous financial statements. That mistake led them to endorse an excessively generous price for the deal.

POSSIBLE REFORMS

Currently little, other than reputation, establishes a firm's credentials for fairness opinion work. While Justice Horsey's decision in Smith v. Van Gorkom left plenty of room for a wide range of experts to qualify--even a valuation by corporate insiders would have helped the directors' case, the record indicates--some CPAs say their professional standards have a lot to be said for them, especially in such a context. Peer review, ethics standards and the ABV programs all help.

Elson, the law professor, thinks fairness opinions are superfluous and play a "minimal" role in mergers. A director who joined Sunbeam's board after its accounting troubles had surfaced, Elson believes managements and boards rarely rely much on them (see case study, page 48). Instead, he would mandate that directors own substantial amounts of stock, thereby aligning their interests with the shareholders. "Substantial equity ownership by directors is the best guarantee of obtaining the best possible price for shareholders," he says. "If your own dollars are at stake, you're going to be more careful."

Stock ownership may not be enough in itself, however. Jerome Van Gorkom, whose name graced the precedent-setting case on this issue, had been Trans Union's CEO for 24 years and he owned a considerable amount of Trans Union stock when he ushered the bargain-basement sale past his unquestioning board.

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RELATED ARTICLE: The Cendant Deal: Limited Liabilities

Cendant was formed in 1997 in a $14 billion stock swap for the shares of HFS Corp. and CUC International. However, CUC had reported millions in phantom revenues. Subsequent to the deal, Cendant had to restate the previous three years' results and CUC's former CEO and CFO both were forced out of the company.

Neither Goldman Sachs, which had advised and written a fairness opinion for CUC, nor Bear Stearns, which had advised and written the opinion for HFS, is likely to be held legally accountable. Experts say they are probably home free because of the standard, carefully worded caveats written into their fairness opinions.

According to John C. Coffee, Jr., who teaches securities law at Columbia University in New York, most legal disputes contesting fairness opinions are settled quietly and out of court. That's the good news. The bad news: The investment bankers pass the buck to auditors. Corporate managers and directors under fire show "much more readiness to sue accountants," Coffee says.

Cendant Corp. slapped Ernst & Young, CUC's auditor for the years in question, with a lawsuit, contending that the accounting firm's clean bill of health for CUC's financial statements fell far short of generally accepted auditing standards. Yet, as CPAs know but the public rarely understands, accountants rely on managers to tell them the truth. E&Y has countersued, accusing Cendant of misleading its auditors.

RELATED ARTICLE: EXECUTIVE SUMMARY

* A FAIRNESS OPINION IS a third-party assessment of whether a deal involving a change in corporate control is fair to the investors. It's essential purpose is to provide a legal defense. In the event of a lawsuit, the opinion bolsters the position of the corporate board approving the deal.

* FAIRNESS OPINIONS ARE OPINIONS--subjective analyses. They are not a substitute for due diligence. Those reading them should consider the motives of those writing them.

* INVESTMENT BANKERS OFTEN prepare fairness opinions that may be biased by other interests. Some commercial bankers, CPAs and consultants also prepare fairness opinions, competing with investment bankers on the basis of greater independence and expertise as well as lower price.

* SOME ADVOCATES FOR BETTER CORPORATE governance disdain fairness opinions, saying they offer investors no useful information.

* A WELL-RESEARCHED FAIRNESS opinion can be valuable to corporate managers and investors because it may prevent a bad deal from going through or force the price of a deal to be renegotiated.

* CAVEATS ARE RIFE IN fairness opinions, limiting the liability of those that prepare them, even when deals go spectacularly sour.

RELATED ARTICLE: Top Dollar for an Opinion

Investment bankers don't like to go on the record about fees. Nonetheless, anonymous sources tell the JofA that fees for fairness opinions often amount to about 25% of the advisory fee on a deal, although that may vary according to the deal's size. The fee for the fairness opinion usually is paid whether or not the deal goes through. Advisory fees, which generally are contingent on the consummation of a deal and may run about 1% of the deal value, also fluctuate with size.

For example, a $100 million deal might fetch a million dollar advisory fee, with the fairness opinion adding another $250,000. A deal of $1 billion might carry an advisory fee of about 0.4%, or $4 million, with another $1 million for the fairness opinion. Investment banks or commercial banks writing fairness opinions may get additional fees by underwriting a stock or bond issue or participating in a syndicated loan to finance the deal.

RELATED ARTICLE: The Tropical-Farah Deal: Assertions and Caveats in a Typical Fairness Opinion

A quick glance at a typical fairness opinion finds that investment bankers and consultants leave themselves lots of wiggle room. Consider, for example, Tropical Sportswear's tender offer last year to purchase Farah Inc., the El Paso, Texas, clothing manufacturer, fl0r a total of $92.7 million.

Before the deal was consummated, Farah engaged the New York investment banking boutique Financo Inc. as an adviser to manage the company's sale to Tropical. As part of that advisory work, Financo wrote a fairness opinion. Right at the opinion's outset, the investment bank was up front about its potential conflict of interest, stating: "In addition to the engagement of Financo to render the opinion, Financo has acted as financial adviser to [Farah]."

The fairness opinion in the Farah deal, a two-page document, was appended to the schedule 14D-9 filed with the SEC (see "Web Resource List," page 51). It is fairly dry stuff, mostly given over to boilerplate. In particular, Financo declares it has "reviewed and analyzed" the terms and conditions of the tender offer as well as a raft of additional material and documents, including

* The financial terms and conditions of the merger agreement.

* Publicly available historical financial and operating data concerning Farah such as annual reports for the previous three years and the most recent quarterly 10-Q reports.

* The most recent internal analyses and forecasts of the company concerning earnings, cash flow, assets and future prospects.

* Publicly available financial, operating and stock market data of peer companies.

* A history of the way Farah's shares have traded over the previous three years.

* A comparison of the terms of the Farah deal with other recent transactions that either were in the same industry or were deemed relevant.

* The marketing and selling strategies that Farah's senior management and board had planned and undertaken.

While the fairness opinion goes on to say that Financo looked at a broad array of other business factors, such as the condition of Farah's machinery and the outlook for its products and markets, it is peppered with numerous caveats. Among these, for example, the opinion asserts that

* While the material presented is believed to be true, it appears "without independent investigation or verification" as to its accuracy and completeness.

* Financo has "relied upon the assurances of senior management of the company [Farah]" and that Financo is not aware of any facts that would cause the financial statements or other information to prove "inaccurate or misleading."

* The material is true only "as of the date of this letter.... we assume no responsibility to update or revise the opinion based upon events or circumstances" that occur later on.

* On legal, regulatory, tax or accounting matters, "we express no opinions."

Fairness opinions "are full of holes because no one wants to get sued," says Charles Elson, a professor at Stetson University College of Law in Saint Petersburg, Florida. Without the caveats, those preparing fairness opinions are vulnerable if a deal goes sour. Accordingly, these caveats are typical. However, people reading fairness opinions don't always pay enough attention to them. That could be a dangerous mistake.

RELATED ARTICLE: Web Resource List--Fairness Opinions

More than 2,000 sites related to fairness opinions currently are on the Web. Although the list below barely scratches the surface, the locations include examples and provide a perspective on the varied approaches used by firms that prepare such opinions.

www.houlihan.com/fairop.htm. Houlihan Valuation Advisors offers a Web site with extensive definitions and well-written examples of applications of the valuation process.

www.valuemetrics.com/solvency.htm. Valuemetrics has an interesting spin with its own valuation approach. It also provides examples.

www.jcbradford.com/busfin/corpfin/advisory.htm. J.C. Bradford & Co.'s site is of particular interest because it shows both applications and commentary from several of the company's clients.

www.westconsulting.com/december1.htm. West Consulting Group's site shows yet another valuation technique. The site is quite easy to understand. It also shows how business valuation fits into the entire scheme of business advisory services.

www.sec.gov/archives/edgar/data/T52324/O000930413-97-000322.txt. Here is an opportunity to look at a real application in context. Read this document, which includes fairness opinions by HAS Associates, Inc. and Ostrowski & Co., Inc. on the acquisition of First Bank of West Hartford by New England Community Bancorp, Inc. You also can search the SEC EDGAR database to find the full texts of other fairness opinions, such as the ones mentioned in this story.

--Contributed by Carolyn S. Sechler, CPA, Phoenix.

PAUL SWEENEY is a freelance writer working out of Brooklyn, New York. His stories have appeared in the New York Times and Business Week. He is also a contributing editor at US Banker. His e-mail address is [e-mail].