The heightened accountability and duty to be informed that Sharer alludes to is perhaps most apparent in today’s litigious transaction environment. When contemplating a proposed transaction, directors are exposed to the risk of personal liability and the potential to destroy shareholder value. To mitigate these risks and better serve shareholders, board members seek the protection and insights that a robust fairness opinion provides.
Before selecting a fairness opinion provider, board members should ask themselves four critical questions.
- What is the purpose of obtaining a fairness opinion?
- Why is obtaining a fairness opinion more important than ever in today’s legal environment?
- Who should board members select as their fairness opinion provider?
- When should a board engage a fairness opinion provider?
Question 1: What is the purpose of obtaining a fairness opinion?
In September 1980, the Trans Union Corporation agreed to a cash-out merger with Marmon Group Inc. for a 48 percent premium to Trans Union’s public share price. Unbeknownst to the Trans Union board of directors, the deal announcement would set in motion a series of Delaware court decisions which would change the landscape of corporate law forever.
In the now famous Van Gorkom decision, 2 the Delaware Supreme Court concluded that the Trans Union board of directors were uninformed when contemplating the cash-out merger with Marmon Group and thus personally liable for monetary damages. The Supreme Court cited, in part, the fact that the Trans Union directors did not obtain a fairness opinion, leaving them unable to properly assess the fair value of the corporation they were surrendering. 3
To the Trans Union board, the seemingly large premium to the company’s share price gave the appearance of an ideal transaction. Nonetheless, the Delaware Supreme Court asserted the directors have a fiduciary duty to fully inform themselves by obtaining a fairness opinion to confirm the consideration offered by Marmon Group was adequate compensation to the Trans Union shareholders.
As a result of the Van Gorkom decision, fairness opinions became commonplace in the realm of corporate decision-making and are now widely considered corporate governance best practice. In fact, many corporations get multiple fairness opinions on significant deals.
Over the nearly 40 years since Van Gorkom, fairness opinions have been obtained to improve the decision-making ability of directors and mitigate their risk of personal liability. A fairness opinion improves the board’s decision-making ability by providing directors with insights into the intrinsic value of what is being surrendered and obtained in a potential transaction. These insights are critical to understand if the consideration being exchanged will create or destroy shareholder value. A fairness opinion also mitigates risk of personal liability for directors as it is key evidence of the board upholding its fiduciary duty of due care.
Question 2: Why is obtaining a fairness opinion more important than ever in today’s legal environment?
The legal environment faced by the Trans Union board of directors was notably different than the one boards operate in today. Two recent legal trends that board members should be cognizant of are the increase in shareholder activism and greater focus on board accountability: shareholder activism and focus on board accountability.
Board members face fundamentally different challenges as compared to before the Great Recession. One notable challenge is the pressures of shareholder activism. Shareholder activism is characterized by the influence of a corporation’s behavior through the exercise of shareholder rights. Activist demands can take many forms, such as proxy battles, shareholder resolutions and litigation. From 2010 to 2016 the number of public companies subjected to activist demands nearly quadrupled. 4
Directors executing a transformative corporate action in response to activist demands can incite litigation when other shareholders believe the transaction is not in their interests. In August 2017, shareholders of a global packaging company complained that “the directors entered into the merger in bad faith in reaction to a threatened proxy contest by an activist investor.” 5 Similarly activist investors have been known to initiate litigation when their demands are not met, as seen in a March 2017 case involving a pharmaceutical company. 6
Amid greater scrutiny, board members that obtain a fairness opinion when executing a significant corporate action, such as a company sale or a major acquisition, will be better protected in the event legal action is brought about by activist investors or other shareholders whose interests are not aligned with activist demands.
Focus on board accountability
From 1996 to 2011, 98% of public companies being acquired obtained at least one fairness opinion. 7 The desire for fairness opinions from boards on the sell-side of a transaction stems from the high likelihood of litigation. This threat of litigation is illustrated by the fact that shareholders of public targets filed lawsuits in 73% of M&A deals valued over $100 million in 2017. 8
In the event of shareholder litigation, the actions of a target’s board of directors will be reviewed in detail to ensure accountability. This is because whenever a sale of a company or control takes place, the Delaware courts will implement the standard of review known as "enhanced scrutiny."
Enhanced scrutiny requires directors to prove that the business decision was performed with adequate care and their decision was reasonable under the circumstances. 9 Boards who do not obtain a fairness opinion are exposed to greater risk of personal liability as fairness opinions are critical in demonstrating adequate care in the eyes of the courts.
Why these matter
Both of these trends result in enhanced risk for directors when executing corporate decisions. The presence of activist shareholders increases the likelihood of litigation, while enhanced board accountability means board decisions will be heavily scrutinized during the litigation process.
The relationship between higher standard of review and greater personal liability for board members is well established. 10 To mitigate risk, inaction is not the answer. Deciding not to execute on a potentially lucrative transaction is still a decision which can be challenged by shareholders. It is incumbent upon directors to seek greater insights that can assist in the decision-making process and improve deal outcomes.
A fairness opinion provides directors with these insights and is a clear demonstration that the board is acting on an informed basis. These analyses have proven to be paramount in the decision-making process, evidenced by an increasing number of boards obtaining multiple fairness opinions in a single transaction.
Question 3: Who should board members select as their fairness opinion provider?
Not all fairness opinion providers are created equal, both in terms of their ability to provide truly independent insights and their rigor of analysis.
Courts have voiced concern about fairness opinions where they deem a lack of independence is present. Fairness opinions provided by companies that also have other fees contingent on the deal closing is an area where there can be a perceived conflict of interest. As noted by CalPERS, the largest public pension fund in the U.S., “We believe there is inherent bias when a contingent fee structure is used in rendering any opinion. There is a very large incentive for an investment bank to find that a transaction is fair, regardless of the circumstances, when the bank will receive the bulk of its fee only if the transaction is successful.” 11
For many reasons, companies will still get a fairness opinion from an investment bank assisting on the deal. In recent years, however, many boards are seeking at least one opinion from an independent provider to have a truly objective advice.
The quality of insights gained and protection afforded to board members from a fairness opinion are dependent upon the rigor of analysis supporting that opinion. A robust fairness opinion often requires expertise that goes well beyond traditional financial modelling and incorporates the findings of in-depth diligence capabilities. Ideally, an opinion provider will be able to perform additional analyses such as:
- Market sizing
- Contingent consideration valuation
- Quantification of tax ramifications and attributes
- Cyber risk assessment
- Synergy assessment
Some opinion providers simply rely on management forecasts to assess the economics of the deal. Other providers leverage these additional capabilities to assess other value pockets and their associated risk in addition to the financial projections. By taking a more comprehensive view of the deal, the fairness opinion provides the board of directors with additional insights that allow the board to make better decisions.
Question 4: When should a board engage a fairness opinion provider?
Including an opinion provider early in the diligence process will allow the provider to uncover unique value insights that can be shared with the board of directors. Review of these insights by the directors is crucial evidence that they have upheld their fiduciary duty of due care by being informed when making a corporate decision.
When is the ideal time to involve a provider? The short answer is it depends on a number of factors but an engaged board will allow a provider enough time to conduct the right level of diligence and research.
For example, in a Delaware Court of Chancery case involving a large beverage distributor, the judge was critical of a fairness opinion that was produced in approximately one week. The opinion was deemed to be “highly suspect” and “a mere afterthought, pure window dressing intended by the defendants to justify the preordained result of a merger.” 12