NASD Scrutinizes Conflicts In Bankers' 'Fairness Opinions'

June 11, 2004

Wall Street bankers involved in the lucrative and thinly policed business of offering "fairness opinions" on the value of corporate mergers and acquisitions may face tough new rules for disclosing the financial incentives that they and the company executives they advise have for pushing through deals.

The NASD, the main self-regulatory body for brokerage firms, has begun a potentially far-reaching inquiry into the fees, methods and possible conflicts of interest connected with such opinions, people familiar with the inquiry say. At a time when the M&A business is gaining momentum in a resurgent economy -- with 7,226 deals totaling $558 billion in the U.S. last year, according to data company Dealogic -- any significant regulatory shift could touch a lot of wallets.

The changes being considered by the NASD, formerly known as the National Association of Securities Dealers, also could help prevent ill-conceived deals that ultimately erode shareholder value or force thousands of layoffs. They could even alter the dynamics of how companies are bought and sold.

The NASD sent letters to several Wall Street firms earlier this year requesting information about their recently issued fairness opinions in an attempt to examine possible conflicts in past deals. The agency's board of governors may vote as soon as this summer to propose new rules governing prospective fairness opinions. Spokeswoman Nancy Condon said that the agency is looking at a variety of "possible approaches" to deal with conflicts of interest involving such opinions but that "primarily, we've been working on disclosure requirements." She declined to comment further on the inquiry.

While the NASD seems to have seized the lead on the issue, other regulators could join in. Securities watchdogs are eager to appear more proactive after being criticized in recent years for allowing longstanding conflicts of interest to fester, including stock research tainted by bankers' desire to tout clients during the technology boom.

The NASD's proposals would require approval by the Securities and Exchange Commission, which is itself conducting an inquiry into a broader array of potential conflicts of interest on Wall Street and looking at ways to mitigate them. New York State's attorney general, Eliot Spitzer, has said in the past that he was considering looking more closely at fairness opinions, but a spokeswoman said yesterday that his office isn't currently active in the area.

Fairness opinions are provided routinely on a host of corporate transactions, including initial public stock offerings, takeovers and spinoffs of company units. In mergers and acquisitions, corporate boards commonly seek these opinions to protect against legal challenges over a decision to do a deal.

At a few million dollars a pop in many cases, they've become a money-making sideline for Wall Street that can also lead to investment-banking work. The opinions are sometimes done by investment bankers whose firms have no other role in the deal. But they also can be prepared by bankers from the same firm that suggested a deal take place and that stands to collect a "success fee" that is a percentage of the deal's price at completion.

When Bank of America Corp. agreed to acquire FleetBoston Financial Corp. for more than $40 billion last fall, Bank of America agreed to pay adviser Goldman Sachs Group Inc. $3 million as a retainer, $5 million for its fairness opinion, and $17 million upon completion of the merger, according to a proxy statement filed on the deal. FleetBoston agreed to pay adviser Morgan Stanley as much as $25 million for the same set of services, the proxy said.

This spring, when Royal Bank of Scotland Group PLC's Citizens Financial Group Inc. agreed to buy Charter One Financial Inc., of Cleveland, for about $10.5 billion, Charter One agreed to pay Lehman Brothers Holdings Inc. $2 million when the merger was announced and $21.2 million at the closing of the merger, according to a Charter One proxy filing on the deal. Lehman's services included a fairness opinion.

Lehman, Morgan Stanley and Goldman declined to comment on the transactions.

Jim Moloney, an attorney at Gibson, Dunn & Crutcher in Irvine, Calif., who often advises on large corporate deals, said that "because fairness is so subjective," banks aren't "insuring or guaranteeing it's the best deal for shareholders. They're simply saying it fits within a range of fairness."

The people familiar with the NASD inquiry said the greater disclosure requirements under discussion could, in effect, make investment bankers responsible for ascertaining independently the fair value of a transaction before certifying to a corporate board that company management is doing the deal at a fair price.

Bankers who provide fairness opinions tend to rely heavily on public filings and information that corporate insiders give them regarding assets and liabilities, according to bankers and management experts. While bankers sometimes do extensive additional work, the potential to win investment-banking business from their clients gives them an incentive to accommodate management and declare that the terms of a proposed deal are fair. The NASD could propose more fact-finding, including requiring that bankers examine the financial rewards that senior officers may receive by doing a deal.

According to a person familiar with discussions within the NASD, some officials there worry about the large number of corporate executives who have "change in control" clauses in their employment contracts that award them big bonuses upon the sale or restructuring of their companies. Such bonuses typically aren't detailed now in the fairness opinions delivered by Wall Street.

In some hotly contested recent mergers, shareholders have alleged that self-interest caused bankers and executives to put a seal of approval on a low price that wasn't in the best interest of the shareholders. The low price might help ensure that the deal went through and so trigger the bonus.

Such change-in-control payments became an issue last year, for example, when France's AXA SA sought to acquire MONY Group Inc. for $1.5 billion. Some shareholders went to court to try to block the vote, arguing that the offer was unacceptably low. They contended one reason company management had pushed the deal was that senior officers stood to make tens of millions of dollars upon its completion, and that the payments weren't adequately disclosed.

Credit Suisse First Boston, a unit of Credit Suisse Group, provided the fairness opinion for MONY. While a Delaware Chancery Court judge required greater disclosures about the payments, it noted that CSFB actually had an incentive to push for a high, not low, price: It stood to earn a separate success fee based on the size of the deal. Its fees in aggregate are expected to total $16 million, according to public filings. Last month, shareholders voted to approve the merger. A CSFB spokesman declined to comment.

Some securities-law specialists question how much beefed-up disclosure would accomplish. They say it might hurt companies by making deals more expensive and time-consuming, while failing to eliminate the problematic financial incentives.

"There's a fundamental conflict to begin with when a company hires an investment banker with the expectation that they will provide the company with the fairness opinion they are looking for," said Lucian Bebchuk, professor of law, economics and finance at Harvard Law School. "Disclosing that this problem exists ... might enable the shareholders to assign a touch less weight to the investment banker's opinion," but the incentives will still exist, he said.

Already, with the NASD inquiry pending, Wall Street lawyers said firms have begun disclosing more about the component parts of their fees when deals are announced. Corporate boards increasingly are forming special committees, often with independent board members, to evaluate potential conflicts that may influence a transaction, said Marjorie Bowen, national director of the fairness-opinion practice at investment bank Houlihan Lokey Howard & Zukin. As a further measure, said Bob Hotz, an investment banker with the firm, "we're starting to see companies ask for a second fairness opinion by an independent bank."

Fairness opinions became common after a 1985 ruling by the Supreme Court of Delaware, the leading jurisdiction for M&A law because of the large number of companies that incorporate in Delaware. In that case, which involved allegations that Trans Union Corp. sold itself too cheaply to the Pritzker family, the court held that Trans Union's board had violated a duty of care and sold the company for too little money. The court stated that getting a fairness opinion would have helped in fulfilling that duty.

The decision prompted corporate boards to routinely seek fairness opinions. But their purpose was as much bullet-proofing a board's decision as exploring valuations.

Fairness opinions "are basically legal documents. They're not really investment documents," asserted Charles M. Elson, professor of corporate governance at the University of Delaware. There is no accepted standard by which bankers should perform valuation analyses for such opinions, he said. "What happens is the board needs an opinion like that to protect itself legally."






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