Business Valuation Services

Expert Witnesses

INTRODUCTION

The fairness opinion has over the past 20 years become a standard feature of merger & acquisition transactions entered into by public companies. Directors and management seek to carry out their duty of care by engaging an outside financial advisor to review the terms of a contemplated transaction and to express an opinion as to their fairness.

Most frequently, the fairness opinion is provided by an investment banker who is instrumental in proposing and helping bring about the transaction. It can be argued on a number of grounds that the investment banker for the deal is the party best qualified to prepare the opinion. In recent years, however, a number of investors and regulators have begun to publicly voice concerns that the investment banker lacks the independence required to provide a truly unbiased look at the transaction. Two recent manifestations of this are the Massachusetts investigation of the Procter & Gamble – Gillette transaction, and the proposed NASD rulemaking on fairness opinions.

Procter & Gamble – Gillette

In the proposed acquisition of The Gillette Company by Procter & Gamble Co., a fairness opinion was prepared for Gillette by Goldman Sachs and UBS Securities. William Galvin, secretary of the commonwealth of Massachusetts is investigating these fairness opinions. He is concerned that, because Goldman Sachs brought the deal together, their opinion might not be objective. He has subpoenaed documents related to the fairness opinion, and has engaged Rajesh Aggarwal, a professor at the University of Virginia, to analyze the opinions. Professor Aggarwal has stated that he found that transaction synergies have been understated in a way that would result in an underestimation of the value of the deal.

As quoted in The New York Times (5/29/05), Professor Aggarwal said “I think we’re going to see more boards hiring independent parties to evaluate transactions …if one of the high-profile deals that are in process now were to blow up because it looked like the board didn’t do enough investigation on behalf of shareholders, you would absolutely see a lot more use of third parties to make sure the deal is good for shareholders.”

“... Congressman Edward Markey… publicly called upon the SEC to investigate conflicts of interest in fairness opinions. ”

In the wake of the Galvin investigation of the Gillette transaction, Massachusetts Congressman Edward Markey, on June 6, 2005, publicly called upon the SEC to investigate conflicts of interest in fairness opinions. He requested that the SEC determine the prevalence of such arrangements by reviewing corporate transactions between January 1, 2003 and June 1, 2005.

NASD Fairness Opinion Rulemaking

The NASD, in November 2004, announced that it was soliciting public comments on a possible new rule establishing procedures to address potential conflicts of interest when its members provide fairness opinions in connection with corporate control transactions (Notice to Members 04-83).

Said NASD Chairman Robert Glauber, “we are concerned that current disclosures in fairness opinions may not sufficiently inform investors about their potential conflicts and limitations…for instance, investors may evaluate a fairness opinion differently if they know that the investment bank rendering it has acted as financial advisor to one of the companies involved, and will receive compensation when the transaction is successfully completed.”

Specifically, the NASD said it was considering whether to propose a rule that would require its members to: (1) disclose in any fairness opinion appearing in any proxy statement any significant conflicts of interest, including, if applicable, that the member has served as an advisor on the transaction in question, and the nature of compensation that the member will receive upon the successful completion of the transaction; and (2) require specific procedures that members must follow to identify and disclose potential conflicts of interest in rendering fairness opinions.

The SEC’s proxy rules require certain disclosures about a fairness opinion that is referred to in a proxy statement. These disclosures must describe the procedures followed, the findings, the bases for and methods used to arrive at the findings, any instructions received from the subject company, and any limitation imposed by the subject company on the scope of the investigation.

The NASD is concerned that the SEC-mandated disclosures may not sufficiently inform investors about the subjective nature of some opinions and their potential biases.

Also, if a transaction provides one group of shareholders, directors, or employees a benefit or payout which is materially different than that received by unaffiliated shareholders, biases may be created in favor of the transaction if the people receiving the benefit were involved in hiring the investment bank, or could direct future business to the investment bank.

The rule making ideas on which the NASD has asked for comments include a rule requiring a clear and complete description of any significant conflict of interest, including whether the member has served as an advisor on the transaction, and the nature of the compensation that the member will receive.

“ ‘We strongly urge the NASD to propose a new rule to address the important issue of fairness opinions and conflicts of interest. ’ ”

Comments to NASD Proposal

The NASD received 20 comment letters in response to its Notice to Members. A substantial majority of the responses were generally supportive of the kind of rule that the NASD had under consideration.

The response of the Ohio Public Employees Retirement System (OPERS) could be considered representative. “We strongly urge the NASD to propose a new rule to address the important issue of fairness opinions and conflicts of interest.”

The Council of Institutional Investors, an association of corporate, public and union pension plans, had this to say; “The Council asks the NASD to expand its review and reform efforts regarding fairness opinions to include additional disclosures of value to investors.”

Several respondents would go further than the NASD, proposing that advisors standing to receive a “success” fee from the transaction be prohibited from providing a fairness opinion. An example of this point of view can be found in the response of the California Public Employees’ Retirement System (CalPERS). “The NASD rule should prohibit investment banks from receiving ‘success’ fees for transactions in which they issue fairness opinions. 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. Contingent fee structures for public accountants are already prohibited by the SEC.”

The AFL-CIO had a similar opinion. “While we generally support the rule as proposed, we encourage the NASD to strengthen its proposal by including an outright ban on the most egregious conflicts, notably arrangements in which part of an investment bank’s fee for rendering its opinion is contingent upon the transaction closing.”

OPERS had this to say; “Ideally, fairness opinions should consist of an independent legal appraisal by outside experts, who are not connected to the transaction, to ensure that the valuation is fair to shareholders.”

A number of respondents also supported the notion that fairness opinions should disclose compensation arrangements that apply to executives in “change-of-control” agreements, on the grounds that such executives may be encouraged to influence the direction of a fairness opinion. Several other respondents contested this point of view, however. A letter from Dewey Balantine LLP, for example, said the following; “We respectfully submit that the evaluation of compensation arrangements is not within a member’s role as a financial advisor or provider of a fairness opinion and that such institutions do not have the level of experience with compensation arrangements to properly advise or comment on such arrangements.”

Finally, there were a number of respondents who felt that a new rule on fairness opinions by the NASD was simply not needed. A letter from the Committee on Securities Regulation of the New York State Bar Association, for example, concluded as follows; “Fairness opinions are sought, and delivered, to address issues arising under state corporations statutes. The state courts have developed a body of law with respect to fairness opinions that reflects the underlying state law purposes sought to be advanced by those corporations statutes. NASD rules specifying procedures for delivery of fairness opinions would introduce a new and potentially troublesome element into this area of state law.”

“The ground appears to be shifting on the issue of financial advisor independence...”

CONCLUSION

The ground appears to be shifting on the issue of financial advisor independence in the preparation of fairness opinions. The mere appearance of a conflict is now coming to be seen to cast a shadow on the independence of the provider of the opinion. This in turn undermines the ability of the opinion to serve its purpose of providing an objective outside look at the deal. Directors are then forced to play defense, having to prove an absence of bias on the part of their financial advisors. And as we all know, it’s not easy to prove a negative.

HAPPENINGS AT HEMPSTEAD & CO.

Senior Appraiser Dave Routzahn, ASA has received his designation as an Accredited Senior Appraiser (ASA) in the American Society of Appraisers in the discipline of business valuation. To earn this designation Dave had to gain five years of full-time experience in business valuation, complete ASA coursework, submit sample valuation reports for peer review, and pass a series of written examinations.

The American Society of Appraisers, based in Washington DC, is the leading multidisciplinary professional society for appraisers.

In his position with Hempstead & Co., Dave prepares valuations of securities of privately-held companies. He holds a Masters in Business Administration in Finance from Drexel University and a BA in Economics from Rowan University. He is a member of the Philadelphia Chapter of the American Society of Appraisers and the Estate and Financial Planning Council of Southern New Jersey.

Hempstead & Co. is a financial consulting firm providing services in the following areas:

• Valuations of Businesses and Corporate Securities
• Fairness Opinions
• Valuations of Stock Options
• Valuations of Intangible Assets
• Loss of Business Damage Analysis
• Mergers & Acquisitions

The members of our professional staff have backgrounds in valuation, finance, accounting, economics, engineering, and investment banking. Professional designations include Accredited Senior Appraiser, American Society of Appraisers (ASA), and Chartered Financial Analyst (CFA). We welcome the opportunity to serve you. Please call Mark Penny at (800)541-3323 or contact him via e-mail at jmpenny@hempsteadco.com.