Fairness Opinions: Session 1
Preamble - the first in a series..
Over the next few months, we will share information about the systems and tools our team use and some of the services we offer.
I call these posts “sessions” because they’re designed to be both informative as well as easy to read, just like when you’re reading something easy. The aim of these sessions is to help you understand these topics better, so you can easily follow conversations with other capital markets professionals.
ABCs of Fairness Opinions
A fairness opinion is a letter issued by an independent financial advisory firm, typically an investment bank, that provides an expert judgment on whether the financial terms of a deal are "fair" to a specific party, such as a company's shareholders or board of directors. While not a guarantee of a deal's success or a recommendation on how to vote, a fairness opinion is a cornerstone of good corporate governance, designed to protect directors and instill confidence in stakeholders.
What is a Fairness Opinion?
At its core, a fairness opinion is a rigorous financial analysis that concludes whether the consideration to be paid or received in a transaction is fair from a financial point of view. It is typically sought by a company’s board of directors or a special committee of the board when evaluating a significant transaction, such as a merger, acquisition, divestiture, or management buyout.
The opinion is not a statement on the overall business strategy or the legal merits of the transaction. Rather, its scope is narrow and specific: it focuses exclusively on the financial terms, such as the exchange ratio in a stock-for-stock merger or the price per share in a cash buyout. The opinion’s primary purpose is to provide the board with an independent, objective perspective to assist them in fulfilling their fiduciary duties—specifically, the duty of care.
The duty of care requires directors to make informed and deliberate decisions on behalf of the company and its shareholders. The landmark 1985 Delaware Supreme Court case, Smith v. Van Gorkom (more on this in another post) forms the basis of the legal definition of the duty of care. Gorkom highlighted the legal risks faced by boards that failed to obtain expert financial advice before approving a major transaction, solidifying the fairness opinion's role as a protective measure for corporate directors.
In Canada, the InterOil decision by the Yukon Court of Appeal in 2017 changed the nature of fairness opinions from being boilerplate simple letters with few disclosures delivered to courts or shareholders for approval to more expansive reports outlining the details that the investment bank or advisor used to form their opinion. In addition, InterOil exposed the inherent conflict of interest of the investment bank or advisor that were paid for their fairness opinion on a contingent vs flat fee basis by requiring such banks and advisors to disclose how they were paid. Accordingly, fairness opinions for Canadian companies are far more bespoke than their US counterparts and more fulsome in their analysis and disclosures.
When Is a Fairness Opinion Required?
While a fairness opinion is often a matter of best practice, it is legally mandated in only a few specific situations. However, its use is far more widespread than legal requirements dictate due to the legal and reputational benefits it provides as was created as a result of Gorkum and InterOil. In general, if there is a perceived conflict of interest in any public company transaction (meaning either party is public), the it is a best practice for the board of directors to seek a fairness opinion from an independent third party.
SEC Regulations:
The U.S. Securities and Exchange Commission (SEC) does not have a blanket rule requiring a fairness opinion for all public company transactions. However, SEC Rule 13E-3, which governs “going-private” transactions, effectively necessitates one. A going-private transaction occurs when a public company is taken private, often by management or a controlling shareholder. Because of the inherent conflict of interest in these deals—where the buyers (insiders) have access to more information than the public shareholders they are buying from—Rule 13E-3 requires the company to provide a detailed discussion of the fairness of the transaction in a Schedule 13E-3 filing, including any fairness opinion received.
In recent years, the SEC has also extended requirements to "adviser-led secondary transactions" in the private funds space. These transactions, where investors are given the option to either sell their interests for cash or exchange them for interests in a new fund, now require the adviser to obtain and distribute an independent fairness or valuation opinion to fund investors.
Nasdaq and NYSE Rules:
As self-regulating bodies you’d think that all major stock exchanges have their own rules on fairness opinions for transaction. Shockingly, the major U.S. stock exchanges do not have explicit rules that mandate a fairness opinion.
Instead, they incorporate rules from the Financial Industry Regulatory Authority (FINRA), which governs investment banks and broker-dealers. FINRA Rule 5150 is particularly relevant. It does not require a fairness opinion, but it dictates specific disclosures that a FINRA member must make if it issues a fairness opinion that is to be provided to public shareholders. The disclosures focus on transparency regarding potential conflicts of interest, such as:
Whether the firm issuing the fairness opinion (ie the broker-dealer) has also acted as a financial advisor on the transaction.
Whether the firm’s fee for its services is contingent upon the successful completion of the deal
Any material relationships that existed between the firm and any party to the transaction in the past two years.
These rules serve to promote objectivity and ensure that shareholders are aware of any relationships that could compromise the independence of the opinion provider.
Fiduciary Duty and Best Practice in Action:
Beyond legal and regulatory mandates, a fairness opinion is highly advisable in any transaction where there is a real or perceived conflict of interest. This includes management buyouts, related-party transactions, or deals where a significant shareholder is on both sides. In these scenarios, the board’s decision is likely to be scrutinized, and an independent fairness opinion provides a crucial layer of protection against future litigation. The opinion demonstrates that the board has exercised due care and due diligence by seeking expert advice from a third party
One common place where there is abundant fairness opinion activity relates to Special Purpose Acquisition Companies or SPACs. The nature of a SPAC is to use it’s equity to purchase the shares of a private business and SPAC has a group of “sponsors” that will receive a substantial financial gain when such a transaction closes. As such, many SPAC board members often hold large financial interests in the SPAC will then seek an independent party to provide their shareholders guidance on the fairness of the transaction.
Main Components of a Fairness Opinion
In addition to the common law and general practices, there are three main bodies that govern professionals who complete fairness opinions for the capital markets. The International Valuation Standards Council (IVSC) has issued a Procedural Guide to Fairness Opinions that is followed by almost all of its member associations, the CBV Institute (formerly the Canadian Institute of Chartered Business Valuators) has several Standards of Practice (510 to 530) that provide the guidance for their fairness opinions and the American Society of Appraisers rely on their Uniform Standards of Professional Practice (USPAP) to guide their members on the disclosures and methods related to fairness opinions.
A fairness opinion, while typically a brief letter, is the culmination of an extensive and meticulous process. The letter itself will contain several standard components:
Scope of Engagement: This section outlines the purpose of the opinion and the specific transaction being evaluated. It defines the audience for whom the opinion is intended (e.g., the board of directors or a special committee) and states that the opinion should not be used for any other purpose.
Disclosure of Materials and Due Diligence: The opinion will list the documents and information the financial advisor reviewed in forming their conclusion. This includes public filings, internal financial forecasts, management presentations, and deal-related documents. It will also state what information was independently verified and what was taken at face value. This transparency is key to demonstrating the rigor of the process.
Valuation Methodologies: This is the analytical heart of the opinion. The financial advisor will describe the various valuation methods used to arrive at the conclusion. Common methods include:
Comparable Company Analysis (CCA): This method values the target company by comparing its key financial metrics and valuation multiples (e.g., enterprise value/EBITDA, P/E ratio) to those of publicly traded companies in a similar industry.
Precedent Transactions Analysis (PTA): This method assesses value by analyzing the prices paid in recent, comparable M&A transactions.
Discounted Cash Flow (DCF) Analysis: This is an intrinsic valuation method that estimates the value of a business based on its projected future cash flows, which are discounted back to their present value.
Conflicts of Interest Disclosure: As required by FINRA and other regulatory bodies, the opinion will clearly state any existing or contemplated relationships between the opinion provider and the parties to the transaction, as well as any contingent compensation arrangements.
The Conclusion: The final and most important section of the letter contains the financial advisor’s conclusion on the fairness of the transaction from a financial point of view. It will state whether the consideration is fair to the shareholders and often expresses the conclusion within a specific valuation range.
Who Normally Writes a Fairness Opinion?
Fairness opinions are almost exclusively prepared by independent, third-party financial advisory firms. These firms are chosen for their expertise in corporate valuation and their ability to provide an objective, unbiased assessment. The most common providers are:
Investment Banks: Large, well-known investment banks are primary players in this market, as they have deep M&A experience and specialized valuation teams.
Independent Financial Advisory Firms: A growing number of firms specialize solely in providing fairness opinions and other financial advisory services. These firms often market their complete lack of conflicts of interest, as they do not provide other services like capital raising or underwriting that could compromise their independence.
Accounting and Consulting Firms: Some of the world's largest accounting and consulting firms, such as PwC and EY, have dedicated deals or valuation groups that provide fairness opinions.
The selection of the opinion provider is a critical decision for the board, as the firm’s reputation and independence are essential to the credibility of the opinion. The board must ensure the chosen firm has no material relationships with any of the parties to the transaction that could lead to a conflict of interest, ensuring that the opinion serves its true purpose: to protect the interests of the shareholders and the integrity of the deal process.
