The National Association of Securities Dealers, Inc., or the NASD, recently proposed new rules that require certain disclosures in fairness opinions delivered by NASD members and require that NASD member firms have procedures regarding the issuance of fairness opinions. The proposed rules are intended to provide additional disclosure and mitigate potential conflicts of interest between the NASD member firm that issues a fairness opinion and the company that requests the fairness opinion. The new rules are subject to final approval by the SEC following a public comment period. If the proposed rules are adopted by the SEC, they will become effective 30 days following publication by the NASD of the SEC's approval.
Background on Fairness Opinions
Boards of directors often obtain fairness opinions in corporate control transactions to help satisfy their fiduciary duties to act with due care and in an informed manner in considering and approving a corporate control transaction. Although fairness opinions are common in corporate control transactions today to assist boards of directors in satisfying their fiduciary duties, there is no statutory or regulatory requirement for a board of directors to receive one. Since it is not required by regulation or statute, a company's board of directors decides whether to obtain a fairness opinion, the scope of the opinion and whom to engage to deliver the opinion. A fairness opinion typically states that the consideration to be paid or received by the company receiving the opinion or its shareholders is fair, from a financial point of view, to that company or its shareholders, depending on the transaction. A typical fairness opinion does not state that the transaction is the best deal that the company or its shareholders could receive, just that the consideration is fair.
If a board does receive a fairness opinion and that opinion is referred to in a proxy statement, the SEC's current proxy rules require that the fairness opinion be fairly summarized and describe (i) the procedures followed, (ii) the findings and recommendations, including the methods for arriving at the findings and recommendations, and (iii) instructions from the company regarding the investigation of fairness, including any limitations placed on the fairness opinion provider.
The Proposed Rules
There has been increasing media coverage regarding potential and perceived conflicts of interest between an NASD member issuing a fairness opinion and the company that is requesting the fairness opinion. Those concerns include situations in which the member firm providing the fairness opinion also represents one or more parties in the underlying transaction or all or a portion of the fee to be paid to the member firm is contingent on the consummation of the underlying transaction.
The NASD proposed the new disclosure rules because it was concerned that the disclosures made to investors in proxy statements may not sufficiently describe these and other potential conflicts and that as a result investors may not be sufficiently informed "about the subjective nature of some opinions and their potential biases." NASD stated that the new NASD disclosure rules were meant to be complementary to the SEC's proxy rules which apply to issuers. The proposed rules require that the following be disclosed in each fairness opinion issued by an NASD member firm that is included in a proxy statement:
- whether the member acted as a financial advisor to any transaction that is the subject of the opinion;
- whether the member will receive any compensation (for rendering the fairness opinion, acting as an advisor or otherwise) that is contingent upon the successful consummation of the transaction;
- any material relationship during the past two years or understood to be contemplated between the member and the companies that are involved in the transaction, as well as any compensation received as a result of any such relationship;
- the information that formed a substantial basis for the fairness opinion and that was supplied by the company requesting the opinion, and whether such information was independently verified; and
- whether the fairness opinion was approved by a fairness committee that followed the procedural requirements set forth in the proposed rules.
In addition to the new disclosure rules, the NASD proposal also includes new procedural rules requiring NASD members to adopt written supervisory procedures to mitigate potential conflicts of interest in rendering fairness opinions. These proposed rules require NASD member firms that issue fairness opinions to have procedures that address the following:
- the types of transactions and circumstances in which the member will use a fairness committee;
- in transactions where the member uses a fairness committee, the process for selecting the committee members, the qualifications for members and the process for ensuring review and approval by persons that are not on the deal team for the transaction;
- the process to determine which valuation analyses are appropriate for the companies involved in the transaction; and
- the process to evaluate the degree to which the amount and nature of the consideration in the transaction benefits any officer, director or employee, or class of such persons, relative to the benefits to the shareholders, is a factor in reaching the fairness determination.
With a few exceptions, the proposed new disclosure rules are not a significant deviation from current disclosure practice. Two of the more significant changes promoted in the press and by some commentators responding to the NASD's request for comments were not included in the NASD's proposed rules. The suggestions were that fairness opinions should be issued by (i) independent advisors that are not otherwise involved in the transaction and (ii) advisors whose fee for rendering the fairness opinion is not contingent on the success of the transaction. The NASD noted that while these comments may be well founded, it believes that these matters should be determined by the board of directors of the issuer and state corporate law and that the NASD's proposed disclosure and procedural rules provide an appropriate mitigation against potential conflicts of interest in rendering fairness opinions.
The proposed rules will require a few changes in process for member firms issuing fairness opinions. Many of the disclosures required by the proposed rules are similar to those commonly made under current disclosure practice in the company's proxy statement. Besides tailoring the disclosures to meet the exact requirements set forth in the proposed rules, the disclosures will have to be made in the fairness opinion itself, even if the same disclosure is made in the body of the company's proxy statement.
While the proposed NASD rules do not require that the opinion provider independently verify the information on which the fairness opinion is based, the proposed rules do require that the opinion provider identify the information provided by the issuer that formed a substantial basis for the fairness opinion and state whether such information was independently verified. The NASD stated that the information must be identified and that "blanket statements that members have not verified information will not by themselves comply with the proposed rule change." The proposed rules do not specify how detailed the identification of information must be. Current practices among opinion providers vary, with some listing the information they reviewed in detail and others describing the information they reviewed very generally. Since an opinion provider often reviews a variety of information supplied by the issuer (especially in circumstances in which the opinion provider is also acting as a financial advisor in connection with the underlying transaction), the opinion provider will now have to determine which information formed a substantial basis for the fairness opinion and identify it in the fairness opinion. It is worth noting that the NASD rule only requires disclosure of such information that is provided by the company requesting the opinion, so information provided by other parties to a transaction need not be disclosed under the new NASD rule. Depending on the circumstances it may be good disclosure practice to still identify such information in the proxy statement and/or the fairness opinion.
While most member firms may have in place internal procedures for the issuance of a fairness opinion, including a committee that approves the issuance of a fairness opinion, the proposed rules will require that member firms revisit these procedures and the composition of their fairness opinion committees. The new rules require only that the member adopt procedures that address the matters and do not specify how detailed or rigorous those procedures should be. In fact, the proposed rules do not even require that the procedures be in writing, although member firms will want to have written procedures to evidence compliance with the proposed rules.
The proposed rules require that member firms that issue fairness opinions adopt procedures regarding the process for determining the appropriate valuation analyses for particular companies and transactions. Rather than insist that every member firm use particular valuation analyses, the proposed rules give each member firm the flexibility to adopt its own procedures for determining the proper valuation analyses to use for different types of companies and transactions. The NASD stated that these procedures should be designed to prevent the use of an inappropriate methodology at the request of an interested party.
Although the proposed rules do not set forth the particular analyses that must be included in considering each fairness opinion, the proposed procedural rules may lead to member firms including new analyses of the relative transaction compensation paid to corporate insiders compared to the company's shareholders. The proposed rules require that each member firm issuing fairness opinions have a procedure to evaluate the degree to which the differential in compensation between corporate insiders and the company's shareholders is a factor in the fairness determination. The NASD stated in the proposed rule release that in determining the differential in compensation, the member firm should include only compensation from deal proceeds and not compensation from pre-existing contractual commitments. The proposed rule does not state how this differential in compensation should be analyzed. In adopting procedures to address this requirement, member firms will likely need to have procedures for (i) determining the amount and type of transaction consideration that benefits corporate insiders, (ii) determining what type of analyses to apply to the differential in compensation, and (iii) how to interpret those analyses. The NASD did not give much guidance to member firms for determining exactly what the analyses should be or what thresholds members should consider as too much differential in compensation. Should member firms compare the differential in compensation as a percentage of the total transaction consideration or as a percentage of the corporate insider's compensation as a result of the transaction? Should the differentials be compared to differentials in compensation in comparable transactions? It is also unclear how often the differential in compensation should be a factor in making the fairness determination. According to the NASD, the considerations for determining fairness are "artificially truncated when the total amount that a buyer is willing to pay and how such payment is allocated is never an appropriate factor in change of control transactions."
The good news for member firms is that the proposed rules focus on disclosure and procedures, rather than prohibitions on delivering fairness opinions for transactions where the member is also advising on the transaction or is receiving a fee contingent on the transaction. In addition, the proposed rules allow each member firm to adopt its own procedures, without mandating that particular procedures must be used by every member firm for each fairness opinion. The bad news is that the proposed rules will require member firms to develop and put in place new procedures and processes for issuing fairness opinions, including the use of new analyses and disclosures.