Shining the Disclosure Light on Fairness Opinions: Delaware Courts Support Enhanced Disclosure in Early 2007 Cases

In a trio of recent cases, the Delaware Chancery Court emphasizes the importance of disclosure to shareholders of information relied upon by financial advisors in making fairness determinations, along with information about compensation arrangements and other relationships that may present potential conflicts of interest for advisors. Delaware courts continue to be sensitive—especially in cash buyouts—to the reliance potentially placed by shareholders on banker fairness opinions and have been judicially active in assuring that such reliance is put in proper context through more fulsome proxy statement disclosure.

There are several important lessons to be learned from these cases:

• Be careful about the projections relied upon by various transaction constituents. If the proxy statement is to include target projections, as in most financial buyer cash transactions, the most recent projections produced by management and relied upon by the financial advisors of the buyer and the target should be in synch and disclosed. Circumstances may also dictate disclosure or explanation of other projections produced by management—for example, when more favorable projections exist, but they lack credibility for some reason or their purpose was inconsistent with the purpose of valuation.


• Be prepared to justify the propriety of, and to disclose fully, the material terms and conditions of past, present and future fee arrangements and other relationships involving a financial advisor that may give the appearance of a conflict of interest or limiting alternatives. This includes the amount of compensation that may be earned, any contingencies affecting payment, the source of payments (including fairness opinion fees, M&A success fees and stapled finance fees) and relationships with parties to the transaction and their affiliates, including both acquirer and target.


• Delaware courts have not yet imposed any requirement to "explain" a banker’s conclusion as to fairness when no such explanation is otherwise part of the corporate record. Accordingly, bankers should continue to choose their words carefully in board meetings and to resist periodic efforts by the Securities and Exchange Commission staff to explain how each valuation analysis relates to the conclusion of fairness when no such explanation was given to the board of directors.

These three cases are summarized below.

In re Netsmart Technologies, Inc. Shareholders Litigation (Del. Ch. March 14, 2007)

This Delaware Chancery Court case involved a preliminary injunctive action against the cash buyout of a microcap public company by a private equity firm. While now best known for the court vice chancellor’s analysis of the target board’s fiduciary duty shortcomings under Revlon, the case involved some important disclosure issues relevant to financial advisors as well.

Delaware courts have never been reluctant to weigh in on proxy statement disclosure matters. Directors of Delaware corporations have a "duty of candor" to disclose fully and fairly all material information within the board’s control when they seek shareholder action. Materiality is viewed in a manner comparable to federal securities laws. Vice Chancellor Leo E. Strine noted that "when stockholders must vote on a transaction in which they would receive cash for their shares, information regarding the financial attractiveness of the deal is of particular importance."

The plaintiffs in this case challenged two sets of undisclosed projections. The first set, prepared by target management and shared with its board early in the process, projected values based on a constant price/earnings (P/E) ratio higher than Netsmart’s trading multiple at the time. But the court concluded these were not material in light of the inclusion in the proxy statement of more current and bullish projections upon which the financial advisor relied. In the court’s view, inclusion of the older projections would only make the deal look fairer to stockholders. Nor did the court feel management’s constant P/E multiple of 25 needed to be disclosed since there was no reliable basis for its use by management or evidence of management’s expertise in predicting future trading multiples.

The second set of undisclosed projections challenged by plaintiffs consisted of the final projections used by the financial advisor in connection with its fairness opinion. Although the proxy statement did include two sets of projections—one used as part of the process of soliciting acquisition interest and another used by the private equity buyer with prospective lenders—the court decided that these projections were not ultimately relied upon by the financial advisor in preparing the fairness opinion. The proxy statement disclosed that the discounted cash flow analysis of the financial advisor covered the years ending 2010 and 2011 and that 82 to 86 percent of the present value of Netsmart’s calculated enterprise value was attributable to the discounted cash flow value calculated from 2011 earnings before interest, taxes, depreciation and amortization. However, neither of the sets of projections included in the proxy statement included any of the financial metrics for the years ending 2010 and 2011 reviewed by the financial advisor. Given the importance of projected financial data for these later years, the court concluded the omission failed to give stockholders the best estimate of management and of the special committee’s investment bank of the company’s future cash flows as of the time the board approved the merger. The court noted the relevance of this information particularly where management, through receipt of stock options in the soon-to-be private company, are especially interested in these forecasts.

In dismissing other alleged deficiencies in relation to disclosure of the fairness opinion, the court did not require a disclosure that the proposed purchase price was at the low end of the range of each of the valuation analyses. The court held that, in the absence of an evidentiary record concerning disclosure of the reasons why the financial advisor still reached its fairness conclusion, there is no affirmative obligation to manufacture and disclose these reasons or their relationship to the analyses disclosed.

Louisiana Municipal Police Employees’ Retirement System, et al. v. Caremark RX, Inc. et al. (Del. Ch. February 23, 2007)

Like Netsmart, this case has received significant attention for its analysis of deal negotiation flaws—in this instance, deal protection measures that, while within customary norms, may have failed to account for deal specific circumstances. On a motion for injunctive relief, the court concluded that the transaction could proceed, subject to appropriate modification of disclosure to shareholders.

One of the disclosure claims involved disclosure of the structure of the investment banker’s compensation. The financial advisory fees were structured so a relatively small portion of the fee was payable upon rendering a fairness opinion, and a much larger amount was payable following "public announcement" of a transaction with CVS and upon consummation of that transaction (or an alternative transaction within nine months). The disclosure in the proxy statement indicated the aggregate fees payable to the financial advisor upon consummation of a transaction and did not reference the approval of the transaction and its public announcement as a condition to realizing the success fee. While technically accurate, the court viewed it as misleading because it failed to disclose the initial requirement bankers had to meet in order to receive their fees.

The court focused on the requirement of "public announcement" of a Caremark/CVS deal (and not another party) as a predicate to receipt of its fees and noted that the "fees are naturally contingent upon approval of the transaction." This fee structure appeared to incent the financial advisor to favor a CVS deal. While it is not unusual for an investment bank to be viewed as inherently incentivized to issue a favorable opinion in a transaction so that it may ultimately realize a success fee, it is far less common contractually to link the realization of a success fee to a particular bidder. As a result, in the court’s view, "knowledge of such financial incentives on the part of the bankers is material to shareholder deliberations."

Ortsman v. Green, et al. (Del. Ch. February 28, 2007)

This was an action for expedited discovery prior to consummation of a proposed cash merger involving Adesa, Inc., a publicly traded Delaware corporation, and a private equity firm buyer. The complaint alleged Revlon fiduciary duty failures and, in particular, focused on the alleged conflicted role of Adesa’s financial advisor, UBS Securities. UBS apparently had acted as financial advisor to Adesa, but also was authorized to offer debt financing to potential acquirers—so-called "staple financing." Credit Suisse was engaged to issue a fairness opinion to the Adesa board.

While the opinion is short on details, the failure to disclose fees paid to UBS and Credit Suisse in this and other transactions involving members of the buying group and issues relating to UBS’s allegedly conflicted role in the deal caused the court to order limited expedited discovery. According to the court, the proxy statement said only that Credit Suisse was paid "a customary fee in connection with its services, a significant portion of which was payable upon rendering by Credit Suisse of its opinion." As the court points out, a reader does not know how much Credit Suisse was paid, whether it would have received the same payout even if unable to render an opinion at the deal value, or how much Credit Suisse may have been paid in the recent past by members of the buyer group. While there is understandable sensitivity among investment banks regarding disclosure of fee arrangements, both SEC requirements for public deals and Delaware case law involving public and private deals now leave little room for omitting detail—especially about applicable contingencies and the amount and timing of fees paid or to be paid by transaction participants to a financial advisor or its affiliates.