M & A Law Prof Blog

The Debut of Rule 2290

I have an article in this week's issue of The Deal on FINRA's new Rule 2290 entitled The Debut of Rule 2290.   The Rule promulgates new disclosure and procedural requirements with respect to fairness opinions for member organizations.  For those who want some flavor, I conclude:

In a hearing before the Delaware Chancery Court shortly after SEC approval of Rule 2290, Marc Wolinsky, a partner at Wachtell, Lipton, Rosen & Katz referred to fairness opinions as: “the Lucy sitting in the box: ‘Fairness Opinions, 5 cents.’” Rule 2290 is unlikely to change the poor reputation fairness opinions currently have on Wall Street. Ultimately, FINRA and the SEC would have done better to address the real problems with fairness opinions, such as their subjectivity and the failure of the investment banks to use best practices in their preparation, rather than piling on more and largely meaningless procedural strictures.

Alternatively, the best solution would be for the Delaware courts to do what, in their hearts, they know is right and overturn the effective requirement for an acquiree fairness opinion promulgated in 1985 in the Smith v. Van Gorkom case: The case fondly referred to by industry as the “Investment Banker’s Full Employment Act of 1985”. This would permit the participants in change of control transactions to assess for themselves the value and worth of a fairness opinion and economically spur investment banks themselves to remedy the current situation. An incentive which today is sorely lacking.

You can check out my full critique of the Rule in this week's issue of The Deal or on their website at The Deal.com.

In re Checkfree Corp.: Delaware vs. the SEC

On Nov. 1 the Delaware Chancery Court issued an opinion in In re Checkfree Corp Securities Litigation.  The case is yet another in the recent line of Chancery Court opinions examining the required disclosure in takeover proxy statements of financial analyses underlying a fairness opinion.  The particular issue in Checkfree was whether management projections are required to be disclosed in a proxy statement if they are utilized by the financial advisor in the preparation of their fairness opinion. 

In this case, Checkfree had agreed to be acquired by Fiserv for $48 a share. In connection with their agreement, the Checkfree Board had received a fairness opinion from Goldman Sachs.  Checkfree's proxy statement to approve the transaction contained the usual summary description of the financial analyses underlying the fairness opinion.  Plaintiffs' claimed that this was deficient under Delaware law and sued to preliminary enjoin completion of the transaction.  More specifically, plaintiffs alleged that: 

the CheckFree board breached its duty to disclose by not including management's financial projections in the company's definitive proxy statement. They argue that the proxy otherwise indicates that management prepared certain financial projections, that these projections were shared with Fiserv, and that Goldman utilized these projections when analyzing the fairness of the merger price.

Here, the plaintiffs' relied heavily on the recent case of In re Netsmart Technologies, Inc. Shareholders Litigation, 924 A.2d 171 (Del. Ch.2007), for the proposition that a company is required to disclose all of the information underlying its fairness opinion in its takeover proxy statement.

The court began its analysis by rejecting this sweeping requirement.  Chancellor Chandler wrote: 

"disclosure that does not include all financial data needed to make an independent determination of fair value is not ... per se misleading or omitting a material fact. The fact that the financial advisors may have considered certain non-disclosed information does not alter this analysis."

The court then put forth the relevant standard:

The In re Pure Resources Court established the proper frame of analysis for disclosure of financial data in this situation: "[S]tockholders are entitled to a fair summary of the substantive work performed by the investment bankers upon whose advice the recommendations of their board as to how to vote on a merger or tender rely."

It then went on to distinguish Netsmart by stating:

the proxy at issue [in Netsmart] did not include a fair summary of all the valuation methods the investment bank used to reach its fairness opinion. Although the Netsmart Court did indeed require additional disclosure of certain management projections used to generate the discounted cash flow analysis conducted by the investment bank, the proxy in that case affirmatively disclosed an early version of some of management's projections. Because management must give materially complete information "[o]nce a board broaches a topic in its disclosures," the Court held that further disclosure was required.

Finally, the court held:

Here, while a clever shareholder might be able to recalculate limited portions of management's projections by toying with some of the figures included in the proxy's charts, the proxy never purports to disclose these projections and in fact explicitly warns that Goldman had to interview members of senior management to ascertain the risks that threatened the accuracy of those projections. One must reasonably infer, therefore, that the projections given to Goldman did not take those risks into account on their own. These raw, admittedly incomplete projections are not material and may, in fact, be misleading.

This is the right decision under Delaware law.  M&A lawyers in the future should now be careful about unnecessary disclosure of projections in proxy statements to avoid triggering NetSmart's requirements.  Relatively simple. 

The problem with this decision is of wider consequence.  Namely, can anyone tell me what exactly is required to be disclosed concerning fairness opinion financial analyses under Delaware law?  In Pure Resources, Netsmart and here, the Delaware courts have created an obligation of disclosure for the analyses underlying fairness opinions under Delaware law.  Yet, while a worthy goal, judge-made disclosure rules are standard-based and decided on a case-by-case basis.  This is a poor way to regulate disclosure.  It would be better done through the traditional way -- SEC rule-making under the Williams Act and proxy rules.  Yet, the SEC has largely abandoned takeover regulation.  In the last seventeen years it has only initiated two major rule-making procedures (the M&A Release and all-holders/best price amendments).  There were rumors two years ago that the SEC was looking at fairness opinion disclosure, but nothing has come of it.  Instead, we are stuck with this, uncertain disclosure rules that arguably do not ameliorate the fundamental issues underlying fairness opinions.  I'm not criticizing Delaware here -- they are doing their best to fill the gap with the tools at hand.  But, this all would be much better done by the SEC.  Is anybody out there? 

SLM: More on Yesterday's Hearing

I thought I would set forth a few more thoughts on yesterday's SLM hearing.  It really is a fun read. 

For those who think that SLM's interpretation of the MAC clause is correct, VC Strine may have revealed his initial leanings yesterday.  VC Strine mused: 

I have to say, the defendants, the weakness from their position is this idea that, basically, one penny on top of what is outlined in the agreement more makes you count the whole thing as an MAE. That is not intuitively the most obvious reading of this. On the other hand, the plaintiffs' position could have been much more clearly drafted if they wished to say that, essentially, all the legislation was a baseline, and you measure the incremental effect.

I have stated before why I disagree with this reading.  Nonetheless, for those who read their tea leaves one could infer that VC Strine's initial thought is that SLM's reading is the correct one.  To be obvious, though, this case has a long way to go before any decision and Flowers et al. will get many more opportunities to influence VC Strine's thinking. 

Otherwise, the transcript is a bit back and forth on this, but VC Strine effectively ruled that there will be a trial in January with reasonable discovery, but only if the parties agree to the covenant waivers in the merger agreement.  So, SLM may conclude that the right strategy for it given the above statement is to avoid just such an agreement.  This is because VC Strine said he would entertain a "mini-trial" or summary judgment disposition with no ancillary or parol evidence if the parties come back to him on that.  Expect SLM to attempt this maneuver, though I think Strine will push back if there is actually no agreement.  Strine seemed quite loathe to make any ruling without just such parol evidence and SLM may overreach here. 

Another great quote in the hearing was also pointed out to me:

THE COURT: A fairness opinion is just a fairness opinion.

MR. WOLINSKY: A fairness opinion, you know -- it's the Lucy sitting in the box: "Fairness Opinions, 5 cents."

Marc Wolinsky is a partner at Wachtell, a firm which regularly advises clients and investment banks on the legal necessity and provision of fairness opinions.  For him to go off message like this in a Delaware court once again exposes the common and openly acknowledged problems with fairness opinions.  As I argue in my article Fairness Opinions, the time has long past for Delaware to overrule the implicit requirement for a target fairness opinion established in Smith v. Van Gorkom. 

SEC Approves FINRA Fairness Opinion Rule

On Oct 11, the SEC approved FINRA's new proposed Rule 2290 regarding fairness opinions (see the SEC approval here; the FINRA rule release here).   The eighth extension of the comment period for the Rule was to run until the end of the month.  However, the SEC approved the rule on an expedited basis.  This is a bit odd -- this rule has been pending for three years, why the rush now?

The Rule obligates member firms of FINRA adhere to the following requirements when preparing and issuing fairness opinions: 

• Rule 2290(a)(1) requires that when a member firm acts as a financial advisor to any party to a transaction that is the subject of a fairness opinion issued by the firm, the member must disclose if the member will receive compensation that is contingent upon the successful completion of the transaction, for rendering the fairness opinion and/or serving as an advisor.
• Rule 2290(a)(2) requires that a member firm disclose if it will receive any other significant payment or compensation that is contingent upon the successful completion of the transaction.
• Rule 2290(a)(3) requires that member firms disclose any material relationships that existed during the past two years or material relationships that are mutually understood to be contemplated in which any compensation was received or is intended to be received as a result of the relationship between the member and any party to the transaction that is the subject of the fairness opinion.
• Rule 2290(a)(4) requires that members disclose if any information that formed a substantial basis for the fairness opinion that was supplied to the member by the company requesting the opinion concerning the companies that are parties to the transaction has been independently verified by the member, and if so, a description of the information or categories of information that were verified.
• Rule 2290(a)(5) requires member disclosure of whether or not the fairness opinion was approved or issued by a fairness committee.
• Rule 2290(a)(6) requires member firms to disclose whether or not the fairness opinion expresses an opinion about the fairness of the amount or nature of the compensation from the transaction underlying the fairness opinion, to the company’s officers, directors or employees, or class of such persons, relative to the compensation to the public shareholders of the company.
• Rule 2290(b)(1) requires that any member issuing a fairness opinion must have written procedures for approval of a fairness opinion by the member.

As I commented before on this Rule:

The broad scope of intended topics in the initial notice to members led some to think that FINRA would finally act to address many of the deficiencies in current fairness opinion practice.  However, the initially promulgated rule was a disappointment, and after three amendments at the SEC's behest it has now been watered down into meaninglessness.  FINRA ultimately did not go so far as to require member investment banks to disclose “any significant conflicts of interest” as it initially considered. Instead, disclosure requirements in the Rule with respect to contingent consideration and relationships largely overlap with current federal securities law as set out in Item 1015(b)(4) of Regulation M-A. There are two other disclosure obligations in the Rule concerning opinion committees and independent verification of information.  These will likely be met with more boiler-plate responses – a practice which the Rule effectively permits. Furthermore, in the amending releases FINRA also watered down the Rule in its interpretation; removing a good bit of the potential for it to go beyond SEC regulation. For example, FINRA took the position in the amending releases that disclosure of contingent compensation and material relationships under the Rule can be descriptive and not quantitative; a statement as to whether it exists or not sufficient. Yet, the number is the important element here: if the amount is high it has more potential to result in bias. In addition, the Rule does nothing about the subjectivity inherent in fairness opinion preparation. It simply addresses the conflicts issue with redundant disclosure requirements that permit the investment banks to engage in the same practices as before with little, if any change.

The only novel aspect of this Rule is the requirement it places on member firms to disclose whether or not the fairness opinion expresses an opinion about the fairness of the amount or nature of the compensation from the transaction underlying the fairness opinion, to the company’s officers, directors or employees, or class of such persons, relative to the compensation to the public shareholders of the company. I have read and re-read this provision and the FINRA commentary upon it. While the purpose can be easily surmised—addressing inordinate retention and compensation paid in connection with change of control transactions—I look forward to learning how the investment banks implement this provision, because I honestly do not know how they can or will other than via the usual boiler-plate response. In any event, this requirement misapprehends what a fairness opinion does and opines to. Retention and other compensatory arrangements do arguably result in a lower price to acquiree stockholders, but do not affect whether the ultimate price itself is fair within the financial parameters of the value of the corporation or the consideration paid.  To rephrase the point, the price can be financially fair in a corporate control transaction but the retention and other compensatory arrangements still egregious.  Trying to analyze them together scrambles the egg.  FINRA should have addressed these issues separately.

Ultimately, FINRA and the SEC would have done better to address the real problems with fairness opinions (their subjectivity, etc.) rather than piling on more and largely meaningless procedural strictures.  For more on this see my article Fairness Opinions. 

FINRA's Fairness Opinion Rules (RIP?)

Does anyone remember the rules proposed by FINRA (the agency formerly known as the NASD) to govern the issuance of fairness opinions?  Back in November 2004, FINRA sent a minor shock wave through the investment banking community by promulgating a notice to members requesting comment on whether to propose new rules “that would address procedures, disclosure requirements, and conflicts of interest when members provide fairness opinions in corporate control transactions.”  More specifically, FINRA requested comment concerning methods to “improve the processes by which investment banks render fairness opinions and manage inherent conflicts.”

FINRA put forth three reasons for requesting comment.  First, the disclosure mandated under SEC regulation for fairness opinions could be perceived as insufficient “to inform investors about the subjective nature of some opinions and their potential biases.”  Second, fairness opinion are by nature subjective and consequently there has arisen a “perceived tendency” that these opinions often support management.  Finally, unaffiliated stockholders sometimes do not receive the benefits in a corporate control transaction that management, directors or other employees do; FINRA hypothesized that this disparity may create biases in favor of the transaction if the people involved in the current or future hiring of the investment bank are those with a differential benefit.

FINRA subsequently proposed Rule 2290 in response to its solicited member comments. Rule 2290 was announced and filed with the SEC for approval on June 22, 2005.  Well, that was 2005.  Since that time, the rule has been stuck in the SEC approval process.  Presumably at SEC behest, it has been amended three times since then.  The latest amendment was on June 7, 2007 (access the rest of the amendments here). 

The broad scope of intended topics in the initial notice to members led some to think that FINRA would finally act to address many of the deficiencies in current fairness opinion practice.  However, the initially promulgated rule was a disappointment, and after three amendments at the SEC's behest it has now been watered down into meaninglessness. FINRA ultimately did not go so far as to require member investment banks to disclose “any significant conflicts of interest” as it initially considered. Instead, disclosure requirements in the Rule with respect to contingent consideration and relationships largely overlap with current federal securities law. There are two other disclosure obligations in the Rule concerning opinion committees and independent verification of information.  These will likely be met with more boiler-plate responses – a practice which the Rule effectively permits. Furthermore, in the amending releases FINRA also watered down the Rule in its interpretation; removing a good bit of the potential for it to go beyond SEC regulation. For example, FINRA took the position in the amending releases that disclosure of contingent compensation and material relationships under the Rule can be descriptive and not quantitative; a statement as to whether it exists or not sufficient. Yet, the number is the important element here: if the amount is high it has more potential to result in bias. In addition, the Rule does nothing about the subjectivity inherent in fairness opinion preparation. It simply addresses the conflicts issue with redundant disclosure requirements that permit the investment banks to engage in the same practices as before with little, if any change.

Given the current state of the Rule, FINRA would be better to simply pull it until such time as the SEC is more willing to contemplate reform.  Unfortunately, the SEC does not appear ready to act any time soon on these issues.  Anyway, if anyone still cares, the eighth extension of the comment period for this proposed rule expires on Oct. 31, 2007. 

The NASD's Fairness Opinion Rules (RIP?)

Does anyone remember the rules proposed by the NASD to govern the issuance of fairness opinions?  Back in November 2004, the NASD sent a minor shock wave through the investment banking community by promulgating a notice to members requesting comment on whether to propose new rules “that would address procedures, disclosure requirements, and conflicts of interest when members provide fairness opinions in corporate control transactions.”  More specifically, the NASD requested comment concerning methods to “improve the processes by which investment banks render fairness opinions and manage inherent conflicts.”

The NASD put forth three reasons for requesting comment.  First, the disclosure mandated under SEC regulation for fairness opinions could be perceived as insufficient “to inform investors about the subjective nature of some opinions and their potential biases.”  Second, fairness opinion are by nature subjective and consequently there has arisen a “perceived tendency” that these opinions often support management.  Finally, unaffiliated stockholders sometimes do not receive the benefits in a corporate control transaction that management, directors or other employees do; the NASD hypothesized that this disparity may create biases in favor of the transaction if the people involved in the current or future hiring of the investment bank are those with a differential benefit.

The NASD subsequently proposed Rule 2290 in response to its solicited member comments. Rule 2290 was announced and filed with the SEC for approval on June 22, 2005.  Well, that was 2005.  Since that time, the rule has been stuck in the SEC approval process.  Presumably at SEC behest, it has been amended three times since then.  The latest amendment was on June 7, 2007 (access the rest of the amendments here). 

The broad scope of intended topics in the initial notice to members led some to think that the NASD would finally act to address many of the deficiencies in current fairness opinion practice.  However, the initially promulgated rule was a disappointment, and after three amendments at the SEC's behest it has now been watered down into meaninglessness. The NASD ultimately did not go so far as to require member investment banks to disclose “any significant conflicts of interest” as it initially considered. Instead, disclosure requirements in the Rule with respect to contingent consideration and relationships largely overlap with current federal securities law. There are two other disclosure obligations in the Rule concerning opinion committees and independent verification of information.  These will likely be met with more boiler-plate responses – a practice which the Rule effectively permits. Furthermore, in the amending releases the NASD also watered down the Rule in its interpretation; removing a good bit of the potential for it to go beyond SEC regulation. For example, the NASD took the position in the amending releases that disclosure of contingent compensation and material relationships under the Rule can be descriptive and not quantitative; a statement as to whether it exists or not sufficient. Yet, the number is the important element here: if the amount is high it has more potential to result in bias. In addition, the Rule does nothing about the subjectivity inherent in fairness opinion preparation. It simply addresses the conflicts issue with redundant disclosure requirements that permit the investment banks to engage in the same practices as before with little, if any change.

Given the current state of the Rule, the NASD would be better to simply pull it until such time as the SEC is more willing to contemplate reform.  Unfortunately, the SEC does not appear ready to act any time soon on these issues.