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by Robert Wietzke, CPA*, CVA Published in National Litigation Consultants’ Review, April 2002 As a professional advisor to attorneys and owners of small public companies and closely held businesses, we have an opportunity to promote our professional expertise and provide a service to the investing public. The recent events in the headlines about accounting irregularities have prompted a call for independence of a company’s accountants from other financial advisors to the company. This is nothing new. In 1993, Stanley Sporkin United States District Court Judge for the District of Columbia, a Certified Public Accountant and former Director of the Division of Enforcement of the Securities and Exchange Commission from 1974 to 1981 stated in a speech entitled “ The time has come: “A call to the accounting profession to join the fight against financial fraud.” He stated, “One of the great hallmarks of our financial markets is their basic honesty and integrity, and our accounting profession has been the key in insuring this state of affairs.” During the recent past, however the profession has not always lived up to its duties and responsibilities.”… “Accounting firms have paid out more money to resolve lawsuits brought against them during the last five years (1988-1993) than during any comparable period in this nation’s history.”… “…now is the time for the profession to join the fight against financial fraud.” “While this seems like an obvious responsibility of the accounting profession … the fact is neither the accounting profession nor the business schools have really embraced this principle.” Sound familiar? This same theme is being repeated in both the financial press and the general press today, almost 10 years later, as a result of the recent questionable accounting practices and undisclosed details of transactions that were less than “arms length”. It is not only CPAs that are being chastised (for good reason) but also investment bankers, attorneys and Corporate Board members. The reason is clear lack of independence leading to greed. Our Opportunity as an Advisor: While we can’t do anything about internal “voodoo” accounting entries unless we are directly involved in the company’s audit, many of these improprieties involve transactions with outsiders who are not at arm’s length. The questionable practices, which enriched few at the expense of the minority shareholder, could have been avoided if the board of directors had hired an independent financial professional to render a Fairness Opinion on pending financial transactions. Profile of a Potential Client: Many pubic companies with a small market capitalization are frustrated due to their inability to convert a product or service with a bright future into a capital stock which rises in value due to the multitude of investment opportunities available to today’s investor. Concurrently, many promising divisions of larger public companies are experiencing the same phenomena due to lack of attention from the parent company executives. As a result, many of these companies are “going private” through management buy-outs, ESOPs and purchase of Company stock by employee benefit plans. Corporate executives, board members and fiduciaries of employee benefit plans of closely held businesses have an obligation to minority stockholders and plan participants to consider available investment opportunities if a sale or merger is contemplated. Such a transaction is subject to intense scrutiny under “fairness” standards, which have developed either through state legislation or precedent setting court cases. To defend against possible lawsuits by minority shareholders, it is prudent to engage an independent financial professional to render a “Fairness Opinion.” The members of a management group taking a Company or a division private, or executives, board members of small public companies and fiduciaries of employee benefit plans as well as their valuation professionals have the misconception that fairness opinions are only for larger publicly held corporations due to their perceived cost. It is not unusual to read of a transaction where the financial advisors, usually a large investment-banking firm, receive fees that exceed a million dollars. (See the case reviewed below where the fee was $3 million!) This perception is not true. Fairness opinions do not have to be rendered by large investment banking firms. Qualified valuation professionals are well suited to perform this work. By qualified, I mean those who have knowledge of the financial markets, valuation techniques, and experience in the transaction arena. An Actual Case: A case in point is my own experience. I am fortunate to have had eight years in public accounting, twelve years as a financial officer with public companies and two years in investment banking prior to starting my own valuation firm. While a “boutique” firm, we have performed several Fairness Opinions for small public companies and closely held companies entering into an ESOP transaction. Our fees are at a premium (because of the additional risk associated with this type of work and the resulting increase in errors and omissions insurance) compared to the estate valuation work we perform, but nowhere near those of investment bankers. We recently completed a fairness opinion for a small public company in the computer service industry with $8.0 million in revenue, which had received an offer from a large public company in a similar business with over $1 billion in revenue. The President was ecstatic that such a large company was interested in his company, which he founded. The Board of Directors, however, desired an opinion as to the fairness of the offer, but was reluctant to pay the large fees that the acquiring company’s investment banker quoted for a fairness opinion (Independent?). A board member who was a former associate of mine while in investment banking referred the Board Chairman to my firm. In performing our analysis, we determined that the company had $2,000,000 of excess cash. The President disclosed in a conversation about our preliminary findings that two minority shareholders had complained about the excess cash and demanded it be distributed. The President was not concerned because they were minority shareholders and he was holding the cash for a future acquisition. This was a lawsuit waiting to happen. I declined to issue a Fairness Opinion letter. The Board rejected the offer, due principally to our findings and discussions with the President about the “real world.” The referring Board member, as a former investment banker, quickly found a private company that was willing to pay three times the original offer, which made it a “fair” transaction. The favorable outcome was exactly the purpose of obtaining the fairness opinion. Legal Background of Fairness: There have been numerous court cases involving this issue brought by minority shareholders. A landmark case is Smith v. Gorkom, a Delaware case in which the court held that directors breached their duty of care in approving a merger where they relied primarily on their President’s twenty minute oral analysis, received no written documentation, valuation or opinions to the fairness of the transaction. The concept of “entire fairness” is discussed at length in Weinberger v. UOP, Inc., a well-known case from 1983, in which entire fairness involves two tests: Fair dealing and Fair price. The Entire Fairness Doctrine is defined as follows:
What is a “Fairness Opinion”? It is a statement by a financial expert that the financial terms of the transaction are fair from a financial point of view. It is most typically obtained to meet the Business Judgment Rule which, although not required by law (except in California under Corporations Code Section 1203), has evolved through the courts. The Business Judgment Rule is defined as follows:
The rule requires that directors act on an informed basis, in good faith, in a manner they believe to be in the best interests of the shareholders or plan participants, and without fraud or self-dealing. The Firm performing the fairness opinion must be independent. A typical case of lack of independence is one involving Medical Care International (MCI) who entered into a merger transaction with Critical Care America to form a new company, Medical Care America (MCA). A Shareholder brought suit when the new company’s stock price fell by more than 50% only weeks after the merger was consummated due to a low earnings. In 1994, a New York Stock Exchange arbitration panel ordered the investment banker rendering the “Fairness Opinion” to pay damages to the former shareholders of MCI. It found that the banker “rubber-stamped” the transaction, failed to perform due diligence regarding future business prospects, relied upon overly optimistic financial projections, and failed to investigate the collectivity of large accounts receivable. Since most of the investment banker’s $3 million fee for the opinion was contingent upon the deal being consummated, it had a direct conflict of interest with MCI’s shareholders. (The above case is outlined by Houlihan Valuation Advisors on their website www.houlihan.com) Typical transactions requiring “Fairness Opinions:”
Components of a Fairness Opinion engagement:
Conclusion: Notes: References for above quotes, definitions and court cases are available upon request.
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