Drew Patten

Law & Valuation
Professor Palmiter
Spring, 1999


Text of Paper

During a merger or acquisition, the investment bank must issue a fairness opinion, which states that the company is paying a fair price for the target company.  Target company shareholders tend to feel that this leads to the bank trying to reduce its liability by allowing the target company to be sold for too low of a price.  Thus, courts are increasing the liability of investment banks by requiring descriptions of the valuation methods used and reasoning for why other methods were not used, and by allowing shareholders to directly sue investment bankers for giving faulty advice.
1.  Why is the liability of investment bankers in the context of mergers and acquisitions increasing?
2.  Is a fairness opinion a good tool for investment bankers?
1.  Third party actions of shareholders against investment bankers have led to increased liability.
2.  A fairness opinion has advantages and disadvantages, and there are possible changes that could make them more useful and help mitigate investment bankers’ liability to target company shareholders.
Courts have reasoned that the increased liability is necessary in that the bankers are indirectly acting as agents of the shareholders, and that they are professionals and should therefore be held to a professional standard of care.  Bankers have their own stake in the outcome of the merger or acquisition, in that they are paid a percentage of the value of the transaction, along with a fee for acting as an advisor, and they may also be fired if they are unable to make a transaction happen.
A fairness opinion comes with many problems of its own.  Such an opinion constitutes a subjective judgment regarding the value of the company, based on many variables and assumptions.  Also, the investment banker must choose which valuation methods and financial variables to use, some of which may be prohibited by the management of the non-target company.  Because of the liability involved, the investment banker must be careful when determining which methods and variables to use and in doing the calculations.  A fairness opinion does have advantages, in that it offers a perspective on the fairness of the deal and provides information for the shareholders to use when determining whether or not to accept the merger or acquisition.
Increased liability has mainly come in two forms. One source came from a Ninth Circuit holding that there is a fiduciary relationship between the bank and its client, with the client having confidence in the bank, thus giving the bank control in the relationship.  Most importantly, increased liability came in the form of allowing shareholders of the target company a third party cause of action against investment bankers for negligently claiming that a transaction’s value was fair in the fairness opinion.  In order for there to be negligent misrepresentation, the plaintiff must prove that the defendant breached the duty of care by misrepresenting a material fact, that this alleged misrepresentation was the actual and proximate cause of harm, and that the plaintiff suffered damages from relying on the alleged misrepresentation.
There are three views guiding the idea of a professional’s duty to a third party.  The first is the Ultramares approach, which is the most limited.  Professional liability is limited to pecuniary harm caused by negligence to those who had a contractual relation or something similar to the professional, or when the professional foresees the third party’s reliance on the representation and there is a relationship linking the professional to the third party.  This approach has been used to infer that there is a form of a privity relationship between shareholders of a target company and investment bankers. The second view is a reasonably foreseeable standard.  The professional’s duty extends to any parties that could be foreseen, but does not require actual knowledge. This has also been used to apply to investment bankers and shareholders. The third view is found in the Restatement (second) is constitutes an actually foreseen approach, which is sort of a compromise between the first two.  Professional duty is extended to a limited group of persons who were actually foreseen to rely on the professional judgment. It has been held that investment bankers could foresee that shareholders would rely on their fairness opinion.
There are possible changes to a fairness opinion that would lead to a better situation for investment bankers.  Increased disclosure of assumptions and forecasts is one possibility.  Also, a detailed explanation of valuation methods should be included in the opinion.  This would lead to a decreased chance of proving negligent misrepresentation.   Also, using several valuation methods to determine the value of the target company would be helpful.  It has also been suggested that creating a set of standards, similar to the Generally Accepted Accounting Principles, would improve fairness opinions and decrease liability, so long as they are not too stringent.  Finally, perhaps eliminating the fairness opinion and using a more detailed and specific document would better serve the purposes that a fairness opinion is supposed to promote.  One drawback to these suggestions is that they may lead to increased fees by investment bankers, thus making there services more difficult to obtain.


Background on the Liability of Investment Bankers

Since the 1980’s two trends have affected the investment banking industry – increased size of mergers and acquisitions and the increased liability of the banks advising the deals.  The weakest link in the entire process is the fairness opinion, a seven paragraph letter in which the banker states that from a financial perspective, management is paying a fair price for the target company.  Many target company shareholders (often the minority shareholders) feel they have been harmed by this note, and that the company was sold for too low of a price.  In order to defend themselves, bankers are having to change some of their practices.  No longer are the courts satisfied with a fairness opinion, but the banks must describe the methodology used and the reasons for not using other methods of valuation for the target company.
Part of the dilemma facing investment banks is that boards of directors are looking to insulate themselves from the shareholders when looking to make risky deals.  If the managers can prove that the investment bank’s advice was inadequate, then the managers can pass the liability along to the bankers.  This argument turns circular in that bankers often have to rely on forecasts and other data provided by managers.  In an effort to perform due diligence, the advisors will have to do their own research.  As a result of Howing Co. v. Nationwide Corp.,[1] the banker is obligated to examine any evidence which points to the value of a security being issued to retire another security be valued at a higher price than the security to be retired.  Instructions are explicitly provided that the bankers include a discussion of methods used and why any methods that were not used were rejected.  This problem came into greater focus when in 1990 NY Supreme Court decided that investment bankers could be sued by directly by shareholders, because of faulty advice given to directors.[2]

This increasing of investment bankers’ liability indicates that the courts believe that investment bankers are the agents of directors, who are the agents of the shareholders.  This implies that bankers are the agents of the shareholders.  Another implication is that bankers are being viewed as professionals, along with lawyers, doctors, accountants and architects, and as such, they must be held to a standard of care that would be provided by any “reasonably prudent, professional investment banker operating under the circumstances.”[3]  This issue is very sticky due to the fact that it is at the juncture of two different ideas in law.  On the one hand, there is a transaction that is for the ultimate benefit of the shareholders, and as such the shareholders have a claim against anyone who decreases the value of the transaction to less than what is reasonable.  On the other hand, directors have the responsibility to make independent decisions for the betterment of the company, within their business judgment.
To add to the cries of injustice, is the compensation structure for investment bankers.  Fees are raised merely for taking on a job as financial counselor, then if the deal is completed, the banker is paid a percentage of the value of the deal.  Because of this structure, it is extremely difficult for a banker to be objective.  But the payments are not the only source of problems, managers fire bankers who cannot close a proposed deal.  Managers have also been known to limit the research done by the investment bankers so that they can close a deal which would add to their fiefdom.
There are many roles that an investment banker may play in an acquisition: (1) an undisclosed principal; (2) a go-between who introduces managers to people whom the managers may not be able to reach on their own; (3) advisor for the company as to whether or not the company fits into the company’s business plan; (4) analyzer of the target; (5) strategy setter for the target acquisition; (6) arranger of finances for the acquisition, and several other roles.  Sometime during all of this, the banker may be asked to provide a fairness opinion.  And this is not a product which usually holds great weight in the negotiations of a banker’s fees.
Saul S. Cohen, General Counsel for Drexel Burnham Lambert at the time of this statement, believes that the courts should be looking to tighten the reigns on the board of directors and keep them responsible for the final say on setting a price for a target company.  Bankers are experts at knowing financial markets and marketing businesses, but they are not so good at evaluating the operational side of companies.[4]  Yet managers are shielded by the business judgment rule, like the one in Delaware.  This rule only holds for managers who are acting in good faith, with adequate information and in a disinterested manner.  Since investment bankers stand to gain considerable sums of money from the closure of a deal, it would be hard to prove that they are disinterested.
Yet as an advisory document, fairness opinions are not without their problems.  The opinions are “judgments, not statements of fact or prophecy,”[5] based upon a set of assumptions which may or may not represent a future state of business.  To further complicate this the valuation process includes many steps and assumptions.  The initial variables include (1) the type and structure of transaction in question, (2) the intended use of the valuation, (3) the financial analyst’s access to data, (4) the time available to create the valuation, and (5) the analyst’s familiarity with the company and industry in question.  Next the banker must choose among the various valuation techniques – omitting any that management has prohibited.  Finally the valuation takes into account many financial variables: (1) historical financial results and present market conditions, (2) evaluation of management’s forecasts of future business, (3) the market value of assets, (4) an evaluation of current management ability, (5) information on any comparable companies, and (6) issues related to the sensitivity of pricing (will a higher price be achieved by waiting?).  After all of this, the investment bank will be ready to issue a fairness opinion and possible price.
Because of these problems, vice-chancellor Berger, of Delaware, believes that investment bankers should develop some sort of self-regulation.[6]  She believes that this set of standards would include rules for the substance and procedures used to value companies, and would be akin to GAAP.  Another solution would be greater disclosure in the fairness opinion.

Investment Bankers and Negligent Misrepresentation

One of the most dangerous actions against investment bankers has come in the form of fairness opinions and negligent misrepresentation charges from shareholders.  The New York appellate court was the first to recognize third-party shareholders’ cause of action against an investment banker for negligently stating that a transaction’s value was fair in the case of Wells v. Shearson Lehman/American Express, Inc. [7]  The document focuses on the consideration as to whether or not shareholders receive a fair value for their shares of a target company, rather than the merits of the transaction.  From the directors’ view such memorandums (1) offer another, more objective, perspective that the deal is fairly priced; (2) possibly pass along the liability of breach of fiduciary duty to the investment bankers; and (3) provide further evidence for shareholders to accept or decline the merger or acquisition transaction.From the point of view of the shareholder, the opinion reduces (1) agency costs of managers acting outside of shareholders’ best interests and (2) the shareholders’ information costs when evaluating an offer.[8]  As evidence that the fairness opinion can be a useful tool, the Delaware Supreme Court “accentuated the need for fairness opinions and … contributed to their ever-widening use”[9] in corporate controlled transactions.
According to Black’s Law Dictionary, “Negligent misrepresentation is a false representation made by a person who has no reasonable grounds for believing it to be true, though he does not know that it is untrue, or even believes it to be true.”  In order to have a negligent misrepresentation case, there must be duty, breach, actual and proximate cause, and harm.[10]  Courts have traditionally protected professionals from foreseeable third-parties by limiting the their duty to those parties to which they actually shared privity.  Proving negligent misrepresentation is a three step process.  First, the plaintiff must prove that the defendant breached the duty of care by misrepresenting a material fact.  Step two is to demonstrate that the alleged misrepresentation was the “actual and proximate” cause of the harm by proving that the shareholders (or their agents, the managers) relied on the alleged misrepresentation.  The third and final step is to show that the plaintiff did indeed suffer damages.
The courts have come up with three views which guide the idea of a professional’s duty to a third party: (1) the Ultramares approach; (2) the reasonably foreseeable standard; and (3) the Second Restatement’s actually foreseen approach.[11]  The Ultramares view comes from the Ultramares Corp. v. Touche, Niven & Co. out of the New York Court of Appeals.  This case limited the scope of accountant liability for pecuniary harm caused by negligence to those who actually had a “contractual relation, or … one approaching it” with said accountant.  This is the most limited view.  Some courts have expanded this view to impose duty upon professionals when the professional actually foresees the third party’s probably reliance on the representation for a specific purpose, and there is some action (such as a pre-existing relationship) linking the professional to the third party.  The Ultramares approach was used in previously mentioned Wells v. Shearson Lehman/American Express, Inc. case to infer that the shareholder-investment banker relationship approached a privity relationship.
The second view comes from the Supreme Court of New Jersey, in the case of H. Rosenblum, Inc. v. Adler.[12]  The court extended duty to any parties that could be foreseen, even without the professional’s actual knowledge of the third-party.  Courts and other defenders of this view believe that professionals can insure themselves to protect against the substantial liabilities that could be raised by foreseeable plaintiffs.  A federal district court in California considered used this view of investment banker-shareholder relationship in Klein v. King.[13]
The Second Restatement’s actually foreseen approach is the third view, and it claims the middle ground between the two previously mentioned opinions.[14]  Professional duty is extended to “a person or one of a limited group of persons” who could be foreseen to rely on the professional judgment.  This approach differs from the reasonably foreseen approach by limiting negligent misrepresentations to people who were actually foreseen, not those who could be foreseen.  Investment bankers were claimed to hold a duty to shareholders whom the bankers could anticipate would rely on their fairness opinion in Dowling v. Narragansett Capital Corp..[15]

The Fiduciary Responsibility of Investment Bankers

Yet another source of liability for investment bankers arose from a Ninth Circuit court in which Bear Stearns lost an appeal.[16]  The court held that the existence of a fiduciary relationship between a bank and its client was fact and inappropriate for a summary judgment disposition.  This “fiduciary relationship” is generally characterized by one party placing confidence in another party, which is willing to accept the confidence; this confidence usually ends up with the accepting party exercising domination or control.[17]
In the Bear Stearns case, a jury found that a fiduciary duty existed between Bear Stearns and Daisy.  Bear Stearns did not breach that duty, and that they had committed professional negligence. This lead to the jury awarding Daisy Systems $109 million, which was 39% of the damages ($277 million) Daisy claimed to have incurred.[18]

Changes to the Fairness Opinion Process

As vice-chancellor Berger, mentioned something needs to be done about fairness opinions.  There are various problems with fairness opinions.  First of all, what is fair?  Is it the value of a firm if it were to continue independent operations, or is it the price that would be achieved in an arms-length auction?  Next, there are several valuation techniques that can produce different results.  Even discounted cash flows have different methods depending on which cash flows are relevant to the valuation (equity cash flows only value the cash available to stockholders, free cash flows and capital cash flows use the cash available to both debt and equity holders, but free cash flows accounts for interest cash flows in the discount factor, where as capital cash flows account for the tax savings in the actual cash flows).[19]  Finally, there are many variables which affect an analysis, to include synergies, cost savings and economies of scale which all change depending on the bidding company.  At best, the valuation used to come up with a fairness opinion is an inexact science.  If courts continue to place a reliance on this piece of paper to let managers off of the hook with shareholders (after all, why go after a top manager when you can sue a wealthy investment banker hired to advise the manager?), something must be done to help protect investment bankers.
One thing that would greatly help bankers is increased disclosure.  When evaluating a company, many assumptions need to be taken into account.  Forecasts are used to project cash flows into the future.  These numbers come from the company’s management.  To come up with a market value, these forecasted cash flows are discounted back to present value.[20]  If time permits, courts like to see independent research by the analyst into these numbers.  Along with the assumptions and forecasts, a detailed explanation of the valuation technique should be included with the fairness opinion.  This would go a long way in helping to lower the liability of misrepresentation, not to mention it would alleviate some of the courts’ scrutiny into the valuation methodology due to subjectivity of the analysis.[21]
Another way to cut down the liability of investment bankers is to use multiple methods of analyzing a firm’s value.  A discounted cash flow is the most reliable method of calculating a market price for a company, however, when discounted cash flow analysis is combined with a comparable company analysis a more accurate approximation of a fair market value can be achieved.  For a more in depth discussion of this analysis, see Steven Kaplan and Richard Ruback’s article “The Market Pricing of Cash Flow Forecasts: Discounted Cash Flow vs. the Method of Comparables” in the Journal of Applied Corporate Finance.
A set of standards, similar to GAAP for accountants, was brought up as a possible change to improve fairness opinions.  This standard could help mitigate the liability of investment bankers, however it could also hinder the valuation process.  If the standards dictate which methods are to be used and stay at a broad level, then the standards could be beneficial.  But if the standards go so far as to dictate what are reasonable numbers to use for such things as interest rates and growth rates, the standards will produce some useless valuations.  The reason that valuations can produce different numbers is because businesses are so varied and each valuation must be taken on an individual case basis to determine which DCF is appropriate and how the market effects the company’s projected value.  To give an example, the market risk free premium is useful when valuing Microsoft, but is not useful for valuing Elizabeth’s Pizza.   But what defines a small cap company?  Is a $10 million company small, if so what about $30 million?
A loose set of standards which address valuation techniques in a broad sense could be useful, but then most legal valuators use standard techniques.  Perhaps the court should require an analyst with a Chartered Financial Analyst designation to sign off on the fairness opinion, in the way that a certified architect must sign a set of drawings.  Or better yet, get rid of the fairness opinion, and in its place require an actual valuation which documents a fair price range and underlying assumptions and methods used to come up with the price.  This would be much more reasonable than a memorandum stating that the price is fair from a financial viewpoint.
However, increasing the work required for the process may cause investment bankers to increase the fees for such projects.  This would in turn drive managers of smaller firms away from using the services of investment bankers, and those managers are the ones who need the services the most.  The reason that larger firms are not as dependent on investment bankers as smaller firms is that most large firms have financial analysts on staff to work in capital budgeting or investor relations departments.  Still from an investment banker’s liability stand point, more disclosure would be the best alternative to lowering liability.

[1] 826 F.2d 1470 (6th Cir. 1987), cert. Denied, 486 U.S. 1059 (1988).
[2] Schneider v. Lazard Freres & Co., 159 A.D.2d 291, 552 N.Y.S.2d 571 (1st Dep’t 1990).
[3] Arthur H. Aufses, III in, “Investment banker liability: a panel discussion.” Delaware Journal of Corporate Law.  Spring, 1991
[4] Comments are from previously cited panel discussion.
[5] Fleischer, supra note 22, § 3, at 2, col. 5.
[6] “Investment banker liability: a panel discussion.”
[7] 127 A.D. 2d 200, 514 N.S.S.2d 1 (1st Dep’t 1987).
[8] Martin, Michael W. “Fairness opinions and negligent misrepresentation: defining investment bankers’ duty to third-party shareholders.”  Fordham Law Review.  October, 1991.
[9]  Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
[10] Michael W. Martin’s article.
[11] All covered in Mr. Martin’s article.
[12] 93 NJ 324, 352-53, 461 A.2d 138, 153 (1983)
[13] [1989-90 Transfer Binder] Fed. Sec. L. Rep. (CCH) P95,002, at 95,599 (N.D. Cal. Mar. 26, 1990).
[14] From First National Bank v. Crawford, 386 SE 2d 310, 312 (W. Va. 1989).
[15] 735 F. Supp. 1105 (D.R.I. 1990).
[16] In re:Daisy Sys. Corp., 97 F.3d 1171, 1177-79 (9th Cir. 1996).
[17] Black’s Law Dictionary 625, (6th ed. 1990).
[18] Haire, M. Breen.  “The fiduciary responsibilities of investment bankers in change-of-control transactions” in re: Daisy Systems Corp.”  New York Law Review. April, 1999.
[19] Ruback, Richard S.  An Introduction to Cash Flow Valuation Methods.  Harvard Business School Note 9-295-155, revised January 19, 1995.
[20] The Delaware courts formally endorsed DCFs in Cede & Co. v. Technicolor, Inc., No. 7129, 1990 Del. Ch. LEXIS 259 (Del. Ch. Oct. 19, 1990).
[21] Eisenhofer, Jaw W. and Reed, John L.  “Valuation Litigation”  Delaware Journal of Corporate Law.  1997.