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Mergers & AcquisitionsFinancial Advisors

Fairness Opinions: Liability Issues an Investment Bank Should Consider – Part One

Contributed by John Casey, Latham & Watkins LLP

Since the Delaware Supreme Court’s 1985 decision in Smith v. Van Gorkom (Trans Union),1 the market for “fairness opinions” has been robust. In Van Gorkom, the directors of Trans Union approved a sale of the company to the Marmon Group

in a cash transaction representing a 48 percent premium over the last closing price of Trans Union stock.2 A group of shareholders challenged the transaction, arguing that the board breached its fiduciary duties by not fully informing themselves before approving the transaction. Despite what seemed to be a good deal for the shareholders, the Delaware Supreme Court found that the directors breached their duty of care and held them personally liable for $25 million.3 One of the court’s criticisms of the board was that it did not elicit a fairness opinion. While the court did not find that fairness opinions were required in every merger or acquisition (indeed, it expressly said otherwise),4 these investment bank “approval stamps” have become nearly ubiquitous in public change of control transactions.5

Over 25 years after Van Gorkom, and countless fairness opinions later, however, there still is very little guidance in the case law on liability standards for investment banks issuing these opinions. A fair amount has been written about who may bring an action against an investment bank,6 but less has been written on the issue of when an investment bank will be held liable.

This two-part article analyzes three issues in connection with an investment bank’s issuance of a fairness opinion: (i) the types of shareholder claims an investment bank may face, (ii) the limited guidance courts have provided on the “standard of care,” and (iii) how investment banks may attempt to mitigate the risk of liability. Part One of the article reviews types of shareholder claims and judicial guidance on the standard of care, and Part Two will discuss strategies to mitigate the risk of liability.

Originally published by Bloomberg Finance L.P. in the Vol. 5, No. 23 edition of the Bloomberg Law Reports — Corporate and M&A Law. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P.

This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney‐client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

Corporate and M&A Law

August 29, 2011

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Types of Claims Faced by Investment Banks

— Negligence/Fiduciary Duty Claims

The most common claims asserted by shareholders against investment banks for issuing fairness opinions sound in fiduciary duty and negligence.7 The key element in both claims is, of course, duty.

— Duty: Contractual Privity Not Required

In the late ‘80s and early ‘90s, there were a handful of cases that held that contractual privity was not required in order for shareholders of a company to bring suit against an investment bank that issued a fairness opinion to the board.8 As stated by these courts, the test for shareholder standing is whether the investment bank should have foreseen shareholder reliance on the fairness opinion.9

Credit: Daniel Acker/Bloomberg

Probably the most troubling of these opinions for investment banks was Schneider v. Lazard Freres & Co.10 In Schneider, shareholders of RJR Nabisco contended that the board conducted a faulty auction of the company that resulted in acceptance of a bid that was considerably lower than could have been obtained in a fair auction. The shareholders sought damages from the investment banks that rendered advice to the special committee of the board that supervised the auction. The bankers argued that their advice was provided solely to the special committee and that, therefore, the shareholders had no right to rely upon that advice.

The court disagreed. It focused on the relationship between the special committee and the shareholders, concluding that such relationship “was essentially that of principal and agent[.]”11 Because the special committee was an “agent” of the shareholders, the court found that the bankers’ duty to the special committee extended to the shareholders, as the “principals” of the special committee.12 Significantly, the court’s holding suggested that the bank’s duty to shareholders was “automatic,” and that there was no need even to show that it was foreseeable that the shareholders would rely upon the fairness opinion.13

— What Types of Conduct Would Be Actionable

Assuming that a “duty” can be established, plaintiffs must still show that the investment bank breached that duty and/or acted negligently. There has, however, been a relative dearth of case law discussing what specific conduct would be considered “negligent” or a breach of fiduciary duty in the preparation of fairness opinions.14 The principal problem is that each fairness opinion is transaction-dependent—involving unique financial considerations and assumptions—so it is difficult to establish a uniform “standard of care.”15

As a general matter, courts have applied a “reasonable investment bank” standard to such claims, looking for evidence that the investment bank did more than “rubber stamp” the fairness of the transaction.16 We address below a handful of cases that have given at least some specific guidance on the standard of care issue.

— Failure to Use Certain Valuation Methods

City Partnership v. Lehman involved a claim by certain limited partners that their vote to approve a sale of the partnership’s assets was solicited through a misleading proxy statement and fairness opinion. The limited partners claimed that the investment bank that issued the fairness opinion—Lehman Brothers—was negligent for not using a discounted cash flow (DCF) analysis, and that had it used such an analysis, its valuation of the assets would have been considerably higher (making the sale price “unfair”).17

While the court found it a “bit troubling” that the proxy statement did not reference the fairness opinion’s employing a DCF method, it held that such an omission was the responsibility of the partnership, not Lehman.18 Additionally, the limited partner plaintiffs, as sophisticated investors, “would have been cognizant of such an omission had they conducted more than a superficial review of the materials.”19 The court went on:

Should Lehman have nevertheless conducted a cash flow analysis and disclosed its results? Perhaps so to make the Fairness Opinion a more complete state-ment of the market value of the Riverside System rather than an abstract concept. However, an argu-ably less than ideal or complete valuation does not necessarily constitute a fraudulent or misleading val-uation effort.20

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— Assumptions About Future Economic Conditions

In Herskowitz v. Nutri/System, Inc.,21 Connecticut National Bank (CNB) was hired by a special committee of Nutri/System to issue a fairness opinion in connection with a proposed sale of the company. CNB issued a fairness opinion that the $7.16 per share offer was fair, premised upon cash flow projections that assumed a 46 percent corporate tax rate for the next five years. At the time, however, there was pending legislation that would have reduced the corporate tax rate. If the legislation passed and was applied to CNB’s DCF valuation, the company’s value would have increased and the $7.16 per share offer would no longer have been fair.

Shareholders brought suit against CNB, arguing that the opinion’s reliance on the 46 percent tax rate was unreasonable. The district court disagreed, granting CNB a directed verdict because the proxy statement indicated that the applicable tax rate could change.

The Third Circuit reversed, finding there was a question whether it was reasonable for CNB to have relied on the then-current 46 percent tax rate. In so holding, it relied upon the plaintiffs’ expert’s opinion that, at the time of the fairness opinion, the tax reform legislation “was virtually certain to become law.”22 The court also noted that CNB employees who worked on the fairness opinion testified that they were aware of the impending tax reforms.

Claims Arising Under the Federal Securities Laws: To Be Actionable, the Opinion Must Be Objectively and Subjectively False

Fairness opinions are often required to be disclosed in registration statements and proxy statements, and are sometimes also disclosed in solicitation/recommendation statements issued in response to tender offers. Investment banks, therefore, sometimes find themselves defending shareholder suits under Section 11 of the Securities Act of 1933 and Sections 14(a) and (d) of the Securities Exchange Act of 1934, which create civil liability for false statements in public disclosure documents.23

To successfully bring a claim under these provisions, shareholders must show that the fairness opinion is false. Courts have held that showing that the investment bank was “negligent” in preparing the fairness opinion is insufficient to show “falsity.” As the district court noted in In re McKesson HBOC, Inc. Securities Litigation, “the securities laws do not create a general cause of action for negligence by investment advisers—they only reach false statements made by those investment advisers.”24

Because a fairness opinion is, by definition, an “opinion,” courts have held that it will be deemed a “false statement” for the purposes of the federal securities laws only if it is “objectively and subjectively false.”25 A fairness opinion is “objectively false if the subject matter of the opinion is not, in fact, fair, and is subjectively false if the speaker does not, in fact, believe the subject matter of the opinion to be fair.”26 Similarly, a claim under

Section 10(b) of the Exchange Act requires shareholders to show scienter, i.e., that “the firm purposefully and intentionally caused a false statement to be issued.”27

The court’s holding suggested that the bank’s duty to shareholders was “automatic,” and that there was no need even to show that it was foreseeable that the shareholders would rely upon the fairness opinion.

The “falsity” and/or scienter requirements of the federal securities laws have led a number of commentators to conclude that shareholders bringing such claims face an uphill battle.28

Look in the next week’s issue of Bloomberg Law Reports—Corporate and M&A Law® for Mr. Casey’s insights into mitigation of risk in connection with issuing fairness opinions.

John Casey is a partner in the Securities Litigation and Professional Liability Group of Latham & Watkins LLP. He practices in the firm’s Chicago office. The author would like to thank his partners, Jeff Hammel, Brad Faris and Tim FitzSimons, for their invaluable insights on this article.

1 488 A.2d 858 (Del. 1985).2 Id. at 869.3 Id. at 893.4 Id. at 876.5 M. Breen Haire, The Fiduciary Responsibilities of Investment Bankers in Change-of-Control Transactions: In re Daisy Systems, Corp., 74 N.Y.U. L. Rev. 277, 292-93 (1999) (“Since [Van Gorkom], [fairness opinions] have become a practical necessity; in fact, the failure to obtain one in a major transaction today would be deemed exceptional.”); Stephen I. Glover & Doketra M. Vansimme, Fairness Opinion Issues Anything but Routine, Nat’l L. J., April 15, 1996, at C13 (“In virtually every significant transaction, the board of directors of the selling company will request at least one invest-ment banking firm to confirm that the price to be paid is fair from a financial point of view . . . . While not required by law, fairness opinions have become standard in mergers and acquisitions.”); but see Helen M. Bowers, Fairness Opinions and the Business Judgment Rule: An Empirical Investigation of Target Firms’ Use of Fairness Opinions, 96 Nw. U. L. Rev. 567, 568 (2002) (concluding that only 61 percent of public mergers and acquisitions from 1980 to 1999 involved the use of fairness opinions).

6 See, e.g., Charles M. Elson, Fairness Opinions: Are They Fair or Should We Care?, 53 Ohio St. L.J. 951, 954 (1992); Ted J. Fiflis, Responsibility of Investment Banks to Shareholders, 70 Wash. U. L.Q. 497 (1992); Michael J. Kennedy, Functional Fairness—The Mechanics, Functions and Liabilities of Fairness Opinions, Practising Law Institute, Corporate Law and Practice Course Handbook Series, 1255 PLI/CORP 605, 658-667 (May/June 2001); John. S. Rubenstein, Merger & Acquisition Fairness Opinions: A Critical Look at Judicial Extensions of Liability to Investment Banks, 93 Geo. L.J. 1723 (June 2005). As these authors conclude, the case law is still fairly unsettled on the issue of when shareholders may bring suit against an investment bank for issuing a fairness opinion.

7 Schneider v. Lazard Freres & Co., 159 A.D.2d 291, 297 (N.Y. App. 1990)

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(“it will be the shareholders’ burden to show that a failure to consider these facts was a failure to exercise that degree of care that a reasonably prudent investment banker would have exercised under the same circumstances”); Kennedy, supra note 6, at 665 (“negligence remains the standard that governs suits regarding fairness opinions”); Michael W. Martin, Fairness Opinions and Negligent Misrepresentation: Defining Investment Bankers’ Duty to Third-Party Shareholders, 60 Fordham L. Rev. 133, 146 (1991-92) (“Negligent misrepre-sentation is likely the most viable cause of action for shareholders against invest-ment bankers who negligently prepare fairness opinions upon which the share-holders then rely.”). Other common law claims that shareholders have brought against investment banks for issuing fairness opinions include aiding and abet-ting breach of fiduciary duty and breach of contractual duties to third-party beneficiaries.

8 Wells v. Shearson Lehman/American Express, Inc., 127 A.D.2d 200, 202 (N.Y. App. 1987); Dowling v. Narragansett Capital Corp., 735 F. Supp. 1105, 1124-25 (D.R.I. 1990); Schneider, 159 A.D.2d 291.

9 See Wells, 127 A.D.2d at 202 (“assuming [the investment banks] were aware (as they must have been) that their opinion would be used to help shareholders decide on the fairness of Metromedia’s stock offer, they can be liable to the shareholders”); Dowling, 735 F. Supp. at 1124-25 (“Salomon was hired to assess the adequacy of the proposed purchase price for NCC’s assets. That assessment was patently intended to guide shareholders in deciding whether to approve the sale. Consequently, Salomon’s duty to exercise reasonable care in preparing its assessment extended to NCC’s shareholders.”).

10 159 A.D.2d 291.11 Id. at 297.12 Id. at 296.13 Id.; see also Kennedy, supra note 6, at 663.14 See, e.g., Steven M. Davidoff, Fairness Opinions, 55 Am. U.L. Rev. 1557, 1567

(Aug. 2006) (“the exact scope of an investment bank’s liability to stockholders for the

rendering of an ‘incorrect’ fairness opinion is still uncertain and subject to much judicial and academic debate”); Haire, supra note 5, at 294 (“There are no objec-tive guidelines or systematic criteria for use in determining whether a control transaction is fair.”).

15 See, e.g., Elson, supra note 6, at 998. (“[F]rom a juridical standpoint . . . it will be almost impossible for a court to formulate the ‘reasonable investment banker’ standard necessary to determine either negligent conduct or the lack thereof. . . . Each industry, indeed each company, has its own set of unique problems that prevents application of some standardized approach. The variables that comprise the various valuation processes are themselves often highly subjective, leaving much room for a bank to maneuver.”); Bowers, supra note 5, at 575 (noting that fairness opinion cases are “relatively small in number and too divergent to estab-lish a legal standard”).

16 One commentator has noted that “[r]elevant questions to determine if the invest-ment bank acted negligently when rendering an opinion could include (1) whether the assumptions used to project financial statements for the valuation analyses were reasonable and (2) whether, under the circumstances, the invest-ment bank’s reliance on its client’s projections was reasonable.” Rubenstein, supra note 6, at 1732; see also Fiflis, supra note 6, at 519 (suggesting the fol-lowing general standard of care for investment banks in issuing fairness opinions: “(1) maintaining the appropriate level of skill; (2) selecting and disclosing the appropriate fairness concept for the transaction; (3) selecting, disclosing, and explaining the measurement techniques used—e.g., discounted cash flow, liqui-dation value; (4) fully disclosing any and all of the bankers’ conflicts of interest; and (5) fully disclosing all qualifications, assumptions and sensitivity studies deemed necessary to give an adequate comprehension of the opinion”); Martin, supra note 7, at 167 (“[A] three pronged standard of care can be construed for investment bankers who render fairness opinions upon which third party share-holders rely: (1) a duty to investigate; (2) a duty to perform a reasonable analy-sis; and (3) a duty to disclose the bases for the opinion”). See also City Partnership Co. v. Lehman Brothers, Inc., 344 F. Supp. 2d 1241, 1249 (D. Colo. 2004) (investment bank not negligent where “[i]t gathered information, financial and otherwise, as it possessed or was provided by [the client], it processed such information, it did not disregard information it was provided, it held internal meet-ings to discuss the fairness opinion, and it met with representatives of [the client] to share its results. . . . [T]here is no credible basis for establishing that Lehman engaged in a charade or merely rubber-stamped a predetermined result sought by [the client].”).

17 City Partnership, 344 F. Supp. at 1244.18 Id. at 1249-50.

19 Id. at 1249.20 Id. at 1250 (emphasis added) (citation omitted). Importantly—and as we will see

in a number of other opinions discussed herein—the court also relied on the plain terms of the engagement agreement, which did not require that Lehman’s analy-sis include any particular valuation methods: “Under the terms of the engage-ment, Lehman was not required to conduct [a DCF] valuation.” Id.

21 857 F.2d 179 (3d Cir. 1988).22 Id.23 See 15 U.S.C. § 77k(a); 15 U.S.C. § 78n(a) & 17 C.F.R. § 240.14a-9(a); 15

U.S.C. § 78n(e).24 126 F. Supp. 2d 1248 (N.D. Cal. 2000).25 Washtenaw County Employees’ Retirement System v. Wells REIT, Inc., No.

1:07-CV-862, at 20 (N.D. Ga. Mar. 31, 2008) (rejecting § 14(a) claim involving Houlihan Lokey fairness opinion included in proxy statement because “plaintiff has failed to allege that Houlihan Lokey did not believe the subject matter of the opinion to be fair”); McKesson, 126 F. Supp. 2d at 1265 (holding that “material statements of opinion are false only if the opinion was not sincerely held” and, “in the case of a fairness opinion, then, the plaintiff must plead with particularity why the statement of opinion was objectively and subjectively false”); In re AOL Time Warner, Inc. Sec. & “ERISA” Litig., 381 F. Supp. 2d 192, 244 (S.D.N.Y. 2004) (dismissing claims against Morgan Stanley because the “Amended Complaint contains no allegation that Morgan Stanley in January 2000 did not believe its stated opinion that the exchange ratio was fair to Time Warner shareholders”); see generally Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1092-1096 (1991) (a statement of opinion is false and actionable only if the opinion is both (1) not believed by the speaker, and (2) objectively untrue).

26 Washtenaw County Employees’ Retirement System, supra, note 25. See also Bond Opportunity Fund v. Unilab Corp., No. 99 Civ. 11074 (S.D.N.Y. May 9, 2003) (“Plaintiffs who charge that a statement of opinion, including a fairness opinion, is materially misleading, must allege with particularity provable facts to demonstrate that the statement of opinion is both objectively and subjectively false.”); In re Global Crossing, Ltd. Securities Litig., 313 F. Supp. 2d 189, 209-210 (S.D.N.Y. 2003) (the issue for Section 11 liability was whether the fairness opinion was “false,” which required a showing that DLJ “misrepresent[ed] its true belief” in issuing the fairness opinion. The court noted that the plaintiffs “nowhere allege that DLJ was aware that its purported opinion about the fairness of the transaction was wrong.”). Note that at least one court has held that recklessness satisfies the “subjectively false” criteria. In re Reliance Secs. Litig., 135 F. Supp. 2d 480, 515-16 (D. Del. 2001) (“To prove that these statements were subjec-tively false the plaintiffs must show that, at a minimum, the Financial Advisors made their statements in reckless disregard as to whether they were false. In turn, that question requires the court to determine whether it was reasonable for the Financial Advisors to rely on the financial statements and other information pro-vided by CTFG. That is, did the Financial Advisors actually rely on the information provided by CTFG and, if so, was that reckless?”).

27 Helfant v. Louisiana Southern Life Ins., 459 F. Supp. 720 (E.D.N.Y. 1978) (“the opinion of an outside investment banking firm, which evaluates the merits of a particular transaction, cannot be considered a misrepresentation within [Section 10(b)] without some allegation that the firm purposefully and intentionally caused a false statement to be issued . . .”).

28 Elson, supra note 6, at 973, 975 (“The . . . primary problem with bringing an action under the antifraud provisions involves the culpability standards that are required. The difficulty shareholders face in meeting these standards is the main reason why the federal securities laws are not hospitable territory for actions on fairness opinions. . . . Given the firmly rooted scienter requirement of Rule 10b-5 actions, it does not appear likely that shareholders angered by a misformed fair-ness opinion will find any solace through an action under the federal securities laws.”); Robert J. Giuffra, Jr., Note, Investment Bankers’ Fairness Opinions in Corporate Control Transactions, 96 Yale L.J. 119, 129 (1986) (“Plaintiff share-holders rarely, if ever, can prove that directors and investment bankers acted with scienter.”).

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Mergers & AcquisitionsFinancial Advisors

Fairness Opinions: Liability Issues an Investment Bank Should Consider – Part Two

Contributed by John Casey, Latham & Watkins LLP

Since the Delaware Supreme Court’s 1985 decision in Smith v. Van Gorkom (Trans Union),1 opinions by investment banks on the fairness of proposed deals have become nearly ubiquitous in public change of control transactions. This two-part article analyzes three issues in connection with an investment bank’s

issuance of a fairness opinion: (i) the types of shareholder claims an investment bank may face, (ii) the limited guidance courts have provided on the “standard of care,” and (iii) how investment banks may attempt to mitigate the risk of liability. Part One of the article (in our August 29, 2011 issue) focused on the types of shareholder claims common in challenging fairness opinions, and judicial guidance on the standard of care. Part Two discusses the strategies to mitigate the risk of liability.

Both regulatory and case law support the proposition that disclaimers that banks are not independently verifying information provided by the board will be upheld.

Strategies to Mitigate Litigation Risk

Largely in response to the Schneider2 case discussed in Part One of this article, the practice of investment banks in issuing fairness opinions evolved. Specifically, in an attempt to prevent a finding of any duty to shareholders, investment banks began to stress in engagement letters and fairness opinions themselves that their opinions were being provided exclusively to the board and that

Originally published by Bloomberg Finance L.P. in the Vol. 5, No. 24 edition of the Bloomberg Law Reports — Corporate and M&A Law. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P.

This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney‐client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

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September 6, 2011

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they were offering no opinion regarding whether shareholders should approve the proposed transaction.3 Additionally, to prevent court attempts to broaden the measure of review required of investment banks in the preparation of fairness opinions, banks also began including disclaimers that they were relying on—and not independently verifying—information provided by the board.4

— Disclaimers that the Fairness Opinion Is Meant Only for the Board and Is Not a Recommendation to Shareholders

Three recent opinions from Illinois discuss “intended for the board only” disclaimers. In Young v. Goldman Sachs & Co.,5 the Circuit Court of Cook County, Illinois, distinguishing Schneider and Wells,6 discussed in Part One of this article, held that an investment bank issuing a fairness opinion to a board did not owe duties to the shareholders because the engagement letter and fairness opinion both stated that the advice was solely for the board:

[T]he stockholders were made aware that the advice offered by Goldman Sachs was solely for the bene-fit of the Board of Directors, thus, the holdings in Schneider and Wells are simply not applicable to the instant matter and cannot be relied upon to sup-port the proposition that Goldman Sachs owed a duty to Plaintiff.7

Similarly, in Joyce v. Morgan Stanley & Co., Inc.,8 the U.S. Court of Appeals for the Seventh Circuit upheld the dismissal of a shareholders’ action challenging Morgan Stanley’s fairness opinion because Morgan Stanley owed the shareholders no duty. In so holding, the court relied upon disclaimer language in Morgan Stanley’s engagement letter and fairness opinion that Morgan Stanley owed duties only to the board, that the opinion was intended only for the board, and that it expressed no opinion on how the shareholders should vote on the transaction.9

Another recent Illinois decision, City of St. Clair Shores Gen. Employees Ret. Sys. v. Inland W. Retail Real Estate Trust, Inc.,10 reached a different result. In St. Clair, plaintiff shareholders of Inland Real Estate Investment Trust (REIT) alleged that the proxy statement and fairness opinion used to solicit their vote on an acquisition was misleading because it overvalued the target entities. The investment bank that issued the opinion moved to dismiss the complaint, arguing that: (i) the fairness opinion was properly based on data provided by the board, (ii) the bank did not have a contractual duty to research the accuracy of these numbers, and (iii) the opinion was provided solely to the special committee, not the shareholders.

The court denied the investment bank’s motion to dismiss, relying upon language in the proxy materials which stated that the fairness opinion “related . . . to the fairness from a financial point of view, to us [the directors] and our stockholders of the consideration to be paid by us in the merger.”11 Even though the proxy materials stated that the fairness opinion did not constitute a “recommendation” to shareholders, the court held

that the “bottom line” was that “plaintiffs have alleged that [the investment bank] issued a misleading Fairness Opinion on the financial fairness of the Internalization, the Opinion was foreseeably included in the Proxy, and the Shareholders relied on the Opinion in deciding how to vote on the Internalization.”12 With additional allegations that the investment bank was familiar with “red flags” in the financial information provided by the Board and was in part compensated on the contingency that the transaction was consummated, the court concluded that “[t]his is enough, at the pleading stage, to support a § 14(a) claim against [the investment bank.]”13

To prevent court attempts to broaden the measure of review required of investment banks in the preparation of fairness opinions, banks also began including disclaimers that they were relying on—and not independently verifying—information provided by the board.

— Disclaimers that the Investment Bank Is Relying Upon—and Is Not Independently Verifying —Information Provided by the Company

Both regulatory and case law support the proposition that disclaimers that banks are not independently verifying information provided by the board will be upheld.

— FINRA Rule 5150

In December 2007, the U.S. Securities and Exchange Commission approved Financial Industry Regulatory Authority (FINRA) (f/k/a the NASD) Rule 2290 (later re-numbered Rule 5150), which requires that, if a member firm knows or has reason to know that its fairness opinion will be provided or described to a company’s public shareholders, that firm must make specific disclosures in the fairness opinion. One of the required disclosures is that, “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.”14 The inclusion of this rule suggests that the SEC does not require the investment bank to independently verify information provided by the board.

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— The Case Law

Consistent with the FINRA rule, courts historically have upheld disclaimers in fairness opinions that the investment bank is relying on information provided by the company and is not independently verifying that information.

— In re Global Crossing

In In re Global Crossing, Ltd. Securities Litigation, 15 plaintiff shareholders brought a claim under Section 11 of the Securities Act of 1933 against an investment bank, Donaldson, Lufkin & Jenrette (DLJ), that issued fairness opinions in connection with two of Global Crossing’s (GC) acquisitions. Plaintiffs argued that DLJ was “at least negligent in not uncovering the illusory basis for GC’s revenues and revenue projections.”16 The court disagreed based on DLJ’s express statement that it was relying on management’s projections and made no independent verification of them:

DLJ had not purported to make a reasonable inves-tigation of the financial information provided by GC. To the contrary, it expressly revealed that it had taken the information at face value, and opined only that, if that information was true, the [transac-tion] was fair.17

While that disclaimer would not exempt DLJ from liability for making false statements under Section 11, plaintiffs offered no evidence that DLJ was aware that the projections were not reliable or that DLJ was “privy to information known to GC executives that would have undermined the financial information on which DLJ purported to rely.”18

— The HA2003 Liquidating Trust

In The HA2003 Liquidating Trust v. Credit Suisse Securities (USA) LLC,19 the bankruptcy trustee of HA-LO Industries brought a negligence claim against Credit Suisse First Boston (CSFB) over a fairness opinion it issued in connection with HA-LO’s acquisition of an e-commerce business, Starbelly.com. CSFB expressly stated that it was relying on the projections provided by HA-LO’s management and would not independently verify those projections.

The trustee complained that CSFB should not have relied on management’s projections and should have heeded the warnings of HA-LO’s accountant, Ernst & Young, which told management that the projections were unrealistic. The trustee further argued that CSFB should have withdrawn or amended its opinion after the market price of many Internet stocks began to decline.20

The district court found for CSFB, noting that CSFB’s engagement letter, the fairness opinion itself and the proxy statement all provided that CSFB would rely on management projections and would not conduct any independent verification thereof.21 The court noted that, even if CSFB had duties beyond those set forth in its engagement letter, they would not have encompassed

independently verifying the projections, given that HA-LO never asked CSFB for its view on the acquisition and excluded it from board meetings, and rejected the plaintiff’s claim that CSFB failed to “update” the opinion because HA-LO never asked it to do so.22

Credit: Kelvin Ma/Bloomberg

On appeal, Judge Easterbrook of the Seventh Circuit affirmed. In relying on management’s projections, “CSFB followed the norm in this business—more to the point, it followed the rules in its contract with HA-LO—and relied on management’s numbers.”23 The court noted that E&Y told management that its projections were unrealistic, but management ignored its advice—”[the bankruptcy trustee] can’t blame that on CSFB.”24 The court also rejected the trustee’s contention that CSFB should have foreseen the end of the dot-com boom. That claim, the court held, was “an appeal to hindsight.”25 According to the court, if CSFB was too optimistic about Internet stocks, so too were all of HA-LO’s managers and thousands of other investors. The court concluded that an “[i]nability to see the future, differs from gross negligence.”26

As for CSFB’s “failure to update” the fairness opinion, Judge Easterbrook again relied upon the plain language of the engagement letter, which required only a single fairness opinion—”CSFB undertook to deliver an opinion as of one date”27—and there was nothing requiring the bank to supplement its original opinion. In short, the engagement letter “says that CSFB has no duty to double-check the predictions about Starbelly.com’s future revenues and no duty to update its opinion. CSFB did what it was hired to do.”28

The Seventh Circuit’s opinion should provide some comfort for investment banks, as reliance on management projections is standard fare for fairness opinions.29 Additionally, unless the engagement letter requires the investment bank to update its opinion, in Judge Easterbrook’s view, such an update or amendment is not required—no matter how greatly circumstances have changed since the fairness opinion was originally issued.30

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Conclusion

Although the case law is far from fully developed, it seems clear that investment banks should include the following categories of language in the engagement letter, in the fairness opinion, and in any proxies or registration statements in which their fairness opinions are discussed: (i) the investment bank’s duty runs only to the board/special committee and not to the shareholders or any other party; (ii) only the relevant board/special committee members in their capacities as directors/committee members are the intended parties; (iii) the opinion is not a recommendation to the shareholders or to anyone else; and (iv) the investment bank relied upon the information provided by the board and did not independently verify it.

More fundamentally, in issuing a fairness opinion, an investment bank should act as a “reasonable investment banker.” Although there is no set of prescribed rules on this topic, the case law—and common sense—suggest at least the following: (i) using appropriate valuation techniques and comparables; (ii) undertaking appropriate due diligence; (iii) making assumptions consistent with current and future economic realities; (iv) critically analyzing management projections (even though it is fairly well-established that investment banks may rely upon management information); (v) ensuring that the individuals responsible for the work are sufficiently experienced in fairness opinions and valuation techniques; and (vi) employing rigorous internal procedures—including the use of a separate fairness opinion committee to review any such opinions before they are issued—that test the decisions/assumptions made.

Taking these steps should help to mitigate the litigation risks faced by investment banks when issuing fairness opinions.

John Casey is a partner in the Securities Litigation and Professional Liability Group of Latham & Watkins LLP. He practices in the firm’s Chicago office. The author would like to thank his partners, Jeff Hammel, Brad Faris and Tim FitzSimons, for their invaluable insights on this article.

1 488 A.2d 858 (Del. 1985).2 Schneider v. Lazard Freres & Co., 159 A.D.2d 291 (N.Y. App. 1990)3 Note that the U.S. Securities & Exchange Commission has stated in writing that

disclaimers from investment banks that expressly state that shareholders do not have a right to rely upon the fairness opinion are improper because they are “inconsistent with the balance of the registrant’s disclosure addressing the fair-ness to shareholders of the proposed transaction from a financial perspective.” See SEC, Division of Corporation Finance’s Current Initiatives and Rulemaking Projects at 12 (Nov. 14, 2000). In response to the SEC’s concerns, investment banks generally have come up with alternative disclaimer language that—while not expressly stating that shareholders may not rely upon the opinion—indicates that the opinion is for the use of the board/special committee and that the invest-ment bank expresses no opinion on how shareholders should vote on the pro-posed transaction.

4 See Steven M. Davidoff, Fairness Opinions, 55 Am. U.L. Rev. 1557, 1567 (Aug. 2006); see also Deborah A. DeMott, Bank Conflicts Raise Threats of Lawsuits over M&A, Int’l Fin. L. Rev. (Aug. 2004) (“In general, a bank’s exposure to liabil-ity is limited by the content of a fairness opinion. That is, fairness opinions con-ventionally state the materials the bank worked with in preparing the opinion and disclose whether the bank relied on representations made by the company’s management and whether the work done was subject to limitations. These state-ments and disclosures limit the bank’s exposure to liability by explicitly informing the reader that a fairness opinion is subject to limitations.”); Steven J. Cleveland, An Economic and Behavioral Analysis of Investment Bankers When Delivering Fairness Opinions, 58 Ala. L. Rev. 299, 322 (2006) (“Bankers commonly assume the accuracy of management’s projections.”).

5 No. 08-CH-28542, Order (filed Ill. Cir. Ct. Cook Cty. Jan. 13, 2009).6 Wells v. Shearson Lehman/American Express, Inc., 127 A.D.2d 200 (N.Y. App.

1987).7 Young, No. 08-CH-28542, Order at 7.8 538 F.3d 797 (7th Cir. 2008).9 Id. at 802.10 635 F. Supp. 2d 783 (N.D. Ill. 2009).11 Id. at 794 (emphasis supplied).12 Id. The court cited In re Reliance Securities Litigation, 135 F. Supp. 2d 480,

513 (D. Del. 2001) in support of its holding. Notably, however, the Reliance Securities court ruled in favor of the investment bank:

The Financial Advisors disclosed that they planned to rely on the financial infor-mation provided by CTFG to reach their conclusion. Further, plaintiffs have not identified facts to suggest that the Financial Advisors[‘] reliance was reckless. As the Financial Advisors argued, they did not contract to re-audit CTFG’s or RAC’s financial statements and projections. Rather, CTFG asked the Financial Advisors to make a judgment based on a limited set of data. The court finds that no rea-sonable juror could conclude that the Financial Advisors recklessly ignored other information, including plaintiff’s so-called red flags, in forming their opinion. Further, given the novelty of the subprime finance industry, the Financial Advisors had few benchmarks against which to compare the growth of RAC or the specif-ics of its loan portfolio. Thus, no reasonable juror could find that the Financial Advisors’ statements were subjectively false. Therefore, the court will grant the Financial Advisors’ motions for summary judgment that they did not recklessly breach duties to the shareholders in issuing their fairness opinions.

Id. at 516.13 City of St. Clair Shores, 635 F. Supp. 2d at 794.14 See FINRA, SEC Approves New NASD Rule 2290 Regarding Fairness

Opinions, Reg. Notice 07-54 (effective Dec. 8, 2007).15 313 F. Supp. 2d 189 (S.D.N.Y. 2003).16 Id. at 195.17 Id. at 210 (emphasis supplied).18 Id.; see also In re AOL Time Warner Sec. & “ERISA” Litig., 381 F. Supp. 2d

192, 244 (S.D.N.Y. 2004) (“It would be nonsensical to attach Section 11 liabil-ity to the issuer of a fairness opinion for failure to investigate the financials of the underlying company, when the issuer has expressly stated that it relied on the integrity of the information provided by the company.”).

19 517 F.3d 454 (7th Cir. 2008).20 Id.21 The HA 2003 Liquidating Trust v. Credit Suisse Secs. (USA) LLC, No. 04-cv-

03163, Order Granting CSFB’s Motion and Order Denying HA-LO’s Motion for Judgment on Partial Findings (filed N.D. Ill. Sept. 20, 2006).

22 Id. at 31.23 HA2003 Liquidating Trust, 517 F.3d at 457.24 Id.25 Id. at 458.26 Id.27 Id.28 Id. at 458-59.29 But see City of St. Clair Shores, 635 F. Supp. 2d at 794 (holding that plaintiffs

stated a Section 14(a) claim against investment bank despite the fact that the opinion made clear that the bank was relying on management’s numbers and undertook no duty to investigate or verify the information).

30 HA2003 Liquidating Trust, 517 F.3d at 458-59. Note that, even when not required by the engagement letter, investment banks—often to avoid confusion and for reputational purposes—will be proactive about updating and/or pulling fairness opinions if it does become clear that circumstances have changed, making the transaction “unfair.”