In recent years, the opinions of sell-side equity analysts have come under scrutiny for their lack of objectivity. Buy recommendations have come to be seen, rightly I think, as payback for investment banking fees. You can safely predict that a firm with a lucrative underwriting or corporate finance relationship will produce favorable research coverage for the client. It's an unspoken quid pro quo, despite the damage it has done to the collective reputation of the sell-side analyst community.
What has escaped scrutiny is the absurd practice of the fairness opinion in merger transactions. A fairness opinion is the formal statement of the investment banking firm providing advice that the price to be paid in a deal is fair to each set of shareholders. It is mandated by longstanding
Securities and Exchange Commission
regulations, and presumes that the adviser is impartial. In reality, the adviser is almost always inherently conflicted by success fees, and the outcome of a fairness evaluation is a foregone conclusion.
The best litmus test for the fairness opinion's validity is to watch what happens when a hostile bid is announced. As long as the target's management is opposed to the bid, I can guarantee you one of the reasons the board will cite in its rejection of the bid is that its adviser has found the bid to be "inadequate." It would be scandalous if a firm hired to defend a target were to conclude that the raider's initial bid was "fair." This leads to the frequent case where, after extracting an extra dollar or two before capitulating, the hostile $25 bid is "inadequate," but the friendly $26 bid becomes "fair." Maybe it's the severance pay and golden parachutes paid out to the targets' management that push the consideration over the mythical demarcation of "fairness."
Even more absurd is a case from last November, when
raised its tender offer for
Columbia Energy Group
to $74 a share. Columbia was determined to remain independent, and the opinion of
Salomon Smith Barney
that the bid was inadequate was trumpeted as proof to holders that they shouldn't tender their shares to NiSource.
By February, after Columbia had scoured the earth for a competing bid and came up empty, they capitulated to a
bid of $71. Now that the deal was friendly, $71 was all of a sudden deemed "fair" by the two advisers. The world didn't change very dramatically between November and February.
A very creative use of a fairness opinion is occurring right now.
of Salt Lake City is merging with cross-town rival
in a deal that was set to close this week. Last month, First Security reported lower than expected results, and disclosed problems in its mortgage lending operation that would reduce earnings going forward.
Concern that these numbers would imperil the merger was quickly reflected in the spread, which widened from 40 cents to $4. Given the First Security developments, Zions would probably like to break the deal, or at least renegotiate the terms of the stock swap. But Zions is constrained by the merger agreement -- every condition had been met and all regulatory approvals had been received.
, Zions' adviser, had issued the requisite fairness opinion in the joint proxy statement, and shareholders on both sides were set to vote on the pact.
In fact, the only reason the merger hadn't already closed was due to accounting problems at Zions. The merger agreement, as is typical, compels Zions' board to recommend its holders vote in favor of the merger.
Zions' board has seemingly come up with a creative solution to its dilemma: Issue an unenthusiastic but legally sufficient recommendation while trumpeting the fact that its adviser has changed its mind. Says the
amended proxy statement, "our financial advisor has withdrawn its fairness opinion and advised Zions that it was no longer able to conclude that the exchange ratio was fair, from a financial point of view, to Zions shareholders."
You see, Goldman Sachs has now decided the deal is
to Zions' holders. The board is effectively signaling to its holders that they should vote no, while complying with the letter, but certainly not the spirit, of the merger agreement. Where in the amended proxy statement is the usual bold-faced print urging holders to vote in favor of the merger? Nowhere to be found.
First Security is fighting back, but I fear the odds are stacked
against them. If Zions can engineer a "no" vote of its own holders, it will escape unscathed. It would be very difficult -- absent a smoking gun -- for First Security to convince a judge that Goldman pulled its fairness opinion solely to facilitate Zions board rallying its own holders to vote no. I suspect in the coming weeks, First Security will agree to a lower, and in Goldman's eyes "fairer" ratio, and the deal will close.
I would never be one to impugn the integrity of Goldman Sachs, but the timing of their about-face is mighty suspicious. It serves the ends of the Zions' board in finding a way to exert maximum pressure on the First Security board to accept a price cut to salvage the deal. The appearance in a proxy statement of a friendly deal of a fairness opinion that concludes the deal is now unfair may be unprecedented. I have certainly never seen one in the hundreds or thousands of proxies I have reviewed.
While an effective tactic to achieve the desire of its client, this course of events has further cheapened fairness opinions. What was originally designed to be a safeguard for shareholders has become a mockery and a farce -- much like the term "initiating coverage with a Buy" for last month's IPO.
David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage, and has been an investor in risk arbitrage and bankruptcy securities since 1987. At the time of publication, Palestra Capital held no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback at