Defective fairness opinion results in a $5 Million award and “existential crisis” in the M&A industry.
After the recent arbitration ruling against First Boston, angst has penetrated the once solid and predictable business of issuing fairness opinionsSince a New York Stock Exchange arbitration panel slammed CS First Boston Corporation last month with a $5 million fine, investment bankers have been paying a bit more attention to the boilerplate legalese in the fairness opinions they issue.
The opinion that had landed First Boston before three NYSE arbitrators was issued in connection with the 1992 merger of two healthcare companies; in the opinion, First Boston disclosed that it had relied, as investment banks often do, on the financial projections of the merging companies’ managements. When the new company’s stock plummeted less than a month after the merger, however, a group of disgruntled shareholders seized on this “reliance clause” as evidence that First Boston had not done sufficient due diligence and was therefore liable for their losses of more than $13 million. The hearing may be the first in which the NYSE has granted arbitration between a company’s shareholders and its investment banker.
Although the arbitration panel awarded the claimants only slightly over a third what they requested, the ruling opens a Pandora’s box of uncertainty for investment banks, for whom the rendering of fairness opinions has been a largely routine but lucrative practice. Unlike a court of law, the NYSE does not publish opinions laying out the reasoning behind its panels’ decisions. Arbitration opinions, which simply describe the award, are of no precedential worth. Their very terseness can, however, give rise to much rending of kerchiefs in the gorges of Wall Street, where $5 million fines are at least an irritation. With no explanation of the arbitrators’ findings — no isolation of which arguments the panel found compelling or reasonable, which flaccid or unfounded — lawyers who would extract lessons from them may as well consult the Delphic oracle.
Futilely or not, M&A lawyers within and without investment banks have been frantically trying to assess the award’s import. Wachtell, Lipton, Rosen & Katz fired off a memo to clients less than a week after the announcement, counseling them to change the usual wording of both their fairness opinions and their indemnification agreements with corporate clients (see “Wachtell, Lipton Opines On Fairness Opinions,” page 9). And Brian Smiley says the phones at his Atlanta law firm, Page & Bacek , which represented members of the shareholder group (some of whom live in the Atlanta area), have been “ringing off the hook” with calls from investment banks’ lawyers, wondering what the ruling means and requesting that the firm place the arbitration briefs and pleadings in the federal document center so they might be scrutinized.
In June 1992, Medical Care International, Inc. (MCI), which ran a number of surgical centers around the country, engaged First Boston as its financial adviser in connection with a planned merger with Critical Care America, Inc. (CCA), which was in the business of providing at-home infusion treatment (such as intravenously administered medication). First Boston received a $3 million fee for its work, which included issuing a fairness opinion in July.
On September 9, shareholders of the companies approved the merger. Less than three weeks later, on September 25, the new company, Medical Care America, Inc. (MCA), announced that earnings for the CCA division would be lower than expected, and MCA stock went into freefall — in a single day MCA’s market value shrank by more than 50%, or $1 billion.
In September 1993, a group of former MCI shareholders brought a claim against First Boston with the NYSE, contending that First Boston had caused them to lose more than $13 million. The investment bank, they asserted, had “grossly overvalued CCA” and consequently approved an exchange ratio that shortchanged MCI shareholders.
Over the course of the arbitration, both sides wheeled out big guns as expert witnesses. Testifying on the share-holders’ behalf was Joel Seligman, co-author of the eleven-volume securities bible, Securities Regulation. Speaking in support of First Boston were Arthur Fleischer of Fried, Frank, Harris, Shriver & Jacobson, and former SEC commissioner A. A. Sommer, Jr., now a partner with Morgan, Lewis & Bockius in Washington, D.C.
In their arbitration brief, the shareholders asserted that First Boston had “rubber stamped” the numbers provided by the managements of the companies. They argued that while First Boston “admits that it blindly relied on the projections and financial statements provided to it by MCI’s and CCA’s managements,” the investment bank had unjustifiably ignored a number of “red flags”:
* A reasonable look at the home infusion business should have shaken First Boston’s acceptance of management forecasts. A June 8, 1992, Wall Street Journal “Heard on the Street” column, for instance, had described price-cutting pressures faced by the industry.
* CCA had a history of writing off large quantities of accounts receivable after acquiring various other companies.
* First Boston had an interest in the merger going forward — much of its fee depended on success — which conflicted with the investment bank’s duty to determine the fairness of the transaction to MCI shareholders; this conflict should have prompted especially careful due diligence.
* Around the same time, First Boston had issued a fairness opinion for a spin-off of Caremark International Inc., also in the home-infusion business. That opinion had appeared in a shareholder document which described, among other risks, that of heightened competition in the home-infusion market. The registration statement in which the disputed opinion appeared, however, did not outline such risks.
Wealthy, Sophisticated Veterans
First Boston, represented by Sullivan & Cromwell, responded by pointing to its engagement letter’s explicit statement that the investment bank would rely solely on information provided by the merging parties. Moreover, First Boston argued in its brief: “Claimants are wealthy, sophisticated veterans of the health care industry, individuals with successful careers as both doctors and businessmen… . By reason of their experience in the health care industry and their large stakes in MCI, the principal claimants were undoubtedly thoroughly familiar with the business trends affecting the industry and were thus able and, indeed, uniquely equipped to evaluate the future prospects of MCI and CCA.”
First Boston answered the specific charges against it as follows:
* The investment bank had probed, challenged, and analyzed CCA’s projections and concluded they were sound. The cited Wall Street Journal article had not been an unambiguous prophesy of doom for the home-infusion business. It had quoted one investment strategist, Steven Resnick of Cowen & Co., as saying many home-infusion providers “do have 25%-30% growth rates” and “are the way to go.”
* CCA’s write-offs after two previous acquisitions hardly formed an alarming “pattern”; anyway, merger-related costs are to be expected.
* In its fairness opinion, First Boston had disclosed, among other things, that much of its fee hinged on success.
* First Boston’s fairness opinion for the spin-off of Caremark — which the claimants had pointed to as evidence that First Boston should have been aware of the merger’s risks –was rendered more than a month after MCAs stock plummeted.
Splitting The Baby
Both the amount of the award — a fraction of the claimants’ losses — and the absence of an accompanying explanation have left investment bankers puzzled about what, specifically, troubled the NYSE, and how they might avoid similarly running afoul of it. At First Boston, the ruling will have no effect on the way the investment bank conducts its business, according to a spokesperson who declines to comment on the facts of the case. Mike Koeneke, who as a managing director signed the disputed fairness opinion, is no longer with First Boston. Asked whether his departure was in any way linked to the arbitration, the spokesperson declined to comment on “a former employee.” Asked about the arbitration, Carlos Ferrer — the head of First Boston’s health-care team, and the man whose signature appears on the investment bank’s engagement letter with MCI — said, “Sorry, you’ve got the wrong guy,” and hung up.
One source at the investment bank believes the award, which was just over a third of the amount requested, had less to do with the merits and more to do with the pseudo-Solomonic wisdom of the arbitration system. “My sense of the way arbitration worked,” this person says, “is at the end of the day they split the baby, gave something to both sides.” Adds Fried, Frank’s Art Fleischer: “[The claimants] got a little over a third of what they asked for. Does that mean they were a third right on their allegation?”
The First Boston source also believes the decision to be an aberration. Though technically an NYSE ruling, this person says, the decision was made by three people, all from the Atlanta business community (claimants in an NYSE arbitration are allowed to choose the jurisdiction): “In analyzing the outcome, I don’t think you can ignore the fact that the claimants had home court advantage here.” This source also points out that, unlike First Boston’s expert witnesses, the claimants’ expert witness, Seligman, is not a practicing lawyer.
First Boston is said to have agreed not to challenge the arbitration award in the courts or through the NYSE, in return for a slight compromise on part of the payment. According to Smiley, the statute of limitations on Section 11 of the Securities Act of 1933 (under which the claimants asserted First Boston was liable) will block an avalanche of copycat arbitration claims in the MCA case. An MCA shareholders’ class-action lawsuit is pending in Texas, he says, which does not target First Boston.
To the investment bankers’ counsel who have been calling Page & Bacek for guidance, Brian Smiley says: “We contended that under Section 11 of the 1933 Securities Act there is a duty to investors that transcends any hedge clause or limitations that might exist between the investment banker and the firm contracting for a fairness opinion. I suggested that there’s always a duty to pay heed to red flags and follow up if there is apparently contradictory evidence developed in the course of a due diligence investigation.”
These words can be small consolation to First Boston. The investment bank, believing the arguments against it to have been meritless, now faces the predicament of carrying on as it did before and running the risk of the same thing happening all over again. It seems likely, at least, that it will not be out of pocket the $5 million, having agreed when its services were engaged to be indemnified against actions like this.
“There’s nothing we feel, in terms of our post mortem, that’s going to cause us to alter our method here,” the First Boston source says. Convinced that it was punished without cause, but still bound by the rules of the New York Stock Exchange, the investment bank cannot say, with certainty, that the same thing won’t happen again. For this reason, its legal department is considering approaching the NYSE to discuss a possible modification of Exchange Rule 600 (a), which allows any non-member to bring any member to arbitration.
Dennis Block, a partner at Weil, Gotshal & Manges and the co-author of a recent New York Law Journal article about fairness opinions, will not be telling investment banking clients to stop relying on managements’ financial projections. “It’s impractical to assume that investment bankers go and do the work of management,” he says. “Bankers aren’t ever going to be as familiar as management with the business.”
Wachtell, Lipton is advising clients to change the language of the reliance clause in their fairness opinions from “we have not undertaken any independent verification” to “we have not assumed any responsibility for independent verification.” In this way an investment bank may avoid the charge of inconsistency if the bank happens, in the course of due diligence, independently to verify some information. The memo also warns that the NYSE’s decision should prompt scrutiny of indemnification agreements to make sure they extend to out-of-court arbitration.
By Corporate Control Alert