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As Regulators Heighten Scrutiny Of Wall Street 'Fairness' Views, Outside Merger Assessments Gain

By ANN DAVIS and DENNIS K. BERMAN
Staff Reporters of THE WALL STREET JOURNAL
January 24, 2005; Page C1

Wall Street hopes second opinions will be just the right remedy for the latest regulatory malady it faces.

U.S. regulators are ratcheting up scrutiny of the value and independence of so-called fairness opinions, which companies seek from their banking advisers to show that a planned merger or acquisition is "fair" to shareholders. Such opinions have become the standard tool used by corporate boards to protect against lawsuits and investor criticism of a deal's terms. But the job of writing the opinion typically falls to the bankers already hired for the main duty of putting a deal together. In such cases, bankers make the lion's share of their fees only if a deal gets done.

Now, some Wall Street firms that perform both duties are rethinking their approach. They are requiring or recommending second opinions in certain transactions where they have heightened incentives to see a deal go through.

The move is aimed, in part, at warding off potentially more-far-reaching changes amid an escalating probe by the National Association of Securities Dealers into the conflicts of interest in the lucrative fairness-opinion business. Some critics of fairness opinions say fee-hungry bankers rubber-stamp the deals their clients want, sometimes acquiescing to ill-conceived transactions that ultimately erode shareholder value or force thousands of unnecessary layoffs.

The NASD has said it is considering requiring bankers to publicly state whether the company executives they are working for might be biased toward a deal because they will receive juicy postmerger bonuses. In addition, it is considering policing how bankers settle on valuation methods to evaluate a company. The NASD hasn't suggested Wall Street deal advisers should abandon the fairness-opinion business and only use outside opinions.

Many on Wall Street are open to more disclosure of potential conflicts but defend current practices. "The reason you don't see unfairness opinions is that those deals won't get done," says James C. Morphy, head of mergers and acquisitions at Sullivan & Cromwell. "In fact, bankers do tell their clients that they can't get to fairness at a given price, and that deal either gets renegotiated or doesn't happen."

While the opinions themselves generate tidy sums -- as much as several million dollars each -- Wall Street makes a great deal more on overall advisory fees along with often getting extra fees for providing the financing for an acquisition.

At least one firm, the Credit Suisse First Boston unit of Credit Suisse Group, has quietly changed its policy on certain transactions to protect both the bank and the client from accusations of conflicts of interest. It now asks its clients to seek second opinions in situations where CSFB is working both sides of a transaction -- advising the seller while also providing financing to the buyer -- say people familiar with its practices. This happens when the seller's bank also finances the buyer's purchase. Known as "staple financing," it has become much more common in the past two years. Other banks are considering a similar policy involving such transactions. A CSFB spokesman declined to comment.

In these staple deals, the investment bank has extra incentives to push the transaction forward: It often will pocket a percentage of the deal's total as the seller's adviser, a separate fee for writing the fairness opinion and still another fee for handling the staple financing.

As recently as a year ago, many Wall Street firms maintained that they could objectively opine on such deals while playing the dual role of the seller's adviser and the buyer's lender, say several mergers-and-acquisitions bankers. They were trying to avoid the risk that corporate boards would farm out part of their work and fees to a competitor or that an outside firm taking a second look might raise issues that could delay or block a deal.

An exception is Goldman Sachs Group Inc., which ordinarily declines to provide the fairness opinion when it both advises the seller and does financing for the buyer. Instead, say bankers familiar with the company's practices, it asks its client to bring in an outside opinion provider. A Goldman spokeswoman declined to comment.

Firms also are being cautious on some complex deals. In October, steelmaker Ispat International NV agreed to merge with LNM Holdings NV to form Mittal Steel Co. The Mittal family controlled the two companies. CSFB advised the special committee of Ispat's board and also provided a fairness opinion.

But given the involvement of the family in both companies, the bank suggested that Ispat receive a second fairness review, in this case provided by investment-banking boutique Houlihan Lokey Howard & Zukin. Such an arrangement wouldn't have happened a few years ago, say people familiar with the matter.

Pledges by firms to address some of the more blatant conflicts involving fairness opinions could shape what is expected to be one of the next big battlegrounds between securities firms and regulators. The NASD is questioning Wall Street firms about how they handled conflicts in recent deals and is soliciting public comments through Feb. 1 on possible reforms. The Wall Street Journal first reported the NASD probe June 11.

The securities industry is gearing up to resist some potentially significant changes to the deal-vetting process while embracing more disclosure. In recent weeks, teams of lawyers advising the Securities Industry Association and an M&A committee of the Association of the Bar of the City of New York have been forging comment letters to the agency. Among the issues that Wall Street firms worry about, says Thomas W. Christopher, a mergers-and-acquisitions attorney for the law firm Kirkland & Ellis LLP, are whether they will be asked to change their valuation methods. The NASD has said it may set out procedures to determine "whether the valuation analyses used are appropriate for the type of transaction and the type of companies" in a deal, though it is unclear how far it will go.

"The NASD is in no position to determine what the right fairness analysis is...that's really invading the province of the investment bank's right to do the analysis itself and the boards of directors to rely on the analysis that they think is right," says Mr. Christopher.

Getting two fairness opinions is more expensive for companies. But the trend is good news for one group: smaller deal-advisory boutiques. Sheryl Cefali, head of Duff & Phelps's fairness-opinion practice on the West Coast, says her firm produced 30% more fairness opinions in 2004, in part because of increased requests for second opinions.

Still, there is a long way to go. Standard & Poor's Corporate Value Consulting, a unit of McGraw-Hill Cos. that does fairness opinions, analyzed deals greater than $500 million in 2004 and found that, in cases where the advisers' roles were disclosed, only 7% identified a separate fairness-opinion provider from the main adviser. That was up from 3% in 2003.

Write to Ann Davis at ann.davis@wsj.com and Dennis K. Berman at dennis.berman@wsj.com