Opinions Labeling Deals 'Fair' Can Be Far From Independent
Banks That Do Them Often Are Advisers on Transactions And Have Fees at Stake
A High-Profit-Margin Item

December 29, 2004; Page A1

In the biggest U.S. merger this year, J.P. Morgan Chase & Co. announced last January it would acquire Bank One Corp. To assure investors it was paying a fair price, J.P. Morgan told them in a proxy filing it had obtained an opinion from one of "the top five financial advisors in the world."


The in-house bankers at J.P. Morgan endorsed the $56.9 billion price -- negotiated by their boss -- as "fair."

But during the negotiations, Bank One Chief Jamie Dimon had suggested selling his bank for billions of dollars less if, among other conditions, he immediately became chief of the merged firm, according to a person familiar with the talks. That suggestion wasn't accepted by J.P. Morgan.

To some J.P. Morgan shareholders who are now suing over the deal, it raises the question: Did Morgan's in-house evaluators endorse a higher price to keep CEO William Harrison in power longer? "Only by retaining a conflicted financial adviser could Harrison control the process and justify paying more than was necessary for Bank One," the investors said, in a pending suit in Delaware Chancery Court.

J.P. Morgan denies that assertion, according to a spokesman, who said that executives at the bank would have no comment. J.P. Morgan, which had disclosed its use of an in-house advisory team, says it made sense to use bankers intimately familiar with its business, and that the board's lawyers said it wasn't necessary to get another opinion. The bank says it negotiated the best deal possible given that it didn't want to hand immediate control to a newcomer. It also says that other shareholders -- from Bank One -- have sued claiming the price was unfairly low.

Boards of directors get "fairness opinions" to show they've independently checked out the price of a deal, thus giving themselves some legal protection from unhappy shareholders. But it is an open secret on Wall Street that fairness opinions can be anything but arm's-length analyses.

Investment bankers frequently write fairness opinions for clients with whom they have longstanding business ties and with whom they hope to continue having relationships. Indeed, an opinion is commonly written by the very bank that suggested the merger or acquisition in the first place -- and that now is acting as adviser on that deal.

In such cases, the investment bank stands to collect a far larger fee if the deal goes through than if it does not. If it goes through, the advisory bank will collect a "success fee" that dwarfs the opinion fee. And, in a further incentive to bless high-priced deals, the success fee is usually tied to the deal's price.

As if these potential conflicts weren't enough, when the merging parties are financial firms, the parties typically get their fairness opinions not from outsiders but from folks right down the hall.

Now, securities regulators may weigh in. The National Association of Securities Dealers has launched an enforcement inquiry into conflicts that can arise with fairness opinions. The NASD is also seeking comment on potential new rules requiring more disclosure of the financial incentives that bankers and their clients have for endorsing deals. There isn't any move to do away with the opinions.

Fairness opinions often vet prices that were set by company executives who, the bankers know, have strong financial incentives to push through a deal. The opinions often are crafted at the last minute, as bleary-eyed bankers scramble to cobble together projections to justify the final price at an impending board meeting or news conference.

In the case of Bank of America Corp.'s recent purchase of FleetBoston Financial Corp., Bank of America called in Goldman Sachs Group as adviser the weekend before the deal was announced. Goldman got $25 million for providing advice, including $5 million for a fairness opinion. Morgan Stanley, which advised Fleet, also collected $25 million, an undisclosed part of it for its fairness opinion. The $47.7 billion deal closed April 1.

"Fairness opinions are one of the highest profit margin businesses on Wall Street. In the BofA-Fleet deal, profitability must surely be setting new heights," said Thomas Brown, a hedge-fund manager with a Web site that follows bank stocks, in a column after the deal was announced. Believing that BofA overpaid, Mr. Brown contended that "the large dollar payment was necessary to get the names of two prestigious firms to provide fairness opinions on a questionable transaction."

A spokeswoman for Bank of America says it paid a premium for Fleet because "we saw value in Fleet that wasn't reflected in its market price," adding that "investors have also seen this value." The spokeswoman says BofA believes Goldman was compensated fairly. Representatives of Goldman and Morgan Stanley declined to comment. Goldman bankers familiar with the deal say the fee reflected years of efforts to help BofA identify acquisition candidates.

Investment banks defend fairness opinions, noting that their own interests sometimes are aligned with those of shareholders. For example, in cases where the bank is advising a takeover target, it and the shareholders both benefit from a high price. The bank's fee is based on the deal's price.

The opinions "are a very useful tool for boards of directors," says Marjorie Bowen, national director of investment bank Houlihan Lokey Howard & Zukin's fairness-opinion practice. Though "there is perception that they are rubber-stamped, people who are not involved in the procedural aspect of processing and reviewing a fairness analysis don't understand how seriously the investment banking community takes them."

NASD Vice Chairman Mary Schapiro says investors place trust in the opinions without realizing how conflicts may have colored the authors' judgment. The NASD's scrutiny of the opinion process comes as mergers-and-acquisition activity is robust; December saw the highest dollar volume of deals world-wide of any month in more than four years.

Fairness opinions became more common after the Delaware Supreme Court said in 1985 that they could help a board demonstrate its "duty of care" in evaluating a transaction. Companies involved in deals now feel they need to get a fairness opinion as legal protection.

Bankers who write the appraisals don't work from scratch. They typically use financial projections supplied by the client and don't vouch for the data. That's one reason attempts to sue securities firms that provide fairness opinions have often failed. Courts have noted that they don't constitute formal recommendations to shareholders.

To say whether a deal is fair, bankers compare it with others of similar size in the same industry. They may look at the price as a multiple of earnings, of book value (assets minus liabilities) or of measures particular to an industry. The banker has plenty of leeway in choosing how to make the analysis. The method is usually explained in a proxy statement. The letter itself merely says the price is fair.

If bankers find it hard to conclude that a deal is fair, they'll often have private discussions with the client.

Here are some issues that have sparked controversy over fairness opinions.

The Numbers Game

Fairness reviews can be quite subjective, and bankers have many ways to slice the data. Consider the projections Piper Jaffray Cos. used to declare a valuation fair in a battle over Best Lock Corp., founded before the Depression by a janitor who had invented locks with a master key and an interchangeable core. Controlling shareholder Russell Best, a grandson of the founder, bought out minority shareholders of Best Lock in 1998, triggering a long legal battle.

The board -- Mr. Best and his wife -- said they had the right to buy out other shareholders without a vote because they controlled the company. They used a value for the whole company of $58 million. They said this was on the "highest point of the recommended ranges" presented by Piper Jaffray.

Shareholders sued Best Lock and its board. They alleged in a Delaware Chancery Court that Piper had agreed to consult with Best Lock's attorney about the valuation method and not to investigate further what others might be willing to pay.

Best Lock gave Piper several sets of projections to set a price. The most pessimistic put future revenue growth at 7%, according to the suit. That is what Piper used, the suit said, even though Best's auditors had provided data to a lender describing 10% annual growth in the 1990s, and even though net income for 1997 was running ahead of projections.

The suit said Piper wouldn't get the last $325,000 of an advisory fee if it didn't justify the price Mr. Best was willing to pay. Piper declined to comment. It wasn't a defendant in the shareholder suit.

In 2002, long after Mr. Best had completed the buyout and just before a trial was set to begin, he sold the company to Stanley Works. The price was $310 million, of which, according to people familiar with the matter, about $100 million went to repay Best's debts. Mr. Best said at the time that the business was more valuable because it had grown through an acquisition. He settled shareholder litigation for an estimated $52 million. In total, the minority shareholders got about triple the compensation that had been endorsed as fair four years before. Mr. Best couldn't be reached to comment.

Side Deals

Fairness opinions frequently ignore deals the client company is simultaneously doing with its executives.

A year ago, BSB Bancorp Inc. of Binghamton, N.Y., announced it would be acquired by a smaller competitor for $337.6 million. Just before the announcement, BSB's board amended "change-of-control" agreements for executives. The result was that its chief executive, Howard Sharp, collected a "severance" package of about $1.64 million, in addition to his retirement benefits of $2 million, according to the acquiring bank -- even though the acquirer hired him at a $450,000 annual salary.

Some critics cried foul, including John Cheevers, an independent stockbroker in nearby Endicott, N.Y., who had put clients into BSB stock. He protested to BSB's board that it was selling the bank for a little over two times book value, while other banks were being sold for more than three times "book." In addition, the premium BSB shareholders got was reduced by the fact that part of it was in cash, triggering a tax bill.

One unhappy BSB shareholder was Rudy Cechanek, an 83-year-old retired engineer who had about $300,000 in BSB stock. He thought BSB could have fetched a higher price, and he was livid when he learned that top executives of BSB would get millions of dollars.

BSB got a fairness opinion from investment bank Keefe, Bruyette & Woods, with which it had an existing relationship. In finding the sale fair, Keefe Bruyette didn't discuss the payments to BSB's chief executive. Keefe was able to collect the largest part of its $2.7 million advisory fee only if the deal went through.

"The fairness opinion really bothered me," Mr. Cechanek says. "The words were there, but the shareholders weren't being treated very fairly. It was written more to protect the executives who were more interested in getting the deal done."

Keefe Bruyette declined to comment. Mr. Sharp didn't return messages left at his home and office. The acquiring bank, Partners Trust Financial Group Inc. in Utica, declined to comment but told analysts the deal would over time greatly improve the combined company's growth prospects. A bank analyst at Ryan Beck & Co., Anthony Davis, says the price was "discounted for a reason" -- BSB's history of having poorly performing loans -- and was arguably a good price.

Close Ties

Peter Siris, a hedge-fund manager and longtime investor and corporate director, says he was blindsided by a bad fairness opinion when he served as a director of Crown American Realty Trust, a real-estate investment trust in Johnstown, Pa.

In anticipation of selling Crown, its chairman and chief executive, Mark Pasquerilla, asked Wachovia Corp.'s investment bankers in 2002 to structure certain transactions with the CEO and his family. Crown retained another investment bank, Ferris, Baker Watts Inc. in Washington, D.C., to render a fairness opinion on these transactions. They included property swaps and certain cash-flow obligations that Mr. Pasquerilla owed to Crown. They needed to be resolved before Crown could be sold.

"The bankers gave us a big fancy book detailing that everything was fair," Mr. Siris says, and in a telephone board meeting, directors gave preliminary approval to execute the complex transactions. But after the vote, Mr. Siris says, he was bothered that "the deal seemed to benefit the CEO more than the company" by giving him favorable terms.

Mr. Siris and other outside directors retained a lawyer and notified the Crown CEO they wouldn't give final approval without additional analyses. These directors, says the lawyer they hired, James Spitzer, "were concerned about the impartiality of the investment bankers, who stood to gain $4 million on the deal and had allegiance to the CEO."

Mr. Spitzer told Wachovia he saw a conflict because one of its bankers had handled other work for a Pasquerilla family company. Wachovia would get only a fraction of its $4 million advisory fee if the deal didn't go through, said someone familiar with the arrangements.

Wachovia offered a new investment-banking team that hadn't done past work for the family. Mr. Siris, acting as the lead director at Crown, says he gave this new team a fresh mandate: "You report directly to the board, not to the CEO. I want an honest fairness opinion, not one that justifies a bad deal."

Ferris Baker defended its process. "We go through a rigorous quality-control process on our fairness opinions, and this is the first I've heard that there was a problem. I'm not conceding there was a problem," said Ferris Baker's head of investment banking, Richard Prins.

Wachovia helped restructure transactions with the CEO's family and wrote a fairness opinion declaring the revised terms "fair" to Crown shareholders. Crown had meanwhile been negotiating to be sold to a rival shopping-mall owner, Pennsylvania Real Estate Investment Trust. The terms of this sale also were revised, and Wachovia declared the new ones "fair" as well. They provided about a 25% better price than before, according to Mr. Siris. In May 2003, Crown's board approved the sale of the company to Pennsylvania REIT.

"It would have been so easy to be seduced by a fairness opinion that cheated shareholders," Mr. Siris says. "It took a lot of work to get the right opinion."

Mr. Pasquerilla, the former Crown CEO, declined to discuss the deals' specifics but said, "We were all in agreement at the end of the day. Our board was a tough board; they did the right thing. This has been a good transaction."

A 'fairness' opinion tells a company's board that a deal's terms are fair to shareholders.
Purpose: Legal protection from an investor claim that a deal was done without due care.
Cost: A few hundred thousand dollars to a few million.
Potential conflicts:
• Bankers may have incentive to call a deal fair because most of their advisory fee is paid only if deal closes.
• Bankers' fee is tied to the deal's price.
• Bankers may support a deal where executives will personally profit, in hopes of securing future work.
• Bankers use financial data supplied by client that wants deal to go through.
• When deal maker is a bank, its own bankers often write the fairness opinion.
Source: WSJ research

Write to Ann Davis at ann.davis@wsj.com and Monica Langley at monica.langley@wsj.com