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FAIRNESS OPINION INDEPENDENCE

The Sarbanes-Oxley Act of 2002 affects corporate governance and financial disclosure. In November 2004, the National Association of Securities Dealers (''NASD'') issued a request to member firms for comments (Notice to Members 04-83) as to whether it should propose a rule that would address procedures, disclosure requirements and conflicts of interest when member firms provide fairness opinions

Potential conflicts of interest that the NASD noted in its request for comments include:

1. investment banks may be influenced by whether the company's management supports the transaction,
2. in addition to issuing the fairness opinion, the investment bank may have acted as the financial advisor to the company in recommending or structuring the transaction, and
3. the investment bank may receive financial advisory fees upon the successful completion of the transaction.

Influence by Company Management
One suggestion to address the issue of fairness opinion independence is to require the use of independent banks that do not have any connection to the client or to have banks that specialize solely in providing fairness opinions. However, Andrew Sorkin of The New York Times notes that "so-called independent banks may be more likely to rubber-stamp a fairness opinion than one of the banks with a long-term relationship with a client because independent banks that do nothing but fairness opinions have so much more to lose by offending the companies that hire them. Sorkin also notes that "A fairness opinion is not a guarantee that the deal is truly fair or good. It is simply a document that reviews a deal's valuation, compares it with the valuation of similar deals and says it's within the parameters.

Same Company Issues Fairness Opinion and
Acts as Advisor on the Transaction
A potential area for conflict arises when an investment bank acts as an advisor in a transaction and also issues a fairness opinion on the same. Critics suggest that this potential conflict of interest would make them more inclined to issue a "fair" opinion. Others argue that having the same bank that advises on the transaction provide the fairness opinion actually makes sense because the bank would have thorough knowledge of the terms of the deal and any special considerations, and they note that if bankers working on the transaction advise companies that the terms of the deal would not be "fair", the deal is often renegotiated or terminated before a fairness opinion is issued.

Some Wall Street firms are requiring second opinions on certain transactions, particularly "staple financing" in which a bank represents the seller and also acts as the lender for the buyer. In staple financing, the bank stands to receive a percentage of the total deal as the seller's advisor, a fee for the fairness opinion, and another fee for handling the financing.

Success Fees
A potential area for conflict arises when an investment bank acts as an advisor in a transaction and also issues a fairness opinion on the same. Critics suggest that this potential conflict of interest would make them more inclined to issue a "fair" opinion. Others argue that having the same bank that advises on the transaction provide the fairness opinion actually makes sense because the bank would have thorough knowledge of the terms of the deal and any special considerations, and they note that if bankers working on the transaction advise companies that the terms of the deal would not be "fair", the deal is often renegotiated or terminated before a fairness opinion is issued.

NASD REQUEST FOR COMMENTS

HFBE Letter to NASD in Response to Request for Comments
HFBE Capital, L.P. ("HFBE") submitted one of twenty comment letters to the NASD regarding the proposal of a rule concerning conflicts of interest when members provide fairness opinions. In the letter, HFBE addressed the issue of whether a firm receiving a significant fee contingent on the consummation of a transaction could provide the impartial and independent assessment as to the fairness of the same transaction, HFBE questioned whether disclosure was enough and if process could be effectively mandated. HFBE opined that certain conflicts could not be waived, thus no level of disclosure would cure the underlying conflict. In addition, HFBE expressed concern that it would be difficult to mandate process requirements that would allow competent member firms to act as service providers in the fairness opinion arena. A copy of the letter submitted by HFBE to the NASD is presented at the end of this paper.

Other Responses to the NASD Request for Comments
The NASD received twenty comment letters (including HFBE's letter) in response to its Notice to Members 04-83, Of the twenty comment letters received, twelve were in favor of the proposed rule change, seven were opposed, and one expressed no opinion.

In response to the request for comments by the NASD, California Public Employee's Retirement System ("Calpers") , the largest U.S. pension fund, said investment banks should be prohibited from judging whether mergers or acquisitions are "fair" to shareholders if they also act as the main advisor on the transaction and would profit if the deal was completed. The American Federation of Labor-Congress of Industrial Organizations (AFL-CIO) sought to prohibit contingent fees but also noted that it did not believe that an investment bank should be prohibited from issuing a fairness opinion simply because it had a business relationship with a company. Standard & Poor's suggested the use of a "List of Documents Relied Upon" to disclose information provided by management upon which the opinion was based.

NASD Proposed Rule 2290
After evaluating the comments, the NASD filed a proposed rule change to establish new NASD Rule 2290, which requires certain disclosures and procedures for the issuance of fairness opinions by NASD members firms. The disclosure regulations would require opinions that will be included in a proxy statement to disclose the following information:

1. whether the member acted as financial advisor to any transaction that is the subject of the fairness opinion, and if applicable, that it will receive compensation for:
   1. rendering the fairness opinion that is contingent upon the successful completion of the transaction;
   2. serving as an advisor that is contingent upon the successful completion of the transaction;
2. any other payment or compensation that the member will receive that is contingent upon the successful completion of the transaction;
3. any material relationship that existed during the past two years or is mutually understood to be contemplated and any compensation received or to be received as a result of the relationship between the member and the companies that are involved in the transaction that is the subject of the fairness opinion;
4. 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 involved in the transaction and whether any such information has been independently verified by the member; and
5. whether the fairness opinion was approved or issued by a fairness committee following the procedures required by the proposed NASD rules designed to provided a balanced review of the transaction.

The procedural requirements mandate that any member issuing a fairness opinion have procedures regarding the approval of fairness opinions by a finn, including:

1. the types of transactions and the circumstances in which the member will use a fairness committee to approve or issue a fairness opinion, and in such transactions where it uses a fairness committee:
   1. the process of selecting personnel to be on the fairness committee;
   2. the necessary qualifications of persons serving on the fairness committee; and
   3. the process to ensure a balanced review by the fairness committee, including the review and approval by persons who do not serve on or advise the "deal team" to the transaction;
2. the process to determine whether the valuation analyses used in the fairness opinion are appropriate for the type of companies that are involved in the transaction; and
3. the process to evaluate the degree to which the amount and nature of the compensation from the transaction underlying the fairness opinion benefits any individual officers, directors or employees, or class of such persons, relative to the benefits to shareholders of the company, is a factor in reaching a fairness determination.

FAIRNESS OPINION ISSUES IN THE NEWS

Fairness Opinions Issued In Regard to P&G
and Gillette Merger Draw Criticism
The Securities Division of the Secretary of State's office for the state of Massachusetts conducted an investigation into fairness opinions issued by Goldman Sachs and UBS who advised Gillette on the acquisition of Gillette by Proctor & Gamble ("P&G"). The Massachusetts Secretary of State, William F. Galvin, has suggested that the proposed deal was below market price. Mr. Galvin commissioned a report from Rajesh K. Aggarwal, an associate professor of commerce at the University of Virginia, to examine the fairness opinions and the value of the proposed merger between P&G and Gillette. The report noted that there were errors in the calculations of the merger synergies and there were discrepancies between the public estimates made by the companies of the synergies that would result from the merger ($14 to $16 billion) and the private estimates made by the companies in internal documents of the synergies ($22 to $28 billion). The report concluded that the synergy discrepancies and errors in the valuation made the merger more valuable to Procter & Gamble and would "benefit P&G shareholders at the expense of Gillette shareholders." Mr. Galvin posted the report on Massachusetts Secretary of State website and urged Gillette shareholders to read the article before voting on the merger and "consider whether the share price offered is fair to them from a financial point of view".

WorldCom Lawsuit Scrutinizes Due Diligence Efforts of Investment Banks
A World Com lawsuit filed by investors who bought $17 billion of WorldCom bonds in 2000 and 2001 claimed that investment banks failed to adequately examine WorldCom's financial health. In denying a motion by the bond underwriters for summary judgment, U.S. District Jude Denise Cote "emphasized that underwriters in the case were obligated to conduct 'a reasonable investigation' into WorldCom's finances, aside from merely relying on the company's audited financial statements or a 'comfort letter' that was provided to them by WorldCom auditor Arthur Andersen LLP.

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