NASD’s Proposed Rule on Fairness Opinions: A Long and Winding Road
By John K. Hughes

The road taken by the National Association of Securities Dealers’ proposed rule on fairness opinions has been long and winding – the latest amendment to the rule was filed by the NASD in early June, nearly two years after the rule was first proposed. A brief background follows.

On June 22, 2005, the NASD initially proposed new Rule 2290. If approved by the Securities and Exchange Commission, Rule 2290 would, in brief, require NASD members providing fairness opinions to (i) include certain additional disclosures in those opinions, and (ii) establish and follow certain procedures in connection with issuing fairness opinions.² The NASD’s initial proposal was described in detail in an earlier Wall Street Lawyer article.³ On November 30, 2005, in response to comments from the SEC staff, the NASD filed a partial amendment to its proposed rule change.⁴ That amendment was summarized in another earlier Wall Street Lawyer article.⁵ On January 25, 2006, the NASD filed a second amendment to its proposed new rule,⁶ and on March 1, 2006, the NASD filed a third amendment.⁷ On June 7, 2007, in response to the notice of proposed rulemaking published in the Federal Register and additional comments, the NASD filed its fourth amendment to proposed Rule 2290.⁸ A brief summary of that latest amendment follows. Overall, the NASD’s fourth revised proposal imposes fewer requirements on investment bankers and NASD members than had been proposed in NASD’s initial proposed rule submission. Many of the requirements are part of current practice, although a few items may require new disclosure.

Regarding Additional Disclosure

Requirement of knowledge of fairness opinion -- Under the NASD’s earlier amended proposed rule change, NASD members were to disclose certain specified information in any fairness opinion that “may be provided, or described, or otherwise referenced to public shareholders.”⁹ The NASD has amended the proposed rule to have it apply to all fairness opinions, so long as “the member issuing the fairness opinion knows or has a reason to know that the fairness opinion will be provided or described to the company’s public shareholders.”¹⁰ The NASD indicated that a member will be deemed to have a reason to know if, for example, the transaction will require a shareholder vote.¹¹ This change was made, the NASD has noted, so as to give greater clarity as to when additional disclosures would be required and to prevent members from unknowingly violating the rule.¹²

“Or otherwise referenced” deleted -- The NASD also has deleted the requirement contained in the initial proposal to have the rule apply in situations where a fairness opinion is “ otherwise referenced” because the NASD believes that the existing language – “provided or described” – is sufficient to delineate the situations in which the rule would apply.¹³

Advisors act for a party, not a transaction -- The NASD also has amended the proposed rule to clarify that members act as financial advisors to parties, and not to the transaction itself.¹⁴

Compensation must be significant -- The amended proposed rule requires disclosure of whether the member acted as a financial advisor to any party in the transaction and whether it will receive contingent payments on completion of the transaction for acting as a financial advisor or opinion provider, or any other significant contingent compensation. The NASD’s initial proposal required disclosure of “any payment or compensation contingent upon the successful completion of the transaction” that the member would receive.¹⁵ The NASD, in response to comments suggesting that the provision was overbroad and that firms would be unable to comply with the required disclosure, amended the provision so as to require disclosure of only “significant” payments or compensation.¹⁶ The NASD has reaffirmed the purpose of the provision – to avoid attempts to circumvent the rule by re characterizing payments as something other than for advisory services – but has sought a balance in alleviating compliance burdens.¹⁷ The NASD has decided not to define “significant” in percentage or dollar terms so as to avoid having such line drawing serve as a de facto standard.¹⁸ NASD had noted, however, that de minimis fees – such as trading fees or other small fees – would not need to be disclosed.¹⁹ Moreover, the NASD did offer that a “significant” payment or contingent compensation is one that “a reasonable reader of the fairness opinion would have an interest in knowing about in order to assess whether the member authoring the fairness opinion has a potential conflict of interest.”²⁰ Another disclosure item is whether any material relationships existed between the opinion provider and the entity receiving the opinion during the past two years or may be contemplated.

Verification of information -- Retreating from its earlier position that it had staked out in the initial amendment, the NASD has amended the proposed rule to retain the provision requiring disclosure “if any information that formed a ‘substantial basis’ for the fairness opinion that was supplied by the company requesting the opinion has been verified and, if so, requiring a description of the verified information or categories of this information.”²¹ Where such information has not been verified, listing each category of information would no longer be required.²² When no information whatsoever has been verified, inclusion of a blanket statement to that effect wouldbe sufficient.²³ Verification is not required. Firms that do, in fact, independently verify information supplied to them about companies that are parties to the transaction, however, must disclose that fact.²⁴ The NASD also suggests that any firm making such a representation explain in the fairness opinion its process or standards for independent verification.²⁵

Approval by fairness committee; executive compensation -- On the subject of fairness committees, the NASD chose to amend language in the proposed rule to clarify that members must specifically disclose whether or not a fairness committee approved or issued the fairness opinion. ²⁶ Opinion practice would need to be revised to include such disclosure, which is not currently typically included. Moreover, as amended, the proposed rule would require NASD members to disclose “whether or not the fairness opinion expresses an opinion about the fairness of the amount or nature of the compensation to any of the company’s officers, directors or employees, or class of such persons, relative to the compensation to the public shareholders of the company.”²⁷ This language is intended to supplant language that had been contained in paragraph (b)(3) of the initial amended proposal.²⁸ Again, opinion practice would need to be revised to include the required disclosure, which is not now provided.

Regarding Supervisory Procedures

Requirement of written procedures --The NASD has added language in the amended proposed rule that makes it a requirement for any NASD member issuing a fairness opinion to have written procedures governing the approval process related to fairness opinions, including the circumstances where a fairness committee would be used when an opinion is to be issued, and the process for determining appropriate valuation analyses to be used.²⁹

Composition of fairness committee -- While matters related to the composition of the fairness committee are discussed further in the earlier summaries of the NASD’s proposed rule, the NASD’s latest amendment would clarify that the proposed rule does not require that the fairness committee be comprised entirely of persons not serving on or advising the deal team.³⁰ In order to determine whether or not a person is considered to be part of the deal team, an analysis of the particular facts and circumstances in each situation would be required.³¹ The determination would depend on the nature and substance of his or her contacts and the advice rendered to the entity receiving the opinion.³²

Selecting appropriate valuation methodologies -- Under the NASD’s initial proposed rule, members would be required to have a process to determine whether the valuation analyses used in the fairness opinion are appropriate.³³ In addition, members’ procedures “would have to state the extent to which the appropriateness of the use of such valuation analyses is determined by the type of company or transaction that is the subject of the fairness opinion.”³⁴ This second requirement was determined by NASD to be unnecessarily duplicative and has been deleted in the latest amendment.³⁵

Evaluating whether executive compensation impacts fairness -- The NASD’s latest amendment deletes all language that had been in the initial proposed rule under the procedure section related to whether executive compensation received impacted the fairness determination. Instead, and as noted above, the amended proposed rule requires the new disclosure on executive compensation in paragraph (a)(6).³⁶

Effective Date to Be Determined

The NASD will announce the effective date of the proposed rule change in a Notice to Members to be published no later than 60 days following SEC approval. The effective date will be 30 days following publication of that Notice.¹

Notes

1. NASD Proposed Rule Change to Establish New NASD Rule 2290 Regarding Fairness Opinions, SR-NASD-2005-080 (proposed June 22, 2005), available at www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_014558.pdf.
2. John K. Hughes, “NASD’s Proposed Rule Change on Fairness Opinions,” WALL STREET LAWYER, August 2005, at 10.
3. NASD Proposed Rule Change to Establish New NASD Rule 2290 Regarding Fairness Opinions, SR-NASD-2005-080 Amendment No. 1 (proposed Nov. 30, 2005), available at www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_015636.pdf.
4. John K. Hughes, “NASD’S Proposed Rule on Fairness Opinions: An Update,” WALL STREET LAWYER, December 2005, at 12.
5. NASD Proposed Rule Change to Establish New NASD Rule 2290 Regarding Fairness Opinions, SR-NASD-2005-080 Amendment No. 2 (proposed Jan. 25, 2006), available at www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_015890.pdf.
6. NASD Proposed Rule Change to Establish New NASD Rule Regarding Fairness Opinions, SR-NASD-080 Amendment No. 3 (proposed Mar. 1, available at www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_016111.pdf.
7. NASD Proposed Rule Change to Establish New NASD Rule 2290 Regarding Fairness Opinions, SR-NASD-2005-080 Amendment No. (proposed June 7, 2007), available at www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_019261.pdf.
8. Amendment No. 1 to Proposed Rule Change, supra note 3, at 5.
9. Amendment No. to Proposed Rule Change, supra note 5, at 4.
10. Id. at 8.
11. Id. at 9.
12. Id. at 8.
13. Id.
14. Proposed Rule 2290(a)(2).
15. Amendment No. to Proposed Rule Change, supra note 5, at 10.
16. Id.
17. Id.
18. Id. at 11.
19. Id.
20. Id. at 13.
21. Id.
22. Id.
23. Id.
24. Id.
25. Id. at 14.
26. Amended Proposed Rule 2290(a)(6).
27. Amendment No. to Proposed Rule Change, supra note 5, at 18-19.
28. Id. at 15.
29. Id. at 16.
30. Id.
31. Id.
32. Id.
33. Id.
34. Id. at 12-13.
35. Id. at 18.
36. Id. at 39.

About the Author

John K. Hughes is a partner with Sidley Austin LLP in Washington, D.C. Barry Gewolb, a summer associate, assisted in the preparation of this article. Contact: jhughes@sidley.com.