Fairness in fairness opinions: Lessons from Enron

In a report dated November 14, 2003, Harrison J. Goldin summarized his findings with respect to certain entities in transactions pertaining to Special Purpose Entities (“SPEs”) of Enron North America Corp. (“Enron”)*.  The conclusion of Mr. Goldin (“The Enron Examiner”) was particularly critical of the appraiser who had completed several fairness opinions on behalf of the Enron Board of Directors.

Summary of Relevant Facts

In June 1999, Enron retained the valuation advisory services of a Big Four accounting firm (the “Appraiser”) to issue a fairness opinion for Enron’s Board of Directors on an SPE transaction referred to as the “Rhythms Transaction”. This transaction involved the transfer of 3.4 million shares of Restricted Enron Stock from Enron to an SPE called LJM1, in exchange for $64 million in notes received from LJM1 as well as a five-year put option on Enron’s Rhythms stock received from “Swap Sub”, the option counterparty. The Appraiser valued the Restricted Enron Stock between $170 and $223 per share, a discount of approximately 20% to 42% from the market value due to the four-year prohibition on sales of the stock. 

In the fairness opinion, the Appraiser ultimately found the transaction to be fair to Enron. The Enron Examiner, after reviewing the basis for the fairness opinion, concluded that under the terms of the transaction, the deal was not fair to Enron and that the entire fairness opinion was of little to no value at all.

Specific deficiencies identified in the Appraiser’s analysis included:

Failure to Act as a Financial Advisor to Enron’s Board

While the engagement letter stated clearly that the fairness opinion was to be rendered “to the Board of Directors (the “Board”) and management and/or special committee,” the Appraiser’s communication was only with management throughout the entire engagement. Apparently, the Appraiser did not meet with or present its opinion to the Board at any time (p. 321).

By not presenting its analysis and opinion to the Enron board, the Appraiser was viewed as negligent in two respects:

1. Failing to help the Board determine whether the price and terms of the transaction were fair to shareholders; and
   
2. Failing to provide an analysis that would enable the Board to meet its fiduciary duty to the corporation and shareholders (p. 322).

Failure to Disclose Conflict of Interest

The Enron Examiner expressed the view that a key part of a thorough fairness opinion is to recognize potential conflicts of interest between the valuator and the involved parties of the transaction. It is generally accepted that independence of the financial advisors providing the fairness opinion is a cornerstone of fairness opinion reliability. If a conflict appears to be present, the advisory firm should, at the very least, disclose its conflict to the client for its consideration.

In this instance, the Appraiser’s firm, being involved with LJM1 in tax advisory services, had a clear conflict of interest in rendering a fairness opinion to Enron, when both Enron and LJM1 were parties in the transaction. The Appraiser did not attempt to communicate any form of conflict of interest to Enron board members. “Had Enron not decided to proceed with the Rhythms Transactions, LJM1 would have lost its principal reason for existing and [the Appraiser’s] tax team would have lost its client. Consequently, [the Appraiser’s] fairness opinion team had a strong incentive to find the Rhythms Transaction fair”(p. 325).

Timing of the [Appraisal for the] Rhythms Engagement: The Appraiser accepted the engagement to render a fairness opinion for the engagement two weeks after it closed. It delivered its fairness opinion on the transaction nearly two months after the transaction was completed (while the Appraiser still charged $800,000 for the fairness engagement). The Enron Examiner expressed the view that this greatly questions the value of obtaining a valuation in the first place: “Fairness opinions are usually rendered to support a board’s decision to enter into a merger agreement and to help directors against claims that the decision constituted a breach of fiduciary duty.” (p. 327).

Relying on Unreasonable Assumptions

External advisors will inevitably rely on information they receive from management because of their knowledge about the workings of the Company. However, this does not waive an Appraiser from responsibility for using this information – the advisor should only utilize information deemed to be reasonable. In the case of the Enron opinion, the Appraiser was aware that Enron and LJM1, through the CFO’s connection with both, were clearly not at arm’s length, and therefore could not be expected to rely on Enron’s contrary claim that the parties were at arm’s length.

Lack of Experience in Rendering Fairness Opinions

The Enron Examiner suggested that providers of fairness opinions should have not only general experience in valuations, but “have experience preparing fairness opinions for reasonably comparable transactions” (p. 334). In this instance, the members of the Appraiser’s valuation team had, by their own admission, little to no prior experience with any valuations.

The Standard of Value

(P. 314) In valuing the restricted stock, the Appraiser assumed that the value to LJM1, the “buyer”, was the same as the value to Enron, the “seller”. This can only be assumed true if both the buyer and seller are at arm’s length, which each was not due to the CFO’s involvement with both Enron and LJM1, and the Appraiser’s involvement with providing services to both LJM1 and Enron concurrently.

Essentially, the restricted stock was valued based off the then-current market value of 3.4 million shares, less:

(a)  the value to Enron of keeping the shares off the market for four years; and

(b) less the future value Enron could receive from a specific buyer willing to pay to waive the sale restrictions for liquidity needs.

Upon subsequent expert review, it was found that the value of keeping the shares off the market was negligible, while the value of possible payment for waiving of the restrictions was small in this case as neither LJM1 nor Swap Sub appeared to have any need for liquidity for the restriction period. The Enron Examiner made the following comments with respect to the standard of value in this instance:

• “As the provider of a fairness opinion (and recipient of a considerable fee for the service), [the Appraiser] had an obligation to ensure that its opinion had value to its intended recipient, the Enron board.” (p. 323).

• “Had [the Appraiser] analyzed the specific liquidity needs of LJM1 and Swap Sub in valuing the Restricted Enron Stock, it would have concluded that any value Enron could receive by waiving the transfer restrictions was far less that the 20% to 42% discount [the Appraiser] had calculated” (p. 318).

In the Enron Examiner’s opinion, Enron gave up considerations of significantly higher value than estimated, making the transaction inherently unfair to Enron.  

The nature of these shortcomings were such that the ENA Examiner concluded:

• The evidence was sufficient for a fact finder to determine that the appraiser had committed professional malpractice and was grossly negligent in preparing and providing these opinions;

• The appraiser breached their duty of care to Enron by failing to perform its fairness opinion engagements with the skill, prudence and diligence expected of, and commonly exercised by, other members of the valuation consulting profession; and

• The evidence was also sufficient for a fact finder to conclude that the appraiser’s negligent and grossly negligent conduct in rendering fairness opinions on two of the transactions were the proximate cause of actual loss or damage to Enron. By rendering fairness opinions that had no value to Enron’s Board, the appraiser had caused Enron to sustain significant monetary damages.  

In preparing this article, we have not undertaken the level of review taken by the Enron Examiner and cannot comment on the conclusions reached, but the areas identified by the author in their analysis highlight a number of areas appraisers should be cognizant of.

Guidance provided through the CICBV Handbook

Appendix B to Standard 110 of the CICBV Handbook (“Appendix B”) sets out disclosure standards pertaining to fairness opinions. The Handbook notes that a fairness opinion is fundamentally different from a valuation report in that the latter presents the appraiser’s methodology that was used to determine the value (or range of values) for the shares or assets of a business entity being appraised. A fairness opinion will generally present a professional opinion as to the fairness, from a financial point of view, of a proposed transaction to security holders (or to a group of security holders).

It should be noted that Appendix B differs significantly from Appendix A to Standard 110 (“Appendix A”). This section of the Handbook sets out disclosure standards for valuation reports that are prepared for the purposes of securities regulations or policies in the context of non-arm’s length transactions (i.e. going pPrivate transactions). This standard provides specific recommendations as to the level of disclosure and support for valuation calculations, forward looking information and the inclusion of historic financial information included in the report.

The provisions of Appendix B encourage the appraiser to prepare the fairness opinion in a manner that allows the reader of the report to evaluate the basis for the appraiser’s conclusion: “the Fairness Opinion should provide the principal reasons supporting the opinion conclusion in sufficient detail to allow the reader to understand the basis of the Fairness Opinion and to form a reasoned view on the opinion conclusion.” However, limits are placed on the level of required disclosure: “The disclosure standards do not require that the level of disclosure provided be sufficient to enable the reader to perform his or her own Fairness Opinion.”

The authors of Appendix B guide appraisers to go beyond a quantitative exercise. The authors draw attention to the need to consider specific facts of the proposed transaction that can have a material impact on the fairness conclusion. “In essence, the range of values as determined may only comprise one of the factors that the opinion provider considered in the particular circumstances.” In considering the fairness of the proposed transaction, it is also noted that if other preferable alternatives exist to that which is proposed, they need to be taken into consideration. This is problematic as an appraiser would not necessarily be aware of discussions management may have had with other parties and/or other alternatives they were contemplating. Regardless, there would be an impetus to ensure that this is considered and management is questioned on their motives.

The Role of Other Sections of the Handbook - CICBV Code of Ethics
The Standards provide specific guidance on the preparation of appraisals (in this instance a fairness opinion). However, broader guidelines as set out in the CICBV Code of Ethics should also be referred to in accepting and then completing a fairness opinion.

General Principles

103 - A member or registered student shall perform his (her) professional services with integrity, good faith and due care and shall sustain his (her) professional competence by keeping informed of, and complying with, developments in practice standards and recommendations.

General Standards of Conduct

203.1 - A member or registered student shall perform his (her) professional services with integrity, good faith and due care.

203.2 - A member or registered student has a duty, in the practice of his (her) profession, to be competent, conscientious, knowledgeable, diligent, and efficient.

Maintaining Professional Competence (pg.4)

204 - A member or registered student shall maintain professional competence by keeping informed of, and complying with, developments in the Institute’s Practice Standards and Recommendations in all functions in which he (she) practices. A member or registered student shall not undertake to provide professional services, which he (she) is not competent to provide by virtue of training or experience or is unable to become competent without undue delay, risk or expense to the client.

With reference to the six deficiencies noted by the Enron Examiner (accepting his version of fact, it is evident that each of these principles were violated.

Conclusion

After reviewing the Enron matter, it is clear that the potential for a fairness opinion file to go astray is high. The CICBV Handbook standards provide a general framework and some guidance, but the exercise of sound judgment of the appraiser is vital in not only completing the analysis of the company of interest, but also in ensuring that the correct skill set is brought to the file in delivering an analysis that adequately meets the end user’s needs.

By Scott Lawritsen, Business Valuation and Litigation support. For more information, please contact your local MNP advisor or Scott at 1.877.500.0792.

* Report of Harrison J. Goldin, the court-appointed examiner in the Enron North America Corp. Bankruptcy Proceeding, respecting his investigation of the role of certain entities in transactions pertaining to special purpose entities, United States Bankruptcy Court, Southern District of New York, Chapter 11. Case No. 01-16034 (AJG), re: Enron Corp. et al., Debtors.

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