Court: Fairness Opinions Are Not Insurance Policies

Just in time for the current business cycle downturn comes an important decision, whose genesis lies at the heart of the previous one. In a recently issued opinion, the U.S. Court of Appeals for the Seventh Circuit determined that an investment bank that provided a fairness opinion in support of a disastrous merger during the height of dot-com mania had no duty or obligation to rescue a client from its own foolishness.

The facts underlying the ill-fated acquisition read almost as a parody of deal-making at the peak of the tech stock bubble. In the spring of 2000, HA-LO Industries, Inc. (the “Purchaser”), a company with real products and services, went deeply into debt to purchase an internet startup company that had no revenues and a burn rate of $3 million a month (the “Seller”) for $240 million in cash and stock. Unsurprisingly, the Seller’s promised technology never bore fruit, and the Purchaser was forced to file for bankruptcy. Even less surprisingly, the Purchaser’s creditors (via a liquidation trust (the “Trust)) cast about for someone to blame, and (no surprise at all) focused on the investment banker that advised the Purchaser’s management and provided a fairness opinion (the “Advisor”).

The Trust assayed two basic lines of attack in an effort to establish that the Advisor had acted with “gross negligence.” First, it argued that the Advisor should not have relied on the revenue projections provided by the Purchaser’s management. (The parties stipulated that the Purchaser’s CEO knew that the revenue projections based on the acquired technology were “wholly speculative” and false.) The Advisor’s engagement letter and the fairness opinion itself both stated that the Advisor was relying upon the Purchaser’s revenue projections and that it was not independently verifying such numbers. The court succinctly disposed of the Trust’s contention:

[It is] impossible to label as “grossly negligent” [the Advisor’s] decision to do what the contract required it to do: use the figures and projections furnished by its client. (emphasis in original)

As the court observed, the financial markets rely on accounting firms, rather than investment banks, to be number verifiers, and it declined to consider imposing liability for the Advisor’s failure to undertake a task that it neither had contracted to undertake nor should reasonably have been expected to perform.

Next, the Trust noted the precipitous drop in the equity markets between the time that the opinion was given and the time the transaction closed. The Advisor’s opinion was dated January, 17, 2000. The NASDAQ index peaked in March, 2000, and had dropped precipitously by the time that the transaction closed on May 2, 2000. The Trust argued that the Advisor should have withdrawn its opinion (or issued a new one). The court disagreed:

The Trust’s assertion that [the Advisor] should have foreseen the end of the dot-com boom is an appeal to hindsight . . . Inability to see the future differs from “gross negligence.”

The court again noted that the Purchaser contracted with, and paid, the Advisor to provide a single opinion as of a specific date. It declined to replace the specified contractual obligations with “a set of duties” derived from tort law.

This case should be closely considered by investors that look to purchase the debt of companies that are in financial distress or that have filed for bankruptcy. Such debt is often bought for mere pennies on the dollar with the hope that value can be extracted from the remnants of the enterprise after senior creditors are paid. Not uncommonly, the only sources of recovery are causes of action that the debtor’s estate may assert against healthy third parties, such as former professional advisors. However, the mere fact of financial failure does not mean that a party (other than the debtor) can be properly blamed.

Judge Easterbrook of the Seventh Circuit neatly encapsulated the essence of the case:

This suit is nothing but an attempt to find a deep pocket to reimburse investors for the costs of managers’ blunders . . . But [the Advisor] did not write an insurance policy against managers’ errors of business judgment.

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About Amir

I hate doctors!
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