Boards, Uncertainty, and the Use of Fairness Opinions

• Author: Melissa B. Frye,Weishen Wang
• Date: 01 January 2010
• DOI: http://doi.org/10.1111/j.1467-8683.2009.00773.x
• Published date: 01 January 2010

Boards, Uncertainty, and the Use of

Fairness Opinions

Melissa B. Frye* and Weishen Wang

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We propose and test a new perspective on why the boards of some acquiring f‌irms purchase a

fairness opinion (FO). Specif‌ically, we examine whether the board’s knowledge explains the use of an FO and the market

reaction to the FO.

Research Findings/Insights: We f‌ind that FOs are more likely to be purchased when the acquiring f‌irm’s board feels

uncertain about the deal. Specif‌ically, we f‌ind that boards with more outside directors are more likely to use an FO, while

boards whose directors hold more outside appointments (busy boards) are less likely to seek an FO. Moreover, we f‌ind that

although the market reacts negatively to the FO, board characteristics both moderate and exacerbate the reaction. When an

FO is used by a busy board, the market reacts more negatively to the merger announcement. In contrast, board indepen-

dence and the average service years for directors seem to moderate the market’s reaction to the FO.

Theoretical/Academic Implications: The results of this study are consistent with the idea that a lack of knowledge and

underlying transaction uncertainty motivates the board to purchase an FO. In addition, our empirical evidence supports a

sophisticated market reaction, where the market recognizes the board’s knowledge when assessing the necessity of the FO.

Practitioner/Policy Implications: This study provides a new perspective on why boards use FOs. A board with more

outside directors may be strong on monitoring, but may lack knowledge on the deal. This essentially provides an example

of a cost associated with an independent board. Further, we show that the market can differentiate the types of boards that

use an FO.

Keywords: Corporate Governance, Merger, Board Knowledge, Fairness Opinion, Market Reaction

INTRODUCTION

In mergers and acquisitions, the boards of acquiring f‌irms

and/or target f‌irms often seek a fairness opinion (FO)

from f‌inancial advisors, usually investment banks. The FO

indicates whether the deal, particularly the price, is fair to

their shareholders. It is essentially a professional opinion

based on collected data with an unambiguous indication of

whether the deal is fair. FOs are not mandatory; however,

Kisgen, Qian, and Song (2009) report that 80 per cent of

targets and 37 per cent of acquirers are willing to pay sub-

stantial fees to obtain a third-party assessment of the merger.

Some studies suggest that directors seek such opinions to

provide legal protection as they may provide evidence of the

board’s due diligence (Bowers & Latham, 2006; Chen &

Sami, 2007; Kisgen et al., 2009; Makhija & Narayanan,

2007). However, Ohta and Yee (2008) stress that this legal

protection or inoculation hypothesis cannot be the whole

story. Specif‌ically, they question why all f‌irms do not use

them if they provide valuable protection as well as why they

are not boilerplate across all transactions.They highlight that

the use of FOs did not increase following the Smith versus

Van Gorkum case in 1985, where the Delaware Supreme

Court rebuked a board for failing to make an informed deci-

sion. Ohta and Yee (2008) further highlight that there are no

cases where a board has been held liable for failing to obtain

an FO.

Moreover, extant studies thatfocus on the legal protection

hypothesis often present inconclusive or even puzzling

results as to why a board would use an FO. Kisgen et al.

(2009) do consider an alternative to the legal protection

hypothesis, which they label “the transaction improvement

hypothesis.” Their results for acquirer FOs support both

hypotheses. Specif‌ically, they f‌ind that deal premiums are

lower for acquirers using an FO (consistent with the trans-

action improvement hypothesis), while they also show that

*Address for correspondence: Department of Finance, College of Business Adminis-

tration,University of Central Florida, Orlando, FL 32816-1400, USA. Tel: 407-823-3097;

Fax: 407-823-6676; E-mail: melissa.frye@bus.ucf.edu

48

Corporate Governance: An International Review, 2010, 18(1): 48–63

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00773.x

deals with acquirer FOs are more likely to be completed and

are associated with greater wealthlosses (consistent with the

legal protection hypothesis). However, they assume that

acquiring f‌irm announcement returns provide a more com-

prehensive assessment, thus they conclude that FOs are

used for legal protection.

In addition to these mixed results, Kisgen et al. (2009) f‌ind

that smaller boards with more outside members are more

likely to use an FO, seemingly indicating that f‌irms with

better corporate governancestructures are more likely to use

an FO. This raises the question as to why a f‌irm with better

governance would need more protection. In contrast,

Bowers and Latham (2006) assume that f‌irms with better

governance (measured by the Gompers, Ishii and Metrick’s,

2003 governance index) would face lower litigation risk and

thus would be less likely to obtain an FO. However, they

f‌ind no evidence that governance affects the demand for

FOs. Makhija and Narayanan (2007) contend that “captured”

boards with more insiders would seek the legal protection of

an FO, but they f‌ind no signif‌icance in their empirical tests

with acquirers. The inconclusiveness on this issue begs a

new viewpoint.

In this paper, we propose and test a fresh perspective on

acquiring f‌irms’ use of FOs. We focus on acquiring f‌irms for

several reasons. Kisgen et al. (2009) note that there is more

variation in the use of FOs by acquiring f‌irms, which raises

the question as to why some f‌irms purchase them while

others do not. Second, most acquiring f‌irms experience

signif‌icant losses in mergers, while targets often gain

(Andrade, Mitchell, & Stafford, 2001). Moeller, Schlinge-

mann, and Stulz (2005) stress the importance of understand-

ing why announcement returns of acquirers are associated

with large losses. Since an FO is an added expense to an

event that, on average, destroys shareholder wealth, the

motivation behind the purchase seems timely and relevant.

Finally, the Kisgen et al. (2009) f‌indings on acquirer FOs are

not always consistent with their legal protection hypothesis.

In our paper, we contend that FOs are more likely to be

purchased when the board has excessive uncertainty associ-

ated with the deal. We maintain that some boards are more

knowledgeable about the value-creating potential of the deal

than others. Such boards will feel more certain about the

merits of the merger and will be less likely to ask investment

bankers whether the deal price is fair. Coles, Daniel, and

Naveen (2008) and Kroll, Walters, and Wright (2008) empha-

size the importance of board knowledge in both the moni-

toring and advising functions of the board.

Under this new perspective, we also expect the market to

recognize the uncertainty of the underlying transaction as

well as the knowledge of the board.We expect that the use of

an FO will signal to the market that the board was unsure

about the synergies of the deal (or that the transaction was

complex). Thus, the market will react more negatively to

deals with an FO. However, we expect the market to temper

this reaction based on the underlying knowledge of the

board. We note that prior studies have considered gover-

nance as a determinant of the use of an FO (Bowers &

Latham, 2006; Kisgen et al., 2009), but they do not examine

whether announcement returns are affected by characteris-

tics of the board using the FO. Makhija and Narayanan

(2007) examine the effect of low inside holdings and low

board independence onlyon target company announcement

returns.

Using multiple proxies for the board’s knowledge as well

as a matched sample to control for the deal uncertainty, our

empirical results suggest that the board’s uncertainty about

the value of the deal is an important determinant of the use

of an FO by an acquiring f‌irm. We f‌ind that larger boards, or

more specif‌ically, those with more outside directors, are

more likely to obtain an FO. Outsiders to the board may feel

less informed about the merger valuation and thus obtain

the FO as a means to gather information.We f‌ind that boards

with busy directors are less likely to use an FO. Serving on

multiple boards may increase the director’s knowledge base

and thus decrease the need to seek an FO. We also f‌ind

evidence that boards are more likely to use an FO when

there is more uncertainty about the underlying transaction.

In general, our results are consistent with Ohta and Yee

(2008) and suggest that the board’s knowledge is important

in explaining the use of an FO.

In terms of market reactions, we f‌ind that overall the

market reacts negatively to the FO; however, board charac-

teristics both moderate and exacerbate the reaction. Specif‌i-

cally, we f‌ind that when an FO is used by a board with a

greater percentage or number of outside directors or by a

board whose members have long tenures with the f‌irm, the

market reacts less negatively. Such boards are likely to have

less knowledge and the market appears to recognize the

necessity of the FO. However, when a busy board, which

should be more knowledgeable, uses an FO, the market

reacts more negatively.

The contribution of our study is twofold.First, we provide

a new perspective on why boards use FOs. We show that a

board with more outside directors may be strong on moni-

toring, but may lack knowledge about the value-enhancing

potentials of the deal. This essentiallyprovides an example of

a cost associated with an independent board. Our framework

of uncertainty may provide a better explanation for the rela-

tion between board characteristics and the use of an

FO than that offered by previous studies, which seemingly

show better governed f‌irms need more legal protection

(Kisgen et al., 2009). Also,our framework and results provide

an alternative explanation to the mixed f‌indings of Kisgen et

al. (2009), where deal premiums are lower but announcement

returns are negative for acquirers with an FO. The use of an

FO maylead to a better transaction (lower deal premium), but

maysignal to the market the board’s lack of knowledge. Thus,

our f‌indings may reconcile the results in Kisgen et al. (2009).

Second, we show that the market does consider the charac-

teristics of the board thatuses an FO. An FO may signal to the

market that the board is unsure about the merger and subse-

quently the market reacts negatively to the FO. However, the

market recognizes the necessity of an FO for boards lacking

knowledge to perform their f‌iduciary duties.

BOARD KNOWLEDGE AND FAIRNESS

OPINIONS (FOs)

The board has both an advisory and monitoring role, which

require extensive knowledge about the f‌irm and its strategic

environment. In the case of mergers and acquisitions, the

BOARDS AND FAIRNESS OPINIONS 49

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