The vast majority of mergers and acquisitions (M&As) in recent decades employ fairness opinions (FOs). FOs are provided by an outside advisor (typically an investment bank), and reflect the advisor’s opinion that the terms of the transaction are “fair” to the shareholders from a financial perspective. Advisors support their opinion that the deal terms are fair using a range of valuation methodologies, the two most common being peer firm comparables and DCF analysis. However, despite the ubiquitous use of FOs in mergers, their role is not well understood. On the one hand, some studies argue that FOs provide new information to market participants and serve as a tool for managers to negotiate over transaction price. On the other hand, it has been conjectured (but not tested) that FOs are used primarily to protect managers and boards from litigation and ensure successful deal completion. In our study, “Litigation risk and strategic M&A valuations”, which is forthcoming in the Journal of Accounting & Economics, we explicitly test this conjecture, with a particular focus on the relation between M&A litigation risk and FO valuations.

Our main hypothesis is that valuations are set strategically in target-sought FOs to mitigate the risk of merger litigation, which typically arises when target shareholders believe the transaction price was too low. When litigation risk is perceived to be high, we predict that FO valuations will be biased downwards such that the agreed-upon takeover price falls at or near the upper end of the range of values considered “fair” to the target shareholders, thereby increasing the chance the deal is completed without a litigious dispute. We expect such strategic valuations to manifest in the selection of lower-valued peers and downward-biased DCF analyses so as to make the takeover price appear relatively attractive in comparison.

A challenge in testing our prediction is to obtain exogenous variation in litigation risk. We address this challenge by exploiting regulatory developments in Delaware that led to the rise of appraisal litigation. Originating as a mechanism to protect minority shareholders forced to give up their shares without consent, appraisal laws give target shareholders the right to oppose a merger offer and receive a judge’s appraised value of their shares in place of the original merger price. Appraisal litigation is costly for acquirers as well as for managers of the target firm, who are frequently named defendants and must commit significant time and personal financial resources to resolve the litigation. Once considered an esoteric remedy that was seldom used in practice, two key regulatory events in Delaware during 2007 led to a surge in its popularity and use.

The first development was a May 2007 ruling by the Delaware Court of Chancery, In re Appraisal of Transkaryotic Therapies, Inc. (“Transkaryotic”), which reduced the risk to investors of seeking appraisal in Delaware. The second development was an amendment to Delaware code §262(h) in August 2007 requiring the payment of pre-judgment interest to investors seeking appraisal; an event that increased the return to appraisal. Studies have found that the 2007 developments led to a substantial increase in the frequency and magnitude of appraisal claims, such that nearly one in three Delaware-incorporated target firms faced appraisal by 2013-2015. Moreover, Delaware experienced a rise in non-appraisal M&A class action lawsuits coinciding with the rise in appraisal litigation. Such lawsuits typically allege a breach of fiduciary duty by the target’s board and management for failing to maximize shareholder value; allegations that downward-biased FO valuations can help to dispute. Hence, deals with Delaware targets after 2007 face an elevated risk of both appraisal and non-appraisal M&A litigation, incentivizing strategic FO valuations that portray the takeover price in a favorable light. We use these events in a difference-in-differences design, comparing the change in FOs for Delaware-incorporated targets (“treated” firms) after 2007 to FOs for targets incorporated elsewhere (“control” firms).

We examine a large sample of hand-collected target-sought FO valuations for mergers completed over 2000-2015. We focus on the two most commonly-used valuation methodologies: peer comparables analysis and DCF analysis. To measure strategic peer selection, we compare the median valuation multiple for the group of selected peers with the distribution of median valuation multiples for all possible peer firm portfolios that could have been selected (where potential peers belong to the same two-digit SIC industry). This process yields a measure of bias for the selected peer group (denoted as Peer Portfolio Percentile or PPP), which serves as our first dependent variable. To measure bias in DCF valuations, we use the ratio of the average of the DCF valuations contained in the FO to the merger price (DCF-to-Deal Price).

Consistent with our hypothesis, we find that after 2007, FO valuations decline for targets incorporated in Delaware compared to targets incorporated elsewhere. Economically, PPP (DCF-to-Deal Price) for Delaware targets falls by 16.2% (5.2%) relative to the sample mean compared to non-Delaware targets. Moreover, both PPP and DCF-to-Deal Price exhibit similar trends for Delaware and non-Delaware target firms in the pre-2008 years, providing reassurance that our findings are not due to pre-existing trends. Overall, we find a robust decline in PPP and DCF-to-Deal Price for Delaware targets coinciding with the rise in Delaware M&A litigation risk.

Next, we explore cross-sectional variation in the relation between litigation risk and strategic valuations by investigating the role of agency conflicts between target management and outside shareholders. Litigation risk is higher when target management is perceived as acting in the acquirer’s interests rather than those of target shareholders, compounding incentives to reduce such risk via strategic valuations. We focus on two sources of agency conflicts: deal type and the deal negotiation process. For deal type, we classify management buyouts (MBOs) and going-private transactions as having high agency conflicts. In MBOs, target managers are in the acquirer role and thus have an incentive to minimize the takeover price. In going-private transactions, target managers may simply wish to close the deal quickly and with minimal uncertainty, and thus fail to maximize the takeover price. We consider deal negotiations as having high agency conflicts when the target CEO is directly involved in the negotiations and the board fails to appoint a special independent committee to evaluate the merger (i.e., when target management has greater ability to affect the deal’s outcome). Consistent with expectations, we find a stronger post-2007 downward bias in PPP and DCF-to-Deal Price for deals with high agency conflicts, suggesting greater use of strategic FO valuations when agency conflicts heighten the risk of litigation.

We explore two possible consequences arising from targets obtaining FOs with lower valuations: appraisal litigation and merger premiums. Consistent with prior research, we find a large (7.6%) overall increase in appraisal petitions among Delaware targets after the Transkaryotic ruling and §262(h) amendment. However, Delaware targets with higher FO valuations (proxied by PPP) exhibit an 11.4% increase in appraisal petitions, whereas those with lower PPP values exhibit an increase of just 7.0%. The results for DCF-to-Deal Price valuations are similar. The findings suggest that downward-biased FO valuations can increase the post-merger value of the combined firm by reducing the likelihood of appraisal litigation.

Second, we investigate the relation between litigation risk, FO valuations, and merger premiums. Consistent with prior research, we find that Delaware targets experience an overall increase in premiums of approximately 3.1% in the post-2007 years. However, the result is driven by targets with higher PPP values, whereas targets with low PPP values experience a small decrease in premiums, suggesting the possibility that the selection of lower-valued peers leads to lower premiums. The findings for DCF-to-Deal Price ratios yield similar inferences. Viewed in conjunction with the findings for appraisal petitions, the results imply that obtaining FOs with strategically lower valuations reduces the threat of appraisal litigation, but may also lead to a lower takeover price for the target.

To further validate the link between litigation risk and strategic valuations, we exploit two Delaware Supreme Court and Chancery Court rulings in late 2015 and early 2016 that led to a dramatic decrease (as opposed to the post-2007 increase we focus on in the earlier part of the paper) in Delaware M&A litigation. We use these developments as a shock reversing Delaware M&A litigation risk by extending our sample through the end of 2018. We find that after the reversal of Delaware litigation risk, both PPP and DCF-to-Deal Price increase (as opposed to the decrease we document around 2007) for Delaware targets relative to non-Delaware targets, consistent with FO valuations increasing when litigation risk falls. Comparing the relative magnitudes of the two opposing shocks, we find that FO valuations returned to approximately pre-2008 levels once litigation risk returned to pre-2008 levels.

In contrast to prior work suggesting that target-sought FOs are used to negotiate a higher takeover price, our findings imply that they are used, at least in part, to mitigate litigation risk and facilitate successful deal completion. Although such strategic behavior can reduce the threat of litigation, we find it often stems from agency conflicts between target firm managers and outside shareholders, and can lead to a lower takeover price. Overall, our findings are relevant to academics, practitioners, and regulators interested in M&A price formation, and highlight the role litigation plays therein.