Among the compelling metrics compiled by Professors Korsmo and Myers in their article on appraisal rights that has been approvingly cited by the Delaware Court of Chancery, they have highlighted two key trends which, taken together, demonstrate the sophistication of the investors now driving what appears to be a pronounced spike in appraisal rights cases. Thus, the following graphs show the sharp increase in the number of petitions filed over the past decade, as well as the sheer size of the dollar amounts at stake.
Prior posts in our “Valuation Basics” series have examined the various components of the cost of equity capital under the Capital Asset Pricing Model (“CAPM”). In this post we continue our discussion of those components, focusing on the equity risk premium and its modifying coefficient, the beta.
The CAPM has become the Delaware Court of Chancery’s preferred method for calculating a company’s cost of equity (i.e., the rate of return an investor would demand in order to purchase the company’s stock). A company’s cost of equity under the CAPM is generally the sum of (1) a risk-free rate, plus (2) the equity risk premium adjusted by a beta, plus (3) a size risk premium.
The “equity risk premium” is the difference between the risk-free rate and the expected return from the market. That is, the equity risk premium predicts how a stock index will perform compared to a risk-free investment, such as a treasury bond. Because not all stocks listed on a particular index perform alike, an appraiser valuing a specific company typically adjusts the equity risk premium by a volatility metric called a “beta.” A company with a beta of 1.0 will have an equity risk premium in line with the market. A company with a beta higher than 1.0 will be more volatile than the market, and a company with a beta of less than 1.0 will be less volatile than the market.
Calculating the Equity Risk Premium
The Ibbotson SBBI Valuation Yearbook provides two methods for calculating the equity risk premium: historic and supply-side. The historic equity risk premium looks at stock market returns against risk-free returns dating back to 1926. The supply-side equity risk premium modifies the historic equity risk premium by adjusting the historic equity risk premium for any inflation included in the price-to-earnings ratio. The supply-side method thus produces a slightly lower equity risk premium than the historic method.
Although the historic equity risk premium is the more traditional method, in its recent appraisal opinions the Delaware Court of Chancery has embraced the supply-side equity risk premium as the prevailing methodology. In Global GT LP v. Golden Telecom, Inc., for example, the court adopted the supply-side method over the historic method because the weight of authority supported a rate of return that was closer to the supply-side equity risk premium.
Small variances in beta can lead to large discrepancies in the overall valuation of a company. For example, suppose an appraiser determines that, as of the merger date, the equity risk premium for Company X was 6%. A beta of 1.5 would increase that number to 9%. A beta of 0.5 would decrease that number to 3%. Assuming Company X had very little debt, this could lead to an almost 6% swing in the weighted average cost of capital. Not surprisingly, therefore, beta calculations are frequently contested in appraisal actions.
Although the historical market beta of a publicly traded company can be calculated by examining the covariance between the stock’s historical performance and that of the S&P 500, this method is often unreliable when calculating the beta of smaller public companies, where the stock may not trade in an efficient market. An alternative method for calculating beta is to use the published betas of guideline companies to select a beta for the subject company. Because the guideline companies have their own unique capital structures, however, the appraiser must “unlever” the guideline betas to remove the impact that the guideline company’s debt has on its beta. An unlevered beta is calculated using the following equation:
where LB is the levered beta of the guideline company; T is the tax rate of the guideline company; D is the percentage of the guideline company’s capital structure that is debt; and E is the percentage of the guideline company’s capital structure that is equity.
After selecting an appropriate unlevered beta for the subject company based on the unlevered betas of the guideline companies, the appraiser must “relever” the selected beta based on the capital structure of the subject company, using the following equation:
UB*[1 + (1 – T)*(D/E)]
where UB is the selected unlevered beta for the subject company; T is the tax rate of the subject company; D is the percentage of the subject company’s capital structure that is debt; and E is the percentage of the subject company’s capital structure that is equity. This levered beta is then applied to the equity risk premium as part of the calculation of the subject company’s cost of equity capital. This is a generally accepted method for calculating beta under the CAPM, although it is not the only method.
Last week, the Delaware Court of Chancery issued an opinion in In re Orchard Enterprises, Inc. Shareholder Litigation (Del. Ch. Aug 22, 2014) concerning an application for attorneys’ fees (we have previously posted about a significant 2012 decision in that same case by former Chancellor Strine). We found the court’s latest decision noteworthy for two reasons. First, the court reaffirmed the principle that an appraisal action brought by an individual shareholder seeking a judicial determination of the fair value of its stock as of the merger date is an entirely separate animal from a shareholder class action in which the plaintiffs allege director misconduct in connection with the price or process leading up to the transaction. Second, the court cited approvingly an upcoming law review article that highlights statistically the benefits of the appraisal process.
In 2010, The Orchard Enterprises, Inc., was acquired by its controlling shareholder for $2.05 per share in cash. Following the merger, several shareholders pursued an appraisal action, which resulted in a judicial determination that the fair value of Orchard was $4.67 per share. After the appraisal action concluded, another shareholder who had not exercised his appraisal rights brought a class action against the board for breach of fiduciary duty. The class action settled before trial. Counsel for the appraisal shareholders objected to the settlement, arguing that they should be reimbursed from the class action settlement for the fees they incurred in the appraisal action because their efforts contributed to the settlement of the class action. Vice Chancellor Laster acknowledged that the appraisal shareholders “raised the bar” for the company by demonstrating that the fair value of Orchard stock was more than double the merger consideration. However, the court ruled that appraisal counsel was not entitled to reimbursement for its fees because the appraisal action was brought on behalf of individual shareholders, not on behalf of all of Orchard’s shareholders.
In a prior post, we observed how former Chancellor Strine (now Chief Justice of the Delaware Supreme Court) repeatedly took the time to clarify the important but often overlooked distinction between fiduciary duty claims and appraisal rights actions. Vice Chancellor Laster has now followed suit in Orchard when he declined to apportion part of the class action settlement to pay the attorneys’ fees incurred by the successful appraisal petitioners. According to the Vice Chancellor, as unsecured creditors who elected not to accept the merger consideration, appraisal petitioners may have interests that conflict with shareholders pursuing breach of fiduciary duty claims after selling their shares in the merger. Moreover, unlike class plaintiffs (who frequently own only a small stake in the company), appraisal petitioners typically have significant holdings that they believe have been undervalued, so they do not need to be offered an additional incentive (such as the reimbursement of attorneys’ fees) in order for them to seek court intervention.
We also recently blogged about a forthcoming law review article by Professors Charles Korsmo and Minor Myers of Brooklyn Law School, which is expected to be published in the Washington University Law Review in 2015. In that article, the authors laud the appraisal process because it ultimately provides an efficient means for benefiting minority shareholders and reducing the cost of raising equity capital. In the new Orchard decision, Vice Chancellor Laster cited this article and expressly recognized that the effect of an appraisal rights petition “may well be a net positive” because the process “reduces agency costs when compared to traditional class actions and results in a more efficient corporation law.” This is a highly significant reaffirmation of the unique and valuable role that appraisal actions will continue to play in enhancing shareholder value.
In a forthcoming law review article expected to be published in 2015 in the Washington University Law Review, “Appraisal Arbitrage and the Future of Public Company M&A,” Charles Korsmo (Associate Professor at Brooklyn Law School) and Minor Myers (Associate Professor at Brooklyn Law School) report their findings showing a large uptick in the number of appraisal petitions being filed, as well as a marked increase in the size of the petitioners’ holdings and an increased level of sophistication among the filers themselves. The authors observe an increased use of arbitrage by which petitioners appear to invest in the target after the M&A deal is announced (for more about arbitrage, see our prior post here). While the authors note that the defense community has decried appraisal arbitrage as an abusive exercise of appraisal rights that ought to be suppressed, the authors argue that this criticism has it precisely backward and that the “new world of appraisal” should be welcomed and encouraged, as it ultimately provides an efficient means for benefiting minority shareholders and actually reducing the cost of raising equity capital.
Among the highly telling data points that Professors Korsmo and Myers collected for their analysis, they found that the value of claims in appraisal in 2013 was nearly $1.5 billion, a tenfold increase from 2004 and nearly 1% of the equity value of all merger activity in 2013. They attribute this surge in appraisal claims to the increased use of appraisal arbitrage in a manner that is transforming what this blog has repeatedly described as an underutilized shareholder remedy into a specialized investment strategy.
An interesting question first addressed many years ago has just resurfaced: can a shareholder seek appraisal rights for shares it acquires after the merger is announced and even after the record date that is set for voting on whether to approve the proposed M&A transaction? Historically the Delaware court said yes, subject to certain other conditions being met, but that may not be the last word on the subject. The New York Times recently blogged about a new case currently before the Delaware courts arising from the buyout of Ancestry.com, showing that this issue is timely again.
First, some background: in 2007, the Delaware Chancery Court opened the door to arbitrage possibilities by its ruling in the appraisal rights case of Transkaryotic Therapies, Inc. In that proceeding, the court permitted a shareholder to exercise appraisal rights for shares acquired after the record date but before the merger vote, provided that the record holder had timely notified the issuer, pre-vote, of a sufficient number of “no” votes or abstentions to cover the number of newly acquired shares being put up for appraisal. The court recognized that owners of stock certificates, such as Cede & Co. — which is typically the nominal owner of shares that are on deposit with the Depository Trust Company, hold their shares in an undifferentiated manner in “fungible bulk,” and so no shareholder has ownership rights to any particular share of stock. Accordingly, there is no voting history attached to any particular share of stock or beneficial owner; all that matters is that the record holder vote no or abstain with respect to a sufficient number of shares to cover the newly acquired shares for which a petitioner wants to seek appraisal.
There are limits as to how late a stockholder may acquire shares for purposes of appraisal; naturally, shares bought after the merger vote, even if acquired before the merger consummation or closing date, won’t count toward appraisal, as they are acquired too late and without sufficient notice to the company.
To illustrate the point, let’s assume that a shareholder currently owns five shares in XYZ Company and an announcement is made on June 10 that ABC Company will be acquiring XYZ. XYZ will be conducting a shareholder meeting regarding the proposed merger on July 1, based on a record date of June 20. Now let’s assume that after the deal is announced and before the July 1 shareholder meeting, our shareholder directs Cede to provide notice to XYZ Company that she will be dissenting with respect to her five shares. Cede then follows those instructions, as well as the directions it receives from all the other beneficial owners for whom it holds shares, and Cede goes ahead and provides notice to the company for all the “no” votes that it has been directed to give. Let’s further assume the total of “no” votes is 100, and in addition to those votes, there are 50 abstentions, so the total number of shares “eligible” for an appraisal demand is 150.
If our shareholder later buys five more shares after the June 20 record date but prior to the July 1 merger vote, she can still seek appraisal for her new total of 10 shares out of the 150 eligible shares for which Cede has given notice. If, however, other dissenting beneficial owners for whom Cede also holds have tendered 145 shares for appraisal, then our shareholder can seek appraisal for only five of her shares, not for the other five in excess of the 150 total eligible shares.
The Transkaryotic opinion back in 2007 was issued by the Delaware Chancery Court, and the rule in this case has not yet been affirmed or otherwise opined on by the Delaware Supreme Court; it is indeed the standing principle today but could become more controversial and may well be revisited if it reaches the Supreme Court and they see things differently. And now that Ancestry.com seems to be taking a run at challenging the Transkaryotic ruling, based in part on a change in the appraisal statute since the time that that case was decided, the Delaware courts may take up this issue again. We’ll watch this case as it proceeds and post any new developments here.
On May 12, 2014, the Delaware Court of Chancery issued its latest appraisal opinion, Laidler v. Hesco Bastion Environmental, Inc., addressing, among other things, the limitations on the use of merger price in an appraisal proceeding.
The petition for appraisal was brought by a former employee of Hesco Bastion USA, Inc. (“Hesco”), which manufactured and sold “Concertainer units” – deployable barriers designed to protect against flooding – in the United States. On January 26, 2012, Hesco was merged into its majority shareholder, the respondent, pursuant to a short-form merger. Immediately prior to the merger, the respondent held 90% of the outstanding equity of Hesco, and the petitioner held 10%. The petitioner refused to accept the $207.50 per share cash consideration offered by the respondent, and instead exercised appraisal rights.
Vice Chancellor Glasscock concluded that the fair value of the petitioner’s shares was $364.24 per share, a 75% increase over the merger consideration. In reaching his conclusion, the Vice Chancellor rejected the respondent’s position that the Court should consider the merger price as persuasive evidence of fair value because it was the result of an arm’s-length negotiation between the controlling shareholder and an independent director. The Court found that it was not an arm’s-length transaction subject to a full market check, but rather a short-form merger consummated by a controlling shareholder who set the merger price. “Under our case law,” the Court stated, “a statutory appraisal is the sole remedy to which the Petitioner is entitled, and to defer to an interested controlling shareholder’s determination of fair value in a transaction such as this would render that remedy illusory.”
Vice Chancellor Glasscock used a direct capitalization of cash flows (“DCCF”) valuation method to determine the fair value of the petitioner’s shares. The Vice Chancellor did not perform a traditional discounted cash flow (“DCF”) analysis because Hesco had not created management projections in its ordinary course of business. The Court relied on the DCCF analysis – which was the sole method applied by the petitioner’s valuation expert and one of the methods applied by the respondent’s valuation expert – determining a normalized figure for annual cash flows in perpetuity and then dividing those cash flows by a capitalization rate. To determine the company’s normalized annual cash flows, the Court averaged the company’s cash flows from the three years preceding the merger. To determine the capitalization rate, the Court subtracted the company’s long-term growth rate (4%) from its weighted average cost of capital (“WACC”) (21.83%). This appears to be the only Delaware case in which the Court based 100% of its valuation on a DCCF analysis.
The Court’s acceptance and application of a DCCF analysis may be significant. The DCCF analysis provides the Court with a methodology for valuing a company where there are no reliable management projections from which to craft a DCF analysis, and where the company is not sufficiently comparable to other companies for the Court to conduct a comparable companies or precedent transactions analysis. Rather than using the merger price as evidence of going concern value, the Court capitalized historical normalized cash flows in perpetuity to independently value the company as a going concern.
The Court’s acceptance of the buildup model to calculate the company’s WACC is also notable. What is the buildup model? The buildup model is similar to the Capital Asset Pricing Model (“CAPM”), except that it adjusts for industry risk by adding an industry-specific equity risk premium rather than using a beta, and also adds a company-specific equity risk premium. In In re Orchard Enterprises, Inc., (Del. Ch. July 18, 2012), then-Chancellor Strine was highly critical of the buildup model, finding that it was not “well accepted by mainstream corporate finance theory” because “its components involve a great deal of subjectivity.” Nevertheless, both parties’ experts used the buildup model in Laidler. The opinion in Laidler, therefore, should not be read as a signal that the Court of Chancery has abandoned the CAPM in favor of the buildup model.
Last month the Delaware governor appointed attorney Andre Bouchard to take the helm of Delaware’s Chancery Court, where he will assume the Chancellor’s position vacated by Chancellor Strine’s elevation to the Delaware Supreme Court. The seventy-eight reported decisions that bear Mr. Bouchard’s name don’t tell the full story of the cases he has handled during his career in private practice, but we do know this much: he has brought at least one appraisal rights petition, in the case of Nagy v. Bistricer, 770 A.2d 43 (Del. Ch. 2000), and his law firm handled several other appraisal rights cases as well, typically as respondents, including as counsel for the respondent company in the well-known line of cases involving Cede & Co. v. Technicolor, Inc.
In Nagy, Mr. Bouchard represented Ernest Nagy, the sole minority stockholder of Riblet Products Corp., a closely held manufacturer of power cords and wires. Riblet was acquired by Coleman Cable Acquisition, Inc. in what then-Vice Chancellor Strine described as “an extremely unusual merger agreement”; the two individuals who were the controlling stockholders and directors of Riblet were also the controlling stockholders and directors of Coleman. Nagy, 770 A.2d at 46. In addition, the disclosures provided to Nagy in connection with his decision whether to seek appraisal or accept the merger consideration contained no information about why or how the two controlling stockholders and directors of the target had approved the merger agreement; no information regarding their interest in the acquirer; and no financial information about the target or the acquirer. Id. Moreover, Nagy was forced to decide whether to exercise appraisal rights even before he knew for certain what the final merger consideration would be.
Based on these unusual facts, the court rejected the company’s argument that appraisal was Nagy’s exclusive remedy, and found, among other things, that Nagy was permitted to pursue his unfair dealing and appraisal claims in a combined civil action; that the controlling shareholders of Riblet breached their fiduciary duties by failing even to attempt to provide Nagy with adequate disclosures that would allow him to make an informed decision as to whether to elect appraisal or accept the merger consideration; and that they breached their fiduciary duties by inequitably coercing Nagy into a forced appraisal.
Of course, the cases Mr. Bouchard handled as an advocate say nothing about how he will view appraisal rights cases once he becomes Chancellor. Indeed, the underlying conduct in Nagy was found to be so egregious that the court actually awarded Nagy attorneys’ fees under the “bad faith” exception to the American rule — by which both parties usually pay their own fees in a lawsuit, win or lose, as opposed to the English rule requiring the loser to pay — for being forced to respond to the defendants’ frivolous arguments made in support of their motion to dismiss and in opposition to Nagy’s motion for summary judgment.
Bouchard’s appointment has been well received among the bar. As reported in Law360 at the time of his initial appointment, Bouchard is expected to be a “more even-keeled judge” than former Chancellor Strine, who was one of the most outspoken Chancellors ever to serve in the Chancery Court. Bouchard has been described by other lawyers as an “outstanding individual” who is not a “flamethrower,” and who was favorably characterized as not necessarily becoming another Chancellor Chandler or a Chancellor Strine, but who will simply be himself, providing a “huge benefit” to the Chancery Court.
In a prior post, we explained how the Capital Asset Pricing Model (“CAPM”) has become one of the frequently employed methods used by the Delaware Court of Chancery to calculate the cost of equity for the discount rate in a DCF analysis. In this post, we focus on one specific component of the CAPM: the equity size premium.
The equity size premium is a number added to the risk-free rate and the equity risk premium (modified by beta) to reflect additional returns on small companies. The argument is that investors may demand a higher rate of return on small companies than they do for large companies because of the increased risk associated with small company investments. The size premium supposedly quantifies the increased risk.
One method the courts have used to determine the size premium is to refer to the Ibbotson SBBI Valuation Yearbook. The Ibbotson tables, published by Morningstar, contain historical capital markets data that include, among other things, total returns and index values for stocks dating back to 1926. Morningstar recently discontinued the Ibbotson SBBI Valuation Yearbook, which means a court seeking to apply a small-size premium will have to look to other valuation materials for mergers occurring after 2013.
The Delaware Court of Chancery has used market capitalization as the benchmark for selecting a size premium. Thus, the court multiplies the amount of outstanding stock by the market price on the day prior to the merger and determines which Ibbotson decile the company falls under. The court then applies the appropriate size premium from the applicable Ibbotson table. The court may accept adjustments to the Ibbotson size premium if there is evidence of individual characteristics that distinguish the subject company from other companies within the same market capitalization decile.
Some valuation experts in appraisal cases have argued that the problem with this market capitalization approach is that it creates circularity based on the market price of the stock. The Delaware courts have acknowledged that the market price of a stock is not determinative of value in an appraisal proceeding because, among other things, the market price reflects a minority discount. The appraisal statute requires that the company be valued as a going concern, exclusive of any trading discounts. Moreover, the market price of a stock is an unreliable indicator of value when the market is inefficient (which is often the case for small companies) or when other factors affect market price. By relying on the market price to determine the size premium for the discount rate, these experts contend, the court is effectively incorporating that minority discount and inefficient market price into its valuation analysis in contravention of Section 262’s mandate that the company be valued as a going concern. An alternative approach to determine the company’s size for the purpose of ascertaining the small-size premium is to conduct an independent valuation of the company using a non-DCF method, such as a valuation based on comparable companies or precedent transactions. This alternative approach avoids the pitfalls of relying on an inefficient and discounted market price in calculating the company’s discount rate.
Among the thirty-five appraisal rights opinions written by Chancellor Strine over the past decade are some of the most cited and comprehensive treatments of the appraisal rights remedy to date. On January 29, 2014, the Delaware General Assembly unanimously confirmed Chancellor Strine’s appointment to the Delaware Supreme Court, where he will also become the court’s next chief justice, further underscoring the already significant deference his decisions have come to receive.
Among the several themes within Chancellor Strine’s vast appraisal rights jurisprudence, two are particularly striking: (i) Chancellor Strine repeatedly took the time to clarify the important but often overlooked distinction between fiduciary duty claims alleging director misconduct, as opposed to appraisal rights actions, which do not involve any accusation of wrongdoing. In addition, (ii) Strine repeatedly emphasized that the courts were required by law to reach “independent” determinations of a stock’s fair going concern value.
This past year, in In re MFW Shareholders Litigation, 67 A.3d 496 (Del Ch. 2013), Chancellor Strine once again spelled out the fundamental difference between (a) fiduciary duty claims brought by shareholders criticizing the board’s conduct in respect of the process or the price of an M&A transaction, on the one hand, and (b) appraisal rights cases involving a purely financial valuation, which does not raise any question of director misconduct. The appraisal rights proceeding requires the court to determine solely the appropriate valuation of the company as a going concern, which value the shareholder believes was not accurately reflected by the acquirer’s purchase price.
Indeed, eight years ago in Delaware Open MRI Radiology Associates v. Kessler, 898 A.2d 290 (Del. Ch. 2006), then-Vice Chancellor Strine provided a more detailed description of the court’s task in deciding an appraisal rights case, with particular emphasis on the fact that the court was duty-bound to make an independent determination of value, a consistent theme in his rulings:
My task in addressing the appraisal aspect of the case is easy enough to state, if more difficult in practice to accomplish with any genuine sense of reliability. Put simply, I must determine the fair value of [the company’s] shares on the merger date and award the [shareholder] a per-share amount consistent with their pro rata share of that value, supplemented by a fair rate of interest, regardless of whether that amount is greater or less than the merger price. Fair value is, by now, a jurisprudential concept that draws more from judicial writings than from the appraisal statute itself. In simple terms, to reach a fair value award, I must determine [the company’s] value as a going concern on the merger date and award the [shareholder] the percentage of that value that tracks its […] pro rata interest in [the company] on that date. In valuing [the company], I may consider all relevant, non-speculative factors bearing on its value as of the merger date. That includes the input provided to me by the contending parties’ experts. But I cannot shirk my duty to arrive at my own independent determination of value, regardless of whether the competing experts have provided widely divergent estimates of value, while supposedly using the same well-established principles of corporate finance. Such a judicial exercise, particularly insofar as it requires the valuation of a small, private company whose shares do not trade in a liquid and deep securities market, using a record shaped by adversaries whose objectives have little to do with reaching a reliable valuation, has at best the virtues of a good-faith attempt at estimation. That is what I endeavor here [emphasis added].
To further underscore the distinction between an appraisal rights case and a fiduciary duty claim challenging the board’s conduct, Strine further clarified in Kessler as follows: “[u]nlike a statutory appraisal action, the success of an equitable action premised on the assertion that a conflicted merger is unfair ultimately turns on whether the court concludes that the conflicted fiduciaries breached their duties.” In an appraisal action, in contrast, there is no comparable question before the court of whether director misconduct was to blame for a low buyout price; the court simply undertakes a valuation analysis.
In MFW, while addressing the various remedies available to minority shareholders in a fiduciary duty action who claim to have suffered harm as the result of a coercive tender offer, Strine once again underscores the fact that even if those shareholders were to fail to meet their burdens of proof in that action, their litigation rights are not extinguished, because they may also exercise appraisal rights as long as they voted no to the merger. And he further emphasized the effectiveness of the appraisal rights remedy: “[a]lthough appraisal is not a cost-free remedy, institutional ownership concentration has made it an increasingly effective one, and there are obvious examples of where it has been used effectively.” For those “obvious examples” he cites Golden Telecom, Inc. v. Global GT LP, 11 A.3d 214 (Del. 2010) (affirming appraisal remedy award of $125.49 per share, as opposed to merger consideration of $105 per share); Montgomery Cellular Hldg. Co. v. Dobler, 880 A.2d 206 (Del. 2005) (affirming appraisal remedy award of $19,621.74 per share for stockholders in short-form merger, as opposed to $8,102.23 per share in merger consideration); and M.G. Bancorporation, Inc. v. Le Beau, 737 A.2d 513 (Del. 1999) (affirming appraisal remedy award of $85 per share for dissenting minority stockholders in short-form merger, as opposed to merger consideration of $41 per share).
Building on Strine’s long-standing recognition that courts must make independent determinations of value, in the Golden Telecom case, the Delaware Supreme Court affirmed then-Vice Chancellor Strine and rejected the company’s challenge to his appraisal decision, in which Strine had refused to defer to the merger price as a measure of fair value. As the Supreme Court held, the appraisal statute “unambiguously calls upon the Court of Chancery to perform an independent valuation of ‘fair value’ at the time of a transaction. . . . Requiring the Court of Chancery to deter — conclusively or presumptively — to the merger price, even in the face of a pristine, unchallenged transactional process, would contravene the unambiguous language of the statute and the reasoned holdings of our precedent.”
Likewise, in In re Orchard Enters., Inc. (Del. Ch. July 18, 2012), Chancellor Strine explained that appraisal actions are unique in that both parties bear the burden of proving their respective valuations by a preponderance of the evidence. But consistent with his prior cautions, he found that the court has discretion to select one of the parties’ valuation models or create its own, but in all events, “the court may not adopt an ‘either-or’ approach to valuation and must use its own independent judgment to determine the fair value of the shares.”
With his promotion to Chief Justice, these important themes in Strine’s body of case law will likely take on greater significance.
Note: This Blog has previously addressed several of the decisions discussed in this post, including Golden Telecom (August 7, 2013, post); MRI Radiology Assocs. v. Kessler (October 16, 2013, post); and Orchard Enterprises (September 13, 2013, and August 7, 2013, posts).
As one Delaware judge put it long ago, the Delaware courts conducting an appraisal proceeding have long ago “rejected placing absolute confidence in the market price for a share of stock.” Kleinwort Benson Ltd. v. Silgan Corp., No. 11107, 1995 Del. Ch. LEXIS 75 (Del. Ch. June 15, 1995) (Chandler, V.C.). For one thing, a publicly traded stock price is solely a measure of the value of a minority position and market price therefore reflects only the value of a single share. Delaware courts thus adjust the market value to compensate for that so-called inherent minority discount.
Furthermore, even if a court wanted to look at a company’s most recent stock price preceding the merger date as a factor in determining enterprise value, that price may already be impacted by short-term news and noise. Indeed, short-term economic and political realities — such as short-term unemployment rates, lending rates and monetary policy — may have an outsized impact on the stock market while having no necessary correlation to the underlying fundamentals of a company or its industry. That markets overreact is implied in the so-called “bounce back” period used to calculate damages under the Private Securities Litigation Reform Act, which determines damages by using the mean trading price during the 90-day period following the dissemination of corrective information rather than the trading price on just the first day.
But even beyond these considerations, the Delaware courts have identified as recently as last week another factor making a public stock price far less reliable in the valuation exercise; namely, the downward pressure a stock price will experience over time as a result of a prolonged sale process. Where a company is on the sales block for an extended time, even the mean stock price measured over a prolonged period of time will not provide the court with sufficient insight into the company’s long-term growth potential to provide a basis for the valuation exercise to be built upon. Thus, evidence that the “stock price may have undervalued the company due to the company’s inability to make acquisitions while it was up for sale” led one court to recently reject the stock’s trading price as an indicator of fair value. Huff Fund Investment Partnership d/b/a Musashi II Ltd. v. CKx, Inc., Case No. 6844-VCG (Nov. 1, 2013).
A stockholder pursuing appraisal rights is entitled to the present value of the long-term going concern value of her stock, often with the expectation that holding onto that stock over the long term is likely to realize more value than what can be achieved in a near-term sale in the existing economic environment. Courts are therefore careful to rise above immediate or even long-term market conditions and are predisposed to give little weight to the stock trading price as a proxy for whatever longer-term value that stock might represent. This is especially so where there is no reliable evidence that the stock trades in an efficient market that would permit a court to even consider whether the stock price is reflective of fair value. Moreover, in any event, Delaware law requires courts to undertake an independent evaluation of the stock’s fair value at the time of a transaction, and courts therefore cannot place too much weight on trading price as a substitute for engaging in their own independent analysis of fair value.