As we have posted before, the Delaware Supreme Court rendered its much-awaited ruling in the DFC Global case on August 1. Here’s a more detailed breakdown of the key elements of that ruling.
I. No Judicial Presumption Imposing Mandatory Merger Price Ruling
The Court started off its opinion by rejecting DFC Global’s request to establish “by judicial gloss” a presumption that fair value would be tethered to merger price in certain cases involving an arm’s-length M&A transaction. The Court said that it would “decline to engage in that act of creation, which in our view has no basis in the statutory text, which gives the Court of Chancery in the first instance the discretion to ‘determine the fair value of the shares’ by taking into account ‘all relevant factors.’” The Court adhered to its 2010 ruling in Golden Telecom in finding the statute’s “all relevant factors” inquiry to be broad, and reaffirmed the chancery court’s discretion to undertake that inquiry until such time as the Delaware legislature may choose to revise the statute in this regard (we are not aware of any such legislative activity currently underway).
The Court said it lacked the ability to craft, on a general basis, the precise preconditions that would be necessary to invoke a merger price presumption. Moreover, the Court found it had little need to do so, given the “proven record” of the chancery courts in exercising their discretion to give the deal price predominant – and at times, even exclusive – weight in those circumstances when they determine that merger price is the “most reliable evidence” of fair value.
II. The Supreme Court Directed Chancery to Reconsider the One-Third Weighting It Gave to Deal Price Given the Apparent Lack of a Conflicted or Management Buyout Here
In its valuation decision, the chancery court examined three metrics – deal price, comparable companies, and a discounted cash flow analysis – and gave equal one-third weight to each of those inputs. In resolving the “record-specific argument” about the role of the deal price in this case, the Supreme Court directed the chancery court to reconsider its approach and disagreed with chancery that regulatory headwinds facing DFC Global undermined the reliability of market prices in this case. In addition, the Supreme Court disagreed with chancery that a financial buyer – such as Lone Star, the private equity buyer here – would perform a valuation analysis that was necessarily lower than that done by a strategic buyer.
To the first point, the Court accepted the “case-specific issues” that DFC Global raised concerning the role that deal price should have in this case. The Court traced the history of the Delaware appraisal statute and the case law arising from it, finding that in 1989, the Supreme Court rejected a reading of the appraisal statute that would measure fair value by the price of stock trading in the public market as of the merger date; as the Court put it, the appraisal definition of “fair value” was more jurisprudential than economic. That definition required a valuation of the petitioners’ shares based on the “going concern” value of the stock, and that notion also disregarded any minority discount that would inhere in a stock-market price. Likewise, this definition of “fair value” as applied by the courts requires the exclusion of any value attributable to expected post-merger synergies to be achieved by the merged entity.
The Court proceeded with a lengthy survey of economics literature confirming the reliability of market pricing when such pricing accurately reflected what a willing buyer and willing seller would agree to without having any compulsion to buy. The Court found that market prices may generally be superior to other valuation techniques where they reflect the collective judgment of many persons who were incorporating publicly available information, as opposed to a single person’s performing his own valuation model, such as a discounted cash flow analysis. The Court thus observed that while chancery has broad discretion to make findings of fact, those findings of fact must be grounded in the record and consistent with principles of corporate finance and economics. With this background in mind, the Court did not believe that there was an adequate record basis in this case to support chancery’s decision to ascribe to deal price one-third of its valuation determination. More specifically, the Court disagreed with the chancellor’s finding that deal price was unreliable because DFC Global was in a trough, given the regulatory uncertainties surrounding its future performance. The Court said that it could not uphold that ruling, given the lack of any evidence in the record suggesting that the markets themselves were incapable of pricing such regulatory risk.
The Supreme Court noted that the chancery court decision observed, “importantly,” that there were no conflicts of interest in this transaction. Indeed, the Supreme Court stated that appraisal actions had the most utility when private companies were being acquired, or where public companies were being sold in a conflicted buyout, in which case market prices would be either unavailable or unreliable.
The Supreme Court thus quoted on two occasions the Chancellor’s finding that the deal here “did not involve the potential conflicts of interest inherent in a management buyout or negotiations to retain existing management.” Rather, in this case, where the company was not shown to have any conflicts relating to the transaction, and because it also had a “deep base of public shareholders” and “highly active trading,” the Supreme Court found that the price at which DFC Global’s shares traded was informative of fair value. The Court thus found that DFC Global’s public shareholders, other buyers in the sales process and even participants in the market for DFC Global’s debt were capable of evaluating the regulatory risk that DFC Global faced, and there was no record evidence to the contrary.
III. The Supreme Court Rejected the Perpetuity Growth Rate Component of the Chancery Court’s Valuation Analysis
Turning to DFC Global’s next case-specific argument, the Court found that the chancery court erred when it increased the perpetuity growth rate it had initially used – from 3.1% to 4.0%, a 29% increase in the growth rate – after acknowledging in a post-trial reargument that it had made a clerical error, using lower working capital numbers in its model than it meant to. The Court found that instead of simply correcting the clerical error that was brought to its attention on reargument, the chancery court revised sharply upward its estimate of the perpetuity growth rate in response to a separate argument. The Supreme Court agreed with DFC Global in ruling that the record evidence did not rationally support the Chancellor’s decision to increase his original discounted cash flow model from an original perpetuity growth rate that was just below the ceiling that the chancery court had previously identified – namely, the risk-free rate for a stable-state company – to a much higher perpetuity growth rate.
The Court concluded its opinion by walking through its several reasons for finding that the trial record in this case did not support the 29% increase in the perpetuity growth rate that the chancery court had made upon reargument. The Court found that the original perpetuity growth rate was already bullish, being near the risk-free rate as it was, and that adding another 0.9% to that figure assumed, without accompanying record support, that another period of robust, above-market growth was on the way. The Supreme Court noted the lack of any evidence to that effect in the record, such as testimony by an industry expert or by management, or even any analysts’ commentary suggesting that the substantial growth of the payday lending industry implied by the Chancellor’s increased perpetuity growth rate was warranted.
In remanding – or, sending back – the case to the chancery court, the Supreme Court provided guidance to the Chancellor that if he were to rely upon a discounted cash flow analysis that generated a value higher than his original model after it was adjusted to use the correct working capital figures, he needed to point to specific bases in the record to validate the assumption that the company would continue to grow at a rate above the risk-free rate going forward into the future, beyond 2018.
IV. The Supreme Court Rejected the Cross-Appeal and Refused to Disregard the Comparable Companies Analysis
Finally, the Court addressed petitioners’ cross-appeal, in which they argued that the chancery court abused its discretion by giving any weight to its comparable companies analysis, and that the DCF model should have been given most, if not all, of the weight in the Court’s valuation analysis. The Supreme Court said that there was no basis to suggest in this case that market-based insights into value, such as a comparable companies analysis, somehow became inherently unreliable in downturns or in the face of regulatory changes that DFC Global faced in this case. Accordingly, the Court said it was not an abuse of discretion for the Chancellor to refuse to rely exclusively on a DCF model, and that his use of other factors, such as the comparable companies analysis, was not an abuse of discretion. To state it in the affirmative, the Supreme Court said the Chancellor was within his discretion in using the comparable companies analysis, as nothing indicated such a market-based metric was unreliable in this case.
Based on these holdings, the Supreme Court decided that it did not need to reach the larger issue of whether the Chancellor was correct in giving equal weight to the three valuation metrics that he used: the deal price, a comparable companies analysis and a DCF model. The Court refused to establish a blanket presumption in favor of tying fair value to merger price in all appropriate cases, and it concluded that the chancery court should continue to exercise its considerable discretion to determine fair value, but while doing so it should also explain why it was according a certain weight to a certain indicator of value. The Supreme Court did not find support in the record for the equal one-third weighting of each metric applied here, and so it directed the chancery court to reconsider its prior conclusions and determine what weighting it should give to each of the relevant factors here based on the guidance provided in this ruling and the specific evidence in the record in this case.
We will continue to monitor this case and post again regarding future developments, including the remand proceedings in the chancery court.
** As previously noted, this law firm was counsel of record to one of the amici briefs filed in this case.
Update: Read DFC analysis from Wachtell Lipton posted on the HLS Forum here.