February 2014

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.

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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).