July 2015

In his second appraisal decision in as many months, Chancellor Bouchard faced the novel question of whether the Chancery Court can approve a settlement between the surviving company and certain non-appearing dissenters, who had never themselves filed or joined in an appraisal petition, if the terms of that settlement are unavailable to all of the dissenters who had perfected appraisal rights.  Under the Chancellor’s decision in Mannix v. PlasmaNet, Inc., the answer is yes.

Mannix was not a valuation decision but a procedural ruling.  The issue arose because Delaware’s appraisal statute is in certain ways similar to the class action device, in which one plaintiff serves as a representative in a lawsuit on behalf of all other similarly situated plaintiffs.  Specifically, the appraisal statute provides that one appraisal petition can serve as the “representative” appraisal action for all other dissenting shareholders, and that the fair value determination reached in that proceeding will be available to all dissenters who have perfected their appraisal rights even if they had not filed their own petition.  As the Chancellor is careful to note, however, there is “at least one notable distinction” between the procedures available in an appraisal proceeding and those in a class action: unlike in class actions, in which shareholders elect to “opt out” of the class to pursue individual claims, appraisal petitioners “opt in” to an appraisal proceeding before the litigation even begins by dissenting from the merger and perfecting their rights in the first place.

In Mannix, certain non-appearing dissenters – i.e., stockholders who neither filed their own petitions nor joined in another’s petition – had settled with the surviving Company and were now asking the Court for their appraisal claims to be released.  The settlement was conditioned on the non-appearing dissenters certifying that they were “accredited investors” under the federal securities laws, a necessary condition because the settlement consideration consisted of their receiving the surviving Company’s unregistered stock.  The Company made the same offer to the named appraisal petitioner (Mannix), who rejected it.

Chancellor Bouchard rejected both of the petitioner’s challenges to the settlement.  The petitioner first argued that the Company could not condition a settlement on a dissenter’s status as an accredited investor, since not every non-appearing dissenter may qualify as accredited.  The Chancellor held that this argument was unsupported by any law or precedent and distinguished two earlier appraisal cases that had raised the specter of a “buy off,” whereby the named appraisal petitioner settles the proceedings to the benefit of himself and the Company, but to the detriment of all other non-appearing appraisal petitioners that he was in effect representing.  Chancellor Bouchard found that these concerns were not before him, where any purported “buy off” – if there even was one – was being undertaken by a non-appearing dissenter, and thus would have no effect whatsoever on Mannix’s ability to prosecute his own appraisal action on behalf of himself and any other non-appearing dissenters who remained.

The Chancellor drew another analogy to class action settlements, citing former Chancellor Allen for the proposition that “a defendant in a putative [i.e., pre-certification] class action is readily permitted under the law to settle a class claim with non-representative class members.”  Likewise, the surviving company in an appraisal proceeding is similarly able to settle directly with non-appearing dissenters.

In general, in making these references to the class action vehicle, the Chancellor made a point of showing how appraisal rights are also representative actions, albeit in different form, and that the statute in fact encouraged the notion of representation by requiring that only one appraisal petition be filed – whether by the surviving corporation itself or by a former stockholder – thereby entitling all former stockholders who perfected their appraisal rights to receive “fair value” even if they did not file a petition themselves.  Indeed, the court noted that the right to appraisal ceases if all interested persons failed to file a petition for appraisal within the statutory 120-day period following consummation of the transaction.

The Chancellor was also unmoved by the petitioner’s second argument, that settling non-appearing dissenters out of an appraisal case would “undercut the economics of the appraisal proceeding” by reducing the total shares at issue and, accordingly, the aggregate recovery available in the proceeding.  The court found that the petitioner happened to be the first shareholder to file an appraisal demand, and thus had already accepted the risk from day one that he might end up being the only one to so file, even though that risk never came to pass.  The Chancellor also observed that if he were to hold otherwise, it would give named appraisal petitioners a “hold-up right” to block any settlement, which was not envisioned by the appraisal statute.

The transaction is also notable for its incredibly small size: the total merger consideration for this deal after adjustments was just $114,000, or six-tenths of a penny for each of the 19,307,715 shares of outstanding PlasmaNet stock, and the named petitioner brought this action seeking appraisal of his 1,700 shares.

The Delaware Chancery Court’s recent opinion in Owen v. Cannon has garnered little notice or press coverage, but deserves attention not only because the hybrid fiduciary duty-appraisal decision is Chancellor Bouchard’s first foray into the appraisal space, but because it reinforces some basic appraisal tenets and yet also bucks what some have called a recent trend of merger price rulings.

The transaction arose from the interactions of the company’s three main principals: Nate Owen, the founder and president of the firm at the center of the lawsuit, Energy Services Group; his brother Bryn, who worked at ESG directly under Nate; and Lynn Cannon, who put up the capital for the Company.  Bryn and Cannon eventually forced Nate out of his job as president (with Cannon being his replacement), and cashed out in a short-form merger Nate’s significant minority stake in ESG for just under $20/share.  After applying a discounted cash flow analysis, and no other valuation methods, Chancellor Bouchard awarded Nate approximately $42 million for his 1.32 million shares of ESG, or just under $32/share.  The Chancellor’s $12/share premium is a departure from a recent slate of appraisal actions, including Ramtron and Ancestry.com, in which the Court of Chancery has rejected income- or market-based valuation methodologies while looking simply to the merger price as fair value.

In his lengthy opinion, Chancellor Bouchard reaffirms a number of bedrock principles of the appraisal analysis:

  • The primacy of the DCF. According to Chancellor Bouchard, the discounted cash flow valuation methodology is the preferred manner in which to determine fair value because “it is the [valuation] approach that merits the greatest confidence within the financial community.”  Chancellor Bouchard’s view on the use of transaction price as proof of fair value was not tested in Owen, as both valuation experts in the case used a DCF exclusively and the Chancellor thus had no occasion to opine on the merits of merger price or any other metric to determine fair value.
  • Reliable management projections can be dispositive. Of course, a DCF is only as good as its inputs.  Much of the Chancellor’s exhaustive 80-page opinion was dedicated to whether or not he could rely on management projections created by Cannon in 2013 in connection with Nate’s buy-out.  Chancellor Bouchard determined that he could, in large part because Cannon created the projections when he was already trying to force Nate out of the company (meaning that the projections already had conservative assumptions baked in), and ESG submitted the projections to Citizens Bank to obtain a $25 million revolver (meaning that it would be a federal crime if the projections were false).  In contrast, the Chancellor applied well-settled Delaware law in rejecting defendants’ expert’s post hoc, litigation-driven projections in their entirety.
  • Tax treatment can mean real money. ESG was a subchapter S corporation, meaning that (unlike in a subchapter C corporation) ESG’s income was only taxed once, at the stockholder’s income rate.  Because Delaware law requires a shareholder in an appraisal to be paid “for that which has been taken from him,” and a “critical component” of what was taken from Nate was the “tax advantage” of owning shares in a subchapter S corporation, Chancellor Bouchard adopted Nate’s argument that the Court’s DCF should be tax affected to take into account ESG’s subchapter S status.  Under the hypothetical posed by the Chancellor in Owen, S Corp tax treatment means a nearly $14 boon to an investor for every $100 of income.
  • Absent identifiable risk of insolvency, inflation is the floor for a terminal growth rate, with a premium to inflation being appropriate for profitable companies. The DCF’s terminal growth rate — which is intended to capture a firm’s future growth rate while still recognizing that firms cannot over time grow materially in excess of the economy’s real growth — is a critical DCF input.  (We described one way to calculate terminal growth here, in an earlier post in our “Valuation Basics Series”).  Applying Delaware precedent, Chancellor Bouchard determined that it was appropriate to set the terminal growth rate at 3%, a “modest” 100 basis points premium over the Fed’s projected 2% inflation rate.  According to the Chancellor (quoting a 2010 Delaware Supreme Court decision), “the rate of inflation is the floor for a terminal value estimate for a solidly profitable company that does not have an identifiable risk of insolvency.”  Chancellor Bouchard, however, rejected Nate’s suggested 5% terminal growth rate (above nominal GDP growth) as too high for ESG, a company facing increasing competitive pressures whose years of rapid growth may have been behind it.

The Chancellor also found breaches of fiduciary duties, generally agreeing that, by Nate’s description, the merger was conducted in a “boom, done, Blitzkrieg style,” with Nate having been given notice (by sheriff’s service) on Friday, May 3, 2013 of a Monday, May 6, 2013 special meeting of shareholders to vote on the merger.  This was especially egregious as ESG had never before held a formal board meeting until Cannon and Bryn orchestrated two such last-minute meetings, the first one being to terminate Nate’s employment with ESG (which meeting Nate found out about while tending to a health issue for his wife).  The May 6 meeting was conducted despite Nate’s request for an adjournment, and the meeting was overseen by an armed guard who stood “at the door with a gun at his hip.”  Nevertheless, the damages award for the fiduciary duty claims equaled those decided by Chancellor Bouchard’s appraisal ruling.

The Chancery Court granted summary judgment in favor of Dell against a number of stockholders who duly noticed their appraisal demands but whose stock certificates had been retitled before the effective date of the merger to their own custodians’ nominees. As is typical for an appraisal challenge, DTC certificated the dissenting stockholders’ shares into the name of its nominee, Cede. But the beneficial owners’ custodians then took the added step of directing DTC to retitle the shares to the name of their own nominees, which change took place prior to the consummation of the merger. The court ruled that this ostensive break in record ownership violated the continuous holder requirement and thus disqualified those beneficial owners from proceeding with their appraisal case.

This ruling dismisses almost a million shares from the Dell appraisal case. Shares that were certificated in the name of Cede, without a further name change, are unaffected by this decision and the rest of the claims remain pending before the court. The ruling only affects those holders whose custodians changed the designee out of Cede’s name and into their own nominees’ names. Interestingly, the court found it irrelevant that the funds themselves were unaware of the retitling of their shares, a process which is undertaken by the custodian without the beneficial owner’s knowledge or consent. Thus, Vice Chancellor Laster found that once a shareholder chooses to hold its shares through intermediaries, it assumes the risk that the intermediaries might take an action against its interests.

Vice Chancellor Laster makes very clear that he felt constrained by Delaware case law to reach this result and that “were it up to me,” a better interpretation of the term “stockholder of record” in the appraisal statute would include the DTC participant list (i.e., the brokers and custodians, not just Cede). Under federal law, Cede is not the record holder, the DTC participants are deemed to be the holders, and the Vice Chancellor would have followed federal law if he did not think that Delaware law so clearly deems only Cede to be the owner of record. In fact, he directed much of his opinion to the Supreme Court itself and seems to want to be reversed. The legislature could conceivably take action first, and contemplating that very possibility, the Vice Chancellor also stated that he did not want to be overridden by the legislature and that there should not be a legislative cure to an issue of statutory construction.

The opinion provides a very detailed account of the process by which shares are held in fungible bulk and then re-certificated by DTC, and how Congress directed the SEC to immobilize share certificates through a depository system in response to the unworkable situation that had arisen under the former paper trading framework. The decision also lays out a comprehensive history of the record holder requirement, from 1899 to the present, in the course of which the court touched on appraisal arbitrage: on the one hand, the court said that including the DTC participants would bring greater clarity to the question of how particular stockholders may have voted. But at the same time, the Vice Chancellor made very clear that he did not thereby intend to undercut the practice of appraisal arbitrage, and as a policy matter he did not understand why critics of appraisal arbitrage oppose the transfer of appraisal rights when the commercial marketplace generally favors the transfer of property, including something as likely to result in an assignment of a litigation claim as a defaulted loan.

Delaware’s latest appraisal decision in LongPath Capital v. Ramtron International Corp. adopted the merger price as its appraisal valuation, but stands apart from the other recent appraisal decisions that likewise fell back on transaction consideration. Here, the court’s lengthy opinion repeatedly lamented the lack of any remotely reliable means of valuation other than the merger price, and the court was careful to satisfy itself that the sales process leading up to the deal was “proper,” “thorough” and “effective,” though these terms remain without precise definition. Ramtron ostensibly joins Chancery’s recent decisions — including Ancestry.com and AutoInfo — in adopting the negotiated deal price as conclusive proof of value. But unlike those two cases, the court in Ramtron found that fair value ($3.07/share) was actually below the deal price ($3.10/share) when accounting for synergies between Ramtron, the semiconductor manufacturer being acquired, and Cypress Semiconductor, the hostile acquirer.

Part of the unique nature of this action was that in a deal valued at $110 million, the merger price represented a 71% premium to the pre-deal stock price. Moreover, the petitioner, who acquired its shares after the merger announcement (more about the arbitrage play later), bought only a small stake worth about $1.5 million. But the bulk of the court’s analysis focused on whether or not the management projections presented in the petitioner’s DCF analysis were reliable, as Delaware courts apply the commonsense rule that a DCF predicated on suspect projections is worthless in an appraisal. The petitioner’s projections were fatally flawed in many respects, though three of the nine flaws identified by the court stand out the most. First, the projections were prepared by new management, using a new methodology (the product-by-product buildup method) and covering a longer time period than earlier forecasts. Furthermore, the projections had not been prepared in the ordinary course of business. Second, Ramtron distorted its revenue figures by engaging in so-called channel stuffing, the practice of pushing excess inventory into distribution channels so that more revenue can be recognized sooner (indeed, the court repeatedly cited an e-mail in which a salesman said that the company will “for sure stuff channel”). Third, Ramtron management provided alternative projections to Ramtron’s bank, which they described as “more accurate” than those cited by the petitioner. Given these deficiencies, the court had no trouble casting aside management’s pre-merger projections and the petitioner’s DCF which relied on them.

Indeed, the court took both experts to task for what appeared to be litigation-driven valuations. The court criticized the respondent’s “eyebrow-raising DCF” which, notwithstanding its reliance on projections that the expert presumed were overly optimistic, somehow still returned a “fair” value two cents below the merger price.

In any event, the court also had little trouble rejecting the petitioner’s suggested “comparable transactions” methodology, a market-based analysis which ascertains going-concern value by identifying precedent transactions involving similar companies and deriving metrics from those deals (and which we will be examining in greater detail in our next “Valuation Basics” post). The petitioner’s expert was hamstrung by a lack of deals involving companies similar to Ramtron, and could only point to two, which were themselves drastically different from each other and which resulted in disparate multiples. Given this “dearth of data points,” the court found that it could not give any weight to a precedent transactions approach. The court was also influenced by the fact that the petitioner’s expert himself only attributed 20% of his valuation to the comparable transactions analysis.

That left merger price, which the court acknowledged “does not necessarily represent the fair value of a company” as that term is used in Delaware law. To demonstrate this truism, the court cited to the short-form merger, in which the controlling stockholder sets the merger price unilaterally, forcing minority stockholders out and leaving them to choose between taking the deal and exercising appraisal rights. According to the court, pegging fair value to the merger price in such a circumstance would render the appraisal remedy a nullity for the minority stockholder — all roads lead to a merger price that has not been independently vetted. In a situation like Ramtron, however, where the company was actively shopped for months and the acquirer raised its bid multiple times, merger price could be deferred to as conclusive (and critically, independent) proof of fair value.

The court was not troubled by the fact that Cypress’s acquisition process was initiated by a hostile offer, or the fact that no other company made a bid for Ramtron. According to Vice Chancellor Parsons, there was no evidence that the hostile offer prevented other companies from bidding on Ramtron — there were six signed NDAs in total — and impediments to a higher bid for Ramtron were a result of the company’s operative reality, not any purported shortcomings in the deal process itself. Having found a fair merger process, the court concluded that the merger price was the best, if not the only, evidence of fair value. Simply put, “if Ramtron could have commanded a higher value, it would have.” Indeed, the court expressed its skepticism over the petitioner’s expert’s valuation of $4.96, as compared to its unaffected stock price of $1.81, suggesting that “the market left an amount on the table exceeding Ramtron’s unaffected market capitalization.” The court could not accept that such a significant market failure occurred here.

Coming back to the arbitrage issue, the Vice Chancellor makes a point of noting that LongPath only began acquiring Ramtron shares a month after the merger was announced. We’ve discussed the practice of appraisal arbitrage extensively, noting the arguments for (here) and against (here). The Court of Chancery has been reluctant to limit the practice thus far (here), and Vice Chancellor Parsons continues that pattern here, consistent with the Corporation Counsel of the Delaware Bar’s own refusal to recommend to the legislature that it limit or eliminate the arbitrage practice altogether, as we’ve previously posted here and here.

As reported in the Wall Street Journal, stockholders owning about 5 percent of AOL, Inc., are seeking greater returns than the $50/share buyout price paid by Verizon Communications by pursuing appraisal of their shares.  The deal was valued at $4.4 billion.  As reported in the article, this appraisal case is yet another example of how the appraisal mechanism has evolved from a “little-used remedy” to a “bona fide investing strategy.”  Thus, as the Wall Street Journal reports, a record 40 appraisal cases were brought in 2014, and another 28 have been filed already in 2015 having a face value of about $1.8 billion.