As reported today in Law360 [$$], the Delaware Supreme Court heard argument yesterday on the chancery court’s ruling in the Dell appraisal case.  The court did not render its decision and did not indicate when it would do so.  We’ll continue to monitor the docket and post when the ruling comes down.

** Note: this law firm is one of the counsel of record in the Dell case.

In Farmers & Merchants Bancorp, an appraisal case involving a small closely-held community bank that was sold in a stock-for-stock deal valued at $83 per share, Chancellor Bouchard disregarded merger price, as well as the “wildly divergent valuations” of both sides’ experts.  He arrived at an independent valuation of $91.90 per share based on his own discounted net income analysis (which is similar to a discounted cash flow but does not adjust net income for non-cash income and expenses and does not consider cash outflows for capital goods).

The court rejected the merger price as a reliable indicator of fair value because the merger was not the product of an auction and was not conditioned on obtaining the approval of a majority of the minority shareholders.  Rather, the sale was driven by the same family that controlled both the target and the acquiror; even though the target formed a special committee to negotiate on behalf of the minority stockholders, the court was not confident that the negotiations were truly arms-length.

Likewise, the court rejected the comparable transaction analysis that the petitioner’s expert put forth.  The petitioner’s expert calculated the median P/E ratio from the eight most comparable companies out of a pool of 160 community bank acquisitions that had taken place over the prior two years.  The court found that the eight selected banks were good comparables but rejected the analysis because the expert failed to adjust for synergies that were potentially incorporated into the merger price of those banks, despite strong evidence from several witnesses that community bank mergers typically do include synergies.  As to the respondent’s expert, the court rejected its comparable transaction multiples because the choice of selected comparables was suspect – it excluded 15 regional banks that would have raised the average P/E ratio significantly – and found that its guideline public company valuation was unreliable since most community banks were not publicly traded, and even the publicly traded shares were less liquid than non-community banks.

In light of these facts, the court gave no weight to the merger price or either expert’s analysis, relying entirely on its own discounted net income analysis, which projected a stream of income using a single year of earnings and applied a long-term growth rate, while using a discount rate calculated under CAPM.  In determining the equity risk premium, the court chose the long-term supply-side as opposed to the historical premium, citing then-Vice Chancellor Strine’s ruling in Golden Telecom that the professional and academic valuation literature favored that approach.

Finally, the court adopted the respondent expert’s 3.0% terminal growth rate over the 4.375% rate suggested by the petitioner.  Citing Owen v. Cannon, the court recognized that Delaware precedent favored a perpetuity growth rate that is a premium, such as 100 basis points, over inflation.  The court also found that the 3.0% rate was consistent with the annual growth rate projected in the target’s strategic plan, which reflected its limited growth potential in a county with a declining population and stagnant economy.  That rate likewise comported with the perpetual growth rates used to value mature companies in several recent cases.

It remains to be seen how much precedential value a decision like this will have on the public M&A that is more commonly the subject of Delaware appraisals, but once again the court has rejected merger price and undertaken a truly independent valuation.

Last week the Delaware Supreme Court’s en banc hearing in the CKx case resulted in a simple affirmance, without opinion, of the Chancery Court’s 2013 decision that the merger price in this particular case was the best proxy for the fair value of petitioners’ stock.  In CKx, the Chancery Court had rejected the valuation methodologies presented by both sides and yet also failed to consider any other valuation approach, pointing instead to the price paid by the acquirer as the most reliable indicator of fair value given its finding that the merger price was the product of a fulsome and robust auction process.  The Supreme Court also rejected the company’s request to set fair value below the merger price after taking out supposed synergistic gains that the acquirer had planned to capture from the merger entity (to which post-merger synergies dissenting stockholders are not entitled by statute).  Likewise, the Supreme Court rejected the company’s cross-appeal challenging the full award of statutory interest at 5.75%, affirming Chancery’s ruling that it had no authority under the appraisal statute to permit the respondent to compel the petitioners to accept a partial pre-payment of the award that would cut off the accrual of interest.

As reported by Reuters, if you read the Supreme Court order in CKx as setting the market price as a floor in appraisal litigation, rather than a ceiling, and after taking the statutory interest award into account, the decision may ultimately incentivize appraisal arbitrage for big investors.

**Note: this law firm is of counsel to the appellant-petitioner shareholders in CKx.

We posted last month about the Delaware Chancery Court’s ruling in Ancestry.com, in which it upheld the growing practice of appraisal arbitrage. The Chancery Court has now rendered its valuation decision in that case, finding the merger price itself to be the most fair measure of stockholder value on a going concern basis. As Reuters has reported, the court also declined to find fair value below the deal price. To the extent that the court relied on merger price for its valuation, it is reminiscent of the same judge’s decision in the CKx case, which is currently scheduled for en banc review next week in the Delaware Supreme Court (as we have previously posted). But unlike the court’s approach in CKx, in Ancestry.com the court undertook a DCF analysis based on the parties’ competing valuations. The court’s own DCF analysis yielded a value 21 cents short of the $32 merger price, but given its uncertainty over the projections, the court said it was uncomfortable insisting that a buyer who actually put its own money at risk nevertheless overpaid. The court refused to second-guess the market price, especially given what it found to be a robust sales process.

The court expressed skepticism over the reliability of any after-the-fact valuation analyses, suggesting that valuation experts are more in the business of reverse engineering to arrive at their pre-selected values than in presenting the court with truly objective values. To underscore the point, the court cited one side’s expert who saw it as his job to “torture the numbers until they confess[ed].” The other side’s expert likewise suggested that if he had reached a valuation that widely departed from the merger price, he would have had to find a way to reconcile those numbers, or, as the court put it, he would have “tailored his analysis to fit the merger price.” One option the court did not address is having the court itself engage a non-party independent valuation expert to report its own analysis directly to the court, which the Chancery Court has done in the past.

With respect to the particular DCF issues the court addressed, the court focused on certain components in the calculation of terminal value that have not traditionally been addressed in court opinions, including how to determine the “plowback” ratio — the percentage of future profits that the company would have to “plowback” into capital expenditures to remain competitive over the long term — and whether to “normalize” EBIT margin. Both of these adjustments can temper the valuation-enhancing effect of a high terminal growth rate. Another interesting issue raised by this case is whether and, how to account for stock-based compensation (SBC) in a DCF, which is especially significant for Internet-based companies in particular, as they tend to have large SBC components to their employee compensation programs. Here, the court concluded that SBC had to be taken into account, and it did so in a way that reduced its valuation.

Finally, the court lamented that appraisal actions are unique in that each party bears the burden of proof, such that if neither party meets its burden, the burden instead falls on the court. But this observation effectively repeats the long-standing principle that courts in appraisal cases are required to perform an independent analysis. In that regard, it will be interesting to see how the Supreme Court reacts next week to this judge’s prior opinion in CKx and whether the court sufficiently discharged its duty to perform an independent valuation when it deferred to the merger price as the only reliable indicator of value after having rejected the valuation methods proposed by the parties, unlike its approach in Ancestry.com.

The Delaware Supreme Court has scheduled the case of Huff Fund Investment Partnership v. CKx Inc. for en banc review in February 2015.

The Chancery Court rejected the valuation methods proposed by the parties and deferred to the merger price as the only reliable indicator of value. The Chancery Court likewise rejected the shareholders’ argument for an upward adjustment to the merger price as well as the company’s argument for a downward adjustment.

On appeal, the parties are asking the Supreme Court to consider whether the Chancery Court erred by:

  • deferring exclusively to the merger price, in lieu of performing any valuation analysis, to determine the stock’s fair value.
  • rejecting both of the DCF valuations presented by the shareholders as well as the company.
  • rejecting the shareholders’ other valuation methodologies; namely, their expert’s (a) guideline publicly-traded companies analysis and (b) precedent transactions valuation.
  • refusing to attribute any value to a corporate acquisition that materialized after the merger price was agreed upon but prior to the time the merger was consummated.
  • refusing to decrease the merger price by certain claimed synergies and other cost-savings that the acquirer expected to achieve.
  • refusing to allow the company to make a partial payment to the shareholders to stop the running of statutory interest prior to the entry of final judgment.

The Supreme Court seldom reviews appraisal cases en banc. In fact, the seminal cases of Weinberger v. UOP, Inc. (1983) and M.G. Bancorporation, Inc. v. Le Beau (1999) are the only other en banc appraisal cases of which we are aware.

**Note: this law firm is of counsel to the appellant-petitioner shareholders in CKx.

 

Like common stockholders, holders of preferred stock may exercise appraisal rights.  The extent of what those rights actually entail, however, may be far more limited than what common shareholders may experience.  As a general rule, preferred stock has the same appraisal rights as common stock, but “[u]nlike common stock, the value of preferred stock is determined solely from the contract rights conferred upon it in the certificate of designation.”  Shaftan v. Morgan Joseph Holdings, Inc., 57 A.3d 928, 942 (Del. Ch. 2012) (citing In re Appraisal of Metromedia International Group, Inc., 971 A.2d 893, 900 (Del. Ch. 2009)).

Delaware courts have consistently ruled that if the company’s certificate of designation is clear in providing just what the preferred stock is to receive upon a merger, then the certificate controls and effectively preempts the rights of the preferred stockholders to seek appraisal.  Thus, as Delaware Chancery has held, when the terms of preferred stock “clearly describe[d] an agreement between the [preferred stockholders] and the company regarding the consideration to be received” by the stockholders in the event of a specific type of merger, and that specific type of merger occurred, the stockholders were deemed to have waived their appraisal rights and were only entitled to the compensation provided for in the governing certificate.  Shaftan 57 A.3d at 928 (citing In re Appraisal of Ford Holdings, Inc. Preferred Stock, 698 A.2d 973, 978 (Del. Ch. 1997)).  Put another way, where the certificate of designation is clear in “contractually establish[ing] the metric for valuing the preferred shares in the event of a merger,” the court need not entertain competing valuation models and undertake the customary appraisal analysis; instead, the court simply views the valuation of the preferred stock “through the defining lens of its certificate of designation, unless the certificate is ambiguous or conflicts with positive law.”  Metromedia, 971 A.2d at 900.

In the case of unclear or indirect drafting in the certificate, the courts will not deprive stockholders of their statutory right to judicial appraisal of their preferred shares.

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.

 

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.