The Delaware Supreme Court made its ruling this week in the ISN Software appraisal case. A three-judge panel (not the full bench) affirmed the Chancery Court’s decision awarding a premium that was more than 2.5 times the merger price, as reported in Law360 [$$]. The Supreme Court affirmed without rendering its own opinion, relying instead on the trial court’s reasoning. ISN Software was a privately held software company, with the appraisal case stemming from the controlling stockholder’s cash-out of some of the minority shares.
As reported in Law360 [$$], on October 11, 2017 the Delaware Supreme Court heard argument appealing the Chancery Court’s ruling in the ISN Software appraisal case. We have previously posted on the trial court’s decision here, in which Vice Chancellor Glasscock awarded a premium to the merger price. The Supreme Court did not rule and did not indicate when it would do so. You can see the complete oral argument here (under the October 11, 2017, listing; ISN Software v. Ad-Venture Capital). Unlike the Dell and DFC Global arguments, the Supreme Court did not convene en banc – that is, with a full five-justice proceeding – and instead conducted argument by a three-justice panel, which did not include the Chief Justice.
We will continue to monitor the docket and post when the ruling is issued.
Law360 [$$] recently carried an analysis by a trio of Delaware attorneys regarding the impact of 2016’s prepayment amendment to Delaware appraisal law. Part of the August 2016 amendments allowed M&A targets to prepay dissenting shareholders an amount of their choosing, thereby stopping the accrual of interest on that portion of the merger price/amount at issue. At the time of the amendments, there was meaningful debate whether the new rules – including the prepayment option – would curtail appraisal filings, with some commentators suggesting that they may in fact increase appraisal filings, focusing on the prepayment option.
This more recent analysis considers the last year of appraisal, and while the authors note that a year of data is insufficient to “draw any firm conclusions,” their analysis shows that “in the year following the Aug. 1, 2016, effective date of the amendment, appraisal filings have continued to increase.” Echoing the pre-amendment analysis that the amendments may increase appraisal activity, the authors make note of the fact that as “appraisal litigation continues its upward trend despite the recent overall decline in M&A activity, this trend may suggest that, as discussed below, the prospect of prepayment is contributing to its continued rise.”
As previous analysis discussed, while prepayment may save on interest for a respondent company subject to appraisal, it otherwise frees up capital for investors to redeploy elsewhere – instead of having that capital ‘locked up’ in the appraisal action. Prepayment introduces additional strategic considerations in appraisal for both investors and respondent companies.
Further to our prior post about Delaware’s two new appraisal decisions, SWS Group was a small, struggling bank holding company that merged on January 1, 2015 into one of its own substantial creditors, Hilltop Holdings. Stockholders of SWS received a mix of cash and Hilltop stock worth $6.92 at closing. Vice Chancellor Glasscock rejected the sale price as an unreliable indicator of fair value and performed his own DCF analysis, setting the fair value at $6.38, a price 7.8% below the merger price.
At trial, the petitioners persuaded the court that its critiques of the sale process were valid. However, the stockholders failed to persuade the court that SWS was on the verge of a turnaround, as the court instead determined that SWS consistently underperformed management projections and, given its structural problems, a turnaround was simply unlikely.
Problems with SWS’s Projections and Performance
As was true in PetSmart, SWS had not historically performed long-term projections, but only created annual budgets that aggregated projections from individual business sectors. Those single-year projections were then extrapolated into three-year “strategic plans” that assumed the annual budgets would be met. The court found, however, that SWS never met those budgets between 2011 and 2014. Also, despite straight-line growth assumptions in the management forecasts, SWS failed to hit its targets and continued to lose money on declining revenues. The various problems facing the company led the court to embrace the respondents’ theory that SWS would continue to face an uphill climb given its relatively small size, which prevented it from scaling its substantial regulatory, technological, and back-office costs.
Hilltop’s Influence on the Sale Process Rendered Merger Price Unreliable
Even before SWS launched its sale process, Hilltop was interested in buying the company (unbeknownst to SWS). Also, since Hilltop had observer status on SWS’s board, it had unique access to SWS’s board meetings and management not available to others. The court found that Hilltop’s acquisition theses were driven by synergies, as it viewed its acquisition of SWS as resulting mainly in cost savings by reduction of overhead. A Special Committee was formed after Hilltop made its initial offer in January 2014, and the court found that even though the committee engaged legal and financial advisors, the management projections that evolved in the sale process were still overly optimistic and unrealistic about SWS’s projected growth. Only two other bidders emerged, one of which was found not to be credible and the other continued to bid through March 2014 despite apparent pressure by Hilltop to proceed with its deal. Finally, in response to Hilltop’s unilateral March 31, 2014 deadline, the board decided to accept its offer, which at that time was valued at $7.75, consisting of 75% Hilltop stock and 25% cash. As of closing on January 1, 2015, the value dropped to $6.92 per share based on a reduction in Hilltop’s own stock price.
Another factor making the deal price unreliable was that Hilltop was a creditor of SWS pursuant to a Credit Agreement. That agreement contained a covenant prohibiting SWS from undergoing a “Fundamental Change,” which was defined to include the sale of SWS. The agreement thus conferred upon Hilltop a veto right over any competing offers, which right Hilltop refused to waive during the sale process.
Valuation Model & DCF Inputs
The court undertook its own DCF analysis, on which it relied exclusively. The court refused to put any weight on petitioners’ comparable companies analysis, finding that the comp set diverged too much from SWS in terms of size, business lines, and performance to be meaningful. The court held that SWS’s unique structure, size, and business model – particularly its composition of a broker-dealer business alongside its banking line – rendered the stockholders’ selected peers not truly comparable.
In performing its DCF valuation, the court used the existing three-year projection period in the management projections, rejecting the stockholders’ argument that SWS had not yet reached a “steady state” and that an additional two years was needed to normalize SWS’s financial performance. The court found that SWS’s declining revenues in the period leading up to the merger deprived it of any basis to assume (unprecedented) straight-line growth beyond the existing three-year projection period. In addition, the court found that the exercise of warrants three months prior to the merger pursuant to the Credit Agreement, which resulted in a change to SWS’s capital structure by cancelling debt in exchange for new shares, was part of SWS’s “operative reality” for purposes of the fair-value determination. This ruling differed from other cases, such as BMC Software and Gearreald, where changes to the company’s balance sheet resulting from actions by the company solely in expectation of the merger – like the company paying off its debt – was not considered to be within the company’s operative reality.
As to the other DCF inputs, the court adopted the respondents’ perpetuity growth rate of 3.35%, which was the midpoint between the long-term inflation rate of 2.3%, and the long-term economic growth rate of 4.4%. In selecting the appropriate equity risk premium, the court observed that whether to use supply-side or historical ERP should be determined on a case-by-case basis. Nevertheless, it found supply-side ERP appropriate as the “default” method in recent Delaware chancery cases, unless a party provided a compelling reason to use historical ERP. With regard to beta, the court found fault with both side’s approach. The respondents’ expert looked at two years of SWS weekly stock returns, which measurement period included a “merger froth” and too much volatility to be reliable. The petitioners’ expert, in contrast, surveyed multiple betas and used a blended median; even though the court found that this approach relied on comparable companies that were not truly comparable, it nevertheless adopted this beta – despite its apparent drawbacks – as the one more closely in line with the record evidence. Finally, to determine size premium, the court took the midpoint of both side’s decile (which was 3.46%), finding that using market capitalization is generally appropriate for public companies (the respondents’ approach), and yet SWS’s capital structure, including its substantial in-the-money warrants and the outsized influence of its major creditor, made it more like a private company and not susceptible to a market cap approach (the petitioners’ argument).
In reaching its final determination of $6.38, the court said that a sub-merger price award was not surprising here given the synergistic nature of the transaction. Also, given the award of statutory interest, which runs from the January 1, 2015 consummation date, it appears that the petitioners will ultimately recover more than the merger price after all.
Last week the Federal Reserve issued another rate hike, just months after its December rate increase. The recent hike has increased the Fed’s discount rate — also known as its primary credit rate — by 0.25%, up to 1.50%. Effective as of March 16, 2017, this will increase the rate of statutory interest in appraisal cases to 6.50%, compounded quarterly, as the appraisal statute sets interest at 5% over the Federal Reserve discount rate.
Last month we wrote about the Lender Processing case, which ultimately awarded deal price and contained an instructive survey of recent appraisal law. For another view of this case, see the January 11, 2017 post on Harvard Corporate Governance.
The Federal Reserve’s recent rate hike, the second one in as many years, has increased the Fed’s discount rate — also known as its primary credit rate — by 0.25%, up to 1.25%. Effective as of December 15, this will increase the rate of statutory interest in appraisal cases to 6.25%, compounded quarterly, as the appraisal statute sets interest at 5% over the Federal Reserve discount rate.
Today Vice Chancellor Laster issued a new appraisal ruling, Merion Capital LP v Lender Processing Services, pegging the appraised fair value to the merger price.
The court found no reason to depart from merger price given the apparently reliable sale process and reliable projections. The court performed its own DCF valuation, which came out 4% above the merger price. Vice Chancellor Laster found that his own valuation’s proximity to merger price gave him comfort as to the reliability of merger price and thus chose not to vary from it in determining fair value.
The court rejected the respondent’s synergies argument — intended to set fair value below the merger price — for being raised too late and unsupported by any evidence. The decision also includes a thorough and instructive survey of recent appraisal case law.
The New York Law Journal recently ran an article, Looking Beyond Delaware: Exercising Shareholder Appraisal Rights in N.Y. [via ALM], which analyzes the New York appraisal statute and observes that while appraisal litigation has remained underutilized outside of Delaware, it is possible that with the uptick in Delaware appraisal New York will see more appraisal litigation in its courts as well. As the article shows, the New York appraisal statute deviates from Delaware’s and provides appraisal rights even beyond merger transactions, extending to share exchanges and all-asset dispositions as well.
For an interesting overview of the appraisal process and a concise summary of the merits and risks associated with litigating appraisal rights, we recommend reviewing the article “Opportunistic Investing – the Case for Appraisal Rights” from Neuberger Berman’s Hedge Funds Solutions Group. In describing appraisal as a “niche, legally intensive strategy” with the “potential for providing compelling uncorrelated returns,” the authors provide some key data points on Delaware appraisal decisions’ premium over merger price. They identify appraisal, a “long-ignored part of corporate law,” as an “important weapon” for hedge funds in their “activist investment arsenal,” while cautioning investors to be selective in the deals they pursue.