On Monday, Law360 [$$] reported that the stockholders in the Clearwire appraisal action filed their opening brief in support of their appeal of the Chancery Court’s ruling, which found the fair value of Clearwire Corp. to be $2.13 per share, well below the $5 per share deal price paid by Sprint Nextel Corp. As reported in the article, on appeal, the stockholders argue that the “staggering discount” awarded by the Chancery Court is “virtually unprecedented.” We have previously posted on the Chancery decision here. We will continue to monitor the appeal and post on new developments as they arise.
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).
Today the Delaware Supreme Court reversed and remanded the appraisal decision of the Chancery Court in the highly watched DFC Global case. A more detailed post will follow, but we wanted to flag the ruling in the meantime.
The court declined DFC Global’s request to impose a presumption by “judicial gloss” that would peg fair value at the merger price in cases involving arm’s-length mergers. The court found that such an approach would have no basis in the statutory text, which gives the Chancery Court discretion to determine fair value by taking into account “all relevant factors.”
The court did accept two other “case-specific” arguments by DFC Global. First, the Supreme Court directed that on remand (i.e., when the trial court gets the case back from the Supreme Court), the Chancery Court — which in its valuation analysis had given equal weight to each of (i) the deal price, (ii) its DFC analysis, and (iii) a comparable companies analysis — should reconsider the weight it gave to the deal price in finding fair value based on certain factors in this case. Second, the Supreme Court found that there was not adequate basis in the record in this case to support the Chancery Court’s increase in the perpetuity growth rate it assumed for DFC Global from 3.1% to 4.0% when it corrected an error that had been raised during reargument.
In addition, the Supreme Court denied the cross-appeal, by which the stockholders argued that the DCF analysis be given primary, if not sole, weight in the valuation analysis. The court found that giving weight to the comparable companies analysis in this case was within the Chancellor’s discretion.
We will continue to monitor the proceedings to follow in the Chancery Court.
**As previously noted, this law firm was counsel of record on one of the amici briefs filed in this case.
As we previously posted, the Chancery Court appraised the fair value of Clearwire Corp. to be $2.13 per share, substantially below the $5 per share merger price paid by Sprint Nextel Corp in July 2013. This post will provide a more detailed breakdown of the ruling and the bases for Vice Chancellor Laster’s opinion.
The Supreme Court heard argument yesterday from DFC Global and its dissenting stockholders. The court has not yet ruled, and nobody can predict how it will decide the case; the following questions and observations are just some of the points that different members of the full five-justice panel raised during argument:
- The court asked DFC Global why they did not introduce an economics expert to corroborate the reliability of the merger price as the measure of the company’s fair value; the Chief Justice said that by not doing so, they didn’t offer much help to the Chancellor in his evaluation of the merger price and the process of wading through the respective valuation experts’ reports.
- The court observed that DFC’s own expert gave 50% weight to the merger price, so it asked why the Chancellor’s one-third weighting of merger price isn’t entitled to deference.
- The court observed that the statutory requirement that the chancery court consider “all relevant factors” in determining fair value is pretty “squishy,” suggesting that the trial court has the discretion to decide which factors to examine and what weight to give them.
- The court asked both sides to describe the relationship between working capital and perpetuity growth rates and whether the calculation of the growth rate is necessarily based on working capital assumptions; e., does a higher level of working capital inevitably mean that a higher growth rate must be used?
- The court observed that the appraisal statute requires the courts to focus on the fair value of the shares and that the pre-existing, unaffected market price would be highly informative of the stock’s fair value, but the jurisdictional definition of fair value looks beyond just the shares to the value of the company as a going concern.
- One of the justices was “troubled” by the Chancellor’s equal weighting of the three chosen valuation sources – merger price, comparable companies analysis, and DFC – insofar as the support for such equal weighting seemed lacking in the record.
- The court asked the stockholders why their valuation expert didn’t open up his own private equity shop if he really believed in the valuation delta between merger price and his own valuation, which came out nearly two times higher than the merger price.
- The court further asked why none of the 40 people apparently contacted during the sale process bid higher, given that valuation gap; are the markets really that broken?
- The court observed that on average, M&A buyers lose out and tend to overpay.
You can see the complete oral argument here (under the June 7, 2017, listing; DFC Global Corp. v. Muirfield Value Partners).
We will post again when the court issues its decision.
**As previously noted, this law firm was counsel of record on one of the amici briefs filed in this case.
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.
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.
In response to the article on appraisal arbitrage by Gaurav Jetley and Xinyu Ji of the Analysis Group, about which we’ve posted before, Villanova Law Professor Richard A. Booth now argues in The Real Problem With Appraisal Arbitrage [via Social Science Research Network] that Jetley and Ji’s charge against the Delaware courts for overly indulging appraisal arbitrage is misdirected. According to Professor Booth, while Jetley and Ji believe that the Delaware courts incentivize arbitrageurs by using a discount rate lower than the rate typically applied by investment bankers, Professor Booth argues that the bigger and more significant problem is that the Delaware courts additionally reduce the discount rate in the terminal period. Nevertheless, after identifying what he believes is the Delaware courts’ truly faulty practice, Professor Booth offers up a full-throated defense of the appraisal remedy in general and arbitrage in particular.
Some Highlights of the Article
- Professor Booth believes that Jetley and Ji’s criticism of the Delaware courts’ use of the so-called supply-side discount rate, rather than the historical rate of return, is overblown. He agrees that the supply-side rate can inflate a valuation, but not by as great a magnitude as Jetley and Ji seem to believe.
- In rebutting the argument that so-called arbs “are not themselves long-term common stock investors and should not be so compensated for the time value of their money,” he observes that “they have bought the stock they hold from legacy investors and thus should be entitled to the same package of rights enjoyed by such investors.” If arbs’ rights were to be curtailed, that would cause stockholders who choose to sell out suffering an even bigger discount, which in turn would raise the price of deals for acquirors, because target stockholders “will be less confident that they will be paid based on the agreed amount when they want to be paid.” In this respect, arbitrage actually serves the acquirors well.
- Professor Booth critiques the presumption of fairness that some Delaware cases have accorded to the deal price:
- First, the deal price may often be too low, as deal price sometimes depends on the percentage of shares bought. Thus, dissenting stockholders may well be entitled to “higher and higher prices as the public float gets smaller and smaller,” which he finds consistent with the policy objective underlying appraisal: to compensate stockholders for being forced to sell out at a time and/or price not of their own choosing.
- Second, Professor Booth cautions against according too much weight to the premium paid over market price, as a depressed stock price will naturally warrant a higher premium; in that case the premium is simply “compensation for a discount built into the market price.”
- Finally, it is inherent in the concept of nearly any acquisition that a buyer is only willing to pay some lesser price than full fair value, in order to extract the expected value to be gained by redeploying the target company to its highest and best use; to that extent, he suggests, “deal price should always be a bit lower than going concern value [emphasis added],” prompting stockholders to hold out.
- Given these factors, he finds that appraisal performs the valuable function of testing deal price against investor expectation based on CAPM. He believes that appraisal thus helps drive price toward fairness, as a robust appraisal remedy will induce bidders to pay a fair price up front. His critique of the court’s further reduction of the discount rate in the terminal period is intended to improve the appraisal process, not undermine it; he encourages the courts to embrace his reforms rather than “hide behind the aw-shucks notion that law-trained judges are ill-suited to address” questions of valuation, finance, and investment banking.
In summary, the author concludes that appraisal arbitrage has gotten a “bad rap” and that appraisal itself works best if arbitrage is made possible; he fears that absent arbitrage, buyers may rely on the hope that potential dissenters will simply decline to exercise any appraisal rights, allowing the bidder to get away with paying a reduced price.
In a new ruling in the DFC Global appraisal case, about which we’ve posted before, Chancellor Bouchard has now reconsidered his prior award of 7% over the merger price and increased his prior award by an extra 9 cents per share, translating to an additional $12 million in value above his prior ruling.
Both sides had asked the court to reconsider different aspects of its ruling, prompting the Chancellor raise the perpetuity growth rate in his DCF model from 3.1% to 4.0%. In reconsidering his ruling, the Chancellor held that he “failed to appreciate the extent to which DFC Global’s projected revenue and working capital need have a codependent relationship,” and that the high-level requirement for working capital necessarily corresponds to a high projected growth rate. In so ruling, the court had to overcome its initial theory that a company’s perpetual growth rate should never exceed the risk-free rate. The court came to realize that this proposition would be true only for companies that have reached a stable stage of development; where a company is expected to achieve fast-paced growth throughout the projection period, the court now agreed that the perpetuity growth rate should indeed be higher than the risk-free rate.
The court’s initial opinion rejected the stockholders’ use of a three-stage DCF model in favor of a two-stage model, but on reconsideration the court recognized that using the two-stage model required increasing the terminal growth rate to sufficiently take into account the company’s growth rate beyond the five-year projection period.
Finally, the court’s new ruling also unwound two adjustments to the company’s baseline projections that the court had inadvertently made in accepting the company’s DCF model wholesale.